**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

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

**Forthe fiscal year ended December 31, 2006**

**OR**

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

**Forthe transition periodfrom          to          **

**CommissionFile Number: 0-24081**

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**EVOLVINGSYSTEMS, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                                                     |   | **84-1010843**                           |
|------------------------------------------------------------------|--------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification Number) |
| **9777 Pyramid Court, Suite 100,  Englewood, Colorado**     |   | **80112**                                |
| (Address of  principal executive offices)                        |   | (Zip Code)                               |

 

**(303) 802-1000**

(Registrant’s telephonenumber, including area code)

Securities registered underSection 12(b) of the Act: **None**

Securities registered underSection 12(g) of the Act:

**Common Stock, par value$0.001 per share**

(Title of class)

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Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act. Yes o No x

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes x No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Exchange Act.
| Large accelerated filer o | Accelerated  filer o | Non-accelerated  filer x |
|--------------------------------|---------------------------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o No x

The approximate aggregatemarket value of the Common Stock held by non-affiliates of the registrant,based upon the last sale price of the Common Stock reported on the NasdaqCapital Market, was approximately $19.1 million as of June 30, 2006.

The number of shares ofCommon Stock outstanding was 16,253,153 as of March 1, 2007.

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**DOCUMENTSINCORPORATED BY REFERENCE**

Theinformation required by Part III (Items 10, 11, 12, 13 and 14) isincorporated by reference to portions of the registrant’s definitive proxystatement for the 2007 Annual Meeting of Stockholders, which will be filed withthe Securities and Exchange Commission within 120 days after the close ofthe 2006 year.

 

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**EVOLVINGSYSTEMS, INC.Annual Report on Form 10-KFor the year ended December 31, 2006Table of Contents**
|          | ** ** | ** **                                                                                                         | ** ** | **Page** | ** ** |
|----------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
|     | ** ** | **PART I**                                                                                                    |       |     |       |   |   |
| Item 1   |       | Business                                                                                                           |       |     | 2          |   |   |
| Item 1A  |       | Risk  Factors                                                                                                      |       |     | 10         |   |   |
| Item 1B  |       | Unresolved Staff Comments                                                                                          |       |     | 25         |   |   |
| Item 2   |       | Properties                                                                                                         |       |     | 25         |   |   |
| Item  3  |       | Legal  Proceedings                                                                                                 |       |     | 26         |   |   |
| Item 4   |       | Submission of Matters to a Vote of Security Holders                                                                |       |     | 26         |   |   |
|     | ** ** | **PART II**                                                                                                   |       |     |       |   |   |
| Item 5   |       | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |       |     | 27         |   |   |
| Item  6  |       | Selected  Financial Data                                                                                           |       |     | 28         |   |   |
| Item 7   |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                        |       |     | 29         |   |   |
| Item 7A  |       | Quantitative and Qualitative Disclosures About Market  Risk                                                        |       |     | 44         |   |   |
| Item 8   |       | Financial Statements and Supplementary Data                                                                        |       |     | 46         |   |   |
|     |       | Report of Independent Registered Public Accounting  Firm                                                           |       |     | 46         |   |   |
|     |       | Consolidated Balance Sheets                                                                                        |       |     | 47         |   |   |
|     |       | Consolidated Statements of Operations                                                                              |       |     | 48         |   |   |
|     |       | Consolidated Statements of Changes in Stockholders’  Equity and Comprehensive Income (Loss)                   |       |     | 49         |   |   |
|     |       | Consolidated Statements of Cash Flows                                                                              |       |     | 50         |   |   |
|     |       | Notes to Consolidated Financial Statements                                                                         |       |     | 51         |   |   |
| Item 9   |       | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                              |       |     | 77         |   |   |
| Item 9A  |       | Controls and Procedures                                                                                            |       |     | 77         |   |   |
| Item  9B |       | Other  Information                                                                                                 |       |     | 77         |   |   |
|     | ** ** | **PART III**                                                                                                  |       |     |       |   |   |
| Item 10  |       | Directors, Executive Officers and Corporate Governance                                                             |       |     | 77         |   |   |
| Item 11  |       | Executive Compensation                                                                                             |       |     | 77         |   |   |
| Item 12  |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters     |       |     | 78         |   |   |
| Item 13  |       | Certain Relationships and Related Transactions, and  Director Independence                                         |       |     | 78         |   |   |
| Item 14  |       | Principal Accounting Fees and Services                                                                             |       |     | 78         |   |   |
|     | ** ** | **PART IV**                                                                                                   |       |     |       |   |   |
| Item 15  |       | Exhibits, Financial Statement Schedules                                                                            |       |     | 78         |   |   |
|     |       | Signatures                                                                                                         |       |     | 81         |   |   |

 

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**FORWARD-LOOKINGSTATEMENTS**

*Except for the historical information contained inthis document, this report contains forward-looking statements includingestimates, projections, statements relating to our business plans, objectivesand expected operating results and assumptions. These forward-lookingstatements generally are identified by the words “believes,” “goals,” “projects,”“expects,” “anticipates,” “estimates,” “intends,” “strategy,” “plan” andsimilar expressions. Forward-looking statements are based on currentexpectations and assumptions and are subject to risks and uncertainties whichmay cause our actual results to differ materially from those discussed here.Factors that could cause or contribute to such differences include, but are notlimited to those discussed in this section, in the sections entitled “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” and “RiskFactors.” We undertake no obligation to update or revise publicly anyforward-looking statements, whether as a result of new information, futureevents or otherwise.*

**PART I**

**ITEM 1.**                BUSINESS

**INTRODUCTION**

Evolving Systems, Inc.is a leading provider of software solutions and services to the wireless,wireline and IP carrier market. We maintain long-standing relationships withmany of the largest wireline, wireless and IP communications carriersworldwide. Our customers rely on us to develop, deploy, enhance, maintain andintegrate complex, highly reliable software solutions for a range of OperationsSupport Systems (“OSS”). Included among our more than 40 global customers isthe largest wireline carrier, the largest wireless carrier and the largestcable company in North America, as well as two of the world’s largest wirelesscarriers headquartered outside of North America. We offer software products andsolutions in three core areas:

·       *numbering solutions* products allow carriers to manage theirtelephone number inventory and number assignment processes. In addition, oursolutions include products that comply with government-mandated requirementsregarding local number portability;

·       *service activation solutions* used to activate complexbundles of voice, video and data services for traditional and next generationwireless and wireline networks; and

·       *mediation solutions* supporting data collection for bothservice assurance and billing applications.

Historically, our products have been used to supporttraditional wireless and wireline network telephony capabilities; however, as aresult of our on-going investment in and improvement of our products, we nowoffer products to carriers to support both their voice and data offerings overInternet Protocol (“IP”) and advanced broadband networks.

We have significantly expanded our portfolio ofproducts as a result of three acquisitions that were made over the periods of November 2003through November 2004. The first acquisition was CMS Communications, Inc.(“CMS”) in November 2003, where we acquired a network mediation andservice assurance solution. Our second acquisition was Telecom SoftwareEnterprises, LLC (“TSE”) in October 2004 where we added LNP and WirelessNumber Portability (“WNP”) number ordering and provisioning monitoring andtesting products. Finally, in November 2004 we acquired Tertio TelecomsLtd. (“Evolving Systems U.K.”), a supplier of OSS software solutions formediation and service activation to communication carriers throughout Europe,the Middle East, Africa and Asia. With this acquisition we expanded our marketsbeyond North America and added an activation solution, *TertioTM,*anda mediation solution, *EvidentTM*, toour product portfolio. The consequence of these acquisitions is a significantlyexpanded product and service capability that now enable us to address a largerportion of our customers’ OSS application needs. Moreover, we have become aglobal company with development capabilities in 

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three continents and asales and deployment capability covering nearly all regions of the world. Ourcustomer base includes many of the world’s largest and fastest growingcommunications carriers. Our customer base includes over 40 customers andsupport for  over 60 carrier networks in41 countries. Today, we are well positioned as a provider of OSS solutions withcomprehensive systems integration capabilities. These complementarycompetencies allow us to implement solutions across much of a carrier’s backoffice, addressing core needs in the complete service fulfillment process.

We report the operationsof our business as two operating segments based on revenue type:  license fees/services revenue and customersupport revenue. We further report geographic information based upon revenuesand long-lived assets in the Americas and all foreign countries.  Further information regarding our operatingsegments and geographical information is contained in Note 12 to ourConsolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K.

**COMPANY BACKGROUND**

Founded in 1985, we initially focused on providingcustom software development and professional services to a limited number oflarge telecommunications companies in the United States. In 1996, concurrentwith the passage of the Telecommunications Act of 1996 (“the Telecom Act”), wemade a strategic decision to add software products to our established professionalservices offerings. The outcome of that decision was the creation of acomprehensive product portfolio, of which we are best known for our LocalNumber Portability and Number Management solutions.

In 2002, we initiated a restructuring plan which, inaddition to significant operational cost reductions and greater leverage ofoffshore development, included the reengineering of our business model toinclude a product and solutions model. This business model reflected a morebalanced mix of products and product enhancements, as well as services, such asintegration services to better meet our customers’ back office requirements. Wecomplement this business model with product development investments driven bymarket research and customer-specific requirements. We license and supportsolutions which include our products as well as product extensions andintegration services.

In 2004 and 2005, with ourgrowing product portfolio and geographic reach, we enhanced our sales model toinclude both direct and indirect channels. We formed new relationships withnetwork equipment providers and system integrators to extend our reach to newgeographical regions as well as help us further penetrate our existingterritories.  In 2006, we added moreregional partners to help with both local selling and deployments in emergingmarkets

**RECENT DEVELOPMENTS**

**Leader in WirelessService Activation**

In June 2006, YankeeGroup, a top industry research analyst firm, ranked us as the market leader inwireless service activation and one of the top three suppliers in the overallservice activation market. The research firm examined the service activationmarket size and growth, along with the features service providers want in asolution and analyzed the vendor landscape in this competitive market.

**NumeriTrackInternational 3.0**

In September 2006, weannounced the general availability of our NumeriTrack® number managementsolution designed for the international markets. The numbering schemes in manyinternational countries vary greatly from the standard 10-digit dialingplan implemented in North America. Consequently, we modified our North Americanversion of NumeriTrack extensively to support the requirements of the variousdialing plans implemented around the world. Our NumeriTrack solution is adedicated number management system that automates and simplifies the storing,assignment, 

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management,analysis and reporting of numbering resources for fixed, mobile and VoIPservices. Designed to work alongside existing billing, activation and numberportability systems, it enables service providers to have a single, centralizedsystem that speeds up response times, reduces error rates and allows for easierintroduction of new technologies and services.

**Accelerated FilerStatus**

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

·       Has a common equity public float of $75 million or more as of thelast business day of its most recently completed second fiscal quarter;

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

·       Previously filed at least one annual report pursuant to Section 13(a) or15(d) of the Exchange Act; and

·       Is not eligible to useForms 10-KSB and 10-QSB.

As of the last businessday of our most recently completed second fiscal quarter, June 30, 2006,our common equity public float was less than $75 million. Therefore, we are notan accelerated filer, as defined in Securities Exchange Act Rule 12b-2,and are not required to comply with the management reporting on internalcontrol over financial reporting for the year ending December 31, 2006under Section 404. Under current SEC rules, we will be required to providea report by management assessing the effectiveness of our internal control overfinancial reporting as of December 31, 2007 and will be required toprovide an auditor’s report on internal control over financial reporting as of December 31,2008.

**INDUSTRY DYNAMICS**

Historically,telecommunications carriers have operated in a highly regulated environment.Deregulation in many countries has stimulated competition which has led to anincrease in the number of telecommunications carriers that operate in a givenmarket. This increase in competition coupled with the emergence of newtelecommunications technologies, such as fiber optics, packet-data networks,digital and wireless telephony as well as Internet-based services hascreated an industry that is in the midst of significant change. Traditional wirelinecustomers are migrating with an increasing frequency to broadband and wirelessservices requiring network operators to make large capital expenditures in theareas of broadband and wireless infrastructure, as well as new productofferings to differentiate themselves. In response to these market changes, wehave broadened our product portfolio through internal R&D, customer-fundedinitiatives and the acquisition of key new products and technologies. Thecompetitive landscape is continually changing as the communications industryconsolidates in almost every geographic market.

**OPERATIONS SUPPORTSYSTEMS (“OSS”)**

OSS encompasses a broad array of software and systemsthat perform critical functions for telecommunications carriers, such asservice fulfillment, service assurance, and billing. Service fulfillmentencompasses ordering, provisioning and activation as well as inventory systems.Ordering systems collect customer information, retrieve current serviceinformation, capture and validate new service requests, verify the availabilityof selected services and transmit completed orders to one or more provisioningOSS. Inventory systems maintain both physical and logical views of all thetelecommunications assets required to 

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turn up a service. Carriersuse provisioning and activation systems to turn up network service and turnservices off and on for new customers, as well as change or add services forexisting customers. Service assurance systems allow carriers to perform thetesting, monitoring and reporting necessary to maintain appropriate networkavailability and feed operational data to other business systems. Serviceassurance systems also allow carriers to track and report on service conditionsor outages in order to dispatch the carrier’s large work force for necessaryrepairs. Carriers use billing systems to collate, manage and report usageinformation for partner and customer billing. OSS systems typically operate ina 24x7 environment to support the real-time communication networks that are thebackbone of the carriers’ service offerings.

Traditionally, as carriershave added new services, such as wireless or Internet-based services,they have either developed their own in-house OSS systems or added new OSSsystems from product vendors. These additional OSS systems can be difficult tointegrate into the carriers operations. In addition, these various OSS systemsoften utilize incompatible elements, making interoperability among the systemsdifficult. These OSS systems are further constrained by the many incrementalchanges that have been made in order to accommodate new computing and networktechnologies and new value-added services such as; call waiting, callforwarding and voice mail, broadband data and video. In addition, carriers havehad to adapt their OSS to comply with government or regulatory mandates that insome cases change how systems and processes are required to work. Despite thesedifficulties, the carriers have been unable to completely replace existing OSSsystems due to the large investment and vast amounts of historical datacontained in these systems. As a result, carriers continue to make incrementalmodifications to these OSS systems, thereby further increasing their complexityand making it more difficult for the systems to interoperate successfully. However,a trend over the past decade has been the replacement of a portion of thecarrier’s legacy OSS environment with OSS software packages designed to meetgrowing complex processes in the areas of service fulfillment, service assuranceand billing.

**PRODUCT PORTFOLIO**

***Numbering Solutions***

Evolving Systems’Numbering Solutions product line includes our Local Number Portability (LNP)and Wireless Number Portability (WNP) products as well as our *NumeriTrack®* number inventory and assignment solution*.*

***LNP and WNP***

Our NumberPortability software solution enables carriers to comply with U.S. and Canadianmandates for regulations implementing LNP and WNP. For traditional wireline,wireless networks, as well as Internet Protocol (“IP”) networks, this requiresservice providers to allow customers the ability to retain, or “port”, theirphone numbers when changing from one service provider to another. Our LNPsoftware for ordering, provisioning, reporting, testing and exchanginginformation between carriers is widely used by wireline, wireless and cableservice providers and is involved in over 45 percent of all portingtransactions in the United States each year. In addition, we developed theinitial custom software used by all eight regional Number PortabilityAdministration Centers (NPACs) in North America to control the porting process.This software receives ported telephone number information from carriers aschanges occur and distributes the data to all subscribing carriers in theregion. Our software was provided under contract to NeuStar, Inc.,formerly a division of Lockheed Martin IMS. Over time, we have expanded ournumber portability product features and developed other number portabilityrelated OSS software products for the wireline, wireless and cable markets. Ourfull LNP and WNP product line comprises the following collection of products:

·       *OrderPath®* order entry;

·       *NumberManager®* network provisioning;

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·       *LNP DataServerTM* data warehousing;

·       *PortExchangeTM* Inter-carrier Communications Processorpre-porting;

·       *VeriPortTM* NPAC testing;

·       *VeriCommTM* Inter-carrier Communications Processor testing;and

·       *VerifyTM* product suite for monitoring carriers’ applicationcommunications for optimum service assurance.

***Number Inventory and Assignment***

We developed our *NumeriTrack®*solution in response to the FCC mandated number conservation and number poolingregulations for both wireline and wireless carriers. These regulations,implemented in 2003, resulted from the FCC’s concern that the U.S. was runningout of 10-digit telephone numbers. As a result, the FCC designedregulations to extend the life of the 10-digit numbering plan well intothe 21st century by changing the way phone numbers areallocated to carriers and specifying rules regarding the assignment andclassification of those numbers. The regulations also require regularutilization reporting by carriers and articulation of circumstances under whichpreviously underutilized telephone numbers must be returned to the “pool” to bereallocated to other carriers. Our NumeriTrack solution, which has beenlicensed to seven carriers, facilitates compliance with the FCC mandates forboth wireline and wireless carriers (and cable carriers providing telephonyservices). Our solution provides inventory management of phone numbers andother assets such as SIM cards and supports inventory assignments andintegration with carriers’ existing back-office systems. The NumeriTracksolution also contains features for the inventory of, and assignment logic for,numbers associated with IP addresses and is used by a large carrier in the U.S.for deployment of a Voice over Internet Protocol (“VoIP”) service offering. Asis the case with our LNP and WNP solutions, the implementation of ourNumeriTrack solution has far-reaching implications for integration withcarriers’ existing OSS environments and business processes. In 2006, wecompleted the work to adapt our NumeriTrack International application formarkets outside of the United States.

Our investments in ourNumeriTrack solution now allow us to sell and deploy this solution in marketsoutside of the United States. The resource management and assignmentcapabilities of NumeriTrack will allow carriers around the globe to acquire andtrack phone numbers and other logical and physical assets for their products onboth traditional and next generation service wireless and wireless networks. Thesystem will efficiently manage those assets through the lifecycle of theservice, allowing carriers to spend less in acquiring new resources such as IPaddresses, phone numbers and SIM cards, for various products and regions.

***Service Activation***

Our service activation solution, *TertioTM*,is employed by carriers to activate new service, including two of the world’slargest wireless carriers. The Tertio application is used by two of world’slargest wireless carriers and some of the world’s most advanced and demandingservice providers. Our solution is these carriers’ next-generation solution andis deployed as the service activation engine for over 40 networks around theworld. Our Tertio product provides a flexible operating environment and can beused by carriers to manage their voice, data, and content service needs forboth their traditional and broadband IP networks.

Tertio is anintegrated solution comprised of five components:

·       TertioService Composer—a modeling tool that simplifies the creation of new services;

·       TertioContent Connector—a tool used for activation of next-generation services;

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·       TertioActivation Designer—a tool that is designed to speed network featureactivation;

·       TertioService Activation—the platform that provides scalability and performance,flexibility and a graphical interface; and

·       TertioService Verification—a module that allows carriers to verify that the servicesimplemented in the network match those that were in the original service order.By providing this capability, carriers can continually check the accuracy oftheir order/activation processes.

Our Tertio solutionaddresses the entire service lifecycle, enabling service providers to betterplan, manage and execute the introduction of new services. Tertio allowscarriers to introduce new network technologies and eases the burden ofintegration with existing devices and systems.

***Mediation***

Our mediation portfolioconsists of network data mediation products and billing mediation. The networkmediation products include our Traffic Data Management System (“TDMS”),acquired in the CMS acquisition, and our next-generation product *Mediation CentralTM*. Our billing mediation product, *EvidentTM*, was acquired as part of the Evolving Systems U.K.acquisition.

***Billing Mediation***

Billing mediation is the process of collecting networkusage data and verifying that usage data is accurate, and is a requiredpre-condition for generating accurate bills for a carrier’s customers. Billingmediation’s importance lies in its ability to provide a systematic point ofreliability and assurance between network consumption and the billing systeminput. Our Evident product supports convergent voice, data, and contentservices. Evident enables the accurate management of data, allowingreconciliation of data inputs and outputs. In addition, Evident providessupport for compliance with relevant regulatory, accounting and data integrityrequirements. This product also provides service usage data for businessintelligence, revenue assurance, and next-generation billing solutions. Our Evidentsolution can be used by wireline, broadband and wireless carriers and providescarrier-grade support in terms of reliability, performance, and scalability.

As carriers bring newservices to market they often need a new mediation process to support those newservices. Our Evident solution has been designed with the flexibility tosupport new service concepts and designs.

***Network Assurance and Data Collection Solutions***

A common challenge for telecommunications carriers isto create an integration layer between network element (“NE”) devices and theOSS applications that provision, monitor and control these devices. Deployingnew devices needed for extending service offerings into the network cantherefore be difficult, time consuming and expensive. Our mediation solutionsprovide a common framework for simplifying the data collection and distributionof critical network data. Our network mediation product, Mediation Central,supports a broad array of technologies that carriers typically deploy in theirnetwork. Mediation Central provides support for wireline, broadband, transportand wireless networks. Our Mediation Central product supports both centralizedand distributed configurations allowing, for example, carriers to deploy asingle solution for all their data collection and distribution needs.

We also offer our TDMSsolution, which is designed to automate key business processes and makevaluable network data available to select employees in the enterprise,including alarm and fault management, capacity and network planning, datacollection, mediation, performance management, service activation, servicedesign and assignment, and service quality analysis. TDMS is installed as thenarrowband traffic collection data system in the two largest wireline carriers.

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**PROFESSIONAL ANDINTEGRATION SERVICES**

Our Professional andIntegration Services team provides expert consulting services and advice forthe design, customization, integration and deployment for our NumberingSolutions, Service Activation and Mediation product portfolios. TheProfessional and Integration Services team works closely with the ProductEngineering and Development teams to ensure we are up to date with the latestproduct developments. These services cover all aspects of the project lifecycleincluding system architecture and design, component design, development andcustomization, system integration and testing, deployment and productionsupport, program and project level management, domain and product expertise. Ourteams work closely with customers and integration partners and have establishedclose, long-term relationships with operators in the Americas, Europe, theMiddle East, Africa and Asia Pacific regions.

**RESEARCH ANDDEVELOPMENT**

We expend amounts on research and development (“R&D”),particularly for new products and/or for enhancements of existing products. Asdiscussed in Note 1 in the notes to our Consolidated Financial Statementsincluded elsewhere in the Annual Report on Form 10-K, R&D isexpensed as incurred. For the years ended December 31, 2006, 2005 and2004, we expensed $3.1 million, $1.9 million and $1.1 million, respectively, inresearch and development costs. The majority of all new R&D investments in2006 have gone into enhancing our Tertio wireless service activation solutionand internationalizing our NumeriTrack inventory and assignment solution.

We focus our productdevelopment efforts on identifying specific industry and customer businessneeds as well as market requirements and then developing solutions thatleverage our existing product capabilities. Based upon the identified customerbusiness needs, our research and development efforts comprise a combination ofdesign and development of new products or features to enhance our existingproducts, and design and development of new product functionality as identifiedin our product “roadmaps.”  We buildinvestment plans for our three principal product areas and we make otherinvestments in tools and product extensions to accelerate the development,implementation and integration process for customer solutions.

**BUSINESS STRUCTUREAND STRATEGY FOR GROWTH**

We have developed a combination product solutionsbusiness model that leverages our products and strong telecommunications domainexpertise with a worldwide work force. This business model combines our U.S.presence and United Kingdom presence with the cost effective offshoredevelopment capabilities provided by our Indian subsidiary.

Our strategy for growthrevolves around Tertio, our wireless service activation product, and ourrecently released international version of our NumeriTrack product. We haverecently made significant investments in both of these products and will focuson both traditional and emerging markets as we build plans to add significantnew functionality to these products. These plans include enhancing andextending the functionality of these platforms to provide a more complete androbust solution set for the activation and number/SIM management for allmarkets. These investments target growth in the market around wireless andwireline convergence of services on IP networks.

**SALES AND MARKETING**

The primary objective ofour sales and marketing efforts is to identify markets for our products, createappropriate sales collateral and direct our sales force to those carrierslikely to need our products and services. Our sales force builds relationshipswith target carriers and educates both existing and potential carriers aboutthe depth and breadth of our capabilities, experience, product portfolio andthe business case for an implementation of our solutions. Our sales andmarketing efforts also include a high-level of 

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interactionwith existing customers and prospects, participation in relevant industrybodies and trade shows, a website presence, presentations at industryconferences and forums, new releases to the industry and other marketinginitiatives. Many of our sales activities are a result of responding torequests for proposals and competitive tenders. The majority of our salesefforts are conducted by direct sales teams. We are increasingly engaging insales activities with channel and business partners or system integrators suchas Alcatel, Siemens and Accenture who have been selected by our customers forlarger solution implementations where our products represent a portion of theoverall solution. We plan to continue this approach of working with global andlocal partners and system integrators.

**COMPETITION**

The market for telecommunications OSS products isintensely competitive and is subject to rapid technological change, changingindustry standards, regulatory developments and consolidation. We faceincreasing demand for improved product performance, reduced prices and rapidintegration capabilities, and pricing pressures. Our existing and potential competitorsinclude many large domestic and international companies that often havesubstantially greater financial, technological, marketing, distribution andother resources, larger installed customer bases and longer-standingrelationships with telecommunications customers than we do. The market fortelecommunications OSS software and services is extremely large. Thatnotwithstanding, we currently hold only a small portion of total market share. Ourstrict focus on numbering solutions, activation solutions and mediationsolutions, has resulted in our achieving a measurable and reasonable marketshare in those three areas.

Our principal competitors in the LNP and WNP marketinclude Telcordia Technologies, Inc., Syniverse Technologies and Neustar.Our principal competitors in activation are Oracle/Metasolv and Comptel. In mediation, we compete with many differentcompanies including Intec, Amdocs and Comptel.

Many of our customers have large internal developmentorganizations, which develop software solutions and provide services similar toour products and services. As a result, our customers often choose to implementtheir own solutions rather than choosing solutions we offer. In addition,companies such as EDS, Perot and IBM Global Services compete with us forintegration work.

We believe that ourability to compete successfully depends on a wide range of factors. We competeby offering quality solutions at a competitive price that are tailoredspecifically to the customer. Furthermore, once our customer has implementedone of our core software products, we are in a preferable position, in contrastto our competitors, to develop additional functionality or react to changes inour customers’ business needs by offering additional products or services. Manyof our customer relationships span five years or more with some extendingbeyond ten years. We believe these long-term relationships also give us acompetitive advantage.

**SIGNIFICANTCUSTOMERS**

In 2006, approximately 26%of our consolidated revenues came from two unrelated customers in thetelecommunications industry, each of which accounted for more than 10% of ourconsolidated revenues. Of these customers, one is located in the U.S. and theother is located in the U.K.  The loss ofeither of these customers would have a material adverse effect on our businessas a whole.

**INTELLECTUALPROPERTY**

We rely on a combinationof copyright, trademark and trade secret laws, as well as confidentialityagreements and licensing arrangements, to establish and protect our proprietaryrights. We presently have U.S. and Canadian patents on elements of ourprincipal LNP OSS products, *NumberManager**®* and *OrderPath**®*.

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**BACKLOG**

We define backlog as firmnon-cancelable sales orders that are anticipated to be delivered and recognizedin revenue over the next twelve months. As of December 31, 2006 and 2005,our backlog, as defined, was approximately $13.8 million and $12.6 million,respectively. Our backlog, as defined, at December 31, 2006 is comprisedof license fees and services of $4.8 million and customer support of $9.0million compared to license fees and services of $3.5 million and customersupport of $9.1 million at December 31, 2005.

**EMPLOYEES**

As of December 31,2006, we employed 227 people including 58 in the United States, 70 in theUnited Kingdom and 99 in Bangalore, India. Of our worldwide staff, 81% areinvolved in product delivery, development, support and professional services,10% in sales and marketing, and 9% in general administration.

**AVAILABLEINFORMATION**

You can find out moreinformation about us at our Internet website located at *www.evolving.com.* The information on our website is not incorporated into this AnnualReport on Form 10-K. Our Annual Reports on Form 10-K,our Quarterly Reports on Form 10-Q, and our Current Reports on Form 8-Kand any amendments to those reports are available free of charge on ourInternet website as soon as reasonably practicable after we electronically filesuch material with the SEC. Additionally, these reports are available at theSEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549or on the SEC’s website at *www.sec.gov*. Informationon the operation of the Public Reference Room can be obtained by callingthe SEC at 1-800-SEC-0330.

**ITEM 1A.**        RISKFACTORS

**Risks related toour 2004 Acquisition of Evolving Systems U.K.**

***We are subject to financial and operating risksassociated with global sales and services.***

Prior to ouracquisition of Evolving Systems U.K. in late 2004, our sales had been limitedto customers in the United States and our only operational experience outsidethe U.S, was with our Indian offshore activities. The acquisition of EvolvingSystems U.K. resulted in the addition of significant sales and operationsoutside the U.S., including Europe, Asia and Africa. Our failure to manage oursales and operations on a global basis could harm our business and operatingresults. Our business outside the U.S. is subject to financial and operatingrisks including:

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

·       difficultiesin maintaining effective controls over financial reporting acrossgeographically dispersed entities, including those related to differentbusiness practices in foreign countries;

·       internalcontrol-related risks of running foreign subsidiaries;

·       changesin the demand for our products and services due to the perception that we arean “American” company in countries where the United States’ foreign policy isnot viewed favorably;

·       fluctuatingforeign currency exchange rates, tariffs, currency repatriation restrictionsand other barriers;

·       difficultiesin staffing and managing foreign subsidiary operations;

·       importor export restrictions;

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·       greaterdifficulties in accounts receivable collection and longer payment cycles;

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

·       potentialhostilities and changes in diplomatic and trade relationships;

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

·       differing customer and/ortechnology standards requirements.

***The indebtednessincurred in connection with the Evolving Systems U.K. acquisition may limit ourability to grow and could adversely affect our financial condition.***

In partial consideration for our acquisition ofEvolving Systems U.K., we made a cash payment of $11.0 million, issued 966,666shares of Series B Convertible Preferred Stock (the “Series BPreferred Stock”), issued a short-term secured note with a principal amount of$4.0 million bearing interest at 5.5% per annum and issued long-term securednotes with an aggregate principal amount of approximately $11.9 million bearinginterest initially at 11% per annum (increasing to 14% on the secondanniversary). The short-term secured note was paid in full as of June 30,2005.

In November 2005, we restructured approximately$13.4 million in debt associated with our 2004 acquisition of Evolving SystemsU.K. Under the terms of the debt restructuring, the Evolving Systems U.K.sellers agreed to exchange their long-term notes for $8.5 million in cash andapproximately $4.9 million in unsecured subordinated notes, due in May 2011.We used proceeds obtained from a five year $8.5 million senior secured termnote provided by a commercial finance company to make the cash payments. Therestructuring reduced our scheduled principal payments through December 31,2007, from approximately $12.0 million to $3.0 million. In addition, we added a$4.5 million revolving credit facility with the same commercial finance companyto be used for working capital and general corporate purposes.

The indebtednessincurred with respect to the acquisition of Evolving Systems U.K. and,possibly, the redemption of the Series B Preferred Stock, is material inrelation to prior levels of indebtedness. We may not have sufficient fundsavailable to meet our operating needs, to pay the interest due on our securednotes or, if required, to redeem the Series B Preferred Stock. The notesare secured by a general lien on all of our assets. If we are unable to pay thenotes as they become due, the holders of the notes could foreclose on all ofour assets. The increased level of our indebtedness, among other things, could:

·       make it difficult for us to obtain any necessary future financing forworking capital, capital expenditures, debt service requirements or otherpurposes;

·       limit our flexibility in planning for, or reacting to changes in, ourbusiness; and

·       make us more vulnerable in the event of a downturn in our business.

Ifwe incur new indebtedness in the future, the related risks that we now facecould intensify. Whether we are able to make required payments on ouroutstanding indebtedness and to satisfy any other future debt obligations willdepend on our future operating performance and our ability to obtain additionaldebt or equity financing.

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***Certain provisionsof the notes payable issued in conjunction with the restructuring of our debtresulting from our acquisition of Evolving Systems U.K. call for theacceleration of payments if certain covenants are breached or cash balancethresholds are achieved.***

The outstandingnotes with our commercial finance company, as well as the sellers of EvolvingSystems U.K., contain certain affirmative and negative covenants that, ifbreached, could result in such notes becoming immediately due and payable. Thecovenants include our agreement to do the following:

·       maintain a specified ratioof debt to EBITDA; minimum EBITDA for the trailing twelve months; and ratio offixed charges to EBITDA;

·       comply with applicable laws and licensing requirements;

·       file and pay all applicable taxes as they become due; and

·       operate in the ordinary course of business.

The covenants also include our agreement not to do any of the following(except as specifically authorized in such notes):

·       liquidate, dissolve or wind-up operations;

·       pay any dividends or make prepayments on any indebtedness;

·       acquire any other businesses or entities or make investments in thirdparties;

·       sell or transfer a substantial portion of our assets;

·       incur additional indebtedness or permit any liens on our assets;

·       change our methods of accounting and record keeping away from generallyaccepted accounting principles;

·       change the nature of our business materially

·       make capital expenditures beyond established thresholds; or

·       take certain other operational actions.

The covenants may limit our flexibility in planningfor, or reacting to changes in, our business. Failure to comply with thecovenants, if not waived, could result in the acceleration of the notes. If weare required to pay the notes on an accelerated basis, it would have asignificant adverse impact on our liquidity and financial condition and couldcause us to incur additional indebtedness.

Additionally, theunsecured notes issued to the Evolving Systems U.K. sellers require us to offerthe note holders a prepayment on such notes at the end of any fiscal quarter ifwe achieve certain minimum cash thresholds. Such a requirement will restrict ourliquidity and cash management flexibility. Until the notes are repaid, ourability to engage in transactions or to enter into agreements requiringsignificant cash investments may be adversely affected.

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

Prior to our acquisition of Evolving Systems U.K.,only one of our stockholders reported beneficial ownership in excess of 5% ofour common stock. Each share of Series B Preferred Stock is initiallyconvertible into three shares of our common stock which could result in theissuance of up to 2,899,998 shares of our common stock. If the shares of Series BPreferred Stock are exchanged for shares of our common stock, such stockholderswould beneficially own approximately 15% of our issued and outstanding sharesof common stock (after giving effect to such conversions). The sale by suchholders of one or more 

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large blocks of our commonstock, or the perception that such sales will occur, could have a negative impacton the market price of our common stock. Additionally, such ownership interestscould effectively deter a third party from making an offer to buy us, whichmight involve a premium over our current stock price or other benefits for ourstockholders, or otherwise prevent changes in the control or management ofEvolving Systems. In addition, there are no restrictions, in the form of astandstill agreement or other agreements with such stockholders, on theirability or their affiliates to purchase additional shares of our common stockand thereby further increase their ownership interests.

The holders of the Series BPreferred Stock are entitled to vote on any matters presented to ourstockholders together with the holders of common stock. While each share of Series BPreferred Stock initially converts into three shares of our common stock, eachsuch share of Series B Preferred Stock is only entitled to approximately2.26 votes in order to comply with certain voting rights rules promulgatedby The Nasdaq Stock Market, Inc. (“Nasdaq”) relatingto the fact that the Series B Preferred Stock was issued at a discount tomarket on the date of issuance. As of the record date, the holders of the Series BPreferred Stock were entitled to an aggregate of approximately 2,184,665 voteson all matters presented to the holders of common stock based on theirownership of the Series B Preferred Stock. The Series B PreferredStock is voluntarily convertible into our common stock at anytime at the optionof the holders thereof, at which time each such share of common stock will beentitled to one vote per share.

***The holders of our Series BPreferred Stock have preferential rights that may be adverse to holders of ourcommon stock.***

The holders of the Series B Preferred Stock havepreferential rights with respect to distributions upon a liquidation ofEvolving Systems, including certain business combinations deemed to be aliquidation. Accordingly, no distributions upon liquidation may be made to theholders of common stock until the holders of the Series B Preferred Stockhave been paid their liquidation preference of $3.89 per share (on an asconverted to common stock basis), subject to adjustment. As a result, itis possible that, on liquidation, all amounts available for the holders ofequity of Evolving Systems would be paid to the holders of the Series BPreferred Stock, and the holders of common stock would not receive any payment.Additionally, in connection with the Evolving Systems U.K. acquisition we areobligated to file and keep effective a registration statement providing for theresale of the shares of our common stock issuable upon the conversion of the Series BPreferred Stock. If we fail to keep the registration statement effective, theholders of the Series B Preferred Stock will have the right to cause us torepurchase for cash the shares of the Series B Preferred Stock for $3.89per share (on an as converted basis), or approximately $11.3 million. If we arerequired to make this payment, it would have a significant adverse impact onour liquidity and could cause us to incur additional indebtedness.

Additionally, the Series B Preferred Stockcontains certain weighted average price based anti-dilution protections that,as long as they remain outstanding, would be triggered if we issued shares ofour common stock (subject to certain adjustments and standard exclusionsrelating to Company options) below $3.89 per share. However, such anti-dilutionadjustments are capped to prohibit the Series B Preferred Stock fromconverting into 20% or more of our outstanding common stock.

In the event that the anti-dilution adjustments aretriggered, the holders of our common stock would be diluted to an unknowndegree. Furthermore, the mere existence of such anti-dilution protections couldmake it difficult or impossible for us to issue any common stock below $3.89per share. In the event the anti-dilution adjustments of the Series BPreferred Stock are triggered, such adjustments would result in a deemed dividendto the Series B Preferred Stock holders that would reduce income availableto common stockholders. The charge would be equal to the number of additionalshares issuable as a result of the anti-dilution calculation, multiplied by thefair value of the common stock on the date of the issuance of the Series BPreferred Stock, which was $4.64 per share. The deemed dividend charge couldcause the price of our common stock to go down.

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***The terms andconditions of the Series B Preferred Stock may have an adverse impact onour results of operations and financial performance.***

If we cannot keep theregistration of the Series B Preferred Stock effective, the Series BPreferred Stock could become mandatorily redeemable. Currently, the Series BPreferred Stock is classified as non-permanent equity since the events thatwould require its redemption have not occurred. If we fail to maintain theeffectiveness of the related registration statement, at the holders’ option theSeries B Preferred Stock would become mandatorily redeemable and theinstrument would be reclassified as a liability. Upon reclassification, the Series BPreferred Stock would be re-measured at its then current fair value and thedifference between its fair value and redemption price would be charged toadditional paid-in capital. Such a charge to equity may negatively impact theprice of our common stock. Subsequent changes to the fair value of thisinstrument would be recognized in earnings, as a charge or income, and suchamounts could be significant and unpredictable.

**Risks Related toOur Business**

***Because ourquarterly and annual operating results are difficult to predict and mayfluctuate, the market price for our stock may be volatile.***

Our operatingresults have fluctuated significantly in the past and may continue to fluctuatesignificantly in the future. Fluctuations in operating results may result involatility of the price of our common stock. These quarterly and annual fluctuationsmay result from a number of factors, including:

·       the size of new contractsand when we are able to recognize the related revenue;

·       our rate of progress underour contracts;

·       consolidation in the communications market;

·       the timing of customer andmarket acceptance of our products and service offerings;

·       our ability to effectively manage offshore software development in India;

·       budgeting cycles of ourcustomers;

·       changes in the terms andrates related to the renewal of support agreements;

·       actual or anticipated changes in U.S. or foreign laws andregulations related to the telecommunications market;

·       judicial or administrativeactions about these laws or regulations;

·       the nature and pace ofenforcement of the Telecom Act as well as other similar foreign statutes,regulations and acts;

·       product lifecycles;

·       the mix of products andservices sold;

·       changes in demand for ourproducts and services;

·       the timing of third-partycontractors’ delivery of software and hardware;

·       level and timing ofexpenses for product development and sales, general and administrativeexpenses;

·       competition by existing andemerging competitors in the communications software markets;

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·       our success in developingand selling new products, controlling costs, attracting and retaining qualifiedpersonnel and expanding our sales and customer focused programs;

·       software defects and otherproduct quality problems;

·       changes in our strategy;

·       foreign exchangefluctuations; and

·       general economicconditions.

Personnel costs are a significant component of ourbudgeted expense levels and, therefore, our expenses are, to a degree, variablebased upon our expectations regarding future revenue. Our revenue is difficultto forecast because the market for our products and services is rapidlychanging, and our sales cycle and the size and timing of significant contractsvary substantially among customers. Accordingly, we may be unable to adjustspending in a timely manner to compensate for any unexpected shortfall inrevenue. Any significant shortfall from anticipated levels of demand for ourproducts and services could adversely affect our business, financial condition,results of operations and cash flows.

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

***Our results of operations could be negatively impactedif we are unable to manage our liquidity.***

Our cash forecastindicates that we will have sufficient liquidity to cover anticipated operatingcosts as well as debt service payments for at least the next twelve months, butthis could be negatively impacted to the extent we are unable to invoice andcollect from our customers in a timely manner, or an unexpected adverse event,or combination of events occurs. Therefore, if the timing of cash generatedfrom operations is insufficient to satisfy our liquidity requirements, we mayrequire access to additional funds to support our business objectives throughanother debt restructuring, a credit facility or possibly the issuance ofadditional equity. Additional financing may not be available at all or, if available,may not be obtainable on terms that are favorable to us and not dilutive.

***If we are unable toproperly supervise our software development subsidiary in India, or ifpolitical or other uncertainties interfere, we may be unable to satisfactorilyperform our customer contracts and our business could be materially harmed.***

In February 2004, weformed Evolving Systems India, a wholly owned subsidiary of Evolving Systems. Itis difficult managing development staff over multiple time zones. We arecurrently experiencing a high level of turnover with our Indian developmentstaff as a result of strong competition for technology-based personnel in India.In addition, salary levels in India are steadily increasing, reducing thecompetitive advantages associated with offshore labor. If we are unable toeffectively manage the Evolving India development staff and/or we continue toexperience high levels of staff turnover, we may fail to provide qualitysoftware in a timely fashion, which could negatively affect our ability tosatisfy our customer contracts. Furthermore, political changes anduncertainties in India could negatively impact the business climate there. As aresult, we may be unable to satisfactorily perform our customer contracts andour business, financial condition and results of operations could be materiallyharmed.

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***We operate a global business that exposes us toadditional currency, economic, regulatory and tax risks***.

A significant partof our revenue comes from international sales. Our international operations aresubject to the risk factors inherent in the conduct of international business,including:

·       unexpectedchanges in regulatory requirements;

·       tariffsand other barriers;

·       politicaland economic instability;

·       limitedintellectual property protection;

·       difficultiesin staffing and managing foreign operations; and

·       potentiallyadverse tax consequences in connection with repatriating funds.

We may not be able tosustain or increase our international revenue or repatriate cash without incurringsubstantial risks involving floating currency exchange rates and income taxexpenses. Any of the foregoing factors may have a material adverse impact onour international operations and, therefore, our business, financial conditionand results of operations.

***Changes orchallenges to the regulations of the communication industry could hurt themarket for our products and services.***

The market for ourtraditional North American OSS products was created and has primarily beendriven by the adoption of regulations under the Telecom Act requiring RegionalBell Operating Companies (“RBOCs”) to implement LNP as a condition to beingpermitted to provide long distance services. Therefore, any changes to theseregulations, or the adoption of new regulations by federal or state regulatoryauthorities under the Telecom Act, or any legal challenges to the Telecom Act,could hurt the market for our products and services. For example, when the FCCdelayed implementation of the Telecom Act with respect to wireless carriersuntil November 2003, these delays impacted our revenue from our WNPproducts and services. Likewise, in mid-2001 when Verizon Wirelesspetitioned the FCC requesting forbearance from this requirement, we saw ourwireless customers delay making decisions to purchase WNP products. WNP wentinto effect in November 2003. Any invalidation, repeal or modification inthe requirements imposed by the Telecom Act or the FCC, could materially harmour business, financial condition and results of operations. In addition,customers may require, or we may find it necessary or advisable, to modify ourproducts or services to address actual or anticipated changes in regulationsaffecting our customers. This could also materially harm our business,financial condition, results of operations, and cash flows. Additionally, withour acquisition of Evolving Systems U.K., we are now subject to numerousregulatory requirements of foreign jurisdictions. Any compliance failures orchanges in such regulations could also materially harm our business, financialcondition, results of operations and cash flows.

***Consolidation in the communications industry mayimpact our financial performance***

The communicationsindustry has experienced and continues to experience significant consolidation,both in the United States and internationally. These consolidations are causingour existing and potential customers to re-evaluate their OSS solutions andtheir capital expenditures. These consolidations have caused us to losecustomers and may result in fewer potential customers requiring OSS solutionsin the future. In addition, combining companies may choose a competitive OSSsolution used by one of the combining companies. As our customers becomelarger, they generally have stronger purchasing power, which can result inreduced prices for our products, lower margins on our products and longer salescycles. Because of the uncertainty resulting from these consolidations and thevariations in our quarterly operating results, it is extremely difficult for usto forecast our quarterly and annual revenue and we have 

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discontinuedproviding revenue guidance. All of these factors can have a negative impact onour financial performance, particularly in any fiscal quarter. This negativeimpact, in turn, could result in noncompliance with certain financial covenantsgoverning our senior secured notes. We successfully amended our covenantseffective June 30, 2006, as further described under “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—Liquidityand Capital Resources.”  However, if wewere unsuccessful in amending the agreements or obtaining a waiver from oursenior lender in future reporting periods, these violations could result insuch notes becoming immediately due and payable. We can give no assurance thatwe would be successful in amending the agreements or obtaining a waiver of anycovenant violation.

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

In the past, andcurrently, we earn a significant portion of our revenue from a small number ofcustomers in the communications industry. This has been mitigated somewhat bythe expansion of our customer base through our recent acquisitions, but, asnoted above, consolidation in the industry continues. The loss of anysignificant customer, delays in delivery or acceptance of any of our productsby a customer, delays in the performance of services for a customer, or delaysin collection of customer receivables could harm our business and operatingresults.

***Our products arecomplex and have a lengthy implementation process; unanticipated difficultiesor delays in the customer acceptance process could result in higher costs anddelayed payments.***

Implementing our solutions can be a relatively complexand lengthy process since we typically customize these solutions for eachcustomer’s unique environment. Often our customers may also require rapiddeployment of our software solutions, resulting in pressure on us to meetdemanding delivery and implementation schedules. Delays in implementation mayresult in customer dissatisfaction and/or damage our reputation which couldmaterially harm our business.

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

***Sales of ourproducts typically require significant review and internal approval processesby our customers over an extended period of time. Interruptions in such processdue to economic downturns, consolidations or otherwise could result in the lossof our sale or deferral of revenues into later periods and adversely affect ourfinancial performance.***

Large communications solutions used forenterprise-wide, mission-critical purposes, involve significant capitalexpenditures and lengthy implementation plans. Prospective customers typicallycommit significant resources to the technical evaluation of our products andservices and require us to spend substantial time, effort and money providingeducation regarding our solutions. This evaluation process often results in anextensive and lengthy sales cycle, typically ranging between three and twelvemonths, making it difficult for us to forecast the timing and magnitude of ourcontracts. For example, customers’ budgetary constraints and internalacceptance reviews may cause potential customers to delay or forego a purchase.The delay or failure to complete one or more large contracts could materiallyharm our business, 

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financial condition,results of operations and cash flows and cause our operating results to varysignificantly from quarter to quarter and year to year.

Mergers and acquisitionsof large communications companies, as well as the formation of new alliances,have resulted in a constantly changing marketplace for our products andservices. Purchasing delays and pricing pressures associated with these changesare common.. In addition, the U.S. communications industry is still recoveringfrom an industry downturn which began in 2000, and many of the companies in thecommunications industry have kept capital expenditures at historically lowlevels in response to changes in the communications marketplace; some companieshave declared bankruptcy, cancelled contracts, delayed payments to theirsuppliers or delayed additional purchases. The delay or failure to complete oneor more large contracts, or the loss of a significant customer, couldmaterially harm our business, financial condition, results of operations, orcash flows, and cause our operating results to vary significantly from quarterto quarter and year to year.

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

Currently, a large portionof our revenue is from contracts that are on a fixed-price basis. We anticipatethat customers will continue to request we provide software and integrationservices as a total solution on a fixed-price basis. These contracts specifycertain obligations and deliverables we must meet regardless of the actualcosts we incur. Projects done on a fixed-price basis are subject to budgetoverruns. On occasion, we have experienced budget overruns, resulting in lowerthan anticipated margins. We may incur similar budget overruns in the future,including overruns that result in losses on these contracts. If we incur budgetoverruns, our margins may be harmed, thereby affecting our overallprofitability.

***Percentage-of-completionaccounting used for most of our projects can result in overstated or understatedprofits or losses***

The revenue for most ofour contracts is accounted for on the percentage-of-completion method ofaccounting. This method of accounting requires us to calculate revenues andprofits to be recognized in each reporting period for each project based on ourpredictions of future outcomes, including our estimates of the total cost tocomplete the project, project schedule and completion date, the percentage ofthe project that is completed and the amounts of any probable unapproved changeorders. Our failure to accurately estimate these often subjective factors couldresult in reduced profits or losses for certain contracts.

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

The market for ourproducts and services is subject to rapid technological changes, evolvingindustry standards, changes in carrier requirements and preferences andfrequent new product introductions and enhancements. The introduction ofproducts that incorporate new technologies and the emergence of new industrystandards can make existing products obsolete and unmarketable. In addition, “internationalizing”products that we have developed for our U.S. customer carriers is a complexprocess. To compete successfully, we must continue to design, develop and sellenhancements to existing products and new products that provide higher levelsof performance and reliability in a timely manner, take advantage oftechnological advancements and changes in industry standards and respond to newcustomer requirements. As a result of the complexities inherent in softwaredevelopment, major new product enhancements and new products can require longdevelopment and testing periods before they are commercially released anddelays in planned delivery dates may occur. We may not be able to successfullyidentify new product opportunities or achieve market acceptance of new productsbrought to market. In addition, products developed by others may cause ourproducts to become obsolete or noncompetitive. If 

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we failto anticipate or respond adequately to changes in technology and customerpreferences, or if our products do not perform satisfactorily, or if we havedelays in product development, we may lose customers and our sales maydeteriorate.

***The market for ournumber portability products is mature in the U.S. and we may not be able tosuccessfully develop new products to remain competitive.***

The market for our numberportability products is mature in the U.S. and we may not be able tosuccessfully identify new product opportunities in the U.S. or abroad orachieve market acceptance of new products brought to the market. Many of thewireless carriers in the U.S. selected solutions from our competitors and it isunclear how many new opportunities there will be with these carriers. If we areunable to identify new product opportunities in the U.S. or areas outside ofthe U.S., sales and profit growth would be adversely affected.

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

We have taken steps toreduce our expenses, such as reductions in staff and general cost controlmeasures. If, as a result of such cost reductions, we have not adequatelyresponded to balance expenses against revenue, or if our fixed costs cannot bereduced enough, our financial condition could be materially harmed. Likewise,cutbacks in staff may have an adverse impact on our ability to generate futurerevenue, because we may not have sufficient staffing to meet any unexpectedincreases in customer demand for our products.

***The communicationsindustry is highly competitive and if our products do not satisfy customerdemand for performance or price, our customers could purchase products andservices from our competitors.***

Our primary markets are intensely competitive and weface continuous demand for improved product performance, new product featuresand reduced prices, as well as intense pressure to accelerate the release ofnew products and product enhancements. Our existing and potential competitorsinclude many large domestic and international companies, including somecompetitors that have substantially greater financial, manufacturing,technological, marketing, distribution and other resources, larger installedcustomer bases and longer-standing relationships with customers than we do. Ourprincipal competitors in the LNP and WNP market include Telcordia Technologies, Inc.,Syniverse Technologies and Tekelec. Our principal competitors in activation areOracle (as a result of its recent acquisition of Metasolv) and Comptel. Inmediation, we compete with many different companies with no single dominantcompetitor. Customers also may offer competitive products or services in thefuture since customers who have purchased solutions from us are not precludedfrom competing with us. Many telecommunications companies have large internaldevelopment organizations, which develop software solutions and provideservices similar to the products and services we provide. We also expectcompetition may increase in the future from application service providers,existing competitors and from other companies that may enter our existing orfuture markets with solutions which may be less costly, provide higherperformance or additional features or be introduced earlier than our solutions.

We believe that ourability to compete successfully depends on numerous factors. For example, thefollowing factors affect our ability to compete successfully:

·       how well we respond to ourcustomers’ needs;

·       the quality and reliabilityof our products and services and our competitors’ products and services;

·       the price for our productsand services, as well as the price for our competitors’ products and services;

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·       how well we manage ourprojects;

·       our technical subjectmatter expertise;

·       the quality of our customerservice and support;

·       the emergence of newindustry standards;

·       the development of technicalinnovations;

·       our ability to attract andretain qualified personnel;

·       regulatory changes; and

·       general market and economicconditions.

Some of these factors arewithin our control, and others are not. A variety of potential actions by ourcompetitors, including a reduction of product prices or increased promotion,announcement or accelerated introduction of new or enhanced products, orcooperative relationships among competitors and their strategic partners, couldnegatively impact the sales of our products and we may have to reduce theprices we charge for our products. Revenue and operating margins mayconsequently decline. We may not be able to compete successfully with existingor new competitors or to properly identify and address the demands of newmarkets. This is particularly true in new markets where standards are not yetestablished. Our failure to adapt to emerging market demands, respond toregulatory and technological changes or compete successfully with existing andnew competitors would materially harm our business, financial condition,results of operations and cash flows.

***Our business depends largely on our ability to attractand retain talented employees.***

Our ability to managefuture expansion, if any, effectively will require us to attract, train,motivate and manage new employees successfully, to integrate new management andemployees into our overall operations and to continue to improve ouroperations, financial and management systems. We may not be able to retainpersonnel or to hire additional personnel on a timely basis, if at all. Becauseof the complexity of our software solutions, a significant time lag existsbetween the hiring date of technical and sales personnel and the time when theybecome fully productive. We have at times experienced high employee turnoverand difficulty in recruiting and retaining technical personnel. In addition,our stock option plan terminated on January 18, 2006 and under Nasdaq rules wewill be required to obtain stockholder approval to establish a new equitycompensation plan. If we are unsuccessful in obtaining this approval, ourability to attract or retain employees may be harmed. Our failure to retainpersonnel or to hire qualified personnel on a timely basis could adverselyaffect our business by impacting our ability to develop new products, tocomplete our projects and secure new contracts.

***Our products arecomplex and may have errors that are not detected until deployment, andlitigation related to warranty and product liability claims could be expensiveand could negatively affect our reputation and profitability.***

Our agreements with ourcustomers typically contain provisions designed to limit our exposure topotential liability for damages arising out of the use of or defects in ourproducts. These limitations, however, tend to vary from customer to customerand it is possible that these limitations of liability provisions may not beeffective. We currently have errors and omissions insurance, which, subject tocustomary exclusions, covers claims resulting from failure of our softwareproducts or services to perform the function or to serve the purpose intended.To the extent that any successful product liability claim is not covered bythis insurance, we may be required to pay for a claim. This could be expensive,particularly since our software products may be used in critical businessapplications. Defending such a suit, regardless of its merits, could beexpensive and require the time and attention of key management personnel,either 

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of whichcould materially harm our business, financial condition and results ofoperations. In addition, our business reputation could be harmed by productliability claims, regardless of their merit or the eventual outcome of theseclaims.

***Our measures to protectour proprietary technology and other intellectual property rights may not beadequate and if we fail to protect those rights, our business would be harmed.***

Our success and ability tocompete are dependent to a significant degree on our proprietary technology. Werely on a combination of patent, copyright, trademark and trade secret laws, aswell as confidentiality agreements and licensing arrangements, to establish andprotect our proprietary rights. We have U.S. and Canadian patents on elementsof our LNP products, ***NumberManager®***and ***OrderPath®***, and U.S. patents onelements of our ***OmniPresenceServer*TM** . Inaddition, we have registered or filed for registration of certain of ourtrademarks. Despite these precautions, it may be possible for a third party tocopy or otherwise obtain and use our products or technology withoutauthorization or to develop similar technology independently through reverseengineering or other means. In addition, the laws of some foreign countries maynot adequately protect our proprietary rights. Our means of protecting ourproprietary rights in the U.S. or abroad may not be adequate or others mayindependently develop technologies that are similar or superior to ourtechnology, duplicate our technology or design around any of our patents.

***In the event thatwe are infringing upon the proprietary rights of others or violating licenses,we may become subject to infringement claims that may prevent us from sellingcertain products and we may incur significant expenses in resolving theseclaims.***

It is also possible that our business activities mayinfringe upon the proprietary rights of others, or that other parties mayassert infringement claims against us. If we become liable to any third partyfor infringing its intellectual property rights, we could be required to paysubstantial damage awards and to develop non-infringing technology, obtainlicenses, or to cease selling the applications that contain the infringingintellectual property. Litigation is subject to inherent uncertainties, and anyoutcome unfavorable to us could materially harm our business. Furthermore, wecould incur substantial costs in defending against any intellectual propertylitigation, and these costs could increase significantly if any dispute were togo to trial. Our defense of any litigation, regardless of the merits of thecomplaint, likely would be time-consuming, costly, and a distraction to ourmanagement personnel. Adverse publicity related to any intellectual propertylitigation also could harm the sale of our products and damage our competitiveposition.

Certain softwaredeveloped or used by Evolving Systems, as well as certain software acquired inour acquisitions of CMS, TSE or Evolving Systems U.K., may include or bederived from software that is made available under an open source softwarelicense.

·       Suchopen source software may be made available under a license such as the GNUGeneral Public License (“GPL”) or GNU Lesser General Public License (“LGPL”)which imposes certain obligations on us in the event we were to distributederivative works based on the open source software. These obligations mayrequire us to make source code for these derivative works available to thepublic or license the derivative works under a particular type of open sourcesoftware license, rather than the license terms we customarily use to protectour software.

·       Thereis little or no legal precedent for interpreting the terms of certain of theseopen source licenses, including the terms addressing the extent to which a derivativework based on open source software may be subject to these licenses. We believewe have complied with our obligations under the various applicable open sourcelicenses. However, if the owner of any open source software were tosuccessfully establish that we had not complied with the terms of an opensource license for 

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a particular derivativework based on that open source software, we may be forced to release the sourcecode for that derivative work to the public or cease distribution of that work.

·       We generally prohibit thecombination of our proprietary software with open source software. Despitethese restrictions, parties may combine our proprietary software with opensource software without our authorization, in which case such parties could beforced to release to the public the source code of our proprietary software.

***Disruptions from terrorist activities or militaryactions may have an adverse effect on our business.***

The continued threat ofterrorism within the U.S. and throughout the world and acts of war may causesignificant disruption to commerce throughout the world. Our business andresults of operations could be materially and adversely affected to the extentthat such disruptions result in delays or cancellations of customer orders, delaysin collecting cash, a general decrease in corporate spending on informationtechnology, or our inability to effectively market, manufacture or ship ourproducts. We are unable to predict whether war and the threat of terrorism orthe responses thereto will result in any long-term commercial disruptions or ifsuch activities or responses will have any long-term material adverse effect onour business, results of operations, financial condition or cash flows.

***We face special risks associated with doing businessin highly corrupt environments.***

Our international businessoperations include projects in developing countries and countries torn byconflict. To the extent we operate outside the U.S., we are subject to theForeign Corrupt Practices Act (FCPA), which generally prohibits U.S. companiesand their intermediaries from paying or offering anything of value to foreigngovernment officials for the purpose of obtaining or keeping business, orotherwise receiving discretionary favorable treatment of any kind. Inparticular, we may be held liable for actions taken by our local partners andagents, even though such parties are not always subject to our control. Anydetermination that we have violated the FCPA (whether directly or through actsof others, intentionally or through inadvertence) could result in sanctionsthat could have a material adverse effect on our business. While we haveprocedures and controls in place to monitor compliance, situations outside ofour control may arise that could potentially put us in violation of the FCPAinadvertently and thus negatively impacting our business.

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

The trading price of our common stock has been subjectto wide fluctuations in response to quarterly variations in operating results,announcements of technological innovations or new products by us or ourcompetitors, merger and acquisition activity, changes in financial estimates bysecurities analysts, the operating and stock price performance of othercompanies that investors may deem comparable to us, general stock market andeconomic considerations and other events or factors. This may continue in thefuture.

In addition, the stockmarket has experienced volatility that has particularly affected the marketprices of stock of many technology companies and often has been unrelated tothe operating performance of these companies. These broad market fluctuationsmay negatively impact the trading price of our common stock. As a result of theforegoing factors, our common stock may not trade at or higher than its currentprice.

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

If our stockholders sellsubstantial amounts of our common stock in the public market, the market priceof our common stock could fall. The perception among investors that such saleswill occur could also produce this effect. These factors also could make itmore difficult to raise funds through future offerings of common stock.

***We are subject tocertain rules and regulations of federal, state and financial marketexchange entities, the compliance with which requires substantial amounts ofmanagement time and company resources. Any material weaknesses in our financialreporting or internal controls could adversely affect our business and theprice of our common stock.***

Because our common stock is publicly traded, we aresubject to certain rules and regulations of federal, state and financialmarket exchange entities charged with the protection of investors and theoversight of companies whose securities are publicly traded. These entities,including the Public Company Accounting Oversight Board, the SEC and Nasdaq,have recently issued new requirements and regulations and are currentlydeveloping additional regulations and requirements in response to recent lawsenacted by Congress, most notably the Sarbanes-Oxley Act of 2002. Ourcompliance with certain of these rules, such as Section 404 of theSarbanes-Oxley Act, is likely to require the commitment of significantmanagerial resources. In addition, establishment of effective internal controlsis further complicated because we are now a global company with multiplelocations and IT systems.

We continue to review ourmaterial internal control systems, processes and procedures for compliance withthe requirements of Section 404. Such a review may result in theidentification of material weaknesses in our internal controls. Disclosures ofmaterial weaknesses in our SEC reports could cause investors to lose confidencein our financial reporting and may negatively affect the price of our stock. Moreover,effective internal controls are necessary to produce reliable financial reportsand to prevent fraud. If we have material weaknesses in our internal controlover financial reporting it may negatively impact our business, results ofoperations and reputation.

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

We have never paid cashdividends on our common stock. We currently intend to retain all futureearnings, if any, for use in the operation of our business. In addition, thenotes issued in connection with the Evolving Systems U.K. acquisition prohibitus from declaring dividends to our common stockholders during the term of thenotes. Accordingly, we do not anticipate paying cash dividends on our commonstock in the foreseeable future.

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

Our restated certificate of incorporation allows ourboard of directors to issue up to 2,000,000 shares of preferred stock and todetermine the price, rights, preferences and privileges of those shares withoutany further vote or action by our stockholders. The rights of the holders of ourcommon stock will be subject to, and may be adversely affected by, the rightsof the holders of any preferred stock that may be issued in the future.Issuance of preferred stock, while providing desired flexibility in connectionwith possible acquisitions and other corporate purposes, could make it moredifficult for a third party to acquire a majority of our outstanding votingstock. In 1999, our board of directors designated 250,000 shares of Series AJunior Participating Preferred Stock that contain “poison pill” provisions. Inconnection with the 

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Evolving Systems U.K.acquisition, we issued 966,666 shares of Series B Preferred Stock. We haveno current plans to issue additional shares of preferred stock.

In addition, we are subject to the anti-takeover provisionsof Section 203 of Delaware General Corporation Law, which prohibit us fromengaging in a “business combination” with an “interested stockholder” for aperiod of three years after the date of the transaction in which theperson became an interested stockholder, unless the business combination isapproved in the prescribed manner. The application of Section 203 andcertain provisions of our restated certificate of incorporation, including aclassified board of directors, may have the effect of delaying or preventingchanges in control of our management, which could adversely affect the marketprice of our common stock by discouraging or preventing takeover attempts thatmight result in the payment of a premium price to our stockholders.

Our executive officers have entered into managementchange in control agreements with us. Each agreement generally provides foracceleration on vesting of options, 50% upon a change in control (as defined insuch agreements) if the executive remains employed with the new entity, or 100%in the event such executive’s employment is terminated. The acceleration ofvesting of options upon a change in control may be viewed as an anti-takeovermeasure and may have the effect of discouraging a merger proposal, tender offeror other attempt to gain control of us.

Our Amended and RestatedStock Option Plan provides for acceleration of vesting under certaincircumstances. Upon certain changes in control of us, vesting on some optionsawarded to directors may be accelerated. In addition, the successor corporationmay assume outstanding stock awards or substitute equivalent stock awards. Ifthe successor corporation refuses to do so, such stock awards will become fullyvested and exercisable for a period of 15 days after notice from us but theoption will terminate if not exercised during that period. As noted above, theacceleration on vesting of options upon a change in control may be viewed as ananti-takeover measure.

***We are very limited in our ability to issue additionalshares of common stock.***

Upon the expiration of ourstock option plan on January 18, 2006, we had approximately 1.2 millionauthorized and unreserved shares of common stock available for issuance. Weare, therefore, limited in our ability to issue shares of common stock whichmay hinder our ability to raise capital, use our common stock as currency forfuture acquisitions or increase the number of shares of common stock availablefor issuance under our stock option plan to attract or retain key employees. Toincrease our authorized shares of common stock requires the approval of thestockholders owning a majority of our then issued and outstanding shares ofcommon stock. Our last two attempts to obtain stockholder approval to increasethe number of our authorized shares of common stock have been unsuccessful dueto lower than required stockholder participation. At our 2007 AnnualStockholders’ Meeting, we will be requesting stockholder approval to increaseour authorized shares of common stock but there can be no guarantee that wewill be successful.

***Failure to maintain our Nasdaq listing could adverselyimpact the liquidity of our common stock.***

The trading price for our common stock has beenvolatile, and we cannot assure our investors that the trading price will not decline,possibly below $1.00. If our stock price remained below the minimum bid priceof $1.00 for 30 consecutive business days, it would result in the Nasdaqinitiating de-listing procedures for our stock. We would be required todisclose publicly on a Form 8-K the commencement of any de-listingprocedures or receipts of any notices relating to failure to meet Nasdaqlisting standards, and any such disclosure might negatively impact our stockprice. If Nasdaq were to initiate delisting procedures, we would have a periodof 180 calendar days from receiving notice from Nasdaq to achieve compliancewith the listing requirements. If we do not achieve compliance during thisperiod, we would be afforded an additional 180 day compliance period if wedemonstrated that we met the criteria for initial 

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listing set forth inMarketplace Rule 4310(c) (except for the bid price requirement setforth in Rule 4310(c)(4)) on the last day of the first compliance period.Compliance can be achieved during any compliance period by meeting the minimum$1.00 bid price for 10 consecutive business days. Compliance with the $1.00minimum bid price would terminate the NASDAQ de-listing procedures.

If we did not meet theNasdaq’s initial listing criteria required to obtain an additional 180 daycompliance period and our stock were to be delisted, trading in our commonstock would continue to be conducted in the Over-The-Counter (OTC) market. As aresult, an investor could find it more difficult to dispose of or obtainaccurate quotations as to the market value of our common stock. In addition, inthe event our common stock were to be delisted, broker-dealers would havecertain additional regulatory burdens imposed upon them, which might discouragethem from effecting transactions in our common stock, further limiting theliquidity of our stock.

**General riskstatement**

Based on all of theforegoing, we believe it is possible for future revenue, expenses and operatingresults to vary significantly from quarter to quarter and year to year. As aresult, quarter-to-quarter and year-to-year comparisons of operating resultsare not necessarily meaningful or indicative of future performance.Furthermore, we believe that it is possible that in any given quarter or fiscalyear our operating results could differ from the expectations of public marketanalysts or investors. In such event or in the event that adverse conditionsprevail, or are perceived to prevail, with respect to our business orgenerally, the market price of our common stock would likely decline.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

None.

**ITEM 2.**                PROPERTIES

Welease office space at various locations which are shown below.  We sublease a portion of our space in ourColumbus, Ohio office. 
| Location                            | ** ** | ** ** | ** ** | **Square  Footage** | ** ** | **Lease  Expiration** | ** ** |
|-------------------------------------|------------|------------|------------|---------------------|------------|-----------------------|------------|
| Englewood,  Colorado (Headquarters) |       | 35,938     |       | 5/31/07             |       |
| Columbus, Ohio                      |       | 15,335     |       | 10/31/07            |       |
| Bath, England                       |       | 5,100      |       | 9/26/10             |       |
| London, England                     |       | 7,765      |       | 3/24/10             |       |
| Bangalore, India                    |       | 1,575      |       | 2/14/07             |       |
| Bangalore, India                    |       | 5,814      |       | 2/8/07              |       |
| Bangalore, India                    |       | 2,186      |       | 4/1/07              |       |
| Bangalore, India                    |       | 1,552      |       | Month-to-month      |       |
| Bangalore, India                    |       | 1,725      |       | 4/21/07             |       |
| Munich, Germany                     |       | 732        |       | Month-to-month      |       |
| Kuala Lumpur, Malaysia              |       | 150        |       | 6/30/07             |       |

 

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**ITEM 3.**                LEGALPROCEEDINGS

During the fourth quarter of 2006, a previous softwarevendor filed a complaint in the Superior Court of New Jersey against usasserting we breached certain provisions of a license agreement. While theoutcome of this matter is uncertain, we believe we have paid all fees due underour license agreement and will vigorously defend this claim.

We are involved in variousother legal matters arising in the normal course of business. We do not believethat any such matters are probable of loss or will have a material impact onour results of operations and financial position.

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

None.

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**PART II**

**ITEM5.**                MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES

Our common stock begantrading publicly through the Nasdaq National Market under the symbol “EVOL” on May 12,1998. Prior to that date, there was no public market for our common stock. Wetransferred from the Nasdaq National Market to the Nasdaq SmallCap Market (nowknown as the Nasdaq Capital Market) on August 28, 2002. The closing priceof our common stock as reported on the Nasdaq Capital Market as of March 1,2007 was $1.87 per share. The following table sets forth for the periodsindicated the high and low closing sale quotations and may not be based onactual transactions for our common stock as reported on the Nasdaq CapitalMarket. The prices reported do not include retail mark-ups, markdowns orcommissions.
|                | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------|------------|---------------------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                                      | ** ** | **2005** | ** ** |
| ** **     | ** ** | **High**                                                      | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $                                                             | 2.96       |   | $ | 1.96 |   | $ | 4.32 |   | $ | 2.26 |   |
| Second Quarter |       | $                                                             | 2.06       |   | $ | 1.25 |   | $ | 3.18 |   | $ | 1.74 |   |
| Third Quarter  |       | $                                                             | 1.44       |   | $ | 0.92 |   | $ | 2.86 |   | $ | 1.86 |   |
| Fourth Quarter |       | $                                                             | 1.38       |   | $ | 1.00 |   | $ | 2.28 |   | $ | 1.67 |   |

 

As of March 1, 2007,there were approximately 163 holders of record of our common stock.

We have not declared orpaid a cash dividend on our common stock. In addition, the notes issued inconnection with the Evolving Systems U.K. acquisition prohibit us fromdeclaring dividends to our common stockholders during the term of the notes. Wecurrently intend to retain future earnings, if any, to finance the growth anddevelopment of our business and, therefore, do not anticipate paying cashdividends in the foreseeable future.

Thegraph below matches Evolving Systems, Inc.’s cumulative 5-year totalshareholder return on common stock with the cumulative total returns of theNASDAQ Composite index, the RDG Software Composite index and the DJ WilshireMicroCap Software Index. The graph tracks the performance of a $100 investmentin our common stock and in each of the indices (with the reinvestment of alldividends) from 12/31/2001 to 12/31/2006.

****

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**ITEM 6. SELECTED FINANCIAL DATA**

The selected financialdata set forth below for each of the years in the five-year period ended December 31,2006, has been derived from our consolidated financial statements. Thefollowing selected financial data should be read in conjunction with “Item 7 -Management’s Discussion and Analysis of Financial Condition and Results ofOperations”, the consolidated financial statements and the notes thereto andother financial information included elsewhere in this Annual Report on Form 10-K.Results for 2004 include amounts related to the acquisition of Evolving SystemsU.K. from the purchase date of November 2, 2004 to December 31, 2004and amounts related to the acquisition of TSE from the purchase date of October 15,2004 to December 31, 2004. Results for 2003 include amounts related to theacquisition of CMS from the purchase date of November 3, 2003 to December 31,2003.
|                                                                                                               | ** ** | **For the Years Ended December 31,**         | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                                    | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                    | ** ** | **(in thousands, except per share amounts)** | ** ** |
| Revenue                                                                                                       |       | $                                                                     | 33,833     |   | $ | 39,452 |   | $ | 26,342 |   | $ | 27,973 |   | $ | 22,963 |   |
| Costs of Revenue and  Operating Expenses:                                                                     |       |                                                                  |       |   |   |   |   |   |   |   |   |
| Cost of revenue, excluding depreciation and  amortization                                                     |       | 13,036                                                                |       | 16,070 |   | 12,936 |   | 11,346 |   | 17,019 |   |
| Sales and marketing                                                                                           |       | 8,962                                                                 |       | 9,643 |   | 4,412 |   | 2,940 |   | 4,907 |   |
| General and administrative                                                                                    |       | 5,138                                                                 |       | 6,818 |   | 5,085 |   | 3,494 |   | 5,420 |   |
| Product development(1)                                                                                        |       | 3,072                                                                 |       | 1,921 |   | 1,066 |   | 2,043 |   | 1,209 |   |
| Depreciation                                                                                                  |       | 1,169                                                                 |       | 1,443 |   | 1,152 |   | 1,182 |   | 1,771 |   |
| Amortization(2)                                                                                               |       | 2,511                                                                 |       | 5,215 |   | 1,667 |   | 130 |   | — |   |
| Impairment of goodwill and intangible assets(3)                                                               |       | 16,516                                                                |       | — |   | — |   | — |   | — |   |
| Restructuring and other expense(4)                                                                            |       | (21                                                                   | )          | (49 | ) | (15 | ) | (9 | ) | 5,079 |   |
| Income (loss) from operations                                                                                 |       | (16,550                                                               | )          | (1,609 | ) | 39 |   | 6,847 |   | (12,442 | ) |
| Interest and other, net                                                                                       |       | (1,837                                                                | )          | (1,692 | ) | 87 |   | 191 |   | 35 |   |
| Income tax expense (benefit)                                                                                  |       | (1,604                                                                | )          | (396 | ) | (298 | ) | 167 |   | — |   |
| Net income (loss)                                                                                             |       | (16,783                                                               | )          | (2,905 | ) | 424 |   | 6,871 |   | (12,407 | ) |
| Deemed dividend for beneficial conversion feature of  Series B convertible redeemable preferred stock(5) |       | —                                                                |       | — |   | 3,306 |   | — |   | — |   |
| Net income (loss) available to common  stockholders                                                           |       | $                                                                     | (16,783    | ) | $ | (2,905 | ) | $ | (2,882 | ) | $ | 6,871 |   | $ | (12,407 | ) |
| Basic income (loss) available to common  stockholdersper common share                                         |       | $                                                                     | (0.88      | ) | $ | (0.16 | ) | $ | (0.18 | ) | $ | 0.48 |   | $ | (0.93 | ) |
| Diluted income (loss) available to common  stockholdersper common share                                       |       | $                                                                     | (0.88      | ) | $ | (0.16 | ) | $ | (0.18 | ) | $ | 0.43 |   | $ | (0.93 | ) |
| Weighted average basic shares outstanding                                                                     |       | 19,100                                                                |       | 18,695 |   | 16,307 |   | 14,205 |   | 13,295 |   |
| Weighted average diluted shares outstanding                                                                   |       | 19,100                                                                |       | 18,695 |   | 16,307 |   | 16,139 |   | 13,295 |   |
| Working capital (deficiency)(6)                                                                               |       | $                                                                     | 803        |   | $ | 447 |   | $ | (3,343 | ) | $ | 13,836 |   | $ | 3,528 |   |
| Total assets(7)                                                                                               |       | 51,338                                                                |       | 67,398 |   | 86,601 |   | 41,701 |   | 24,765 |   |
| Long-term debt, net of current portion                                                                        |       | 11,370                                                                |       | 14,373 |   | 11,959 |   | 183 |   | 141 |   |
| Series B convertible redeemable preferred stock                                                          |       | 11,281                                                                |       | 11,281 |   | 11,281 |   | — |   | — |   |
| Stockholders’  equity(8)                                                                                 |       | $                                                                     | 10,158     |   | $ | 22,124 |   | $ | 29,314 |   | $ | 26,473 |   | $ | 5,891 |   |

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(1)          In 2004 and 2003, weexpensed $90,000 and $233,000, respectively, of in-process research anddevelopment associated with the acquisitions of Evolving Systems U.K. and CMS.

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(2)          Withthe acquisition of Evolving Systems U.K. and TSE, intangible asset amortizationhas become a significant expense and is now being shown separately on thestatements of operations. Amortization expense for the year ended December 31,2003 of $130,000 has been reclassified to conform to the current period’spresentation.

(3)          In2006, we recognized an impairment of $16.5 million on goodwill and amortizableintangible assets related to our L&S operating segment.

(4)          In2002, we incurred $5.1 million in restructuring and other expenses relatedto our headcount reduction; headquarters lease restructure, satellite officeclosures and asset impairments.

(5)          In November 2004, we issued 966,666 shares of Series BPreferred Stock as part of our acquisition of Evolving Systems U.K. Based upon the various features of the Series BPreferred Stock, the fair value of this security was estimated toapproximate the stated redemption price. Since the conversion price of the Series BPreferred Stock was fixed in the purchase agreement to equal $3.50 per commonshare, a beneficial conversion feature existed on the acquisition date equal tothe difference between the value of our common stock on the acquisition date,or $4.64, and the conversion price stated in the purchase agreement. Thebeneficial conversion feature was recognized as a reduction in net incomeavailable to common stockholders of $3.3 million on the acquisition date sincethe Series B Preferred Stock was immediately convertible to common stock.

(6)          Thedecrease in working capital during 2004 was a result of our acquisition of twocompanies, TSE and Evolving Systems U.K., during the fourth quarter of 2004. Inthose transactions we paid cash of $1.5 million and $11.0 million for TSE andEvolving Systems U.K., respectively. The TSE transaction also included ashort-term note payable of approximately $889,000. The acquisition of EvolvingSystems U.K. also included the issuance of seller-financed notes ofapproximately $15.9 million, including a short-term note of $4.0 million and along-term note of approximately $11.9 million. The purchase price related tothese two acquisitions, including estimated transaction costs of $2.0 million,reduced our working capital by approximately $19.4 million.

(7)          Thedecrease in total assets from 2004 to 2005 and 2005 to 2006 is primarily due toimpairment of intangible asset, amortization of intangible assets, goodwillimpairment, adjustments to goodwill related to the acquisitions of TSE andEvolving Systems U.K., foreign currency translation adjustments and use of cashto pay short-term obligations owed as a result of the acquisitions of TSE andEvolving Systems U.K.

(8)          Thedecrease in equity from 2005 to 2006 is primarily a result of the impairment ofgoodwill and intangible assets recorded during 2006.

**ITEM7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**FORWARD-LOOKING STATEMENTS**

*This Management’s Discussion and Analysis of FinancialCondition and Results of Operations contains forward-looking statementsthat have been made pursuant to the provisions of the Private SecuritiesLitigation Reform Act of 1995. These forward-looking statements are basedon current expectations, estimates, and projections about Evolving Systems’industry, management’s beliefs, and certain assumptions made by management.Forward-looking statements include our expectations regarding product,services, and customer support revenue; our expectations associated withEvolving India, Evolving Systems U.K. and TSE, and short- and long-termcash needs. In some cases, words such as “anticipates”, “expects”, “intends”, “plans”,“believes”, “estimates”, variations of these words, and similar expressions areintended to identify forward-looking statements. The following discussionshould be read in conjunction with, and is qualified in its entirety by, theconsolidated financial statements and the notes thereto included elsewhere inthis Annual Report on Form 10-K. Our actual results could differmaterially from those anticipated in these forward-looking statements asa result of certain factors, including those set forth in this section and in “Item1A - Risk Factors.”*

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**OVERVIEW**

We are a provider of software solutions and servicesto the wireless, wireline and IP carrier market. We maintain long-standingrelationships with many of the largest wireline, wireless and IP communicationscarriers worldwide. Our customers rely on us to develop, deploy, enhance,maintain and integrate complex, highly reliable software solutions for a rangeof Operations Support Systems (“OSS”). Our activation solution is the leadingpackaged solution for activation in the wireless industry.

We recognize revenue in accordance with the prescribedaccounting standards for software revenue recognition under generally acceptedaccounting principles. As a result, our license fees and services revenuesfluctuate from period to period as a result of the timing of revenuerecognition on existing projects.

We acquired TSE in October 2004and Evolving Systems U.K. in November 2004. These acquisitions wereaccounted for as purchase business combinations is accordance with generallyaccepted accounting principles and their results of operations were combinedwith Evolving Systems from the acquisition date forward. Therefore, the resultsof operations for the year ended December 31, 2004 reflect the results ofoperations for TSE and Evolving Systems U.K. from October 2004 and November 2004,respectively, through December 31, 2004.

***Implementation of SFAS 123R***

EffectiveJanuary 1, 2006, we adopted SFAS No. 123(R), *Share-Based Payment*(“SFAS 123R”)*,*using the modified prospective method. Prior to January 1,2006, we applied the intrinsic-value-based method in accounting for employeestock-based compensation arrangements and the fair value method only fordisclosure purposes. Under these methods, stock-based compensation costs werenot recorded in the financial statements but were disclosed in the notes to thefinancial statements together with pro forma disclosure of earnings andearnings per share based upon the fair value method of accounting forstock-based compensation. Because the fair value recognition provisions ofSFAS 123R require recognition of stock-based compensation expense in thefinancial statements, the application of SFAS 123R negatively impacted ourresults of operations. For the year ended December 31, 2006, we recorded$0.8 million of stock-based compensation expense associated with our stockoption and employee stock purchase plans which were allocated to the variousexpense line items within our statements of operations. As we previouslyapplied the fair value method for disclosure purposes only, we believe thedisclosures in previously issued reports are reasonably comparable to currentperiod recorded expenses except for the requirement to now estimate forfeituresin the amount of compensation expense recognized, as compared to recordingforfeitures as they occurred in our prior period pro forma disclosures. As of December 31,2006, there were $1.3 million of total unrecognized compensation costs relatedto unvested stock options. These costs are expected to be recognized over aweighted average period of 1.4 years. The following table summarizes thestock-based compensation expenses recorded in the statements of operations (inthousands).
|                                                                            | ** ** | **For the Year Ended  December 31, 2006** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| Cost of license  fee and services, excluding depreciation and amortization |       |                                                               | $          | 57 |   |   |
| Cost of customer  support, excluding depreciation and amortization         |       |                                                               | 8          |   |   |
| Sales and  marketing                                                       |       |                                                               | 183        |   |   |
| General and  administrative                                                |       |                                                               | 513        |   |   |
| Product  development                                                       |       |                                                               | 47         |   |   |
|                                                                       |       |                                                               | $          | 808 |   |   |

 

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***Impairment of Goodwill and Intangible Assets***

We recognized a goodwill impairment charge of $10.9million at June 30, 2006 related to our License Fees and Servicesoperating segment. The impairment resulted from the decline in the fair valueof goodwill initially recorded associated with our acquisitions of EvolvingSystems U.K., TSE and CMS.

In addition, we recordedan impairment of intangible assets of $5.6 million at June 30, 2006related to intangible assets acquired in the acquisitions of Evolving SystemsU.K., CMS and TSE. An evaluation of product strategy and development plansresulted in the determination that the undiscounted cash flows associated withthese assets would not be sufficient to recover the carrying amounts of theseassets. This non-cash impairment charge resulted in acceleration of futureamortization expense associated with these assets.

***Cost Reductions***

During 2005, we implemented a number of cost reducingstrategies targeted at integrating our 2004 acquisitions, includingidentification of several duplicative roles that were eliminated followingthese acquisitions. In July 2005, we undertook cost reduction measuresthat involved an additional 10% reduction in our workforce, includingindividuals at all levels of our U.S. and U.K. operations. We recordedseverance costs of $845,000 during 2005 related to these cost reductions. Inaddition, we transitioned Evolving Systems U.K. third-party softwaredevelopment to our offshore development team in our India subsidiary. We havecontinued to increase utilization of our Evolving Systems India subsidiarywhich now employs approximately 100 people.

Net of the impairment of goodwill and intangibleassets, our costs of revenue and operating expenses decreased $7.2 million, or18%, to $33.9 million for the year ended December 31, 2006 from $41.1million for the year ended December 31, 2005. These cost reductionmeasures account for a significant portion of the decrease in our costs ofrevenue and operating expenses for the year ended December 31, 2006 ascompared to the year ended December 31, 2005. Our intangible amortizationdecreased $2.7 million over these periods as certain of our intangible assetsfrom our acquisitions became fully amortized and/or were written down as aresult of impairment at June 30, 2006. Stock-based compensation costs of$0.8 million resulting from the implementation of SFAS 123R partially offsetthese decreases in expense.

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**RESULTS OFOPERATIONS**

Thefollowing table presents our consolidated statements of operations incomparative format.

| ** **                                                                           | ** ** | **For the Year Ended  December 31,** | ** ** | ** ** | ** ** | **For the Year Ended  December 31,** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|------------|------------|----------------------------------------------------------|------------|------------|------------|
| ** **                                                                           | ** ** | **2006**                                                 | ** ** | **2005**   | ** ** | **Change**                                               | ** ** | **2005**   | ** ** | **2004** | ** ** | **Change** | ** ** |
| **Revenue:**                                                                         | ** ** | ** **                                               | ** ** | ** ** | ** ** | ** **                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and services                                                            |       | $                                                        | 15,883     |       | $          | 19,779                                                   |       | $          | (3,896     | ) | $ | 19,779 |   | $ | 11,074 |   | $ | 8,705 |   |
| Customer support                                                                     |       | 17,950                                                   |       | 19,673     |       | (1,723                                                   | )          | 19,673     |       | 15,268 |   | 4,405 |   |
| Total revenue                                                                        |       | 33,833                                                   |       | 39,452     |       | (5,619                                                   | )          | 39,452     |       | 26,342 |   | 13,110 |   |
| **Costs of revenue and operating  expenses:**                                        | ** ** | ** **                                               | ** ** | ** ** | ** ** | ** **                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Costs of license fees and related services,  excluding depreciation and amortization |       | 7,342                                                    |       | 9,491      |       | (2,149                                                   | )          | 9,491      |       | 5,866 |   | 3,625 |   |
| Costs of customer support, excluding depreciation  and amortization                  |       | 5,694                                                    |       | 6,579      |       | (885                                                     | )          | 6,579      |       | 7,070 |   | (491 | ) |
| Sales and marketing                                                                  |       | 8,962                                                    |       | 9,643      |       | (681                                                     | )          | 9,643      |       | 4,412 |   | 5,231 |   |
| General and administrative                                                           |       | 5,138                                                    |       | 6,818      |       | (1,680                                                   | )          | 6,818      |       | 5,085 |   | 1,733 |   |
| Product development                                                                  |       | 3,072                                                    |       | 1,921      |       | 1,151                                                    |       | 1,921      |       | 1,066 |   | 855 |   |
| Depreciation                                                                         |       | 1,169                                                    |       | 1,443      |       | (274                                                     | )          | 1,443      |       | 1,152 |   | 291 |   |
| Amortization                                                                         |       | 2,511                                                    |       | 5,215      |       | (2,704                                                   | )          | 5,215      |       | 1,667 |   | 3,548 |   |
| Impairment of goodwill and intangible assets                                         |       | 16,516                                                   |       | —     |       | 16,516                                                   |       | —     |       | — |   | — |   |
| Restructuring and other expense (recovery)                                           |       | (21                                                      | )          | (49        | )          | 28                                                       |       | (49        | )          | (15 | ) | (34 | ) |
| Total costs of  revenue and operating expenses                                       |       | 50,383                                                   |       | 41,061     |       | 9,322                                                    |       | 41,061     |       | 26,303 |   | 14,758 |   |
| Income (loss)  from operations                                                       |       | (16,550                                                  | )          | (1,609     | )          | (14,941                                                  | )          | (1,609     | )          | 39 |   | (1,648 | ) |
| Interest income                                                                      |       | 160                                                      |       | 116        |       | 44                                                       |       | 116        |       | 304 |   | (188 | ) |
| Interest expense                                                                     |       | (1,992                                                   | )          | (1,636     | )          | (356                                                     | )          | (1,636     | )          | (301 | ) | (1,335 | ) |
| Gain (loss) on foreign exchange transactions                                         |       | (5                                                       | )          | (172       | )          | 167                                                      |       | (172       | )          | 84 |   | (256 | ) |
| Income (loss)  before income taxes                                                   |       | (18,387                                                  | )          | (3,301     | )          | (15,086                                                  | )          | (3,301     | )          | 126 |   | (3,427 | ) |
| Income tax benefit                                                                   |       | (1,604                                                   | )          | (396       | )          | (1,208                                                   | )          | (396       | )          | (298 | ) | (98 | ) |
| Net income (loss)                                                                    |       | (16,783                                                  | )          | (2,905     | )          | (13,878                                                  | )          | (2,905     | )          | 424 |   | (3,329 | ) |
| Beneficial conversion feature                                                        |       | —                                                   |       | —     |       | —                                                   |       | —     |       | 3,306 |   | (3,306 | ) |
| Net loss available to  common stockholders                                           |       | $                                                        | (16,783    | )          | $          | (2,905                                                   | )          | $          | (13,878    | ) | $ | (2,905 | ) | $ | (2,882 | ) | $ | (23 | ) |

 

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***Revenue***

Revenueis comprised of license fees and services and customer support. License feesand services revenue represent the fees we receive from the licensing of oursoftware products and those services directly related to the delivery of thelicensed product as well as integration services and time and materials work. Customersupport revenue includes annual support fees, recurring maintenance fees, minorproduct upgrades and warranty fees. Warranty fees are typically bundled with alicense sale and the related revenue, based on vendor specific objectiveevidence (“VSOE”), is deferred and recognized ratably over the warranty period.The following table presents our revenue by product line (in thousands).

| ** **           | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------|------------|---------------------------------------------------------------|------------|
| ** **           | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Activation           |       | $                                                             | 16,717     |   | $ | 18,868 |   | $ | 3,252 |   |
| Numbering  solutions |       | 12,006                                                        |       | 15,336 |   | 19,048 |   |
| Mediation            |       | 5,110                                                         |       | 5,248 |   | 4,042 |   |
|                 |       | $                                                             | 33,833     |   | $ | 39,452 |   | $ | 26,342 |   |

 

***License Fees and Services***

License fees and services revenue decreased 20% or$3.9 million to $15.9 million for the year ended December 31, 2006compared to $19.8 million for the year ended December 31, 2005. Thedecline was a result of a decrease of $1.8 million in revenue from ouractivation products and a decrease of $2.1 million in revenue from our numberingsolutions products. The decline in activation products revenue was due to fewerlicense sales resulting from industry consolidation, competitive pressures andlonger customer purchasing cycles. The decline in numbering solutions licensefees and services revenue was due to the maturity of the narrowband numberingsolutions market in the U.S.

License fees and services revenue increased 79% or$8.7 million to $19.8 million for the year ended December 31, 2005compared to $11.1 million for the year ended December 31, 2004. Thisincrease was due to activation sales related to products acquired in theEvolving Systems U.K. acquisition, which was offset by lower revenues from ournumbering solutions products. The decline in numbering solutions license feesand services was due to industry consolidation and smaller overall licensesales, which is reflective of the maturity of the narrowband numberingsolutions market in the U.S.

***Customer Support***

Customer support revenues decreased 9% or $1.7 millionto $18.0 million for the year ended December 31, 2006 from $19.7 millionfor the year ended December 31, 2005. The decrease in customer supportrevenue included a decrease of $0.3 million in our activation products, adecrease of $1.2 million from our numbering solutions products and a decreaseof $0.2 million in our mediation products. The decrease in activation revenueis a result of pricing pressures on support contract renewals. The decrease inthe numbering solutions revenue was due to industry consolidation and smalleroverall license sales, which is reflective of the maturity of the narrowbandnumbering solutions market in the U.S. The decline in mediation revenue isconsistent with our focus on our activation and numbering solutions products.

Customer support revenues increased 29% or $4.4million to $19.7 million for the year ended December 31, 2005 from $15.3for the year ended December 31, 2004. This increase is due to increasedrevenue from the support of activation products acquired in the EvolvingSystems U.K. acquisition, which is partially offset by lower revenue from thenumbering solutions products. Industry consolidation and price reductions formature and stable products accounted for the decline in numbering solutionscustomer support revenue during 2005.

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***Costs of Revenue, excluding depreciation andamortization***

Costs of revenue consistprimarily of personnel costs, facilities costs, the costs of third-partysoftware and all other direct costs associated with these personnel. Costs ofrevenue, excluding depreciation and amortization were $13.0 million, $16.1million and $12.9 million for the years ended December 31, 2006, 2005 and2004, respectively.

***Costs of License Fees and Services, excludingdepreciation and amortization***

Costs of revenue for license fees and servicesdecreased 23% or $2.1 million to $7.3 million for the year ended December 31,2006 from $9.5 million for the year ended December 31, 2005. The decreasewas due to decreased revenue as well as cost savings from our 2005 cost savinginitiatives. As a percentage of license fees and services revenue, costs oflicense fees and services, excluding depreciation and amortization, decreasedto 46% for the year ended December 31, 2006 from 48% for the year ended December 31,2005. This decrease was due to cost savings as well as savings from theincreased utilization of our offshore development subsidiary in Bangalore,India.

Costs of revenue for license fees and servicesincreased 62% or $3.6 million to $9.5 million for the year ended December 31,2005 from $5.9 million for the year ended December 31, 2004. The increasewas primarily due to higher employee related costs to support the increasedvolume of license and services projects as a result of the Evolving SystemsU.K. acquisition, as well as additional costs associated with maintaininginternational offices. This increase was offset by savings generated from ourcontinued investment in our offshore development in Bangalore, India. Cost oflicense fees and services were 48% of license fees and services revenue for theyear ended December 31, 2005 as compared to 53% for the year ended December 31,2004. This reduction of cost as a percentage of revenue was a result of thecost reductions implemented during 2005 which are discussed above as well aslower costs resulting from the increased utilization of our Bangalore offshoredevelopment subsidiary.

***Costs of Customer Support, excluding depreciation andamortization***

Costs of revenue for customer support decreased 13% or$0.9 million to $5.7 million for the year ended December 31, 2006 from$6.6 million for the year ended December 31, 2005. The decrease was due toreduced revenue as well as cost savings. As a percentage of customer supportrevenue, costs of customer support revenue, excluding depreciation andamortization, decreased to 32% for the year ended December 31, 2006 from33% for the year ended December 31, 2005. This decrease was primarily dueto cost reductions as well as savings from the increased utilization of ouroffshore development subsidiary in Bangalore, India.

Costs of revenue for customer support decreased 7% or$0.5 million to $6.6 million for the year ended December 31, 2005 from$7.1 million for the year ended December 31, 2004. This decrease resultsfrom savings realized from higher utilization of our offshore development teamin India, partially offset by higher employee related cost to support moreproducts as a result of our acquisitions of TSE and Evolving Systems U.K. Costsof customer support were 33% of customer support revenue for the year ended December 31,2005 compared to 46% for the year ended December 31, 2004. This decreasewas the result of the cost reductions implemented during 2005 which arediscussed above.

***Sales and Marketing***

Sales and marketing expenses primarily consist ofcompensation costs including bonuses and commissions, other employee relatedcosts, travel expenses, advertising and occupancy expenses. Sales and marketingexpenses decreased 7% or $0.7 million to $9.0 million for the year ended December 31,2006 from $9.6 million for the year ended December 31, 2005. Cost savingmeasures targeted at reducing the 

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number of U.S. salespersonnel were somewhat offset by sales and marketing investments made in Asiaand Central and Latin America as well as stock-based compensation expensesrecorded during the year ended December 31, 2006. As a percentage of totalrevenue, sales and marketing expenses for the year ended December 31, 2006and 2005, increased to 26% from 24%, respectively. This increase was a result ofdecreased revenue without proportional decreases in sales and marketingexpenses during the year ended December 31, 2006 as compared to the sameperiod in 2005.

Sales and marketingexpenses increased 119% or $5.2 million to $9.6 million for the year ended December 31,2005 from $4.4 million for the year ended December 31, 2004. Sales andmarketing expenses as a percentage of total revenue increased to 24% in 2005compared to 17% in 2004. These increases were primarily a result of additionalcosts associated with having an international sales force, increased expensesrelated to expanded headcount for sales initiatives designed to penetrate newmarkets and higher advertising and marketing costs to introduce the combinedcompany’s products and offerings into new regional markets.

***General and Administrative***

General and administrative expenses consistprincipally of employee related costs, professional fees and occupancy costsfor the following departments: facilities, finance, legal, human resources andexecutive management. General and administrative expenses decreased 25% or $1.7million to $5.1 million for the year ended December 31, 2006 from $6.8million for the year ended December 31, 2005. As a percentage of totalrevenue, general and administrative expenses for the year ended December 31,2006 and 2005, decreased to 15% from 17%, respectively. These decreases wereprimarily a result of cost saving measures and reductions in professional andlegal fees which were offset by stock-based compensation costs recorded duringthe year ended December 31, 2006. As part of the reduction in professionalfees, we did not incur any professional fees during 2006 for compliance effortsrelated to the Sarbanes-Oxley Act. Under the requirements of the Sarbanes-OxleyAct, we will be required to provide a report by management assessing theeffectiveness of our internal control over financial reporting for the yearended December 31, 2007. We expect this will result in an increase inprofessional fees during 2007 and subsequent years.

General and administrative expenses increased 34% or$1.7 million to $6.8 million for the year ended December 31, 2005 from$5.1 million for the year ended December 31, 2004. This increase wasprimarily due to additional costs from Evolving Systems U.K. In addition, weincurred increased expenses related to audit and tax services as a result ofbeing a larger, international company as well as increased professionalservices in the U.S. related to initiating the documentation of internalcontrols that will be required under the Sarbanes-Oxley Act. As a percentage oftotal revenue, general and administrative expenses declined to 17% in 2005 from19% in 2004. This decline is attributable to the cost reductions implementedduring 2005 which are discussed above.

***Product Development***

Product development expenses consist primarily ofemployee-related costs for product development and the write-off of in-processresearch and development during 2004. Product development expenses increased60% or $1.2 million to $3.1 million for the year ended December 31, 2006from $1.9 million for the year ended December 31, 2005. As a percentage oftotal revenue, product development expenses increased to 9% in 2006 from 5% in2005. These increases were due to costs incurred to “internationalize” ourNumeriTrack product as well as costs attributable to product enhancementsduring 2006.

Product developmentexpenses increased 80% or $0.9 million to $1.9 million for the year ended December 31,2005 from $1.1 million for the year ended December 31, 2004. As apercentage of total revenue, product development expenses increased to 5% in2005 from 4% in 2004. These increases were 

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due toadditional costs from TSE and Evolving Systems U.K. as well as costsattributable to upgrade releases for existing products and new product releasesduring 2005.

***Depreciation***

Depreciation expense consists of depreciation oflong-lived property and equipment. Depreciation expenses decreased 19% or $0.3million to $1.2 million for the year ended December 31, 2006 from$1.4 million for the year ended December 31, 2005. This decrease is aresult of certain assets becoming fully depreciated.

Depreciation expensesincreased 25% or $0.3 million to $1.4 million for the year ended December 31,2005 from $1.2 million for the year ended December 31, 2004. This increasewas directly attributable to depreciation of property and equipment acquired inthe TSE and Evolving Systems U.K. acquisitions.

***Amortization***

Amortization expense consists of amortization ofidentifiable intangibles related to our acquisitions of CMS, TSE and EvolvingSystems U.K. Amortization expenses decreased 52% or $2.7 million to $2.5 millionfor the year ended December 31, 2006 from $5.2 million for the year ended December 31,2005. This decrease was attributable to certain intangible assets becomingfully amortized as well as the impairment of certain intangible assets during2006.

Amortization expensesincreased 213% or $3.5 million to $5.2 million for the year ended December 31,2005 from $1.7 million for the year ended December 31, 2004. This increasewas directly attributable to amortization of intangible assets acquired in theCMS, TSE and Evolving Systems U.K. acquisitions as there was only approximatelytwo months of amortization expenses in 2004 related to the TSE and EvolvingSystems U.K. acquisitions.

***Impairment of Goodwill and Intangible Assets***

We recorded a goodwill impairment of $10.9 millionrelated to impairment of our License Fees and Services operating segment during2006. Continuedpricing pressures and consolidation in the telecommunications industrynegatively impacted our achievement of forecasted revenues associated with theacquisitions of CMS in November 2003, TSE in October 2004 andEvolving Systems U.K. in November 2004. The market price of our commonstock declined as a result of our operating results. Based upon these events,we determined that a triggering event had occurred and we conducted a goodwillimpairment analysis as of June 30, 2006. This goodwill impairment analysisresulted in the $10.9 million goodwill impairment charge. We estimated the fairvalue of each reporting unit using the expected present value of future cashflows and other market factors.

As a result of the eventsthat led to a triggering event related to the goodwill impairment, we firstreviewed intangible assets in accordance with SFAS 144. An evaluation ofproduct strategy and development plans resulted in the determination that theundiscounted cash flows associated with these assets would not be sufficient torecover the carrying amounts of these assets. This review indicated that $5.6million of intangible assets related to our License Fees and Services andCustomer Support operating segments were impaired. The impaired intangibleassets were purchased software, purchased licenses and customer relationshipswhich were acquired through our acquisitions of Evolving Systems U.K., CMS andTSE. As a result of the impairment of intangible assets, our futureamortization expense will be lower than originally projected by the amount ofthe $5.6 million impairment charge.

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***Interest Income***

Interest income includes interest income earned oncash and cash equivalents. Interest income for the year ended December 31,2006 increased $44,000 as compared to the year ended December 31, 2005 asa result of higher cash and cash equivalents balances.

Interest income for theyear ended December 31, 2005 decreased 62% or $0.2 million to $0.1 millionas compared to the year ended December 31, 2004 as a result of lower balancesof cash and cash equivalents.

***Interest Expense***

Interest expense includes interest expense on ourlong-term debt and capital lease obligations as well as amortization of debtissuance costs. Interest expense for the year ended December 31, 2006increased $0.4 million to $2.0 million as compared to $1.6 million for the yearended December 31, 2005. This increase was a result of higher variableinterest rates on our senior debt obligations and increased amortization ofdebt issuance costs.

Interest expense for theyear ended December 31, 2005 increased $1.3 million to $1.6 million ascompared to the year ended December 31, 2004 as a result of the debtincurred in connection with the acquisitions of TSE and Evolving Systems U.K.

***Gain (Loss) on Foreign Exchange Transactions***

Gain (loss) on foreign exchange transactions consistsprimarily of realized foreign currency transaction gains and losses. Foreigncurrency transaction gains and losses result from transactions denominated in acurrency other than the functional currency of the respective subsidiary. Foreigncurrency transaction loss decreased $0.2 million to $5,000 for the year ended December 31,2006 compared to $0.2 million the year ended December 31, 2005. Theselosses were primarily generated by Evolving Systems U.K. transactionsdenominated in currencies other than its functional currency.

Gain (loss) on foreignexchange transactions decreased $0.3 million to a $0.2 million loss for theyear ended December 31, 2005 compared to the year ended December 31,2004. This decrease was primarily attributable to realized foreign currencytransaction losses of $0.2 million during 2005 compared to realized transactiongains of $0.1 million during 2004. These gains and losses were primarilygenerated by Evolving Systems U.K. transactions denominated in currencies otherthan its functional currency.

***Income Tax Benefit***

We recorded net income tax benefit of $1.6 million,$0.4 million and $0.3 million during the years ended December 31, 2006,2005 and 2004, respectively. The U.S. has net operating loss carryforwards of$49.5 million which are used to offset any U.S. tax liability. Our tax expenseor benefit relate to our U.K-based subsidiary.

The net income tax benefit for the year ended December 31,2006 of $1.6 million related primarily to our U.K.-based operations andconsisted of current income tax expense of $0.3 million and a deferred taxbenefit of $1.9 million. During 2006, we recorded a $224,000 current tax benefit for research anddevelopment expenses related to a change in estimate based on our as filed 2005tax return for Evolving Systems U.K. The deferred tax benefit of $1.9 millionrelates primarily to amortization expense on intangible assets.

The net income tax benefit for the year ended December 31,2005 of $0.4 million related primarily to our U.K.-based operations andconsisted of current income tax expense of $0.8 million and a deferred taxbenefit of $1.2 million.

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The net income tax benefit for the year ended December 31,2004 of $0.3 million related primarily toour U.K.-based operations and consisted of current income tax expense of$0.3 million and a deferred tax benefit of $0.6 million.

In conjunction with the acquisition of EvolvingSystems U.K., certain identifiable intangible assets were recorded. Since theamortization of these identifiable intangibles is not deductible for income taxpurposes, a long-term deferred tax liability of $4.6 million was established atthe acquisition date for the expected difference between what would be expensedfor financial reporting purposes and what would be deductible for income taxpurposes. As of December 31, 2006 and 2005, this deferred tax liabilitywas $1.5 million and $3.1 million, respectively. The deferred taxliability relates to Evolving Systems U.K. and has no impact on our ability torecover the U.S. based deferred tax assets. This deferred tax liability will berecognized as the identifiable intangibles are amortized.

We made an adjustment during the year ended December 31,2005 as we determined that we had incorrectly recorded the purchase accountingentries related to our purchase of Evolving Systems U.K. during the year ended December 31,2004 which had the effect of overstating goodwill by $426,000 and overstatingthe net deferred foreign income tax liability by $435,000 on the 2004consolidated balance sheet. In addition, the reported net income in 2004 shouldhave been $9,000 higher. We corrected this error at December 31, 2005. Weassessed the impact on the 2005 and 2004 consolidated financial statements anddetermined that the impact was not material to either period.

A full valuation allowancewas recorded against our U.S. net deferred tax assets as of December 31,2006 and 2005 as we determined that it was more likely than not that we willnot realize our U.S. deferred tax assets. Such assets primarily consist ofcertain net operating loss carryforwards. Our assessment of the realizabilityof our domestic deferred tax assets was made using all available evidence. Inparticular, we considered both historical results and projections ofprofitability for only the reasonably foreseeable future periods and any taxplanning strategies.

***Deemed Dividend for Beneficial Conversion of Series BPreferred Stock***

Based upon the various features of the Series B Preferred Stock,fair value of this security was determined to approximate the stated redemptionprice. Since the conversion price of the Series B Preferred Stock wasfixed in the purchase agreement to equal $3.50 per common share, a beneficialconversion feature existed on the acquisition date equal to the differencebetween the value of our common stock on the acquisition date, or $4.64, andthe conversion price stated in the purchase agreement. For the year ended December 31,2004, the beneficial conversion feature was recognized as a reduction of netincome available to common stockholders of $3.3 million on the acquisition datesince the Series B Preferred Stock was immediately convertible to commonstock.

**FINANCIAL CONDITION**

Our working capitalposition of $0.8 million at December 31, 2006 reflects an increase of $0.4million from our working capital position of $0.4 million December 31,2005. Our working capital position increased despite a $1.0 million prepaymenton our senior note payable and a $1.0 million increase in the current portionof long-term debt, in accordance with the repayment schedule associated withour senior note payable. The $1.0 million prepayment resulted from theamendment of our senior debt agreements at June 30, 2006.

**LIQUIDITY ANDCAPITAL RESOURCES**

We have historically financed operations through acombination of cash flow from operations and equity transactions. At December 31,2006, our principal source of liquidity was $5.1 million in cash and 

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cash equivalents and $2.5million of unused availability under a revolving credit facility. The revolvingcredit facility is available through November 2010.

Net cash provided by operating activities for theyears ended December 31, 2006, 2005 and 2004 was $3.4 million, $0.4million and $4.3 million, respectively. Net income (loss) plus non-cashoperating adjustments was $2.6 million for 2006, $4.0 million for 2005 and $2.7million for 2004. Changes in operating assets and liabilities reflected a netincrease in cash from operating activities in 2006 of $4.4 million and adecrease of $5.3 million in 2005 from 2004. These fluctuations were primarilyattributable to the timing of billings and collections for existing projectswhich vary based upon the specific billing schedules in each contract andaffect the reported amounts of contract receivables, unbilled work-in-processand unearned revenue.

Net cash used by investing activities was $0.6million, $1.4 million and $11.7 million for the years ended December 31,2006, 2005 and 2004, respectively. During 2006, we purchased $0.5 million inproperty and equipment to support operations and paid additional cashconsideration to the TSE sellers of approximately $0.2 million. During 2005, wepurchased $0.8 million in property and equipment to support operations, paidadditional cash consideration to the TSE sellers of approximately $0.8 million,including $0.3 million which was accrued as of December 31, 2004, andreceived $0.1 million in settlement of pre-acquisition contingencies from theEvolving U.K. acquisition.  Cash used in2004 for investing activities consisted of $1.2 million in property andequipment purchases and $10.5 million associated with the purchase of TSE andEvolving Systems U.K.

Net cash used in financing activities was $1.9 millionand $5.9 million for the years ended December 31, 2006 and 2005,respectively, compared to net cash provided by financing activities of$0.5 million for the year ended December 31, 2004. The net cash usedduring 2006 of $1.9 million included $2.0 million in principal payments onour senior debt facility. During 2005, we paid $16 million toward reduction ofour obligations incurred in connection with the TSE and Evolving Systems U.K.acquisitions which included a debt restructuring prepayment of $8.5 million tothe Evolving Systems U.K. sellers. This prepayment was funded through proceedsobtained from an $8.5 million senior note payable that matures in November 2010.We restructured the remaining $4.9 million in debt obligations to the EvolvingSystems U.K. sellers. The addition of the senior note payable and restructuringof the Evolving Systems U.K. seller debt reduced our scheduled principalpayments through December 31, 2007, from approximately $12.0 millionto $3.0 million.  In addition, weobtained a $4.5 million senior revolving credit facility in November 2005which required a minimum draw down of $2.0 million.

Our capital expenditures over the last three yearsaveraged $0.8 million. A financial covenant on our senior note payableprohibits capital expenditures in excess of $1.4 million. Over the next twelvemonths, we expect our capital expenditure requirements will approximate $1.0million which will be used to support operations.

We believe that ourcurrent cash and cash equivalents, together with anticipated cash flow fromoperations will be sufficient to meet our working capital and capitalexpenditure requirements for at least the next twelve months. In making thisassessment, we considered the following:

·       Ourcash and cash equivalents balance at December 31, 2006 of$5.1 million;

·       Theavailability under our revolving credit facility of $2.5 million at December 31,2006;

·       Ourdemonstrated ability to generate positive operating cash flows;

·       Ourbacklog of approximately $13.8 million, including $4.8 million in license feesand services and $9.0 million in customer support at December 31, 2006;

·       Ourplanned capital expenditures; and

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·       Ourcash forecast which indicates that we will have sufficient liquidity to coveranticipated operating costs as well as debt service payments.

We are exposed to foreign currency rate risks whichimpact the carrying amount of our foreign subsidiaries and our consolidatedequity, as well as our consolidated cash position due to translationadjustments. For the year ended December 31, 2006, the effect of exchange ratechanges resulted in a $0.4 million increase to consolidated cash. For theyear ended December 31, 2005, the effect of exchange rate changes resultedin a $0.6 million reduction of consolidated cash. During the year ended December 31,2004, the effect of exchange rate changes resulted in a $0.3 million increaseto consolidated cash. We do not currently hedge our foreign currency exposure,but we intend to monitor the rate changes and may hedge our exposures if we seesignificant negative trends in exchange rates.

On June 30, 2006, weamended our Minimum Trailing Twelve Months EBITDA and Fixed Charge CoverageRatio covenants related to our senior credit facility. As part of thisamendment, we made a prepayment of principal on our senior note payable in theamount of $1.0 million. See Note 5 to the Consolidated Financial Statements foradditional information on the covenant amendments.

**Off-Balance SheetArrangements**

We have no off-balancesheet arrangements that have a material current effect or that are reasonablylikely to have a material future effect on our financial condition, changes infinancial condition, revenues or expenses, results of operations, liquidity,capital expenditures, or capital resources.

**ContractualObligations and Commercial Commitments**

Thefollowing summarizes our significant contractual obligations as of December 31,2006, which are comprised of a capital lease, operating leases and principaland interest payments on our long-term debt, assuming no prepayments are made(in thousands).

| ** **          | ** ** | **Payments due by period** | ** ** |
|---------------------|------------|-------------------------------------------|------------|
| ** **          | ** ** | **Total**                                 | ** ** | **2007** | ** ** | **2008-2009** | ** ** | **2010-2011** | ** ** | **2012 and  thereafter** | ** ** |
| Long-term debt      |       | $                                         | 13,370     |   | $ | 2,000 |   |   | $ | 4,500 |   |   |   | $ | 6,870 |   |   |   | $ | — |   |   |
| Interest on debt(1) |       | 6,658                                     |       | 795 |   |   | 802 |   |   |   | 5,061 |   |   |   | — |   |   |
| Capital lease       |       | 77                                        |       | 42 |   |   | 35 |   |   |   | — |   |   |   | — |   |   |
| Operating leases    |       | 2,139                                     |       | 952 |   |   | 930 |   |   |   | 257 |   |   |   | — |   |   |
| Total commitments   |       | $                                         | 22,244     |   | $ | 3,789 |   |   | $ | 6,267 |   |   |   | $ | 12,188 |   |   |   | $ | — |   |   |

----

(1)          Interest on debtrepresents cash interest payment obligations assuming all indebtedness at December 31,2006 will be paid in accordance with its contractual terms and maturity andassumes interest rates on variable interest debt as of December 31, 2006will remain unchanged in future periods.

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**CRITICAL ACCOUNTINGPOLICIES**

Our significant accountingpolicies are disclosed in Note 1 of our Consolidated Financial Statementsincluded elsewhere in this Annual Report on Form 10-K. The followingdiscussion addresses our most critical accounting policies, which are thosethat are both important to the portrayal of our financial condition and resultsof operations and that require significant judgment or use of complexestimates.

***Revenue Recognition***

We derive revenue from two primary sources: licensefees/services and customer support. We recognize revenue in accordance withStatement of Position (“SOP”) 97-2, “Software Revenue Recognition,” asamended and interpreted by SOP 98-9, “Modification of SOP 97-2,Software Revenue Recognition, With Respect to Certain Transactions.” Inaddition we have applied Staff Accounting Bulletin (“SAB”) No. 104, “RevenueRecognition,” which provides further interpretive guidance for public companieson the recognition, presentation and disclosure of revenue in financial statements.

The majority of our license fees and services revenueis generated from fixed-price contracts which provide for licenses to oursoftware products and services.  Generally, when the services are determined tobe essential to the functionality of the delivered software, we recognizerevenue using the percentage-of-completion method of accounting, in accordancewith SOP 97-2 and SOP 81-1, “Accounting for Long-Term ConstructionType Contracts.”  The percentage ofcompletion for each contract is estimated based on the ratio of direct laborhours incurred to total estimated direct labor hours. Since estimated directlabor hours and project costs, and changes thereto, can have a significantimpact on revenue recognition, these estimates are critical and are reviewed bymanagement regularly. Amounts billed in advance of services being performed arerecorded as unearned revenue. Unbilled work-in-progress represents revenueearned but not yet billable under the terms of the fixed-price contracts. Allsuch amounts are expected to be billed and collected within 12 months.

We may encounter budget and schedule overruns onfixed price contracts caused by increased labor, overhead or material costs.Adjustments to cost estimates are made in the periods in which the factsrequiring such revisions become known. Estimated losses, if any, are recordedin the period in which current estimates of total contract revenue and contractcosts indicate a loss.

In arrangements where the services are not essentialto the functionality of the delivered software, we recognize license revenuewhen a license agreement has been signed, delivery has occurred, the fee isfixed or determinable and collectibility is reasonably assured. Whereapplicable, fees from multiple element arrangements are unbundled and recordedas revenue as the elements are delivered to the extent that vendor specificobjective evidence (“VSOE”) of fair value of the undelivered elements exist. IfVSOE for the undelivered elements does not exist, fees from such arrangementsare deferred until the earlier of the date that VSOE does exist on theundelivered elements or all of the elements have been delivered.

Services revenue provided under fixed-pricecontracts is generally recognized using the percentage of completion methoddescribed above. Revenue from professional services provided pursuant totime-and-materials contracts and training services are recognized as theservices are performed, as that is when our obligation to our customers undersuch arrangements is fulfilled.

Customer support andmaintenance revenue is generally recognized ratably over the service contractperiod. When maintenance or training services are bundled with the originallicense fee arrangement, their fair value, based upon VSOE, is deferred andrecognized during the periods such services are provided.

***Allowance for Doubtful Accounts***

We make judgments relatedto our ability to collect outstanding accounts receivable. We provideallowances for receivables when their collection becomes doubtful by recordingan expense. Generally, we 

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determinethe allowance based on our assessment of the realization of receivables usinghistorical information and current economic trends, including assessing theprobability of collection from customers. If the financial condition of ourcustomers were to deteriorate, resulting in an impairment of their ability tomake payments owed to us, an increase in the allowance for doubtful accountswould be required. We evaluate the adequacy of the allowance regularly and makeadjustments accordingly. Adjustments to the allowance for doubtful accountscould materially affect our results of operations.

***Income Taxes***

We account for incometaxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109,“Accounting for Income Taxes.” Significant judgment is required in determiningour provision for income taxes. We assess the likelihood that our deferred taxasset will be recovered from future taxable income, and to the extent webelieve that recovery is not likely, we establish a valuation allowance. Weconsider future taxable income projections, historical results and ongoing taxplanning strategies in assessing the recoverability of deferred tax assets.However, adjustments could be required in the future if we determine that theamount to be realized is less or greater than the amount that we recorded. Suchadjustments, if any, could have a material impact on our results of ouroperations.

***Goodwill***

Goodwill is the excess ofacquisition cost of an acquired entity over the fair value of the identifiablenet assets acquired. Goodwill is not amortized, but tested for impairmentannually or whenever indicators of impairment exist. These indicators mayinclude a significant change in the business climate, legal factors, operatingperformance indicators, competition, sale or disposition of a significantportion of the business or other factors. For purposes of the goodwillevaluation, we compare the fair value of each of our reporting units to itsrespective carrying amount. If the carrying value of a reporting unit were toexceed its fair value, we would then compare the fair value of the reportingunit’s goodwill to its carrying amount, and any excess of the carrying amountover the fair value would be charged to operations as an impairment loss. Duringthe year ended December 31, 2006, we recorded an impairment of goodwill. SeeNote 3 to the Consolidated Financial Statements for further details.

***Intangible Assets***

We allocate the cost of an acquired company to thetangible and identifiable intangible assets and liabilities acquired, with theremaining amount being recorded as goodwill. Certain intangible assets areamortized over their estimated lives, while in-process research and developmentis recorded as a one-time charge to product development expense in thestatements of operations on the acquisition date.

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 important which could trigger an impairment review include thefollowing:

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

·       Significantchanges in the manner of use of the acquired assets or the strategy of theoverall business;

·       Significantnegative industry or economic trends;

·       Significantdecline in our stock price for a sustained period; and/or

·       Ourmarket capitalization relative to net book value.

If we determine that thecarrying value of intangibles and/or long-lived assets may not be recoverablebased on the existence of one or more of the above indicators of impairment, wemeasure any impairment 

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based onthe estimated discounted cash flows expected to result from the use of theasset and its eventual disposition and compare that to the asset’s carryingamount. Any impairment loss recognized would represent the excess of the asset’scarrying value over its estimated fair value. Significant estimates andjudgments are required when estimating such fair values. If it is determinedthat the intangibles are impaired, an impairment charge would be recorded andthe amount could be material. We recorded an impairment of intangible assetsduring the year ended December 31, 2006. See Note 3 to the ConsolidatedFinancial Statements for further details.

***Capitalization of Internal Software Development Costs***

We expend amounts onresearch and development (“R&D”), particularly for new products and/or forenhancements of existing products. For internal development of softwareproducts that are to be licensed by us, we follow Statement of FinancialAccounting Standards (“SFAS”) No. 86, “Accounting for the Costs ofComputer Software to Be Sold, Leased, or Otherwise Marketed” (“SFAS 86”). SFAS86 requires that the cost of developing software be expensed prior toestablishing technological feasibility, and those costs be capitalized oncetechnological feasibility has been established. Capitalization ceases upongeneral release of the software. The determination of whether internal softwareR&D costs are subject to capitalization is, by its nature, highlysubjective and involves significant judgments. This decision couldsignificantly affect earnings during the development period. Further, oncecapitalized, the software costs are generally amortized on a straight-linebasis over the estimated economic life of the product. The determination of theexpected useful life of a product is highly judgmental. Finally, capitalizedsoftware costs must be assessed for impairment if facts and circumstanceswarrant such a review. We did not capitalize any internal software R&Dcosts during the years ended December 31, 2006, 2005, or 2004. Inaddition, we did not have any capitalized internal software R&D costsincluded in our December 31, 200 and 2005 Consolidated Balance Sheets. Webelieve that during these periods no material internal software R&D costswere required to be capitalized. Our conclusion is primarily based on the factthat the feature-rich, pre-integrated, and highly-scalable nature of our productsrequires that our development efforts include complex design, coding andtesting methodologies, which include next generation software languages anddevelopment tools. Development projects of this nature carry a highdegree of development risk. Substantially all of our internal software R&Defforts are of this nature, and therefore, we believe the period betweenachieving technological feasibility and the general release of the software tooperations is so short that any costs incurred during this period are notmaterial.

***Stock-based Compensation***

We adopted SFAS No. 123(Revised),“Share-Based Payment” (“SFAS 123R”) effective January 1, 2006. Thisstatement replaced SFAS No. 123, “Accounting for Stock-Based Compensation”(“SFAS 123”) and superseded APB Opinion No. 25, “Accounting for StockIssued to Employees.”  Under the modifiedprospective method of adoption, we are required to apply a fair-value-basedmeasurement method in accounting for share-based payment transactions withemployees and record compensation cost for all stock awards granted after January 1,2006 and awards modified, repurchased, or cancelled after that date. Inaddition, we are required to record compensation costs associated with thevesting of unvested options outstanding at January 1, 2006 using theguidance under SFAS 123. From January 1, 2006, stock option grants andemployee stock purchase plan purchases were accounted for under SFAS 123R. Weuse the Black-Scholes model to estimate the fair value of each option grant onthe date of grant. This model requires the use of estimates for expected termof the options and expected volatility of the price of our common stock.

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**RECENT ACCOUNTINGPRONOUNCEMENTS**

In July 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes—An Interpretation of FASB Statement No. 109” (“FIN48”), which clarifies the accounting for uncertainty in income taxes recognizedin an enterprise’s financial statements in accordance with FASB Statement No. 109,“Accounting for Income Taxes” (“SFAS 109”).FIN 48 also prescribes a recognition threshold and measurement attribute forthe financial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. In addition, FIN 48 provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. The provisions of FIN 48 are effective forfiscal years beginning after December 15, 2006. We are currentlyevaluating the impact the adoption of FIN 48 will have on our consolidatedfinancial statements, if any.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidanceon how the effects of the carryover or reversal of prior year misstatementsshould be considered in quantifying a current year misstatement. SAB 108 iseffective for fiscal years ending after November 15, 2006. Theimplementation of SAB 108 did not have a material impact on our consolidatedfinancial statements.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value,establishes a framework for measuring fair value under generally acceptedaccounting principles, and expands disclosures about fair value measurements.SFAS 157 is effective for financial statements issued for fiscal years andinterim periods beginning after November 15, 2007. We have not completedour evaluation of the impact of this standard on our consolidated financialstatements.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities—Including an Amendment of FASB Statement No. 115” (“SFAS159”). SFAS 159 permits entities to choose to measure eligible items at fairvalue at specific election dates (the ‘‘fair value option’’). Unrealized gainsand losses on items for which the fair value option has been elected shall bereported in earnings at each subsequent reporting period. This accountingstandard is effective for us beginning January 1, 2008. We are currentlyassessing the impact of SFAS 159.

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In the ordinary course of business, we are exposed tocertain market risks, including changes in foreign currency exchange rates andinterest rates. Uncertainties that are either non-financial or non-quantifiablesuch as political, economic, tax, other regulatory, or credit risks are notincluded in the following assessment of market risks.

Our cash balances are subject to interest ratefluctuations and as a result, interest income amounts may fluctuate fromcurrent levels. We are exposed to interest rate risk related to our seniorsecured term note and senior revolving credit facility entered into in November 2005.These obligations are variable interest rate notes based on short-term LIBOR. Fluctuationsin LIBOR affect our interest rate risk. Assuming no change in the amountsoutstanding, a hypothetical 10% increase in our existing variable interestrates would increase our annual interest expense by approximately $0.1 million.

We are exposed to fluctuations of the U.S. dollar (ourfunctional currency) against the currencies of our operating subsidiaries. Anyincrease (decrease) in the value of the U.S. dollar against any foreigncurrency that is the functional currency of one of our operating subsidiarieswill cause the parent company to experience unrealized foreign currencytranslation losses (gains) with respect to amounts already invested insuch foreign currencies. In addition, we and our operating subsidiaries areexposed to foreign currency risk to the extent that we enter into transactionsdenominated in currencies other than our 

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respective functionalcurrencies, such as revenues and related accounts receivable (includingintercompany amounts) that are denominated in a currency other than their ownfunctional currency. Changes in exchange rates with respect to these items willresult in unrealized (based upon period-end exchange rates) or realized foreigncurrency transaction gains and losses upon settlement of the transactions. Inaddition, we are exposed to foreign exchange rate fluctuations related to ouroperating subsidiaries’ monetary assets and liabilities and the financialresults of foreign subsidiaries and affiliates when their respective financialstatements are translated into U.S. dollars for inclusion in our consolidatedfinancial statements. Cumulative translation adjustments are recorded inaccumulated other comprehensive income (loss) as a separate component ofequity. As a result of foreign currency risk, we may experience economic lossand a negative impact on earnings and equity with respect to our holdingssolely as a result of foreign currency exchange rate fluctuations.

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

| ** **           | ** ** | **December 31,** | ** ** |
|----------------------|------------|-----------------------|------------|
| **Spot rates:** | ** ** | ** **            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Great British  pound |       | 0.51069               |       | 0.58126 |   |
| Indian rupee         |       | 44.11116              |       | 45.04505 |   |
|                      |            |                       |            |  |  |  |  |

 

| ** **              | ** ** | **For the Years Ended  December 31,** | ** ** |
|-------------------------|------------|-----------------------------------------------------------|------------|
| **Average rates:** | ** ** | ** **                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Great British  pound    |       | 0.543739                                                  |       | 0.54989 |   |
| Indian rupee            |       | 45.15648                                                  |       | 44.14848 |   |
|                         |            |                                                           |            |  |  |  |  |

 

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

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**ITEM8.**                FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersEvolving Systems, Inc.:

We have audited the accompanying consolidated balancesheets of Evolving Systems, Inc. and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of operations, changesin stockholders’ equity and comprehensive income (loss), and cash flows foreach of the years in the three-year period ended December 31, 2006. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

We conducted our audits in accordance with the standardsof the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Evolving Systems, Inc. and subsidiaries as of December 31,2006 and 2005, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2006, inconformity with U.S. generally accepted accounting principles.

As discussed in note 8 tothe accompanying consolidated financial statements, effective January 1,2006, the Company adopted Statement of Financial Accounting Standards No. 123(R),*Share-Based Payment*.

**KPMG LLP**

Denver, ColoradoMarch 14, 2007

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**EVOLVINGSYSTEMS, INC.CONSOLIDATED BALANCE SHEETS(in thousands except share data)**

| ** **                                                                                                                                                                 | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                                 | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                                            |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                  |       | $                     | 5,076      |   | $ | 3,883 |   |
| Current portion of restricted cash                                                                                                                                         |       | 300                   |       | — |   |
| Contract receivables, net of allowance for doubtful  accounts of $70 and $48 at December 31, 2006 and 2005, respectively                                              |       | 9,206                 |       | 10,766 |   |
| Unbilled work-in-progress                                                                                                                                                  |       | 1,064                 |       | 1,147 |   |
| Deferred foreign income taxes                                                                                                                                              |       | 15                    |       | 5 |   |
| Prepaid and other current assets                                                                                                                                           |       | 1,686                 |       | 1,335 |   |
| Total current assets                                                                                                                                                       |       | 17,347                |       | 17,136 |   |
| Property and  equipment, net                                                                                                                                               |       | 1,349                 |       | 1,775 |   |
| Amortizable  intangible assets, net                                                                                                                                        |       | 6,155                 |       | 13,350 |   |
| Goodwill                                                                                                                                                                   |       | 26,027                |       | 34,073 |   |
| Long-term  restricted cash                                                                                                                                                 |       | —                |       | 300 |   |
| Other long-term  assets                                                                                                                                                    |       | 460                   |       | 764 |   |
| Total assets                                                                                                                                                               |       | $                     | 51,338     |   | $ | 67,398 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                              | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                       |       |                  |       |   |   |
| Current portion of capital lease obligations                                                                                                                               |       | $                     | 37         |   | $ | 34 |   |
| Current portion of long-term debt                                                                                                                                          |       | 2,000                 |       | 1,000 |   |
| Accounts payable and accrued liabilities                                                                                                                                   |       | 4,428                 |       | 6,001 |   |
| Unearned revenue                                                                                                                                                           |       | 10,079                |       | 9,654 |   |
| Total current liabilities                                                                                                                                                  |       | 16,544                |       | 16,689 |   |
| Long-term liabilities:                                                                                                                                                     |       |                  |       |   |   |
| Capital lease obligations, net of current portion                                                                                                                          |       | 34                    |       | 71 |   |
| Other long-term obligations                                                                                                                                                |       | 749                   |       | 83 |   |
| Long-term debt, net of current portion                                                                                                                                     |       | 11,370                |       | 14,373 |   |
| Deferred foreign income taxes                                                                                                                                              |       | 1,202                 |       | 2,777 |   |
| Total liabilities                                                                                                                                                          |       | 29,899                |       | 33,993 |   |
| Commitments and  contingencies (Note 11)                                                                                                                                   |       |                  |       |   |   |
| Series B convertible redeemable preferred stock                                                                                                                       |       | 11,281                |       | 11,281 |   |
| Stockholders’ equity:                                                                                                                                                 |       |                  |       |   |   |
| Preferred stock; $.001 par value; 2,000,000 shares  authorized; 966,666 shares of Series B issued and outstanding (shown  above)                                      |       | —                |       | — |   |
| Common stock, $0.001 par value; 25,000,000 shares  authorized; 16,233,646 and 6,137,821 shares issued and outstanding as of December 31,  2006 and 2005, respectively |       | 16                    |       | 16 |   |
| Additional paid-in capital                                                                                                                                                 |       | 68,825                |       | 67,891 |   |
| Accumulated other comprehensive income (loss)                                                                                                                              |       | 1,466                 |       | (2,417 | ) |
| Accumulated deficit                                                                                                                                                        |       | (60,149               | )          | (43,366 | ) |
| Total stockholders’ equity                                                                                                                                            |       | 10,158                |       | 22,124 |   |
| Total liabilities  and stockholders’ equity                                                                                                                           |       | $                     | 51,338     |   | $ | 67,398 |   |

 

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

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**EVOLVING SYSTEMS, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands except per share data)**

| ** **                                                                                                 | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **REVENUE**                                                                                                | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and services                                                                                  |       | $                                                             | 15,883     |   | $ | 19,779 |   | $ | 11,074 |   |
| Customer support                                                                                           |       | 17,950                                                        |       | 19,673 |   | 15,268 |   |
| Total revenue                                                                                              |       | 33,833                                                        |       | 39,452 |   | 26,342 |   |
| **COSTS  OF REVENUE AND OPERATING EXPENSES**                                                               | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Costs of license fees and services, excluding  depreciation and amortization                               |       | 7,342                                                         |       | 9,491 |   | 5,866 |   |
| Costs of customer support, excluding depreciation  and amortization                                        |       | 5,694                                                         |       | 6,579 |   | 7,070 |   |
| Sales and marketing                                                                                        |       | 8,962                                                         |       | 9,643 |   | 4,412 |   |
| General and administrative                                                                                 |       | 5,138                                                         |       | 6,818 |   | 5,085 |   |
| Product development                                                                                        |       | 3,072                                                         |       | 1,921 |   | 1,066 |   |
| Depreciation                                                                                               |       | 1,169                                                         |       | 1,443 |   | 1,152 |   |
| Amortization                                                                                               |       | 2,511                                                         |       | 5,215 |   | 1,667 |   |
| Impairment of goodwill and intangible assets                                                               |       | 16,516                                                        |       | — |   | — |   |
| Restructuring and other expenses (recovery)                                                                |       | (21                                                           | )          | (49 | ) | (15 | ) |
| Total costs of  revenue and operating expenses                                                             |       | 50,383                                                        |       | 41,061 |   | 26,303 |   |
| Income (loss) from operations                                                                              |       | (16,550                                                       | )          | (1,609 | ) | 39 |   |
| Interest and  other:                                                                                       |       |                                                          |       |   |   |   |   |
| Interest income                                                                                            |       | 160                                                           |       | 116 |   | 304 |   |
| Interest expense                                                                                           |       | (1,992                                                        | )          | (1,636 | ) | (301 | ) |
| Gain (loss) on foreign exchange transactions                                                               |       | (5                                                            | )          | (172 | ) | 84 |   |
| Interest and  other income (expense), net                                                                  |       | (1,837                                                        | )          | (1,692 | ) | 87 |   |
| Income (loss) before income taxes                                                                          |       | (18,387                                                       | )          | (3,301 | ) | 126 |   |
| Income tax benefit                                                                                         |       | (1,604                                                        | )          | (396 | ) | (298 | ) |
| Net income (loss)                                                                                          |       | (16,783                                                       | )          | (2,905 | ) | 424 |   |
| Deemed dividend for beneficial conversion feature on  Series B convertible redeemable preferred stock |       | —                                                        |       | — |   | 3,306 |   |
| Net loss  available to common stockholders                                                                 |       | $                                                             | (16,783    | ) | $ | (2,905 | ) | $ | (2,882 | ) |
| Basic and diluted loss available to common  stockholders per common share                                  |       | $                                                             | (0.88      | ) | $ | (0.16 | ) | $ | (0.18 | ) |
| Weighted average  basic and diluted shares outstanding                                                     |       | 19,100                                                        |       | 18,695 |   | 16,307 |   |

 

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

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**EVOLVINGSYSTEMS, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITYAND COMPREHENSIVE INCOME (LOSS)(in thousands, except share data)**

| ** **                                                                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | ** **        | ** ** | **Accumulated**        | ** ** | ** **             | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|------------|------------|
| ** **                                                                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**    | ** ** | **Other**              | ** ** | ** **             | ** ** | **Total**  | ** ** |
| ** **                                                                                                        | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Comprehensive** | ** ** | **Accumulated**        | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                                        | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**       | ** ** | **Income (Loss)** | ** ** | **Deficit**            | ** ** | **Equity** | ** ** |
| **Balance at December 31, 2003**                                                                             |       | 15,778,540            |       |        | $          | 16                |       |                   |       | $                      | 67,342     |       |       |   | $ | — |   |   |   | $ | (40,885 | ) |   |   | $ | 26,473 |   |   |
| Stock option and warrant exercises                                                                                |       | 191,762               |       |        | —     |              |       |                   | 349        |                   |       |       | —     |   |   |   | — |   |   |   | 349 |   |   |
| Common stock issued pursuant to the Employee Stock  Purchase Plan                                                 |       | 16,915                |       |        | —     |              |       |                   | 58         |                   |       |       | —     |   |   |   | — |   |   |   | 58 |   |   |
| Beneficial conversion feature recorded upon the  issuance of Series B convertible redeemable preferred stock |       | —                |       |        | —     |              |       |                   | 3,306      |                   |       |       | —     |   |   |   | — |   |   |   | 3,306 |   |   |
| Deemed dividend for beneficial conversion feature of  Series B convertible redeemable preferred stock        |       | —                |       |        | —     |              |       |                   | (3,306     | )                      |       |       | —     |   |   |   | — |   |   |   | (3,306 | ) |   |
| Tax benefit of stock options                                                                                      |       | —                |       |        | —     |              |       |                   | 16         |                   |       |       | —     |   |   |   | — |   |   |   | 16 |   |   |
| Comprehensive income:                                                                                             |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Net income                                                                                                        |       | —                |       |        | —     |              |       |                   | —     |                   |       |       | —     |   |   |   | 424 |   |   |   |   |   |   |
| Foreign currency translation adjustment                                                                           |       | —                |       |        | —     |              |       |                   | —     |                   |       |       | 1,994      |   |   |   | — |   |   |   |   |   |   |
| Comprehensive income                                                                                              |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |   |   |   |   |   |   |   | 2,418 |   |   |
| **Balance at December 31, 2004**                                                                             |       | 15,987,217            |       |        | 16         |              |       |                   | 67,765     |                   |       |       | 1,994      |   |   |   | (40,461 | ) |   |   | 29,314 |   |   |
| Stock option exercises                                                                                            |       | 132,488               |       |        | —     |              |       |                   | 71         |                   |       |       | —     |   |   |   | — |   |   |   | 71 |   |   |
| Common stock issued pursuant to the Employee Stock  Purchase Plan                                                 |       | 18,116                |       |        | —     |              |       |                   | 55         |                   |       |       | —     |   |   |   | — |   |   |   | 55 |   |   |
| Comprehensive loss:                                                                                               |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                                          |       | —                |       |        | —     |              |       |                   | —     |                   |       |       | —     |   |   |   | (2,905 | ) |   |   |   |   |   |
| Foreign currency translation adjustment                                                                           |       | —                |       |        | —     |              |       |                   | —     |                   |       |       | (4,411     | ) |   |   | — |   |   |   |   |   |   |
| Comprehensive loss                                                                                                |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |   |   |   |   |   |   |   | (7,316 | ) |   |
| **Balance at December 31, 2005**                                                                             |       | 16,137,821            |       |        | 16         |              |       |                   | 67,891     |                   |       |       | (2,417     | ) |   |   | (43,366 | ) |   |   | 22,124 |   |   |
| Stock option exercises                                                                                            |       | 12,469                |       |        | —     |              |       |                   | 14         |                   |       |       | —     |   |   |   | — |   |   |   | 14 |   |   |
| Common stock issued pursuant to the Employee Stock  Purchase Plan                                                 |       | 83,356                |       |        | —     |              |       |                   | 112        |                   |       |       | —     |   |   |   | — |   |   |   | 112 |   |   |
| Stock-based compensation expense                                                                                  |       | —                |       |        | —     |              |       |                   | 808        |                   |       |       | —     |   |   |   | — |   |   |   | 808 |   |   |
| Comprehensive loss:                                                                                               |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |   |   |   |   |   |   |   |   |   |   |
| Net loss                                                                                                          |       | —                |       |        | —     |              |       |                   | —     |                   |       |       | —     |   |   |   | (16,783 | ) |   |   |   |   |   |
| Foreign currency translation adjustment                                                                           |       | —                |       |        | —     |              |       |                   | —     |                   |       |       | 3,883      |   |   |   | — |   |   |   |   |   |   |
| Comprehensive loss                                                                                                |       |                  |       |        |       |              |       |                   |       |                   |       |       |       |   |   |   |   |   |   |   | (12,900 | ) |   |
| **Balance  at December 31, 2006**                                                                            |       | 16,233,646            |       |        | $          | 16                |       |                   |       | $                      | 68,825     |       |       |   | $ | 1,466 |   |   |   | $ | (60,149 | ) |   |   | $ | 10,158 |   |   |

 

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

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**EVOLVING SYSTEMS, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands)**

| ** **                                                                                | ** ** | **For the Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                                | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss)                                                                         |       | $                                                             | (16,783    | ) | $ | (2,905 | ) | $ | 424 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                                                          |       |   |   |   |   |
| Depreciation                                                                              |       | 1,169                                                         |       | 1,443 |   | 1,152 |   |
| Amortization of intangible assets                                                         |       | 2,511                                                         |       | 5,215 |   | 1,667 |   |
| Amortization of debt issuance costs                                                       |       | 273                                                           |       | 105 |   | 9 |   |
| Stock-based compensation                                                                  |       | 808                                                           |       | — |   | — |   |
| Impairment of goodwill and intangible assets                                              |       | 16,516                                                        |       | — |   | — |   |
| Interest expense added to debt principal                                                  |       | —                                                        |       | 1,191 |   | — |   |
| Acquired in-process research and development                                              |       | —                                                        |       | — |   | 90 |   |
| Gain on disposal of property and equipment                                                |       | (18                                                           | )          | (8 | ) | (4 | ) |
| Unrealized foreign currency transaction (gains) and  losses, net                          |       | 5                                                             |       | 179 |   | (77 | ) |
| Tax benefit from stock options                                                            |       | —                                                        |       | — |   | 16 |   |
| Provision for (recovery of) bad debt                                                      |       | 28                                                            |       | 4 |   | (21 | ) |
| Benefit from foreign deferred income taxes                                                |       | (1,891                                                        | )          | (1,177 | ) | (600 | ) |
| Change  in operating assets and liabilities:                                              |       |                                                          |       |   |   |   |   |
| Contract receivables                                                                      |       | 1,983                                                         |       | (172 | ) | 2,423 |   |
| Unbilled work-in-progress                                                                 |       | 192                                                           |       | 219 |   | 583 |   |
| Prepaid and other assets                                                                  |       | (171                                                          | )          | 440 |   | 160 |   |
| Accounts payable and accrued liabilities                                                  |       | (1,622                                                        | )          | (1,224 | ) | 627 |   |
| Unearned revenue                                                                          |       | 20                                                            |       | (2,978 | ) | (2,080 | ) |
| Other                                                                                     |       | 346                                                           |       | 63 |   | (27 | ) |
| Net cash provided by operating activities                                                 |       | 3,366                                                         |       | 395 |   | 4,342 |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of property and equipment                                                       |       | (477                                                          | )          | (758 | ) | (1,170 | ) |
| Proceeds from sale of property and equipment                                              |       | 20                                                            |       | 18 |   | 6 |   |
| Business combinations and earnout payments                                                |       | (153                                                          | )          | (652 | ) | (10,547 | ) |
| Net cash used in investing activities                                                     |       | (610                                                          | )          | (1,392 | ) | (11,711 | ) |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Capital lease payments                                                                    |       | (34                                                           | )          | (31 | ) | (29 | ) |
| Principal payments on long-term debt                                                      |       | (2,025                                                        | )          | (13,389 | ) | — |   |
| Proceeds from the issuance of long-term debt, net of  issuance costs                      |       | —                                                        |       | 9,898 |   | — |   |
| Payment of amounts to Evolving U.K. sellers                                               |       | —                                                        |       | (2,617 | ) | — |   |
| Proceeds from the issuance of stock                                                       |       | 126                                                           |       | 126 |   | 407 |   |
| Restricted cash                                                                           |       | —                                                        |       | 100 |   | 100 |   |
| Net cash provided by (used in) financing activities                                       |       | (1,933                                                        | )          | (5,913 | ) | 478 |   |
| Effect of foreign exchange rate changes on cash                                           |       | 370                                                           |       | (593 | ) | 278 |   |
| Net increase (decrease) in cash and cash equivalents                                      |       | 1,193                                                         |       | (7,503 | ) | (6,613 | ) |
| Cash and cash equivalents at beginning of year                                            |       | 3,883                                                         |       | 11,386 |   | 17,999 |   |
| Cash and cash equivalents at end of year                                                  |       | $                                                             | 5,076      |   | $ | 3,883 |   | $ | 11,386 |   |
| Supplemental  disclosure of other cash and non-cash items:                                |       |                                                          |       |   |   |   |   |
| Interest paid                                                                             |       | $                                                             | 1,065      |   | $ | 211 |   | $ | 22 |   |
| Income taxes paid                                                                         |       | $                                                             | 740        |   | $ | 389 |   | $ | 70 |   |

 

The accompanying notes are an integral part of these consolidated financial statements

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**EVOLVING SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1—ORGANIZATION ANDSUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

**Organization—**We are a provider of software solutions and servicesto the wireless, wireline and IP carrier market. We maintain long-standingrelationships with many of the largest wireline, wireless and IP communicationscarriers worldwide. Our customers rely on us to develop, deploy, enhance,maintain and integrate complex, highly reliable software solutions for a rangeof Operations Support Systems (“OSS”). We offer software products and solutionsin three core areas:  *numbering solutions* that enable carriers to comply withgovernment-mandated requirements regarding number portability as well asproviding phone number management and assignment capabilities; *service activation solutions* used to activate complexbundles of voice, video and data services for traditional and next generationwireless and wireline networks; and *mediation solutions*supporting data collection for both service assurance and billing applications.

We significantly expanded our core portfolio thatincluded ordering and provisioning solutions for Local Number Portability (“LNP”)and a number inventory and assignment platform, as a result of three acquisitionswe made over a period of 12 months from November of 2003 to November of2004. Through the acquisition of CMS Communications, Inc. (“CMS”) in November 2003we acquired a network mediation and service assurance solution to add to ourproduct portfolio. Additionally, with the acquisition of Telecom SoftwareEnterprises, LLC (“TSE”) in October 2004 we added LNP and Wireless NumberPortability (“WNP”) number ordering and provisioning testing products whichprovide new OSS system integration capabilities. Finally, in November 2004,we acquired Tertio Telecoms Ltd. (“Evolving Systems U.K.”), a privately heldsupplier of OSS software solutions to communication carriers throughout Europe,the Middle East, Africa and Asia, expanding our markets beyond North America.Evolving Systems U.K.’s activation solution *TertioTM,*andmediation solution *EvidentTM*,strengthened our overall product portfolio.

**Principles ofConsolidation**—The consolidated financial statements include the accounts of EvolvingSystems and subsidiaries, all of which are wholly owned. All significantintercompany transactions and balances have been eliminated in consolidation.

**Use of Estimates**—The preparation offinancial statements in conformity with accounting principles generallyaccepted in the U.S. requires us to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities, at the date of the financial statements, as well as thereported amounts of revenue and expenses during the reporting period. We madeestimates with respect to revenue recognition for estimated hours to completeprojects accounted for using the percentage of completion method, allowance fordoubtful accounts, income tax valuation allowance, fair values of long-livedassets, valuation of intangible assets and goodwill, useful lives for property,equipment and intangible assets, business combinations, capitalization ofinternal software development costs and fair value of stock-based compensationamounts. Actual results could differ from these estimates.

**Foreign CurrencyTranslation**—Our functional currency is the U.S. dollar. Thefunctional currency of our foreign operations, generally, is the respectivelocal currency for each foreign subsidiary. Assets and liabilities of foreignoperations denominated in local currencies are translated at the spot rate ineffect at the applicable reporting date. Our consolidated statements ofoperations are translated at the weighted average rate of exchange during theapplicable period. The resulting unrealized cumulative translation adjustment,net of applicable income taxes, is recorded as a component of accumulated othercomprehensive income (loss) in stockholders’ equity. Realized and unrealizedtransaction gains and losses 

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**generatedby transactions denominated in a currency different from the functionalcurrency of the applicable entity are recorded in other income (loss) in theperiod in which they occur.**

**Cash and Cash Equivalents**—All highly liquidinvestments and investments with a maturity of three months or less whenpurchased are considered to be cash equivalents. All cash equivalents arecarried at cost, which approximates fair value. We have cash investmentpolicies that limit investments to investment grade securities and certificatesof deposit.

**Restricted Cash**—As of December 31,2006 and 2005, we had $300,000 of restricted cash related to our headquarterslease. The restricted cash requirement was reduced by $100,000 in December 2005and the remainder will become unrestricted within 60 days of the expiration ofour lease. We are renegotiating lease terms with our existing landlord.

**ContractReceivables and Allowance for Doubtful Accounts**—Contract receivables arerecorded at the invoiced amount and do not bear interest. The allowance fordoubtful accounts is our best estimate of the amount of probable credit lossesin accounts receivable. We determine the allowance based on historical write-offexperience and information received during collection efforts. We review ourallowance for doubtful accounts monthly and past due balances over 90 daysare reviewed individually for collectibility. Account balances are chargedagainst the allowance after all means of collection have been exhausted and thepotential for recovery is considered remote. We do not have any off-balance-sheetcredit exposure related to our customers.

Thefollowing table reflects the activity in the allowance for doubtful accounts:

| **Fiscal  Year** | ** ** | ** **                       | ** ** | **Description** | ** ** | **Balance at  Beginning  of Period** | ** ** | **Bad Debt  Expense/  (Recovery)** | ** ** | **Write-Offs  Charged to  Allowance** | ** ** | **Effects of  Foreign  Currency  Exchange  Rates** | ** ** | **Balance at  End of  Period** | ** ** |
|------------------|------------|----------------------------------|------------|-----------------|------------|------------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|------------------------------------------|------------|
| 2006             |       | Allowance for doubtful  accounts |       |            | $          | 48                                             |       |                                    |       | $                                          | 28         |                                                    |       |                                     | $          | — |   |   |   | $ | (6 | ) |   |   | $ | 70 |   |   |
| 2005             |       | Allowance for doubtful  accounts |       |            | $          | 44                                             |       |                                    |       | $                                          | 4          |                                                    |       |                                     | $          | — |   |   |   | $ | — |   |   |   | $ | 48 |   |   |
| 2004             |       | Allowance for doubtful accounts  |       |            | $          | 65                                             |       |                                    |       | $                                          | (21        | )                                                       |       |                                     | $          | — |   |   |   | $ | — |   |   |   | $ | 44 |   |   |

 

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**Concentration of Credit Risk—**Financial instruments that potentially subject us to concentrations ofcredit risk consist primarily of contract receivables and unbilledwork-in-progress. We perform on-going evaluations of customers’ financialcondition and, generally, require no collateral from customers.

A substantial portion ofour revenue is from a limited number of customers, all in the telecommunicationsindustry. The following tables depict the percentage` of revenue and percentageof contract receivables generated from significant customers (defined ascontributing at least 10%):
|                            | ** ** | **For the Years Ended  December 31,** |
|----------------------------|------------|-----------------------------------------------------------|
| ** **                 | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Customer A—U.S.       |       |                                                      | — |   |   |   | — |   |   |   | 12 | % |   |
| Customer B—U.S.       |       |                                                      | 13 | % |   |   | 14 | % |   |   | 23 | % |   |
| Customer C—U.S.       |       |                                                      | — |   |   |   | — |   |   |   | 14 | % |   |
| Customer D—U.S.       |       |                                                      | — |   |   |   | — |   |   |   | 12 | % |   |
| Customer F—Luxembourg |       |                                                      | — |   |   |   | 12 | % |   |   | — |   |   |
| Customer G—U.K.       |       |                                                      | 13 | % |   |   | 12 | % |   |   | — |   |   |
| Total % of Revenue         |       |                                                      | 26 | % |   |   | 38 | % |   |   | 61 | % |   |

 
|                                  | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Customer B—U.S.             |       |                  | 40         | % |   |   | 25 | % |   |
| Customer F—Luxembourg       |       |                  | 11         | % |   |   | 13 | % |   |
| Total % of Contract  Receivables |       |                  | 51         | % |   |   | 38 | % |   |

 

**Fair Value of FinancialInstruments**—The carrying amounts for certain financialinstruments, including cash and cash equivalents, contract receivables andaccounts payable, approximate fair value due to their short maturities. Weestimate the fair value of our debt based on current rates offered to us fordebt of the same remaining maturities, if available, or if not available, basedon discounted future cash flows using current market interest rates. As of December 31,2006 and 2005, we believe that the carrying amounts of our variable ratelong-term debt approximated fair value due to the notes carrying a currentmarket rate of interest. We estimated that the fair value of our fixed ratelong-term debt was approximately $4.6 million at December 31, 2006 andbelieve that the fair value approximated the carrying amount at December 31,2005 as the terms were recently re-negotiated.

**RevenueRecognition**—We recognize revenue fromtwo primary sources: license fees and services, and customer support, inaccordance with Statement of Position (“SOP”) 97-2, “Software RevenueRecognition,” as amended and interpreted by SOP 98-9, “Modification ofSOP 97-2, Software Revenue Recognition, With Respect to CertainTransactions.”  Staff Accounting Bulletin(“SAB”) No. 104, “Revenue Recognition,” provides further interpretiveguidance for public companies on the recognition, presentation and disclosureof revenue in financial statements. In addition to the criteria describedbelow, we generally recognize revenue when an agreement is signed, the fee isfixed or determinable and collectibility is reasonably assured.

The majority of our license fees and services revenueis generated from fixed-price contracts, which provide for licenses to oursoftware products and services to customize such software to meet our customers’use.  Generally, when the services aredetermined to be essential to the functionality of the delivered software, werecognize revenue using the percentage-of-completion method of accounting, inaccordance with SOP 97-2 and SOP 81-1, “Accounting for Long-Term ConstructionType Contracts.”  The percentage ofcompletion for each contract is estimated based on the ratio of direct laborhours incurred to total estimated direct labor hours. Since estimated directlabor hours, and changes thereto, can have a significant impact on revenuerecognition, these estimates are critical and are reviewed regularly. Amounts 

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billed in advance ofservices being performed are recorded as unearned revenue. Unbilledwork-in-progress represents revenue earned but not yet billable under the termsof the fixed-price contracts. All such amounts are expected to be billed andcollected within 12 months.

We may encounter budget and schedule overruns onfixed price contracts caused by increased labor or overhead costs. Adjustmentsto cost estimates are made in the periods in which the facts requiring suchrevisions become known. Estimated losses, if any, are recorded in the period inwhich current estimates of total contract revenue and contract costs indicate aloss.

In arrangements where the services are not essentialto the functionality of the software, we recognize license revenue upondelivery. To the extent that Vendor Specific Objective Evidence (“VSOE”) of thefair value of the undelivered elements exists, fees from multiple element arrangementsare unbundled and recorded as revenue as the elements are delivered. If VSOEfor the undelivered elements does not exist, fees from such arrangements aredeferred until the earlier of the date that VSOE does exist on the undeliveredelements or all of the elements have been delivered.

Services revenue from fixed-price contracts isgenerally recognized using the proportional performance method of accounting,which is similar to the percentage of completion method described above.Revenue from professional services provided pursuant to time-and-materialsbased contracts and training services are recognized as the services areperformed, as that is when our obligation to our customers under sucharrangements is fulfilled.

Customer support, including maintenance revenue, isgenerally recognized ratably over the service contract period. When maintenanceis bundled with the original license fee arrangement, its fair value, basedupon VSOE, is deferred and recognized during the periods when services are provided.

**Sales, Use andOther Value Added Tax—**Revenueis recorded net of applicable state, use and other value added taxes.

**Advertising and PromotionCosts**—All advertising and promotion costs are expensed asincurred. Advertising costs totaled approximately $287,000, $594,000 and$72,000, for the years ended December 31, 2006, 2005 and 2004,respectively.

**Capitalizationof Internal Software Development Costs**—We expend amounts onresearch and development (“R&D”), particularly for new products and/or forenhancements of existing products. For internal development of softwareproducts that are to be licensed by us, we follow Statement of FinancialAccounting Standards No. 86, “Accounting for the Costs of ComputerSoftware to Be Sold, Leased, or Otherwise Marketed” (“SFAS 86”). SFAS 86requires that the cost of developing software be expensed prior to establishingtechnological feasibility and those costs be capitalized once technologicalfeasibility has been established. Capitalization ceases upon general release ofthe software. The determination of whether internal software R&D costs aresubject to capitalization is, by its nature, highly subjective and involvessignificant judgments. This decision could significantly affect earnings duringthe development period. Further, once capitalized, the software costs aregenerally amortized on a straight-line basis over the estimated economic lifeof the product. The determination of the expected useful life of a product ishighly judgmental. Finally, capitalized software costs must be assessed forrealizability at the end of each reporting period. We did not capitalize anyinternal software R&D costs during the years ended December 31,2006, 2005 or 2004 due to the high degree of development risk involved in eachof our software development projects and the resulting short period of timebetween achieving technological feasibility and the general release of thesoftware. In addition, we did not have any capitalized internal softwareR&D costs included in our December 31, 2006 and 2005 consolidatedbalance sheets.

**Property and Equipment andLong-Lived Assets**—Property and equipment are stated at cost orestimated fair value if acquired in an acquisition, less accumulateddepreciation, and are depreciated over their estimated useful lives, generallytwo to four years or the lease term, if shorter, using the straight-line 

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**method.Leasehold improvements are stated at cost, less accumulated amortization, andare amortized over the shorter of the lease term or estimated useful life ofthe asset. Maintenance and repair costs are expensed as incurred.**

Our long-lived assets, such as property and equipmentand purchased intangible assets subject to amortization are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset or asset group may not be recoverable. Therecoverability of an asset or asset group is evaluated by comparing itscarrying amount to the estimated undiscounted future cash flows expected to begenerated by the asset or asset group. If the carrying amount of an asset orasset group exceeds its estimated future cash flows, an impairment charge isrecognized as the amount by which the carrying amount of the asset exceeds theestimated fair value of the asset.

**Goodwill**—Goodwill is the excessof acquisition cost of an acquired entity over the fair value of theidentifiable 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 animpairment loss. During the year ended December 31, 2006, we recorded animpairment of goodwill. See Note 3 for further details.

**IntangibleAssets**—Amortizable intangible assets consist primarily of purchased softwareand licenses, customer contracts and relationships, trademark and tradenames,and business partnerships acquired in conjunction with our purchases of CMS,TSE and Evolving Systems U.K. These definite 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:

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

·       Significantchanges in the manner of use of the acquired assets or the strategy of theoverall business;

·       Significantnegative industry or economic trends; and/or

·       Significantdecline in our stock price for a sustained period.

If, as a result of the existence of one or more of theabove indicators of impairment, we determine that the carrying value ofintangibles and/or long-lived assets may not be recoverable, we compare theestimated undiscounted cash flows expected to result from the use of the assetand its eventual disposition to the asset’s carrying amount. If an amortizableintangible or long-lived asset is not deemed to be recoverable, an impairmentloss is recognized representing the excess of the asset’s carrying value overits estimated fair value. During the year ended December 31, 2006, werecorded an impairment of amortizable intangible assets. See Note 3 for furtherdetails.

**Stock-basedCompensation**—We adopted SFAS No. 123(Revised),“Share-Based Payment” (“SFAS 123R”) effective January 1, 2006. Thisstatement replaced SFAS No. 123, “Accounting for Stock-Based Compensation”(“SFAS 123”) and superseded APB Opinion No. 25, “Accounting for StockIssued to Employees.”  Under the modifiedprospective method of adoption, we are required to apply a fair-value-basedmeasurement method to account for share-based payment transactions withemployees and record compensation cost for all stock awards granted after January 1,2006 and awards modified, 

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**repurchased,or cancelled after that date. In addition, we are required to recordcompensation costs associated with the vesting of unvested options outstandingat January 1, 2006 using the guidance under SFAS 123. Stock-basedcompensation is a non-cash expense because we settle these obligations byissuing shares of our common stock instead of settling such obligations withcash payments. Compensation cost for options is recognized on a straight-linebasis over the vesting period using an estimated forfeiture rate.  Effective January 1, 2006, stock optiongrants and employee stock purchase plan purchases were accounted for under SFAS123R. We used the Black-Scholes model to estimate the fair value of each optiongrant 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.**

**Income Taxes**—We account for incometaxes in accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS109”). Deferred tax assets and liabilities are recorded for the estimatedfuture tax effects of temporary differences between the tax bases of assets andliabilities and amounts reported in the accompanying consolidated balancesheets, as well as operating loss and tax credit carry-forwards. Deferredtax assets and liabilities are measured using enacted tax rates expected to beapplied to taxable income in the years in which those temporary differences areexpected to be recovered or settled. Deferred tax assets are reduced by avaluation allowance if, based on available evidence, it is more likely than notthat these benefits will not be realized. We evaluate tax benefits recorded inour consolidated financial statements and record accruals for any amountsdeemed not probable of being sustained.

**Reclassifications**—Certain prior periodbalances have been reclassified to conform to the current year’s presentation.

**RecentAccounting Pronouncements**—In July 2006, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48,“Accounting for Uncertainty in Income Taxes—An Interpretation of FASB StatementNo. 109” (“FIN 48”), which clarifies the accounting for uncertainty inincome tax benefits recognized in an enterprise’s financial statements inaccordance with SFAS 109. FIN 48also prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. In addition, FIN 48 provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition. The provisions of FIN 48 are effective forfiscal years beginning after December 15, 2006. We are currentlyevaluating the impact the adoption of FIN 48 will have on our consolidatedfinancial statements, if any.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidanceon how the effects of the carryover or reversal of prior year misstatements shouldbe considered in quantifying a current year misstatement. SAB 108 is effectivefor fiscal years ending after November 15, 2006. The implementation of SAB108 did not have an impact on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value,establishes a framework for measuring fair value under generally acceptedaccounting principles, and expands disclosures about fair value measurements.SFAS 157 is effective for financial statements issued for fiscal years andinterim periods beginning after November 15, 2007. We have not completedour evaluation of the impact of this standard on our consolidated financialstatements or our future estimates of fair value.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities—Including an Amendment of FASB Statement No. 115”(SFAS 159). SFAS 159 permits entities to choose to measure eligible items atfair value at specific election dates (the ‘‘fair value option’’). Unrealizedgains and losses on items for which the fair value option has been electedshall be 

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reportedin earnings at each subsequent reporting period. This accounting standard iseffective for us beginning January 1, 2008. We are currently assessing theimpact of SFAS 159.

**NOTE 2—BUSINESSCOMBINATIONS**

On November 2, 2004, we acquired all of theoutstanding shares of privately held, United Kingdom-based Evolving SystemsU.K. Total consideration for Evolving Systems U.K.’s net assets approximated $40.2 million, consisting of $11.0million in cash, approximately $15.9 million in seller-financed notes, 966,666shares of Series B Preferred Stock with an estimated fair value ofapproximately $11.3 million and approximately $2.0 million in transactionrelated costs. The acquisition was recorded as a purchase businesscombination and Evolving Systems U.K.’s results of operations have beencombined with Evolving Systems’ from the acquisition date forward.

On October 15, 2004,we acquired all of the outstanding ownership interests in privately heldTSE. Total consideration for TSE approximated $2.4 million, consisting of$1.5 million in cash, a note payable of $889,000 and approximately $55,000 intransaction related costs. The note payable was due and paid on March 31,2005. We agreed to pay additional consideration of up to $3.5 millioncontingent upon the achievement of certain specified revenue and gross marginresults. Up to $2.5 million of the contingent consideration was payable over a24 month period from the closing date and additional contingent considerationof up to $1.0 million may be paid through the year 2011 if certain specifiedsales of TSE products occur. The contingent consideration will not be recordeduntil the contingency is resolved and the additional consideration isdistributable. We recorded additional contingent consideration and resultinggoodwill of $27,000 and $488,000 during the years ended December 31, 2006and 2005, respectively, related to certain specified gross margin resultsachieved by the sale of TSE products. During the year ending December 31,2006, we expensed additional contingent consideration of $126,000 related togoodwill in our license and services reporting unit impaired in the secondquarter of 2006. The additional contingent consideration is paid within 45 daysof the last day of the quarter in which it is earned. The acquisition wastreated as a purchase business combination and the results of TSE’s operationshave been combined with Evolving Systems’ from the acquisition date forward.

**Pro Forma FinancialInformation (Unaudited)**

Thefinancial information in the table below summarizes the combined results ofoperations of Evolving Systems, Inc., TSE and Evolving Systems U.K. on apro forma basis, as though the companies had been combined as of the beginningof 2004. The impact of the In-Process Research and Development (“IPR&D”)charges associated with the acquisitions has been excluded. This pro formafinancial information is presented for informational purposes only and is notnecessarily indicative of the results of operations that would have beenachieved had the acquisitions actually taken place as of the beginning of theperiod presented below. The following amounts are in thousands, except pershare amounts.
|                                     | ** ** | **For the Year Ended  December 31, 2004** | ** ** |
|-------------------------------------|------------|--------------------------------------------------------------------|------------|
| Revenue                             |       |                                                               | $          | 48,188 |   |   |
| Net income                          |       |                                                               | $          | 585 |   |   |
| Basic and diluted income  per share |       |                                                               | $          | 0.03 |   |   |

 

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**NOTE 3—GOODWILL ANDINTANGIBLE ASSETS**

Changesin the carrying amount of goodwill by reporting unit were as follows (inthousands): 
|                                                        | ** ** | **License and Services** | ** ** | **Customer Support** | ** ** | **Total** | ** ** |
|--------------------------------------------------------|------------|------------------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                             | ** ** | **U.S.**                           | ** ** | **U.K.**                  | ** ** | **U.S.**  | ** ** | **U.K.** | ** ** | **Goodwill** | ** ** |
| Balance as of  December 31, 2004                       |       | $                                  | 2,782      |                      | $          | 17,907    |       | $ | 5,809 |   | $ | 11,200 |   | $ | 37,698 |   |
| Adjustments to goodwill                                |       | 296                                |       | (741                      | )          | 199       |       | (300 | ) | (546 | ) |
| Effects of changes in foreign currency exchange  rates |       | —                             |       | (1,674                    | )          | —    |       | (1,405 | ) | (3,079 | ) |
| Balance as of  December 31, 2005                       |       | 3,078                              |       | 15,492                    |       | 6,008     |       | 9,495 |   | 34,073 |   |
| TSE earnout                                            |       | 2                                  |       | —                    |       | 25        |       | — |   | 27 |   |
| Goodwill impairment charge                             |       | (3,080                             | )          | (7,831                    | )          | —    |       | — |   | (10,911 | ) |
| Effects of changes in foreign currency exchange  rates |       | —                             |       | 1,283                     |       | —    |       | 1,555 |   | 2,838 |   |
| Balance as of December  31, 2006                       |       | $                                  | —     |                      | $          | 8,944     |       | $ | 6,033 |   | $ | 11,050 |   | $ | 26,027 |   |

 

We recorded goodwill adjustments during the year endedDecember 31, 2005 for contingent consideration related to certain specifiedgross margin results achieved by the sale of TSE products during the year.  We also recorded goodwill adjustments duringthe year ended December 31, 2005 related to the finalization of the Tertiopurchase price.

We adjusted goodwillduring the year ended December 31, 2005 as we determined we hadincorrectly accounted for income taxes related to the purchase accounting forEvolving Systems U.K. acquired in November 2004. This error had the effectof overstating goodwill by $426,000 and overstating the net deferred foreignincome tax liability by $435,000 on the 2004 consolidated balance sheet. Inaddition, the reported net income in 2004 should have been $9,000 higher. Wecorrected this error at December 31, 2005. We assessed the impact on the2005 and 2004 consolidated financial statements and determined that the impactwas not material to either period.

During 2006, we recognizeda goodwill impairment charge in our License and Services reporting units of$10.9 million. Due to continued pricing pressures on services and consolidationin the telecommunications industry, revenues and cash flows had been lower thanexpected and those lower operating results had a negative impact on the marketprice of our common stock. Based upon this trend, we reviewed our business planduring the second quarter of 2006. As a result of these events, we determined thata triggering event had occurred and conducted a goodwill impairment analysis. Thisgoodwill impairment related to goodwill from our acquisitions of CMS in November 2003,TSE in October 2004 and Evolving Systems U.K. in November 2004. Thefair value of our reporting units were estimated using the present value ofexpected future cash flows and the valuation employed a combination of presentvalue techniques to measure fair value. We also considered market factors.

Our annual goodwillimpairment test was conducted as of July 31, 2006, and it was determinedthat goodwill was not impaired as of the test date. From July 31, 2006through December 31, 2006, no events have occurred that we believe mayhave impaired goodwill.

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Identifiableintangible assets are amortized on a straight-line basis over estimated livesranging from one to seven years and include the cumulative effects of foreigncurrency exchange rates. As of December 31, 2006 and 2005, identifiableintangibles were as follows (in thousands):
|                            | ** ** | **December 31, 2006** | ** ** | **December 31, 2005**    | ** ** | **Weighted-**             | ** ** |
|----------------------------|------------|---------------------------------|------------|------------------------------------|------------|---------------------------|------------|
| ** **                 | ** ** | **(1)  Gross  Amount**          | ** ** | **(1)  Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying  Amount** | ** ** | **Average  Amortization   Period** | ** ** |
| Purchased  software        |       |                            | $          | 2,038                              |       |                      |       | $ | 237 |   |   |   | $ | 1,801 |   |   | $ | 8,350 |   |   | $ | 2,090 |   |   | $ | 6,260 |   |   | 4.7 yrs |   |   |
| Customer  contracts        |       |                            | —     |                               |       |                      | —     |   |   |   | — |   |   | 1,997 |   |   | 1,968 |   |   | 29 |   |   | — |   |   |
| Purchased  licenses        |       |                            | 227        |                               |       |                      | 49         |   |   |   | 178 |   |   | 1,335 |   |   | 576 |   |   | 759 |   |   | 2.3 yrs |   |   |
| Trademarks and  tradenames |       |                            | 879        |                               |       |                      | 63         |   |   |   | 816 |   |   | 1,068 |   |   | 207 |   |   | 861 |   |   | 7.0 yrs |   |   |
| Business  partnerships     |       |                            | 143        |                               |       |                      | 14         |   |   |   | 129 |   |   | 1,332 |   |   | 222 |   |   | 1,110 |   |   | 5.0 yrs |   |   |
| Customer  relationships    |       |                            | 3,657      |                               |       |                      | 426        |   |   |   | 3,231 |   |   | 5,989 |   |   | 1,658 |   |   | 4,331 |   |   | 5.6 yrs |   |   |
|                       |       |                            | $          | 6,944                              |       |                      |       | $ | 789 |   |   |   | $ | 6,155 |   |   | $ | 20,071 |   |   | $ | 6,721 |   |   | $ | 13,350 |   |   | 5.4 yrs |   |   |

----

(1)          Inassociation with our impairment of intangible assets during the second quarterof 2006, we established a new cost basis for amortizable intangible assets at June 30,2006 and reduced the accumulated amortization to nil at June 30, 2006. Wealso re-evaluated estimated remaining useful lives.

As a result of the eventsthat led to the goodwill impairment, we first reviewed intangible assets forrecoverability in accordance with SFAS 144. Our evaluation of product strategyand development plans resulted in our determination that the undiscounted cashflows associated with these assets would not be sufficient to recover thecarrying amounts of these assets. As a result of this review we recorded a $5.6 millionintangible asset impairment at June 30, 2006. This was comprised of $4.2million of purchased software and purchased license intangible assets in theLicense Fees and Services reporting units associated with the acquisitions ofCMS and TSE as well as $1.4 million of customer relationship and businesspartnership intangible assets in the Customer Support operating segmentassociated with the acquisition of Evolving U.K. The fair values of our intangible assets wereestimated using the present value of expected future cash flows.

Amortizationexpense of identifiable intangible assets was $2.5 million, $5.2 million and$1.7 million for the years ended December 31, 2006, 2005 and 2004,respectively. As Evolving Systems U.K. uses the Great British pound as itsfunctional currency, the amount of future amortization actually recorded willbe based upon exchange rates in effect at that time. Expected futureamortization expense related to identifiable intangibles based on our carryingamount as of December 31, 2006 was as follows (in thousands):
| Years ending | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------|------------|------------|------------|------------|------------|
| 2007              |       | $          | 1,546      |       |
| 2008              |       | 1,410      |       |
| 2009              |       | 907        |       |
| 2010              |       | 871        |       |
| 2011              |       | 682        |       |
| Thereafter        |       | 739        |       |
|              |       | $          | 6,155      |       |

 

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**NOTE4—BALANCE SHEET COMPONENTS**

Thecomponents of certain balance sheet line items are as follows (dollar amountsin thousands):
|                                                 | ** ** | **December 31,** | ** ** | **Estimated** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|---------------|------------|
| ** **                                      | ** ** | **2006**              | ** ** | **2005**      | ** ** | **Useful Life** | ** ** |
| **Property and equipment:**                     |       |                  |       |          |       |   |   |   |   |
| Computer equipment and  purchased software      |       | $                     | 26,132     |          | $          | 25,791 |   |   | 2-4 yrs |   |   |
| Furniture, fixtures and  leasehold improvements |       | 1,948                 |       | 1,896         |       |   | 5-7 yrs |   |   |
|                                            |       | 28,080                |       | 27,687        |       |   |   |   |   |
| Less accumulated  depreciation                  |       | (26,731               | )          | (25,912       | )          |   |   |   |   |
|                                            |       | $                     | 1,349      |          | $          | 1,775 |   |   |   |   |   |

 
|                                          | ** ** | **December 31,** | ** ** | ** ** | ** ** |
|------------------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                               | ** ** | **2006**              | ** ** | **2005**   | ** ** | ** ** | ** ** |
| **Assets acuired under capital  lease:** |       |                  |       |       |       |   |   |   |   |
| Original book value                      |       | $                     | 104        |       | $          | 104 |   |   |   |   |   |
| Accumulated depreciation                 |       | (85                   | )          | (59        | )          |   |   |   |   |
| Net book value                           |       | $                     | 19         |       | $          | 45 |   |   |   |   |   |

 

Includedin property and equipment at December 31, 2006 and 2005 are assets undercapital lease. Depreciation expense related to assets under capital leases was$26,000 in each of the years ended December 31, 2006, 2005 and 2004.
|                                                | ** ** | **December 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                                     | ** ** | **2006**              | ** ** | **2005**   | ** ** | ** ** | ** ** |
| **Accounts payable and accrued  liabilities:** |       |                  |       |       |       |   |   |   |   |
| Accounts payable                               |       | $                     | 930        |       | $          | 1,674 |   |   |   |   |   |
| Accrued compensation and  related expenses     |       | 1,388                 |       | 1,171      |       |   |   |   |   |
| Restructuring payable                          |       | —                |       | 5          |       |   |   |   |   |
| Foreign income taxes  payable                  |       | —                |       | 492        |       |   |   |   |   |
| Accrued liabilities                            |       | 2,110                 |       | 2,659      |       |   |   |   |   |
|                                           |       | $                     | 4,428      |       | $          | 6,001 |   |   |   |   |   |

 

 

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**NOTE 5**—LONG-TERM DEBT

Ournotes payable consist of the following (in thousands):

| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Senior note  payable to financial institution, interest at the one-month London InterBank  Offered Rate (“LIBOR”) plus a margin of 6.25%; however, the LIBOR rate cannot  be less than 3.75%, interest rate was 11.60% and 10.61% at December 31,  2006 and 2005, respectively; interest payments are due monthly, principal  installments are due quarterly with final maturity on November 14, 2010.  The margin of 6.25% can be reduced to 5.25% if we meet and maintain certain  financial requirements. The loan is secured by substantially all of our  assets and a pledge of the stock of our subsidiaries. |       | $                     | 6,500      |   | $ | 8,500 |   |
| $4.5 million  senior revolving credit facility payable to financial institution, interest  at one-month LIBOR plus 4.0%; however, the LIBOR rate cannot be less than  3.75%, interest rate was 9.35% and 8.36% at December 31, 2006 and 2005,  respectively; interest payments are due monthly with final maturity on  November 14, 2010. The loan is secured by substantially all of the  assets of Evolving Systems U.K.                                                                                                                                                                                                    |       | 2,000                 |       | 2,003 |   |
| Long-term  unsecured subordinated notes payable, interest ranges from 11-14% with  a weighted average rate of 12.84%, accrued interest and principal are due in  full on May 16, 2011                                                                                                                                                                                                                                                                                                                                                                                                                                              |       | 4,870                 |       | 4,870 |   |
| Total notes  payable                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       | 13,370                |       | 15,373 |   |
| Less current  portion                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |       | (2,000                | )          | (1,000 | ) |
| Long-term debt,  excluding current installments                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |       | $                     | 11,370     |   | $ | 14,373 |   |

 

In November 2005, we used proceeds obtained fromthe $8.5 million senior note payable to extinguish certain Evolving U.K. sellerfinanced notes through payment of $8.5 million in cash and issuance of$4.87 million in long-term unsecured subordinated notes payable to thesellers.

We also obtained a $4.5 million senior revolvingcredit facility in November 2005. We had approximately $2.5 millionavailable under the senior revolving credit facility at December, 31, 2006. Thesenior credit facility has an annual management fee based upon 0.5% of the dailyaverage maximum borrowings allowed under the senior revolving credit facilityand is paid monthly in arrears. Borrowings under the senior revolving creditfacility are limited to a multiple of our EBITDA less the balance of the seniornote payable. The multiple ranges from 2.50 in the first year to 1.75 in thefourth year. The agreement mandated an initial borrowing of $2.0 million whichremains outstanding at December 31, 2006. The senior revolving creditfacility includes the same covenants and restrictions as the senior notepayable. Evolving Systems and our U.S. subsidiaries executed a guaranty of thesenior revolving credit facility.

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Thesenior note payable and senior revolving credit facility subject us to certainfinancial covenants. Certain of these covenants were amended effective June 30,2006. The Minimum Trailing Twelve Months EBITDA covenant, as defined in theagreement, was amended as follows:

| ** **                                                      | ** ** | **Original Covenant** | ** ** | **Amended Covenant** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| June 30,  2006                                             |       |                       | $          | 5,500,000                 |       |   |   | $ | 4,500,000 |   |   |
| September 30,  2006 and December 31, 2006             |       |                       | 6,000,000  |                      |       |   | 4,325,000 |   |   |
| March 31,  2007                                            |       |                       | 6,500,000  |                      |       |   | 4,500,000 |   |   |
| June 30,  2007                                             |       |                       | 6,500,000  |                      |       |   | 4,850,000 |   |   |
| September 30,  2007                                        |       |                       | 7,000,000  |                      |       |   | 5,000,000 |   |   |
| December 31,  2007                                         |       |                       | 7,000,000  |                      |       |   | 5,200,000 |   |   |
| March 31,  2008 and June 30, 2008                     |       |                       | 7,250,000  |                      |       |   | 5,200,000 |   |   |
| September 30, 2008  and the end of each quarter thereafter |       |                       | 7,250,000  |                      |       |   | 5,400,000 |   |   |

 

TheFixed Charge Coverage Ratio covenant, which is the ratio of trailing twelvemonths EBITDA less unfinanced capital expenditures and less income andfranchise taxes paid in cash to fixed charges for the preceding twelve months,as further defined in the agreement, was amended as follows:

| ** **                                                      | ** ** | **Original Covenant** | ** ** | **Amended Covenant** | ** ** |
|-----------------------------------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| September 30,  2006 and the end of each quarter thereafter |       |                       | 1.20 to 1  |                      |       |   | 1.15 to 1 |   |   |
|                                                                 |            |                            |            |                           |            |  |  |  |  |

 

Fixed charges are defined as total debt service,dividends, repurchases or redemption of equity and/or distributions in cash.

The senior agreements contain a Leverage Ratiocovenant which specifies a leverage ratio of senior debt to trailing twelvemonths EBITDA of 2.25 to 1 as of December 31, 2006. This quarterlyrequired leverage ratio decreases to 2.0 to 1 at December 31, 2007 and1.75 to 1 at December 31, 2008.

The senior agreements also limit capital expenditures to$1.4 million per year.

We were in compliance with all of our covenants as of December 31,2006.

As part of the amendment of the loan agreements in June 2006with our senior lender, we were required to make a prepayment of principal onthe senior note payable of $1.0 million and pay a fee of $25,000 to the seniorlender. These amounts were paid during July 2006.

The long-term unsecured subordinated notes payable of$4.87 million bear interest at 11% through December 31, 2007 and 14%thereafter. Interest expense is recognized using an effective rate of 12.84%. Theunsecured subordinated notes are subordinate to the senior note and seniorrevolving credit facility. The unsecured subordinated notes payable agreementssubject us to certain affirmative and negative covenants; however, certaincovenants are not in effect until the senior note and senior revolving creditfacility are paid in full. Outstanding amounts of the unsecured subordinatednotes may be accelerated upon the occurrence of an uncured event of default. Accruedinterest on the unsecured subordinated notes payable is separately reflected onthe balance sheet under “Other long-term obligations.”

Thescheduled principal payments on our notes payable are as follows (inthousands):

| **Year ending December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| 2007                                        |       | $          | 2,000      |       |
| 2008                                        |       | 2,500      |       |
| 2009                                        |       | 2,000      |       |
| 2010                                        |       | 2,000      |       |
| 2011                                        |       | 4,870      |       |
|                                        |       | $          | 13,370     |       |

 

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**NOTE 6**—INCOME TAXES

Thepre-tax income (loss) on which the provision for income taxes was computed isas follows (in thousands):

| ** ** | ** ** | **For the Years Ended December 31,** | ** ** |
|------------|------------|---------------------------------------------------------------|------------|
| ** ** | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Domestic   |       | $                                                             | (7,113     | ) | $ | (2,161 | ) | $ | 1,113 |   |
| Foreign    |       | (11,274                                                       | )          | (1,140 | ) | (987 | ) |
| Total      |       | $                                                             | (18,387    | ) | $ | (3,301 | ) | $ | 126 |   |

 

Theexpense (benefit) for income taxes consists of the following (in thousands):

| ** **              | ** ** | **For the Years Ended  December 31,** | ** ** |
|-------------------------|------------|-----------------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current:                |       |                                                      |       |   |   |   |   |
| Federal                 |       | $                                                         | —     |   | $ | (10 | ) | $ | 25 |   |
| Foreign                 |       | 287                                                       |       | 791 |   | 291 |   |
| State                   |       | —                                                    |       | — |   | (14 | ) |
| Total current           |       | 287                                                       |       | 781 |   | 302 |   |
| Deferred:               |       |                                                      |       |   |   |   |   |
| Federal                 |       | —                                                    |       | — |   | — |   |
| Foreign                 |       | (1,891                                                    | )          | (1,177 | ) | (600 | ) |
| State                   |       | —                                                    |       | — |   | — |   |
| Total deferred          |       | (1,891                                                    | )          | (1,177 | ) | (600 | ) |
| Net income tax  benefit |       | $                                                         | (1,604     | ) | $ | (396 | ) | $ | (298 | ) |

 

As of December 31, 2006 and 2005, we had netoperating loss carryforwards (“NOL”) of approximately $49.5 million and $47.8million, respectively, related to U.S. federal and state jurisdictions. Thefederal NOL expires at various times beginning in 2018 and ending in 2027. Inaddition, we have research and experimentation credit carryforwards ofapproximately $1.3 million which may expire at various times beginning in 2011.Of our $49.5 million NOL, $9.6 million is related to stock compensationexpense, the benefit of which, if realized, will be a increase to equity asopposed to a reduction in tax expense. The Internal Revenue Code places certainlimitations on the annual amount of net operating loss carryforwards which canbe utilized if certain changes in ownership occur. Changes in our ownershiphave occurred that limit the future utilization of the NOL’s.

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Deferredtax assets and liabilities reflect the net tax effects of temporary differencesbetween the carrying amount of assets and liabilities for financial reportingpurposes and the amounts used for income tax purposes. Significant componentsof our deferred tax assets and liabilities were as follows (in thousands):

| ** **                                         | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Deferred tax  assets:                              |       |                  |       |   |   |
| Net operating loss carryforwards                   |       | $                     | 18,504     |   | $ | 17,842 |   |
| Research and experimentation credit carryforwards  |       | 1,287                 |       | 1,287 |   |
| Equity compensation                                |       | 137                   |       | — |   |
| Deferred revenue                                   |       | 35                    |       | 5 |   |
| Depreciable assets                                 |       | 512                   |       | 467 |   |
| Acquired intangibles                               |       | 406                   |       | — |   |
| Other                                              |       | 60                    |       | 105 |   |
| Total deferred tax assets                          |       | 20,941                |       | 19,706 |   |
| Deferred tax  liabilities:                         |       |                  |       |   |   |
| Undistributed foreign earnings                     |       | (180                  | )          | (77 | ) |
| Acquired intangibles                               |       | (1,471                | )          | (3,739 | ) |
| Total deferred tax liabilities                     |       | (1,651                | )          | (3,816 | ) |
| Net deferred tax  asset before valuation allowance |       | 19,290                |       | 15,890 |   |
| Valuation  allowance                               |       | (20,477               | )          | (18,662 | ) |
| Net deferred tax  liability                        |       | $                     | (1,187     | ) | $ | (2,772 | ) |

 

| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Financial  statement classification: |       |                  |       |   |   |
| Current deferred tax asset           |       | $                     | 15         |   | $ | 5 |   |
| Long-term deferred tax liability     |       | (1,202                | )          | (2,777 | ) |
| Net deferred tax  liability          |       | $                     | (1,187     | ) | $ | (2,772 | ) |

 

In conjunction with the acquisition of EvolvingSystems U.K., certain identifiable intangible assets were recorded. A deferredtax liability of $4.6 million was established at the acquisition date for theexpected difference between what would be expensed for financial reportingpurposes and what would be deductible for income tax purposes. This deferredtax liability related to Evolving Systems U.K. and has no impact on our abilityto recover our U.S. based deferred tax assets. As of December 31, 2006 and2005, this deferred tax liability was $1.5 million and $3.1 million,respectively. This deferred tax liability will be recognized as theidentifiable intangibles are amortized.

We continue to maintain a full valuation allowance onthe domestic net deferred tax asset as we have determined it is more likelythan not that we will not realize our domestic deferred tax assets. Such assetsprimarily consist of certain net operating loss carryforwards. We assessed therealizability of our domestic deferred tax assets using all available evidence.In particular, we considered both historical results and projections ofprofitability for the reasonably foreseeable future periods. We are required toreassess our conclusions regarding the realization of our deferred tax assetsat each financial reporting date. A future evaluation could result in aconclusion that all or a portion of the valuation allowance is no longernecessary which could have a material impact on our results of operations andfinancial position.

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Theincome tax benefit differs from the amount computed by applying the U.S.federal income tax rate of 34% to income (loss) before income taxes as follows(in thousands):

| ** **                                                    | ** ** | **For the Years Ended  December 31,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| U.S. federal  income tax expense (benefit) at statutory rates |       | $                                                         | (6,252     | ) | $ | (1,122 | ) | $ | 34 |   |
| State income tax  expense (benefit), net of federal   impact  |       | (163                                                      | )          | (64 | ) | 37 |   |
| Goodwill  impairment                                          |       | 3,217                                                     |       | — |   | — |   |
| Non-deductible  meals                                         |       | 12                                                        |       | 18 |   | 18 |   |
| Foreign rate  differential                                    |       | 240                                                       |       | 75 |   | 41 |   |
| Foreign deemed  dividends                                     |       | (77                                                       | )          | 127 |   | — |   |
| Change in  valuation allowance                                |       | 1,815                                                     |       | 604 |   | (439 | ) |
| Equity  compensation                                          |       | 121                                                       |       | — |   | — |   |
| Research and  development expenses                            |       | (483                                                      | )          | (59 | ) | — |   |
| Other, net                                                    |       | (34                                                       | )          | 25 |   | 11 |   |
| Income tax  benefit                                           |       | $                                                         | (1,604     | ) | $ | (396 | ) | $ | (298 | ) |

 

The change in the valuation allowance during 2006resulted primarily from 2006 losses which increased the net operating losscarryforwards and adjustments based on the estimated 2006 income tax returns.

During 2006, we recorded a $224,000 tax benefit forresearch and development expenses related to a change in estimate based on ouras filed 2005 tax return for Evolving Systems U.K. In addition, we recorded anincome tax receivable of approximately $275,000 as of December 31, 2006primarily as a result of this change in estimate which is included in prepaidand other current assets on our consolidated balance sheet.

During 2004, we formedEvolving Systems India, a wholly owned subsidiary of Evolving Systems which isused for offshore product development. We were granted a tax holiday by Indiawhich extends through March 2009. Under the terms of the tax holiday, weare not liable for income taxes associated with our operations in India.

**NOTE 7**—STOCKHOLDERS’ EQUITY

**(a)   Series BConvertible Redeemable Preferred Stock**

On November 2, 2004, we issued 966,666 shares of Series BPreferred Stock in connection with our acquisition of Evolving Systems U.K.Based on the specific features of the Series B Preferred Stock, theissuance date fair value was estimated to be approximately the same as itsvalue upon redemption, which is the same as its value upon liquidation. The Series BPreferred Stock is entitled to dividends on an as-converted basis with thecommon stock and is, therefore, considered a participating security and sharesissuable upon conversion are included in weighted average shares outstandingfor purposes of calculating basic earnings per share. Upon the occurrence ofcertain material events (liquidation, merger, etc.), the holders of Series BPreferred Stock are entitled to receive a preference payment that is senior tothe common stock, but subordinate to our senior and unsecured subordinate debt,equal to the sum of the number of shares of common stock into which each shareof Series B Preferred Stock is convertible as of the date of such eventmultiplied by $3.89 per share (subject to adjustment for stock splits andcombinations), or $11.3 million at December 31, 2006 and 2005.

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Shares of Series B Preferred Stock may beconverted into our common stock at the option of the holder at any time. Eachshare of Series B Preferred Stock is initially convertible into threeshares of common stock. The conversion ratio is subject to adjustment as aresult of price-based anti-dilution protections for issuances of our commonstock below $3.50 per share. We may also cause the Series B PreferredStock to automatically convert after November 2, 2006 in the event thatthe 45 day average market price for our common stock is equal to or greaterthan $8.75 (subject to adjustment for stock splits and combinations).

The holders of Series B Preferred Stock vote withthe holders of the shares of common stock as one class with each share ofSeries B Preferred Stock entitled to approximately 2.7 votes due to theapplication of Nasdaq Marketplace Rule 4351 which provides certain votinglimitations on shares issued below market price. A majority of holders ofSeries B Preferred Stock must also consent to certain corporate actionsprior to us engaging in such actions (*i.e*.,issuing certain additional classes of stock, amending our charter documents inan adverse manner to the Series B Preferred Stock, changing the size orterm of the Board, or repurchasing or redeeming other classes of stock).Additionally, subject to certain limitations, for so long as the Series Bholders hold no less than five percent of our common stock (on an as convertedbasis), they shall as a group be entitled to elect one person to the Board.

Additionally, the Series B Preferred Stockcontains certain weighted average price based anti-dilution protections that,as long as those securities remain outstanding, would be triggered if we issuedshares of our common stock (subject to certain adjustments and standardexclusions relating to stock options) below $3.89 per share.

The holders of Series B Preferred Stock may alsorequire us to redeem all or any portion of the Series B Preferred Stockfor a price equal to $11.67 per share (subject to adjustment for stock splitsand combinations) in the event that we fail to maintain the shelf registrationof the common stock underlying such shares or otherwise breaches certain othercovenants. If we are not able to maintain effectiveness of the shelf registration,we would be required to revalue the Series B Preferred Stock at fair valueand reclassify the instrument to liabilities.

Sincethe conversion price of the Series B Preferred Stock was fixed in thepurchase agreement to equal $3.50 per common share, a beneficial conversionfeature existed on the acquisition date equal to the difference between thevalue of our common stock on the acquisition date, or $4.64, and the conversionprice stated in the purchase agreement. The beneficial conversion feature wasrecognized as a reduction in net income available to common stockholders of$3.3 million on November 2, 2004 since the Series B Preferred Stockwas immediately convertible to common stock.

**(b)   CertainAnti-Takeover Provisions**

Our restated certificate of incorporation allows theboard of directors to issue up to 2,000,000 shares of preferred stock and todetermine the price, rights, preferences and privileges of those shares withoutany further vote or action by our stockholders. The rights of the holders ofour common stock will be subject to, and may be adversely affected by, therights of the holders of any preferred stock that may be issued in the future.Issuance of preferred stock, while providing desired flexibility in connectionwith possible acquisitions and other corporate purposes, could make it moredifficult for a third party to acquire a majority of our outstanding votingstock. In 1999, our Board of Directors designated 250,000 shares ofSeries A Junior Participating Preferred Stock that contain “poison pill”provisions. In connection with the Evolving Systems U.K. acquisition, we issued966,666 shares of Series B Preferred Stock.

In addition, we are subject to the anti-takeover provisionsof Section 203 of Delaware General Corporation Law which prohibit us fromengaging in a “business combination” with an “interested stockholder” for aperiod of three years after the date of the transaction in which theperson became an interested stockholder, unless the business combination isapproved in the prescribed manner. The 

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application ofSection 203 and certain provisions of our restated certificate ofincorporation, including a classified board of directors, may have the effectof delaying or preventing changes in control of our management, which couldadversely affect the market price of our common stock by discouraging orpreventing takeover attempts that might result in the payment of a premiumprice to our stockholders.

**NOTE 8**—SHARE-BASED COMPENSATION

Weadopted SFAS 123R effectiveJanuary 1, 2006 using the modified prospective method. We previouslyapplied the intrinsic-value-based method in accounting for the recognition ofstock-based compensation arrangements and the fair value method only fordisclosure purposes. Because we historically granted options with exerciseprices equal to the fair market value of our common stock at the grant date,the adoption of SFAS 123R on January 1, 2006 did not result in asignificant impact on our financial statements. Further, as a result of thepreceding, our consolidated statements of operations from January 1, 2006forward include charges for stock-based compensation. We recognized $0.8million, or $0.04 per share, of compensation expense in the consolidatedstatements of operations for the year ended December 31, 2006 with respectto our stock-based compensation plans. The following table summarizesstock-based compensation expenses recorded in the statement of operations (inthousands):

| ** **                                                                   | ** ** | **For the Year  Ended  December 31,  2006** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Cost of license  fee and services, excluding depreciation and   amortization |       |                                                       | $          | 57 |   |   |
| Cost of customer  support, excluding depreciation and amortization           |       |                                                       | 8          |   |   |
| Sales and  marketing                                                         |       |                                                       | 183        |   |   |
| General and  administrative                                                  |       |                                                       | 513        |   |   |
| Product  development                                                         |       |                                                       | 47         |   |   |
|                                                                         |       |                                                       | $          | 808 |   |   |

 

**Stock Option Plan**

In January 1996, our stockholders approved “TheAmended and Restated Stock Option Plan” (the “Option Plan”). Initially,3,150,000 shares were reserved for issuance under the Option Plan. Subsequently,the Option Plan was amended, as approved by the stockholders, to increase thenumber of shares available for issuance to 8,350,000. Options issued under theOption Plan were at the discretion of the Board of Directors, including thevesting provisions of each stock option granted. Options were granted with anexercise price equal to the market price of our common stock on the date ofgrant, generally vest over four years and expire no more than ten years fromthe date of grant. The Option Plan terminated on January 18, 2006; optionsgranted before that date were not affected by the plan termination.

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Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes model. The Black-Scholes model uses four variables to calculatethe fair value of each option grant. The expected term of share options grantedis derived using the simplified method prescribed by the SEC Staff AccountingBulletin 107, “Share-Based Payment.”  Therisk-free interest rate is based upon the rate currently available onzero-coupon U.S. Treasury instruments with a remaining term equal to theexpected term of the stock options. The expected volatility is based uponhistorical volatility of our common stock over a period equal to the expectedterm of the stock options. The expected dividend yield is zero and is basedupon historical and anticipated payment of dividends. The weighted-averageassumptions used in the fair value calculations are as follows:  

| ** **               | ** ** | **For the Years Ended  December 31,** | ** ** |
|--------------------------|------------|-----------------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected term  (years)   |       | 6.1                                                       |       | 5.94 |   |   | 4 |   |   |
| Risk-free  interest rate |       | 4.35                                                      | %          | 4.31 | % |   | 2.7 | % |   |
| Expected  volatility     |       | 121.14                                                    | %          | 122.50 | % |   | 133 | % |   |
| Expected dividend yield  |       | 0                                                         | %          | 0 | % |   | 0 | % |   |

 

Thefollowing is a summary of stock option activity under the plan for the yearended December 31, 2006: 

| ** **                                     | ** ** | **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, 2005 |       |                                            | 4,279      |                                   |       |                                                         | $          | 3.14                                             |       |   |   |   |   |   |   |   |   |   |
| Options granted                                |       |                                            | 15         |                                   |       |                                                         | 2.32       |                                             |       |   |   |   |   |   |   |   |   |
| Less options forfeited                         |       |                                            | (111       | )                                      |       |                                                         | 2.36       |                                             |       |   |   |   |   |   |   |   |   |
| Less options expired                           |       |                                            | (113       | )                                      |       |                                                         | 4.05       |                                             |       |   |   |   |   |   |   |   |   |
| Less options exercised                         |       |                                            | (12        | )                                      |       |                                                         | 1.10       |                                             |       |   |   |   |   |   |   |   |   |
| Options  outstanding at December 31, 2006 |       |                                            | 4,058      |                                   |       |                                                         | $          | 3.14                                             |       |   |   | 6.50 |   |   |   | $ | 239 |   |   |
| Options exercisable at  December 31, 2006 |       |                                            | 3,145      |                                   |       |                                                         | $          | 3.40                                             |       |   |   | 6.11 |   |   |   | $ | 237 |   |   |

 

The weighted-average grant-date fair value of stockoptions granted during the years ended December 31, 2006, 2005 and 2004was $2.05, $1.94 and $4.96, respectively.

As of December 31, 2006, there were approximately$1.3 million of total unrecognized compensation costs related to unvested stockoptions. These costs are expected to be recognized over a weighted averageperiod of 1.4 years.

The total intrinsic value of stock option exercisesfor the years ended December 31, 2006, 2005 and 2004 was $15,000, $0.2million and $1.1 million, respectively. The total fair value of stock awardsvested during the years ended December 31, 2006, 2005 and 2004 was $0.4million, $5.3 million and $1.8 million, respectively.

The deferred income tax benefits from stock optionsexpense related to Evolving Systems U.K. totaled approximately $27,000 for theyear ended December 31, 2006.

Cash received from stock option exercises for the yearended December 31, 2006 was $14,000.

We previously applied the intrinsic-value-based methodin accounting for the recognition of employee stock-based compensationarrangements and the fair value method for disclosure purposes.

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Thefollowing table illustrates the effect on net income (loss) if the fair valuemethod had been applied to all outstanding and unvested awards in each period (in thousands, except per share data):

| ** **                                                                                                                                 | ** ** | **For the Years Ended  December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                                                                                 | ** ** | **2005**                                                  | ** ** | **2004** | ** ** |
| Net loss available  to common stockholders, as reported                                                                                    |       | $                                                         | (2,905     | ) | $ | (2,882 | ) |
| Stock-based compensation expense that would have  been included in net loss if the fair-value-based method had been applied to  all awards |       | (5,210                                                    | )          | (2,071 | ) |
| Pro forma net loss                                                                                                                         |       | $                                                         | (8,115     | ) | $ | (4,953 | ) |
| Loss per common  share, as reported:                                                                                                       |       |                                                      |       |   |   |
| Basic and Diluted                                                                                                                          |       | $                                                         | (0.16      | ) | $ | (0.18 | ) |
| Pro forma loss  per common share:                                                                                                          |       |                                                      |       |   |   |
| Basic and Diluted                                                                                                                          |       | $                                                         | (0.43      | ) | $ | (0.30 | ) |

 

Fair value stock based compensation expense for theyear ended December 31, 2005 in the above table includes $2.5 million ofcompensation expense associated with the acceleration of vesting of options in December 2005whereby we accelerated the vesting of unvested and “out-of-the-money” stockoptions with an exercise price equal to or greater than $4.64. The accelerationof vesting was effective for stock options outstanding as of December 12,2005. As a result of the acceleration, approximately 603,000 stock options witha range of exercise prices of $4.64 to $14.15 and a weighted average exerciseprice of $6.17 (including approximately 341,000 stock options held bydirectors and executive officers with a weighted average exercise price of$7.12) became exercisable on December 12, 2005. This price range wasselected as it covered the most significant portion of future compensationcosts for out-of-the-money options. In addition, we believe that because theoptions accelerated have exercise prices in excess of the current market valueof our common stock, the options have limited economic value and are not fullyachieving their original objective of incentive compensation and employeeretention. Aside from the acceleration of the vesting date, the terms andconditions of the stock option agreements governing the underlying stockoptions remain unchanged. The purpose of the acceleration was to eliminatefuture compensation expense associated with the accelerated options upon theadoption of SFAS 123R effective January 1, 2006. We estimate that futurecompensation expense will be reduced by approximately $2.5 million as aresult of the acceleration of vesting.

In December 2005, wegranted 1,130,000 options to purchase shares of our common stock at an exerciseprice of $2.15 per share to employees and directors in light of the pendingexpiration of our stock option plan on January 18, 2006. We structured thegrants in order to reduce the future impact on earnings as a result of theimplementation of SFAS 123R by immediately vesting 25% of the options on thedate of grant. The remaining 75% of the options vest in equal quarterlytranches beginning March 28, 2007. The pro forma disclosures for the yearended December 31, 2005 reflect approximately $0.6 million of compensationexpense associated with the immediate vesting of 25% of the options.

**Employee StockPurchase Plan**

Under the Employee Stock Purchase Plan (“ESPP”), weare authorized to issue up to 1,100,000 shares of our common stock to full-timeemployees, nearly all of whom are eligible to participate. Under the terms ofthe ESPP, employees may elect to have up to 15% of their gross salarieswithheld through payroll deduction to purchase our common stock, capped at$25,000 annually. The purchase price of the stock is 85% of the lower of themarket price at the beginning or end of each three-month participation period. Asof December 31, 2006, there were 353,000 shares available for purchase. Forthe year ended December 31, 2006, we recorded compensation expense of$46,000 associated with grants under the ESPP which includes 

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the fair value of thelook-back feature of each grant as well as the 15% discount on the purchaseprice. This expense fluctuates each period based upon employee participation.

Thefair value of each grant made under our ESPP is estimated on the date of grantusing the Black-Scholes model. The Black-Scholes model uses four variables tocalculate the fair value of each option grant. The expected term of each grantis based upon the three-month (six-month in 2005 and 2004) participation periodof each grant. The risk-free interest rate is based upon the rate currentlyavailable on zero-coupon U.S. Treasury instruments with a remaining term equalto the expected term of each grant. The expected volatility is based uponhistorical volatility of our common stock. The expected dividend yield is basedupon historical and anticipated payment of dividends. The weighted averageassumptions used in the fair value calculations are as follows:

| ** **               | ** ** | **For the Years Ended  December 31,** | ** ** |
|--------------------------|------------|-----------------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected term  (years)   |       | 0.25                                                      |       | 0.5 |   | 0.5 |   |
| Risk-free  interest rate |       | 5.02                                                      | %          | 3.04 | % | 2.67 | % |
| Expected  volatility     |       | 78.18                                                     | %          | 90.59 | % | 133 | % |
| Expected dividend yield  |       | 0                                                         | %          | 0 | % | 0 | % |

 

Cash received fromemployee stock plan purchases for the years ended December 31, 2006 was$113,000.

**NOTE 9**—BENEFIT PLANS

We have established a defined contribution retirementplan for our employees under section 401(k) of the Internal Revenue Code(the “401(k) Plan”) that is available to all U.S. employees 21 yearsof age or older with a month of service. Employees may contribute up to 15% ofgross compensation not to exceed the maximum statutory contribution amount. Wemay make discretionary matching contributions. All employee contributions arefully vested immediately and employer contributions vest over a period of threeyears. For the years ended December 31, 2006, 2005 and 2004, we madediscretionary matching contributions using funds available in the 401(k) Plan’sforfeiture account.

Evolving Systems U.K. has established a definedcontribution pension scheme that is available to all employees in their firstfull month of employment. Employees may contribute a percentage of theirearnings, the amount of which is dependent upon the age of the employee, not toexceed the maximum statutory contribution amount. We match 5% of employeecontributions. All contributions are immediately vested in their entirety.

During 2006, 2005 and 2004, we recorded a consolidatedexpense (benefit) of $366,000, $295,000 and ($102,000), respectively, under theaforementioned plans. The benefit in 2004 was a result of utilizing fundsremaining in the 401(k) Plan’s forfeiture account to fund the match for2004.

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**NOTE 10—EARNINGS PER SHARE**

Basicearnings per share (“EPS”) is computed by dividing net income or loss availableto common stockholders by the weighted average number of shares of common stockoutstanding during the period, including common stock issuable underparticipating securities, such as the Series B Preferred Stock. DilutedEPS is computed using the weighted average number of shares of common stockoutstanding, including participating securities, plus all potentially dilutivecommon stock equivalents using the treasury stock method. Common stockequivalents consist of stock options. The following is the reconciliation ofthe numerators and denominators of the basic and diluted EPS computations (inthousands except per share data):

| ** **                                             | ** ** | **For the Years Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Basic and dilute  loss per common share:               |       |                                                          |       |   |   |   |   |
| Net loss                                               |       | $                                                             | (16,783    | ) | $ | (2,905 | ) | $ | (2,882 | ) |
| Weighted average common shares outstanding             |       | 16,200                                                        |       | 16,054 |   | 15,824 |   |
| Participating securities                               |       | 2,900                                                         |       | 2,641 |   | 483 |   |
| Basic and diluted weighted average shares  outstanding |       | 19,100                                                        |       | 18,695 |   | 16,307 |   |
| Basic and diluted loss  per common share               |       | $                                                             | (0.88      | ) | $ | (0.16 | ) | $ | (0.18 | ) |

 

Weighted average optionsto purchase 3.3 million, 2.4 million and 0.5 million shares of common stockequivalents were excluded from the computation of diluted weighted averageshares outstanding for the years ended December 31, 2006, 2005 and 2004,respectively, because the effect would have been anti-dilutive since theirexercise prices were greater than the average market value of our common stockfor the period. Weighted average options to purchase 0.9 million, 1.1 millionand 2.5 million shares of common stock were excluded from the computation ofdiluted weighted average shares outstanding for the years ended December 31,2006, 2005 and 2004, respectively, as their effect would have beenanti-dilutive as a result of the net loss for the period.

**NOTE 11**—COMMITMENTS AND CONTINGENCIES

**(a)****          LeaseCommitments**

We lease office and operating facilities and equipmentunder non-cancelable operating leases. Current facility leases include ourheadquarters; the Columbus, Ohio office which was assumed as part of the CMSacquisition; the London, England, Bath, England and Munich, Germany officeswhich were assumed as part of the Evolving Systems U.K. acquisition; theBangalore, India office; the Kuala Lumpur, Malaysia office; and the GreenwoodVillage, Colorado office which was assumed as part of the TSE acquisition. Rentexpense was $1.6 million, $1.6 million and $1.2 million for the years ended December 31,2006, 2005 and 2004, respectively. Rent expense is net of sublease rentalincome of $142,000, $279,000 and $1,000 for the years ended December 31,2006, 2005 and 2004, respectively.

Our headquarters facility lease contains a clause thatadjusts the lease rate every year. The lease rate increases 3% annually as of June 1.We account for the effect of such escalating lease payments as if the leaserate were consistent over the lease term.

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Futureminimum commitments under non-cancelable operating leases and capital leases asof December 31, 2006, net of rental income under non-cancelable subleases,are as follows (in thousands):

| ** **                                          | ** ** | **Operating**

**Leases** | ** ** | **Capital**

**Leases** | ** ** |
|-----------------------------------------------------|------------|---------------------------|------------|-------------------------|------------|
| 2007                                                |       |                      | $          | 952                     |       |   |   | $ | 42 |   |   |
| 2008                                                |       |                      | 465        |                    |       |   | 35 |   |   |
| 2009                                                |       |                      | 465        |                    |       |   | — |   |   |
| 2010                                                |       |                      | 257        |                    |       |   | — |   |   |
| Total minimum  lease payments                       |       |                      | $          | 2,139                   |       |   |   | 77 |   |   |
| Less: Amount  representing interest                 |       |                      |       |                    |       |   | (6 | ) |   |
| Principal balance  of capital lease obligations     |       |                      |       |                    |       |   | 71 |   |   |
| Less: Current  portion of capital lease obligations |       |                      |       |                    |       |   | (37 | ) |   |
| Long-term portion of  capital lease obligations     |       |                      |       |                    |       |   | $ | 34 |   |   |

 

**(b)****          OtherCommitments**

As permitted under Delaware law, we have agreementswith officers and directors under which we agree to indemnify them for certainevents or occurrences while the officer or director is, or was serving, at ourrequest in this capacity. The term of the indemnification period is indefinite.There is no limit on the amount of future payments we could be required to makeunder these indemnification agreements; however, we maintain Director andOfficer insurance policies, as well as an Employment Practices LiabilityInsurance Policy, that may enable us to recover a portion of any amounts paid.As a result of our insurance policy coverage, we believe the estimated fairvalue of these indemnification agreements is minimal. Accordingly, there wereno liabilities recorded for these agreements as of December 31, 2006 and2005.

We enter into standard indemnification terms withcustomers, as discussed below, in the ordinary course of business. As we maysubcontract the development of deliverables under customer contracts, we couldbe required to indemnify customers for work performed by subcontractors.Depending upon the nature of the customer indemnification, the potential amountof future payments we could be required to make under these indemnificationagreements may be unlimited. We may be able to recover damages from asubcontractor if the indemnification to customers results from thesubcontractor’s failure to perform. To the extent we are unable to recoverdamages from a subcontractor, we could be required to reimburse the indemnifiedparty for the full amount. We have never incurred costs to defend lawsuits orsettle claims relating to indemnification arising out of subcontractors’failure to perform. As a result, we believe the estimated fair value of theseagreements is minimal. Accordingly, there were no liabilities recorded forthese agreements as of December 31, 2006 and 2005.

Our standard license agreements contain productwarranties that the software will be free of material defects and will operatein accordance with the stated requirements for a limited period of time. Theproduct warranty provisions require us to cure any defects through anyreasonable means. We believe the estimated fair value of the product warrantyprovisions in the license agreements in place with our customers is minimal. Accordingly,there were no liabilities recorded for these product warranty provisions as of December 31,2006 and 2005.

Our software arrangements generally include a productindemnification provision whereby we will indemnify and defend a customer inactions brought against the customer for claims that our products infringe upona copyright, trade secret, or valid patent. We have not historically incurredany significant costs related to product indemnification claims. Accordingly,there were no liabilities recorded for these indemnification provisions as of December 31,2006 and 2005.

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In relation to theacquisitions of Evolving Systems U.K., Telecom Software Enterprises, LLC (TSE)and CMS Communications, Inc. (CMS), we agreed to indemnify certain partiesfrom any losses, actions, claims, damages or liabilities (or actions in respectthereof) resulting from any claim raised by a third party. We do not believethat there will be any claims related to these indemnifications. Accordingly,there were no liabilities recorded for these agreements as of December 31,2006 and 2005.

**(c)****           Litigation**

During the fourth quarter of 2006, a previous vendorfiled a complaint in the Superior Court of New Jersey against us asserting webreached certain provisions of a license agreement. While the outcome of thismatter is uncertain, we believe we have paid all fees due under our licenseagreement and will vigorously defend this claim.

We are involved in variousother legal matters arising in the normal course of business. We do not believethat any such matters are probable of loss or will have a material impact onour results of operations and financial position.

**NOTE 12**—SEGMENT INFORMATION

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

We currently operate business as two operatingsegments based on revenue type:  licensefees and services revenue and customer support revenue (as shown on theconsolidated statements of operations). License fees and services (L&S)revenue represents the fees received from the license of software products andthose services directly related to the delivery of the licensed products, aswell as fees for custom development, integration services and time andmaterials work. Customer support (CS) revenue includes annual support fees,recurring maintenance fees, fees for maintenance 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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Revenueinformation by segments was as follows (in thousands):

| ** **                                                                 | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenue**                                                                | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and services                                                  |       | $                                                             | 15,883     |   | $ | 19,779 |   | $ | 11,074 |   |
| Customer support                                                           |       | 17,950                                                        |       | 19,673 |   | 15,268 |   |
|                                                                       |       | 33,833                                                        |       | 39,452 |   | 26,342 |   |
| **Revenue  less cost of revenue, excluding depreciation and amortization** | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and services                                                  |       | 8,541                                                         |       | 10,288 |   | 5,208 |   |
| Customer support                                                           |       | 12,256                                                        |       | 13,094 |   | 8,198 |   |
|                                                                       |       | 20,797                                                        |       | 23,382 |   | 13,406 |   |
| **Unallocated  costs**                                                     | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Other operating expenses                                                   |       | 17,172                                                        |       | 18,382 |   | 10,563 |   |
| Depreciation and amortization                                              |       | 3,680                                                         |       | 6,658 |   | 2,819 |   |
| Impairment of goodwill and intangible assets                               |       | 16,516                                                        |       | — |   | — |   |
| Restructuring and other                                                    |       | (21                                                           | )          | (49 | ) | (15 | ) |
| Interest income                                                            |       | (160                                                          | )          | (116 | ) | (304 | ) |
| Interest expense                                                           |       | 1,992                                                         |       | 1,636 |   | 301 |   |
| Foreign currency exchange loss                                             |       | 5                                                             |       | 172 |   | (84 | ) |
| **Income (loss) from before  income taxes**                                |       | $                                                             | (18,387    | ) | $ | (3,301 | ) | $ | 126 |   |

 

***Geographic Regions***

We areheadquartered in Englewood, a suburb of Denver, Colorado. We use customerlocations as the basis for attributing revenues to individual countries. Weprovide products and services on a global basis through our office in Coloradoand U.K.-based Evolving Systems U.K. subsidiary. Additionally, personnel inBangalore, India, provide software development services to our globaloperations. Financial information relating to operations by geographic region,as reviewed by the CODM, is as follows (in thousands):

| ** **                           | ** ** | **For the Year Ended**

**December 31, 2006** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **L&S**                                                            | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**                          | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Americas                             |       | $                                                                      | 3,780      |   | $ | 11,336 |   | $ | 15,116 |   |
| Europe, Middle East, Africa and Asia |       | 12,103                                                                 |       | 6,614 |   | 18,717 |   |
| Total revenues                       |       | $                                                                      | 15,883     |   | $ | 17,950 |   | $ | 33,833 |   |

 

| ** **                           | ** ** | **For the Year Ended**

**December 31, 2005** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **L&S**                                                            | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**                          |       |                                                                   |       |   |   |   |   |
| Americas                             |       | $                                                                      | 6,119      |   | $ | 12,747 |   | $ | 18,866 |   |
| Europe, Middle East, Africa and Asia |       | 13,660                                                                 |       | 6,926 |   | 20,586 |   |
| Total revenues                       |       | $                                                                      | 19,779     |   | $ | 19,673 |   | $ | 39,452 |   |

 

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| ** **                           | ** ** | **For the Year Ended**

**December 31, 2004** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                           | ** ** | **L&S**                                                            | ** ** | **CS** | ** ** | **Total** | ** ** |
| **Revenue**                          | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Americas                             |       | $                                                                      | 8,189      |   | $ | 14,389 |   | $ | 22,578 |   |
| Europe, Middle East, Africa and Asia |       | 2,885                                                                  |       | 879 |   | 3,764 |   |
| Total revenues                       |       | $                                                                      | 11,074     |   | $ | 15,268 |   | $ | 26,342 |   |

 

| ** **                           | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Long-lived assets, net**           |       |                  |       |   |   |
| Americas                             |       | $                     | 7,903      |   | $ | 13,172 |   |
| Europe, Middle East, Africa and Asia |       | 25,628                |       | 36,026 |   |
|                                 |       | $                     | 33,531     |   | $ | 49,198 |   |

 

Revenuerelated to our product lines is as follows (in thousands):

| ** **           | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------|------------|---------------------------------------------------------------|------------|
| ** **           | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Revenue**          |       |                                                          |       |   |   |   |   |
| Activation           |       | $                                                             | 16,717     |   | $ | 18,868 |   | $ | 3,252 |   |
| Numbering  solutions |       | 12,006                                                        |       | 15,336 |   | 19,048 |   |
| Mediation            |       | 5,110                                                         |       | 5,248 |   | 4,042 |   |
| Total revenues       |       | $                                                             | 33,833     |   | $ | 39,452 |   | $ | 26,342 |   |

 

**NOTE 13**—QUARTERLY FINANCIAL INFORMATION(UNAUDITED)

Quarterlyfinancial information is as follows (in thousands, except per share data):

| ** **                                   | ** ** | **First**   | ** ** | **Second**  | ** ** | **Third**   | ** ** | **Fourth**  | ** ** |
|----------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-------------|------------|
| ** **                                   | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** | **Quarter** | ** ** |
| **Year Ended December 31,  2006**       |       |        |       |        |       |        |       |        |       |   |   |
| Total revenue                                |       | $           | 8,128      |        | $          | 8,240       |       |        | $          | 8,667 |   |   | $ | 8,798 |   |
| Less: cost of revenue and operating expenses |       | 9,386       |       | 25,312      |       |        | 7,989      |        |       | 7,696 |   |
| Income (loss)  from operations               |       | (1,258      | )          | (17,072     | )          |        | 678        |        |       | 1,102 |   |
| Income (loss)  before income taxes           |       | (1,730      | )          | (17,561     | )          |        | 218        |        |       | 686 |   |
| Net income (loss)                            |       | $           | (1,651     | )           | $          | (16,186     | )          |        | $          | 42 |   |   | $ | 1,012 |   |
| Net income (loss) per  common share:         |       |        |       |        |       |        |       |        |       |   |   |
| Basic                                        |       | $           | (0.09      | )           | $          | (0.85       | )          |        | $          | 0.00 |   |   | $ | 0.05 |   |
| Diluted                                      |       | $           | (0.09      | )           | $          | (0.85       | )          |        | $          | 0.00 |   |   | $ | 0.05 |   |
| **Year  Ended December 31, 2005**       | ** ** | ** **  | ** ** | ** **  | ** ** |        |       |        | ** ** | ** ** | ** ** |
| Total revenue                                |       | $           | 9,838      |        | $          | 9,926       |       |        | $          | 9,570 |   |   | $ | 10,118 |   |
| Less: cost of revenue and operating expenses |       | 11,759      |       | 10,204      |       |        | 9,908      |        |       | 9,190 |   |
| Income (loss)  from operations               |       | (1,921      | )          | (278        | )          |        | (338       | )           |       | 928 |   |
| Income (loss)  before income taxes           |       | (2,426      | )          | (705        | )          |        | (809       | )           |       | 639 |   |
| Net income (loss)                            |       | $           | (2,148     | )           | $          | (689        | )          |        | $          | (926 | ) |   | $ | 858 |   |
| Net income (loss) per  common share:         |       |        |       |        |       |        |       |        |       |   |   |
| Basic                                        |       | $           | (0.12      | )           | $          | (0.04       | )          |        | $          | (0.05 | ) |   | $ | 0.05 |   |
| Diluted                                      |       | $           | (0.12      | )           | $          | (0.04       | )          |        | $          | (0.05 | ) |   | $ | 0.04 |   |

 

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**NOTE 14 – SUBSEQUENT EVENT**

**On March 15, 2007, holders of441,377 shares of Series B Convertible Preferred Stock with a carrying value of$5.1 million, or approximately 46% of the outstanding shares, converted theirshares of preferred stock into 1,324,131 shares of our common stock inaccordance with the conversion provisions of the Series B Convertible PreferredStock.  This conversion will increase thenumber of shares of our common stock outstanding by 1.3 million shares.  Because we have previously included the SeriesB Convertible Preferred Stock as a participating security for basic EPS purposes,this conversion will not change our future basic or diluted EPS calculations.**

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**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

**ITEM 9A.**        CONTROLSAND PROCEDURES

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

Our management, with the participation of the ChiefExecutive Officer and Chief Financial Officer, has evaluated the effectivenessof our disclosure controls and procedures as of the end of the period coveredby this Annual Report on Form 10-K. Based on that evaluation, ourChief Executive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures were effective as of the end of such period.

In designing and evaluating our disclosure controlsand procedures, management recognized that disclosure controls and procedures,no matter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the disclosure controls andprocedures are met. Additionally, in designing disclosure controls andprocedures, we are required to apply judgment in evaluating the cost-benefitrelationship of possible disclosure controls and procedures. The design of anydisclosure controls and procedures also is based in part upon certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions.

*Changes in internalcontrol over financial reporting.**  *Duringthe fiscal quarter ended December 31, 2006, there was no change in ourinternal control over financial reporting or in other factors that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

**ITEM 9B.**       OTHERINFORMATION

None.

**PART III**

**ITEM 10.**         DIRECTORS,EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Incorporated by referenceto the sections of Evolving Systems, Inc. 2007 Proxy Statement,anticipated to be filed within 120 days of December 31, 2006,entitled “Proposal No. 1—Election of Directors,” “Management” and “InformationRegarding the Board and Its Committees.”

**ITEM 11.**         EXECUTIVECOMPENSATION

Incorporated by referenceto the section of Evolving Systems, Inc. 2007 Proxy Statement, anticipatedto be filed within 120 days of December 31, 2006, entitled “ExecutiveCompensation.”

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**ITEM 12.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

Incorporated by referenceto the section of the Evolving Systems, Inc. 2007 Proxy Statement,anticipated to be filed within 120 days of December 31, 2006,entitled “Information RegardingBeneficial Ownership of Principal Stockholders, Directors, and Management.”

**ITEM 13.**         CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Incorporated by referenceto the sections of the Evolving Systems, Inc. 2007 Proxy Statement,anticipated to be filed within 120 days of December 31, 2006,entitled “Certain Relationship and Related Transactions” and “InformationRegarding the Board and Its Committees.”

**ITEM 14.**         PRINCIPALACCOUNTING FEES AND SERVICES

Incorporated by referenceto the section of the Evolving Systems, Inc. 2007 Proxy Statement,anticipated to be filed within 120 days of December 31, 2006,entitled “Report of the Audit Committee.”

**PART IV**

**ITEM 15.**         EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

(a)   The following documents are filed as part of this AnnualReport on Form 10-K:

Consolidated Financial Statements.

Consolidated FinancialStatement Schedules have been omitted because the required information is notpresent, or not present in amounts sufficient to require submission of theschedules or because the required information is provided in the ConsolidatedFinancial Statements or Notes thereto.

**EXHIBIT INDEX**

| Exhibit  Number | ** ** | **Description of Document**                                                                                                                                                                                                                                                                                          |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1†       |       | Restated Certificate of Incorporation.                                                                                                                                                                                                                                                                               |
| 3.1(a)          |       | Certificate of  Incorporation of Evolving Systems Holdings, Inc. filed as  Exhibit 3.1(a) to the Registrant’s Form 8-K filed  November 17, 2005 and incorporated herein by reference.                                                                                                  |
| 3.1(b)          |       | Bylaws of Evolving  Systems Holdings, Inc. filed as Exhibit 3.1(b) to the  Registrant’s Form 8-K filed November 17, 2005 and  incorporated herein by reference.                                                                                                                        |
| 3.1(c)          |       | Certificate of Amendment  to Certificate of Designation of Series B Convertible Preferred Stock  filed as Exhibit 3.1(c) to the Registrant’s Form 8-K  filed November 17, 2005 and incorporated herein by reference.                                                                   |
| 3.2†       |       | Amended and Restated  Bylaws.                                                                                                                                                                                                                                                                                        |
| 4.1†       |       | Reference is made to  Exhibits 3.1 and 3.2.                                                                                                                                                                                                                                                                     |
| 4.2†       |       | Specimen stock  certificate representing shares of Common Stock.                                                                                                                                                                                                                                                     |
| 10.1† *    |       | Indemnification  Agreement, entered into by the Registrant and each of its directors and  executive officers, dated as of January 1, 1998.                                                                                                                                                                      |
| 10.1(a)         |       | Credit Agreement among  Evolving Systems, Inc., Telecom Software Enterprises, LLC, Evolving  Systems Holdings, Inc. and CapitalSource Finance LLC, as Agent filed as Exhibit 10.1(a) to the  Registrant’s Form 8-K filed November 17, 2005 and  incorporated herein by reference. |

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| Exhibit  Number | ** ** | **Description of Document**                                                                                                                                                                                                                                                                                                                                                                                                 |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(b)         |       | Security Agreement among  Evolving Systems, Inc., Telecom Software Enterprises, LLC, Evolving  Systems Holdings, Inc. and CapitalSource Finance LLC, as Agent filed as Exhibit 10.1(b) to the  Registrant’s Form 8-K filed November 17, 2005 and  incorporated herein by reference.                                                                                                      |
| 10.1(c)         |       | Pledge Agreement between  Evolving Systems, Inc. and CapitalSource Finance LLC, as Agent filed as  Exhibit 10.1(c) to the Registrant’s Form 8-K filed  November 17, 2005 and incorporated herein by reference.                                                                                                                                                                                |
| 10.1(d)         |       | Acknowledgment of  Intellectual Property Collateral Lien among Evolving Systems, Inc.,  Telecom Software Enterprises, LLC, Evolving Systems Holdings, Inc. and  CapitalSource Finance LLC, as Agent filed  as Exhibit 10.1(d) to the Registrant’s Form 8-K filed  November 17, 2005 and incorporated herein by reference.                                                                |
| 10.1(e)         |       | Revolving Facility  Agreement among Evolving Systems Ltd, Evolving Systems Holdings Ltd.,  Evolving Systems, Inc., Telecom Software Enterprises, LLC, Evolving  Systems Holdings, Inc. and CSE Finance, Inc., as Lender,  CapitalSource Finance LLC, as Agent filed  as Exhibit 10.1(e) to the Registrant’s Form 8-K filed  November 17, 2005 and incorporated herein by reference. |
| 10.1(f)         |       | Charge Over Shares (US  Secured Obligations) between Evolving Systems Holdings, Inc. and  CapitalSource Finance LLC, as Collateral Agent filed as Exhibit 10.1(f) to the Registrant’s Form 8-K  filed November 17, 2005 and incorporated herein by reference.                                                                                                                                 |
| 10.1(g)         |       | Charge Over Shares (UK  Secured Obligations) between Evolving Systems Holdings, Inc. and  CapitalSource Finance LLC, as Collateral Agent filed as Exhibit 10.1(g) to the Registrant’s Form 8-K  filed November 17, 2005 and incorporated herein by reference.                                                                                                                                 |
| 10.1(h)         |       | Debenture among Evolving  Systems Holdings Ltd., Evolving Systems Ltd. and CapitalSource Finance LLC,  as Collateral Agent filed as  Exhibit 10.1(h) to the Registrant’s Form 8-K filed  November 17, 2005 and incorporated herein by reference.                                                                                                                                                   |
| 10.1(i)         |       | Guaranty among Evolving  Systems, Inc., Telecom Software Enterprises, LLC, Evolving Systems  Holdings, Inc. and CapitalSource Finance LLC, as Agent filed as Exhibit 10.1(i) to the  Registrant’s Form 8-K filed November 17, 2005 and  incorporated herein by reference.                                                                                                                |
| 10.1(j)         |       | Subordination Agreement  among Evolving Systems, Inc., Telecom Software Enterprises, LLC,  Evolving Systems Holdings, Inc., the Junior Creditors (as listed in the  agreement) and CapitalSource Finance LLC, as Agent filed as Exhibit 10.1(j) to the Registrant’s Form 8-K  filed November 17, 2005 and incorporated herein by reference.                                              |
| 10.1(k)         |       | Form of  Subordinated Note filed as Exhibit 10.1(k) to the Registrant’s  Form 8-K filed November 17, 2005 and incorporated herein by  reference.                                                                                                                                                                                                                                              |
| 10.2† *    |       | Amended and Restated Stock  Option Plan.                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.3† *    |       | Employee Stock Purchase  Plan.                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.10†     |       | Software Development  Agreement, by and between the Registrant and American Telephone and Telegraph  Company, dated as of May 1, 1993. (The division of American  Telephone & Telegraph Company responsible for this Agreement has  split off from AT&T and is now known as Lucent Technologies, Inc.).                                                                                              |
| 21(a)           |       | Subsidiaries of the  Registrant.                                                                                                                                                                                                                                                                                                                                                                                            |
| 23.1            |       | Consent of KPMG LLP,  Independent Registered Public Accounting Firm related to Registration  Statements on Forms S-3 and S-8.                                                                                                                                                                                                                                                                                               |

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| Exhibit  Number | ** ** | **Description of Document**                                                                                                                                    |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 24.1            |       | Power of Attorney  (included on signature page)                                                                                                                |
| 31.1            |       | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                     |
| 31.2            |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                     |
| 32.1            |       | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2            |       | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

----

†                     Incorporatedby reference to the Registrant’s Registration Statement on Form S-1 No. 333-43973.

*                    Identifieseach management contract or compensatory plan or arrangement.

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**SIGNATURES**

**Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.**

**EVOLVING SYSTEMS, INC.**

| /s/  STEPHEN K. GARTSIDE, JR.  |   | Chief Executive  Officer and Director |   | March 15, 2007 |
|--------------------------------|--------|---------------------------------------|--------|---------------------|
| Stephen  K. Gartside, Jr. |   |                                  |   |                |

 

**POWER OF ATTORNEY**

KNOW ALL MEN BY THESE PRESENTS, that each person whosesignature appears below constitutes and appoints Stephen K. Gartside, Jr.and Anita T. Moseley, or any of them, his or her attorney-in-fact, each withthe power of substitution, for him or her in any and all capacities, to signany amendments to this Report, and to file the same, with exhibits thereto andother documents in connections therewith, with the Securities and ExchangeCommission, hereby ratifying and confirming all that each of saidattorneys-in-fact, or his or her substitute or substitutes, may do or cause tobe done by virtue hereof.

**Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the datesindicated.**

|                                | **Signature** | ** **                                            | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------------|---------------|-------------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/ STEPHEN K.  GARTSIDE, JR.  |          | Chief Executive  Officer and Director                 |       | March 15, 2007 |
| Stephen  K. Gartside, Jr. |          |                                                  |       |                |
| /s/ BRIAN R.  ERVINE           |          | Executive Vice  President, Chief Financial            |       | March 15, 2007 |
| Brian  R. Ervine               |          | Officer (Principal  Financial and Accounting Officer) |       |                |
| /s/ GEORGE A.  HALLENBECK      |          | Chairman of the  Board of Directors                   |       | March 15, 2007 |
| George  A. Hallenbeck          |          |                                                  |       |                |
| /s/ DAVID J.  NICOL            |          | Director                                              |       | March 15, 2007 |
| David  J. Nicol                |          |                                                  |       |                |
| /s/ PHILIP M.  NECHES          |          | Director                                              |       | March 15, 2007 |
| Philip  M. Neches              |          |                                                  |       |                |
| /s/ STEVE B. WARNECKE          |          | Director                                              |       | March 15, 2007 |
| Steve B. Warnecke              |          |                                                  |       |                |

 

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