**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 JUNE 30, 2005****OR****o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
                EXCHANGE ACT OF 1934****FOR
                THE TRANSITION PERIOD
                FROM                      TO****Commission
                File Number: 000-27427**








**ALTIGEN
      COMMUNICATIONS, INC.**


(Exact
      name of Registrant as specified in its charter)





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








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





Indicate
      by check mark whether the registrant is an accelerated
      filer.     YES o NO ý





The
      number of shares of our common stock outstanding as of August 10, 2005 was:
      14,703,999 shares









**Table
      of Contents**





**PART
                I. FINANCIAL INFORMATION**Item
                1.
            Financial
                Statements:Balance
                Sheets as of June 30,
                2005 and September 30, 2004
            3Statements
                of Operations for
                the Three and Nine Months Ended June 30, 2005 and 2004
            4Statements
                of Cash Flows for
                the Nine Months Ended June 30, 2005 and 2004
            5Notes
                to Financial
                Statements
            6Item
                2.
            Management’s
                Discussion and
                Analysis of Financial Condition and Results of
                Operations
            12Item
                3.
            Quantitative
                and Qualitative Disclosures About Market Risk
            25Item
                4.
            Controls
                and Procedures
            25**PART
                II. OTHER INFORMATION**Item
                1.
            Legal
                Proceedings
            26Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            26Item
                3.
            Defaults
                Upon Senior Securities
            26Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            26Item
                5
            Other
                Information
            26Item
                6.
            Exhibits
            26**SIGNATURE**
            27**EXHIBIT
                INDEX**
            28






-2-


**PART
      I. FINANCIAL INFORMATION**


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





**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**UNAUDITED
      CONDENSED CONSOLIDATED BALANCE SHEETS**


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


**June
                30,**
              **2005**
            
            **September
                30,**
              **2004****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            2.410
            
            $
            2,898Short-term
                investments
            
            
            6,674
            
            
            7,136Accounts
                receivable, net of allowances of $26 and $35 at June 30, 2005 and
                September 30, 2004, respectively
            
            
            2,522
            
            
            1,857Inventories
            
            
            1,051
            
            
            1,058Prepaid
                expenses and other current assets
            
            
            124
            
            
            67Total
                current assets
            
            
            12,781
            
            
            13,016Property
                and equipment:Furniture
                and equipment
            
            
            1,014
            
            
            987Computer
                software
            
            
            920
            
            
            9151,934
            
            
            1,902Less:
                Accumulated depreciation and amortization
            
            
            (1,768
            )
            
            (1,750
            )Net
                property and equipment
            
            
            166
            
            
            152Other
                non-current assets:Long-term
                investments
            
            
            250
            
            
            274Long-term
                deposit
            
            
            74
            
            
            74Other
            
            
            192
            
            
            —Total
                other non-current assets
            
            
            516
            
            
            348Total
                assets
            
            $
            13,463
            
            $
            13,516**LIABILITIES
                AND STOCKHOLDERS’ EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            966
            
            $
            798Accrued
                liabilities:Payroll
                and related benefits
            
            
            284
            
            
            330Warranty
                (Note 3)
            
            
            373
            
            
            424Marketing
            
            
            99
            
            
            139Other
            
            
            574
            
            
            493Deferred
                revenue
            
            
            632
            
            
            518Total
                current liabilities
            
            
            2,928
            
            
            2,702Long-term
                deferred rent and other
            
            
            129
            
            
            145Stockholders’
                equity:Convertible
                preferred stock, $0.001 par value; Authorized - 5,000,000 shares;
                None
                issued and outstanding at June 30, 2005 and September 30,
                2004
            
            
            —
            
            
            —Common
                stock, $0.001 par value; Authorized - 50,000,000 shares; Outstanding
                -
                15,767,894 shares at June 30, 2005 and 15,462,506 shares at September
                30,
                2004
            
            
            16
            
            
            15Treasury
                stock at cost - 1,063,895 shares at June 30, 2005 and September 30,
                2004
            
            
            (1,014
            )
            
            (1,014
            )Additional
                paid-in capital
            
            
            62,852
            
            
            62,505Accumulated
                other comprehensive gain (loss)
            
            
            —
            
            
            (2
            )Accumulated
                deficit
            
            
            (51,448
            )
            
            (50,835
            )Total
                stockholders’ equity
            
            
            10,406
            
            
            10,669Total
                liabilities and stockholders’ equity
            
            $
            13,463
            
            $
            13,516


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







-3-


**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**


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


**Three
                  Months Ended June 30,**
              ****
              **Nine
                  Months Ended June 30,**
              ********
              ****
              **2005**
              ****
              **2004**
              ****
              **2005**
              ****
              **2004**Net
                  revenues:Hardware
              
              $
              3,655
              
              $
              3,395
              
              $
              9,573
              
              $
              9,552Software
              
              
              462
              
              
              488
              
              
              1,620
              
              
              1,254Total
                  net revenues
              
              
              4,117
              
              
              3,883
              
              
              11,193
              
              
              10,806Cost
                  of revenues:Hardware
              
              
              1,862
              
              
              1,438
              
              
              4,704
              
              
              4,064Software
              
              
              34
              
              
              42
              
              
              119
              
              
              104Total
                  cost of revenues
              
              
              1,896
              
              
              1,480
              
              
              4,823
              
              
              4,168Gross
                  profit
              
              
              2,221
              
              
              2,403
              
              
              6,370
              
              
              6,638Operating
                  expenses:Research
                  and development
              
              
              862
              
              
              754
              
              
              2,619
              
              
              2,400Sales
                  and marketing
              
              
              1,034
              
              
              1,041
              
              
              3,023
              
              
              3,087General
                  and administrative
              
              
              490
              
              
              449
              
              
              1,495
              
              
              1,331Total
                  operating expenses
              
              
              2,386
              
              
              2,244
              
              
              7,137
              
              
              6,818Income
                  (loss) from operations
              
              
              (165
              )
              
              159
              
              
              (767
              )
              
              (180
              )Interest
                  and other income, net
              
              
              69
              
              
              26
              
              
              165
              
              
              72Net
                  income (loss) before income taxes
              
              
              (96
              )
              
              185
              
              
              (602
              )
              
              (108
              )Income
                  taxes
              
              
              —
              
              
              —
              
              
              11
              
              
              —Net
                  income (loss)
              
              $
              (96
              )
              $
              185
              
              $
              (613
              )
              $
              (108
              )Basic
                  and diluted net income (loss) per share
              
              $
              (0.01
              )
              $
              0.01
              
              $
              (0.04
              )
              $
              (0.01
              )Weighted
                  average shares used in computing basic net income (loss) per
                  share
              
              
              14,677
              
              
              14,307
              
              
              14,570
              
              
              14,194Weighted
                  average shares used in computing diluted net income (loss) per
                  share
              
              
              14,677
              
              
              15,659
              
              
              14,570
              
              
              14,194


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








-4-


**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**UNAUDITED
      CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(in
      thousands)**


**Nine
                months Ended June 30,****2005**
            
            **2004**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss
            
            $
            (613
            )
            $
            (108
            )Adjustments
                to reconcile net loss to net cash used in operating
                activities:Depreciation
                and amortization
            
            
            72
            
            
            112Changes
                in operating assets and liabilitiesAccounts
                receivable
            
            
            (665
            )
            
            (265
            )Inventories
            
            
            7
            
            
            53Prepaid
                expenses and other assets
            
            
            (33
            )
            
            (7
            )Accounts
                payable
            
            
            168
            
            
            (422
            )Accrued
                liabilities
            
            
            (57
            )
            
            (248
            )Deferred
                revenue
            
            
            114
            
            
            (174
            )Deferred
                rent
            
            
            (16
            )
            
            173Net
                cash used in operating activities
            
            
            (1,023
            )
            
            (886
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchases
                of short-term investments
            
            
            (13,894
            )
            
            (20,312
            )Proceeds
                from sale and maturities of short-term investments
            
            
            14,356
            
            
            19,237Changes
                in other non-current assets
            
            
            (192
            )
            
            (50
            )Purchases
                of property and equipment
            
            
            (85
            )
            
            (37
            )Net
                cash provided by (used in) investing activities
            
            
            185
            
            
            (1,162
            )CASH
                FLOWS FROM FINANCING ACTIVITIES:Proceeds
                from issuances of common stock
            
            
            350
            
            
            333Net
                cash provided by financing activities
            
            
            350
            
            
            333NET
                INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
            
            
            (488
            )
            
            (1,715
            )CASH
                AND CASH EQUIVALENTS, BEGINNING OF PERIOD
            
            
            2,898
            
            
            8,548CASH
                AND CASH EQUIVALENTS, END OF PERIOD
            
            $
            2,410
            
            $
            6,833


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. (“AltiGen,” the “Company,”“we,” or “our”) designs,
      manufactures and markets 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.





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 (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, 2004, included
      in
      the Company’s 2004 Annual Report on Form 10-K filed with the SEC on December 29,
      2004. 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.





In
      March
      2005, the Company determined that investments in Auction Rate Securities (“ARS”)
      should not be considered cash equivalents in prior periods. ARS generally have
      long-term stated maturities; however, these investments have characteristics
      similar to short-term investments because at pre-determined intervals, generally
      between 7 to 49 days after the purchase, there is a new auction process. As
      of
      June 30, 2005, the Company held $2.5 million of investments in ARS that were
      classified as short-term investments, available for sale. The Company
      reclassified $2.5 million of investments in ARS that were previously included
      in
      cash and cash equivalents as of September 30, 2004 to short-term investments,
      available for sale. The Company has included purchases and sales of ARS in
      its
      Unaudited Condensed Consolidated Statements of Cash Flows as a component of
      its
      investing activities.





The
      reclassifications described above have been made to conform prior period amounts
      to the current presentation. The reclassifications did not impact previously
      reported revenues, total operating expense, income (loss) from operations,
      net
      income (loss), total assets, total liabilities or stockholders’ equity.





Additionally,
      in June 2005, the Company revised the presentation of its Unaudited Condensed
      Consolidated Statements of Operations to separate net revenues and cost of
      revenues by source (hardware and software).





**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 June 30, 2005, our cash and cash equivalents
      consisted of commercial paper and cash deposited in checking and money market
      accounts. For the nine months ended June 30, 2005 and 2004, we did not make
      any
      cash payments for interest or income taxes.





Unrealized
      gains from short-term investments were $0 at June 30, 2005 and unrealized losses
      from short-term investments were $2,000 at September 30, 2004.





**INVENTORIES**




Inventories
      (which include costs associated with components assembled by third-party
      assembly manufacturers, as well as internal labor and allocable overhead) are
      stated at the lower of cost (which approximates actual cost on first-in,
      first-out method) or market. Provisions, when required, are made to reduce
      excess and obsolete inventories to their estimated net realizable values. We
      regularly monitor inventory quantities on hand and record a provision for excess
      and obsolete inventories based primarily on our estimated forecast of product
      demand and production requirements for the next six months. We did not record
      any provision for excess and obsolete inventories for the nine months ended
      June
      30, 2005 and 2004. The components of inventories include (in
      thousands):







-6-




**June
                30,**
              **2005**
            
            **September
                30,**
              **2004**Raw
                materials
            
            $
            240
            
            $
            68Work-in-progress
            
            
            138
            
            
            95Finished
                goods
            
            
            673
            
            
            895$
            1,051
            
            $
            1,058





**LONG-TERM
      INVESTMENT**





As
      of
      June 30, 2005, we held an investment of common stock in a private Taiwanese
      telecommunication company valued at approximately $195,000 accounted for using
      the cost method. Our interest in the company is approximately 2%, which interest
      does not allow us to exercise significant influence.





In
      July
      2004, we purchased common stock of a private Korean telecommunications company
      for **** approximately
      $ 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.





We
      perform a periodic review of our investments for impairment. Our investments
      are
      considered impaired when a review of the investees’ 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.





**REVENUE
      RECOGNITION**





We
      account for the recognition of software license revenues in accordance with
      Statement of Position (“SOP”) 97-2, “Software Revenue Recognition.” Revenues
      consist of sales to end-users, including resellers, and to distributors.
      Revenues 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 revenues until our distributors
      sell 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 revenues consist of license revenues 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 to end-users and resellers 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**





We
      account for stock-based compensation in accordance with the provisions of
      Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock
      Issued to Employees,” and comply with the disclosure provisions of Statement of
      Financial Accounting Standards (“SFAS”) No. 123 as amended by SFAS
      No. 148, “Accounting for Stock-Based Compensation — Transition
      and Disclosures.” Deferred compensation recognized under APB Opinion No. 25
      is amortized to expense using the graded vesting method. We account for stock
      options issued to non-employees in accordance with the provisions of SFAS
      No. 123 and Emerging Issues Task Force (“EITF”) No. 96-18 under the
      fair value based method.







-7-


We
      adopted the disclosure-only provisions of SFAS No. 123, and accordingly,
      no
      expense has been recognized for options granted to employees under our various
      option plans. We amortize deferred stock-based compensation over the vesting
      periods of the applicable stock purchase rights and stock options, generally
      four years. Had compensation expense been determined based on the fair value
      at
      the grant date for awards, consistent with the provisions of SFAS No. 123,
      the Company's pro forma net loss and net loss per share would be as follows
      (in
      thousands, except per share data):





**Three
                Months Ended**
              **June
                30,**
            ****
            **Nine
                Months Ended**
              **June
                30,**
            ********
            ****
            **2005**
            ****
            **2004**
            ****
            **2005**
            ****
            **2004**Reported
                net income (loss)
            
            $
            (96
            )
            $
            185
            
            $
            (613
            )
            $
            (108
            )Add:
                Total stock-based employee compensation expense included in reported
                net
                loss under APB No. 25
            
            
            --
            
            
            --
            
            
            --
            
            
            --Deduct:
                Total stock-based compensation determined under fair value based
                method
                for all awards
            
            
            (438
            )
            
            (290
            )
            
            (1,253
            )
            
            (1,029
            )Pro
                forma net loss under SFAS No. 123
            
            $
            (534
            )
            $
            (105
            )
            $
            (1,866
            )
            $
            (1,137
            )Basic
                and diluted net income (loss) per share - as reported
            
            $
            (0.01
            )
            $
            0.01
            
            $
            (0.04
            )
            $
            (0.01
            )Basic
                and diluted net loss per share - pro forma
            
            $
            (0.04
            )
            $
            (0.01
            )
            $
            (0.13
            )
            $
            (0.08
            )


The
      fair
      value of each option grant is estimated on 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
                June 30,**
            
            **Employee
                Stock Option Plan**
              **for
                Nine Months**
              **Ended
                June 30,****2005**
            
            **2004**
            
            **2005**
            
            **2004**Expected
                life (in years)
            
            
            5
            
            
            5
            
            
            5
            
            
            5Risk-free
                interest rate
            
            
            3.7
            %
            
            3.4
            %
            
            3.7
            %
            
            3.4
            %Estimated
                volatility
            
            
            101
            %
            
            107
            %
            
            101
            %
            
            107
            %Expected
                dividend
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %





**Employee
                Stock Purchase Plan**
              **for
                Three Months**
              **Ended
                June 30,**
            
            **Employee
                Stock Purchase Plan**
              **for
                Nine Months**
              **Ended
                June 30,****2005**
            
            **2004**
            
            **2005**
            
            **2004**Expected
                life (in years)
            
            
            0.5
            
            
            0.5
            
            
            0.5
            
            
            0.5Risk-free
                interest rate
            
            
            3.2
            %
            
            1.3
            %
            
            3.2
            %
            
            1.3
            %Estimated
                volatility
            
            
            100
            %
            
            107
            %
            
            100
            %
            
            107
            %Expected
                dividend
            
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %
            
            0.0
            %


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.






-8-


**COMPUTATION
      OF BASIC AND DILUTED NET INCOME (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 loss per share is
      calculated by dividing net income (loss) by the weighted average shares of
      common stock outstanding during the period. Diluted
      earnings per share reflects the potential dilution that could occur if
      securities or other contracts to issue common stock were exercised or converted
      into common stock.  For
      all
      periods but the quarter ended June 30, 2004, basic and diluted net loss per
      share numbers were identical as potential common shares resulting from the
      exercise of stock options were antidilutive





**Three
                Months**
              **Ended
                June 30,**
            
            **Nine
                Months**
              **Ended
                June 30,****2005**
            
            **2004**
            
            **2005**
            
            **2004****(in
                thousands, except per share data)**Net
                income (loss)
            
            $
            (96
            )
            $
            185
            
            $
            (613
            )
            $
            (108
            )Weighted
                average shares outstanding -basic
            
            
            14,677
            
            
            14,307
            
            
            14,570
            
            
            14,194Add:
                Dilutive stock options
            
            
            —
            
            
            1,352
            
            
            —
            
            
            —Weighted
                average shares outstanding -diluted
            
            
            14,677
            
            
            15,659
            
            
            14,570
            
            
            14,194Basic
                and diluted earnings per share
            
            $
            (0.01
            )
            $
            0.01
            
            $
            (0.04
            )
            $
            (0.01
            )





**COMPREHENSIVE
      INCOME**





Comprehensive
      loss consists of net loss plus the effect of foreign currency translation
      adjustments and other unrealized gains and losses, which were not material
      for
      each of the three and nine months ended June 30, 2005 and 2004, respectively.
      Accordingly, comprehensive loss closely approximates actual net
      loss.





**SEGMENT
      REPORTING**





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





Net
      revenue by geographic region based on customer location for the three and nine
      months ended June 30, 2005 and 2004, respectively, were as follows:





**Three
                Months Ended**
              **June
                30,**
            ****
            **Nine
                Months Ended**
              **June
                30,**
            ********
            ****
            **2005**
            ****
            **2004**
            ****
            **2005**
            ****
            **2004**Americas
            
            
            92
            %
            
            91
            %
            
            89
            %
            
            91
            %International
            
            
            8
            %
            
            9
            %
            
            11
            %
            
            9
            %100
            %
            
            100
            %
            
            100
            %
            
            100
            %


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





Net
      revenue by customers that individually accounted for more than 10% of our
      revenue for the three and nine months ended June 30, 2005 and 2004,
      respectively, were as follows:





**Three
                Months Ended**
              **June
                30,**
            ****
            **Nine
                Months Ended**
              **June
                30,**
            ********
            ****
            **2005**
            ****
            **2004**
            ****
            **2005**
            ****
            **2004**AltiSys
                Communications, Inc.
            
            
            17
            %
            
            14
            %
            
            16
            %
            
            16
            %Ingram
                Micro (see Note 5)
            
            
            --
            
            
            12
            %
            
            --
            
            
            15
            %Synnex
                Information Technology
            
            
            55
            %
            
            45
            %
            
            53
            %
            
            47
            %Graybar
                Electric Company, Inc.
            
            
            15
            %
            
            12
            %
            
            11
            %
            
            7
            %








-9-


**2.
      RECENT ACCOUNTING PRONOUNCEMENTS**




In
      November 2004, the Financial Accounting Standards Board (FASB) issued Statement
      of Financial Accounting Standards No. 151 (SFAS 151), “Inventory Costs, an
      amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4.”  SFAS
      151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing” to clarify
      the accounting for abnormal amounts of idle facility expense, freight handling
      costs, and wasted material (spoilage). SFAS 151 requires that those items be
      recognized as current-period charges regardless of whether they meet the
      criterion of “so abnormal.” In addition, SFAS 151 requires that allocation of
      fixed production overhead to the costs of conversion be based on the normal
      capacity of the production facilities. The provisions of SFAS 151 will be
      effective for fiscal years beginning after June 15, 2005. The Company is
      currently evaluating the provisions of SFAS 151 and does not believe
      that
      its adoption will have a material impact on the Company’s financial condition,
      results of operations or liquidity.





In
      December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets,
      which eliminates the exception for nonmonetary exchanges of similar productive
      assets and replaces it with a general exception for exchanges of nonmonetary
      assets that do not have commercial substance. SFAS No. 153 will be effective
      for
      nonmonetary asset exchanges occurring in fiscal periods beginning after June
      15,
      2005. The Company is currently evaluating the provisions of SFAS No.
      153
      and does not believe that its adoption will have a material impact on the
      Company’s financial condition, results of operations or liquidity.





In
      December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, which
      establishes standards for transactions in which an entity exchanges its equity
      instruments for goods or services. In March 2005, the SEC issued Staff
      Accounting Bulletin No. 107 - Share-Based Payment, which provides interpretive
      guidance related to SFAS No. 123(R). SFAS No. 123(R) requires a public entity
      to
      measure the cost of employee services received in exchange for an award of
      equity instruments based on the grant-date fair value of the award. This
      eliminates the exception to account for such awards using the intrinsic method
      previously allowable under APB Opinion No. 25. SFAS No. 123(R) will be effective
      beginning with the first interim or annual reporting period of our fiscal year
      beginning on or after June 15, 2005. The
      Company is currently evaluating the provisions of SFAS No. 123(R) and
      has
      not yet determined whether to use the modified prospective or the modified
      retrospective methods allowed by SFAS No. 123(R) .
      The
      Company expects that the new standards will have a material effect on its
      results from operations.





In
      March
      2005, the FASB issued FIN 47, “Accounting for Conditional Asset Retirement
      Obligations, an interpretation of FASB Statement No. 143” (“FIN 47”),
      which requires an entity to recognize a liability for the fair value of a
      conditional asset retirement obligation when incurred if the liability’s fair
      value can be reasonably estimated. FIN 47 is effective for fiscal years
      ending after December 15, 2005. The Company is currently evaluating
      the
      effect that the adoption of FIN 47 will have on its consolidated results
      of
      operations and financial condition but does not expect it to have a material
      impact.




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





**3.
      WARRANTY**





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





Changes
      in our warranty liability for the three and nine months ended June 30, 2005
      and
      2004, respectively, are as follows (in thousands):








-10-




**Three
                Months Ended**
              **June
                30,**
            ****
            **Nine
                Months Ended**
              **June
                30,**
            ********
            ****
            **2005**
            ****
            **2004**
            ****
            **2005**
            ****
            **2004**Beginning
                balance
            
            $
            386
            
            $
            659
            
            $
            424
            
            $
            644Provisions
                for warranty liability
            
            
            27
            
            
            26
            
            
            70
            
            
            109Warranty
                cost including labor, components and scrap
            
            
            (40
            )
            
            (62
            )
            
            (121
            )
            
            (130
            )Ending
                balance
            
            $
            373
            
            $
            623
            
            $
            373
            
            $
            623


**4.
      COMMITMENTS AND CONTINGENCIES**





*Commitments*





We
      lease
      our facilities under various operating lease agreements expiring on various
      dates through February 2009. The lease for our headquarters expires
      on
      February 21, 2009. Rent
      expense for this operating lease totaled approximately $128,000 and $380,000
      for
      the three and nine months ended June 30, 2005, respectively as compared to
      $117,000 and $391,000 for the three and nine months ended June 30, 2004,
      respectively. Minimum future lease payments under a noncancellable operating
      lease as of June 30, 2005 are as follows (in thousands):





Fiscal
                Year Ending September 30,
            
            **Capital**
              **Leases**
            ****
            **Operating
                Leases**Remainder
                of 2005
            
            $
            2
            
            $
            1062006
            
            
            8
            
            
            4032007
            
            
            8
            
            
            3612008
            
            
            3
            
            
            271Thereafter
            
            
            —
            
            
            92Total
                minimum lease payment
            
            
            21
            
            $
            1,233Amount
                representing interest
            
            
            4Present
                value of minimum lease payment
            
            
            17Current
                portion
            
            
            6Long-term
                portion
            
            $
            11


*Contingencies*





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




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





**5.
      TERMINATION OF DISTRIBUTION AGREEMENT**





On
      January 17, 2005, we sent written notice to Ingram Micro to terminate our
      distribution agreement and this agreement terminated on July 20, 2005. As of
      June 30, 2005, the balances outstanding with Ingram Micro were $22,000 in
      accounts receivable and the payment for these balances was received in July
      2005.






-11-


**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 is based on the beliefs of our management as well as assumptions made
      by
      and information currently available to our management. Additional
      forward-looking statements may be identified by the words
“anticipate,”“believe,”“expect,”“intend,”“plan,” or the negative of such terms,
      or similar expressions, as they relate to us or our management.





The
      forward-looking statements contained herein reflect our judgment as of the
      date
      of this report with respect to future events, the outcome of which is subject
      to
      certain risks, which 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
“Certain Factors Affecting Business, Operating Results, and Financial Condition”
      below.





**OVERVIEW**





We
      provide converged Internet protocol phone systems to small-to-medium sized
      businesses and branch offices of larger corporations which have less than 500
      employees per site. We first recognized revenues from product sales of our
      Quantum board and AltiWare software in July 1996. We generated net revenues
      of $4.1 million and $11.2 million for the three and nine months ended June
      30,
      2005, respectively, compared to net revenues of $3.9 million and $10.8 million
      for the three and nine months ended June 30, 2004, respectively. As of June
      30,
      2005, we had an accumulated deficit of $51.5 million.





We
      derive
      our revenues from sales of our AltiServ system, which includes hardware and
      software bundled into a suite of telephone systems. Product revenues consist
      of
      sales to end-users (including dealers) and to distributors. Revenues 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 on the inventories they carry on hand and
      return of products on termination.





Our
      cost
      of revenues 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 include the state
      of
      the economy, the market acceptance of our products, our ability to add new
      resellers and our ability to design, develop, and release new products. We
      engage third-party assemblers, which, for the three and nine months ended June
      30, 2005, were All Quality Services and Bestronics, each 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 achieve
      or 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,
      or maintain such reductions if they occur, could materially adversely affect
      our
      gross margins and operating results.





We
      continue to focus on 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. We also are continuing
      to focus on creating new product offerings. In particular, we are focusing
      on
      developing products that allow us to enhance our position in our target market
      segment and to enter new geographical markets. Additionally, we intend to
      continue to focus on selling our existing products to small-to-medium sized
      businesses and branch offices of larger corporations, which have no more than
      500 employees per site and emphasize the use of Internet protocol phone systems
      in their operations. Furthermore, we plan to continue to recruit additional
      resellers and distributors that focus on selling phone systems to our target
      customers. There can be no assurance, however, that we will be successful in
      developing any new products or enhancements to existing products, entering
      new
      geographical or product markets or expanding our network of resellers and
      distributors. We believe that the adoption rate for this new technology is
      much
      faster with small-to-medium sized businesses and branch offices of larger
      corporations which have less then 500 employees per site because they do not
      have significant investments in traditional phone systems. We believe that
      these
      businesses are looking for call center-type administration to increase the
      productivity and efficiency of their contacts with customers. Assuming
      continuing market trends, successful product enhancements, continuing acceptance
      of the call center products, continuing growth in the marketplaces of China,
      the
      United Kingdom and Norway, and a continuing moderate recovery in the North
      American economy, we expect to see continued revenue growth year over
      year.








-12-


**CRITICAL
      ACCOUNTING POLICIES**





*Revenue
      recognition.* Revenues
      consist of sales to end-users, including resellers, and to distributors.
      Revenues 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 revenues consist of
      product revenues 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 revenues until such distributors
      sell 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 revenues is also deferred and reported
      in
      the consolidated balance sheets as inventory. Our total deferred revenue was
      $633,000 as of June 30, 2005.





Software
      components are generally not sold separately from our hardware components.
      Software revenues consist of license revenues 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 to end-users and resellers because: (1) the PCS fee is included
      with the initial licensing fee; (2) the PCS included with the initial
      license fee is for one year or less; (3) the estimated cost of providing
      PCS during the arrangement is insignificant; and (4) unspecified
      upgrades/enhancements offered for minimal or no cost during PCS arrangements
      historically have been and are expected to continue to be minimal and
      infrequent. All estimated costs of providing the services, including upgrades
      and enhancements, are accrued for at the time of delivery.





*Allowance
      for Doubtful Accounts.* The
      allowance for doubtful accounts is based on our assessment of the collectibility
      of specific customer accounts and the aging of the accounts receivable. If
      there
      were a deterioration of a major customer’s creditworthiness, or actual defaults
      were higher than our historical experience, we could be required to increase
      our
      allowance and our earnings could be adversely affected. Our allowance for
      doubtful accounts was $26,000 as of June 30, 2005.





*Inventory.* Inventory is stated at the lower of cost (first-in, first-out method) or market.
      Our inventory balance was $1.1 million as of June 30, 2005. We regularly
      review value of inventory in detail, with consideration given to future customer
      demand for our products, obsolescence from rapidly changing technology, and
      other factors. If actual market conditions are less favorable than those
      projected by management, and our estimates prove to be inaccurate, we could
      be
      required to increase our inventory provision and our gross margins could be
      adversely affected. Our inventory allowance was $2.5 million as of June
      30,
      2005.





*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 $373,000 as of June 30, 2005.








-13-


**Results
      of Operations**





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




**Three
                  Months Ended**
              
              **Nine
                  Months Ended****June
                  30**
              
              **June
                  30****2005**
              
              **2004**
              
              **2005**
              
              **2004**Consolidated
                  Statements of Operations Data:Net
                  revenues:Hardware
              
              
              88.8
              %
              
              87.4
              %
              
              85.5
              %
              
              88.4
              %Software
              
              
              11.2
              
              
              12.6
              
              
              14.5
              
              
              11.6Total
                  net revenues
              
              
              100.0
              
              
              100.0
              
              
              100.0
              
              
              100.0Cost
                  of revenues:Hardware
              
              
              45.2
              
              
              37.0
              
              
              42.0
              
              
              37.6Software
              
              
              0.9
              
              
              1.1
              
              
              1.1
              
              
              1.0Total
                  cost of revenues
              
              
              46.1
              
              
              38.1
              
              
              43.1
              
              
              38.6Gross
                  profit
              
              
              53.9
              
              
              61.9
              
              
              56.9
              
              
              61.4Operating
                  expenses:Research
                  and development
              
              
              20.9
              
              
              19.4
              
              
              23.4
              
              
              22.2Sales
                  and marketing
              
              
              25.1
              
              
              26.8
              
              
              27.0
              
              
              28.6General
                  and administrative
              
              
              11.9
              
              
              11.6
              
              
              13.4
              
              
              12.3Total
                  operating expenses
              
              
              57.9
              
              
              57.8
              
              
              63.8
              
              
              63.1Income
                  (loss) from operations
              
              
              (4.0
              )
              
              4.1
              
              
              (6.9
              )
              
              (1.7
              )Interest
                  and other income, net
              
              
              1.7
              
              
              0.7
              
              
              1.5
              
              
              0.7Net
                  income (loss) before income taxes
              
              
              (2.3
              )
              
              4.8
              
              
              (5.4
              )
              
              (1.0
              )Income
                  taxes
              
              
              —
              
              
              —
              
              
              0.1
              
              
              —Net
                  income (loss)
              
              
              (2.3
              )%
              
              4.8
              %
              
              (5.5
              )%
              
              (1.0
              )%


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








Net
      Revenue by Geographic Area:


**Three
                Months Ended**
              **June
                30,**
            ****
            **Nine
                Months Ended**
              **June
                30,**
            ********
            ****
            **2005**
            ****
            **2004**
            ****
            **2005**
            ****
            **2004**Americas
            
            
            92
            %
            
            91
            %
            
            89
            %
            
            91
            %International
            
            
            8
            %
            
            9
            %
            
            11
            %
            
            9
            %100
            %
            
            100
            %
            
            100
            %
            
            100
            %





Net
      Revenue by Customers:


**Three
                Months Ended**
              **June
                30,**
            ****
            **Nine
                Months Ended**
              **June
                30,**
            ********
            ****
            **2005**
            ****
            **2004**
            ****
            **2005**
            ****
            **2004**AltiSys
                Communications, Inc.
            
            
            17
            %
            
            14
            %
            
            16
            %
            
            16
            %Ingram
                Micro
            
            
            --
            
            
            12
            %
            
            --
            
            
            15
            %Synnex
                Information Technology
            
            
            55
            %
            
            45
            %
            
            53
            %
            
            47
            %Graybar
                Electric Company, Inc.
            
            
            15
            %
            
            12
            %
            
            11
            %
            
            7
            %








-14-


Revenues
      generated in the Americas accounted for $3.8 million, or 92%, and $10.0
      million, or 89%, for the three and nine months ended June 30, 2005,
      respectively, as compared to $3.5 million, or 91%, and $9.8 million, or 91%,
      for
      the three and nine months ended June 30, 2004. Net revenues increased 6% to
      $4.1 million for the three months ended June 30, 2005 as compared to
      $3.9 million for the three months ended June 30, 2004 primarily as a
      result
      of increased customer acceptance of our new pricing and packaging strategy
      for
      our product bundling by including AltiView software, which offers more features
      than other products on the market and the penetration of our AltiContact Manager
      (ACM) in the call center market.  Net
      revenues increased 4% to $11.2 million for the nine months ended June
      30,
      2005 from $10.8 million for the nine months ended June 30, 2004 primarily
      as a result of selling more products into the call center market space as
      compared with the same period last year.





**Cost
      of revenues.** Cost of
      revenues for the three months ended June 30, 2005 increased $0.4 million or
      28%
      to $1.9 million from approximately $1.5 million for the three months ended
      June
      30, 2004. Cost of revenues for the nine months ended June 30, 2005 increased
      $0.6 million or 16% to $4.8 million from approximately $4.2 million for the
      nine
      months ended June 30, 2004 primarily due to an increase in overall sales of
      our
      products in the prior quarter. Cost of revenues as a percentage of net revenues
      increased from 38% and 39% for the three and nine months ended June 30, 2004,
      respectively, as compared to 46% and 43% for the three and nine months ended
      June 30, 2005, respectively. This increase primarily was caused by a lower
      profit margin as a result of lower selling prices on our low-end product
      bundles. No provision for excess or obsolete inventory was necessary in the
      three and nine months ended June 30, 2005.





**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 increased to
      $862,000 for the three months ended June 30, 2005 from $754,000 for the same
      period in fiscal 2004. This increase was primarily the result of an increase
      in
      headcount-related costs of $25,000 resulting from increases in salary for the
      research and development workforce, an increase in prototype expenses related
      to
      design, development and testing of our new product of $46,000 and an increase
      in
      equipment, recruiting, consultant expenses of $13,000. Research and development
      expenses as a percentage of revenue increased to 21% for the three months ended
      June 30, 2005 from 19% for the same period in fiscal 2004. Research and
      development increased to $2.6 million for the nine months ended June 30, 2005
      from $2.4 million for the same period in fiscal 2004. This increase was the
      result of an increase in headcount-related costs of $109,000 resulting from
      increase in salary for research and development workforce, an increase in
      prototype expenses related to design, development and testing of our new product
      of $74,000 and an increase in equipment, legal expenses of $41,000. Research
      and
      development expenses as a percentage of revenue increased to 23% for the nine
      months ended June 30, 2005 from 22% for the same period in fiscal 2004. We
      expect research and development expenses to remain relatively flat due to the
      uncertainty about customers' spending patterns in the current economic
      environment. Management continues to monitor research and development 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 remained unchanged at $1.0 million for the three months
      ended June 30, 2005 and 2004, respectively. Sales and marketing expenses as
      a
      percentage of revenue decreased to 25% for the three months ended June 30,
      2005
      from 26% for the same period in fiscal 2004 primarily due to an increase in
      revenue in the quarter. Sales and marketing expenses decreased to $3.0 million
      for the nine months ended June 30, 2005 from approximately $3.1 million for
      the
      same period in fiscal 2004. This decrease was primarily the result of a decrease
      in headcount-related cost of $22,000 resulting from a decrease in sales
      workforce, a decrease in relocation expense of $40,000 and a decrease in dealer
      training of $4,000. Sales and marketing expenses as a percentage of revenue
      decreased to 27% for the nine months ended June 30, 2005 from 28% for the same
      period in fiscal 2004 as a result of an overall increase in revenue during
      the
      nine months ended June 30, 2005. We expect sales and marketing expenses to
      remain relatively flat due to the uncertainty about customers' spending patterns
      in the current economic environment; however, some expenses, such as
      commissions, vary with revenues.





**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 $490,000 for the three months ended June
      30, 2005 from $449,000 for the same period in fiscal 2004. This increase was
      primarily the result of an increase in headcount-related costs of $15,000
      resulting from hiring new employees and an increase in financial audit fees
      of
      $76,000 reduced by the decrease in legal, insurance and telephone expenses
      of
      $50,000. General and administrative expenses as a percentage of revenue remained
      unchanged at 12% for the three months ended June 30, 2005 and 2004,
      respectively. General and administrative expenses increased to $1.5 million
      for
      the nine months ended June 30, 2005 from $1.3 million for the same period in
      fiscal 2004. This increase was primarily the result of an increase in financial
      audit fees of $165,000. General and administrative expenses as a percentage
      of
      revenue increased to 13% for the nine months ended June 30, 2005 from 12% for
      the same period in fiscal 2004. We expect general and administrative expenses
      to
      remain relatively flat due to the uncertainty about customers' spending patterns
      in the current economic environment.





-15-


**Interest
      and other income, net.** Net
      interest and other income increased to $69,000 and $165,000 for the three and
      nine months ended June 30, 2005, respectively, from $26,000 and $72,000 for
      the
      same period in fiscal 2004. The
      increase in net interest and other income for the three and nine months ended
      June 30, 2005 was primarily a result of higher interest rates .
      We
      expect net interest and other income to remain relatively flat as we have
      limited cash reserves to invest.





**Liquidity
      and Capital Resources**





Since
      inception, we primarily have financed our operations through the sale of equity
      securities. As of June 30, 2005, we had cash, cash equivalents, and short-term
      investments totaling $9.1 million, which consisted of cash and cash
      equivalents of $2.4 million and $6.7 million of short-term
      investments.





*Changes
      in Cash Flows*





During
      the nine months ended June 30, 2005, net cash used in operating activities
      was
      $1.0 million, which was approximately $137,000 higher than the cash used in
      operating activities during the same period of fiscal 2004 due to lower revenue
      being generated in the second quarter of fiscal 2005. For the nine months ended
      June 30, 2005, net cash provided by investing activities was $185,000, which
      was
      primarily attributable to proceeds from maturities of short-term investments.





Net
      accounts receivable increased to $2.5 million at June 30, 2005 from
      $1.9 million at September 30, 2004. The increase in net accounts
      receivable was primarily due to an increase in revenue.





We
      ended
      the third quarter of fiscal 2005 with a cash conversion cycle of 60 days
      as
      compared to 66 days for the third quarter of fiscal 2004. 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 added to days of supply in inventories, reduced by days of payable
      outstanding.





Inventories
      remained unchanged at $1.1 million at June 30, 2005 and September 30,
      2004
      and our inventory turn rate increased to 7.1 times at June 30, 2005 from 5.7
      times at September 30, 2004. Our inventory turn rate represents the
      number
      of times inventory is replenished during the quarter. Inventory management
      will
      continue to be an area of focus as we balance the need to maintain strategic
      inventory levels to help ensure competitive lead times with the risk of
      inventory obsolescence due to rapidly changing technology and customer
      requirements.





Accounts
      payable increased to $966,000 at June 30, 2005 from $798,000 at
      September 30, 2004. This increase primarily was due to more inventories
      purchased in the last month of the last quarter as a result of an increase
      in
      production. Our accrued payroll-related liabilities decreased to $284,000 at
      June 30, 2005 from $330,000 at September 30, 2004, primarily as a result
      of
      a decrease in employee stock purchase contribution.




During
      the nine months ended June 30, 2005, our net cash provided by financing
      activities was primarily attributable to the $350,000 of proceeds from the
      exercise of employee stock options and stock purchases through our employee
      stock purchase plan





*Liquidity
      and Capital Resources*





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





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





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







-16-


We
      do not
      have any material commitments for capital expenditures as of June 30, 2005.
      We
      have commitments under our noncancellable operating lease in the amount of
      $1.2 million as of June 30, 2005. The following table represents our
      future
      commitments as of June 30, 2005 (in thousands):





**Payments
                Due by Period**
            ******Contractual
                Obligations**
            ****
            **Total**
            ****
            **Less
                than**
              **1
                Year**
            ****
            **1
                - 3 Years**
            ****
            **3
                - 5 Years**
            ****
            **More
                than**
              **5
                Years**Operating
                lease obligations
            
            $
            1,233
            
            $
            106
            
            $
            764
            
            $
            363
            
            $
            --Capital
                lease obligations
            
            
            21
            
            
            2
            
            
            16
            
            
            3
            
            
            --Total
            
            $
            1,254
            
            $
            108
            
            $
            780
            
            $
            366
            
            $
            --


We
      believe we have sufficient cash reserves to allow us to continue operations
      for
      more than a year.





**Recent
      Accounting Pronouncements**




In
      November 2004, the Financial Accounting Standards Board (FASB) issued Statement
      of Financial Accounting Standards No. 151 (SFAS 151), “Inventory Costs, an
      amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4.”  SFAS
      151 amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing” to clarify
      the accounting for abnormal amounts of idle facility expense, freight handling
      costs, and wasted material (spoilage). SFAS 151 requires that those items be
      recognized as current-period charges regardless of whether they meet the
      criterion of “so abnormal.” In addition, SFAS 151 requires that allocation of
      fixed production overhead to the costs of conversion be based on the normal
      capacity of the production facilities. The provisions of SFAS 151 will be
      effective for fiscal years beginning after June 15, 2005. The Company is
      currently evaluating the provisions of SFAS 151 and does not believe
      that
      its adoption will have a material impact on the Company’s financial condition,
      results of operations or liquidity.





In
      December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets,
      which eliminates the exception for nonmonetary exchanges of similar productive
      assets and replaces it with a general exception for exchanges of nonmonetary
      assets that do not have commercial substance. SFAS No. 153 will be effective
      for
      nonmonetary asset exchanges occurring in fiscal periods beginning after June
      15,
      2005. The Company is currently evaluating the provisions of SFAS No.
      153
      and does not believe that its adoption will have a material impact on the
      Company’s financial condition, results of operations or liquidity.





In
      December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, which
      establishes standards for transactions in which an entity exchanges its equity
      instruments for goods or services. In March 2005, the SEC issued Staff
      Accounting Bulletin No. 107 - Share-Based Payment, which provides interpretive
      guidance related to SFAS No. 123(R). SFAS No. 123(R) requires a public entity
      to
      measure the cost of employee services received in exchange for an award of
      equity instruments based on the grant-date fair value of the award. This
      eliminates the exception to account for such awards using the intrinsic method
      previously allowable under APB Opinion No. 25. SFAS No. 123(R) will be effective
      beginning with the first interim or annual reporting period of our first fiscal
      year beginning on or after June 15, 2005. The
      Company is currently evaluating the provisions of SFAS No. 123(R) and
      has
      not yet determined whether to use the modified prospective or the modified
      retrospective methods allowed by SFAS No. 123(R) .
      The
      Company expects that the new standards will have a material effect on our
      results from operations.





In
      March
      2005, the FASB issued FIN 47, “Accounting for Conditional Asset Retirement
      Obligations, an interpretation of FASB Statement No. 143” (“FIN 47”),
      which requires an entity to recognize a liability for the fair value of a
      conditional asset retirement obligation when incurred if the liability’s fair
      value can be reasonably estimated. FIN 47 is effective for fiscal years
      ending after December 15, 2005. The Company is currently evaluating
      the
      effect that the adoption of FIN 47 will have on its consolidated results
      of
      operations and financial condition but does not expect it to have a material
      impact.




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








-17-


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





*Risks
      Related to AltiGen*





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





We
      have
      had a history of operating losses since our inception, and as of June 30, 2005,
      we had an accumulated deficit of $51.5 million. We may incur operating
      losses in the future, and these losses could be substantial and impact our
      ability to maintain profitability. We do not expect to materially increase
      expenditures for product development, general and administrative expenses,
      and
      sales and marketing expenses; however, if we cannot maintain current revenue
      growth, we will not be able to achieve or maintain profitability or positive
      operating cash flows. Even if we achieve profitability and positive operating
      cash flows, we may not be able to sustain or increase profitability or positive
      operating cash flows on a quarterly or annual basis.





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





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





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





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





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





•
            our
                ability to respond effectively to competitive pressures;





•
            our
                success in supporting our products and
                systems;





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





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





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





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





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





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







-18-


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





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





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





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





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





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





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





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





Sales
      through our three key distributors, AltiSys, Graybar and Synnex, accounted
      for
      87% and 80% of our net revenues for the three and nine months ended June 30,
      2005. Our business and operating results will suffer if any one of these
      distributors (or any additional distributors) does not continue distributing
      our
      products, fails to distribute the volume of our products that it currently
      distributes or fails to expand our customer base. We also need to establish
      and
      maintain relationships with additional distributors and original equipment
      manufacturers. We may not be able to establish, or successfully manage,
      relationships with additional distribution partners. In addition, our agreements
      with distributors typically provide for termination by either party upon written
      notice to the other party. For example, our agreement with Synnex provides
      for
      termination, with or without cause, by either party upon 30 days’ written
      notice to the other party, or upon insolvency or bankruptcy. Generally, these
      agreements are non-exclusive and distributors sell products that compete with
      ours. If we fail to establish or maintain relationships with distributors and
      original equipment manufacturers, our ability to increase or maintain our sales
      and our customer base will be substantially harmed. As of July 20, 2005, our
      agreement with Ingram Micro was terminated.







-19-


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





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





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





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





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





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





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





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





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





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





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







-20-


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





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





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





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





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





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





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





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





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





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







-21-


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




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





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





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





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





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





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





For
      the
      three and nine months ended June 30, 2005, approximately 8% and 11% of our
      net
      revenues, respectively, came from customers outside of the Americas. We intend
      to expand our international sales and marketing efforts. Our efforts are subject
      to a variety of risks associated with conducting business internationally,
      any
      of which could seriously harm our business, financial condition and results
      of
      operations. These risks include:





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





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





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





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





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





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





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





We
      perform final assembly, software installation and testing of our products at
      our
      facility in Fremont, California. Our facility is located on or near known
      earthquake fault zones and may be subject to rolling electrical blackouts and
      is
      vulnerable to damage or interruption








-22-


from
      fire, floods, earthquakes, power loss, telecommunications failures and similar
      events. If such a disaster or interruption occurs, our ability to perform final
      assembly, software installation and testing of our products at our facility
      would be seriously, if not completely, impaired. If we were unable to obtain
      an
      alternative place or way to perform these functions, our business, financial
      condition and results of operations would suffer. The insurance we maintain
      may
      not be adequate to cover our losses against fires, floods, earthquakes and
      general business interruptions.





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





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





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




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





*If,
      as of the end of our 2006 fiscal year, we are unable to assert that our internal
      control over financial reporting is effective, or if our auditors are unable
      to
      confirm our assessment, investors could lose confidence in our reported
      financial information, and the trading price of our stock price and our business
      could be adversely affected.*




We
      are in
      the process of documenting, and plan to test during the next fiscal year, our
      internal control procedures in order to satisfy the requirements of Section
      404
      of the Sarbanes-Oxley Act. Commencing on September 30, 2006, the end of our
      2006
      fiscal year, the Sarbanes-Oxley Act requires annual management assessments
      of
      the effectiveness of our internal controls over financial reporting and a report
      by our independent registered public accounting firm addressing these
      assessments. During the course of our testing we may identify deficiencies
      which
      we may not be able to remediate in time to meet the deadline imposed by the
      Sarbanes-Oxley Act for compliance with the requirements of Section 404. In
      addition, if we fail to achieve and maintain the adequacy of our internal
      controls, as such standards are modified, supplemented, or amended from time
      to
      time, we may not be able to ensure that we can conclude on an ongoing basis
      that
      we have effective internal controls over financial reporting in accordance
      with
      Section 404 of the Sarbanes-Oxley Act. Effective internal controls are important
      to help produce reliable financial reports and to prevent financial fraud.
      If we
      are unable to assert that our internal control over financial reporting is
      effective as of the end of our 2006 fiscal year, or if our auditors are unable
      to attest that our management’s report is fairly stated or they are unable to
      express an opinion on our management’s evaluation or on the effectiveness of the
      internal controls, we could lose investor confidence in the accuracy and
      completeness of our financial reports, investors could lose confidence in our
      reported financial information, and the trading price of our stock and our
      business could be adversely affected.





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




In
      December 2004 FASB adopted Statement No. 123(R), “Share-Based Payment.” In April
      2005, the SEC announced a delay of the effective date until the first interim
      or
      annual reporting period of a company’s first fiscal year beginning on or after
      June 15, 2005. SFAS No. 123(R) will require us, starting in the first quarter
      of
      fiscal year 2006 which begins on October 1, 2005, to measure compensation costs
      for all stock based compensation (including stock options and our employee
      stock
      purchase plan, as currently constructed) at fair value and take a compensation
      charge equal to that value. We expect that this statement will have a material
      effect on our results from operations.






-23-


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





*Risks
      Related to the Industry*





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





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





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





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





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





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








-24-


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





*Market
      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 short-term investments; however, we have concluded that a change
      in interest rates does not 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
      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.








-25-


**PART
      II. OTHER INFORMATION**





**Item
      1. Legal Proceedings****.**





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





See
      Note
      4 in the Notes to Unaudited Condensed Consolidated Financial Statements of
      this
      Form 10-Q titled “Commitments and Contigencies.”





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





None





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





None





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





None





**Item
      5. Other Information** **.**





None





**Item
      6. Exhibits** **.**








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










-26-


**SIGNATURE**





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




**ALTIGEN
                COMMUNICATIONS, INC.**Date: August
                15, 2005
              By:
              /s/ Philip
                M. McDermottPhilip
                  M. McDermott,
                Chief Financial Officer
                (Principal Financial and Accounting
                  Officer)


-27-


**EXHIBIT
      INDEX**





**Exhibit**
              **Number**
            
            **Description**3.1
                (1)
            
            Amended
                and Restated Certificate of Incorporation.3.2
                (2)
            
            Second
                Amended and Restated Bylaws.31.1
            
            Certification
                of Principal Executive Officer.31.2
            
            Certification
                of Principal Financial Officer.32.1
            
            Certification
                of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002.32.2
            
            Certification
                of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of
                2002.





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














-28-