**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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** **

**FORM 10-Q**

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

 

**Commission File Number: 0-24081**

 

**EVOLVING SYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

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

 

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

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).Yes o No ý

 

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

 

As of November 14,2005 there were 16,090,009 shares outstanding of Registrant’s Common Stock (parvalue $0.001 per share).

 

 

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Forward-LookingInformation

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements that havebeen 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 these words,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 the Company’s AnnualReport on Form 10-K for the year ended December 31, 2004 under “RiskFactors” on pages 9 through 22 as well as additional risks described inthis Form 10-Q.  Unless required bylaw, we undertake no obligation to update publicly any forward-lookingstatements, whether as a result of new information, future events, or otherwise.  However, readers should carefully review therisk factors set forth in other reports or documents the Company files fromtime to time with the Securities and Exchange Commission, particularly theQuarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

 

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**EVOLVING SYSTEMS, INC.**

**Quarterly Report on Form 10-Q**

**September 30, 2005**

**Table of Contents**

 
| **PART  I – FINANCIAL INFORMATION** |                                                                                                                          |
|------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------|
| Item 1                                   | Financial Statements                                                                                                          |   |
|                                     | Condensed Consolidated Balance  Sheets (Unaudited) as of September 30, 2005 and December 31, 2004                             |   |
|                                     | Condensed Consolidated  Statements of Operations (Unaudited) for the Three and Nine Months Ended  September 30, 2005 and 2004 |   |
|                                     | Condensed Consolidated  Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30,  2005 and 2004           |   |
|                                     | 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 Market Risk  Disclosures                                                                         |   |
| Item 4                                   | Controls and Procedures                                                                                                       |   |
| **PART  II – OTHER INFORMATION**    |                                                                                                                          |
| Item 1                                   | Legal Proceedings                                                                                                             |   |
| Item 6                                   | Exhibits                                                                                                                      |   |
| Signatures                               |                                                                                                                          |   |

 

3

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PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                          | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                                                                          |       |                    |       |                   |       |
| Current assets:                                                                                                                                                                     |       |                    |       |                   |       |
| Cash and cash equivalents                                                                                                                                                           |       | $                       | 3,423      |                   | $          | 11,386 |   |
| Restricted cash                                                                                                                                                                     |       | 100                     |       | 100                    |       |
| Contract receivables, net of allowance of $44 at  2005 and 2004                                                                                                                     |       | 4,989                   |       | 11,296                 |       |
| Unbilled work-in-progress                                                                                                                                                           |       | 1,489                   |       | 1,323                  |       |
| Prepaid and other current assets                                                                                                                                                    |       | 1,700                   |       | 1,832                  |       |
| Total current assets                                                                                                                                                                |       | 11,701                  |       | 25,937                 |       |
| Property and  equipment, net                                                                                                                                                        |       | 2,015                   |       | 2,563                  |       |
| Intangible  assets, net                                                                                                                                                             |       | 14,649                  |       | 19,993                 |       |
| Goodwill                                                                                                                                                                            |       | 35,060                  |       | 37,698                 |       |
| Restricted cash                                                                                                                                                                     |       | 300                     |       | 300                    |       |
| Total assets                                                                                                                                                                        |       | $                       | 63,725     |                   | $          | 86,491 |   |
|                                                                                                                                                                                |       |                    |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                       |       |                    |       |                   |       |
| Current  liabilities:                                                                                                                                                               |       |                    |       |                   |       |
| Current portion of notes payable and long-term  obligations                                                                                                                         |       | $                       | 4,455      |                   | $          | 31 |   |
| Short-term notes payable                                                                                                                                                            |       | —                  |       | 4,880                  |       |
| Accounts payable and accrued liabilities                                                                                                                                            |       | 5,796                   |       | 8,357                  |       |
| Payable to Tertio sellers                                                                                                                                                           |       | —                  |       | 2,664                  |       |
| Deferred income taxes, foreign                                                                                                                                                      |       | 98                      |       | 265                    |       |
| Unearned revenue                                                                                                                                                                    |       | 7,822                   |       | 13,083                 |       |
| Total current liabilities                                                                                                                                                           |       | 18,171                  |       | 29,280                 |       |
| Long-term liabilities                                                                                                                                                               |       |                    |       |                   |       |
| Long-term obligations                                                                                                                                                               |       | 80                      |       | 125                    |       |
| Notes payable, net of current portion                                                                                                                                               |       | 8,697                   |       | 11,849                 |       |
| Deferred income taxes, foreign                                                                                                                                                      |       | 3,346                   |       | 4,642                  |       |
| Total liabilities                                                                                                                                                                   |       | 30,294                  |       | 45,896                 |       |
|                                                                                                                                                                                |       |                    |       |                   |       |
| Commitments and  contingencies (Note 11)                                                                                                                                            |       |                    |       |                   |       |
|                                                                                                                                                                                |       |                    |       |                   |       |
| Series B convertible redeemable preferred stock;  $.001 par value; 966,666 shares issued and outstanding at September 30, 2005  and December 31, 2004                               |       | 11,281                  |       | 11,281                 |       |
|                                                                                                                                                                                |       |                    |       |                   |       |
| Stockholders’  equity:                                                                                                                                                         |       |                    |       |                   |       |
| Common stock, $.001 par value; 25,000,000 shares  authorized; 16,058,878 and 15,987,217 shares issued and outstanding as of  September 30, 2005 and December 31, 2004, respectively |       | 16                      |       | 16                     |       |
| Additional paid-in capital                                                                                                                                                          |       | 67,859                  |       | 67,765                 |       |
| Accumulated other comprehensive income (loss)                                                                                                                                       |       | (1,502                  | )          | 1,994                  |       |
| Accumulated deficit                                                                                                                                                                 |       | (44,223                 | )          | (40,461                | )          |
| Total stockholders’ equity                                                                                                                                                     |       | 22,150                  |       | 29,314                 |       |
| Total liabilities and stockholders’ equity                                                                                                                                     |       | $                       | 63,725     |                   | $          | 86,491 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| **REVENUE**                                                                  |       |                                  |       |                                 |       |   |   |   |   |
| License fees and services                                                    |       | $                                     | 4,821      |                                 | $          | 810 |   | $ | 14,643 |   | $ | 6,412 |   |
| Customer support                                                             |       | 4,749                                 |       | 4,929                                |       | 14,691 |   | 10,354 |   |
| Total revenue                                                                |       | 9,570                                 |       | 5,739                                |       | 29,334 |   | 16,766 |   |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                                 |       |                                  |       |                                 |       |   |   |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 2,285                                 |       | 808                                  |       | 7,654 |   | 3,003 |   |
| Costs of customer support, excluding depreciation  and amortization          |       | 1,578                                 |       | 1,807                                |       | 5,244 |   | 5,286 |   |
| Sales and marketing                                                          |       | 2,427                                 |       | 942                                  |       | 7,242 |   | 2,779 |   |
| General and administrative                                                   |       | 1,445                                 |       | 1,100                                |       | 5,426 |   | 2,969 |   |
| Product development                                                          |       | 452                                   |       | 152                                  |       | 1,058 |   | 884 |   |
| Depreciation                                                                 |       | 363                                   |       | 272                                  |       | 1,123 |   | 811 |   |
| Amortization                                                                 |       | 1,354                                 |       | 213                                  |       | 4,170 |   | 645 |   |
| Restructuring and other expenses (income)                                    |       | 4                                     |       | —                               |       | (47 | ) | — |   |
| Total costs of  revenue and operating expenses                               |       | 9,908                                 |       | 5,294                                |       | 31,870 |   | 16,377 |   |
| Income (loss)  from operations                                               |       | (338                                  | )          | 445                                  |       | (2,536 | ) | 389 |   |
| Interest income (expense), net                                               |       | (372                                  | )          | 89                                   |       | (1,130 | ) | 213 |   |
| Other income (expense), net                                                  |       | (99                                   | )          | 3                                    |       | (273 | ) | 3 |   |
| Income (loss)  before income taxes                                           |       | (809                                  | )          | 537                                  |       | (3,939 | ) | 605 |   |
| Income tax expense (benefit)                                                 |       | 117                                   |       | 20                                   |       | (177 | ) | 12 |   |
| Net income  (loss)                                                           |       | $                                     | (926       | )                                    | $          | 517 |   | $ | (3,762 | ) | $ | 593 |   |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| **Basic  income (loss) per common share**                                    |       | $                                     | (0.05      | )                                    | $          | 0.03 |   | $ | (0.20 | ) | $ | 0.04 |   |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| **Diluted  income (loss) per common share**                                  |       | $                                     | (0.05      | )                                    | $          | 0.03 |   | $ | (0.20 | ) | $ | 0.03 |   |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| Weighted average  basic shares outstanding                                   |       | 18,665                                |       | 15,890                               |       | 18,634 |   | 15,860 |   |
| Weighted average  diluted shares outstanding                                 |       | 18,665                                |       | 16,906                               |       | 18,634 |   | 17,378 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                                | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                |       |                                 |       |   |   |
| Net income  (loss)                                                                        |       | $                                    | (3,762     | ) | $ | 593 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                                 |       |   |   |
| Depreciation                                                                              |       | 1,123                                |       | 811 |   |
| Amortization of intangible assets                                                         |       | 4,170                                |       | 646 |   |
| Amortization of debt issuance costs                                                       |       | 34                                   |       | — |   |
| Interest expense added to debt principal                                                  |       | 1,016                                |       | — |   |
| Gain on disposal of property and equipment                                                |       | (12                                  | )          | (3 | ) |
| Bad debt recovery                                                                         |       | —                               |       | (21 | ) |
| Foreign deferred income tax benefit                                                       |       | (1,251                               | )          | — |   |
| Change in operating assets and liabilities:                                               |       |                                 |       |   |   |
| Contract receivables                                                                      |       | 6,034                                |       | 7,104 |   |
| Unbilled work-in-progress                                                                 |       | (103                                 | )          | 591 |   |
| Prepaid and other assets                                                                  |       | 73                                   |       | (302 | ) |
| Accounts payable and accrued liabilities                                                  |       | (1,371                               | )          | (304 | ) |
| Unearned revenue                                                                          |       | (4,903                               | )          | (5,707 | ) |
| Long-term obligations                                                                     |       | (20                                  | )          | (27 | ) |
| Net cash provided by operating activities                                                 |       | 1,028                                |       | 3,381 |   |
|                                                                                      |       |                                 |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                |       |                                 |       |   |   |
| Purchases of property and equipment                                                       |       | (656                                 | )          | (1,087 | ) |
| Proceeds from sale of property and equipment                                              |       | 18                                   |       | 5 |   |
| Business combinations                                                                     |       | (545                                 | )          | 41 |   |
| Net cash used in investing activities                                                     |       | (1,183                               | )          | (1,041 | ) |
|                                                                                      |       |                                 |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                |       |                                 |       |   |   |
| Capital lease payments                                                                    |       | (23                                  | )          | (21 | ) |
| Principal payments on notes payable                                                       |       | (4,889                               | )          | — |   |
| Payment of amount due to Tertio sellers                                                   |       | (2,617                               | )          | — |   |
| Proceeds from issuance of stock                                                           |       | 94                                   |       | 377 |   |
| Net cash (used in) provided by financing activities                                       |       | (7,435                               | )          | 356 |   |
|                                                                                      |       |                                 |       |   |   |
| Effect of foreign exchange rate changes on cash                                           |       | (373                                 | )          | (3 | ) |
|                                                                                      |       |                                 |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                      |       | (7,963                               | )          | 2,693 |   |
| Cash and cash equivalents at beginning of period                                          |       | 11,386                               |       | 17,999 |   |
| Cash and cash equivalents at end of period                                                |       | $                                    | 3,423      |   | $ | 20,692 |   |
|                                                                                      |       |                                 |       |   |   |
| Supplemental  disclosure of other cash and non-cash financing transactions:               |       |                                 |       |   |   |
| Interest paid                                                                             |       | $                                    | 155        |   | $ | 12 |   |
| Taxes paid                                                                                |       | $                                    | 104        |   | $ | — |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

*Use of Estimates*.The preparation of financial statements in conformity with GAAP requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements, as well as the reported amounts ofrevenue and expenses during the reporting period. Estimates have been made bymanagement with respect to revenue recognition, allowance for doubtful accounts,income taxes, intangible assets and goodwill, business combinations, andcapitalization of internal software development costs.  Actual results could differ from theseestimates.

 

*ForeignCurrency Translation*. The Company’s foreign subsidiaries'functional currency is generally the local currency of the countries in whichthey operate. Their assets and liabilities are translated into U.S. dollars atthe exchange rates in effect at the balance sheet date. Revenues, expenses, andcash flows are generally translated at the average rates of exchange prevailingduring the period. Translation gains and losses are included in comprehensiveincome (loss) within stockholders’ equity. Realized and unrealized transactiongains and losses resulting from the remeasurement of non-functional currencyfinancial instruments are included in the determination of net income (loss). Forthe three and nine months ended September 30, 2005 and 2004, net transaction losseswere approximately $100,000 and $285,000, and $1,000 and $3,000, respectively.

 

*ComprehensiveIncome*. The Company’s comprehensive income (loss) iscomprised of its net income (loss) and foreign currency translation adjustment. For the three and nine months ended September 30, total comprehensive income(loss) was approximately $(1.8) million and $(7.3) million, for 2005, and$517,000 and $586,000, for 2004, respectively.

 

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

 

*Reclassification.*As a result of the significance of the intangible assets andthe related amortization expense from the acquisitions of Tertio TelecomsLimited (“Tertio”) and Telecom Software Enterprises LLC (“TSE”), the Company isnow reporting amortization expense as a separate line item on the statements ofoperations. In quarterly periods prior to December 31, 2004, amortization ofintangibles was shown within costs of license fees and services and costs ofcustomer support. Prior period balances have been reclassified to conform tothe current period’s presentation.

 

*RevenueRecognition.*The Company recognizes revenue from two primarysources: license fees and services, and customer support, in accordance withStatement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amendedand interpreted by SOP 98-9, “Modification of SOP 97-2, Software RevenueRecognition, With Respect to Certain Transactions.”  Staff Accounting Bulletin (“SAB”)No. 104, “Revenue Recognition,” provides further interpretive guidance forpublic companies on the recognition, presentation and disclosure of revenue infinancial statements.  In addition to thecriteria described below, the Company recognizes revenue only when an agreementis signed, the fee is fixed or determinable and collectibility is reasonablyassured.

 

Themajority of the Company’s license fees and services revenue is generated fromfixed-price contracts, which provide for licenses to its software products andservices.  Generally, when the servicesare determined to be essential to the functionality of the delivered software,revenue is recognized using the percentage-of-completion method of accounting,in accordance with SOP 97-2 and SOP 81-1, “Accounting for Long-TermConstruction Type Contracts.”  Thepercentage of completion for each contract is estimated based on the ratio ofdirect labor hours incurred to total estimated direct labor hours.  Since estimated direct labor hours andproject costs, and changes thereto, can have a significant impact on revenuerecognition, these estimates are critical and are reviewed by managementregularly.  Amounts billed in advance ofservices being performed are recorded as unearned revenue. Unbilledwork-in-progress represents revenue earned but not yet billable under the termsof the fixed-price contracts. All such amounts are expected to be billed andcollected within 12 months.

 

TheCompany may encounter budget and schedule overruns on fixed pricecontracts caused by increased labor, overhead or material costs. Adjustments tocost estimates are made in the periods in which the facts requiring suchrevisions become known.

 

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Estimated losses, if any,are recorded in the period in which current estimates of total contract revenueand contract costs indicate a loss.

 

Inarrangements where the services are not essential to the functionality of thesoftware, the Company recognizes license revenue upon delivery.  To the extent that Vendor Specific ObjectiveEvidence (“VSOE”) of the fair value of the undelivered elements exists, feesfrom multiple element arrangements are unbundled and recorded as revenue as theelements are delivered.  If VSOE for theundelivered elements does not exist, fees from such arrangements are deferreduntil the earlier of the date that VSOE does exist on the undelivered elementsor all of the elements have been delivered.

 

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

 

Customersupport, including maintenance revenue, is generally recognized ratably overthe service contract period. When maintenance or training services are bundledwith the original license fee arrangement, their fair value, based upon VSOE,is deferred and recognized during the periods when services are provided.

 

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

 

**Tertio**

 

On November 2,2004, the Company acquired all of the outstanding shares of privately-held, U.K.-basedTertio. Total consideration for Tertio’s net assets was approximately $40.2 million, consisting of $11.0million in cash, approximately $15.9 million in seller-financed notes, of which$4.0 million was paid during the first half of 2005, 966,666 shares of Series BPreferred Stock with an estimated fair value of approximately $11.3 million andapproximately $2.0 million in estimated transaction-related costs. Ofthe total purchase price, 10% was deposited in escrow with Wells Fargo Bank,N.A. as escrow agent to secure the sellers’ representations and warrantiesunder the purchase agreement.  Of the funds deposited in escrow, 80% willremain in escrow until November 2, 2005 and the remaining 20% will remainin escrow until November 2, 2007, unless sooner released to the Company inpayment of indemnification claims.  Theacquisition was recorded as a purchase business combination and Tertio’sresults of operations have been combined with Evolving Systems’ from theacquisition date.

 

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

 

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

 

**TSE**

 

On October 15,2004, the Company acquired all of the outstanding ownership interests inprivately-held TSE. Total consideration for TSE approximated $2.4 million,consisting of $1.5 million in cash, a note payable of $889,000 andapproximately $55,000 in transaction-related costs.  The note payable was due and paid on March 31,2005. Of the total purchase price, $250,000 was deposited in escrow for oneyear with Wells Fargo Bank, N.A. as escrow agent to secure the sellers’representations and warranties under the purchase agreement.  The Companyagreed to pay additional consideration of up to $3.5 million contingent uponthe achievement of certain specified revenue and gross margin results. Up to$2.5 million of the contingent consideration may be payable over a 24 monthperiod from the closing date and additional contingent consideration of up to$1.0 million may be paid through the year 2011 if certain specified sales ofTSE products occur. In accordance with Statement of Financial AccountingStandard (“SFAS”) No. 141, the contingent consideration will not berecorded until the contingency is resolved and the additional consideration isdistributable. During the three and nine months ended September 30, 2005,the Company recorded additional contingent consideration and resulting goodwillrelated to certain specified gross margin results achieved by the sale of TSEproducts during the period of approximately $99,000 and $330,000, respectively.The additional contingent consideration is paid within 45 days of the last dayof the quarter in which it is earned. The acquisition was treated as a purchasebusiness combination and the results of TSE’s operations have been combinedwith Evolving Systems’ from the acquisition date forward.

 

TSE’sproducts are sold to U.S. wireline and wireless carriers, and provide forsimulation of the nation’s centralized Number Portability Administration Center(“NPAC”) and a testing environment for critical back office systems thatcarriers use for enabling number portability. Other products in the TSEportfolio are used for enhanced integration between back office OperationalSupport Systems (“OSS”).  TSE hasinstalled its products at many of the leading wireless and wireline carriers inNorth America. By acquiring TSE, the Company expanded its customer base andextended the set of Local Number Portability (“LNP”) solutions it offers itscustomers. The primary reason for a valuation which gives rise to goodwill isrelated to the value the Company placed on TSE’s solid reputation as a providerof LNP products, the Company’s expectation of new customers and the experiencedemployees acquired in the TSE acquisition.

 

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**Pro Forma Financial Information**

 

The financial information in the table belowsummarizes the combined results of operations of Evolving Systems, Inc.,TSE and Evolving Systems U.K. on a pro forma basis, as though the companies hadbeen combined during the period presented below.  The impact of the In-Process Researchand Development (“IPR&D”) chargesassociated with the acquisitions has been excluded.  This pro forma financial information ispresented for informational purposes only and is not necessarily indicative ofthe results of operations that would have been achieved had the acquisitionsactually taken place as of the beginning of the period presented below.  The following amounts are in thousands,except per share amounts.

 
| ** **                  | ** ** | **Three Months Ended  September 30, 2004** | ** ** | **Nine Months Ended  September, 2004** | ** ** |
|-----------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|
| Revenues                    |       | $                                          | 12,439     |                                   | $          | 36,149 |   |
| Net income                  |       | $                                          | 1,612      |                                   | $          | 913 |   |
| Basic earnings  per share   |       | $                                          | 0.10       |                                   | $          | 0.05 |   |
| Diluted earnings  per share |       | $                                          | 0.08       |                                   | $          | 0.05 |   |

 

**(3) Goodwilland Intangible Assets**

 

The Company has recorded goodwill and intangibleassets from its acquisitions of CMS in 2003, and TSE and Tertio in 2004.  In accordance with SFAS No. 142,goodwill is not amortized but is subject to an impairment test at leastannually at the reporting unit level by applying a fair-value-based test. Changesin the carrying amounts of goodwill by reporting unit for the nine months endedSeptember 30, 2005 are as follows:

 
| **Goodwill:**                              | ** ** | **License and  Services** | ** ** | **Customer  Support** | ** ** | **Total  Goodwill** | ** ** |
|--------------------------------------------|------------|---------------------------|------------|-----------------------|------------|---------------------|------------|
| Balance as of  December 31, 2004           |       | $                         | 20,689     |                  | $          | 17,009              |       | $ | 37,698 |   |
| Adjustments to  goodwill                   |       | 145                       |       | (328                  | )          | (183                | )          |
| Effects of foreign currency exchange rates |       | (1,518                    | )          | (937                  | )          | (2,455              | )          |
| Balance as of  September 30, 2005          |       | $                         | 19,316     |                  | $          | 15,744              |       | $ | 35,060 |   |

 

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

 

The Company’s annual goodwill impairment test wasconducted as of July 31, 2005, and it was determined that goodwill was notimpaired as of the test date.

 

Identifiable intangibles are amortized overestimated finite lives of from one to seven years, and include the cumulative effectsof changes in foreign currency exchange rates.

 
| ** **                          | ** ** | **September 30, 2005** | ** ** | **December 31, 2004**         | ** ** |
|-------------------------------------|------------|------------------------|------------|-------------------------------|------------|
| **Identifiable intangible assets:** | ** ** | **Gross  Amount**      | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** |
| Purchased  software                 |       | $                      | 8,835      |                          | $          | 1,999 |   | $ | 6,836 |   | $ | 9,180 |   | $ | 326 |   | $ | 8,854 |   |
| Customer  contracts                 |       | 1,701                  |       | 1,555                         |       | 146 |   | 1,859 |   | 305 |   | 1,891 |   |
| Purchased  licenses                 |       | 1,335                  |       | 509                           |       | 826 |   | 1,335 |   | 309 |   | 1,026 |   |
| Trademarks and  tradenames          |       | 1,094                  |       | 167                           |       | 927 |   | 1,196 |   | 33 |   | 1,163 |   |
| Business  partnerships              |       | 1,365                  |       | 178                           |       | 1,187 |   | 1,491 |   | 35 |   | 1,456 |   |
| Customer  relationships             |       | 6,411                  |       | 1,684                         |       | 4,727 |   | 6,740 |   | 800 |   | 5,603 |   |
|                                |       | $                      | 20,741     |                          | $          | 6,092 |   | $ | 14,649 |   | $ | 21,801 |   | $ | 1,808 |   | $ | 19,993 |   |
|                                     |            |                        |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

9

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Amortizationexpense of identifiable intangible assets was $1.4 million and $4.2 million forthe three and nine months ended September 30, 2005, respectively, and $214,000and $646,000 for the three and nine months ended September 30, 2004,respectively.

 

**(4) Earnings Per Common Share**

 

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

 
| ** **                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                         | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average common shares outstanding         |       | 16,055                                |       | 15,890                               |       | 16,024 |   | 15,860 |   |
| Participating securities                           |       | 2,610                                 |       | —                               |       | 2,610 |   | — |   |
| Basic weighted average common shares outstanding   |       | 18,665                                |       | 15,890                               |       | 18,634 |   | 15,860 |   |
| Effect of dilutive securities                      |       | —                                |       | 1,016                                |       | — |   | 1,518 |   |
| Diluted weighted average common shares outstanding |       | 18,665                                |       | 16,906                               |       | 18,634 |   | 17,378 |   |

 

Weightedaverage options to purchase 779,000 and 1.2 million shares of common stock wereexcluded from the dilutive stock calculation for the three and nine monthsended September 30, 2005, respectively, as their effect would have beenanti-dilutive as a result of the net loss for the period. Weighted average optionsto purchase 2.6 million and 2.4 million shares of common stock were excludedfrom the dilutive stock calculation for the three and nine months ended September30, 2005, respectively, because their exercise prices were greater than theaverage fair value of the Company’s stock for the period.

 

Weightedaverage options to purchase 442,000 and 409,000 shares of common stock wereexcluded from the dilutive stock calculation for the three and nine monthsended September 30, 2004, because their exercise prices were greater than theaverage fair value of the Company’s stock for the period.

 

Theparticipating securities reflect 966,666 shares of Series B Preferred Stock,convertible into 2.9 million shares of the Company’s common stock, less the96,667 shares of Series B Preferred Stock, convertible into 290,000 shares ofthe Company’s common stock, that are held in escrow.  In accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 128 “Earnings Per Share”, shares thatare contingently issuable are not included in the computation of basic EPSuntil all necessary conditions have been satisfied (in essence, when issuanceof the shares are no longer contingent).

 

**(5) Stock-BasedCompensation**

 

TheCompany applies the intrinsic-value-based method prescribed by AccountingPrinciples Board (“APB”) Opinion No. 25, “Accounting for Stock Issued toEmployees,” and related interpretations in accounting for employee stock-basedcompensation arrangements. Non-employee stock compensation arrangements areaccounted for under SFAS No. 123, “Accounting for Stock-Based Compensation” and Emerging IssuesTask Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instrumentsthat are Issued to Other than Employees, or in Conjunction with Selling Goodsor Services.”

 

SFAS No. 123 and SFAS No. 148, “Accounting for Stock-Based Compensation -Transition and Disclosure, an amendment of FASB Statement No. 123,”established accounting and disclosure requirements using a fair-value-basedmethod of accounting for stock-based employee compensation plans. As permittedby existing accounting standards, the Company has elected to continue to applythe intrinsic-value-based method of accounting described above, and has adoptedonly the disclosure requirements of SFAS No. 123, as amended. Thefollowing table illustrates the effect on net income (loss) if the fair-value-basedmethod had been applied to all outstanding and unvested awards in each period(in thousands, except per share data):

 

10

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| ** **                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss), as reported                                |       | $                                     | (926       | )                                    | $          | 517 |   | $ | (3,762 | ) | $ | 593 |   |
| Stock-based compensation expense under the fair  value method |       | 407                                   |       | 513                                  |       | 1,632 |   | 1,487 |   |
| Pro forma net income (loss)                                   |       | $                                     | (1,333     | )                                    | $          | 4 |   | $ | (5,394 | ) | $ | (894 | ) |
|                                                          |       |                                  |       |                                 |       |   |   |   |   |
| Earnings (loss) per common share, as reported:                |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                         |       | $                                     | (0.05      | )                                    | $          | 0.03 |   | $ | (0.20 | ) | $ | 0.04 |   |
| Diluted                                                       |       | $                                     | (0.05      | )                                    | $          | 0.03 |   | $ | (0.20 | ) | $ | 0.03 |   |
| Pro forma loss per common share:                              |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                         |       | $                                     | (0.07      | )                                    | $          | 0.00 |   | $ | (0.29 | ) | $ | (0.06 | ) |
| Diluted                                                       |       | $                                     | (0.07      | )                                    | $          | 0.00 |   | $ | (0.29 | ) | $ | (0.05 | ) |

 

**(6) Concentration of Credit Risk**

 

For the three and nine months ended September 30, 2005,the Company recognized 45% (20%, 13% and 12%) and 39% (12%, 13% and 14%),respectively, of total revenue from three significant customers (defined ascontributing at least 10%), in the communications industry.  For the three months ended September 30,2004, the Company recognized 72% (47%, 14% and 11%) of total revenue from threesignificant customers, all in the communications industry. For the nine monthsended September 30, 2004, the Company recognized 72% (24%, 18%, 17% and 13%) oftotal revenue from four significant customers, all in the communicationsindustry.

 

As of September30, 2005, three significant customers accounted for approximately 50% (25%, 13%and 12%) of contract receivables.  At December 31,2004, three significant customers accounted for approximately 58% (30%, 17% and11%) of contract receivables.

 

TheCompany earns a significant portion of its revenue from a small number ofcustomers in the communications industry. This has been mitigated somewhat bythe expansion of the Company’s customer base through recent acquisitions. Theloss of any significant customer, delays in delivery or acceptance of any ofour products by a customer, delays in the performance of services for acustomer, or delays in collection of customer receivables, however, could bematerially harmful to the Company’s business, financial condition, results ofoperations and cash flows.

 

**(7) NotesPayable**

 

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

 
| ** **                                                                                                                                                                                                           | ** ** | **As of  September 30,** | ** ** | **As of  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                                                                                           | ** ** | **2005**                 | ** ** | **2004**                | ** ** |
| Long-term seller financed notes payable (Tertio),  interest at weighted average rate of 11.62%, due in varying quarterly  principal installments beginning March 31, 2006, with final maturity on  December 31, 2007 |       | $                        | 13,195     |                    | $          | 11,950 |   |
| Short-term seller financed note payable (Tertio),  interest at 5.50%, $2,000 due and paid March 31, 2005 and $2,000 due and paid  June 30, 2005                                                                      |       | —                   |       | 4,000                   |       |
| Promissory notes payable to TSE sellers, interest at  5.00%, due and paid March 31, 2005                                                                                                                             |       | —                   |       | 889                     |       |
| Debt issuance costs                                                                                                                                                                                                  |       | (76                      | )          | (110                    | )          |
| Total notes payable                                                                                                                                                                                                  |       | 13,119                   |       | 16,729                  |       |
| Less: current portion, net                                                                                                                                                                                           |       | (4,422                   | )          | (4,880                  | )          |
| Long-term debt, net of current portion                                                                                                                                                                               |       | $                        | 8,697      |                    | $          | 11,849 |   |
|                                                                                                                                                                                                                      |            |                          |            |                         |            |  |  |  |  |

 

TheCompany entered into the long-term seller-financed notes payable (“Long-TermNotes”) on November 2, 2004, in conjunction with the acquisition of Tertio.  From the acquisition date through November 2,2006, the Long-Term Notes bear interest at 11.0% per annum. From November 2,2006 through the maturity date of December 31, 2007, the notes will bearinterest at 14.0% per annum. Interest is recognized using an effective rate of11.62% for the term of the notes. Interest is accrued and added to theprincipal balance through December 31, 2005, and beginning March 31,2006, interest is payable in cash on a quarterly basis in addition to thescheduled principal payments. Accrued interest of approximately $1.2 millionhas been added to the principal balance of the Long-Term Notes during the ninemonths ended September 30, 2005. The Long-Term Notes payable may be prepaid atany time without

 

11

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penalty. Beginning in March 2005,if the Company’s quarterly cash balances exceed $7.0 million, the holder of theLong-Term Notes may require a prepayment on the note equal to the amount bywhich the quarterly cash balance exceeds $7.0 million. Based on its projectionsof cash balances, the Company believes that these additional payments will notbe required through September 30, 2006. The scheduled principal payments on theLong-Term Notes are as follows (in thousands):

 

| **Principal Payment  Date** | ** ** | **Amount** | ** ** |
|-----------------------------|------------|------------|------------|
| March 31, 2006              |       | $          | 1,340      |   |
| June 30, 2006               |       | 3,110      |       |
| December 31,  2006          |       | 1,430      |       |
| March 31, 2007              |       | 1,870      |       |
| June 30, 2007               |       | 3,110      |       |
| December 31,  2007          |       | 2,335      |       |
|                        |       | $          | 13,195     |   |

 

Thenotes are secured by substantially all of the assets of Evolving Systems and apledge, subject to certain limitations, of the shares of its subsidiaries.

 

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

 

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

 

See also Note 13, Subsequent Events, for changes tothe Company’s notes payable.

 

**(8) IncomeTaxes**

 

TheCompany recorded net income tax (expense) benefit of $(117,000) and $177,000 forthe three and nine months ended September 30, 2005, respectively. The net (expense)benefit during the three and nine months ended September 30, 2005 consists ofcurrent income tax expense of approximately $419,000 and $1.0 million,respectively, and a deferred tax benefit of $302,000 and $1.2 million,respectively, both of which are related to the Company’s UK-based operations.  The Company recorded current income taxexpense of $20,000 and $12,000 for the three and nine months ended September30, 2004, respectively, related primarily to U.S. state income taxes.

 

Inconjunction with the acquisition of Tertio, certain identifiable intangibleassets were recorded.  Since theamortization of these identifiable intangibles is not deductible for income taxpurposes, a long-term deferred tax liability of $4.6 million was established atthe acquisition date for the expected difference between what would be expensedfor financial reporting purposes and what would be deductible for income taxpurposes. As of September 30, 2005, this deferred tax liability was $3.3million. This deferred tax liability is carried on the books of the Company’sUnited Kingdom subsidiary, and has no impact on the Company’s ability torecover its U.S.-based deferred tax assets.

 

Inconjunction with the acquisition of Tertio, future revenue under contracts inexistence at the acquisition dates was reduced to an amount equal to theCompany’s estimated costs to fulfill its obligations under the contracts plus areasonable profit margin on the Company’s estimated fulfillment effort.  The resulting reduction of future revenuerecorded for financial reporting purposes is not deductible for income taxpurposes and thus, a current deferred tax liability of approximately $600,000was established at the acquisition date. As of September 30, 2005, thisdeferred tax liability was $98,000.  Bothof the aforementioned deferred tax liabilities will be recognized as areduction of deferred income tax expense as the identifiable intangibles areamortized and the contract revenue is recognized.

 

As of September30, 2005 and December 31, 2004, the Company continued to maintain a fullvaluation allowance on its domestic net deferred tax asset, primarilyconsisting of certain net operating loss carryforwards.  The Company’s assessment of this valuationallowance was made using all available evidence, both positive andnegative.  The Company considered itsrecent historical domestic losses, potential tax planning strategies, andprojected future profitability; however, greater weight was given to historicalresults, as that evidence is more objectively verifiable.  Given the weight of the evidence, the Companyconcluded that a full valuation allowance for its deferred tax asset wasrequired.  The Company is required toreassess its conclusions regarding its deferred tax asset valuation allowance ateach financial reporting date. It is reasonably possible that future evaluationcould result in a conclusion that all or a portion of the valuation allowanceis no longer necessary, which could have a material impact on the Company’sresults of operations and financial position.

 

**(9) Restructuring and Other Expenses**

 

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

 

12

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At September30, 2005 and December 31, 2004, the remaining accrual related to theclosure of the satellite offices.  Becausethe costs to sublease or terminate these lease commitments are based onestimates, the Company may incur additional costs related to the satelliteoffice closures, disclosed as restructuring and other expenses (recovery) inthe statements of operations.  As of September30, 2005 approximately $9,000 was included in accounts payable and accruedliabilities.

 

**(10) SegmentInformation**

 

Inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterpriseand Related Information,” the Company defines operating segments as componentsof an enterprise for which separate financial information is reviewed regularlyby the chief operating decision-making group, to evaluate performance and tomake operating decisions. The Company has identified its Chief ExecutiveOfficer and Chief Financial Officer as its chief operating decision-makers.These chief operating decision makers review revenues by segment and reviewoverall results of operations. 

 

TheCompany currently operates its business as two operating segments based onrevenue type: license fees/services revenue and customer support revenue (asshown on the consolidated statements of operations).  License fees and services revenue representsthe fees received from the license of software products and those servicesdirectly related to the delivery of the licensed products, as well as fees for customdevelopment, integration services and time and materials work.  Customer support revenue includes annualsupport fees, recurring maintenance fees, fees for maintenance upgrades andwarranty services.  Warranty services thatare similar to software maintenance services are typically bundled with alicense sale and the related revenue, based on VSOE, is deferred and recognizedratably over the warranty period. Total assets by segment have not beenspecified because the information is not available to the chief operatingdecision-making group.

 

Segmentinformation is as follows (in thousands):

 
| ** **                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenue**                                                                |       |                                  |       |                                 |       |   |   |   |   |
| License fees and services                                                  |       | $                                     | 4,821      |                                 | $          | 810 |   | $ | 14,643 |   | $ | 6,412 |   |
| Customer support                                                           |       | 4,749                                 |       | 4,929                                |       | 14,691 |   | 10,354 |   |
|                                                                       |       | $                                     | 9,570      |                                 | $          | 5,739 |   | $ | 29,334 |   | $ | 16,766 |   |
|                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| **Revenue less cost of revenue, excluding  depreciation and amortization** |       |                                  |       |                                 |       |   |   |   |   |
| License fees and services                                                  |       | $                                     | 2,536      |                                 | $          | 2 |   | $ | 6,989 |   | $ | 3,409 |   |
| Customer support                                                           |       | 3,171                                 |       | 3,122                                |       | 9,447 |   | 5,068 |   |
|                                                                       |       | 5,707                                 |       | 3,124                                |       | 16,436 |   | 8,477 |   |
|                                                                       |       |                                  |       |                                 |       |   |   |   |   |
| **Unallocated costs**                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Other operating expenses                                                   |       | 4,324                                 |       | 2,194                                |       | 13,726 |   | 6,632 |   |
| Depreciation and amortization                                              |       | 1,717                                 |       | 485                                  |       | 5,293 |   | 1,456 |   |
| Restructuring and other                                                    |       | 4                                     |       | —                               |       | (47 | ) | — |   |
| **Income (loss) from operations**                                          |       | $                                     | (338       | )                                    | $          | 445 |   | $ | (2,536 | ) | $ | 389 |   |

 

***Geographic Regions***

 

The Company, headquartered in Denver, Colorado, usesthe customer locations as the basis of attributing revenues to individualcountries. With the acquisition of London based Tertio, the Company nowprovides products and services on a global basis.  Additionally, the Company’s personnel inBangalore, India, provide support to the Company’s global operations.  Financial information relating to the Company’soperations by geographic region is as follows (in thousands):

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenue**                          | ** ** | ** **                            | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| United States                        |       | $                                     | 4,539      |                                 | $          | 5,739 |   | $ | 14,256 |   | $ | 16,766 |   |
| Europe, Middle East, Africa and Asia |       | 5,031                                 |       | —                               |       | 15,078 |   | — |   |
| Total Revenue                        |       | $                                     | 9,570      |                                 | $          | 5,739 |   | $ | 29,334 |   | $ | 16,766 |   |

 

13

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| ** **                           | ** ** | **As of  September 30,** | ** ** | **As of  December 31,** | ** ** |
|--------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **2005**                 | ** ** | **2004**                | ** ** |
| **Long-lived  assets, net**          |       |                     |       |                    |       |
| United States                        |       | $                        | 1,108      |                    | $          | 1,563 |   |
| Europe, Middle East, Africa and Asia |       | 907                      |       | 1,000                   |       |
| Total long-lived  assets, net        |       | $                        | 2,015      |                    | $          | 2,563 |   |

 

**(11)Commitments and Contingencies**

 

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

 

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

 

TheCompany’s standard license agreements contain warranties that the software willbe free of material defects and will operate in accordance with the statedrequirements for a limited period of time. The warranty provisions require the Company to cure any defects throughany reasonable means.  To date, no formalclaims under the warranty provisions have been brought to the Company’sattention.  The Company believes theestimated fair value of the warranty provisions in the license agreements inplace with its customers is minimal. Accordingly, the Company has not recorded liabilities for these warrantyprovisions as of September 30, 2005 and December 31, 2004.

 

TheCompany’s software arrangements generally include a product indemnificationprovision that the Company will indemnify and defend a client in actionsbrought against the client for claims that the Company’s products infringe upona copyright, trade secret, or valid patent. Historically, the Company has notincurred any significant costs related to product indemnification claims.Accordingly, the Company has no liabilities recorded as of September 30, 2005and December 31, 2004.

 

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

 

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

 

**(12)Recent Accounting Pronouncements**

 

In May2005, the FASB issued SFAS No. 154, “Accounting for Changes and ErrorCorrections – a Replacement of APB Opinion No. 20 and FASB Statement No. 3”(SFAS 154).  SFAS 154 requiresretrospective application of voluntary changes in accounting principles, unlessimpracticable.  SFAS 154 supersedes theguidance in APB Opinion No. 20 and SFAS No. 3, but does not change anytransition provisions of existing pronouncements.  Generally, elective accounting changes willno longer result in a cumulative effect of a change in accounting in the incomestatement, because the effects of any elective changes will be reflected asprior period adjustments to all periods presented.  SFAS 154 will be effective beginning infiscal 2006 and will affect any accounting changes that we elect to makethereafter.

 

In March2005, the FASB issued FASB Interpretation No. 47, “Accounting for ConditionalAsset Retirement Obligations, an interpretation of FASB Statement No. 143” (FIN47).  FIN 47 clarifies that conditionalasset retirement obligations meet the definition of liabilities and should berecognized when incurred if their fair values can be reasonably estimated.  The cumulative effect of

 

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initially applying FIN 47would be recognized as a change in accounting principle.  FIN 47 is effective no later than the end offiscal years ending after December 15, 2005. We do not expect FIN 47 to have a material impact on our financialcondition or results of operations.

 

InDecember 2004, the FASB issued SFAS No. 123(Revised), “Share-BasedPayment.” This statement replaces SFAS No. 123, “Accounting forStock-Based Compensation” and supersedes APB Opinion No. 25, “Accountingfor Stock Issued to Employees.” Under the modified prospective method ofadoption, SFAS No. 123(R) requires companies to apply afair-value-based measurement method in accounting for share-based paymenttransactions with employees and to record compensation cost for all stockawards granted after the required effective date and to awards modified, repurchased,or cancelled after that date. In addition, the Company is required to recordcompensation expense (as awards previously granted continue to vest) for theunvested portion of those awards that remain outstanding at the date ofadoption. In accordance with adoption provisions released by the SEC, SFAS123(R) will be effective for the Company on January 1, 2006. Managementhas not yet determined the impact that SFAS 123(R) will have on its financialposition and results of operations, but expects that the stock incentive plans’pro forma disclosure provides a reasonable measure of the expected annualimpact.

 

**(13)  Subsequent Events**

 

On November 14,2005, the Company replaced its Long-Term Notes with the Tertio Sellers with aSubordinated Note, and entered into a Senior Term Note and a Senior RevolvingFacility with a commercial finance company.

 

The$8.5 million Senior Term Note bears interest at LIBOR plus an applicablemargin.  The LIBOR rate varies, but canbe no less than 3.75%.  LIBOR wasapproximately 4.1% on November 14, 2005. The standard applicable margin of 6.25% may be reduced to 5.25% if theCompany meets and maintains certain financial requirements.  The Senior Term Note is secured by substantiallyall of the U.S. assets of Evolving Systems, Inc.  The Senior Term Note subjects the Company tocertain affirmative and negative covenants, including a financial covenantrelated to the Company’s EBITDA, as defined. The agreement restricts capital expenditures to specified limits andprohibits the Company from declaring dividends to its common stockholders.  The Senior Term Note requires quarterlyprincipal and monthly interest payments through October 2010.

 

TheCompany used the $8.5 million proceeds of the Senior Term Note to pay down aportion of the Long-Term Notes with the Tertio sellers.  The Long-Term Notes were exchanged forunsecured Subordinated Notes of approximately $4.9 million, bearing interest at11% through December 31, 2007, and 14% thereafter.  The Subordinated Notes subject the Company toaffirmative and negative covenants; however, certain covenants are not ineffect until the Senior Term Note and Senior Revolving Facility are paid.  The Senior Term Note and Senior RevolvingFacility are senior to the Subordinated Notes. The Subordinated Notes are payable in full, including accrued interest,in May 2011.

 

Thescheduled principal payments under the Senior Term Note and Subordinated Notesare as follows (in thousands):

 

| **Year  ending  December 31,** | ** ** | **Amount** | ** ** |
|------------------------------------------|------------|------------|------------|
| 2006                                     |       | $          | 1,000      |   |
| 2007                                     |       | 2,000      |       |
| 2008                                     |       | 2,500      |       |
| 2009                                     |       | 2,000      |       |
| 2010                                     |       | 1,000      |       |
| Thereafter                               |       | 4,900      |       |
|                                     |       | $          | 13,400     |   |

 

 

Additionally,the Company obtained a $4.5 million Senior Revolving Facility that bearsinterest at LIBOR plus 4.0%, and has an annual management fee of 0.05%.  The LIBOR rate varies, but can be no lessthan 3.75%.  Borrowings under the SeniorRevolving Facility are limited to a multiple of the Company’s EBITDA, asdefined, less the balance of the Senior Term Note.  The multiple ranges from 2.50 in the firstyear to 1.75 in the fourth year.  Theagreement mandates an initial borrowing of $2.0 million.  The Senior Revolving Facility is secured bysubstantially all of the assets of Evolving Systems U.K. and includes the samecovenants and restrictions as the Senior Term Note.  The Senior Revolving Facility requiresmonthly payments of interest and fees, with the unpaid balance due in October 2010.

 

If theCompany is in compliance with all financial covenants of the Senior Term Noteand Senior Revolving Facility, no events of default have occurred, and certainminimum liquidity conditions are met, early payment is allowed under thoseagreements.

 

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

 

OVERVIEW

 

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

 

Thecore Evolving Systems portfolio that included ordering and provisioningsolutions for Local Number Portability (“LNP”), as well as a number inventoryand assignment platform, has recently been expanded, as a result of threeacquisitions we made over a period of 12 months from November of 2003 to November of2004. Through the acquisition of CMS Communications, Inc. (“CMS”) in November 2003we acquired a network mediation and service assurance solution to add to ourproduct portfolio. Additionally, with the acquisition of Telecom SoftwareEnterprises, LLC (“TSE”) on October 15, 2004 we added LNP and WirelessNumber Portability (“WNP”) number ordering and provisioning testing productswhich provide new OSS system integration capabilities.  On November 2, 2004, we acquired TertioTelecoms Ltd. (“Tertio”), a privately held supplier of OSS software solutionsto communication carriers throughout Europe, the Middle East, Africa and Asia,expanding our markets beyond North America. Tertio’s leading activation solution, ***ProvidentTM,***now called ***TertioTM***, andmediation solution ***EvidentTM***, strengthen ouroverall product portfolio. Our significantly expanded product and servicecapabilities now enable us to address a larger portion of our customer’sapplication needs. Also, as a result of these acquisitions, we have become acompany with global reach and a customer base that includes many of the world’sleading communications carriers.  We arepositioned as a provider of OSS, NSS and comprehensive systems integrationcapabilities. These complementary competencies enable us to address andimplement solutions across much of a customer’s back office.

 

**CompanyBackground**

 

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

 

Historically,we have helped our customers integrate our products into their existingbusiness process and OSS environments. In 2002, we initiated a restructuringplan, which, in addition to significant operational cost reductions and greaterleverage of offshore development, included the reengineering of our businessmodel to a solutions strategy.  The solutionsbusiness model reflects a more balanced mix of services and products, as wellas integration and product enhancements for our customers’ back office to meetthe specific requirements of each customer. Solutions which include ourproducts, as well as product extensions and integration, are typically licensedto our customers and supported by us. In 2004, we expanded our direct salesreach to include indirect sales through partnerships with network equipmentproviders and system integrators, such as Siemens, Alcatel and Accenture.  We anticipate these channel sales will extendour reach to new geographical regions as well as help us further penetrate ourexisting territories.  We have alsocreated packaged products with our channel partners, where we provide theunderlying product and our partner provides some or most of the integrationservices.

 

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**CriticalAccounting Policies**

 

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

 

**•**                  Revenuerecognition

 

**•**                  Allowancefor doubtful accounts

 

**•**                  Incometaxes

 

**•**                  Intangibleassets

 

**•**                  Businesscombinations

 

**•**                  Capitalizationof internal software development costs

 

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

 

**RecentDevelopments**

 

**Acquisitionof TSE**

 

In October 2004,we acquired TSE.  TSE’s ***VeriPortTM*** and ***VerifyTM***products are sold to United States of America (“U.S.”) wirelineand wireless carriers, and provide for simulation of the nation’s centralizedNumber Portability Administration Centers (“NPAC”) and a testing environmentfor critical back office systems that carriers use to enable numberportability. Other products in the TSE portfolio are used for enhancedintegration between back office OSS systems. TSE has installed its products at several of the leading wireless andwireline carriers in the U.S. By acquiring TSE, we have expanded our customerbase and our numbering solutions products.

 

**Acquisitionof Tertio**

 

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

 

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

 

**Expansionof Offshore Development Subsidiary**

 

In February 2004,we formed Evolving Systems Networks India Private Limited, a wholly ownedsubsidiary of Evolving Systems (“Evolving Systems India”).  For several years, offshore development,through a subcontractor, had been a key aspect of our low-cost,accelerated-deployment strategy. Having our own offshore subsidiary provides uswith more control, flexibility and lower costs than we had using an offshorethird party contractor. As of September 30, 2005, we had 83 employees in ourIndia office with plans for further expansion as demand dictates.

 

**CustomerSupport Revenue Deferral**

 

Duringthe first and second quarter of 2004, we deferred the recognition of customersupport revenue for one of our largest customers. Under this maintenancearrangement, the customer purchased professional services, specified licensedsoftware upgrades and support services. Since fair value of the undelivered specified licensed software upgradesdid not exist, all of the revenue related to this contract was deferred untilthe specified licensed software upgrades were delivered and accepted by thecustomer.  During the third quarter of2004, we delivered and obtained acceptance of the specified licensed softwareupgrades. Since vendor specific objective evidence of fair value existed forall of the remaining undelivered elements in the arrangement, we recognized theresidual amount of revenue for all delivered elements at that time.  Accordingly, during the three and nine monthsended September 30, 2004, we recognized approximately $1.1 million and $2.1million, respectively of customer support revenue related to thiscontract.  Our 2005 customer supportcontract with the same customer did not contain these additional accountingelements, and was not deferred.

 

**AcceleratedFiler Status**

 

Companiesconsidered accelerated filers under Securities Exchange Act Rule 12b-2, arerequired to comply with the internal control reporting and disclosurerequirements of Section 404 of the Sarbanes-Oxley Act of 2002, for fiscal yearsending on or after November 15, 2004. An accelerated filer is defined as acompany that meets the following conditions as of the end of its fiscal year:

 

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

 

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

 

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

 

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

 

As ofthe last business day of our most recently completed second fiscal quarter,June 30, 2005, our common equity public float was less than $75 million,therefore we are not an accelerated filer, as defined in Securities ExchangeAct Rule 12b-2, and are not required to comply with the management reporting oninternal control over financial reporting for the year ending December 31,2005. In September 2005, the SEC extended for one year the compliance datesregarding the internal control reporting requirements rules for companies thatare not accelerated filers.  If ourfiling status does not change as of June 30, 2006, the next measurement date, wemust begin complying with the internal control reporting and disclosurerequirements for our fiscal year ending December 31, 2007.

 

**CostReductions**

 

InJuly 2005, we undertook cost reduction measures that involved a 10% reductionin our workforce, including individuals at all levels of our U.S. and U.K.operations. The efforts around the cost reductions were also designed to betterintegrate our recent acquisitions. These reductions will save the Company morethan $3.0 million annually, with the impact of the savings realized beginningin the fourth quarter of 2005.  TheCompany paid related severance costs of $477,000 and $580,000, respectively, inthe three and nine months ended September 30, 2005.

 

Tomeet our long-term goals, including revenue growth, we continue to makeinvestments in our products. We are currently investing in both serviceactivation and numbering solutions products to expand the number of productsthat we offer and achieve greater international sales of our existing numberingsolutions products. These activities may cause research and developmentexpenses to increase in future periods compared to prior periods. 

 

**Resultsof Operations**

 

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

 
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| **REVENUE**                                                                  |       |                                  |       |                                 |       |   |   |   |   |
| License fees and services                                                    |       | 50                                    | %          | 14                                   | %          | 50 | % | 38 | % |
| Customer support                                                             |       | 50                                    | %          | 86                                   | %          | 50 | % | 62 | % |
| Total revenue                                                                |       | 100                                   | %          | 100                                  | %          | 100 | % | 100 | % |
|                                                                         |       |                                  |       |                                 |       |   |   |   |   |
| **COSTS OF REVENUE AND OPERATING EXPENSES**                                  |       |                                  |       |                                 |       |   |   |   |   |
| Costs of license fees and services, excluding  depreciation and amortization |       | 24                                    | %          | 14                                   | %          | 26 | % | 18 | % |
| Costs of customer support, excluding depreciation  and amortization          |       | 16                                    | %          | 31                                   | %          | 18 | % | 31 | % |
| Sales and marketing                                                          |       | 25                                    | %          | 16                                   | %          | 25 | % | 16 | % |
| General and administrative                                                   |       | 15                                    | %          | 19                                   | %          | 18 | % | 18 | % |
| Product development                                                          |       | 5                                     | %          | 3                                    | %          | 3 | % | 5 | % |
| Depreciation                                                                 |       | 4                                     | %          | 5                                    | %          | 4 | % | 5 | % |
| Amortization                                                                 |       | 14                                    | %          | 4                                    | %          | 14 | % | 4 | % |
| Restructuring and other expenses (recovery)                                  |       | —                                | %          | —                               | %          | — | % | — | % |
| Total costs of revenue and operating expenses                                |       | 103                                   | %          | 92                                   | %          | 108 | % | 97 | % |
| Income (loss) from operations                                                |       | (3                                    | )%         | 8                                    | %          | (8 | )% | 3 | % |
| Interest income (expense), net                                               |       | (4                                    | )%         | 1                                    | %          | (4 | )% | 1 | % |
| Other income (expense), net                                                  |       | (1                                    | )%         | —                               | %          | (1 | )% | — | % |
| Income (loss) before income taxes                                            |       | (8                                    | )%         | 9                                    | %          | (13 | )% | 4 | % |
| Income tax (expense) benefit                                                 |       | (1                                    | )%         | —                               | %          | — | % | — | % |
| Net income (loss)                                                            |       | (9                                    | )%         | 9                                    | %          | (13 | )% | 4 | % |

 

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**The threeand nine months ended September 30, 2005 compared to the three and nine monthsended September 30, 2004**

 

**Revenue**

 

Revenueis comprised of license fees/services and customer support.  License fees and services revenue representthe fees we receive from the licensing of our software products and thoseservices directly related to the delivery of the licensed product as well asintegration services and time and materials work.  Customer support revenue includes annual support, recurringmaintenance, maintenance upgrades and warranty services.  Warranty services consist of maintenanceservices and are typically bundled with a license sale and the related revenue,based on VSOE, is deferred and recognized ratably over the warranty period.  The following table presents the Company’s approximaterevenue by product group (in thousands).

 

| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **           | ** ** | **2005**                              | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numbering  solutions |       | $                                     | 4,000      |                                 | $          | 4,900 |   | $ | 11,700 |   | $ | 14,300 |   |
| Mediation            |       | 900                                   |       | 800                                  |       | 3,800 |   | 2,500 |   |
| Activation           |       | 4,700                                 |       | —                               |       | 13,800 |   | — |   |
|                 |       | $                                     | 9,600      |                                 | $          | 5,700 |   | $ | 29,300 |   | $ | 16,800 |   |

 

**License Feesand Services**

 

Licensefees and services revenue increased 495% to $4.8 million for the three monthsended September 30, 2005, from $810,000 for the three months ended September 30,2004.  License fees and services revenueincreased 128% to $14.6 million for the nine months ended September 30, 2005,from $6.4 million for the nine months ended September 30, 2004.  The increase in license fees and servicesrevenue is due to activation sales related to products acquired in the Tertioacquisition, offset by lower revenue from our number solutions products.  The decline in number solutions products isdue to industry consolidation and smaller overall license sales, which isreflective of the maturity of the narrowband numbering solutions market in theU.S.

 

**Customer Support**

 

Customersupport revenue decreased 4% to $4.7 million for the three months ended September30, 2005, from $4.9 million for the three months ended September 30, 2004.  Third quarter numbering solutions revenue waslower in 2005, compared to 2004, because of the recognition in the thirdquarter of 2004 of a previously deferred, large customer support contract forapproximately $1.1 million.  This decreasein customer support revenue during the third quarter of 2005 was offset by increasedrevenue related to the support of activation products acquired in the Tertioacquisition.

 

Customersupport revenue increased 42% to $14.7 million for the nine months ended September30, 2005, from $10.4 million for the nine months ended September 30, 2004.  The increase in customer support revenueduring the first nine months of 2005 is due to increased revenue related to thesupport of activation products acquired in the Tertio acquisition, partiallyoffset by price reductions in certain customer support contracts.

 

**Costs ofRevenue, Excluding Depreciation and Amortization**

 

Costs of revenue, excluding depreciation andamortization, consist primarily of personnel costs, facilities costs, the costsof third-party software and all other direct costs associated with thesepersonnel. Total costs of revenue, excluding depreciation and amortization,were $3.9 million and $2.6 million for the three months ended September 30, 2005and 2004, respectively and $12.9 million and $8.3 million for the nine monthsended September 30, 2005 and 2004, respectively.  These costs are discussed further, below.

 

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

 

Costsof license fees and services, excluding depreciation and amortization, were $2.3million and $808,000 for the three months ended September 30, 2005 and 2004,respectively.  The increase of $1.5million, or 183%, is due to more projects in delivery as a result of the Tertioacquisition. As a percentage of license fees and services revenue, costs oflicense fees and services, excluding depreciation and amortization, decreasedto 47% for the three months ended September 30, 2005 from 99% for the threemonths ended September 30, 2004.  Thedecrease as a percentage of license fees and services revenue was due tocertain fixed costs being applied to a low level of revenue in 2004.

 

Costsof license fees and services, excluding depreciation and amortization, were $7.7million and $3.0 million for the nine months ended September 30, 2005 and2004, respectively.  The increase of $4.7million, or 155%, is due to more projects in delivery as a result of the Tertioacquisition, as well as additional costs incurred in the first half of the yearrelated to transitioning from using third-party consultants for U.K.development to utilizing Evolving Systems personnel in India, via our offshoredevelopment model. As a percentage of license fees and services revenue, costsof license fees and services, excluding depreciation and amortization,increased to 52% for the nine months ended September 30, 2005 from 47% for the ninemonths ended September 30, 2004.  Theincrease as a percentage of

 

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license fees and servicesrevenues was due to the aforementioned additional costs in the first half ofthe year related to the U.K. development transition to our offshore developmentmodel, including some duplicate operations during the transition, offset bysavings from our offshore development model and certain fixed costs beingapplied to a higher level of revenue in 2005.

 

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

 

Costsof customer support, excluding depreciation and amortization, were $1.6 millionand $1.8 million for the three months ended September 30, 2005 and 2004,respectively.  The decrease of $229,000,or 13%, is due to savings from transitioning to using Evolving Systems India personnel,offset by additional projects from the Tertio and TSE acquisitions.  As a percentage of customer support revenue, costsof customer support revenue, excluding depreciation and amortization, decreasedto 33% for the three months ended September 30, 2005 from 37% for the threemonths ended September 30, 2004.  Thedecrease as a percentage of customer support revenue was due to the higherlevel of revenue in the third quarter of 2004 arising from the large customersupport contract described above, as well as the savings from transitioning tousing Evolving Systems India personnel.

 

Costsof customer support, excluding depreciation and amortization, were $5.2 millionand $5.3 million for the nine months ended September 30, 2005 and 2004,respectively.  The decrease of $100,000,or 1%, is due to decreased fees for third party software maintenance andsavings from transitioning to using Evolving Systems India personnel, offset byadditional projects from the Tertio and TSE acquisitions and the cost in thefirst half of the year to transition to using Evolving Systems India personnel.  As a percentage of customer support revenue,costs of customer support revenue, excluding depreciation and amortization,decreased to 36% for the nine months ended September 30, 2005 from 51% for thenine months ended September 30, 2004.  Thedecrease as a percentage of customer support revenue was due to savings fromour offshore development model, decreased fees for third party softwaremaintenance, and certain fixed costs being applied to a higher level of revenuein 2005, offset by the aforementioned additional costs in the first half of theyear related to transitioning to our offshore development model.

 

**Sales andMarketing**

 

Salesand marketing expenses primarily consist of compensation costs, including bonusesand commissions, travel expenses, advertising and occupancy expenses.  Sales and marketing expenses were $2.4million and $942,000 for the three months ended September 30, 2005 and 2004,respectively. The increase of $1.5 million, or 158%, is due to additional costsfrom Evolving Systems U.K. and TSE, expenses in the U.S. related to increasedheadcount for sales initiatives designed to penetrate new markets, as well as anew company marketing campaign.  As apercentage of total revenue, sales and marketing expenses for the three monthsended September 30, 2005 and 2004, increased to 25% from 16%, respectively.  The increase as a percentage of revenue isdue to the combination of increased expenses from Evolving Systems U.K. and theincreased expenses in the U.S., which exceeded the increase in revenue duringthe period.

 

Salesand marketing expenses were $7.2 million and $2.8 million for the nine monthsended September 30, 2005 and 2004, respectively. The increase of $4.5 million,or 161%, is due to additional costs from Evolving Systems U.K. and TSE, increasedexpenses in the U.S. related to increased headcount for sales initiativesdesigned to penetrate new markets, and a new company marketing campaign.  As a percentage of total revenue, sales andmarketing expenses for the nine months ended September 30, 2005 and 2004, increasedto 25% from 16%, respectively.  Theincrease as a percentage of revenue is due to the combination of increasedexpenses from Evolving Systems U.K. and TSE, and the increased expenses in theU.S., which exceeded the increase in revenue during the period.

 

**Generaland Administrative**

 

Generaland administrative expenses consist principally of employee related costs andprofessional fees for the following departments: facilities, finance, legal,human resources, and executive management. General and administrative expenses were $1.4 million and $1.1 million forthe three months ended September 30, 2005 and 2004, respectively.  The increase of $344,000, or 31%, is primarilydue to costs from Evolving Systems U.K. As a percentage of total revenue, general and administrative expenses forthe three months ended September 30, 2005 and 2004, decreased to 15% from 19%,respectively.  The decrease as a percentageof revenue is due to the increase in revenue from Evolving Systems U.K. andTSE, partially offset by the combination of increased expenses from EvolvingSystems U.K..

 

Generaland administrative expenses were $5.4 million and $3.0 million for the ninemonths ended September 30, 2005 and 2004, respectively.  The increase of $2.4 million, or 83%, isprimarily due to costs related to the integration of Tertio, expenses fromEvolving Systems U.K., and increased expenses in the U.S. related to significantlyhigher levels of professional fees.  As apercentage of total revenue, general and administrative expenses for the ninemonths ended September 30, 2005 and 2004, was 18%.  The expense as a percentage of revenue heldsteady due to the combination of increased expenses from Evolving Systems U.K.and increased professional fees in the U.S., which was matched by the increasein revenue during the period.

 

**ProductDevelopment**

 

Productdevelopment expenses consist primarily of employee related costs, offshoredevelopment subcontractor expenses and costs to start up our offshore Indianfacility.  Product development expenseswere $452,000 and $152,000 for the three months ended September 30, 2005 and2004, respectively. The increase of $300,000, or 198%, is due to costs relatedto development work on international numbering solutions products andadditional work on our activation products, such as Tertio Content Connector.  As a percentage of revenue, productdevelopment expenses for the three months ended September 30, 2005 and 2004,increased to 5% from

 

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3%, respectively.  The increase in costs as a percentage ofrevenue is due to additional research and development efforts in the thirdquarter of 2005 that have not yet resulted in an increase in revenue during thequarter.

 

Productdevelopment expenses were $1.1 million and $884,000 for the nine months ended September30, 2005 and 2004, respectively. The increase of $174,000, or 20%, is due to costsrelated to development work on new activation and billing mediation productsand features, and international numbering solutions products.  As a percentage of revenue, productdevelopment expenses for the nine months ended September 30, 2005 and 2004,decreased to 3% from 5%, respectively. The decrease as a percentage of revenue is primarily due to theincreased revenue during 2005 compared to 2004, partially offset by additionalresearch and development efforts in the second and third quarters of 2005 thathave not yet resulted in an increase in revenue.

 

**Amortization**

 

Amortizationexpense consists of amortization of identifiable intangibles from ouracquisitions of CMS, TSE and Tertio. Amortization expense was $1.4 million and$213,000 for the three months ended September 30, 2005 and 2004,respectively.  The increase inamortization expense of $1.1 million, or 534%, is due to amortization relatedto identifiable intangibles from the acquisitions of Tertio and TSE.  As a percentage of revenue, amortizationexpense for the three months ended September 30, 2005 and 2004, increased to 14%from 4%, respectively.  The increase as apercentage of revenue is due to the aforementioned increase in expenses, which wasgreater than the increase in revenue during the period.

 

Amortizationexpense was $4.2 million and $646,000 for the nine months ended September 30,2005 and 2004, respectively.  Theincrease in amortization expense of $3.5 million, or 546%, is due toamortization related to identifiable intangibles from the acquisitions ofTertio and TSE.  As a percentage ofrevenue amortization expense for the nine months ended September 30, 2005 and2004, increased to 14% from 4%.  Theincrease as a percentage of revenue is due to the aforementioned increase inexpenses, which was greater than the increase in revenue during the period.

 

**Restructuringand Other Expenses (Income)**

 

Weclosed all of our satellite field offices during 2002.  Because the costs to sublease or terminatethese lease commitments are based on estimates, we may incur additional costsrelated to the satellite office closures. During the three months ended September 30, 2005 we recorded a net expenseof $4,000, related to a lease deposit withholding of $7,000 and a recovery of$3,000.  During the nine months endedSeptember 30, 2005, we recorded a net recovery of $48,000 related to theclosure of the satellite offices, as the actual costs to close these facilitieswere less than our original estimate. As of September 30, 2005 approximately $9,000was included in accounts payable and accrued liabilities related to the closureof the satellite offices.

 

**InterestIncome (Expense), Net**

 

Interestincome (expense), net was ($372,000) and $89,000 for the three months endedSeptember 30, 2005.  Interest income(expense), net was ($1.1 million) and $213,000 for the nine months endedSeptember 30, 2005.  The changes for thethree and nine month periods of $461,000 and $1.3 million, respectively, weredue primarily to the interest expense on the notes payable associated with theacquisition of Tertio and TSE.

 

**Other Income(Expense), Net**

 

Otherincome (expense), net, was ($99,000) and $3,000 for the three months ended September30, 2005 and 2004, respectively.  Otherincome (expense), net, was ($273,000) and $3,000 for the nine months endedSeptember 30, 2005 and 2004, respectively. The changes for the three and nine month periods of $102,000 and$276,000, respectively, related to foreign currency transaction losses notpresent before the acquisition of Tertio in the fourth quarter of 2004.

 

**IncomeTaxes**

 

TheCompany recorded net income tax (expense) benefit of $(117,000) and $177,000for the three and nine months ended September 30, 2005, respectively. The netbenefit during the three and nine months ended September 30, 2005 consists ofcurrent income tax expense of approximately $419,000 and $1.0 million,respectively and a deferred tax benefit of $302,000 and $1.2 million,respectively, both of which are related to the Company’s UK-based operations.

 

Inconjunction with the acquisition of Tertio, certain identifiable intangibleassets were recorded.  Since the identifiableintangible amortization is not deductible for income tax purposes, a long-termdeferred tax liability of $4.6 million was established at the acquisition datefor the expected difference between what would be expensed for financialreporting purposes and what would be deductible for income tax purposes. As of September30, 2005, this deferred tax liability was $3.3 million. This deferred taxliability is carried on the books of the Company’s United Kingdom subsidiary,and has no impact on the Company’s ability to recover its U.S.-based deferredtax assets.

 

Inconjunction with the acquisition of Tertio, future revenue under contracts inexistence at the acquisition dates was reduced to an amount equal to theCompany’s estimated costs to fulfill its obligations under the contracts plus areasonable profit margin on the Company’s estimated fulfillment effort.  The resulting reduction of future revenuerecorded for financial reporting purposes is not deductible for income taxpurposes and, thus, a current deferred tax liability of approximately $600,000was established at the acquisition date. As of September 30, 2005, thisdeferred tax liability was $98,000.  Bothof the aforementioned deferred tax liabilities will be recognized as areduction of deferred income tax expense as the identifiable intangibles areamortized and the contract revenue is recognized.

 

21

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**Liquidityand Capital Resources**

 

Wehave historically financed operations through cash flows from operations andequity transactions.  At September 30,2005, our principal source of liquidity was $3.4 million in cash and cashequivalents.

 
| ** **                | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| Cash provided  (used) by: |       |                                |       |   |   |
| Operating activities      |       | $                                   | 1,028      |   | $ | 3,381 |   |
| Investing activities      |       | (1,183                              | )          | (1,041 | ) |
| Financing activities      |       | (7,435                              | )          | 356 |   |
| Effect of exchange rates  |       | (373                                | )          | (3 | ) |
| Net cash provided (used)  |       | $                                   | (7,963     | ) | $ | 2,693 |   |

 

Netcash provided by operating activities consists primarily of our net income(loss), adjusted for non-cash charges (including depreciation, amortization, interestexpense and deferred taxes) and changes in working capital. Our net income(loss) for the nine months ended September 30, 2005 and 2004, was $(3.8)million and $593,000, respectively, while our non-cash charges were net sourcesof $5.1 million and $1.4 million, respectively. For the nine months ended September 30, 2005 and 2004, the primaryworking capital factors were contract receivables (a source of $6.0 million and$7.1 million, respectively) and unearned revenue (a use of $4.9 million and$5.7 million, respectively).

 

Netcash used by investing activities during the nine months ended September 30,2005 and 2004, was for capital expenditures of $656,000 and $1.1 million,respectively, primarily for domestic internal hardware that improvedperformance and reliability of our product development environment, as well asservers and computers for Evolving Systems India, as well as net cash outflowsof $545,000 in 2005 related to the TSE acquisitions.

 

Financingactivities in the nine months ended September 30, 2005, consisted primarily ofprincipal payments on notes payable of $4.9 million, and payments to the Tertiosellers of $2.6 million.  Cash providedby financing activities for the nine months ended September 30, 2005 and 2004,related to proceeds from the issuance of stock of $94,000 and $377,000,respectively.

 

Workingcapital (deficit) at September 30, 2005 was ($6.5) million compared to ($3.3)million at December 31, 2004. As previously mentioned, we acquired twocompanies, TSE and Tertio, during the fourth quarter of 2004. We made net paymentsof approximately $8.1 million during the nine months ended September 30, 2005related to notes payable, an acquired dividend obligation assumed, andcontingent consideration related to the TSE and Tertio acquisitions. The acquisitionof Tertio also included the issuance of long-term seller-financed notes (“Long-TermNotes”) of approximately $11.9 million of which $4.5 million is due within thenext twelve months. We believe that our current cash and cash equivalents,together with anticipated cash flow from operations will be sufficient to meetour working capital and capital expenditure requirements for at least the nexttwelve months. In making this assessment we considered the following:

 

•                  Ourcash and cash equivalents balance at September 30, 2005 of $3.4 million.

 

•                  Ourability to generate positive cash flows from operations. During 2003, 2004 andthe nine months ended September 30, 2005 we generated cash flows fromoperations of $6.9 million, $4.3 million and $1.0 million, respectively.

 

•                  Ourbacklog of approximately $13.8 million, including $4.6 million in license feesand services and $9.2 million in customer support at September 30, 2005.

 

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

 

•                  NotwithstandingLong-Term Notes restructuring, our cash forecast indicates that we will havesufficient liquidity to cover anticipated operating costs as well as debtservice payments.

 

To theextent we are unable to invoice and collect in a timely manner under ourcustomer revenue arrangements, it could have a material adverse impact on ourability to meet our intended business objectives. Management believes that wehave the ability to further reduce operating expenses, if necessary, such thatcurrent working capital (exclusive of deferred revenue) and cash flows fromoperations will be adequate to meet our cash needs through the next twelvemonths.

 

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

 

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us and would not bedilutive.

 

On November 14,2005, we replaced our Long-Term Notes with the Tertio Sellers with aSubordinated Note, and entered into a Senior Term Note and a Senior RevolvingFacility with a commercial finance company. The new debt agreements improve our liquidity position by extending ourprincipal payments and providing additional borrowing capacity.

 

The$8.5 million Senior Term Note bears interest at LIBOR plus an applicablemargin.  The LIBOR rate varies, but canbe no less than 3.75%.  LIBOR wasapproximately 4.1% on November 14, 2005. The standard applicable margin of 6.25% may be reduced to 5.25% as wemeet and maintain certain financial requirements.  The Senior Term Note requires quarterlyprincipal and monthly interest payments through October 2010.

 

Weused the $8.5 million proceeds of the Senior Term Note to pay down a portion ofour Long-Term Notes with the Tertio sellers. The Long-Term Notes were exchanged for unsecured Subordinated Notes ofapproximately $4.9 million, bearing interest at 11% through December 31,2007, and 14% thereafter.  TheSubordinated Notes are payable in full, including accrued interest, in May 2011.

 

Acomparison of the scheduled principal payments under our new and old notes isas follows (in thousands):

 

| **Year ending  December 31,** | ** ** | **New  Amount** | ** ** | **Old  Amount** | ** ** |
|------------------------------------|------------|-----------------|------------|-----------------|------------|
| 2006                               |       | $               | 1,000      |            | $          | 5,900 |   |
| 2007                               |       | 2,000           |       | 7,500           |       |
| 2008                               |       | 2,500           |       | —          |       |
| 2009                               |       | 2,000           |       | —          |       |
| 2010                               |       | 1,000           |       | —          |       |
| Thereafter                         |       | 4,900           |       | —          |       |
|                               |       | $               | 13,400     |            | $          | 13,400 |   |

 

Additionally,we obtained a $4.5 million Senior Revolving Facility that bears interest atLIBOR plus 4.0%, and has an annual management fee of 0.05%.  The LIBOR rate varies, but can be no lessthan 3.75%.  Borrowings under the SeniorRevolving Facility are limited to a multiple of our EBITDA, as defined, lessthe balance of the Senior Term Note.  Themultiple ranges from 2.50 in the first year to 1.75 in the fourth year.  The agreement mandates an initial borrowingof $2.0 million.  The Senior RevolvingFacility requires monthly payments of interest and fees, with the unpaidbalance due in October 2010.

 

**FactorsThat Might Affect Operating Results**

 

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

 

**Risksrelated to Tertio Acquisition**

 

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

 

Historicallysales of our products have been limited to customers in the United States. Priorto our acquisition of Tertio, our only international operational experience waswith our Indian offshore activities. The acquisition of Tertio resulted in theaddition of significant sales and operations outside the United States,including Europe, Asia and Africa. If we are unable to manage our sales andoperations on a global basis, our financial condition or results of operationscould be materially adversely affected. Our international business is subject to financial and operating risksincluding:

 

**•**                  unexpected changes in, or impositions of, legislative orregulatory requirements;

 

**•**                  difficulties inmaintaining effective controls over financial reporting across geographicallydispersed entities, including those related to different business practices inforeign countries;

 

**•**                  internal control-related risks of running a foreignsubsidiary;

 

**•**                  changes in thedemand for our products and services due to the perception that we are an “American”company in countries where the United States’ foreign policy is not viewedfavorably;

 

**•**                  fluctuating exchange rates, tariffs,currency repatriation restrictions and other barriers;

 

**•**                  difficulties in staffing and managingforeign subsidiary operations;

 

**•**                  import or export restrictions;

 

**•**                  greater difficulties in accountsreceivable collection and longer payment cycles;

 

23

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**•**                  potentiallyadverse tax consequences and additional tax considerations such as foreignwithholding taxes and payment of value added tax (VAT);

 

**•**                  potential hostilities and changes indiplomatic and trade relationships;

 

**•**                  changes in a country’s economic orpolitical conditions; and

 

**•**                  differing customer and/or technologystandards requirements.

 

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

 

In consideration for our acquisition of Tertio, wemade a cash payment of $11.0 million, issued 966,666 shares of Series BRedeemable Convertible Preferred Stock (the Series B Preferred Stock), issued ashort-term secured note with a principal amount of $4.0 million bearinginterest at 5.5% per annum and issued long-term secured notes with an aggregateprincipal amount of approximately $11.9 million bearing interest initially at11% per annum (increasing to 14% on the second anniversary).  Each shareof Series B Preferred Stock is initially convertible into three shares of ourcommon stock which could result in the issuance of up to 2,899,998 shares ofour common stock. 

 

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

 

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

 

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

 

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

 

The holders of the Series B Preferred Stock havepreferential rights with respect to distributions upon a liquidation ofEvolving Systems, including certain business combinations deemed to be aliquidation.  Accordingly, no distributions upon liquidation may be madeto the holders of common stock until the holders of the Series B PreferredStock have been paid their liquidation preference of $3.89 per share (on an asconverted common stock basis), subject to adjustment. As a result, it ispossible that, on liquidation, all amounts available for the holders of equityof Evolving Systems would be paid to the holders of the Series B PreferredStock, and that the holders of common stock would not receive anypayment.  Additionally, in connection with the Tertio acquisition we areobligated to file and keep effective a registration statement providing for theresale of the shares of our common stock issuable upon the conversion of theSeries B Preferred Stock.  If we fail to keep the registration statementeffective, the holders of the Series B Preferred Stock will have the right tocause us to repurchase for cash the shares of the Series B Preferred Stock for$3.89 per share (on an as converted basis), or approximately $11.3 million. Ifwe are required to make this payment, it would have a significant adverseimpact on our liquidity and could cause us to incur additional indebtedness.

 

Additionally, the Series B Preferred Stock containscertain weighted average price based anti-dilution protections that, as long asthey remain outstanding, would be triggered if we issued shares of our commonstock (subject to certain adjustments and

 

24

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standard exclusionsrelating to Company options) below $3.89 per share. However, such anti-dilutionadjustments are capped to prohibit the Series B Preferred Stock from convertinginto 20% or more of our outstanding common stock.

 

In the event that we issued shares below thisthreshold, the holders of our common stock would be diluted to an unknowndegree.  Furthermore, the mere existenceof such anti-dilution protections could make it difficult for us to issue anycommon stock below $3.89 per share, if at all. In the event the anti-dilution adjustments of the Series B PreferredStock are triggered, such adjustments would result in a deemed dividend to theSeries B Preferred Stock holders that would reduce income available to commonstockholders.  The charge would be equalto the number of additional shares issuable as a result of the anti-dilutioncalculation, multiplied by the fair value of the common stock on the date ofthe issuance of the Series B Preferred Stock, which was $4.64 per share.  The deemed dividend charge could negativelyaffect the price of our common stock.

 

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

 

The indebtedness incurred with respect to thelong-term secured notes and, possibly, the redemption of the Series B PreferredStock, is material in relation to our current level of indebtedness.  Noassurance can be given that sufficient funds will be available to meet ouroperating needs, to pay the interest due on the long-term secured notes or, ifrequired, to redeem the Series B Preferred Stock.  The notes are securedby a general lien on all of our assets.  If we are unable to pay the notesas they become due, the holders of the notes could foreclose on all of ourassets.  The increased level of ourindebtedness, among other things, could:

 

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

 

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

 

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

 

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

 

***The terms and conditions of the Series B Preferred Stock mayhave an adverse impact on our results of operations and financial performance.***

 

The inability to keep the registration of the Series BPreferred Stock effective could result in the Series B Preferred Stock becomingmandatorily redeemable.  Currently, theSeries B Preferred Stock is classified as non-permanent equity since the eventsthat would require its redemption have not occurred.  If we fail to maintain the effectiveness ofthe related registration statement, the Series B Preferred Stock will becomemandatorily redeemable at the option of the holders and the instrument will bereclassified as a liability.  Uponreclassification, the Series B Preferred Stock will be re-measured at its thencurrent fair value and the difference between its fair value and redemptionprice will be charged to additional paid-in capital.  Such a charge to equity may negatively impactthe price of our common stock. Subsequent changes to the fair value of this instrument would berecognized in earnings, as a charge or income, and such amounts could besignificant and unpredictable. 

 

***Certain provisions of the notes payable issued inconjunction with the Tertio acquisition call for the acceleration of paymentsif certain covenants are breached or cash balance thresholds are achieved.***

 

The notes issued inconjunction with the Tertio acquisition contain certain affirmative andnegative covenants that, if breached, could result in such notes becomingimmediately due and payable. The covenants include the Company’s agreement todo the following:

 

**•**                  comply with applicable laws and licensingrequirements;

 

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

 

**•**                  operate in the ordinary course of business.

 

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

 

**•**                  liquidate, dissolve or wind-up operations;

 

25

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**•**                  pay any dividends or make prepayments on anyindebtedness;

 

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

 

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

 

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

 

**•**                  make capital expenditures beyond establishedthresholds; or

 

**•**                  take certain other operational actions.

 

The covenants may limitthe Company’s flexibility in planning for, or reacting to changes in, itsbusiness. Failure to comply with such covenants, if not waived, could result inthe acceleration of the notes. If the Company is required to pay the notes onan accelerated basis, it would have a significant adverse impact on the Company’sliquidity and financial condition and could cause us to incur additionalindebtedness.

 

Additionally, the notesissued in conjunction with the Tertio acquisition require us to offer the noteholders a prepayment on such notes in the amount that our closing cash balanceexceeds $7.0 million at the end of any fiscal quarter beginning with thequarter ended March 31, 2005. Such a requirement will restrict ourliquidity and cash management flexibility. Until the notes are repaid, ourability to engage in transactions or to enter into agreements requiringsignificant cash investments may be adversely affected.

 

**RisksRelated to Our Business**

 

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

 

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

 

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

 

•                  ourrate of progress under our contracts;

 

•                  acquisition and integration costs;

 

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

 

•                  our ability to effectively manage offshoresoftware development in India;

 

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

 

•                  judicialor administrative actions about these laws or regulations;

 

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

 

•                  productlifecycles;

 

•                  themix of products and services sold;

 

•                  changesin demand for our products and services;

 

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

 

•                  budgetingcycles of our customers;

 

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

 

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

 

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

 

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

 

•                  softwaredefects and other product quality problems;

 

26

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•                  changesin our strategy;

 

•                  theextent of industry consolidation;

 

•                  foreignexchange fluctuations; and

 

•                  generaleconomic conditions.

 

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

 

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

 

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

 

Our cash forecastindicates that we will have sufficient liquidity to cover anticipated operatingcosts as well as debt service payments for at least the next twelve months, butto the extent we are unable to invoice and collect in a timely manner under ourcustomer revenue arrangements, or an unexpected adverse event, or combinationof events occurs, it could have an adverse impact on our ability to meet ourintended business objectives. Therefore, if the timing of cash generated fromoperations is insufficient to satisfy our liquidity requirements, we mayrequire access to additional funds to support our business objectives through debtrestructuring, a credit facility or possibly the issuance of additional equity.There can be no assurance that additional financing will be available at all orthat if available, such financing will be obtainable on terms favorable to usand would not be dilutive.

 

***Ourinternational operations pose complex foreign currency, economic, regulatoryand tax risks, which may have a material adverse effect on our business, financial conditionand results of operations.***

 

For the three and nine months ended September 30,2005, we generated revenue of approximately $5.0 million and $15.1 million,respectively, from our foreign subsidiaries, representing 53% and 51%,respectively, of our total consolidated revenue.  We anticipate that international revenue willcontinue to account for a significant percentage of our total revenue.  Our international operations are subject tothe risk factors inherent in the conduct of international business, including:

 

•                   unexpected changes in regulatoryrequirements; 

 

•                    tariffs andother barriers;

 

•      political and economic instability;

 

•      limited intellectual property protection;

 

•      difficulties in staffing and managingforeign operations; and

 

•                   potentially adverse tax consequencesin connection with repatriating funds.

 

We may not be able to sustain or increase ourinternational revenue or repatriate cash without incurring substantial risksinvolving floating currency exchange rates and income tax expenses.  Any of the foregoing factors may have amaterial adverse effect on our international operations and, therefore, ourbusiness, financial condition and results of operations.

 

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

 

Themarket for our traditional North American OSS products was created and hasprimarily been driven by the adoption of regulations under the Telecom Actrequiring Regional Bell Operating Companies (“RBOCs”) to implement LNP as acondition to being permitted to provide long distance services. Therefore, anychanges to these regulations, or the adoption of new regulations by federal orstate regulatory authorities under the Telecom Act, or any legal challenges tothe Telecom Act, could hurt the market for our products and services. Forexample, when the FCC delayed implementation of the Telecom Act with respect towireless carriers until November 2003, these delays had an impact on ourrevenue from our WNP products and services. Likewise, in mid-2001 when VerizonWireless petitioned the FCC requesting forbearance from this requirement, wesaw our wireless customers delay making

 

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decisions to purchase WNPproducts. WNP went into effect in November 2003.  Any invalidation, repeal or modification inthe requirements imposed by the Telecom Act or the FCC, could materially harmour business, financial condition and results of operations. In addition,customers may require, or we may find it necessary or advisable, to modify ourproducts or services to address actual or anticipated changes in regulationsaffecting our customers. This could also materially harm our business,financial condition, results of operations, and cash flows.  Additionally, with our acquisition of Tertio,we are now subject to numerous regulatory requirements of foreignjurisdictions.  Any compliance failuresor changes in such regulations could also materially harm our business,financial condition, results of operations and cash flows.

 

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

 

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

 

***The integration of entities that we have recentlyacquired may not achieve the expected results and may result in unexpectedliabilities and costs***

 

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

 
| **•** |   | we may have  difficulty assimilating the operations and personnel of the acquired company;                                                                                                                                                              |
|------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | we may have  difficulty effectively integrating the acquired technologies or products with  our current products and technologies;                                                                                                                      |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | we may incur  unanticipated liabilities that are not covered by our indemnification rights  under the applicable acquisition agreements;                                                                                                                |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | customers of the  acquired company may decide not to renew their contracts with the combined  entity and other ongoing business may be disrupted by transition and  integration issues;                                                                 |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | we may not be  successful in cross-selling products between Evolving Systems’ and the  acquired companies’ customer bases;                                                                                                                    |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | the financial  and strategic goals for the acquired and combined businesses may not be  achieved;                                                                                                                                                       |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | due diligence  processes may have failed to identify significant issues with product  quality, intellectual property ownership, product architecture, legal and  financial contingencies, and product development;                                      |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | significant  impairment charges may be recorded if intangible assets, including goodwill,  acquired in business combinations are determined to be unrecoverable or impaired;                                                                            |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | acquisitions and  their subsequent integration require considerable time and commitment of  management, which can distract management from day-to-day operations and  result in additional costs which reduce profits;                                  |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | we do not know  if we have or will be able to identify and purchase assets and/or companies  that will complement our business;                                                                                                                         |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | our stockholders  may experience additional dilution of their interests in Evolving Systems as  a result of the issuance of convertible preferred stock, other convertible  instruments and/or common stock in connection with our acquisitions;        |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | certain  management and other employees of Tertio and TSE, or future acquisitions, may  be critical to the success of the acquired company, and we do not know if we  will be successful in retaining these individuals in the combined companies;  and |
|       |   |                                                                                                                                                                                                                                                    |
| •     |   | the price of our  stock may go down as stockholders who received stock in prior acquisitions,  or any future transaction, elect to sell their shares, or the marketplace  does not favorably view the transaction.                                      |

 

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

 

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

 

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

 

Themajority of our existing contracts provide for acceptance testing by thecustomer, which can be a lengthy process. Unanticipated difficulties or delaysin the customer acceptance process could result in higher costs, delayedpayments, and deferral of revenue recognition. In addition, if our softwarecontains defects or we otherwise fail to satisfy acceptance criteria withinprescribed times, the customer may be entitled to cancel its contract andreceive a refund of all or a portion of amounts paid or other amounts asdamages, which could exceed related contract revenue and which could result ina future charge to earnings. Any failure or delay in achieving final acceptanceof our software and services could have a material harmful effect on ourbusiness, financial condition, results of operations and cash flows.

 

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

 

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

 

Mergersand acquisitions of large communications companies, as well as the formation ofnew alliances, have resulted in a constantly changing marketplace for ourproducts and services. Delays associated with these changes are common. Theseconsolidations have caused us to lose customers and it is possible that wecould lose additional customers as a result of more consolidations. Inaddition, the U.S. communications industry is still recovering from an industrydownturn which began in 2000, and many of the companies in the communicationsindustry have kept capital expenditures at historically low levels in responseto changes in the communications marketplace; some companies have declaredbankruptcy, cancelled contracts, delayed payments to their suppliers or delayedadditional purchases.  The delay orfailure to complete one or more large contracts, or the loss of a significantcustomer, could materially harm our business, financial condition, results ofoperations, or cash flows, and cause our operating results to varysignificantly from quarter to quarter and year to year.

 

***Many of ourproducts and services are sold on a fixed-price basis.  If we incur budget overruns, our margins andresults of operations may be materially harmed.***

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

In February 2004,we formed Evolving Systems India, a wholly owned subsidiary of EvolvingSystems, to transfer the services provided by our Indian subcontractor,Infosys, to Evolving Systems India.  Ifwe are unable to effectively manage the Evolving India development staff and/orwe experience high levels of staff turnover, we may fail to provide qualitysoftware in a timely fashion, which could negatively affect our ability tosatisfy our customer contracts. Furthermore, political changes and uncertainties in India couldnegatively impact the business climate there. As a result, we may be unable to satisfactorily perform our customercontracts and our business, financial condition and results of operations couldbe materially harmed.

 

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

 

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

 

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

 

•                  howwell we respond to our customers’ needs;

 

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

 

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

 

•                  howwell we manage our projects;

 

•                  ourtechnical subject matter expertise;

 

•                  thequality of our customer service and support;

 

•                  theemergence of new industry standards;

 

•                  thedevelopment of technical innovations;

 

•                  ourability to attract and retain qualified personnel;

 

•                  regulatorychanges; and

 

•                  generalmarket and economic conditions.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

•                  Such open source software may be madeavailable under a license such as the GNU General Public License (“GPL”) or

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

***We are subject tocertain rules and regulations of federal, state and financial market exchangeentities, the compliance of which requires substantial amounts of managementtime and company resources.***

 

Becauseour common stock is publicly traded, we are subject to certain rules andregulations of federal, state and financial market exchange entities chargedwith the protection of investors and the oversight companies whose securitiesare publicly traded.  These entities,including the Public Company Accounting Oversight Board, the SEC and theNasdaq, have recently issued new requirements and regulations and are currentlydeveloping additional regulations and requirements in response to recent lawsenacted by Congress, most notably the Sarbanes-Oxley Act of 2002.  Our compliance with certain of these rules,such as Section 404 of the Sarbanes-Oxley Act, is likely to require thecommitment of significant managerial resources. We are currently reviewing ourmaterial internal control systems, processes and procedures for compliance withthe requirements of Section 404. There can be no assurance that such a review will not result in theidentification of significant deficiencies or material weaknesses in our internalcontrols.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

***General risk statement.***

 

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

 

ITEM  3.  QUANTITATIVE ANDQUALITATIVE MARKET RISK DISCLOSURES

 

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

 

**ForeignExchange Risk**

 

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

 

TheCompany has assets and liabilities, including a substantial portion of itsintangible assets and its cash balances, in its United Kingdom subsidiary,denominated in the British Pound.  To the extent that the exchange ratebetween the US Dollar and the British pound fluctuates, such fluctuation willhave an impact on the Company’s comprehensive income in the form of translationadjustments, and could have an impact on the Company’s liquidity position inthat the Company’s UK cash balances are maintained in British Pounds.

 

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

 

**InterestRate Risk**

 

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

 

ITEM 4.  CONTROLSAND PROCEDURES

 

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

 

(b) Changesin internal controls. There has not been any change in our internal controlover financial reporting (as such term is defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act of 1934, as amended) during theperiod covered by this report, that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

**PART II.  OTHER INFORMATION**

 

ITEM 1. LEGAL PROCEEDINGS

 

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

 

ITEM 6. EXHIBITS

 

(a)          Exhibits

 

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

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

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

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

 

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**SIGNATURE**

 

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

 
| Date: November 14,  2005 | /s/ BRIAN R.  ERVINE                          |   |
|-------------------------------|-----------------------------------------------|--------|
|                          | Brian R. Ervine                               |
|                          | Executive Vice  President, Chief              |
|                          | Financial and  Administrative Officer,        |
|                          | Treasurer and  Assistant Secretary            |
|                          | (Principal  Financial and Accounting Officer) |

 

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