**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**








**FORM
      10-Q**





**x QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934****FOR
                THE QUARTERLY PERIOD ENDED MARCH 31, 2006****OR****o TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934****FOR
                THE TRANSITION PERIOD
                FROM                      TO****Commission
                File Number 000-27427**








**ALTIGEN
      COMMUNICATIONS, INC.**


(Exact
      name of registrant as specified in its charter)





**DELAWARE**
            
            **94-3204299**(State
                or other jurisdiction of
              incorporation
                or organization)
            
            (I.R.S.
                Employer
              Identification
                Number)**4555
                Cushing Parkway**
              **Fremont,
                CA**
            
            **94538**(Address
                of principal executive offices)
            
            (Zip
                Code)Registrant’s
                telephone number, including area code:**(510)
                252-9712**










Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.     YES x NO  o




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


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





The
      number of shares of our common stock outstanding as of May 11, 2006 was:
      14,976,633 shares.













1


**Table
      of Contents**





**PART
                I. FINANCIAL INFORMATION**Item
                1.
            Financial
                Statements:Balance
                Sheets as of March 31, 2006 and September 30, 2005
            3Statements
                of Operations for the Three and Six Months Ended March 31, 2006 and
                2005
            4Statements
                of Cash Flows for the Six Months Ended March 31, 2006 and
                2005
            5Notes
                to Financial Statements
            6Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            11Item
                3.
            Quantitative
                and Qualitative Disclosures About Market Risk
            18Item
                4.
            Controls
                and Procedures
            18**PART
                II. OTHER INFORMATION**Item
                1.
            Legal
                Proceedings
            19Item
                1A.
            Risk
                Factors
            19Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            26Item
                3.
            Defaults
                Upon Senior Securities
            26Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            26Item
                5
            Other
                Information
            26Item
                6.
            Exhibits
            26**SIGNATURE**
            27**EXHIBIT
                INDEX**
            28








2


**PART
      I. FINANCIAL INFORMATION**




**Item
                1.**
            **Financial
                Statements**





**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**UNAUDITED
      CONDENSED CONSOLIDATED BALANCE SHEETS**


**(in
      thousands, except share and per share amounts)**




**March
                31,**
              **2006**
            
            **September
                30,**
              **2005****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            4,867
            
            $
            3,963Short-term
                investments
            
            
            4,388
            
            
            5,459Accounts
                receivable, net of allowances of $36 and $40 at March 31, 2006 and
                September 30, 2005, respectively
            
            
            2,158
            
            
            1,957Inventories
            
            
            1,614
            
            
            965Prepaid
                expenses and other current assets
            
            
            253
            
            
            148Total
                current assets
            
            
            13,280
            
            
            12,492Property
                and equipment:Furniture
                and equipment
            
            
            1,634
            
            
            1,405Computer
                software
            
            
            920
            
            
            9202,554
            
            
            2,325Less:
                Accumulated depreciation and amortization
            
            
            (1,904
            )
            
            (1,803
            )Net
                property and equipment
            
            
            650
            
            
            522Other
                non-current assets:Long-term
                investments
            
            
            223
            
            
            247Long-term
                deposit
            
            
            74
            
            
            74Total
                other non-current assets
            
            
            297
            
            
            321Total
                assets
            
            $
            14,227
            
            $
            13,335**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            972
            
            $
            653Accrued
                liabilities:Payroll
                and related benefits
            
            
            331
            
            
            317Warranty
                (Note 2)
            
            
            276
            
            
            264Marketing
            
            
            57
            
            
            58Accrued
                expense
            
            
            248
            
            
            272Other
            
            
            325
            
            
            288Deferred
                revenue
            
            
            764
            
            
            507Total
                current liabilities
            
            
            2,973
            
            
            2,359Deferred
                Rent
            
            
            219
            
            
            258Stockholders’
                equity:Convertible
                preferred stock, $0.001 par value; Authorized - 5,000,000 shares;
                Outstanding - none at March 31, 2006 and September 30,
                2005
            
            
            —
            
            
            —Common
                stock, $0.001 par value; Authorized - 50,000,000 shares; Outstanding
                -
                16,018,849 shares at
              March
                31, 2006and
                15,782,071 shares at September 30, 2005
            
            
            16
            
            
            16Treasury
                stock at cost - 1,063,895 shares at March 31, 2006 and September
                30,
                2005
            
            
            (1,014
            )
            
            (1,014
            )Additional
                paid-in capital
            
            
            63,515
            
            
            62,863Accumulated
                other comprehensive income (loss)
            
            
            1
            
            
            (1
            )Accumulated
                deficit
            
            
            (51,483
            )
            
            (51,146
            )Total
                stockholders’ equity
            
            
            11,035
            
            
            10,718Total
                liabilities and stockholders’ equity
            
            $
            14,227
            
            $
            13,335





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








3


**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**


**(in
      thousands, except per share amounts)**





**Three
                Months Ended March 31,**
            
            **Six
                Months Ended March 31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                revenue:Hardware
            
            $
            3,828
            
            $
            2,354
            
            $
            7,923
            
            $
            5,918Software
            
            
            346
            
            
            447
            
            
            654
            
            
            1,158Total
                net revenue
            
            
            4,174
            
            
            2,801
            
            
            8,577
            
            
            7,076Cost
                of revenue:Hardware
            
            
            1,909
            
            
            1,227
            
            
            3,906
            
            
            2,842Software
            
            
            26
            
            
            33
            
            
            47
            
            
            85Total
                cost of revenue
            
            
            1,935
            
            
            1,260
            
            
            3,953
            
            
            2,927Gross
                profit
            
            
            2,239
            
            
            1,541
            
            
            4,624
            
            
            4,149Operating
                expenses:Research
                and development
            
            
            895
            
            
            935
            
            
            1,922
            
            
            1,757Sales
                and marketing
            
            
            999
            
            
            988
            
            
            2,090
            
            
            1,989General
                and administrative
            
            
            527
            
            
            529
            
            
            1,085
            
            
            1,004Total
                operating expenses
            
            
            2,421
            
            
            2,452
            
            
            5,097
            
            
            4,750Loss
                from operations
            
            
            (182
            )
            
            (911
            )
            
            (473
            )
            
            (601
            )Equity
                in net loss of investee
            
            
            (14
            )
            
            —
            
            
            (24
            )
            
            —Interest
                and other income, net
            
            
            85
            
            
            53
            
            
            168
            
            
            94Net
                loss before tax
            
            
            (111
            )
            
            (858
            )
            
            (329
            )
            
            (507
            )Income
                taxes
            
            
            9
            
            
            —
            
            
            9
            
            
            10Net
                loss
            
            $
            (120
            )
            $
            (858
            )
            $
            (338
            )
            $
            (517
            )Basic
                and diluted net loss per share
            
            $
            (0.01
            )
            $
            (0.06
            )
            $
            (0.02
            )
            $
            (0.04
            )Weighted
                average shares used in computing basic and diluted net loss per
                share
            
            
            14,937
            
            
            14,575
            
            
            14,889
            
            
            14,516





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








4





**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(in
      thousands)**




**Six
                Months Ended March
                31,****2006**
            
            **2005**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss
            
            $
            (338
            )
            $
            (517
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
            
            
            100
            
            
            47Stock
                based compensation
            
            
            436
            
            
            —Equity
                in net loss of investee
            
            
            24
            
            
            —Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (201
            )
            
            165Inventories
            
            
            (649
            )
            
            (73
            )Prepaid
                expenses and other current assets
            
            
            (105
            )
            
            (56
            )Accounts
                payable
            
            
            319
            
            
            (103
            )Accrued
                liabilities
            
            
            38
            
            
            (127
            )Deferred
                revenue
            
            
            257
            
            
            218Deferred
                rent
            
            
            (38
            )
            
            (17
            )Net
                cash used in operating activities
            
            
            (157
            )
            
            (463
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchases
                of short-term investments
            
            
            (6,404
            )
            
            (12,226
            )Proceeds
                from sale of short-term investments
            
            
            7,476
            
            
            12,797Changes
                in long-term investments
            
            
            —
            
            
            (90
            )Purchases
                of property and equipment
            
            
            (229
            )
            
            (63
            )Net
                cash provided by investing activities
            
            
            843
            
            
            418CASH
                FLOWS FROM FINANCING ACTIVITIES:Proceeds
                from issuances of common stock, net of issuance costs
            
            
            218
            
            
            264Net
                cash provided by financing activities
            
            
            218
            
            
            264NET
                INCREASE IN CASH AND CASH EQUIVALENTS
            
            
            904
            
            
            219CASH
                AND CASH EQUIVALENTS, BEGINNING OF PERIOD
            
            
            3,963
            
            
            2,898CASH
                AND CASH EQUIVALENTS, END OF PERIOD
            
            $
            4,867
            
            $
            3,117SUPPLEMENTAL
                DISCLOSURE OF CASH FLOW INFORMATION:Cash
                paid during the period for:Income
                taxes
            
            $
            (1
            )
            
            —Interest
            
            $
            (9
            )
            
            —





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





5


**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**NOTES
      TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
      STATEMENTS**





**1.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





**BASIS
      OF PRESENTATION**





AltiGen
      Communications, Inc. (“we or the Company”) is a pioneer in Internet protocol
      telephony systems. We design, manufacture and market next generation, Internet
      protocol phone systems and contact centers that use both the Internet and the
      public telephone network to take advantage of the convergence of voice and
      data
      communications. Unlike traditional proprietary phone systems, our systems are
      designed with open architecture and are built on an industry standard platform.
      This adherence to industry standards allows our products to play an important
      role in the small-to-medium sized business market by delivering phone systems
      that can integrate with other technologies and provide integrated voice and
      data
      solutions. We believe this enables our customers, small-to medium-sized
      businesses, to implement communication systems that provide competitive return
      on investment versus alternative technology investments.





The
      accompanying unaudited condensed consolidated financial statements have been
      prepared in conformity with (i) generally accepted accounting principles (GAAP)
      for interim financial information; (ii) the instructions for Form 10-Q and
      (iii)
      Article 10 of Regulation S-X. Accordingly, certain information and footnote
      disclosures normally included in financial statements prepared in accordance
      with GAAP have been condensed, or omitted, pursuant to the rules and regulations
      of the Securities and Exchange Commission (SEC). These unaudited condensed
      consolidated financial statements reflect the operations of the Company and
      its
      wholly-owned subsidiary. All significant intercompany transactions and balances
      have been eliminated. In our opinion, these unaudited condensed consolidated
      financial statements include all adjustments necessary (which are of a normal
      and recurring nature) for a fair presentation of the Company’s financial
      position, results of operations and cash flows for the periods
      presented.





These
      financial statements should be read in conjunction with our audited consolidated
      financial statements for the fiscal year ended September 30, 2005, included
      in
      the Company’s 2005 Annual Report on Form 10-K filed with the SEC on December 28,
      2005. AltiGen’s results of operations for any interim period are not necessarily
      indicative of the results of operations for any other interim period or for
      a
      full fiscal year.





During
      the quarter ended March 31, 2006, the Company determined that certain items
      as
      reported in the December 31, 2005 income statement were improperly classified.
      The Company reclassified $13,000 from hardware revenue to software revenue.





**CASH
      AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS**





We
      consider all highly liquid investments with an original maturity of three months
      or less from the date of purchase to be cash equivalents. Short-term investments
      are in highly liquid financial instruments with original maturities greater
      than
      three-months but less than one year and are classified as “available-for-sale”
investments. Investments are reported at their fair value, with unrealized
      gains
      and losses excluded from earnings and reported as a separate component of
      stockholders’ equity. As of March 31, 2006, our cash and cash equivalents
      consisted of commercial paper and cash deposited in checking and money market
      accounts.





Unrealized
      gains from short-term investments were $1,000 at March 31, 2006 and unrealized
      losses from short-term investments were $1,000 at September 30,
      2005.





**INVENTORIES**





Inventories
      (which include costs associated with components assembled by third-party
      assembly manufacturers, as well as internal labor and allocable overhead) are
      stated at the lower of cost (which approximates actual cost on first-in,
      first-out method) or market. Provisions, when required, are made to reduce
      excess and obsolete inventories to their estimated net realizable values.





6


We
      regularly monitor inventory quantities on hand and record a provision for excess
      and obsolete inventories based primarily on our estimated forecast of product
      demand and production requirements for the next six months. We did not record
      any provision for excess and obsolete inventories for the six months ended
      March
      31, 2006 and 2005. The components of inventories include (in
      thousands):







**March
                31,**
              **2006**
            
            
            **September
                30,**
              **2005**Raw
                materials
            
            $
            412
            
            $
            144Work-in-progress
            
            
            192
            
            
            84Finished
                goods
            
            
            1,010
            
            
            737$
            1,614
            
            $
            965





**LONG-TERM
      INVESTMENTS**





As
      of
      March 31, 2006, we held an investment of common stock in a private Taiwanese
      telecommunication company valued at approximately $195,000 accounted for using
      the cost method. Our interest in the company is approximately 2%, which interest
      does not allow us to exercise significant influence.





In
      July
      2004, we purchased common stock of a private Korean telecommunications company
      for **** $ 79,000.
      As a result of this investment, we acquired approximately 23% of the voting
      power of the company and have the right to nominate and have elected one of
      the
      three members of the company’s current board of directors.  We are
      accounting for this investment using the equity method and record our minority
      interest in our results of operations. As of March 31, 2006, our investment
      in
      the Korean company had a remaining book value of approximately
      $29,000.





We
      perform a periodic review of our investments for impairment. Our investments
      are
      considered impaired when a review of the corporate operations and other
      indicators of impairment indicate that the carrying value of the investment
      is
      not likely to be recoverable. Such indicators include, but are not limited
      to,
      limited capital resources, limited prospects of receiving additional financing,
      and limited prospects for liquidity of the related securities. As of March
      31,
      2006, we did not record any investment impairments.





**REVENUE
      RECOGNITION**





We
      account for the recognition of software license revenue in accordance with
      Statement of Position (“SOP”) 97-2, “Software Revenue Recognition.” Revenue
      consists of sales to end-users, including resellers, and to distributors.
      Revenue from sales to end-users are recognized upon shipment, when risk of
      loss
      has passed to the customer, collection of the receivable is reasonably assured,
      persuasive evidence of an arrangement exits, and the price is fixed and
      determinable. Sales to distributors are made under terms allowing certain rights
      of return and protection against subsequent price declines on the Company’s
      products held by its distributors. Upon termination, any unsold products may
      be
      returned by the distributor for a full refund. These agreements may be canceled
      by either party based on a specified notice. As a result of the above
      provisions, we defer recognition of distributor revenue until such distributors
      resell our products to their customers. The amounts deferred as a result of
      this
      policy are reflected as “deferred revenue” in the accompanying consolidated
      balance sheets. The related cost of revenue is also deferred and reported in
      the
      consolidated balance sheets as inventory.





Software
      components are generally not sold separately from our hardware components.
      Software revenue consists of license revenue that are recognized upon the
      delivery of application products. We provide limited post-contract customer
      support (“PCS”), consisting primarily of technical support and “bug” fixes. In
      accordance with SOP 97-2, revenue earned on software arrangements involving
      multiple elements is allocated to each element based upon the relative fair
      values of the elements. Although we provide PCS, the revenue allocated to this
      element is recognized together with the initial licensing fee on delivery of
      the
      software because: (1) the PCS fee is included with the initial licensing
      fee; (2) the PCS included with the initial license fee is for one year or
      less; (3) the estimated cost of providing PCS during the arrangement is
      insignificant; and (4) unspecified upgrades/enhancements offered for
      minimal or no cost during PCS arrangements historically have been and are
      expected to continue to be minimal and infrequent. All estimated costs of
      providing the services, including upgrades and enhancements, are accrued for
      at
      the time of delivery.




**STOCK-BASED
      COMPENSATION**





Commencing
      October 1, 2005 we adopted the provisions of Statement of Financial Accounting
      Standard (“SFAS”) No. 123(R), “Share Based Payment” (“SFAS No. 123(R)”), which
      requires all share-based compensation, including grants of stock options, to
      be
      recognized in the income statement as an operating expense, based on their
      fair
      market values. For the six months ended March 31, 2006, stock compensation
      was
      accounted under SFAS No. 123(R) while for the six months ended March 31, 2005,
      stock-based compensation was accounted under Accounting Principles Board (APB),
      Opinion No. 25 APB (25).





Prior
      to
      adopting SFAS No. 123(R), we accounted for stock-based employee compensation
      under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock
      Issued to Employees,” as
      amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and
      Disclosures.” We have applied
      the modified prospective method in adopting SFAS No. 123(R) and, accordingly,
      we
      recorded compensation costs as the requisite service was rendered for the
      unvested portion of previously issued awards that remain outstanding at the
      initial date of adoption. Periods prior to the adoption of SFAS No. 123(R)
      have
      not been restated.





7


The
      following table summarizes the total stock-based compensation expense for the
      three and six months ended March 31, 2006 and is included in the Unaudited
      Condensed Consolidated Statements of Operations (in thousands):





**Three
                Months Ended March 31,**
            
            **Six
                Months Ended**
              **March
                31,****2006**
            
            **2006**Cost
                of goods sold
            
            $
            8
            
            $
            20Research
                and development
            
            
            59
            
            
            159Selling,
                general and administrative
            
            
            109
            
            
            257Pre-tax
                stock-based compensation expense
            
            
            176
            
            
            436Income
                tax
            
            
            —
            
            
            —Net
                stock-based compensation expense
            
            $
            176
            
            $
            436





The
      following table illustrates the effects on net income and earnings per share
      if
      the fair value based method had been applied to the prior periods as required
      under SFAS No. 123(R). The reported net income and earnings per share for the
      three and six months ended March 31, 2005 have been presented below to reflect
      the impact had the Company been required to include the amortization of the
      Black-Scholes option value as an expense (in thousands, except for per share
      data):




**Three
                Months Ended March 31,**
            
            
            **Six
                Months Ended March 31,****2005**
            
            
            **2005**Net
                loss
            
            $
            (858
            )
            $
            (517
            )Add:
                stock-based employee compensation expense included in reported net
                loss
                under APB No. 25
            
            
            —
            
            
            —Deduct:
                Total stock-based compensation determined under fair value based
                method
                prior to adoption of SFAS No. 123R, net of related tax
                effects
            
            
            (409
            )
            
            (815
            )Net
                loss - pro forma
            
            $
            (1,267
            )
            $
            (1,332
            )Basic
                and diluted net loss per share:As
                reported
            
            $
            (0.06
            )
            $
            (0.04
            )Pro
                forma
            
            $
            (0.09
            )
            $
            (0.09
            )





The
      fair
      value of each option grant during the six months ended March 31, 2006 and 2005
      were estimated at the date of grant using the Black-Scholes option pricing
      model, and is not subject to revaluation as a result of subsequent stock price
      fluctuations. The following weighted-average assumptions are used:





**Employee
                Stock Option Plan**
              **for
                Three Months**
              **Ended
                March 31,**
            
            **Employee
                Stock Option Plan**
              **for
                Six Months**
              **Ended
                March 31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Expected
                Life (in years)
            
            
            5
            
            
            5
            
            
            5
            
            
            5Risk-free
                interest rate
            
            
            4.4
            %
            
            3.7
            %
            
            4.4
            %
            
            3.7
            %Volatility
            
            
            96
            %
            
            102
            %
            
            96
            %
            
            102
            %Expected
                dividend
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %





The
      fair
      value of each purchase rights granted under the Company’s Employee Stock
      Purchase Plan during the six months ended March 31, 2006 and 2005 were estimated
      at the date of grant using the Black-Scholes option pricing model, and is not
      subject to revaluation as a result of subsequent stock price fluctuations.
      The
      following weighted-average assumptions are used:





**Employee
                Stock Purchase Plan**
              **for
                Three Months**
              **Ended
                March 31,**
            
            **Employee
                Stock Purchase Plan**
              **for
                Six Months**
              **Ended
                March 31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Expected
                Life (in years)
            
            
            0.5
            
            
            0.5
            
            
            0.5
            
            
            0.5Risk-free
                interest rate
            
            
            4.3
            %
            
            3.1
            %
            
            4.3
            %
            
            3.1
            %Volatility
            
            
            98
            %
            
            100
            %
            
            98
            %
            
            100
            %Expected
                dividend
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %








8


The
      following table summarizes the Company’s stock option plan as of March 31, 2006,
      and changes during the three months ended March 31, 2006:




**Number
                of**
              **Shares**
            
            
            **Weighted-**
              **average**
              **Exercise Price**
            
            
            **Weighted-**
              **average**
              **Remaining**
              **Contractual**
              **Term**Outstanding
                at January 1, 2005
            
            
            3,781,316
            
            $
            3.79Granted
            
            
            4,000
            
            
            1.80Exercised
            
            
            (46,056
            )
            
            0.77Forfeitures
                and cancellations
            
            
            (114,570
            )
            
            7.20Outstanding
                at March 31, 2006
            
            
            3,624,690
            
            $
            3.72
            
            
            6.01Vested
                and expected to vest at March 31, 2006
            
            
            3,545,858
            
            $
            3.73
            
            
            0.19Exercisable
                at March 31, 2006
            
            
            2,866,781
            
            $
            3.92
            
            
            5.45





During
      the three months ended March 31, 2006, 2.9 million shares of options are
      exercisable with a weighted-average exercise price of $3.92. The
      weighted-average remaining contractual term for outstanding options at March
      31,
      2006 was 6.0 years.





As
      of
      March 31, 2006, approximately $767,000 represents the estimated unamortized
      expense remaining. This expense is to be recognized over a weighted average
      period of approximately 4 years.





Under
      the
      1999 Employee Stock Purchase Plan, 875,038 shares of common stock are reserved
      for issuance at September 30, 2005 to eligible employees at a price of 85%
      of the lower of the fair market value of the common stock on the first day
      of
      the offering period or a specified exercise date (last trading day in April
      or
      October). During
      the six months ended March 31, 2006, 48,913 shares were purchased by and
      distributed to employees at a price of $1.31 per share.





The
      Black-Scholes option pricing model was developed for use in estimating the
      fair
      value of traded options that have no vesting restrictions and are fully
      transferable. In addition, option pricing models require the input of highly
      subjective assumptions, including the expected stock price volatility. We use
      projected volatility rates, which are based upon historical volatility rates
      since our initial public offering, trended into future years. We also use
      historical data to estimate option forfeitures. Because our employee stock
      options have characteristics significantly different from those of traded
      options and because changes in the subjective input assumptions can materially
      affect the fair value estimate, in management’s opinion, the existing models do
      not necessarily provide a reliable single measure of the fair value of our
      options.





**COMPUTATION
      OF BASIC AND DILUTED NET LOSS PER SHARE**





Historical
      net income (loss) per share has been calculated under SFAS No. 128,
“Earnings per Share.” SFAS No. 128 requires companies to compute earnings
      per share under two methods (basic and diluted). Basic net income (loss) per
      share is calculated by dividing net income (loss) by the weighted average shares
      of common stock outstanding during the period. Diluted
      earnings per share reflects the potential dilution that could occur if
      securities or other contracts to issue common stock were exercised or converted
      into common stock. For
      the
      three and six months ended March 31, 2006 and 2005, respectively, basic and
      diluted net loss per share numbers were identical as potential common shares
      resulting from the exercise of stock options were antidilutive.





**COMPREHENSIVE
      INCOME**





Comprehensive
      loss for the six months ended March 31, 2006 and 2005, respectively, were as
      follows (in thousands):





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Net
                loss
            
            $
            (120
            )
            $
            (858
            )
            $
            (338
            )
            $
            (517
            )Unrealized
                gain (loss )
            
            
            1
            
            
            1
            
            
            (2
            )
            
            1$
            (119
            )
            $
            (857
            )
            $
            (340
            )
            $
            (516
            )






9


**SEGMENT
      REPORTING**





We
      are
      organized and operate as one operating segment. We operate primarily in one
      geographic area, the Americas, which is comprised of the United States, Canada,
      Mexico, Central America and the Caribbean.





Net
      revenue by geographic region based on customer location for the three and six
      months ended March 31, 2006 and 2005, respectively, were as
      follows:





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Americas
            
            
            93
            %
            
            92
            %
            
            92
            %
            
            88
            %International
            
            
            7
            %
            
            8
            %
            
            8
            %
            
            12
            %100
            %
            
            100
            %
            
            100
            %
            
            100
            %





International
      is comprised of revenue primarily from China, the United Kingdom and Norway.
      All
      significant long-lived assets are located in the United States for all periods
      presented.





Net
      revenue by customers that individually accounted for more than 10% of our
      revenue for the three and six months ended March 31, 2006 and 2005,
      respectively, were as follows:





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**AltiSys
            
            
            15
            %
            
            23
            %
            
            16
            %
            
            15
            %Synnex
            
            
            52
            %
            
            58
            %
            
            55
            %
            
            52
            %Graybar
            
            
            17
            %
            
            8
            %
            
            15
            %
            
            9
            %





**2.
      WARRANTY**





The
      Company provides a one year warranty for hardware products starting upon
      shipment to end users. We historically have experienced minimal warranty costs.
      Factors that affect our warranty liability include the number of installed
      units, historical experience and management’s judgment regarding anticipated
      rates of warranty claims and cost per claim. We assess the adequacy of our
      recorded warranty liability every quarter and make adjustments to the liability
      if necessary.




Changes
      in our warranty liability for the three and six months ended March 31, 2006
      and
      2005, respectively, are as follows (in thousands):





**Three
                Months Ended March 31,**
            
            **Six
                Months Ended March 31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Beginning
                balance
            
            $
            252
            
            $
            407
            
            $
            264
            
            $
            424Provisions
                for warranty liability
            
            
            56
            
            
            20
            
            
            79
            
            
            43Warranty
                cost including labor, components and scrap
            
            
            (33
            )
            
            (41
            )
            
            (68
            )
            
            (81
            )Ending
                balance
            
            $
            275
            
            $
            386
            
            $
            275
            
            $
            386





**3.
      COMMITMENTS AND CONTINGENCIES**





*Commitments*





We
      lease
      our facilities under several operating lease agreements expiring on various
      dates through February 2009. In December 2003, we leased approximately
      32,000 square feet to serve as our headquarters for corporate administration,
      research and development, manufacturing, and sales and marketing in Fremont,
      California. The lease for our headquarters expires on February 21, 2009. Rent
      expense for all operating leases totaled approximately $132,000 and $258,000
      for
      the three and six months ended March 31, 2006, respectively as compared to
      $126,000 and $252,000 for the three and six months ended March 31, 2005,
      respectively. The increase from $252,000 to $258,000 or the six months ended
      March 31, 2005 and 2006, respectively, was related to the renewal of our
      building lease agreement for the Beijing office starting in the second quarter
      of fiscal 2006. In addition, we lease certain equipment under capital lease
      arrangements. Minimum future lease payments under all noncancellable capital
      and
      operating leases as of March 31, 2006 are as follows (in
      thousands):




10




Capital
            
            OperatingFiscal
                Year Ending September 30,
            
            Leases
            
            LeasesRemainder
                of 2006
            
            $
            26
            
            $
            2582007
            
            
            52
            
            
            4462008
            
            
            48
            
            
            2862009
            
            
            44
            
            
            922010
            
            
            33
            
            
            —Total
                minimum lease payment
            
            $
            203
            
            $
            1,082Amount
                representing interest
            
            $
            34Present
                value of minimum lease payment
            
            
            169Total
                minimum lease payment
            
            $
            203Current
                portion plus current portion of interest
            
            $
            52Long-term
                portion plus long-term portion of interest
            
            
            151Total
                capital lease commitments
            
            $
            203





*Contingencies*





We
      may
      become party to litigation in the normal course of our business. Litigation
      in
      general and intellectual property and securities litigation in particular,
      can
      be expensive and disruptive to normal business operations. Moreover, the results
      of complex litigation are difficult to predict.




On
      September 6, 2002, Vertical Networks, Inc. filed suit against us in
      the United States District Court for the Northern District of California,
      alleging infringement of Vertical Networks’ U.S. Patents Nos. 6,266,341;
      6,289,025; 6,292,482; 6,389,009; and 6,396,849. On October 28, 2002,
      Vertical Networks amended its complaint to add allegations of infringement
      of
      U.S. Patents Nos. 5,617,418 and 5,687,174. Vertical Networks filed a second
      amended complaint on November 20, 2002 to identify our products and/or
      activities that allegedly infringe the seven patents-in-suit. Vertical Networks
      seeks a judgment of patent infringement and an award of damages, including
      treble damages for alleged willful infringement, and attorneys’ fees and costs.
      We filed an answer and counterclaims for declaratory relief on December 9,
      2002. On December 26, 2002, Vertical Networks filed its answer to our
      counterclaims. Vertical Networks served its preliminary infringement contentions
      on us on April 9, 2003 and we served Vertical Networks our preliminary
      invalidity contentions on June 3, 2003 and July 14, 2003. To date, the
      parties have exchanged some discovery, but no depositions have been taken,
      and
      no motions are currently pending. On October 7, 2003, the parties filed a
      stipulation to stay this action, pending the outcome of the reissue of some
      of
      the subject patents before the U.S. Patent and Trademark Office. We believe
      we
      have strong defenses and arguments in this dispute and intend to vigorously
      defend our position. Management’s view is that any loss from this litigation is
      currently not probable or estimable; therefore, the Company has not established
      a reserve on its balance sheet as to any liability related to the outcome of
      this action.





**Item
      2. Management’s Discussion and Analysis of Financial Condition and Results of
      Operations**





**FORWARD-LOOKING
      INFORMATION**





This
      report contains certain forward-looking statements (within the meaning of
      Section 27A of the Securities Act of 1933, as amended, and Section 21E
      of the Securities Exchange Act of 1934, as amended) and information relating
      to
      us that are based on the beliefs of our management as well as assumptions made
      by and information currently available to our management. Additional
      forward-looking statements may be identified by the words “anticipate,”
“believe, ” “expect, ” “intend, ” “plan, ” or the negative of such terms, or
      similar expressions, as they relate to us or our management.





The
      forward-looking statements contained herein reflect our good faith judgment,
      based on the information available to us as of the date of this report. Actual
      results may differ materially from those anticipated in our forward looking
      statements due to certain risks, including risks described below, which risks
      may have a significant impact on our business or financial condition. You are
      cautioned that forward-looking statements are inherently uncertain. Although
      we
      believe that the expectations reflected in these forward-looking statements
      are
      reasonable, we cannot guarantee future results, levels of activity, performance
      or achievements. You should carefully review the cautionary statements contained
      in this Form 10-Q, including those found in “Certain Factors Affecting
      Business, Operating Results, and Financial Condition” below.








11


**OVERVIEW**





We
      are a
      pioneer in Internet protocol telephony systems. We believe that we are a market
      leader in providing products and services to small and medium sized businesses.
      We design, manufacture and market next generation, Internet protocol phone
      systems and contact centers that use both the Internet and the public telephone
      network to take advantage of the convergence of voice and data communications.
      Unlike traditional proprietary phone systems, our systems are designed with
      open
      architecture and are built on an industry standard platform. This adherence
      to
      industry standards allows our products to play an important role in the
      small-to-medium sized business market by delivering phone systems that can
      integrate with other technologies and provide integrated voice and data
      solutions. We believe this enables our customers to implement communication
      systems that provide competitive return on investment versus alternative
      technology investments. We generated net revenue of $4.2 million and $8.6
      million for the three and six months ended March 31, 2006, respectively,
      compared to net revenue of $2.8 million and $7.0 million for the three and
      six
      months ended March 31, 2005, respectively. As of March 31, 2006, we had an
      accumulated deficit of $51.5 million. Net cash used in operating activities
      was $157,000 for the six month ended March 31, 2006.





We
      derive
      our revenue from sales of our AltiServ telephone systems. Product revenue
      consists of sales to end-users (including dealers) and to distributors. Revenue
      from product sales to end users and resellers are recognized upon shipment.
      We
      defer recognition of revenue for sales to distributors until they resell our
      products to their customers. Upon shipment, we also provide a reserve for the
      estimated cost that may be incurred for product warranty. Under our distribution
      contracts, a distributor has the right, in certain circumstances, to return
      products it determines are overstocked, so long as it provides an offsetting
      purchase order for products in an amount equal to or greater than the dollar
      value of the returned products. In addition, we provide distributors protection
      from subsequent price reductions.





Our
      cost
      of revenue consists of component and material costs, direct labor costs,
      provisions for excess and obsolete inventory, warranty costs and overhead
      related to the manufacturing of our products. Several factors that have affected
      and will continue to affect our revenue growth are the state of the economy,
      the
      market acceptance of our products, our ability to add new resellers and our
      ability to design, develop, and release new products. We engage third-party
      assemblers, including All Quality Services and Bestronics, to insert the
      hardware components into the printed circuit board of our products. We select
      our manufacturing partners with the goals of ensuring a reliable supply of
      high-quality finished products and lowering per unit product costs as a result
      of manufacturing economies of scale. We cannot assure you that we will maintain
      the volumes required to realize these economies of scale or when or if such
      cost
      reductions will occur. The failure to obtain such cost reductions could
      materially adversely affect our gross margins and operating results.





We
      continue to focus on (i) developing enhancements to our current products to
      provide greater functionality and increased capabilities, based on market
      research, customer feedback and our competitors’ product offerings and (ii)
      creating new product offerings. In particular, we are developing products in
      an
      effort to enhance our position in our target market segment and seeking to
      enter
      new geographical markets. Additionally, we intend to continue to focus on
      selling our products to small-to-medium sized businesses and branch offices
      of
      larger corporations. Also, we plan to continue to recruit additional resellers
      and distributors that focus on selling phone systems to our target customers.
      We
      believe that the adoption rate for Internet telephony  is
      much
      faster with small-to-medium sized businesses because they have no significant
      investment on their books for traditional phone systems. Also we believe that
      small-to-medium sized businesses are looking for call center-type administration
      to increase the productivity and efficiency of their contacts with customers.
      Assuming that current market trends, including the continuing acceptance of
      the
      call center products, continuing growth in the marketplaces of Asia, Latin
      America, the Caribbean, and the status quo of the North American economy
      continues and that we are successful in enhancing our products, we expect to
      see
      continued revenue growth for fiscal year 2006.





**CRITICAL
      ACCOUNTING POLICIES**





*Revenue
      recognition.* Revenue
      consist of sales to end-users, including resellers, and to distributors. Revenue
      from sales to end-users are recognized upon shipment, when risk of loss has
      passed to the customer, collection of the receivable is reasonably assured,
      persuasive evidence of an arrangement exists, and the price is fixed and
      determinable. We provide for estimated sales returns and allowances and warranty
      costs related to such sales at the time of shipment. Net revenue consists of
      product revenue reduced by estimated sales returns and allowances. Sales to
      distributors are made under terms allowing certain rights of return and
      protection against subsequent price declines on our products held by our
      distributors. Upon termination, any unsold products may be returned by the
      distributor for a full refund. These agreements may be canceled without cause
      by
      either party following a specified notice period. As a result of the above
      provisions, we defer recognition of distributor revenue until such distributors
      resell our products to their customers. The amounts deferred as a result of
      this
      policy are reflected as “deferred revenue” in the accompanying consolidated
      balance sheets. The related cost of revenue is also deferred and reported in
      the
      consolidated balance sheets as inventory. Our total deferred revenue was
      $764,000 and $736,000 as of March 31, 2006 and March 31, 2005, respectively.




12


Software
      components are generally not sold separately from our hardware components.
      Software revenue consists of license revenue that are recognized upon the
      delivery of application products. We provide limited post-contract customer
      support (“PCS”), consisting primarily of technical support and “bug” fixes. In
      accordance with SOP 97-2, revenue earned on software arrangements involving
      multiple elements is allocated to each element based upon the relative fair
      values of the elements. Although we provide PCS, the revenue allocated to this
      element is recognized together with the initial licensing fee on delivery of
      the
      software because: (1) the PCS fee is included with the initial licensing
      fee; (2) the PCS included with the initial license fee is for one year or
      less; (3) the estimated cost of providing PCS during the arrangement is
      insignificant; and (4) unspecified upgrades/enhancements offered for
      minimal or no cost during PCS arrangements historically have been and are
      expected to continue to be minimal and infrequent. All estimated costs of
      providing the services, including upgrades and enhancements are accrued for
      at
      the time of delivery.





*Allowance
      for Doubtful Accounts.* The
      allowance for doubtful accounts is based on our assessment of the collectibility
      of specific customer accounts and the aging of the accounts receivable. If
      there
      were a deterioration of a major customer’s creditworthiness, or actual defaults
      were higher than our historical experience, we could be required to increase
      our
      allowance and our earnings could be adversely affected. Our allowance for
      doubtful accounts was $36,000 and $29,000 as of March 31, 2006 and 2005,
      respectively.





*Inventory* .
      Inventory is stated at the lower of cost (first-in, first-out method) or market.
      Our inventory balance was $1.6 million as of March 31, 2006. We regularly review
      value of inventory in detail, with consideration given to future customer demand
      for our products, obsolescence from rapidly changing technology, and other
      factors. If actual market conditions are less favorable than those projected
      by
      management, and our estimates prove to be inaccurate, we could be required
      to
      increase our inventory provision and our gross margins could be adversely
      affected. As of December 2001, we had established a reserve to write off $3.5
      million of excess inventory which management believed would not be sold. 
During 2002 through 2005, we reversed a portion of the reserve related to
      inventory which was sold.  The amounts of such reversals were $167,000,
      $293,000 and $401,000 in fiscal years ending 2005, 2004 and 2003,
      respectively.  Our
      inventory allowance was $2.3 million as of March 31, 2006 compared to $2.5
      million as of March 31, 2005.




13


*Warranty.* We
      accrue for warranty costs based on estimated product return rates and the
      expected material and labor costs to provide warranty services. If actual return
      rates and repair and replacement costs differ significantly from our estimates,
      our gross margin could be adversely affected. The liability for product
      warranties was $276,000 and $386,000 as of March 31, 2006 and March 31, 2005,
      respectively.





**Results
      of Operations**





The
      following table sets forth consolidated statements of operations data for the
      periods indicated as a percentage of net revenue.





**Three
                Months Ended March 31,**
            
            **Six
                Months Ended March 31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Consolidated
                Statements of Operations Data:Net
                revenue:Hardware
            
            
            91.7
            %
            
            84.0
            %
            
            92.4
            %
            
            83.6
            %Software
            
            
            8.3
            
            
            16.0
            
            
            7.6
            
            
            16.4Total
                net revenue
            
            
            100.0
            
            
            100.0
            
            
            100.0
            
            
            100.0Cost
                of revenue:Hardware
            
            
            45.7
            
            
            43.8
            
            
            45.6
            
            
            40.2Software
            
            
            0.6
            
            
            1.2
            
            
            0.5
            
            
            1.2Total
                cost of revenue
            
            
            46.3
            
            
            45.0
            
            
            46.1
            
            
            41.4Gross
                profit
            
            
            53.7
            
            
            55.0
            
            
            53.9
            
            
            58.6Operating
                expenses:Research
                and development
            
            
            21.4
            
            
            33.3
            
            
            22.4
            
            
            24.8Sales
                and marketing
            
            
            24.0
            
            
            35.3
            
            
            24.4
            
            
            28.1General
                and administrative
            
            
            12.7
            
            
            18.9
            
            
            12.6
            
            
            14.2Total
                operating expenses
            
            
            58.1
            
            
            87.5
            
            
            59.4
            
            
            67.1Income
                (loss) from operations
            
            
            (4.4
            )
            
            (32.5
            )
            
            (5.5
            )
            
            (8.5
            )Equity
                in net loss of investee
            
            
            (0.3
            )
            
            —
            
            
            (0.3
            )
            
            —Interest
                and other income, net
            
            
            2.0
            
            
            1.9
            
            
            2.0
            
            
            1.3Net
                income (loss) before taxes
            
            
            (2.7
            )
            
            (30.6
            )
            
            (3.8
            )
            
            (7.2
            )Provision
                for income taxes
            
            
            0.2
            
            
            —
            
            
            0.1
            
            
            0.1Net
                income (loss)
            
            
            (2.9
            )%
            
            (30.6
            )%
            
            (3.9
            )%
            
            (7.3
            )%








**Revenue,
      net.** Revenue
      consist of sales to end users (including resellers) and
      distributors.





International
      is comprised of revenue primarily from China, the United Kingdom and Norway.
      All
      significant long-lived assets are located in the United States for all periods
      presented.





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**Americas
            
            
            93
            %
            
            92
            %
            
            92
            %
            
            88
            %International
            
            
            7
            %
            
            8
            %
            
            8
            %
            
            12
            %100
            %
            
            100
            %
            
            100
            %
            
            100
            %




14


Net
      revenue by customers that individually accounted for more than 10% of our
      revenue for the three and six months ended March 31, 2006 and 2005,
      respectively, were as follows:





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2006**
            
            **2005**
            
            **2006**
            
            **2005**AltiSys
            
            
            15
            %
            
            23
            %
            
            16
            %
            
            15
            %Synnex
            
            
            52
            %
            
            58
            %
            
            55
            %
            
            52
            %Graybar
            
            
            17
            %
            
            8
            %
            
            15
            %
            
            9
            %





Revenue
      generated in the Americas accounted for $3.9 million or 93% and $7.9
      million or 92%, for the three and six months ended March 31, 2006, respectively,
      as compared to $2.6 million, or 92%, and $6.2 million, or 88%, for the three
      and
      six months ended March 31, 2005, respectively. Net revenue increased 49% to
      $4.2 million for the three months ended March 31, 2006 as compared to
      $2.8 million for the three months ended March 31, 2005. This increase was
      largely attributable to increased sales of telephone systems of 44% in the
      Americas.  Net
      revenue increased 21% to $8.6 million for the six months ended March 31,
      2006 from $7.1 million for the six months ended March 31, 2005 primarily
      due to higher sales of telephone systems of 44% in the Americas which was offset
      in part from a price reduction on our smaller telephone system bundle in the
      second quarter of fiscal 2005 and lower international revenue as compared with
      the same period last year.





For
      the
      three and six months ended March 31, 2006, we incurred a net loss of $120,000
      and $338,000, respectively. However, for such periods, we recognized $176,000
      and $436,000, respectively, of non-cash stock based-compensation expense and
      as
      a result of the adoption of SFAS No. 123(R). We generated a modest net profit
      in
      each period when the SFAS No. 123(R) expense is excluded.





**Cost
      of revenue.** Cost of
      revenue for the three months ended March 31, 2006 increased $675,000 or 54%
      to
      $1.9 million from approximately $1.3 million for the three months ended March
      31, 2005 primarily due to an increase in volume of sales of our products over
      the prior year quarter and an increase in operating cost for the period. Cost
      of
      revenue as a percentage of net revenue increased from 45% and 41% for the three
      and six months ended March 31, 2005, respectively, as compared to 46% for both
      the three and six months ended March 31, 2006. This increase in the six month
      comparison was caused primarily by a lower profit margin as a result of a price
      reduction on our smaller telephone system bundles. No provision for excess
      or
      obsolete inventory was necessary in the three and six months ended March 31,
      2006.





**Research
      and development expenses.** Research
      and development expenses consist principally of salaries and related personnel
      expenses, consultant fees and prototype expenses related to the design,
      development and testing of our products and enhancement of our converged
      telephone system software. Research and development expenses decreased to
      $895,000 for the three months ended March 31, 2006 from $935,000 for the same
      period in fiscal 2005. This decrease was primarily the result of lower legal
      expenses of $34,000, headcount-related costs of $55,000 resulting from decrease
      in salary and other related payroll expenses, offset in part by an increase
      of
      $59,000 due to non-cash stock-based compensation required by SFAS No.123(R)
      in
      the current period. Research and development expenses as a percentage of revenue
      decreased to 21% for the three months ended March 31, 2006 from 33% for the
      same
      period in fiscal 2005. Research and development expenses increased to $1.9
      million for the six months ended March 31, 2006 from $1.8 million for the same
      period in fiscal 2005. This increase was primarily the result of an increase
      of
      $159,000 of non-cash stock-based compensation expense required by SFAS No.
      123(R). Research and development expenses as a percentage of revenue decreased
      slightly from 24% for the six months ended March 31, 2005 to 22% for the six
      months ended March 31, 2006. We believe that research and development expenses
      will increase in the future periods over the long term due to development of
      new
      products and continued efforts in the improvement of the current products.
      In
      the short term, we expect research and development expenses to remain consistent
      as management continues to monitor expenses and plans to keep them in line
      with
      expected revenue opportunities.





**Sales
      and marketing expenses.** Sales
      and marketing expenses consist primarily of salaries, commissions and related
      expenses for personnel engaged in marketing, sales and customer support
      functions, as well as trade shows, advertising, and promotional expenses. Sales
      and marketing expenses increased to $999,000 for the three months ended March
      31, 2006 from approximately $988,000 for the same period in fiscal 2005. This
      increase was due to a $49,000 increase of non-cash stock-based compensation
      expense required by SFAS No. 123(R), offset in part by lower head count related
      expenses in the marketing organization. Sales and marketing expenses as a
      percentage of revenue decreased to 24% for the three months ended March 31, 2006
      from 35% for the same period in fiscal 2005. For the six months ended March
      31,
      2006, sales and marketing expenses increased to $2.1 million from approximately
      $2.0 million for the same period in fiscal 2005. This was primarily attributable
      to $111,000 increase of non-cash stock-based compensation expense required
      by
      SFAS No. 123(R). Sales and marketing expenses as a percentage of revenue
      decreased to 24% for the six months ended March 31, 2006 from 28% for the same
      period in fiscal 2005. We anticipate sales and marketing expenses to remain
      consistent; however, some expenses vary with revenue, such as commissions.
      If we
      are successful in enhancing our products, we expect to see continued revenue
      growth for fiscal year 2006 and, consequently, expect an increase in sales
      and
      marketing expenses.





15


**General
      and administrative expenses.** General
      and administrative expenses consist of salaries and related expenses for (i)
      executive, finance, human resources and administrative personnel, (ii)
      facilities, (iii) allowance for doubtful accounts, (iv) legal, and (v) other
      general corporate expenses. General and administrative expenses decreased to
      $527,000 for the three months ended March 31, 2006 from $529,000 in the same
      period in the prior year. The decrease is primarily the result of a lower
      insurance expense of $52,000, and a decrease in other general expenses, offset
      by an increase of $60,000 for non-cash stock-based compensation expense required
      by SFAS No. 123(R). General
      and administrative expenses for the six months ended March 31, 2006 increased
      to
      $1.1 million from $1.0 million as compared with the same period in the prior
      year fiscal. This was mainly the result of a $146,000 non-cash stock-based
      compensation expense required by SFAS No. 123(R). General
      and administrative expenses as a percentage of revenue decreased to 13% for
      the
      three months ended March 31, 2006 from 19% for the same period in fiscal 2005.
      For the six months ended March 31, 2006, general and administrative expenses
      as
      a percentage of revenue decreased to 13% as compared to 19% during the same
      period in the prior year. We expect general and administrative expenses to
      remain consistent as we continue to focus on controlling costs.





**Equity
      in net loss of investee** .  In
      July
      2004, we purchased common stock of a private Korean telecommunications company
      for **** $ 79,000.
      As a result of this investment, we acquired approximately 23% of the voting
      power of the company and have the right to nominate and have elected one of
      the
      three members of the company's current board of directors.  We are
      accounting for this investment using the equity method. The
      total
      equity in net losses of the Korea investee was approximately $105,000 of which
      23%, or $24,000, is recognized in the six months ended March 31,
      2006.





**Interest
      and other income, net.** Net
      interest and other income increased to $85,000 and $168,000 for the three and
      six months ended March 31, 2006, respectively, from $53,000 and $94,000 for
      the
      same periods in fiscal 2005. The
      increase in net interest and other income for the three and six months ended
      March 31, 2006 was primarily a result of higher interest rates on
      investments. We
      expect net interest and other income to remain relatively flat as we have
      limited cash reserves to invest.





**Liquidity
      and Capital Resources**





Since
      inception, we have financed our operations primarily through the sale of equity
      securities. As of March 31, 2006, we had cash and short-term investments
      totaling $9.3 million consisting of cash and cash equivalents of
      $4.9 million and $4.4 million of short-term investment with a maturity
      of greater than 90 days.




**Six
                Months Ended March 31,**
              **(in
                thousands)****2006**
            
            **2005**Cash
                and cash equivalents
            
            $
            4,867
            
            $
            3,117Short-term
                investments
            
            
            4,388
            
            
            6,565Total
                cash, cash equivalents and short-term investments
            
            $
            9,255
            
            $
            9,682Cash
                used in operating activities
            
            $
            (157
            )
            $
            (463
            )Cash
                provided by investing activities
            
            $
            843
            
            $
            418Cash
                provided by financing activities
            
            $
            218
            
            $
            264Net
                increase in cash and cash equivalents
            
            $
            904
            
            $
            219








*Changes
      in Cash Flows*





During
      the six months ended March 31, 2006, net cash used in operating activities
      of
      was $157,000, which was approximately $306,000 lower than the cash used in
      operating activities during the same period in fiscal 2005. This was primarily
      due to a lower net loss of $338,000, an increase in accounts payable and
      non-cash stock-based compensation expense of $436,000. The stock-based
      compensation expense is the result of our adoption of SFAS No. 123(R) starting
      on October 1, 2005. The lower loss was partially offset by an increase in
      inventory of $649,000 as well as an increase in accounts receivable of $201,000.
      Factors that helped to reduce the net cash used in operations were an increase
      of $257,000 in deferred revenue and depreciation and amortization of
      approximately $100,000.





For
      the
      six months ended March 31, 2006, net cash provided by investing activities
      was
      $843,000, which was primarily attributable to proceeds from maturities of
      short-term investments.





Net
      accounts receivable increased to $2.2 million at March 31, 2006 from
      $2.0 million at September 30, 2005. The increase in net accounts receivable
      was primarily due to higher deferred revenue and increases in days sales
      outstanding (DSO) at 47 days as of March 31, 2006 from 41 days as of September
      30, 2005.




16


We
      ended
      the second quarter of fiscal 2006 with a cash conversion cycle of 76 days
      as compared to 87 days for the second quarter of fiscal 2005. The cash
      conversion cycle is the duration between purchase of inventories and services
      and the collection of the cash from the sale of our products and services and
      is
      a metric on which we have focused as we continue to try to efficiently manage
      our assets. The cash conversion cycle results from the calculation of DSO added
      to days of supply in inventories (DOS), reduced by days of payable outstanding
      (DPO).




Inventories
      increased to $1.6 million at March 31, 2006 from $965,000 at September 30,
      2005 and our inventory turn rate decreased to 4.8 times at March 31, 2006 from
      6.8 times at September 30, 2005. Our annualized inventory turn rate
      represents the number of times inventory is replenished during the year. The
      increase in inventory is the result of higher finished goods and work in
      process. Inventory management will continue to be an area of focus as we balance
      the need to maintain strategic inventory levels to help ensure competitive
      lead
      times with the risk of inventory obsolescence due to rapidly changing technology
      and customer requirements.





Accounts
      payable increased to $972,000 at March 31, 2006 from $653,000 at
      September 30, 2005. This increase was primarily attributable to an increase
      in product purchased in fiscal 2006. Accrued payroll-related liabilities
      increased to $331,000 at March 31, 2006 from $317,000 at September 30,
      2005, primarily as a result of an increase of $8,000 in accrued commission
      and
      an increase of $6,000 in accrued vacation.




During
      the six months ended March 31, 2006, our net cash provided by financing
      activities was primarily attributable to the $218,000 of proceeds from the
      exercise of employee stock options and stock purchases through our employee
      stock purchase plan.





*Liquidity
      and Capital Resources*





We
      intend
      to continue to invest our cash in excess of current operating requirements
      in
      short-term, interest bearing investment-grade securities.





Our
      cash
      needs depend on numerous factors, including market acceptance of and demand
      for
      our products, our ability to develop and introduce new products and enhancements
      to existing products, the prices at which we can sell our products, the
      resources we devote to developing, marketing, selling and supporting our
      products, the timing and expense associated with expanding our distribution
      channels, increases in manufacturing costs and the prices of the components
      we
      purchase, as well as other factors. If we need and are unable to raise
      additional capital or if sales from our new products or enhancements are lower
      than expected, we will be required to make additional reductions in operating
      expenses and capital expenditures to ensure that we will have adequate cash
      reserves to fund operations.





Additional
      financing, if required, may not be available on acceptable terms, or at all.
      We
      also may require additional capital to acquire or invest in complementary
      businesses or products, or obtain the right to use complementary technologies.
      If we need and cannot raise funds on acceptable terms, we may not be able to
      further develop or enhance our products, take advantage of future opportunities,
      or respond to competitive pressures or unanticipated requirements, which could
      seriously harm our business. Even if additional financing is available, we
      may
      be required to obtain the consent of our stockholders, which we may or may
      not
      be able to obtain. In addition, the issuance of equity or equity-related
      securities will dilute the ownership interest of our stockholders and the
      issuance of debt securities could increase our risk or perceived
      risk.




We
      do not
      have any material commitments for capital expenditures as of March 31, 2006.
      We
      have commitments under our noncancellable operating lease in the amount of
      $1.3 million as of March 31, 2006. The following table represents our
      future commitments as of March 31, 2006 (in thousands):




Payment
                Due by PeriodContractual
                Obligations
            
            
            Total
            
            
            Less
                than
              1
                Year
            
            
            1
                -
                3 Years
            
            
            3
                -
                5 Years
            
            
            More
                than
              5
                YearsOperating
                leases obligation
            
            $
            1,082
            
            $
            258
            
            $
            732
            
            $
            92
            
            $
            —Capital
                leases obligation
            
            
            203
            
            
            26
            
            
            100
            
            
            77
            
            
            —Total
            
            $
            1,285
            
            $
            284
            
            $
            832
            
            $
            169
            
            $
            —





We
      believe we have sufficient cash reserves to allow us to continue operations
      for
      at least the next twelve months.




17


*Recent
      Accounting Pronouncements*





In
      May
      2005, the FASB issued SFAS No. 154, “Accounting Changes and Error
      Corrections” (“SFAS 154”) which replaces Accounting Principles Board
      Opinions No. 20 “Accounting Changes” and SFAS No. 3, “Reporting
      Accounting Changes in Interim Financial Statements—An Amendment of APB Opinion
      No. 28.” SFAS 154 provides guidance on the accounting for and
      reporting of accounting changes and error corrections. It establishes
      retrospective application, or the latest practicable date, as the required
      method for reporting a change in accounting principle and the reporting of
      a
      correction of an error. SFAS 154 is effective for accounting changes and
      corrections of errors made in fiscal years beginning after December 15,
      2005 is required to be adopted by us in the first quarter of fiscal year 2007.
      We are currently evaluating the effect that the adoption of SFAS 154 will
      have on our consolidated results of operations and financial condition but
      do
      not expect it to have a material impact.





**Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk.**





*Interest
      Rate Risk.* Our
      interest income is sensitive to changes in the general level of U.S. interest
      rates, particularly since the majority of our investments are in cash
      equivalents and short-term instruments. Due to the short-term nature of our
      cash
      equivalents and investments, we have concluded that a change in interest rates
      does not pose a material market risk to us.





*Foreign
      Currency Exchange Risk.* We
      face
      foreign exchange currency fluctuations with our subsidiary in China, however,
      due to the strength in China’s economy, we do not foresee foreign exchange
      currency fluctuations to pose a material market risk to us.





**Item
      4. Controls and Procedures****.**





*(a)*  *Evaluation
      of disclosure controls and procedures* .
      Our
      management evaluated, with the participation of our Chief Executive Officer
      and
      our Chief Financial Officer, the effectiveness of our disclosure controls and
      procedures as of the end of the period covered by this Quarterly Report on
      Form 10-Q. Based on this evaluation, our Chief Executive Officer and our
      Chief Financial Officer have concluded that our disclosure controls and
      procedures are effective to ensure that information we are required to disclose
      in reports that we file or submit under the Securities Exchange Act of 1934
      is
      accumulated and communicated to our management, including our principal
      executive and principal financial officers, as appropriate to allow timely
      decisions regarding required disclosure, and that such information is recorded,
      processed, summarized and reported within the time periods specified in
      Securities and Exchange Commission rules and forms.





*(b)*  *Changes
      in internal control over financial reporting* .
      There
      was no change in our internal control over financial reporting that occurred
      during the period covered by this Quarterly Report on Form 10-Q that has
      materially affected, or is reasonably likely to materially affect, our internal
      control over financial reporting.





18


**PART
      II. OTHER INFORMATION**





**Item
      1. Legal Proceedings.**





On
      September 6, 2002, Vertical Networks, Inc. filed suit against us in
      the United States District Court for the Northern District of California,
      alleging infringement of Vertical Networks’ U.S. Patents Nos. 6,266,341;
      6,289,025; 6,292,482; 6,389,009; and 6,396,849. On October 28, 2002,
      Vertical Networks amended its complaint to add allegations of infringement
      of
      U.S. Patents Nos. 5,617,418 and 5,687,174. Vertical Networks filed a second
      amended complaint on November 20, 2002 to identify our products and/or
      activities that allegedly infringe the seven patents-in-suit. Vertical Networks
      seeks a judgment of patent infringement and an award of damages, including
      treble damages for alleged willful infringement, and attorneys’ fees and costs.
      We filed an answer and counterclaims for declaratory relief on December 9,
      2002. On December 26, 2002, Vertical Networks filed its answer to our
      counterclaims. Vertical Networks served its preliminary infringement contentions
      on us on April 9, 2003 and we served Vertical Networks our preliminary
      invalidity contentions on June 3, 2003 and July 14, 2003. To date, the
      parties have exchanged some discovery, but no depositions have been taken,
      and
      no motions are currently pending. On October 7, 2003, the parties filed a
      stipulation to stay this action, pending the outcome of the reissue of some
      of
      the subject patents before the U.S. Patent and Trademark Office. We believe
      we
      have strong defenses and arguments in this dispute and intend to vigorously
      defend our position. Management’s view is that any loss from this litigation is
      currently not probable or estimable; therefore, the Company has not established
      a reserve on its balance sheets as to any liability related to the outcome
      of
      this action.





From
      time
      to time, we may become party to litigation and subject to claims arising in
      the
      ordinary course of our business. To date, these actions have not had a material
      adverse effect on our financial position, result of operations or cash flows.
      Although the results of litigation and claims cannot be predicted with
      certainty, we believe that the final outcome of such matters would not have
      a
      material adverse effect on our business, financial position, results of
      operation and cash flows.





**Item
      1A. Risk Factors**





**CERTAIN
      FACTORS AFFECTING BUSINESS, OPERATING RESULTS, AND FINANCIAL
      CONDITION**





You
      should carefully consider the risks described below and all of the information
      contained in this Form 10-Q. If any of the following risks occur, our
      business, financial condition and result of operations could be harmed, the
      trading price of our common stock could decline and you may lose all or part
      of
      your investment in our common stock.





***Risks
      Related to Our Business***





** ***We
      have had a history of losses and may incur future losses, which may prevent
      us
      from maintaining profitability*** *.*





We
      have
      had a history of operating losses since our inception, and as of March 31,
      2006,
      we had an accumulated deficit of $51.5 million. We may incur operating losses
      in
      the future, and these losses could be substantial and impact our ability to
      maintain profitability. We do not expect to increase expenditures for product
      development, general and administrative expenses, and sales and marketing
      expenses; however, if we cannot maintain current revenue or revenue growth,
      we
      will not achieve or sustain profitability or positive operating cash flows.
      Even
      if we achieve profitability and positive operating cash flows, we may not be
      able to sustain or increase profitability or positive operating cash flows
      on a
      quarterly or annual basis.





***Our
      operating results vary, making future operating results difficult to
      predict*** *.*





Our
      quarterly and annual operating results have varied significantly in the past
      and
      likely will vary significantly in the future. A number of factors, many of
      which
      are beyond our control, have caused and may cause our operating results to
      vary,
      including:





our
      ability to respond effectively to competitive pricing pressures;




•
              our
                  ability to respond effectively to competitive pricing
                  pressures;


•
            our
                ability to establish or increase market acceptance of our technology,
                products and systems;





•
            our
                success in expanding our network of distributors, dealers and companies
                that buy our products in bulk, customize them for particular applications
                or customers, and resell them under their own
                names;





•
            market
                acceptance of products and systems incorporating our technology and
                enhancements to our product applications on a timely
                basis;





•
            our
                ability to respond effectively to competitive pressures;





•
            our
                success in supporting our products and
                systems;





•
            our
                sales cycle, which may vary substantially from customer to
                customer;





•
            unfavorable
                changes in the prices and delivery of the components we
                purchase;





•
            the
                size and timing of orders for our products, which may vary depending
                on
                the season, and the contractual terms of the
                orders;





•
            the
                size and timing of our expenses, including operating expenses and
                expenses
                of developing new products and product
                enhancements;





•
            deferrals
                of customer orders in anticipation of new products, services or product
                enhancements introduced by us or by our competitors;
                and





•
            our
                ability to attain and maintain production volumes and quality levels
                for
                our products.




19


Our
      future projected budgets and commitments are based in part on our expectations
      of future sales. If our sales do not meet expectations, it will be difficult
      for
      us to reduce our expenses quickly and, consequently, our operating results
      may
      suffer.





Our
      dealers often require immediate shipment and installation of our products.
      As a
      result, we have historically operated with limited backlog, and our sales and
      operating results in any quarter primarily depend on orders booked and shipped
      during that quarter.





Any
      of
      the above factors could harm our business, financial condition and results
      of
      operations. We believe that period-to-period comparisons of our results of
      operations are not meaningful, and you should not rely upon them as indicators
      of our future performance.





***Our
      market is highly competitive and we may not have the resources to adequately
      compete*** *.*





The
      market for our integrated, multifunction telecommunications systems is new,
      rapidly evolving and highly competitive. We expect competition to intensify
      in
      the future as existing competitors develop new products and new competitors
      enter the market. We believe that a critical component to success in this market
      is the ability to establish and maintain strong partner and customer
      relationships with a wide variety of domestic and international providers.
      If we
      fail to establish or maintain these relationships, we will be at a serious
      competitive disadvantage.





We
      face
      competition from companies providing traditional private telephone systems.
      Our
      principal competitors that produce these telephone systems are Avaya
      Communications, NEC and Nortel Networks. We also compete against providers
      of
      multi-function telecommunications systems, including 3Com Corporation, and
      Cisco
      Systems, Inc., as well as any number of future competitors. Many of our
      competitors are substantially larger than we are and have significantly greater
      name recognition, financial resources, sales and marketing teams, technical
      and
      customer support, manufacturing capabilities and other resources. These
      competitors also may have more established distribution channels and stronger
      relationships with service providers. These competitors may be able to respond
      more rapidly to new or emerging technologies and changes in customer
      requirements or to devote greater resources to the development, promotion and
      sale of their products. These competitors may enter our existing or future
      markets with products that may be less expensive, provide higher performance
      or
      additional features or be introduced earlier than our phone systems. We also
      expect that other companies may enter our market with better products and
      technologies. If any technology that is competing with ours is more reliable,
      faster, less expensive or has other advantages over our technology, then the
      demand for our products and services could decrease and harm our
      business.





We
      expect
      our competitors to continue to improve the performance of their current products
      and introduce new products or new technologies. If our competitors successfully
      introduce new products or enhance their existing products, our sales or market
      acceptance of our products and services could be reduced, price competition
      could be increased or make our products could become obsolete. To remain
      competitive, therefore, we must continue to invest significant resources in
      research and development, sales and marketing and customer support. We may
      not
      have sufficient resources to make these investments or to make the technological
      advances necessary to be competitive, which in turn will cause our business
      to
      suffer.





***We
      sell our products through dealers and distributors, which limits our ability
      to
      control the timing of our sales, and which makes it more difficult to predict
      our revenue.***





We
      do not
      recognize revenue from the sale of our products to our distributors until these
      products are sold to either resellers or end-users. We have little control
      over
      the timing of product sales to dealers and end users. Our lack of control over
      the revenue that we recognize from our distributors’ sales to resellers and
      end-users limits our ability to predict revenue for any given period. Our future
      projected budgets and commitments are based in part on our expectations of
      future sales. If our sales do not meet expectations, it will be difficult for
      us
      to reduce our expenses quickly, and consequently our operating results may
      suffer.





20


***We
      rely on resellers to promote, sell, install and support our products, and their
      failure to do so may substantially reduce our sales and thus seriously harm
      our
      business*** *.*





We
      rely
      on resellers who can provide high quality sales and support services. As with
      our distributors, we compete with other telecommunications systems providers
      for
      our resellers’ business as our resellers generally market competing products. If
      a reseller promotes a competitor’s products to the detriment of our products or
      otherwise fails to market our products and services effectively, we could lose
      market share. In addition, the loss of a key reseller or the failure of
      resellers to provide adequate customer service could cause our business to
      suffer. If we do not properly train our resellers to sell, install and service
      our products, our business will suffer.





***Software
      or hardware errors may seriously harm our business and damage our reputation,
      causing loss of customers and revenue*** *.*





Users
      expect telephone systems to provide a high level of reliability. Our products
      are inherently complex and may have undetected software or hardware errors.
      We
      have detected and may continue to detect errors and product defects in our
      installed base of products, new product releases and product upgrades. End
      users
      may install, maintain and use our products improperly or for purposes for which
      they were not designed. These problems may degrade or terminate the operation
      of
      our products, which could cause end users to lose telephone service, cause
      us to
      incur significant warranty and repair costs, damage our reputation and cause
      significant customer relations problems. Any significant delay in the commercial
      introduction of our products due to errors or defects, any design modifications
      required to correct these errors or defects or any negative effect on customer
      satisfaction as a result of errors or defects could seriously harm our business,
      financial condition and results of operations.





Any
      claims brought because of problems with our products or services could seriously
      harm our business, financial condition and results of operations. We currently
      offer a one-year hardware guarantee to end-users. If our products fail within
      the first year, we face replacement costs. Our insurance policies may not
      provide sufficient or any coverage should a claim be asserted. In addition,
      our
      introduction of products and systems with reliability, quality or compatibility
      problems could result in reduced revenue, uncollectible accounts receivable,
      delays in collecting accounts receivable, warranties and additional costs.
      Our
      customers, end users or employees could find errors in our products and systems
      after we have begun to sell them, resulting in product redevelopment costs
      and
      loss of, or delay in, their acceptance by the markets in which we compete.
      Further, we may experience significant product returns in the future. Any of
      these events could have a material adverse effect on our business, financial
      condition and results of operations.





***Our
      market is subject to changing preferences; failure to keep up with these changes
      would result in our losing market share, thus seriously harming our business,
      financial condition and results of operations.***





Our
      customers and end users expect frequent product introductions and have changing
      requirements for new products and features. In order to be competitive,
      therefore, we need to develop and market new products and product enhancements
      that respond to these changing requirements on a timely and cost-effective
      basis. Our failure to do so promptly and cost effectively would seriously harm
      our business, financial condition and results of operations. Also, introducing
      new products could require us to write-off existing inventory as obsolete,
      which
      could harm our results of operations.





***We
      depend on attracting and retaining qualified personnel to maintain and expand
      our business; our failure to promptly attract and retain qualified personnel
      may
      seriously harm our business, financial condition and results of
      operations*** *.*





We
      depend, in large part, on our ability to attract and retain highly skilled
      personnel, particularly engineers and sales and marketing personnel. We need
      highly trained technical personnel to design and support our server-based
      telecommunications systems. In addition, we need highly trained sales and
      marketing personnel to expand our marketing and sales operations in order to
      increase market awareness of our products and generate increased revenue.
      Competition for highly trained personnel is intense, especially in the San
      Francisco Bay Area where most of our operations are located. We cannot be
      certain that we will be successful in our recruitment and retention efforts.
      If
      we fail to attract or retain qualified personnel or suffer from delays in hiring
      required personnel, our business, financial condition and results of operations
      may be seriously harmed.





***FASB’s
      adoption of SFAS No. 123(R) will cause, and changes to existing accounting
      pronouncements or taxation rules or practices may cause, adverse revenue
      fluctuations, affect our reported results of operations or how we conduct our
      business*** *.*





In
      December 2004, the FASB issued SFAS No. 123(R), Stock-Based Compensation, which
      establishes standards for transactions in which an entity exchanges its equity
      instruments for goods or services. In March 2005, the SEC issued Staff
      Accounting Bulletin No. 107 - Stock-Based Compensation, which provides
      interpretive guidance related to SFAS No. 123(R). SFAS No. 123(R) requires
      a
      public entity to measure the cost of employee services received in exchange
      for
      an award of equity instruments based on the grant-date fair value of the award.
      This eliminates the exception to account for such awards using the intrinsic
      method previously allowable under APB Opinion No. 25. SFAS No. 123(R). We have
      adopted this standard starting October 1, 2005. This standard will have material
      impact on our results of operations.




21


Also,
      a
      change in accounting pronouncements or taxation rules or practices can have
      a
      significant effect on our reported results and may even affect our reporting
      of
      transactions completed before the change is effective. Other new accounting
      pronouncements or taxation rules and varying interpretations of accounting
      pronouncements or taxation practice have occurred and may occur in the future.
      This change to existing rules, future changes, if any, or the questioning of
      current practices may adversely affect our reported financial results or the
      way
      we conduct our business.





***If,
      as of the end of our 2007 fiscal year, we are unable to assert that our internal
      control over financial reporting is effective, or if our auditors are unable
      to
      confirm our assessment, investors could lose confidence in our reported
      financial information, and the trading price of our stock price and our business
      could be adversely affected.***




We
      are in
      the process of documenting, and plan to test during the current fiscal year,
      our
      internal control procedures in order to satisfy the requirements of Section
      404
      of the Sarbanes-Oxley Act. Commencing on September 30, 2007, the end of our
      2007
      fiscal year, the Sarbanes-Oxley Act will require annual management assessments
      of the effectiveness of our internal controls over financial reporting and
      a
      report by our independent registered public accounting firm addressing these
      assessments. During the course of our testing we may identify deficiencies
      which
      we may not be able to remediate in time to meet the deadline imposed by the
      Sarbanes-Oxley Act for compliance with the requirements of Section 404. In
      addition, if we fail to achieve and maintain the adequacy of our internal
      controls, as such standards are modified, supplemented, or amended from time
      to
      time, we may not be able to ensure that we can conclude on an ongoing basis
      that
      we have effective internal controls over financial reporting in accordance
      with
      Section 404 of the Sarbanes-Oxley Act. Effective internal controls are important
      to help produce reliable financial reports and to prevent financial fraud.
      If we
      are unable to assert that our internal control over financial reporting is
      effective as of the end of our 2007 fiscal year, or if our auditors are unable
      to attest that our management’s report is fairly stated or they are unable to
      express an opinion on our management’s evaluation or on the effectiveness of the
      internal controls, we could lose investor confidence in the accuracy and
      completeness of our financial reports, investors could lose confidence in our
      reported financial information, and the trading price of our stock and our
      business could be adversely affected.





***If
      we do not manage our growth effectively, our business will
      suffer.***





We
      may
      not be successful in managing our future growth. We have expanded our operations
      rapidly since our inception. In order to manage this expansion and grow in
      the
      future, we will need to expand or enhance our management, manufacturing,
      research and development and sales and marketing capabilities. We may not be
      able to hire the management, staff or other personnel required to do
      so.





We
      may
      not be able to install adequate control systems in an efficient and timely
      manner, and our current or planned operational systems, procedures and controls
      may not be adequate to support our future operations. Difficulties in installing
      and implementing new systems, procedures and controls may significantly burden
      our management and our internal resources. Delays in the implementation of
      new
      systems or operational disruptions when we transition to new systems would
      impair our ability to accurately forecast sales demand, manage our product
      inventory and record and report financial and management information on a timely
      and accurate basis.





Lead
      times for materials and components used in the assembly of our products vary
      significantly, and depend on factors such as the supplier, contract terms and
      demand for a component at a given time. If orders do not match forecasts, we
      may
      have excess or inadequate inventory of certain materials and components, which
      may seriously harm our business, financial condition and results of
      operations.





***Losing
      any of our key distributors would harm our business. We also need to establish
      and maintain relationships with additional distributors and original equipment
      manufacturers*** *.*





Sales
      through our three key distributors, Altisys, Graybar and Synnex, accounted
      for
      84% and 86% for the three and six months end months ended March 31, 2006,
      respectively. Our business and operating results will suffer if any one of
      these
      distributors does not continue distributing our products, fails to distribute
      the volume of our products that it currently distributes or fails to expand
      our
      customer base. We also need to establish and maintain relationships with
      additional distributors and original equipment manufacturers. We may not be
      able
      to establish, or successfully manage, relationships with additional distribution
      partners. In addition, our agreements with distributors typically provide for
      termination by either party upon written notice to the other party. For example,
      our agreement with Synnex provides for termination, with or without cause,
      by
      either party upon 30 days’ written notice to the other party, or upon
      insolvency or bankruptcy. Generally, these agreements are non-exclusive and
      distributors sell products that compete with ours. If we fail to establish
      or
      maintain relationships with distributors and original equipment manufacturers,
      our ability to increase or maintain our sales and our customer base will be
      substantially harmed.





***We
      rely on sole-sourced components and third party technology and products; if
      these components are not available, our business may
      suffer*** *.*





We
      purchase technology from third parties that are incorporated into many of our
      products, including virtually all of our hardware products. We order
      sole-sourced components using purchase orders and do not have supply contracts
      for them. One sole-sourced component, a Texas Instruments Digital Processing
      (TI
      DSP) chip, is particularly important to our business because it is included
      in
      virtually all of our hardware products. If we were unable to purchase an
      adequate supply of these sole-sourced components on a timely basis, we would
      be
      required to develop alternative products, which could entail qualifying an
      alternative source or redesigning our products based on different components.
      Our inability to obtain these sole-sourced components, especially the Texas
      Instruments Digital Processing (TI DSP) chip, could significantly delay shipment
      of our products, which could have a negative effect on our business, financial
      condition and results of operations





22


***Compliance
      with changing regulations of corporate governance and public disclosure may
      result in additional expenses*** *.*




Changing
      laws, regulations and standards relating to corporate governance and public
      disclosure, including the Sarbanes-Oxley Act, new SEC regulations and Nasdaq
      National Market rules, are creating uncertainty for companies such as ours.
      These new or changed laws, regulations and standards are subject to varying
      interpretations in many cases due to their lack of specificity, and as a result,
      their application in practice may evolve over time as new guidance is provided
      by regulatory and governing bodies, which could result in continuing uncertainty
      regarding compliance matters and higher costs necessitated by ongoing revisions
      to disclosure and governance practices. As a result, our efforts to comply
      with
      evolving laws, regulations and standards have resulted in, and are likely to
      continue to result in, increased general and administrative expenses and a
      diversion of management time and attention from revenue-generating activities
      to
      compliance activities. In particular, our efforts to comply with Section 404
      of
      the Sarbanes-Oxley Act and the related regulations regarding our required
      assessment of our internal controls over financial reporting and our external
      auditors’ audit of that assessment has required the commitment of significant
      financial and managerial resources. We expect these efforts to require the
      continued commitment of significant resources. Further, our board members,
      chief
      executive officer, and chief financial officer could face an increased risk
      of
      personal liability in connection with the performance of their duties. As a
      result, we may have difficulty attracting and retaining qualified board members
      and executive officers, which could harm our business. If our efforts to comply
      with new or changed laws, regulations and standards differ from the activities
      intended by regulatory or governing bodies due to ambiguities related to
      practice, our reputation may be harmed.





***Our
      facility is vulnerable to damage from earthquakes and other natural disasters
      and other business interruptions; any such damage could seriously or completely
      impair our business.***





We
      perform final assembly, software installation and testing of our products at
      our
      facility in Fremont, California. Our facility is located on or near known
      earthquake fault zones and may be subject to rolling electrical blackouts and
      is
      vulnerable to damage or interruption from fire, floods, earthquakes, power
      loss,
      telecommunications failures and similar events. If such a disaster or
      interruption occurs, our ability to perform final assembly, software
      installation and testing of our products at our facility would be seriously,
      if
      not completely, impaired. If we were unable to obtain an alternative place
      or
      way to perform these functions, our business, financial condition and results
      of
      operations would suffer. The insurance we maintain may not be adequate to cover
      our losses against fires, floods, earthquakes and general business
      interruptions. We
      engage
      third-party assemblers to insert the hardware components into the printed
      circuit board. We selected our manufacturing partners with the goals of ensuring
      a reliable supply of high-quality finished products and lowering per unit
      product costs as a result of manufacturing economies of scale.





***Our
      strategy to outsource assembly and test functions in the future could delay
      delivery of products, decrease quality or increase
      costs.***





Based
      on
      volume or customer requirements, we may begin outsourcing some assembly and
      test
      functions. In addition, we may determine that we need to establish assembly
      and
      test operations overseas to better serve our international customers.
      Establishing overseas assembly and test operations may be more difficult or
      take
      longer than we anticipate. This outsourcing strategy involves certain risks,
      including the potential lack of adequate capacity and reduced control over
      delivery schedules, manufacturing yield, quality and costs. In the event that
      any significant subcontractors were to become unable or unwilling to continue
      to
      manufacture or test our products in the required volumes, we would have to
      identify and qualify acceptable replacements. Finding replacements could take
      time and we cannot be sure that additional sources would be available to us
      on a
      timely basis. Any delay or increase in costs in the assembly and testing of
      products by third-party subcontractors could seriously harm our business,
      financial condition and results of operations.





***Our
      planned expansion in international markets will involve new risks that our
      previous domestic operations have not prepared us to address; our failure to
      address these risks could harm our business, financial condition and results
      of
      operations.***





For
      the
      three and six months ended March 31, 2006, approximately 7% and 8%, respectively
      and of our net revenue came from customers outside of the Americas. We intend
      to
      expand our international sales and marketing efforts. Our efforts are subject
      to
      a variety of risks associated with conducting business internationally, any
      of
      which could seriously harm our business, financial condition and results of
      operations. These risks include:





•
            tariffs,
                duties, price controls or other restrictions on foreign currencies
                or
                trade barriers, such as import or export licensing imposed by foreign
                countries, especially on
                technology;





•
            potential
                adverse tax consequences, including restrictions on repatriation
                of
                earnings;





•
            fluctuations
                in foreign currency exchange rates, which could make our products
                relatively more expensive in foreign markets;
                and





•
            conflicting
                regulatory requirements in different countries that may require us
                to
                invest significant resources customizing our products for each
                country.




23


***Any
      failure by us to protect our intellectual property could harm our business
      and
      competitive position*** *.*





Our
      success depends, to a certain extent, upon our proprietary technology. We
      currently rely on a combination of patent, trade secret, copyright and trademark
      law, together with non-disclosure and invention assignment agreements, to
      establish and protect the proprietary rights in the technology used in our
      products.





Although
      we have filed patent applications, we are not certain that our patent
      applications will result in the issuance of patents, or that any patents issued
      will provide commercially significant protection of our technology. In addition,
      other individuals or companies may independently develop substantially
      equivalent proprietary information not covered by patents to which we own
      rights, may obtain access to our know-how or may claim to have issued patents
      that prevent the sale of one or more of our products. Also, it may be possible
      for third parties to obtain and use our proprietary information without our
      authorization. Further, the laws of some countries, such as those in Japan,
      one
      of our target markets, may not adequately protect our intellectual property
      or
      such protection may be uncertain. Our success also depends on trade secrets
      that
      cannot be patented and are difficult to protect. If we fail to protect our
      proprietary information effectively, or if third parties use our proprietary
      technology without authorization, our competitive position and business will
      suffer.





***If
      we are unable to raise additional capital when needed, we may be unable to
      develop or enhance our products and services*** *.*





We
      may
      seek additional funding in the future. If we cannot raise funds on acceptable
      terms, we may be unable to develop or enhance our products and services, take
      advantage of future opportunities or respond to competitive pressures or
      unanticipated requirements. We also may be required to reduce operating costs
      through lay-offs or reduce our sales and marketing or research and development
      efforts. If we issue equity securities, stockholders may experience additional
      dilution or the new equity securities may have rights, preferences or privileges
      senior to those of our common stock.





***We
      may face infringement issues that could harm our business by requiring us to
      license technology on unfavorable terms or temporarily or permanently cease
      sales of key products*** *.*





We
      may
      become parties to litigation in the normal course of our business. Litigation
      in
      general, and intellectual property and securities litigation in particular,
      can
      be expensive and disruptive to normal business operations. Moreover, the results
      of complex litigation are difficult to predict.





On
      September 6, 2002, Vertical Networks, Inc. filed suit against us in
      the United States District Court for the Northern District of California,
      alleging infringement of Vertical Networks’ U.S. Patents Nos. 6,266,341;
      6,289,025; 6,292,482; 6,389,009; and 6,396,849. On October 28, 2002,
      Vertical Networks amended its complaint to add allegations of infringement
      of
      U.S. Patents Nos. 5,617,418 and 5,687,174. Vertical Networks filed a second
      amended complaint on November 20, 2002 to identify our products and/or
      activities that allegedly infringe the seven patents-in-suit. Vertical Networks
      seeks a judgment of patent infringement and an award of damages, including
      treble damages for alleged willful infringement, and attorneys’ fees and costs.
      We filed an answer and counterclaims for declaratory relief on December 9,
      2002. On December 26, 2002, Vertical Networks filed its answer to our
      counterclaims. Vertical Networks served its preliminary infringement contentions
      on us on April 9, 2003 and we served Vertical Networks our preliminary
      invalidity contentions on June 3, 2003 and July 14, 2003. To date, the
      parties have exchanged some discovery, but no depositions have been taken,
      and
      no motions are currently pending. On October 7, 2003, the parties filed a
      stipulation to stay this action, pending the outcome of the reissue of some
      of
      the subject patents before the U.S. Patent and Trademark Office. We believe
      we
      have strong defenses and arguments in this dispute and intend to vigorously
      defend our position. Management’s view is that any loss from this litigation is
      currently not probable or estimable. Therefore, we have not established a
      reserve on our balance sheets as to any liability related to the outcome of
      this
      action.





More
      generally, litigation related to these types of claims may require us to acquire
      licenses under third party patents that may not be available on acceptable
      terms, if at all. We believe that an increasing portion of our revenue in the
      future will come from sales of software applications for our hardware products.
      The software market traditionally has experienced widespread unauthorized
      reproduction of products in violation of developers’ intellectual property
      rights. This activity is difficult to detect, and legal proceedings to enforce
      developers’ intellectual property rights are often burdensome and involve a high
      degree of uncertainty and substantial costs.





***Our
      products may not meet the legal standards required for their sale in some
      countries; if we cannot sell our products in these countries, our results of
      operations may be seriously harmed.***





The
      United States and other countries in which we intend to sell our products have
      standards for safety and other certifications that must be met for our products
      to be legally sold in those countries. We have tried to design our products
      to
      meet the requirements of the countries where we sell or plan to sell them.
      We
      also have obtained or are trying to obtain the certifications that we believe
      are required to sell our products in these countries. We cannot, however,
      guarantee that our products meet all of these standards or that we will be
      able
      to obtain any certifications required. In addition, there is, and will likely
      continue to be, an increasing number of laws and regulations pertaining to
      the
      products we offer and may offer in the future. These laws or regulations may
      include, for example, more stringent safety standards, requirements for
      additional or more burdensome certifications or more stringent consumer
      protection laws.





If
      our
      products do not meet a country’s standards or we do not receive the
      certifications required by a country’s laws or regulations, then we may not be
      able to sell our products in that country. This inability to sell our products
      may seriously harm our results of operation by reducing our sales or requiring
      us to invest significant resources to conform our products to these
      standards.





24


***Risks
      Related to the Industry***





***Integrated,
      multifunction telecommunications systems may not achieve widespread
      acceptance.***





The
      market for integrated, multifunction telecommunications systems is relatively
      new and rapidly evolving. Businesses have invested substantial resources in
      the
      existing telecommunications infrastructure, including traditional private
      telephone systems, and may be unwilling to replace these systems in the near
      term or at all. Businesses also may be reluctant to adopt integrated,
      multifunction telecommunications systems because of their concern about the
      current limitations of data networks, including the Internet. For example,
      end
      users sometimes experience delays in receiving calls and reduced voice quality
      during calls when routing calls over data networks. Moreover, businesses that
      begin to route calls over the same networks that currently carry only their
      data
      also may experience these problems if the networks do not have sufficient
      capacity to carry all of these communications at the same time.





***Evolving
      standards may delay our product introductions, increase our product development
      costs or cause end users to defer or cancel plans to purchase our products,
      any
      of which could adversely affect our business.***




The
      standards in our market are still evolving. These standards are designed to
      ensure that integrated, multifunction telecommunications products from different
      manufacturers can operate together. Some of these standards are proposed by
      other participants in our market, including some of our competitors, and include
      proprietary technology. In recent years, these standards have changed, and
      new
      standards have been proposed, in response to developments in our market. Our
      failure to conform our products to existing or future standards may limit their
      acceptance by market participants. We may not anticipate which standards will
      achieve the broadest acceptance in our market in the future, and we may take
      a
      significant amount of time and expense to adapt our products to these standards.
      We also may have to pay additional royalties to developers of proprietary
      technologies that become standards in our market. These delays and expenses
      may
      seriously harm our results of operations. In addition, customers and users
      may
      defer or cancel plans to purchase our products due to concerns about the ability
      of our products to conform to existing standards or to adapt to new or changed
      standards, and this could seriously harm our results of operations.





***Future
      regulation or legislation could harm our business or increase our cost of doing
      business*** *.*





The
      Federal Communications Commission (FCC) has submitted a report to Congress
      stating that it may regulate certain Internet services if it determines that
      such Internet services are functionally equivalent to conventional
      telecommunications services. The increasing growth of the voice over data
      network market and the popularity of supporting products and services, heighten
      the risk that national governments will seek to regulate the transmission of
      voice communications over networks such as the Internet. In addition, large
      telecommunications companies may devote substantial lobbying efforts to
      influence the regulation of this market so as to benefit their interests, which
      may be contrary to our interests. These regulations may include, for example,
      assessing access or settlement charges, imposing tariffs or imposing regulations
      based on encryption concerns or the characteristics and quality of products
      and
      services. In February 2004, the FCC found that an entirely Internet based voice
      over Internet protocol service was an unregulated information service. At the
      same time, the FCC began a broader proceeding to examine what its role should
      be
      in this new environment of increased consumer choice and what can be done to
      meet its role of safeguarding the public interest. Future laws, legal decisions
      or regulations, as well as changes in interpretations of existing laws and
      regulations, could require us to expend significant resources to comply with
      them. In addition, these future events or changes may create uncertainty in
      our
      market that could reduce demand for our products.




25


**Item
      2. Unregistered Sales of Equity Securities and Use of
      Proceeds.**





None





**Item
      3. Defaults Upon Senior Securities.**





None





**Item
      4. Submission of Matters to a Vote of Security Holders.**




On
      February 9, 2006, we held our annual meeting of stockholders to seek their
      approval as to the following matters:




·
            The
                re-election of Kenneth Tai and Tacheng Chester Wang as Class I
                directors.




As
      to the
      re-election:




·
            Mr.
                Tai received 12,427,425 votes for re-election and 91,860 shares withheld.


·
            Mr.
                Wang received 12,421,575 votes for re-election and 97,710 shares
                withheld.





The
      ratification of the appointment of Deloitte & Touche LLP as our independent
      registered public accounting firm for the fiscal year ending September 30,
      2006.




As
      to the
      ratification of the appointment of Deloitte & Touche LLP:




12,470,552
      shares voted for the appointment, 23,614 shares voted against the appointment
      and 25,119 shares abstained from voting.




In
      addition, the terms of the following directors continued after the date of
      the
      meeting: Richard B. Black, Gilbert Hu and Mike Mon Yen Tsai.




There
      were 14,902,501 shares issued, outstanding and eligible to vote at the meeting.





**Item
      5. Other Information.**





None





**Item
      6. Exhibits.**





Please
      refer to the Exhibit Index of this report on Form 10-Q.




26


**SIGNATURE**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.





ALTIGEN
                COMMUNICATIONS, INC.Date:
                May 15, 2006
            By:
            /s/ Philip
              M.
              McDermottPhilip
                M. McDermott,Chief
                Financial Officer
              (Principal
                  Financial and Accounting
                  Officer)




27


**EXHIBIT
      INDEX**





**Exhibit**
              **Number**
            
            **Description**3.1
                (1)
            
            Amended
                and Restated Certificate of Incorporation.3.2
                (2)
            
            Second
                Amended and Restated Bylaws.31.1
            
            Certification
                of Principal Executive Officer, filed herewith.31.2
            
            Certification
                of Principal Financial Officer, filed herewith.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, filed
                herewith.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, filed
                herewith.







(1)
            Incorporated
                by reference to exhibit filed with the Registrant’s Registration Statement
                on Form S-1 (No. 333-80037) declared effective on
                October 4, 1999.(2)
            Incorporated
                by reference to exhibit filed with the Registrant’s Quarterly Report on
                Form 10-Q for the quarter ended March 31,
                2004.








28