** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

| **x**                                                                                                                            |   | **Quarterly Report Pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|
|                                                                                                                             |   |                                                                                                    |
| **For the  quarterly period ended September 30, 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)

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes x No o

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

| Large accelerated filer o |   | Accelerated  filer o |   | Non-accelerated  filer x |
|--------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act).   Yes o  No x

As ofOctober 31, 2006 there were 16,233,646 shares outstanding of Registrant’sCommon Stock (par value $0.001 per share).

 

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**EVOLVING SYSTEMS, INC.Quarterly Report on Form 10-QSeptember 30, 2006Table of Contents**
| **PART I — FINANCIAL  INFORMATION**   |
|--------------------------------------------|
| Item  1                                    |   | Financial  Statements |
|                                       |   | Condensed Consolidated Balance Sheets as of September  30, 2006 and December 31, 2005 (Unaudited) |
|                                       |   | Condensed Consolidated Statements of Operations for  the Three and Nine Months Ended September 30, 2006 and 2005 (Unaudited) |
|                                       |   | Condensed Consolidated Statements of Changes In  Stockholders’ Equity and Comprehensive Loss for the Nine Months Ended  September 30, 2006 (Unaudited) |
|                                       |   | Condensed Consolidated Statements of Cash Flows for  the Nine Months Ended September 30, 2006 and 2005 (Unaudited) |
|                                       |   | Notes to Unaudited Condensed Consolidated Financial  Statements |
| Item 2                                     |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |
| Item 3                                     |   | Quantitative and Qualitative Disclosures About Market  Risk |
| Item 4                                     |   | Controls and Procedures |
|                                       |   |   |
| **PART II  — OTHER INFORMATION** |
| Item  1                                    |   | Legal  Proceedings |
| Item 1A                                    |   | Risk Factors |
| Item  2                                    |   | Unregistered  Sales of Equity Securities and Use of Proceeds |
| Item 3                                     |   | Defaults upon Senior Securities |
| Item 4                                     |   | Submission of Matters to a Vote of Security Holders |
| Item  5                                    |   | Other  Information |
| Item 6                                     |   | Exhibits |
|                                       |   |   |
| Signature                                  |   |   |

 

 

2

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**PART I —FINANCIAL INFORMATION**

**Item 1. Financial Statements**

**EVOLVINGSYSTEMS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(in thousands except share data)(unaudited)**

 
| ** **                                                                                                                                                                            | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                            | ** ** | ** **                   |       |                        |       |
| Current assets:                                                                                                                                                                       |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                            |       | $                            | 4,521      |                        | $          | 3,883 |   |
| Current portion  of restricted cash                                                                                                                                                   |       | 300                          |       | —                      |       |
| Contract  receivables, net of allowance of $69 at September 30, 2006 and $48 at  December 31, 2005                                                                               |       | 5,936                        |       | 10,766                      |       |
| Unbilled  work-in-progress                                                                                                                                                            |       | 1,325                        |       | 1,147                       |       |
| Deferred foreign  income taxes                                                                                                                                                        |       | 12                           |       | 5                           |       |
| Prepaid and  other current assets                                                                                                                                                     |       | 1,632                        |       | 1,335                       |       |
| Total current  assets                                                                                                                                                                 |       | 13,726                       |       | 17,136                      |       |
| Property and equipment,  net                                                                                                                                                          |       | 1,395                        |       | 1,775                       |       |
| Amortizable intangible  assets, net                                                                                                                                                   |       | 6,321                        |       | 13,350                      |       |
| Goodwill                                                                                                                                                                              |       | 25,127                       |       | 34,073                      |       |
| Long-term restricted  cash                                                                                                                                                            |       | —                       |       | 300                         |       |
| Other long-term assets                                                                                                                                                                |       | 498                          |       | 764                         |       |
| Total assets                                                                                                                                                                          |       | $                            | 47,067     |                        | $          | 67,398 |   |
|                                                                                                                                                                                  |       |                         |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                        |       |                         |       |                        |       |
| Current liabilities:                                                                                                                                                                  |       |                         |       |                        |       |
| Current portion  of capital lease obligations                                                                                                                                         |       | $                            | 36         |                        | $          | 34 |   |
| Current portion  of long-term debt                                                                                                                                                    |       | 1,750                        |       | 1,000                       |       |
| Accounts payable  and accrued liabilities                                                                                                                                             |       | 5,041                        |       | 6,001                       |       |
| Unearned revenue                                                                                                                                                                      |       | 7,496                        |       | 9,654                       |       |
| Total current  liabilities                                                                                                                                                            |       | 14,323                       |       | 16,689                      |       |
| Long-term liabilities:                                                                                                                                                                |       |                         |       |                        |       |
| Capital lease  obligations, net of current portion                                                                                                                                    |       | 43                           |       | 71                          |       |
| Other long-term  obligations                                                                                                                                                          |       | 574                          |       | 83                          |       |
| Long-term debt,  net of current portion                                                                                                                                               |       | 11,870                       |       | 14,373                      |       |
| Deferred foreign  income taxes                                                                                                                                                        |       | 1,163                        |       | 2,777                       |       |
| Total  liabilities                                                                                                                                                                    |       | 27,973                       |       | 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; 16,212,716 and 16,137,821  shares issued and outstanding as of September 30, 2006 and December 31, 2005,  respectively |       | 16                           |       | 16                          |       |
| Additional  paid-in capital                                                                                                                                                           |       | 68,624                       |       | 67,891                      |       |
| Accumulated  other comprehensive income (loss)                                                                                                                                        |       | 334                          |       | (2,417                      | )          |
| Accumulated  deficit                                                                                                                                                                  |       | (61,161                      | )          | (43,366                     | )          |
| Total  stockholders’ equity                                                                                                                                                      |       | 7,813                        |       | 22,124                      |       |
| Total liabilities and  stockholders’ equity                                                                                                                                      |       | $                            | 47,067     |                        | $          | 67,398 |   |

 

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

 

3

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**EVOLVINGSYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands except per share data)(unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **REVENUE**                                                                  | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** |   |   | ** ** |
| License fees and  services                                                   |       | $                                                    | 3,990      |                                                | $          | 4,821 |   | $ | 11,855 |   | $ | 14,643 |   |
| Customer support                                                             |       | 4,677                                                |       | 4,749                                               |       | 13,180 |   | 14,691 |   |
| Total revenue                                                                |       | 8,667                                                |       | 9,570                                               |       | 25,035 |   | 29,334 |   |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING  EXPENSES**                                 |       |                                                 | ** ** |                                                |       |   |   |   |   |
| Costs of license  fees and services, excluding depreciation and amortization |       | 1,991                                                |       | 2,285                                               |       | 5,523 |   | 7,654 |   |
| Costs of  customer support, excluding depreciation and amortization          |       | 1,235                                                |       | 1,578                                               |       | 4,412 |   | 5,244 |   |
| Sales and  marketing                                                         |       | 2,123                                                |       | 2,427                                               |       | 6,919 |   | 7,242 |   |
| General and  administrative                                                  |       | 1,171                                                |       | 1,445                                               |       | 3,959 |   | 5,426 |   |
| Product  development                                                         |       | 848                                                  |       | 452                                                 |       | 2,394 |   | 1,058 |   |
| Depreciation                                                                 |       | 285                                                  |       | 363                                                 |       | 861 |   | 1,123 |   |
| Amortization                                                                 |       | 336                                                  |       | 1,354                                               |       | 2,126 |   | 4,170 |   |
| Impairment of  goodwill and intangible assets                                |       | —                                               |       | —                                              |       | 16,516 |   | — |   |
| Restructuring  and other expense (recovery)                                  |       | —                                               |       | 4                                                   |       | (23 | ) | (59 | ) |
| Total costs of revenue  and operating expenses                               |       | 7,989                                                |       | 9,908                                               |       | 42,687 |   | 31,858 |   |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Income (loss) from  operations                                               |       | 678                                                  |       | (338                                                | )          | (17,652 | ) | (2,524 | ) |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Other income  (expense):                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Interest income                                                              |       | 46                                                   |       | 21                                                  |       | 120 |   | 100 |   |
| Interest expense                                                             |       | (498                                                 | )          | (393                                                | )          | (1,503 | ) | (1,230 | ) |
| Foreign currency  exchange loss                                              |       | (8                                                   | )          | (99                                                 | )          | (38 | ) | (285 | ) |
| Other expense,  net                                                          |       | (460                                                 | )          | (471                                                | )          | (1,421 | ) | (1,415 | ) |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Income (loss) before  income taxes                                           |       | 218                                                  |       | (809                                                | )          | (19,073 | ) | (3,939 | ) |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax  expense (benefit)                                                |       | 176                                                  |       | 117                                                 |       | (1,278 | ) | (177 | ) |
|                                                                         |       |                                                 | ** ** |                                                |       |   |   |   |   |
| Net income (loss)                                                            |       | $                                                    | 42         | ** **                                          | $          | (926 | ) | $ | (17,795 | ) | $ | (3,762 | ) |
|                                                                         |       |                                                 | ** ** |                                                |       |   |   |   |   |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Basic earnings (loss)  per common share                                      |       | $                                                    | 0.00       |                                                | $          | (0.05 | ) | $ | (0.93 | ) | $ | (0.20 | ) |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Diluted earnings (loss)  per common share                                    |       | $                                                    | 0.00       |                                                | $          | (0.05 | ) | $ | (0.93 | ) | $ | (0.20 | ) |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average basic  shares outstanding                                   |       | 19,112                                               |       | 18,665                                              |       | 19,089 |   | 18,634 |   |
| Weighted average diluted shares outstanding                                  |       | 19,310                                               |       | 18,665                                              |       | 19,089 |   | 18,634 |   |

 

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

 

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**EVOLVING SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYAND COMPREHENSIVE LOSS(in thousands, except share data)(unaudited)**

** **
| ** **                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | **Accumulated**   | ** ** | ** **             | ** ** | ** **             | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**              | ** ** | ** **             | ** ** | **Total** | ** ** |
| ** **                                                        | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated**        | ** ** | **Stockholders’** | ** ** |
| ** **                                                        | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income (Loss)** | ** ** | **Deficit**            | ** ** | **Equity** | ** ** |
| Balance at December 31,  2005                                     |       | 16,137,821            |       | $           | 16         |              | $          | 67,891                 |       | $                      | (2,417     | ) | $ | (43,366 | ) | $ | 22,124 |   |
| Stock option exercises                                            |       | 12,219                |       | —      |       | 13                |       | —                 |       | —                 |       | 13 |   |
| Common stock issued  pursuant to the Employee Stock Purchase Plan |       | 62,676                |       | —      |       | 95                |       | —                 |       | —                 |       | 95 |   |
| Stock-based  compensation expense                                 |       | —                |       | —      |       | 625               |       | —                 |       | —                 |       | 625 |   |
| Comprehensive loss:                                               |       |                  |       |        |       |              |       |                   |       |                   |       |   |   |
| Net loss                                                          |       | —                |       | —      |       | —            |       | —                 |       | (17,795                | )          |   |   |
| Foreign currency  translation adjustment, net of tax              |       | —                |       | —      |       | —            |       | 2,751                  |       | —                 |       |   |   |
| Comprehensive loss                                                |       |                  |       |        |       |              |       |                   |       |                   |       | (15,044 | ) |
| Balance at September 30, 2006                                     |       | 16,212,716            |       | $           | 16         |              | $          | 68,624                 |       | $                      | 334        |   | $ | (61,161 | ) | $ | 7,813 |   |

 

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

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**EVOLVINGSYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)(unaudited)**

 
| ** **                                                                       | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                       |       |                                                |       |   |   |
| Net loss                                                                         |       | $                                                   | (17,795    | ) | $ | (3,762 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                                                |       |   |   |
| Depreciation                                                                     |       | 861                                                 |       | 1,123 |   |
| Amortization of intangible assets                                                |       | 2,126                                               |       | 4,170 |   |
| Amortization of debt issuance costs                                              |       | 204                                                 |       | 34 |   |
| Equity compensation                                                              |       | 625                                                 |       | — |   |
| Impairment of goodwill and intangible assets                                     |       | 16,516                                              |       | — |   |
| Interest expense added to debt principal                                         |       | —                                              |       | 1,016 |   |
| Gain on disposal of property and equipment                                       |       | (20                                                 | )          | (12 | ) |
| Foreign currency transaction losses, net                                         |       | 38                                                  |       | 285 |   |
| Benefit from foreign deferred income taxes                                       |       | (1,810                                              | )          | (1,251 | ) |
| Change in operating assets and liabilities:                                      |       |                                                |       |   |   |
| Contract receivables                                                             |       | 5,211                                               |       | 5,749 |   |
| Unbilled work-in-progress                                                        |       | (89                                                 | )          | (103 | ) |
| Prepaid and other assets                                                         |       | (143                                                | )          | 73 |   |
| Accounts payable and accrued liabilities                                         |       | (756                                                | )          | (1,371 | ) |
| Unearned revenue                                                                 |       | (2,396                                              | )          | (4,903 | ) |
| Other                                                                            |       | 171                                                 |       | (20 | ) |
| Net cash provided by operating activities                                        |       | 2,743                                               |       | 1,028 |   |
|                                                                             |       |                                                |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                       |       |                                                |       |   |   |
| Purchases of property and equipment                                              |       | (397                                                | )          | (656 | ) |
| Proceeds from sale of property and equipment                                     |       | 20                                                  |       | 18 |   |
| Business combinations and earnout payments                                       |       | (153                                                | )          | (545 | ) |
| Net cash used in investing activities                                            |       | (530                                                | )          | (1,183 | ) |
|                                                                             |       |                                                |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                       |       |                                                |       |   |   |
| Capital lease payments                                                           |       | (26                                                 | )          | (23 | ) |
| Principal payments on long-term debt and issuance  costs                         |       | (1,775                                              | )          | (4,889 | ) |
| Payment of amount due to Evolving Systems U.K.  sellers                          |       | —                                              |       | (2,617 | ) |
| Proceeds from issuance of common stock                                           |       | 109                                                 |       | 94 |   |
| Net cash used in financing activities                                            |       | (1,692                                              | )          | (7,435 | ) |
|                                                                             |       |                                                |       |   |   |
| Effect of foreign exchange rate changes on cash                                  |       | 117                                                 |       | (373 | ) |
|                                                                             |       |                                                |       |   |   |
| Net increase (decrease) in cash and cash equivalents                             |       | 638                                                 |       | (7,963 | ) |
| Cash and cash equivalents at beginning of period                                 |       | 3,883                                               |       | 11,386 |   |
| Cash and cash equivalents at end of period                                       |       | $                                                   | 4,521      |   | $ | 3,423 |   |
|                                                                             |       |                                                |       |   |   |
| Supplemental  disclosure of other cash and non-cash financing transactions:      |       |                                                |       |   |   |
| Interest paid                                                                    |       | $                                                   | 820        |   | $ | 155 |   |
| Income taxes  paid                                                               |       | $                                                   | 569        |   | $ | 104 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(1)  Basis of Presentation**

**Organization. **We are a provider ofsoftware solutions and services to wireless, wireline and IP communicationscarriers worldwide.  We develop, deploy,enhance, maintain and integrate complex software solutions for a range ofOperations Support Systems (“OSS”).  Weoffer software products and solutions in three areas — a service activationsolution that is used to activate complex bundles of voice, video and dataservices; numbering solutions which enable carriers to comply withgovernment-mandated requirements regarding number portability, phone numberconservation, management and assignment; and mediation solutionssupporting data collection for both network service assurance and billingapplications.

Our portfolio of products whichincludes ordering and provisioning solutions for Local Number Portability (“LNP”),as well as a number inventory and assignment platform, was expandedsignificantly in 2004 as a result of three acquisitions we made over a periodof 12 months from November of 2003 to November of 2004. Through the acquisitionof CMS Communications, Inc. (“CMS”) in November 2003 we acquired a networkmediation and service assurance solution. With the acquisition of TelecomSoftware Enterprises, LLC (“TSE”) in October 2004 we added LNP and WirelessNumber Portability (“WNP”) number ordering and provisioning testing productswhich provide new OSS system integration capabilities.  Finally, in November 2004, we 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 our markets beyond North America. EvolvingSystems U.K.’s activation solution ***TertioTM,***andmediation solution ***EvidentTM***, increased ouroverall product portfolio.

***Interim Consolidated FinancialStatements***.  Theaccompanying unaudited condensed consolidated financial statements of EvolvingSystems have been prepared in accordance with accounting principles generallyaccepted in the United States of America (“GAAP”) and in conformity with theinstructions to Form 10-Q and Article 10 of Regulation S-X and the relatedrules and regulations of the Securities and Exchange Commission (“SEC”).  Accordingly, certain information and notedisclosures normally included in financial statements prepared in accordancewith GAAP have been condensed or omitted pursuant to such rules andregulations. However, we believe that the disclosures included in these financialstatements are adequate to make the information presented not misleading. Theunaudited condensed consolidated financial statements included in this documenthave been prepared on the same basis as the annual consolidated financialstatements, and in our opinion, reflect all adjustments, which include normalrecurring adjustments necessary for a fair presentation in accordance with GAAPand SEC regulations for interim financial statements. The results for the threeand nine months ended September 30, 2006 are not necessarily indicative of theresults that we will have for any subsequent period.  These unaudited condensed consolidatedfinancial statements should be read in conjunction with the audited consolidatedfinancial statements and the notes to those statements for the year endedDecember 31, 2005 included in our Annual Report on Form 10-K.

***Useof Estimates***.  Thepreparation of financial statements in conformity with GAAP requires us to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements, as well as the reported amounts of revenue andexpenses during the reporting period. We have made estimates with respect torevenue recognition for hours and associated costs to complete projectsaccounted for using the percentage of completion method, allowance for doubtfulaccounts, income tax valuation allowance, fair values of long-lived assets,valuation of intangible assets and goodwill, business combinations,capitalization of internal software development costs and fair value ofstock-based compensation amounts.  Actualresults could differ from these estimates.

***Foreign Currency Translation***.  Our functional currency is the U.S.dollar.  The functional currency of ourforeign operations is generally the respective local currency for each foreignsubsidiary.  Assets and liabilities offoreign operations denominated in local currencies are translated at the spotrate in effect at the applicable reporting date.  Our consolidated statements of operations aretranslated at the average rate of exchange during the applicable period.  The resulting unrealized cumulativetranslation adjustment, net of applicable income taxes, is recorded as acomponent of accumulated other comprehensive income (loss) in stockholders’equity.  Realized and unrealizedtransaction gains and losses generated by transactions denominated in acurrency different from the functional currency of the applicable entity arerecorded in other income (expense) in the period in which they occur.

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

***Goodwill and Intangible Assets***.  We account for goodwill in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwilland Other Intangible Assets.” Our reporting units are tested annually, inaccordance with SFAS No. 142, as of July 31 to determine whether theircarrying value exceeds their fair value. Should this be the case, the value ofthe goodwill may be impaired and written down. Goodwill is also tested forimpairment on an interim basis if an event occurs or circumstances changebetween annual tests that would more likely than not reduce the fair value ofthe reporting unit below its 

7

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carryingamount. If we determine the fair value of the goodwill is less than thecarrying value, an impairment loss is recognized in an amount equal to thedifference. Impairment losses, if any, are reflected in operating income orloss in the consolidated statements of operations.  During the quarter ended June 30, 2006, werecorded an impairment of goodwill and intangible assets.  See Note 2 for further details.

We account for long-lived assets, includingamortizable intangible assets, in accordance with SFAS No. 144, “Accounting forthe Impairment or Disposal of Long-Lived Assets” (“SFAS 144”).  Accordingly, we review finite-lived assetsfor impairment whenever an event occurs or circumstances change which indicatethat the carrying amount of such assets may not be fully recoverable.  Determination of recoverability is based onan estimate of undiscounted future cash flows resulting from the use of theasset and its eventual disposition. Measurement of an impairment loss is based on the fair value of theasset compared to its carrying value.  Ifwe determine the fair value of the asset is less than the carrying value, animpairment loss is incurred in an amount equal to the difference.   Impairment losses are reflected in operatingincome or loss in the consolidated statements of operations.  During the quarter ended June 30, 2006, werecorded an impairment of amortizable intangible assets.  See Note 2 for further details.

***Revenue Recognition****. *We recognize revenue from twoprimary sources: license fees and services, and customer support, in accordancewith Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” asamended and interpreted by SOP 98-9, “Modification of SOP 97-2, SoftwareRevenue Recognition, With Respect to Certain Transactions.”  Staff Accounting Bulletin (“SAB”)No. 104, “Revenue Recognition,” provides further interpretive guidance forpublic companies on the recognition, presentation and disclosure of revenue infinancial statements.  In addition to thecriteria described below, we recognize revenue only when an agreement issigned, the fee is fixed or determinable and collectibility is reasonablyassured.

Themajority of our license fees and services revenue is generated from fixed-pricecontracts, which provide for licenses to our software products andservices.   Generally, when the servicesare determined to be essential to the functionality of the delivered software,revenue is recognized using the percentage-of-completion method of accounting,in accordance with SOP 97-2 and SOP 81-1, “Accounting for Long-TermConstruction Type Contracts.”  Thepercentage of completion for each contract is estimated based on the ratio ofdirect labor hours incurred to total estimated direct labor hours.  Since estimated direct labor hours, andchanges thereto, can have a significant impact on revenue recognition, theseestimates are critical and are reviewed regularly.  Amounts billed in advance of services beingperformed are recorded as unearned revenue. Unbilled work-in-progressrepresents revenue earned but not yet billable under the terms of the fixed-pricecontracts. All such amounts are expected to be billed and collected within12 months.

We may encounterbudget and schedule overruns on fixed price contracts caused by increasedlabor, overhead or material costs. Adjustments to cost estimates are made inthe periods in which the facts requiring such revisions become known. Estimatedlosses, if any, are recorded in the period in which current estimates of totalcontract revenue and contract costs indicate a loss.

In arrangementswhere the services are not essential to the functionality of the software, werecognize license revenue upon delivery. To the extent that Vendor Specific Objective Evidence (“VSOE”) of thefair value of the undelivered elements exists, fees from multiple elementarrangements are unbundled and recorded as revenue as the elements aredelivered.  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.

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

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

***Stock-based Compensation.***  We adopted SFAS No. 123(Revised), *Share-Based Payment* (“SFAS 123R”) effective January 1,2006.  This statement replaced SFASNo. 123, *Accounting for Stock-Based Compensation*(“SFAS 123”) and superseded APB Opinion No. 25, *Accountingfor Stock Issued to Employees*. Under the modified prospective methodof adoption, we are required to apply a fair-value-based measurement method inaccounting for share-based payment transactions with employees and recordcompensation cost for all stock awards granted after January 1, 2006 and awardsmodified, repurchased, or cancelled after that date. In addition, we arerequired to record compensation costs associated with the vesting of unvestedoptions outstanding at January 1, 2006 using the guidance under SFAS 123.  From January 1, 2006, stock option grants andemployee stock purchase plan purchases were accounted for under SFAS 123R.  We use the Black-Scholes model to estimatethe fair value of each option grant on the date of grant.  This model requires the use of estimates forexpected term of the options and expected volatility of the price of our commonstock.

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

***New Accounting Pronouncements. ***InJuly 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes — AnInterpretation of FASB Statement No. 109” (“FIN 48”), which clarifies theaccounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with 

8

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FASB Statement No.109, “Accounting for Income Taxes” (“SFAS109”).  FIN 48 also prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return.  In addition, FIN 48provides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition.  The provisions of FIN 48 are effective forfiscal years beginning after December 15, 2006. We are currently evaluating the impact the adoption of FIN 48 will haveon our consolidated financial statements, if any.

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin No.108,Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements (SAB 108). SAB 108 providesinterpretive guidance on how the effects of the carryover or reversal of prioryear misstatements should be considered in quantifying a current yearmisstatement. SAB 108 is effective for fiscal years ending after November 15,2006.  We have not completed our evaluationof the impact of this standard on our consolidated financial statements.

In September 2006,the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157). SFAS 157defines fair value, establishes a framework for measuring fair value undergenerally accepted accounting principles, and expands disclosures about fairvalue measurements. SFAS 157 is effective for financial statements issued forfiscal years and interim periods beginning after November 15, 2007. We have notcompleted our evaluation of the impact of this standard on our consolidatedfinancial statements.

**(2)Goodwill and Intangible Assets**

Changes in the carryingamounts of goodwill by segment for the nine months ended September 30, 2006 areas follows (in thousands):

 

|                                             | ** ** | **License and  Services** | ** ** | **Customer  Support** | ** ** | **Total  Goodwill** | ** ** |
|---------------------------------------------|------------|--------------------------------|------------|-----------------------|------------|---------------------|------------|
| Balance as of  December 31, 2005            |       | $                              | 18,530     |                  | $          | 15,543              |       | $ | 34,073 |   |
| TSE earnout                                 |       | 2                              |       | 1                     |       | 3                   |       |
| Goodwill  impairment charge                 |       | (10,911                        | )          | —                |       | (10,911             | )          |
| Effects of  foreign currency exchange rates |       | 978                            |       | 984                   |       | 1,962               |       |
| Balance as of September  30, 2006           |       | $                              | 8,599      |                  | $          | 16,528              |       | $ | 25,127 |   |

 

During 2006, we recognized agoodwill impairment charge in our License and Services operating segment of$10.9 million which includes a third quarter reclassification of $0.2 millionfrom our intangible asset impairment expense. Due to continued pricing pressures onservices and consolidation in the telecommunications industry, revenues andcash flows had been lower than expected in recent quarters and those loweroperating results had a negative impact on the market price of our commonstock.  Based upon this trend, wereviewed our business plan during the second quarter of 2006.  As a result of these events, we determinedthat a triggering event had occurred and conducted a goodwill impairmentanalysis.  This goodwill impairmentrelated to goodwill from our acquisitions of CMS in November 2003, TSE inOctober 2004 and Evolving Systems U.K. in November 2004.  The fair value of our reporting units wereestimated using the present value of expected future cash flows and thevaluation employed a combination of present value techniques to measure fairvalue and considered market factors.

Inaddition, we conducted our annual goodwill impairment test as of July 31,2006.  Based upon that evaluation, weconcluded that goodwill was not further impaired as of the test date.

Identifiable intangibles are amortized over estimated finite lives offrom one to seven years, and include the cumulative effects of changes inforeign currency exchange rates.  Thefollowing table summarizes identifiable intangible assets (in thousands):

9

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| **Identifiable**

**intangible assets:** | ** ** | ** **                       | ** ** | **December 31, 2005** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **September 30, 2006** | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                    | ** ** | **Gross  Amount**                | ** ** | **Accumulated  Amortization**   | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Average  Amortization  Period** | ** ** |
| ** **                                    | ** ** | ** **                       | ** ** | **(1)**                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(1)** | ** ** |
| Purchased  software                           |       | $                                | 1,962      |                            | $          | 119 |   | $ | 1,843 |   | $ | 8,350 |   | $ | 2,090 |   | $ | 6,260 |   | 4.6 yrs |   |
| Customer  contracts                           |       | —                           |       | —                          |       | — |   | 1,997 |   | 1,968 |   | 29 |   | — |   |
| Purchased  licenses                           |       | 227                              |       | 24                              |       | 203 |   | 1,335 |   | 576 |   | 759 |   | 2.3 yrs |   |
| Trademarks and  tradenames                    |       | 840                              |       | 30                              |       | 810 |   | 1,068 |   | 207 |   | 861 |   | 7.0 yrs |   |
| Business  partnerships                        |       | 137                              |       | 7                               |       | 130 |   | 1,332 |   | 222 |   | 1,110 |   | 5.0 yrs |   |
| Customer  relationships                       |       | 3,544                            |       | 209                             |       | 3,335 |   | 5,989 |   | 1,658 |   | 4,331 |   | 5.6 yrs |   |
|                                          |       | $                                | 6,710      |                            | $          | 389 |   | $ | 6,321 |   | $ | 20,071 |   | $ | 6,721 |   | $ | 13,350 |   | 5.3 yrs |   |

----

(1)  Inassociation with our impairment of intangible assets during the second quarterof 2006, we established new costs basis for amortizable intangible assets atJune 30, 2006 and re-evaluated estimated remaining useful lives.

As a result of the events that led to the goodwillimpairment, we first reviewed intangible assets for recoverability inaccordance with SFAS 144.  Our evaluationof product strategy and development plans resulted in our determination thatthe undiscounted cash flows associated with these assets would not besufficient to recover the carrying amounts of these assets.  As a result of this review we recorded $5.6million of intangible asset impairment which included a third quarterreclassification of $0.2 million to our goodwill impairment expense.  This was comprised of $4.2 million ofpurchased software and purchased license intangible assets in the License Feesand Services operating segment associated with the acquisitions of CMS and TSEas well as $1.4 million of customer relationship and business partnershipintangible assets in the Customer Support operating segment associated with theacquisition of Evolving U.K.  The fair values of ourintangible assets were estimated using the present value of expected futurecash flows.

We recorded amortization expense of identifiableintangible assets of $0.3 million and $2.1 million for the three and ninemonths ended September 30, 2006, respectively, and $1.4 million and $4.2million for the three and nine months ended September 30, 2005,respectively.  Expected future amortization expense related to identifiable intangibleassets based on carrying amounts as of September 30, 2006 is as follows (inthousands):

 

| 12 months ending September 30: | ** ** | ** ** | ** ** |
|----------------------------------------------------|------------|------------|------------|
| 2007                                               |       | $          | 1,519      |   |
| 2008                                               |       | 1,474      |       |
| 2009                                               |       | 926        |       |
| 2010                                               |       | 834        |       |
| 2011                                               |       | 742        |       |
| Thereafter                                         |       | 826        |       |
|                                               |       | $          | 6,321      |   |

** (3) Earnings Per Common Share**

Basic earnings per share (“EPS”) is computed bydividing net income or loss available to common stockholders by the weightedaverage number of shares outstanding during the period, including common stockissuable under participating securities, such as the Series B ConvertibleRedeemable Preferred Stock (“Series B Preferred Stock”). Diluted EPS iscomputed using the weighted average number of shares outstanding, includingparticipating securities, plus all potentially dilutive common stockequivalents. Common stock equivalents consist of stock options and shares heldin escrow. The following is the reconciliation of the denominator of the basicand diluted EPS computations (in thousands):

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|                                                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                          | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Weighted average  common shares outstanding         |       | 16,212                                               |       | 16,055                                              |       | 16,189 |   | 16,024 |   |
| Participating  securities                           |       | 2,900                                                |       | 2,610                                               |       | 2,900 |   | 2,610 |   |
| Basic weighted  average common shares outstanding   |       | 19,112                                               |       | 18,665                                              |       | 19,089 |   | 18,634 |   |
| Effect of  dilutive securities                      |       | 198                                                  |       | —                                              |       | — |   | — |   |
| Diluted weighted  average common shares outstanding |       | 19,310                                               |       | 18,665                                              |       | 19,089 |   | 18,634 |   |

 

Weighted averageoptions to purchase 1.0 million shares of common stock were excluded from thedilutive stock calculation for the nine months ended September 30, 2006 astheir effect would have been anti-dilutive as a result of the net loss for theperiod.  Weighted average options topurchase 3.6 million and 3.2 million shares of common stock were excluded fromthe dilutive stock calculation for the three and nine months ended September30, 2006 because their exercise prices were greater than the average fair valueof our common stock for the period.

Weighted average options to purchase 0.8 million and1.2 million shares of common stock were excluded from the dilutive stockcalculation for the three and nine months ended September 30, 2005,respectively, as their effect would have been anti-dilutive as a result of thenet loss for the periods.  Weightedaverage options to purchase 2.6 million and 2.4 million shares of commons stockwere excluded from the dilutive stock calculation for the three and nine monthsended September 30, 2005, respectively, because their exercise prices weregreater than the average fair value of our common stock for the period.

 **(4) Share-BasedCompensation**

We adopted SFAS 123R effective January 1, 2006 using the modified prospectivemethod.  We previously applied theintrinsic-value-based method in accounting for the recognition of stock-basedcompensation arrangements and the fair value method only for disclosurepurposes.  Because we historicallygranted options with exercise prices equal to the fair market value of ourcommon stock at the grant date, the adoption of SFAS 123R did not result in asignificant impact on our financial statements. Further, as a result of the preceding, our statements of operations fromJanuary 1, 2006 forward include charges for stock-based compensation.  We recognized $181,000, or $0.01 per share,of compensation expense in the statement of operations for the three monthsended September 30, 2006 and $625,000, or $0.03 per share, of compensationexpense in the statement of operations for the nine months ended September 30,2006 with respect to our stock-based compensation plans.  The following table summarizes stock-basedcompensation expenses recorded in the statements of operations (in thousands):

 

|                                                                            | ** ** | **Three  Months Ended  September 30,  2006** | ** ** | **Nine  Months Ended  September 30,  2006** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Cost of license  fee and services, excluding depreciation and amortization |       | $                                                      | 13         |                                                  | $          | 44 |   |
| Cost of customer  support, excluding depreciation and amortization         |       | 2                                                      |       | 7                                                     |       |
| Sales and  marketing                                                       |       | 39                                                     |       | 145                                                   |       |
| General and  administrative                                                |       | 115                                                    |       | 394                                                   |       |
| Product  development                                                       |       | 12                                                     |       | 35                                                    |       |
|                                                                       |       | $                                                      | 181        |                                                  | $          | 625 |   |

**StockOption Plan**

In January 1996, ourstockholders approved “The Amended and Restated Stock Option Plan” (the “OptionPlan”).  Initially, 3,150,000 shares werereserved for issuance under the Option Plan. Subsequently, the Option Plan was amended, as approved by thestockholders, to increase the number of shares available for issuance to8,350,000.Options issued under theOption Plan were at the discretion of the Board of Directors, including thevesting provisions of each stock option granted. Options were granted with anexercise price equal to the market price of our common stock on the date ofgrant, generally vest over four years and expire no more than ten years fromthe date of grant. The Option Plan terminated on January 18, 2006; optionsgranted before that date were not affected by the plan termination.

The fair value of each optiongrant is estimated on the date of grant using the Black-Scholes model.  The Black-Scholes model uses four assumptionsto calculate the fair value of each option grant.  The expected term of share options granted isderived using the simplified method prescribed by the SEC Staff AccountingBulletin 107, “Share-Based Payment.”  Therisk-free interest rate is based upon the rate currently available onzero-coupon U.S. Treasury instruments with a remaining term equal to theexpected term of the stock 

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options. The expected volatility is based upon historical volatility of ourcommon stock over a period equal to the expected term of the stockoptions.  The expected dividend yield iszero and is based upon historical and anticipated payment of dividends.  The weighted-average assumptions used in thefair value calculations are as follows:  

|                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
|                     |       | **2006**                                             |       | **2005**                                            |       | **2006** |   | **2005** |   |
| Expected term  (years)   |       | *                                                    |       | 5                                                   |       | 6.1 |   | 5 |   |
| Risk-free  interest rate |       | *                                                    |       | 4.00                                                | %          | 4.35 | % | 3.75 | % |
| Expected  volatility     |       | *                                                    |       | 123.25                                              | %          | 121.14 | % | 124.40 | % |
| Expected dividend yield  |       | *                                                    |       | 0                                                   | %          | 0 | % | 0 | % |

----

*             Nonegranted.

The following is a summary of stock optionactivity under the plan for the nine months ended September 30, 2006: 

|                                            | ** ** | **Number of  Shares  (in  thousands)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term  (Years)** | ** ** | **Aggregate  Intrinsic  Value  (in  thousands)** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------------------------|------------|--------------------------------------------------|------------|
| Options  outstanding at December 31, 2005  |       | 4,279                                       |       | $                                       | 3.14       |                                                          |       |                                             |       |   |
| Options granted                            |       | 15                                          |       | $                                       | 2.32       |                                                          |       |                                             |       |   |
| Less options forfeited                     |       | (88                                         | )          | $                                       | 2.42       |                                                          |       |                                             |       |   |
| Less options expired                       |       | (75                                         | )          | $                                       | 4.21       |                                                          |       |                                             |       |   |
| Less options exercised                     |       | (12                                         | )          | $                                       | 1.11       |                                                          |       |                                             |       |   |
| Options  outstanding at September 30, 2006 |       | 4,119                                       |       | $                                       | 3.14       |                                                          | 6.77       |                                             | $          | 152 |   |
| Options exercisable at  September 30, 2006 |       | 3,134                                       |       | $                                       | 3.41       |                                                          | 6.11       |                                             | $          | 151 |   |

 

There were no options grantedduring the three months ended September 30, 2006.  The weighted-average grant-date fair value ofstock options granted during the nine months ended September 30, 2006 was$2.05.  The weighted-average grant-datefair value of stock options granted during the three and nine months endedSeptember 30, 2005 was $1.87 and $2.23, respectively.

As of September 30, 2006, therewas approximately $1.5 million of total unrecognized compensation costs relatedto unvested stock options.  These costsare expected to be recognized over a weighted average period of 1.6 years.

The total intrinsic value ofstock option exercises for the three months ended September 30, 2006 and 2005was $1,000 and $21,000, respectively. The total fair value of stock awards vested during the three monthsended September 30, 2006 and 2005 was $0.1 million and $0.4 million,respectively.

The total intrinsic value ofstock option exercises for the nine months ended September 30, 2006 and 2005was $14,000 and $115,000, respectively. The total fair value of stock awards vested during the nine months endedSeptember 30, 2006 and 2005 was $0.4 million and $1.6 million, respectively.

The deferred income tax benefitsfrom stock options expense related to Evolving Systems U.K. totaledapproximately $7,000 and $20,000 for the three and nine months ended September30, 2006, respectively.

Cash received from stock optionexercises for the three months ended September 30, 2006 and September 30, 2005was $1,000 and $5,000, respectively. Cash received from stock option exercises for the nine months endedSeptember 30, 2006 and September 30, 2005 was $13,000 and $39,000,respectively.

**Employee Stock PurchasePlan**

Under the Employee Stock PurchasePlan (“ESPP”), we are authorized to issue up to 1,100,000 shares of our commonstock to full-time employees, nearly all of whom are eligible to participate.Under the terms of the ESPP, employees may elect to have up to 15% of theirgross salaries withheld through payroll deduction to purchase our common stock,capped at $25,000 annually. The purchase price of the stock is 85% of the lowerof the market price at the beginning or end of each three-month participationperiod. As of September 30, 2006, there were 373,000 shares available forpurchase.  For the three and nine monthsended September 30, 2006, we recorded compensation expense of $8,000 and$32,000, respectively, associated with grants under the ESPP which includes thefair value of the 

12

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look-back feature of each grant as well as the 15%discount on the purchase price.  Thisexpense fluctuates each period based upon employee participation.

The fair value of each grant madeunder our ESPP is estimated on the date of grant using the Black-Scholes model.  The Black-Scholes model uses four assumptionsto calculate the fair value of each option grant.  The expected term of each grant is based uponthe three-month (six-month in 2005) participation period of each grant.  The risk-free interest rate is based upon therate currently available on zero-coupon U.S. Treasury instruments with aremaining term equal to the expected term of each grant.  The expected volatility is based uponhistorical volatility of our common stock. The expected dividend yield is based upon historical and anticipatedpayment of dividends.  The weightedaverage assumptions used in the fair value calculations are as follows: 

|                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected term  (years)   |       | 0.25                                                 |       | 0.5                                                 |       | 0.25 |   | 0.5 |   |
| Risk-free  interest rate |       | 5.08                                                 | %          | 3.53                                                | %          | 5.02 | % | 3.25 | % |
| Expected  volatility     |       | 73.43                                                | %          | 92.46                                               | %          | 79.35 | % | 94.63 | % |
| Expected dividend yield  |       | 0                                                    | %          | 0                                                   | %          | 0 | % | 0 | % |

 

Cash received from employee stockplan purchases for the three months ended September 30, 2006 and September 30,2005 was $23,000 and $26,000, respectively. Cash received from employee stock plan purchases for the nine monthsended September 30, 2006 and September 30, 2005 was $95,000 and $55,000, respectively.

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

|                                                                                                                                            | ** ** | **Three Months  Ended  September 30,  2005** | ** ** | **Nine Months  Ended  September 30,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Net loss, as  reported                                                                                                                     |       | $                                                      | (926       | )                                                     | $          | (3,762 | ) |
| Stock-based compensation expense that would have  been included in net loss if the fair-value-based method had been applied to  all awards |       | (407                                                   | )          | (1,632                                                | )          |
| Pro forma net loss                                                                                                                         |       | $                                                      | (1,333     | )                                                     | $          | (5,394 | ) |
|                                                                                                                                       |       |                                                   |       |                                                  |       |
| Loss per common  share, as reported:                                                                                                       |       |                                                   |       |                                                  |       |
| Basic and diluted                                                                                                                          |       | $                                                      | (0.05      | )                                                     | $          | (0.20 | ) |
| Pro forma loss  per common share:                                                                                                          |       |                                                   |       |                                                  |       |
| Basic and  diluted                                                                                                                         |       | $                                                      | (0.07      | )                                                     | $          | (0.29 | ) |

 

**(5) Concentration of Credit Risk**

For the three months endedSeptember 30, 2006, three significant customers (defined as contributing atleast 10%) accounted for 43% (15%, 15% and 13%), respectively, of totalrevenue.  These customers were located in the U.S., U.K. and U.K., respectively.  For the nine months ended September 30, 2006,two significant customers accounted for 26% (13% and 13%), respectively, oftotal revenue.  These customers were located in the U.S. andU.K., respectively.  For the threeand nine months ended September 30, 2005, three significant customers (definedas contributing at least 10%) accounted for 45% (20%, 13% and 12%) and 39%(12%, 13% and 14%), respectively, of total revenue.  For the three months endedSeptember 30, 2005, these customers were located in Luxembourg, U.K. and U.S.,respectively.  For the nine months endedSeptember 30, 2005, these customers were located in the U.S., U.K. andLuxembourg, respectively.

As of September 30, 2006, four significant customersaccounted for approximately 51% (15%, 14%, 11% and 11%) of contractreceivables.  These customers werelocated in Pakistan, U.S., U.K. and U.K, respectively.  At December 31, 2005, two significantcustomers accounted for approximately 38% (25% and 13%) of contractreceivables.  These customers werelocated in the U.S. and Luxembourg, respectively.

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**(6) Long-term Debt**

Notes payableconsist of the following (in thousands):
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Senior note payable to  financial institution, interest at (1) the greater of 3.75% or the one-month  London InterBank Offered Rate (“LIBOR”) plus (2) a margin of 6.25%, interest  rate was 11.58% at September 30, 2006, interest payments are due monthly,  principal installments are due quarterly with final maturity on November 14,  2010. The margin of 6.25% can be reduced to 5.25% if we meet and maintain  certain financial requirements (not met as of September 30, 2006). Loan is  secured by substantially all of the assets of Evolving Systems and its U.S.  subsidiaries and a pledge of stock of foreign subsidiaries of Evolving  Systems |       | $                            | 6,750      |                        | $          | 8,500 |   |
| $4.5 million  senior revolving credit facility payable to financial institution, interest  at (1) the greater of 3.75% or the one-month LIBOR plus (2) a margin of 4.0%,  interest rate was 9.33% at September 30, 2006, interest payments are due  monthly with final maturity on November 14, 2010. Loan is secured by  substantially all of the assets of Evolving Systems U.K.                                                                                                                                                                                                                                                                                         |       | 2,000                        |       | 2,003                       |       |
| Long-term  unsecured subordinated notes payable, interest ranges from 11-14% with a  weighted average rate of 12.84%, accrued interest and principal are due in  full May 16, 2011                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       | 4,870                        |       | 4,870                       |       |
| Total notes payable                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       | 13,620                       |       | 15,373                      |       |
| Less current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       | (1,750                       | )          | (1,000                      | )          |
| Long-term debt, excluding current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       | $                            | 11,870     |                        | $          | 14,373 |   |

The senior notepayable and senior revolving credit facility subject us to certain financialcovenants.  Certain of these covenantswere amended effective June 30, 2006. The Minimum Trailing Twelve Months EBITDA covenant, as defined in theagreement, was amended as follows:

|                                                            | ** ** | **Original Covenant** | ** ** | **Amended Covenant** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| June 30, 2006                                              |       | $                          | 5,500,000  |                      | $          | 4,500,000 |   |
| September 30,  2006 and December 31, 2006                  |       | $                          | 6,000,000  |                      | $          | 4,325,000 |   |
| March 31, 2007                                             |       | $                          | 6,500,000  |                      | $          | 4,500,000 |   |
| June 30, 2007                                              |       | $                          | 6,500,000  |                      | $          | 4,850,000 |   |
| September 30,  2007                                        |       | $                          | 7,000,000  |                      | $          | 5,000,000 |   |
| December 31,  2007                                         |       | $                          | 7,000,000  |                      | $          | 5,200,000 |   |
| March 31, 2008  and June 30, 2008                          |       | $                          | 7,250,000  |                      | $          | 5,200,000 |   |
| September 30, 2008 and  the end of each quarter thereafter |       | $                          | 7,250,000  |                      | $          | 5,400,000 |   |

The Fixed ChargeCoverage Ratio covenant, which is the ratio of trailing twelve months EBITDAless unfinanced capital expenditures and less income and franchise taxes paidin cash to fixed charges for the preceding twelve months, as further defined inthe agreement, was amended as follows:

|                                                            | ** ** | **Original Covenant** | ** ** | **Amended Covenant** | ** ** |
|------------------------------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| September 30,  2006 and the end of each quarter thereafter |       | 1.20 to 1                  |       | 1.15 to 1                 |       |

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

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

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

14

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We were in compliance with all our covenants as ofSeptember 30, 2006.

As part of the amendment of the loan agreements withour senior lender, we were required to make a prepayment of principal on thesenior note payable of $1.0 million and pay a fee of $25,000 to the seniorlender.  These amounts were paid duringJuly 2006.

**(7)Income Taxes**

We recorded net income tax expense of $0.2 million andnet income tax benefit of $1.3 million for the three and nine months endedSeptember 30, 2006, respectively.  Thenet expense/benefit during the three and nine months ended September 30, 2006consisted of current income tax expense of approximately $0.2 million and $0.5million, respectively, and a deferred tax benefit of $0 and $1.8 million,respectively, all of which were related to our UK-based operations.

We recorded net income tax expense of $0.1 million andnet income tax benefit of $0.2 million for the three and nine months endedSeptember 30, 2005, respectively.  Thenet expense/benefit during the three and nine months ended September 30, 2005consisted of current income tax expense of approximately $0.4 million and $1.0million, respectively, and a deferred tax benefit of $0.3 million and $1.2million, respectively, all of which were related to our UK-based operations.

In conjunction with the acquisition of EvolvingSystems U.K., certain identifiable intangible assets were recorded.  Since the amortization of these identifiableintangibles is not deductible for income tax purposes, we established along-term deferred tax liability of $4.6 million at the acquisition date forthe expected difference between what would be expensed for financial reportingpurposes and what would be deductible for income tax purposes. As of September30, 2006 and December 31, 2005, this deferred tax liability was $1.5 millionand $3.1 million, respectively.  Thisdeferred tax liability was reduced by $1.5 million as a result of the goodwilland intangible asset impairments recorded at June 30, 2006.  This deferred tax liability relates toEvolving Systems U.K., and has no impact on our ability to recover U.S.-baseddeferred tax assets.

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

As of September 30, 2006 and December 31, 2005,we continued to maintain a full valuation allowance on our domestic netdeferred tax asset as we determined it was more likely than not that we willnot realize our domestic deferred tax assets. Such assets primarily consist of net operating loss carryforwards.  We assessed the realizability of our domesticdeferred tax assets using all available evidence.  In particular, we considered both historicalresults and projections of profitability for reasonably foreseeable futureperiods.  We are required to reassessconclusions regarding the realization of deferred tax assets at each financialreporting date. A future evaluation could result in a conclusion that all or aportion of the valuation allowance is no longer necessary which could have amaterial impact on our results of operations and financial position.

**(8)Segment Information**

In accordance with SFAS No. 131, “Disclosuresabout Segments of an Enterprise and Related Information,” we define operatingsegments as components of an enterprise for which separate financialinformation is reviewed regularly by the chief operating decision-making groupto evaluate performance and to make operating decisions. We have identified ourChief Executive Officer and Chief Financial Officer as our chief operatingdecision-makers (CODM). These chief operating decision makers review revenuesby segment and review overall results of operations.

We currently operate business as two operatingsegments based on revenue type:  licensefees and services revenue and customer support revenue (as shown on theconsolidated statements of operations). License fees and services (L&S) revenue represents the fees receivedfrom the license of software products and those services directly related tothe delivery of the licensed products, as well as fees for custom development,integration services and time and materials work.  Customer support (CS) revenue includes annualsupport fees, recurring maintenance fees, fees for maintenance upgrades andwarranty services.  Warranty servicesthat are similar to software maintenance services are typically bundled with alicense sale. Total assets by segment have not been disclosed as theinformation is not available to the chief operating decision-making group.

15

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Segment information is as follows (in thousands):

 
| ** **                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Revenue**                                                                |       |                                                 |       |                                                |       |   |   |   |   |
| License fees and services                                                  |       | $                                                    | 3,990      |                                                | $          | 4,821 |   | $ | 11,855 |   | $ | 14,643 |   |
| Customer support                                                           |       | 4,677                                                |       | 4,749                                               |       | 13,180 |   | 14,691 |   |
|                                                                       |       | $                                                    | 8,667      |                                                | $          | 9,570 |   | $ | 25,035 |   | $ | 29,334 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| **Revenue  less cost of revenue, excluding depreciation and amortization** |       |                                                 |       |                                                |       |   |   |   |   |
| License fees and services                                                  |       | $                                                    | 1,999      |                                                | $          | 2,536 |   | $ | 6,332 |   | $ | 6,989 |   |
| Customer support                                                           |       | 3,442                                                |       | 3,171                                               |       | 8,768 |   | 9,447 |   |
|                                                                       |       | 5,441                                                |       | 5,707                                               |       | 15,100 |   | 16,436 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| **Unallocated  costs**                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Other operating expenses                                                   |       | 4,142                                                |       | 4,324                                               |       | 13,272 |   | 13,726 |   |
| Depreciation and amortization                                              |       | 621                                                  |       | 1,717                                               |       | 2,987 |   | 5,293 |   |
| Impairment of goodwill and intangible assets                               |       | —                                               |       | —                                              |       | 16,516 |   | — |   |
| Restructuring and other                                                    |       | —                                               |       | 4                                                   |       | (23 | ) | (59 | ) |
| Interest income                                                            |       | (46                                                  | )          | (21                                                 | )          | (120 | ) | (100 | ) |
| Interest expense                                                           |       | 498                                                  |       | 393                                                 |       | 1,503 |   | 1,230 |   |
| Foreign currency exchange loss                                             |       | 8                                                    |       | 99                                                  |       | 38 |   | 285 |   |
| **Income (loss) before income  taxes**                                     |       | $                                                    | 218        |                                                | $          | (809 | ) | $ | (19,073 | ) | $ | (3,939 | ) |

 

***Geographic Regions***

We are headquartered inEnglewood, a suburb of Denver, Colorado. We use customer locations as the basis for attributing revenues toindividual countries.  We provideproducts and services on a global basis through our London-based EvolvingSystems U.K. subsidiary.  Additionally,personnel in Bangalore, India, provide software development services to ourglobal operations.  Financial informationrelating to operations by geographic region, as reviewed by the CODM, is asfollows (in thousands):

 
| ** **                           | ** ** | **Three Months Ended September 30,** | ** ** |
|--------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **L&S**                                              | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**                          |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Americas                             |       | $                                                        | 601        |   | $ | 3,034 |   | $ | 3,635 |   | $ | 1,569 |   | $ | 2,970 |   | $ | 4,539 |   |
| Europe, Middle East, Africa and Asia |       | 3,389                                                    |       | 1,643 |   | 5,032 |   | 3,252 |   | 1,779 |   | 5,031 |   |
| Total Revenue                        |       | $                                                        | 3,990      |   | $ | 4,677 |   | $ | 8,667 |   | $ | 4,821 |   | $ | 4,749 |   | $ | 9,570 |   |

 
| ** **                           | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **L&S**                                             | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**                          |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Americas                             |       | $                                                       | 2,050      |   | $ | 8,400 |   | $ | 10,430 |   | $ | 4,614 |   | $ | 9,642 |   | $ | 14,256 |   |
| Europe, Middle East, Africa and Asia |       | 9,805                                                   |       | 4,780 |   | 14,605 |   | 10,029 |   | 5,049 |   | 15,078 |   |
| Total Revenue                        |       | $                                                       | 11,855     |   | $ | 13,180 |   | $ | 25,035 |   | $ | 14,643 |   | $ | 14,691 |   | $ | 29,334 |   |

 

16

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|                                      | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Long-lived  assets, net**          |       |                         |       |                        |       |
| Americas                             |       | $                            | 8,123      |                        | $          | 13,172 |   |
| Europe, Middle East, Africa and Asia |       | 24,720                       |       | 36,026                      |       |
| Total long-lived  assets, net        |       | $                            | 32,843     |                        | $          | 49,198 |   |

 

Financial information relating to product groupings isas follows (in thousands):

|                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Revenue**         |       |                                                 |       |                                                |       |   |   |   |   |
| Activation          |       | $                                                    | 3,997      |                                                | $          | 4,685 |   | $ | 12,473 |   | $ | 13,810 |   |
| Numbering solutions |       | 2,912                                                |       | 3,948                                               |       | 8,243 |   | 11,694 |   |
| Mediation           |       | 1,758                                                |       | 937                                                 |       | 4,319 |   | 3,830 |   |
|                |       | $                                                    | 8,667      |                                                | $          | 9,570 |   | $ | 25,035 |   | $ | 29,334 |   |

 

**(9) Commitments and Contingencies**

As permitted under Delaware law, we have agreementswith officers and directors under which we agree to indemnify them for certainevents or occurrences while the officer or director is, or was serving, at ourrequest in this capacity. The term of the indemnification period is indefinite.There is no limit on the amount of future payments we could be required to makeunder these indemnification agreements; however, we maintain Director andOfficer insurance policies, as well as an Employment Practices Liability InsurancePolicy, that may enable us to recover a portion of any amounts paid. As aresult of our insurance policy coverage, we believe the estimated fair value ofthese indemnification agreements is minimal. Accordingly, there were noliabilities recorded for these agreements as of September 30, 2006 andDecember 31, 2005.

We enter into standard indemnification terms withcustomers, as discussed below, in the ordinary course of business.  As we may subcontract the development ofdeliverables under customer contracts, we could be required to indemnifycustomers for work performed by subcontractors. Depending upon the nature ofthe customer indemnification, the potential amount of future payments we couldbe required to make under these indemnification agreements may be unlimited. Wemay be able to recover damages from a subcontractor if the indemnification tocustomers results from the subcontractor’s failure to perform. To the extent weare unable to recover damages from a subcontractor, we could be required toreimburse the indemnified party for the full amount. We have never incurredcosts to defend lawsuits or settle claims relating to indemnification arisingout of subcontractors’ failure to perform. As a result, we believe theestimated fair value of these agreements is minimal. Accordingly, there were noliabilities recorded for these agreements as of September 30, 2006 andDecember 31, 2005.

Our standard license agreements contain productwarranties that the software will be free of material defects and will operatein accordance with the stated requirements for a limited period of time.  The product warranty provisions require us tocure any defects through any reasonable means. We believe the estimated fair value of the product warranty provisionsin the license agreements in place with our customers is minimal.  Accordingly, there were no liabilitiesrecorded for these product warranty provisions as of September 30, 2006 andDecember 31, 2005.

Our software arrangements generally include a productindemnification provision whereby we will indemnify and defend a customer inactions brought against the customer for claims that our products infringe upona copyright, trade secret, or valid patent. We have not historically incurredany significant costs related to product indemnification claims. Accordingly,there were no liabilities recorded for these indemnification provisions as ofSeptember 30, 2006 and December 31, 2005.

In relation to the acquisitions of Evolving SystemsU.K., Telecom Software Enterprises, LLC (TSE) and CMS Communications, Inc.(CMS), we agreed to indemnify certain parties from any losses, actions, claims,damages or liabilities (or actions in respect thereof) resulting from any claimraised by a third party.  We do notbelieve that there will be any claims related to these indemnifications.Accordingly, there were no liabilities recorded for these agreements as ofSeptember 30, 2006 and December 31, 2005.

From time to time we may be involved in various legalproceedings arising in the normal course of business operations. We are notcurrently involved in any such proceedings.

17

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**Item 2. Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

**Special Note About Forward-LookingStatements**

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

**OVERVIEW**

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

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

***Implementation of SFAS 123R***

Effective January 1, 2006, we adopted SFASNo. 123(R), *Share-Based Payment*(“SFAS 123R”)*,*using the modified prospective method.  Prior to January 1, 2006, we applied theintrinsic-value-based method in accounting for employee stock-basedcompensation arrangements and the fair value method only for disclosurepurposes.  Under these methods,stock-based compensation costs were not recorded in the financial statementsbut were disclosed in the notes to the financial statements together with proforma disclosure of earnings and earnings per share.  Because the fair value recognition provisionsof SFAS 123R require recognition of stock-based compensation expense inthe financial statements, the application of SFAS 123R has and willnegatively impact our results of operations. For the three and nine months ended September 30, 2006, we recorded$181,000 and $625,000, respectively, of stock-based compensation expensesassociated with our stock option and employee stock purchase plans which wereallocated to the various expense line items within our statements ofoperations.  As we previously applied thefair value method for disclosure purposes, we believe the disclosure inpreviously issued reports are reasonably comparable to current period recordedexpenses except for the requirement to now estimate forfeitures in the amountof compensation expense recognized, as compared to recording forfeitures asthey occurred in our prior period pro forma disclosures.   As of September 30, 2006, there was $1.5million of total unrecognized compensation costs related to unvested stockoptions. These costs are expected to be recognized over a weighted averageperiod of 1.6 years.  The following tablesummarizes the stock-based compensation expenses recorded in the statements ofoperations (in thousands).

|                                                                            | ** ** | **Three Months  Ended  September 30,  2006** | ** ** | **Nine Months  Ended  September 30,  2006** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Cost of license  fee and services, excluding depreciation and amortization |       | $                                                      | 13         |                                                  | $          | 44 |   |
| Cost of customer  support, excluding depreciation and amortization         |       | 2                                                      |       | 7                                                     |       |
| Sales and  marketing                                                       |       | 39                                                     |       | 145                                                   |       |
| General and  administrative                                                |       | 115                                                    |       | 394                                                   |       |
| Product  development                                                       |       | 12                                                     |       | 35                                                    |       |
|                                                                       |       | $                                                      | 181        |                                                  | $          | 625 |   |

 

18

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***Cost Reductions***

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

Our costs ofrevenue and operating expenses decreased $1.9 million, or 19%, to $8.0 millionfor the three months ended September 30, 2006 from $9.9 million for the threemonths ended September 30, 2005.  Thesecost reduction measures account for a significant portion of the decrease inour costs of revenue and operating expenses for the three months endedSeptember 30, 2006 as compared to the three months ended September 30,2005.  Our intangible amortizationdecreased $1.0 million over these periods as certain of our intangible assetsfrom our acquisitions became fully amortized and/or were written down as aresult of impairment at June 30, 2006. Stock-based compensation costs of $0.2 million resulting from theimplementation of SFAS 123R partially offset these decreases in expense.

***Impairmentof Goodwill and Intangible Assets***

We recognized agoodwill impairment charge of $10.9 million at June 30, 2006 related to ourLicense Fees and Services operating segment. The impairment resulted from thedecline in the fair value of goodwill initially recorded associated with ouracquisitions of Evolving Systems U.K., TSE and CMS.

In addition, werecorded an impairment of intangible assets of $5.6 million at June 30, 2006related to intangible assets acquired in the acquisitions of Evolving SystemsU.K., CMS and TSE.  An evaluation ofproduct strategy and development plans resulted in the determination that theundiscounted cash flows associated with these assets would not be sufficient torecover the carrying amounts of these assets. This non-cash impairment charge resulted in acceleration of futureamortization expense associated with these assets.

 

19

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**RESULTS OF OPERATIONS**

The following table presents the unauditedconsolidated statements of operations reflected as a percentage of totalrevenue.

** **

 
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|------------|
| ** **                                                                   | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006**   | ** ** | **2005** | ** ** | ** ** |
| **REVENUE**                                                                  |       |                                                 |       |                                                |       |       |   |   |   |   |
| License fees and  services                                                   |       | 46                                                   | %          | 50                                                  | %          | 47         | % | 50 | % |   |
| Customer support                                                             |       | 54                                                   | %          | 50                                                  | %          | 53         | % | 50 | % |   |
| Total revenue                                                                |       | 100                                                  | %          | 100                                                 | %          | 100        | % | 100 | % |   |
|                                                                         |       |                                                 |       |                                                |       |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING  EXPENSES**                                 |       |                                                 |       |                                                |       |       |   |   |   |   |
| Costs of license  fees and services, excluding depreciation and amortization |       | 23                                                   | %          | 24                                                  | %          | 22         | % | 26 | % |   |
| Costs of  customer support, excluding depreciation and amortization          |       | 14                                                   | %          | 17                                                  | %          | 18         | % | 18 | % |   |
| Sales and  marketing                                                         |       | 25                                                   | %          | 25                                                  | %          | 27         | % | 25 | % |   |
| General and  administrative                                                  |       | 14                                                   | %          | 15                                                  | %          | 16         | % | 18 | % |   |
| Product  development                                                         |       | 10                                                   | %          | 5                                                   | %          | 10         | % | 3 | % |   |
| Depreciation                                                                 |       | 3                                                    | %          | 4                                                   | %          | 3          | % | 4 | % |   |
| Amortization                                                                 |       | 4                                                    | %          | 14                                                  | %          | 9          | % | 14 | % |   |
| Impairment of  goodwill and intangible assets                                |       | —                                               | %          | —                                              | %          | 66         | % | — | % |   |
| Restructuring  and other                                                     |       | —                                               | %          | —                                              | %          | —     | % | — | % |   |
| Total costs of revenue  and operating expenses                               |       | 93                                                   | %          | 104                                                 | %          | 171        | % | 108 | % |   |
| Income (loss) from  operations                                               |       | 7                                                    | %          | (4                                                  | )%         | (71        | )% | (8 | )% |   |
| Interest income                                                              |       | 1                                                    | %          | —                                              | %          | 1          | % | — | % |   |
| Interest expense                                                             |       | (6                                                   | )%         | (4                                                  | )%         | (6         | )% | (4 | )% |   |
| Foreign currency  exchange loss                                              |       | —                                               | %          | (1                                                  | )%         | —     | % | (1 | )% |   |
| Other expense, net                                                           |       | (5                                                   | )%         | (5                                                  | )%         | (5         | )% | (5 | )% |   |
| Income (loss) before  income taxes                                           |       | 2                                                    | %          | (9                                                  | )%         | (76        | )% | (13 | )% |   |
| Income tax expense (benefit)                                                 |       | 2                                                    | %          | 1                                                   | %          | (5         | )% | — | % |   |
| Net income (loss)                                                            |       | 0                                                    | %          | (10                                                 | )%         | (71        | )% | (13 | )% |   |

 

***Revenue***

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

** **

|                      | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **           | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Activation           |       | $                                                    | 3,997      |                                                | $          | 4,685 |   | $ | 12,473 |   | $ | 13,810 |   |
| Numbering  solutions |       | 2,912                                                |       | 3,948                                               |       | 8,243 |   | 11,694 |   |
| Mediation            |       | 1,758                                                |       | 937                                                 |       | 4,319 |   | 3,830 |   |
|                 |       | $                                                    | 8,667      |                                                | $          | 9,570 |   | $ | 25,035 |   | $ | 29,334 |   |

 

20

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***LicenseFees and Services***

License fees andservices revenue decreased 17% or $0.8 million to $4.0 million for the threemonths ended September 30, 2006, from $4.8 million for the three months endedSeptember 30, 2005.  The decrease inlicense fees and services revenue was primarily a result of a decrease of $0.7million in revenue from our activation products and a decrease of $1.0 millionin revenue from our number solutions products offset by an increase of $0.9million in revenue from our mediation products. The decline in activation revenue was due to fewer license sales resultingfrom longer customer purchasing cycles. The decline in numbering solutions revenue was due to the maturity ofthe narrowband numbering solutions market in the U.S.  The increase in mediation revenue was aresult of an increase in subscriber licenses for existing mediation customers.

License fees andservices revenue decreased 19% or $2.7 million to $11.9 million for the ninemonths ended September 30, 2006, from $14.6 million for the nine months endedSeptember 30, 2005.  The decrease inlicense fees and services revenue was primarily a result of a decrease of $1.0million in revenue from our activation products and a decrease of $2.4 millionin revenue from our number solutions products offset by an increase of $0.7million in revenue from our mediation products. The decline in activation revenue was due to fewer license salesresulting from longer customer purchasing cycles.  The decline in numbering solutions revenuewas due to the maturity of the US market and the delay to market of ourinternational NumeriTrack® product.  Inaddition, a contract signed during the nine months ended September 30, 2006with an international customer was ended by mutual agreement pendingavailability of the production version of our international NumeriTrack®product. We released our international NumeriTrack® product during September2006 and believe an international market exists for this product.  The increase in mediation revenue was aresult of an increase in subscriber licenses for existing mediation customers.

***Customer Support***

Customer support revenue decreased $0.1 million, or2%, to $4.7 million for the three months ended September 30, 2006, from $4.8million for the three months ended September 30, 2005.  The decrease in customer support revenueincluded a decrease of $0.1 million in our activation products, an increase of$0.1 million from our numbering solutions products and a decrease of $0.1million in our mediation products.  Thedecrease in activation revenue is a result ofpricing pressures on support contract renewals.  The increase in the numbering solutionsrevenue was due to the release of revenue which had been held-back pendingresolution of contract items with a customer. The decline in mediation revenue is consistent with our focus on ouractivation and numbering solutions products.

Customer support revenue decreased $1.5 million, or10%, to $13.2 million for the nine months ended September 30, 2006, from $14.7million for the nine months ended September 30, 2005.  The decrease in customer support revenueincluded a decrease of $0.3 million in our activation products, a decrease of$1.0 million from our numbering solutions products and a decrease of $0.2million in our mediation products.  Thedecrease in activation revenue is a result of pricingpressures on support contract renewals. The decrease in the numbering solutions revenue was due to industryconsolidation and smaller overall license sales, which is reflective of thematurity of the narrowband numbering solutions market in the U.S.  The decline in mediation revenue isconsistent with our focus on our activation and numbering solutions products.

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

Costs of revenue, excluding depreciation andamortization, consist primarily of personnel costs, facilities costs, cost ofthird-party software, partner commissions and all other direct costs associatedwith these personnel.  Partnercommissions increased over prior years as we entered into new partnerships inemerging markets in an effort to expand the geographic reach of our products.   Costs of revenue, excluding depreciation andamortization, were $3.2 million and $3.9 million for the three months endedSeptember 30, 2006 and 2005, respectively, and $9.9 million and $12.9 millionfor the nine months ended September 30, 2006, respectively.  These costs are discussed further below.

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

Costs of license fees and services, excludingdepreciation and amortization, were $2.0 million and $2.3 for the three monthsended September 30, 2006 and 2005, respectively.  The decrease of $0.3 million, or 13%, wasprimarily due to decreased revenue.  As apercentage of license fees and services revenue, costs of license fees andservices, excluding depreciation and amortization, increased to 50% for thethree months ended September 30, 2006 from 47% for the three months endedSeptember 30, 2005.  This increase was aresult of an estimated loss on an existing customer contract.  In accordance with our revenue recognitionpolicy, we record estimated losses in the period in which current estimates oftotal contract value and contract costs indicate a loss.  Accordingly, we recorded an estimated loss of$150,000, or 4% of license fees and services revenue, on an existing customercontract.  This loss related to phase oneof a two phase project; however, because we do not have a contract for phasetwo of this project, there is no guarantee that we will be able to recover thecontract loss we will incur in phase one.

Costs of license fees and services, excludingdepreciation and amortization, were $5.5 million and $7.6 for the nine monthsended September 30, 2006 and 2005, respectively.  The decrease of $2.1 million, or 28%, was dueto decreased revenue as well as cost savings. As a percentage of license fees and services revenue, costs of licensefees and services, excluding depreciation and amortization, decreased to 47%for the three months ended September 30, 2006 from 52% for the three monthsended September 30, 

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2005.  This decrease was due to cost savings as well as savings from the increasedutilization of our offshore development subsidiary in Bangalore, Indiawhich were offset by the $150,000 estimate loss on the contract describedabove.

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

Costs of customer support, excluding depreciation andamortization, decreased $0.4 million, or 22%, to $1.2 million for thethree months ended September 30, 2006 from $1.6 million for the threemonths ended September 30, 2005.  As apercentage of customer support revenue, costs of customer support revenue,excluding depreciation and amortization, decreased to 26% for the three monthsended September 30, 2006 from 33% for the three months ended September 30,2005.  This decrease was primarily due tocost reductions as well as savings from theincreased utilization of our offshore development subsidiary in Bangalore,India.

Costs of customer support, excluding depreciation andamortization, decreased $0.8 million, or 16%, to $4.4 million for the ninemonths ended September 30, 2006 from $5.2 million for the nine monthsended September 30, 2005.  The decreasewas due to reduced revenue as well as cost savings.  As a percentage of customer support revenue,costs of customer support revenue, excluding depreciation and amortization,decreased to 33% for the nine months ended September 30, 2006 from 36% for thenine months ended September 30, 2005. This decrease was primarily due to cost reductions as well as savings from the increased utilizationof our offshore development subsidiary in Bangalore, India.

***Sales and Marketing***

Sales and marketing expenses primarily consist ofcompensation costs, including bonuses and commissions, travel expenses,advertising, marketing and occupancy expenses. Sales and marketing expenses decreased $0.3 million, or 12%, to $2.1million for the three months ended September 30, 2006 from $2.4 million for thethree months ended September 30, 2005. As a percentage of total revenue, sales and marketing expenses remainedflat at 25% for the three months ended September 30, 2006 and 2005,respectively.

Sales and marketing expenses decreased $0.3 million,or 4%, to $6.9 million for the nine months ended September 30, 2006 and from$7.2 million for the nine months ended September 30, 2005.  Recent costsaving measures were somewhat offset by sales and marketing investments made inAsia and Central and Latin America as well as stock based compensation expensesduring the nine months ended September 30, 2006.  As a percentage of total revenue, sales andmarketing expenses for the nine months ended September 30, 2006 and 2005,increased to 27% from 25%, respectively. This increase was a result of decreased revenue without proportionaldecreases in sales and marketing expenses during the nine months endedSeptember 30, 2006 as compared to the same period in 2005.

***General and Administrative***

General and administrative expenses consistprincipally of employee related costs and professional fees for the followingdepartments: facilities, finance, legal, human resources, and certain executivemanagement.  General and administrativeexpenses decreased $0.3 million, or 19%, to $1.2 million from $1.5million for the three months ended September 30, 2006 and 2005,respectively.  This decrease wasprimarily a result of cost saving measures and reductions in professional andlegal fees which were offset by stock-based compensation costs recorded duringthe three months ended September 30, 2006. As a percentage of total revenue, general and administrative expensesfor the three months ended September 30, 2006 and 2005, decreased to 14% from15%, respectively.

General and administrative expenses decreased $1.5million, or 27%, to $3.9 million from $5.4 million for the nine monthsended September 30, 2006 and 2005, respectively.  As a percentage of total revenue, general andadministrative expenses for the nine months ended September 30, 2006 and 2005,decreased to 16% from 18%, respectively. These decreases were primarily a result of cost saving measures andreductions in professional and legal fees which were offset by stock-basedcompensation costs recorded during the nine months ended September 30, 2006.

***Product Development***

Product development expenses consist primarily ofemployee related costs and, in 2005, included offshore development andsubcontractor expenses.  Productdevelopment expenses increased $0.4 million, or 88%, to $0.8 million from $0.4million for the three months ended September 30, 2006 and 2005,respectively.  As a percentage ofrevenue, product development expenses for the three months ended September 30,2006 and 2005, increased to 10% from 5%, respectively.  These increases were due to product releaseenhancements as well as “internationalizing” our NumeriTrack® product.

Product development expenses increased $1.3 million,or 126%, to $2.4 million from $1.1 million for the nine months ended September30, 2006 and 2005, respectively.  As apercentage of revenue, product development expenses for the nine months ended September30, 2006 and 2005, increased to 10% from 3%, respectively.  These increases were due to product releaseenhancements as well as “internationalizing” our NumeriTrack® product.

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***Amortization***

Amortization expense consists of amortization ofidentifiable intangible assets acquired through our acquisitions of CMS, TSEand Evolving Systems U.K.  Amortizationexpense was $0.3 million and $1.4 million for the three months ended September30, 2006 and 2005, respectively.  Thedecrease in amortization expense of $1.0 million, or 75%, was a result ofcertain intangible assets becoming fully amortized as well as the impairment ofcertain intangible assets.

Amortization expense was $2.1 million and $4.2 millionfor the nine months ended September 30, 2006 and 2005, respectively.  The decrease in amortization expense of $2.1million, or 49%, was a result of certain intangible assets becoming fullyamortized as well as the impairment of certain intangible assets.

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

We recorded a goodwill impairment of $10.9 millionrelated to impairment of our License Fees and Services operating segment whichincludes a third quarter reclassification of $0.2 million from our intangibleasset impairment expense.  Continued pricingpressures and consolidation in the telecommunications industry negativelyimpacted our achievement of forecasted revenues associated with theacquisitions of CMS in November 2003, TSE in October 2004 and Evolving SystemsU.K. in November 2004.  The market priceof our common stock declined as a result of our recent operating results.  Based upon these events, we determined that atriggering event had occurred and we conducted a goodwill impairment analysisas of June 30, 2006.  This goodwillimpairment analysis resulted in the goodwill impairment charge notedabove.  We estimated the fair value ofeach reporting unit using the expected present value of future cash flows andother market factors.

As a result of the events that led to a triggeringevent related to the goodwill impairment, we first reviewed intangible assetsin accordance with FAS 144.  Anevaluation of product strategy and development plans resulted in thedetermination that the undiscounted cash flows associated with these assetswould not be sufficient to recover the carrying amounts of these assets.  This review indicated that $5.6 million ofintangible assets related to the License Fees and Services and Customer Supportoperating segment were impaired which included a third quarter reclassificationof $0.2 million to our goodwill impairment expense.  The impaired intangible assets were purchasedsoftware, purchased licenses and customer relationships which were acquiredthrough our acquisitions of Evolving Systems U.K., CMS and TSE.  As a result of the impairment of intangibleassets, our future amortization expense will be lower than originally projectedby the amount of the $5.6 million impairment charge.

***Interest Expense***

Interest expense was $0.5 million and $0.4 million forthe three months ended September 30, 2006 and 2005, respectively.  The increase of $0.1 million, or 27%, relatedto higher levels of debt, an increase in variable interest rates and increasedamortization of debt issuance costs.

Interest expense was $1.5 million and $1.2 million forthe nine months ended September 30, 2006 and 2005, respectively.  The increase of $0.3 million, or 22%, relatedto higher levels of debt, an increase in variable interest rates and increasedamortization of debt issuance costs.

***Foreign Currency Exchange Loss***

Foreign currency transactionlosses resulted from transactions denominated in a currency other than thefunctional currency of the respective subsidiary and were $8,000 and$99,000 for the three months ended September 30, 2006 and 2005, respectively.  The losses were generated primarily throughthe remeasurement of certain non-functional currency denominated financialassets and liabilities of our Evolving Systems U.K. subsidiary.

Foreign currency transactionlosses were $38,000 and $285,000 for the nine months ended September 30, 2006and 2005, respectively.  Thelosses were generated primarily through the remeasurement of financial assetsand liabilities of our Evolving Systems U.K. subsidiary.

***Income Taxes***

We recorded net income tax expense of $0.2 million and$0.1 million for the three months ended September 30, 2006 and 2005,respectively.  The net income tax expenseduring the three months ended September 30, 2006 consisted of current foreignincome tax expense of $0.2 million and a deferred foreign tax benefit of $0both of which are related to our UK-based operations.  The net income tax benefit during the threemonths ended September 30, 2005 consisted of current foreign income tax expenseof approximately $0.4 million and a deferred foreign tax benefit of $0.3million both of which are related to our UK-based operations.

We recorded net income tax benefit of $1.3 million andnet income tax benefit of $0.2 million for the nine months ended September 30,2006 and 2005, respectively.  The netincome tax expense during the nine months ended September 30, 2006 consisted ofcurrent foreign income tax expense of approximately $0.5 million and a deferredforeign tax benefit of $1.8 million both of which are related to our UK-basedoperations.  The net income tax benefitduring the nine months ended September 30, 2005 consisted of current foreignincome tax expense of approximately $1.0 million and a deferred foreign taxbenefit of $1.2 million both of which are related to our UK-based operations.

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In conjunction with the acquisition of EvolvingSystems U.K., certain identifiable intangible assets were recorded.  Since the identifiable intangibleamortization is not deductible for income tax purposes, a long-term deferredtax liability of $4.6 million was established at the acquisition date for theexpected difference between what would be expensed for financial reportingpurposes and what would be deductible for income tax purposes. As of September30, 2006 and December 31, 2005, this deferred tax liability was $1.5 millionand $3.1 million, respectively.  Thisdeferred tax liability was reduced by $1.4 million as a result of the goodwilland intangible impairment charges recorded. This deferred tax liability is carried on the books of our UnitedKingdom subsidiary, and has no impact on our ability to recover our U.S.-baseddeferred tax assets.  The aforementioneddeferred tax liability will be recognized as a reduction of deferred income taxexpense as the identifiable intangibles are amortized.

**FINANCIAL CONDITION**

 Our workingcapital position decreased $1.0 million to a negative $0.6 million as ofSeptember 30, 2006 from a positive $0.4 million as of December 31, 2005  The decrease in our working capital positionis directly attributable to the $0.8 million increase in current portion oflong-term debt at September 30, 2006, in accordance with the repayment scheduleassociated with our bank debt.  Variousfluctuations in other current assets and current liabilities further affect ourworking capital position.

**CONTRACTUALOBLIGATIONS**

There have been no material changes to the contractualobligations as disclosed in our 2005 Annual Report on Form 10-K except asdisclosed in note 6 to the condensed consolidated financial statements includedin this Form 10-Q.

**LIQUIDITY AND CAPITAL RESOURCES**

We have historically financed operations through cashflows from operations and equity transactions. At September 30, 2006, our principal source of liquidity was $4.5million in cash and cash equivalents as well as $2.3 million available underour revolving line of credit.  The $2.3million in availability under our revolving line of credit reflects the reducedavailability resulting from standby letters of credit of $0.2 million.  The following table summarizes our statementsof cash flows (in thousands):

|                           | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------|------------|-----------------------------------------------------|------------|
| ** **                | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Cash provided  (used) by: |       |                                                |       |   |   |
| Operating activities      |       | $                                                   | 2,743      |   | $ | 1,028 |   |
| Investing activities      |       | (530                                                | )          | (1,183 | ) |
| Financing activities      |       | (1,692                                              | )          | (7,435 | ) |
| Effect of exchange rates  |       | 117                                                 |       | (373 | ) |
| Net cash  provided (used) |       | $                                                   | 638        |   | $ | (7,963 | ) |

 

Net cash provided by operatingactivities for the nine months ended September 30, 2006 and 2005 was $2.7million and $1.0 million, respectively. Net loss plus non-cash operating adjustments was $0.7 million for thenine months ended September 30, 2006 compared to $1.6 million for the ninemonths ended September 30, 2005.  Changesin operating assets and liabilities reflected a net increase in cash fromoperating activities of $2.0 million for the nine months ended September 30,2006 as compared to a decrease in cash of $0.6 million for the nine monthsended September 30, 2005.  Thesefluctuations were primarily attributable to a decrease in amortization expenseand the timing of billings and collections for existing projects which varybased upon the specific billing schedules in each contract and affect thereported amounts of contract receivables, unbilled work-in-process and unearnedrevenue.

Net cash used by investing activities during the ninemonths ended September 30, 2006 and 2005 was $0.5 million and $1.2million.  The cash used for the ninemonths ended September 30, 2006 related primarily to purchases of property andequipment of $0.4 million and payment of TSE contingent consideration of $0.2million.  The cash used for the ninemonths ended September 30, 2005 related primarily to purchase of property andequipment of $0.7 million and net cash outflows of $0.5 million related to theTSE acquisition.

Financing activities in the nine months endedSeptember 30, 2006 and 2005, consisted primarily of principal payments on notespayable and amounts due Evolving Systems U.K. sellers.  During the nine months ended September 30,2006, we paid $1.8 million in principal payments on the senior term noteentered into in November 2005. During the nine months ended September 30, 2005,we paid $7.5 million in payments on obligations resulting from our acquisitionsduring 2004.  The restructuring of ourdebt during November 2005 significantly reduced our short-term obligationsunder our long-term debt arrangements.

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

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•       Our cash and cash equivalents balance at September 30, 2006 of$4.5 million.

•       The availability under our revolving credit facility of $2.3million at September 30, 2006.

•       Our demonstrated ability to generate positive cash flows fromoperations.

•       Our backlog as of September 30, 2006 of approximately $12.0million, including $4.1 million in license fees and services and $7.9 millionin customer support.

•       Our planned capital expenditures.

•       Our cash forecast which indicates that we will have sufficientliquidity to cover anticipated operating costs and capital expenditures as wellas debt service payments.

We are exposed to foreign currency rate risks which impact the carryingamount of our foreign subsidiaries and our consolidated equity, as well as ourconsolidated cash position due to translation adjustments.  For the nine months ended September 30, 2006,the effect of exchange rate changes resulted in a $0.1 million increase toconsolidated cash.  During the ninemonths ended September 30, 2005, the effect of exchange rate changes resultedin a $0.4 million decrease in consolidated cash.  We do not currently hedge our foreigncurrency exposure, but we monitor rate changes and may hedge our exposures ifwe see significant negative trends in exchange rates.

**OFF-BALANCE SHEET ARRANGEMENTS**

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

**Item3.  Quantitative and Qualitative MarketRisk Disclosures**

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

***Interest Rate Risks***

Our cash balances are subject tointerest rate fluctuations and as a result, interest income amounts mayfluctuate from current levels.  We areexposed to interest rate risk related to our $6.8 million senior secured termnote and $2.0 million outstanding on our revolving credit facility entered intoin November 2005.  These obligations arevariable interest rate notes based on short-term LIBOR.  Fluctuations in LIBOR affect our interestrates.  Assuming no change in the amountsoutstanding, a hypothetical 10% increase in our existing variable interestrates would increase our annual interest expense by approximately $0.1 million.

***ForeignCurrency Risk***

We are exposed to unfavorable fluctuations of the U.S.dollar (our functional currency) against the currencies of our operatingsubsidiaries. Any increase (decrease) in the value of the U.S. dollaragainst any foreign currency that is the functional currency of one of ouroperating subsidiaries will cause the parent company to experience unrealizedforeign currency translation losses (gains) with respect to amountsalready invested in such foreign currencies. In addition, we and our operating subsidiaries are exposed to foreigncurrency risk to the extent that we enter into transactions denominated incurrencies other than our respective functional currencies, such as accountsreceivable (including intercompany amounts) that are denominated in a currencyother than their own functional currency. Changes in exchange rates withrespect to these items will result in unrealized (based upon period-endexchange rates) or realized foreign currency transaction gains and losses uponsettlement of the transactions. In addition, we are exposed to foreign exchangerate fluctuations related to our operating subsidiaries’ monetary assets andliabilities and the financial results of foreign subsidiaries and affiliateswhen their respective financial statements are translated into U.S. dollars forinclusion in our consolidated financial statements. Cumulative translationadjustments are recorded in accumulated other comprehensive income(loss) as a separate component of equity. As a result of foreign currencyrisk, we may experience economic loss and a negative impact on earnings andequity with respect to our holdings solely as a result of foreign currencyexchange rate fluctuations.

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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:     | ** ** | **September 30,  2006** | ** ** | **December 31, 2005** | ** ** |
|----------------------|------------|------------------------------|------------|---------------------------------|------------|
| Great British  Pound |       | 0.53412                      |       | 0.58126                         |       |
| Indian Rupee         |       | 45.80852                     |       | 45.04505                        |       |

 

|                         | ** ** | **Three months ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|
| **Average rates:** | ** ** | **September 30,  2006**     | ** ** | **September 30,  2005** | ** ** |
| Great British  Pound    |       | 0.53356                          |       | 0.56025 |   |
| Indian Rupee            |       | 46.24360                         |       | 43.98893 |   |

 

At the present time, we do not hedgeour foreign currency exposure or use derivative financial instruments that aredesigned to reduce our long-term exposure to foreign currency exchange risk. To the extent that translation and transaction gain and losses becomesignificant, we will consider various options to reduce this risk.

**Item4.  Controls and Procedures**

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

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

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

*Changes in internal control over financial reporting. *During the three and nine months ended September 30,2006, there were no changes in our internal controls over financial reportingor in other factors that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

**PART II — OTHER INFORMATION**

**Item 1. Legal Proceedings**

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

**Item1A.  Risk Factors**

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

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

The communicationsindustry has experienced and continues to experience significant consolidation,both in the United States and internationally. These consolidations are causing our existing and potential customers tore-evaluate their OSS solutions and their capital expenditures.  The result of such consolidations may befewer potential customers requiring OSS solutions as well as 

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combining companieschoosing a competitive OSS solution used by one of the combiningcompanies.  In addition, largercommunications companies generally have stronger purchasing power, which canresult in reduced prices for our products, lower margins on our products andlonger sales cycles.  Because of theuncertainty resulting from these consolidations and the variations in ourquarterly operating results, it is extremely difficult for us to forecast ourquarterly and annual revenue and we have discontinued providing revenueguidance.  All of these factors can havea negative impact on our financial performance, particularly in any fiscalquarter.  This negative impact, in turn,could result in noncompliance with certain financial covenants governing oursenior secured notes.  We successfullyamended our covenants effective June 30, 2006. However, if we were unsuccessful in amending the agreements or obtaininga waiver from our senior lender in future reporting periods, these violations couldresult in such notes becoming immediately due and payable.  We can give no assurance that we would besuccessful in amending the agreements or obtaining a waiver of any covenantviolation.

***Risk Related to Continued NASDAQListing***

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

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

**Item2.  Changes in Securities**

None

**Item 3.  Defaultson Senior Securities**

None

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

None

**Item 5. Other Information**

None

**Item6.  Exhibits**

(a)   Exhibits

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

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

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

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

 

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**SIGNATURE**

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

 
| Date: November 13, 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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