**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**

| **x**                                                                                                                                                                                                                      |   | **Quarterly Report Pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                       |   |                                                                                                     |
| **For the  quarterly period ended March 31, 2007**                                                                                                                                                                         |
|                                                                                                                                                                                                                       |   |                                                                                                     |
| **OR**                                                                                                                                                                                                                     |
| ** **                                                                                                                                                                                                                 |   | ** **                                                                                               |
| **o**                                                                                                                                                                                                                      |   | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934** |
|                                                                                                                                                                                                                       |   |                                                                                                     |
| **For the  transition period  from               to               ** |

 

**Commission File Number: 0-24081**

**EVOLVING SYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

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

 

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

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

 

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

As of May 3, 2007 there were 17,657,028 sharesoutstanding of Registrant’s Common Stock (par value $0.001 per share).

 

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**EVOLVING SYSTEMS, INC.Quarterly Report on Form 10-QMarch 31, 2007Table of Contents**
| **PART I – FINANCIAL  INFORMATION** |                                                                                                                                                     |
|------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                     |                                                                                                                                                     |   |
| Item 1                                   | Financial Statements                                                                                                                                     |   |
|                                     | Condensed Consolidated Balance  Sheets as of March 31, 2007 and December 31, 2006 (Unaudited)                                                            |   |
|                                     | Condensed Consolidated  Statements of Operations for the Three Months Ended March 31, 2007 and 2006  (Unaudited)                                         |   |
|                                     | Condensed Consolidated  Statements of Changes In Stockholders’ Equity and Comprehensive Loss for the  Three Months Ended March 31, 2007 (Unaudited) |   |
|                                     | Condensed Consolidated  Statements of Cash Flows for the Three Months Ended March 31, 2007 and 2006  (Unaudited)                                         |   |
|                                     | Notes to  Unaudited Condensed Consolidated Financial Statements                                                                                          |   |
| Item 2                                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                              |   |
| Item 3                                   | Quantitative  and Qualitative Disclosures About Market Risk                                                                                              |   |
| Item 4                                   | Controls and  Procedures                                                                                                                                 |   |
|                                     |                                                                                                                                                     |   |
| **PART II – OTHER  INFORMATION**    |                                                                                                                                                     |
| Item 1                                   | Legal Proceedings                                                                                                                                        |   |
| Item  1A                                 | Risk Factors                                                                                                                                             |   |
| Item 2                                   | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                             |   |
| Item 3                                   | Defaults upon  Senior Securities                                                                                                                         |   |
| Item 4                                   | Submission  of Matters to a Vote of Security Holders                                                                                                     |   |
| Item 5                                   | Other Information                                                                                                                                        |   |
| Item  6                                  | Exhibits                                                                                                                                                 |   |
|                                     |                                                                                                                                                     |   |
| Signature                                |                                                                                                                                                     |   |

 

 

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**PART I — FINANCIAL INFORMATION**

**ITEM 1. FINANCIAL STATEMENTS**

**EVOLVINGSYSTEMS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(in thousands except share data)(unaudited)**
| ** **                                                                                                                                                                                              | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                              | ** ** | ** **               |       |                        |       |
| Current assets:                                                                                                                                                                                         |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                              |       | $                        | 7,965      |                        | $          | 5,076 |   |
| Current portion  of restricted cash                                                                                                                                                                     |       | 300                      |       | 300                         |       |
| Contract  receivables, net of allowance of $70 at March 31, 2007 and December 31, 2006                                                                                                                  |       | 7,681                    |       | 9,206                       |       |
| Unbilled  work-in-progress                                                                                                                                                                              |       | 488                      |       | 1,064                       |       |
| Deferred foreign  income taxes                                                                                                                                                                          |       | —                   |       | 15                          |       |
| Prepaid and  other current assets                                                                                                                                                                       |       | 1,513                    |       | 1,686                       |       |
| Total current  assets                                                                                                                                                                                   |       | 17,947                   |       | 17,347                      |       |
| Property and  equipment, net                                                                                                                                                                            |       | 1,115                    |       | 1,349                       |       |
| Amortizable  intangible assets, net                                                                                                                                                                     |       | 5,776                    |       | 6,155                       |       |
| Goodwill                                                                                                                                                                                                |       | 26,069                   |       | 26,027                      |       |
| Other long-term  assets                                                                                                                                                                                 |       | 412                      |       | 460                         |       |
| Total assets                                                                                                                                                                                            |       | $                        | 51,319     |                        | $          | 51,338 |   |
|                                                                                                                                                                                                    |       |                     |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                           |       |                     |       |                        |       |
| Current  liabilities:                                                                                                                                                                                   |       |                     |       |                        |       |
| Current portion  of capital lease obligations                                                                                                                                                           |       | $                        | 38         |                        | $          | 37 |   |
| Current portion  of long-term debt                                                                                                                                                                      |       | 2,125                    |       | 2,000                       |       |
| Accounts payable  and accrued liabilities                                                                                                                                                               |       | 4,574                    |       | 4,428                       |       |
| Deferred foreign  income taxes                                                                                                                                                                          |       | 41                       |       | —                      |       |
| Unearned revenue                                                                                                                                                                                        |       | 10,451                   |       | 10,079                      |       |
| Total current  liabilities                                                                                                                                                                              |       | 17,229                   |       | 16,544                      |       |
| Long-term  liabilities:                                                                                                                                                                                 |       |                     |       |                        |       |
| Capital lease  obligations, net of current portion                                                                                                                                                      |       | 24                       |       | 34                          |       |
| Other long-term  obligations                                                                                                                                                                            |       | 911                      |       | 749                         |       |
| Long-term debt,  net of current portion                                                                                                                                                                 |       | 10,561                   |       | 11,370                      |       |
| Deferred foreign  income taxes                                                                                                                                                                          |       | 1,139                    |       | 1,202                       |       |
| Total  liabilities                                                                                                                                                                                      |       | 29,864                   |       | 29,899                      |       |
|                                                                                                                                                                                                    |       |                     |       |                        |       |
| Commitments and  contingencies (Note 10)                                                                                                                                                                |       |                     |       |                        |       |
|                                                                                                                                                                                                    |       |                     |       |                        |       |
| Series B  convertible redeemable preferred stock                                                                                                                                                        |       | 6,130                    |       | 11,281                      |       |
|                                                                                                                                                                                                    |       |                     |       |                        |       |
| Stockholders’  equity:                                                                                                                                                                             |       |                     |       |                        |       |
| Preferred stock,  $0.001 par value; 2,000,000 shares authorized; 525,289 and 966,666 shares of  Series B issued and outstanding as of March 31, 2007 and December 31, 2006,  respectively (shown above) |       | —                   |       | —                      |       |
| Common stock,  $0.001 par value; 25,000,000 shares authorized; 17,577,284 and 16,233,646  shares issued and outstanding as of March 31, 2007 and December 31, 2006,  respectively                       |       | 18                       |       | 16                          |       |
| Additional  paid-in capital                                                                                                                                                                             |       | 74,241                   |       | 68,825                      |       |
| Accumulated  other comprehensive income                                                                                                                                                                 |       | 1,541                    |       | 1,466                       |       |
| Accumulated  deficit                                                                                                                                                                                    |       | (60,475                  | )          | (60,149                     | )          |
| Total  stockholders’ equity                                                                                                                                                                        |       | 15,325                   |       | 10,158                      |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                        |       | $                        | 51,319     |                        | $          | 51,338 |   |

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

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**EVOLVINGSYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands except per share data)(unaudited)**
| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **REVENUE**                                                                  | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| License fees and services                                                    |       | $                                                | 3,991      |   | $ | 3,899 |   |
| Customer support                                                             |       | 4,470                                            |       | 4,229 |   |
| Total revenue                                                                |       | 8,461                                            |       | 8,128 |   |
|                                                                         |       |                                             |       |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                                 | ** ** | ** **                                       |       |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 1,924                                            |       | 1,875 |   |
| Costs of customer support, excluding depreciation  and amortization          |       | 1,493                                            |       | 1,626 |   |
| Sales and marketing                                                          |       | 2,040                                            |       | 2,555 |   |
| General and administrative                                                   |       | 1,550                                            |       | 1,407 |   |
| Product development                                                          |       | 549                                              |       | 747 |   |
| Depreciation                                                                 |       | 288                                              |       | 293 |   |
| Amortization                                                                 |       | 388                                              |       | 897 |   |
| Restructuring and other expense (recovery)                                   |       | (1                                               | )          | (14 | ) |
| Total costs of  revenue and operating expenses                               |       | 8,231                                            |       | 9,386 |   |
|                                                                         |       |                                             |       |   |   |
| Income (loss)  from operations                                               |       | 230                                              |       | (1,258 | ) |
|                                                                         |       |                                             |       |   |   |
| Other income (expense):                                                      |       |                                             |       |   |   |
| Interest income                                                              |       | 64                                               |       | 38 |   |
| Interest expense                                                             |       | (464                                             | )          | (509 | ) |
| Gain on extinguishment of debt                                               |       | 42                                               |       | — |   |
| Foreign currency exchange loss                                               |       | (58                                              | )          | (1 | ) |
| Other expense, net                                                           |       | (416                                             | )          | (472 | ) |
|                                                                         |       |                                             |       |   |   |
| Loss before  income taxes                                                    |       | (186                                             | )          | (1,730 | ) |
|                                                                         |       |                                             |       |   |   |
| Income tax expense (benefit)                                                 |       | 140                                              |       | (79 | ) |
|                                                                         | ** ** | ** **                                       |       |   |   |
| Net loss                                                                     |       | $                                                | (326       | ) | $ | (1,651 | ) |
|                                                                         | ** ** | ** **                                       |       |   |   |
| Basic and  diluted loss per common share                                     |       | $                                                | (0.02      | ) | $ | (0.09 | ) |
|                                                                         |       |                                             |       |   |   |
| Weighted average basic  and diluted shares outstanding                       |       | 19,153                                           |       | 19,066 |   |

 

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

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**EVOLVINGSYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’EQUITY**

**ANDCOMPREHENSIVE LOSS**

**(inthousands, except share data)**

**(unaudited)**

** **
| ** **                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** **             | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|-----------------|------------|------------------------|------------|------------|------------|
| ** **                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**       | ** ** | **Total**              | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                                        | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income**      | ** ** | **Deficit**            | ** ** | **Equity** | ** ** |
| **Balance  at December 31, 2006**                                 |       | 16,233,646            |       | $           | 16         |              | $          | 68,825          |       | $                      | 1,466      |       | $          | (60,149 | ) | $ | 10,158 |   |
| Common stock  issued pursuant to the Employee Stock Purchase Plan |       | 19,507                |       | 1           |       | 16                |       | —          |       | —                 |       | 17         |       |
| Stock-based  compensation expense                                 |       | —                |       | —      |       | 249               |       | —          |       | —                 |       | 249        |       |
| Preferred stock  conversion                                       |       | 1,324,131             |       | 1           |       | 5,151             |       |            |       |                   |       | 5,152      |       |
| Comprehensive  loss:                                              |       |                  |       |        |       |              |       |            |       |                   |       |       |       |
| Net loss                                                          |       | —                |       | —      |       | —            |       | —          |       | (326                   | )          |       |       |
| Foreign currency translation adjustment                           |       | —                |       | —      |       | —            |       | 75              |       | —                 |       |       |       |
| Comprehensive  loss                                               |       |                  |       |        |       |              |       |            |       |                   |       | (251       | )          |
| **Balance at March 31, 2007**                                     |       | 17,577,284            |       | $           | 18         |              | $          | 74,241          |       | $                      | 1,541      |       | $          | (60,475 | ) | $ | 15,325 |   |

 

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

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**EVOLVINGSYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)(unaudited)**
| ** **                                                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                       |       |                                             |       |   |   |
| Net loss                                                                         |       | $                                                | (326       | ) | $ | (1,651 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                                             |       |   |   |
| Depreciation                                                                     |       | 288                                              |       | 293 |   |
| Amortization of intangible assets                                                |       | 388                                              |       | 897 |   |
| Amortization of debt issuance costs                                              |       | 64                                               |       | 57 |   |
| Equity compensation                                                              |       | 249                                              |       | 236 |   |
| Gain on disposal of property and equipment                                       |       | (1                                               | )          | (13 | ) |
| Gain on extinguishment of debt                                                   |       | (42                                              | )          | — |   |
| Foreign currency transaction losses, net                                         |       | 58                                               |       | 1 |   |
| Benefit from foreign deferred income taxes                                       |       | (9                                               | )          | (180 | ) |
| Change in operating assets and liabilities:                                      |       |                                             |       |   |   |
| Contract receivables                                                             |       | 1,479                                            |       | 3,013 |   |
| Unbilled work-in-progress                                                        |       | 576                                              |       | 428 |   |
| Prepaid and other current assets                                                 |       | 161                                              |       | (47 | ) |
| Accounts payable and accrued liabilities                                         |       | 344                                              |       | (742 | ) |
| Unearned revenue                                                                 |       | 366                                              |       | (15 | ) |
| Other                                                                            |       | 161                                              |       | — |   |
| Net cash provided by operating activities                                        |       | 3,756                                            |       | 2,277 |   |
|                                                                             |       |                                             |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                       |       |                                             |       |   |   |
| Purchases of property and equipment                                              |       | (233                                             | )          | (110 | ) |
| Proceeds from sale of property and equipment                                     |       | 1                                                |       | 13 |   |
| Earnout payments from business combinations                                      |       | (24                                              | )          | — |   |
| Net cash used in investing activities                                            |       | (256                                             | )          | (97 | ) |
|                                                                             |       |                                             |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                       |       |                                             |       |   |   |
| Capital lease payments                                                           |       | (9                                               | )          | (8 | ) |
| Principal payments on long-term debt                                             |       | (642                                             | )          | (250 | ) |
| Proceeds from issuance of common stock                                           |       | 17                                               |       | 51 |   |
| Net cash used in financing activities                                            |       | (634                                             | )          | (207 | ) |
|                                                                             |       |                                             |       |   |   |
| Effect of foreign exchange rate changes on cash                                  |       | 23                                               |       | (27 | ) |
|                                                                             |       |                                             |       |   |   |
| Net increase in cash and cash equivalents                                        |       | 2,889                                            |       | 1,946 |   |
| Cash and cash equivalents at beginning of period                                 |       | 5,076                                            |       | 3,883 |   |
| Cash and cash equivalents at end of period                                       |       | $                                                | 7,965      |   | $ | 5,829 |   |
|                                                                             |       |                                             |       |   |   |
| Supplemental  disclosure of other cash and non-cash transactions:                |       |                                             |       |   |   |
| Interest paid                                                                    |       | $                                                | 244        |   | $ | 269 |   |
| Income taxes paid                                                                |       | $                                                | 2          |   | $ | 441 |   |
| Conversion of  preferred stock into common stock                                 |       | $                                                | 5,152      |   | $ | — |   |

 

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

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**EVOLVINGSYSTEMS, INC.NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1 –BASIS OF PRESENTATION**

**Organization -**Weare a global provider of software solutions and services to the wireless,wireline and IP carrier market. We maintain long-standing relationships withmany of the largest wireline, wireless and IP communications carriersworldwide. Our customers rely on us to develop, deploy, enhance, maintain andintegrate complex, highly reliable software solutions for a range of OperationsSupport Systems (“OSS”).  We offersoftware products and solutions in three core areas:  numbering solutions that enablecarriers to comply with government-mandated requirements regarding numberportability as well as providing phone number management and assignmentcapabilities; service activation solutions used to activate complexbundles of voice, video and data services for traditional and next generationwireless and wireline networks; and mediation solutions supporting datacollection for both service assurance and billing applications.

**Interim Consolidated Financial Statements**– The accompanying unaudited condensed consolidated financial statements havebeen prepared in accordance with accounting principles generally accepted inthe United States of America (“GAAP”) and in conformity with the instructionsto Form 10-Q and Article 10 of Regulation S-X and the related rules andregulations of the Securities and Exchange Commission (“SEC”).  Accordingly, certain information and notedisclosures normally included in financial statements prepared in accordancewith GAAP have been condensed or omitted pursuant to such rules andregulations. However, we believe that the disclosures included in thesefinancial statements are adequate to make the information presented notmisleading. The unaudited condensed consolidated financial statements includedin this document have been prepared on the same basis as the annualconsolidated financial statements, and in our opinion, reflect all adjustments,which include normal recurring adjustments necessary for a fair presentation inaccordance with GAAP and SEC regulations for interim financial statements. Theresults for the three months ended March 31, 2007 are not necessarilyindicative of the results that we will have for any subsequent period.  These unaudited condensed consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements and the notes to those statements for theyear ended December 31, 2006 included in our Annual Report on Form 10-K.

**Use of Estimates -**The preparation of financial statements inconformity with accounting principles generally accepted in the U.S. requiresus to make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities, at thedate of the financial statements, as well as the reported amounts of revenueand expenses during the reporting period. We made estimates with respect torevenue recognition for estimated hours to complete projects accounted for usingthe percentage of completion method, allowance for doubtful accounts, incometax valuation allowance, fair values of long-lived assets, valuation ofintangible assets and goodwill, useful lives for property, equipment andintangible assets, business combinations, capitalization of internal softwaredevelopment costs and fair value of stock-based compensation amounts.  Actual results could differ from theseestimates.

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

**Principles of Consolidation-**The consolidatedfinancial statements include the accounts of Evolving Systems and subsidiaries,all of which are wholly owned.  Allsignificant intercompany transactions and balances have been eliminated inconsolidation.

**Goodwill -**Goodwillis the excess of acquisition cost of an acquired entity over the fair value ofthe identifiable net assets acquired. Goodwill is not amortized, but tested for impairment annually orwhenever indicators of impairment exist. These indicators may include asignificant change in the business climate, legal factors, operatingperformance indicators, competition, sale or disposition of a significantportion of the business or other factors. For purposes of the goodwillevaluation, we compare the fair value of each of our reporting units to itsrespective carrying amount. If the carrying value of a reporting unit were toexceed its fair value, we would then compare the fair value of the reportingunit’s goodwill to its carrying amount, and any excess of the carrying amount overthe fair value would be charged to operations as an impairment loss.

**Intangible Assets -**Amortizableintangible assets consist primarily of purchased software and licenses,customer contracts and relationships, trademark and tradenames, and businesspartnerships acquired in conjunction with our purchases of CMS, TSE andEvolving Systems U.K.  These finite lifeassets are amortized using the straight-line method over their estimated lives.

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

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

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

·                  Significant negative industry or economic trends;and/or

·                  Significant decline in our stock price for asustained period.

If, as a result of the existenceof one or more of the above indicators of impairment, we determine that thecarrying value of intangibles and/or long-lived assets may not be recoverable,we compare the estimated undiscounted cash flows expected to result from theuse of the asset and its eventual disposition to the asset’s carrying amount.If an amortizable intangible or long-lived asset is not deemed to berecoverable, an impairment loss is recognized representing the excess of theasset’s carrying value over its estimated fair value.

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

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

We may encounterbudget and schedule overruns on fixed price contracts caused by increasedlabor or overhead costs. Adjustments to cost estimates are made in the periodsin which the facts requiring such revisions become known. Estimated losses, ifany, are recorded in the period in which current estimates of total contractrevenue and contract costs indicate a loss.

In arrangementswhere the services are not essential to the functionality of the software, werecognize license revenue upon delivery. To the extent that Vendor-Specific Objective Evidence (“VSOE”) of thefair value of undelivered elements exists, fees from multiple elementarrangements are unbundled and recorded as revenue as the elements aredelivered.  If VSOE for the undeliveredelements does not exist, fees from such arrangements are deferred until theearlier of the date that VSOE does exist on the undelivered elements or all ofthe elements have been delivered.

Servicesrevenue from fixed-price contracts is generally recognized using 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 our obligation to ourcustomers under such arrangements is fulfilled.

Customersupport, including maintenance revenue, is generally recognized ratably overthe service contract period. When maintenance is bundled with the originallicense fee arrangement, its fair value, based upon VSOE, is deferred andrecognized during the periods when services are provided.

**Stock-basedCompensation -** We account for stock-based compensationunder Statement of Financial Accounting Standards No. 123(Revised), “Share-BasedPayment” (“SFAS 123R”).  This statementreplaced SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS123”) and superseded APB Opinion No. 25, “Accounting for Stock Issued toEmployees.”  Under SFAS 123R, we apply afair-value-based measurement method to account for share-based paymenttransactions with employees and directors and record compensation cost for allstock awards granted after January 1, 2006 and awards modified, repurchased, orcancelled after that date. In addition, we record compensation costs associatedwith the vesting of unvested options outstanding at January 1, 2006 using theguidance under SFAS 123.  Stock-basedcompensation is a non-cash expense because we settle these obligations byissuing shares of our common stock instead of settling such obligations withcash payments.  Compensation cost foroptions is recognized on a straight-line basis over the vesting period using anestimated forfeiture rate.   EffectiveJanuary 1, 2006, stock option grants and employee stock purchase plan purchaseswere accounted for under SFAS 123R.  Weused the Black-Scholes model to estimate the fair value of each option grant onthe date of grant.  This model requiresthe use of estimates for expected term of the options and expected volatilityof the price of our common stock.

8

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**RecentAccounting Pronouncements -**We adopted FinancialAccounting Standards Board (“FASB”) Interpretation No. 48, “Accounting forUncertainty in Income Taxes – An Interpretation of FASB Statement No. 109” (“FIN48”) effective January 1, 2007.  FIN 48clarifies the accounting for uncertainty in income tax benefits recognized in anenterprise’s financial statements in accordance with SFAS 109.  FIN 48 alsoprescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return.  In addition, FIN48 provides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure and transition.

We have anunrecognized domestic tax benefit of approximately $0.4 million which did notchange significantly during the three months ended March 31, 2007.  The application of FIN 48 would have resultedin a decrease to retained earnings of $0.4 million, except that the decreasewas fully offset by the application of a valuation allowance.  In addition, future changes in theunrecognized tax benefit will have no impact on the effective tax rate whilethe valuation allowance exists.  Weexpect that the unrecognized tax benefit will not change significantly within thenext twelve months.

We file our tax returnsas prescribed by the tax laws of federal as well as various state and foreignjurisdictions in which we operate.  Wemay be subject to examination by the Internal Revenue Service (“IRS”) forcalendar years 2003 through 2006 and HM Revenue and Customs in the U.K. forcalendar years 2005 and 2006. Additionally, any domestic net operating losses that were generated inprior years and utilized in these years may also be subject to examination bythe IRS.

As discussed inNote 6 to the consolidated financial statements in the 2006 Form 10-K, we havea valuation allowance against the full amount of our domestic net deferred taxasset.  We currently provide a valuationallowance against domestic deferred tax assets when it is more likely than notthat the domestic portion of our deferred tax assets will not be realized.  Our deferred tax asset valuation allowancedecreased approximately $0.4 million during the three months ended March 31,2007 to approximately $20.0 million as of March 31, 2007, which includes theimpact of applying FIN 48.

InSeptember 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS157”). SFAS 157 defines fair value, establishes a framework for measuring fairvalue under generally accepted accounting principles, and expands disclosuresabout fair value measurements. SFAS 157 is effective for financial statementsissued for fiscal years and interim periods beginning after November 15, 2007.We have not completed our evaluation of the impact of this standard on ourconsolidated financial statements or our future estimates of fair value.

In February 2007,the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities - Including anAmendment of FASB Statement No. 115” (“SFAS 159”).  SFAS 159 permits entities to choose to measureeligible items at fair value at specific election dates (the ‘‘fair valueoption’’). Unrealized gains and losses on items for which the fair value optionhas been elected shall be reported in earnings at each subsequent reportingperiod. This accounting standard is effective for us beginning January 1, 2008.We are currently assessing the impact of SFAS 159.

**NOTE 2 –GOODWILL AND INTANGIBLE ASSETS**

We recorded goodwill as a resultof three acquisitions which occurred over the period from November 2003 toNovember 2004. We acquired CMS Communications, Inc. (“CMS”) in November 2003,Telecom Software Enterprises, LLC (“TSE”) in October 2004 and Tertio TelecomsLtd. (“Evolving Systems U.K.”) in November 2004.

Changesin the carrying amount of goodwill by reporting unit were as follows (inthousands):
|                                                        | ** ** | **License and Services** | ** ** | **Customer Support** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|------------------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                             | ** ** | **U.S.**                           | ** ** | **U.K.**                  | ** ** | **U.S.**  | ** ** | **U.K.** | ** ** | **Goodwill** | ** ** |
| Balance as of  December 31, 2006                       |       | $                                  | —     |                      | $          | 8,944     |       | $ | 6,033 |   | $ | 11,050 |   | $ | 26,027 |   |
| Effects of changes in foreign currency exchange  rates |       | —                             |       | 19                        |       | —    |       | 23 |   | 42 |   |
| Balance as of March 31,  2007                          |       | $                                  | —     |                      | $          | 8,963     |       | $ | 6,033 |   | $ | 11,073 |   | $ | 26,069 |   |

 

Ourannual goodwill impairment test was conducted as of July 31, 2006, and wedetermined that goodwill was not impaired as of the test date.  From July 31, 2006 through March 31, 2007, noevents have occurred that we believe may have impaired goodwill.

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

9

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| ** **                 | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** | **Weighted-**             | ** ** |
|----------------------------|------------|------------------------------|------------|---------------------------------|------------|---------------------------|------------|
| ** **                 | ** ** | **Gross  Amount**            | ** ** | **Accumulated  Amortization**   | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Average  Amortization  Period** | ** ** |
| Purchased  software        |       | $                            | 2,042      |                            | $          | 351                       |       | $ | 1,691 |   | $ | 2,038 |   | $ | 237 |   | $ | 1,801 |   | 4.7  yrs |   |
| Purchased  licenses        |       | 227                          |       | 73                              |       | 154                       |       | 227 |   | 49 |   | 178 |   | 2.3  yrs |   |
| Trademarks and  tradenames |       | 880                          |       | 94                              |       | 786                       |       | 879 |   | 63 |   | 816 |   | 7.0  yrs |   |
| Business  partnerships     |       | 144                          |       | 22                              |       | 122                       |       | 143 |   | 14 |   | 129 |   | 5.0  yrs |   |
| Customer  relationships    |       | 3,663                        |       | 640                             |       | 3,023                     |       | 3,657 |   | 426 |   | 3,231 |   | 5.6  yrs |   |
|                       |       | $                            | 6,956      |                            | $          | 1,180                     |       | $ | 5,776 |   | $ | 6,944 |   | $ | 789 |   | $ | 6,155 |   | 5.4 yrs |   |

 

Amortization expense ofidentifiable intangible assets was $0.4 million and $0.9 million for the threemonths ended March 31, 2007 and 2006, respectively.  As Evolving Systems U.K. uses theGreat British pound as its functional currency, the amount of futureamortization actually recorded will be based upon exchange rates in effect atthat time. Expected future amortizationexpense related to identifiable intangibles based on our carrying amount as ofMarch 31, 2007 was as follows (in thousands):
| **Years ending March 31,** | ** ** | ** ** | ** ** |
|----------------------------|------------|------------|------------|
| 2008                       |       | $          | 1,537      |   |
| 2009                       |       | 1,263      |       |
| 2010                       |       | 897        |       |
| 2011                       |       | 872        |       |
| 2012                       |       | 589        |       |
| Thereafter                 |       | 618        |       |
|                       |       | $          | 5,776      |   |

**NOTE 3 – EARNINGS PER COMMONSHARE**

Basic earnings per share (“EPS”) is computed bydividing net income or loss available to common stockholders by the weightedaverage number of shares outstanding during the period, including common stockissuable under participating securities, such as the Series B ConvertibleRedeemable Preferred Stock (“Series B Preferred Stock”). Diluted EPS iscomputed using the weighted average number of shares outstanding, includingparticipating securities, plus all potentially dilutive common stockequivalents. Common stock equivalents consist of stock options and shares heldin escrow. The following is the reconciliation of the denominator of the basicand diluted EPS computations (in thousands):
|                                                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                             | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Weighted average  common shares outstanding            |       | 16,695                                           |       | 16,166 |   |
| Participating  securities                              |       | 2,458                                            |       | 2,900 |   |
| Basic and diluted  weighted average shares outstanding |       | 19,153                                           |       | 19,066 |   |

 

Weighted average options to purchase 0.7 million and1.9 million shares of common stock were excluded from the dilutive stock calculationfor the three months ended March 31, 2007 and 2006, respectively, as theireffect would have been anti-dilutive as a result of the net loss for theperiod.  Weighted average options topurchase 3.4 million and 2.4 million shares of common stock were excluded fromthe dilutive stock calculation for the three months ended March 31, 2007 and2006, respectively, because their exercise prices were greater than the averagefair value of our common stock for the period.

**NOTE 4 –SHARE-BASED COMPENSATION**

We adopted SFAS 123R effective January 1, 2006 using the modified prospectivemethod.  We previously applied theintrinsic-value-based method in accounting for the recognition of stock-basedcompensation arrangements and the fair value method only for disclosurepurposes.  Our statements of operationsfrom January 1, 2006 forward include charges for stock-based compensation.  We recognized $0.2 million, or $0.01 pershare, of compensation expense in the statement of operations for the threemonths ended March 31, 2007 and $0.2 million, or $0.01 per share, ofcompensation expense in the statement of operations for the three months endedMarch 31, 2006 with respect to our stock-based compensation plans.  The following table summarizes stock-basedcompensation expenses recorded in the consolidated statements of operations (inthousands):

10

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|                                                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Cost of license  fee and services, excluding depreciation and amortization |       | $                                                | 22         |   | $ | 17 |   |
| Cost of customer  support, excluding depreciation and amortization         |       | (2                                               | )          | 2 |   |
| Sales and  marketing                                                       |       | 39                                               |       | 55 |   |
| General and  administrative                                                |       | 183                                              |       | 151 |   |
| Product  development                                                       |       | 7                                                |       | 11 |   |
|                                                                       |       | $                                                | 249        |   | $ | 236 |   |

The negativeamount in the table above for the three months ended March 31, 2007 resultedfrom the true-up of estimated forfeitures to actual forfeitures.

**StockOption Plan**

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

In March 2007 upon the hiring ofour Vice President of World Wide Sales and Marketing, in accordance with NASDAQMarketplace Rule 4350(i)(1)(a)(iv)the board of directors approved an inducement award under a stand-alone equityincentive plan.  We granted 100,000non-qualified options to purchase shares of our common stock at an exerciseprice equal to the market price of our common stock on the date of grant.  The options vest over four years and expireten years from the date of grant.

The fair value of each optiongrant is estimated on the date of grant using the Black-Scholes model.  The Black-Scholes model uses four assumptionsto calculate the fair value of each option grant.  The expected term of share options granted isderived using the simplified method prescribed by the SEC Staff AccountingBulletin 107, “Share-Based Payment.”  Therisk-free interest rate is based upon the rate currently available onzero-coupon U.S. Treasury instruments with a remaining term equal to theexpected term of the stock options.  Theexpected volatility is based upon historical volatility of our common stockover a period equal to the expected term of the stock options.  The expected dividend yield is zero and isbased upon historical and anticipated payment of dividends.  The weighted-average assumptions used in thefair value calculations are as follows:  
|                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|
| ** **               | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Expected term  (years)   |       | 6.1                                              |       | 6.1 |   |
| Risk-free  interest rate |       | 4.5                                              | %          | 4.35 | % |
| Expected  volatility     |       | 108.0                                            | %          | 121.14 | % |
| Expected dividend yield  |       | 0                                                | %          | 0 | % |

 

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The following is a summary ofstock option activity under the plan for the three months ended March 31, 2007:
|                                           | ** ** | **Number of  Shares  (in  thousands)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term  (Years)** | ** ** | **Aggregate  Intrinsic  Value  (in thousands)** | ** ** |
|-------------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------------------------|------------|------------------------------------------------------|------------|
| Options  outstanding at December 31, 2006 |       | 4,058                                       |       | $                                       | 3.14       |                                                          |       |                                                 |       |   |
| Options granted                           |       | 100                                         |       | $                                       | 1.72       |                                                          |       |                                                 |       |   |
| Less options forfeited                    |       | (4                                          | )          | $                                       | 2.15       |                                                          |       |                                                 |       |   |
| Less options expired                      |       | (26                                         | )          | $                                       | 3.22       |                                                          |       |                                                 |       |   |
| Less options exercised                    |       | —                                      |       | $                                       | —     |                                                          |       |                                                 |       |   |
| Options  outstanding at March 31, 2007    |       | 4,128                                       |       | $                                       | 3.10       |                                                          | 6.34       |                                                 | $          | 749 |   |
|                                      |       |                                        |       |                                    |       |                                                          |       |                                                 |       |
| Options exercisable at  March 31, 2007    |       | 3,237                                       |       | $                                       | 3.36       |                                                          | 5.67       |                                                 | $          | 724 |   |

 

The weighted-average grant-datefair value of stock options granted during the three months ended March 31,2007 and 2006 was $1.45 and $2.05, respectively.

As of March 31, 2007, there wasapproximately $1.2 million of total unrecognized compensation costs related tounvested stock options.  These costs areexpected to be recognized over a weighted average period of 1.4 years.

The total intrinsic value ofstock option exercises for the three months ended March 31, 2007 and 2006 was$0 and $13,000, respectively.  The totalfair value of stock options vested during the three months ended March 31, 2007and 2006 was $0.2 million and $0.1 million, respectively.

The deferred income tax benefitsfrom stock option expense related to Evolving Systems U.K. totaledapproximately $11,000 and $7,000 for the three months ended March 31, 2007 and2006, respectively.

Cash received from stock optionexercises for the three months ended March 31, 2007 and 2006 was $0 and$13,000, respectively.

**Employee Stock PurchasePlan**

Under the Employee Stock PurchasePlan (“ESPP”), we are authorized to issue up to 1,100,000 shares of our commonstock to full-time employees, nearly all of whom are eligible to participate.Under the terms of the ESPP, employees may elect to have up to 15% of theirgross compensation withheld through payroll deduction to purchase our commonstock, capped at $25,000 annually. The purchase price of the stock is 85% ofthe lower of the market price at the beginning or end of each three-monthparticipation period. As of March 31, 2007, there were 333,000 shares availablefor purchase.  For the three months endedMarch 31, 2007 and 2006, we recorded compensation expense of $6,000 and$15,000, respectively, associated with grants under the ESPP which includes thefair value of the look-back feature of each grant as well as the 15% discounton the purchase price.  This expensefluctuates each period based upon employee participation.

The fair value of each grant madeunder our ESPP is estimated on the date of grant using the Black-Scholesmodel.  The Black-Scholes model uses fourassumptions to calculate the fair value of each option grant.  The expected term of each grant is based uponthe three-month participation period of each grant.  The risk-free interest rate is based upon therate currently available on zero-coupon U.S. Treasury instruments with aremaining term equal to the expected term of each grant.  The expected volatility is based uponhistorical volatility of our common stock. The expected dividend yield is based upon historical and anticipatedpayment of dividends.  The weightedaverage assumptions used in the fair value calculations are as follows: 
|                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------|------------|--------------------------------------------------|------------|
| ** **               | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Expected term  (years)   |       | 0.25                                             |       | 0.25 |   |
| Risk-free  interest rate |       | 5.1                                              | %          | 4.8 | % |
| Expected  volatility     |       | 70.0                                             | %          | 86.4 | % |
| Expected dividend yield  |       | 0                                                | %          | 0 | % |

 

Cash received from employee stock plan purchases for the three monthsended March 31, 2007 and 2006 was $17,000 and $38,000, respectively.

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**NOTE 5 – CONCENTRATION OF CREDIT RISK**

For the three months endedMarch 31, 2007, two significant customers (defined as contributing at least10%) accounted for 34% (22% and 12%) of total revenue.  Thesecustomers are large telecommunications operators and were located in the U.S.and U.K., respectively.  For thethree months ended March 31, 2006, two significant customers accounted for 26%(13% and 13%) of total revenue.  These customers are large telecommunicationsoperators and were located in the U.S. and U.K., respectively.

As of March 31, 2007, three significant customersaccounted for approximately 47% (18%, 17% and 12%) of contractreceivables.  These customers are largetelecommunications operators and were located in the U.S., U.S. and U.K,respectively.  At December 31, 2006, two significantcustomers accounted for approximately 51% (40% and 11%) of contractreceivables.  These customers are largetelecommunications operators and were located in the U.S. andLuxembourg, respectively.

**NOTE 6 – LONG-TERM DEBT**

Notes payableconsist of the following (in thousands):
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| Senior note  payable to financial institution, interest at one-month London InterBank  Offered Rate (“LIBOR”) plus a margin of 6.25%; however, the LIBOR rate cannot  be less than 3.75%; interest rate was 11.57% at March 31, 2007 and 11.60% at  December 31, 2006, respectively; interest payments are due monthly, principal  installments are due quarterly with final maturity on November 14, 2010. The  margin of 6.25% can be reduced to 5.25% if we meet and maintain certain  financial requirements (not met as of March 31, 2007 or December 31,2006).  The loan is secured by substantially all of our assets and a pledge of the  stock of our subsidiaries. |       | $                  | 5,919      |                  | $          | 6,500 |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |       |               |       |                  |       |
| $4.5 million  senior revolving credit facility payable to financial institution, interest  at one-month LIBOR plus 4.0%; however, the LIBOR rate cannot be less than  3.75%; interest rate was 9.32% at March 31, 2007 and 9.35% at December 31,  2006, respectively; interest payments are due monthly with final maturity on  November 14, 2010. Loan is secured by substantially all of the assets of Evolving  Systems U.K.                                                                                                                                                                                                                                                        |       | 2,000              |       | 2,000                 |       |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |       |               |       |                  |       |
| Long-term  unsecured subordinated notes payable, interest ranges from 11-14% with a  weighted average rate of 12.84%, accrued interest and principal are due in  full May 16, 2011.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       | 4,767              |       | 4,870                 |       |
| Total notes  payable                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |       | 12,686             |       | 13,370                |       |
| Less current  portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |       | (2,125             | )          | (2,000                | )          |
| Long-term debt,  excluding current portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |       | $                  | 10,561     |                  | $          | 11,370 |   |

 

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

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

The senior notepayable and senior revolving credit facility subject us to certain financialcovenants.  We were in compliance withthese covenants as of March 31, 2007.

**NOTE 7 –INCOME TAXES**

We recorded net income tax expense of $0.1 million forthe three months ended March 31, 2007. The net expense during the three months ended March 31, 2007 consistedof current income tax expense of approximately $0.2 million and a deferred taxbenefit of $0.1 million both of which were related to our U.K.-basedoperations.

We recorded net income tax benefit of $0.1 million forthe three months ended March 31, 2006. The net benefit during the three months ended March 31, 2006 consistedof current income tax expense of $0.1 million and a deferred tax benefit of$0.2 million, both of which were related to our U.K.-based operations.

In conjunction with the acquisition of EvolvingSystems U.K., we recorded certain identifiable intangible assets.  Since the 

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amortizationof these identifiable intangibles is not deductible for income tax purposes, weestablished a long-term deferred tax liability of $4.6 million at theacquisition date for the expected difference between what would be expensed forfinancial reporting purposes and what would be deductible for income taxpurposes. As of March 31, 2007 and December 31, 2006, this deferred taxliability was $1.4 million and $1.5 million, respectively.  This deferred tax liability relates toEvolving Systems U.K., and has no impact on our ability to recover U.S.-baseddeferred tax assets.  This deferred taxliability will be recognized as a reduction of deferred income tax expense asthe identifiable intangibles are amortized.

As of March 31, 2007 and December 31, 2006, wecontinued to maintain a full valuation allowance on our domestic net deferredtax asset as we determined it was more likely than not that we will not realizeour domestic deferred tax assets.  Suchassets primarily consist of net operating loss carryforwards.  We assessed the realizability of our domesticdeferred tax assets using all available evidence.  In particular, we considered both historicalresults and projections of profitability for reasonably foreseeable futureperiods.  We are required to reassessconclusions regarding the realization of deferred tax assets at each financialreporting date. A future evaluation could result in a conclusion that all or aportion of the valuation allowance is no longer necessary which could have amaterial impact on our results of operations and financial position.

**NOTE 8 –STOCKHOLDERS’ EQUITY**

On March 15, 2007, holders of 441,377 shares of Series BConvertible Preferred Stock with a carrying value of $5.1 million, orapproximately 46% of the outstanding preferred stock, converted their shares ofpreferred stock into 1,324,131 shares of our common stock in accordance withthe conversion provisions of the Series B Convertible Preferred Stock.  As we previously included the Series BConvertible Preferred Stock as a participating security for basic EPS purposes,this conversion will not change our current or future basic or diluted EPScalculations.

**NOTE 9 –SEGMENT INFORMATION**

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

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

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Segment information is as follows (in thousands):
|                                                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **Revenue**                                                                |       |                                             |       |   |   |
| License fees and  services                                                 |       | $                                                | 3,991      |   | $ | 3,899 |   |
| Customer support                                                           |       | 4,470                                            |       | 4,229 |   |
|                                                                       |       | 8,461                                            |       | 8,128 |   |
|                                                                       |       |                                             |       |   |   |
| **Revenue  less cost of revenue, excluding depreciation and amortization** |       |                                             |       |   |   |
| License fees and  services                                                 |       | 2,067                                            |       | 2,024 |   |
| Customer support                                                           |       | 2,977                                            |       | 2,603 |   |
|                                                                       |       | 5,044                                            |       | 4,627 |   |
|                                                                       |       |                                             |       |   |   |
| **Unallocated  costs**                                                     |       |                                             |       |   |   |
| Other operating  expenses                                                  |       | 4,139                                            |       | 4,709 |   |
| Depreciation and  amortization                                             |       | 676                                              |       | 1,190 |   |
| Restructuring  and other                                                   |       | (1                                               | )          | (14 | ) |
| Interest income                                                            |       | (64                                              | )          | (38 | ) |
| Interest expense                                                           |       | 464                                              |       | 509 |   |
| Gain on debt  extinguishment                                               |       | (42                                              | )          | — |   |
| Foreign currency  exchange loss                                            |       | 58                                               |       | 1 |   |
| **Loss before income taxes**                                               |       | $                                                | (186       | ) | $ | (1,730 | ) |

***Geographic Regions***

We are headquartered inEnglewood, a suburb of Denver, Colorado. We use customer locations as the basis for attributing revenues toindividual countries.  We provide productsand services on a global basis through our headquarter and our London-basedEvolving Systems U.K. subsidiary. Additionally, personnel in Bangalore, India provide software developmentservices to our global operations. Financial information relating to operations by geographic region, asreviewed by the CODM, is as follows (in thousands):
|                                      | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **L&S**                                          | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**                          |       |                                                 |       |   |   |   |   |   |   |   |   |   |   |
| Americas                             |       | $                                                    | 1,022      |   | $ | 2,654 |   | $ | 3,676 |   | $ | 745 |   | $ | 2,705 |   | $ | 3,450 |   |
| Europe, Middle East, Africa and Asia |       | 2,969                                                |       | 1,816 |   | 4,785 |   | 3,154 |   | 1,524 |   | 4,678 |   |
| Total Revenue                        |       | $                                                    | 3,991      |   | $ | 4,470 |   | $ | 8,461 |   | $ | 3,899 |   | $ | 4,229 |   | $ | 8,128 |   |

 
|                                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| **Long-lived  assets, net**          |       |               |       |                  |       |
| Americas                             |       | $                  | 7,680      |                  | $          | 7,903 |   |
| Europe, Middle East, Africa and Asia |       | 25,280             |       | 25,628                |       |
| Total long-lived  assets, net        |       | $                  | 32,960     |                  | $          | 33,531 |   |

 

15

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Financial information relating to product groupingswas as follows (in thousands):
|                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------|------------|--------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **Revenue**         |       |                                             |       |   |   |
| Activation          |       | $                                                | 4,574      |   | $ | 4,239 |   |
| Numbering solutions |       | 2,801                                            |       | 2,743 |   |
| Mediation           |       | 1,086                                            |       | 1,146 |   |
|                |       | $                                                | 8,461      |   | $ | 8,128 |   |

 

**NOTE 10 – COMMITMENTS AND CONTINGENCIES**

As permitted under Delaware law, we have agreementswith officers and directors under which we agree to indemnify them for certainevents or occurrences while the officer or director is, or was serving, at ourrequest in this capacity. The term of the indemnification period is indefinite.There is no limit on the amount of future payments we could be required to makeunder these indemnification agreements; however, we maintain Director and Officerinsurance policies, as well as an Employment Practices Liability InsurancePolicy, that may enable us to recover a portion of any amounts paid. As aresult of our insurance policy coverage, we believe the estimated fair value ofthese indemnification agreements is minimal. Accordingly, there were noliabilities recorded for these agreements as of March 31, 2007 andDecember 31, 2006.

We enter into standard indemnification terms withcustomers, as discussed below, in the ordinary course of business.  As we may subcontract the development ofdeliverables under customer contracts, we could be required to indemnifycustomers for work performed by subcontractors. Depending upon the nature ofthe customer indemnification, the potential amount of future payments we couldbe required to make under these indemnification agreements may be unlimited. Wemay be able to recover damages from a subcontractor if the indemnification tocustomers results from the subcontractor’s failure to perform. To the extent weare unable to recover damages from a subcontractor, we could be required toreimburse the indemnified party for the full amount. We have never incurredcosts to defend lawsuits or settle claims relating to indemnification arisingout of subcontractors’ failure to perform. As a result, we believe theestimated fair value of these agreements is minimal. Accordingly, there were noliabilities recorded for these agreements as of March 31, 2007 andDecember 31, 2006.

Our standard license agreements contain product warrantiesthat the software will be free of material defects and will operate inaccordance with the stated requirements for a limited period of time.  The product warranty provisions require us tocure any defects through any reasonable means. We believe the estimated fair value of the product warranty provisionsin the license agreements in place with our customers is minimal.  Accordingly, there were no liabilitiesrecorded for these product warranty provisions as of March 31, 2007 andDecember 31, 2006.

Our software arrangements generally include a productindemnification provision whereby we will indemnify and defend a customer inactions brought against the customer for claims that our products infringe upona copyright, trade secret, or valid patent. We have not historically incurredany significant costs related to product indemnification claims. Accordingly,there were no liabilities recorded for these indemnification provisions as ofMarch 31, 2007 and December 31, 2006.

In relation to the acquisitions of Evolving SystemsU.K., Telecom Software Enterprises, LLC (TSE) and CMS Communications, Inc.(CMS), we agreed to indemnify certain parties from any losses, actions, claims,damages or liabilities (or actions in respect thereof) resulting from any claimraised by a third party.  We do notbelieve that there will be any claims related to these indemnifications.Accordingly, there were no liabilities recorded for these agreements as ofMarch 31, 2007 and December 31, 2006.

During the fourth quarter of 2006,a previous software vendor filed a complaint in the Superior Court of NewJersey against us asserting we breached certain provisions of a licenseagreement.  While the outcome of thismatter is uncertain, we believe we have paid all fees due under our licenseagreement and we are vigorously defending this claim.

We are involved in various otherlegal matters arising in the normal course of business.  Losses were recorded for these matters to theextent they were probable of loss and the amount of loss could be reasonablyestimated.

**NOTE 11 – SUBSEQUENT EVENT**

On April 13, 2007, holders of 20,374 shares of Series BConvertible Preferred Stock with a carrying value of $0.2 million, orapproximately 4% of the outstanding shares, converted their shares of preferredstock into 61,122 shares of our common stock in accordance with the conversionprovisions of the Series B Convertible Preferred Stock.  This conversion will increase the number ofshares of our common stock outstanding by 61,122 shares.  Because we have previously included theSeries B Convertible Preferred Stock as a participating security for basic EPSpurposes, this conversion will not change our future basic or diluted EPScalculations.

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

**SPECIAL NOTE ABOUT FORWARD-LOOKINGSTATEMENTS**

*This Quarterly Report on Form 10-Q containsforward-looking statements that have been made pursuant to the provisions ofthe Private Securities Litigation Reform Act of 1995.  These forward-looking statements are based oncurrent expectations, estimates, and projections about Evolving Systems’industry, management’s beliefs, and certain assumptions made bymanagement.  Forward-looking statementsinclude our expectations regarding product, services, and maintenance revenue,annual savings associated with the organizational changes effected in prioryears, and short- and long-term cash needs. In some cases, words such as “anticipates”, “expects”, “intends”, “plans”,“believes”, “estimates”, variations of these words, and similar expressions areintended to identify forward-looking statements.  The statements are not guarantees of futureperformance and are subject to certain risks, uncertainties, and assumptionsthat are difficult to predict; therefore, actual results may differ materiallyfrom those expressed or forecasted in any forward-looking statements.  Risks and uncertainties of our businessinclude those set forth in our Annual Report on Form 10-K for the year endedDecember 31, 2006 under “Item 1A. Risk Factors” as well as additional risksdescribed in this Form 10-Q.  Unlessrequired by law, we undertake no obligation to update publicly anyforward-looking statements, whether as a result of new information, futureevents, or otherwise.  However, readersshould carefully review the risk factors set forth in other reports ordocuments we file from time to time with the Securities and ExchangeCommission, particularly the Quarterly Reports on Form 10-Q and anyCurrent Reports on Form 8-K.*

**OVERVIEW**

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

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

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**RESULTS OF OPERATIONS**

The following table presents the unauditedconsolidated statements of operations reflected as a percentage of totalrevenue.
|                                                                              | ** ** | **Three Months  Ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **REVENUE**                                                                  |       |                                             |       |   |   |
| License fees and services                                                    |       | 47                                               | %          | 48 | % |
| Customer support                                                             |       | 53                                               | %          | 52 | % |
| Total revenue                                                                |       | 100                                              | %          | 100 | % |
|                                                                         |       |                                             |       |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                                 |       |                                             |       |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 23                                               | %          | 23 | % |
| Costs of customer support, excluding depreciation  and amortization          |       | 18                                               | %          | 20 | % |
| Sales and marketing                                                          |       | 24                                               | %          | 32 | % |
| General and administrative                                                   |       | 18                                               | %          | 17 | % |
| Product development                                                          |       | 7                                                | %          | 9 | % |
| Depreciation                                                                 |       | 3                                                | %          | 4 | % |
| Amortization                                                                 |       | 4                                                | %          | 11 | % |
| Total costs of  revenue and operating expenses                               |       | 97                                               | %          | 116 | % |
|                                                                         |       |                                             |       |   |   |
| Income (loss)  from operations                                               |       | 3                                                | %          | (16 | )% |
|                                                                         |       |                                             |       |   |   |
| Interest income                                                              |       | 1                                                | %          | 1 | % |
| Interest expense                                                             |       | (6                                               | )%         | (6 | )% |
| Gain on debt extinguishment                                                  |       | 1                                                | %          | — | % |
| Foreign currency exchange loss                                               |       | (1                                               | )%         | — | % |
| Other expense,  net                                                          |       | (5                                               | )%         | (5 | )% |
|                                                                         |       |                                             |       |   |   |
| Loss before  income taxes                                                    |       | (2                                               | )%         | (21 | )% |
|                                                                         |       |                                             |       |   |   |
| Income tax expense (benefit)                                                 |       | 2                                                | %          | (1 | )% |
|                                                                         |       |                                             |       |   |   |
| Net loss                                                                     |       | (4                                               | )%         | (20 | )% |

 

***Revenue***

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

|                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------|------------|--------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Activation          |       | $                                                | 4,574      |   | $ | 4,239 |   |
| Numbering solutions |       | 2,801                                            |       | 2,743 |   |
| Mediation           |       | 1,086                                            |       | 1,146 |   |
|                |       | $                                                | 8,461      |   | $ | 8,128 |   |

 

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***LicenseFees and Services***

License fees andservices revenue increased 2%, or $0.1 million, to $4.0 million for the threemonths ended March 31, 2007 from $3.9 million for the three months ended March31, 2006.  This increase in license feesand services revenue was composed of an increase of $0.1 million in revenuefrom our activation products and an increase of $0.1 million in revenue fromour numbering solutions products offset by a decrease of $0.1 million inrevenue from our mediation products. These results are consistent with our focus on our core activation andnumbering solutions products.

***Customer Support***

Customer support revenue increased $0.3 million, or6%, to $4.5 million for the three months ended March 31, 2007 from $4.2 millionfor the three months ended March 31, 2006. The increase in customer support revenue resulted from an increase of$0.3 million in our activation products and an increase of $0.1 million inmediation customer support revenue which were offset by a decrease of $0.1million from our numbering solutions products. The increase in activation customer support revenue is a result of increased license fees and services sales of ouractivation products.  The decreasein numbering solutions customer support revenue was due to one of our productsreaching its end of life as we no longer support any customers on this product.

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

Costs of revenue, excluding depreciation andamortization, consist primarily of personnel costs and other direct costsassociated with these personnel, facilities costs, cost of third-party softwareand partner commissions.  Costs ofrevenue, excluding depreciation and amortization, were $3.4 million and $3.5million for the three months ended March 31, 2007 and 2006, respectively.  These costs are discussed further below.

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

Costs of license fees and services, excludingdepreciation and amortization, were $1.9 million for each of the three monthsended March 31, 2007 and 2006.  As apercentage of license fees and services revenue, costs of license fees andservices, excluding depreciation and amortization, remained consistent at 48%for each of the three months ended March 31, 2007 and 2006.

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

Costs of customer support, excluding depreciation andamortization, decreased $0.1 million, or 8%, to $1.5 million for the threemonths ended March 31, 2007 from $1.6 million for the three months endedMarch 31, 2006.  As a percentage ofcustomer support revenue, costs of customer support revenue, excludingdepreciation and amortization, decreased to 33% for the three months endedMarch 31, 2007 from 38% for the three months ended March 31, 2006.  These decreases were primarily due to costefficiencies achieved through a slightly reduced headcount.

***Sales and Marketing***

Sales and marketing expenses primarily consist of compensationcosts, including bonuses and commissions, travel expenses, advertising,marketing and facilities expenses.  Salesand marketing expenses decreased $0.5 million, or 20%, to $2.0 million for thethree months ended March 31, 2007 from $2.5 million for the three months endedMarch 31, 2006.  As a percentage of totalrevenue, sales and marketing expenses decreased to 24% for the three monthsended March 31, 2007 from 32% for the three months ended March 31, 2006. Thesedecreases were a result of sales force reductions in mature markets; however,we plan to continue to grow our sales force in emerging markets.  In addition, our EVP of Sales and Marketingwas promoted to President effective January 1, 2007 and a portion of hisemployee related costs were allocated to general and administrativeexpense.  This senior sales and marketingposition was not replaced until mid-March 2007 when we hired a new VicePresident of World Wide Sales and Marketing.

***General and Administrative***

General and administrative expenses consistprincipally of employee related costs and professional fees for the followingdepartments: facilities, finance, legal, human resources, and certain executivemanagement.  General and administrativeexpenses increased $0.1 million, or 10%, to $1.5 million from $1.4million for the three months ended March 31, 2007 and 2006,respectively.  As a percentage of totalrevenue, general and administrative expenses for the three months ended March31, 2007 and 2006, increased to 18% from 17%, respectively.  These increases were a result of increasedprofessional and legal fees.  Inaddition, our EVP of Sales and Marketing was promoted to President effectiveJanuary 1, 2007 and a portion of his employee related costs became a componentof general and administrative expense.

***Product Development***

Product development expenses consist primarily ofemployee related costs and subcontractor expenses.  Product development expenses decreased $0.2million, or 27%, to $0.5 million from $0.7 million for the three months endedMarch 31, 2007 and 2006, respectively. As a percentage of revenue, product development expenses for the threemonths ended March 31, 2007 and 2006, decreased to 7% from 9%, respectively.  These decreases were due to the completion ofcertain product release enhancements as well

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as thecompletion of the “internationalization” of our NumeriTrack® product, whichwere under production during the three months ended March 31, 2006.

***Amortization***

Amortization expense consists of amortization ofidentifiable intangible assets acquired through our acquisitions of CMS, TSEand Evolving Systems U.K.  Amortizationexpense was $0.4 million and $0.9 million for the three months ended March 31,2007 and 2006, respectively.  Thedecrease in amortization expense of $0.5 million, or 57%, was primarily aresult the impairment of certain intangible assets at June 30, 2006.

***Interest Expense***

Interest expense includesinterest expense on our long-term debt and capital lease obligations as well asamortization of debt issuance costs.  Interestexpense was $464,000 and $509,000 for the three months ended March 31, 2007 and2006, respectively.  The decrease of$45,000 primarily related to reduced levels of debt.

***Gain on Debt Extinguishment***

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

***Foreign Currency Exchange Loss***

Foreign currency transaction lossesresulted from transactions denominated in a currency other than the functionalcurrency of the respective subsidiary and were $58,000 and $1,000 forthe three months ended March 31, 2007 and 2006, respectively.  The losses were generated primarily throughthe remeasurement of certain non-functional currency denominated financialassets and liabilities of our Evolving Systems U.K. subsidiary.

***Income Taxes***

We recorded income tax expense of $0.1 million for thethree months ended March 31, 2007 and income tax benefit of $0.1 million forthe three months ended March 31, 2006. The net income tax expense during the three months ended March 31, 2007consisted of current foreign income tax expense of $0.2 million and a deferredforeign tax benefit of $0.1 million both of which are related to our UK-basedoperations.  The net income tax benefitduring the three months ended March 31, 2006 consisted of current foreignincome tax expense of $0.1 million and a deferred foreign tax benefit of $0.2million both of which are related to our UK-based operations.

In conjunction with the acquisition of EvolvingSystems U.K., certain identifiable intangible assets were recorded.  Since the identifiable intangibleamortization is not deductible for income tax purposes, a long-term deferredtax liability of $4.6 million was established at the acquisition date for theexpected difference between what would be expensed for financial reportingpurposes and what would be deductible for income tax purposes. As of March 31,2007 and December 31, 2006, this deferred tax liability was $1.4 million and$1.5 million, respectively.  Thisdeferred tax liability is carried on the books of our United Kingdomsubsidiary, and has no impact on our ability to recover our U.S.-based deferredtax assets.  The aforementioned deferredtax liability will be recognized as a reduction of deferred income tax expenseas the identifiable intangibles are amortized.

**FINANCIAL CONDITION**

 Our workingcapital position decreased $0.1 million to $0.7 million as of March 31, 2007from a $0.8 million as of December 31, 2006. The decrease in our working capital position is primarily attributableto the $0.1 million increase in current portion of long-term debt as of March31, 2007, in accordance with the repayment schedule associated with our seniordebt.

**CONTRACTUALOBLIGATIONS**

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

**LIQUIDITY AND CAPITAL RESOURCES**

We have historically financed operations through cashflows from operations and equity transactions. At March 31, 2007, our principal source of liquidity was $8.0 million incash and cash equivalents as well as $2.5 million available under our revolving

20

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lineof credit.  The following table summarizesour statements of cash flows (in thousands):

|                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------|------------|--------------------------------------------------|------------|
| ** **                | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Cash provided (used)  by: |       |                                             |       |   |   |
| Operating  activities     |       | $                                                | 3,756      |   | $ | 2,277 |   |
| Investing  activities     |       | (256                                             | )          | (97 | ) |
| Financing  activities     |       | (634                                             | )          | (207 | ) |
| Effect of  exchange rates |       | 23                                               |       | (27 | ) |
| Net cash provided         |       | $                                                | 2,889      |   | $ | 1,946 |   |

 

Net cash provided by operatingactivities for the three months ended March 31, 2007 and 2006 was $3.8 million and $2.3 million,respectively.  Net loss plus non-cashoperating adjustments was $0.7 million for the three months ended March31, 2007 compared to a negative $0.3 millionfor the three months ended March 31, 2006.  Changes in operating assets andliabilities reflected a net increase in cash from operating activities of $3.1million for the three months ended March 31, 2007 as compared to a net increase in cash of $2.6 million for the threemonths ended March 31, 2006.  This fluctuation was primarily attributableto the timing of billings and collections for existing projects which varybased upon the specific billing schedules in each contract and affect thereported amounts of contract receivables, unbilled work-in-process and unearnedrevenue.  In addition, we made a largeU.K. income tax payment in the first quarter of 2006 which was not required inthe first quarter of 2007.

Net cash used by investing activities during the threemonths ended March 31, 2007 and 2006 was $0.3 million and $0.1 million.  The cash used for the three months endedMarch 31, 2007 related primarily to purchases of property and equipment of $0.2million.  The cash used for the threemonths ended March 31, 2006 related primarily to purchases of property andequipment of $0.1 million.

Financing activities in the three months ended March31, 2007 and 2006 consisted primarily of principal payments on notespayable.  During the three months endedMarch 31, 2007 and 2006, we paid $0.6 million and $0.3 million, respectively,in principal payments on notes payable. We paid $81,000 in Excess Cash Flow payments (as defined in our seniorloan agreement) to our senior lender during the three months ended March 31,2007.  In addition, of the $77,000 wepaid in March 2007 to retire subordinated debt and accrued interest held by oneof our subordinated note holders, $61,000 was applied to principal and $16,000to accrued interest.

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

·                  Our cash andcash equivalents balance at March 31, 2007 of $8.0 million.

·                  The availabilityunder our revolving credit facility of $2.5 million at March 31, 2007.

·                  Our demonstratedability to generate positive cash flows from operations.

·                  Our backlog asof March 31, 2007 of approximately $16.7 million, including $5.8 million inlicense fees and services and $10.9 million in customer support.

·                  Our plannedcapital expenditures.

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

We are exposed to foreign currency rate risks which impact the carryingamount of our foreign subsidiaries and our consolidated equity, as well as ourconsolidated cash position due to translation adjustments.  For the three months ended March 31,2007, the effect of exchange rate changesresulted in a $23,000 increase to consolidated cash.  During the three months ended March31, 2006, the effect of exchange ratechanges resulted in a $27,000 decrease in consolidated cash.  We do not currently hedge our foreigncurrency exposure, but we monitor rate changes and may hedge our exposures ifwe see significant negative trends in exchange rates.

**OFF-BALANCE SHEET ARRANGEMENTS**

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

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**ITEM3.  QUANTITATIVE AND QUALITATIVE MARKETRISK DISCLOSURES**

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

***Interest Rate Risks***

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

***ForeignCurrency Risk***

We are exposed to favorable and unfavorablefluctuations of the U.S. dollar (our functional currency) against thecurrencies of our operating subsidiaries. Any increase (decrease) in thevalue of the U.S. dollar against any foreign currency that is the functionalcurrency of one of our operating subsidiaries will cause the parent company toexperience unrealized foreign currency translation losses (gains) withrespect to amounts already invested in such foreign currencies.  In addition, we and our operating subsidiariesare exposed to foreign currency risk to the extent that we enter intotransactions denominated in currencies other than our respective functionalcurrencies, such as accounts receivable (including intercompany amounts) thatare denominated in a currency other than their own functional currency. Changesin exchange rates with respect to these items will result in unrealized (basedupon period-end exchange rates) or realized foreign currency transaction gainsand losses upon settlement of the transactions. In addition, we are exposed toforeign exchange rate fluctuations related to our operating subsidiaries’monetary assets and liabilities and the financial results of foreignsubsidiaries and affiliates when their respective financial statements aretranslated into U.S. dollars for inclusion in our consolidated financialstatements. Cumulative translation adjustments are recorded in accumulatedother comprehensive income (loss) as a separate component of equity. As aresult of foreign currency risk, we may experience economic loss and a negativeimpact on earnings and equity with respect to our holdings solely as a resultof foreign currency exchange rate fluctuations.

The relationship between the Great British pound,Indian rupee and the U.S. dollar, which is our functional currency, is shownbelow, per one U.S. dollar:
| Spot rates:     | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------|------------|--------------------------|------------|-----------------------------|------------|
| Great British  Pound |       | 0.50963                  |       | 0.51069                     |       |
| Indian Rupee         |       | 43.42162                 |       | 44.11116                    |       |

 
|                         | ** ** | **Three months ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|
| **Average rates:** | ** ** | **March 31,  2007**         | ** ** | **March 31,  2006** | ** ** |
| Great British  Pound    |       | 0.51177                          |       | 0.57085 |   |
| Indian Rupee            |       | 44.109463                        |       | 44.25170 |   |

 

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

**ITEM4.  CONTROLS AND PROCEDURES**

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

Our management, including our Chief Executive Officerand Chief Financial Officer, has evaluated the effectiveness of our disclosurecontrols and procedures as of the end of the period covered by this QuarterlyReport on Form 10-Q.  Based on that evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that our disclosure controlsand procedures were effective as of the end of such period.

In designing and evaluating our disclosure controlsand procedures, management recognized that disclosure controls and procedures,no matter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the 

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

*Changes in internal control over financialreporting. *During the three months ended March 31,2007, there were no changes in our internal controls over financial reportingor in other factors that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

**PART II —OTHER INFORMATION**

**ITEM 1. LEGAL PROCEEDINGS**

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

We are involved in various otherlegal matters arising in the normal course of business.  Losses were recorded for these matters to theextent they were probable of loss and the amount of loss could be reasonablyestimated.

**ITEM1A.  RISK FACTORS**

ThisQuarterly Report on Form 10-Q should be read in conjunction with the riskfactors defined in our Annual Report on Form 10-K for the year ended December31, 2006 under “Item 1A. Risk Factors.”

**ITEM2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

None

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES**

None

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

None

**ITEM 5. OTHER INFORMATION**

None

**ITEM6.  EXHIBITS**

(a)          Exhibits

Exhibit 10.20(a) – Amendment to Management Change inControl Agreement – Thaddeus Dupper

Exhibit 10.20(b) – Amendment to Management Change inControl Agreement – Brian R. Ervine

Exhibit 10.20(c) – Amendment to Management Change inControl Agreement – Anita T. Moseley

Exhibit 10.20(d) – Amendment to Management Change inControl Agreement – Stuart Cochran

Exhibit 10.21 – Fifth Amendment to Office BuildingLease Agreement

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

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

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

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

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**SIGNATURE**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
| Date: May 11, 2007 |   | /s/ BRIAN R. ERVINE                          |   |
|--------------------|--------|----------------------------------------------|--------|
|               |   | Brian R. Ervine                              |
|               |   | Executive Vice President, Chief              |
|               |   | Financial and Administrative Officer,        |
|               |   | Treasurer and Assistant Secretary            |
|               |   | (Principal Financial and Accounting Officer) |

 

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