**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 DECEMBER 31,
                2006**




**OR**




**oTRANSITION
                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  o No x





The
      number of shares of our common stock outstanding as of February 9, 2007 was:
      15,149,669 shares














**Table
      of Contents**




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




**PART
      I. FINANCIAL INFORMATION**





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





**ALTIGEN
      COMMUNICATIONS, INC. AND SUBSIDIARY**


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(UNAUDITED)**


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




**December
                31,**
              **2006**
            
            **September
                30,**
              **2006****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            5,660
            
            $
            5,053Short-term
                investments
            
            
            4,334
            
            
            4,869Accounts
                receivable, net of allowances of $48 and $38 at December 31,2006
                and
                September 30, 2006, respectively
            
            
            2,449
            
            
            2,230Inventories
            
            
            1,797
            
            
            1,382Prepaid
                expenses and other current assets
            
            
            187
            
            
            123Total
                current assets
            
            
            14,427
            
            
            13,657Property
                and equipment:Furniture
                and equipment
            
            
            1,792
            
            
            1,783Computer
                software
            
            
            920
            
            
            9202,712
            
            
            2,703Less:
                Accumulated depreciation
            
            
            (2,085
            )
            
            (2,022
            )Net
                property and equipment
            
            
            627
            
            
            681Other
                non-current assets:Long-term
                investments
            
            
            208
            
            
            211Long-term
                deposit
            
            
            95
            
            
            95Total
                other non-current assets
            
            
            303
            
            
            306Total
                assets
            
            $
            15,357
            
            $
            14,644**LIABILITIES
                AND STOCKHOLDERS' EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            1,188
            
            $
            837Accrued
                liabilities:Payroll
                and related benefits
            
            
            271
            
            
            328Warranty
            
            
            267
            
            
            263Marketing
            
            
            83
            
            
            68Accrued
                expense
            
            
            248
            
            
            263Other
            
            
            357
            
            
            340Deferred
                revenue
            
            
            821
            
            
            531Total
                current liabilities
            
            
            3,235
            
            
            2,630Long-term
                deferred rent and other
            
            
            157
            
            
            177Stockholders'
                equity:Convertible
                preferred stock, $0.001 par value; Authorized—5,000,000
                shares; Outstanding—none
                at December 31, 2006 and September 30, 2006
            
            
            —
            
            
            —Common
                stock, $0.001 par value; Authorized—50,000,000
                shares; Outstanding—16,213,564
                shares at December 31, 2006 and16,157,364
                shares at September 30, 2006
            
            
            16
            
            
            16Treasury
                stock at cost—1,063,895 shares at December 31, 2006 and September 30,
                2006
            
            
            (1,014
            )
            
            (1,014
            )Additional
                paid-in capital
            
            
            64,215
            
            
            63,993Accumulated
                other comprehensive loss
            
            
            —
            
            
            —Accumulated
                deficit
            
            
            (51,252
            )
            
            (51,158
            )Total
                stockholders' equity
            
            
            11,965
            
            
            11,837Total
                liabilities and stockholders' equity
            
            $
            15,357
            
            $
            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**
                **December
                  31,****2006**
              
              **2005**Net
                  revenue:Hardware
              
              $
              3,959
              
              $
              4,109Software
              
              
              413
              
              
              294Total
                  net revenue
              
              
              4,372
              
              
              4,403Cost
                  of revenue:Hardware
              
              
              1,984
              
              
              1,997Software
              
              
              27
              
              
              21Total
                  cost of revenue
              
              
              2,011
              
              
              2,018Gross
                  profit
              
              
              2,361
              
              
              2,385Operating
                  expenses:Research
                  and development
              
              
              817
              
              
              1,027Sales
                  and marketing
              
              
              1,169
              
              
              1,091General
                  and administrative
              
              
              582
              
              
              558Total
                  operating expenses
              
              
              2,568
              
              
              2,676Loss
                  from operations
              
              
              (207
              )
              
              (291
              )Equity
                  in net loss of investee
              
              
              (3
              )
              
              (10
              )Interest
                  and other income, net
              
              
              120
              
              
              83Net
                  loss before taxes
              
              
              (90
              )
              
              (218
              )Income
                  tax provision
              
              
              (4
              )
              
              —Net
                  loss
              
              $
              (94
              )
              $
              (218
              )Basic
                  and diluted net loss per share
              
              $
              (0.01
              )
              $
              (0.01
              )Weighted
                  average shares used in computing basic net loss per share
              
              
              15,130
              
              
              14,842Weighted
                  average shares used in computing diluted net income (loss) per
                  share
              
              
              15,130
              
              
              14,842





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)**




**Three
                Months Ended**
              **December
                31,****2006**
            
            **2005**CASH
                FLOWS FROM OPERATING ACTIVITIES:Net
                loss
            
            $
            (94
            )
            $
            (218
            )Adjustments
                to reconcile net income (loss) to net cash used in operating
                activities:Depreciation
            
            
            63
            
            
            49Stock
                based compensation
            
            
            151
            
            
            260Equity
                in net loss of investee
            
            
            3
            
            
            9Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            (219
            )
            
            (239
            )Inventories
            
            
            (415
            )
            
            (338
            )Prepaid
                expenses and other current assets
            
            
            (64
            )
            
            (30
            )Accounts
                payable
            
            
            351
            
            
            414Accrued
                liabilities
            
            
            (36
            )
            
            66Deferred
                revenue
            
            
            290
            
            
            (104
            )Long-term
                deferred rent and other
            
            
            (20
            )
            
            (19
            )Net
                cash provided by (used in) operating activities
            
            
            10
            
            
            (150
            )CASH
                FLOWS FROM INVESTING ACTIVITIES:Purchases
                of short-term investments
            
            
            (5,689
            )
            
            (5,369
            )Proceeds
                from sale of short-term investments
            
            
            6,224
            
            
            6,462Purchases
                of property and equipment
            
            
            (9
            )
            
            (127
            )Net
                cash provided by investing activities
            
            
            526
            
            
            966CASH
                FLOWS FROM FINANCING ACTIVITIES:Proceeds
                from issuances of common stock, net of issuance costs
            
            
            71
            
            
            117Net
                cash provided by financing activities
            
            
            71
            
            
            117NET
                INCREASE IN CASH AND CASH EQUIVALENTS
            
            
            607
            
            
            933CASH
                AND CASH EQUIVALENTS, BEGINNING OF PERIOD
            
            
            5,053
            
            
            3,963CASH
                AND CASH EQUIVALENTS, END OF PERIOD
            
            $
            5,660
            
            $
            4,896





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 December 31, 2006, 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.
      W e
      did not
      record any provision for excess and obsolete inventories for the three months
      ended December 31, 2006 and 2005. The components of inventories include (in
      thousands):





**December
                31,**
              ****2006****
            
            **September
                30,**
              ****2006****Raw
                materials
            
            $
            707
            
            $
            497Work-in-progress
            
            
            94
            
            
            75Finished
                goods
            
            
            996
            
            
            810$
            1,797
            
            $
            1,382




6


**LONG-TERM
      INVESTMENTS**





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





In
      July
      2004, we purchased common stock of a private Korean telecommunications company
      for **** $ 79,000.
      As a result of this investment, we acquired approximately 23% of the voting
      power of the company and have the right to nominate and have elected one of
      the
      three members of the company's current board of directors.  We are
      accounting for this investment using the equity method and record our minority
      interest of their results in our results of operations. As of December 31,
      2006,
      our investment in the Korean company had a remaining book value of approximately
      $13,000 compared to $16,000 at September 30, 2006.





We
      perform a periodic review of our investments for impairment. Our investments
      are
      considered impaired when a review of the corporate operations and other
      indicators of impairment indicate that the carrying value of the investment
      is
      not likely to be recoverable. Such indicators include, but are not limited
      to,
      limited capital resources, limited prospects of receiving additional financing,
      and limited prospects for liquidity of the related securities. No write-downs
      were recorded as of December 31, 2006.





**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), “Share Based Payment” (“SFAS No. 123(R)”), which
      requires all share-based payments, 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 months ended December 31, 2006 and December 31, 2005 and is included
      in
      the Unaudited Condensed Consolidated Statements of Operations (in
      thousands):





**Three
                Months Ended**
              **December
                31,**
            
            **Three
                Months Ended**
              **December
                31,****2006**
            
            **2005**Cost
                of goods sold
            
            $
            7
            
            $
            12Research
                and development
            
            
            53
            
            
            100Selling,
                general and administrative
            
            
            91
            
            
            148Pre-tax
                stock-based compensation expense
            
            
            151
            
            
            260Income
                tax
            
            
            —
            
            
            —Net
                stock-based compensation expense
            
            $
            151
            
            $
            260





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





**Employee
                Stock Option Plan**
              **for
                Three Months Ended**
              **December
                31,****2006**
            
            **2005**Expected
                Life (in years)
            
            
            5
            
            
            5Risk-free
                interest rate
            
            
            4.5
            %
            
            4.4
            %Volatility
            
            
            92
            %
            
            97
            %Expected
                dividend
            
            
            0.0
            %
            
            0.0
            %





The
      fair
      value of each purchase rights granted under the Company’s Employee Stock
      Purchase Plan during the three months ended December 31, 2006 and December
      31,
      2005 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 Purchase Plan**
              **for
                Three Months Ended**
              **December
                31,****2006**
            
            **2005**Expected
                Life (in years)
            
            
            0.5
            
            
            0.5Risk-free
                interest rate
            
            
            5.0
            %
            
            4.3
            %Volatility
            
            
            93
            %
            
            98
            %Expected
                dividend
            
            
            0.0
            %
            
            0.0
            %





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


**Number
                      of Shares**
                  
                  **Weighted-**
                    **average**
                    **Exercise**
                    **Price**
                  
                  **Weighted-**
                    **Average**
                    **Remaining
                      Contractual Term**Outstanding
                      at October 1, 2006
                  
                  
                  3,559,170
                  
                  $
                  3.76Granted
                  
                  
                  5,000
                  
                  
                  1.57Exercised
                  
                  
                  (12,430
                  )
                  
                  0.61Forfeitures
                      and cancellations
                  
                  
                  (40,161
                  )
                  
                  2.87Outstanding
                      at December 31, 2006
                  
                  
                  3,511,579
                  
                  $
                  3.78
                  
                  
                  5.37Vested
                      and expected to vest at December 31, 2006
                  
                  
                  3,469,768
                  
                  $
                  3.79
                  
                  
                  0.10Exercisable
                      at December 31, 2006
                  
                  
                  3,043,991
                  
                  $
                  3.90
                  
                  
                  4.99
  8




During
      the three months ended December 31, 2006, 3.0 million shares of Company common
      stock issuable upon exercise of outstanding options are exercisable with a
      weighted-average exercise price of $3.90. The weighted-average remaining
      contractual term for outstanding options at December 31, 2006 was 5.4 years.





As
      of
      December 31, 2006, estimated forfeiture costs associated with such options
      were
      approximately $369,000. This cost is to be recognized over a weighted average
      period of approximately 4 years.





Under
      the
      1999 Employee Stock Purchase Plan (the “1999 Purchase Plan”), we had reserved as
      of September 30, 2006, 765,640 shares of common stock for issuance to eligible
      employees at a price equal to 85% of the lower of the fair market value of
      the
      common stock on the first day of the offering period or a specified exercise
      date (last trading day in April or October). During
      the three months ended December 31, 2006, 43,770 shares were purchased by and
      distributed to employees at a price of $1.35 per share.





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





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





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





Basic
      and
      diluted loss per share for each of the two quarters in the period ended December
      31, 2006 and 2005 were as follows (in thousands, except for per share data):


**Three
                  Months Ended**
                **December
                  31,****2006**
              
              **2005**Net
                  loss
              
              $
              (94
              )
              $
              (218
              )Weighted
                  average shares outstanding-basic income (loss) per share
              
              
              15,130
              
              
              14,842Weighted
                  average shares outstanding-
                  diluted income (loss) per share
              
              
              15,130
              
              
              14,842Basic
                  loss per share
              
              $
              (0.01
              )
              $
              (0.01
              )Diluted
                  net income (loss) per share
              
              $
              (0.01
              )
              $
              (0.01
              )





**COMPREHENSIVE
      INCOME**





Comprehensive
      loss for the three months ended December 31, 2006 and 2005 were as follows
      (in
      thousands):





**Three
                Months Ended**
              **December
                31,********2006**
            
            **2005**Net
                loss
            
            $
            (94
            )
            $
            (218
            )Unrealized
                loss
            
            
            —
            
            
            (3
            )$
            (94
            )
            $
            (221
            )




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 months
      ended December 31, 2006 and 2005, respectively, were as follows:





**Three
                Months Ended**
              **December
                31****,****2006**
            
            **2005**Americas
            
            
            90
            %
            
            91
            %International
            
            
            10
            %
            
            9
            %





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





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





**Three
                Months Ended**
              **December
                31,****2006**
            
            **2005**AltiSys
            
            
            13
            %
            
            17
            %Synnex
            
            
            49
            %
            
            56
            %Graybar
            
            
            18
            %
            
            13
            %





**2.
      WARRANTY**





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





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





**Three
                Months Ended**
              **December
                31,****2006**
            
            **2005**Beginning
                balance
            
            $
            263
            
            $
            264Provisions
                for warranty liability
            
            
            48
            
            
            23Warranty
                cost including labor, components and scrap
            
            
            (44
            )
            
            (35
            )Ending
                balance
            
            $
            267
            
            $
            252





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 $141,000
      and
      $126,000 for the three months ended December 31, 2006 and 2005, respectively.
      In
      addition, we lease certain equipment under capital lease arrangements. Minimum
      future lease payments under all noncancellable capital and operating leases
      as
      of December 31, 2006 are as follows (in thousands):





Capital
            
            OperatingFiscal
                Year Ending September 30,
            
            Leases
            
            LeasesRemainder
                of 2007
            
            $
            40
            
            $
            3232008
            
            
            47
            
            
            2862009
            
            
            44
            
            
            922010
            
            
            33
            
            
            —Total
                minimum lease payment
            
            $
            164
            
            $
            701Amount
                representing interest
            
            $
            23Present
                value of minimum lease payment
            
            
            141Total
                minimum lease payment
            
            $
            164Current
                portion plus current portion of interest
            
            $
            52Long-term
                portion plus long-term portion of interest
            
            
            112Total
                capital lease commitments
            
            $
            164




*Contingencies*





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




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





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





**FORWARD-LOOKING
      INFORMATION**





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




11




The
      forward-looking statements contained herein reflect our judgment as of the
      date
      of this report with respect to future events, the outcome of which is subject
      to
      certain risks that may have a significant impact on our business, operating
      results or financial condition. You are cautioned that these forward-looking
      statements are inherently uncertain. Should one or more of these risks or
      uncertainties materialize, or should underlying assumptions prove incorrect,
      actual results or outcomes may vary materially from those described herein.
      Although we believe that the expectations reflected in these forward-looking
      statements are reasonable, we cannot guarantee future results, levels of
      activity, performance or achievements. You should carefully review the
      cautionary statements contained in this Form 10-Q, including those found in
      "Certain Factors Affecting Business, Operating Results, and Financial Condition"
      below.





**OVERVIEW**





We
      are a
      pioneer and market leader in Internet protocol telephony systems for small-to
      medium-sized businesses. We design, manufacture and market next generation,
      Internet protocol phone systems and contact centers that use both the Internet
      and the public telephone network to take advantage of the convergence of voice
      and data communications. Unlike traditional proprietary phone systems, our
      systems are designed with open architecture and are built on an industry
      standard platform. This adherence to industry standards allows our products
      to
      play an important role in the small-to medium-sized business market by
      delivering phone systems that can integrate with other technologies and provide
      integrated voice and data solutions. We believe this enables our customers
      to
      implement communication systems that have an increased return compared to past
      technology investments. We generated net revenue of $4.4 million for each of
      the
      three months ended December 31, 2006 and 2005, respectively. As of December
      31,
      2006 we had an accumulated deficit of $51.3 million. Net cash provided by
      operating activities was $10,000 for the three months ended December 31,
      2006.





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 three months ended December 31, 2006, 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; we expect to see continued revenue growth for fiscal year 2007, as
      a
      result of our enhanced products.




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
      $821,000 and $403,000 as of December 31, 2006 and December 31, 2005,
      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
      were a deterioration of a major customer’s creditworthiness, or actual defaults
      were higher than our historical experience, we could be required to increase
      our
      allowance and our earnings could be adversely affected. Our allowance for
      doubtful accounts was $48,000 and $74,000 as of December 31, 2006 and 2005,
      respectively.





*Inventory* .
      Inventory is stated at the lower of cost (first-in, first-out method) or market.
      Our inventory balance was $1.8 million and $1.3 million as of December 31,
      2006
      and December 31, 2005, 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. Our inventory
      allowance was $2.3 million as of December 31, 2006.





*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 $267,000 and $252,000 as of December 31, 2006 and December 31,
      2005, respectively.




13


**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**
              **December
                31,****2006**
            
            **2005**Consolidated
                Statements of Operations Data:Net
                revenue:Hardware
            
            
            90.6
            %
            
            93.3
            %Software
            
            
            9.4
            
            
            6.7Total
                net revenue
            
            
            100.0
            
            
            100.0Cost
                of revenue:Hardware
            
            
            45.4
            
            
            45.3Software
            
            
            0.6
            
            
            0.5Total
                cost of revenue
            
            
            46.0
            
            
            45.8Gross
                profit
            
            
            54.0
            
            
            54.2Operating
                expenses:Research
                and development
            
            
            18.7
            
            
            23.3Sales
                and marketing
            
            
            26.7
            
            
            24.8General
                and administrative
            
            
            13.3
            
            
            12.7Total
                operating expenses
            
            
            58.7
            
            
            60.8Loss
                from operations
            
            
            (4.7
            )
            
            (6.6
            )Equity
                in net loss of investee
            
            
            (0.1
            )
            
            (0.2
            )Interest
                and other income, net
            
            
            2.7
            
            
            1.9Net
                loss before taxes
            
            
            (2.1
            )
            
            (4.9
            )Income
                tax provision
            
            
            (0.1
            )
            
            —Net
                loss
            
            
            (2.2
            )%
            
            (4.9
            )%





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





Net
      Revenue by Geographic Area:





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





**Three
                Months Ended**
              **December
                31****,****2006**
            
            **2005**Americas
            
            
            90
            %
            
            91
            %International
            
            
            10
            %
            
            9
            %





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




14


Net
      Revenue by Customer:





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





**Three
                Months Ended**
              **December
                31,****2006**
            
            **2005**AltiSys
            
            
            13
            %
            
            17
            %Synnex
            
            
            49
            %
            
            56
            %Graybar
            
            
            18
            %
            
            13
            %




Revenue
      generated in the Americas
      accounted for $4.0 million or 90% of revenue for the three months ended
      December 31, 2006 and $4.0 million or 91% of revenue for the three months
      ended December 31, 2005. Net revenue for both the three months ended December
      31, 2006 and 2005 was $4.4 million.





For
      the
      three months ended December 31, 2006, we incurred a net loss of $94,000. During
      the same period, we recognized $151,000 of non-stock based compensation expense
      due to the adoption of SFAS No. 123(R).





**Cost
      of revenue.** Cost of
      revenue for both the three months ended December 31, 2006 and December 31,
      2005
      was $2.0 million. Cost of revenue as a percentage of net revenue was 46% for
      both the three months ended December 31, 2006 and 2005, respectively. No
      additional provision for excess or obsolete inventory was necessary in the
      three
      months ended December 31, 2006 and December 31, 2005.





**Research
      and development expenses.** Research
      and development expenses consist principally of costs related to 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
      by approximately $210,000 from $1.0 million in the three months ended December
      31, 2005 to $817,000 in the three months ended December 31, 2006. Research
      and
      development expenses as a percentage of revenue decreased from 23% in the three
      months ended December 31, 2005 to 19% in the three months ended December 31,
      2006. The expense decrease in absolute dollars in research and development
      was a
      result of decrease in equipment expenses of approximately $8,000; legal expense
      of approximately $15,000; project expenses of approximately $64,000; payroll
      related expenses of approximately $21,000 and $47,000 of non-cash stock based
      compensation expense required by SFAS No. 123(R). We believe that research
      and
      development expenses will increase in the future periods over the long term
      due
      to development of new products and continued efforts in the improvement of
      the
      current products. In the short term, we expect research and development expenses
      to remain consistent as management continues to monitor expenses and plans
      to
      keep them in line with expected revenue opportunities.





**Sales
      and marketing expenses.** Sales
      and marketing expenses consist primarily of salaries, commissions and related
      expenses for personnel engaged in marketing, sales and customer support
      functions, as well as trade shows, advertising, and promotional expenses. Sales
      and marketing expenses for the three months ended December 31, 2006 were $1.2
      million compared to $1.1 million for the three months ended December 31, 2005.
      Sales and marketing expenses as a percentage of revenue were 27% and 25% for
      the
      three months ended December 31, 2006 and 2005, respectively. The
      expense increase in absolute was primarily due to a $19,000 increase in partner
      conference expenses; an increase of approximately $26,000 in travel; payroll
      related costs also increased by approximately $17,000 as well as advertising
      expenses of approximately $9,000. We
      anticipate sales and marketing expenses to remain consistent; however, some
      expenses vary with revenue, such as commissions. If we are successful in
      enhancing our products, we expect to see continued revenue growth for fiscal
      year 2007 and, consequently, expect an increase in sales and marketing
      expenses.





**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 were $582,000 for the three months ended December 31,
      2006 and $558,000 for the three months ended December 31, 2005. The
      expense increase in absolute dollars in general and administrative expenses
      in
      the three month period ended December 31, 2006 as compared to the same period
      in
      the prior year was primarily attributable
      to increased legal expenses associated with corporate governance
      matters. General and administrative expenses as a percentage of revenue
      were 13% for both the three months ended December 31, 2006 and 2005,
      respectively. We expect general and administrative expenses to increase due
      to
      the cost associated with compliance with Section 404 of the Sarbanes-Oxley
      Act
      during fiscal year 2008.




15


**Equity
      investment in common stock of private company.** In
      July
      2004, we purchased common stock of a private Korean telecommunications company
      for **$** 79,000.
      As a result of this investment, we acquired approximately 23% of the voting
      power of the company and have the right to nominate and have elected one of
      the
      three members of the company's board of directors.  We are accounting for
      this investment using the equity method. The
      total
      equity in net losses of this company was approximately $13,000 of which 23%,
      or
      $3,000, was recognized in the three months ended December 31, 2006.





**Interest
      and other income, net.** Net
      interest and other income increased to $120,000 for the three months ended
      December 31, 2006 from $83,000 for the three months ended December 31, 2005. The
      increase in net interest and other income for the three months ended December
      31, 2006 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 December 31, 2006, we had cash and short-term investments
      totaling $10.0 million consisting of cash and cash equivalents of
      $5.7 million and $4.3 million of short-term investment with a maturity
      of greater than 90 days (in thousands):





**Three
                Months Ended**
              **December
                31,****2006**
            
            **2005**Cash
                and cash equivalents
            
            $
            5,660
            
            $
            4,896Short-term
                investments
            
            
            4,334
            
            
            4,364Total
                cash, cash equivalents and short-term investments
            
            $
            9,994
            
            $
            9,260Cash
                provided by (used in) operating activities
            
            $
            10
            
            $
            (150
            )Cash
                provided by investing activities
            
            $
            526
            
            $
            966Cash
                provided by financing activities
            
            $
            71
            
            $
            117Net
                increase in cash and cash equivalents
            
            $
            607
            
            $
            933





*Changes
      in Cash Flows*





The
      Company’s net cash provided by operating activities of $10,000 in the three
      months ended December 31, 2006 was primarily due to a lower net loss of
      $94,000, a reduction in depreciation and amortization of approximately $63,000
      and non-cash stock based compensation expense of $151,000. These factors were
      partially offset by an increase in accounts receivables of $219,000 and deferred
      revenue of approximately $290,000. The increase in deferred revenue was
      primarily due to more products being shipped to distribution channels
      than was sold. For
      the
      three months ended December 31, 2006, net cash provided by non-operating
      activities was $526,000, which was primarily attributable to proceeds from
      maturities of short-term investments.





Net
      accounts receivable increased to $2.4 million at December 31, 2006 from
      $2.2 million at September 30, 2006. The increase in net accounts receivable
      was primarily due to a $306,000 payment tied up in holiday mail and received
      on
      January 2, 2007, which also contributed to the increases in days sales
      outstanding (DSO) at 50 days as of December 31, 2006 from 44 as of September
      30,
      2006.





We
      ended
      the first quarter of fiscal 2007 with a cash conversion cycle of 78 days as
      compared to 55 days for the first quarter of fiscal 2006. The cash conversion
      cycle is the duration between purchase of inventories and services and the
      collection of the cash from the sale of our products and services and is a
      metric on which we have focused as we continue to try to efficiently manage
      our
      assets. The cash conversion cycle results from the calculation of days of sales
      outstanding (DSO) added to days of supply in inventories (DOS), reduced by
      days
      of payable outstanding (DPO).





Inventories
      increased to $1.8 million at December 31, 2006 from $1.4 million at
      September 30, 2006 and our inventory turn rate decreased to 4.5 at December
      31, 2006 from 5.9 at September 30, 2006. This increase in inventories was
      primarily attributable to the new product introduction of our MAX1000. 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.




16


Accounts
      payable increased to $1.2 million at December 31, 2006 from $837,000 at
      September 30, 2006. This
      increase to accounts payable during this period was primarily attributable
      to an
      increase in the number of components purchased in the first quarter of fiscal
      2007. Accrued pa yroll-related
      liabilities decreased to $271,000 at December 31, 2006 from $328,000 at
      September 30, 2006, primarily as a result of a decrease of $19,000 in
      commissions and $38,000 decrease in employee stock purchase plan
      contribution.





During
      the three months ended December 31, 2006, our net cash provided by financing
      activities was $71,000 which was related to the proceeds from the exercise
      of
      employee stock option and stock purchases through our employee stock purchase
      plan.




*Liquidity
      and Capital Resources*





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





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





Additional
      financing, if required, may not be available on acceptable terms, or at all.
      We
      also may require additional capital to acquire or invest in complementary
      businesses or products, or obtain the right to use complementary technologies.
      If we cannot raise needed funds in the future if needed, 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 December 31, 2006.
      We have a commitment under our noncancellable capital and operating lease in
      the
      amount of $865,000 as of December 31, 2006. 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 $10.0 million as of December 31, 2006. The
      following table represents our future commitments as of December 31, 2006 (in
      thousands):


Payment
                  Due by PeriodContractual
                  Obligations
              
              Total
              
              Less
                  than
                1
                  Year
              
              1
                  -
                  3 Years
              
              3
                  -
                  5 Years
              
              More
                  than
                5
                  YearsOperating
                  leases obligation
              
              $
              701
              
              $
              323
              
              $
              378
              
              $
              —
              
              $
              —Capital
                  leases obligation
              
              
              164
              
              
              40
              
              
              91
              
              
              33
              
              
              —Total
              
              $
              865
              
              $
              363
              
              $
              469
              
              $
              33
              
              $
              —




17


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





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





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





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





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





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




18


**PART
      II. OTHER INFORMATION**





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





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





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





**Item
      1A. Risk Factors**





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





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





***Risks
      Related to Our Business***





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





We
      have
      had a history of operating losses since our inception and, as of December 31,
      2006, we had an accumulated deficit of $51.3 million. We may incur operating
      losses in the future, and these losses could be substantial and impact our
      ability to maintain profitability. We do not expect to increase expenditures
      for
      product development, general and administrative expenses, and sales and
      marketing expenses; however, if we cannot maintain current revenue or revenue
      growth, we will not achieve or sustain profitability or positive operating
      cash
      flows. Even if we achieve profitability and positive operating cash flows,
      we
      may not be able to sustain or increase profitability or positive operating
      cash
      flows on a quarterly or annual basis.





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




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




·
            our
                ability to respond effectively to competitive pricing
                pressures;





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





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





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





·
            our
                success in supporting our products and
                systems;




19





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





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





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





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





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





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





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





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





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





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





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





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





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





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





We
      do not
      recognize revenue from the sale of our products to our distributors until these
      products are sold to either resellers or end-users. Sales through direct dealers
      accounted for 20% of our net revenue and sales through our three key
      distributors, Altisys, Graybar and Synnex, accounted for 80% of our net
      revenue in the three months ended December 31, 2006. We have little control
      over
      the timing of product sales to dealers and end users. Our lack of control over
      the revenue that we recognize from our distributors’ sales to resellers and
      end-users limits our ability to predict revenue for any given period. Our future
      projected budgets and commitments are based in part on our expectations of
      future sales. If our sales do not meet expectations, it will be difficult for
      us
      to reduce our expenses quickly, and consequently our operating results may
      suffer.




20




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





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





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





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





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





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





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





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





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





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




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




21





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





***If,
      as of the end of our 2008 fiscal year, we are unable to assert that our internal
      control over financial reporting is effective, investors could lose confidence
      in our reported financial information, and the trading price of our stock price
      and our business could be adversely affected.***




We
      are in
      the process of documenting, and plan to test our internal control procedures
      in
      order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act.
      Commencing on September 30, 2008, the end of our 2008 fiscal year, the
      Sarbanes-Oxley Act requires annual management assessments of the effectiveness
      of our internal controls over financial reporting. During the course of our
      testing we may identify deficiencies which we may not be able to remediate
      in
      time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance
      with
      the requirements of Section 404. In addition, if we fail to achieve and maintain
      the adequacy of our internal controls, as such standards are modified,
      supplemented, or amended from time to time, we may not be able to ensure that
      we
      can conclude on an ongoing basis that we have effective internal controls over
      financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act.
      Effective internal controls are important to help produce reliable financial
      reports and to prevent financial fraud. If we are unable to assert that our
      internal control over financial reporting is effective as of the end of our
      2008
      fiscal year, we could lose investor confidence in the accuracy and completeness
      of our reported financial information, and the trading price of our stock and
      our business could be adversely affected.





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





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





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





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





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





Sales
      through our three key distributors, Altisys, Graybar and Synnex, accounted
      for
      80% of our net revenue in the three months ended December 31, 2006. Our business
      and operating results will suffer if any one of these distributors does not
      continue distributing our products, fails to distribute the volume of our
      products that it currently distributes or fails to expand our customer base.
      We
      also need to establish and maintain relationships with additional distributors
      and original equipment manufacturers. We may not be able to establish, or
      successfully manage, relationships with additional distribution partners. In
      addition, our agreements with distributors typically provide for termination
      by
      either party upon written notice to the other party. For example, our agreement
      with Synnex provides for termination, with or without cause, by either party
      upon 30 days’ written notice to the other party, or upon insolvency or
      bankruptcy. Generally, these agreements are non-exclusive and distributors
      sell
      products that compete with ours. If we fail to establish or maintain
      relationships with distributors and original equipment manufacturers, our
      ability to increase or maintain our sales and our customer base will be
      substantially harmed.




22


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





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





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




Changing
      laws, regulations and standards relating to corporate governance and public
      disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and
      Nasdaq National Market rules, are creating uncertainty for companies such as
      ours. These new or changed laws, regulations and standards are subject to
      varying interpretations in many cases due to their lack of specificity, and
      as a
      result, their application in practice may evolve over time as new guidance
      is
      provided by regulatory and governing bodies, which could result in continuing
      uncertainty regarding compliance matters and higher costs necessitated by
      ongoing revisions to disclosure and governance practices. As a result, our
      efforts to comply with evolving laws, regulations and standards have resulted
      in, and are likely to continue to result in, increased general and
      administrative expenses and a diversion of management time and attention from
      revenue-generating activities to compliance activities. In particular, our
      efforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 and the
      related regulations regarding our required assessment of our internal controls
      over financial reporting and our external auditors’ audit of that assessment has
      required the commitment of significant financial and managerial resources.
      We
      expect these efforts to require the continued commitment of significant
      resources. Further, our board members, chief executive officer, and chief
      financial officer could face an increased risk of personal liability in
      connection with the performance of their duties. As a result, we may have
      difficulty attracting and retaining qualified board members and executive
      officers, which could harm our business. If our efforts to comply with new
      or
      changed laws, regulations and standards differ from the activities intended
      by
      regulatory or governing bodies due to ambiguities related to practice, our
      reputation may be harmed.





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





We
      perform final assembly, software installation and testing of our products at
      our
      facility in Fremont, California. Our facility is located on or near known
      earthquake fault zones and may be subject to rolling electrical blackouts and
      is
      vulnerable to damage or interruption from fire, floods, earthquakes, power
      loss,
      telecommunications failures and similar events. If such a disaster or
      interruption occurs, our ability to perform final assembly, software
      installation and testing of our products at our facility would be seriously,
      if
      not completely, impaired. If we were unable to obtain an alternative place
      or
      way to perform these functions, our business, financial condition and results
      of
      operations would suffer. The insurance we maintain may not be adequate to cover
      our losses against fires, floods, earthquakes and general business
      interruptions.





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





We
      may
      begin to outsource a substantial amount of our product assembly and test
      functions. This outsourcing strategy involves certain risks, including the
      potential lack of adequate capacity and reduced control over delivery schedules,
      manufacturing yield, quality and costs. In the event that any of our significant
      subcontractors were to become unable or unwilling to continue to manufacture
      or
      test our products in the required volumes, we would have to identify and qualify
      acceptable replacements. Finding replacements could take time and we cannot
      be
      sure that additional sources would be available to us on a timely basis. Any
      delay or increase in costs in the assembly and testing of products by
      third-party subcontractors could seriously harm our business, financial
      condition and results of operations.





***Our
      expansion in international markets has been slow and steady. However, our plan
      is to accelerate this growth rate and will involve new risks that our previous
      domestic operations have not prepared us to address; our failure to address
      these risks could harm our business, financial condition and results of
      operations.***





For
      the
      three months ended December 31, 2006, approximately 10% of our net revenue
      came
      from customers outside of the Americas. We intend to expand our international
      sales and marketing efforts. Our efforts are subject to a variety of risks
      associated with conducting business internationally, any of which could
      seriously harm our business, financial condition and results of operations.
      These risks include:




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




23




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





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





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





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





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





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





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





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





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





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





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





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




24





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





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





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





***Risks
      Related to the Industry***





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





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





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




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





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





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




25





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





None





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





None





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





None




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





None





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




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




26





**SIGNATURE**





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




ALTIGEN
                COMMUNICATIONS, INC.Date:
                February 14, 2007
            By:
            /s/
                Philip M. McDermottPhilip
                M. McDermott,Chief
                Financial Officer(Principal
                Financial and Accounting
                Officer)


27




**EXHIBIT
      INDEX**





**Exhibit**
              **Number**
            
            **Description**3.1
                (1)
            
            Amended
                and Restated Certificate of Incorporation.3.2
                (2)
            
            Second
                Amended and Restated Bylaws.31.1
            
            Certification
                of Principal Executive Officer, filed herewith.31.2
            
            Certification
                of Principal Financial Officer, filed herewith.32.1
            
            Certification
                of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, file
                herewith.32.2
            
            Certification
                of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as
                Adopted
                Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, file
                herewith.





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


28