Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

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

 

**For the quarterly period ended September 30,2008**

 

**OR**

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

 

**For the transition periodfrom               to**

 

**Commission File Number: 0-24081**

** **

**EVOLVING SYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

 

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

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past90 days.  Yes xNo o

 

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

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

 

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

 

As of October 31, 2008 there were 19,401,786shares outstanding of Registrant’s Common Stock (par value $0.001 per share).

 

 

 

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**EVOLVING SYSTEMS, INC.**

**Quarterly Report on Form 10-Q**

**September 30, 2008**

**Table of Contents**

 
| **PART I  – FINANCIAL INFORMATION** |
|-----------------------------------------------|
| Item 1                                        | Financial  Statements |
|                                          | Condensed  Consolidated Balance Sheets as of September 30, 2008 and  December 31, 2007 (Unaudited) |
|                                          | Condensed Consolidated  Statements of Operations for the Three and Nine Months Ended  September 30, 2008 and 2007 (Unaudited) |
|                                          | Condensed Consolidated Statements of Changes In  Stockholders’ Equity and Comprehensive Income (Loss) for the Nine Months  Ended September 30, 2008 (Unaudited) |
|                                          | Condensed Consolidated  Statements of Cash Flows for the Nine Months Ended September 30, 2008  and 2007 (Unaudited) |
|                                          | Notes to  Unaudited Condensed Consolidated Financial Statements |
| Item 2                                        | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
| Item 3                                        | Quantitative  and Qualitative Disclosures About Market Risk |
| Item 4                                        | Controls and  Procedures |
| ** **                                    | ** ** |
| **PART II – OTHER  INFORMATION**    |
| Item 1                                        | Legal Proceedings |
| Item  1A                                      | Risk  Factors |
| Item 2                                        | Unregistered  Sales of Equity Securities and Use of Proceeds |
| Item 3                                        | Defaults  upon Senior Securities |
| Item 4                                        | Submission  of Matters to a Vote of Security Holders |
| Item 5                                        | Other Information |
| Item  6                                       | Exhibits |
|                                          |   |
| Signature                                     |   |

 

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**PART I— FINANCIAL INFORMATION**

**ITEM1.  FINANCIAL STATEMENTS**

**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands except share data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                                           | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                           |       |                         |       |                        |       |
| Current assets:                                                                                                                                                                                                      |       |                         |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                           |       | $                            | 5,629      |                        | $          | 7,271 |   |
| Contract  receivables, net of allowance of $36 at September 30, 2008 and $66 at  December 31, 2007                                                                                                         |       | 4,438                        |       | 10,959                      |       |
| Unbilled  work-in-progress                                                                                                                                                                                           |       | 1,871                        |       | 922                         |       |
| Deferred foreign  income taxes                                                                                                                                                                                       |       | 4                            |       | 4                           |       |
| Prepaid and  other current assets                                                                                                                                                                                    |       | 1,636                        |       | 1,331                       |       |
| Total current  assets                                                                                                                                                                                                |       | 13,578                       |       | 20,487                      |       |
| Property and equipment,  net                                                                                                                                                                                         |       | 1,364                        |       | 1,677                       |       |
| Amortizable  intangible assets, net                                                                                                                                                                                  |       | 3,232                        |       | 4,687                       |       |
| Goodwill                                                                                                                                                                                                             |       | 24,586                       |       | 26,417                      |       |
| Long-term  restricted cash                                                                                                                                                                                           |       | 100                          |       | 100                         |       |
| Other long-term  assets                                                                                                                                                                                              |       | 252                          |       | 359                         |       |
| Total assets                                                                                                                                                                                                         |       | $                            | 43,112     |                        | $          | 53,727 |   |
|                                                                                                                                                                                                                 |       |                         |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                        |       |                         |       |                        |       |
| Current  liabilities:                                                                                                                                                                                                |       |                         |       |                        |       |
| Current portion  of capital lease obligations                                                                                                                                                                        |       | 20                           |       | $                           | 20         |   |
| Current portion  of long-term debt                                                                                                                                                                                   |       | 2,000                        |       | 2,500                       |       |
| Accounts payable  and accrued liabilities                                                                                                                                                                            |       | 4,703                        |       | 5,903                       |       |
| Deferred foreign  income taxes                                                                                                                                                                                       |       | 27                           |       | 34                          |       |
| Unearned revenue                                                                                                                                                                                                     |       | 6,271                        |       | 10,635                      |       |
| Total current  liabilities                                                                                                                                                                                           |       | 13,021                       |       | 19,092                      |       |
| Long-term  liabilities:                                                                                                                                                                                              |       |                         |       |                        |       |
| Capital lease  obligations, net of current portion                                                                                                                                                                   |       | 64                           |       | 79                          |       |
| Other long-term  obligations                                                                                                                                                                                         |       | 1,219                        |       | 1,477                       |       |
| Long-term debt,  net of current portion                                                                                                                                                                              |       | 5,383                        |       | 8,686                       |       |
| Deferred foreign  income taxes                                                                                                                                                                                       |       | 630                          |       | 878                         |       |
| Total  liabilities                                                                                                                                                                                                   |       | 20,317                       |       | 30,212                      |       |
|                                                                                                                                                                                                                 |       |                         |       |                        |       |
| Commitments and  contingencies (Note 10)                                                                                                                                                                             |       |                         |       |                        |       |
|                                                                                                                                                                                                                 |       |                         |       |                        |       |
| Series B  convertible redeemable preferred stock                                                                                                                                                                |       | —                       |       | 5,587                       |       |
|                                                                                                                                                                                                                 |       |                         |       |                        |       |
| Stockholders’  equity:                                                                                                                                                                                          |       |                         |       |                        |       |
| Preferred stock,  $0.001 par value; 2,000,000 shares authorized; 0 and 478,750 shares of  Series B issued and outstanding as of September 30, 2008 and  December 31, 2007, respectively (shown above) |       | —                       |       | —                      |       |
| Common stock,  $0.001 par value; 40,000,000 shares authorized; 19,388,072 and 17,914,770  shares issued and outstanding as of September 30, 2008 and  December 31, 2007, respectively                      |       | 19                           |       | 18                          |       |
| Additional  paid-in capital                                                                                                                                                                                          |       | 81,604                       |       | 75,317                      |       |
| Accumulated  other comprehensive income (loss)                                                                                                                                                                       |       | (401                         | )          | 2,144                       |       |
| Accumulated  deficit                                                                                                                                                                                                 |       | (58,427                      | )          | (59,551                     | )          |
| Total  stockholders’ equity                                                                                                                                                                                     |       | 22,795                       |       | 17,928                      |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                     |       | $                            | 43,112     |                        | $          | 53,727 |   |

 

The accompanying notesare an integral part of these condensed consolidated financial statements.

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(unaudited)**

 
| ** **                                                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| **REVENUE**                                                                                        | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and  services                                                                         |       | $                                                    | 4,539      |                                                | $          | 4,692 |   | $ | 14,713 |   | $ | 13,425 |   |
| Customer support                                                                                   |       | 4,490                                                |       | 4,619                                               |       | 13,088 |   | 13,468 |   |
| Total revenue                                                                                      |       | 9,029                                                |       | 9,311                                               |       | 27,801 |   | 26,893 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Costs of license  fees and services, excluding depreciation and amortization                       |       | 1,977                                                |       | 2,097                                               |       | 6,103 |   | 5,962 |   |
| Costs of customer  support, excluding depreciation and       amortization |       | 1,581                                                |       | 1,532                                               |       | 4,706 |   | 4,741 |   |
| Sales and  marketing                                                                               |       | 2,004                                                |       | 2,003                                               |       | 6,385 |   | 6,228 |   |
| General and  administrative                                                                        |       | 1,281                                                |       | 1,350                                               |       | 3,942 |   | 4,549 |   |
| Product  development                                                                               |       | 792                                                  |       | 665                                                 |       | 2,810 |   | 1,572 |   |
| Depreciation                                                                                       |       | 189                                                  |       | 189                                                 |       | 671 |   | 729 |   |
| Amortization                                                                                       |       | 371                                                  |       | 396                                                 |       | 1,130 |   | 1,176 |   |
| Restructuring  and other recovery                                                                  |       | —                                               |       | —                                              |       | — |   | (1 | ) |
| Total costs of  revenue and operating expenses                                                     |       | 8,195                                                |       | 8,232                                               |       | 25,747 |   | 24,956 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Income from  operations                                                                            |       | 834                                                  |       | 1,079                                               |       | 2,054 |   | 1,937 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Other income  (expense):                                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Interest income                                                                                    |       | 29                                                   |       | 86                                                  |       | 146 |   | 231 |   |
| Interest expense                                                                                   |       | (278                                                 | )          | (419                                                | )          | (897 | ) | (1,334 | ) |
| Gain (loss) on  extinguishment of debt                                                             |       | —                                               |       | —                                              |       | (290 | ) | 42 |   |
| Foreign currency  exchange gain                                                                    |       | 130                                                  |       | 168                                                 |       | 272 |   | 7 |   |
| Other expense,  net                                                                                |       | (119                                                 | )          | (165                                                | )          | (769 | ) | (1,054 | ) |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Income before  income taxes                                                                        |       | 715                                                  |       | 914                                                 |       | 1,285 |   | 883 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax  expense                                                                                |       | 122                                                  |       | 345                                                 |       | 161 |   | 569 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Net income                                                                                         |       | $                                                    | 593        |                                                | $          | 569 |   | $ | 1,124 |   | $ | 314 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and  diluted income per common share                                                         |       | $                                                    | 0.03       |                                                | $          | 0.03 |   | $ | 0.06 |   | $ | 0.02 |   |
|                                                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average  basic shares outstanding                                                         |       | 19,386                                               |       | 19,201                                              |       | 19,374 |   | 19,178 |   |
| Weighted average  diluted shares outstanding                                                       |       | 19,746                                               |       | 19,550                                              |       | 19,809 |   | 19,546 |   |

 

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

 

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**EVOLVINGSYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCHANGES IN STOCKHOLDERS’ EQUITY**

**ANDCOMPREHENSIVE INCOME (LOSS)**

**(inthousands, except share data)**

**(unaudited)**

 
| ** **                                                             | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated**   | ** ** | ** **             | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|-------------------|------------|------------------------|------------|------------|------------|
| ** **                                                             | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**         | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                             | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated**   | ** ** | **Stockholders’** | ** ** |
| ** **                                                             | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income (Loss)** | ** ** | **Deficit**            | ** ** | **Equity** | ** ** |
| **Balance  at December 31, 2007**                                 |       | 17,914,770            |       | $           | 18         |              | $          | 75,317            |       | $                      | 2,144      |       | $          | (59,551 | ) | $ | 17,928 |   |
| Stock option  exercises                                                |       | 5,054                 |       | —      |       | 4                 |       | —            |       | —                 |       | 4          |       |
| Common stock  issued pursuant to the Employee Stock Purchase Plan      |       | 31,998                |       | —      |       | 52                |       | —            |       | —                 |       | 52         |       |
| Stock-based  compensation expense                                      |       | —                |       | —      |       | 645               |       | —            |       | —                 |       | 645        |       |
| Preferred stock  conversion                                            |       | 1,436,250             |       | 1           |       | 5,586             |       | —            |       | —                 |       | 5,587      |       |
| Comprehensive  income (loss):                                          |       |                  |       |        |       |              |       |              |       |                   |       |       |       |
| Net income                                                             |       | —                |       | —      |       | —            |       | —            |       | 1,124                  |       |       |       |
| Foreign currency  translation      Adjustment |       | —                |       | —      |       | —            |       | (2,545            | )          | —                 |       |       |       |
| Comprehensive  loss                                                    |       |                  |       |        |       |              |       |              |       |                   |       | (1,421     | )          |
| **Balance  at September 30, 2008**                                |       | 19,388,072            |       | $           | 19         |              | $          | 81,604            |       | $                      | (401       | )          | $          | (58,427 | ) | $ | 22,795 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                         |       |                                                |       |   |   |
| Net income                                                                         |       | $                                                   | 1,124      |   | $ | 314 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                                |       |   |   |
| Depreciation                                                                       |       | 671                                                 |       | 729 |   |
| Amortization of  intangible assets                                                 |       | 1,130                                               |       | 1,176 |   |
| Amortization of  debt issuance costs                                               |       | 112                                                 |       | 181 |   |
| Stock-based  compensation                                                          |       | 645                                                 |       | 543 |   |
| Gain on disposal  of property and equipment                                        |       | —                                              |       | (1 | ) |
| (Gain) loss on  extinguishment of debt                                             |       | 290                                                 |       | (42 | ) |
| Foreign currency  transaction gains, net                                           |       | (272                                                | )          | (7 | ) |
| Benefit from  foreign deferred income taxes                                        |       | (186                                                | )          | (132 | ) |
| Change in  operating assets and liabilities:                                       |       |                                                |       |   |   |
| Contract  receivables                                                              |       | 6,494                                               |       | 4,616 |   |
| Unbilled  work-in-progress                                                         |       | (1,067                                              | )          | (1,118 | ) |
| Prepaid and  other current assets                                                  |       | (450                                                | )          | 299 |   |
| Accounts payable  and accrued liabilities                                          |       | (517                                                | )          | 358 |   |
| Unearned revenue                                                                   |       | (4,158                                              | )          | (3,035 | ) |
| Other                                                                              |       | (255                                                | )          | 532 |   |
| Net cash  provided by operating activities                                         |       | 3,561                                               |       | 4,413 |   |
|                                                                               |       |                                                |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                         |       |                                                |       |   |   |
| Purchases of  property and equipment                                               |       | (755                                                | )          | (445 | ) |
| Proceeds from  sale of property and equipment                                      |       | —                                              |       | 1 |   |
| Earnout payments  from business combinations                                       |       | —                                              |       | (24 | ) |
| Reduction in  restricted cash                                                      |       | —                                              |       | 200 |   |
| Net cash used in  investing activities                                             |       | (755                                                | )          | (268 | ) |
|                                                                               |       |                                                |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                         |       |                                                |       |   |   |
| Capital lease  payments                                                            |       | (15                                                 | )          | (16 | ) |
| Principal  payments on long-term debt                                              |       | (7,798                                              | )          | (1,641 | ) |
| Proceeds from  issuance of long-term debt                                          |       | 4,000                                               |       | — |   |
| Payments for  debt issuance costs                                                  |       | (347                                                | )          | — |   |
| Proceeds from  issuance of common stock                                            |       | 56                                                  |       | 71 |   |
| Net cash used in  financing activities                                             |       | (4,104                                              | )          | (1,586 | ) |
|                                                                               |       |                                                |       |   |   |
| Effect of foreign  exchange rate changes on cash                                   |       | (344                                                | )          | (28 | ) |
|                                                                               |       |                                                |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                              |       | (1,642                                              | )          | 2,531 |   |
| Cash and cash  equivalents at beginning of period                                  |       | 7,271                                               |       | 5,076 |   |
| Cash and cash  equivalents at end of period                                        |       | $                                                   | 5,629      |   | $ | 7,607 |   |
|                                                                               |       |                                                |       |   |   |
| Supplemental  disclosure of other cash and non-cash transactions:                  |       |                                                |       |   |   |
| Interest paid                                                                      |       | $                                                   | 1,070      |   | $ | 640 |   |
| Income taxes  paid                                                                 |       | $                                                   | 354        |   | $ | 79 |   |
| Conversion of  preferred stock into common stock                                   |       | $                                                   | 5,587      |   | $ | 5,389 |   |

 

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

 

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**EVOLVING SYSTEMS, INC.**

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

** **

**NOTE 1 –BASIS OF PRESENTATION**

 

**Organization–**We are a provider of software solutions and services to thewireless, wireline and IP carrier markets with long-standing relationships withmany of the largest 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”).  We offer software products and solutions inthree core areas:  service activationsolutions used to activate complex bundles of voice, video and dataservices for traditional and next generation wireless and wirelinenetworks;  numbering solutionsthat enable carriers to comply with government-mandated requirements regardingnumber portability as well as providing phone number management and assignmentcapabilities; and mediation solutions supporting data collection forboth service assurance and billing applications.

** **

**Interim Consolidated FinancialStatements** – The accompanying unaudited condensedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (“GAAP”)and in conformity with the instructions to Form 10-Q and Article 10of Regulation S-X and the related rules and regulations of the Securitiesand Exchange Commission (“SEC”). Accordingly, certain information and note disclosures normally includedin financial statements prepared in accordance with GAAP have been condensed oromitted pursuant to such rules and regulations. However, we believe thatthe disclosures included in these financial statements are adequate to make theinformation presented not misleading. The unaudited condensed consolidatedfinancial statements included in this document have been prepared on the samebasis as the annual consolidated financial statements, and in our opinion,reflect all adjustments, which include normal recurring adjustments necessaryfor a fair presentation in accordance with GAAP and SEC regulations for interimfinancial statements. The results for the three and nine months ended September 30,2008 are not necessarily indicative of the results that we will have for anysubsequent period.  These unauditedcondensed consolidated financial statements should be read in conjunction withthe audited consolidated financial statements and the notes to those statementsfor the year ended December 31, 2007 included in our Annual Report on Form 10-K.

** **

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

** **

**ForeignCurrency Translation –**Our functional currency is the U.S.dollar.  The functional currency of ourforeign operations, generally, is the respective local currency for eachforeign subsidiary.  Assets andliabilities of foreign operations denominated in local currencies aretranslated at the spot rate in effect at the applicable reporting date.  Our consolidated statements of operations aretranslated at the weighted average rate of exchange during the applicableperiod.  The resulting unrealizedcumulative translation adjustment, net of applicable income taxes, is recordedas a component of accumulated other comprehensive income (loss) in stockholders’equity.  Realized and unrealizedtransaction gains and losses generated by transactions denominated in acurrency different from the functional currency of the applicable entity arerecorded in other income (loss) in the period in which they occur.

** **

**Principlesof Consolidation –**The consolidated financial statementsinclude the accounts of Evolving Systems and subsidiaries, all of which arewholly owned.  All significantintercompany transactions and balances have been eliminated in consolidation.

** **

**Goodwill –**Goodwill is the excess of acquisition cost of an acquiredentity over the fair value of the identifiable net assets acquired.  Goodwill is not amortized, but tested forimpairment annually or whenever indicators of impairment exist. Theseindicators may include a significant change in the business climate, legalfactors, operating performance indicators, competition, sale or disposition ofa significant portion of the business or other factors. For purposes of thegoodwill evaluation, we compare the fair value of each of our reporting unitsto its respective carrying amount. If the carrying value of a reporting unitwere to exceed its fair value, we would then compare the fair value of thereporting unit’s goodwill to its carrying amount, and any excess of thecarrying amount over the fair value would be charged to operations as an impairmentloss.

** **

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

 

We assess theimpairment of identifiable intangibles if events or changes in circumstancesindicate that the carrying value of the asset may not be recoverable. Factorsthat we consider significant which could trigger an impairment analysis includethe following:

 

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| · |   | Significant under-performance relative to historical  or projected future operating results;              |
|--------|--------|-----------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                      |
| · |   | Significant changes in the manner of use of the  acquired assets or the strategy of the overall business; |
|   |   |                                                                                                      |
| · |   | Significant negative industry or economic trends;  and/or                                                 |
|   |   |                                                                                                      |
| · |   | Significant decline in our stock price for a  sustained period.                                           |

 

If, as a result ofthe existence of one or more of the above indicators of impairment, wedetermine that the carrying value of intangibles and/or long-lived assets maynot be recoverable, we compare the estimated undiscounted cash flows expectedto result from the use of the asset and its eventual disposition to the asset’scarrying amount. If an amortizable intangible or long-lived asset is not deemedto be recoverable, we will recognize an impairment loss representing the excessof the asset’s carrying value over its estimated fair value.

** **

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

 

The majority of ourlicense fees and services revenue is generated from fixed-price contracts,which provide for licenses to our software products and services to customizesuch software to meet our customers’ use.  When the services are determined to be essential to the functionality ofthe delivered software, we recognize revenue using the percentage-of-completionmethod of accounting, in accordance with SOP 97-2 and SOP 81-1, “Accounting forLong-Term Construction Type Contracts.” The percentage of completion for each contract is estimated based on theratio of direct labor hours incurred to total estimated direct laborhours.  Since estimated direct laborhours, and changes thereto, can have a significant impact on revenuerecognition, these estimates are critical and are reviewed regularly.  Amounts billed in advance of services beingperformed are recorded as unearned revenue. Unbilled work-in-progress representsrevenue earned but not yet billable under the terms of the fixed-pricecontracts. All such amounts are expected to be billed and collected within12 months.

 

We may encounter budgetand schedule overruns or underuns on fixed price contracts caused by increasedor decreased labor or overhead costs. Adjustments to cost estimates are made inthe periods in which the facts requiring such revisions become known.Adjustments to revenue estimates are recorded in the period in which currentestimates of total contract revenue and contract costs indicate a change isnecessary.

 

In arrangements whereservices are not essential to the functionality of the software, we recognizelicense revenue upon delivery.  To theextent that Vendor-Specific Objective Evidence (“VSOE”) of the fair value ofundelivered elements exists, fees from multiple element arrangements areunbundled and recorded as revenue as the elements are delivered.  If VSOE for the undelivered elements does notexist, fees from such arrangements are deferred until the earlier of the datethat VSOE does exist on the undelivered elements or all of the elements havebeen delivered.

 

We recognize servicesrevenue from fixed-price contracts using the proportional performance method ofaccounting, which is similar to the percentage of completion method describedabove. Revenue from professional services provided pursuant totime-and-materials based contracts and training services are recognized as theservices are performed, as that is when our obligation to our customers undersuch arrangements is fulfilled.

 

We recognize customersupport, including maintenance revenue, ratably over the service contractperiod. When maintenance is bundled with the original license fee arrangement,its fair value, based upon VSOE, is deferred and recognized during the periodswhen services are provided.

** **

**Stock-based Compensation –** We account forstock-based compensation under Statement of Financial Accounting Standards No. 123(Revised),“Share-Based Payment” (“SFAS 123R”). This statement replaced SFAS No. 123, “Accounting for Stock-BasedCompensation” (“SFAS 123”) and superseded APB Opinion No. 25, “Accountingfor Stock Issued to Employees.”  UnderSFAS 123R, we apply a fair-value-based measurement method to account forshare-based payment transactions with employees and directors and recordcompensation cost for all stock awards granted after January 1, 2006 andawards modified, repurchased, or cancelled after that date. In addition, werecord compensation costs associated with the vesting of unvested optionsoutstanding at January 1, 2006 using the guidance under SFAS 123.  Stock-based compensation is a non-cashexpense because we settle these obligations by issuing shares of our commonstock instead of settling such obligations with cash payments.  We recognized compensation cost for stockawards on a straight-line basis over the vesting period using an estimatedforfeiture rate.   Effective January 1,2006, stock option grants, restricted stock grants, and employee stock purchaseplan purchases were accounted for under SFAS 123R.  We used the Black-Scholes model to estimatethe fair value of each option grant on the date of grant.  This model requires the use of estimates forexpected term of the options and expected volatility of the price of our commonstock.

 

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**Recent Accounting Pronouncements –**InDecember 2007, the SEC issued Staff Accounting Bulletin 110, *Share-Based Payment* (“SAB 110”), which amends StaffAccounting Bulleting 107 (“SAB 107”), *Share-Based Payment*,to permit public companies, under certain circumstances, to use the simplifiedmethod of SAB 107 for employee option grants after December 31, 2007.  Use of the simplified method after December 31,2007 is permitted only for companies whose historical data about theiremployees’ exercise behavior does not provide a reasonable basis for estimatingthe expected term of the options.  Wecurrently use the simplified method to estimate expected term for employeeoption grants as adequate historical experience is not available to provide areasonable estimate.  SAB 110 iseffective for employee options granted after December 31, 2007.  We adopted SAB 110 effective January 1,2008 and will continue to apply the simplified method until adequate historicalexperience is readily available to provide a reasonable estimate of theexpected term for employee option grants.

 

In February 2007,the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities - Including anAmendment of FASB Statement No. 115” (“SFAS 159”).  SFAS 159 permits entities to choose to measureeligible items at fair value at specific election dates (the “fair value option”).Unrealized gains and losses on items for which the fair value option has beenelected are reported in earnings at each subsequent reporting period. Thisaccounting standard is effective for us beginning January 1, 2008.  We have elected not to apply the fair valueoption allowed under SFAS 159.

 

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes a framework formeasuring fair value under generally accepted accounting principles, andexpands disclosures about fair value measurements. In February 2008, theFASB issued Staff Position No. 157-2, which delayed the effective date ofSFAS 157 to fiscal years ending after November 15, 2008 for non-financialassets and liabilities, except for items that are recognized or disclosed atfair value in the financial statements on a recurring basis (at leastannually).  The adoption of SFAS 157 didnot have a material effect on our consolidated financial statements.

 

**NOTE 2 –GOODWILL AND INTANGIBLE ASSETS**

 

We recordedgoodwill as a result of three acquisitions which occurred over the period from November 2003to November 2004. We acquired CMS in November 2003, TSE in October 2004and Evolving Systems U.K. in November 2004.

 

Changes in the carrying amount of goodwill by reporting unit were asfollows (in thousands):

 
| ** **                                             | ** ** | **License and Services** | ** ** | **Customer Support** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|------------------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                             | ** ** | **U.S.**                           | ** ** | **U.K.**                  | ** ** | **U.S.**  | ** ** | **U.K.** | ** ** | **Goodwill** | ** ** |
| Balance as of  December 31, 2007                  |       | $                                  | —     |                      | $          | 9,118     |       | $ | 6,033 |   | $ | 11,266 |   | $ | 26,417 |   |
| Effects of  changes in foreign currency exchange rates |       | —                             |       | (819                      | )          | —    |       | (1,012 | ) | (1,831 | ) |
| Balance as of  September 30, 2008                 |       | $                                  | —     |                      | $          | 8,299     |       | $ | 6,033 |   | $ | 10,254 |   | $ | 24,586 |   |

 

We conducted our annual goodwill impairment test as of July 31,2008, and we determined that goodwill was not impaired as of the testdate.  From July 31, 2008 through September 30,2008, no events have occurred that we believe may have impaired goodwill.

 

Identifiable intangible assets are amortized on a straight-line basisover estimated lives ranging from one to seven years and include the cumulativeeffects of foreign currency exchange rates. As of September 30, 2008 and December 31, 2007, identifiableintangibles were as follows (in thousands):

 
| ** **                 | ** ** | **September 30, 2008** | ** ** | **December 31, 2007** | ** ** | **Weighted-**             | ** ** |
|----------------------------|------------|----------------------------------|------------|---------------------------------|------------|---------------------------|------------|
| ** **                 | ** ** | **(1)  Gross  Amount**           | ** ** | **Accumulated  Amortization**   | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Average  Amortization  Period** | ** ** |
| Purchased  software        |       | $                                | 1,912      |                            | $          | 972                       |       | $ | 940 |   | $ | 2,072 |   | $ | 700 |   | $ | 1,372 |   | 4.7 yrs |   |
| Purchased  licenses        |       | 227                              |       | 218                             |       | 9                         |       | 227 |   | 146 |   | 81 |   | 2.3 yrs |   |
| Trademarks and  tradenames |       | 815                              |       | 262                             |       | 553                       |       | 896 |   | 192 |   | 704 |   | 7.0 yrs |   |
| Business  partnerships     |       | 133                              |       | 60                              |       | 73                        |       | 146 |   | 44 |   | 102 |   | 5.0 yrs |   |
| Customer  relationships    |       | 3,472                            |       | 1,815                           |       | 1,657                     |       | 3,707 |   | 1,279 |   | 2,428 |   | 5.5 yrs |   |
|                       |       | $                                | 6,559      |                            | $          | 3,327                     |       | $ | 3,232 |   | $ | 7,048 |   | $ | 2,361 |   | $ | 4,687 |   | 5.3 yrs |   |

 

----

(1)  Changes in intangible values as of September 30, 2008compared to December 31, 2007 are the direct result of changes in foreigncurrency exchange rates for the periods then ended.

 

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Amortizationexpense of identifiable intangible assets was $0.4 million and $1.1 million forthe three and nine months ended September 30, 2008, respectively, and $0.4million and $1.2 million for the three and nine months ended September 30,2007.  As Evolving Systems U.K. uses theGreat British pound as its functional currency, the amount of futureamortization actually recorded will be based upon exchange rates in effect atthat time. Expected future amortization expense related to identifiableintangibles based on our carrying amount as of September 30, 2008 was asfollows (in thousands):

 
| **Twelve months ending  September 30,** | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|------------|------------|
| 2009                                                   |       | $          |  901  |   |
| 2010                                                   |       | 810        |       |
| 2011                                                   |       | 720        |       |
| 2012                                                   |       | 458        |       |
| 2013                                                   |       | 343        |       |
| Thereafter                                             |       | —     |       |
|                                                   |       | $          | 3,232      |   |

 

**NOTE 3 –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 thedenominator of the basic and diluted EPS computations (in thousands):

 
| ** **                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                          | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Weighted average  common shares outstanding         |       | 19,386                                               |       | 17,686                                              |       | 19,209 |   | 17,349 |   |
| Participating  securities                           |       | —                                               |       | 1,515                                               |       | 165 |   | 1,829 |   |
| Basic weighted  average shares outstanding          |       | 19,386                                               |       | 19,201                                              |       | 19,374 |   | 19,178 |   |
| Effect of  dilutive securities                      |       | 360                                                  |       | 349                                                 |       | 435 |   | 368 |   |
| Diluted weighted  average common shares outstanding |       | 19,746                                               |       | 19,550                                              |       | 19,809 |   | 19,546 |   |

 

Weighted average options to purchase 3.7 million and3.6 million shares of common stock were excluded from the dilutive stockcalculation for the three and nine months ended September 30, 2008,respectively, because their exercise prices were greater than the average fairvalue of our common stock for those periods.

 

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

** **

**NOTE 4 –SHARE-BASED COMPENSATION**

 

We adopted SFAS 123R effectiveJanuary 1, 2006 using the modified prospective method.  We previously applied theintrinsic-value-based method in accounting for the recognition of stock-basedcompensation arrangements and the fair value method only for disclosure purposes.  Our statements of operations from January 1,2006 forward include charges for stock-based compensation.  We recognized $0.2 million and $0.6 millionof compensation expense in the consolidated statements of operations for thethree and nine months ended September 30, 2008, respectively, with respectto our stock-based compensation plans. We recognized $0.2 million and $0.5 million of compensation expense inthe consolidated statements of operations for the three and nine months ended September 30,2007, respectively, with respect to our stock-based compensation plans.  The following table summarizes stock-basedcompensation expenses recorded in the consolidated statements of operations (inthousands):

 

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| ** **                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Cost of license  fee and services, excluding depreciation and amortization |       | $                                                    | 16         |                                                | $          | 12 |   | $ | 46 |   | $ | 46 |   |
| Cost of customer  support, excluding depreciation and amortization         |       | 1                                                    |       | 1                                                   |       | 5 |   | — |   |
| Sales and  marketing                                                       |       | 18                                                   |       | 40                                                  |       | 101 |   | 108 |   |
| General and  administrative                                                |       | 133                                                  |       | 103                                                 |       | 431 |   | 371 |   |
| Product  development                                                       |       | 21                                                   |       | 6                                                   |       | 62 |   | 18 |   |
|                                                                       |       | $                                                    | 189        |                                                | $          | 162 |   | $ | 645 |   | $ | 543 |   |

 

**StockOption/Incentive Plans**

 

In January 1996,our stockholders approved an Amended and Restated Stock Option Plan (the “OptionPlan”).  Under the Option Plan, asamended, 8,350,000 shares were reserved for issuance.  Options issued under the Option Plan were atthe discretion of the Board of Directors, including the vesting provisions ofeach stock option granted. Options were granted with an exercise price equal tothe closing price of our common stock on the date of grant, generally vest overfour years and expire no more than ten years from the date of grant. The OptionPlan terminated on January 18, 2006; options granted before that date werenot affected by the plan termination.  AtSeptember 30, 2008, 3,824,487 options remained outstanding under theOption Plan.

 

In March 2007,upon the hiring of our Vice President of World Wide Sales and Marketing, inaccordance with NASDAQ Marketplace Rule 4350(i)(1)(a)(iv), the board ofdirectors approved an inducement award under a stand-alone equity incentiveplan.  We granted 100,000 non-qualifiedoptions to purchase shares of our common stock at an exercise price equal tothe closing price of our common stock on the date of grant.  The options vest over four years and expireten years from the date of grant.

 

In June 2007,our stockholders approved the 2007 Stock Incentive Plan (the “2007 Stock Plan”).  A maximum of 2,000,000 shares may be issuedunder the 2007 Stock Plan.  Awardspermitted under the 2007 Stock Plan include: Stock Options, Stock Appreciation Rights, Restricted Stock, RestrictedStock Units, Performance Awards and Other Stock-Based Awards.  Awards issued under the 2007 Stock Plan areat the discretion of the Board of Directors. As applicable, awards are granted with an exercise price equal to theclosing price of our common stock on the date of grant, generally vest overfour years and expire no more than ten years from the date of grant.

 

In December 2007,under the 2007 Stock Plan, we awarded a total of 137,500 shares of restrictedstock to members of our board of directors and senior management.  The fair market value for share-basedcompensation expensing is equal to the closing price of our common stock on thedate of grant.  The restrictions on thestock award are released over four years for awards granted to employees andover one year for awards granted to members of the board of directors.

 

The fair value ofeach option grant is estimated on the date of grant using the Black-Scholesmodel.  The Black-Scholes model uses fourassumptions to calculate the fair value of each option grant.  The expected term of share options granted isderived using the simplified method as prescribed by the SEC Staff AccountingBulletin 107 (“SAB 107”), “Share-Based Payment.”  In January 2008, we adopted theprovisions of Staff Accounting Bulletin 110, “Share-Based Payment,” whichallows us to continue to calculate the expected term of share options grantedusing the simplified method as prescribed under SAB 107. The risk-free interestrate is based upon the rate currently available on zero-coupon U.S. Treasuryinstruments with a remaining term equal to the expected term of the stockoptions.  The expected volatility isbased upon historical volatility of our common stock over a period equal to theexpected term of the stock options.  Theexpected dividend yield is zero and is based upon historical and anticipatedpayment of dividends.  The weighted-averageassumptions used in the fair value calculations are as follows:

 
| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **               | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Expected term  (years)   |       | *                                                    |       | 6.1                                                 |       | 6.2 |   | 6.2 |   |
| Risk-free  interest rate |       | *                                                    |       | 4.69                                                | %          | 2.70 | % | 4.70 | % |
| Expected  volatility     |       | *                                                    |       | 107.18                                              | %          | 101.9 | % | 107.68 | % |
| Expected dividend  yield |       | *                                                    |       | 0                                                   | %          | 0 | % | 0 | % |

 

----

*   None granted.

 

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The following is asummary of stock option activity under the three stock incentive plans for thenine months ended September 30, 2008:

 
| ** **                                      | ** ** | **Number of  Shares  (in  thousands)** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term  (Years)** | ** ** | **Aggregate  Intrinsic  Value  (in thousands)** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------------------------|------------|------------------------------------------------------|------------|
| Options outstanding  at December 31, 2007  |       | 4,534                                       |       | $                                       | 3.02       |                                                          |       |                                                 |       |   |
| Options granted                                 |       | 80                                          |       | $                                       | 2.06       |                                                          |       |                                                 |       |   |
| Less options  forfeited                         |       | (69                                         | )          | $                                       | 2.28       |                                                          |       |                                                 |       |   |
| Less options  expired                           |       | (72                                         | )          | $                                       | 4.53       |                                                          |       |                                                 |       |   |
| Less options  exercised                         |       | (5                                          | )          | $                                       | 0.76       |                                                          |       |                                                 |       |   |
| Options  outstanding at September 30, 2008 |       | 4,468                                       |       | $                                       | 2.99       |                                                          | 5.31       |                                                 | $          | 438 |   |
|                                            |       |                                        |       |                                    |       |                                                          |       |                                                 |       |
| Options  exercisable at September 30, 2008 |       | 3,719                                       |       | $                                       | 3.16       |                                                          | 4.68       |                                                 | $          | 438 |   |

 

Theweighted-average grant-date fair value of stock options granted during  the nine months ended September 30, 2008was $1.67.  No options were grantedduring the three months ended September 30, 2008.

 

As of September 30,2008, there were approximately $1.4 million of total unrecognized compensationcosts related to unvested stock options. These costs are expected to be recognized over a weighted average periodof 1.3 years.

 

The totalintrinsic value of stock option exercises for the three months ended September 30,2008 and 2007 was $5,000 and $0, respectively. The total fair value of stock options vested during each of the threemonth periods ended September 30, 2008 and 2007 was $0.2 million.

 

The totalintrinsic value of stock option exercises for the nine months ended September 30,2008 and 2007 was $5,000 and $23,000, respectively.  The total fair value of stock options vestedduring the nine months ended September 30, 2008 and 2007 was $0.7 millionand $0.5 million, respectively.

 

The deferredincome tax benefits from stock option expense related to Evolving Systems U.K.totaled approximately $14,000 and $10,000 for the three months ended September 30,2008 and 2007, respectively.  Thedeferred income tax benefits from stock option expense related to EvolvingSystems U.K. totaled approximately $43,000 and $30,000 for the nine monthsended September 30, 2008 and 2007, respectively.

 

Cash received fromstock option exercises for the three months ended September 30, 2008 and2007 was $4,000 and $0, respectively. Cash received from stock option exercises for the nine months ended September 30,2008 and 2007 was $4,000 and $19,000, respectively.

** **

**EmployeeStock Purchase Plan**

 

Under the EmployeeStock Purchase Plan (“ESPP”), we are authorized to issue up to 1,100,000 sharesof our common stock to full-time employees, nearly all of whom are eligible toparticipate. Under the terms of the ESPP, employees may elect to have up to 15%of their gross compensation withheld through payroll deduction to purchase ourcommon stock, capped at $25,000 annually. The purchase price of the stock is85% of the lower of the closing price on the first day or the last day of eachthree-month participation period. As of September 30, 2008, there were260,000 shares available for purchase. We recorded compensation expense of $6,000 for each of the three monthperiods ended September 30, 2008 and September 30, 2007 , and $17,000for each of the nine month periods ended September 30, 2008 and September 30,2007 associated with grants under the ESPP which includes the fair value of thelook-back feature of each grant as well as the 15% discount on the purchaseprice.

 

The fair value ofeach grant made under our ESPP is estimated on the date of grant using theBlack-Scholes model.  The Black-Scholesmodel uses four assumptions to calculate the fair value of each option grant.  The expected term of each grant is based uponthe three-month participation period of each grant.  The risk-free interest rate is based upon therate currently available on zero-coupon U.S. Treasury instruments with aremaining term equal to the expected term of each grant.  The expected volatility is based uponhistorical volatility of our common stock. The expected dividend yield is based upon historical and anticipatedpayment of dividends.  The weightedaverage assumptions used in the fair value calculations are as follows:

 

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| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **               | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Expected term  (years)   |       | 0.25                                                 |       | 0.25                                                |       | 0.25 |   | 0.25 |   |
| Risk-free  interest rate |       | 1.15                                                 | %          | 3.99                                                | %          | 1.40 | % | 4.73 | % |
| Expected  volatility     |       | 65.87                                                | %          | 64.59                                               | %          | 68.22 | % | 68.34 | % |
| Expected  dividend yield |       | 0                                                    | %          | 0                                                   | %          | 0 | % | 0 | % |

 

Cash received fromemployee stock plan purchases for the three months ended September 30,2008 and 2007 was approximately $16,000 and $19,000, respectively.  Cash received from employee stock planpurchases for each of the nine months ended September 30, 2008 and 2007was approximately $52,000.

 

**NOTE 5 – CONCENTRATION OF CREDIT RISK**

 

For the three andnine months ended September 30, 2008, two significant customers (definedas contributing at least 10%) accounted for 33% (17% and 16%) and 29% (16% and13%), respectively, of total revenue. These customers are large telecommunications operators located in theU.S. and U.K., respectively.  For thethree months ended September 30, 2007, three significant customersaccounted for 44% (20%, 13%, and 11%) of total revenue.  These customers are large telecommunicationsoperators located in the U.S., U.K. and U.K., respectively.  For the nine months ended September 30,2007, two significant customers accounted for and 35% (21% and 14%) of totalrevenue.  These customers are largetelecommunications operators located in the U.S. and U.K., respectively.

 

As of September 30, 2008, three significant customers accountedfor approximately 39% (16%, 13%, and 10%) of contract receivables.  These customers are large telecommunicationsoperators located in the U.K., Chile, and the U.S., respectively.  At December 31, 2007, one significantcustomer accounted for approximately 42% of contract receivables.  This customer is a large telecommunicationsoperator located in the U.S.

** **

**NOTE 6 – LONG-TERM DEBT**

 

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

 
| ** **                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Senior term loan  with financial institution, interest at a fixed rate of 8.25%, principal  installments and interest payments are due monthly with final maturity on  February 22, 2010. The loan is secured by substantially all of our  assets.                                                                                                                                 |       | $                      | 2,833      |                  | $          | — |   |
|                                                                                                                                                                                                                                                                                                                                                                                    |       |                   |       |                  |       |   |   |
| Senior note  payable to financial institution, interest at the one-month London InterBank  Offered Rate (“LIBOR”) plus a margin of 5.25% at December 31, 2007;  however, the LIBOR rate cannot be less than 3.75%, interest rate was 10.25%  at December 31, 2007. In February 2008, this note payable was  replaced by our new $4.0 million senior term loan. |       | —                 |       | 4,419                 |       |
|                                                                                                                                                                                                                                                                                                                                                                                    |       |                   |       |                  |       |
| $4.5 million  senior revolving credit facility payable to financial institution, interest  at one-month LIBOR plus 4.0%; however, the LIBOR rate cannot be less than  3.75%; interest rate was 9.00% at December 31, 2007. In  February 2008, this revolver was replaced with our $6.0 million senior  revolving credit facilities.                                           |       | —                 |       | 2,000                 |       |
|                                                                                                                                                                                                                                                                                                                                                                                    |       |                   |       |                  |       |
| Long-term  unsecured subordinated notes payable, interest ranges from 11-14% with a  weighted average rate of 12.60% and 12.82% at September 30, 2008 and  December 31, 2007, respectively, accrued interest and principal are due  in full May 16, 2011.                                                                                                                |       | 4,550                  |       | 4,767                 |       |
| Total debt                                                                                                                                                                                                                                                                                                                                                                              |       | 7,383                  |       | 11,186                |       |
| Less current  portion                                                                                                                                                                                                                                                                                                                                                                   |       | (2,000                 | )          | (2,500                | )          |
| Long-term debt,  excluding current portion                                                                                                                                                                                                                                                                                                                                              |       | $                      | 5,383      |                  | $          | 8,686 |   |

 

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OnFebruary 22, 2008, we replaced our existing senior term note and seniorrevolving facility with a new $4.0 million senior term loan, a $1.0 millionU.S. revolving credit facility (“U.S. Revolving Facility”) and a $5.0 millionU.K. revolving credit facility (“U.K. Revolving Facility”).

 

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

 

The remainingscheduled principal payments as of September 30, 2008 on our senior termloan are as follows (in thousands):

 
| **Year ending December 31,** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2008                                        |       | $          | 500        |   |
| 2009                                        |       | 2,000      |       |
| 2010                                        |       | 333        |       |
|                                        |       | $          | 2,833      |   |

 

Additionally,we obtained a new $1.0 million U.S. Revolving Facility that bears interest atPrime Rate plus 0.5%.  Prime Rate was5.00% as of September 30, 2008. Borrowings under the senior revolving facilities are limited to apercentage of our eligible accounts receivable and cash.  The U.S. Revolving Facility is secured by allassets of Evolving Systems, Inc. and is subject to the same covenants asthe senior term loan.  All accruedinterest on outstanding borrowings under the U.S. Revolving Facility is paidmonthly, with any outstanding balance due with a final maturity of February 22,2011.  As of September 30, 2008, wehad $1.0 million in availability, but no borrowing outstanding under this U.S.Revolving Facility.

 

Wealso entered into a $5.0 million U.K. Revolving Facility that bears interest atPrime Rate plus 0.5%.  Prime Rate was5.00% as of September 30, 2008. Borrowings under the U.K. Revolving Facility are limited to a percentageof our eligible accounts receivable and cash. The U.K. Revolving Facility is secured by all assets of Evolving SystemsHoldings Limited and Evolving Systems Limited and is subject to the samecovenants as the Senior Term Loan.  Allaccrued interest on outstanding borrowings under the Senior Revolving Facility ispaid monthly, with any outstanding balance due with a final maturity of February 22,2011.  As of September 30, 2008, wehad $4.7 million in availability, but no borrowing outstanding under this U.K.Revolving Facility,

 

Inconnection with the replacement of our existing senior term note and seniorrevolving facility with the new senior term loan and U.S. Revolving Facilityand the U.K. Revolving Facility, we recorded a write-off of debt issuance costsassociated with the retired senior debt of approximately $0.3 million.  Additionally, we capitalized debt issuancecosts related to our new senior debt of approximately $0.3 million.  These newly capitalized debt issuance costswill be amortized over the term of the new senior debt.

 

On February 22,2008, we paid $272,000 to retire $279,000 of subordinated debt and relatedaccrued interest held by two of our subordinated note holders.  The retirements included principal of$217,000 and accrued interest of $62,000. The $7,000 gain on extinguishment of this debt is reflected within ourother income (expense) on the consolidated statements of operations.  On February 22, 2008, we also paid$728,000 in accrued interest to the remaining subordinated note holders.

 

We were in compliance with all of our debt covenantsas of September 30, 2008.

** **

**NOTE 7 – INCOME TAXES**

 

Werecorded net income tax expense of $122,000 and $345,000 for the three monthsended September 30, 2008 and 2007, respectively.  The net expense during the three months endedSeptember 30, 2008 consisted of current income tax expense of $186,000,partially offset by a deferred tax benefit of $64,000, both of which wereprimarily related to our U.K.-based operations. The net expense during the three months ended September 30, 2007consisted of current income tax expense of $407,000, partially offset by adeferred tax benefit of $62,000, both of which were primarily related to ourU.K.-based operations.

 

Werecorded net income tax expense of $161,000 and $569,000 for the nine monthsended September 30, 2008 and 2007, respectively.  The net expense during the nine months ended September 30,2008 consisted of current income tax expense of $367,000, partially offset by adeferred tax benefit of $206,000, both of which were primarily related to ourU.K.-based operations.  The net expenseduring the nine months ended September 30, 2007 consisted of currentincome tax expense of $670,000, partially offset by a deferred tax benefit of$101,000, both of which were primarily related to our U.K.-based operations.

 

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EffectiveApril 2007, our Indian subsidiary was subject to a 10% minimum alternativetax.  This tax did not have a materialimpact on our results for the three and nine months ended September 30,2008, and we do not expect this tax to have a material impact on futureresults.

 

Inconjunction with the acquisition of Evolving Systems U.K., we recorded certainidentifiable intangible assets.  Sincethe amortization of these identifiable intangibles is not deductible for incometax purposes, we established a long-term deferred tax liability of $4.6 millionat the acquisition date for the expected difference between what would beexpensed for financial reporting purposes and what would be deductible forincome tax purposes. As of September 30, 2008 and December 31, 2007,this component of the deferred tax liability was $0.9 million and $1.2 million,respectively.  This deferred taxliability relates to Evolving Systems U.K., and has no impact on our ability torecover U.S.-based deferred tax assets. This deferred tax liability will be recognized as a reduction ofdeferred income tax expense as the identifiable intangibles are amortized.

 

As of September 30,2008 and December 31, 2007 we continued to maintain a full valuationallowance on the domestic net deferred tax asset as we have determined it ismore likely than not that we will not realize our domestic deferred taxassets.  Such assets primarily consist ofcertain net operating loss carryforwards. We assessed the realizability of our domestic deferred tax assets usingall available evidence.  In particular,we considered both historical results and projections of profitability for thereasonably foreseeable future periods. We are required to reassess our conclusions regarding the realization ofour deferred tax assets at each financial reporting date. A 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 our results ofoperations and financial position.

 

Effective January 1,2007, we adopted the provisions of FASB Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109”(“FIN 48”).  FIN 48 prescribes arecognition threshold and a measurement attribute for the financial statementrecognition and measurement of tax positions taken or expected to be taken in atax return.  For those benefits to berecognized, a tax position must be more-likely-than-not to be sustained uponexamination by taxing authorities.  Therewas not a material impact on our consolidated financial position and results ofoperations as a result of the adoption of the provisions of FIN 48.

 

On January 1,2007, we recorded a FIN 48 transition adjustment consisting of a $0.4 milliondecrease in our deferred tax assets related to Research and Development TaxCredits that was offset by a corresponding decrease in our valuation allowancebecause we determined that it was not more likely than not that our deferredtax assets will be realized.  As of September 30,2008 and December 31, 2007, we had no liability for unrecognized taxbenefits.  We do not believe there willbe any material changes our unrecognized tax positions over the next twelvemonths.

 

We conductbusiness globally and, as a result, Evolving Systems, Inc. or one or moreof our subsidiaries file income tax returns in the U.S. federal jurisdictionand various state and foreign jurisdictions. In the normal course of business, we are subject to examination bytaxing authorities throughout the world, including the U.S., the U.K., Germanyand India.

 

**NOTE 8 – STOCKHOLDERS’ EQUITY**

 

OnFebruary 25, 2008, holders of 461,758 shares of Series B PreferredStock with a carrying value of $5.4 million, or approximately 96% of theoutstanding preferred stock, converted their shares of preferred stock into1,385,274 shares of our common stock in accordance with the conversionprovisions of the Series B Preferred Stock.  On March 19, 2008, a holder of 16,992shares of Series B Preferred Stock with a carrying value of $0.2 million,which represented the remainder of the outstanding preferred stock, convertedhis shares of preferred stock into 50,976 shares of our common stock inaccordance with the conversion provisions of the Series B PreferredStock.  As we previously includedthe Series B Convertible Preferred Stock as a participating security forbasic EPS purposes, these conversions did not change our basic or diluted EPScalculations.

 

**NOTE 9 – SEGMENT INFORMATION**

 

Inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterpriseand Related Information,” we define operating segments as components of anenterprise for which separate financial information is reviewed regularly bythe chief operating decision-making group to evaluate performance and to makeoperating decisions. We have identified our Chief Executive Officer and ChiefFinancial Officer as our chief operating decision-makers (CODM). These chiefoperating decision makers review revenues by segment and review overall resultsof operations.

 

Wecurrently operate business as two operating segments based on revenuetype:  license fees and services revenueand customer support revenue (as shown on the consolidated statements ofoperations).  License fees and services(L&S) revenue represents the fees received from the license of software productsand those services directly related to the delivery of the licensed products,as well as fees for custom development, integration services and time andmaterials work.  Customer support (CS)revenue includes annual support fees, recurring maintenance fees, fees formaintenance upgrades and warranty services. Warranty services that are similar to software maintenance services aretypically bundled with a license sale. Total assets by segment have not beendisclosed as the information is not available to the chief operatingdecision-making group.

 

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Segment information is as follows (in thousands):

 
| ** **                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Revenue**                                                                |       |                                                 |       |                                                |       |   |   |   |   |
| License fees and  services                                                 |       | $                                                    | 4,539      |                                                | $          | 4,692 |   | $ | 14,713 |   | $ | 13,425 |   |
| Customer support                                                           |       | 4,490                                                |       | 4,619                                               |       | 13,088 |   | 13,468 |   |
|                                                                       |       | 9,029                                                |       | 9,311                                               |       | 27,801 |   | 26,893 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| **Revenue  less cost of revenue, excluding depreciation and amortization** |       |                                                 |       |                                                |       |   |   |   |   |
| License fees and  services                                                 |       | 2,562                                                |       | 2,595                                               |       | 8,610 |   | 7,463 |   |
| Customer support                                                           |       | 2,909                                                |       | 3,087                                               |       | 8,382 |   | 8,727 |   |
|                                                                       |       | 5,471                                                |       | 5,682                                               |       | 16,992 |   | 16,190 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| **Unallocated  costs**                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Other operating  expenses                                                  |       | 4,077                                                |       | 4,018                                               |       | 13,137 |   | 12,349 |   |
| Depreciation and  amortization                                             |       | 560                                                  |       | 585                                                 |       | 1,801 |   | 1,905 |   |
| Restructuring  and other                                                   |       | —                                               |       | —                                              |       | — |   | (1 | ) |
| Interest income                                                            |       | (29                                                  | )          | (86                                                 | )          | (146 | ) | (231 | ) |
| Interest expense                                                           |       | 278                                                  |       | 419                                                 |       | 897 |   | 1,334 |   |
| (Gain) loss on  debt extinguishment                                        |       | —                                               |       | —                                              |       | 290 |   | (42 | ) |
| Foreign currency  exchange gain                                            |       | (130                                                 | )          | (168                                                | )          | (272 | ) | (7 | ) |
| **Income  before income taxes**                                            |       | $                                                    | 715        |                                                | $          | 914 |   | $ | 1,285 |   | $ | 883 |   |

 

***Geographic Regions***

 

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

 
| ** **     | ** ** | **Three Months Ended September 30,** | ** ** |
|----------------|------------|----------------------------------------------------------|------------|
| ** **     | ** ** | **2008**                                                 | ** ** | **2007** | ** ** |
| ** **     | ** ** | **L&S**                                              | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**    |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| United States  |       | $                                                        | 318        |   | $ | 2,561 |   | $ | 2,879 |   | $ | 221 |   | $ | 2,772 |   | $ | 2,993 |   |
| United Kingdom |       | 1,527                                                    |       | 641 |   | 2,168 |   | 1,868 |   | 654 |   | 2,522 |   |
| Other          |       | 2,694                                                    |       | 1,288 |   | 3,982 |   | 2,603 |   | 1,193 |   | 3,796 |   |
| Total Revenue  |       | $                                                        | 4,539      |   | $ | 4,490 |   | $ | 9,029 |   | $ | 4,692 |   | $ | 4,619 |   | $ | 9,311 |   |

 
| ** **     | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------|------------|---------------------------------------------------------|------------|
| ** **     | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| ** **     | ** ** | **L&S**                                             | ** ** | **CS** | ** ** | **Total** | ** ** | **L&S** | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**    |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| United States  |       | $                                                       | 1,539      |   | $ | 7,470 |   | $ | 9,009 |   | $ | 1,169 |   | $ | 7,929 |   | $ | 9,098 |   |
| United Kingdom |       | 3,914                                                   |       | 1,958 |   | 5,872 |   | 4,625 |   | 2,001 |   | 6,626 |   |
| Other          |       | 9,260                                                   |       | 3,660 |   | 12,920 |   | 7,631 |   | 3,538 |   | 11,169 |   |
| Total Revenue  |       | $                                                       | 14,713     |   | $ | 13,088 |   | $ | 27,801 |   | $ | 13,425 |   | $ | 13,468 |   | $ | 26,893 |   |

 
| ** **                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| **Long-lived  assets, net**   |       |                   |       |                  |       |
| United States                 |       | $                      | 7,134      |                  | $          | 7,814 |   |
| United Kingdom                |       | 21,971                 |       | 24,883                |       |
| Other                         |       | 77                     |       | 84                    |       |
| Total long-lived  assets, net |       | $                      | 29,182     |                  | $          | 32,781 |   |

 

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

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **           | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Revenue**          |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Activation           |       | $                                                    | 5,457      |                                                | $          | 5,309 |   | $ | 15,475 |   | $ | 14,787 |   |
| Numbering  solutions |       | 2,825                                                |       | 2,678                                               |       | 9,249 |   | 8,759 |   |
| Mediation            |       | 747                                                  |       | 1,324                                               |       | 3,077 |   | 3,347 |   |
|                 |       | $                                                    | 9,029      |                                                | $          | 9,311 |   | $ | 27,801 |   | $ | 26,893 |   |

 

**NOTE 10 – COMMITMENTS ANDCONTINGENCIES**

** **

**(a)          Other Commitments**

 

Aspermitted under Delaware law, we have agreements with officers and directorsunder which we agree to indemnify them for certain events or occurrences whilethe officer or director is, or was serving, at our request in this capacity.The term of the indemnification period is indefinite. There is no limit on theamount of future payments we could be required to make under theseindemnification agreements; however, we maintain Director and Officer insurancepolicies, as well as an Employment Practices Liability Insurance Policy, thatmay enable us to recover a portion of any amounts paid. As a result of ourinsurance policy coverage, we believe the estimated fair value of theseindemnification agreements is minimal. Accordingly, there were no liabilitiesrecorded for these agreements as of September 30, 2008 or December 31,2007.

 

Weenter into standard indemnification terms with customers and suppliers, asdiscussed below, in the ordinary course of business.  As we may subcontract the development ofdeliverables under customer contracts, we could be required to indemnifycustomers for work performed by subcontractors. Depending upon the nature ofthe customer indemnification, the potential amount of future payments we couldbe required to make under these indemnification agreements may be unlimited. Wemay be able to recover damages from a subcontractor if the indemnification tocustomers results from the subcontractor’s failure to perform. To the extent weare unable to recover damages from a subcontractor, we could be required toreimburse the indemnified party for the full amount. We have never incurredcosts to defend lawsuits or settle claims relating to indemnification arisingout of subcontractors’ failure to perform. As a result, we believe theestimated fair value of these agreements is minimal. Accordingly, there were noliabilities recorded for these agreements as of September 30, 2008 or December 31,2007.

 

Ourstandard license agreements contain product warranties that the software willbe free of material defects and will operate in accordance with the statedrequirements for a limited period of time. The product warranty provisions require us to cure any defects throughany reasonable means.  We believe theestimated fair value of the product warranty provisions in the licenseagreements in place with our customers is minimal.  Accordingly, there were no liabilitiesrecorded for these product warranty provisions as of September 30, 2008 orDecember 31, 2007.

 

Oursoftware arrangements generally include a product indemnification provisionwhereby we will indemnify and defend a customer in actions brought against thecustomer for claims that our products infringe upon a copyright, trade secret,or valid patent. We have not historically incurred any significant costsrelated to product indemnification claims. Accordingly, there were noliabilities recorded for these indemnification provisions as of September 30,2008 or December 31, 2007.

 

Inrelation to the acquisitions of Evolving Systems U.K., TSE and CMS, we agreedto indemnify certain parties from any losses, actions, claims, damages orliabilities (or actions in respect thereof) resulting from any claim raised bya third party.  We do not believe thatthere will be any claims related to these indemnifications. Accordingly, therewere no liabilities recorded for these agreements as of September 30, 2008or December 31, 2007.

 

**(b)         Litigation**

 

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

 

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

** **

**NOTE11 – RELATED PARTY TRANSACTIONS**

 

Effective January 1,2008, we entered into a consulting agreement with Stephen K. Gartside, Jr.,our previous President and CEO and current Chairman of the Board.  Under the agreement, we will pay Mr. Gartsidea fee of $20,000 for consulting services provided to us during 2008.  We had current obligations in theconsolidated balance sheets, under the agreement, of $5,000 and $0 as of September 30,2008 and December 31, 2007, respectively. We recorded $5,000 and $0 of general and administrative expense in theconsolidated statements of operations, related to this agreement, for the threemonths ended September 30, 2008 and 2007, respectively.  

 

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We recorded$15,000 and $0 of general and administrative expense in the consolidatedstatements of operations, related to this agreement, for the nine months ended September 30,2008 and 2007, respectively.

 

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

** **

**SPECIAL NOTE ABOUT FORWARD-LOOKINGSTATEMENTS**

 

*ThisQuarterly Report on Form 10-Q contains forward-looking statements thathave been made pursuant to the provisions of the Private Securities LitigationReform Act of 1995.  Theseforward-looking statements are based on current expectations, estimates, andprojections about Evolving Systems’ industry, management’s beliefs, and certainassumptions made by management. Forward-looking statements include our expectations regarding product,services, and maintenance revenue, annual savings associated with theorganizational changes effected in prior years, and short- and long-term cashneeds.  In some cases, words such as “anticipates,”“expects,” “intends,” “plans,” “believes,” “estimates,” variations of thesewords, and similar expressions are intended to identify forward-lookingstatements.  The statements are notguarantees of future performance and are subject to certain risks,uncertainties, and assumptions that are difficult to predict; therefore, actualresults may differ materially from those expressed or forecasted in anyforward-looking statements.  Risks anduncertainties of our business include those set forth in our Annual Report on Form 10-Kfor the year ended December 31, 2007 under “Item 1A. Risk Factors” as wellas additional risks described in this Form 10-Q.  Unless required by law, we undertake noobligation to update publicly any forward-looking statements, whether as aresult of new information, future events, or otherwise.  However, readers should carefully review therisk factors set forth in other reports or documents we file from time to timewith the Securities and Exchange Commission, particularly the Quarterly Reportson Form 10-Q and any Current Reports on Form 8-K.*

 

**OVERVIEW**

 

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

 

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

 

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**RESULTSOF OPERATIONS**

 

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

 
| ** **                                                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| **REVENUE**                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| License fees and  services                                                   |       | 50                                                   | %          | 50                                                  | %          | 53 | % | 50 | % |
| Customer support                                                             |       | 50                                                   | %          | 50                                                  | %          | 47 | % | 50 | % |
| Total revenue                                                                |       | 100                                                  | %          | 100                                                 | %          | 100 | % | 100 | % |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Costs of license  fees and services, excluding depreciation and amortization |       | 22                                                   | %          | 23                                                  | %          | 22 | % | 22 | % |
| Costs of  customer support, excluding depreciation and amortization          |       | 18                                                   | %          | 16                                                  | %          | 17 | % | 18 | % |
| Sales and  marketing                                                         |       | 22                                                   | %          | 22                                                  | %          | 23 | % | 23 | % |
| General and  administrative                                                  |       | 14                                                   | %          | 14                                                  | %          | 14 | % | 17 | % |
| Product  development                                                         |       | 9                                                    | %          | 7                                                   | %          | 10 | % | 6 | % |
| Depreciation                                                                 |       | 2                                                    | %          | 2                                                   | %          | 3 | % | 3 | % |
| Amortization                                                                 |       | 4                                                    | %          | 4                                                   | %          | 4 | % | 4 | % |
| Restructuring  and other                                                     |       | —                                               | %          | —                                              | %          | — | % | — | % |
| Total costs of  revenue and operating expenses                               |       | 91                                                   | %          | 88                                                  | %          | 93 | % | 93 | % |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Income from  operations                                                      |       | 9                                                    | %          | 12                                                  | %          | 7 | % | 7 | % |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Interest income                                                              |       | —                                               | %          | 1                                                   | %          | 1 | % | 1 | % |
| Interest expense                                                             |       | (3                                                   | )%         | (5                                                  | )%         | (3 | )% | (5 | )% |
| Loss on debt  extinguishment                                                 |       | —                                               | %          | —                                              | %          | (1 | )% | — | % |
| Foreign currency  exchange gain                                              |       | 2                                                    | %          | 2                                                   | %          | 1 | % | — | % |
| Other expense,  net                                                          |       | (1                                                   | )%         | (2                                                  | )%         | (2 | )% | (4 | )% |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Income before  income taxes                                                  |       | 8                                                    | %          | 10                                                  | %          | 5 | % | 3 | % |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax  expense                                                          |       | 1                                                    | %          | 4                                                   | %          | 1 | % | 2 | % |
|                                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Net income                                                                   |       | 7                                                    | %          | 6                                                   | %          | 4 | % | 1 | % |

 

***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,recurring maintenance, maintenance upgrades and warranty services.  Warranty services consist of maintenanceservices and are typically bundled with a license sale and the related revenue,based on Vendor-Specific Objective Evidence (VSOE), is deferred and recognizedratably over the warranty period.  The following table presents our revenue byproduct group (in thousands):

 
| ** **           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **           | ** ** | **2008**                                             | ** ** | **2007**                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Activation           |       | $                                                    | 5,457      |                                                | $          | 5,309 |   | $ | 15,475 |   | $ | 14,787 |   |
| Numbering  solutions |       | 2,825                                                |       | 2,678                                               |       | 9,249 |   | 8,759 |   |
| Mediation            |       | 747                                                  |       | 1,324                                               |       | 3,077 |   | 3,347 |   |
|                 |       | $                                                    | 9,029      |                                                | $          | 9,311 |   | $ | 27,801 |   | $ | 26,893 |   |

 

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**LicenseFees and Services**

 

License fees and services revenue decreased 3%, or$0.2 million, to $4.5 million for the three months ended September 30,2008 from $4.7 million for the three months ended September 30, 2007.  This decrease in license fees and servicesrevenue was composed of a $0.5 million decrease in revenue from our mediationproducts, partially offset by an increase of $0.2 million in revenue from ournumbering solutions products and an increase of $0.1 million in revenue fromour activation products.  The decrease inour mediation product revenue is the result of a decline in sales to ourexisting customer base.  The increase inour numbering solutions product revenue is the result of our expansion intointernational markets with our*NumeriTrack®*and our*Dynamic SIM Allocation*TM solutions.  Our*Dynamic SIM Allocation*solution uses core technology from both our service activation products and ournumbering solutions *NumeriTrack*product.  When reporting revenue resultswe apportion the revenue associated with*Dynamic SIM Allocation*solution evenly across our activation and numbering solutions product revenuegroups.  The increase in our activationproduct revenue is the result of growth in the activation customer account baseas well as to revenue from our *Dynamic SIM Allocation*solution.

 

License fees and services revenue increased 10%, or $1.3 million, to$14.7 million for the nine months ended September 30, 2008 from $13.4million for the nine months ended September 30, 2007.  This increase in license fees and servicesrevenue was composed of an increase of $0.6 million in revenue from ouractivation products, an increase of $0.6 million in revenue from our numberingsolutions products and an increase of $0.1 million in revenue from ourmediation products.  The increase in ouractivation product revenue is the result of growth in the activation customeraccount base as well as to revenue from our *Dynamic SIM Allocation*solution.  The increase in our numberingsolutions product revenue is the result of our expansion into internationalmarkets with our*NumeriTrack* and our*Dynamic SIM Allocation* solutions.  The increase in our mediation product revenueis the result of follow on sales from our existing mediation account base.

** **

**Customer Support**

 

Customer support revenue decreased $0.1 million, or 3%, to $4.5 millionfor the three months ended September 30, 2008 from $4.6 million for thethree months ended September 30, 2007. The decrease in customer support revenue resulted from a decrease of$0.1 million in our numbering solutions customer support revenue and a decreaseof $0.1 million in our mediation customer support revenue, partially offset byan increase of $0.1 million in activation customer support revenue.  The decrease in numbering solutions customersupport revenue is due to a decline in the numbering solutions support accountbase.  The decrease in mediation customersupport revenue is the result of a decline in our network mediation accountbase.  The increase in activationcustomer support revenue is due to new customer sales.

 

Customer support revenue decreased $0.4 million, or 3%, to $13.1million for the nine months ended September 30, 2008 from $13.5 millionfor the nine months ended September 30, 2007.  The decrease in customer support revenueresulted from a decrease of $0.3 million in our mediation products customersupport revenue and a decrease of $0.1 million in numbering solutions customersupport revenue.  The decrease inmediation customer support revenue is the result of a decline in our networkmediation account base.

*** ***

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

 

Costs of revenue, excluding depreciation and amortization, consistprimarily of personnel costs and other direct costs associated with thesepersonnel, facilities costs, cost of third-party software and partnercommissions.  Costs of revenue, excludingdepreciation and amortization, were $3.6 million for each of the three monthperiods ended September 30, 2008 and 2007. Costs of revenue, excludingdepreciation and amortization, were $10.8 million and $10.7 million for thenine months ended September 30, 2008 and 2007, respectively.   These costs are discussed further below.

** **

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

 

Costs of license fees and services, excluding depreciation andamortization, decreased $0.1 million, or 6%, to $2.0 million for the threemonths ended September 30, 2008 from $2.1 million for the three monthsended September 30, 2007.  As apercentage of license fees and services revenue, costs of license fees andservices, excluding depreciation and amortization, decreased to 44% for thethree months ended September 30, 2008 from 45% for the three months ended September 30,2007.  These decreases are due to lowercosts needed to support lower customer support revenue.

 

Costs of license fees and services, excludingdepreciation and amortization, increased $0.1 million, or 2%, to $6.1 millionfor the nine months ended September 30, 2008 from $6.0 million for thenine months ended September 30, 2007.  The increase in costs is attributed toincreased customer support revenues and to the higher cost of internationalbusiness.  As a percentage of licensefees and services revenue, costs of license fees and services, excludingdepreciation and amortization, decreased to 42% for the nine months ended September 30,2008 from 44% for the nine months ended September 30, 2007, due to theincreased utilization of our lower cost offshore development resources inIndia.

 

**Costs of Customer Support, Excluding Depreciationand Amortization**

 

Costs of customer support, excluding depreciation and amortization,increased $0.1 million, or 3%, to $1.6 million for the three months ended September 30,2008 from $1.5 million for the three months ended September 30,2007.  As a percentage of 

 

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customer support revenue, costs of customer support revenue, excludingdepreciation and amortization, increased to 35% for the three months ended September 30,2008 from 33% for the three months ended September 30, 2007.  These increases are due to increased employeeefforts needed to support the existing and new customer account base.

 

Costs of customer support, excluding depreciation and amortization,remained constant at $4.7 million for each of the nine month periods ended September 30,2008 and 2007.  As a percentage ofcustomer support revenue, costs of customer support revenue, excluding depreciationand amortization, increased to 36% for the nine months ended September 30,2008 from 35% for the nine months ended September 30, 2007.  This percentage increase is due to increasedemployee efforts needed to support the existing and new customer account base.

*** ***

***Salesand Marketing***

 

Sales and marketing expenses primarily consist of compensation costs,including bonuses and commissions, travel expenses, advertising, marketing andfacilities expenses.  Sales and marketingexpenses remained constant at $2.0 million for each of the three month periodsended September 30, 2008 and 2007. As a percentage of total revenue, sales and marketing expenses remainedconstant at 22% for each of the three month periods ended September 30,2008 and 2007.

 

Sales and marketing expenses increased $0.2 million, or 3%, to $6.4million for the nine months ended September 30, 2008 from $6.2 million forthe nine months ended September 30, 2007. As a percentage of total revenue, sales and marketing expenses remainedconstant at 23% for each of the nine month periods ended September 30,2008 and 2007.  The increase in theexpense base is the result of increased travel costs associated with ourexpansion into new international markets, as well as to higher incentivecompensation related to our improved financial results.

*** ***

***Generaland Administrative***

 

General and administrative expenses consist principally of employeerelated costs and professional fees for the following departments: facilities,finance, legal, human resources, and certain executive management.  General and administrative expenses decreased$0.1 million, or 5%, to $1.3 million from $1.4 million for the threemonths ended September 30, 2008 and 2007, respectively.  This decrease was a result of decreasedprofessional fees.  As a percentage oftotal revenue, general and administrative expenses remained constant for thethree months ended September 30, 2008 and 2007 at 14%.

 

General and administrative expenses decreased $0.6 million, or 13%, to$3.9 million from $4.5 million for the nine months ended September 30,2008 and 2007, respectively.  As apercentage of total revenue, general and administrative expenses for the ninemonths ended September 30, 2008 and 2007, decreased to 14% from 17%,respectively.  These decreases were aresult of decreased professional fees as well as to lower landlord costsrelated to our headquarter’s facility lease.

*** ***

***ProductDevelopment***

 

Product development expenses consist primarily of employee relatedcosts and subcontractor expenses.  Productdevelopment expenses increased $0.1 million, or 19%, to $0.8 million from $0.7million for the three months ended September 30, 2008 and 2007,respectively.  As a percentage ofrevenue, product development expenses for the three months ended September 30,2008 and 2007, increased to 9% from 7%, respectively.  These increases are the result of increasedinvestments made in our activation products, including, the development of *Tertio Service Verification* and *TertioService Activation*.  Inaddition, we have invested in the development of our *Dynamic SIMAllocation* product.

 

Product development expenses increased $1.2 million, or 79%, to $2.8million from $1.6 million for the nine months ended September 30, 2008 and2007, respectively.  As a percentage ofrevenue, product development expenses for the nine months ended September 30,2008 and 2007, increased to 10% from 6%, respectively.  These increases are the result of increasedinvestments made in our activation products, including, but not limited to, thedevelopment of our *Tertio ServiceVerification*, *Tertio Service Activation*and *Tertio Process Management*products.  In addition, we have invested in thedevelopment of our *Dynamic SIM Allocation*product.

*** ***

***Depreciation***

 

Depreciation expense consists of depreciation of long-lived propertyand equipment.  Depreciation expense was$0.2 million for each of the three month periods ended September 30, 2008and 2007, respectively, and $0.7 million for each of the nine month periodsended September 30, 2008 and 2007, respectively.

*** ***

***Amortization***

 

Amortization expense consists of amortization of identifiableintangible assets acquired through our acquisitions of CMS, TSE and EvolvingSystems U.K.  Amortization expenseremained constant at $0.4 million for each of the three month periods ended September 30,2008 and 2007.

 

Amortization expense decreased $0.1 million, or 4%, to $1.1 millionfrom $1.2 million for the nine months ended September 30, 2008 and 2007,respectively.  This decrease wasprimarily the result of certain intangible assets reaching their end of life.

 

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***Interest Expense***

 

Interestexpense includes interest expense on our long-term debt and capital leaseobligations as well as amortization of debt issuance costs.  Interest expense was $0.3 million and $0.4million for the three months ended September 30, 2008 and 2007,respectively, and interest expense was $0.9 million and $1.3 million for thenine months ended September 30, 2008 and 2007, respectively.  These decreases of $0.1 million and $0.4million, for the three and nine months ended September 30, 2008,respectively, were the result of reduced levels of debt and to lower interestrates on our senior debt.

*** ***

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

 

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

 

In March 2007,we paid $77,000 to retire $119,000 of subordinated debt and related accruedinterest held by one of our subordinated note holders, resulting in a $42,000gain on debt extinguishment.  The retireddebt included principal of $103,000 and accrued interest of $16,000.

*** ***

***Foreign Currency Exchange Gain***

 

Foreign currency transaction gains resulted from transactionsdenominated in a currency other than the functional currency of the respectivesubsidiary and were $130,000 and $168,000 for the three months ended September 30,2008 and 2007, respectively, and $272,000 and $7,000 for the nine months ended September 30,2008 and 2007, respectively.  The gainswere generated primarily through the remeasurement of certain non-functionalcurrency denominated financial assets and liabilities of our Evolving SystemsU.K. subsidiary.

*** ***

***Income Taxes***

 

Werecorded net income tax expense of $122,000 and $345,000 for the three monthsended September 30, 2008 and 2007, respectively.  The net expense during the three months endedSeptember 30, 2008 consisted of current income tax expense of $186,000,partially offset by a deferred tax benefit of $64,000, both of which wereprimarily related to our U.K.-based operations. The net expense during the three months ended September 30, 2007consisted of current income tax expense of $407,000, partially offset by adeferred tax benefit of $62,000, both of which were primarily related to ourU.K.-based operations.  Our effective taxrate of 17% for the three months ended September 30, 2008 was down from aneffective rate of 38% for the three months ended September 30, 2007.  This reduction in our effective tax raterelates to a change in earnings mix amongst our tax jurisdictions.  We also had an increased benefit fromresearch and development tax credits for our U.K.-based operations.  Additionally, the U.K. corporate tax ratedecreased from 30% to 28% effective April 1, 2008.

 

Werecorded net income tax expense of $161,000 and $569,000 for the nine monthsended September 30, 2008 and 2007, respectively.  The net expense during the nine months ended September 30,2008 consisted of current income tax expense of $367,000, partially offset by adeferred tax benefit of $206,000, both of which were primarily related to ourU.K.-based operations.  The net expenseduring the nine months ended September 30, 2007 consisted of currentincome tax expense of $670,000, partially offset by a deferred tax benefit of$101,000, both of which were primarily related to our U.K.-basedoperations.  Our effective tax rate of13% for the nine months ended September 30, 2008 was down from aneffective rate of 64% for the nine months ended September 30, 2007.  This reduction in our effective tax raterelates to a change in earnings mix amongst our tax jurisdictions.  We also had an increased benefit fromresearch and development tax credits for our U.K.-based operations.  Additionally, the U.K. corporate tax ratedecreased from 30% to 28% effective April 1, 2008.

 

Inconjunction with the acquisition of Evolving Systems U.K., we recorded certainidentifiable intangible assets.  Sincethe amortization of these identifiable intangibles is not deductible for incometax purposes, we established a long-term deferred tax liability of $4.6 millionat the acquisition date for the expected difference between what would beexpensed for financial reporting purposes and what would be deductible forincome tax purposes. As of September 30, 2008 and December 31, 2007,this component of the deferred tax liability was $0.9 million and $1.2 million,respectively.  This deferred taxliability relates to Evolving Systems U.K., and has no impact on our ability torecover U.S.-based deferred tax assets. This deferred tax liability will be recognized as a reduction ofdeferred income tax expense as the identifiable intangibles are amortized.

** **

**FINANCIAL CONDITION**

 

Ourworking capital position decreased $0.8 million to $0.6 million as of September 30,2008 from $1.4 million as of December 31, 2007.  The decrease in our working capital positionis primarily attributable to $3.0 million in existing cash used to retire our$2.0 million revolving credit facility and to retire $1.0 million related toour subordinated notes, including accrued non-current interest.  These debt payments were unscheduled paymentsand reduced balances classified as long-term as of December 31, 2007.  This decrease in our working capital positiondue to early debt payments and capital expenditures was partially offset bycash received as part of our debt refinance of $4.0 million, of which $2.0million is classified as current.   Seealso, “Liquidity and Capital 

 

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Resources,” for further discussion of our working capital.

 

**CONTRACTUALOBLIGATIONS**

 

Therehave been no material changes to the contractual obligations as disclosed inour 2007 Annual Report on Form 10-K.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

We have historically financed operations through cashflows from operations as well as debt and equity transactions.  At September 30, 2008, our principalsource of liquidity was $5.6 million in cash and cash equivalents as well as$5.7 million available under our revolving lines of credit.  The following table summarizes our statementsof cash flows (in thousands):

 
| ** **                | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------|------------|-----------------------------------------------------|------------|
| ** **                | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
| Cash provided  (used) by: |       |                                                |       |   |   |
| Operating  activities     |       | $                                                   | 3,287      |   | $ | 4,413 |   |
| Investing  activities     |       | (481                                                | )          | (268 | ) |
| Financing  activities     |       | (4,105                                              | )          | (1,586 | ) |
| Effect of  exchange rates |       | (343                                                | )          | (28 | ) |
| Net cash  provided (used) |       | $                                                   | (1,642     | ) | $ | 2,531 |   |

 

Net cash provided by operating activities for the nine months ended September 30,2008 and 2007 was $3.3 million and $4.4 million, respectively.  This $1.1 million decrease in cash providedby operating activities is primarily attributable to $0.8 million inunscheduled interest payments made on our subordinated notes during the ninemonths ended September 30, 2008.

 

Net cash used by investing activities for the nine months ended September 30,2008 and 2007 was $0.5 million and $0.3 million.  The cash used for the nine months ended September 30,2008 related entirely to purchases of property and equipment of $0.5million.  The cash used for the ninemonths ended September 30, 2007 related primarily to purchases of propertyand equipment of $0.5 million, partially offset by reductions in restrictedcash of $0.2 million.

 

Net cash used in financing activities for the nine months ended September 30,2008 and 2007 was $4.1 million and $1.6 million, respectively.  Financing activities for the nine monthsended September 30, 2008 consisted of principal payments on existing debtof approximately $7.8 million, partially offset by borrowings related to ournew senior term loan of approximately $3.7 million, net of issuance costs.  Financing activities in the nine months endedSeptember 30, 2007 consisted of principal payments on notes payable of$1.6 million.

 

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

 

·                  Our cash andcash equivalents balance at September 30, 2008 of $5.6 million;

 

·                  The availabilityunder our revolving credit facilities of $5.7 million at September 30,2008;

 

·                  Our demonstratedability to generate positive cash flows from operations;

 

·                  Our backlog asof September 30, 2008 of approximately $13.7 million, including $6.5million in license fees and services and $7.2 million in customer support;

 

·                  Our plannedcapital expenditures; and

 

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

 

We are exposed to foreign currency rate risks which impact the carryingamount of our foreign subsidiaries and our consolidated equity, as well as ourconsolidated cash position due to translation adjustments.  For the nine months ended September 30,2008, the effect of exchange rate changes resulted in a $344,000 decrease toconsolidated cash.  During the ninemonths ended September 30, 2007, the effect of exchange rate changesresulted in a $28,000 decrease in consolidated cash.  We do not currently hedge our foreigncurrency exposure, but we monitor rate changes and may hedge our exposures ifwe see significant negative trends in exchange rates.

 

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**OFF-BALANCESHEET ARRANGEMENTS**

 

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

 

**ITEM3.  QUANTITATIVE AND QUALITATIVE MARKETRISK DISCLOSURES**

 

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

*** ***

***InterestRate Risks***

 

Our cash balancesare subject to interest rate fluctuations and as a result, interest incomeamounts may fluctuate from current levels. We are exposed to interest rate risk related to our senior revolvingcredit facilities entered into in February 2008.  These obligations are variable interest ratenotes based on Prime Rate.  Fluctuationsin Prime Rate affect our interest rates.

*** ***

***ForeignCurrency Risk***

 

We are exposed tofavorable and unfavorable fluctuations of the U.S. dollar (our functionalcurrency) against the currencies of our operating subsidiaries. Any increase(decrease) in the value of the U.S. dollar against any foreign currencythat is the functional currency of one of our operating subsidiaries will causethe parent company to experience unrealized foreign currency translation losses(gains) with respect to amounts already invested in such foreigncurrencies.  In addition, we and ouroperating subsidiaries are exposed to foreign currency risk to the extent thatwe enter into transactions denominated in currencies other than our respectivefunctional currencies, such as accounts receivable (including intercompanyamounts) that are denominated in a currency other than their own functionalcurrency. Changes in exchange rates with respect to these items will result inunrealized (based upon period-end exchange rates) or realized foreign currencytransaction gains and losses upon settlement of the transactions. In addition,we are exposed to foreign exchange rate fluctuations related to our operatingsubsidiaries’ monetary assets and liabilities and the financial results offoreign subsidiaries and affiliates when their respective financial statementsare translated into U.S. dollars for inclusion in our consolidated financialstatements. Cumulative translation adjustments are recorded in accumulatedother comprehensive income (loss) as a separate component of equity. As aresult of foreign currency risk, we have and may continue to experienceeconomic loss and negative impacts on earnings and equity with respect to ourholdings solely as a result of foreign currency exchange rate fluctuations.

 

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

 
| **Spot rates:** | ** ** | **September 30,  2008** | ** ** | **December 31, 2007** | ** ** |
|----------------------|------------|------------------------------|------------|---------------------------------|------------|
| Great British  Pound |       | 0.55038                      |       | 0.50092                         |       |
| Indian Rupee         |       | 47.25898                     |       | 39.43218                        |       |

 
| ** **              | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **Average rates:** | ** ** | **September 30,  2008**     | ** ** | **September 30,  2007**    | ** ** | **September 30,  2008** | ** ** | **September 30,  2007** | ** ** |
| Great British  Pound    |       | 0.52865                          |       | 0.49494                         |       | 0.51390 |   | 0.50352 |   |
| Indian Rupee            |       | 43.72414                         |       | 40.52512                        |       | 41.62863 |   | 41.91718 |   |

 

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

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

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

 

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

 

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

 

During the three and ninemonths ended September 30, 2008, there were no changes in our internalcontrols over financial reporting (as defined in Rule 13a-15(f) underthe Exchange Act) or in other factors that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II — OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

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

 

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

** **

**ITEM1A.  RISK FACTORS**

 

This Quarterly Report on Form 10-Q should be read in conjunctionwith the risk factors defined in our Annual Report on Form 10-K for theyear ended December 31, 2007 under “Item 1A. Risk Factors.”

*** ***

***The Current Economic Environment and Fluctuations in Currency ExchangeRates Could Adversely Impact Our Business.***

 

In recent months, domestic and global economies have experiencedsignificant difficulties within the financial and credit markets, and theseadverse economic conditions are predicted to continue into the foreseeablefuture. The current unfavorable economic conditions as well as fluctuations incurrency exchange rates could adversely affect our business, financialcondition, operating results and cash flows. Because of the severity and the far-reaching impacts of the situation,all companies could be adversely affected by the current economic conditions toa certain degree, including us and our customers. There can be no assurancesregarding the performance of our business, and the potential impact to ourcustomers and the markets they serve, resulting from the current economicconditions.

** **

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

** **

None

** **

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES**

** **

None

 

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

 

None

 

**ITEM 5. OTHER INFORMATION**

 

None

** **

**ITEM6.  EXHIBITS**

 

(a)          Exhibits

 

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

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

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

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

 

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**SIGNATURE**

 

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

 
| Date: November 12,  2008 | /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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