**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, 2007**

 

**OR**
| ** ** | ** ** | ** **                                                                                              |
|------------|------------|---------------------------------------------------------------------------------------------------------|
| **o**      | ** ** | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |
|       |       |                                                                                                    |

**For the transition periodfrom               to               **

 

**Commission File Number: 0-24081**

**EVOLVING SYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                    | **84-1010843**                        |
|-----------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) | (I.R.S. Employer  Identification No.) |

 

| **9777 Pyramid Court, Suite 100 Englewood,  Colorado** | **80112**  |
|-------------------------------------------------------------|------------|
| (Address of principal executive offices)                    | (Zip Code) |
|                                                        |       |

**(303) 802-1000**

(Registrant’s telephonenumber, 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 of October 31, 2007 there were 17,777,270 sharesoutstanding of Registrant’s Common Stock (par value $0.001 per share).

 

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**EVOLVING SYSTEMS, INC.**

**Quarterly Report on Form 10-Q**

**September 30, 2007**

**Table of Contents**

 

 
| **PART I  — FINANCIAL INFORMATION**   |
|--------------------------------------------|
| Item 1                                     |   | Financial Statements |
|                                       |   | Condensed  Consolidated Balance Sheets as of September 30, 2007 and December 31, 2006  (Unaudited) |
|                                       |   | Condensed  Consolidated Statements of Operations for the Three and Nine Months Ended  September 30, 2007 and 2006 (Unaudited) |
|                                       |   | Condensed  Consolidated Statements of Changes In Stockholders’ Equity and Comprehensive  Income for the Nine Months Ended September 30, 2007 (Unaudited) |
|                                       |   | Condensed Consolidated  Statements of Cash Flows for the Nine Months Ended September 30, 2007 and  2006 (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**

**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                                  | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                                                                                                  | ** ** | ** **              | ** ** | ** **             | ** ** |
| Current assets:                                                                                                                                                                                             |       |                    |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                                                  |       | $                       | 7,607      |                   | $          | 5,076 |   |
| Current portion  of restricted cash                                                                                                                                                                         |       | —                  |       | 300                    |       |
| Contract  receivables, net of allowance of $72 at September 30, 2007 and $70 at  December 31, 2006                                                                                                          |       | 4,940                   |       | 9,206                  |       |
| Unbilled  work-in-progress                                                                                                                                                                                  |       | 2,253                   |       | 1,064                  |       |
| Deferred foreign  income taxes                                                                                                                                                                              |       | —                  |       | 15                     |       |
| Prepaid and  other current assets                                                                                                                                                                           |       | 1,384                   |       | 1,686                  |       |
| Total current  assets                                                                                                                                                                                       |       | 16,184                  |       | 17,347                 |       |
| Property and  equipment, net                                                                                                                                                                                |       | 1,013                   |       | 1,349                  |       |
| Amortizable  intangible assets, net                                                                                                                                                                         |       | 5,180                   |       | 6,155                  |       |
| Goodwill                                                                                                                                                                                                    |       | 26,931                  |       | 26,027                 |       |
| Long-term  restricted cash                                                                                                                                                                                  |       | 100                     |       | —                 |       |
| Other long-term  assets                                                                                                                                                                                     |       | 343                     |       | 460                    |       |
| Total assets                                                                                                                                                                                                |       | $                       | 49,751     |                   | $          | 51,338 |   |
|                                                                                                                                                                                                        |       |                    |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                               | ** ** | ** **              | ** ** | ** **             | ** ** |
| Current  liabilities:                                                                                                                                                                                       |       |                    |       |                   |       |
| Current portion  of capital lease obligations                                                                                                                                                               |       | $                       | 19         |                   | $          | 37 |   |
| Current portion  of long-term debt                                                                                                                                                                          |       | 2,375                   |       | 2,000                  |       |
| Accounts payable  and accrued liabilities                                                                                                                                                                   |       | 4,746                   |       | 4,428                  |       |
| Deferred foreign  income taxes                                                                                                                                                                              |       | 52                      |       | —                 |       |
| Unearned revenue                                                                                                                                                                                            |       | 7,137                   |       | 10,079                 |       |
| Total current  liabilities                                                                                                                                                                                  |       | 14,329                  |       | 16,544                 |       |
| Long-term  liabilities:                                                                                                                                                                                     |       |                    |       |                   |       |
| Capital lease  obligations, net of current portion                                                                                                                                                          |       | 85                      |       | 34                     |       |
| Other long-term  obligations                                                                                                                                                                                |       | 1,281                   |       | 749                    |       |
| Long-term debt,  net of current portion                                                                                                                                                                     |       | 9,311                   |       | 11,370                 |       |
| Deferred foreign  income taxes                                                                                                                                                                              |       | 1,052                   |       | 1,202                  |       |
| Total  liabilities                                                                                                                                                                                          |       | 26,058                  |       | 29,899                 |       |
|                                                                                                                                                                                                        |       |                    |       |                   |       |
| Commitments and  contingencies (Note 10)                                                                                                                                                                    |       |                    |       |                   |       |
|                                                                                                                                                                                                        |       |                    |       |                   |       |
| Series B  convertible redeemable preferred stock                                                                                                                                                            |       | 5,892                   |       | 11,281                 |       |
|                                                                                                                                                                                                        |       |                    |       |                   |       |
| Stockholders’  equity:                                                                                                                                                                                 |       |                    |       |                   |       |
| Preferred stock,  $0.001 par value; 2,000,000 shares authorized; 504,915 and 966,666 shares of  Series B issued and outstanding as of September 30, 2007 and December 31,  2006, respectively (shown above) |       | —                  |       | —                 |       |
| Common stock,  $0.001 par value; 40,000,000 shares authorized; 17,685,969 and 16,233,646  shares issued and outstanding as of September 30, 2007 and December 31, 2006,  respectively                       |       | 18                      |       | 16                     |       |
| Additional  paid-in capital                                                                                                                                                                                 |       | 74,826                  |       | 68,825                 |       |
| Accumulated  other comprehensive income                                                                                                                                                                     |       | 2,792                   |       | 1,466                  |       |
| Accumulated  deficit                                                                                                                                                                                        |       | (59,835                 | )          | (60,149                | )          |
| Total  stockholders’ equity                                                                                                                                                                            |       | 17,801                  |       | 10,158                 |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                            |       | $                       | 49,751     |                   | $          | 51,338 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| **REVENUE**                                                                  | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and  services                                                   |       | $                                     | 4,692      |                                 | $          | 3,990 |   | $ | 13,425 |   | $ | 11,855 |   |
| Customer support                                                             |       | 4,619                                 |       | 4,677                                |       | 13,468 |   | 13,180 |   |
| Total revenue                                                                |       | 9,311                                 |       | 8,667                                |       | 26,893 |   | 25,035 |   |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                                 | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Costs of license  fees and services, excluding depreciation and amortization |       | 2,097                                 |       | 1,991                                |       | 5,962 |   | 5,523 |   |
| Costs of  customer support, excluding depreciation and amortization          |       | 1,532                                 |       | 1,235                                |       | 4,741 |   | 4,412 |   |
| Sales and  marketing                                                         |       | 2,003                                 |       | 2,123                                |       | 6,228 |   | 6,919 |   |
| General and  administrative                                                  |       | 1,350                                 |       | 1,171                                |       | 4,549 |   | 3,959 |   |
| Product  development                                                         |       | 665                                   |       | 848                                  |       | 1,572 |   | 2,394 |   |
| Depreciation                                                                 |       | 189                                   |       | 285                                  |       | 729 |   | 861 |   |
| Amortization                                                                 |       | 396                                   |       | 336                                  |       | 1,176 |   | 2,126 |   |
| Impairment of  goodwill and intangible assets                                |       | —                                |       | —                               |       | — |   | 16,516 |   |
| Restructuring  and other expense (recovery)                                  |       | —                                |       | —                               |       | (1 | ) | (23 | ) |
| Total costs of  revenue and operating expenses                               |       | 8,232                                 |       | 7,989                                |       | 24,956 |   | 42,687 |   |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Income (loss)  from operations                                               |       | 1,079                                 |       | 678                                  |       | 1,937 |   | (17,652 | ) |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Other income  (expense):                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Interest income                                                              |       | 86                                    |       | 46                                   |       | 231 |   | 120 |   |
| Interest expense                                                             |       | (419                                  | )          | (498                                 | )          | (1,334 | ) | (1,503 | ) |
| Gain on  extinguishment of debt                                              |       | —                                |       | —                               |       | 42 |   | — |   |
| Foreign currency  exchange gain (loss)                                       |       | 168                                   |       | (8                                   | )          | 7 |   | (38 | ) |
| Other expense,  net                                                          |       | (165                                  | )          | (460                                 | )          | (1,054 | ) | (1,421 | ) |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Income (loss)  before income taxes                                           |       | 914                                   |       | 218                                  |       | 883 |   | (19,073 | ) |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Income tax  expense (benefit)                                                |       | 345                                   |       | 176                                  |       | 569 |   | (1,278 | ) |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Net income  (loss)                                                           |       | $                                     | 569        |                                 | $          | 42 |   | $ | 314 |   | $ | (17,795 | ) |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Basic and  diluted income (loss) per common share                            |       | $                                     | 0.03       |                                 | $          | 0.00 |   | $ | 0.02 |   | $ | (0.93 | ) |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average  basic shares outstanding                                   |       | 19,201                                |       | 19,112                               |       | 19,178 |   | 19,089 |   |
| Weighted average  diluted shares outstanding                                 |       | 19,550                                |       | 19,310                               |       | 19,546 |   | 19,089 |   |

 

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

 

4

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**EVOLVINGSYSTEMS, INC.**

** CONDENSED CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’EQUITY**

**ANDCOMPREHENSIVE INCOME**

**(inthousands, except share data)**

**(unaudited)**

 
| ** **                                                        | ** ** | ** **        | ** ** | ** ** | ** ** | **Additional  Paid-in**

**Capital** | ** ** | **Accumulated  Other**

**Comprehensive**

**Income** | ** ** | ** ** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|-------------------------------------------------------------------|------------|-------------------|------------|------------|------------|--------------------------------------|------------|-------------------------------------------------------|------------|------------|------------|---------------------------------------|------------|
| ** **                                                        | ** ** | ** **        | ** ** | ** ** | ** ** | ** **                           | ** ** | ** **                                            | ** ** | ** ** |
| ** **                                                        | ** ** | **Common  Stock** | ** ** | ** ** | ** ** | **Accumulated**

**Deficit**         | ** ** | ** **                                            |
| ** **                                                        | ** ** | **Shares**        | ** ** | **Amount** | ** ** | ** **                           | ** ** | ** **                                            | ** ** |
| **Balance  at December 31, 2006**                                 |       | 16,233,646        |       | $          | 16         |                                 | $          | 68,825                                                |       | $          | 1,466      |                                  | $          | (60,149 | ) | $ | 10,158 |   |
| Stock option  exercises                                           |       | 19,688            |       | —     |       | 19                                   |       | —                                                |       | —     |       | 19                                    |       |
| Common stock  issued pursuant to the Employee Stock Purchase Plan |       | 47,382            |       | 1          |       | 51                                   |       | —                                                |       | —     |       | 52                                    |       |
| Stock-based  compensation expense                                 |       | —            |       | —     |       | 543                                  |       | —                                                |       | —     |       | 543                                   |       |
| Preferred stock  conversion                                       |       | 1,385,253         |       | 1          |       | 5,388                                |       | —                                                |       | —     |       | 5,389                                 |       |
| Comprehensive  income:                                            |       |              |       |       |       |                                 |       |                                                  |       |       |       |                                  |       |
| Net income                                                        |       | —            |       | —     |       | —                               |       | —                                                |       | 314        |       |                                  |       |
| Foreign currency  translation adjustment                          |       | —            |       | —     |       | —                               |       | 1,326                                                 |       | —     |       |                                  |       |
| Comprehensive  income                                             |       |              |       |       |       |                                 |       |                                                  |       |       |       | 1,640                                 |       |
| **Balance  at September 30, 2007**                                |       | 17,685,969        |       | $          | 18         |                                 | $          | 74,826                                                |       | $          | 2,792      |                                  | $          | (59,835 | ) | $ | 17,801 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                                | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2007**                                       | ** ** | **2006** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                |       |                                           |       |   |   |
| Net income  (loss)                                                                        |       | $                                              | 314        |   | $ | (17,795 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                                           |       |   |   |
| Depreciation                                                                              |       | 729                                            |       | 861 |   |
| Amortization of  intangible assets                                                        |       | 1,176                                          |       | 2,126 |   |
| Amortization of  debt issuance costs                                                      |       | 181                                            |       | 204 |   |
| Stock-based  compensation                                                                 |       | 543                                            |       | 625 |   |
| Impairment of  goodwill and intangible assets                                             |       | —                                         |       | 16,516 |   |
| Gain on disposal  of property and equipment                                               |       | (1                                             | )          | (20 | ) |
| Gain on  extinguishment of debt                                                           |       | (42                                            | )          | — |   |
| Foreign currency  transaction (gains) losses, net                                         |       | (7                                             | )          | 38 |   |
| Benefit from  foreign deferred income taxes                                               |       | (132                                           | )          | (1,810 | ) |
| Change in  operating assets and liabilities:                                              |       |                                           |       |   |   |
| Contract  receivables                                                                     |       | 4,616                                          |       | 5,211 |   |
| Unbilled  work-in-progress                                                                |       | (1,118                                         | )          | (89 | ) |
| Prepaid and  other current assets                                                         |       | 299                                            |       | (143 | ) |
| Accounts payable  and accrued liabilities                                                 |       | 358                                            |       | (756 | ) |
| Unearned revenue                                                                          |       | (3,035                                         | )          | (2,396 | ) |
| Other                                                                                     |       | 532                                            |       | 171 |   |
| Net cash  provided by operating activities                                                |       | 4,413                                          |       | 2,743 |   |
|                                                                                      |       |                                           |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                |       |                                           |       |   |   |
| Purchases of  property and equipment                                                      |       | (445                                           | )          | (397 | ) |
| Proceeds from  sale of property and equipment                                             |       | 1                                              |       | 20 |   |
| Earnout payments  from business combinations                                              |       | (24                                            | )          | (153 | ) |
| Reduction in  restricted cash                                                             |       | 200                                            |       | — |   |
| Net cash used in  investing activities                                                    |       | (268                                           | )          | (530 | ) |
|                                                                                      |       |                                           |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                |       |                                           |       |   |   |
| Capital lease  payments                                                                   |       | (16                                            | )          | (26 | ) |
| Principal  payments on long-term debt                                                     |       | (1,641                                         | )          | (1,775 | ) |
| Proceeds from  issuance of common stock                                                   |       | 71                                             |       | 109 |   |
| Net cash used in  financing activities                                                    |       | (1,586                                         | )          | (1,692 | ) |
|                                                                                      |       |                                           |       |   |   |
| Effect of  foreign exchange rate changes on cash                                          |       | (28                                            | )          | 117 |   |
|                                                                                      |       |                                           |       |   |   |
| Net increase in  cash and cash equivalents                                                |       | 2,531                                          |       | 638 |   |
| Cash and cash  equivalents at beginning of period                                         |       | 5,076                                          |       | 3,883 |   |
| Cash and cash  equivalents at end of period                                               |       | $                                              | 7,607      |   | $ | 4,521 |   |
|                                                                                      |       |                                           |       |   |   |
| Supplemental  disclosure of other cash and non-cash transactions:                         |       |                                           |       |   |   |
| Interest paid                                                                             |       | $                                              | 640        |   | $ | 820 |   |
| Income taxes  paid                                                                        |       | $                                              | 79         |   | $ | 569 |   |
| Conversion of  preferred stock into common stock                                          |       | $                                              | 5,389      |   | $ | — |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**NOTE 1 —BASIS OF PRESENTATION**

**Organization—**We are a globalprovider of software solutions and services to the wireless, wireline and IPcarrier market. We maintain long-standing relationships with many of thelargest wireline, wireless and IP communications carriers worldwide. Ourcustomers rely on us to develop, deploy, enhance, maintain and integratecomplex, highly reliable software solutions for a range of Operations SupportSystems (“OSS”).  We offer softwareproducts and solutions in three core areas: service activation solutions used to activate complex bundles ofvoice, video and data services for traditional and next generation wireless andwireline networks; numbering solutions that enable carriers to complywith government-mandated requirements regarding number portability as well asproviding phone number management and assignment capabilities; and mediationsolutions supporting data collection for both service assurance and billingapplications.

**Interim Consolidated Financial Statements** — The accompanying unaudited condensedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (“GAAP”)and in conformity with the instructions to Form 10-Q and Article 10 ofRegulation S-X and the related rules and regulations of the Securities andExchange Commission (“SEC”). Accordingly, certain information and note disclosures normally includedin financial statements prepared in accordance with GAAP have been condensed oromitted pursuant to such rules and regulations. However, we believe thatthe disclosures included in these financial statements are adequate to make theinformation presented not misleading. The unaudited condensed consolidatedfinancial statements included in this document have been prepared on the samebasis as the annual consolidated financial statements, and in our opinion,reflect all adjustments, which include normal recurring adjustments necessaryfor a fair presentation in accordance with GAAP and SEC regulations for interimfinancial statements. The results for the nine months ended September 30, 2007are not necessarily indicative of the results that we will have for anysubsequent period.  These unauditedcondensed consolidated financial statements should be read in conjunction withthe audited consolidated financial statements and the notes to those statementsfor the year ended December 31, 2006 included in our Annual Report on Form10-K.

**Use of Estimates —  **The preparation of financial statements in conformitywith accounting principles generally accepted in the U.S. 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 made estimates with respect to revenuerecognition for estimated hours to complete projects accounted for using thepercentage of completion method, allowance for doubtful accounts, income taxvaluation allowance, fair values of long-lived assets, valuation of intangibleassets and goodwill, useful lives for property, equipment and intangibleassets, business combinations, capitalization of internal software developmentcosts and fair value of stock-based compensation amounts.  Actual results could differ from theseestimates.

**Foreign Currency Translation****—**** **Our functional currency is the U.S. dollar.  The functional currency of our foreignoperations is the respective local currency for each foreign subsidiary.  Assets and liabilities of foreign operationsdenominated in local currencies are translated at the spot rate in effect atthe applicable reporting date.  Ourconsolidated statements of operations are translated at the weighted averagerate of exchange during the applicable period. The resulting unrealized cumulative translation adjustment, net ofapplicable income taxes, is recorded as a component of accumulated othercomprehensive income (loss) in stockholders’ equity.  Realized and unrealized transaction gains andlosses generated by transactions denominated in a currency different from thefunctional currency of the applicable entity are recorded in other income(loss) in the period in which they occur.

**Principles of Consolidation****—**** **The consolidated financial statements include theaccounts of Evolving Systems and subsidiaries, all of which are wholly owned.  All significant intercompany transactions andbalances have been eliminated in consolidation.

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

**Intangible Assets****—**** **Amortizable intangible assets consist primarily ofpurchased software and licenses, customer contracts and relationships,trademark and tradenames, and business partnerships acquired in conjunctionwith our purchases of CMS Communications, Inc. (“CMS”), Telecom SoftwareEnterprises, LLC (“TSE”) and Tertio Telecoms Ltd. (“Evolving Systems U.K.”).  These finite life assets are amortized usingthe straight-line method over their estimated lives.

 

7

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We assess the impairment ofidentifiable intangibles if events or changes in circumstances indicate thatthe carrying value of the asset may not be recoverable. Factors that weconsider significant which could trigger an impairment analysis include, butare not limited to, the following:

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

•                  Significant changesin the manner of use of the acquired assets or the strategy of the overallbusiness;

•                  Significant negativeindustry or economic trends; and/or

•                  Significant declinein our stock price for a sustained period.

If, as a result of the existenceof any indicators of impairment, we determine that the carrying value ofintangibles and/or long-lived assets may not be recoverable, we compare theestimated undiscounted cash flows expected to result from the use of the assetand its eventual disposition to the asset’s carrying amount. If an amortizableintangible or long-lived asset is not deemed to be recoverable, we willrecognize an impairment loss representing the excess of the asset’s carryingvalue over its estimated fair value.

**RevenueRecognition****—  **We recognize revenue from two primary sources: licensefees and services, and customer support, in accordance with Statement ofPosition (“SOP”) 97-2, “Software Revenue Recognition,” as amended andinterpreted by SOP 98-9, “Modification of SOP 97-2, Software RevenueRecognition, 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 generally recognize revenue when an agreement issigned, the fee is fixed or determinable and collectibility is reasonablyassured.

The majority of our license fees and services revenueis generated from fixed-price contracts, which provide for licenses to oursoftware products and services to customize such software to meet our customers’use.   Generally, when the services are determined tobe essential to the functionality of the delivered software, we recognizerevenue using the percentage-of-completion method of accounting, in accordancewith SOP 97-2 and SOP 81-1, “Accounting for Long-Term Construction TypeContracts.”  The percentage of completionfor each contract is estimated based on the ratio of direct labor hoursincurred to total estimated direct labor hours. Since estimated direct labor hours, and changes thereto, can have asignificant impact on revenue recognition, these estimates are critical and arereviewed regularly.  Amounts billed inadvance of services being performed are recorded as unearned revenue. Unbilledwork-in-progress represents revenue earned but not yet billable under the termsof the fixed-price contracts. All such amounts are expected to be billed andcollected within 12 months.

We may encounter budget and schedule overruns onfixed price contracts caused by increased labor or overhead costs. Adjustmentsto cost estimates are made in the periods in which the facts requiring suchrevisions become known. Estimated losses, if any, are recorded in the period inwhich current estimates of total contract revenue and contract costs indicate aloss.

In arrangements where the services are not essentialto the functionality of the software, we recognize license revenue upondelivery.  To the extent thatVendor-Specific Objective Evidence (“VSOE”) of the fair value of undeliveredelements exists, fees from multiple element arrangements are unbundled andrecorded as revenue as the elements are delivered.  If VSOE for the undelivered elements does notexist, fees from such arrangements are deferred until the earlier of the datethat VSOE does exist on the undelivered elements or all of the elements havebeen delivered.

Services revenue from fixed-price contracts isgenerally recognized using the proportional performance method of accounting,which is similar to the percentage of completion method described above.Revenue from professional services provided pursuant to time-and-materialsbased contracts and training services are recognized as the services areperformed, as that is when our obligation to our customers under sucharrangements is fulfilled.

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

**Stock-basedCompensation****—** We account forstock-based compensation under Statement of Financial Accounting Standards No.123(Revised), “Share-Based Payment” (“SFAS 123R”).  This statement replaced SFAS No. 123, “Accountingfor Stock-Based Compensation” (“SFAS 123”) and superseded APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  UnderSFAS 123R, we apply a fair-value-based measurement method to account forshare-based payment transactions with employees and directors and recordcompensation cost for all stock awards granted after January 1, 2006 and awardsmodified, repurchased, or cancelled after that date. In addition, we recordcompensation costs associated with the vesting of unvested options outstandingat January 1, 2006 using the guidance under SFAS 123.  Stock-based compensation is a non-cashexpense because we settle these obligations by issuing shares of our commonstock instead of settling such obligations with cash payments.  Compensation cost for options is recognizedon a straight-line basis over the vesting period using an estimated forfeiturerate.   Effective January 1, 2006, stockoption grants and employee stock purchase plan purchases were accounted forunder SFAS 123R.  We used theBlack-Scholes model to estimate the fair value of each option grant on the dateof grant.  This model requires the use ofestimates for expected term of the options and expected volatility of the priceof our common stock.

 

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**Recent Accounting Pronouncements -**In February 2007, the FinancialAccounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities - Including an Amendment of FASB Statement No. 115” (“SFAS159”).  SFAS 159 permits entities tochoose to measure eligible items at fair value at specific election dates (the ‘‘fairvalue option’’). Unrealized gains and losses on items for which the fair valueoption has been elected shall be reported in earnings at each subsequentreporting period. This accounting standard is effective for us beginningJanuary 1, 2008. We are currently assessing the impact of SFAS 159.

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes aframework for measuring fair value under generally accepted accountingprinciples, and expands disclosures about fair value measurements. SFAS 157 iseffective for financial statements issued for fiscal years and interim periodsbeginning after November 15, 2007. We have not completed our evaluation of theimpact of this standard on our consolidated financial statements or our futureestimates of fair value.

**NOTE 2 —GOODWILL AND INTANGIBLE ASSETS**

We recorded goodwill as a resultof three acquisitions which occurred over the period from November 2003 toNovember 2004. We acquired CMS in November 2003, TSE in October 2004 andEvolving Systems U.K. in November 2004.

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

 
| ** **                                             | ** ** | **License and Services** | ** ** | **Customer Support** | ** ** | **Total**

**Goodwill** | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|----------------------|------------|-------------------------|------------|
| ** **                                             | ** ** | **U.S.**                 | ** ** | **U.K.**             | ** ** | **U.S.**                | ** ** | **U.K.** | ** ** | ** ** |
| Balance as of  December 31, 2006                       |       | $                        | —     |                 | $          | 8,944                   |       | $ | 6,033 |   | $ | 11,050 |   | $ | 26,027 |   |
| Effects of  changes in foreign currency exchange rates |       | —                   |       | 404                  |       | —                  |       | 500 |   | 904 |   |
| Balance as of  September 30, 2007                      |       | $                        | —     |                 | $          | 9,348                   |       | $ | 6,033 |   | $ | 11,550 |   | $ | 26,931 |   |

 

Weconducted our annual goodwill impairment test as of July 31, 2007, and wedetermined that goodwill was not impaired as of the test date.  From July 31, 2007 through September 30,2007, no events have occurred that we believe may have impaired goodwill.

Identifiableintangible assets are amortized on a straight-line basis over estimated livesranging from one to seven years and include the cumulative effects of foreigncurrency exchange rates.  As of September30, 2007 and December 31, 2006, identifiable intangibles were as follows (inthousands):

 
| ** **                 | ** ** | **September 30, 2007** | ** ** | **December 31, 2006**         | ** ** | ** **                | ** ** |
|----------------------------|------------|------------------------|------------|-------------------------------|------------|---------------------------|------------|
| ** **                 | ** ** | **Gross  Amount**      | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Weighted-  Average  Amortization  Period** | ** ** |
| Purchased  software        |       | $                      | 2,117      |                          | $          | 597                       |       | $ | 1,520 |   | $ | 2,038 |   | $ | 237 |   | $ | 1,801 |   | 4.7 yrs |   |
| Purchased  licenses        |       | 227                    |       | 121                           |       | 106                       |       | 227 |   | 49 |   | 178 |   | 2.3 yrs |   |
| Trademarks and  tradenames |       | 918                    |       | 164                           |       | 754                       |       | 879 |   | 63 |   | 816 |   | 7.0 yrs |   |
| Business  partnerships     |       | 150                    |       | 38                            |       | 112                       |       | 143 |   | 14 |   | 129 |   | 5.0 yrs |   |
| Customer  relationships    |       | 3,774                  |       | 1,086                         |       | 2,688                     |       | 3,657 |   | 426 |   | 3,231 |   | 5.6 yrs |   |
|                       |       | $                      | 7,186      |                          | $          | 2,006                     |       | $ | 5,180 |   | $ | 6,944 |   | $ | 789 |   | $ | 6,155 |   | 5.4 yrs |   |

 

Amortization expense ofidentifiable intangible assets was $0.4 million and $1.2 million for the threeand nine months ended September 30, 2007, respectively, and $0.3 millionand $2.1 million for the three and nine months ended September 30, 2006.  As Evolving Systems U.K. uses the Great British pound as its functionalcurrency, the amount of future amortization actually recorded will be basedupon exchange rates in effect at that time. Expectedfuture amortization expense related to identifiable intangibles based on ourcarrying amount as of September 30, 2007 was as follows (in thousands):

| **Twelve months ending September 30,** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|
| 2008                                   |       | $          | 1,552      |   |
| 2009                                   |       | 1,003      |       |
| 2010                                   |       | 912        |       |
| 2011                                   |       | 811        |       |
| 2012                                   |       | 516        |       |
| Thereafter                             |       | 386        |       |
|                                   |       | $          | 5,180      |   |

 

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**NOTE 3 — EARNINGS PER COMMONSHARE**

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

 

| ** **                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                          | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Weighted average  common shares outstanding         |       | 17,686                                |       | 16,212                               |       | 17,349 |   | 16,189 |   |
| Participating  securities                           |       | 1,515                                 |       | 2,900                                |       | 1,829 |   | 2,900 |   |
| Basic weighted  average shares outstanding          |       | 19,201                                |       | 19,112                               |       | 19,178 |   | 19,089 |   |
| Effect of  dilutive securities                      |       | 349                                   |       | 198                                  |       | 368 |   | — |   |
| Diluted weighted  average common shares outstanding |       | 19,550                                |       | 19,310                               |       | 19,546 |   | 19,089 |   |

 

Weighted average options to purchase 3.5 million and3.1 million shares of common stock were excluded from the dilutive stockcalculation for the three and nine months ended September 30, 2007,respectively, because their exercise prices were greater than the average fairvalue of our common stock for those periods.

Weighted average options to purchase 1.0 millionshares of common stock were excluded from the dilutive stock calculation forthe nine months ended September 30, 2006 as their effect would have beenanti-dilutive as a result of the net loss for the period.   Weighted average options to purchase 3.6million and 3.2 million shares of common stock were excluded from the dilutivestock calculation for the three and nine months ended September 30, 2006,respectively, because their exercise prices were greater than the average fairvalue of our common stock for those periods.

**NOTE 4 —SHARE-BASED COMPENSATION**

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.  Our statements of operations fromJanuary 1, 2006 forward include charges for stock-based compensation.  We recognized $162,000, or $0.01 per share,and $543,000, or $0.03 per share, of compensation expense in the statement ofoperations for the three and nine months ended September 30, 2007, respectivelywith respect to our stock-based compensation plans.  We recognized $181,000, or $0.01 per share,and $625,000, or $0.03 per share, of compensation expense in the statement ofoperations for the three and nine months ended September 30, 2006, respectivelywith respect to our stock-based compensation plans.  The following table summarizes stock-basedcompensation expenses recorded in the consolidated statements of operations (inthousands):

 

| ** **                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Cost of license  fee and services, excluding depreciation and amortization |       | $                                     | 12         |                                 | $          | 13 |   | $ | 46 |   | $ | 44 |   |
| Cost of customer  support, excluding depreciation and amortization         |       | 1                                     |       | 2                                    |       | — |   | 7 |   |
| Sales and  marketing                                                       |       | 40                                    |       | 39                                   |       | 108 |   | 145 |   |
| General and administrative                                                 |       | 103                                   |       | 115                                  |       | 371 |   | 394 |   |
| Product  development                                                       |       | 6                                     |       | 12                                   |       | 18 |   | 35 |   |
|                                                                       |       | $                                     | 162        |                                 | $          | 181 |   | $ | 543 |   | $ | 625 |   |

 

**StockOption/Incentive Plans**

                In January 1996, our stockholders approved “The Amended andRestated Stock Option Plan” (the “Option Plan”).  Initially, 3,150,000 shares were reserved forissuance 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 

 

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discretion of the Board of Directors, including thevesting provisions of each stock option granted. Options were granted with anexercise price equal to the closing 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.

                InMarch 2007 upon the hiring of our Vice President of World Wide Sales andMarketing, in accordance with NASDAQ Marketplace Rule 4350(i)(1)(a)(iv) the board of directors approved an inducementaward under a stand-alone equity incentive plan.  We granted 100,000 non-qualified options topurchase shares of our common stock at an exercise price equal to the closingprice of our common stock on the date of grant. The options vest over four years and expire ten years from the date ofgrant.

                InJune 2007, our stockholders approved the “2007 Stock Incentive Plan” (the “2007Stock Plan”).  A maximum of 2,000,000shares may be issued under the 2007 Stock Plan. Awards permitted under the 2007 Stock Plan include:  Stock Options, Stock Appreciation Rights,Restricted Stock, Restricted Stock Units, Performance Awards and OtherStock-Based Awards.  Awards issued underthe 2007 Stock Plan are at the discretion of the Board of Directors.  As applicable, awards are granted with anexercise price equal to the closing price of our common stock on the date ofgrant, generally vest over four years and expire no more than ten years fromthe date of grant.

                Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes model.  The Black-Scholesmodel uses four assumptions to calculate the fair value of each optiongrant.  The expected term of shareoptions granted is derived using the simplified method prescribed by the SECStaff Accounting Bulletin 107, “Share-Based Payment.”  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 the stock options.  The expected volatility is based uponhistorical volatility of our common stock over a period equal to the expectedterm of the stock options.  The expecteddividend yield is zero and is based upon historical and anticipated payment ofdividends.  The weighted-averageassumptions used in the fair value calculations are as follows:  

| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected term  (years)   |       | 6.1                                   |       | *                                    |       | 6.2 |   | 6.1 |   |
| Risk-free  interest rate |       | 4.69                                  | %          | *                                    |       | 4.70 | % | 4.35 | % |
| Expected  volatility     |       | 107.18                                | %          | *                                    |       | 107.68 | % | 121.14 | % |
| Expected  dividend yield |       | 0                                     | %          | *                                    |       | 0 | % | 0 | % |

----

*   None granted.

 

The following is a summary of stock option activity underthe three stock incentive plans for the nine months ended September 30, 2007: 

| ** **                                 | ** ** | **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, 2006  |       | 4,058                                  |       | $                                     | 3.14       |                                                        |       |                                            |       |   |
| Options granted                            |       | 255                                    |       | $                                     | 2.03       |                                                        |       |                                            |       |   |
| Less options  forfeited                    |       | (33                                    | )          | $                                     | 2.20       |                                                        |       |                                            |       |   |
| Less options  expired                      |       | (61                                    | )          | $                                     | 3.76       |                                                        |       |                                            |       |   |
| Less options  exercised                    |       | (20                                    | )          | $                                     | 0.98       |                                                        |       |                                            |       |   |
| Options  outstanding at September 30, 2007 |       | 4,199                                  |       | $                                     | 3.08       |                                                        | 5.96       |                                            | $          | 539 |   |
|                                       |       |                                   |       |                                  |       |                                                        |       |                                            |       |
| Options  exercisable at September 30, 2007 |       | 3,372                                  |       | $                                     | 3.31       |                                                        | 5.30       |                                            | $          | 539 |   |

 

                Theweighted-average grant-date fair value of stock options granted during thethree and nine months ended September 30, 2007 was $1.79 and $1.71,respectively.

                Asof September 30, 2007, there were approximately $1.2 million of totalunrecognized compensation costs related to unvested stock options.  These costs are expected to be recognizedover a weighted average period of 1.3 years.

 

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                Thetotal intrinsic value of stock option exercises for the three months endedSeptember 30, 2007 and 2006 was $0 and $1,000, respectively.  The total fair value of stock options vestedduring the three months ended September 30, 2007 and 2006 was $0.2 million and$0.1 million, respectively.

                Thetotal intrinsic value of stock option exercises for the nine months endedSeptember 30, 2007 and 2006 was $23,000 and $14,000, respectively.  The total fair value of stock options vestedduring the nine months ended September 30, 2007 and 2006 was $0.5 million and$0.4 million, respectively.

                Thedeferred income tax benefits from stock option expense related to EvolvingSystems U.K. totaled approximately $10,000 and $7,000 for the three monthsended September 30, 2007 and 2006, respectively.  The deferred income tax benefits from stockoption expense related to Evolving Systems U.K. totaled approximately $30,000and $20,000 for the nine months ended September 30, 2007 and 2006,respectively.

                Cashreceived from stock option exercises for the three months ended September 30,2007 and 2006 was $0 and $1,000, respectively. Cash received from stock option exercises for the nine months endedSeptember 30, 2007 and 2006 was $19,000 and $13,000, respectively.

**                EmployeeStock Purchase Plan**

                Underthe Employee Stock Purchase Plan (“ESPP”), we are authorized to issue up to1,100,000 shares of our common stock to full-time employees, nearly all of whomare eligible to participate. Under the terms of the ESPP, employees may electto have up to 15% of their gross compensation withheld through payrolldeduction to purchase our common stock, capped at $25,000 annually. Thepurchase price of the stock is 85% of the lower of the closing price on thefirst day or the last day of each three-month participation period. As ofSeptember 30, 2007, there were 305,000 shares available for purchase.  For the three and nine months ended September30, 2007, we recorded compensation expense of $6,000 and $17,000, respectively,and for the three and nine months ended September 30, 2006, we recorded compensationexpense of $8,000 and $32,000, respectively, associated with grants under theESPP which includes the fair value of the look-back feature of each grant aswell as the 15% discount on the purchase price. This expense fluctuates each period based upon employee participation.

                Thefair value of each grant made under our ESPP is estimated on the date of grantusing the Black-Scholes model.  TheBlack-Scholes model uses four assumptions to calculate the fair value of eachoption grant.  The expected term of eachgrant is based upon the three-month 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,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **               | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected term  (years)   |       | 0.25                                  |       | 0.25                                 |       | 0.25 |   | 0.25 |   |
| Risk-free  interest rate |       | 3.99                                  | %          | 5.08                                 | %          | 4.73 | % | 5.02 | % |
| Expected  volatility     |       | 64.59                                 | %          | 73.43                                | %          | 68.34 | % | 79.35 | % |
| Expected  dividend yield |       | 0                                     | %          | 0                                    | %          | 0 | % | 0 | % |

                Cash received from employeestock plan purchases for the three months ended September 30, 2007 and 2006 wasapproximately $19,000 and $23,000, respectively.  Cash received from employee stock planpurchases for the nine months ended September 30, 2007 and 2006 wasapproximately $52,000 and $95,000, respectively.

**NOTE 5 — CONCENTRATION OF CREDIT RISK**

For the nine months endedSeptember 30, 2007, two significant customers accounted for 35% (21% and 14%,respectively) of total revenue.  These customers were located in the U.S. andU.K., respectively.  For the nine months endedSeptember 30, 2006, two significant customers accounted for 26% (13% and 13%,respectively) of total revenue.  These customers were located in the U.S. andU.K., respectively.

As of September 30, 2007, two significant customersaccounted for approximately 27% (14% and 13%, respectively) of contractreceivables.  These customers are located inthe U.K. and Chile, respectively.  AtDecember 31, 2006, two significant customers accounted for approximately51% (40% and 11%) of contract receivables. These customers are large telecommunicationsoperators located inthe U.S. and Luxembourg, respectively.

 

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**NOTE 6 —LONG-TERM DEBT**

Notes payable consist ofthe following (in thousands):

| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| Senior note  payable to financial institution, interest at one-month London InterBank  Offered Rate (“LIBOR”) plus a margin of 5.25% at September 30, 2007 and 6.25%  at December 31, 2006; however, the LIBOR rate cannot be less than 3.75%;  interest rate was 10.74% at September 30, 2007 and 11.60% at December 31,  2006, respectively; interest payments are due monthly, principal installments  are due quarterly with final maturity on November 14, 2010. The margin of  6.25% reduced to 5.25% since December 31, 2006 as we met and continue to  maintain certain financial requirements (not met as of December 31, 2006).  The loan is secured by substantially all of our assets and a pledge of the  stock of our subsidiaries. |       | $                       | 4,919      |                   | $          | 6,500 |   |
| $4.5 million  senior revolving credit facility payable to financial institution ($2.5  million availability at September 30, 2007), interest at one-month LIBOR plus  4.0%; however, the LIBOR rate cannot be less than 3.75%; interest rate was  9.49% at September 30, 2007 and 9.35% at December 31, 2006, respectively;  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                   |       | 2,000                  |       |
| Long-term  unsecured subordinated notes payable, interest ranges from 11-14% with a  weighted average rate of 12.82% at September 30, 2007 and 12.84% at December  31, 2006, accrued interest and principal are due in full May 16, 2011.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |       | 4,767                   |       | 4,870                  |       |
| Total notes  payable                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |       | 11,686                  |       | 13,370                 |       |
| Less current  portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |       | (2,375                  | )          | (2,000                 | )          |
| Long-term debt,  excluding current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       | $                       | 9,311      |                   | $          | 11,370 |   |

In accordance withthe terms of our senior note payable agreement, we made an Excess Cash Flowpayment (as defined in the agreement) to our senior lender in the amount of$81,000 during March 2007.

In March 2007, wepaid $77,000 to retire $119,000 of subordinated debt and related accruedinterest held by one of our subordinated note holders.  The retirement included principal of $103,000and accrued interest of $16,000.  The$42,000 gain on extinguishment of this debt was reflected within other income(expense) on the consolidated statement of operations.

The senior notepayable and senior revolving credit facility subject us to certain financialcovenants.  We were in compliance withthese covenants as of September 30, 2007.

**NOTE 7 — INCOME TAXES**

We adopted Financial Accounting Standards Board (“FASB”)Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — AnInterpretation of FASB Statement No. 109” (“FIN 48”) effective January 1,2007.  FIN 48 clarifies the accountingfor uncertainty in income tax benefits recognized in an enterprise’s financialstatements in accordance with SFAS 109.  FIN 48 also prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.  In addition, FIN 48 provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.

Upon adoption of FIN 48, no adjustment to theConsolidated Financial Statements was required. As of the date of adoption, wehad an unrecognized domestic tax benefit of approximately $0.4 million whichdid not change significantly during the nine months ended September 30,2007.  The application of FIN 48 wouldhave resulted in a decrease to retained earnings of $0.4 million, except thatthe decrease was fully offset by the application of a valuation allowance.  In addition, future changes in theunrecognized tax benefit will have no impact on the effective tax rate whilethe valuation allowance exists.  Weexpect that the unrecognized tax benefit will not change significantly withinthe next twelve months.

We file our tax returns as prescribed by U.S. federaltax laws as well as tax laws of various state and foreign jurisdictions inwhich we operate.  We may be subject toexamination by the Internal Revenue Service (“IRS”) for calendar years 2003through 2006 

 

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and HM Revenue andCustoms in the U.K. for calendar years 2005 and 2006.  Additionally, any domestic net operatinglosses that were generated in prior years and utilized in these years may alsobe subject to examination by the IRS.

Effective April 2007, our Indian subsidiary is subjectto a 10% minimum alternative tax.  Thistax did not have a material effect on our results for the three and nine monthsended September 30, 2007 and we do not expect this tax to have a materialimpact on future results.

We recorded income tax expense of $0.3 million and$0.2 million for the three months ended September 30, 2007 and September 30,2006, respectively.  The income taxexpense during the three months ended September 30, 2007 consisted of currentforeign income tax expense of $407,000 and a deferred tax benefit of$62,000.  The $407,000 current foreignincome tax expense is comprised of $398,000 and $9,000 current foreign incometax expense related to our UK-based operations and India-based operations,respectively.  The $62,000 deferred taxbenefit is comprised of a $118,000 deferred tax benefit related to our UK-basedoperations, partially offset by $56,000 of deferred income tax expense in theU.S. related to the estimated non-recoverability of foreign tax withholding dueto the significant net operating loss carryforwards in our U.S. federal andstate jurisdictions.  The income taxbenefit during the three months ended September 30, 2006 consisted of currentforeign income tax expense of $0.2 million related to our UK-based operations.

We recorded income tax expense of $0.6 million for thenine months ended September 30, 2007 and income tax benefit of $1.3 million forthe nine months ended September 30, 2006. The income tax expense during the nine months ended September 30, 2007consisted of current foreign income tax expense of $670,000 and a deferred taxbenefit of $101,000.  The $670,000current foreign income tax expense is comprised of $654,000 and $16,000 currentforeign income tax expense related to our UK-based operations and India-basedoperations, respectively.  The $101,000deferred tax benefit is comprised of a $157,000 deferred tax benefit related toour UK-based operations, partially offset by $56,000 of deferred income taxexpense in the U.S. related to the estimated non-recoverability of foreign taxwithholding due to the significant net operating loss carryforwards in our U.S.federal and state jurisdictions.  Theincome tax benefit during the nine months ended September 30, 2006 consisted ofcurrent foreign income tax expense of $0.5 million and a deferred foreign taxbenefit of $1.8 million both of which are related to our UK-based operations.

In conjunction with the acquisition of EvolvingSystems U.K., we recorded certain identifiable intangible assets.  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, 2007 and December 31, 2006, this deferred tax liability was $1.3 millionand $1.5 million, respectively.  Thisdeferred tax liability relates to Evolving Systems U.K., and has no impact onour ability to recover U.S.-based deferred tax assets.  This deferred tax liability will berecognized as a reduction of deferred income tax expense as the identifiableintangibles are amortized.

As of September 30, 2007 and December 31, 2006,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.

**NOTE 8 — STOCKHOLDERS’ EQUITY**

On March 15, 2007, holders of 441,377 shares of Series BPreferred Stock with a carrying value of $5.1 million, or approximately 46% ofthe outstanding preferred stock, converted their shares of preferred stock into1,324,131 shares of our common stock in accordance with the conversion provisionsof the Series B Preferred Stock.  OnApril 13, 2007, holders of 20,374 shares of Series B Preferred Stock with acarrying value of $0.2 million, or approximately 4% of the outstanding shares,converted their shares of preferred stock into 61,122 shares of our commonstock in accordance with the conversion provisions of the Series B PreferredStock.  As we previously included theSeries B Preferred Stock as a participating security for basic EPS purposes,these conversions did not change our basic or diluted EPS calculations.

**NOTE 9 — 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 our 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 

 

14

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represents the feesreceived from the license of software products and those services directlyrelated to the delivery of the licensed products, as well as fees for customdevelopment, 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 CODM.

Segment information is as follows (in thousands):

| ** **                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended   September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                              | ** ** | **2006**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Revenue**                                                                | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and  services                                                 |       | $                                     | 4,692      |                                  | $          | 3,990 |   | $ | 13,425 |   | $ | 11,855 |   |
| Customer support                                                           |       | 4,619                                 |       | 4,677                                 |       | 13,468 |   | 13,180 |   |
|                                                                       |       | 9,311                                 |       | 8,667                                 |       | 26,893 |   | 25,035 |   |
|                                                                       |       |                                  |       |                                  |       |   |   |   |   |
| **Revenue  less cost of revenue, excluding depreciation and amortization** | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and  services                                                 |       | 2,595                                 |       | 1,999                                 |       | 7,463 |   | 6,332 |   |
| Customer support                                                           |       | 3,087                                 |       | 3,442                                 |       | 8,727 |   | 8,768 |   |
|                                                                       |       | 5,682                                 |       | 5,441                                 |       | 16,190 |   | 15,100 |   |
|                                                                       |       |                                  |       |                                  |       |   |   |   |   |
| **Unallocated  costs**                                                     | ** ** | ** **                            | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other operating  expenses                                                  |       | 4,018                                 |       | 4,142                                 |       | 12,349 |   | 13,272 |   |
| Depreciation and  amortization                                             |       | 585                                   |       | 621                                   |       | 1,905 |   | 2,987 |   |
| Impairment of  goodwill and intangible assets                              |       | —                                |       | —                                |       | — |   | 16,516 |   |
| Restructuring  and other                                                   |       | —                                |       | —                                |       | (1 | ) | (23 | ) |
| Interest income                                                            |       | (86                                   | )          | (46                                   | )          | (231 | ) | (120 | ) |
| Interest expense                                                           |       | 419                                   |       | 498                                   |       | 1,334 |   | 1,503 |   |
| Gain on debt  extinguishment                                               |       | —                                |       | —                                |       | (42 | ) | — |   |
| Foreign currency  exchange loss                                            |       | (168                                  | )          | 8                                     |       | (7 | ) | 38 |   |
| **Income  (loss) before income taxes**                                     |       | $                                     | 914        |                                  | $          | 218 |   | $ | 883 |   | $ | (19,073 | ) |

***Geographic Regions***

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

 

| ** **     | **Three Months Ended September 30,** | ** **  |
|----------------|--------------------------------------|-------------|
| ** **     | ** **                           | **2007**    | ** ** | **2006** | ** ** |
| ** **     | ** **                           | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**    | ** **                           | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| United States  |                                 | $           | 221 |   | $ | 2,772 |   | $ | 2,993 |   | $ | 405 |   | $ | 3,023 |   | $ | 3,428 |   |
| United Kingdom |                                 | 1,868       |   | 654 |   | 2,522 |   | 2,077 |   | 631 |   | 2,708 |   |
| Other          |                                 | 2,603       |   | 1,193 |   | 3,796 |   | 1,508 |   | 1,023 |   | 2,531 |   |
| Total Revenue  |                                 | $           | 4,692 |   | $ | 4,619 |   | $ | 9,311 |   | $ | 3,990 |   | $ | 4,677 |   | $ | 8,667 |   |

 

| ** **     | ** ** | **Nine Months Ended September 30,** |
|----------------|------------|-------------------------------------|
| ** **     | ** ** | **2007**                            | ** ** | **2006** | ** ** |
| ** **     | ** ** | **L&S**                         | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**    | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| United States  |       | $                                   | 1,169 |   | $ | 7,929 |   | $ | 9,098 |   | $ | 1,560 |   | $ | 8,378 |   | $ | 9,938 |   |
| United Kingdom |       | 4,625                               |   | 2,001 |   | 6,626 |   | 4,987 |   | 1,663 |   | 6,650 |   |
| Other          |       | 7,631                               |   | 3,538 |   | 11,169 |   | 5,308 |   | 3,139 |   | 8,447 |   |
| Total Revenue  |       | $                                   | 13,425 |   | $ | 13,468 |   | $ | 26,893 |   | $ | 11,855 |   | $ | 13,180 |   | $ | 25,035 |   |

 

15

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| ** **                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                    | ** ** | **2007**          | ** ** | **2006**         | ** ** |
| **Long-lived  assets, net**   | ** ** | ** **        | ** ** | ** **       | ** ** |
| United States                 |       | $                 | 7,352      |             | $          | 7,986 |   |
| United Kingdom                |       | 25,680            |       | 25,406           |       |
| Other                         |       | 92                |       | 139              |       |
| Total long-lived  assets, net |       | $                 | 33,124     |             | $          | 33,531 |   |

 

Financial information relating to product groupings was as follows (inthousands):

 

| ** **           | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended   September 30,** | ** ** |
|----------------------|---------------------------------------|------------|---------------------------------------|------------|
| **Revenue**          | ** **                            | **2007**   | ** **                            | **2006**   | ** ** | **2007** | ** ** | **2006** | ** ** |
| Activation           |                                  | $          | 5,309                                 |       | $ | 3,997 |   | $ | 14,787 |   | $ | 12,473 |   |
| Numbering  solutions |                                  | 2,678      |                                  | 2,912      |   | 8,759 |   | 8,243 |   |
| Mediation            |                                  | 1,324      |                                  | 1,758      |   | 3,347 |   | 4,319 |   |
|                 |                                  | $          | 9,311                                 |       | $ | 8,667 |   | $ | 26,893 |   | $ | 25,035 |   |

 

**NOTE 10 — COMMITMENTS ANDCONTINGENCIES**

**(a)****         ****LeaseCommitments**

 

                        During the nine monthsended September 30, 2007, we entered into a lease amendment for ourheadquarters location in Englewood, Colorado. This amendment extended the term of our existing agreement for an additional65 month period, reduced our rentable square footage and reduced our monthlyrent obligation.

 

                        During the nine monthsended September 30, 2007, we also terminated our existing capital leaseagreement for certain assets at our headquarters location and replaced it witha new capital lease agreement.

 

                        Futureminimum commitments at September 30, 2007 under these new agreements are:

** **

| ** **                                          | ** ** | **Operating Leases** | ** ** | **Capital Leases** | ** ** |
|-----------------------------------------------------|------------|----------------------|------------|--------------------|------------|
| 2007                                                |       | $                    | 78         |               | $          | 8 |   |
| 2008                                                |       | 470                  |       | 30                 |       |
| 2009                                                |       | 482                  |       | 30                 |       |
| 2010                                                |       | 494                  |       | 30                 |       |
| 2011                                                |       | 506                  |       | 30                 |       |
| Thereafter                                          |       | 430                  |       | 11                 |       |
| Total minimum  lease payments                       |       | $                    | 2,460      |               | 139        |   |
| Less: Amount  representing interest                 |       |                 |       | (35                | )          |
| Principal  balance of capital lease obligations     |       |                 |       | 104                |       |
| Less: Current  portion of capital lease obligations |       |                 |       | (19                | )          |
| Long-term portion  of capital lease obligations     |       |                 |       | $                  | 85         |   |

 

There have been no other material changes to thecontractual obligations as disclosed in our 2006 Annual Report on Form 10-K.

**(b)****            ****OtherCommitments**

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 LiabilityInsurance Policy, that may enable us to recover a portion of any amounts paid.As a result of our insurance policy coverage, we believe the estimated fairvalue of these indemnification agreements is minimal. Accordingly, there wereno liabilities recorded for these agreements as of September 30, 2007 and December 31,2006.

 

16

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From time to time, we enter into standardindemnification terms with customers and suppliers, in the ordinary course ofbusiness.  As we may subcontract thedevelopment of deliverables under customer contracts, we could be required toindemnify customers for work performed by subcontractors. Depending upon thenature of the customer indemnification, the potential amount of future paymentswe could be required to make under these indemnification agreements may beunlimited. We may be able to recover damages from a subcontractor if theindemnification to customers results from the subcontractor’s failure toperform. To the extent we are unable to recover damages from a subcontractor,we could be required to reimburse the indemnified party for the full amount. Wehave never incurred costs to defend lawsuits or settle claims relating toindemnification arising out of subcontractors’ failure to perform. As a result,we believe the estimated fair value of these agreements is minimal.Accordingly, there were no liabilities recorded for these agreements as ofSeptember 30, 2007 and December 31, 2006.

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, 2007 andDecember 31, 2006.

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, 2007 and December 31, 2006.

In relation to the acquisitions of Evolving SystemsU.K., TSE and CMS, we agreed to indemnify certain parties from any losses,actions, claims, damages or liabilities (or actions in respect thereof)resulting from any claim raised by a third party.  We do not believe that there will be any claimsrelated to these indemnifications. Accordingly, there were no liabilitiesrecorded for these agreements as of September 30, 2007 and December 31,2006.

During the fourth quarter of2006, a previous software vendor filed a complaint in the Superior Court of NewJersey against us asserting we breached certain provisions of a licenseagreement.  While the outcome of thismatter is uncertain, we believe we have paid all fees due under our licenseagreement and we are vigorously defending this claim.

We are involved in various otherlegal matters arising in the normal course of business.  Losses, including estimated costs to defend,are recorded for these matters to the extent they were probable of loss and theamount of loss could be reasonably estimated.

**NOTE 11 — SUBSEQUENT EVENT**

On October 1, 2007, a holder of 26,165 shares of Series BPreferred Stock with a carrying value of $0.3 million, or approximately 5% ofthe outstanding shares at September 30, 2007, converted his shares of preferredstock into 78,495 shares of our common stock in accordance with the conversionprovisions of the Series B Preferred Stock. Because we previously included the Series B Preferred Stock as aparticipating security for basic EPS purposes, this conversion did not change ourbasic or diluted EPS calculations.

 

17

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**ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**SPECIAL NOTE ABOUT FORWARD-LOOKINGSTATEMENTS**

*This Quarterly Report on Form 10-Q containsforward-looking statements that have been made pursuant to the provisions ofthe Private Securities Litigation Reform Act of 1995.  These forward-looking statements are based oncurrent expectations, estimates, and projections about Evolving Systems’industry, management’s beliefs, and certain assumptions made by management.  Forward-looking statements include ourexpectations regarding product, services, and maintenance revenue, annualsavings associated with the organizational changes effected in prior years, andshort- and long-term cash needs.  In somecases, words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “estimates,”variations of these words, and similar expressions are intended to identifyforward-looking statements.  Thestatements are not guarantees of future performance and are subject to certainrisks, uncertainties, and assumptions that are difficult to predict; therefore,actual results may differ materially from those expressed or forecasted in anyforward-looking statements.  Risks anduncertainties of our business include those set forth in our Annual Report onForm 10-K for the year ended December 31, 2006 under “Item 1A. Risk Factors” aswell as additional risks described in this Form 10-Q.  Unless required by law, we undertake noobligation to update publicly any forward-looking statements, whether as aresult of new information, future events, or otherwise.  However, readers should carefully review therisk factors set forth in other reports or documents we file from time to timewith the Securities and Exchange Commission, particularly the Quarterly Reportson Form 10-Q and any Current Reports on Form 8-K.*

 

**OVERVIEW**

We are a provider of software solutions and servicesto the wireless, wireline and IP carrier market. We maintain long-standingrelationships with many of the largest wireline, wireless and IP communicationscarriers worldwide. Our customers rely on us to develop, deploy, enhance,maintain and integrate complex, highly reliable software solutions for a rangeof Operations Support Systems (“OSS”). Our activation solution is a leading packaged solution for serviceactivation in the wireless industry.

We recognize revenue inaccordance with the prescribed accounting standards for software revenuerecognition under generally accepted accounting principles.  Our license fees and services revenuesfluctuate from period to period as a result of the timing of revenuerecognition on existing projects.

 

18

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**RESULTS OF OPERATIONS**

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

 
| ** **                                                                   | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                             | ** ** | **2006**                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| **REVENUE**                                                                  | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and  services                                                   |       | 50                                   | %          | 46                                  | %          | 50 | % | 47 | % |
| Customer support                                                             |       | 50                                   | %          | 54                                  | %          | 50 | % | 53 | % |
| Total revenue                                                                |       | 100                                  | %          | 100                                 | %          | 100 |   | 100 | %  |
|                                                                         |       |                                 |       |                                |       |   |   |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                                 | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Costs of license  fees and services, excluding depreciation and amortization |       | 23                                   | %          | 23                                  | %          | 22 | % | 22 | % |
| Costs of  customer support, excluding depreciation and amortization          |       | 16                                   | %          | 14                                  | %          | 18 | % | 18 | % |
| Sales and  marketing                                                         |       | 22                                   | %          | 25                                  | %          | 23 | % | 27 | % |
| General and  administrative                                                  |       | 14                                   | %          | 14                                  | %          | 17 | % | 16 | % |
| Product  development                                                         |       | 7                                    | %          | 10                                  | %          | 6 | % | 10 | % |
| Depreciation                                                                 |       | 2                                    | %          | 3                                   | %          | 3 | % | 3 | % |
| Amortization                                                                 |       | 4                                    | %          | 4                                   | %          | 4 | % | 9 | % |
| Impairment of  goodwill and intangible assets                                |       | —                               | %          | —-                             | %          | — | % | 66 | % |
| Restructuring  and other                                                     |       | —                               | %          | —                              | %          | — | % | — | % |
| Total costs of  revenue and operating expenses                               |       | 88                                   | %          | 93                                  | %          | 93 | % | 171 | % |
|                                                                         |       |                                 |       |                                |       |   |   |   |   |
| Income (loss)  from operations                                               |       | 12                                   | %          | 7                                   | %          | 7 | % | (71 | )% |
|                                                                         |       |                                 |       |                                |       |   |   |   |   |
| Interest income                                                              |       | 1                                    | %          | 1                                   | %          | 1 | % | 1 | % |
| Interest expense                                                             |       | (5                                   | )%         | (6                                  | )%         | (5 | )% | (6 | )% |
| Gain on debt  extinguishment                                                 |       | —                               | %          | —                              | %          | — | % | — | % |
| Foreign currency  exchange loss                                              |       | 2                                    | %          | —                              | %          | — | % | — | % |
| Other expense,  net                                                          |       | (2                                   | )%         | (5                                  | )%         | (4 | )% | (5 | )% |
|                                                                         |       |                                 |       |                                |       |   |   |   |   |
| Income (loss)  before income taxes                                           |       | 10                                   | %          | 2                                   | %          | 3 | % | (76 | )% |
|                                                                         |       |                                 |       |                                |       |   |   |   |   |
| Income tax  expense (benefit)                                                |       | 4                                    | %          | 2                                   | %          | 2 | % | (5 | )% |
|                                                                         |       |                                 |       |                                |       |   |   |   |   |
| Net income  (loss)                                                           |       | 6                                    | %          | 0                                   | %          | 1 | % | (71 | )% |

 

***Revenue***

Revenueis comprised of license fees/services and customer support.  License fees and services revenue representthe fees we receive from the licensing of our software products and thoseservices directly related to the delivery of the licensed product as well asintegration services and time and materials work.  Customer support revenue includesannual support, recurring maintenance, maintenance upgrades and warrantyservices.  Warranty services consist ofmaintenance services and are typically bundled with a license sale and therelated revenue, based on Vendor-Specific Objective Evidence (VSOE), isdeferred 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,** | ** ** |
|----------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **           | ** ** | **2007**                              | ** ** | **2006**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Activation           |       | $                                     | 5,309      |                                 | $          | 3,997 |   | $ | 14,787 |   | $ | 12,473 |   |
| Numbering  solutions |       | 2,678                                 |       | 2,912                                |       | 8,759 |   | 8,243 |   |
| Mediation            |       | 1,324                                 |       | 1,758                                |       | 3,347 |   | 4,319 |   |
|                 |       | $                                     | 9,311      |                                 | $          | 8,667 |   | $ | 26,893 |   | $ | 25,035 |   |

 

19

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**License Feesand Services**

License fees and services revenue increased 18%, or$0.7 million, to $4.7 million for the three months ended September 30, 2007from $4.0 million for the three months ended September 30, 2006.  This increase in license fees and services revenuewas composed of an increase of $1.2 million in revenue from our activationproducts, reflecting our selling efforts in emerging international markets andfollow on sales from our existing account base, offset by a decrease of $0.5million in revenue from our mediation products, reflecting lower revenue fromour existing account base.

License fees and services revenue increased 13%, or$1.6 million, to $13.4 million for the nine months ended September 30, 2007from $11.9 million for the nine months ended September 30, 2006.  This increase in license fees and servicesrevenue was composed of an increase of $1.8 million in revenue from ouractivation products and an increase of $1.0 million in revenue from our numberingsolutions products offset by a decrease of $1.2 million in revenue from ourmediation products.  This growth is dueto our expansion into new international markets for both activation and numbersolutions (NumeriTrack®), follow on sales from our existing activation accountbase, partially offset by lower revenue from our existing mediation accountbase.

**Customer Support**

Customer support revenue decreased $0.1 million, or1%, to $4.6 million for the three months ended September 30, 2007 from $4.7million for the three months ended September 30, 2006.  The decrease in customer support revenueresulted from a decrease of $0.2 million in our numbering solutions customersupport revenue offset by an increase of $0.1 million in activation customersupport revenue.  The increase inactivation customer support revenue was a result of our increased installed base. The decrease in numbering solutions customer support revenue was due toone of our products reaching its end of life.

Customer support revenue increased $0.3 million, or2%, to $13.5 million for the nine months ended September 30, 2007 from $13.2million for the nine months ended September 30, 2006.  The increase in customer support revenueresulted from an increase of $0.5 million in our activation products and anincrease of $0.2 million in mediation customer support revenue which wereoffset by a decrease of $0.4 million from our numbering solutionsproducts.  The increase in activationcustomer support revenue was a result of ourincreased installed base.  Thedecrease in numbering solutions customer support revenue was due to one of ourproducts reaching its end of life.

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

Costs of revenue, excluding depreciation andamortization, consist primarily of personnel costs and other direct costsassociated with these personnel, facilities costs, cost of third-party softwareand partner commissions.  Costs ofrevenue, excluding depreciation and amortization, were $3.7 million and $3.2million for the three months ended September 30, 2007 and 2006, respectively.Costs of revenue, excluding depreciation and amortization, were $10.7 millionand $9.9 million for the nine months ended September 30, 2007 and 2006,respectively.   These costs are discussedfurther below.

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

Costs of license fees and services, excludingdepreciation and amortization, were $2.1 million and $2.0 million for the threemonths ended September 30, 2007 and 2006, respectively.  The increase in costs is attributed toincreased labor necessary to support the increase in license fees and servicesrevenue.  As a percentage of license feesand services revenue, costs of license fees and services, excludingdepreciation and amortization, decreased to 45% for the three months endedSeptember 30, 2007 from 50% for the three months ended September 30, 2006, dueto incremental revenues growing at a faster rate than incremental costs.

Costs of license fees and services, excludingdepreciation and amortization, were $6.0 million and $5.5 million for the ninemonths ended September 30, 2007 and 2006, respectively.  The increase in costs is attributed toincreased labor necessary to support the increase in license fees and servicesrevenue.  As a percentage of license feesand services revenue, costs of license fees and services, excludingdepreciation and amortization, decreased to 44% for the nine months endedSeptember 30, 2007 from 47% for the nine months ended September 30, 2006, dueto incremental revenues growing at a faster rate than incremental costs.

**Costs ofCustomer Support, Excluding Depreciation and Amortization**

Costs of customer support, excluding depreciation andamortization, increased $0.3 million, or 24%, to $1.5 million for thethree months ended September 30, 2007 from $1.2 million for the threemonths ended September 30, 2006.  As apercentage of customer support revenue, costs of customer support revenue,excluding depreciation and amortization, increased to 33% for the three monthsended September 30, 2007 from 26% for the three months ended September 30,2006.  These increases are due to highersupport costs for recent numbering solutions releases.

Costs of customer support, excluding depreciation andamortization, increased $0.3 million, or 7%, to $4.7 million for the ninemonths ended September 30, 2007 from $4.4 million for the nine months endedSeptember 30, 2006.  As a percentage ofcustomer support revenue, costs of customer support revenue, excluding depreciationand amortization, increased to 35% for the nine months ended September 30, 2007from 33% for the nine months ended September 30, 2006.  These increases are due to higher supportcosts for recent numbering solutions releases.

 

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***Sales and Marketing***

Sales and marketing expenses primarily consist ofcompensation costs, including bonuses and commissions, travel expenses,advertising, marketing and facilities expenses. Sales and marketing expenses decreased $0.1 million, or 6%, to $2.0million for the three months ended September 30, 2007 from $2.1 million for thethree months ended September 30, 2006. As a percentage of total revenue, sales and marketing expenses decreasedto 22% for the three months ended September 30, 2007 from 25% for the threemonths ended September 30, 2006.  Thesedecreases are the result of reduced headcount.

Sales and marketing expenses primarily consist ofcompensation costs, including bonuses and commissions, travel expenses,advertising, marketing and facilities expenses. Sales and marketing expenses decreased $0.7 million, or 10%, to $6.2million for the nine months ended September 30, 2007 from $6.9 million for thenine months ended September 30, 2006.  Asa percentage of total revenue, sales and marketing expenses decreased to 23%for the nine months ended September 30, 2007 from 27% for the nine months endedSeptember 30, 2006.  These decreases arethe result of reduced headcount.

***General and Administrative***

General and administrative expenses consist principallyof employee related costs and professional fees for the following departments:facilities, finance, legal, human resources, and certain executivemanagement.  General and administrativeexpenses increased $0.2 million, or 15%, to $1.4 million from $1.2 million forthe three months ended September 30, 2007 and 2006, respectively.  As a percentage of total revenue, general andadministrative expenses for the three months ended September 30, 2007 and 2006,increased to 15% from 14%, respectively. These increases were a result of increased professional and legal fees.

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 increased $0.6 million, or 15%, to $4.5 million from $3.9million for the nine months ended September 30, 2007 and 2006,respectively.  As a percentage of totalrevenue, general and administrative expenses for the nine months endedSeptember 30, 2007 and 2006, increased to 17% from 16%, respectively.  These increases were a result of increasedprofessional and legal fees, as well as higher incentive compensation earneddue to the improved results from operations.

***Product Development***

Product development expenses consist primarily ofemployee related costs and subcontractor expenses.  Product development expenses decreased $0.2million, or 22%, to $0.6 million from $0.8 million for the three months endedSeptember 30, 2007 and 2006, respectively. As a percentage of revenue, product development expenses for the threemonths ended September 30, 2007 and 2006, decreased to 7% from 10%,respectively.  These decreases were dueto the completion of certain product release enhancements as well as thecompletion of the “internationalization” of our NumeriTrack® product, whichwere under production during the three months ended September 30, 2006.

Product development expenses consist primarily ofemployee related costs and subcontractor expenses.  Product development expenses decreased $0.8million, or 34%, to $1.6 million from $2.4 million for the nine months endedSeptember 30, 2007 and 2006, respectively. As a percentage of revenue, product development expenses for the ninemonths ended September 30, 2007 and 2006, decreased to 6% from 10%,respectively.  These decreases were dueto the completion of certain product release enhancements as well as thecompletion of the “internationalization” of our NumeriTrack® product, whichwere under production during the nine months ended September 30, 2006.

***Amortization***

Amortization expense consists of amortization ofidentifiable intangible assets acquired through our acquisitions of CMS, TSEand Evolving Systems U.K.  Amortizationexpense increased $0.1 million, or 18%, to $0.4 million from $0.3 million forthe three months ended September 30, 2007 and 2006, respectively.  This increase is primarily due to foreigncurrency exchange fluctuations related to the Evolving Systems U.K. acquiredintangibles as they are denominated in Great British Pounds.

  Amortizationexpense consists of amortization of identifiable intangible assets acquiredthrough our acquisitions of CMS, TSE and Evolving Systems U.K.  Amortization expense decreased $0.9 million,or 45%, to $1.2 million from $2.1 million for the nine months ended September30, 2007 and 2006, respectively.  Thisdecrease was primarily the result of the impairment of certain intangible assetsat June 30, 2006.

***Interest Expense***

Interest expense includesinterest expense on our long-term debt and capital lease obligations as well asamortization of debt issuance costs.  Interest expense was $0.4 million and$0.5 million for the three months ended September 30, 2007 and 2006, respectively,and interest expense was $1.3 million and $1.5 million for the nine monthsended September 30, 2007 and 2006, respectively.  These decreases of $0.1 million and $0.2million, for the three and nine months ended September 30, 2007, respectively,were primarily related to reduced levels of debt.

 

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***Gain on Debt Extinguishment***

In March 2007, wepaid $77,000 to retire $119,000 of subordinated debt and related accruedinterest held by one of our subordinated note holders.  The retired debt included principal of$103,000 and accrued interest of $16,000.

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

Foreign currency transaction gains (losses) resultedfrom transactions denominated in a currency other than the functional currencyof the respective subsidiary. We recorded foreign currency transactions gainsof $168,000 and foreign currency transaction losses of $8,000 for the threemonths ended September 30, 2007 and 2006, respectively. We recorded  foreign currency transactions gains of $7,000and foreign currency transaction losses of $38,000 for the nine months endedSeptember 30, 2007 and 2006, respectively. The gains (losses) were generatedprimarily through the remeasurement of certain non-functional currency denominatedfinancial assets and liabilities of our Evolving Systems U.K. subsidiary.

***Income Taxes***

We recorded income tax expense of $0.3 million and$0.2 million for the three months ended September 30, 2007 and September 30,2006, respectively.  The income taxexpense during the three months ended September 30, 2007 consisted of currentforeign income tax expense of $407,000 and a deferred tax benefit of$62,000.  The $407,000 current foreignincome tax expense is comprised of $398,000 and $9,000 current foreign incometax expense related to our UK-based operations and India-based operations,respectively.  The $62,000 deferred taxbenefit is comprised of a $118,000 deferred tax benefit related to our UK-basedoperations, partially offset by $56,000 of deferred income tax expense in theU.S. related to the estimated non-recoverability of foreign tax withholding dueto the significant net operating loss carryforwards in our U.S. federal andstate jurisdictions.  The income taxbenefit during the three months ended September 30, 2006 consisted of currentforeign income tax expense of $0.2 million related to our UK-based operations.

We recorded income tax expense of $0.6 million for thenine months ended September 30, 2007 and income tax benefit of $1.3 million forthe nine months ended September 30, 2006. The income tax expense during the nine months ended September 30, 2007consisted of current foreign income tax expense of $670,000 and a deferred taxbenefit of $101,000.  The $670,000current foreign income tax expense is comprised of $654,000 and $16,000 currentforeign income tax expense related to our UK-based operations and India-basedoperations, respectively.  The $101,000deferred tax benefit is comprised of a $157,000 deferred tax benefit related toour UK-based operations, partially offset by $56,000 of deferred income taxexpense in the U.S. related to the estimated non-recoverability of foreign taxwithholding due to the significant net operating loss carryforwards in our U.S.federal and state jurisdictions.  Theincome tax benefit during the nine months ended September 30, 2006 consisted ofcurrent foreign income tax expense of $0.5 million and a deferred foreign taxbenefit of $1.8 million both of which are related to our UK-based operations.

In conjunction with the acquisition of EvolvingSystems U.K., we recorded certain identifiable intangible assets.  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, 2007 and December 31, 2006, this deferred tax liability was $1.3 millionand $1.5 million, respectively.  Thisdeferred tax liability relates to Evolving Systems U.K., and has no impact onour ability to recover U.S.-based deferred tax assets.  This deferred tax liability will berecognized as a reduction of deferred income tax expense as the identifiableintangibles are amortized.

**FINANCIALCONDITION**

Our working capital position increased $1.1 million to$1.9 million as of September 30, 2007 from $0.8 million as of December 31,2006.  The increase in our workingcapital position is attributable to the decrease in current liabilities,primarily in unearned revenue resulting from ratable revenue recognition onannual maintenance contracts, partially offset by an increase in the currentportion of long-term debt, in accordance with the repayment schedule associatedwith our senior debt.

**CONTRACTUAL OBLIGATIONS**

                        During the nine monthsended September 30, 2007, we entered into a lease amendment for ourheadquarters location in Englewood, Colorado. This amendment extended the term of our existing agreement for anadditional 65 month period, reduced our rentable square footage and reduced ourmonthly rent obligation.

 

                        During the nine monthsended September 30, 2007, we also terminated our existing capital lease agreementfor certain assets at our headquarters location and replaced it with a newcapital lease agreement.

 

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                        Futureminimum commitments at September 30, 2007 under these new agreements are:

** **

| ** **                                          | ** ** | **Operating Leases** | ** ** | **Capital Leases** | ** ** |
|-----------------------------------------------------|------------|----------------------|------------|--------------------|------------|
| 2007                                                |       | $                    | 78         |               | $          | 8 |   |
| 2008                                                |       | 470                  |       | 30                 |       |
| 2009                                                |       | 482                  |       | 30                 |       |
| 2010                                                |       | 494                  |       | 30                 |       |
| 2011                                                |       | 506                  |       | 30                 |       |
| Thereafter                                          |       | 430                  |       | 11                 |       |
| Total minimum  lease payments                       |       | $                    | 2,460      |               | 139        |   |
| Less: Amount  representing interest                 |       |                 |       | (35                | )          |
| Principal  balance of capital lease obligations     |       |                 |       | 104                |       |
| Less: Current  portion of capital lease obligations |       |                 |       | (19                | )          |
| Long-term  portion of capital lease obligations     |       |                 |       | $                  | 85         |   |

 

There have been no other material changes to thecontractual obligations as disclosed in our 2006 Annual Report on Form 10-K.

**LIQUIDITYAND CAPITAL RESOURCES**

We have historicallyfinanced operations through cash flows from operations and equitytransactions.  At September 30, 2007, ourprincipal source of liquidity was $7.6 million in cash and cash equivalents aswell as $2.5 million available under our revolving line of credit.  The following table summarizes our statementsof cash flows (in thousands):

| ** **                | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------|------------|--------------------------------------|------------|
| ** **                | ** ** | **2007**                             | ** ** | **2006** | ** ** |
| Cash provided  (used) by: |       |                                 |       |   |   |
| Operating  activities     |       | $                                    | 4,413      |   | $ | 2,743 |   |
| Investing  activities     |       | (268                                 | )          | (530 | ) |
| Financing  activities     |       | (1,586                               | )          | (1,692 | ) |
| Effect of  exchange rates |       | (28                                  | )          | 117 |   |
| Net cash  provided        |       | $                                    | 2,531      |   | $ | 638 |   |

 

Net cash provided by operating activities for the ninemonths ended September 30, 2007 and 2006 was $4.4 million and $2.7 million,respectively.  The primary contributionto the improvement in cash provided by operating activities is the result ofnet income of $0.3 million plus non-cash operating adjustments of $2.4 millionfor the nine months ended September 30, 2007 compared to a net loss of $17.8million plus non-cash operating adjustments of $18.5 million for the ninemonths ended September 30, 2006.  Changesin operating assets and liabilities reflected a net increase in cash fromoperating activities of $1.7 million for the nine months ended September 30,2007 as compared to a net increase in cash of $2.0 million for the nine monthsended September 30, 2006.

Net cash used by investing activities for the ninemonths ended September 30, 2007 and 2006 was $0.3 million and $0.5million.  The cash used for the ninemonths ended September 30, 2007 related primarily to purchases of property andequipment of $0.5 million, partially offset by reductions in restricted cash of$0.2 million.  The cash used for the ninemonths ended September 30, 2006 related primarily to purchases of property andequipment of $0.4 million and acquisition related earnout payments of $0.1million.

Financing activities in the nine months endedSeptember 30, 2007 and 2006 consisted primarily of principal payments on notespayable.  During the nine months endedSeptember 30, 2007 and 2006, we paid $1.6 million and $1.8 million,respectively, in principal payments on notes payable.  We paid $81,000 in Excess Cash Flow payments(as defined in our senior loan agreement) to our senior lender during the ninemonths ended September 30, 2007.  Inaddition, of the $77,000 we paid during the nine months ended to retiresubordinated debt and accrued interest held by one of our subordinated noteholders, $61,000 was applied to principal and $16,000 to accrued interest.

 

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

•                  Our cash and cash equivalents balance atSeptember 30, 2007 of $7.6 million.

•                  The availability under our revolvingcredit facility of $2.5 million at September 30, 2007.

•                  Our demonstrated ability to generatepositive cash flows from operations.

•                  Our backlog as of September 30, 2007 ofapproximately $12.5 million, including $4.7 million in license fees andservices and $7.8 million in customer support.

•                  Our planned capital expenditures.

•                  Our cash forecast which indicates that wewill have sufficient liquidity to cover anticipated operating costs and capitalexpenditures as well as debt service payments.

We are exposed to foreign currency rate risks whichimpact the carrying amount of our foreign subsidiaries and our consolidatedequity, as well as our consolidated cash position due to translationadjustments.  For the nine months endedSeptember 30, 2007, the effect of exchange rate changes resulted in a $28,000decrease to consolidated cash.  Duringthe nine months ended September 30, 2006, the effect of exchange rate changesresulted in a $117,000 increase 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.

 

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**ITEM 3.  QUANTITATIVEAND QUALITATIVE MARKET RISK DISCLOSURES**

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

***Interest Rate Risks***

                Ourcash balances are subject to interest rate fluctuations and as a result,interest income amounts may fluctuate from current levels.  We are exposed to interest rate risk relatedto our senior secured term note and our senior revolving credit facilityentered into in November 2005.  Theseobligations are variable interest rate notes based on short-term LIBOR.  Fluctuations in LIBOR affect our interest rates.  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 favorable and 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 unrealized foreigncurrency translation losses (gains) with respect to amounts alreadyinvested in such foreign currencies.  Inaddition, we and our operating subsidiaries are exposed to foreign currencyrisk to the extent that we enter into transactions denominated in currenciesother than our respective functional currencies, such as accounts receivable(including intercompany amounts) that are denominated in a currency other thantheir own functional currency. Changes in exchange rates with respect to theseitems will result in unrealized (based upon period-end exchange rates) orrealized foreign currency transaction gains and losses upon settlement of thetransactions. In addition, we are exposed to foreign exchange rate fluctuationsrelated to our operating subsidiaries’ monetary assets and liabilities and thefinancial results of foreign subsidiaries and affiliates when their respectivefinancial statements are translated into U.S. dollars for inclusion in ourconsolidated financial statements. Cumulative translation adjustments arerecorded in accumulated other comprehensive income (loss) as a separatecomponent of equity. As a result of foreign currency risk, we may experienceeconomic loss and a negative impact on earnings and equity with respect to ourholdings solely as a result of foreign currency exchange rate fluctuations.

The relationship between the Great British pound,Indian rupee and the U.S. dollar, which is our functional currency, is shownbelow, per one U.S. dollar:

| **Spot rates:**      | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|----------------------|------------|------------------------|------------|-----------------------|------------|
| Great British  Pound |       | 0.48860                |       | 0.51069               |       |
| Indian Rupee         |       | 39.79376               |       | 44.11116              |       |

 

| ** **           | ** ** | **Three months ended**  | ** ** | **Nine months ended**   | ** ** |
|----------------------|------------|-------------------------|------------|-------------------------|------------|
| **Average rates:**   | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
| Great British  Pound |       | 0.49494                 |       | 0.53356                 |       | 0.50352 |   | 0.55086 |   |
| Indian Rupee         |       | 40.52512                |       | 46.24360                |       | 41.91718 |   | 45.24218 |   |

 

At the present time, we do not hedge our foreigncurrency exposure or use derivative financial instruments that are designed toreduce 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.

**ITEM 4.  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, including our Chief Executive Officer and ChiefFinancial Officer, has evaluated the effectiveness of our disclosure controlsand procedures as of the end of the period covered by this Quarterly Report onForm 10-Q.  Based on that evaluation, our Chief Executive Officer andChief Financial Officer have concluded that our disclosure controls andprocedures were effective as of the end of such period.

In designing and evaluating our disclosure controls and procedures,management recognized that disclosure controls and procedures, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the 

 

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disclosurecontrols and procedures are met.  Additionally, in designing disclosurecontrols and procedures, our management necessarily was required to apply itsjudgment in evaluating the cost-benefit relationship of possible disclosurecontrols and procedures. The design of any disclosure controls and proceduresalso is based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions.

                        *Changes ininternal control over financial reporting. *During the three and nine months ended September 30, 2007,there were no changes in our internal controls over financial reporting or inother 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**

During the fourth quarter of2006, a previous software vendor filed a complaint in the Superior Court of NewJersey against us asserting we breached certain provisions of a licenseagreement.  While the outcome of thismatter is uncertain, we believe we have paid all fees due under our licenseagreement and we are vigorously defending this claim.

We are involved in various other legal matters arising in the normalcourse of business.  Losses were recordedfor these matters to the extent they were probable of loss and the amount ofloss could be reasonably estimated.

**ITEM1A.  RISK FACTORS**

This Quarterly Report on Form 10-Q should be read inconjunction with the risk factors defined in our Annual Report on Form 10-K forthe year ended December 31, 2006 under “Item 1A. Risk Factors.”

**ITEM2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

**               **None

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES**

**               **None

**ITEM 4. SUBMISSION OF MATTERS TO A VOTEOF SECURITY HOLDERS**

None

 

**ITEM 5. OTHER INFORMATION**

                None

**ITEM6.  EXHIBITS**

(a)          Exhibits

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

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

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

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

 

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**SIGNATURE**

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

 
| Date: November  8, 2007 | /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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