Table of Contents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 
| **x** | ** ** | **Quarterly Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |
|-------|------------|--------------------------------------------------------------------------------------------------------|

 

**For the quarterly period ended September 30,2009**

 

**OR**

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

 

**For the transition periodfrom               to               **

 

**Commission File Number: 0-24081**

 

**EVOLVING SYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                    | ** ** | **84-1010843**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation or  organization) |       | (I.R.S. Employer Identification No.) |
| ** **                                                      | ** ** | ** **                           |
| **9777 Pyramid Court, Suite 100 Englewood,  Colorado**     | ** ** | **80112**                            |
| (Address of principal executive offices)                        |       | (Zip Code)                           |

 

**(303) 802-1000**

(Registrant’s telephone number, including area code)

 

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

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).  Yes o No o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer, or asmaller reporting company.  Seedefinition of “large accelerated filer”, “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

 

| Large  accelerated filer  ̈           |   | Accelerated  filer  ̈    |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated  filer  ̈             |   | Smaller  reporting company x |
| (Do not check if  a smaller reporting company) |   |                              |

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).  Yes  ̈ No x

 

As of October 29,2009 there were 9,920,893 shares outstanding of Registrant’s Common Stock (parvalue $0.001 per share).

 

 

 

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**EVOLVING SYSTEMS, INC.**

**Quarterly Report on Form 10-Q**

**September 30, 2009**

**Table of Contents**

 
| **PART I – FINANCIAL INFORMATION** |
|----------------------------------------------|
| Item 1                                       | Financial  Statements |
|                                         | Condensed Consolidated Balance Sheets as of  September 30, 2009 and December 31, 2008 (Unaudited) |
|                                         | Condensed Consolidated Statements of Operations for  the Three and Nine Months Ended September 30, 2009 and 2008 (Unaudited) |
|                                         | Condensed Consolidated  Statements of Changes In Stockholders’ Equity and Comprehensive Income (Loss)  for the Nine Months Ended September 30, 2009 (Unaudited) |
|                                         | Condensed Consolidated Statements of Cash Flows for  the Nine Months Ended September 30, 2009 and 2008 (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**

 

**EVOLVING SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **2009**               | ** ** | **2008**              | ** ** |
| **ASSETS**                                                                                                                                                                                   | ** ** | ** **             |       |                  |       |
| Current assets:                                                                                                                                                                              |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                    |       | $                      | 5,153      |                  | $          | 5,783 |   |
| Contract receivables, net of allowance for doubtful  accounts of $534 at September 30, 2009 and December 31, 2008                                                                  |       | 8,266                  |       | 11,484                |       |
| Unbilled work-in-progress                                                                                                                                                                    |       | 2,195                  |       | 1,910                 |       |
| Deferred income taxes                                                                                                                                                                        |       | 5                      |       | 5                     |       |
| Prepaid and other current assets                                                                                                                                                             |       | 1,594                  |       | 1,304                 |       |
| Total current assets                                                                                                                                                                         |       | 17,213                 |       | 20,486                |       |
| Property and equipment, net                                                                                                                                                                  |       | 1,264                  |       | 1,277                 |       |
| Amortizable intangible assets, net                                                                                                                                                           |       | 2,042                  |       | 2,374                 |       |
| Goodwill                                                                                                                                                                                     |       | 22,288                 |       | 20,811                |       |
| Long-term restricted cash                                                                                                                                                                    |       | 50                     |       | 100                   |       |
| Long-term deferred income taxes                                                                                                                                                              |       | —                 |       | 56                    |       |
| Other long-term assets                                                                                                                                                                       |       | 130                    |       | 307                   |       |
| Total assets                                                                                                                                                                                 |       | $                      | 42,987     |                  | $          | 45,411 |   |
|                                                                                                                                                                                         |       |                   |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                               |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                         |       |                   |       |                  |       |
| Current portion of capital lease obligations                                                                                                                                                 |       | $                      | 24         |                  | $          | 21 |   |
| Current portion of long-term debt                                                                                                                                                            |       | 833                    |       | 2,000                 |       |
| Accounts payable and accrued liabilities                                                                                                                                                     |       | 4,862                  |       | 5,198                 |       |
| Deferred income taxes                                                                                                                                                                        |       | 23                     |       | 20                    |       |
| Unearned revenue                                                                                                                                                                             |       | 7,431                  |       | 11,445                |       |
| Total current liabilities                                                                                                                                                                    |       | 13,173                 |       | 18,684                |       |
| Long-term liabilities:                                                                                                                                                                       |       |                   |       |                  |       |
| Capital lease obligations, net of current portion                                                                                                                                            |       | 41                     |       | 59                    |       |
| Other long-term obligations                                                                                                                                                                  |       | 333                    |       | 1,402                 |       |
| Long-term debt, net of current portion                                                                                                                                                       |       | 2,977                  |       | 4,883                 |       |
| Deferred income taxes                                                                                                                                                                        |       | 330                    |       | 441                   |       |
| Total liabilities                                                                                                                                                                            |       | 16,854                 |       | 25,469                |       |
|                                                                                                                                                                                         |       |                   |       |                  |       |
| Commitments and contingencies (Note 10)                                                                                                                                                      |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                   |       |                   |       |                  |       |
| Preferred stock, $0.001 par value; 2,000,000 shares  authorized; no shares issued and outstanding as of September 30, 2009  and December 31, 2008                                  |       |                   |       |                  |       |
| Common stock, $0.001 par value; 40,000,000 shares  authorized; 9,818,357 and 9,753,393 shares issued and outstanding as of September 30,  2009 and December 31, 2008, respectively |       | 10                     |       | 10                    |       |
| Additional paid-in capital                                                                                                                                                                   |       | 82,684                 |       | 81,824                |       |
| Accumulated other comprehensive loss                                                                                                                                                         |       | (3,338                 | )          | (5,270                | )          |
| Accumulated deficit                                                                                                                                                                          |       | (53,223                | )          | (56,622               | )          |
| Total stockholders’ equity                                                                                                                                                              |       | 26,133                 |       | 19,942                |       |
| Total liabilities and stockholders’ equity                                                                                                                                              |       | $                      | 42,987     |                  | $          | 45,411 |   |

 

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

 

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**EVOLVINGSYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousandsexcept per share data)**

**(unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                   | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                   | ** ** | **2009**               | ** ** | **2008**               | ** ** | **2009** | ** ** | **2008** | ** ** |
| **REVENUE**                                                                  |       |                   |       |                   |       |   |   |   |   |
| License fees and services                                                    |       | $                      | 5,836      |                   | $          | 4,539 |   | $ | 15,940 |   | $ | 14,713 |   |
| Customer support                                                             |       | 4,077                  |       | 4,490                  |       | 12,445 |   | 13,088 |   |
| Total revenue                                                                |       | 9,913                  |       | 9,029                  |       | 28,385 |   | 27,801 |   |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING  EXPENSES**                                 |       |                   |       |                   |       |   |   |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 1,984                  |       | 1,977                  |       | 5,726 |   | 6,103 |   |
| Costs of customer support, excluding depreciation  and amortization          |       | 1,452                  |       | 1,581                  |       | 4,286 |   | 4,706 |   |
| Sales and marketing                                                          |       | 2,032                  |       | 2,004                  |       | 5,861 |   | 6,385 |   |
| General and administrative                                                   |       | 1,546                  |       | 1,281                  |       | 4,378 |   | 3,942 |   |
| Product development                                                          |       | 919                    |       | 792                    |       | 2,300 |   | 2,810 |   |
| Depreciation                                                                 |       | 160                    |       | 189                    |       | 474 |   | 671 |   |
| Amortization                                                                 |       | 194                    |       | 371                    |       | 548 |   | 1,130 |   |
| Total costs of revenue and operating expenses                                |       | 8,287                  |       | 8,195                  |       | 23,573 |   | 25,747 |   |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Income from operations                                                       |       | 1,626                  |       | 834                    |       | 4,812 |   | 2,054 |   |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Other income (expense)                                                       |       |                   |       |                   |       |   |   |   |   |
| Interest income                                                              |       | 1                      |       | 29                     |       | 24 |   | 146 |   |
| Interest expense                                                             |       | (145                   | )          | (278                   | )          | (563 | ) | (897 | ) |
| Loss on extinguishment of debt                                               |       | —                 |       | —                 |       | — |   | (290 | ) |
| Foreign currency exchange gain (loss)                                        |       | 226                    |       | 130                    |       | (436 | ) | 272 |   |
| Other income (expense), net                                                  |       | 82                     |       | (119                   | )          | (975 | ) | (769 | ) |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Income before income taxes                                                   |       | 1,708                  |       | 715                    |       | 3,837 |   | 1,285 |   |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Income tax expense                                                           |       | 380                    |       | 122                    |       | 438 |   | 161 |   |
| Net income                                                                   |       | $                      | 1,328      |                   | $          | 593 |   | $ | 3,399 |   | $ | 1,124 |   |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Basic income per common share                                                |       | $                      | 0.14       |                   | $          | 0.06 |   | $ | 0.35 |   | $ | 0.12 |   |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Diluted income per common share                                              |       | $                      | 0.13       |                   | $          | 0.06 |   | $ | 0.34 |   | $ | 0.11 |   |
|                                                                         |       |                   |       |                   |       |   |   |   |   |
| Weighted average basic shares outstanding                                    |       | 9,797                  |       | 9,693                  |       | 9,780 |   | 9,687 |   |
| Weighted average diluted shares outstanding                                  |       | 10,249                 |       | 9,873                  |       | 10,024 |   | 9,904 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY AND COMPREHENSIVEINCOME (LOSS)**

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

**(unaudited)**

 
| ** **                                                        | ** ** | ** **       | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated**   | ** ** | ** **             | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|------------------|------------|-------------|------------|-------------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                        | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**         | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                        | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated**   | ** ** | **Stockholders’** | ** ** |
| ** **                                                        | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income (Loss)** | ** ** | **(Deficit)**          | ** ** | **Equity** | ** ** |
| **Balance at December 31, 2008**                             | ** ** | **9,753,393**    | ** ** | **$**       | **10**     | ** **        | **$**      | **81,824**        | ** ** | **$**                  | **(5,270** | **)**      | **$**      | **(56,622** | **)** | **$** | **19,942** | ** ** |
| Stock option exercises                                            |       | 33,279           |       | —      |       | 160               |       | —            |       | —                 |       | 160        |       |
| Common Stock issued pursuant to the Employee Stock  Purchase Plan |       | 31,685           |       | —      |       | 51                |       | —            |       | —                 |       | 51         |       |
| Stock-based compensation expense                                  |       | —           |       | —      |       | 649               |       | —            |       | —                 |       | 649        |       |
| Comprehensive income:                                             |       |             |       |        |       |              |       |              |       |                   |       |       |       |
| Net income                                                        |       | —           |       | —      |       | —            |       | —            |       | 3,399                  |       |       |       |
| Foreign currency translation adjustment                           |       | —           |       | —      |       | —            |       | 1,932             |       | —                 |       |       |       |
| Comprehensive income                                              |       |             |       |        |       |              |       |              |       |                   |       | 5,331      |       |
| **Balance at September 30, 2009**                            | ** ** | **9,818,357**    | ** ** | **$**       | **10**     | ** **        | **$**      | **82,684**        | ** ** | **$**                  | **(3,338** | **)**      | **$**      | **(53,223** | **)** | **$** | **26,133** | ** ** |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                         | ** ** | **2009**                                 | ** ** | **2008** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                         |       |                                     |       |   |   |
| Net income                                                                         |       | $                                        | 3,399      |   | $ | 1,124 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities: |       |                                     |       |   |   |
| Depreciation                                                                       |       | 474                                      |       | 671 |   |
| Amortization of intangible assets                                                  |       | 548                                      |       | 1,130 |   |
| Amortization of debt issuance costs                                                |       | 101                                      |       | 112 |   |
| Stock based compensation                                                           |       | 649                                      |       | 645 |   |
| Loss on extinguishment of debt                                                     |       | —                                   |       | 290 |   |
| Unrealized foreign currency transaction (gains) and  losses, net                   |       | 436                                      |       | (272 | ) |
| Benefit from foreign deferred income taxes                                         |       | (89                                      | )          | (186 | ) |
| Change in operating assets and liabilities:                                        |       |                                     |       |   |   |
| Contract receivables                                                               |       | 3,022                                    |       | 6,494 |   |
| Unbilled work-in-progress                                                          |       | (142                                     | )          | (1,067 | ) |
| Prepaid and other assets                                                           |       | (188                                     | )          | (450 | ) |
| Accounts payable and accrued liabilities                                           |       | (573                                     | )          | (517 | ) |
| Unearned revenue                                                                   |       | (4,381                                   | )          | (4,158 | ) |
| Other long-term obligations                                                        |       | (1,069                                   | )          | (255 | ) |
| Net cash provided by operating activities                                          |       | 2,187                                    |       | 3,561 |   |
|                                                                               |       |                                     |       |   |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                         |       |                                     |       |   |   |
| Purchase of property and equipment                                                 |       | (439                                     | )          | (755 | ) |
| Net cash used in investing activities                                              |       | (439                                     | )          | (755 | ) |
|                                                                               |       |                                     |       |   |   |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                         |       |                                     |       |   |   |
| Capital lease payments                                                             |       | (15                                      | )          | (15 | ) |
| Principal payments on long-term debt                                               |       | (3,073                                   | )          | (7,798 | ) |
| Proceeds from issuance of long-term debt                                           |       | —                                   |       | 4,000 |   |
| Payments for debt issuance costs                                                   |       | —                                   |       | (347 | ) |
| Proceeds from the issuance of stock                                                |       | 211                                      |       | 56 |   |
| Net cash used in financing activities                                              |       | (2,877                                   | )          | (4,104 | ) |
|                                                                               |       |                                     |       |   |   |
| Effect of exchange rate changes on cash                                            |       | 499                                      |       | (344 | ) |
|                                                                               |       |                                     |       |   |   |
| Net decrease in cash and cash equivalents                                          |       | (630                                     | )          | (1,642 | ) |
| Cash and cash equivalents at beginning of period                                   |       | 5,783                                    |       | 7,271 |   |
| Cash and cash equivalents at end of period                                         |       | $                                        | 5,153      |   | $ | 5,629 |   |
|                                                                               |       |                                     |       |   |   |
| Supplemental disclosure of other cash and non-cash  financing transactions:        |       |                                     |       |   |   |
| Interest paid                                                                      |       | $                                        | 1,542      |   | $ | 1,070 |   |
| Income taxes paid                                                                  |       | 681                                      |       | 354 |   |
| Conversion of preferred stock into common stock                                    |       | —                                   |       | 5,587 |   |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

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**EVOLVINGSYSTEMS, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 – BASIS OF PRESENTATION**

 

**Organization-**We are a provider of software solutions and servicesto the wireless, wireline and IP carrier markets. We maintain long-standingrelationships with many of the largest wireline, wireless and cable companiesworldwide. 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 four core areas:  service activation solutions used toactivate complex bundles of voice, video and data services for traditional andnext generation wireless and wireline networks; numbering solutions that enable carriers to comply withgovernment-mandated requirements regarding number portability as well asproviding phone number management and assignment capabilities; SIM cardactivation solutions used to dynamically allocate and assign resources to awireless device when it is first used, and mediation solutionssupporting data collection for both service assurance and billing applications.

 

**Interim Consolidated Financial Statements** – Theaccompanying unaudited condensed consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”) and in conformity with the instructions to Form 10-Qand 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 nine months ended September 30, 2009 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, 2008 included in our Annual Report on Form 10-K.

 

**Use of Estimates -**The preparation of financialstatements in conformity with accounting principles generally accepted in theU.S. requires us to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities, at the date of the financial statements, as well as the reportedamounts of revenue and expenses during the reporting period. We made estimateswith respect to revenue recognition for estimated hours to complete projectsaccounted for using the percentage-of-completion method, allowance for doubtfulaccounts, income tax valuation allowance, fair values of long-lived assets,valuation of intangible assets and goodwill, useful lives for property,equipment and intangible assets, business combinations, capitalization ofinternal software development costs and fair value of stock-based compensationamounts.  Actual results could differfrom these estimates.

 

**EarningsPer Share** - On July 1, 2009, we announced that our Board ofDirectors approved a one-for-two reverse split of our common stock, aspreviously authorized and approved by our stockholders at the June 9, 2009annual meeting, which took effect at 11:59 p.m. (Eastern time) on July 20,2009 (the “Effective Time”). Our common stock began trading on a post-splitbasis on July 21, 2009. As a result of the reverse stock split, every twoshares of our common stock was combined into one share of common stock. Thereverse stock split affected all of our common stock outstanding immediatelyprior to the Effective Time of the reverse stock split as well as the number ofshares of common stock available for issuance under our equity incentive plans.In addition, the reverse stock split reduced the number of shares of commonstock issuable upon the exercise of stock options. Our common stock outstandingat June 30, 2009 was approximately 19.6 million shares. Adjusting forthe reverse stock split, the common stock outstanding at June 30, 2009 wasreduced to approximately 9.8 million shares. The number of authorizedshares of common stock remains at 40.0 million. The reverse split did notaffect the par value of our common stock which remains at $0.001. As a resultof the reverse stock split, the stated capital on our balance sheetattributable to our common stock was reduced in proportion to the size of thereverse stock split. Common stock and additional paid-in capital balances, allshare amounts, stock option amounts and per share/option prices appearing inthis Quarterly Report on Form 10-Q reflect the reverse stock split for allperiods presented.

 

**Foreign Currency Translation -**Our functional currency isthe U.S. dollar.  The functional currencyof our foreign operations is the respective local currency for each foreignsubsidiary.  Assets and liabilities offoreign operations denominated in local currencies are translated at the spotrate in effect at the applicable reporting date.  Our consolidated statements of operations aretranslated at the weighted average rate of exchange during the applicableperiod.  The resulting unrealizedcumulative translation adjustment, net of applicable income taxes, is recordedas a component of accumulated other comprehensive income (loss) instockholders’ equity.  Realized andunrealized transaction gains and losses generated by transactions denominatedin a currency different from the functional currency of the applicable entityare recorded in other income (loss) in the period in which they occur.

 

**Principles of Consolidation -**The consolidated financialstatements include the accounts of Evolving Systems, Inc. and 

 

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subsidiaries,all of which are wholly owned.  Allsignificant intercompany transactions and balances have been eliminated inconsolidation.

 

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

 

**Intangible Assets -**Amortizable intangibleassets consist primarily of purchased software and licenses, customer contractsand relationships, trademarks and tradenames, and business partnershipsacquired in conjunction with our purchases of CMS Communications, Inc.(“CMS”), Telecom Software Enterprises, LLC (“TSE”) and Tertio Telecoms Ltd.(“Evolving Systems U.K.”).  Thesedefinite life assets are amortized using the straight-line method over theirestimated lives.

 

We assess the impairment of identifiable intangibles if events orchanges in circumstances indicate that the carrying value of the asset may notbe recoverable. Factors that we consider significant which could trigger animpairment analysis include the following:

 

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

 

·                  Significant changes in the manner of use ofthe acquired assets or the strategy of the overall business;

 

·                  Significant negative industry or economictrends; and/or

 

·                  Significant decline in our stock price for asustained period.

 

If, as a result of the existence of one or more of the above indicatorsof impairment, we determine that the carrying value of intangibles and/orlong-lived assets may not be recoverable, we compare the estimated undiscountedcash flows expected to result from the use of the asset and its eventualdisposition to the asset’s carrying amount. If an amortizable intangible orlong-lived asset is not deemed to be recoverable, we recognize an impairmentloss representing the excess of the asset’s carrying value over its estimatedfair value.

 

**Fair Value of Financial Instruments -**The carryingamounts for certain financial instruments, including cash and cash equivalents,contract receivables and accounts payable, approximate fair value due to theirshort maturities.  We estimate the fairvalue of our debt based on current rates offered to us for debt of the sameremaining maturities, if available, or if not available, based on discountedfuture cash flows using current market interest rates.  As of September 30, 2009, we estimatedthe fair value of our fixed rate senior term loan and subordinated notes was$0.9 million and $3.4 million, respectively. As of December 31, 2008, weestimated the fair value of our fixed rate senior term loan and subordinatednotes was $2.4 million and $6.0 million, respectively.

 

**Revenue Recognition -**We generallyrecognize revenue when an agreement is signed, the fee is fixed or determinableand collectability is reasonably assured. We recognize revenue from two primarysources: license fees and services, and customer support.   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.   When the services are determined to beessential to the functionality of the delivered software, we recognize revenueusing the percentage-of-completion method of accounting. We estimate thepercentage-of-completion for each contract based on the ratio of direct laborhours incurred to total estimated direct labor hours and recognize revenuebased on the percent complete multiplied by the contract amount.  Since estimated direct labor hours, andchanges thereto, can have a significant impact on revenue recognition, theseestimates are critical and we review them regularly.  We record amounts billed in advance ofservices being performed as unearned revenue. Unbilled work-in-progressrepresents revenue earned but not yet billable under the terms of thefixed-price contracts. All such amounts are expected to be billed and collectedwithin 12 months.

 

Wemay encounter budget and schedule overruns on fixed-price contracts causedby increased labor or overhead costs. We make adjustments to cost estimates inthe period in which the facts requiring such revisions become known. We recordestimated losses, if any, in the period in which current estimates of totalcontract revenue and contract costs indicate a loss. If revisions to costestimates are obtained after the balance sheet date but before the issuance ofthe interim or annual financial statements, we make adjustments to the interimor annual financial statements accordingly.

 

In arrangements where the services are not essential to thefunctionality of the delivered software, we recognize license revenue when alicense agreement has been signed, delivery has occurred, the fee is fixed ordeterminable and collectability is reasonably assured. Where applicable, weunbundle and record as revenue fees from multiple element arrangements as theelements are delivered to the extent that vendor specific objective evidence(“VSOE”) of fair value of the undelivered elements exist. If VSOE for theundelivered elements 

 

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does not exist, we defer fees from such arrangements until the earlierof the date that VSOE does exist on the undelivered elements or all of theelements have been delivered.

 

Werecognize revenue from fixed-price service contracts using the proportionalperformance method of accounting, which is similar to thepercentage-of-completion method described above. We recognize revenue fromprofessional services provided pursuant to time-and-materials based contractsand training services as the services are performed, as that is when ourobligation to our customers under such arrangements is fulfilled.

 

Werecognize customer support, including maintenance revenue, ratably over theservice contract period. When maintenance is bundled with the original licensefee arrangement, its fair value, based upon VSOE, is deferred and recognizedduring the periods when services are provided.

 

**Stock-based Compensation -** We account for stock-based compensationby applying a fair-value-based measurement method to account for share-basedpayment transactions with employees and directors and record compensation costfor all stock awards granted after January 1, 2006 and awards modified,repurchased, or cancelled after that date. We record compensation costsassociated with the vesting of unvested options on a straight-line basis overthe vesting period.  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.    We use theBlack-Scholes model to estimate the fair value of each option grant on the dateof grant.  This model requires the use ofestimates for expected term of the options and expected volatility of the priceof our common stock.

 

**Income Taxes**- We record deferredtax assets and liabilities for the estimated future tax effects of temporarydifferences between the tax bases of assets and liabilities and amountsreported in the accompanying consolidated balance sheets, as well as operatingloss and tax credit carry-forwards. We measure deferred tax assets andliabilities using enacted tax rates expected to be applied to taxable income inthe years in which those temporary differences are expected to be recovered orsettled.  We reduce deferred tax assetsby a valuation allowance if, based on available evidence, it is more likelythan not that these benefits will not be realized.  We evaluate tax benefits recorded in ourconsolidated financial statements and record accruals for any amounts deemednot probable of being sustained.

 

Effective January 1, 2007, we adopted a recognition threshold anda measurement attribute for the financial statement recognition and measurementof tax positions taken or expected to be taken in a tax return.  For those benefits to be recognized, a taxposition must be more likely than not to be sustained upon examination bytaxing authorities.  There was nomaterial impact on the company’s consolidated financial position and results ofoperations as a result of this adoption.

 

As of September 30, 2009 and December 31, 2008, we had noliability for unrecognized tax benefits. We do not believe there will be any material changes to our unrecognizedtax positions over the next twelve months.

 

**Recent Accounting Pronouncements -**In August 2009,the FASB issued Accounting Standards Update (“ASU”) 2009-05, Measuring Liabilities at Fair Value, to amend FASBAccounting Standards CodificationTM (“ASC”) 820, Fair Value Measurements andDisclosures, to clarify how entities should estimate the fair value ofliabilities. ASC 820, as amended, includes clarifying guidance forcircumstances in which a quoted price in an active market is not available, theeffect of the existence of liability transfer restrictions, and the effect ofquoted prices for the identical liability, including when the identicalliability is traded as an asset. The amended guidance in ASC 820 onmeasuring liabilities at fair value is effective for the first interim orannual reporting period beginning after August 28, 2009, with earlierapplication permitted. We do not believe that the adoption of the amendedguidance in ASC 820 will have a significant effect on our consolidatedfinancial statements.

 

In October 2009, the FASB issued ASU 2009-13,Multiple-Deliverable Revenue Arrangements – a consensus of the FASB EmergingIssues Task Force, to amend certain guidance in FASB ASC 605, RevenueRecognition, 25, “Multiple-Element Arrangements”. The amended guidance inASC 605-25 (1) modifies the separation criteria by eliminating thecriterion that requires objective and reliable evidence of fair value for theundelivered item(s), and (2) eliminates the use of the residual method ofallocation and instead requires that arrangement consideration be allocated, atthe inception of the arrangement, to all deliverables based on their relativeselling price. The amended guidance in ASC 605-25 is effectiveprospectively for revenue arrangements entered into or materially modified infiscal years beginning on or after June 15, 2010, with early applicationand retrospective application permitted. The Company expects to prospectivelyapply the amended guidance in ASC 605-25 beginning January 1, 2010.The Company does not believe that the adoption of the amendments toASC 605-25 will have a significant effect on its consolidated financialstatements.

 

In October 2009, the FASB issued ASU 2009-14, Certain RevenueArrangements That Include Software Elements – a consensus of the FASB EmergingIssues Task Force, to amend the scope of arrangements under ASC 985,Software, 605, “Revenue Recognition” to exclude tangible productscontaining software components and non-software components that functiontogether to deliver a product’s essential functionality. The amended guidancein ASC 605-25 and ASC 985-605 is effective prospectively for revenuearrangements entered into or materially modified in fiscal years beginning onor after June 15, 2010, with early application and retrospectiveapplication permitted. The Company expects to prospectively apply the amendedguidance in ASC 985-605, concurrently with the amended guidance inASC 605-25, beginning on January 1, 2010. The Company does notbelieve that the 

 

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adoptionof the amended guidance in ASC 605-25 and ASC 985-605 will have asignificant effect on its consolidated financial statements.

 

**NOTE 2 – GOODWILL AND INTANGIBLE ASSETS**

 

We recorded goodwill as a result of three acquisitions which occurredover the period from November 2003 to November 2004. We acquired CMSin November 2003, TSE in October 2004 and Evolving Systems U.K. in November 2004.

 

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

 
| ** **                                             | ** ** | **License and Services** | ** ** | **Customer Support** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|----------------------|------------|-----------|------------|
| ** **                                             | ** ** | **US**                   | ** ** | **UK**               | ** ** | **US**    | ** ** | **UK** | ** ** | **Goodwill** | ** ** |
| Balance as of December 31, 2008                   |       | $                        | —     |                 | $          | 6,611     |       | $ | 6,033 |   | $ | 8,167 |   | $ | 20,811 |   |
| Effects of changes in foreign currency exchange  rates |       | —                   |       | 661                  |       | —    |       | 816 |   | 1,477 |   |
| Balance as of September 30, 2009                  |       | $                        | —     |                 | $          | 7,272     |       | $ | 6,033 |   | $ | 8,983 |   | $ | 22,288 |   |

 

We conducted our annual goodwill impairmenttest as of July 31, 2009, and we determined that goodwill was not impairedas of the test date. From July 31, 2009 through September 30, 2009,no events have occurred that we believe may have impaired goodwill.

 

We amortized identifiable intangible assetson a straight-line basis over estimated lives ranging from one to seven yearsand include the cumulative effects of foreign currency exchange rates.  As of September 30, 2009 and December 31,2008, identifiable intangibles were as follows (in thousands):

 
| ** **                | ** ** | **September 30, 2009** | ** ** | **December 31, 2008**    | ** ** | **Weighted-**             | ** ** |
|---------------------------|------------|-----------------------------|------------|-------------------------------|------------|---------------------------|------------|
| ** **                | ** ** | **(1)  Gross  Amount**      | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **(1)  Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Average  Amortization  Period** | ** ** |
| Purchased software        |       | $                           | 1,712      |                          | $          | 1,214                     |       | $ | 498 |   | $ | 1,583 |   | $ | 902 |   | $ | 681 |   | 4.6 yrs |   |
| Purchased licenses        |       | 227                         |       | 227                           |       | —                    |       | 227 |   | 227 |   | — |   | 2.3 yrs |   |
| Trademarks and tradenames |       | 714                         |       | 332                           |       | 382                       |       | 649 |   | 232 |   | 417 |   | 7.0 yrs |   |
| Business partnerships     |       | 117                         |       | 76                            |       | 41                        |       | 106 |   | 53 |   | 53 |   | 5.0 yrs |   |
| Customer relationships    |       | 3,176                       |       | 2,055                         |       | 1,121                     |       | 2,986 |   | 1,763 |   | 1,223 |   | 5.3 yrs |   |
|                      |       | $                           | 5,946      |                          | $          | 3,904                     |       | $ | 2,042 |   | $ | 5,551 |   | $ | 3,177 |   | $ | 2,374 |   | 5.2 yrs |   |

 

----

(1)  Changes in intangible gross values as of September 30,2009 compared to December 31, 2008 are the direct result of changes inforeign currency exchange rates for the periods then ended.

 

Amortization expense of identifiable intangible assets was $0.2 and$0.5 million for the three and nine months ended September 30, 2009,respectively, and $0.4 and $1.1 million for the three and nine months ended September 30,2008, respectively.  As Evolving SystemsU.K. uses the British Pound Sterling as its functional currency, the amount offuture amortization actually recorded will be based upon exchange rates ineffect at that time. Expected future amortization expense related toidentifiable intangibles based on our carrying amount as of September 30,2009 was as follows (in thousands):

 
| **Twelve months ending  September 30,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2010                                         |       | $          | 710        |   |
| 2011                                         |       | 631        |       |
| 2012                                         |       | 401        |       |
| 2013                                         |       | 300        |       |
|                                         |       | $          | 2,042      |   |

 

**NOTE 3 – EARNINGS PER COMMON SHARE**

 

We compute basic earnings per share (“EPS”) 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 previously outstanding Series BConvertible Redeemable Preferred Stock (“Series B Preferred Stock”). Wecompute diluted EPS using the weighted average number of shares outstanding,including participating securities, plus all potentially dilutive common stockequivalents. Common stock equivalents consist of stock options.

 

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OnJanuary 1, 2009, we adopted a policy providing that unvested share-basedpayment awards that contain non-forfeitable rights to dividends or dividend equivalents,whether paid or unpaid, are participating securities and shall be included inthe computation of both basic and diluted earnings pershare.   Upon adoption, both basic and diluted income per sharefor 2009 and 2008 remained unchanged.

 

The following is the reconciliation of thedenominator of the basic and diluted EPS computations (in thousands):

 
| ** **                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                 | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| Basic income per common and preferred share:               | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                       | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income available to common and preferred  stockholders |       | $                                          | 1,328      |                                      | $          | 593 |   | $ | 3,399 |   | $ | 1,124 |   |
| Weighted average common shares outstanding                 |       | 9,797                                      |       | 9,693                                     |       | 9,780 |   | 9,522 |   |
| Participating securities                                   |       | —                                     |       | —                                    |       | — |   | 165 |   |
| Basic weighted average shares outstanding                  |       | 9,797                                      |       | 9,693                                     |       | 9,780 |   | 9,687 |   |
| Basic income per common and preferred share                |       | $                                          | 0.14       |                                      | $          | 0.06 |   | $ | 0.35 |   | $ | 0.12 |   |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Diluted income per common and preferred share:             |       |                                       |       |                                      |       |   |   |   |   |
|                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Net income available to common and preferred  stockholders |       | $                                          | 1,328      |                                      | $          | 593 |   | $ | 3,399 |   | $ | 1,124 |   |
| Weighted average common shares outstanding                 |       | 9,797                                      |       | 9,693                                     |       | 9,780 |   | 9,522 |   |
| Participating securities                                   |       | —                                     |       | —                                    |       | — |   | 165 |   |
| Effect of dilutive securities – options               |       | 452                                        |       | 180                                       |       | 244 |   | 217 |   |
| Diluted weighted average shares outstanding                |       | 10,249                                     |       | 9,873                                     |       | 10,024 |   | 9,904 |   |
| Diluted income per common and preferred share              |       | $                                          | 0.13       |                                      | $          | 0.06 |   | $ | 0.34 |   | $ | 0.11 |   |

 

For the three months ended September 30, 2009and 2008, 0.9 million and 1.9 million shares of common stock were excluded fromthe dilutive stock calculation because their exercise prices were greater thanthe average fair value of our common stock for the period. For each of the ninemonth periods ended September 30, 2009 and 2008, 1.8 million shares ofcommon stock were excluded from the dilutive stock calculation because theirexercise prices were greater than the average fair value of our common stockfor the period.

 

**NOTE 4 – SHARE-BASED COMPENSATION**

 

Weaccount for stock-based compensation by applying a fair-value-based measurementmethod to account for share-based payment transactions with employees anddirectors and record compensation cost for all stock awards granted after January 1,2006 and awards modified, repurchased, or cancelled after that date, using themodified prospective method. We record compensation costs associated with thevesting of unvested options on a straight-line basis over the vesting period.We recognized $0.2 million for each of the three months ended September 30,2009 and 2008 and $0.6 million for each of the nine months ended September 30,2009 and 2008, respectively, of compensation expense in the consolidatedstatements of operations, with respect to our stock-based compensationplans.  The following table summarizesstock-based compensation expenses recorded in the statement of operations (inthousands):

 
| ** **                                                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                  | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| Cost of license fees and services, excluding depreciation  and amortization |       | $                                          | 16         |                                      | $          | 16 |   | $ | 51 |   | $ | 46 |   |
| Cost of customer support, excluding depreciation  and amortization          |       | 2                                          |       | 1                                         |       | 6 |   | 5 |   |
| Sales and marketing                                                         |       | 36                                         |       | 18                                        |       | 107 |   | 101 |   |
| General and administrative                                                  |       | 146                                        |       | 133                                       |       | 417 |   | 431 |   |
| Product development                                                         |       | 23                                         |       | 21                                        |       | 68 |   | 62 |   |
|                                                                        |       | $                                          | 223        |                                      | $          | 189 |   | $ | 649 |   | $ | 645 |   |

 

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**Stock Incentive Plans**

 

In January 1996, our stockholders approved an Amended and RestatedStock Option Plan (the “Option Plan”). Under the Option Plan, as amended, and after the reverse stock split,4,175,000 shares were reserved for issuance. Options issued under the Option Plan were at the discretion of the Boardof Directors, including the vesting provisions of each stock option granted.Options were granted with an exercise price equal to the closing price of ourcommon stock on the date of grant, generally vest over four years and expire nomore than ten years from the date of grant. The Option Plan terminated on January 18,2006; options granted before that date were not affected by the plantermination.  At September 30, 2009and 2008, 1.8 million and 1.9 million options remained outstanding under theOption Plan, respectively.

 

In March 2007, upon the hiring of our Vice President of World WideSales and Marketing, in accordance with NASDAQ Marketplace Rule 4350(i)(1)(a)(iv),the Board of Directors approved an inducement award under a stand-alone equityincentive plan.  We granted 50,000non-qualified options to purchase shares of our common stock at an exerciseprice equal to the closing price of our common stock on the date of grant.  The options vest over four years and expireten years from the date of grant. At September 30, 2009 and 2008, 50,000options remained outstanding under this plan.

 

In June 2007, our stockholders approved the 2007 Stock IncentivePlan (the “2007 Stock Plan”).  As aresult of the reverse stock split on July 21, 2009, a maximum of 1,000,000shares can be issued under the 2007 Stock Plan. Awards permitted under the 2007Stock Plan include:  Stock Options, StockAppreciation Rights, Restricted Stock, Restricted Stock Units, PerformanceAwards and Other Stock-Based Awards. Awards issued under the 2007 Stock Plan are at the discretion of theBoard of Directors.  As applicable,awards are granted with an exercise price equal to the closing price of ourcommon stock on the date of grant, generally vest over four years and expire nomore than ten years from the date of grant. At September 30, 2009 and 2008, 0.5 million and 0.3 million optionsremained outstanding under the 2007 Stock Plan, respectively.

 

In December 2008, under the 2007 Stock Plan, we awarded a total of52,500 shares of restricted stock to members of our Board of Directors andsenior management. There were no issuances of restricted stock during either ofthree or nine months ended September 30, 2009 or 2008. During the threemonths ended September 30, 2009 and 2008, 10,000 and 7,000 shares ofrestricted stock vested, respectively. During the nine months ended September 30, 2009 and 2008, 31,000and 21,000 shares of restricted stock vested, respectively. There were noforfeitures of restricted stock during the either of the three or nine monthsended September 30, 2009 and 2008. The fair market value for share-basedcompensation expensing is equal to the closing price of our common stock on thedate of grant. The restrictions on the stock award are released generally overfour years for senior management and over one year for board members.

 

The fair value of each option grant is estimated on the date of grantusing the Black-Scholes model.  TheBlack-Scholes model uses four assumptions to calculate the fair value of eachoption grant.  The expected term of shareoptions granted is derived using the simplified method, which we adopted in January 2008.The risk-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  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| Expected term (years)   |       | *                                          |       | *                                         |       | 5.3 |   | 6.2 |   |
| Risk-free interest rate |       | *                                          |       | *                                         |       | 2.4 | % | 2.7 | % |
| Expected volatility     |       | *                                          |       | *                                         |       | 78.0 | % | 101.9 | % |
| Expected dividend yield |       | *                                          |       | *                                         |       | 0 | % | 0 | % |

 

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* - None granted

 

The following is a summary of stock option activity under the plans forthe nine months ended September 30, 2009:

 

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| ** **                                     | ** ** | ** **         | ** ** | ** **    | ** ** | **Weighted-**   | ** ** | ** **         | ** ** |
|------------------------------------------------|------------|--------------------|------------|---------------|------------|-----------------|------------|--------------------|------------|
| ** **                                     | ** ** | ** **         | ** ** | ** **    | ** ** | **Average**     | ** ** | ** **         | ** ** |
| ** **                                     | ** ** | ** **         | ** ** | **Weighted-** | ** ** | **Remaining**   | ** ** | **Aggregate**      | ** ** |
| ** **                                     | ** ** | **Number of**      | ** ** | **Average**   | ** ** | **Contractual** | ** ** | **Intrinsic**      | ** ** |
| ** **                                     | ** ** | **Shares**         | ** ** | **Exercise**  | ** ** | **Term**        | ** ** | **Value**          | ** ** |
| ** **                                     | ** ** | **(in thousands)** | ** ** | **Price**     | ** ** | **(Years)**     | ** ** | **(in thousands)** | ** ** |
| Options outstanding at December 31, 2008  |       | 2,327              |       | $             | 5.62       |            |       |               | $          | 78 |   |
| Options granted                                |       | 75                 |       | $             | 3.38       |            |       |               |       |   |
| Less options forfeited                         |       | (4                 | )          | $             | 1.97       |            |       |               |       |   |
| Less options expired                           |       | (5                 | )          | $             | 5.38       |            |       |               |       |   |
| Less options exercised                         |       | (33                | )          | $             | 4.79       |            |       |               |       |   |
| Options outstanding at September 30, 2009 |       | 2,360              |       | $             | 5.56       |            | 5.15       |               | $          | 5,760 |   |
|                                           |       |               |       |          |       |            |       |               |       |
| Options exercisable at September 30, 2009 |       | 2,000              |       | $             | 5.98       |            | 4.53       |               | $          | 4,414 |   |

 

·                  All stock option amountshave been adjusted for the reverse stock split

 

There were no stock options granted during the three months ended September 30,2009 and 2008. The weighted-average grant-date fair value of stock optionsgranted during the nine months ended September 30, 2009 and 2008 was $2.20and $3.35, respectively.

 

As of September 30, 2009, there was approximately $1.0 million oftotal unrecognized compensation costs related to unvested stock options.  These costs are expected to be recognizedover a weighted average period of 2.0 years.

 

The total fair value of stock options vested during each of the threemonths ended September 30, 2009 and 2008 was $0.2 million. The total fairvalue of stock options vested during each of the nine months ended September 30,2009 and 2008 was $0.7 million.

 

The deferred income tax benefits from stock option expense related toEvolving Systems U.K. totaled approximately $15,000 and $14,000 for the threemonths ended September 30, 2009 and 2008, respectively. The deferredincome tax benefits from stock option expense related to Evolving Systems U.K.totaled approximately $45,000 and $43,000 for the nine months ended September 30,2009 and 2008, respectively.

 

Cash received from stock option exercises for the three months ended September 30,2009 and 2008 was $0.2 million and $4,000, respectively. Cash received fromstock option exercises for the nine months ended September 30, 2009 and2008 was $0.2 million and $4,000, respectively.

 

**Employee Stock Purchase Plan**

 

Under the Employee Stock Purchase Plan (“ESPP”), we were previouslyauthorized to issue up to 1,100,000 shares of our common stock to full-timeemployees, nearly all of whom are eligible to participate. After the reversestock split, we are now authorized to issue up to 550,000 shares under theESPP. Under the terms of the ESPP, employees may elect to have up to 15% oftheir gross compensation withheld through payroll deduction to purchase ourcommon stock, capped at $25,000 annually. The purchase price of the stock is85% of the lower of the market price at the beginning or end of each three-monthparticipation period. As of September 30, 2009, there were approximately92,000 shares available for purchase. For the three months ended September 30, 2009 and 2008, we recordedcompensation expense of $5,000 and $6,000, respectively, and $16,000 and $17,000for the nine months ended September 30, 2009 and 2008, associated withgrants under the ESPP which includes the fair value of the look-back feature ofeach grant as well as the 15% discount on the purchase price.  This expense fluctuates each period basedupon employee participation.

 

The fair value of each purchase made under our ESPP is estimated on thedate of purchase using the Black-Scholes model. The Black-Scholes model uses four assumptions to calculate the fairvalue of each purchase.  The expectedterm of each purchase is based upon the three-month participation period ofeach offering.  The risk-free interestrate is based upon the rate currently available on zero-coupon U.S. Treasuryinstruments with a remaining term equal to the expected term of eachoffering.  The expected volatility isbased upon historical volatility of our common stock.  The expected dividend yield is based uponhistorical and anticipated payment of dividends.  The weighted average assumptions used in thefair value calculations are as follows:

 

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| ** **              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| Expected term (years)   |       | 0.25                                       |       | 0.25                                      |       | 0.25 |   | 0.25 |   |
| Risk-free interest rate |       | 0.2                                        | %          | 1.2                                       | %          | 0.1 | % | 1.4 | % |
| Expected volatility     |       | 66.0                                       | %          | 65.9                                      | %          | 65.2 | % | 68.2 | % |
| Expected dividend yield |       | 0                                          | %          | 0                                         | %          | 0 | % | 0 | % |

 

Cash received from employee stock plan purchases for each of the threemonth periods ended September 30, 2009 and 2008 was $16,000.  Cash received from employee stock planpurchases for the nine months ended September 30, 2009 and 2008 was$51,000 and $52,000, respectively.

 

We issued shares related to the ESPP of 9,000 and 5,000 for the threemonths ended September 30, 2009 and 2008, respectively. We issued sharesrelated to the ESPP of 32,000 and 16,000 for the nine months ended September 30,2009 and 2008, respectively.

 

**NOTE 5 – CONCENTRATION OF CREDIT RISK**

 

For the three months ended September 30, 2009, two significantcustomers (defined as contributing at least 10%) accounted for 28% (15% and13%) of total revenue.  These customersinclude a large telecommunications operators located in the U.S. and Asia,respectively.  For the nine months ended September 30,2009, one significant customer accounted for 20% of total revenue. Thiscustomer is a large telecommunications operator in the U.S. For the three andnine months ended September 30, 2008, two significant customers accountedfor 33% (17% and 16%) and 29% (16% and 13%), respectively, of totalrevenue.  These customers are largetelecommunications operators located in the U.S. and U.K., respectively.

 

As of September 30, 2009, two significant customers accounted forapproximately 41% of contract receivables and unbilled work-in-progress.  These customers are a wirelesscompany located inAfrica and a large telecommunications operator in Asia.  AtDecember 31, 2008, one significant customer accounted for approximately45% of contract receivables and unbilled work-in-progress.  This customer is a largetelecommunications operator located in the U.S.

 

**NOTE 6 – LONG-TERM DEBT**

 

Long-termdebt consists of the following (in thousands):

 
| ** **                                                                                                                                                                                                                                                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                              | ** ** | **2009**               | ** ** | **2008**              | ** ** |
| Senior term loan with financial institution,  interest at a fixed rate of 8.25%, principal installments and interest  payments are due monthly with final maturity on February 22, 2010. The  loan is secured by substantially all of our assets.                  |       | $                      | 833        |                  | $          | 2,333 |   |
| Long-term unsecured subordinated notes payable,  interest ranges from 11-14% with a weighted average rate of 12.62% and 13.72%  at September 30, 2009 and December 31, 2008, respectively, accrued  interest and principal are due in full May 16, 2011. |       | 2,977                  |       | 4,550                 |       |
| Total debt                                                                                                                                                                                                                                                              |       | 3,810                  |       | 6,883                 |       |
| Less current portion                                                                                                                                                                                                                                                    |       | (833                   | )          | (2,000                | )          |
| Long-term debt, excluding current portion                                                                                                                                                                                                                               |       | $                      | 2,977      |                  | $          | 4,883 |   |

 

On February 22, 2008, we replaced our existingsenior term note and senior revolving facility with a new $4.0 million seniorterm loan, a $1.0 million U.S. revolving credit facility (“U.S. RevolvingFacility”) and a $5.0 million U.K. revolving credit facility (“U.K. RevolvingFacility”).  On December 18, 2008 wemodified our U.S. and U.K. Revolving Facilities. The U.S. Revolving Facility isnow a $2.5 million credit facility and the U.K. Revolving Facility is now a$3.5 million facility. All other terms and conditions remained the same. Therehave been no borrowings on either facility and therefore there are nooutstanding balances on either facility as of September 30, 2009.

 

We used proceeds from the $4.0 million seniorterm loan to pay down our prior senior term note balance of approximately $3.8million.  The $4.0 million senior termloan bears interest at a fixed rate of 8.25% and is payable in 24 equal monthlyinstallments of principal, plus all accrued interest, beginning March 10,2008, with final maturity on February 22, 2010.  The senior term loan is secured bysubstantially all assets of Evolving Systems, Inc. and subjects us tocertain affirmative and negative covenants, including financial covenantsrelated to maintaining a specified ratio of debt to EBITDA, as defined, minimumEBITDA, minimum liquidity, and a specified fixed charge ratio.

 

The remaining scheduled principal payments as of September 30,2009 on our long-term debt are as follows (in thousands):

 

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| **Year ending September 30,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2010                               |       | $          | 833        |   |
| 2011                               |       | 2,977      |       |
|                               |       | $          | 3,810      |   |

 

Our $2.5 million U.S. Revolving Facilitybears interest at Prime Rate plus 0.5%. Prime Rate was 3.25% as of September 30, 2009.  Borrowings under the senior revolving facilitiesare limited to a percentage of our eligible accounts receivable and cash.  The U.S. Revolving Facility is secured by allassets of Evolving Systems, Inc. and is subject to the same covenants asthe senior term loan.  All accruedinterest on outstanding borrowings under the U.S. Revolving Facility is paidmonthly, with any outstanding balance due with a final maturity of February 22,2011.  As of September 30, 2009, wehad $1.7 million in availability, but no borrowing outstanding under this U.S.Revolving Facility.

 

Our $3.5 million U.K. Revolving Facilitybears interest at Prime Rate plus 0.5%. Prime Rate was 3.25% as of September 30, 2009.  Borrowings under the U.K. Revolving Facilityare limited to a percentage of our eligible accounts receivable and cash.  The U.K. Revolving Facility is secured by allassets of Evolving Systems Holdings Ltd. and Evolving Systems Ltd. and issubject to the same covenants as the Senior Term Loan.  All accrued interest on outstandingborrowings under the U.K. Revolving Facility is paid monthly, with anyoutstanding balance due with a final maturity of February 22, 2011.  As of September 30, 2009, we had $3.5million in availability, but no borrowing outstanding under this U.K. RevolvingFacility.

 

In connection with the replacement of ourexisting senior term note and senior revolving facility with the new seniorterm loan and U.S. Revolving Facility and the U.K. Revolving Facility, duringthe three months ended March 31, 2008, we recorded a write-off of debtissuance costs associated with the retired senior debt of approximately $0.3million.  Additionally, we capitalizeddebt issuance costs related to our new senior debt of approximately $0.3million.  These newly capitalized debtissuance costs are being amortized over the term of the new senior debt.

 

On April 20, 2009, we made an optionalpre-payment of $1.0 million to the holders of our subordinated notes.  On March 11, 2009, we paid $2.0 millionagainst our subordinated notes, including accrued non-current interest. Bothpayments were unscheduled and reduced balances that otherwise would have beenclassified as long-term as of December 31, 2009.

 

On February 22, 2008, we paid $272,000to retire $279,000 of subordinated debt and related accrued interest held bytwo of our subordinated note holders. The retirements included principal of $217,000 and accrued interest of$62,000.  The $7,000 gain onextinguishment of this debt is reflected within our other income (expense) onthe consolidated statements of operations. On February 22, 2008, we also paid $728,000 in accrued interest tothe remaining subordinated note holders.

 

The remaining long-term unsecured subordinated notes payable of $3.0million, at September 30, 2009, accrued interest at 11% through December 31,2007 and 14% thereafter.  Interestexpense was recognized using an effective rate of 12.62% through September 30,2009 and 13.72% through December 31, 2008.

 

Theunsecured subordinated notes are subordinate to the senior note and seniorrevolving credit facility.  The unsecuredsubordinated notes payable agreements subject us to certain affirmative andnegative covenants; however, certain covenants are not in effect until thesenior note and senior revolving credit facility are paid in full.  Outstanding amounts of the unsecuredsubordinated notes may be accelerated upon the occurrence of an uncured eventof default or if we achieve certain minimum cash thresholds.  Accrued interest on the unsecuredsubordinated notes payable is separately reflected on the Consolidated BalanceSheets under “Other long-term obligations.”

 

Wewere in compliance with all of our debt covenants as of September 30, 2009and December 31, 2008.

 

**NOTE 7 – INCOME TAXES**

 

We recorded net income tax expense of $380,000 and$122,000 for the three months ended September 30, 2009 and 2008,respectively.  The net expense during thethree months ended September 30, 2009 consisted of income tax expense of$444,000 and a deferred tax benefit of $64,000. The net expense during thethree months ended September 30, 2008 consisted of income tax expense of$186,000 and a deferred tax benefit of $64,000, related to our U.K.-basedoperations.

 

We recorded net income tax expense of $438,000 and$161,000 for the nine months ended September 30, 2009 and 2008, respectively.  The net expense during the nine months ended September 30,2009 consisted of income tax expense of $610,000 and a deferred tax benefit of$172,000. The net expense during the nine months ended September 30, 2008consisted of income tax expense of $367,000 and a deferred tax benefit of$206,000, related to our U.K.-based operations.

 

In conjunction with the acquisition of EvolvingSystems U.K., we recorded certain identifiable intangible assets.  Since the amortization of these identifiableintangibles is not deductible for income tax purposes, we established along-term deferred tax liability of $4.6 million at the acquisition date forthe expected difference between what would be expensed for financial reportingpurposes and what would be deductible for income tax purposes. As of September 30,2009 and December 31, 2008, this component of the deferred tax liabilitywas $0.6 million and $0.7 million, respectively.  This deferred tax liability relates toEvolving Systems 

 

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U.K.,and has no impact on our ability to recover U.S.-based deferred taxassets.  This deferred tax liability willbe recognized as a reduction of deferred income tax expense as the identifiableintangibles are amortized.

 

Asof September 30, 2009 and December 31, 2008 we continued to maintaina full valuation allowance on the domestic net deferred tax asset as we havedetermined it is more likely than not that we will not realize our domesticdeferred tax assets.  Such assetsprimarily consist of certain 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 the reasonably foreseeable futureperiods.  We are required to reassess ourconclusions regarding the realization of our deferred tax assets at eachfinancial reporting date. A future evaluation could result in a conclusion thatall or a portion of the valuation allowance is no longer necessary which couldhave a material impact on our results of operations and financial position.

 

Effective January 1, 2007, we adopted a recognition threshold anda measurement attribute for the financial statement recognition and measurementof tax positions taken or expected to be taken in a tax return.  For those benefits to be recognized, a tax positionmust be more likely than not to be sustained upon examination by taxingauthorities.  There was not a materialimpact on the company’s consolidated financial position and results ofoperations as a result of this adoption.

 

On January 1, 2007, we recorded a transition adjustment consistingof a $0.4 million decrease in our deferred tax assets related to Research andDevelopment Tax Credits that was offset by a corresponding decrease in ourvaluation allowance because we determined that it was not more likely than notthat our deferred tax assets would be realized. As of September 30, 2009 and December 31, 2008, we had noliability for unrecognized tax benefits. We do not believe there will be any material changes in our unrecognizedtax positions over the next twelve months.

 

We conduct business globally and, as a result, Evolving Systems, Inc.or one or more of our subsidiaries file income tax returns in the U.S. federaljurisdiction and various state and foreign jurisdictions.  In the normal course of business, we aresubject to examination by taxing authorities throughout the world, namely theUnited Kingdom, Germany and India.  Withfew exceptions, we are no longer subject to U.S. federal, state and local, ornon-U.S. income tax examinations for years before 2005.

 

**NOTE 8 – STOCKHOLDERS’ EQUITY**

 

On February 25, 2008, holders of 461,758 sharesof Series B Preferred Stock with a carrying value of $5.4 million, orapproximately 96% of the outstanding preferred stock, converted their shares ofpreferred stock into 692,637 shares of our common stock in accordance with theconversion provisions of the Series B Preferred Stock.  On March 19, 2008, a holder of 16,992shares of Series B Preferred Stock with a carrying value of $0.2 million,which represented the remainder of the outstanding preferred stock, convertedhis shares of preferred stock into 25,488 shares of our common stock inaccordance with the conversion provisions of the Series B PreferredStock.  As we previously includedthe Series B Convertible Preferred Stock as a participating security forbasic EPS purposes, these conversions did not change our basic or diluted EPScalculations.

 

On March 4, 2009 our Board of Directors adopteda stockholder rights plan that is designed to strengthen the ability of theBoard of Directors to protect Evolving Systems’ stockholders.  The planwas not adopted in response to any unsolicited offer or takeover attempt. Underthe plan, each common stockholder of the Company at the close of business on March 16,2009 received a dividend of one right for each share of the Company’s commonstock held of record on that date.  Each right will entitle the holder topurchase from the Company, in certain circumstances, two one-hundredths of ashare of newly-created Series C junior participating preferred stock ofthe Company for an initial purchase price of $8.00 per share. The rightsdistribution will not be taxable to stockholders and the distribution of rightsunder the plan will not interfere with the Company’s business plans or bedilutive to or affect the Company’s reported per share results.

 

**NOTE 9 – SEGMENT INFORMATION**

 

We define operating segments as components of ourenterprise for which separate financial information is reviewed regularly bythe chief operating decision-makers to evaluate performance and to makeoperating decisions. We have identified our Chief Executive Officer and ChiefFinancial Officer as our chief operating decision-makers (CODM). These chiefoperating decision makers review revenues by segment and review overall resultsof operations.

 

We currently operate our business as two operatingsegments based on revenue type:  licensefees and services revenue and customer support revenue (as shown on theconsolidated statements of operations). License fees and services (L&S) revenue represents the fees receivedfrom the license of software products and those services directly related tothe delivery of the licensed products, such as fees for custom development andintegration services.  Customer support(CS) revenue includes annual support fees, recurring maintenance fees, fees formaintenance upgrades and warranty services. Warranty services that are similar to software maintenance services aretypically bundled with a license sale. Total assets by segment have not beendisclosed as the information is not available to the chief operatingdecision-makers.

 

Segment information is as follows (in thousands):

 

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| ** **                                                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                  | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Revenue**                                                                 | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** |   |   |   |
| License  fees and services                                                  |       | $                                          | 5,836      |                                      | $          | 4,539 |   | $ | 15,940 |   | $ | 14,713 |   |
| Customer  support                                                           |       | 4,077                                      |       | 4,490                                     |       | 12,445 |   | 13,088 |   |
| Total  revenue                                                              |       | 9,913                                      |       | 9,029                                     |       | 28,385 |   | 27,801 |   |
|                                                                        |       |                                       |       |                                      |       |   |   |   |   |
| **Revenue less costs of revenue, excluding depreciation and  amortization** |       |                                       |       |                                      |       |   |   |   |   |
| License  fees and services                                                  |       | 3,852                                      |       | 2,562                                     |       | 10,214 |   | 8,610 |   |
| Customer  support                                                           |       | 2,625                                      |       | 2,909                                     |       | 8,159 |   | 8,382 |   |
|                                                                        |       | 6,477                                      |       | 5,471                                     |       | 18,373 |   | 16,992 |   |
| **Unallocated Costs**                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Other  operating expenses                                                   |       | 4,497                                      |       | 4,077                                     |       | 12,539 |   | 13,137 |   |
| Depreciation  and amortization                                              |       | 354                                        |       | 560                                       |       | 1,022 |   | 1,801 |   |
| Interest  income                                                            |       | (1                                         | )          | (29                                       | )          | (24 | ) | (146 | ) |
| Interest  expense                                                           |       | 145                                        |       | 278                                       |       | 563 |   | 897 |   |
| Loss  on extinguishment of debt                                             |       | —                                     |       | —                                    |       | — |   | 290 |   |
| Foreign  currency exchange gain (loss)                                      |       | (226                                       | )          | (130                                      | )          | 436 |   | (272 | ) |
| **Income before income taxes**                                              |       | $                                          | 1,708      |                                      | $          | 715 |   | $ | 3,837 |   | $ | 1,285 |   |

 

***Geographic Regions***

 

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

 
| ** **      | ** ** | **Three Months Ended September 30,** | ** ** |
|-----------------|------------|-------------------------------------------|------------|
| ** **      | ** ** | **2009**                                  | ** ** | **2008** | ** ** |
| ** **      | ** ** | **L&S**                               | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**     |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| United  States  |       | $                                         | 335        |   | $ | 2,208 |   | $ | 2,543 |   | $ | 318 |   | $ | 2,561 |   | $ | 2,879 |   |
| United  Kingdom |       | 673                                       |       | 553 |   | 1,226 |   | 1,527 |   | 641 |   | 2,168 |   |
| Indonesia       |       | 1,342                                     |       | 28 |   | 1,370 |   | 18 |   | 27 |   | 45 |   |
| Other           |       | 3,486                                     |       | 1,288 |   | 4,774 |   | 2,676 |   | 1,261 |   | 3,937 |   |
| Total  revenues |       | $                                         | 5,836      |   | $ | 4,077 |   | $ | 9,913 |   | $ | 4,539 |   | $ | 4,490 |   | $ | 9,029 |   |

 
| ** **      | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------|------------|------------------------------------------|------------|
| ** **      | ** ** | **2009**                                 | ** ** | **2008** | ** ** |
| ** **      | ** ** | **L&S**                              | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**     |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| United  States  |       | $                                        | 1,681      |   | $ | 7,114 |   | $ | 8,795 |   | $ | 1,539 |   | $ | 7,470 |   | $ | 9,009 |   |
| United  Kingdom |       | 1,998                                    |       | 1,572 |   | 3,570 |   | 3,914 |   | 1,958 |   | 5,872 |   |
| Other           |       | 12,261                                   |       | 3,759 |   | 16,020 |   | 9,260 |   | 3,660 |   | 12,920 |   |
| Total  revenues |       | $                                        | 15,940     |   | $ | 12,445 |   | $ | 28,385 |   | $ | 14,713 |   | $ | 13,088 |   | $ | 27,801 |   |

 
| ** **                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2009**               | ** ** | **2008**              | ** ** |
| **Long-lived  assets, net** | ** ** | ** **             | ** ** | ** **            | ** ** |
| United  States              |       | $                      | 6,839      |                  | $          | 7,060 |   |
| United  Kingdom             |       | 18,564                 |       | 17,327                |       |
| Other                       |       | 191                    |       | 75                    |       |
|                        |       | $                      | 25,594     |                  | $          | 24,462 |   |

 

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Financialinformation relating to product groupings was as follows (in thousands):

** **
| ** **          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **          | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Revenue**         | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Activation          |       | $                                          | 6,429      |                                      | $          | 5,457 |   | $ | 16,945 |   | $ | 15,475 |   |
| Numbering solutions |       | 3,050                                      |       | 2,825                                     |       | 9,821 |   | 9,249 |   |
| Mediation           |       | 434                                        |       | 747                                       |       | 1,619 |   | 3,077 |   |
| Total  revenues     |       | $                                          | 9,913      |                                      | $          | 9,029 |   | $ | 28,385 |   | $ | 27,801 |   |

 

**NOTE10 — COMMITMENTS AND CONTINGENCIES**

 

**(a)****                                  OtherCommitments**

 

Aspermitted under Delaware law, we have agreements with officers and directorsunder which we agree to indemnify them for certain events or occurrences whilethe officer or director is, or was, serving at our request in this capacity.The term of the indemnification period is indefinite. There is no limit on theamount of future payments we could be required to make under theseindemnification agreements; however, we maintain Director and Officer insurancepolicies, as well as an Employment Practices Liability Insurance Policy, thatmay enable us to recover a portion of any amounts paid. As a result of ourinsurance policy coverage, we believe the estimated fair value of theseindemnification agreements is minimal. Accordingly, there were no liabilitiesrecorded for these agreements as of September 30, 2009 or December 31,2008.

 

Weenter into standard indemnification terms with customers and suppliers, in theordinary course of business, for third party claims arising under ourcontracts. In addition, as we may subcontract the development of deliverablesunder customer contracts, we could be required to indemnify customers for workperformed by subcontractors. Depending upon the nature of the indemnification,the potential amount of future payments we could be required to make underthese indemnification agreements may be unlimited. We may be able to recoverdamages from a subcontractor or other supplier if the indemnification resultsfrom the subcontractor’s or supplier’s failure to perform. To the extent we areunable to recover damages from a subcontractor or other supplier, we could berequired to reimburse the indemnified party for the full amount. We have neverincurred costs to defend lawsuits or settle claims relating to anindemnification. As a result, we believe the estimated fair value of theseagreements is minimal. Accordingly, there were no liabilities recorded forthese agreements as of September 30, 2009 or December 31, 2008.

 

Ourstandard license agreements contain product warranties that the software willbe free of material defects and will operate in accordance with the statedrequirements for a limited period of time. The product warranty provisions require us to cure any defects throughany reasonable means.  We believe theestimated fair value of the product warranty provisions in the licenseagreements in place with our customers is minimal.  Accordingly, there were no liabilitiesrecorded for these product warranty provisions as of September 30, 2009 orDecember 31, 2008.

 

Oursoftware arrangements generally include a product indemnification provisionwhereby we will indemnify and defend a customer in actions brought against thecustomer for claims that our products infringe upon a copyright, trade secret,or valid patent of a third party. We have not historically incurred anysignificant costs related to product indemnification claims. Accordingly, therewere no liabilities recorded for these indemnification provisions as of September 30,2009 or December 31, 2008.

 

Inrelation to the acquisitions of Evolving Systems U.K., TSE and CMS, we agreedto indemnify certain parties from any losses, actions, claims, damages orliabilities (or actions in respect thereof) resulting from any claim raised bya third party.  We do not believe thatthere will be any claims related to these indemnifications. Accordingly, therewere no liabilities recorded for these agreements as of September 30, 2009or December 31, 2008.

 

**(b)****                                  Litigation**

 

We are involved invarious legal matters arising in the normal course of business.  Losses, including estimated costs to defend,were recorded for these matters to the extent they were probable of loss andthe amount of loss could be reasonably estimated.

 

**NOTE11 — RELATED PARTY TRANSACTIONS**

 

During 2008, weentered into a consulting agreement with Stephen K. Gartside, Jr., ourprevious President and CEO and current Chairman of the Board.  Under the agreement, we paid Mr. Gartsidean annual fee of $20,000 for consulting services provided to us during 2008. Wehad current obligations in the consolidated balance sheets, under theagreement, of $5,000 as of  December 31,

 

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2008.  We recorded $5,000 and $15,000 of general andadministrative expense in the consolidated statements of operations, related tothis agreement, for the three and nine months ended September 30, 2008.This contract terminated December 31, 2008.

 

**NOTE12 — SUBSEQUENT EVENTS**

 

Weevaluated our September 30, 2009 financial statements for subsequentevents through November 3, 2009, the date the financial statements wereavailable to be issued. Other than the events noted below, we are not aware ofany subsequent events which would require recognition or disclosure in thefinancial statements.

 

On October 15,2009, we announced that George A. Hallenbeck, 67, resigned from our Board ofDirectors. There are no disagreements with the Company. The Board of Directorsis currently evaluating whether it will fill the vacancy resulting from Mr. Hallenbeck’sresignation in accordance with our Bylaws.

 

EffectiveOctober 15, 2009, we entered into a consulting agreement with Mr. Hallenbeckto provide consulting services. Mr. Hallenbeck is one of the founders ofthe Company. Under the consulting agreement, we will pay Mr. Hallenbeck anannual fee of $10,000 for his services through May 31, 2012.

 

**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**SPECIAL NOTE ABOUT FORWARD-LOOKINGSTATEMENTS**

 

*ThisQuarterly Report on Form 10-Q contains forward-looking statements thathave been made pursuant to the provisions of the Private Securities LitigationReform Act of 1995.  Theseforward-looking statements are based on current expectations, estimates, andprojections about Evolving Systems’ industry, management’s beliefs, and certainassumptions made by management. Forward-looking statements include our expectations regarding product,services, and maintenance revenue, annual savings associated with theorganizational changes effected in prior years, and short- and long-term cashneeds.  In some cases, words such as “anticipates”,“expects”, “intends”, “plans”, “believes”, “estimates”, variations of thesewords, and similar expressions are intended to identify forward-lookingstatements.  The statements are notguarantees of future performance and are subject to certain risks,uncertainties, and assumptions that are difficult to predict; therefore, actualresults may differ materially from those expressed or forecasted in anyforward-looking statements.  Risks anduncertainties of our business include those set forth in our Annual Report on Form 10-Kfor the year ended December 31, 2008 under “Item 1A. Risk Factors” as wellas additional risks described in this Form 10-Q.  Unless required by law, we undertake noobligation to update publicly any forward-looking statements, whether as aresult of new information, future events, or otherwise.  However, readers should carefully review therisk factors set forth in other reports or documents we file from time to timewith the Securities and Exchange Commission, particularly the Quarterly Reportson Form 10-Q and any Current Reports on Form 8-K.*

 

**OVERVIEW**

 

We area worldwide provider of software solutions and services to telecommunicationscarriers, with 70 network operators in over 40 countries.  Our customers rely on us to develop, deploy,enhance, maintain and integrate complex, highly reliable software solutions fora range of Operations Support Systems (“OSS”). Our activation solution is a leading packaged solution for serviceactivation in the wireless industry.

 

Werecognize revenue in accordance with the prescribed accounting standards forsoftware revenue recognition under generally accepted accountingprinciples.  Our license fees andservices revenues fluctuate from period to period as a result of the timing ofrevenue recognition on existing projects.

 

**RECENTDEVELOPMENTS**

 

Beginning in thefourth quarter of 2008, the U.S. Dollar strengthened against many othercurrencies, including the British Pound Sterling and the Euro. As a result, theportion of the Company’s revenue which is denominated in foreign currencies,when converted to U.S. Dollars, is reduced. At the same time, with more than 50% of the Company’s operating expensesoriginating overseas, the strengthening dollar conversely lowers expensesincurred outside of the U.S. The net effect of our foreign currencytranslations for the three months ended September 30, 2009 was a $0.3million decrease in revenue and a $0.6 million decrease in operating expensesversus the three months ended September 30, 2008.  The net effect of our foreign currencytranslations for the nine months ended September 30, 2009 was a $2.2million decrease in revenue and a $3.3 million decrease in operating expensesversus the nine months ended September 30, 2008.

 

We reported netincome of $1.3 million and $3.4 million for the three and nine months ended September 30,2009, respectively. This is the sixth consecutive quarter in which we havereported net income.  Our twelve monthbacklog as of September 30, 2009 was $16.8 million, including $9.3 millionin license fees and services and $7.5 million in customer support.

 

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**RESULTSOF OPERATIONS**

 

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

 
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                   | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| **REVENUE**                                                                  | ** ** | ** **                                 |       |                                      | ** ** | ** ** |   |   |   |
| License  fees and services                                                   |       | 59                                         | %          | 50                                        | %          | 56 | % | 53 | % |
| Customer  support                                                            |       | 41                                         | %          | 50                                        | %          | 44 | % | 47 | % |
| Total  revenue                                                               |       | 100                                        | %          | 100                                       | %          | 100 | % | 100 | % |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING EXPENSES**                                  |       |                                       |       |                                      |       |   |   |   |   |
| Costs  of license fees and services, excluding depreciation and amortization |       | 20                                         | %          | 22                                        | %          | 20 | % | 22 | % |
| Costs  of customer support, excluding depreciation and amortization          |       | 15                                         | %          | 18                                        | %          | 15 | % | 17 | % |
| Sales  and marketing                                                         |       | 20                                         | %          | 22                                        | %          | 21 | % | 23 | % |
| General  and administrative                                                  |       | 16                                         | %          | 14                                        | %          | 15 | % | 14 | % |
| Product  development                                                         |       | 9                                          | %          | 9                                         | %          | 8 | % | 10 | % |
| Depreciation                                                                 |       | 2                                          | %          | 2                                         | %          | 2 | % | 3 | % |
| Amortization                                                                 |       | 2                                          | %          | 4                                         | %          | 2 | % | 4 | % |
| Total  costs of revenue and operating expenses                               |       | 84                                         | %          | 91                                        | %          | 83 | % | 93 | % |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Income  from operations                                                      |       | 16                                         | %          | 9                                         | %          | 17 | % | 7 | % |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Other  income (expense)                                                      |       |                                       |       |                                      |       |   |   |   |   |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Interest  income                                                             |       | 0                                          | %          | 0                                         | %          | 0 | % | 1 | % |
| Interest  expense                                                            |       | (1                                         | )%         | (3                                        | )%         | (2 | )% | (3 | )% |
| Loss  on extinguishment of debt                                              |       | —                                     |       | —                                    |       | — |   | (1 | )% |
| Foreign  currency exchange gain (loss)                                       |       | 2                                          | %          | 2                                         | %          | (1 | )% | 1 | % |
| Other  income (expense), net                                                 |       | 1                                          | %          | (1                                        | )%         | (3 | )% | (2 | )% |
|                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Income  before income taxes                                                  |       | 17                                         | %          | 8                                         | %          | 14 | % | 5 | % |
| Income  tax expense                                                          |       | 4                                          | %          | 1                                         | %          | 2 | % | 1 | % |
| Net  income                                                                  |       | 13                                         | %          | 7                                         | %          | 12 | % | 4 | % |

 

***Revenue***

 

Revenueis comprised of license fees/services and customer support.  License fees and services revenue representthe fees we receive from the licensing of our software products and thoseservices directly related to the delivery of the licensed product as well asintegration and consulting services. Customer supportrevenue includes annual support, recurring maintenance, maintenance upgradesand warranty services.  Warranty servicesconsist of maintenance services and are typically bundled with a license saleand the related revenue, based on Vendor-Specific Objective Evidence (VSOE),isdeferred and recognized ratably over the warranty period.  The following table presents our revenue byproduct group (in thousands):

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **           | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Revenue**          | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Activation           |       | $                                          | 6,429      |                                      | $          | 5,457 |   | $ | 16,945 |   | $ | 15,475 |   |
| Numbering  solutions |       | 3,050                                      |       | 2,825                                     |       | 9,821 |   | 9,249 |   |
| Mediation            |       | 434                                        |       | 747                                       |       | 1,619 |   | 3,077 |   |
| Total  revenues      |       | $                                          | 9,913      |                                      | $          | 9,029 |   | $ | 28,385 |   | $ | 27,801 |   |

 

Revenuefor the three months ended September 30, 2009 and 2008 was $9.9 millionand $9.0 million, respectively. The increase of $0.9 million was primarily dueto increased revenue from our *Dynamic SIM Allocation**TM*(“DSA”) andinternational

 

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*NumeriTrack®*products.

 

Revenuefor the nine months ended September 30, 2009 and 2008 was $28.4 millionand $27.8 million, respectively. The increase of $1.6 million is primarily dueto increased revenue from our new DSA and international *NumeriTrack*products.

 

***License Fees and Services***

 

License fees and services revenue increased 29%, or $1.3 million, to$5.8 million for the three months ended September 30, 2009 from $4.5million for the three months ended September 30, 2008.    This increase in license fees and servicesrevenue was composed of an increase of $1.0 million in revenue from ouractivation products, an increase of $0.4 million in revenue from our numberingsolutions products and a decrease of $0.1 million in revenue from our mediationproducts.  The increase in our activationand numbering solutions product revenue is the result of increased sales of DSAand international *NumeriTrack*offset by thestrengthened U.S. Dollar. The decrease in mediation product revenue is due tolower sales to our existing mediation account base.

 

License fees and services revenue increased 8%, or $1.2 million, to$15.9 million for the nine months ended September 30, 2009 from $14.7million for the nine months ended September 30, 2008.  This increase in license fees and servicesrevenue was composed of an increase of $1.8 million in revenue from ouractivation products, an increase of $0.6 million in revenue from our numberingsolutions products and a decrease of $1.2 million in revenue from our mediationproducts.  The increase in our activationproduct revenue is the result of increased DSA and international *NumeriTrack* sales, partially offset by the strengthened U.S.Dollar. The decrease in our mediation product revenue is the result of lowersales to our existing mediation account base.

 

***Customer Support***

 

Customer support revenue decreased $0.4 million, or 9%, to $4.1 millionfor the three months ended September 30, 2009 from $4.5 million for thethree months ended September 30, 2008. The decrease in customer supportrevenue resulted primarily from a decrease of $0.1 million in activationrevenue, a decrease of $0.1 million in numbering solutions revenue and a $0.2million decrease in mediation revenue. The overall decrease in customer supportrevenue is primarily the result of pricing pressures from customers.

 

Customer support revenue decreased $0.7 million, or 5%, to $12.4 millionfor the nine months ended September 30, 2009 from $13.1 million for thenine months ended September 30, 2008. The decrease in customer support revenue resulted from a decrease of$0.4 million in activation revenue and a decrease of $0.3 million in mediationrevenue.  The overall decrease incustomer support revenue is primarily the result of the strengthened U.S.dollar and pricing pressures from customers.

 

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

 

Costsof revenue, excluding depreciation and amortization, consist primarily ofpersonnel costs and other direct costs associated with these personnel,facilities costs, costs of third-party software and partner commissions.  Costs of revenue, excluding depreciation andamortization, were $3.4 million and $3.6 for the three months ended September 30,2009 and 2008, respectively. Costs of revenue, excluding depreciation andamortization, were $10.0 million and $10.8 million for the nine months ended September 30,2009 and 2008, respectively.

 

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

 

Costs of license fees and services, excluding depreciation andamortization, remained at $2.0 million for the three months ended September 30,2009 and 2008. Costs remained approximately the same during the period due toincreased hours spent on license and services projects to support the increasedrevenue during the period, offset by the effects of the strengthening U.S.Dollar. As a percentage of license fees and services revenue, costs of licensefees and services, excluding depreciation and amortization decreased to 34% forthe three months ended September 30, 2009 from 44% for the three monthsended September 30, 2008.  Thedecrease in costs as a percentage of revenue is due to the increase in licensefees and services revenue from increased sales of DSA and international *NumeriTrack* which have lower costs than our legacy productsand the strengthened U.S. Dollar.

 

Costs of license fees and services, excluding depreciation andamortization, decreased $0.4 million, or 6%, to $5.7 million for the ninemonths ended September 30, 2009 from $6.1 million for the nine monthsended September 30, 2008.  Thedecrease in costs is primarily the result of the effects of the strengtheningU.S. Dollar. As a percentage of license fees and services revenue, costs oflicense fees and services, excluding depreciation and amortization, decreasedto 36% for the nine months ended September 30, 2009 from 41% for the ninemonths ended September 30, 2008. The decrease in costs as a percentage of revenue is due to the increasein license fees and services revenue from increased sales of DSA andinternational *NumeriTrack* which have lowercosts than our legacy products and the strengthened U.S. Dollar.

 

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

 

Costs of customer support, excluding depreciation and amortization,decreased $0.1 million, or 8%, to $1.5 million for the three months ended September 30,2009 from $1.6 million for the three months ended September 30,2008.  The decrease in costs of customersupport is primarily the result of the strengthened U.S. Dollar. As apercentage of customer support revenue, costs of customer support revenue,excluding depreciation and amortization, increased to 36% for the three monthsended September 30, 2009

 

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from 35% for the three months ended September 30,2008.  The increase in costs as apercentage of revenue is primarily the result of the decreased customer supportrevenue from pricing pressures during the period.

 

Costs of customer support, excluding depreciation and amortization,decreased $0.4 million, or 9%, to $4.3 million for the nine months ended September 30,2009 from $4.7 million for the nine months ended September 30,2008.  As a percentage of customersupport revenue, costs of customer support revenue, excluding depreciation andamortization, decreased to 34% for the nine months ended September 30,2009 from 36% for the nine months ended September 30, 2008. Thesedecreases are primarily the result of the strengthened U.S. Dollar, partiallyoffset by decreased customer support revenue from pricing pressures.

 

***Salesand Marketing***

 

Salesand marketing expenses primarily consist of compensation costs, includingincentive compensation and commissions, travel expenses, advertising, marketingand facilities expenses. Sales and marketing expenses remained at $2.0 millionfor the three months ended September 30, 2009 and 2008.  As a percentage of total revenue, sales andmarketing expenses decreased to 20% for the three months ended September 30,2009 from 22% for the three months ended September 30, 2008. The decreaseas a percentage of revenue is primarily due to increased revenue during theperiod.

 

Sales and marketing expenses decreased $0.5 million, or 8%, to $5.9million for the nine months ended September 30, 2009 from $6.4 million forthe nine months ended September 30, 2008. As a percentage of total revenue, sales and marketing expenses decreasedto 21% for the nine months ended September 30, 2009 from 23% for the ninemonths ended September 30, 2008. The decrease in the expense andpercentage of revenue is primarily due to the effects of the strengthening U.S.Dollar, partially offset by higher commissions related to increased sales ofDSA.

 

***Generaland Administrative***

 

General and administrative expenses consist principally of employeerelated costs and professional fees for the following departments: facilities,finance, legal, human resources, and certain executive management.  General and administrative expenses increased$0.3 million, or 21%, to $1.6 million from $1.3 million for the three monthsended September 30, 2009 and 2008, respectively.  As a percentage of total revenue, general andadministrative expenses for the three months ended September 30, 2009 and2008, increased to 16% from 14%, respectively. These increases were primarily due to increased incentive compensationdue to improved financial results and increased professional fees.

 

General and administrative expenses increased $0.5 million, or 11%, to$4.4 million from $3.9 million for the nine months ended September 30,2009 and 2008, respectively.  As apercentage of total revenue, general and administrative expenses for the ninemonths ended September 30, 2009 and 2008, increased to 15% from 14%,respectively.  These increases wereprimarily due to increased incentive compensation due to improved financialresults and increased professional fees.

 

***ProductDevelopment***

 

Productdevelopment expenses consist primarily of employee related costs andsubcontractor expenses.  Productdevelopment expenses increased $0.1 million, or 16%, to $0.9 million from $0.8million for the three months ended September 30, 2009 and 2008,respectively.  As a percentage ofrevenue, product development expenses for the three months ended September 30,2009 and 2008, remained at 9%.  Theincrease in expenses is due to an increased effort in DSA and legacy numberingproduct development expenses.

 

Product development expenses decreased $0.5 million, or 18%, to $2.3million from $2.8 million for the nine months ended September 30, 2009 and2008, respectively.  As a percentage ofrevenue, product development expenses for the nine months ended September 30,2009 and 2008, decreased to 8% from 10%, respectively.  These decreases are the result of decreasedhours, compared to 2008, spent on internationalizing our *NumeriTrack*product,as well as the effects of the strengthening U.S. Dollar.

 

***Amortization***

 

Amortizationexpense consists of amortization of identifiable intangible assets acquiredthrough our acquisitions of Evolving Systems U.K., TSE and CMS.  Amortization expense decreased $0.2 millionor 48% to $0.2 million for the three months ended September 30, 2009 from$0.4 million for the three months ended September 30, 2008. As apercentage of revenue, amortization expense for the three months ended September 30,2009 and 2008, decreased to 2% from 4%, respectively. The decrease inamortization expense is due to all CMS, and some TSE intangible assets beingfully amortized during 2008 and the effects of the strengthened U.S. Dollar.

 

Amortizationexpense decreased $0.6 million or 52% to $0.5 million for the nine months endedSeptember 30, 2009 from $1.1 million for the nine months ended September 30,2008. As a percentage of revenue, amortization expense for the nine monthsended September 30, 2009 and 2008, decreased to 2% from 4%, respectively.The decrease in amortization expense is due to all CMS, and some TSE intangibleassets being fully amortized during 2008 and the effects of the strengthenedU.S. Dollar.

 

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***Depreciation***

 

Depreciationexpense consists of depreciation of long-lived property and equipment.  Depreciation expense remained at $0.2 millionfor the three months ended September 30, 2009 and 2008. As a percentage oftotal revenue, depreciation expense for the three months ended September 30,2009 and 2008, remained at 2%.

 

Depreciationexpense decreased $0.2 million or 29% to $0.5 million for the nine months endedSeptember 30, 2009 from $0.7 million for the nine months ended September 30,2008. As a percentage of total revenue, depreciation expense for the ninemonths ended September 30, 2009 and 2008, remained at 2%. The decrease inexpense is a result of certain assets becoming fully depreciated and theeffects of the strengthened U.S. Dollar.

 

***InterestExpense***

 

Interestexpense includes interest expense on our long-term debt and capital leaseobligations as well as amortization of debt issuance costs.  Interest expense was $0.1 million and $0.3million for the three months ended September 30, 2009 and 2008,respectively. The decrease of $0.2 million is due to lower debt balances on oursubordinated debt and the continued payments on our senior term loan.

 

Interestexpense was $0.6 million and $0.9 million for the nine months ended September 30,2009 and 2008, respectively. The decrease of $0.3 million is due to lower debtbalances as we continue to pay down our subordinated debt and the continuedpayments on our senior term loan.

 

***Gain(Loss) on Debt Extinguishment***

 

In February 2008,we wrote-off the remaining debt issuance costs of $297,000 related to oursenior term note payable that was replaced during the three months ended March 31,2008.  This loss related to the debtissuance cost write-off was partially offset by a $7,000 gain resulting from uspaying $272,000 to retire $279,000 of subordinated debt and related accruedinterest held by two of our subordinated note holders.  The retirements included principal of$217,000 and accrued interest of $62,000.

 

***ForeignCurrency Exchange Gain (Loss)***

 

Foreign currency transaction gains (losses) resulted from transactionsdenominated in a currency other than the functional currency of the respectivesubsidiary and were $226,000 and $130,000 for the three months ended September 30,2009 and 2008, respectively, and $(436,000) and $272,000 for the nine monthsended September 30, 2009 and 2008, respectively.  The gains (losses) were generated primarilythrough the re-measurement of certain non-functional currency denominatedfinancial assets and liabilities of our Evolving Systems U.K. subsidiary.

 

***IncomeTaxes***

 

Werecorded net income tax expense of $380,000 and $122,000 for the three monthsended September 30, 2009 and 2008, respectively.  The net expense during the three months endedSeptember 30, 2009 consisted of current income tax expense of $444,000,partially offset by a deferred tax benefit of $64,000. The current tax expenseprimarily related to income tax related to our U.K.-based operations andnon-recoverable foreign withholding tax and estimated Alternative Minimum Tax (“AMT”)due in the U.S. The deferred tax benefit was related to the intangible assetsrelated to our U.K.-based operations. The net expense during the three monthsended September 30, 2008 consisted of current income tax expense of$186,000 and deferred tax benefit of $64,000. Our effective tax rate of 22% forthe three months ended September 30, 2009 was up from an effective rate of17% for the three months ended September 30, 2008.  This increase in our effective tax raterelates principally to an increased non-recoverable foreign withholding tax.

 

Werecorded net income tax expense of $438,000 and $161,000 for the nine monthsended September 30, 2009 and 2008, respectively.  The net expense during the nine months ended September 30,2009 consisted of current income tax expense of $610,000, partially offset by adeferred tax benefit of $172,000. The current tax expense primarily consistedof income tax related to our U.K. operations and non-recoverable foreignwithholding tax and estimated AMT due in the U.S. The deferred tax expense wasprimarily related to the intangible assets related to our U.K.-basedoperations. The net expense during the nine months ended September 30,2008 consisted of current income tax expense of $367,000, partially offset by adeferred tax benefit of $206,000, both of which were primarily related to ourU.K.-based operations.  Our effective taxrate of 11% for the nine months ended September 30, 2009 was down from 13%for the nine months ended September 30, 2008.  This decrease in our effective tax raterelates principally to increased research and development tax credits relatedto our U.K. subsidiary.

 

Inconjunction with the acquisition of Evolving Systems U.K., we recorded certainidentifiable intangible assets.  Sincethe amortization of these identifiable intangibles is not deductible for incometax purposes, we established a long-term deferred tax liability of $4.6 millionat the acquisition date for the expected difference between what would beexpensed for financial reporting purposes and what would be deductible forincome tax purposes. As of September 30, 2009 and December 31, 2008,this component of the deferred tax liability was $0.6 million and $0.7 million,respectively.  This deferred taxliability relates to Evolving Systems U.K., and has no impact on our ability torecover U.S.-based deferred tax assets. This deferred tax liability will be recognized as a reduction ofdeferred income tax expense as the identifiable intangibles are amortized.

 

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**FINANCIALCONDITION**

 

Ourworking capital position increased $2.2 million to $4.0 million as of September 30,2009 from $1.8 million as of December 31, 2008.

 

**CONTRACTUALOBLIGATIONS**

 

Therehave been no material changes to the contractual obligations as disclosed inour 2008 Annual Report on Form 10-K.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

Wehave historically financed operations through cash flows from operations andequity transactions.  At September 30,2009, our principal source of liquidity was $5.2 million in cash and cash equivalents,$8.3 million in contract receivables, net of allowance, as well as $5.2 millionavailable under our revolving credit facilities.

 

Netcash provided by operating activities for the nine months ended September 30,2009 and 2008 was $2.2 million and $3.6 million, respectively.  The decrease in cash provided by operatingactivities for the nine months ended September 30, 2009 was due primarilyto decreased cash provided from contract receivables and accrued interest paidon our subordinated debt during the nine months ended September 30, 2009.

 

Netcash used in investing activities during each of the nine months ended September 30,2009 and 2008 was $0.4 and $0.8 million, respectively.  The cash used for the nine months ended September 30,2009 and 2008 was related to purchases of property and equipment.

 

Netcash used in financing activities for the nine months ended September 30,2009 and 2008 was $2.8 million and $4.1 million, respectively.  Financing activities in the nine months endedSeptember 30, 2009 consisted primarily of principal payments on existingdebt, of approximately $3.1 million. Financing activities in the nine months ended September 30, 2008consisted of principal payments on existing debt, of approximately $7.8million, partially offset by borrowings related to our senior term loan, ofapproximately $3.7 million, net of issuance costs.

 

Webelieve that our current cash and cash equivalents, together with anticipatedcash flow from operations and availability under our revolving line of creditwill be sufficient to meet our working capital, capital expenditure andfinancing requirements for at least the next twelve months. In making thisassessment we considered the following:

 

·                  Our cash andcash equivalents balance at September 30, 2009 of $5.2 million;

 

·                  The availabilityunder our revolving credit facilities of $5.2 million at September 30,2009;

 

·                  Our demonstratedability to generate positive cash flows from operations;

 

·                  Our backlog asof September 30, 2009 of approximately $16.8 million, including $9.3million in license fees and services and $7.5 million in customer support.

 

We are exposed to foreigncurrency rate risks which impact the carrying amount of our foreignsubsidiaries and our consolidated equity, as well as our consolidated cashposition due to translation adjustments. For the nine months ended September 30, 2009, the effect ofexchange rate changes resulted in a $0.5 million increase to consolidatedcash.  During the nine months ended September 30,2008, the effect of exchange rate changes resulted in a $0.3 million decreasein consolidated cash.  We do notcurrently hedge our foreign currency exposure, but we monitor rate changes andmay hedge our exposures if we see significant negative trends in exchangerates.

 

**OFF-BALANCESHEET ARRANGEMENTS**

 

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

 

**ITEM3.  QUANTITATIVE AND QUALITATIVE MARKETRISK DISCLOSURES**

 

In the ordinarycourse of business, we are exposed to certain market risks, including changesin interest rates and foreign currency exchange rates. Uncertainties that areeither non-financial or non-quantifiable such as political, economic, tax,other regulatory, or credit risks are not included in the following assessmentof market risks.

 

***InterestRate Risks***

 

Our cash balancesare subject to interest rate fluctuations and as a result, interest incomeamounts may fluctuate from current levels. We could be exposed to interest rate risk related to our seniorrevolving credit facilities entered into in February 2008.  These obligations are variable interest ratenotes based on Prime Rate.  Fluctuationsin Prime Rate affect our interest rates. As of September 30, 2009 and2008, there was no balance due on our senior revolving credit facilities.

 

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***ForeignCurrency Risk***

 

We are exposed tofavorable and unfavorable fluctuations of the U.S. dollar (our functionalcurrency) against the currencies of our operating subsidiaries. Any increase(decrease) in the value of the U.S. dollar against any foreign currencythat is the functional currency of one of our operating subsidiaries will causethe parent company to experience unrealized foreign currency translation losses(gains) with respect to amounts already invested in such foreigncurrencies.  In addition, we and ouroperating subsidiaries are exposed to foreign currency risk to the extent thatwe enter into transactions denominated in currencies other than our respectivefunctional currencies, such as accounts receivable (including intercompanyamounts) that are denominated in a currency other than their own functionalcurrency. Changes in exchange rates with respect to these items will result inunrealized (based upon period-end exchange rates) or realized foreign currencytransaction gains and losses upon settlement of the transactions. In addition,we are exposed to foreign exchange rate fluctuations related to our operatingsubsidiaries’ monetary assets and liabilities and the financial results offoreign subsidiaries and affiliates when their respective financial statementsare translated 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.

 

Therelationship between the British Pound Sterling, Indian rupee and the U.S.dollar, which is our functional currency, is shown below, per one U.S. dollar:

 
| ** **              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **              | ** ** | **2009**               | ** ** | **2008**              | ** ** |
| **Spot  rates:**        | ** ** | ** **             | ** ** | ** **            | ** ** |
| British  Pound Sterling |       | 0.62816                |       | 0.69096               |       |
| Indian  Rupee           |       | 48.16956               |       | 49.21259              |       |

 
| ** **              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2009**                                   | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2008** | ** ** |
| **Average  rates:**     | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| British  Pound Sterling |       | 0.60943                                    |       | 0.52865                                   |       | 0.65070 |   | 0.5139 |   |
| Indian  Rupee           |       | 48.75878                                   |       | 43.72414                                  |       | 49.51497 |   | 41.62863 |   |

 

At the present time, we do not hedge our foreign currency exposure or usederivative financial instruments that are designed to reduce our long-termexposure to foreign currency exchange risk.  To the extentthat translation and transaction gain and losses become significant, we willconsider various options to reduce this risk.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

We maintain “disclosurecontrols and procedures,” as such term is defined in Rule 13a-15(e) underthe Securities Exchange Act of 1934 (the “Exchange Act”), that are designed toprovide reasonable assurance that information required to be disclosed by us inreports that we file or submit under the Exchange Act is recorded, processed,summarized, and reported within the time periods specified in Securities andExchange Commission rules and forms, and that such information isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure.

 

Our management,including our Chief Executive Officer and Chief Financial Officer, hasevaluated the effectiveness of our disclosure controls and procedures as of theend of the period covered by this Quarterly Report on Form 10-Q. Based on that evaluation, our Chief Executive Officer and Chief FinancialOfficer have concluded that our disclosure controls and procedures wereeffective as of the end of such period.

 

In designing andevaluating our disclosure controls and procedures, management recognized thatdisclosure controls and procedures, no matter how well conceived and operated,can provide only reasonable, not absolute, assurance that the objectives of thedisclosure controls and procedures are met.  Additionally, in designingdisclosure controls and procedures, our management necessarily was required toapply its judgment in evaluating the cost-benefit relationship of possibledisclosure controls and procedures. The design of any disclosure controls andprocedures also is based in part upon certain assumptions about the likelihoodof future events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions.

 

Duringthe three months ended September 30, 2009, there were no changes in ourinternal controls over financial reporting (as defined in Rule 13a-15(f) underthe Exchange Act) or in other factors that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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**PART II— OTHER INFORMATION**

 

**ITEM1.  LEGAL PROCEEDINGS**

 

We are involved invarious legal matters arising in the normal course of business.  Losses, including estimated costs to defend,were recorded for these matters to the extent they were probable of loss andthe amount of loss could be reasonably estimated.

 

**ITEM1A.  RISK FACTORS**

 

This Quarterly Report on Form 10-Qshould be read in conjunction with the risk factors defined in our AnnualReport on Form 10-K for the year ended December 31, 2008 under “Item1A. 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 31.1 — Certification pursuant to Section 302of the Sarbanes-Oxley Act of 2002

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

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

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

 

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**SIGNATURE**

 

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

 
| Date:  November 3, 2009 | /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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