**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, 2004****OR****o**
      **TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934****FOR
      THE TRANSITION PERIOD
      FROM                      TO****Commission
      File Number 000-27427**








**ALTIGEN
COMMUNICATIONS, INC.**


(Exact
name of Registrant as specified in its charter)





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











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





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





The
number of shares of our common stock outstanding as of February 9, 2005 was:
  14,563,687 shares













**Table
of Contents**





**PART
      I. FINANCIAL INFORMATION**Item
      1.
    Financial
      Statements:Balance
      Sheets as of December 31, 2004 and September 30, 2004
    3Statements
      of Operations for the Three Months Ended December 31, 2004 and
      2003
    4Statements
      of Cash Flows for the Three Months Ended December 31, 2004 and
      2003
    5Notes
      to Financial Statements
    6Item
      2.
    Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
    12Item
      3.
    Quantitative
      and Qualitative Disclosures about Market Risk
    25Item
      4.
    Controls
      and Procedures
    25**PART
      II. OTHER INFORMATION**Item
      1.
    Legal
      Proceedings
    26Item
      2.
    Unregistered
      Sales of Equity Securities and Use of Proceeds
    26Item
      3.
    Defaults
      Upon Senior Securities
    26Item
      4.
    Submission
      of Matters to a Vote of Security Holders
    26Item
      5
    Other
      Information
    26Item
      6.
    Exhibits
    26**SIGNATURE**
    27**EXHIBIT
      INDEX**
    28




2




**PART
I. FINANCIAL INFORMATION**




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





**ALTIGEN
COMMUNICATIONS, INC. AND SUBSIDIARY**


**UNAUDITED
CONDENSED CONSOLIDATED BALANCE SHEETS**


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





**December
      31,**
      **2004**
    
    **September
      30,**
      **2004****ASSETS**Current
      assets:Cash
      and cash equivalents
    
    $
    6,753
    
    $
    5,367Short-term
      investments
    
    
    3,261
    
    
    4,667Accounts
      receivable, net of allowances of $30 and $35 at December 31, 2004 and
      September 30, 2004, respectively
    
    
    2,015
    
    
    1,857Inventories
    
    
    890
    
    
    1,058Prepaid
      expenses and other current assets
    
    
    168
    
    
    67Total
      current assets
    
    
    13,087
    
    
    13,016Property
      and equipment:Furniture
      and equipment
    
    
    1,004
    
    
    987Computer
      software
    
    
    920
    
    
    9151,924
    
    
    1,902Less:
      Accumulated depreciation and amortization
    
    
    (1,772
    )
    
    (1,750
    )Net
      property and equipment
    
    
    152
    
    
    152Other
      non-current assets:Long-term
      investment
    
    
    255
    
    
    274Long-term
      deposit
    
    
    74
    
    
    74Total
      other non-current assets
    
    
    329
    
    
    348Total
      assets
    
    $
    13,568
    
    $
    13,516**LIABILITIES
      AND STOCKHOLDERS' EQUITY**Current
      liabilities:Accounts
      payable
    
    $
    724
    
    $
    798Accrued
      liabilities:Payroll
      and related benefits
    
    
    273
    
    
    330Warranty
      (Note 3)
    
    
    407
    
    
    424Marketing
    
    
    126
    
    
    139Other
    
    
    424
    
    
    493Deferred
      revenue
    
    
    295
    
    
    518Total
      current liabilities
    
    
    2,249
    
    
    2,702Long-term
      deferred rent
    
    
    134
    
    
    145Stockholders'
      equity:Convertible
      preferred stock, $0.001 par value; Authorized - 5,000,000 shares; None
      issued and outstanding at December 31, 2004 and September 30,
      2003
    
    
    --
    
    
    --Common
      stock, $0.001 par value; Authorized - 50,000,000 shares; Outstanding -
      15,594,607 shares at December 31, 2004 and 15,462,506 shares at September
      30, 2004
    
    
    15
    
    
    15Treasury
      stock at cost - 1,063,895 shares at December 31, 2004 and September 30,
      2004
    
    
    (1,014
    )
    
    (1,014
    )Additional
      paid-in capital
    
    
    62,678
    
    
    62,505Accumulated
      other comprehensive loss
    
    
    --
    
    
    (2
    )Accumulated
      deficit
    
    
    (50,494
    )
    
    (50,835
    )Total
      stockholders' equity
    
    
    11,185
    
    
    10,669Total
      liabilities and stockholders' equity
    
    $
    13,568
    
    $
    13,516





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





3




**ALTIGEN
COMMUNICATIONS, INC. AND SUBSIDIARY**


**UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**


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




**Three
      Months Ended December 31,****2004**
    
    **2003**Net
      revenue:Hardware
    
    $
    3,564
    
    $
    3,220Software
    
    
    711
    
    
    410Total
      net revenue
    
    
    4,275
    
    
    3,630Cost
      of revenues:Hardware
    
    
    1,615
    
    
    1,406Software
    
    
    52
    
    
    32Total
      cost of revenues
    
    
    1,667
    
    
    1,438Gross
      profit
    
    
    2,608
    
    
    2,192Operating
      expenses:Research
      and development
    
    
    822
    
    
    828Sales
      and marketing
    
    
    1,001
    
    
    1,013General
      and administrative
    
    
    475
    
    
    422Total
      operating expenses
    
    
    2,298
    
    
    2,263Income
      (loss) from operations
    
    
    310
    
    
    (71
    )Interest
      and other income, net
    
    
    42
    
    
    25Net
      income (loss) before tax
    
    
    352
    
    
    (46
    )Income
      taxes
    
    
    10
    
    
    --Net
      income (loss)
    
    $
    342
    
    $
    (46
    )Basic
      and diluted net income (loss) per share
    
    $
    0.02
    
    $
    (0.00
    )Weighted
      average shares used in computing basic net income (loss) per
      share
    
    
    14,459
    
    
    14,116Weighted
      average shares used in computing diluted net income (loss) per
      share
    
    
    15,797
    
    
    14,116





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





4





**ALTIGEN
COMMUNICATIONS, INC. AND SUBSIDIARY**


**UNAUDITED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**


**(in
thousands)**





**Three
      Months Ended December 31,****2004**
    
    **2003**CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      Income (loss)
    
    $
    342
    
    $
    (46
    )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
    
    
    22
    
    
    73Changes
      in operating assets and liabilitiesAccounts
      receivable
    
    
    (158
    )
    
    (331
    )Inventories
    
    
    168
    
    
    196Prepaid
      expenses and other current assets
    
    
    (101
    )
    
    (21
    )Accounts
      payable
    
    
    (74
    )
    
    (445
    )Accrued
      liabilities
    
    
    (156
    )
    
    7Deferred
      revenue
    
    
    (223
    )
    
    (144
    )Deferred
      rent
    
    
    (11
    )
    
    --Net
      cash used in operating activities
    
    
    (191
    )
    
    (711
    )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchases
      of short-term investments
    
    
    (1,594
    )
    
    (3,369
    )Proceeds
      from sale and maturities of short-term investments
    
    
    3,000
    
    
    1,591Changes
      in other non-current assets
    
    
    19
    
    
    (50
    )Purchases
      of property and equipment
    
    
    (22
    )
    
    (7
    )Net
      cash provided by (used in) investing activities
    
    
    1,403
    
    
    (1,835
    )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from issuances of common stock
    
    
    174
    
    
    109Net
      cash provided by financing activities
    
    
    174
    
    
    109NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    
    
    1,386
    
    
    (2,437
    )CASH
      AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    5,367
    
    
    8,548CASH
      AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    6,753
    
    $
    6,111





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. designs, manufactures and markets next generation,
time-tested Internet protocol phone systems and contact centers that use both
the Internet and the public telephone network to take advantage of the
convergence of voice and data communications.





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





These
financial statements should be read in conjunction with our audited consolidated
financial statements for the fiscal year ended September 30, 2004, included in
the Company's 2004 Annual Report on Form 10-K filed with the SEC on December 29,
2004. AltiGen's results of operations for any interim period are not necessarily
indicative of the results of operations for any other interim period or for a
full fiscal year.





**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, 2004, our cash and cash equivalents
consisted of commercial paper and cash deposited in checking and money market
accounts. For the three months ended December 31, 2004 and 2003, we did not make
any cash payments for interest or income taxes.





Unrealized
loss from short-term investments were $0 at December 31, 2004 and $2,000 at
September 30, 2004, respectively.





**INVENTORIES**





Inventories
(which include costs associated with components assembled by third-party
assembly manufacturers, as well as internal labor and allocable overhead) are
stated at the lower of cost (which approximates actual cost on first-in,
first-out method) or market. Provisions, when required, are made to reduce
excess and obsolete inventories to their estimated net realizable values. We
regularly monitor inventory quantities on hand and record a provision for excess
and obsolete inventories based primarily on our estimated forecast of product
demand and production requirements for the next six months. We did not record
any provision for excess and obsolete inventories for the three months ended
December 31, 2004 and 2003. The components of inventories include (in
thousands):





**December
      31,**
      **2004**
    
    **September
      30,**
      **2004**Raw
      materials
    
    $
    248
    
    $
    68Work-in-progress
    
    
    87
    
    
    95Finished
      goods
    
    
    555
    
    
    895$
    890
    
    $
    1,058





**LONG-TERM
INVESTMENT**





As of
December 31, 2004, 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.





6





In July
2004, we purchased common stock of a private Korean telecommunications company
for **** approximately **$** 79,000.
As a result of this investment, we acquired approximately 23% of the voting
power of the company and have the right to nominate and have elected one of the
three members of the company's current board of directors.  We are
accounting for this investment using the equity method.





We
perform a periodic review of our investments for impairment. Our investments are
considered impaired when a review of the investees' operations and other
indicators of impairment indicate that the carrying value of the investment is
not likely to be recoverable. Such indicators include, but are not limited to,
limited capital resources, limited prospects of receiving additional financing,
and limited prospects for liquidity of the related securities.





**REVENUE
RECOGNITION**





We
account for the recognition of software license revenues in accordance with
Statement of Position ("SOP") 97-2, "Software Revenue Recognition." Revenues
consist of sales to end-users, including resellers, and to distributors.
Revenues from sales to end-users are recognized upon shipment, when risk of loss
has passed to the customer, collection of the receivable is reasonably assured,
persuasive evidence of an arrangement exits, and the price is fixed and
determinable. Sales to distributors are made under terms allowing certain rights
of return and protection against subsequent price declines on the Company's
products held by its distributors. Upon termination, any unsold products may be
returned by the distributor for a full refund. These agreements may be canceled
by either party based on a specified notice. As a result of the above
provisions, we defer recognition of distributor revenues until 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 revenues consist of license revenues that are recognized upon the
delivery of application products. We provide limited post-contract customer
support ("PCS"), consisting primarily of technical support and "bug" fixes. In
accordance with SOP 97-2, revenue earned on software arrangements involving
multiple elements is allocated to each element based upon the relative fair
values of the elements. Although we provide PCS, the revenue allocated to this
element is recognized together with the initial licensing fee on delivery of the
software because: (1) the PCS fee is included with the initial licensing
fee; (2) the PCS included with the initial license fee is for one year or
less; (3) the estimated cost of providing PCS during the arrangement is
insignificant; and (4) unspecified upgrades/enhancements offered for
minimal or no cost during PCS arrangements historically have been and are
expected to continue to be minimal and infrequent. All estimated costs of
providing the services, including upgrades and enhancements, are accrued for at
the time of delivery.





**STOCK-BASED
COMPENSATION**





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





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





7





Three
      Months Ended
      December
      31,2004
    
    2003Reported
      net income (loss)
    
    $
    342
    
    $
    (46
    )Add:
      Total stock-based employee compensation expense included in reported net
      loss under APB No. 25
    
    
    --
    
    
    --Deduct:
      Total stock-based compensation determined under fair value based method
      for all awards
    
    
    (396
    )
    
    (246
    )Pro
      forma net loss under SFAS No. 123
    
    $
    (54
    )
    $
    (292
    )Basic
      and diluted net income (loss) per share – as reported
    
    $
    0.02
    
    $
    (0.00
    )Basic
      and diluted net loss per share – pro forma
    
    $
    (0.00
    )
    $
    (0.02
    )




The fair
value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model, and is not subject to revaluation as a
result of subsequent stock price fluctuations. The following weighted-average
assumptions are used:




**Employee
      Stock Option Plan**
      **for
      Three Months**
      **Ended
      December 31,****2004**
    
    **2003**Expected
      Life (in years)
    
    
    5
    
    
    5Risk-free
      interest rate
    
    
    3.5
    %
    
    3.4
    %Volatility
    
    
    103
    %
    
    113
    %Expected
      dividend
    
    
    0.0
    %
    
    0.0
    %




**Employee
      Stock Purchase Plan**
      **for
      Three Months**
      **Ended
      December 31,****2004**
    
    **2003**Expected
      Life (in years)
    
    
    0.5
    
    
    0.5Risk-free
      interest rate
    
    
    2.5
    %
    
    1.1
    %Volatility
    
    
    102
    %
    
    113
    %Expected
      dividend
    
    
    0.0
    %
    
    0.0
    %





The
Black-Scholes option pricing model was developed for use in estimating the fair
value of traded options that have no vesting restrictions and are fully
transferable. In addition, option pricing models require the input of highly
subjective assumptions, including the expected stock price volatility. We use
projected volatility rates, which are based upon historical volatility rates
since our initial public offering, trended into future years.





**COMPUTATION
OF BASIC AND DILUTED NET INCOME (LOSS) PER SHARE**





Historical
net income (loss) per share has been calculated under SFAS No. 128,
"Earnings per Share." SFAS No. 128 requires companies to compute earnings
per share under two methods (basic and diluted). Basic net income (loss) per
share is calculated by dividing net income (loss) by the weighted average shares
of common stock outstanding during the period. Diluted
earnings per share reflects the potential dilution that could occur if
securities or other contracts to issue common stock were exercised or converted
into common stock.  For all
periods but the quarter ended December 31, 2004, basic and diluted net loss per
share numbers were identical as potential common shares resulting from the
exercise of stock options were antidilutive


8




**Three
      Months**
      **Ended
      December 31,****2004**
    
    
    **2003****(in
      thousands, except per share data)**Net
      Income (loss)
    
    $
    342
    
    $
    (46
    )Weighted
      average shares outstanding –
      basic
    
    
    14,459
    
    
    14,116Add:
      Dilutive stock options
    
    
    1,338
    
    
    --Weighted
      average shares outstanding –
      diluted
    
    
    15,797
    
    
    14,116Basic
      and diluted earnings (loss) per share
    
    $
    0.02
    
    $
    (0.00
    )





**COMPREHENSIVE
INCOME**





Comprehensive
income (loss) consists of net income (loss) plus the effect of foreign currency
translation adjustments and other unrealized gains and losses, which were not
material for each of the three months ended December 31, 2004 and 2003,
respectively. Accordingly, comprehensive income (loss) closely approximates
actual net income (loss).





**SEGMENT
REPORTING**





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





Net
revenue by geographic region based on customer location for the three months
ended December 31, 2004 and 2003, respectively, were as follows:




**Three
      Months Ended**
      **December
      31,**
    ********
    ****
    **2004**
    ****
    **2003**Americas
    
    
    85
    %
    
    92
    %International
    
    
    15
    %
    
    8
    %100
    %
    
    100
    %


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




Net
revenue by customers that individually accounted for more than 10% of our
revenue for the three months ended December 31, 2004 and 2003, respectively,
were as follows:




**Three
      Months Ended**
      **December
      31,**
    ********
    ****
    **2004**
    ****
    **2003**AltiSys
    
    
    10
    %
    
    17
    %Ingram
      Micro (see Note 5)
    
    
    7
    %
    
    18
    %Synnex
    
    
    49
    %
    
    48
    %Graybar
    
    
    10
    %
    
    --





Graybar
became our distributor starting in June 2003 but did not generate any
significant revenue for the three months ended December 31, 2003.







9


**2.
RECENT ACCOUNTING PRONOUNCEMENTS**





In July
2004, the EITF reached a consensus on Issue No. 02-14, "Whether an Investor
Should Apply the Equity Method of Accounting to Investments Other Than Common
Stock" ("EITF No. 02-14"). The consensus was that an investor should only apply
the equity method of accounting when it has investments in either common stock
(as already required by APB Opinion No. 18) or in-substance common stock of a
corporation, provided that the investor has the ability to exercise significant
influence over the operating and financial policies of the investee. EITF No.
02-14 defines in-substance common stock and provides guidance on determining
whether an investment is substantially similar to the common stock of the
investee. EITF No. 02-14 should be applied in the first reporting period
beginning after September 15, 2004 The
adoption of this standard did not have a material impact on our consolidated
financial statements.





In
November 2004, the Financial
Accounting Standards Board (" FASB")
issued SFAS No. 151, "Inventory Costs." The statement requires that abnormal
amounts of idle facility expense, freight handling costs and wasted material be
recognized as current-period expenses. In addition, the statement requires that
the allocation of production overhead be based on normal capacity. The adoption
of this standard in October 2004 did not have a material impact on our
consolidated financial statements.





In
December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets,
which eliminates the exception for nonmonetary exchanges of similar productive
assets and replaces it with a general exception for exchanges of nonmonetary
assets that do not have commercial substance. SFAS No. 153 will be effective for
nonmonetary asset exchanges occurring in fiscal periods beginning after June 15,
2005. The adoption of SFAS No. 153 is not expected to have material impact on
our consolidated financial statements.





Also in
December 2004, the FASB issued SFAS No. 123, "Share-Based Payments (revised
2004)," (SFAS No. 123R). This statement eliminates the option to apply the
intrinsic value measurement provisions of APB Opinion No. 25, "Accounting for
Stock Issued to Employees", to stock compensation awards issued to employees.
Rather the statement requires companies 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. That cost will be recognized over the period during
which an employee is required to provide services in exchange for the
award – the requisite service period
(usually the vesting period). SFAS No. 123R will also require enterprises to
measure the cost of employee services received in exchange for employee stock
purchase plan ("ESPP") awards and we will be required to expense the grant-date
fair value of our ESPP awards. SFAS No. 123R will be effective for our fiscal
quarter beginning July 1, 2005. We have not yet quantified the effect of the
future adoption of SFAS No. 123R on a going forward basis.





**3.
WARRANTY**





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





Changes
in our warranty liability for the three months ended December 31, 2004 and 2003,
respectively, are as follows (in thousands):




**Three
      Months Ended**
      **December
      31,**
    ********
    ****
    **2004**
    ****
    **2003**Beginning
      balance
    
    $
    424
    
    $
    644Provisions
      for warranty liability
    
    
    23
    
    
    60Warranty
      cost including labor, components and scrap
    
    
    (40
    )
    
    (34
    )Ending
      balance
    
    $
    407
    
    $
    670










10


**4.
COMMITMENTS AND CONTINGENCIES**





*Commitments*





We lease
our facilities under various operating lease agreements expiring on various
dates through February 2009. The lease for our headquarters expires on
February 21, 2009. Rent
expense for this operating lease totaled approximately $126,000 and $162,000 for
the three months ended December 31, 2004 and 2003, respectively. Minimum future
lease payments under a noncancellable operating lease as of December 31, 2004
are as follows (in thousands):





Fiscal
      Year Ending September 30,
    
    Capital
      Leases
    
    Operating
      Leases2005
    
    
    4
    
    
    3142006
    
    
    2
    
    
    4032007
    
    
    2
    
    
    3612008
    
    
    --
    
    
    271Thereafter
    
    
    --
    
    
    92Total
      minimum lease payment
    
    
    8
    
    $
    1,441Amount
      representing interest
    
    
    1Present
      value of minimum lease payment
    
    
    7Current
      portion
    
    
    4Long-term
      portion
    
    $
    3





*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.





**5.
SUBSEQUENT EVENT**





In
January 2005, we sent 90 days written notice to Ingram Micro to terminate our
distribution agreement. As of December 31, 2004, the balances outstanding with
Ingram Micro were $45,000 in inventory and $136,000 in accounts
receivable.







11


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





**FORWARD-LOOKING
INFORMATION**





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





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





**OVERVIEW**





We
provide converged Internet protocol phone systems to small-to-medium sized
businesses. We first recognized revenues from product sales of our Quantum board
and AltiWare software in July 1996. We generated net revenues of $4.3
million and $3.6 million for the three months ended December 31, 2004 and 2003,
respectively. As of December 31, 2004, we had an accumulated deficit of
$50.5 million.





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





Our cost
of revenues consists of component and material costs, direct labor costs,
provisions for excess and obsolete inventory, warranty costs and overhead
related to the manufacturing of our products. Several factors that have
affected, and will continue to affect, our revenue growth include the state of
the economy, the market acceptance of our products, our ability to add new
resellers and our ability to design, develop, and release new products. We
engage third-party assemblers, which, for the three months ended December 31,
2004, 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 achieve
or maintain the volumes required to realize these economies of scale or when or
if such cost reductions will occur. The failure to obtain such cost reductions,
or maintain such reductions if they occur, could materially adversely affect our
gross margins and operating results.





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





12


**CRITICAL
ACCOUNTING POLICIES**





*Revenue
recognition.* Revenues
consist of sales to end-users, including resellers, and to distributors.
Revenues from sales to end-users are recognized upon shipment, when risk of loss
has passed to the customer, collection of the receivable is reasonably assured,
persuasive evidence of an arrangement exists, and the price is fixed and
determinable. We provide for estimated sales returns and allowances and warranty
costs related to such sales at the time of shipment. Net revenues consist of
product revenues reduced by estimated sales returns and allowances. Sales to
distributors are made under terms allowing certain rights of return and
protection against subsequent price declines on our products held by its
distributors. Upon termination, any unsold products may be returned by the
distributor for a full refund. These agreements may be canceled without cause by
either party following a specified notice period. As a result of the above
provisions, we defer recognition of distributor revenues until such distributors
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 revenues is also deferred and reported in
the consolidated balance sheets as inventory. Our total deferred revenue was
$295,000 as of December 31, 2004.





Software
components are generally not sold separately from our hardware components.
Software revenues consist of license revenues that are recognized upon the
delivery of application products. We provide limited post-contract customer
support ("PCS"), consisting primarily of technical support and "bug" fixes. In
accordance with SOP 97-2, revenue earned on software arrangements involving
multiple elements is allocated to each element based upon the relative fair
values of the elements. Although we provide PCS, the revenue allocated to this
element is recognized together with the initial licensing fee on delivery of the
software 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 $30,000 as of December 31, 2004.





*Inventory.* Inventory is stated at the lower of cost (first-in, first-out method) or market.
Our inventory balance was $0.9 million as of December 31, 2004. We
regularly review value of inventory in detail, with consideration given to
future customer demand for our products, obsolescence from rapidly changing
technology, and other factors. If actual market conditions are less favorable
than those projected by management, and our estimates prove to be inaccurate, we
could be required to increase our inventory provision and our gross margins
could be adversely affected. Our inventory allowance was $2.6 million as of
December 31, 2004.





*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 $407,000 as of December 31, 2004.





13


**Results
of Operations**





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





**Three
      Months Ended**
      **December
      31****2004**
    
    **2003**Consolidated
      Statements of Operations Data:Net
      revenue:Hardware
    
    
    83.4
    %
    
    88.7
    %Software
    
    
    16.6
    
    
    11.3Total
      net revenue
    
    
    100.0
    
    
    100.0Cost
      of revenues:Hardware
    
    
    37.8
    
    
    38.7Software
    
    
    1.2
    
    
    0.9Total
      cost of revenues
    
    
    39.0
    
    
    39.6Gross
      profit
    
    
    61.0
    
    
    60.4Operating
      expenses:Research
      and development
    
    
    19.2
    
    
    22.8Sales
      and marketing
    
    
    23.4
    
    
    27.9General
      and administrative
    
    
    11.1
    
    
    11.6Total
      operating expenses
    
    
    53.7
    
    
    62.3Income
      (loss) from operations
    
    
    7.3
    
    
    (1.9
    )Interest
      and other income, net
    
    
    0.9
    
    
    0.7Net
      income (loss) before tax
    
    
    8.2
    
    
    (1.2
    )Provision
      for income taxes
    
    
    0.2
    
    
    --Net
      income (loss)
    
    
    8.0
    %
    
    (1.2
    )%








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





Net
Revenue by Geographic Area:




Three
      Months Ended
      December
      31,2004
    
    2003Americas
    
    
    85
    %
    
    92
    %International
    
    
    15
    %
    
    8
    %100
    %
    
    100
    %





14


Net
Revenue by Customers:




Three
      Months Ended
      December
      31,2004
    
    2003AltiSys
    
    
    10
    %
    
    17
    %Ingram
      Micro (see Note 5)
    
    
    7
    %
    
    18
    %Synnex
    
    
    49
    %
    
    48
    %Graybar
    
    
    10
    %
    
    --





Revenues
generated in the Americas accounted for $3.6 million or 85% of revenues for
the three months ended December 31, 2004 and $3.3 million or 92% of
revenues for the three months ended December 31, 2003. Net revenues increased
18% to $4.3 million for the three months ended December 31, 2004 from
$3.6 million for the three months ended December 31, 2003 due to the
increased sales in telephone systems as a result of increasing our market
presence through better performing resellers , selling more products into the
call center market space, the sales of larger systems and the doubling of our
international revenues, primarily through sales in China. Effective
February 7, 2005, we lowered the price on our AltiServ1-IP Internet Protocol
business system in response to increased price competition in the 8 to 50 users
target market. The potential negative impact to our gross profit in
the second quarter of fiscal year 2005 could be approximately
$90,000.


****


**Cost
of revenues.** Cost of
revenues for the three months ended December 31, 2004 increased
$0.3 million or 16% to $1.7 million from approximately
$1.4 million for the three months ended December 31, 2003 primarily due to
an increase in overall sales of products and the requisite increase in product
costs. Cost of revenues as a percentage of net revenues remained unchanged at
approximately 39% for the three months ended December 31, 2004 and 2003,
respectively. No additional provision for excess or obsolete inventory was
necessary in the three months ended December 31, 2004.





**Research
and development expenses.** Research
and development expenses consist principally of salaries and related personnel
expenses, consultant fees and prototype expenses related to the design,
development and testing of our products and enhancement of our converged
telephone system software. Research and development expenses remained unchanged
at $0.8 million for the three months ended December 31, 2004 and 2003,
respectively. We expect research and development expenses to remain relatively
flat due to the uncertainty about customers' spending patterns in the current
economic environment. Management continues to monitor research and development
expenses and plans to keep them in line with expected revenue opportunities.


****


**Sales
and marketing expenses.** Sales
and marketing expenses consist primarily of salaries, commissions and related
expenses for personnel engaged in marketing, sales and customer support
functions, as well as trade shows, advertising, and promotional expenses. Sales
and marketing expenses remained unchanged at $1.0 million for the three months
ended December 31, 2004 and 2003, respectively. We expect sales and marketing
expenses to remain relatively flat due to the uncertainty about customers'
spending patterns in the current economic environment; however, some expenses
vary with revenues, such as commissions, which move with sales of our products.


****


**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 remained unchanged at $0.4 million for the three months
ended December 31, 2004 and 2003, respectively. We expect to maintain general
and administrative expenses at the same level, except for the impact complying
with Section 404 of the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") during
fiscal year 2005. We have not completed our estimates of the cost of this
compliance.





I **nterest
and other income, net.** Net
interest and other income increased slightly to $42,000 for the three months
ended December 31, 2004 from $25,000 for the three months ended December 31,
2003. The
increase in net interest and other income for the three months ended December
31, 2004 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.








15


**Liquidity
and Capital Resources**





Since
inception, we primarily have financed our operations through the sale of equity
securities. As of December 31, 2004, we had cash, cash equivalents, and
short-term investments totaling $10.0 million, which consisted of cash and
cash equivalents of $6.8 million and $3.2 million of short-term
investments.





*Changes
in Cash Flows*





During
the three months ended December 31, 2004, net cash used in operating activities
was $191,000, which was approximately $520,000 lower than the cash used in
operating activities during the same period of fiscal 2004 due to a net profit
being generated in the first quarter of fiscal 2005. For the three months ended
December 31, 2004, net cash provided by non-operating activities was $1.4
million, which was primarily attributable to proceeds from maturities of
short-term investments.





Net
accounts receivable slightly increased to $2.0 million at December 31, 2004
from $ 1.9 million at September 30, 2004. The increase in net accounts
receivable was primarily due to increases in revenue.





We ended
the first quarter of fiscal 2005 with a cash conversion cycle of 51 days as
compared to 64 days for the first quarter of fiscal 2004. The cash conversion
cycle is the duration between purchase of inventories and services and the
collection of the cash from the sale of our products and services and is a
metric on which we have focused as we continue to try to efficiently manage our
assets. The cash conversion cycle results from the calculation of days of sales
outstanding added to days of supply in inventories , reduced by days of payable
outstanding .





Inventories
decreased to $0.9 million at December 31, 2004 from $1.1 million at
September 30, 2004 and our inventory turn rate increased to 7.4 times at
December 31, 2004 from 5.7 times at September 30, 2004. Our inventory turn
rate represents the number of times inventory is replenished
during the quarter. Inventory management will continue to be an area of focus as
we balance the need to maintain strategic inventory levels to help ensure
competitive lead times with the risk of inventory obsolescence due to rapidly
changing technology and customer requirements.





Accounts
payable decreased to $724,000 at December 31, 2004 from $798,000 at
September 30, 2004. This decrease primarily was due to inventory purchased
in the last month of the prior quarter for which payment was made in the quarter
ended December 31, 2004. Our accrued payroll-related liabilities decreased to
$273,000 at December 31, 2004 from $330,000 at September 30, 2004,
primarily as a result of a decrease in employee stock purchase plan contribution
due to a common stock purchase made under our ESPP in November 2004.




In the
first quarter of fiscal 2005, our net cash provided by financing activities was
primarily attributable to the $174,000 of proceeds from the exercise of employee
stock options and stock purchases through our employee stock purchase
plan





*Liquidity
and Capital Resources*





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





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





16


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





We do not
have any material commitments for capital expenditures as of December 31, 2004.
We have commitments under our noncancellable operating lease in the amount of
$1.4 million as of December 31, 2004. The following table represents our
future commitments as of December 31, 2004 (in thousands):








Payment
      Due by PeriodTotal
    
    Less
      than
      1
      Year
    
    1 -
      3 Years
    
    3 -
      5 Years
    
    More
      than
      5
      YearsOperating
      leases obligation
    
    $
    1,441
    
    $
    314
    
    $
    764
    
    $
    363
    
    $
    --Capital leases
      obligation
    
    
    8
    
    
    4
    
    
    4
    
    
    --
    
    
    --Total
    
    $
    1,449
    
    $
    318
    
    $
    768
    
    $
    363
    
    $
    --


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





**Recent
Accounting Pronouncements**





In July
2004, the EITF reached a consensus on Issue No. 02-14, "Whether an Investor
Should Apply the Equity Method of Accounting to Investments Other Than Common
Stock" ("EITF No. 02-14"). The consensus was that an investor should only apply
the equity method of accounting when it has investments in either common stock
(as already required by APB Opinion No. 18) or in-substance common stock of a
corporation, provided that the investor has the ability to exercise significant
influence over the operating and financial policies of the investee. EITF No.
02-14 defines in-substance common stock and provides guidance on determining
whether an investment is substantially similar to the common stock of the
investee. EITF No. 02-14 should be applied in the first reporting period
beginning after September 15, 2004. The
adoption of this standard did not have a material impact on our consolidated
financial statements.





In
November 2004, the Financial
Accounting Standards Board (" FASB")
issued SFAS No. 151, "Inventory Costs." The statement requires that abnormal
amounts of idle facility expense, freight handling costs and wasted material be
recognized as current-period expenses. In addition, the statement requires that
the allocation of production overhead be based on normal capacity. The adoption
of this standard in October 2004 did not have a material impact on our
consolidated financial statements.





In
December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets,
which eliminates the exception for nonmonetary exchanges of similar productive
assets and replaces it with a general exception for exchanges of nonmonetary
assets that do not have commercial substance. SFAS No. 153 will be effective for
nonmonetary asset exchanges occurring in fiscal periods beginning after June 15,
2005. The adoption of SFAS No. 153 is not expected to have material impact on
our consolidated financial statements.





Also in
December 2004, the FASB issued SFAS No. 123, "Share-Based Payments (revised
2004)," (SFAS No. 123R). This statement eliminates the option to apply the
intrinsic value measurement provisions of APB Opinion No. 25, "Accounting for
Stock Issued to Employees", to stock compensation awards issued to employees.
Rather the statement requires companies 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. That cost will be recognized over the period during
which an employee is required to provide services in exchange for the award -
the requisite service period (usually the vesting period). SFAS No. 123R will
also require enterprises to measure the cost of employee services received in
exchange for employee stock purchase plan ("ESPP") awards and we will be
required to expense the grant-date fair value of our ESPP awards. SFAS No. 123R
will be effective for our fiscal quarter beginning July 1, 2005. We have not yet
quantified the effect of the future adoption of SFAS No. 123R on a going forward
basis.





17


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





*Risks
Related to AltiGen*





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





We have
had a history of operating losses since our inception, and as of December 31,
2004, we had an accumulated deficit of $50.5 million. We may incur
operating losses in the future, and these losses could be substantial and impact
our ability to maintain profitability. We do not expect to increase expenditures
for product development, general and administrative expenses, and sales and
marketing expenses; however, if we cannot maintain current revenues or revenue
growth, we will not maintain profitability or positive operating cash flows.
Even if we achieve profitability and positive operating cash flows, we may not
be able to sustain or increase profitability or positive operating cash flows on
a quarterly or annual basis.





*We
have a limited operating history, which makes it difficult to evaluate our
business and our future prospects.*





We
shipped our first products in July 1996. As a result of our limited
operating history, we have limited financial data that you can use to evaluate
our business. You must consider our prospects in light of the risks, expenses
and challenges we might encounter because we are at an early stage of
development in a new and rapidly evolving market. To address these risks and
achieve profitability and increased sales levels, we must:





§
    Establish
      and increase market acceptance of our technology, products and
      systems;





§
    Expand
      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;





§
    Introduce
      products and systems incorporating our technology and enhancements to our
      product applications on a timely basis;





§
    Respond
      effectively to competitive pressures; and





§
    Successfully
      market and support our products and
systems.





We may
not successfully meet any of these challenges, and our failure to do so will
seriously harm our business and results of operations. In addition, because of
our limited operating history, we have limited insight into trends that may
emerge and harm our business.





*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, may cause our operating results to vary,
including:





§
    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;





18





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





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





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





Sales
through our three key distributors, Altisys, Graybar and Synnex, accounted for
69% of our net revenues for the three months ended December 31, 2004. Graybar
became our distributor starting in June 2003. Our business and operating results
will suffer if any one of these distributors (or any additional distributors)
does not continue distributing our products, fails to distribute the volume of
our products that it currently distributes or fails to expand our customer base.
We also need to establish and maintain relationships with additional
distributors and original equipment manufacturers. We may not be able to
establish, or successfully manage, relationships with additional distribution
partners. In addition, our agreements with distributors typically provide for
termination by either party upon written notice to the other party. For example,
our agreement with Synnex provides for termination, with or without cause, by
either party upon 30 days' written notice to the other party, or upon
insolvency or bankruptcy. Generally, these agreements are non-exclusive and
distributors sell products that compete with ours. If we fail to establish or
maintain relationships with distributors and original equipment manufacturers,
our ability to increase or maintain our sales and our customer base will be
substantially harmed. In January 2005, we sent 90 days written notice to Ingram
Micro to terminate our distribution agreement.





19


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





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





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





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





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





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





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





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





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





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





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







20


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





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





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





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





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





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





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





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





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





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








21


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


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





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





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





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





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





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





For the
three months ended December 31, 2004, approximately 15% of our net revenues came
from customers outside of the Americas. We intend to expand our international
sales and marketing efforts. Our efforts are subject to a variety of risks
associated with conducting business internationally, any of which could
seriously harm our business, financial condition and results of operations.
These risks include:





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





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





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





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





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





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










22


*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.*





Based on
volume or customer requirements, we may begin outsourcing some assembly and test
functions. In addition, we may determine that we need to establish assembly and
test operations overseas to better serve our international customers.
Establishing overseas assembly and test operations may be more difficult or take
longer than we anticipate. This outsourcing strategy involves certain risks,
including the potential lack of adequate capacity and reduced control over
delivery schedules, manufacturing yield, quality and costs. In the event that
any significant subcontractor 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.





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





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





*If,
as of the end of our 2005 fiscal year, we are unable to assert that our internal
control over financial reporting is effective, or if our auditors are unable to
confirm our assessment, investors could lose confidence in our reported
financial information, and the trading price of our stock price and our business
could be adversely affected.*


**


We are in
the process of documenting, and plan to test during the current fiscal year, our
internal control procedures in order to satisfy the requirements of Section 404
of the Sarbanes-Oxley Act. Commencing on September 30, 2005, the end of our 2005
fiscal year, the Sarbanes-Oxley Act requires annual management assessments of
the effectiveness of our internal controls over financial reporting and a report
by our independent registered public accounting firm addressing these
assessments. During the course of our testing we may identify deficiencies which
we may not be able to remediate in time to meet the deadline imposed by the
Sarbanes-Oxley Act for compliance with the requirements of Section 404. In
addition, if we fail to achieve and maintain the adequacy of our internal
controls, as such standards are modified, supplemented, or amended from time to
time, we may not be able to ensure that we can conclude on an ongoing basis that
we have effective internal controls over financial reporting in accordance with
Section 404 of the Sarbanes-Oxley Act. Effective internal controls are important
to help produce reliable financial reports and to prevent financial fraud. If we
are unable to assert that our internal control over financial reporting is
effective as of the end of our 2005 fiscal year, or if our auditors are unable
to attest that our management's report is fairly stated or they are unable to
express an opinion on our management's evaluation or on the effectiveness of the
internal controls, we could lose investor confidence in the accuracy and
completeness of our financial reports, investors could lose confidence in our
reported financial information, and the trading price of our stock and our
business could be adversely affected.





*FASB's
adoption of Statement 123R will cause, and changes to existing accounting
pronouncements or taxation rules or practices may cause, adverse revenue
fluctuations, affect our reported results of operations or how we conduct our
business.*





In
December 2004 FASB adopted Statement 123R, "Share-Based Payment," which will
require us, starting in the fourth quarter of fiscal year 2005, to measure
compensation costs for all stock based compensation (including stock options and
our employee stock purchase plan, as currently constructed) at fair value and
take a compensation charge equal to that value. This statement will have a
future effect on our net income.





23





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





*Risks
Related to the Industry*





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





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





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





In
April 1998, the Federal Communications Commission 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. Future laws, legal decisions or regulations, as well as changes in
interpretations of existing laws and regulations, could require us to expend
significant resources to comply with them. In addition, these future events or
changes may create uncertainty in our market that could reduce demand for our
products.





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





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





24


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





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





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





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





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





25


**PART
II. OTHER INFORMATION**





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





We may
become parties to litigation in the normal course of our business. Litigation in
general, and intellectual property and securities litigation in particular, can
be expensive and disruptive to normal business operations. Moreover, the results
of complex litigation are difficult to predict.
  See Note 4 in the Notes to Unaudited Condensed
  Consolidated Financial Statements of this Form 10-Q titled "Commitments and
  Contingencies."


**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 11,
    2005
    By:
    /s/ Philip M.
    McDermottPhilip M. McDermott,Chief
      Financial Officer(Principal Financial and Accounting
      Officer)







27




**EXHIBIT
INDEX**





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




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