**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**











**FORM
      10-Q**





**ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                EXCHANGE ACT OF 1934****FOR
                THE QUARTERLY PERIOD ENDED MARCH 31, 2007****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**








Former
      name, former address and former fiscal year, if changed since last report:
      N/A




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 ý 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.


Large
      accelerated filer o Accelerated filer o Non-accelerated filer ý





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 9, 2007
      was: 15,586,050 shares













**Table
      of Contents**





**PART
                I. FINANCIAL INFORMATION**Item
                1.
            Condensed
                Consolidated Financial StatementsCondensed
                Consolidated Balance Sheets as of March 31, 2007 and September 30,
                2006
                (Unaudited)
            3Condensed
                Consolidated Statements of Operations for the Three and Six Months
                Ended
                March 31, 2007 and 2006 (Unaudited)
            4Condensed
                Consolidated Statements of Cash Flows for the Six Months Ended March
                31,
                2007 and 2006 (Unaudited)
            5Notes
                to Condensed Consolidated 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
                6.
            Exhibits
            19**SIGNATURE**
            20**EXHIBIT
                INDEX**
            21





2


**PART
      I. FINANCIAL INFORMATION**





**Item
                1.**
            **Condensed
                Consolidated Financial
                Statements**





**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(UNAUDITED)**


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





**March,
                31,**
              **2007**
            
            **September
                30,**
              **2006****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            6,813
            
            $
            5,053Short-term
                investments
            
            
            3,010
            
            
            4,869Accounts
                receivable, net of allowances of $42 and $38 at March 31,2007 and
                September 30, 2006, respectively.
            
            
            1,582
            
            
            2,230Inventories
            
            
            1,950
            
            
            1,382Prepaid
                expenses and other current assets
            
            
            204
            
            
            123Total
                current assets
            
            
            13,559
            
            
            13,657Property
                and equipment:Furniture
                and equipment
            
            
            1,816
            
            
            1,783Computer
                software
            
            
            920
            
            
            9202,736
            
            
            2,703Less:
                Accumulated depreciation
            
            
            (2,146
            )
            
            (2,022
            )Net
                property and equipment
            
            
            590
            
            
            681Other
                non-current assets:Long-term
                investments
            
            
            208
            
            
            211Long-term
                deposit
            
            
            95
            
            
            95Total
                other non-current assets
            
            
            303
            
            
            306Total
                assets
            
            $
            14,452
            
            $
            14,644**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            675
            
            $
            837Accrued
                liabilities:Payroll
                and related benefits
            
            
            316
            
            
            328Warranty
            
            
            257
            
            
            263Marketing
            
            
            77
            
            
            68Accrued
                expense
            
            
            239
            
            
            263Other
            
            
            331
            
            
            340Deferred
                revenue
            
            
            486
            
            
            531Total
                current liabilities
            
            
            2,381
            
            
            2,630Long-term
                deferred rent and other
            
            
            135
            
            
            177Stockholders'
                equity:Convertible
                preferred stock, $0.001 par value; Authorized—5,000,000
                shares; Outstanding—none
                at March 31, 2007 and September 30, 2006
            
            
            —
            
            
            —Common
                stock, $0.001 par value; Authorized—50,000,000
                shares; Outstanding—16,269,508
                shares at March 31, 2007 and16,157,364
                shares at September 30, 2006
            
            
            16
            
            
            16Treasury
                stock at cost—1,063,895 shares at March 31, 2007 and September 30, 2006
            
            
            (1,014
            )
            
            (1,014
            )Additional
                paid-in capital
            
            
            64,358
            
            
            63,993Accumulated
                other comprehensive loss
            
            
            —
            
            
            —Accumulated
                deficit
            
            
            (51,424
            )
            
            (51,158
            )Total
                stockholders' equity
            
            
            11,936
            
            
            11,837Total
                liabilities and stockholders' equity
            
            $
            14,452
            
            $
            14,644





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




3




**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**(UNAUDITED)**


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





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Net
                revenue:Hardware
            
            $
            3,842
            
            $
            3,828
            
            $
            7,801
            
            $
            7,923Software
            
            
            303
            
            
            346
            
            
            716
            
            
            654Total
                net revenue
            
            
            4,145
            
            
            4,174
            
            
            8,517
            
            
            8,577Cost
                of revenue:Hardware
            
            
            1,876
            
            
            1,909
            
            
            3,860
            
            
            3,906Software
            
            
            28
            
            
            26
            
            
            55
            
            
            47Total
                cost of revenue
            
            
            1,904
            
            
            1,935
            
            
            3,915
            
            
            3,953Gross
                profit
            
            
            2,241
            
            
            2,239
            
            
            4,602
            
            
            4,624Operating
                expenses:Research
                and development
            
            
            825
            
            
            895
            
            
            1,642
            
            
            1,922Sales
                and marketing
            
            
            1,109
            
            
            999
            
            
            2,278
            
            
            2,090General
                and administrative
            
            
            590
            
            
            527
            
            
            1,172
            
            
            1,085Total
                operating expenses
            
            
            2,524
            
            
            2,421
            
            
            5,092
            
            
            5,097Loss
                from operations
            
            
            (283
            )
            
            (182
            )
            
            (490
            )
            
            (473
            )Equity
                in net loss of investee
            
            
            (1
            )
            
            (14
            )
            
            (4
            )
            
            (24
            )Interest
                and other income, net
            
            
            115
            
            
            85
            
            
            235
            
            
            168Net
                loss before tax
            
            
            (169
            )
            
            (111
            )
            
            (259
            )
            
            (329
            )Income
                taxes
            
            
            (3
            )
            
            (9
            )
            
            (7
            )
            
            (9
            )Net
                loss
            
            $
            (172
            )
            $
            (120
            )
            $
            (266
            )
            $
            (338
            )Basic
                and diluted net loss per share
            
            $
            (0.01
            )
            $
            (0.01
            )
            $
            (0.02
            )
            $
            (0.02
            )Weighted
                average shares used in computing basic and diluted net loss per
                share
            
            
            15,163
            
            
            14,937
            
            
            15,146
            
            
            14,889





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




4




**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(UNAUDITED)**


**(In
      thousands)**




**Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss
            
            $
            (266
            )
            $
            (338
            )Adjustments
                to reconcile net income (loss) to net cash used in operating
                activities:Depreciation
            
            
            124
            
            
            100Stock
                based compensation
            
            
            256
            
            
            436Equity
                in net loss of investee
            
            
            3
            
            
            24Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            648
            
            
            (201
            )Inventories
            
            
            (568
            )
            
            (649
            )Prepaid
                expenses and other current assets
            
            
            (81
            )
            
            (105
            )Accounts
                payable
            
            
            (162
            )
            
            319Accrued
                liabilities
            
            
            (42
            )
            
            38Deferred
                revenue
            
            
            (45
            )
            
            257Long-term
                deferred rent and other
            
            
            (42
            )
            
            (38
            )Net
                cash used in operating activities
            
            
            (175
            )
            
            (157
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchases
                of short-term investments
            
            
            (10,997
            )
            
            (6,404
            )Proceeds
                from sale of short-term investments
            
            
            12,856
            
            
            7,476Purchases
                of property and equipment
            
            
            (33
            )
            
            (229
            )Net
                cash provided by investing activities
            
            
            1,826
            
            
            843CASH
                FLOWS FROM FINANCING ACTIVITIES:Proceeds
                from issuances of common stock, net of issuance costs
            
            
            109
            
            
            218Net
                cash provided by financing activities
            
            
            109
            
            
            218NET
                INCREASE IN CASH AND CASH EQUIVALENTS
            
            
            1,760
            
            
            904CASH
                AND CASH EQUIVALENTS, BEGINNING OF PERIOD
            
            
            5,053
            
            
            3,963CASH
                AND CASH EQUIVALENTS, END OF PERIOD
            
            $
            6,813
            
            $
            4,867SUPPLEMENTAL
                DISCLOSURE OF CASH FLOW INFORMATION:Cash
                paid during the period for:Income
                taxes
            
            $
            (1
            )
            $
            (1
            )Interest
            
            $
            7
            
            $
            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 and market leader in
      Voice over Internet Protocol (VoIP) telephony systems for small-to 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 function with other technologies to provide integrated voice and data
      solutions. We believe this enables our customers to implement communication
      systems that have an increased return versus past technology
      investments.





The
      accompanying unaudited condensed consolidated financial statements have been
      prepared in conformity with generally accepted accounting principles for interim
      financial information and with the instructions for Form 10-Q and Article 10
      of
      Regulation S-X. Accordingly, certain information and footnote disclosures
      normally included in financial statements prepared in accordance with generally
      accepted accounting principles have been condensed, or omitted, pursuant to
      the
      rules and regulations of the Securities and Exchange Commission (the “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, 2006, included
      in
      the Company’s 2006 Annual Report on Form 10-K filed with the SEC on December 29,
      2006. 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.





**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, 2007, our cash and cash equivalents
      consisted of commercial paper and cash deposited in checking and money market
      accounts.





**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 value. Provisions, when required, are made to reduce
      excess and obsolete inventories to their estimated net realizable values. 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. A s
      of
      September 30, 2006, we recognized $122,000 of provision for excess and obsolete
      inventories offset by a $301,000 reversal of inventories from prior year. For
      the six months ended March 31, 2007, we recognized $9,000 of
      provision for excess and obsolete inventories. We did not record any provision
      for excess and obsolete inventories for the six months ended March 31, 2006.
      The
      components of inventories include (in thousands):





**March
                31,**
            
            **September
                30,****2007**
            
            **2006**Raw
                materials
            
            $
            655
            
            $
            497Work-in-progress
            
            
            205
            
            
            75Finished
                goods
            
            
            1,090
            
            
            810$
            1,950
            
            $
            1,382







6


**LONG-TERM
      INVESTMENTS**





As
      of
      March 31, 2007, we held an investment of common stock in a private Taiwanese
      telecommunication company valued at approximately $195,000 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 of their results in our results of operations. As of March 31, 2007,
      our investment in the Korean company had a remaining book value of approximately
      $12,000.





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. No write-downs
      were recorded as of March 31, 2007.





**REVENUE
      RECOGNITION**





We
      account for the recognition of software license revenue in accordance with
      Statement of Position ("SOP") 97-2, "Software 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 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 consist 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), Stock-Based Compensation (“SFAS No. 123(R)”),
      which requires all share-based compensations, including grants of stock options,
      to be recognized in the income statement as an operating expense, based on
      their
      fair values.





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,” and
      comply with the disclosure provisions of SFAS No. 123, as amended by SFAS
      No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosures.”
The Company has applied
      the modified prospective method in adopting SFAS No. 123(R). Accordingly,
      periods prior to adoption have not been restated.




7




As
      of
      October 1, 2005, under the adoption of SFAS No. 123(R) 1.3 million of unvested
      stock options were outstanding.





The
      following table summarizes the total stock-based compensation expense for the
      three and six months ended March 31, 2007 and March 31, 2006 from all of the
      Company’s stock compensation plans, included in the Unaudited Condensed
      Consolidated Statements of Operations (in thousands):





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Cost
                of goods sold
            
            $
            4
            
            $
            8
            
            $
            11
            
            $
            20Research
                and development
            
            
            36
            
            
            59
            
            
            89
            
            
            159Selling,
                general and administrative
            
            
            65
            
            
            109
            
            
            156
            
            
            257Pre-tax
                stock-based compensation expense
            
            
            105
            
            
            176
            
            
            256
            
            
            436Income
                tax
            
            
            —
            
            
            —
            
            
            —
            
            
            —Net
                stock-based compensation expense
            
            $
            105
            
            $
            176
            
            $
            256
            
            $
            436








The
      fair
      value of each option grant during the six months ended March 31, 2007 and March
      31, 2006 was 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,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Expected
                Life (in years)
            
            5
            
            5
            
            5
            
            5Risk-free
                interest rate
            
            4.8
            %
            4.4
            %
            4.8
            %
            4.4
            %Volatility
            
            92
            %
            96
            %
            92
            %
            96
            %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 month ended March 31, 2007 and March 31, 2006
      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,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Expected
                Life (in years)
            
            0.5
            
            0.5
            
            0.5
            
            0.5Risk-free
                interest rate
            
            5.1
            %
            4.3
            %
            5.1
            %
            4.3
            %Volatility
            
            91
            %
            98
            %
            91
            %
            98
            %Expected
                dividend
            
            0.0
            %
            0.0
            %
            0.0
            %
            0.0
            %





The
      following table summarizes the activity in the Company’s stock option plan
      during the three months ended March 31, 2007:




**Number
                of Shares**
            
            **Weighted-**
              **average**
              **Exercise
                Price**
            
            **Weighted-****Average**
              **Remaining
                Contractual Term**Outstanding
                at January 1, 2007
            
            
            3,511,579
            
            $
            3.78Granted
            
            
            24,000
            
            
            1.56Exercised
            
            
            (52,448
            )
            
            0.73Forfeitures
                and cancellations
            
            
            (52,658
            )
            
            4.84Outstanding
                at March 31, 2007
            
            
            3,430,473
            
            $
            3.79
            
            
            5.08Vested
                and expected to vest at March 31, 2007
            
            
            3,366,831
            
            $
            3.81
            
            
            5.03Exercisable
                at March 31, 2007
            
            
            3,023,580
            
            $
            3.92
            
            
            4.72




8


During
      the three months ended March 31, 2007, 3.0 million shares of Company common
      stock issuable upon exercise of outstanding options were exercisable with a
      weighted-average exercise price of $3.92. The weighted-average remaining
      contractual term for outstanding options at March 31, 2007 was 5.1 years.





As
      of
      March 31, 2007, estimated forfeiture costs associated with such options were
      approximately $309,000. This cost is to be recognized over a weighted average
      period of approximately 4 years.





Under
      the
      1999 Employee Stock Purchase Plan (the “1999 Purchase Plan”), we had reserved as
      of September 30, 2006, 765,640 shares of common stock for issuance to eligible
      employees at a price equal to 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, 2007, 47,266 shares were purchased by and
      distributed to employees at a price of $1.35 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, the existing models do not in management's
      opinion, 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 reflect 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, 2007 and 2006, basic and diluted net loss
      per share numbers were identical as potential common shares resulting from
      the
      exercise of stock options were antidilutive.





Basic
      and
      diluted loss per share for each of the three and six month periods ended March
      31, 2007 and March 31, 2006 are computed as follows (in thousands, except for
      per share data):





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Net
                loss
            
            $
            (172
            )
            $
            (120
            )
            $
            (266
            )
            $
            (338
            )Weighted
                average shares outstanding-basic income (loss) per share
            
            
            15,163
            
            
            14,937
            
            
            15,146
            
            
            14,889Weighted
                average shares outstanding-
                diluted income (loss) per share
            
            
            15,163
            
            
            14,937
            
            
            15,146
            
            
            14,889Basic
                loss per share
            
            $
            (0.01
            )
            $
            (0.01
            )
            $
            (0.02
            )
            $
            (0.02
            )Diluted
                net income (loss) per share
            
            $
            (0.01
            )
            $
            (0.01
            )
            $
            (0.02
            )
            $
            (0.02
            )








**COMPREHENSIVE
      LOSS**





Comprehensive
      loss consists of net loss and net unrealized gain (losses) on
      available-for-sales investments. Comprehensive loss for the three and six month
      periods ended March 31, 2007 and 2006 were as follows (in thousands):





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Net
                loss
            
            $
            (172
            )
            $
            (120
            )
            $
            (266
            )
            $
            (338
            )Change
                in unrealized gain (loss) on securities available for sale
            
            
            —
            
            
            —
            
            
            —
            
            
            —Comprehensive
                loss
            
            $
            (172
            )
            $
            (120
            )
            $
            (266
            )
            $
            (338
            )







9




**SEGMENT
      REPORTING**





We
      are
      organized and operate as two operating segments, the Americas and International.
      The Americas is comprised of the United States, Canada, Mexico, Central America
      and the Caribbean. The International segment is comprised of China, the United
      Kingdom and Norway.





Net
      revenue by geographic region based on customer location for the three and six
      months ended March 31, 2007 and 2006, respectively, were as
      follows:





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Americas
            
            
            91
            %
            
            93
            %
            
            90
            %
            
            92
            %International
            
            
            9
            %
            
            7
            %
            
            10
            %
            
            8
            %Total
            
            
            100
            %
            
            100
            %
            
            100
            %
            
            100
            %





International
      is comprised of revenue primarily from China, the United Kingdom and Norway.
      Most significant long-lived assets are located in the United States. Our
      hardware tooling used to develop the IP710 and the IP705 phones is located
      in
      Taiwan.





Net
      revenue by customers that individually accounted for more than 10% of our
      revenue for the three and six months ended March 31, 2007 and 2006,
      respectively, were as follows:








**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**
            
            **2007**
            
            **2006**AltiSys
            
            
            14
            %
            
            15
            %
            
            14
            %
            
            16
            %Synnex
            
            
            54
            %
            
            52
            %
            
            51
            %
            
            55
            %Graybar
            
            
            13
            %
            
            17
            %
            
            15
            %
            
            15
            %








**2.
      WARRANTY**





The
      Company provides a one-year warranty for hardware products. 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, 2007
      and
      2006, respectively, are as follows (in thousands):





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Beginning
                balance
            
            $
            267
            
            $
            252
            
            $
            263
            
            $
            264Provisions
                for warranty liability
            
            
            37
            
            
            56
            
            
            85
            
            
            79Warranty
                cost including labor, components and scrap
            
            
            (47
            )
            
            (33
            )
            
            (91
            )
            
            (68
            )Ending
                balance
            
            $
            257
            
            $
            275
            
            $
            257
            
            $
            275




10


**3.
      COMMITMENTS AND CONTINGENCIES**





*Commitments*





We
      lease
      our facilities under various 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 facility in
      Fremont, California. The lease for our headquarters expires on February 21,
      2009. Rent expense for all operating leases totaled approximately $142,000
      and
      $283,000 for the three and six months ended March 31, 2007, respectively as
      compared to $132,000 and $258,000 for three and six months ended March 31,
      2006,
      respectively. 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, 2007 are as follows (in thousands):





Capital
            
            OperatingFiscal
                Year Ending September 30,
            
            Leases
            
            LeasesRemainder
                of 2007
            
            $
            26
            
            $
            2012008
            
            
            47
            
            
            2862009
            
            
            44
            
            
            922010
            
            
            33
            
            
            —Total
                minimum lease payment
            
            $
            150
            
            $
            579Amount
                representing interest
            
            $
            20Present
                value of minimum lease payment
            
            
            130Total
                minimum lease payment
            
            $
            150Current
                portion plus current portion of interest
            
            $
            51Long-term
                portion plus long-term portion of interest
            
            
            99Total
                capital lease commitments
            
            $
            150








*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. Although the
      patents have now reissued, the plaintiff requested that the stay continue
      and the court granted a temporary continuation of the stay. We believe we have
      strong defenses and arguments in this dispute and intend to vigorously litigate
      our position. Management’s view is that any loss from this litigation is 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.





**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.





11





The
      forward-looking statements contained herein reflect our judgment as of the
      date
      of this report with respect to future events, the outcome of which is subject
      to
      certain risks that may have a significant impact on our business, operating
      results or financial condition. You are cautioned that these forward-looking
      statements are inherently uncertain. Should one or more of these risks or
      uncertainties materialize, or should underlying assumptions prove incorrect,
      actual results or outcomes may vary materially from those described herein.
      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
      our Form 10-K filed with the SEC on December 29, 2006.





**OVERVIEW**





We
      are a
      pioneer and market leader in Internet protocol telephony systems for small-to
      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 have an increased return compared to past
      technology investments. We
      generated net revenue of $4.1 million and $8.5 million for the three and six
      months ended March 31, 2007, respectively, compared to net revenue of $4.2
      million and $8.6 million for the three and six months ended March 31, 2006,
      respectively. As of March 31, 2007, we had an accumulated deficit of
      $51.4 million. Net cash used in operating activities was $175,000 for the
      six month ended March 31, 2007.





We
      derive
      our revenue from sales of our AltiServ telephone systems. Product revenue is
      comprised of direct sales to end-users (including dealers) and sales 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 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, which for the six months ended March 31, 2007, were All Quality
      Services and Bestronics in San Jose, 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. 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 our market
      research, customer feedback and our competitors' product offerings and (ii)
      creating new product offerings to both enhance our position in our target market
      segment and enter new geographical markets. Additionally, we intend to continue
      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 this Internet telephony  is
      much
      faster with small-to medium-sized businesses because many of them 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 continue; including the
      growth in acceptance of the call center products, the growth in the marketplaces
      of Asia, Latin America, the Caribbean, and the status quo of the North American
      economy; as a result of our enhanced products, we expect to see continued
      revenue growth for fiscal year 2007.





12


**CRITICAL
      ACCOUNTING POLICIES**





*Revenue
      recognition.* Revenues
      are comprised of direct sales to end-users, including resellers, and sales
      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
      consist 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 its
      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 $486,000 and $764,000 as of March 31, 2007 and March
      31, 2006, respectively.





Software
      components are generally not sold separately from our hardware components.
      Software revenue consist 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
      was 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 $42,000 and $36,000 as of March 31, 2007 and 2006,
      respectively.





*Inventory* .
      Inventory is stated at the lower of cost (first-in, first-out method) or market.
      Our inventory balance was $1.9 million and $1.6 million as of March 31, 2007
      and
      March 31, 2006, respectively. We regularly review the value of our 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, AltiGen had established a reserve to write off $3.5 million of excess
      inventory which management believed would not be sold.  During 2002 through
      2006, AltiGen reversed a portion of the reserve related to inventory which
      was
      sold.  The amounts of such reversals were $301,000, $167,000 and $293,000
      in fiscal years ending 2006, 2005 and 2004, respectively. During the quarters
      ended March 31, 2007 and 2006, respectively, inventory allowance was
      $2.3 million.





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 $257,000 and $276,000 as of March 31, 2007 and March 31, 2006,
      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,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Consolidated
                Statements of Operations Data:Net
                revenue:Hardware
            
            
            92.7
            %
            
            91.7
            %
            
            91.6
            %
            
            92.4
            %Software
            
            
            7.3
            
            
            8.3
            
            
            8.4
            
            
            7.6Total
                net revenue
            
            
            100.0
            
            
            100.0
            
            
            100.0
            
            
            100.0Cost
                of revenue:Hardware
            
            
            45.3
            
            
            45.7
            
            
            45.3
            
            
            45.6Software
            
            
            0.7
            
            
            0.6
            
            
            0.7
            
            
            0.5Total
                cost of revenue
            
            
            46.0
            
            
            46.3
            
            
            46.0
            
            
            46.1Gross
                profit
            
            
            54.0
            
            
            53.7
            
            
            54.0
            
            
            53.9Operating
                expenses:Research
                and development
            
            
            19.9
            
            
            21.4
            
            
            19.3
            
            
            22.4Sales
                and marketing
            
            
            26.8
            
            
            24.0
            
            
            26.7
            
            
            24.4General
                and administrative
            
            
            14.2
            
            
            12.7
            
            
            13.8
            
            
            12.6Total
                operating expenses
            
            
            60.9
            
            
            58.1
            
            
            59.8
            
            
            59.4Loss
                from operations
            
            
            (6.9
            )
            
            (4.4
            )
            
            (5.8
            )
            
            (5.5
            )Equity
                in net loss of investee
            
            
            (0.0
            )
            
            (0.3
            )
            
            (0.0
            )
            
            (0.3
            )Interest
                and other income, net
            
            
            2.8
            
            
            2.0
            
            
            2.8
            
            
            2.0Net
                loss before taxes
            
            
            (4.1
            )
            
            (2.7
            )
            
            (3.0
            )
            
            (3.8
            )Provision
                for income taxes
            
            
            (
                0.1
            )
            
            (0.2
            )
            
            (
                0.1
            )
            
            (0.1
            )Net
                loss
            
            
            (4.2
            )%
            
            (2.9
            )%
            
            (3.1
            )%
            
            (3.9
            )%








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





Net
      Revenue by Geographic Area:





Net
      revenue by geographic region based on customer location for the three and six
      months ended March 31, 2007 and 2006, respectively, were as
      follows:





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**
            
            **2007**
            
            **2006**Americas
            
            
            91
            %
            
            93
            %
            
            90
            %
            
            92
            %International
            
            
            9
            %
            
            7
            %
            
            10
            %
            
            8
            %Total
            
            
            100
            %
            
            100
            %
            
            100
            %
            
            100
            %








14


International
      is comprised of revenue primarily from China, the United Kingdom and Norway.
      Most significant long-lived assets are located in the United States. Our
      hardware tooling used to develop the IP710 and the IP705 phones is located
      in
      Taiwan.





Net
      Revenue by Customer:





Net
      revenue by customers that individually accounted for more than 10% of our
      revenue for the three and six months ended March 31, 2007 and 2006,
      respectively, were as follows:





**Three
                Months Ended**
              **March
                31,**
            
            **Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**
            
            **2007**
            
            **2006**AltiSys
            
            
            14
            %
            
            15
            %
            
            14
            %
            
            16
            %Synnex
            
            
            54
            %
            
            52
            %
            
            51
            %
            
            55
            %Graybar
            
            
            13
            %
            
            17
            %
            
            15
            %
            
            15
            %





Revenue
      generated in the Americas accounted for $3.8 million or 91% and $7.7
      million or 90%, for the three and six months ended March 31, 2007, respectively,
      as compared to $3.9 million, or 93%, and $7.9 million, or 92%, for the three
      and
      six months ended March 31, 2006, respectively. Net revenue decreased 1% to
      $4.1 million for the three months ended March 31, 2007 as compared to
      $4.2 million for the three months ended March 31, 2006. The decrease is
      largely attributable to change in our product mix. Total units shipped increased
      by 21%, however, due to product mix the average selling price per unit dropped
      by approximately 21%. We sold more of the smaller units in the second quarter
      of
      fiscal 2007 compared to the same period in fiscal 2006. Net revenue decreased
      1%
      to $8.5 million for the six months ended March 31, 2007 from
      $8.6 million for the six months ended March 31, 2006. This is primarily due
      to change in our product mix. Total units shipped increased by 6%, however,
      due
      to product mix, the average selling price per unit dropped by approximately
      8%.
      We sold more of the smaller units in the six months ended March 31, 2007
      compared to the same period in the prior year.





For
      the
      three and six months ended March 31, 2007, we incurred a net loss of $172,000
      and $266,000, respectively. During such periods, we recognized $105,000 and
      $256,000, respectively, of non-cash stock based-compensation expense and as
      a
      result of the adoption of SFAS No. 123(R).





**Cost
      of revenue.**  Cost
      of
      revenue for the three and six months ended March 31, 2007 and March 31, 2006
      was
      $1.9 million and $3.9 million, respectively. Cost of revenue as a percentage
      of
      net revenue was 46% for both the three and six months ended March 31, 2007
      and
      March 31, 2006, respectively.





**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
      $825,000, or 20% of revenue, for the three months ended March 31, 2007 from
      $895,000, or 21% of revenue, for the same period in fiscal 2006. This expense
      decrease in absolute dollars was primarily the result of decrease in project
      related expenses of approximately $63,000 and payroll related expenses of
      approximately $6,000. Research and development expenses decreased to $1.6
      million, or 19% of revenue, for the six months ended March 31, 2007 from $1.9
      million, or 22% of revenue, for the same period in fiscal 2006. This expense
      decrease in absolute dollars is attributable to a reduction in project related
      expenses of approximately $106,000; $70,000 reduction in non-cash stock-based
      compensation required by SFAS No.123(R); payroll related expenses of
      approximately $42,000 and overhead allocations of approximately $42,000. We
      believe that continued spending on research and development to develop new
      products and improve manufacturing process is critical to our success and,
      consequently, expect to increase research and development expenses in the future
      periods over the long term. 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 $1.1 million for the three months ended
      March 31, 2007 from approximately $999,000 for the same period in fiscal 2006.
      This increase in absolute dollars was primarily the result of increase in
      advertising expenses of approximately $73,000 and $23,000 in service related
      expenses. Sales and marketing expenses as a percentage of revenue increased
      to
      27% for the three months ended March 31, 2007 from 24% for the same period
      in
      fiscal 2006. For the six months ended March 31, 2007, sales and marketing
      expenses increased to $2.3 million from approximately $2.1 million for the
      same
      period in fiscal 2006. The expense increase in absolute dollars was the result
      of increased advertising expenses of approximately $82,000; partner conference
      expenses of approximately $27,000; $22,000 in travel related expenses and
      $40,000 in service related expenses. Sales and marketing expenses as a
      percentage of revenue increased to 27% for the six months ended March 31, 2007
      from 24% for the same period in fiscal 2006. We anticipate sales and marketing
      expenses will increase in future periods over the long term due to increased
      staffing levels, particularly in sales, as well as increased commission expense
      to the extent the Company achieves higher sales levels. If we are successful
      in
      enhancing our products, we expect to see continued revenue growth for fiscal
      year 2007 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
      executive, finance and administrative personnel, facilities, allowance for
      doubtful accounts, legal, and other general corporate expenses. General and
      administrative expenses increased to $590,000 for the three months ended March
      31, 2007 from $527,000 in the same period in the prior year. The increase in
      absolute dollars was primarily related to an increase in consulting related
      services of approximately $37,000; $12,000 increase in legal expenses associated
      with corporate governance matters; and $8,000 increase in travel related
      expenses. General and administrative expenses for the six months ended March
      31,
      2007 increased to $1.2 million from $1.1 million as compared with the same
      period in the prior year. This was mainly the result of a $47,000 increase
      in
      consulting related services and $44,000 increase in legal expenses related
      to
      corporate governance matters. General and administrative expenses as a
      percentage of revenue increased 14% for the three months ended March 31, 2007
      from 13% for the same period in fiscal 2006. For the six months ended March
      31,
      2007, general and administrative expenses as a percentage of revenue increased
      to 14% as compared to 13% during the same period in the prior year. In the
      short
      term, we expect general and administrative expenses to remain consistent as
      we
      continue to focus on controlling costs. In
      the
      long term, we expect general and administrative expenses to increase due to
      costs associated with Sarbanes-Oxley 404 compliance efforts during fiscal year
      2008.





**Equity
      investment in common stock of private company.** 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 board of directors.  We are accounting for
      this investment using the equity method. The
      total
      equity in net losses of this company was approximately $1,000 and $4,000 for
      the
      three and six months ended March 31, 2007, respectively, compared to $14,000
      and
      $24,000 for the same period in fiscal 2006.





**Interest
      and other income, net.** Net
      interest and other income increased to $115,000 and $235,000 for the three
      and
      six months ended March 31, 2007, respectively, from $85,000 and $168,000 for
      the
      same periods in fiscal 2006. The
      increase in net interest and other income for the six months ended March 31,
      2007 was primarily a result of higher interest rates .
      We
      expect net interest and other income to remain relatively flat with little
      change in cash available to invest.





**Liquidity
      and Capital Resources**





Since
      inception, we have financed our operations primarily through the sale of equity
      securities. As of March 31, 2007, we had cash and short-term investments
      totaling $9.8 million consisting of cash and cash equivalents of
      $6.8 million and $3.0 million of short-term investment with a maturity
      of greater than 90 days (in thousands):





**Six
                Months Ended**
              **March
                31,****2007**
            
            **2006**Cash
                and cash equivalents
            
            $
            6,813
            
            $
            4,867Short-term
                investments
            
            
            3,010
            
            
            4,388Total
                cash, cash equivalents and short-term investments
            
            $
            9,823
            
            $
            9,255Cash
                used in operating activities
            
            $
            (175
            )
            $
            (157
            )Cash
                provided by investing activities
            
            $
            1,826
            
            $
            843Cash
                provided by financing activities
            
            $
            109
            
            $
            218Net
                increase in cash and cash equivalents
            
            $
            1,760
            
            $
            904





*Changes
      in Cash Flows*





During
      the six months ended March 31, 2007, t he
      Company’s net cash used in operating activities was $175,000, which was
      approximately $18,000 higher than the cash used in operating activities during
      the same period in fiscal 2006. This was primarily due to a decrease of $648,000
      in accounts receivable, a $162,000 reduction in accounts payable, approximately
      $45,000 decrease in deferred revenue and a decrease of $256,000 in stock based
      compensation expense. These factors were partially offset by an increase in
      net
      inventories of $568,000, depreciation and amortization of approximately $124,000
      and prepaid expenses of $81,000.





For
      the
      six months ended March 31, 2007, the Company’s net cash provided by investing
      activities was $1.8 million, which was primarily attributable to proceeds from
      maturities of short-term investments .




16


Net
      accounts receivable decreased to $1.6 million at March 31, 2007 from
      $2.2 million at September 30, 2006. The decrease in net accounts receivable
      was primarily due to lower deferred revenue, decreasing sales and decrease
      in
      days sales outstanding (DSO) at 34 days as of March 31, 2007 from 44 as of
      September 30, 2006.





We
      ended
      the second quarter of fiscal 2007 with a cash conversion cycle of 95 days as
      compared to 76 days for the second quarter of fiscal 2006. 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 days of sales
      outstanding (DSO) added to days of supply in inventories (DOS), reduced by
      days
      of payable outstanding (DPO).





Inventories
      increased to $1.9 million at March 31, 2007 from $1.4 million at
      September 30, 2006 and our inventory turn rate decreased to 4.0 at March
      31, 2007 from 5.9 at September 30, 2006. This increase in inventories was
      primarily attributable to the new product introduction of our MAX1000
      Voice over IP (VoIP) phone system .
      Our
      annualized inventory turn rate represents the number of times inventory is
      replenished during the year. 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 decreased to $675,000 at March 31, 2007 from $837,000 at
      September 30, 2006. This
      decrease to accounts payable during this period was the result of routine period
      to period fluctuations.





Generally,
      as sales levels rise, the Company expects inventories, accounts receivable
      and
      accounts payable to increase. However, there will be routine fluctuations in
      these accounts from period to period that may be significant in
      amount.





During
      the six months ended March 31, 2007, our net cash provided by financing
      activities was $109,000 which was related to the proceeds from the exercise
      of
      employee stock option and stock purchases through our employee stock purchase
      plan.




*Liquidity
      and Capital Resources*





We
      intend
      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 cannot raise needed funds in the future, on acceptable terms, we may
      not
      be able to further develop or enhance our products, take advantage of
      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
      the risk or perceived risk of investing in our securities.




We
      do not
      have any material commitments for capital expenditures as of March 31, 2007.
      We
      have a commitment under our noncancellable capital and operating lease in the
      amount of $729,000 as of March 31, 2007. We believe, we have sufficient cash
      reserves to allow us to continue operations for more than a year. Our cash
      and
      short-term investments totaled $9.8 million as of March 31, 2007. The
      following table represents our future commitments as of March 31, 2007 (in
      thousands):





Payment
                Due by PeriodContractual
                Obligations
            
            Total
            
            Less
                than
              1
                Year
            
            1
                -
                3 Years
            
            3
                -
                5 Years
            
            More
                than
              5
                YearsOperating
                leases obligation
            
            $
            579
            
            $
            201
            
            $
            378
            
            $
            $
                —
            
            $
            —Capital
                leases obligation
            
            
            150
            
            
            26
            
            
            91
            
            
            33
            
            
            —Total
            
            $
            729
            
            $
            227
            
            $
            469
            
            $
            33
            
            $
            —




17


**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 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. Although the
      patents have now reissued, the plaintiff requested that the stay continue
      and the court granted a temporary continuation of the stay. 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
      6. Exhibits****.**




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





19





**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 11, 2007
            By:
            /s/
                Philip M. McDermottPhilip
                M. McDermott,Chief
                Financial Officer(Principal
                Financial and Accounting Officer)





20




**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, file
                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, file
                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.







21