**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **WASHINGTON,
        D.C. 20549**
 
 **FORM
        10-Q**
 **x**
                **QUARTERLY
                    REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                    ACT OF
                    1934**
  **FOR
          THE QUARTERLY PERIOD ENDED JUNE 30, 2007**
  **OR**
  **o**
                **TRANSITION
                    REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                    ACT OF
                    1934**
  **FOR
          THE TRANSITION PERIOD FROM ______________ TO ______________**
 
 **Commission
          File Number 000-27427**
 
 **ALTIGEN
        COMMUNICATIONS, INC.**
 (Exact
        name of Registrant as specified in its charter)
 
 **DELAWARE**
              
              **94-3204299**(State
                  or other jurisdiction of
                incorporation
                  or organization)
              
              (I.R.S.
                  Employer
                Identification
                  Number)**4555
                  Cushing Parkway**
                **Fremont,
                  CA**
              
              **94538**(Address
                  of principal executive offices)
              
              (Zip
                  Code)
 Registrant’s
          telephone number, including area code: **(510)
          252-9712**
  Former
        name, former address and former fiscal year, if changed since last report:
        N/A
  Indicate
        by check mark whether the registrant (1) has filed all reports required to
        be
        filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period that the registrant was required
        to file such reports), and (2) has been subject to such filing requirements
        for
        the past 90 days.   YES x NO  o
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange
        Act.  Large accelerated filer o Accelerated filer o Non-accelerated filer x
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Exchange Act).    Yes  ̈ No  x
 
 The
        number of shares of our common stock outstanding as of August 9, 2007 was:
        15,643,445 shares
  
 
 
 
 **Table
        of Contents**
 **PART
                    I. FINANCIAL INFORMATION**Item
                    1.
                Condensed
                    Consolidated Financial Statements (unaudited)Condensed
                    Consolidated Balance Sheets as of June 30, 2007 and September
                    30, 2006
                3Condensed
                    Consolidated Statements of Operations for the Three and Nine
                    Months Ended
                    June 30, 2007 and 2006
                4Condensed
                    Consolidated Statements of Cash Flows for the Nine Months Ended
                    June 30,
                    2007 and 2006
                5Notes
                    to Condensed Consolidated 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
                19Item
                    4.
                Controls
                    and Procedures
                19**PART
                    II. OTHER INFORMATION**Item
                    1.
                Legal
                    Proceedings
                20Item
                    6.
                Exhibits
                21**SIGNATURE**
                22**EXHIBIT
                    INDEX**
                23
  2
  **PART
        I. FINANCIAL INFORMATION**
 
 **Item
                  1.**
              **Condensed
                  Consolidated Financial
                  Statements**
 
 **ALTIGEN
        COMMUNICATIONS, INC. AND SUBSIDIARY**
 **CONDENSED
        CONSOLIDATED BALANCE SHEETS**
 **(UNAUDITED)**
 **(In
        thousands, except share and per share amounts)**
 
 **June
                  30,2007**
              
              **September
                  30,2006****ASSETS**Current
                  assets:Cash
                  and cash equivalents
              
              $
              8,173
              
              $
              5,053Short-term
                  investments
              
              
              1,891
              
              
              4,869Accounts
                  receivable, net of allowances of $32 and $38 at June 30, 2007 and
                  September 30, 2006, respectively.
              
              
              2,082
              
              
              2,230Inventories
              
              
              2,010
              
              
              1,382Prepaid
                  expenses and other current assets
              
              
              220
              
              
              123Total
                  current assets
              
              
              14,376
              
              
              13,657Property
                  and equipment:Furniture
                  and equipment
              
              
              1,824
              
              
              1,783Computer
                  software
              
              
              938
              
              
              9202,762
              
              
              2,703Less:
                  Accumulated depreciation
              
              
              (2,209
              )
              
              (2,022
              )Net
                  property and equipment
              
              
              553
              
              
              681Other
                  non-current assets:Long-term
                  investments
              
              
              210
              
              
              211Long-term
                  deposit
              
              
              168
              
              
              95Total
                  other non-current assets
              
              
              378
              
              
              306Total
                  assets
              
              $
              15,307
              
              $
              14,644**LIABILITIES
                  AND STOCKHOLDERS' EQUITY**Current
                  liabilities:Accounts
                  payable
              
              $
              981
              
              $
              837Accrued
                  liabilities:Payroll
                  and related benefits
              
              
              349
              
              
              328Warranty
              
              
              249
              
              
              263Marketing
              
              
              79
              
              
              68Accrued
                  expense
              
              
              251
              
              
              263Other
              
              
              382
              
              
              340Deferred
                  revenue
              
              
              618
              
              
              531Total
                  current liabilities
              
              
              2,909
              
              
              2,630Long-term
                  deferred rent and other
              
              
              115
              
              
              177Stockholders'
                  equity:Convertible
                  preferred stock, $0.001 par value; Authorized—5,000,000
                  shares; Outstanding—none
                  at June 30, 2007 and September 30, 2006
              
              
              —
              
              
              —Common
                  stock, $0.001 par value; Authorized—50,000,000
                  shares; Outstanding—16,705,742
                  shares at June 30, 2007 and16,157,364
                  shares at September 30, 2006
              
              
              16
              
              
              16Treasury
                  stock at cost—1,063,895 shares at June 30, 2007 and September 30, 2006
              
              
              (1,014
              )
              
              (1,014
              )Additional
                  paid-in capital
              
              
              65,230
              
              
              63,993Accumulated
                  other comprehensive loss
              
              
              —
              
              
              —Accumulated
                  deficit
              
              
              (51,949
              )
              
              (51,158
              )Total
                  stockholders' equity
              
              
              12,283
              
              
              11,837Total
                  liabilities and stockholders' equity
              
              $
              15,307
              
              $
              14,644
 
 The
        accompanying notes are an integral part of these unaudited condensed
        consolidated financial statements.
  3
 
 **ALTIGEN
        COMMUNICATIONS, INC. AND SUBSIDIARY**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS**
 **(UNAUDITED)**
 **(In
        thousands, except per share amounts)**
 
 **Three
                  Months Ended**
                **June
                  30,**
              
              **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Net
                  revenue:Hardware
              
              $
              3,840
              
              $
              4,426
              
              $
              11,641
              
              $
              12,349Software
              
              
              341
              
              
              380
              
              
              1,057
              
              
              1,034Total
                  net revenue
              
              
              4,181
              
              
              4,806
              
              
              12,698
              
              
              13,383Cost
                  of revenue:Hardware
              
              
              1,920
              
              
              2,066
              
              
              5,780
              
              
              5,972Software
              
              
              28
              
              
              29
              
              
              83
              
              
              76Total
                  cost of revenue
              
              
              1,948
              
              
              2,095
              
              
              5,863
              
              
              6,048Gross
                  profit
              
              
              2,233
              
              
              2,711
              
              
              6,835
              
              
              7,335Operating
                  expenses:Research
                  and development
              
              
              860
              
              
              932
              
              
              2,502
              
              
              2,853Sales
                  and marketing
              
              
              1,405
              
              
              1,160
              
              
              3,683
              
              
              3,250General
                  and administrative
              
              
              604
              
              
              516
              
              
              1,776
              
              
              1,601Total
                  operating expenses
              
              
              2,869
              
              
              2,608
              
              
              7,961
              
              
              7,704Income
                  (loss) from operations
              
              
              (636
              )
              
              103
              
              
              (1,126
              )
              
              (369
              )Equity
                  in net income (loss) of investee
              
              
              3
              
              
              (8
              )
              
              (1
              )
              
              (32
              )Interest
                  and other income, net
              
              
              111
              
              
              100
              
              
              347
              
              
              268Net
                  income (loss) before taxes
              
              
              (522
              )
              
              195
              
              
              (780
              )
              
              (133
              )Income
                  taxes
              
              
              (4
              )
              
              (5
              )
              
              (11
              )
              
              (14
              )Net
                  income (loss)
              
              $
              (526
              )
              $
              190
              
              $
              (791
              )
              $
              (147
              )Basic
                  and diluted net income (loss) per share
              
              $
              (0.03
              )
              $
              0.01
              
              $
              (0.05
              )
              $
              (0.01
              )Weighted
                  average shares used in computing basic net income (loss) per
                  share
              
              
              15,505
              
              
              15,000
              
              
              15,266
              
              
              14,926Weighted
                  average shares used in computing diluted net income (loss) per
                  share
              
              
              15,505
              
              
              15,605
              
              
              15,266
              
              
              14,926
 
 The
        accompanying notes are an integral part of these unaudited condensed
        consolidated financial statements.
  4
 
 **ALTIGEN
        COMMUNICATIONS, INC. AND SUBSIDIARY**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **(UNAUDITED)**
 **(In
        thousands)**
  **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  loss
              
              $
              (791
              )
              $
              (147
              )Adjustments
                  to reconcile net income (loss) to net cash used in operating
                  activities:Depreciation
              
              
              187
              
              
              156Stock
                  based compensation
              
              
              417
              
              
              627Equity
                  in net loss of investee
              
              
              1
              
              
              33Changes
                  in operating assets and liabilities:Accounts
                  receivable
              
              
              148
              
              
              (342
              )Inventories
              
              
              (628
              )
              
              (639
              )Prepaid
                  expenses and other current assets
              
              
              (97
              )
              
              (36
              )Accounts
                  payable
              
              
              144
              
              
              396Accrued
                  liabilities
              
              
              48
              
              
              64Deferred
                  revenue
              
              
              87
              
              
              54Long-term
                  deferred rent and other
              
              
              (62
              )
              
              (59
              )Net
                  cash provided by (used in) operating activities
              
              
              (546
              )
              
              107CASH
                  FLOWS FROM INVESTING ACTIVITIES:Purchases
                  of short-term investments
              
              
              (17,086
              )
              
              (6,900
              )Net
                  proceeds from sale of short-term investments
              
              
              20,064
              
              
              10,435Changes
                  in long-term deposits
              
              
              (73
              )
              
              —Purchases
                  of property and equipment
              
              
              (59
              )
              
              (354
              )Net
                  cash provided by investing activities
              
              
              2,846
              
              
              3,181CASH
                  FLOWS FROM FINANCING ACTIVITIES:Proceeds
                  from issuances of common stock, net of issuance costs
              
              
              820
              
              
              302Net
                  cash provided by financing activities
              
              
              820
              
              
              302NET
                  INCREASE IN CASH AND CASH EQUIVALENTS
              
              
              3,120
              
              
              3,590CASH
                  AND CASH EQUIVALENTS, BEGINNING OF PERIOD
              
              
              5,053
              
              
              3,963CASH
                  AND CASH EQUIVALENTS, END OF PERIOD
              
              $
              8,173
              
              $
              7,553SUPPLEMENTAL
                  DISCLOSURE OF CASH FLOW INFORMATION:Cash
                  paid during the period for:Income
                  taxes
              
              $
              (20
              )
              $
              (1
              )Interest
              
              $
              (10
              )
              $
              (13
              )
 
 The
        accompanying notes are an integral part of these unaudited condensed
        consolidated financial statements.
  5
  **ALTIGEN
        COMMUNICATIONS, INC. AND SUBSIDIARY**
 **NOTES
        TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL
        STATEMENTS**
 
 **1.
        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**
 
 **BASIS
        OF PRESENTATION**
 
 AltiGen
        Communications, Inc. (“we” or the “Company”) is a pioneer and market leader in
        Voice over Internet Protocol (VoIP) telephony systems for small-to medium-sized
        businesses. We design, manufacture and market next generation, Internet protocol
        phone systems and contact centers that use both the Internet and the public
        telephone network to take advantage of the convergence of voice and data
        communications. Unlike traditional proprietary phone systems, our systems
        are
        designed with open architecture and are built on an industry standard platform.
        This adherence to industry standards allows our products to play an important
        role in the small-to medium- sized business market by delivering phone systems
        that can function with other technologies to provide integrated voice and
        data
        solutions. We believe this enables our customers to implement communication
        systems that have an increased return versus past technology
        investments.
 
 The
        accompanying unaudited condensed consolidated financial statements have been
        prepared in conformity with generally accepted accounting principles for
        interim
        financial information and with the instructions for Form 10-Q and Article
        10 of
        Regulation S-X. Accordingly, certain information and footnote disclosures
        normally included in financial statements prepared in accordance with generally
        accepted accounting principles have been condensed, or omitted, pursuant
        to the
        rules and regulations of the Securities and Exchange Commission (the “SEC”).
        These unaudited condensed consolidated financial statements reflect the
        operations of the Company and its wholly-owned subsidiary. All significant
        intercompany transactions and balances have been eliminated. In our opinion,
        these unaudited condensed consolidated financial statements include all
        adjustments necessary (which are of a normal and recurring nature) for a
        fair
        presentation of the Company’s financial position, results of operations and cash
        flows for the periods presented.
 
 These
        financial statements should be read in conjunction with our audited consolidated
        financial statements for the fiscal year ended September 30, 2006, included
        in
        the Company’s 2006 Annual Report on Form 10-K filed with the SEC on December 29,
        2006. AltiGen’s results of operations for any interim period are not necessarily
        indicative of the results of operations for any other interim period or for
        a
        full fiscal year.
 
 **CASH
        AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS**
 
 We
        consider all highly liquid investments with an original maturity of three
        months
        or less from the date of purchase to be cash equivalents. Short-term investments
        are in highly liquid financial instruments with original maturities greater
        than
        three-months but less than one year and are classified as “available-for-sale”
investments. Investments are reported at their fair value, with unrealized
        gains
        and losses excluded from earnings and reported as a separate component of
        stockholders’ equity. As of June 30, 2007, our cash and cash equivalents
        consisted of commercial paper and cash deposited in checking and money market
        accounts.
 
 **INVENTORIES**
 
 Inventories
        (which include costs associated with components assembled by third-party
        assembly manufacturers, as well as internal labor and allocable overhead)
        are
        stated at the lower of cost (which approximates actual cost on first-in,
        first-out method) or market value. Provisions, when required, are made to
        reduce
        excess and obsolete inventories to their estimated net realizable values.
        We
        regularly monitor inventory quantities on hand and record a provision for
        excess
        and obsolete inventories based primarily on our estimated forecast of product
        demand and production requirements for the next six months. A s
        of
        September 30, 2006, we recognized $122,000 of provision for excess and obsolete
        inventories offset by a $301,000 reversal of inventories from prior year.
        For
        the nine months ended June 30, 2007, we recognized $22,000 of
        provision for excess and obsolete inventories. The components of inventories
        include (in thousands):
 
 **June
                  30,**
              
              **September
                  30,****2007**
              
              **2006**Raw
                  materials
              
              $
              815
              
              $
              497Work-in-progress
              
              
              144
              
              
              75Finished
                  goods
              
              
              1,051
              
              
              810$
              2,010
              
              $
              1,382
  6
  **LONG-TERM
        INVESTMENTS**
 
 As
        of
        June 30, 2007, we held an investment of common stock in a private Taiwanese
        telecommunication company valued at approximately $195,000 using the cost
        method. Our interest in the company is approximately 2%, which does not allow
        us
        to exercise significant influence.
 
 In
        July
        2004, we purchased common stock of a private Korean telecommunications company
        for **** $ 79,000.
        As a result of this investment, we acquired approximately 23% of the voting
        power of the company. This gives us the right to nominate and elect one of
        the
        three members of the company's current board of directors.  We are
        accounting for this investment using the equity method and record our minority
        interest in our results of operations. As of June 30, 2007, our investment
        in
        the Korean company had a remaining book value of approximately
        $14,000.
 
 We
        perform a periodic review of our investments for impairment. Our investments
        are
        considered impaired when a review of the corporate operations and other
        indicators of impairment indicate that the carrying value of the investment
        is
        not likely to be recoverable. Such indicators include, but are not limited
        to,
        limited capital resources, limited prospects of receiving additional financing,
        and limited prospects for liquidity of the related securities. The Company
        determined that no write-downs existed in the nine months ended June 30,
        2007.
 
 **REVENUE
        RECOGNITION**
 
 We
        account for the recognition of software license revenue in accordance with
        Statement of Position ("SOP") 97-2, "Software Revenue Recognition.” Revenue
        consist of sales to end-users, including resellers, and to distributors.
        Revenue
        from sales to end-users are recognized upon shipment, when risk of loss has
        passed to the customer, collection of the receivable is reasonably assured,
        persuasive evidence of an arrangement exits, and the price is fixed and
        determinable. Sales to distributors are made under terms allowing certain
        rights
        of return and protection against subsequent price declines on the Company's
        products held by its distributors. Upon termination, any unsold products
        may be
        returned by the distributor for a full refund. These agreements may be canceled
        by either party based on a specified notice. As a result of the above
        provisions, we defer recognition of distributor revenue until such distributors
        resell our products to their customers. The amounts deferred as a result
        of this
        policy are reflected as "deferred revenue" in the accompanying consolidated
        balance sheets. The related cost of revenue is also deferred and reported
        in the
        consolidated balance sheets as inventory.
 
 Software
        components are generally not sold separately from our hardware components.
        Software revenue consist of license revenue that are recognized upon the
        delivery of application products. We provide limited post-contract customer
        support ("PCS"), consisting primarily of technical support and "bug" fixes.
        In
        accordance with SOP 97-2, revenue earned on software arrangements involving
        multiple elements is allocated to each element based upon the relative fair
        values of the elements. Although we provide PCS, the revenue allocated to
        this
        element is recognized together with the initial licensing fee on delivery
        of the
        software because: (1) the PCS fee is included with the initial licensing
        fee; (2) the PCS included with the initial license fee is for one year or
        less; (3) the estimated cost of providing PCS during the arrangement is
        insignificant; and (4) unspecified upgrades/enhancements offered for
        minimal or no cost during PCS arrangements historically have been and are
        expected to continue to be minimal and infrequent. All estimated costs of
        providing the services, including upgrades and enhancements, are accrued
        for at
        the time of delivery.
 
 **STOCK-BASED
        COMPENSATION**
 
 Commencing
        October 1, 2005, we adopted the provisions of Statement of Financial Accounting
        Standard (“SFAS”) No. 123(R), Stock-Based Compensation (“SFAS No. 123(R)”),
        which requires all share-based compensations, including grants of stock options,
        to be recognized in the income statement as an operating expense, based on
        their
        fair values.
 
 Prior
        to
        adopting SFAS No. 123(R), we accounted for stock-based employee compensation
        under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock
        Issued to Employees,” and
        comply with the disclosure provisions of SFAS No. 123, as amended by SFAS
        No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosures.”
The Company has applied
        the modified prospective method in adopting SFAS No. 123(R). Accordingly,
        periods prior to adoption have not been restated.
  7
 
 As
        of
        October 1, 2005, under the adoption of SFAS No. 123(R) 1.3 million of unvested
        stock options were outstanding.
 
 The
        following table summarizes the total stock-based compensation expense for
        the
        three and nine months ended June 30, 2007 and June 30, 2006 from all of the
        Company’s stock compensation plans, included in the Unaudited Condensed
        Consolidated Statements of Operations (in thousands):
 
 **Three
                  Months Ended**
                **June
                  30,**
              
              **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Cost
                  of goods sold
              
              $
              6
              
              $
              9
              
              $
              17
              
              $
              29Research
                  and development
              
              
              57
              
              
              62
              
              
              146
              
              
              221Selling,
                  general and administrative
              
              
              98
              
              
              120
              
              
              254
              
              
              377Pre-tax
                  stock-based compensation expense
              
              
              161
              
              
              191
              
              
              417
              
              
              627Income
                  tax
              
              
              —
              
              
              —
              
              
              —
              
              
              —Net
                  stock-based compensation expense
              
              $
              161
              
              $
              191
              
              $
              417
              
              $
              627
 
 The
        fair
        value of each option grant during the nine months ended June 30, 2007 and
        June
        30, 2006 was estimated at the date of grant using the Black-Scholes option
        pricing model, and is not subject to revaluation as a result of subsequent
        stock
        price fluctuations. The following weighted-average assumptions are
        used:
  **Employee
                  Stock Option Plan**
                **Three
                  Months Ended**
                **June
                  30,**
              
              **Employee
                  Stock Option Plan**
                **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Expected
                  Life (in years)
              
              
              5
              
              
              5
              
              
              5
              
              
              5Risk-free
                  interest rate
              
              
              4.6
              %
              
              4.9
              %
              
              4.6
              %
              
              4.9
              %Volatility
              
              
              91
              %
              
              95
              %
              
              91
              %
              
              95
              %Expected
                  dividend
              
              
              0.0
              %
              
              0.0
              %
              
              0.0
              %
              
              0.0
              %
 
 The
        fair
        value of each purchase rights granted under the Company’s Employee Stock
        Purchase Plan during the nine month ended June 30, 2007 and June 30, 2006
        were
        estimated at the date of grant using the Black-Scholes option pricing model,
        and
        is not subject to revaluation as a result of subsequent stock price
        fluctuations. The following weighted-average assumptions are used:
 
 **Employee
                  Stock Purchase Plan Three Months Ended**
                **June
                  30,**
              
              **Employee
                  Stock Purchase Plan Nine Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Expected
                  Life (in years)
              
              
              0.5
              
              
              0.5
              
              
              0.5
              
              
              0.5Risk-free
                  interest rate
              
              
              5.0
              %
              
              5.0
              %
              
              5.0
              %
              
              5.0
              %Volatility
              
              
              90
              %
              
              96
              %
              
              90
              %
              
              96
              %Expected
                  dividend
              
              
              0.0
              %
              
              0.0
              %
              
              0.0
              %
              
              0.0
              %
 
 The
        following table summarizes the activity in the Company’s stock option plan
        during the three months ended June 30, 2007:
 **Options**
                  
                  **Number
                      of Shares**
                  
                  **Weighted
                      Average Exercise Price**
                  
                  **Weighted
                      Average Remaining Contractual Term**Options
                      outstanding at April 1, 2007
                  
                  
                  3,430,473
                  
                  $
                  3.79Options
                      granted
                  
                  
                  739,000
                  
                  $
                  1.77Options
                      exercised
                  
                  
                  (388,750
                  )
                  $
                  1.66Options
                    forfeitures or expired
                  
                  
                  (49,791
                  )
                  $
                  5.01Options
                      outstanding at June 30, 2007
                  
                  
                  3,730,932
                  
                  $
                  3.60
                  
                  
                  5.36Options
                      vested and expected to vest at June 30, 2007
                  
                  
                  3,601,530
                  
                  $
                  3.65
                  
                  
                  5.24Options
                      exercisable at June 30, 2007
                  
                  
                  3,041,013
                  
                  $
                  3.89
                  
                  
                  4.59
 
 8
  At
        June
        30, 2007, the intrinsic value of the ending outstanding stock options was
        $924,000. The total ending vested and expected to vest stock options were
        3.6
        million shares, the weighted average exercise price was $3.65, the intrinsic
        value was $923,000, and the remaining contractual term was 5.24 years. The
        total
        ending exercisable stock options were 3.0 million shares, the intrinsic value
        was $920,000, the weighted average exercise price was $3.89, and the remaining
        contractual term was 4.59 years.
 
 Under
        the
        1999 Employee Stock Purchase Plan (the “1999 Purchase Plan”), we had reserved as
        of September 30, 2006, 765,640 shares of common stock for issuance to eligible
        employees at a price equal to 85% of the lower of the fair market value of
        the
        common stock on the first day of the offering period or a specified exercise
        date (last trading day in April or October). During
        the nine months ended June 30, 2007, 94,750 shares were purchased by and
        distributed to employees at a price of $1.35 per share.
 
 The
        Black-Scholes option pricing model was developed for use in estimating the
        fair
        value of traded options that have no vesting restrictions and are fully
        transferable. In addition, option pricing models require the input of highly
        subjective assumptions, including the expected stock price volatility. We
        use
        projected volatility rates, which are based upon historical volatility rates
        since our initial public offering, trended into future years. We also use
        historical data to estimate option forfeitures. Because our employee stock
        options have characteristics significantly different from those of traded
        options and because changes in the subjective input assumptions can materially
        affect the fair value estimate, the existing models do not in management's
        opinion, provide a reliable single measure of the fair value of our options.
 
 **COMPUTATION
        OF BASIC AND DILUTED NET 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
        (loss) per share under two methods (basic and diluted). Basic net income
        (loss)
        per share is calculated by dividing net income (loss) by the weighted average
        shares of common stock outstanding during the period. Diluted
        earnings (loss) per share reflect the potential dilution that could occur
        if
        securities or other contracts to issue common stock were exercised or converted
        into common stock.
 
 Basic
        and
        diluted income (loss) per share for each of the three and nine month periods
        ended June 30, 2007 and June 30, 2006 are computed as follows (in thousands,
        except for per share data):
 **Three
                  Months Ended**
                **June
                  30,**
              
              **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Net
                  income (loss)
              
              $
              (526
              )
              $
              190
              
              $
              (791
              )
              $
              (147
              )Weighted
                  average shares outstanding-basic income (loss) per share
              
              
              15,505
              
              
              15,000
              
              
              15,266
              
              
              14,926Weighted
                  average shares outstanding-
                  diluted income (loss) per share
              
              
              15,505
              
              
              15,605
              
              
              15,266
              
              
              14,926Basic
                  income (loss) per share
              
              $
              (0.03
              )
              $
              0.01
              
              $
              (0.05
              )
              $
              (0.01
              )Diluted
                  income (loss) per share
              
              $
              (0.03
              )
              $
              0.01
              
              $
              (0.05
              )
              $
              (0.01
              )
  **COMPREHENSIVE
        INCOME (LOSS)**
 
 Comprehensive
        income consists of net income (loss) and net unrealized gain (losses) on
        available-for-sales investments. Comprehensive loss for the three and nine
        month
        periods ended June 30, 2007 and 2006 were as follows (in thousands):
 **Three
                    Months Ended**
                  **June
                    30,**
                
                **Nine
                    Months Ended**
                  **June
                    30,****2007**
                
                **2006**
                
                **2007**
                
                **2006**Net
                    income (loss)
                
                $
                (526
                )
                $
                190
                
                $
                (791
                )
                $
                (147
                )Change
                    in unrealized gain (loss) on securities available for sale
                
                
                —
                
                
                1
                
                
                —
                
                
                (1
                )Comprehensive
                    income (loss)
                
                $
                (526
                )
                $
                189
                
                $
                (791
                )
                $
                (148
                )
  9
  **SEGMENT
        REPORTING**
 
 We
        are
        organized and operate as two operating segments, the Americas and International.
        The Americas is comprised of the United States, Canada, Mexico, Central America
        and the Caribbean. The International segment is comprised of China, the United
        Kingdom and Norway.
 
 Net
        revenue by geographic region based on customer location for the three and
        nine
        months ended June 30, 2007 and 2006, respectively, were as follows:
 
 **Three
                  Months Ended**
                **June
                  30,**
              
              **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Americas
              
              
              92
              %
              
              88
              %
              
              91
              %
              
              90
              %International
              
              
              8
              %
              
              12
              %
              
              9
              %
              
              10
              %Total
              
              
              100
              %
              
              100
              %
              
              100
              %
              
              100
              %
 
 International
        is comprised of revenue primarily from China, the United Kingdom and Norway.
        Most significant long-lived assets are located in the United States. Our
        hardware tooling used to develop the IP710 and the IP705 phones as well as
        the
        tooling used to develop the face plate for the MAX1000 Voice over IP phone
        system are located in Taiwan.
 
 Net
        revenue by customers that individually accounted for more than 10% of our
        revenue for the three and nine months ended June 30, 2007 and 2006,
        respectively, were as follows:
 
 **Three
                  Months Ended**
                **June
                  30,**
              
              **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Synnex
              
              
              52
              %
              
              58
              %
              
              52
              %
              
              56
              %AltiSys
              
              
              17
              %
              
              12
              %
              
              15
              %
              
              15
              %Graybar
              
              
              14
              %
              
              13
              %
              
              15
              %
              
              14
              %
 
 **2.
        WARRANTY**
 
 The
        Company provides a one-year warranty for hardware products. We historically
        have
        experienced minimal warranty costs. Factors that affect our provision for
        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 provision for warranty
        liability every quarter and make adjustments to the liability if necessary.
 
 Changes
        in our provision for warranty liability for the three and nine months ended
        June
        30, 2007 and 2006, respectively, are as follows (in thousands):
 
 **Three
                  Months Ended June 30,**
              
              **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Beginning
                  balance
              
              $
              257
              
              $
              276
              
              $
              263
              
              $
              264Provision
                  for warranty liability
              
              
              39
              
              
              50
              
              
              124
              
              
              129Warranty
                  cost including labor, components and scrap
              
              
              (47
              )
              
              (30
              )
              
              (138
              )
              
              (97
              )Ending
                  balance
              
              $
              249
              
              $
              296
              
              $
              249
              
              $
              296
  10
  **3.
        COMMITMENTS AND CONTINGENCIES**
  *Commitments*
  We
        lease
        our facilities under various operating lease agreements expiring on various
        dates through February 2009. In December 2003, we leased approximately
        32,000 square feet to serve as our headquarters for corporate administration,
        research and development, manufacturing, and sales and marketing facility
        in
        Fremont, California. The lease for our headquarters expires on February 21,
        2009. Rent expense for all operating leases totaled approximately $134,000
        and
        $417,000 for the three and nine months ended June 30, 2007, respectively,
        as
        compared to $140,000 and $399,000 for three and nine months ended June 30,
        2006,
        respectively. The increase from $399,000 to $417,000 for the nine months
        ended
        June 30, 2006 and 2007, respectively, was related to the renewal of our building
        lease agreement for the Beijing office starting in the last month of second
        quarter of fiscal 2006. Additionally, in June 2007, our Shanghai branch entered
        into a new lease for a new building for a period of three years. We also
        lease
        certain equipment under capital lease arrangements. Minimum future lease
        payments under all noncancellable capital and operating leases as of June
        30,
        2007 are as follows (in thousands):
 Capital
              
              OperatingFiscal
                  Year Ending September 30,
              
              Leases
              
              LeasesRemainder
                  of 2007
              
              $
              13
              
              $
              1212008
              
              
              47
              
              
              5262009
              
              
              44
              
              
              3322010
              
              
              33
              
              
              220Total
                  minimum lease payment
              
              $
              137
              
              $
              1,199Amount
                  representing interest
              
              $
              17Present
                  value of minimum lease payment
              
              
              120Total
                  minimum lease payment
              
              $
              137Current
                  portion plus current portion of interest
              
              $
              49Long-term
                  portion plus long-term portion of interest
              
              
              88Total
                  capital lease commitments
              
              $
              137
  *Contingencies*
 
 We
        may
        become party to litigation in the normal course of our business. Litigation
        in
        general and intellectual property and securities litigation in particular,
        can
        be expensive and disruptive to normal business operations. Moreover, the
        results
        of complex litigation are difficult to predict.
  On
        September 6, 2002, Vertical Networks, Inc. filed suit against us in
        the United States District Court for the Northern District of California,
        alleging infringement of Vertical Networks’ U.S. Patents Nos. 6,266,341;
        6,289,025; 6,292,482; 6,389,009; and 6,396,849. On October 28, 2002,
        Vertical Networks amended its complaint to add allegations of infringement
        of
        U.S. Patents Nos. 5,617,418 and 5,687,174. Vertical Networks filed a second
        amended complaint on November 20, 2002 to identify our products and/or
        activities that allegedly infringe the seven patents-in-suit. Vertical Networks
        seeks a judgment of patent infringement and an award of damages, including
        treble damages for alleged willful infringement, and attorneys’ fees and costs.
        We filed an answer and counterclaims for declaratory relief on December 9,
        2002. On December 26, 2002, Vertical Networks filed its answer to our
        counterclaims. Vertical Networks served its preliminary infringement contentions
        on us on April 9, 2003 and we served Vertical Networks our preliminary
        invalidity contentions on June 3, 2003 and July 14, 2003. To date, the
        parties have exchanged some discovery, but no depositions have been taken,
        and
        no motions are currently pending. On October 7, 2003, the parties filed a
        stipulation to stay this action, pending the outcome of the reissue of some
        of
        the subject patents before the U.S. Patent and Trademark Office. Although
        the
        patents have now reissued, the plaintiff requested that the stay continue
        and
        the court granted a temporary continuation of the stay. We believe we have
        strong defenses and arguments in this dispute and intend to vigorously litigate
        our position. Management’s view is that any loss from this litigation is not
        probable or estimable. Therefore, we have not established a reserve on our
        balance sheets as to any liability related to the outcome of this
        action.
 
 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 are based on the beliefs of our management as well as assumptions
        made
        by and information currently available to our management. Additional forward
        looking statements may be identified by the words "anticipate," "believe,"
        "expect," "intend," "plan," or the negative of such terms, or similar
        expressions, as they relate to us or our management.
 
 The
        forward-looking statements contained herein reflect our judgment as of the
        date
        of this report with respect to future events, the outcome of which is subject
        to
        certain risks that may have a significant impact on our business, operating
        results or financial condition. You are cautioned that these forward-looking
        statements are inherently uncertain. Should one or more of these risks or
        uncertainties materialize, or should underlying assumptions prove incorrect,
        actual results or outcomes may vary materially from those described herein.
        Although we believe that the expectations reflected in these forward-looking
        statements are reasonable, we cannot guarantee future results, levels of
        activity, performance or achievements. You should carefully review the
        cautionary statements contained in this Form 10-Q, including those found in
        our Form 10-K filed with the SEC on December 29, 2006.
 
 **OVERVIEW**
 
 We
        are a
        pioneer and market leader in Internet protocol telephony systems for small-to
        medium-sized businesses. We design, manufacture and market next generation,
        Internet protocol phone systems and contact centers that use both the Internet
        and the public telephone network to take advantage of the convergence of
        voice
        and data communications. Unlike traditional proprietary phone systems, our
        systems are designed with open architecture and are built on an industry
        standard platform. This adherence to industry standards allows our products
        to
        play an important role in the small-to medium-sized business market by
        delivering phone systems that can be used with other technologies to provide
        integrated voice and data solutions. We believe this enables our customers
        to
        implement communication systems that have an increased return compared to
        the
        legacy telephone systems. We generated net revenue of $4.2 million and $12.7
        million for the three and nine months ended June 30, 2007, respectively,
        compared to net revenue of $4.8 million and $13.4 million for the three and
        nine
        months ended June 30, 2006, respectively. As of June 30, 2007, we had an
        accumulated deficit of $51.9 million. Net cash used in operating activities
        was $546,000 for the nine months ended June 30, 2007.
 
 We
        derive
        our revenue from sales of our AltiServ telephone systems. Product revenue
        is
        comprised of direct sales to end-users (including dealers) and sales to
        distributors. Revenue from product sales to end users and resellers are
        recognized upon shipment. We defer recognition of revenue for sales to
        distributors until they resell our products to their customers. Upon shipment,
        we also provide a reserve for the estimated cost that may be incurred for
        product warranty. Under our distribution contracts, a distributor has the
        right,
        in certain circumstances, to return products it determines are overstocked,
        so
        long as it provides an offsetting purchase order for products in an amount
        equal
        to or greater than the dollar value of the returned products. In addition,
        we
        provide distributors protection from subsequent price reductions.
 
 Our
        cost
        of revenue consists of component and material costs, direct labor costs,
        provisions for excess and obsolete inventory, warranty costs and overhead
        related to the manufacturing of our products. Several factors that have affected
        and will continue to affect our revenue growth are the state of economy,
        the
        market acceptance of our products, our ability to add new resellers and our
        ability to design, develop, and release new products. We engage third-party
        assemblers, which for the nine months ended June 30, 2007, were All Quality
        Services and Bestronics in San Jose, to insert the hardware components into
        the
        printed circuit board. We selected our manufacturing partners with the goals
        of
        ensuring a reliable supply of high-quality finished products and lowering
        per
        unit product costs as a result of manufacturing economies of scale. We cannot
        assure you that we will maintain the volumes required to realize these economies
        of scale or when or if such cost reductions will occur. The failure to obtain
        such cost reductions could materially adversely affect our gross margins
        and
        operating results.
 
 We
        continue to focus on (i) developing enhancements to our current products
        to
        provide greater functionality and increased capabilities, based on our market
        research, customer feedback and our competitors' product offerings and (ii)
        creating new product offerings to both enhance our position in our target
        market
        segment and enter new geographical markets. Additionally, we intend to continue
        selling our products to small-to medium-sized businesses and branch offices
        of
        larger corporations. Also, we plan to continue to recruit additional resellers
        and distributors that focus on selling phone systems to our target customers.
        We
        believe that the adoption rate for this Internet telephony  is
        much
        faster with small-to medium-sized businesses because many of them have no
        significant investment on their books for traditional phone systems. Also
        we
        believe that small-to medium-sized businesses are looking for call center-type
        administration to increase the productivity and efficiency of their contacts
        with customers. Assuming that current market trends continue; including the
        growth in acceptance of the call center products, the growth in the marketplaces
        of Asia, Latin America, the Caribbean, and the status quo of the North American
        economy; as a result of our enhanced products, we expect to see continued
        demand
        for our product.
  12
  **CRITICAL
        ACCOUNTING POLICIES**
 
 *Revenue
        recognition.* Revenues
        are comprised of direct sales to end-users, including resellers, and sales
        to
        distributors. Revenue from sales to end-users are recognized upon shipment,
        when
        risk of loss has passed to the customer, collection of the receivable is
        reasonably assured, persuasive evidence of an arrangement exists, and the
        price
        is fixed and determinable. We provide for estimated sales returns and allowances
        and warranty costs related to such sales at the time of shipment. Net revenue
        consist of product revenue reduced by estimated sales returns and allowances.
        Sales to distributors are made under terms allowing certain rights of return
        and
        protection against subsequent price declines on our products held by its
        distributors. Upon termination, any unsold products may be returned by the
        distributor for a full refund. These agreements may be canceled without cause
        by
        either party following a specified notice period. As a result of the above
        provisions, we defer recognition of distributor revenue until such distributors
        resell our products to their customers. The
        amounts deferred as a result of this policy are reflected as “deferred revenue”
in the accompanying consolidated balance sheets. The related cost of revenue
        is
        also deferred and reported in the consolidated balance sheets as inventory.
        Our
        total deferred revenue was $618,000 and $561,000 as of June 30, 2007 and
        June
        30, 2006, respectively.
 
 Software
        components are generally not sold separately from our hardware components.
        Software revenue consist of license revenue that are recognized upon the
        delivery of application products. We provide limited post-contract customer
        support (“PCS”), consisting primarily of technical support and “bug” fixes. In
        accordance with SOP 97-2, revenue earned on software arrangements involving
        multiple elements is allocated to each element based upon the relative fair
        values of the elements. Although we provide PCS, the revenue allocated to
        this
        element is recognized together with the initial licensing fee on delivery
        of the
        software because: (1) the PCS fee is included with the initial licensing
        fee; (2) the PCS included with the initial license fee is for one year or
        less; (3) the estimated cost of providing PCS during the arrangement is
        insignificant; and (4) unspecified upgrades/enhancements offered for
        minimal or no cost during PCS arrangements historically have been and are
        expected to continue to be minimal and infrequent. All estimated costs of
        providing the services, including upgrades and enhancements are accrued for
        at
        the time of delivery.
 
 *Allowance
        for Doubtful Accounts.* The
        allowance for doubtful accounts is based on our assessment of the collectibility
        of specific customer accounts and the aging of the accounts receivable. If
        there
        was a deterioration of a major customer’s creditworthiness, or actual defaults
        were higher than our historical experience, we could be required to increase
        our
        allowance and our earnings could be adversely affected. Our allowance for
        doubtful accounts was $32,000 and $47,000 as of June 30, 2007 and 2006,
        respectively.
 
 *Inventory* .
        Inventory is stated at the lower of cost (first-in, first-out method) or
        market.
        Our inventory balance was $2.0 million and $1.6 million as of June 30, 2007
        and
        June 30, 2006, respectively. We regularly review the value of our inventory
        in
        detail, with consideration given to future customer demand for our products,
        obsolescence from rapidly changing technology, and other factors. If actual
        market conditions are less favorable than those projected by management,
        and our
        estimates prove to be inaccurate, we could be required to increase our inventory
        provision and our gross margins could be adversely affected. As of December
        2001, AltiGen had established a reserve to write off $3.5 million of excess
        inventory which management believed would not be sold.  During 2002 through
        2006, AltiGen reversed a portion of the reserve related to inventory which
        was
        sold.  The amounts of such reversals were $301,000, $167,000 and $293,000
        in fiscal years ending 2006, 2005 and 2004, respectively. During the quarters
        ended June 30, 2007 and 2006, respectively, inventory allowance was
        $2.3 million.
  13
  *Warranty.* We
        accrue for warranty costs based on estimated product return rates and the
        expected material and labor costs to provide warranty services. If actual
        return
        rates and repair and replacement costs differ significantly from our estimates,
        our gross margin could be adversely affected. The liability for product
        warranties was $249,000 and $296,000 as of June 30, 2007 and June 30, 2006,
        respectively.
 
 **Results
        of Operations**
 
 The
        following table sets forth consolidated statements of operations data for
        the
        periods indicated as a percentage of net revenue.
 
 **Three
                  Months Ended June 30,**
              
              **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Consolidated
                  Statements of Operations Data:Net
                  revenue:Hardware
              
              
              91.8
              %
              
              92.1
              %
              
              91.7
              %
              
              92.3
              %Software
              
              
              8.2
              
              
              7.9
              
              
              8.3
              
              
              7.7Total
                  net revenue
              
              
              100.0
              
              
              100.0
              
              
              100.0
              
              
              100.0Cost
                  of revenue:Hardware
              
              
              45.9
              
              
              43.0
              
              
              45.5
              
              
              44.6Software
              
              
              0.7
              
              
              0.6
              
              
              0.7
              
              
              0.6Total
                  cost of revenue
              
              
              46.6
              
              
              43.6
              
              
              46.2
              
              
              45.2Gross
                  profit
              
              
              53.4
              
              
              56.4
              
              
              53.8
              
              
              54.8Operating
                  expenses:Research
                  and development
              
              
              20.6
              
              
              19.4
              
              
              19.7
              
              
              21.3Sales
                  and marketing
              
              
              33.6
              
              
              24.1
              
              
              29.0
              
              
              24.3General
                  and administrative
              
              
              14.4
              
              
              10.7
              
              
              14.0
              
              
              12.0Total
                  operating expenses
              
              
              68.6
              
              
              54.2
              
              
              62.7
              
              
              57.6Income
                  (loss) from operations
              
              
              (15.2
              )
              
              2.2
              
              
              (8.9
              )
              
              (2.8
              )Equity
                  in net income (loss) of investee
              
              
              0.1
              
              
              (0.2
              )
              
              —
              
              
              (0.2
              )Interest
                  and other income, net
              
              
              2.7
              
              
              2.1
              
              
              2.8
              
              
              2.0Net
                  income (loss) before taxes
              
              
              (12.4
              )
              
              4.1
              
              
              (6.1
              )
              
              (1.0
              )Provision
                  for income taxes
              
              
              (
                  0.1
              )
              
              (0.1
              )
              
              (
                  0.1
              )
              
              0.1Net
                  income (loss)
              
              
              (12.5
              )%
              
              4.0
              %
              
              (6.2
              )%
              
              (1.1
              )%
 
 **Revenue,
        net** .
        Revenue
        consist of sales to end users (including resellers) and
        distributors.
 
 Net
        Revenue by Geographic Area:
 
 Net
        revenue by geographic region based on customer location for the three and
        nine
        months ended June 30, 2007 and 2006, respectively, were as
        follows:
 
 **Three
                  Months Ended**
                **June
                  30,**
              
              **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Americas
              
              
              92
              %
              
              88
              %
              
              91
              %
              
              90
              %International
              
              
              8
              %
              
              12
              %
              
              9
              %
              
              10
              %Total
              
              
              100
              %
              
              100
              %
              
              100
              %
              
              100
              %
 
 14
 International
        is comprised of revenue primarily from China, the United Kingdom and Norway.
        Most significant long-lived assets are located in the United States. Our
        hardware tooling used to develop the IP710 and the IP705 phones as well as
        the
        tooling used to develop the face plate for the MAX1000 Voice over IP phone
        system are located in Taiwan.
 
 Net
        Revenue by Customer:
 
 Net
        revenue by customers that individually accounted for more than 10% of our
        revenue for the three and nine months ended June 30, 2007 and 2006,
        respectively, were as follows:
 
 **Three
                  Months Ended**
                **June
                  30,**
              
              **Nine
                  Months Ended**
                **June
                  30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Synnex
              
              
              52
              %
              
              58
              %
              
              52
              %
              
              56
              %AltiSys
              
              
              17
              %
              
              12
              %
              
              15
              %
              
              15
              %Graybar
              
              
              14
              %
              
              13
              %
              
              15
              %
              
              14
              %
 
 Revenue
        generated in the Americas accounted for $3.8 million or 92% and $12.0
        million or 91%, for the three and nine months ended June 30, 2007, respectively,
        as compared to $4.2 million, or 88%, and $12.1 million, or 90%, for the three
        and nine months ended June 30, 2006, respectively. Revenue generated
        internationally accounted for $335,000 or 8% and $1.0 million or 9% for the
        three and nine months ended June 30, 2007, respectively, as compared to $565,000
        or 12% and $1.3 million or 10% in the prior year.
 
 Net
        revenue decreased 13% to $4.2 million for the three months ended June 30,
        2007 as compared to $4.8 million for the three months ended June 30, 2006.
        This decrease is largely attributable to change in our product mix. Total
        units
        shipped increased by 9%, however, due to product mix the average selling
        price
        per unit dropped by approximately 20%. We sold more of the smaller units
        in the
        second and third quarter of fiscal 2007 compared to the same period in fiscal
        2006. Net revenue decreased 5% to $12.7 million for the nine months ended
        June 30, 2007 from $13.4 million for the nine months ended June 30, 2006.
        This is primarily due to change in our product mix. Total units shipped
        increased by 7%, however, due to product mix, the average selling price per
        unit
        dropped by approximately 12%. We sold more of the smaller units in the nine
        months ended June 30, 2007 compared to the same period in the prior year.
        The
        increase in the sales of our smaller telephone systems is primarily due to
        lower
        prices of our new MAX1000
        Voice over IP phone systems com pared
        to
        lower end products in the same period in the prior year.
 
 For
        the
        three and nine months ended June 30, 2007, we incurred a net loss of $526,000
        and $791,000, respectively. During such periods, we recognized $161,000 and
        $417,000, respectively, of non-cash stock based-compensation expense as a
        result
        of the adoption of SFAS No. 123(R).
 
 **Cost
        of revenue.**  Cost
        of
        revenue for the three months ended June 30, 2007 decreased $148,000, or 7%
        to
        $1.9 million from approximately $2.1 million for the three months ended June
        30,
        2006. Cost of revenue for the nine months ended June 30, 2007 decreased
        $185,000, or 3%, to $5.9 million from approximately $6.0 million for the
        nine
        months ended June 30, 2006. This decrease was primarily due to selling smaller
        sized telephone systems. Cost of revenue as a percentage of net revenue
        increased to 47% and 46% for the three and nine months ended June 30, 2007,
        respectively, as compared to 44% and 45% for the three and nine months ended
        June 30, 2006, respectively. The increase was primarily caused by a shift
        in our
        product mix to smaller sized systems.
  **Research
        and development expenses** **.**  Research
        and development expenses consist principally of salaries and related personnel
        expenses, consultant fees and prototype expenses related to the design,
        development and testing of our products and enhancement of our converged
        telephone system software. Research and development expenses decreased to
        $860,000, or 21% of revenue, for the three months ended June 30, 2007 from
        $932,000, or 19% of revenue, for the same period in fiscal 2006. This expense
        decrease in absolute dollars was primarily the result of a decrease in project
        related expenses of approximately $72,000. Research and development expenses
        decreased to $2.5 million, or 20% of revenue, for the nine months ended June
        30,
        2007 from $2.9 million, or 21% of revenue, for the same period in fiscal
        2006.
        This expense decrease in absolute dollars is attributable to a reduction
        in
        project related expenses of approximately $204,000; $75,000 reduction in
        non-cash stock-based compensation required by SFAS No.123(R); payroll related
        expenses of approximately $16,000 and overhead allocations of approximately
        $91,000. We believe that continued spending on research and development to
        develop new products and improve manufacturing process is critical to our
        success and, consequently, expect to increase research and development expenses
        in the future periods over the long term. In the short term, we expect research
        and development expenses to remain consistent as management continues to
        monitor
        expenses and plans to keep them in line with expected revenue
        opportunities.
 
 **Sales
        and marketing expenses** **.**  Sales
        and
        marketing expenses consist primarily of salaries, commissions and related
        expenses for personnel engaged in marketing, sales and customer support
        functions, as well as trade shows, advertising, and promotional expenses.
        Sales
        and marketing expenses increased to $1.4 million, or 34% or revenue, for
        the
        three months ended June 30, 2007 from approximately $1.2 million, or 24%
        of
        revenue, for the three months ended June 30, 2006. This increase in absolute
        dollars was primarily the result of $40,000 increase in travel related expenses;
        headcount-related costs also increased by approximately $111,000; and $90,000
        in
        service related expenses. These expenses were partially offset by a decrease
        in
        advertising expenses of approximately $26,000; and $13,000 in non-cash
        stock-based compensation expenses. For the nine months ended June 30, 2007,
        sales and marketing expenses increased to $3.7 million or 29% of revenue
        from
        approximately $3.3 million, or 24% of revenue, for the same period in fiscal
        2006. The expense increase in absolute dollars was the result of increased
        advertising expenses of approximately $59,000; partner conference expenses
        of
        approximately $34,000; $62,000 in travel related expenses; headcount-related
        costs of approximately $155,000; and $129,000 in service related expenses.
        We
        anticipate sales and marketing expenses will increase in future periods over
        the
        long term due to increased staffing levels, particularly in sales and increased
        marketing activities.
 
 15
 **General
        and administrative expenses** .
        General
        and administrative expenses consist of salaries and related expenses for
        executive, finance and administrative personnel, facilities, allowance for
        doubtful accounts, legal, and other general corporate expenses. General and
        administrative expenses increased to $604,000, or 14% of revenue, for the
        three
        months ended June 30, 2007 from $516,000, or 11% of revenue, for the same
        period
        in the prior year. The increase in absolute dollars was primarily related
        to an
        increase in consulting related services of approximately $32,000, and payroll
        related expenses of approximately $59,000. General and administrative expenses
        for the nine months ended June 30, 2007 increased to $1.8 million, or 14%
        of
        revenue, from $1.6 million, or 12% of revenue for the nine months ended June
        30,
        2006. This was mainly the result of a $79,000 increase in consulting related
        services; $55,000 increase in legal expenses related to corporate governance
        matters; accounting fees of approximately $48,000; and $14,000 increase in
        travel related expenses. In the short term, we expect general and administrative
        expenses to remain consistent as we continue to focus on controlling costs. In
        the
        long term, we expect general and administrative expenses to increase due
        to
        costs associated with Sarbanes-Oxley 404 compliance efforts during fiscal
        year
        2008.
 
 **Equity
        investment in common stock of private company.** Equity
        investment in common stock of private company is primarily the Company’s
        allocated portion of the net income or losses of a private Korean
        telecommunications company acquired in July 2004. We purchased common stock
        of a
        private Korean telecommunications company fo r
        approximately $ 79,000.
        As a result of this investment, we acquired approximately 23% of the voting
        power of the company. This gives us the right to nominate and elect one of
        the
        three members of the Company’s current board of directors. We are accounting for
        this investment using the equity method. For the three months ended June
        30,
        2007, the total equity in net income of this company was approximately $3,000
        compared to net losses of $8,000 for the same period in fiscal 2006. For
        the
        nine months ended June 30, 2007 and 2006, t he
        total
        equity in net losses of this company was approximately $1,000 and $32,000
        respectively.
 
 **Interest
        and other income, net.** Net
        interest and other income increased to $112,000 and $348,000 for the three
        and
        nine months ended June 30, 2007, respectively, from $100,000 and $268,000
        for
        the same periods in fiscal 2006. The
        increase in net interest and other income for the nine months ended June
        30,
        2007 was primarily a result of higher interest rates .
        We
        expect net interest and other income to remain relatively flat with little
        change in cash available to invest.
 
 **Liquidity
        and Capital Resources**
 
 Since
        inception, we have financed our operations primarily through the sale of
        equity
        securities. As of June 30, 2007, the Company’s principal sources of liquidity
        included cash, cash equivalents and short-term investments totaling $10.1
        million as compared with $9.5 million as of June 30, 2006. As of June 30,
        2007,
        $8.2 million is liquid and classified as cash and cash equivalents compared
        with
        $7.6 million as of June 30, 2006. During the quarters ended June 30, 2007
        and
        2006, respectively, short-term investments were approximately $1.9 million
        with
        a maturity of greater than 90 days (in thousands):
 
 **Nine
                  Months EndedJune 30,****2007**
              
              **2006**Cash
                  and cash equivalents
              
              $
              8,173
              
              $
              7,553Short-term
                  investments
              
              
              1,891
              
              
              1,924Total
                  cash, cash equivalents and short-term investments
              
              $
              10,064
              
              $
              9,477Cash
                  provided by (used in) operating activities
              
              $
              (546
              )
              $
              107Cash
                  provided by investing activities
              
              $
              2,846
              
              $
              3,181Cash
                  provided by financing activities
              
              $
              820
              
              $
              302Net
                  increase in cash and cash equivalents
              
              $
              3,120
              
              $
              3,590
  16
  *Changes
        in Cash Flows*
  During
        the nine months ended June 30, 2007, the Company’s net cash used in operating
        activities was $546,000 compared to net cash provided by operating activities
        of
        $107,000 during the same period in fiscal 2006. This was primarily a result
        of
        net loss of $791,000, a $144,000 increase in accounts payable, an increase
        of
        net inventories of $628,000, and non-cash stock based compensation expense
        of
        $417,000. These factors were partially off-set by a decrease in accounts
        receivable of $148,000, and depreciation and amortization of $187,000. The
        increase in accounts payable during this period was the result of routine
        period
        to period fluctuations. The increase in non-cash stock based compensation
        is the
        result of the Company implementing SFAS No. 123(R). The net cash provided
        by
        operating activities of $107,000 for the nine months ended Jun 30, 2006 was
        primarily due to net loss of $147,000, an increase in accounts receivable
        of
        $342,000, and increase in net inventories of $639,000, non-cash stock based
        compensation expense of $627,000 which were partially offset by depreciation
        and
        amortization of approximately $156,000, and an increase in accounts payables
        of
        $396,000 .
 
 For
        the
        nine months ended June 30, 2007, net cash provided by investing activities
        was
        $2.8 million, which was primarily attributable to proceeds from maturities
        of
        short-term investments exceeding purchases of short-term investments by $3.0
        million. Net cash provided by investing activities for the nine months ended
        June 30, 2006 was approximately $3.2 million, which was primarily due to
        purchases of short-term investments exceeding maturities by $4.0
        million.
 
 The
        Company’s cash provided by financing activities in the nine months ended June
        30, 2007, was primarily due to the sale of common stock from the Company’s
        employee stock plan and the proceeds from the exercise of employee stock
        options, which was approximately $820,000.
 
 Net
        accounts receivable decreased to $2.1 million at June 30, 2007 from
        $2.2 million at September 30, 2006. The decrease in net accounts receivable
        was primarily due to decrease in net revenue.
 
 We
        ended
        the third quarter of fiscal 2007 with a cash conversion cycle of 92 days
        as
        compared to 67 days for the third quarter of fiscal 2006. The cash conversion
        cycle is the duration between purchase of inventories and services and the
        collection of the cash from the sale of our products and services and is
        a
        metric on which we have focused as we continue to try to efficiently manage
        our
        assets. The cash conversion cycle results from the calculation of days of
        sales
        outstanding (DSO) added to days of supply in inventories (DOS), reduced by
        days
        of payable outstanding (DPO).
  Inventories
        increased to $2.0 million at June 30, 2007 from $1.4 million at
        September 30, 2006 and our inventory turn rate decreased to 3.9 at June 30,
        2007 from 5.9 at September 30, 2006. This increase in inventories was
        primarily attributable to the new product introduction of our MAX1000
        Voice over IP (VoIP) phone system .
        Our
        annualized inventory turn rate represents the number of times inventory is
        replenished during the year. Inventory management will continue to be an
        area of
        focus as we balance the need to maintain strategic inventory levels to help
        ensure competitive lead times with the risk of inventory obsolescence due
        to
        rapidly changing technology and customer requirements.
 
 Accounts
        payable increased to $981,000 at June 30, 2007 from $837,000 at
        September 30, 2006. This
        increase was due to more inventories purchased in the last month of the quarter
        as a result of increased production.
 
 Generally,
        as sales levels rise, the Company expects inventories, accounts receivable
        and
        accounts payable to increase. However, there will be routine fluctuations
        in
        these accounts from period to period that may be significant in
        amount.
  17
  *Liquidity
        and Capital Resources*
 
 We
        intend
        to invest our cash in excess of current operating requirements in short-term,
        interest bearing investment-grade securities.
 
 Our
        cash
        needs depend on numerous factors, including market acceptance of and demand
        for
        our products, our ability to develop and introduce new products and enhancements
        to existing products, the prices at which we can sell our products, the
        resources we devote to developing, marketing, selling and supporting our
        products, the timing and expense associated with expanding our distribution
        channels, increases in manufacturing costs and the prices of the components
        we
        purchase, as well as other factors. If we need and are unable to raise
        additional capital or if sales from our new products or enhancements are
        lower
        than expected, we will be required to make additional reductions in operating
        expenses and capital expenditures to ensure that we will have adequate cash
        reserves to fund operations.
 
 Additional
        financing, if required, may not be available on acceptable terms, or at all.
        We
        also may require additional capital to acquire or invest in complementary
        businesses or products, or obtain the right to use complementary technologies.
        If we cannot raise needed funds in the future, on acceptable terms, we may
        not
        be able to further develop or enhance our products, take advantage of
        opportunities, or respond to competitive pressures or unanticipated
        requirements, which could seriously harm our business. Even if additional
        financing is available, we may be required to obtain the consent of our
        stockholders, which we may or may not be able to obtain. In addition, the
        issuance of equity or equity-related securities will dilute the ownership
        interest of our stockholders and the issuance of debt securities could increase
        the risk or perceived risk of investing in our securities.
  We
        do not
        have any material commitments for capital expenditures as of June 30, 2007.
        We
        have a commitment under our noncancellable capital and operating lease in
        the
        amount of $1.3 million as of June 30, 2007. We believe, we have sufficient
        cash
        reserves to allow us to continue operations for more than a year. Our cash
        and
        short-term investments totaled $10.1 million as of June 30, 2007. The
        following table represents our future commitments as of June 30, 2007 (in
        thousands):
 
 Payment
                  Due by PeriodContractual
                  Obligations
              
              Total
              
              Less
                  than
                1
                  Year
              
              1
                  -
                  3 Years
              
              3
                  -
                  5 Years
              
              More
                  than
                5
                  YearsOperating
                  leases obligation
              
              $
              1,199
              
              $
              121
              
              $
              858
              
              $
              220
              
              $
              --Capital
                  leases obligation
              
              
              137
              
              
              13
              
              
              91
              
              
              33
              
              
              --Total
              
              $
              1,336
              
              $
              134
              
              $
              949
              
              $
              253
              
              $
              --
  18
  **Item
        3. Quantitative and Qualitative Disclosures About Market
        Risk.**
 
 *(a)
        Interest Rate Risk.* Our
        interest income is sensitive to changes in the general level of U.S. interest
        rates, particularly since the majority of our investments are in cash
        equivalents and short-term instruments. Due to the short-term nature of our
        cash
        equivalents and investments, we have concluded that a change in interest
        rates
        does not pose a material market risk to us.
 
 *(b)
        Foreign Currency Exchange Risk.* We
        face
        foreign exchange currency fluctuations with our subsidiary in China, however,
        due to the strength in China’s economy, we do not foresee foreign exchange
        currency fluctuations to pose a material market risk to us.
 
 **Item
        4. Controls and Procedures****.**
 
 *(a)
        Evaluation of disclosure controls and procedures* .
        Our
        management evaluated, with the participation of our Chief Executive Officer
        and
        our Chief Financial Officer, the effectiveness of our disclosure controls
        and
        procedures as of the end of the period covered by this Quarterly Report on
        Form 10-Q. Based on this evaluation, our Chief Executive Officer and our
        Chief Financial Officer have concluded that our disclosure controls and
        procedures are effective to ensure that information we are required to disclose
        in reports that we file or submit under the Securities Exchange Act of 1934
        is
        accumulated and communicated to our management including our principal executive
        and principal financial officers, as appropriate, to allow timely decisions
        regarding disclosure and that such information is recorded, processed,
        summarized and reported within the time periods specified in Securities and
        Exchange Commission rules and forms.
 
 *(b)
        Changes in internal control over financial reporting* .
        There
        was no change in our internal control over financial reporting that occurred
        during the period covered by this Quarterly Report on Form 10-Q that has
        materially affected, or is reasonably likely to materially affect, our internal
        control over financial reporting.
  19
  **PART
        II. OTHER INFORMATION**
 
 **Item
        1. Legal Proceedings****.**
 
 On
        September 6, 2002, Vertical Networks, Inc. filed suit against us in
        the United States District Court for the Northern District of California,
        alleging infringement of Vertical Networks’ U.S. Patents Nos. 6,266,341;
        6,289,025; 6,292,482; 6,389,009; and 6,396,849. On October 28, 2002,
        Vertical Networks amended its complaint to add allegations of infringement
        of
        U.S. Patents Nos. 5,617,418 and 5,687,174. Vertical Networks filed a second
        amended complaint on November 20, 2002 to identify our products and/or
        activities that allegedly infringe the seven patents-in-suit. Vertical Networks
        seeks a judgment of patent infringement and an award of damages, including
        treble damages for alleged willful infringement, and attorneys’ fees and costs.
        We filed an answer and counterclaims for declaratory relief on December 9,
        2002. On December 26, 2002, Vertical Networks filed its answer to our
        counterclaims. Vertical Networks served its preliminary infringement contentions
        on us on April 9, 2003 and we served Vertical Networks our preliminary
        invalidity contentions on June 3, 2003 and July 14, 2003. To date, the
        parties have exchanged some discovery, but no depositions have been taken,
        and
        no motions are currently pending. On October 7, 2003, the parties filed a
        stipulation to stay this action, pending the outcome of the reissue of some
        of
        the subject patents before the U.S. Patent and Trademark Office. Although
        the
        patents have now reissued, the plaintiff requested that the stay continue
        and
        the court granted a temporary continuation of the stay. We believe we have
        strong defenses and arguments in this dispute and intend to vigorously defend
        our position. Management’s view is that any loss from this litigation is
        currently not probable or estimable; therefore, the Company has not established
        a reserve on its balance sheets as to any liability related to the outcome
        of
        this action.
 
 From
        time
        to time, we may become party to litigation and subject to claims arising
        in the
        ordinary course of our business. To date, these actions have not had a material
        adverse effect on our financial position, result of operations or cash flows.
        Although the results of litigation and claims cannot be predicted with
        certainty, we believe that the final outcome of such matters would not have
        a
        material adverse effect on our business, financial position, results of
        operation and cash flows.
  20
  **Item
        6. Exhibits****.**
  Please
        refer to the Exhibit Index of this report on Form 10-Q.
  21
  **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 13, 2007
              By:
              /s/
                Philip M. McDermottPhilip
                  M. McDermott,
                  Chief
                    Financial Officer
                    (Principal
                      Financial and Accounting
                      Officer)
  22
  **EXHIBIT
        INDEX**
 
 **Exhibit****Number**
              
              **Description**3.1
                  (1)
              
              Amended
                  and Restated Certificate of Incorporation.3.2
                  (2)
              
              Second
                  Amended and Restated Bylaws.31.1
              
              Certification
                  of Principal Executive Officer, filed herewith.31.2
              
              Certification
                  of Principal Financial Officer, filed herewith.32.1
              
              Certification
                  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350,
                  as Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed
                  herewith.32.2
              
              Certification
                  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350,
                  as Adopted
                  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed
                  herewith.
 
 (1)
              Incorporated
                  by reference to exhibit filed with the Registrant's Registration
                  Statement
                  on Form S-1 (No. 333-80037) declared effective on
                  October 4, 1999.(2)
              Incorporated
                  by reference to exhibit filed with the Registrant's Quarterly Report
                  on
                  Form 10-Q for the quarter ended March 31,
                  2004.
  23