**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**

 
| **ý** | ** ** | **Quarterly Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**                                                                                                                   |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                     |
| ** ** | ** ** | **For the quarterly period ended June 30,  2005**                                                                                                                                                                   |
|       |       |                                                                                                                                                                                                                     |
| ** ** | ** ** | **OR**                                                                                                                                                                                                                   |
| ** ** | ** ** | ** **                                                                                                                                                                                                               |
| **o**      | ** ** | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**                                                                                                                  |
|       |       |                                                                                                                                                                                                                     |
| ** ** | ** ** | **For the transition period from               to               ** |

 

**Commission File Number: 0-24081**

 

**EVOLVING SYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

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

 

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

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).  Yes oNo ý

 

As of August 5,2005 there were 16,049,754 shares outstanding of Registrant’s Common Stock (parvalue $0.001 per share).

 

 

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**EVOLVING SYSTEMS, INC.**

**Quarterly Report on Form 10-Q**

**June 30, 2005**

**Table of Contents**

 
| ** ** | PART I – FINANCIAL INFORMATION                                                                           |   |
|------------|--------------------------------------------------------------------------------------------------------------------|--------|
| Item 1     | Financial  Statements                                                                                              |   |
|       | Consolidated  Balance Sheets (Unaudited) as of June 30, 2005 and December 31,  2004                      |   |
|       | Consolidated  Statements of Operations (Unaudited) for the Three and Six Months Ended June 30,  2005 and 2004 |   |
|       | Consolidated  Statements of Cash Flows (Unaudited) for the Six Months Ended June 30,  2005 and 2004           |   |
|       | Notes  to Unaudited Consolidated Financial Statements                                                              |   |
| Item  2    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                        |   |
| Item  3    | Quantitative  and Qualitative Market Risk Disclosures                                                              |   |
| Item 4     | Controls  and Procedures                                                                                           |   |
| ** ** | PART II – OTHER INFORMATION                                                                              |   |
| Item 1     | Legal  Proceedings                                                                                                 |   |
| Item 2     | Changes  in Securities                                                                                             |   |
| Item 3     | Defaults on Senior  Securities                                                                                     |   |
| Item  4    | Submission  of Matters to a Vote of Security Holders                                                               |   |
| Item 5     | Other  Information                                                                                                 |   |
| Item 6     | Exhibits                                                                                                           |   |
| Signature  |                                                                                                               |

 

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PART I. FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

**EVOLVING SYSTEMS, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(in thousands except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                 | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                 |       |                    |       |                        |       |
| Current assets:                                                                                                                                                                            |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                  |       | $                       | 4,567      |                        | $          | 11,386 |   |
| Current portion of restricted cash                                                                                                                                                         |       | 100                     |       | 100                         |       |
| Contract receivables, net of allowance of $44 at June 30,  2005 and December 31, 2004                                                                                            |       | 6,065                   |       | 11,296                      |       |
| Unbilled work-in-progress                                                                                                                                                                  |       | 1,467                   |       | 1,323                       |       |
| Prepaid and other current assets                                                                                                                                                           |       | 1,742                   |       | 1,832                       |       |
| Total current assets                                                                                                                                                                       |       | 13,941                  |       | 25,937                      |       |
| Property and equipment, net                                                                                                                                                                |       | 2,269                   |       | 2,563                       |       |
| Intangible assets, net                                                                                                                                                                     |       | 16,282                  |       | 19,993                      |       |
| Goodwill                                                                                                                                                                                   |       | 35,596                  |       | 37,698                      |       |
| Long-term restricted cash                                                                                                                                                                  |       | 300                     |       | 300                         |       |
| Total assets                                                                                                                                                                               |       | $                       | 68,388     |                        | $          | 86,491 |   |
|                                                                                                                                                                                       |       |                    |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                              |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                                                       |       |                    |       |                        |       |
| Current portion of notes payable and long-term  obligations                                                                                                                                |       | $                       | 4,451      |                        | $          | 31 |   |
| Short-term notes payable                                                                                                                                                                   |       | —                  |       | 4,880                       |       |
| Accounts payable and accrued liabilities                                                                                                                                                   |       | 6,125                   |       | 8,357                       |       |
| Payable to Tertio sellers                                                                                                                                                                  |       | —                  |       | 2,664                       |       |
| Deferred foreign income taxes                                                                                                                                                              |       | 128                     |       | 265                         |       |
| Unearned revenue                                                                                                                                                                           |       | 10,298                  |       | 13,083                      |       |
| Total current liabilities                                                                                                                                                                  |       | 21,002                  |       | 29,280                      |       |
| Long-term liabilities:                                                                                                                                                                     |       |                    |       |                        |       |
| Long-term obligations                                                                                                                                                                      |       | 88                      |       | 125                         |       |
| Notes payable, net of current portion                                                                                                                                                      |       | 8,336                   |       | 11,849                      |       |
| Deferred foreign income taxes                                                                                                                                                              |       | 3,735                   |       | 4,642                       |       |
| Total liabilities                                                                                                                                                                          |       | 33,161                  |       | 45,896                      |       |
|                                                                                                                                                                                       |       |                    |       |                        |       |
| Commitments and contingencies                                                                                                                                                              |       |                    |       |                        |       |
|                                                                                                                                                                                       |       |                    |       |                        |       |
| Series B convertible redeemable preferred  stock; $.001 par value; 966,666 shares issued and outstanding as of June 30,  2005 and December 31, 2004.                        |       | 11,281                  |       | 11,281                      |       |
|                                                                                                                                                                                       |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                 |       |                    |       |                        |       |
| Common stock, $0.001 par value; 25,000,000 shares  authorized; 16,037,477 and 15,987,217 shares issued and outstanding as of June 30,  2005 and December 31, 2004, respectively. |       | 16                      |       | 16                          |       |
| Additional paid-in capital                                                                                                                                                                 |       | 67,828                  |       | 67,765                      |       |
| Other comprehensive income (loss)                                                                                                                                                          |       | (600                    | )     | 1,994                       |       |
| Accumulated deficit                                                                                                                                                                        |       | (43,298                 | )          | (40,461                     | )          |
| Total stockholders’ equity                                                                                                                                                            |       | 23,946                  |       | 29,314                      |       |
| Total liabilities and stockholders’ equity                                                                                                                                            |       | $                       | 68,388     |                        | $          | 86,491 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **REVENUE**                                                                  |       |                                 |       |                               |       |   |   |   |   |
| License fees and services                                                    |       | $                                    | 4,741      |                               | $          | 2,383 |   | $ | 9,822 |   | $ | 5,602 |   |
| Customer support                                                             |       | 5,185                                |       | 2,878                              |       | 9,942 |   | 5,425 |   |
| Total revenue                                                                |       | 9,926                                |       | 5,261                              |       | 19,764 |   | 11,027 |   |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING EXPENSES**                                  |       |                                 |       |                               |       |   |   |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 2,393                                |       | 1,125                              |       | 5,369 |   | 2,194 |   |
| Costs of customer support, excluding depreciation  and amortization          |       | 1,636                                |       | 1,816                              |       | 3,667 |   | 3,480 |   |
| Sales and marketing                                                          |       | 2,423                                |       | 901                                |       | 4,815 |   | 1,837 |   |
| General and administrative                                                   |       | 1,481                                |       | 934                                |       | 3,982 |   | 1,869 |   |
| Product development                                                          |       | 495                                  |       | 241                                |       | 605 |   | 732 |   |
| Depreciation                                                                 |       | 384                                  |       | 265                                |       | 760 |   | 539 |   |
| Amortization                                                                 |       | 1,395                                |       | 214                                |       | 2,816 |   | 432 |   |
| Restructuring and other expenses (recovery)                                  |       | (3                                   | )          | —                             |       | (51 | ) | — |   |
| Total costs of revenue and operating expenses                                |       | 10,204                               |       | 5,496                              |       | 21,963 |   | 11,083 |   |
| Loss from operations                                                         |       | (278                                 | )          | (235                               | )          | (2,199 | ) | (56 | ) |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Other income (expense):                                                      |       |                                 |       |                               |       |   |   |   |   |
| Interest income (expense), net                                               |       | (368                                 | )          | 67                                 |       | (758 | ) | 124 |   |
| Other income (expense), net                                                  |       | (59                                  | )          | —                             |       | (174 | ) | — |   |
| Total other income (expense), net                                            |       | (427                                 | )          | 67                                 |       | (932 | ) | 124 |   |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Income (loss) before income taxes                                            |       | (705                                 | )          | (168                               | )          | (3,131 | ) | 68 |   |
| Benefit from income taxes                                                    |       | 16                                   |       | —                             |       | 294 |   | 8 |   |
| Net income (loss)                                                            |       | $                                    | (689       | )                                  | $          | (168 | ) | $ | (2,837 | ) | $ | 76 |   |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| **Basic income (loss) per common share**                                     |       | $                                    | (0.04      | )                                  | $          | (0.01 | ) | $ | (0.15 | ) | $ | 0.00 |   |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| **Diluted income (loss) per common share**                                   |       | $                                    | (0.04      | )                                  | $          | (0.01 | ) | $ | (0.15 | ) | $ | 0.00 |   |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Weighted average basic shares outstanding                                    |       | 18,639                               |       | 15,853                             |       | 18,619 |   | 15,845 |   |
| Weighted average diluted shares outstanding                                  |       | 18,639                               |       | 15,853                             |       | 18,619 |   | 17,590 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                                | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                 |       |                               |       |   |   |
| Net income (loss)                                                                         |       | $                                  | (2,837     | ) | $ | 76 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                               |       |   |   |
| Depreciation                                                                              |       | 760                                |       | 539 |   |
| Amortization of intangible assets                                                         |       | 2,816                              |       | 432 |   |
| Amortization of debt issuance costs                                                       |       | 26                                 |       | — |   |
| Interest expense added to debt principal                                                  |       | 660                                |       | — |   |
| Gain on disposal of property and equipment                                                |       | (12                                | )          | — |   |
| Bad debt recovery                                                                         |       | —                             |       | (21 | ) |
| Benefit from foreign deferred income taxes                                                |       | (920                               | )          | — |   |
| Change in operating assets and liabilities:                                               |       |                               |       |   |   |
| Contract receivables                                                                      |       | 5,044                              |       | 6,743 |   |
| Unbilled work-in-progress                                                                 |       | (53                                | )          | 606 |   |
| Prepaid and other assets                                                                  |       | 51                                 |       | (350 | ) |
| Accounts payable and accrued liabilities                                                  |       | (1,243                             | )          | (665 | ) |
| Unearned revenue                                                                          |       | (2,482                             | )          | (2,490 | ) |
| Long-term obligations                                                                     |       | (20                                | )          | (19 | ) |
| Net cash provided by operating activities                                                 |       | 1,790                              |       | 4,851 |   |
|                                                                                      |       |                               |       |   |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                 |       |                               |       |   |   |
| Purchase of property and equipment                                                        |       | (529                               | )          | (756 | ) |
| Proceeds from sale of property and equipment                                              |       | 18                                 |       | 3 |   |
| Business combinations, net of cash acquired                                               |       | (365                               | )          | 41 |   |
| Net cash used in investing activities                                                     |       | (876                               | )          | (712 | ) |
|                                                                                      |       |                               |       |   |   |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                 |       |                               |       |   |   |
| Capital lease payments                                                                    |       | (15                                | )          | (14 | ) |
| Principal payments on notes payable                                                       |       | (4,889                             | )          | — |   |
| Payment of amount due to Tertio sellers                                                   |       | (2,616                             | )          | — |   |
| Proceeds from the issuance of stock                                                       |       | 63                                 |       | 340 |   |
| Net cash (used in) provided by financing activities                                       |       | (7,457                             | )          | 326 |   |
|                                                                                      |       |                               |       |   |   |
| Effect of exchange rate changes on cash                                                   |       | (276                               | )          | (2 | ) |
|                                                                                      |       |                               |       |   |   |
| Net (decrease) increase in cash and cash equivalents                                      |       | (6,819                             | )          | 4,463 |   |
| Cash and cash equivalents at beginning of period                                          |       | 11,386                             |       | 17,999 |   |
| Cash and cash equivalents at end of period                                                |       | $                                  | 4,567      |   | $ | 22,462 |   |
|                                                                                      |       |                               |       |   |   |
| Supplemental disclosure of other cash and non-cash  financing transactions:               |       |                               |       |   |   |
| Interest paid                                                                             |       | $                                  | 147        |   | $ | 7 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

 

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

**(1)****   Basisof Presentation**

 

*Interim ConsolidatedFinancial Statements*. The accompanying consolidated financialstatements of Evolving Systems, Inc. (“Evolving Systems” or the “Company”)have been prepared pursuant to the rules and regulations of the Securitiesand Exchange Commission (“SEC”).  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”) have been condensed or omitted pursuant tosuch rules and regulations. However, management believes that thedisclosures included in these financial statements are adequate to make theinformation presented not misleading. The unaudited consolidated financialstatements included in this document have been prepared on the same basis asthe annual consolidated financial statements, and in management’s opinion, reflectall adjustments, which include normal recurring adjustments, necessary for afair presentation in accordance with GAAP. The results for the three and sixmonths ended June 30, 2005 are not necessarily indicative of the resultsthat the Company will have for any subsequent quarter or full fiscal year.  These consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and the notes to those statements for the year ended December 31,2004 included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2004.

 

*Use of Estimates*.The preparation of financial statements in conformity with accountingprinciples generally accepted in the U.S. requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements as well as the reported amounts of revenue and expenses during thereporting period. Estimates have been made by management with respect to thecollectibility of accounts receivable, estimates to complete long-termcontracts and in establishing the estimated fair values of acquired assets andliabilities. Actual results could differ from these estimates.

 

*ForeignCurrency Translation*. The Company’s foreign subsidiaries useas their functional currency the local currency of the countries in which theyoperate. Their assets and liabilities are translated into U.S. dollars at theexchange rates in effect at the balance sheet date. Revenues, expenses, andcash flows are translated at the average rates of exchange prevailing duringthe period. Translation gains and losses are included in comprehensive income(loss) within stockholders’ equity. Realized and unrealized transaction gainsand losses resulting from the remeasurement of non-functional currencyfinancial instruments are included in the determination of net income (loss). Forthe three and six months ended June 30, 2005 transaction gains wereapproximately $61,000 and $125,000, respectively. For the three and six monthsended June 30, 2004, transaction gains (losses) were approximately $1,000and ($2,000), respectively.

 

*ComprehensiveIncome*. The Company’s comprehensive income (loss) iscomprised of its net income (loss) and foreign currency translation adjustment. For the three and six months ended June 30, 2005 total comprehensiveloss was approximately $2.2 million and $5.4 million, respectively. For thethree and six months ended June 30, 2004, total comprehensive income (loss)was ($177,000) and $69,000, respectively.

 

*Principlesof Consolidation*. The consolidated financial statementsinclude the accounts of the Company and its subsidiaries, all of which arewholly owned.  All significantintercompany transactions and balances have been eliminated.

 

*Reclassification.*As a result of the significance of the intangible assets andthe related amortization expense from the acquisitions of Tertio TelecomsLimited (“Tertio”) and Telecom Software Enterprises LLC. (“TSE”), the Companyis now reporting amortization expense as a separate line item on the statementsof operations. In quarterly periods prior to December 31, 2004,amortization of intangibles was shown within costs of license fees and servicesand costs of customer support. Prior period balances have been reclassified toconform with the current period’s presentation.

 

*RevenueRecognition.*The Company derives revenue from two primarysources: license fees/services and customer support.  We recognize revenue in accordance withStatements of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amendedand interpreted by SOP 98-9, “Modification of SOP 97-2, Software RevenueRecognition, With Respect to Certain Transactions.” In addition we have appliedthe provisions of Staff Accounting Bulletin (“SAB”) No. 104, “RevenueRecognition,” which provides further interpretive guidance for public companieson the recognition, presentation and disclosure of revenue in financialstatements.

 

Themajority of the Company’s license fees and services revenue is generated fromfixed-price contracts which provide for both licenses to its software productsand services. Revenue under these arrangements, where the services aredetermined to be essential to the functionality of the delivered software, isrecognized using the percentage-of-completion method of accounting, inaccordance with SOP 97-2 and SOP 81-1, “Accounting for Long-Term ConstructionType Contracts,” once a license agreement has been signed, the fee is fixed ordeterminable and collectibility is reasonably assured.  The percentage of completion for eachcontract is estimated based on the ratio of direct labor hours incurred tototal estimated direct labor hours.  Theestimated percentage of completion on contracts entered into by the Company’s UnitedKingdom (“U.K.”) subsidiary, Tertio, are based upon the ratio of direct projectcosts incurred to total estimated direct project costs.  The use of direct project costs approximateswhat would have resulted had direct labor hours been used since the majority ofdirect project costs consist of direct labor. Due to the fact that the estimated direct labor hours and project costs,and changes thereto, can have a significant impact on revenue recognition,these estimates are critical and are reviewed by management regularly. Amountsbilled in advance of services being performed are recorded as unearned revenue.Unbilled work-in-progress represents revenue earned but not yet billable underthe terms of the fixed-price contracts. All

 

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such amounts are expectedto be billed and collected during the succeeding 12 months.

 

Inarrangements where the services are not essential to the functionality of thedelivered software, the Company recognizes license revenue when a licenseagreement has been signed, delivery has occurred, the fee is fixed ordeterminable and collectibility is reasonably assured. Where applicable, feesfrom multiple element arrangements are unbundled and recorded as revenue as theelements are delivered to the extent that Vendor Specific Objective Evidence (“VSOE”)of the fair value of the undelivered elements exists. If VSOE for theundelivered elements does not exist, fees from such arrangements are deferreduntil the earlier of the date that VSOE does exist on the undelivered elementsor all of the elements have been delivered.

 

Servicesrevenue provided under fixed-price contracts is generally recognized using the proportionalperformance method of accounting, which is similar to the percentage ofcompletion method described above. Revenue from professional services providedpursuant to time-and-materials based contracts and training services arerecognized as the services are performed, as that is when the Company’s obligationto its customers under such arrangements is fulfilled.

 

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

 

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

 

**(2) ****Business Combinations**

 

**Tertio**

 

On November 2,2004, the Company acquired all of the outstanding shares of privately-held, U.K.-basedTertio. Total consideration for Tertio’s net assets determined in accordancewith GAAP approximated $40.2million, consisting of $11.0 million in cash, approximately $15.9 million inseller-financed notes, of which $4.0 million was paid during the first half of2005, 966,666 shares of Series B Preferred Stock with an estimated fairvalue of approximately $11.3 million and approximately $2.0 million inestimated transaction-related costs. Of the total purchase price, 10%was deposited in escrow with Wells Fargo Bank, N.A. as escrow agent to securethe sellers’ representations and warranties under the purchase agreement. Of the funds deposited in escrow, 80% will remain in escrow until November 2,2005 and the remaining 20% will remain in escrow until November 2, 2007,unless sooner released to the Company in payment of indemnification claims.Both Evolving Systems and Tertio operate on a calendar year. The acquisition was recorded as apurchase business combination and Tertio’s results of operations have beencombined with Evolving Systems’ from the acquisition date forward.

 

Tertio’sactivation and mediation solutions fit well with elements of the Company’sproduct portfolio, enabling it to provide activation solutions andstrengthening its current network mediation and service assurance offerings.  In addition, the acquisition provides theCompany with global reach and a customer base that includes many of the world’sleading communications carriers. The purchase price for Tertio includedgoodwill because the Company concluded that increased scale may be achievedfrom a financial, customer and product perspective. In addition, Tertio broughta quality, experienced work force.

 

In January 2005,Tertio changed its name to Evolving Systems Limited and is sometimes referredto in this Form 10-Q as “Evolving Systems U.K.”.

 

**TSE**

 

On October 15,2004, the Company acquired all of the outstanding ownership interests inprivately-held TSE. Total GAAP consideration for TSE approximated $2.4million, consisting of $1.5 million in cash, a note payable of $889,000 andapproximately $55,000 in transaction-related costs.  The note payable was due and paid on March 31,2005. Of the total purchase price, $250,000 was deposited in escrow for oneyear with Wells Fargo Bank, N.A. as escrow agent to secure the sellers’representations and warranties under the purchase agreement.  The Companyagreed to pay additional consideration of up to $3.5 million contingent uponthe achievement of certain specified revenue and gross margin results. Up to$2.5 million of the contingent consideration may be payable over a 24 monthperiod from the closing date and additional contingent consideration of up to$1.0 million may be paid through the year 2011 if certain specified sales ofTSE products occur. In accordance with Statement of Financial AccountingStandard (“SFAS”) No. 141, the contingent consideration will not berecorded until the contingency is resolved and the additional consideration isdistributable. The Company paid $447,000 of contingent consideration recordedat December 31, 2004 during the first quarter of 2005.  During the three and six months ended June 30,2005, the Company recorded additional contingent consideration and resulting goodwillrelated to certain specified gross margin results achieved by the sale of TSEproducts during the period of approximately $182,000 and $238,000. Theadditional contingent consideration is paid within 45 days of the last day ofthe quarter in which it is earned. The acquisition was treated as a purchasebusiness combination and the results of TSE’s operations have been combinedwith Evolving Systems’ from the acquisition date forward. Both Evolving Systemsand TSE operate on a calendar year.

 

TSE’sproducts are sold to U.S. wireline and wireless carriers, and provide forsimulation of the nation’s centralized Number Portability Administration Center(“NPAC”) and a testing environment for critical back office systems thatcarriers use for enabling number portability. Other products in the TSEportfolio are used for enhanced integration between back office OperationalSupport

 

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Systems (“OSS”).  TSE has installed its products at many of theleading wireless and wireline carriers in North America. By acquiring TSE, theCompany has expanded its customer base and extended the set of solutions itoffers its Local Number Portability (“LNP”) customers. The primary reason for avaluation which gives rise to goodwill is related to the value the Companyplaced on the TSE’s solid reputation as a provider of LNP products, the Company’sexpectation of new customers and the experienced employees acquired in the TSEacquisition.

 

**Pro Forma Financial Information**

 

The financial information in the table belowsummarizes the combined results of operations of Evolving Systems, Inc.,TSE and Tertio on a pro forma basis, as though the companies had been combinedas of the period presented below.  Theimpact of the In-Process Research and Development (“IPR&D”) charges associated with the acquisitions hasbeen excluded.  This pro forma financialinformation is presented for informational purposes only and is not necessarilyindicative of the results of operations that would have been achieved had theacquisitions actually taken place as of the beginning of the period presentedbelow.  The following amounts are inthousands, except per share amounts.

 
| ** **             | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **             | ** ** | **2004**                              | ** ** | **2004**                            | ** ** |
| Revenues               |       | $                                     | 11,419     |                                | $          | 23,710 |   |
| Net loss               |       | $                                     | (636       | )                                   | $          | (699 | ) |
| Basic loss per share   |       | $                                     | (0.03      | )                                   | $          | (0.04 | ) |
| Diluted loss per share |       | $                                     | (0.03      | )                                   | $          | (0.04 | ) |

 

**(3) Goodwilland Intangible Assets**

 

The Company has recorded goodwill and intangibleassets from its acquisitions of CMS in 2003 and TSE and Tertio in 2004.  In accordance with SFAS No. 142,goodwill is not amortized but is subject to an impairment test at leastannually.  Goodwill is assessed on anannual basis for impairment at the reporting unit level by applying afair-value-based test. Changes in the carrying amounts of goodwill by reportingunit for the six months ended June 30, 2005 are as follows (in thousands):

 
| ** **                                 | ** ** | **License and  Services** | ** ** | **Customer  Support** | ** ** | **Total  Goodwill** | ** ** |
|--------------------------------------------|------------|---------------------------|------------|-----------------------|------------|---------------------|------------|
| Balance as of December 31, 2004       |       | $                         | 20,689     |                  | $          | 17,009              |       | $ | 37,698 |   |
| Adjustments to goodwill                    |       | (52                       | )          | (67                   | )          | (119                | )          |
| Effects of foreign currency exchange rates |       | (390                      | )          | (321                  | )          | (711                | )          |
| Balance as of March 31, 2005          |       | 20,247                    |       | 16,621                |       | 36,868              |       |
| Adjustments to goodwill                    |       | (4                        | )          | (152                  | )          | (156                | )          |
| Effects of foreign currency exchange rates |       | (705                      | )          | (411                  | )          | (1,116              | )          |
|                                       |       | $                         | 19,538     |                  | $          | 16,058              |       | $ | 35,596 |   |
|                                            |            |                           |            |                       |            |                     |            |  |  |  |  |

 

The Company recorded goodwill adjustments during thesix months ended June 30, 2005 related to the finalization of the Tertiopurchase price and contingent consideration and resulting goodwillrelated to certain specified gross margin results achieved by the sale of TSE productsduring the period. The Company may have additional purchase price adjustmentsrelated to Tertio as acquired contingencies are resolved and adjustmentsrelated to TSE as contingent consideration is earned.

 

The Company’s annual goodwill impairment test wasconducted as of July 31, 2004, and it was determined that goodwill, atthat time related solely to the CMS acquisition, was not impaired as of thetest date. The Company will continue to monitor the carrying value ofthe acquired identifiable intangibles and goodwill as it executes on itsbusiness plan.  The Company expects to perform its annual required test inthe third quarter of 2005.  If the Company determines that a substantialrevision to its original financial projections related to the acquisitions isnecessary, it is reasonably possible that a review for impairment of theCompany’s goodwill and/or related long-lived intangible assets in connectionwith the annual impairment test, or in future assessments, may indicate thatthese assets are impaired, and the amount of impairment could be substantial. Additionally, goodwill is assessed forimpairment at each reporting period end if certain events have occurredindicating that an impairment may have occurred.

 

Identifiable intangible balances include the cumulativeeffects of changes in foreign currency exchange rates since the acquisitiondate and were as follows as of June 30, 2005 (in thousands):

 
| ** **                                       | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Useful  Life** | ** ** |
|--------------------------------------------------|------------|-------------------|------------|-------------------------------|------------|------------------|------------|
| **Identifiable intangible assets:**              |       |              |       |                          |       |             |       |
| Purchased software                               |       | $                 | 8,691      |                          | $          | 1,260            |       | 5 yrs |   |
| Customer contracts                               |       | 2,079             |       | 1,389                         |       | 1 yr             |       |
| Purchased licenses                               |       | 1,335             |       | 443                           |       | 5 yrs            |       |
| Trademarks and tradenames                        |       | 1,121             |       | 124                           |       | 6 yrs            |       |
| Partnerships                                     |       | 1,397             |       | 133                           |       | 7 yrs            |       |
| Maintenance agreements and related relationships |       | 6,159             |       | 1,151                         |       | 2-7 yrs          |       |
|                                             |       | $                 | 20,782     |                          | $          | 4,500            |       |   |   |
|                                                  |            |                   |            |                               |            |                  |            |  |  |  |  |

 

8

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As of December 31, 2004, identifiableintangibles were as follows (in thousands):

 
| ** **                          | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Estimated  Useful Life** | ** ** |
|-------------------------------------|------------|-------------------|------------|-------------------------------|------------|----------------------------|------------|
| **Identifiable intangible assets:** |       |              |       |                          |       |                       |       |
| Purchased software                  |       | $                 | 9,180      |                          | $          | 326                        |       | 5 yrs |   |
| Customer contracts                  |       | 2,196             |       | 305                           |       | 1 yr                       |       |
| Purchased licenses                  |       | 1,335             |       | 309                           |       | 5 yrs                      |       |
| Trademarks and tradenames           |       | 1,196             |       | 33                            |       | 6 yrs                      |       |
| Business partnerships               |       | 1,491             |       | 35                            |       | 7 yrs                      |       |
| Customer relationships              |       | 6,403             |       | 800                           |       | 2-7 yrs                    |       |
|                                |       | $                 | 21,801     |                          | $          | 1,808                      |       |   |   |

 

Amortizationexpense of identifiable intangible assets was $1.4 million and $2.8 million forthe three and six months ended June 30, 2005, respectively, and $214,000and $432,000 for the three and six months ended June 30, 2004,respectively.

 

**(4) Earnings Per Common Share**

 

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

 
| ** **                                           | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                           | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average common shares outstanding           |       | 16,029                               |       | 15,853                             |       | 16,009 |   | 15,845 |   |
| Participating securities                             |       | 2,610                                |       | —                             |       | 2,610 |   | — |   |
| Basic weighted average common shares outstanding     |       | 18,639                               |       | 15,853                             |       | 18,619 |   | 15,845 |   |
| Effect of dilutive securities - options and warrants |       | —                               |       | —                             |       | — |   | 1,745 |   |
| Diluted weighted average common shares outstanding   |       | 18,639                               |       | 15,853                             |       | 18,619 |   | 17,590 |   |

 

Weightedaverage options to purchase 818,000 and 1.3 million shares of common stock wereexcluded from the dilutive stock calculation for the three and six months endedJune 30, 2005, respectively, as their effect would have been anti-dilutiveas a result of the net loss for the period. Weighted average options topurchase 2.8 million and 2.3 million shares of common stock were excluded fromthe dilutive stock calculation for the three and six months ended June 30,2005, respectively, because their exercise prices were greater than the averagefair value of the Company’s stock for the period.

 

Weightedaverage options to purchase 2.9 million shares of common stock were excludedfrom the dilutive stock calculation for the three months ended June 30,2004, as their effect would have been anti-dilutive as a result of the net lossfor the period. Weighted average options to purchase 393,000 shares of commonstock were excluded from the dilutive stock calculation for the six monthsended June 30, 2004 because their exercise prices were greater than theaverage fair value of the Company’s stock for the period.

 

Theparticipating securities reflect 966,666 shares of Series B PreferredStock, convertible into 2.9 million shares of the Company’s common stock, lessthe 96,667 shares of Series B Preferred Stock, convertible into 290,000shares of the Company’s common stock, that are held in escrow.  In accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 128 “Earnings Per Share”, shares thatare contingently issuable are not included in the computation of basic EPSuntil all necessary conditions have been satisfied (in essence, when issuanceof the shares are no longer contingent).

 

**(5) Stock-BasedCompensation**

 

TheCompany applies the intrinsic-value-based method prescribed by AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations in accounting for employee stock-basedcompensation arrangements. Non-employee stock compensation arrangements areaccounted for under SFAS No. 123 and Emerging Issues Task Force (“EITF”)Issue No. 96-18, “Accounting for Equity Instruments that are Issued toOther than Employees, or in Conjunction with

 

9

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Selling Goods orServices.”

 

SFAS No. 123,“Accounting for Stock-BasedCompensation” and SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure, anamendment of FASB Statement No. 123,” established accounting anddisclosure requirements using a fair-value-based method of accounting for stock-basedemployee compensation plans. As permitted by existing accounting standards, theCompany has elected to continue to apply the intrinsic-value-based method ofaccounting described above, and has adopted only the disclosure requirements ofSFAS No. 123, as amended. The following table illustrates the effecton net income (loss) if the fair-value-based method had been applied to alloutstanding and unvested awards in each period (in thousands, except per sharedata):

 
| ** **                                                    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss), as reported                                |       | $                                    | (689       | )                                  | $          | (168 | ) | $ | (2,837 | ) | $ | 76 |   |
| Stock based compensation expense under the fair  value method |       | (617                                 | )          | (395                               | )          | (1,225 | ) | (579 | ) |
| Pro forma net loss                                            |       | $                                    | (1,306     | )                                  | $          | (563 | ) | $ | (4,062 | ) | $ | (503 | ) |
|                                                          |       |                                 |       |                               |       |   |   |   |   |
| Earnings (loss) per common share as reported:                 |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                         |       | $                                    | (0.04      | )                                  | $          | (0.01 | ) | $ | (0.15 | ) | $ | 0.00 |   |
| Diluted                                                       |       | $                                    | (0.04      | )                                  | $          | (0.01 | ) | $ | (0.15 | ) | $ | 0.00 |   |
| Pro forma loss per common share:                              |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                         |       | $                                    | (0.07      | )                                  | $          | (0.04 | ) | $ | (0.22 | ) | $ | (0.03 | ) |
| Diluted                                                       |       | $                                    | (0.07      | )                                  | $          | (0.04 | ) | $ | (0.22 | ) | $ | (0.03 | ) |

 

**(6) Concentration of Credit Risk**

 

For the three and six months ended June 30, 2005,the Company recognized 27% (14% and 13%) and 26% (14% and 12%), respectively, oftotal revenue from two significant customers (defined as contributing at least 10%),in the telecommunications industry.  Forthe three months ended June 30, 2004, the Company recognized 70% (20%,16%, 13%, 11% and 10%) of total revenue from five significant customers, all inthe telecommunications industry. For the six months ended June 30, 2004,the Company recognized 68% (23%, 19%, 14% and 12%) of total revenue from foursignificant customers, all in the telecommunications industry.

 

As of June 30,2005, two significant customers accounted for approximately 20% (10% and 10%)of contract receivables.  At December 31,2004, three significant customers accounted for approximately 58% (30%, 17% and11%) of contract receivables.

 

In thepast, and currently, the Company earns a significant portion of its revenuefrom a small number of customers in the communications industry. This has beenmitigated somewhat by the expansion of the Company’s customer base throughrecent acquisitions. However, the loss of any significant customer, delays indelivery or acceptance of any of our products by a customer, delays in theperformance of services for a customer, or delays in collection of customerreceivables could be materially harmful to the Company’s business, financialcondition, results of operations and cash flows.

 

**(7) NotesPayable**

 

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

 
| ** **                                                                                                                                                                                                             | ** ** | **As of June 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| Long-term seller financed notes payable, interest at  weighted average rate of 11.62%, due in varying quarterly principal  installments beginning March 31, 2006, with final maturity on December 31,  2007. |       | $                             | 12,839     |   |
| Debt issuance costs                                                                                                                                                                                                    |       | (84                           | )          |
| Total notes payable                                                                                                                                                                                                    |       | 12,755                        |       |
| Less current portion, net                                                                                                                                                                                              |       | (4,419                        | )          |
| Long-term debt, excluding current installments, net                                                                                                                                                                    |       | $                             | 8,336      |   |

 

TheCompany entered into the long-term seller-financed notes payable (“Long-TermNotes”) on November 2, 2004, in conjunction with the acquisition ofTertio.  From the acquisition date throughNovember 2, 2006, the Long-Term Notes bear interest at 11.0% per annum.From November 2, 2006 through the maturity date of December 31, 2007,the notes will bear interest at 14.0% per annum. For accounting purposes,interest is recognized using an effective rate of 11.62% for the term of thenotes. Interest is accrued and added to the principal balance through December 31,2005, and beginning March 31, 2006, interest is payable in cash on aquarterly basis in addition to the scheduled principal payments. Accruedinterest of approximately $889,000 has been added to the

 

10

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principal balance of theLong-Term Notes from their inception through June 30, 2005. The Long-Term Notespayable may be prepaid at any time without penalty. Beginning in March 2005,if the Company’s quarterly cash balances exceed $7.0 million, the holder of theLong-Term Notes may require a prepayment on the note equal to the amount bywhich the quarterly cash balance exceeds $7.0 million. Based on its projectionsof cash balances, the Company believes that these additional payments will notbe required through June 30, 2006. The scheduled principal payments on theLong-Term Notes are as follows (in thousands):

 

| **Principal Payment date** | ** ** | **Amount** | ** ** |
|----------------------------|------------|------------|------------|
| March 31, 2006        |       | $          | 1,340      |   |
| June 30, 2006         |       | 3,110      |       |
| December 31, 2006     |       | 1,430      |       |
| March 31, 2007        |       | 1,870      |       |
| June 30, 2007         |       | 3,110      |       |
| December 31, 2007     |       | 1,979      |       |
|                       |       | $          | 12,839     |   |

 

The Long-TermNotes have an effective interest rate of approximately 11.62% and a maturitydate of December 31, 2007.  Thenotes are secured by substantially all of the assets of Evolving Systems and apledge, subject to certain limitations, of the shares of its subsidiaries.

 

The Long-TermNotes subject the Company to certain affirmative and negative covenants,including a financial covenant indexed to the Company’s computation of EBITDA,as defined. The Company is required to comply with such covenants beginning June 30,2005 and was in compliance as of that date.

 

TheCompany also entered into short-term seller financed notes payable on November 2,2004, in conjunction with the acquisition of Tertio.  The first installments of $2.0 million werepaid on March 31, 2005. The final installments of $2.0 million plusaccrued interest were paid on June 30, 2005. The short-term sellerfinanced note bore interest at a rate per annum equal to five and one-halfpercent, due on each of the previously mentioned payment dates.

 

Thenotes issued in connection with the Tertio acquisition prohibit the Companyfrom declaring dividends to our common stockholders during the term of thenotes.

 

**(8) IncomeTaxes**

 

TheCompany recorded a net income tax benefit of $16,000 and $294,000 for the threeand six months ended June 30, 2005, respectively. The net benefit duringthe three and six months ended June 30, 2005 consists of current incometax expense of approximately $436,000 and $626,000, respectively and a deferredtax benefit of $452,000 and $920,000, respectively, both of which are relatedto the Company’s UK-based operations.

 

Inconjunction with the acquisition of Tertio, certain identifiable intangibleassets were recorded.  Since theamortization of these identifiable intangibles is not deductible for income taxpurposes, a long-term deferred tax liability of $4.6 million was established atthe acquisition date for the expected difference between what would be expensedfor financial reporting purposes and what would be deductible for income taxpurposes. As of June 30, 2005, this deferred tax liability was $3.7million. This deferred tax liability is carried on the books of the Company’sUnited Kingdom subsidiary, and has no impact on the Company’s ability torecover its U.S.-based deferred tax assets.

 

Inconjunction with the acquisition of Tertio, future revenue under contracts inexistence at the acquisition dates was reduced to an amount equal to theCompany’s estimated costs to fulfill its obligations under the contracts plus areasonable profit margin on the Company’s estimated fulfillment effort.  The resulting reduction of future revenuerecorded for financial reporting purposes is not deductible for income taxpurposes and thus, a current deferred tax liability of approximately $600,000was established at the acquisition date. As of June 30, 2005, thisdeferred tax liability was $128,000. Both of the aforementioned deferred tax liabilities will be recognizedas a reduction of current income tax expense as the identifiable intangiblesare amortized and the contract revenue is recognized.

 

As of June 30,2005 and December 31, 2004, the Company continued to maintain a fullvaluation allowance on its domestic net deferred tax asset due to uncertaintiesrelated to the Company’s ability to utilize its domestic deferred tax assets,primarily consisting of certain net operating loss carryforwards, before theyexpire.  The Company’s assessment of thisvaluation allowance was made using all available evidence, both positive andnegative.  In particular, the Companyconsidered both its historical results and its projections of profitability forthe reasonably foreseeable future periods. The Company’s realization of its recorded net deferred tax assets isdependent on future taxable income and, therefore, the Company cannot conclude thatit is more likely than not that it will realize such benefits.  The Company is required to reassess itsconclusions regarding the realization of its deferred tax assets at eachfinancial reporting date. It is reasonably possible that future evaluationcould result in a conclusion that all or a portion of the valuation allowanceis no longer necessary which could have a material impact on the Company’sresults of operations and financial position.

 

11

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**(9) Restructuring and Other Expenses**

 

Inearly 2002, management implemented a restructuring plan (the “Plan”) due to thedownturn in the U.S. telecommunications industry, the Company’s sharp declinein revenue, the FCC’s delay in ruling on wireless number portability and otherfactors.  The Plan included workforcereductions, restructuring of the Company’s headquarters building lease, theclosure of its satellite field offices and the write down of certain fixedassets, all of which were executed in 2002. At June 30, 2005 and December 31,2004, the remaining accrual related to the closure of the satellite offices.

 

*Closure of satellite offices.*  The Company closed all of its satellite fieldoffices during 2002.  Because the coststo sublease or terminate these lease commitments are based on estimates, theCompany may incur additional costs related to the satellite officeclosures.  During the three and six monthsended June 30, 2005 the Company recorded a recovery of $3,000 and $48,000related to the closure of the satellite offices as the actual costs to close thesefacilities were less than its original estimate.  As of June 30, 2005 approximately $13,000was included in accounts payable and accrued liabilities, and approximately $1,000was included in long-term obligations, related to the closure of the satelliteoffices.

 

Thefollowing table summarizes the change in the accrual balance since December 31,2004 (in thousands):

 
| ** **                             | ** ** | **Closure of Satellite Offices** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| Accrual balance December 31, 2004 |       | $                                | 79         |   |
| 1st quarter adjustments                |       | (48                              | )          |
| 1st quarter cash payments, net         |       | (15                              | )          |
| Accrual balance March 31, 2005    |       | 16                               |       |
| 2nd quarter cash payments              |       | (3                               | )          |
| Accrual balance June 30, 2005     |       | $                                | 13         |   |

 

**(10) SegmentInformation**

 

Inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterpriseand Related Information,” the Company defines operating segments as componentsof an enterprise for which separate financial information is available.  This information is reviewed regularly by thechief operating decision-maker, or decision-making group, to evaluateperformance and to make operating decisions. The Company has identified itsChief Executive Officer and Chief Financial Officer as its chief operatingdecision-makers. These chief operating decision makers review revenues bysegment and review overall results of operations.

 

TheCompany currently operates its business as two operating segments based onrevenue type: license fees/services revenue and customer support revenue (asshown on the consolidated statements of operations).  License fees and services revenue representsthe fees received from the license of software products and those servicesdirectly related to the delivery of the licensed products as well as customdevelopment, integration services and time and materials work.  Customer support revenue includes annualsupport fees, recurring maintenance fees, fees for maintenance upgrades andwarranty fees.  Warranty services aretypically bundled with a license sale and the related revenue, based on VSOE,is deferred and recognized ratably over the warranty period. With theacquisition of Tertio, the Company now provides products and services on aglobal basis. In addition, the Company has a product development facility inBangalore, India.  Total assets bysegment have not been specified because the information is not available to thechief operating decision-making group.

 

Segmentinformation is as follows (in thousands):

 
| ** **                                                   | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenue**                                                  |       |                                 |       |                               |       |   |   |   |   |
| License fees and services                                    |       | $                                    | 4,741      |                               | $          | 2,383 |   | $ | 9,822 |   | $ | 5,602 |   |
| Customer support                                             |       | 5,185                                |       | 2,878                              |       | 9,942 |   | 5,425 |   |
|                                                         |       | 9,926                                |       | 5,261                              |       | 19,764 |   | 11,027 |   |
|                                                         |       |                                 |       |                               |       |   |   |   |   |
| **Segment profit, excluding depreciation and  amortization** |       |                                 |       |                               |       |   |   |   |   |
| License fees and services                                    |       | 2,348                                |       | 1,258                              |       | 4,453 |   | 3,408 |   |
| Customer support                                             |       | 3,549                                |       | 1,062                              |       | 6,275 |   | 1,945 |   |
|                                                         |       | 5,897                                |       | 2,320                              |       | 10,728 |   | 5,353 |   |
|                                                         |       |                                 |       |                               |       |   |   |   |   |
| Other operating expenses                                     |       | 4,399                                |       | 2,076                              |       | 9,402 |   | 4,438 |   |
| Depreciation and amortization                                |       | 1,779                                |       | 479                                |       | 3,576 |   | 971 |   |
| Restructuring and other                                      |       | (3                                   | )          | —                             |       | (51 | ) | — |   |
| Loss from operations                                         |       | $                                    | (278       | )                                  | $          | (235 | ) | $ | (2,199 | ) | $ | (56 | ) |
|                                                              |            |                                      |            |                                    |            |  |  |  |  |  |  |  |  |  |

 

12

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***Geographic Regions***

 

The Company uses the customer locations as the basisof attributing revenues to individual countries. Financial information relatingto the Company’s operations by geographic region is as follows (in thousands):

 
| ** **                           | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                           | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenue**                          |       |                                 |       |                               |       |   |   |   |   |
| United States                        |       | $                                    | 4,701      |                               | $          | 5,261 |   | $ | 9,717 |   | $ | 11,027 |   |
| Europe, Middle East, Africa and Asia |       | 5,225                                |       | —                             |       | 10,047 |   | — |   |
| Total revenues                       |       | $                                    | 9,926      |                               | $          | 5,261 |   | $ | 19,764 |   | $ | 11,027 |   |

 
|                                 |   | **As of June 30,  2005** | ** ** | **As of December 31,  2004** |   |
|--------------------------------------|--------|-------------------------------|------------|-----------------------------------|--------|
|                                 |   |                          |       |                              |   |
| **Long-lived  assets, net**          |   |                          |       |                              |   |
| United States                        |   | $                             | 1,239      |                              | $      | 1,563 |   |
| Europe, Middle East, Africa and Asia |   | 1,030                         |       | 1,000                             |   |
| Total long-lived assets              |   | $                             | 2,269      |                              | $      | 2,563 |   |

 

**(11)Commitments and Contingencies**

Aspermitted under Delaware law, the Company has agreements with its officers anddirectors under which it agrees to indemnify them for certain events oroccurrences while the officer or director is, or was serving, at the Company’srequest in this capacity. The term of the indemnification period is indefinite.There is no limit on the amount of future payments the Company could berequired to make under these indemnification agreements; however, the Companymaintains Director and Officer insurance policies, as well as an EmploymentPractices Liability Insurance Policy, that may enable it to recover a portionof any future amounts paid. As a result of the Company’s insurance policycoverage, it believes the estimated fair value of these indemnificationagreements is minimal. Accordingly, the Company has no liabilities recorded forthese agreements as of June 30, 2005 and December 31, 2004.

 

TheCompany enters into standard indemnification terms with its customers, asdiscussed below, in the ordinary course of business. Because the Companysubcontracts some of the development of its deliverables under its customercontracts, the Company could be required to indemnify its customers for workperformed by its subcontractors. Depending upon the nature of the customerindemnification, the potential amount of future payments the Company could berequired to make under these indemnification agreements may be unlimited. TheCompany may be able to recover damages from a subcontractor if theindemnification to its customers results from the subcontractor’s failure toperform. To the extent the Company is unable to recover damages from its subcontractors;the Company could be required to reimburse the indemnified party for the fullamount. The Company has never incurred costs to defend lawsuits or settleclaims relating to indemnification arising out of its subcontractors’ failureto perform. As a result, the Company believes the estimated fair value of theseagreements is minimal. Accordingly, the Company has no liabilities recorded forthese agreements as of June 30, 2005 and December 31, 2004.

 

TheCompany’s standard license agreements contain a warranty provision that thesoftware will be free of material defects and will operate in accordance withthe stated requirements.  The warrantyprovisions require the Company to cure any defects through any reasonablemeans.  To date, no claims under thewarranty provisions have been brought to the Company’s attention.  The Company’s customers typically purchaseannual maintenance services as well and as a matter of course, the Companyprovides fixes for known defects through the provision of such maintenanceservices.  As a result, the Companybelieves the estimated fair value of the warranty provisions in the licenseagreements in place with its customers is minimal.  Accordingly, the Company has not recordedliabilities for these warranty provisions as of June 30, 2005 and December 31,2004.

 

TheCompany’s software arrangements generally include a product indemnificationprovision that will indemnify and defend a client in actions brought againstthe client that claim the Company’s products infringe upon a copyright, tradesecret, or valid patent. Historically, the Company has not incurred anysignificant costs related to product indemnification claims. Accordingly, theCompany has no liabilities recorded as of June 30, 2005 and December 31,2004.

 

Inrelation to the acquisitions of Tertio, TSE and CMS, the Company agreed toindemnify certain parties of and from any losses, actions, claims, damages orliabilities (or actions in respect thereof) resulting from any claim raised bya third party. The Company does not believe that there will be any claimsrelated to these indemnifications. Accordingly, the Company has no liabilitiesrecorded for these agreements as of June 30, 2005 and December 31,2004.

 

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

 

(12) Recent AccountingPronouncements

 

In December 2004,the FASB issued SFAS No. 123(Revised), “Share-Based Payment.” Thisstatement replaces SFAS No. 123, “Accounting for Stock-Based Compensation”and supersedes APB Opinion No. 25, “Accounting for Stock Issued to

 

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Employees.” Under themodified prospective method of adoption, SFAS No. 123(R) requirescompanies to apply a fair-value-based measurement method in accounting forshare-based payment transactions with employees and to record compensation costfor all stock awards granted after the required effective date and to awardsmodified, repurchased, or cancelled after that date. In addition, the Companyis required to record compensation expense (as awards previously grantedcontinue to vest) for the unvested portion of those awards that remainoutstanding at the date of adoption. In accordance with adoption provisionsreleased by the SEC, SFAS 123(R) will be effective for the Company on January 1,2006. Management has not yet determined the impact that SFAS 123(R) will haveon its financial position and results of operations, but expects that the stockincentive plans’ pro forma disclosure provides a reasonable measure of theexpected annual impact.

 

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

 

OVERVIEW

 

*ThisManagement’s Discussion and Analysis of Financial Condition and Results ofOperations contains forward-looking statements that have been made pursuant tothe provisions of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are based oncurrent expectations, estimates, and projections about Evolving Systems’industry, management’s beliefs, and certain assumptions made bymanagement.  Forward-looking statementsinclude our expectations regarding product, services, and maintenance revenue,annual savings associated with the organizational changes effected in prioryears, and short- and long-term cash needs. In some cases, words such as “anticipates”, expects”, “intends”, “plans”,“believes”, “estimates”, variations of these words, and similar expressions areintended to identify forward-looking statements.  The statements are not guarantees of futureperformance and are subject to certain risks, uncertainties, and assumptionsthat are difficult to predict; therefore, actual results may differ materiallyfrom those expressed or forecasted in any forward-looking statements.  Risks and uncertainties of our businessinclude those set forth in the Company’s Annual Report on Form 10-K forthe year ended December 31, 2004 under “Risk Factors” on pages 9through 22 as well 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 the Company files fromtime to time with the Securities and Exchange Commission, particularly theQuarterly Reports on Form 10-Q and any Current Reports on Form8-K.*

 

EvolvingSystems, Inc. (“we”, “our”, “us”) is a provider of mission criticalsoftware products and services to communications carriers. We maintainlong-standing relationships with many of the largest wireline, wireless andcable communications carriers worldwide. Our customers rely on us to develop,deploy, enhance, maintain and integrate complex, highly reliable softwaresolutions for a range of Operations Support Systems (“OSS”) and Network SupportSystems (“NSS”). Included among our more than 40 customers are four of thelargest wireline carriers in North America, one of the largest cable companiesin North America and three of the world’s 10 largest wireless carriers. Weoffer software products and solutions in three core areas — numbering solutionsthat enable carriers to comply with government-mandated requirements regardingnumber portability and phone number conservation; a service activation solutionthat is used to activate complex bundles of voice, video and data services; andmediation solutions supporting data collection for both service assurance andbilling applications.  Historically, ourproducts have been used to support traditional telephony capabilities; however,today many communications carriers are using our products to support Voice overInternet Protocol (“VoIP”) offerings.

 

Thecore Evolving Systems portfolio that included ordering and provisioningsolutions for Local Number Portability (“LNP”), as well as a number inventoryand assignment platform, has recently been expanded, as a result of threeacquisitions we made over a period of 12 months from November of 2003 to November of2004. Through the acquisition of CMS Communications, Inc. (“CMS”) in November 2003we acquired a network mediation and service assurance solution to add to ourproduct portfolio. Additionally, with the acquisition of Telecom SoftwareEnterprises, LLC (“TSE”) on October 15, 2004 we added LNP and WirelessNumber Portability (“WNP”) number ordering and provisioning testing productswhich provide new OSS system integration capabilities.  Most recently, on November 2, 2004, weacquired Tertio Telecoms Ltd. (“Tertio”), a privately held supplier of OSSsoftware solutions to communication carriers throughout Europe, the MiddleEast, Africa and Asia, expanding our markets beyond North America.  Tertio’s activation solution, ***ProvidentTM,***and mediation solution ***EvidentTM***, strengthen our overallproduct portfolio. Our significantly expanded product and service capabilitiesnow enable us to address a larger portion of our customer’s application needs. Also,as a result of these acquisitions, we have become a company with global reachand a customer base that includes many of the world’s leading communicationscarriers.  We are positioned as aprovider of OSS, NSS and comprehensive systems integration capabilities. Thesecomplementary competencies enable us to address and implement solutions acrossmuch of a customer’s back office.

 

**CompanyBackground**

 

Foundedin 1985, we initially focused on providing custom software development andprofessional services to a limited number of telecommunications companies inthe United States. In 1996, concurrent with the passage of theTelecommunications Act of 1996 (“the Telecom Act”), we made a strategicdecision to add software products to our established professional servicesofferings. Since that time we have built a strong product portfolio, of whichwe are best known for our LNP and service activation solutions.

 

Historically,we have helped our customers integrate our products into their existingbusiness process and OSS environments. In 2002, we initiated a restructuringplan, which, in addition to significant operational cost reductions and greaterleverage of offshore

 

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development, included thereengineering of our business model to a solutions strategy.  The solutions business model reflects a morebalanced mix of services and products, as well as integration and productenhancements for our customers’ back office to meet the specific requirementsof each customer. This customer specific effort is complementary to productdevelopment investments driven by more traditional marketing efforts. Solutionswhich include our products, as well as product extensions and integration, aretypically licensed to our customers and supported by us. In 2004, our salesreach was expanded to include both direct and indirect sales.  New partnerships with network equipmentproviders and system integrators to extend our reach to new geographicalregions as well as helping us further penetrate our existing territories wereachieved during the year.  We have alsocreated packaged products with our channel partners, where we provide theunderlying product and our partner provides some or most of the integrationservices.

 

**CriticalAccounting Policies**

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operations is basedon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America, or GAAP. We review the accounting policies we use in reporting ourfinancial results on a regular basis. The preparation of our consolidatedfinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenue and expenses, and relateddisclosure of contingent assets and liabilities. In many cases, the accountingtreatment of a particular transaction is specifically dictated by GAAP and doesnot require our judgment in its application. Our senior management has reviewed these critical accounting policiesand related disclosures with our Audit Committee.  We have identified the policies below ascritical to our business operations and the understanding of our results ofoperations.

 

•                  Revenuerecognition

 

•                  Allowancefor doubtful accounts

 

•                  Incometaxes

 

•                  Intangibleassets

 

•                  Businesscombinations

 

•                  Capitalizationof internal software development costs

 

For adetailed discussion on the application of these accounting policies, see “Item7: Management’s Discussion and Analysis of Financial Condition and Results ofOperations” in our Annual Report on Form 10-K for the year ended December 31,2004.

 

**RecentDevelopments**

 

**Acquisitionof TSE**

 

In October 2004,we acquired TSE.  TSE’s ***VeriPortTM*** and ***VerifyTM***products are sold to United States of America (“U.S.”) wirelineand wireless carriers, and provide for simulation of the nation’s centralizedNumber Portability Administration Center (“NPAC”) and a testing environment forcritical back office systems that carriers use for enabling number portability.Other products in the TSE portfolio are used for enhanced integration betweenback office OSS systems.  TSE hasinstalled its products at several of the leading wireless and wireline carriersin North America. By acquiring TSE, we have expanded our customer base andextended the set of solutions we offer our numbering solutions customers.

 

**Acquisitionof Tertio**

 

In November 2004,we acquired Tertio, our third acquisition in a twelve month period. Byacquiring Tertio we became a global company with a customer base that includesmany of the world’s largest communication carriers. Tertio’s activation and mediation solutions,Provident and Evident, fit well with elements of our product portfolio,enabling us to provide activation solutions and strengthening our currentmediation and service assurance offerings.

 

In January 2005,we changed Tertio’s name to Evolving Systems Limited (“Evolving Systems U.K.”).We also renamed the Provident activation product “Tertio”, to build on thestrong recognition of the Tertio brand in the service activation market. Thename changes are reflected in this filing where appropriate.

 

**Expansionof Offshore Development Subsidiary**

 

In February 2004,we formed Evolving Systems Networks India Private Limited, a wholly ownedsubsidiary of Evolving Systems (“Evolving Systems India”).  For several years, offshore development,through a subcontractor, had been a key aspect of our low-cost,accelerated-deployment strategy. With the formation of Evolving Systems Indiawe now have more control and flexibility and lower costs than with our previousoutsourced development, which used an offshore third party contractor. As of June 30,2005, we had approximately 78 employees in our Indian office with plans forfurther expansion as demand dictates.

 

**CustomerSupport Revenue Deferral**

 

Duringthe first and second quarter of 2004, we deferred the recognition of customersupport revenue for one of our largest customers. Under this maintenancearrangement, the customer purchased professional services, specified licensedsoftware upgrades and support services. Since fair value of the undelivered specified licensed software upgradesdid not exist, all of the revenue related

 

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to this contract wasdeferred until the specified licensed software upgrades were delivered andaccepted by the customer.  During thethird quarter of 2004, we delivered and obtained acceptance of the specifiedlicensed software upgrades. Since vendor specific objective evidence of fairvalue existed for all of the remaining undelivered elements in the arrangement,we recognized the residual amount of revenue for all delivered elements at thattime.  Our 2005 customer support contractwith the same customer did not contain these additional accounting elements,and was not deferred. Accordingly, during the three and six months ended June 30,2005, we recognized approximately $1.1 million and $2.1 million, respectivelyof customer support revenue related to this contract.

 

**AcceleratedFiler Status**

 

Companiesconsidered accelerated filers under Securities Exchange Act Rule 12b-2,are required to comply with the internal control reporting and disclosurerequirements of Section 404 of the Sarbanes-Oxley Act of 2002, for fiscalyears ending on or after November 15, 2004. An accelerated filer isdefined as a company that meets the following conditions as of the end of itsfiscal year:

 

•                  Its common equity public float was$75 million or more as of the last business day of its most recently completedsecond fiscal quarter;

 

•                  The company has been subject to thereporting requirements of Section 13(a) or 15(d) of the ExchangeAct for a period of at least 12 calendar months;

 

•                  The company has previously filed atleast one annual report pursuant to Section 13(a) or 15(d) ofthe Exchange Act; and

 

•                  The company is not eligible to useForms 10-KSB and 10-QSB.

 

As ofthe last business day of our most recently completed second fiscal quarter, June 30,2005, our common equity public float was less than $75 million, therefore weare not an accelerated filer, as defined in Securities Exchange Act Rule 12b-2,and are not required to comply with the management reporting on internalcontrol over financial reporting for the year ending December 31, 2005.Since we are not an accelerated filer in 2004 we must begin complying with theinternal control reporting and disclosure requirements for our fiscal yearending December 31, 2006.

 

**CostReductions**

 

In July 2005,we undertook cost reduction measures that involved a 10% reduction in ourworkforce, including individuals at all levels of our U.S. and U.K. operations.The efforts around the cost reductions are also designed to better integrateour recent acquisitions. These reductions will save the Company more than $3.0million annually, with the impact of the savings realized beginning in thefourth quarter of 2005.

 

Tomeet our long-term goals, including revenue growth, we continue to makeinvestments in our products. We are currently investing in both serviceactivation and number solutions products to expand the number of products thatwe can offer our newly expanded customer base and internationalize our existingnumbering solutions products. These activities will cause product developmentexpenses to increase in future periods compared to prior periods.

 

**Resultsof Operations**

 

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

 
| ** **                                                                   | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| **REVENUE**                                                                  |       |                                 |       |                               |       |   |   |   |   |
| License fees and services                                                    |       | 48                                   | %          | 45                                 | %          | 50 | % | 51 | % |
| Customer support                                                             |       | 52                                   | %          | 55                                 | %          | 50 | % | 49 | % |
| Total revenue                                                                |       | 100                                  | %          | 100                                | %          | 100 | % | 100 | % |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING EXPENSES**                                  |       |                                 |       |                               |       |   |   |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 24                                   | %          | 21                                 | %          | 27 | % | 20 | % |
| Costs of customer support, excluding depreciation  and amortization          |       | 17                                   | %          | 35                                 | %          | 19 | % | 31 | % |
| Sales and marketing                                                          |       | 24                                   | %          | 17                                 | %          | 24 | % | 17 | % |
| General and administrative                                                   |       | 15                                   | %          | 18                                 | %          | 20 | % | 17 | % |
| Product development                                                          |       | 5                                    | %          | 4                                  | %          | 3 | % | 6 | % |
| Depreciation                                                                 |       | 4                                    | %          | 5                                  | %          | 4 | % | 5 | % |
| Amortization                                                                 |       | 14                                   | %          | 4                                  | %          | 14 | % | 4 | % |
| Restructuring and other expenses                                             |       | —                               |       | —                             |       | — |   | — |   |
| Total costs of revenue and operating expenses                                |       | 103                                  | %          | 104                                | %          | 111 | % | 100 | % |
|                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Loss from operations                                                         |       | (3                                   | )%         | (4                                 | )%         | (11 | )% | (1 | )% |
| Other income (expense), net                                                  |       | (4                                   | )%         | 1                                  | %          | (5 | )% | 1 | % |
| Income (loss) before income taxes                                            |       | (7                                   | )%         | (3                                 | )%         | (16 | )% | 1 | % |
| Benefit from income taxes                                                    |       | —                               |       | —                             |       | 2 | % | — |   |
| Net income (loss)                                                            |       | (7                                   | )%         | (3                                 | )%         | (14 | )% | 1 | % |

 

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**The threeand six months ended June 30, 2005 compared to the three and six monthsended June 30, 2004**

 

**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 includes annual support fees,recurring maintenance fees, maintenance upgrades and warranty fees.  Warranty services consist of maintenanceservices and are typically bundled with a license sale and the related revenue,based on VSOE, is deferred and recognized ratably over the warranty period.  Total revenue was $9.9 million and $5.3 millionfor the three months ended June 30, 2005 and 2004, respectively, and $19.7million and $11.0 million for the six months ended June 30, 2005 and 2004,respectively. The following table presents the Company’s revenue by product group(in thousands).

 
| ** **          | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **          | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numbering solutions |       | $                                    | 3,957      |                               | $          | 4,247 |   | $ | 7,747 |   | $ | 9,348 |   |
| Mediation           |       | 1,038                                |       | 1,014                              |       | 2,893 |   | 1,679 |   |
| Activation          |       | 4,931                                |       | —                             |       | 9,124 |   | — |   |
|                |       | $                                    | 9,926      |                               | $          | 5,261 |   | $ | 19,764 |   | $ | 11,027 |   |

 

**License Feesand Services**

 

Licensefees and services revenue increased 99% to $4.7 million for the three monthsended June 30, 2005, from $2.4 million for the three months ended June 30,2004.  The increase in license fees andservices revenue is due to activation sales related to products acquired in theTertio acquisition, offset by lower revenue from our number portability andinventory products.  The decline innumber portability and inventory products is due to industry consolidation andsmaller overall license sales which is reflective of the maturity of thenarrowband numbering solutions market in the U.S.

 

Licensefees and services revenue increased 75% to $9.8 million for the six monthsended June 30, 2005, from $5.6 million for the six months ended June 30,2004.  The increase in license fees andservices revenue is primarily due to activation and mediation sales related toproducts acquired in the Tertio acquisition, offset by lower revenue from ournumber portability and inventory products. The decline in number portability and inventory products is due toindustry consolidation and smaller overall license sales which is reflective ofthe maturity of the narrowband numbering solutions market in the U.S.

 

**Customer Support**

 

Customersupport revenue increased 80% to $5.2 million for the three months ended June 30,2005, from $2.9 million for the three months ended June 30, 2004.  The increase in customer support revenue duringthe second quarter of 2005 is due to increased revenue related to the supportof activation products acquired in the Tertio acquisition as well as increased customersupport revenue related to numbering solutions products, partially offset by pricereductions in certain customer support contracts. Numbering solutions customersupport revenue was lower in the second quarter of 2004 due to a large customersupport contract that was deferred until the acceptance of specified upgrades,which occurred during the third quarter of 2004.

 

Customersupport revenue increased 83% to $9.9 million for the six months ended June 30,2005, from $5.4 million for the six months ended June 30, 2004.  The increase in customer support revenueduring the first half of 2005 is due to increased revenue related to thesupport of activation products acquired in the Tertio acquisition as well asincreased customer support revenue related to numbering solutions products, partiallyoffset by price reductions in certain customer support contracts. Numberingsolutions customer support revenue was lower in the first half of 2004 due to alarge customer support contract that was deferred until the acceptance ofspecified upgrades, which occurred during the third quarter of 2004.

 

**Costs ofRevenue, Excluding Depreciation and Amortization**

 

Costsof revenue, excluding depreciation and amortization, consist primarily ofpersonnel costs, facilities costs, the costs of third-party software and allother direct costs associated with these personnel. Total costs of revenue,excluding depreciation and amortization, were $4.0 million and $2.9 millionfor the three months ended June 30, 2005 and 2004, respectively and $9.0million and $5.7 million for the six months ended June 30, 2005 and 2004, respectively.

 

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**Costs of LicenseFees and Services, Excluding Depreciation and Amortization**

 

Costsof license fees and services, excluding depreciation and amortization, were $2.4million and $1.1 million for the three months ended June 30, 2005 and2004, respectively.  The increase of $1.3million, or 113%, is due to more projects in delivery as a result of the Tertioacquisition, as well as additional costs related to the U.K. developmenttransition to our off-shore development model which utilizes Evolving SystemsIndia. As a percentage of license fees and services revenue, costs of license feesand services, excluding depreciation and amortization, increased to 50% for thethree months ended June 30, 2005 from 47% for the three months ended June 30,2004.  The increase as a percentage of licensefees and services revenues was due to the aforementioned increased costs relatedto the U.K. development transition to our off-shore development model and theincreased costs from Evolving Systems U.K. and TSE which exceeded the increasein revenue during the period.

 

Costsof license fees and services, excluding depreciation and amortization, were $5.4million and $2.2 million for the six months ended June 30, 2005 and2004, respectively.  The increase of $3.2million, or 145%, is due to more projects in delivery as a result of the Tertioacquisition, as well as additional costs related to the U.K. development transitionto our off-shore development model which utilizes Evolving Systems India. As apercentage of license fees and services revenue, costs of license fees andservices, excluding depreciation and amortization, increased to 55% for the sixmonths ended June 30, 2005 from 39% for the six months ended June 30,2004.  The increase as a percentage oflicense fees and services revenues was due to the aforementioned increasedcosts related to the U.K. development transition to our off-shore developmentmodel and the increased costs from Evolving Systems U.K. and TSE which exceededthe increase in revenue during the period.

 

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

 

Costsof customer support, excluding depreciation and amortization, were $1.6 millionand $1.8 million for the three months ended June 30, 2005 and 2004,respectively.  The decrease of $180,000,or 10%, is due to decreased third party software maintenance fees and savingsfrom the transition to Evolving India from our Indian subcontractor, partiallyoffset by increased hours worked on customer support projects to supportproducts acquired in the Tertio and TSE acquisitions.  Higher 2005 revenue from Evolving SystemsU.K. and TSE customer support contracts as well as the deferral of theaforementioned large support contract in 2004 decreased the percentage of costsof customer support revenue, excluding depreciation, as a percentage of revenuefrom 63% for the three months ended June 30, 2004 to 32% for the threemonths ended June 30, 2005.

 

Costsof customer support, excluding depreciation and amortization, were $3.7 millionand $3.5 million for the six months ended June 30, 2005 and 2004,respectively.  The increase of $187,000,or 5%, is due to increased hours worked on customer support projects to supportproducts acquired in the Tertio and TSE acquisitions, partially offset by decreasedthird party software maintenance fees and savings from the transition toEvolving India from our Indian subcontractor. Higher 2005 revenue from Evolving Systems U.K. and TSE customer supportcontracts as well as the deferral of the aforementioned large support contractin 2004 decreased the percentage of costs of customer support revenue,excluding depreciation, as a percentage of revenue from 64% for the six monthsended June 30, 2004 to 37% for the six months ended June 30, 2005.

 

**Sales andMarketing**

 

Salesand marketing expenses primarily consist of compensation costs, including bonusesand commissions, travel expenses, advertising and occupancy expenses.  Sales and marketing expenses were $2.4million and $901,000 for the three months ended June 30, 2005 and 2004,respectively. The increase of $1.5 million, or 169%, is due to additional costsfrom Evolving Systems U.K. and TSE as well as increased expenses in the U.S.related to increased headcount for sales initiatives designed to penetrate newmarkets.  As a percentage of total revenue,sales and marketing expenses increased to 24% for the three months ended June 30,2005 from 17% for the three months ended June 30, 2004.  The increase as a percentage of revenue isdue to the combination of increased expenses from Evolving Systems U.K. and theincreased expenses in the U.S., which exceeded the increase in revenue duringthe period.

 

Salesand marketing expenses were $4.8 million and $1.8 million for the six monthsended June 30, 2005 and 2004, respectively. The increase of $3.0 million,or 162%, is due to additional costs from Evolving Systems U.K. and TSE as wellas increased expenses in the U.S. related to increased headcount for salesinitiatives designed to penetrate new markets. As a percentage of total revenue, sales and marketing expenses increasedto 24% for the six months ended June 30, 2005 from 17% for the six monthsended June 30, 2004.  The increaseas a percentage of revenue is due to the combination of increased expenses fromEvolving Systems U.K. and the increased expenses in the U.S., which exceededthe increase in revenue during the period.

 

**Generaland Administrative**

 

Generaland administrative expenses consist principally of employee related costs andprofessional fees for the following departments: facilities, finance, legal,human resources, and executive management. General and administrative expenses were $1.5 million and $934,000 forthe three months ended June 30, 2005 and 2004, respectively.  The increase of $547,000 or 59%, is primarilydue to costs from Evolving Systems U.K. As a percentage of total revenue, general and administrative expenses decreasedto 15% for the three months ended June 30, 2005 from 18% for the threemonths ended June 30, 2004.  The decreaseas a percentage of revenue is due to the increase in revenue from Tertio andTSE, partially offset by the combination of increased expenses from Evolving SystemsU.K..

 

Generaland administrative expenses were $4.0 million and $1.9 million for the sixmonths ended June 30, 2005 and 2004, respectively.  The increase of $2.1 million or 113%, isprimarily due to costs related to the integration of Tertio, expenses fromEvolving Systems U.K. as well as increased expenses in the U.S. related tosignificantly higher levels of professional fees.  As a percentage of total revenue, general andadministrative expenses increased to 20% for the six months ended June 30,2005 from 17%

 

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for the six months ended June 30,2004.  The increase as a percentage ofrevenue is due to the combination of increased expenses from Evolving SystemsU.K. and increased professional fees in the U.S., which was greater than theincrease in revenue during the period.

 

**ProductDevelopment**

 

Productdevelopment expenses consist primarily of employee related costs, offshoredevelopment subcontractor expenses and costs to start up our offshore Indianfacility.  Product development expenseswere $495,000 and $241,000 for the three months ended June 30, 2005 and2004, respectively. The increase of $254,000, or 105%, is due to costs relatedto development work on new numbering product ***ServiceLinkTM***and additional work on our acquired U.K. products, partially offset bydecreased costs in the U.S. as development in 2005 was principally focused oncustomer specific projects rather than general research and developmentefforts. Costs for customer-specific projects are reflected as costs of therelated revenue.  As a percentage ofrevenue, product development expenses were 5% for the three months ended June 30,2005 and 2004.  The costs as a percentageof revenue did not change during the quarter as the aforementioned increasedcosts were matched by the increase in revenue during the quarter.

 

Productdevelopment expenses were $605,000 and $732,000 for the six months ended June 30,2005 and 2004, respectively. The decrease of $127,000, or 17%, is due to decreasedcosts in the U.S. as development in 2005 was principally focused on customerspecific projects rather than general research and development efforts,partially offset by costs related to development work on Evolving Systems U.K.products. Costs for customer-specific projects are reflected as costs of therelated revenue.  As a percentage ofrevenue, product development expenses were 3% for the six months ended June 30,2005 and 7% for the six month ended June 30, 2004.  The decrease as a percentage of revenue is primarilydue to the increased revenue during the first half of 2005 compared to 2004.

 

**Amortization**

 

Amortizationexpense consists of amortization of identifiable intangibles from ouracquisitions of CMS, TSE and Tertio. Amortization expense was $1.4 million and$214,000 for the three months ended June 30, 2005 and 2004,respectively.  The increase inamortization expense of $1.2 million or 552% is due to amortization related toidentifiable intangibles from the acquisitions of Tertio and TSE.  As a percentage of revenue amortizationexpense increased to 14% for the three months ended June 30, 2005 from 4%for the three months ended June 30, 2004. The increase as a percentage ofrevenue is due to the aforementioned increase in expenses which was greaterthan the increase in revenue during the period.

 

Amortizationexpense was $2.8 million and $432,000 for the six months ended June 30,2005 and 2004, respectively.  Theincrease in amortization expense of $2.4 million or 552% is due to amortizationrelated to identifiable intangibles from the acquisitions of Tertio andTSE.  As a percentage of revenueamortization expense increased to 14% for the six months ended June 30,2005 from 4% for the six months ended June 30, 2004. The increase as a percentageof revenue is due to the aforementioned increase in expenses which was greaterthan the increase in revenue during the period.

 

**Restructuringand Other Expense**

 

Duringthe three and six months ended June 30, 2005, we recorded a restructuring recoveryof $3,000 and $51,000 in accordance with the Company’s restructuring plan, asfollows:

 

•                  *Closure of satelliteoffices.*  We closed all of oursatellite field offices during 2002. Because the costs to sublease or terminate these lease commitments arebased on estimates, we may incur additional costs related to the satelliteoffice closures.  During the three andsix months ended June 30, 2005 we recorded a recovery of $3,000 and $51,000related to the closure of the satellite offices as the actual costs to closethis facilities were less than our original estimate. As of June 30, 2005approximately $13,000 was included in accounts payable and accrued liabilitiesrelated to the closure of the satellite offices.

 

**Other Income(Expense), Net**

 

Otherincome (expense), net, was ($427,000) and $67,000 for the three months ended June 30,2005 and 2004, respectively.  The expenseduring 2005 is primarily due to interest expense from the notes payable issuedin the acquisition of Tertio.

 

Otherincome (expense), net, was ($932,000) and $124,000 for the six months ended June 30,2005 and 2004, respectively.  The expenseduring 2005 is primarily due to interest expense from the notes payable issuedin the acquisitions of TSE and Tertio.

 

**IncomeTaxes**

 

TheCompany recorded a net income tax benefit of $16,000 and $294,000 for the threeand six months ended June 30, 2005, respectively. The net benefit duringthe three and six months ended June 30, 2005 consists of current incometax expense of approximately $436,000 and $626,000, respectively and a deferredtax benefit of $452,000 and $920,000, respectively, both of which are relatedto the Company’s UK-based operations. For the six months ended June 30,2005, this represents an 9% effective tax rate, reflecting the blend of theestimated effective tax rate of our domestic pretax income of approximately 2%and the estimated effective tax rate related to our U.K. pretax income of approximately30%.

 

Inconjunction with the acquisition of Tertio, certain identifiable intangibleassets were recorded.  Since theamortization of these identifiable intangibles is not deductible for income taxpurposes, a long-term deferred tax liability of $4.6 million was established atthe acquisition date for the expected difference between what would be expensedfor financial reporting purposes and

 

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what would be deductiblefor income tax purposes. As of June 30, 2005, this deferred tax liabilitywas $3.7 million. This deferred tax liability is carried on the books of theCompany’s United Kingdom subsidiary, and has no impact on the Company’s abilityto recover its U.S.-based deferred tax assets.

 

Inconjunction with the acquisition of Tertio, future revenue under contracts inexistence at the acquisition dates was reduced to an amount equal to theCompany’s estimated costs to fulfill its obligations under the contracts plus areasonable profit margin on the Company’s estimated fulfillment effort.  The resulting reduction of future revenue recordedfor financial reporting purposes is not deductible for income tax purposes andthus, a current deferred tax liability of approximately $600,000 wasestablished at the acquisition date. As of June 30, 2005, this deferredtax liability was $128,000.  Both of theaforementioned deferred tax liabilities will be recognized as a reduction ofcurrent income tax expense as the identifiable intangibles are amortized andthe contract revenue is recognized.

 

**Liquidityand Capital Resources**

 

Wehave historically financed operations through cash flows from operations andequity transactions.  At June 30,2005, our principal source of liquidity was $4.6 million in cash and cashequivalents.

 

Netcash provided by operating activities was $1.8 million for the six months endedJune 30, 2005. The main factors in the cash provided by operatingactivities for the three months ended June 30, 2005 were decreases in contractreceivables of $5.0 million, interest expense added to debt principal of $660,000and depreciation and amortization of $3.6 million. Offsetting increases tocash flows from operating activities for the six months ended June 30, 2005was the net loss of $2.8 million, decreases in accounts payable and accruedliabilities of $1.2 million, unearned revenue of $2.5 million and the deferredforeign income tax benefit of $925,000.

 

Netcash provided by operating activities was $4.9 million for the six months endedJune 30, 2004.  The cash generatedfrom operating activities is primarily due to decreases in contract receivablesof $6.7 million and unbilled work-in-progress of $606,000 and depreciation andamortization of $971,000.  Offsettingincreases to cash flows from operating activities for the six months ended June 30,2004 were decreases in prepaid and other assets of $350,000, accounts payableand accrued liabilities of $665,000 and unearned revenue of $2.5 million.

 

Netcash used by investing activities during the six months ended June 30, 2005was $876,000. Cash used by investing activities for the six months ended June 30,2005 consisted of outflows of $365,000 related to contingent consideration paidto the sellers of TSE, partially offset by inflows related to the settlement ofpre-acquisition contingencies from the Tertio acquisition and outflows of $529,000for capital expenditures primarily related to the Tertio integration.

 

Netcash used by investing activities during the six months ended June 30,2004 of $712,000 was primarily due to capital expenditures of $756,000 fordomestic internal hardware that improved performance and reliability of ourproduct development environment, as well as servers and computers for EvolvingSystems India.

 

Financingactivities used $7.5 million in cash during the six months ended June 30,2005. During the first half of 2005, we made payments of $7.5 million on acquisitionrelated notes payable and an acquired dividend payable assumed in the Tertioacquisition. We received proceeds of $63,000 during the six months ended June 30,2005, from the issuance of approximately 37,000 shares of common stock relatedto our stock option and employee stock purchase plans.

 

Financingactivities provided $326,000 for the six months ended June 30, 2004,related to the exercise of approximately 165,000 stock options.

 

Workingcapital (deficit) at June 30, 2005 was ($7.1) million compared to ($3.3)million at December 31, 2004. As previously mentioned, we acquired twocompanies, TSE and Tertio, during the fourth quarter of 2004. We made net paymentsof approximately $8.0 million during the six months ended June 30, 2005related to notes payable, an acquired dividend obligation assumed andcontingent consideration related to the TSE and Tertio acquisitions. Theacquisition of Tertio also includes the issuance of long-term seller-financednotes (“Long-Term Notes”) of approximately $11.9 million of which $4.5 millionis due within the next twelve months. We believe that our current cash and cashequivalents, together with anticipated cash flow from operations will besufficient to meet our working capital and capital expenditure requirements forat least the next twelve months. In making this assessment we considered thefollowing:

 

•                  Ourcash and cash equivalents balance at June 30, 2005 of $4.6 million.

 

•                  Ourability to generate positive cash flows from operations. During 2003, 2004 andthe six months ended June 30, 2005 we generated cash flows from operationsof $6.9 million, $4.3 million and $1.8 million, respectively.

 

•                  Ourbacklog of approximately $14.5 million, including $3.3 million in license feesand services and $11.2 million in customer support at June 30, 2005.

 

•                  InJuly 2005, we took steps to reduce our cost structure by reducing ourworkforce in the U.S. and U.K. by 10%. This will allow us to save more thanapproximately $3.0 million annually.

 

•                  Webelieve that we can restructure the Long-Term Notes which would lower theinterest rate and extend maturity.

 

•                  Ourcash forecast indicates that we will have sufficient liquidity to coveranticipated operating costs as well as debt 

 

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service payments.

 

To theextent we are unable to invoice and collect in a timely manner under ourcustomer revenue arrangements, it could have an adverse impact on our abilityto meet our intended business objectives. Management believes that we have theability to further reduce operating expenses, if necessary, such that currentworking capital (exclusive of deferred revenue) and cash flows from operationswill be adequate to meet our cash needs through the next twelve months.

 

Notwithstandingthese assessments, if the timing of cash generated from operations isinsufficient to satisfy our liquidity requirements, or an unexpected adverseevent, or combination of events occurs, we may require access to additionalfunds to support our business objectives through debt restructuring, a creditfacility or possibly the issuance of additional equity. There can be noassurance that additional financing will be available at all or that ifavailable, such financing will be obtainable on terms favorable to us and wouldnot be dilutive.

 

We issuedthe Long-Term Notes payable on November 2, 2004, in conjunction with theacquisition of Tertio.  From theacquisition date through November 2, 2006, the Long-Term Notes bear interestat 11.0% per annum. From November 2, 2006 through the maturity date of December 31,2007, the notes will bear interest at 14.0% per annum. Interest is accrued tothe principal balance through December 31, 2005, and beginning March 31,2006, interest is payable on a quarterly basis in addition to the scheduledprincipal payments. The Long-Term Notes may be prepaid at any time withoutpenalty. Beginning on March 31, 2005, if our quarterly cash balancesexceed $7.0 million the holder of the Long-Term Notes may require a prepaymenton the note equal to the amount by which the quarterly cash balance exceeds$7.0 million. Based on our current cash projections, no such additionalpayments will be required during the twelve months ended June 30, 2006.The scheduled principal payments on the long-term seller financed notes are asfollows (in thousands):

 
| **Principal Payment date** | ** ** | **Amount** | ** ** |
|----------------------------|------------|------------|------------|
| March 31, 2006        |       | $          | 1,340      |   |
| June 30, 2006         |       | 3,110      |       |
| December 31, 2006     |       | 1,430      |       |
| March 31, 2007        |       | 1,870      |       |
| June 30, 2007         |       | 3,110      |       |
| December 31, 2007     |       | 1,979      |       |
|                       |       | $          | 12,839     |   |

 

TheLong-Term Notes subject us to certain affirmative and negative covenants,including a financial covenant indexed to our computation of EBITDA, asdefined.  We are required to comply withsuch covenants beginning June 30, 2005 and we were in compliance as ofthat date.

 

**FactorsThat Might Affect Operating Results**

 

Theseresults should be read in conjunction with the risk factors defined in theCompany’s Annual Report on Form 10-K for the year ended December 31,2004. Statements contained in this Quarterly Report with respect to futurerevenue and expenses are “forward-looking statements” within the meaning of Section 21Eof the Securities Exchange Act of 1934, as amended. Actual results may differ.Among the factors that could cause actual results to differ are those describedbelow and in more detail in our Annual Report on Form 10-K.

 

**Risks related to Tertio Acquisition**

 

***We are subject to financial and operating risks associatedwith international sales and services.***

 

Historicallysales of our products have been limited to customers in the United States. Ouronly international operational experience has been with our Indian offshoredevelopment subsidiary. The acquisition of Tertio resulted in the addition of significantsales and operations outside the United States, including Europe, Asia andAfrica. If we are unable to manage our sales and operations on a global basis,our financial condition or results of operations could be materially adverselyaffected.  Our international business issubject to financial and operating risks including:

 

•                  unexpectedchanges in, or impositions of, legislative or regulatory requirements;

 

•                  difficulties in maintaining effectivecontrols over financial reporting across geographically dispersed entities,including those related to different business practices in foreign countries;

 

•                  internalcontrol-related risks of running a foreign subsidiary;

 

•                  changes in the demand for ourproducts and services due to the perception that we are an “American” companyin countries where the United States’ foreign policy is not viewed favorably;

 

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•                  fluctuatingexchange rates, tariffs, currency repatriation restrictions and other barriers;

 

•                  difficultiesin staffing and managing foreign subsidiary operations;

 

•                  importor export restrictions;

 

•                  greaterdifficulties in accounts receivable collection and longer payment cycles;

 

•                  potentially adverse tax consequencesand additional tax considerations such as foreign withholding taxes and paymentof value added tax (VAT);

 

•                  potentialhostilities and changes in diplomatic and trade relationships;

 

•                  changesin a country’s economic or political conditions; and

 

•                  differingcustomer and/or technology standards requirements.

 

***Our stockholders will be diluted by the conversion ofoutstanding Series B Redeemable Convertible Preferred Stock.***

 

In consideration for our acquisition of Tertio, wemade a cash payment of $11.0 million, issued 966,666 shares of Series BRedeemable Convertible Preferred Stock (the Series B Preferred Stock),issued a short-term secured note with a principal amount of $4.0 millionbearing interest at 5.5% per annum and issued long-term secured notes with anaggregate principal amount of approximately $11.9 million bearing interestinitially at 11% per annum (increasing to 14% on the second anniversary). Each share of Series B Preferred Stock is initially convertible into threeshares of our common stock which could result in the issuance of up to2,899,998 shares of our common stock.

 

Prior to our acquisition of Tertio, only one of ourstockholders reported beneficial ownership in excess of 5% of our commonstock.  If the shares of Series BPreferred Stock are exchanged for shares of our common stock, such stockholderswould beneficially own approximately 15.3% of our issued and outstanding sharesof common stock (after giving effect to such conversions).  The sale bysuch holders of one or more large blocks of our common stock could have anegative impact on the market price of our common stock.  Additionally, such ownership interests couldeffectively deter a third party from making an offer to buy us, which mightinvolve a premium over our current stock price or other benefits for ourstockholders, or otherwise prevent changes in the control or management ofEvolving Systems.  In addition, there are no restrictions, in the form ofa standstill agreement or other agreements with such stockholders, on theirability or their affiliates to purchase additional shares of our common stockand thereby further increase their ownership interests.

 

The holders of the Series B Preferred Stock areentitled to vote on any matters presented to our stockholders together with theholders of common stock.  While eachshare of Series B Preferred Stock initially converts into three shares ofthe Company’s common stock, each such share of Series B Preferred Stock isonly entitled to approximately 2.26 votes in order to comply with certainvoting rights rules promulgated by NASDAQ relating to the fact that the Series BPreferred Stock was issued at a discount to market on the date of issuance. Asof the date hereof, the holders of the Series B Preferred Stock wereentitled to an aggregate of approximately 2,184,665 votes on all matterspresented to the holders of common stock based on their ownership of the Series BPreferred Stock.  The Series BPreferred Stock is voluntarily convertible into our common stock at anytime atthe option of the holders thereof, at which time each such share of commonstock will be entitled to one vote per share.

 

On May 16, 2005, the Company sought the approvalof its stockholders to exchange the $11.9 million long-term notes issued inconnection with our acquisition of Tertio into convertible notes.  While the note exchange proposal received therequisite number of votes for approval, a required amendment to the Company’scertificate of incorporation to increase the number of authorized shares ofcommon stock to effectuate any such conversions did not receive enough votes,which therefore caused the note exchange proposal to fail.  As a result, the long-term notes will remainoutstanding in accordance with their terms. The Company may, but is not obligated to, resubmit such proposals to itsstockholders in the future for their reconsideration. Accordingly, if theexchange of all or any portion of the long-term notes to convertible notes iseventually approved or otherwise authorized, the Company’s stockholders wouldexperience additional dilution of their ownership interests and voting rights.

 

***The holders of our Series B Preferred Stock havepreferential rights that may be adverse to holders of our common stock.***

 

The holders of the Series B Preferred Stock havepreferential rights with respect to distributions upon a liquidation ofEvolving Systems, including certain business combinations deemed to be aliquidation.  Accordingly, no distributions upon liquidation may be madeto the holders of common stock until the holders of the Series B PreferredStock have been paid their liquidation preference of $3.89 per share (on an asconverted to common stock basis), subject to adjustment.  As a result, itis possible that, on liquidation, all amounts available for the holders ofequity of Evolving Systems would be paid to the holders of the Series BPreferred Stock, and that the holders of common stock would not receive anypayment.  Additionally, in connection with the Tertio acquisition we areobligated to file and keep effective a registration statement providing for theresale of the shares of our common stock issuable upon the conversion of the Series BPreferred Stock.  If the Securities and Exchange Commission refuses todeclare the registration statement effective or we fail to keep

 

22

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the registrationstatement effective, the holders of the Series B Preferred Stock will havethe right to cause us to repurchase for cash the shares of the Series BPreferred Stock for $3.89 per share (on an as converted basis), orapproximately $11.3 million. If we are required to make this payment, it wouldhave a significant adverse impact on our liquidity and could cause us to incuradditional indebtedness.

 

Additionally, the Series B Preferred Stock containcertain weighted average price based anti-dilution protections that, as long asthey remain outstanding, would be triggered if we issued shares of our commonstock (subject to certain adjustments and standard exclusions relating toCompany options) below $3.89 per share. However, such anti-dilution adjustmentsare capped to prohibit the Series B Preferred Stock from converting into20% or more of our outstanding common stock.

 

In the event that we issued shares below thisthreshold, the holders of our common stock would be diluted to an unknowndegree.  Furthermore, the mere existenceof such anti-dilution protections could make it difficult for us to issue anycommon stock below $3.89 per share, if at all. In the event the anti-dilution adjustments of the Series BPreferred Stock are triggered, such adjustments would result in a deemeddividend to the Series B Preferred Stock holders that would reduce incomeavailable to common stockholders.  Thecharge would be equal to the number of additional shares issuable as a resultof the anti-dilution calculation, multiplied by the fair value of the commonstock on the date of the issuance of the Series B Preferred Stock, whichwas $4.64 per share.  The deemed dividendcharge could negatively affect the price of our common stock.

 

***The indebtedness incurred in connection with the Tertioacquisition may limit our ability to grow and could adversely affect ourfinancial condition.***

 

The indebtedness incurred with respect to theshort-term and long-term secured notes and, possibly, the redemption of the Series BPreferred Stock, is material in relation to our current level ofindebtedness.  No assurance can be given that sufficient funds will beavailable to meet our operating needs, to pay the interest due on the short-termand long-term secured notes or, if required, to redeem  the Series B Preferred Stock.  Thenotes are secured by a general lien on all of our assets.  If we areunable to pay the notes as they become due, the holders of the notes couldforeclose on all of our assets.  Theincreased level of our indebtedness, among other things, could:

 

•                  make it difficult for us to obtain any necessaryfuture financing for working capital, capital expenditures, debt servicerequirements or other purposes;

 

•                  limit our flexibility in planning for, orreacting to changes in, our business; and

 

•                  make us more vulnerable in the event of adownturn in our business.

 

If we incur new indebtedness inthe future, the related risks that we now face could intensify. Whether we areable to make required payments on our outstanding indebtedness and to satisfyany other future debt obligations will depend on our future operatingperformance and our ability to obtain additional debt or equity financing.

 

***The terms and conditions of the Series B PreferredStock may have an adverse impact on our results of operations and financialperformance.***

 

The inability to register shares of our common stockunderlying the Series B Preferred Stock and/or an inability to keep suchregistration effective could result in the Series B Preferred Stockbecoming mandatorily redeemable. Currently, the Series B Preferred Stock is classified asnon-permanent equity since the events that would require its redemption havenot occurred.  If we are unable to obtainand maintain the effectiveness of the related registration statement, the Series BPreferred Stock will become mandatorily redeemable at the option of the holdersand the instrument will be reclassified as a liability.  Upon reclassification, the Series BPreferred Stock will be re-measured at its then current fair value and thedifference between its fair value and redemption price will be charged toadditional paid-in capital.  Such chargeto equity may negatively impact the price of our common stock.  Subsequent changes to the fair value of thisinstrument would be recognized in earnings, as a charge or income, and suchamounts could be significant and unpredictable.

 

***Certain provisions of the note payable issued in conjunctionwith the Tertio acquisition call for the acceleration of payments if certaincovenants are breached or cash balance thresholds are achieved.***

 

Thenotes issued in conjunction with the Tertio acquisition contain certainaffirmative and negative covenants that, if breached, could result in theacceleration of such notes becoming immediately due and payable. The covenantsinclude the Company’s agreement to do the following:

 

•                  comply with applicable laws and licensingrequirements;

 

•                  file and pay all applicable taxes as they becomedue; and

 

23

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•                  operate in the ordinary course of business.

 

•                  The covenants also include the Company’sagreement not to do any of the following (except as specifically authorized insuch notes):

 

•                  liquidate, dissolve or wind-up operations;

 

•                  pay any dividends or make prepayments on anyindebtedness;

 

•                  acquire any other businesses or entities or makeinvestments in third parties;

 

•                  sell or transfer a substantial portion of theCompany’s assets;

 

•                  incur additional indebtedness or permit any lienson the Company’s assets;

 

•                  make capital expenditures beyond establishedthresholds; or

 

•                  take certain other operational actions.

 

Thecovenants may limit the Company’s flexibility in planning for, or reacting tochanges in, its business. Failure to comply with such covenants, if not waived,could result in the acceleration of the notes. If the Company is required topay the notes on an accelerated basis, it would have a significant adverseimpact on the Company’s liquidity and financial condition and could cause us toincur additional indebtedness.

 

Additionally,the notes issued in conjunction with the Tertio acquisition require us to offerthe note holders a prepayment on such notes in the amount that our closing cashbalance exceeds $7.0 million at the end of any fiscal quarter beginningwith the quarter ended March 31, 2005. Such a requirement will restrictour liquidity and cash management flexibility. Until the notes are repaid, ourability to engage in transactions or to enter into agreements requiringsignificant cash investments may be adversely affected.

 

**RisksRelated to Our Business**

 

***Because our quarterly and annual operating results aredifficult to predict and may fluctuate, the market price for our stock may bevolatile.***

 

Ouroperating results have fluctuated significantly in the past and may continue tofluctuate significantly in the future. Fluctuations in operating results mayresult in volatility of the price of our common stock. These quarterly andannual fluctuations may result from a number of factors, including:

 

•                  thesize of new contracts and when the related revenue is recognized;

 

•                  ourrate of progress under our contracts;

 

•                  acquisition and integration costs;

 

•                  thetiming of customer and market acceptance of our products and service offerings;

 

•                  our ability to effectively manage offshoresoftware development in India;

 

•                  actualor anticipated changes in government laws and regulations related to thetelecommunications market;

 

•                  judicialor administrative actions about these laws or regulations;

 

•                  thenature and pace of enforcement of the Telecom Act as well as other similarforeign statutes, regulations and acts;

 

•                  productlifecycles;

 

•                  themix of products and services sold;

 

•                  changesin demand for our products and services;

 

•                  thetiming of third-party contractors’ delivery of software and hardware;

 

•                  budgetingcycles of our customers;

 

•                  changesin the terms and rates related to the renewal of support agreements;

 

24

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•                  leveland timing of expenses for product development and sales, general andadministrative expenses;

 

•                  competitionby existing and emerging competitors in the communications software markets;

 

•                  oursuccess in developing and selling new products, controlling cost, attractingand retaining qualified personnel and expanding our sales and customer focusedprograms;

 

•                  softwaredefects and other product quality problems;

 

•                  changesin our strategy;

 

•                  theextent of industry consolidation;

 

•                  foreignexchange fluctuations; and

 

•                  generaleconomic conditions.

 

Ourexpense levels are based in significant part on our expectations regardingfuture revenue. Our revenue is difficult to forecast as the market for ourproducts and services is rapidly changing, and our sales cycle and the size andtiming of significant contracts vary substantially among customers.Accordingly, we may be unable to adjust spending in a timely manner tocompensate for any unexpected shortfall in revenue. Any significant shortfallfrom anticipated levels of demand for our products and services could have amaterial adverse effect on our business, financial condition, results ofoperations and cash flows.

 

Basedon these factors, we believe our future quarterly and annual operating resultsmay vary significantly from quarter to quarter and year to year. As a result,quarter-to-quarter and year-to-year comparisons of operating results are notnecessarily meaningful nor do they indicate what our future performance willbe. Furthermore, we believe that in future reporting periods if our operatingresults fall below the expectations of public market analysts or investors, itis possible that the market price of our common stock could go down.

 

***Our results of operations could be negatively impacted if we are unableto manage our liquidity.***

 

Our cash forecastindicates that we will have sufficient liquidity to cover anticipated operatingcosts as well as debt service payments, but to the extent we are unable toinvoice and collect in a timely manner under our customer revenue arrangements,or an unexpected adverse event, or combination of events occurs, it could havean adverse impact on our ability to meet our intended business objectives.Therefore, if the timing of cash generated from operations is insufficient tosatisfy our liquidity requirements, we may require access to additional fundsto support our business objectives through debt restructuring, a creditfacility or possibly the issuance of additional equity. There can be noassurance that additional financing will be available at all or that ifavailable, such financing will be obtainable on terms favorable to us and wouldnot be dilutive.

 

***Ourinternational  operations pose complexforeign currency, economic, regulatory and tax risks, which  may have a material adverse effect on ourbusiness, financial condition and results of operations.***

 

Forthe three and six months ended June 30, 2005, we generated revenue ofapproximately $5.2 million and $10.0 million, respectively, from our foreignsubsidiaries, representing 53% and 51%, respectively, of our total consolidatedrevenue.  We anticipate thatinternational revenue will continue to account for a significant percentage ofour total revenue.  Our international operationsare subject to the risk factors inherent in the conduct of internationalbusiness, including:

 

•      unexpectedchanges in regulatory requirements;

 

•                   tariffs and other barriers;

 

•      political and economic instability;

 

•      limited intellectual property protection;

 

•      difficulties in staffing and managingforeign operations; and

 

•                   potentially adverse tax consequencesin connection with repatriating funds.

 

We maynot be able to sustain or increase our international revenue or repatriate suchrevenues without incurring substantial risks involving floating currencyexchange rates and income tax expenses. Any of the foregoing factors may have a material adverse effect on ourinternational operations and, therefore, our business, financial condition andresults of operations.

 

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***Changes to theregulations of the communication industry, or challenges thereto, could hurtthe market for our products and services.***

 

Themarket for our traditional North American OSS products was created and hasprimarily been driven by the adoption of regulations under the Telecom Actrequiring Regional Bell Operating Companies (“RBOCs”) to implement LNP as acondition to being permitted to provide long distance services. Therefore, anychanges to these regulations, or the adoption of new regulations by federal orstate regulatory authorities under the Telecom Act, or any legal challenges tothe Telecom Act, could hurt the market for our products and services. Forexample, when the FCC delayed implementation of the Telecom Act with respect towireless carriers until November 2003, these delays had an impact on ourrevenue from our WNP products and services. Likewise, in mid-2001 when VerizonWireless petitioned the FCC requesting forbearance from this requirement, wesaw our wireless customers delay making decisions to purchase WNP products. WNPwent into effect in November 2003.  Anyinvalidation, repeal or modification in the requirements imposed by the TelecomAct or the FCC, could materially harm our business, financial condition andresults of operations. In addition, customers may require, or we may find itnecessary or advisable, to modify our products or services to address actual oranticipated changes in regulations affecting our customers. This could alsomaterially harm our business, financial condition, results of operations, andcash flows.  Additionally, with ouracquisition of Tertio, we are now subject to numerous regulatory requirementsof foreign jurisdictions.  Any compliancefailures or changes in such regulations could also materially harm ourbusiness, financial condition, results of operations and cash flows.

 

***We depend on alimited number of significant customers for a substantial portion of ourrevenues, and the loss of one or more of these customers could adversely affectour business.***

 

In thepast, and currently, we earn a significant portion of our revenue from a smallnumber of customers in the communications industry. This has been mitigatedsomewhat by the expansion of our customer base through our recent acquisitions.However, the loss of any significant customer, delays in delivery or acceptanceof any of our products by a customer, delays in the performance of services fora customer, or delays in collection of customer receivables could be materiallyharmful to our business, financial condition, results of operations and cashflows.

 

***The integration of entities that we haverecently acquired may not achieve the expected results and may result inunexpected liabilities and costs***

 

Theintegration of Tertio and TSE or future acquisitions may present risks and wemay be unable to achieve the product, financial or strategic goals intended atthe time of any acquisition. The risks we may encounter in such transactionsinclude:

 
| • |   | we may have  difficulty assimilating the operations and personnel of the acquired company;                                                                                                                                                                                                                                                                                                                                                                           |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | we may have  difficulty effectively integrating the acquired technologies or products with  our current products and technologies;                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | we may incur  unanticipated liabilities that are not covered by our indemnification rights  under the applicable acquisition agreements;                                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | we may have  difficulty in maintaining controls, procedures and policies during the  transition and integration, as well as successfully completing in 2005  management’s assessment of its internal controls over financial reporting as  required by Section 404(a) of the Sarbanes-Oxley Act and our  independent registered public accounting firm’s examination thereon as  required by Section 404(b) of the Sarbanes-Oxley Act; |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | customers of the  acquired company may decide not to renew their contracts with the combined  entity and other ongoing business may be disrupted by transition and  integration issues;                                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | we may not be  successful in cross-selling products between Evolving Systems’ and the  acquired companies’ customer bases;                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | the financial  and strategic goals for the acquired and combined businesses may not be  achieved;                                                                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | due diligence  processes may have failed to identify significant issues with product  quality, intellectual property ownership, product architecture, legal and  financial contingencies, and product development;                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | significant  impairment charges may be recorded if intangible assets, including goodwill,  acquired in business combinations are determined to be unrecoverable or  impaired;                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | acquisitions and  their subsequent integration require considerable time and commitment of  management, which can distract management from day-to-day operations and  result in additional costs which reduce profits;                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | we do not know  if we have or will be able to identify and purchase assets and/or companies  that will complement our business;                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| • |   | our stockholders  may experience additional dilution of their interests in Evolving Systems as  a result of the issuance of convertible preferred stock, other convertible  instruments and/or common stock in connection with                                                                                                                                                                                                                                       |

 

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|   |   | our  acquisitions;                                                                                                                                                                                                                                                                        |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                      |
| • |   | certain management  and other employees of Tertio and TSE, or future acquisitions, may be  critical to the success of the acquired company, and we do not know if we  will be successful in retaining these individuals in the combined companies;  and                                   |
|   |   |                                                                                                                                                                                                                                                                                      |
| • |   | the price of our  stock may go down as stockholders who received stock in the CMS transaction,  and those receiving stock in connection with the Tertio transaction, or any  future transaction, elect to sell their shares, or the marketplace does not  favorably view the transaction. |

 

Basedon all of the foregoing, we believe it is possible for future revenue, expensesand operating results to vary significantly from quarter to quarter and year toyear. As a result, quarter-to-quarter and year-to-year comparisons of operatingresults are not necessarily meaningful or indicative of future performance.

 

***Our products are complex and have a lengthy implementationprocess; unanticipated difficulties or delays in the customer acceptanceprocess could result in higher costs and delayed payments.***

 

Implementingour solutions can be a relatively complex and lengthy process since wetypically customize these solutions for each customer’s unique environment.Often our customers may also require rapid deployment of our softwaresolutions, resulting in pressure on us to meet demanding delivery andimplementation schedules. Delays in implementation may result in customerdissatisfaction and/or damage our reputation. This could materially harm ourbusiness, financial condition, results of operations and cash flows.

 

The majority of ourexisting contracts provide for acceptance testing by the customer, which can bea lengthy process. Unanticipated difficulties or delays in the customeracceptance process could result in higher costs, delayed payments, and deferralof revenue recognition. In addition, if our software contains defects or weotherwise fail to satisfy acceptance criteria within prescribed times, thecustomer may be entitled to cancel its contract and receive a refund of all ora portion of amounts paid or other amounts as damages, which could exceedrelated contract revenue and which could result in a future charge to earnings.Any failure or delay in achieving final acceptance of our software and servicescould have a material harmful effect on our business, financial condition,results of operations and cash flows.

 

***Our products typically require significant review andinternal approval processes by our customers over an extended period oftime.  Interruptions in such process dueto economic downturns, consolidations or otherwise could result in the loss ofour sales and adversely affect our financial performance.***

 

Large communicationssolutions used for enterprise-wide, mission-critical purposes, involvesignificant capital expenditures and lengthy implementation plans. Prospectivecustomers typically commit significant resources to the technical evaluation ofour products and services and require us to spend substantial time, effort andmoney providing education regarding our solutions. This evaluation processoften results in an extensive and lengthy sales cycle, typically rangingbetween three and twelve months, making it difficult for us to forecast thetiming and magnitude of sales contracts. For example, customers’ budgetary constraintsand internal acceptance reviews may cause potential customers to delay orforego a purchase. The delay or failure to complete one or more large contractscould materially harm our business, financial condition, results of operationsand cash flows and cause our operating results to vary significantly fromquarter to quarter and year to year.

 

The U.S.communications industry has recently experienced significant reorganization andconsolidation. This may continue. Mergers and acquisitions of large communications companies, as well asthe formation of new alliances, have resulted in a constantly changingmarketplace for our products and services. Delays associated with these changesare common. These consolidations have caused us to lose customers and it ispossible that we could lose additional customers as a result of moreconsolidations. In addition, the U.S. communications industry is stillrecovering from the recent industry downturn (which began in the second half of2000), and many of the companies in the communications industry have keptcapital expenditures at historically low levels in response to changes in thecommunications marketplace; some companies have declared bankruptcy, cancelledcontracts, delayed payments to their suppliers or delayed additionalpurchases.  The delay or failure tocomplete one or more large contracts, or the loss of a significant customer,could materially harm our business, financial condition, results of operations,or cash flows, and cause our operating results to vary significantly fromquarter to quarter and year to year.

 

***Many of ourproducts and services are sold on a fixed-price basis, if we incur budgetoverruns, our margins and results of operations may be materially harmed.***

 

Currently,a large portion of our revenue is from contracts that are on a fixed-pricebasis. We anticipate that customers will continue to request we providesoftware and integration services as a total solution on a fixed-price basis.These contracts specify certain obligations and deliverables we must meetregardless of the actual costs we incur. Projects done on a fixed-price basisare subject to budget overruns. On occasion, we have experienced budgetoverruns, resulting in lower than anticipated margins. We can give no assurancewe will not incur similar budget overruns in the future, including overrunsthat result in losses on these contracts. If we incur budget overruns, ourmargins and results of operations may be materially harmed.

 

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***The industry inwhich we compete is subject to rapid technological change, if we fail todevelop or introduce new, reliable and competitive products in a timelyfashion, our business may suffer.***

 

Themarket for our products and services is subject to rapid technological changes,evolving industry standards, changes in carrier requirements and preferencesand frequent new product introductions and enhancements. The introduction ofproducts that incorporate new technologies and the emergence of new industrystandards can make existing products obsolete and unmarketable. To competesuccessfully, we must continue to design, develop and sell enhancements toexisting products and new products that provide higher levels of performanceand reliability in a timely manner, take advantage of technologicaladvancements and changes in industry standards and respond to new customerrequirements. As a result of the complexities inherent in software development,major new product enhancements and new products can require long developmentand testing periods before they are commercially released and delays in planneddelivery dates may occur. There can be no assurance we will successfullyidentify new product opportunities or will achieve market acceptance of newproducts brought to market. In addition, products developed by others may causeour products to become obsolete or noncompetitive. If we fail to anticipate orrespond adequately to changes in technology and customer preferences, or if ourproducts do not perform satisfactorily, or if we have delays in productdevelopment, our business, financial condition, results of operations may bematerially harmed.

 

***The market for ournumber portability products is mature and we may not be able to successfullydevelop new products to remain competitive.***

 

Themarket for our number portability products is mature in the U.S and we may notbe able to successfully identify new product opportunities in the U.S. orabroad or achieve market acceptance of new products brought to the market.  Although wireless number portability was onlyrecently mandated in the U.S., many of the wireless carriers selected solutionsfrom our competitors and it is unclear how many new opportunities there will bewith these carriers.  If we are unable toidentify new product opportunities in the U.S. or abroad, our business,financial condition, results of operations or cash flows could be materiallyharmed.

 

***The steps that wehave taken to reduce costs may have a negative impact on our ability to growand generate future revenue.***

 

Wehave taken steps to reduce our expenses, such as reductions in staff andgeneral cost control measures. If, as a result of such cost reductions, we havenot adequately responded to balance expenses against revenue, or if our fixedcosts cannot be reduced enough, our financial condition could be materiallyharmed. Likewise, cutbacks in staff may have an impact on our ability togenerate future revenue.

 

***If we are unable to properly supervise oursoftware development subsidiary in India, or if political or otheruncertainties interfere,******we may be unable to satisfactorily perform our customercontracts and our business could be materially harmed.***

 

In February 2004,we formed Evolving Systems India, a wholly owned subsidiary of EvolvingSystems, to transfer the services provided by our Indian subcontractor,Infosys, to Evolving Systems India.  Ifwe are unable to effectively manage the Evolving India development staff and/orwe experience high levels of staff turnover, we may  fail to provide quality software in a timelyfashion, which could negatively affect our ability to satisfy our customercontracts.  Furthermore, politicalchanges and uncertainties in India could negatively impact the business climatethere.  As a result, we may be unable tosatisfactorily perform our customer contracts and our business, financialcondition and results of operations could be materially harmed.

 

***The communications industry is highlycompetitive and if our products do not satisfy customer demand for performanceor price, our customers could purchase products and services from ourcompetitors.***

 

Ourprimary markets are intensely competitive and are subject to rapidtechnological changes, evolving industry standards and regulatory developments.We face continuous demand for improved product performance, new productfeatures and reduced prices, as well as intense pressure to accelerate therelease of new products and product enhancements. Our existing and potentialcompetitors include many large domestic and international companies, includingsome competitors that have substantially greater financial, manufacturing,technological, marketing, distribution and other resources, larger installedcustomer bases and longer-standing relationships with customers than we do. Ourprincipal competitors in the LNP and WNP market include Telcordia Technologies, Inc.,Syniverse Technologies and Tekelec. Our principal competitors in activation areMetasolv and Comptel. In mediation, we compete with many different companieswith no single dominant competitor. There also can be no assurance thatcustomers will not offer competitive products or services in the future sincecustomers who have purchased solutions from us are not precluded from competingwith us. Many telecommunications companies have large internal developmentorganizations, which develop software solutions and provide services similar tothe products and services we provide. We also expect competition may increasein the future from Application Service Providers, existing competitors and fromother companies that may enter our existing or future markets with solutionswhich may be less costly, provide higher performance or additional features orbe introduced earlier than our solutions.

 

Webelieve that our ability to compete successfully depends on numerous factors.For example, the following factors affect our ability to compete successfully:

 

•                  howwell we respond to our customers’ needs;

 

•                  thequality and reliability of our products and services and our competitors’products and services;

 

•                  theprice for our products and services, as well as the price for our competitors’products and services;

 

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•                  howwell we manage our projects;

 

•                  ourtechnical subject matter expertise;

 

•                  thequality of our customer service and support;

 

•                  theemergence of new industry standards;

 

•                  thedevelopment of technical innovations;

 

•                  ourability to attract and retain qualified personnel;

 

•                  regulatorychanges; and

 

•                  generalmarket and economic conditions.

 

Someof these factors are within our control, and others are not. A variety ofpotential actions by our competitors, including a reduction of product pricesor increased promotion, announcement or accelerated introduction of new orenhanced products, or cooperative relationships among competitors and theirstrategic partners, could harm our business, financial condition, results ofoperations and cash flows. There can be no assurance that we will be able tocompete successfully with existing or new competitors or that we will properlyidentify and address the demands of new markets. This is particularly true innew markets where standards are not yet established. Our failure to adapt toemerging market demands, respond to regulatory and technological changes orcompete successfully with existing and new competitors would materially harmour business, financial condition, results of operations and cash flows.

 

***Our failure to attract and retain qualifiedpersonnel on a timely basis could materially harm our business.***

 

Ourability to manage future expansion, if any, effectively will require us toattract, train, motivate and manage new employees successfully, to integratenew management and employees into our overall operations and to continue toimprove our operations, financial and management systems. There can be noassurance that we will be able to retain personnel or to hire additionalpersonnel on a timely basis, if at all. Because of the complexity of oursoftware solutions, a significant time lag exists between the hiring date oftechnical and sales personnel and the time when they become fully productive.We have at times experienced difficulty in recruiting and retaining suchpersonnel. In addition, our stock option plan terminates on January 19,2006 and under Nasdaq rules we will be required to obtain stockholderapproval to establish a new equity compensation plan. If we are unsuccessful inobtaining this approval, our ability to attract or retain employee may beharmed. Our failure to retain personnel or to hire qualified personnel on atimely basis could materially harm our business, financial condition, resultsof operations and cash flows.

 

***Our products are complex and may haveerrors that are not detected until deployment, and litigation related towarranty and product liability claims could be expensive and could negativelyaffect our reputation and profitability.***

 

Ouragreements with our customers typically contain provisions designed to limitour exposure to potential liability for damages arising out of the use of ordefects in our products. These limitations, however, tend to vary from customerto customer and it is possible that these limitations of liability provisionsmay not be effective. We currently have errors and omissions insurance, which,subject to customary exclusions, covers claims resulting from failure of oursoftware products or services to perform the function or to serve the purposeintended. To the extent that any successful product liability claim is notcovered by this insurance, we may be required to pay for a claim. This could beexpensive, particularly since our software products may be used in criticalbusiness applications. Defending such a suit, regardless of its merits, couldbe expensive and require the time and attention of key management personnel,either of which could materially harm our business, financial condition andresults of operations. In addition, our business reputation could be harmed byproduct liability claims, regardless of their merit or the eventual outcome ofthese claims.

 

***There can be no assurances that ourmeasures to protect our proprietary technology and other intellectual propertyrights are adequate and if we fail to protect those rights, our business wouldbe harmed.***

 

Oursuccess and ability to compete are dependent to a significant degree on ourproprietary technology. We rely on a combination of patent, copyright,trademark and trade secret laws, as well as confidentiality agreements andlicensing arrangements, to establish and protect our proprietary rights. Wehave U.S. patents on elements of our LNP products, ***NumberManager®***and ***OrderPath®***, and elements of ourOmniPresenceServer application and have applied for patent protection onvarious other elements of our ***OmniPresenceServer***TM application and our ServiceXpressTest Harness application. In addition, we have registered or filed forregistration of certain of our trademarks. Despite these precautions, it may bepossible for a third party to copy or otherwise obtain and use our products ortechnology without authorization or to develop similar technology independentlythrough reverse engineering or other means. In addition, the laws of someforeign countries may not adequately protect our proprietary rights. There canbe no assurance that our means of protecting our proprietary rights in the U.S.or abroad will be adequate or that others will not independently developtechnologies that are similar or superior to our technology, duplicate ourtechnology or design around any of our patents.

 

***In the event that we are infringing uponthe proprietary rights of others or violating licenses, we may become subjectto infringement claims that may prevent us from selling certain products and wemay incur significant expenses in resolving these claims.***

 

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It isalso possible that our business activities may infringe upon the proprietaryrights of others, or that other parties may assert infringement claims againstus. If we become liable to any third party for infringing its intellectualproperty rights, we could be required to pay substantial damage awards and todevelop non-infringing technology, obtain licenses, or to cease selling theapplications that contain the infringing intellectual property. Litigation issubject to inherent uncertainties, and any outcome unfavorable to us couldmaterially harm our business. Furthermore, we could incur substantial costs indefending against any intellectual property litigation, and these costs couldincrease significantly if any dispute were to go to trial. Our defense of anylitigation, regardless of the merits of the complaint, likely would betime-consuming, costly, and a distraction to our management personnel. Adversepublicity related to any intellectual property litigation also could harm thesale of our products and damage our competitive position.

 

Certainsoftware developed or used by Evolving Systems, as well as certain softwareacquired in our acquisitions of TSE or Tertio, may include or be derived fromsoftware that is made available under an open source software license.

 

•             Such open source software may be madeavailable under a license such as the GNU General Public License (“GPL”) or GNULesser General Public License (“LGPL”) which imposes certain obligations on usin the event we were to distribute derivative works based on the open sourcesoftware.  These obligations may requireus to make source code for these derivative works available to the public orlicense the derivative works under a particular type of open source softwarelicense, rather than the license terms we customarily use to protect oursoftware.

 

•             There is little or no legal precedent forinterpreting the terms of certain of these open source licenses, including theterms addressing the extent to which a derivative work based on open sourcesoftware may be subject to these licenses. We    believe we have compliedwith our obligations under the various applicable open source licenses.  However, if the owner of any open sourcesoftware were to successfully establish that we had not complied with the termsof an open source license for a particular derivative work based on that opensource software, we may be forced to release the source code for thatderivative work to the public or cease distribution of that work.

 

•                  We generally prohibit the combinationof our proprietary software with open source software.  Despite these restrictions, parties maycombine our proprietary software with open source software without ourauthorization, in which case such parties could be forced to release to thepublic the source code of our proprietary software.

 

***Disruptions from terrorist activities or military actionsmay have an adverse effect on our business.***

 

Thecontinued threat of terrorism within the U.S. and throughout the world and actsof war may cause significant disruption to commerce throughout the world. Ourbusiness and results of operations could be materially and adversely affectedto the extent that such disruptions result in delays or cancellations ofcustomer orders, delays in collecting cash, a general decrease in corporatespending on information technology, or our inability to effectively market,manufacture or ship our products. We are unable to predict whether war and thethreat of terrorism or the responses thereto will result in any long-termcommercial disruptions or if such activities or responses will have anylong-term material adverse effect on our business, results of operations,financial condition or cash flows.

 

***The trading priceof our stock has been subject to wide fluctuations and may continue toexperience volatility in the future.***

 

Thetrading price of our common stock has been subject to wide fluctuations inresponse to quarterly variations in operating results, announcements oftechnological innovations or new products by us or our competitors, merger andacquisition activity, changes in financial estimates by securities analysts,the operating and stock price performance of other companies that investors maydeem comparable to us, general stock market and economic considerations andother events or factors. This may continue in the future.

 

Inaddition, the stock market has experienced volatility that has particularlyaffected the market prices of stock of many technology companies and often hasbeen unrelated to the operating performance of these companies. These broadmarket fluctuations may negatively impact the trading price of our commonstock. As a result of the foregoing factors, we cannot assure our investorsthat our common stock will trade at or higher than its current price.

 

***Sales of largeblocks of our stock may result in the reduction in the market price of ourstock and make it more difficult to raise funds in the future.***

 

If ourstockholders sell substantial amounts of our common stock in the public market,the market price of our common stock could fall. The perception among investorsthat such sales will occur could also produce this effect. These factors alsocould make it more difficult to raise funds through future offerings of commonstock.

 

***We are subject tocertain rules and regulations of federal, state and financial marketexchange entities, the compliance of which requires substantial amounts ofmanagement time and company resources.***

 

Becauseour common stock is publicly traded, we are subject to certain rules andregulations of federal, state and financial market exchange entities chargedwith the protection of investors and the oversight companies whose securitiesare publicly traded.  These entities,including the Public Company Accounting Oversight Board, the SEC and theNasdaq, have recently issued new

 

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requirements andregulations and are currently developing additional regulations andrequirements in response to recent laws enacted by Congress, most notably theSarbanes-Oxley Act of 2002.  Ourcompliance with certain of these rules, such as Section 404 of theSarbanes-Oxley Act, is likely to require the commitment of significant andmanagerial resources. We are currently reviewing our material internal controlsystems, processes and procedures in compliance with the requirements of Section 404.  There can be no assurance that such a reviewwill not result in the identification of significant deficiencies or materialweaknesses in our internal controls.

 

***We have never paiddividends and do not anticipate paying cash dividends on our common stock inthe foreseeable future.***

 

Wehave never paid cash dividends on our common stock. We currently intend toretain all future earnings, if any, for use in the operation of our business.In addition, the notes issued in connection with the Tertio acquisitionprohibit us from declaring dividends to our common stockholders during the termof the notes. Accordingly, we do not anticipate paying cash dividends on ourcommon stock in the foreseeable future.

 

***Certain provisionsof our charter document, employment arrangements and Delaware law maydiscourage or prevent takeover attempts that could result in the payment of apremium price to our stockholders.***

 

Ourrestated certificate of incorporation allows our board of directors to issue upto 2,000,000 shares of preferred stock and to determine the price, rights,preferences and privileges of those shares without any further vote or actionby our stockholders. The rights of the holders of our common stock will besubject to, and may be adversely affected by, the rights of the holders of anypreferred stock that may be issued in the future. Issuance of preferred stock,while providing desired flexibility in connection with possible acquisitionsand other corporate purposes, could make it more difficult for a third party toacquire a majority of our outstanding voting stock. In 1999, our Board ofdirectors designated 250,000 shares of Series A Junior ParticipatingPreferred Stock that contain “poison pill” provisions. In connection with theTertio acquisition, we issued 966,666 shares of Series B Preferred Stock.We have no current plans to issue additional shares of preferred stock.

 

Inaddition, we are subject to the anti-takeover provisions of Section 203 ofDelaware General Corporation Law, which prohibit us from engaging in a “businesscombination” with an “interested stockholder” for a period of three yearsafter the date of the transaction in which the person became an interestedstockholder, unless the business combination is approved in the prescribedmanner. The application of Section 203 and certain provisions of ourrestated certificate of incorporation, including a classified board ofdirectors, may have the effect of delaying or preventing changes in control ofour management, which could adversely affect the market price of our commonstock by discouraging or preventing takeover attempts that might result in thepayment of a premium price to our stockholders.

 

Our executive officers have entered into managementchange in control agreements with the Company. Each agreement generallyprovides for an acceleration on vesting of options, 50% upon a change incontrol (as defined in such agreements) if the executive remains employed withthe new entity, or 100% in the event such executive’s employment is terminated.The acceleration of vesting of options upon a change in control may be viewedas an anti-takeover measure and may have the effect of discouraging a mergerproposal, tender offer or other attempt to gain control of the Company.

 

OurAmended and Restated Stock Option Plan provides for acceleration of vestingunder certain circumstances. Upon certain changes in control of the Company,vesting on some options awarded to directors may be accelerated. In addition,the successor corporation may assume outstanding stock awards or substituteequivalent stock awards. If the successor corporation refuses to do so, suchstock awards will become fully vested and exercisable for a period of 15 daysafter notice from us but the option will terminate if not exercised during thatperiod. As noted above, the acceleration of vesting of options upon a change incontrol may be viewed as an anti-takeover measure.

 

***We are very limited in ourability to issue additional shares of common stock.***

 

As ofthe date hereof, we have less than 50,000 authorized and unreserved shares ofcommon stock available for issuance.  Weare, therefore, limited in our ability to issue shares of common stock whichmay hinder our ability to raise capital, use our common stock as currency forfuture acquisitions or increase the number of shares of common stock availablefor issuance under our stock option plan. To increase our authorized shares of common stock requires the approvalof the stockholders owning a majority of our then issued and outstanding sharesof common stock.  Our last two attemptsto obtain stockholder approval to increase the number of our authorized sharesof common stock have been unsuccessful due to lower than required stockholderparticipation.  There can be noassurances that our stockholders will in the future approve an increase in ourauthorized shares of common stock.

 

***General risk statement.***

 

Basedon all of the foregoing, we believe it is possible for future revenue, expensesand operating results to vary significantly from quarter to quarter. As aresult, quarter-to-quarter comparisons of operating results are not necessarilymeaningful or indicative of future performance. Furthermore, we believe that itis possible that in any given quarter, including the current quarter, ouroperating results could differ from the expectations of public market analystsor investors. In such event, or in the event that adverse conditions prevail,or are perceived to prevail, with respect to our business or generally, themarket price of our common stock would likely go down.

 

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ITEM  3. QUANTITATIVE AND QUALITATIVE MARKET RISK DISCLOSURES

 

**ForeignExchange Risk**

 

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

 

TheCompany has a substantial portion of its intangible assets and its cashbalances in its United Kingdom subsidiary, denominated in the BritishPound.  To the extent that the exchange rate between the US Dollar and theBritish pound fluctuates, such fluctuation will have an impact on the Company’scomprehensive income in the form of translation adjustments, and could have animpact on the Company’s liquidity position in that the Company’s UK cashbalances are maintained in British Pounds.

 

Wetransact business in various foreign currencies. As we continue to expand ourinternational business, we are subject to increasing exposure from adversemovements in foreign exchange rates. At the present time, we do not hedge ourforeign currency exposure, nor do we use derivative financial instruments forspeculative trading purposes.

 

**InterestRate Risk**

 

In theordinary course of business we are exposed to the risk of changes in interestrates.  Our cash balances are subject tointerest rate fluctuations and as such, interest income amounts may fluctuatefrom current levels.

 

Foradditional information about Evolving Systems’ risk factors see EvolvingSystems’ Annual Report on Form 10-K for the year ended December 31,2004.

 

ITEM 4.  CONTROLS AND PROCEDURES

 

(a) Evaluationof disclosure controls and procedures. As of June 30, 2005, the end of theperiod covered by this report, we evaluated, under the supervision of our ChiefExecutive Officer and our Chief Financial Officer, the effectiveness of ourdisclosure controls and procedures. Based on this evaluation, our Chief ExecutiveOfficer and our Chief Financial Officer concluded that our disclosure controlsand procedures are effective to ensure that information we are required todisclose in reports that we file or submit under the Securities Exchange Act of1934 are recorded, processed, summarized, and reported within the time periodsspecified in SEC rules and forms.

 

(b) Changesin internal controls. During the period covered by this report, there were nochanges in our internal controls or other factors that materially affected, orare reasonably likely to materially affect, our internal controls overfinancial reporting, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

**PART II.  OTHER INFORMATION**

 

ITEM 1. LEGAL PROCEEDINGS

 

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

 

ITEM 2. CHANGES IN SECURITIES

 

None

 

ITEM 3. DEFAULTS ON SENIOR SECURITIES

 

None

 

ITEM 4. SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

 

TheCompany held its Annual Meeting of Stockholders on May 16, 2005.  According to the final proxy tally receivedfrom the Company’s transfer agent, the results of the voting on Proposals 1-4,as described in the Company’s Proxy Statement, were as follows:

 

## Proposal #1: Election of TwoDirectors

 

Peter J. Skinner waselected to serve a three-year term.

 
| For      |   | 14,885,090 |   |
|----------|--------|------------|--------|
| Withheld |   | 483,754    |   |

 

Steve B. Warnecke waselected to serve a three-year term.

 
| For      |   | 15,030,717 |   |
|----------|--------|------------|--------|
| Withheld |   | 338,127    |   |

 

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# Proposal#2: Exchange of Long-Term Notes For Convertible Notes

 

Stockholders approved theexchange of long-term notes for convertible notes, but this proposal failedbecause Proposal #3 did not pass.

 
| For     |   | 6,487,036 |   |
|---------|--------|-----------|--------|
| Against |   | 1,332,103 |   |
| Abstain |   | 50,473    |   |

 

## Proposal #3: Amend Certificate ofIncorporation to Increase Authorized Shares

 
| For     |   | 7,162,598 |   |
|---------|--------|-----------|--------|
| Against |   | 650,230   |   |
| Abstain |   | 56,784    |   |

 

This proposal required “Yes”votes representing a majority (8,012,052) of the shares of the Company’s commonstock issued and outstanding (16,024,102) as of the record date of March 22,2005.

 

## Proposal #4: Ratification ofIndependent Registered Public Accounting Firm

 

KPMG LLP was ratified asthe independent registered public accounting firm for the year ended December 31,2005.

 
| For     |   | 15,180,948 |   |
|---------|--------|------------|--------|
| Against |   | 118,088    |   |
| Abstain |   | 69,808     |   |

 

ITEM 5. OTHER INFORMATION

 

None

 

ITEM 6. EXHIBITS

 

(a)         Exhibits

 

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

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

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

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

 

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**SIGNATURE**

 

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

 
| Date: August 12,  2005 | /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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