# **UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

# **FORM 10-Q**

 

**(Mark one)**
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|------------|------------|---------------------------------------------------------------------------------------------------------|

 

**For thequarterly period ended June 30, 2005**

 

**OR**

 
| **o** | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|-------|------------|----------------------------------------------------------------------------------------------------------|

 

**For thetransition period from                  to                  .**

 

**CommissionFile No.: 000-20698**

 

**BROOKTROUT, INC.**

(Exact Name of Registrant asSpecified in Its Charter)

 
| **MASSACHUSETTS**                  | ** ** | **04-2814792**       |
|------------------------------------|------------|----------------------|
| (State or  Other Jurisdiction      |       | (I.R.S.  Employer    |
| of  Incorporation or Organization) |       | Identification  No.) |

 

**250 FIRSTAVENUE, NEEDHAM, MASSACHUSETTS 02494**

(Address of Principal ExecutiveOffices) (Zip Code)

 

Registrant’s telephone number,including area code: **(781) 449-4100**

 

Indicate by check mark whether theregistrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities and Exchange Act of 1934 during the preceding12 months (or for other such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes ý     No o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the ExchangeAct).  Yes ý     No o

 

As of July 29, 2005, 12,752,143 sharesof common stock, $0.01 par value per share, were outstanding.

 

 

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**BROOKTROUT, INC.FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2005**

 

**TABLE OFCONTENTS**

 
| **PART I  – FINANCIAL INFORMATION** | ** **                                                                                                                                                | ** ** |
|-----------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Item 1.                                       | Unaudited Condensed Consolidated Financial Statements                                                                                                     |       |   |
|                                          | Unaudited Condensed Consolidated Balance  Sheets as of June 30, 2005 and December 31, 2004                                                      |       |   |
|                                          | Unaudited Condensed Consolidated Statements  of Operations for the Three and Six Months Ended June 30, 2005 and June 30,  2004                  |       |   |
|                                          | Unaudited Condensed Consolidated Statements  of Comprehensive Income (Loss) for the Three and Six Months Ended June 30,  2005 and June 30, 2004 |       |   |
|                                          | Unaudited Condensed Consolidated Statements  of Cash Flows for the Six Months Ended June 30, 2005 and June 30,  2004                            |       |   |
|                                          | Notes to Unaudited Condensed Consolidated  Financial Statements                                                                                           |       |   |
| Item 2.                                       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                               |       |   |
|                                          | Overview                                                                                                                                                  |       |   |
|                                          | Application of Critical Accounting Policies                                                                                                               |       |   |
|                                          | Results of Operations                                                                                                                                     |       |   |
|                                          | Liquidity and Capital Resources                                                                                                                           |       |   |
|                                          | Recent Accounting Pronouncement                                                                                                                           |       |   |
|                                          | Factors That May Affect Future Results                                                                                                               |       |   |
| Item 3.                                       | Quantitative and Qualitative Disclosures  About Market Risk                                                                                               |       |   |
| Item 4.                                       | Controls and Procedures                                                                                                                                   |       |   |
|                                          |                                                                                                                                                      |       |   |
| **PART II – OTHER INFORMATION**     | ** **                                                                                                                                                | ** ** |
| Item 2.                                       | Unregistred Sales of Equity Securities and  Use of Proceeds                                                                                               |       |   |
| Item 4.                                       | Submission of Matters to a Vote of Security  Holders                                                                                                      |       |   |
| Item 6.                                       | Exhibits                                                                                                                                                  |       |   |
|                                          | Signatures                                                                                                                                                |       |   |
|                                          | Exhibit Index                                                                                                                                        |       |   |

 

“BROOKTROUT” and the “NEW NETWORK” are trademarks or registeredtrademarks of Brooktrout, Inc.

 

----

 

**PART I – FINANCIAL INFORMATION**

 

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

 

**BROOKTROUT, INC.UNAUDITED CONDENSED CONSOLIDATED BALANCESHEETS***(in thousands, exceptshare and per share data)*

 
| * *                                                                                                                                          | * *   | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
|                                                                                                                                              | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| **Assets**                                                                                                                                        |       |              |       |                  |       |
| Current assets:                                                                                                                                   |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                         |       | $                 | 14,721     |                  | $          | 18,452 |   |
| Marketable debt securities                                                                                                                        |       | 36,269            |       | 34,250                |       |
| Accounts receivable, less  allowances for doubtful accounts and sales returns of $749 at June 30,  2005 and $1,048 at December 31, 2004 |       | 9,284             |       | 10,346                |       |
| Inventory                                                                                                                                         |       | 5,413             |       | 4,118                 |       |
| Income tax receivable                                                                                                                             |       | 236               |       | 810                   |       |
| Deferred tax assets                                                                                                                               |       | 3,289             |       | 3,286                 |       |
| Prepaid expenses and other  current assets                                                                                                        |       | 1,674             |       | 2,096                 |       |
|                                                                                                                                              |       |              |       |                  |       |
| Total current assets                                                                                                                              |       | 70,886            |       | 73,358                |       |
|                                                                                                                                              |       |              |       |                  |       |
| Equipment and furniture,  less accumulated depreciation and amortization of $17,235 at June 30,  2005 and $16,799 at December 31, 2004  |       | 2,545             |       | 2,477                 |       |
| Deferred tax assets                                                                                                                               |       | 16,033            |       | 15,492                |       |
| Intangible assets, less  accumulated amortization of $10,666 at June 30, 2005 and $9,986 at December 31,  2004                          |       | 4,979             |       | 5,658                 |       |
| Other assets, less  accumulated amortization of $2,907 at June 30, 2005 and $2,622 at December 31,  2004                                |       | 2,169             |       | 2,092                 |       |
|                                                                                                                                              |       |              |       |                  |       |
| Total assets                                                                                                                                      |       | $                 | 96,612     |                  | $          | 99,077 |   |
|                                                                                                                                              |       |              |       |                  |       |
| **Liabilities and Stockholders’ Equity**                                                                                                     |       |              |       |                  |       |
| Current liabilities:                                                                                                                              |       |              |       |                  |       |
| Accounts payable                                                                                                                                  |       | $                 | 6,707      |                  | $          | 5,776 |   |
| Accrued expenses                                                                                                                                  |       | 5,493             |       | 6,369                 |       |
| Accrued compensation and  commissions                                                                                                             |       | 2,081             |       | 3,093                 |       |
| Accrued warranty costs                                                                                                                            |       | 1,270             |       | 1,248                 |       |
| Customer deposits                                                                                                                                 |       | 658               |       | 709                   |       |
|                                                                                                                                              |       |              |       |                  |       |
| Total current liabilities                                                                                                                         |       | 16,209            |       | 17,195                |       |
|                                                                                                                                              |       |              |       |                  |       |
| Long-term liabilities                                                                                                                             |       | 142               |       | 192                   |       |
|                                                                                                                                              |       |              |       |                  |       |
| Total liabilities                                                                                                                                 |       | 16,351            |       | 17,387                |       |
|                                                                                                                                              |       |              |       |                  |       |
| Commitments and contingencies (Note 7)                                                                                                            |       |              |       |                  |       |
|                                                                                                                                              |       |              |       |                  |       |
| Stockholders’ equity:                                                                                                                        |       |              |       |                  |       |
| Preferred stock, $1.00 par  value; authorized 100,000 shares; issued and outstanding, none                                                        |       | —            |       | —                |       |
| Common stock, $0.01 par  value; authorized 80,000,000 shares; issued 12,751,490 at June 30, 2005  and 12,786,604 at December 31, 2004   |       | 128               |       | 128                   |       |
| Additional paid-in capital                                                                                                                        |       | 64,745            |       | 66,065                |       |
| Accumulated other  comprehensive loss                                                                                                             |       | (237              | )          | (143                  | )          |
| Notes receivable — officers                                                                                                                  |       | (9,845            | )          | (9,845                | )          |
| Retained earnings                                                                                                                                 |       | 25,470            |       | 25,485                |       |
|                                                                                                                                              |       |              |       |                  |       |
| Total stockholders’ equity                                                                                                                   |       | 80,261            |       | 81,690                |       |
|                                                                                                                                              |       |              |       |                  |       |
| Total liabilities and stockholders’ equity                                                                                                   |       | $                 | 96,612     |                  | $          | 99,077 |   |

 

See notes to unauditedcondensed consolidated financial statements.

 

1

----

 

**BROOKTROUT, INC.UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS***(in thousands, except pershare data)*

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Revenue                                                |       | $                                     | 18,654     |                                | $          | 19,193 |   | $ | 36,504 |   | $ | 37,886 |   |
| Costs and  expenses:                                   |       |                                  |       |                                |       |   |   |   |   |
| Cost of  product sold                                  |       | 5,895                                 |       | 6,306                               |       | 11,378 |   | 12,274 |   |
| Research and  development                              |       | 4,265                                 |       | 4,847                               |       | 9,129 |   | 9,332 |   |
| In-process  research and development                   |       | —                                |       | 2,490                               |       | — |   | 2,490 |   |
| Selling,  general and administrative                   |       | 8,452                                 |       | 8,711                               |       | 16,961 |   | 16,829 |   |
| Total costs  and expenses                              |       | 18,612                                |       | 22,354                              |       | 37,468 |   | 40,925 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Operating  income (loss)                               |       | 42                                    |       | (3,161                              | )          | (964 | ) | (3,039 | ) |
| Other  income, net                                     |       | 325                                   |       | 117                                 |       | 645 |   | 299 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Income  (loss) before income taxes                     |       | 367                                   |       | (3,044                              | )          | (319 | ) | (2,740 | ) |
| Income tax  (benefit) provision                        |       | (106                                  | )          | (117                                | )          | (304 | ) | 5 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Net income  (loss)                                     |       | $                                     | 473        |                                | $          | (2,927 | ) | $ | (15 | ) | $ | (2,745 | ) |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Net income  (loss) per common share, basic and diluted |       | $                                     | 0.04       |                                | $          | (0.22 | ) | $ | (0.00 | ) | $ | (0.21 | ) |
| Weighted  average shares outstanding, basic            |       | 12,709                                |       | 13,020                              |       | 12,737 |   | 12,937 |   |
| Weighted  average shares outstanding, diluted          |       | 13,428                                |       | 13,020                              |       | 12,737 |   | 12,937 |   |

 

See notes to unauditedcondensed consolidated financial statements.

 

2

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**BROOKTROUT, INC.UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OFCOMPREHENSIVE INCOME (LOSS)***(in thousands)*

 
| ** **                                                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                           | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                 |       |                                  |       |                                |       |   |   |   |   |
| Net income  (loss)                                                   |       | $                                     | 473        |                                | $          | (2,927 | ) | $ | (15 | ) | $ | (2,745 | ) |
| Other  comprehensive income (loss):                                  |       |                                  |       |                                |       |   |   |   |   |
| Unrealized  gains (losses) on marketable debt securities, net of tax |       | 37                                    |       | (109                                | )          | (17 | ) | (112 | ) |
| Foreign  currency translation adjustments                            |       | (33                                   | )          | (15                                 | )          | (77 | ) | (12 | ) |
|                                                                 |       |                                  |       |                                |       |   |   |   |   |
| Total other  comprehensive income (loss)                             |       | 4                                     |       | (124                                | )          | (94 | ) | (124 | ) |
|                                                                 |       |                                  |       |                                |       |   |   |   |   |
| Comprehensive  income (loss)                                         |       | $                                     | 477        |                                | $          | (3,051 | ) | $ | (109 | ) | $ | (2,869 | ) |

 

See notes to unauditedcondensed consolidated financial statements.

 

3

----

 

**BROOKTROUT, INC.UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTSOF CASH FLOWS***(in thousands)*

 
| ** **                                                                  | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities:**                                  |       |                                |       |   |   |
| Net loss                                                                    |       | $                                   | (15        | ) | $ | (2,745 | ) |
| Adjustments  to reconcile net loss to cash flows from operating activities: |       |                                |       |   |   |
| Depreciation  and amortization                                              |       | 1,357                               |       | 1,260 |   |
| Amortization  of acquired and licensed software                             |       | 285                                 |       | 349 |   |
| Tax benefit  from stock option activity                                     |       | 404                                 |       | — |   |
| Inventory  obsolescence expense                                             |       | 129                                 |       | 275 |   |
| Provision  for doubtful accounts and sales returns                          |       | 117                                 |       | 33 |   |
| Deferred  income taxes                                                      |       | (158                                | )          | (50 | ) |
| In-process  research and development                                        |       | —                              |       | 2,490 |   |
| Increase  (decrease) in cash from changes in:                               |       |                                |       |   |   |
| Accounts  receivable                                                        |       | 945                                 |       | 1,188 |   |
| Inventory                                                                   |       | (1,424                              | )          | (142 | ) |
| Prepaid  expenses and other assets                                          |       | 678                                 |       | 365 |   |
| Current and  long-term liabilities                                          |       | (1,036                              | )          | (1,083 | ) |
|                                                                        |       |                                |       |   |   |
| Cash flows  from operating activities                                       |       | 1,282                               |       | 1,940 |   |
|                                                                        |       |                                |       |   |   |
| **Cash  flows from investing activities:**                                  |       |                                |       |   |   |
| Maturities  of marketable debt securities                                   |       | 13,617                              |       | 7,652 |   |
| Sales of  marketable debt securities                                        |       | 1,749                               |       | 6,811 |   |
| Purchases of  marketable debt securities                                    |       | (17,413                             | )          | (15,698 | ) |
| Expenditures  for equipment and furniture                                   |       | (746                                | )          | (678 | ) |
| Expenditures  for purchased and licensed software                           |       | (496                                | )          | (599 | ) |
| Acquisition  of subsidiary, net of cash acquired                            |       | —                              |       | (8,255 | ) |
|                                                                        |       |                                |       |   |   |
| Cash flows  from investing activities                                       |       | (3,289                              | )          | (10,767 | ) |
|                                                                        |       |                                |       |   |   |
| **Cash  flows from financing activities:**                                  |       |                                |       |   |   |
| Exercises of  stock options, net of common stock received                   |       | 978                                 |       | 2,982 |   |
| Repurchase  of the Company’s common stock                              |       | (2,702                              | )          | (854 | ) |
|                                                                        |       |                                |       |   |   |
| Cash flows  from financing activities                                       |       | (1,724                              | )          | 2,128 |   |
|                                                                        |       |                                |       |   |   |
| Decrease in  cash and cash equivalents                                      |       | (3,731                              | )          | (6,699 | ) |
| Cash and  cash equivalents, beginning of year                               |       | 18,452                              |       | 28,081 |   |
|                                                                        |       |                                |       |   |   |
| Cash and  cash equivalents, end of year                                     |       | $                                   | 14,721     |   | $ | 21,382 |   |
|                                                                        |       |                                |       |   |   |
| **Supplemental  schedule of cash flow information:**                   |       |                                |       |   |   |
| Tax payments                                                                |       | $                                   | 60         |   | $ | 43 |   |
| Tax refunds  received                                                       |       | $                                   | 619        |   | $ | 323 |   |
|                                                                        |       |                                |       |   |   |
| **Non-cash  activities:**                                                   |       |                                |       |   |   |
| Common stock  received for exercise of stock options                        |       | $                                   | —     |   | $ | 37 |   |

 

See notes to unauditedcondensed consolidated financial statements.

 

4

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**BROOKTROUT,INC.**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. Description of Business and Summary of SignificantAccounting Policies and Practices**

 

***(a) Description of Business***

 

Brooktrout, Inc. (the “Company” or “Brooktrout”) develops,manufactures and sells software and hardware products that enable thedevelopment of communications systems and services. The Company sells itsproducts to system vendors, service providers, enterprise customers, originalequipment manufacturers, and value-added resellers, both domestically andinternationally, through a direct sales force and a two-tiered distributionsystem.

 

***(b) Use of Estimates***

 

Accounting policies, methods and estimates are an integral part of theunaudited condensed consolidated financial statements and are based uponmanagement’s current judgments. These policies, methods, and estimates affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenue and expenses during the reporting periods. The judgmentsmade by management are based on knowledge and experience with regard to pastand current events and assumptions about future events that are believed to bereasonable under the circumstances. The Company’s management evaluates theseestimates and assumptions and adjusts them if expectations concerning events,including future events, affecting them differ markedly from management’scurrent judgments.

 

***(c) Principles of Consolidation***

 

The Company has prepared the accompanying unaudited condensedconsolidated financial statements pursuant to the rules and regulations ofthe Securities and Exchange Commission (“SEC”) regarding interim financialreporting. These unaudited condensed consolidated financial statements shouldbe read in conjunction with the audited consolidated financial statementsincluded in the Company’s Annual Report on Form 10-K for the fiscal yearended December 31, 2004.

 

The accompanying unaudited condensed consolidated financial statementshave been prepared on the same basis as the audited consolidated financialstatements and include all adjustments, consisting only of normal recurringadjustments, necessary for the fair presentation of interim periods presented.The unaudited condensed consolidated financial statements include the accountsof the Company and its wholly owned subsidiaries. All significant intercompanybalances and transactions have been eliminated in consolidation. The operatingresults for the interim periods presented are not necessarily indicative of theresults that could be expected for the full year. 

 

***(d) Revenue Recognition***

 

Revenue from product sales is recognized when the risk of loss andtitle pass to the customer, generally at the time of shipment, provided thatpersuasive evidence of an arrangement exists, the fee is fixed or determinable,and collection is reasonably assured. To the extent that one or more of theseconditions are not met, which has occurred from time-to-time, revenue isdeferred until such time as all four criteria are met. Revenue from sales tocertain distributors is recognized on a “sell-through” basis, that is, when thedistributors report to the Company that resale of the product to the ultimatecustomer of the distributor has occurred. If the Company receives a paymentfrom a customer prior to meeting all of the revenue recognition criteria, thepayment is recorded as a customer deposit or deferred revenue. In addition,customers are offered the option to enter into maintenance contracts onselected products that are renewable. Prepaid maintenance fees on thesecontracts are deferred and recognized evenly over the term of the maintenancecontract.  

 

The Company records a provision for estimated sales returns andallowances as a deduction from sales in the same period that the relatedrevenue is recorded. These estimates are based on historical sales returns,analysis of credit memo data and other known factors. In addition, the Companyperiodically offers rebate programs to customers that require the Company toestimate the cost of the program. The Company records a provision for theestimated cost of the program as a deduction from sales based on or upon theresults of previous rebate programs and other known factors. 

 

***(e) Concentration of Credit Risk***

 

The Company holds its temporary cash, cashequivalents, and marketable debt securities in highly rated financialinstruments and with highly rated financial institutions. In addition, theCompany’s investment policy limits its exposure to concentrations of creditrisk by requiring diversification of investments in debt securities.

 

The Company sells its products to variouscustomers in the high technology industry. The Company generally requires nocollateral. To reduce credit risk, the Company performs credit evaluations ofits customers. The Company maintains allowances for doubtful accounts forestimated losses resulting from its customers’ inability to make requiredpayments. At June 30, 2005 and December 31, 2004, 14% and 19%, respectively,of the Company’s accounts receivable were due from one customer. A secondcustomer represented 14% and 9% of the Company’s accounts receivable at June 30,2005 and December 31, 2004, respectively.

 

5

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The Company has one customer that generatesmore than 10% of total revenue. This customer accounted for approximately 19%and 15% of revenue for the three months ended June 30, 2005 and 2004,respectively. In the six months ended June 30, 2005 and 2004, this samecustomer accounted for approximately 18% and 16% of revenue, respectively.

 

***(f) Stock-Based Compensation***

 

The Company uses the intrinsic value method to measure compensationexpense associated with the grants of stock options or awards to employees. TheCompany accounts for stock options and awards to non-employees using the fairvalue method.

 

Under the intrinsic value method, compensation associated with stockawards to employees is determined as the excess, if any, of the current fairvalue of the underlying common stock on the date compensation is measured overthe price an employee must pay to exercise the award. The measurement date foremployee awards is generally the date of grant. Under the fair value method,compensation associated with stock awards to non-employees is determined basedon the estimated fair value of the award itself, measured using either currentmarket data or an established option pricing model. The measurement date fornon-employee awards is generally the date that performance of certain servicesis complete.

 

Had the Company used the fair value method to measure compensationrelated to stock awards to employees, reported net income (loss) and net income(loss) per common share would have been as follows:

 
| ** **                                                         | ** **   | **Three Months Ended  June 30,**      | *** *** | **Six Months Ended  June 30,** | *** *** |
|--------------------------------------------------------------------|--------------|--------------------------------------------|--------------|-------------------------------------|--------------|
| ** **                                                         | ** **   | **2005**                                   | ** **   | **2004**                            | ** **   | **2005** | ** ** | **2004** | ** ** |
| *** ***                                                       | *** *** | **(in thousands, except per share  data)** | ** **   |
|                                                               |         |                                       |         |                                |         |   |   |   |   |
| Net income  (loss), as reported                                    |         | $                                          | 473          |                                | $            | (2,927 | ) | $ | (15 | ) | $ | (2,745 | ) |
| Stock-based  compensation recorded                                 |         | —                                     |         | —                              |         | — |   | — |   |
| Pro forma  stock-based compensation, net of tax                    |         | (995                                       | )            | (1,094                              | )            | (2,000 | ) | (2,481 | ) |
|                                                               |         |                                       |         |                                |         |   |   |   |   |
| Net loss,  pro forma                                               |         | $                                          | (522         | )                                   | $            | (4,021 | ) | $ | (2,015 | ) | $ | (5,226 | ) |
|                                                               |         |                                       |         |                                |         |   |   |   |   |
| Net loss per  common share, basic and diluted pro forma            |         | $                                          | (0.04        | )                                   | $            | (0.31 | ) | $ | (0.16 | ) | $ | (0.40 | ) |
|                                                               |         |                                       |         |                                |         |   |   |   |   |
| Net income  (loss) per common share, basic and diluted as reported |         | $                                          | 0.04         |                                | $            | (0.22 | ) | $ | (0.00 | ) | $ | (0.21 | ) |

 

Basic weighted average shares outstanding were usedin calculating the pro forma net loss per common share in each of the periodspresented since the use of diluted weighted average shares outstanding wouldhave had an anti-dilutive effect.

 

For purposes of determining the disclosures providedabove, the fair value of options from the Company’s stock option plans andemployee stock purchase plan on their grant date, considered to be themeasurement date, was estimated using the Black-Scholes option-pricing model.Key assumptions used to apply this pricing model were as follows:

 
| ** **                               | ** ** | **2005**                 | ** ** | **2004**                            | ** ** |
|------------------------------------------|------------|--------------------------|------------|-------------------------------------|------------|
| ** **                               | ** ** | **Stock  Option  Plans** | ** ** | **Employee  Stock  Purchase  Plan** | ** ** | **Stock  Option  Plans** | ** ** | **Employee  Stock  Purchase  Plan** | ** ** |
|                                     |       |                     |       |                                |       |   |   |   |   |
| Risk-free  interest rate                 |       | 3.6                      | %          | 3.3                                 | %          | 4.1 | % | 1.6 | % |
| Expected  life of option grants (years)  |       | 5.2                      |       | 0.5                                 |       | 5.6 |   | 0.5 |   |
| Expected  volatility of underlying stock |       | 79                       | %          | 42                                  | %          | 87 | % | 84 | % |
| Dividend  yield                          |       | 0                        | %          | 0                                   | %          | 0 | % | 0 | % |

 

6

----

 

The estimated weighted average fair value of option grants made from the Company’s stock option plans andemployee stock purchase plan, per option, during the three and sixmonths ended June 30, 2005 and 2004 are as follows:

 
| ** **                    | ** ** | **Three Months Ended  June 30,** | *** *** | **Six Months Ended  June 30,** | *** *** |
|-------------------------------|------------|---------------------------------------|--------------|-------------------------------------|--------------|
| ** **                    | ** ** | **2005**                              | ** **   | **2004**                            | ** **   | **2005** | ** ** | **2004** | ** ** |
|                          |       |                                  |         |                                |         |   |   |   |   |
| Stock option  plans           |       | $                                     | 6.79         |                                | $            | 8.03 |   | $ | 7.76 |   | $ | 8.54 |   |
| Employee  stock purchase plan |       | $                                     | 1.20         |                                | $            | 2.42 |   | $ | 1.20 |   | $ | 2.42 |   |

 

***(g) Earnings Per Share***

 

Basic earnings per common share is computed using the weighted averagenumber of common shares outstanding during each period. Diluted earnings percommon share is calculated by dividing the net income (loss) by the sum of theweighted average number of common shares outstanding and all additional commonshares that would have been outstanding if potentially dilutive securities hadbeen issued, using the treasury method, if such shares have a dilutive effect.

 

A reconciliation of weighted average shares used for the basic anddiluted computations is as follows:

 
| ** **                           | ** **   | **Three Months Ended  June 30,** | *** *** | **Six Months Ended  June 30,** | *** *** |
|--------------------------------------|--------------|---------------------------------------|--------------|-------------------------------------|--------------|
| ** **                           | ** **   | **2005**                              | ** **   | **2004**                            | ** **   | **2005** | ** ** | **2004** | ** ** |
| ** **                           | *** *** | **(in thousands)**                    | *** *** |
|                                 |         |                                  |         |                                |         |   |   |   |   |
| Weighted  average shares for basic   |         | 12,709                                |         | 13,020                              |         | 12,737 |   | 12,937 |   |
| Dilutive  effect of stock options    |         | 719                                   |         | —                              |         | — |   | — |   |
|                                 |         |                                  |         |                                |         |   |   |   |   |
| Weighted  average shares for diluted |         | 13,428                                |         | 13,020                              |         | 12,737 |   | 12,937 |   |

 

Stock options to purchase approximately 1,509,000 shares and 4,026,000shares were excluded from the computation of diluted earnings per share in thethree and six months ended June 30, 2005, respectively. For the threemonths ended June 30, 2005, certain stock options were excluded becausethe exercise price of the stock options exceeds the average market price of theCompany’s common stock and, as a result, would have had an anti-dilutiveeffect. As a result of the net loss for the six months ended June 30,2005, all outstanding stock options were excluded because of theiranti-dilutive effect.

 

Stock options to purchase approximately 3,626,000 shares were excludedfrom the computation of diluted earnings per share in the three and six monthsended June 30, 2004, respectively. As a result of the net loss for thethree and six months ended June 30, 2004, all outstanding stock optionswere excluded because of their anti-dilutive effect. 

 

***(h) New Accounting Standard***

 

In December 2004, the FinancialAccounting Standards Board issued Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”), which revisesSFAS No. 123, “Accounting for Stock-Based Compensation” and supercedesAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees,” and its related interpretations. In April 2005, the SECannounced the adoption of a rule that defers the effective date of SFAS No. 123(R)to fiscal years beginning after June 15, 2005. The Company expects toadopt SFAS No. 123(R) using the modified prospective application method.Adoption of SFAS No. 123(R) will increase stock compensation expense. Theactual impact on future years will be dependant on a number of factors,including the Company’s stock price and the level of future grants and awardsmade from the Company’s stock-based compensation plans. The pro forma effect onthe Company’s financial results using a fair value based approach is disclosedin Note 1(f), “Stock-Based Compensation.” The pro forma effects disclosed arenot necessarily representative of the effects on the results of operations inthe future for the reasons provided above.

 

7

----

 

**2. Marketable Debt Securities**

 

Marketable debt securities consisted of the following:

 
| ** **                       | ** ** | **Amortized  Cost** | ** ** | **Unrealized  Gains** | ** ** | **Unrealized  Losses** | ** ** | **Market  Value** | ** ** |
|----------------------------------|------------|---------------------|------------|-----------------------|------------|------------------------|------------|-------------------|------------|
| ** **                       | ** ** | **(in thousands)**  | ** ** |
| June 30,  2005:             |       |                |       |                  |       |                   |       |              |       |
| U.S.  government notes and bonds |       | $                   | 11,957     |                  | $          | 3                      |       | $                 | (73        | ) | $ | 11,887 |   |
| Corporate  debt securities       |       | 24,492              |       | 3                     |       | (113                   | )          | 24,382            |       |
|                             |       |                |       |                  |       |                   |       |              |       |
| Total                            |       | $                   | 36,449     |                  | $          | 6                      |       | $                 | (186       | ) | $ | 36,269 |   |
|                             |       |                |       |                  |       |                   |       |              |       |
| December 31,  2004:         |       |                |       |                  |       |                   |       |              |       |
| U.S.  government notes and bonds |       | $                   | 12,864     |                  | $          | —                 |       | $                 | (61        | ) | $ | 12,803 |   |
| Corporate  debt securities       |       | 20,783              |       | —                |       | (90                    | )          | 20,693            |       |
| Foreign  investments             |       | 755                 |       | —                |       | (1                     | )          | 754               |       |
|                             |       |                |       |                  |       |                   |       |              |       |
| Total                            |       | $                   | 34,402     |                  | $          | —                 |       | $                 | (152       | ) | $ | 34,250 |   |

 

The unrealized losses related to these securities at June 30, 2005are not material to the Company’s financial position or results from operationsand is not considered to be a permanent decline in the market value of suchsecurities.

 

The amortized cost and estimated fair valueof marketable debt securities at June 30, 2005, by contractual maturityare shown below. Actual maturities may differ from the contractual maturitiesbecause the issuers of the securities may have the right to repay theobligations without prepayment penalties.

 
| ** **                             | ** ** | **Amortized  Cost** | ** ** | **Market  Value** | ** ** |
|----------------------------------------|------------|---------------------|------------|-------------------|------------|
| ** **                             | ** ** | **(in thousands)**  | ** ** |
| Marketable  debt securities:           |       |                |       |              |       |
| Due in one  year or less               |       | $                   | 22,527     |              | $          | 22,420 |   |
| Due after  one year through five years |       | 13,922              |       | 13,849            |       |
|                                   |       |                |       |              |       |
| Total                                  |       | $                   | 36,449     |              | $          | 36,269 |   |

 

Realized gains and losses from the sale ofmarketable debt securities were not material to the Company’s results fromoperations in any of the periods presented.

 

**3. Inventory**

 

The components of inventory, net of reserves, are as follows:

 
| ** **       | ** **   | **June 30,**  | ** ** | **December 31,** | ** ** |
|------------------|--------------|--------------------|------------|-----------------------|------------|
| ** **       | ** **   | **2005**           | ** ** | **2004**              | ** ** |
| *** ***     | *** *** | **(in thousands)** | ** ** |
|             |         |               |       |                  |       |
| Raw  materials   |         | $                  | 955        |                  | $          | 724 |   |
| Work in  process |         | 465                |       | 537                   |       |
| Finished  goods  |         | 3,993              |       | 2,857                 |       |
|             |         |               |       |                  |       |
| Total            |         | $                  | 5,413      |                  | $          | 4,118 |   |

 

8

----

 

Thefollowing is a rollforward of reserves provided for inventory obsolescence:

 
| ** **                    | ** ** | **Six Months Ended  June 30,** | *** *** |
|-------------------------------|------------|-------------------------------------|--------------|
| ** **                    | ** ** | **2005**                            | ** **   | **2004** | ** ** |
| ** **                    | ** ** | **(in thousands)**                  | ** **   |
|                          |       |                                |         |   |   |
| Balance,  beginning of period |       | $                                   | 2,943        |   | $ | 4,379 |   |
| Provisions                    |       | 129                                 |         | 275 |   |
| Write offs                    |       | (658                                | )            | (1,059 | ) |
| Other                         |       | —                              |         | 29 |   |
|                          |       |                                |         |   |   |
| Balance, end  of period       |       | $                                   | 2,414        |   | $ | 3,624 |   |

 

**4. Valuation and Qualifying Accounts**

 

*Allowances for doubtful accounts and sales returns:*

 

The following is a rollforward of allowances provided for doubtfulaccounts and sales returns:

 
| ** **                    | ** ** | **Six Months Ended  June 30,** | *** *** |
|-------------------------------|------------|-------------------------------------|--------------|
| ** **                    | ** ** | **2005**                            | ** **   | **2004** | ** ** |
| ** **                    | ** ** | **(in thousands)**                  | ** **   |
|                          |       |                                |         |   |   |
| Balance,  beginning of period |       | $                                   | 1,048        |   | $ | 843 |   |
| Provisions                    |       | 117                                 |         | 33 |   |
| Write-offs                    |       | (1                                  | )            | (27 | ) |
| Recoveries                    |       | 9                                   |         | 42 |   |
| Rebate  payments to customers |       | (424                                | )            | (118 | ) |
| Other                         |       | —                              |         | 74 |   |
|                          |       |                                |         |   |   |
| Balance, end  of period       |       | $                                   | 749          |   | $ | 847 |   |

 

*Accrued warranty costs:*

 

The following is a rollforward of accrued warranty costs:

 
| ** **                    | ** **   | **Six Months Ended  June 30,** | *** *** |
|-------------------------------|--------------|-------------------------------------|--------------|
| ** **                    | ** **   | **2005**                            | ** **   | **2004** | ** ** |
| *** ***                  | *** *** | **(in thousands)**                  | ** **   |
|                          |         |                                |         |   |   |
| Balance,  beginning of period |         | $                                   | 1,248        |   | $ | 1,138 |   |
| Provisions  for claims        |         | 257                                 |         | 164 |   |
| Claims  incurred              |         | (235                                | )            | (117 | ) |
| Other                         |         | —                              |         | 12 |   |
|                          |         |                                |         |   |   |
| Balance, end  of period       |         | $                                   | 1,270        |   | $ | 1,197 |   |

 

**5. Stockholders’ Equity**

 

On October 20, 2004, the Company’s Board ofDirectors authorized a program for the repurchase of up to 1,000,000 shares ofthe Company’s common stock. Under this program, shares may be repurchased priorto October 19, 2005 and in such amounts as market conditions warrant, andsubject to regulatory and other considerations. The Company plans to use theshares repurchased under these programs for general corporate purposes, including the Company’s stock option plans,employee stock purchase plan and other stock benefit plans. The Companyrepurchased 211,530 shares for approximately $2.7 million under these programsduring the six months ended June 30, 2005.

 

9

----

 

**6. Segment Reporting**

 

The Company develops, manufactures and sells softwareand hardware products that enable the development of communications systems andservices. The Company sells its products to system vendors, service providers,enterprise customers, original equipment manufacturers, and value-addedresellers, both domestically and internationally, through a direct sales forceand a two-tiered distribution system. The Company has one operating segment.The Company’s products, while designed for different customers and differentprincipal markets, otherwise have similar economic characteristics.

 

*Geographic Information*– Revenues are derived from the following geographic areas; international salesare principally exports from the United States:

 
| ** **     | ** ** | **Three Months Ended  June 30,** | *** *** | **Six Months Ended  June 30,** | *** *** |
|----------------|------------|---------------------------------------|--------------|-------------------------------------|--------------|
| ** **     | ** ** | **2005**                              | ** **   | **2004**                            | ** **   | **2005** | ** ** | **2004** | ** ** |
|           |       |                                  |         |                                |         |   |   |   |   |
| United  States |       | 80                                    | %            | 81                                  | %            | 79 | % | 79 | % |
| International  |       | 20                                    |         | 19                                  |         | 21 |   | 21 |   |
|           |       |                                  |         |                                |         |   |   |   |   |
|           |       | 100                                   | %            | 100                                 | %            | 100 | % | 100 | % |

 

Substantially all of our assets are located within the United States.

 

**7. Commitments and Contingencies**

 

From time-to-time, the Company is a party to legaland other actions, which may include allegations of patent infringement madeagainst us and/or our customers, which arise in the normal course of business.The Company, taking into account advice of counsel, does not currently believethe eventual outcome of any such pending or potential matters, includingmatters in which we may have an obligation on behalf of our customers, willhave a material effect on the Company’s consolidated financial condition orresults of operations.

 

10

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

 

*The following discussion should be read in conjunctionwith the condensed consolidated financial statements and related notesappearing elsewhere in this quarterly report and in our Annual Report on Form 10-Kfor the year ended December 31, 2004. The discussion containsforward-looking statements that involve known and unknown risks anduncertainties, including those set forth below under “Factors That May AffectFuture Results.”*

 

**Overview**

 

We develop software and hardware platforms that original equipmentmanufacturers, developers, network operators and corporate informationtechnology managers build into their communications systems. Customersincorporate our products into applications, systems and services that allowvoice, fax and data to be distributed over both IP packet-based networks, whichwe refer to as the New Network, and the traditional circuit-switched telephonenetwork. We supply products for media processing, network interface, callcontrol and signal processing, including protocols that allow Internet andtraditional telephony systems to communicate. Our strategy is to partner withour customers and collaborate closely with them to accelerate their delivery ofnew applications and services to end-users, help increase their existingbusiness, and expand into new markets. In April 2004, we completed ouracquisition of all of the outstanding capital stock of SnowShore Networks, Inc.,or SnowShore, a provider of voice over IP, or VOIP, communicationsinfrastructure products for the media server market.

 

We measure our operating success using both financial and marketmetrics. The financial metrics include revenue, gross profit, operatingexpenses, operating income and net income, as well as working capital and cashflows from operating activities. Key market metrics include the total number ofcustomers, the number of customers whose purchases exceed $100,000, and theportion of our revenue that is generated by the sales of products to enterpriseand service provider customers. Our long-term business model stresses ourcommitment to establishing and maintaining close customer relationships,increasing penetration of the telecommunications markets that we serve andcontinuing to develop innovative products.

 

The most significant trend that has impacted our business during thepast few years has been the unfavorable economic conditions affecting thecommunications industry. During the past few years we continued to invest indeveloping products that we believe our customers will need when the economyrecovers. We are now seeing signs that the economic conditions in our industrymay be improving with modest revenue growth from 2002 to 2003 and furthergrowth from 2003 to 2004. Many companies that had reduced their capitalexpenditures during the recent economic downturn have begun to invest again intheir communications networks. The evolution and acceptance of the New Networkis contributing to these infrastructure investments as enterprises and serviceproviders begin to use the IP networks for fax and VOIP transmissions.

 

**Applicationof Critical Accounting Policies**

 

Management’s discussion and analysis of financial condition and resultsof operations is based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe United States of America. We make estimates and assumptions in thepreparation of the consolidated financial statements that affect the reportedamounts of assets and liabilities, revenue and expenses, and the relateddisclosures of contingent assets and liabilities. These estimates form thebasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. We base our estimates andjudgments on historical experience and onvarious other assumptions that we believe are reasonable under thecircumstances. However, actual results may differ from these estimates underdifferent assumptions or conditions.

 

We consider the following to be the critical accounting policies andareas where significant judgment is applied, which we believe an investorshould understand when assessing our financial reporting and performance:

 

•                  Revenuerecognition; 

 

•                  Allowances fordoubtful accounts; 

 

•                  Inventoryallowances;

 

•                  Intangibleassets;

 

•                  Income taxes; and

 

•                  Accrued warrantycosts.

 

11

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This listing is not intended to be a comprehensive list of all of oursignificant accounting policies. For further information on our criticalaccounting policies, and on our significant accounting policies in general, werefer the reader to the discussion of those policies in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2004, and to Note 1 to theunaudited condensed consolidated financial statements in Part I, Item 1 ofthis report.

 

**Results of Operations**

 

The following discussion focuses on our results of operations. The tablebelow sets forth certain unaudited condensed consolidated statements ofoperations data as percentages of total revenue for the periods presented.

 
| ** **                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                           | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Revenue                              |       | 100                                   | %          | 100                                 | %          | 100 | % | 100 | % |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Cost of  product sold                |       | 32                                    |       | 33                                  |       | 31 |   | 32 |   |
| Gross profit                         |       | 68                                    |       | 67                                  |       | 69 |   | 68 |   |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Operating  expenses:                 |       |                                  |       |                                |       |   |   |   |   |
| Research and  development            |       | 23                                    |       | 25                                  |       | 25 |   | 25 |   |
| In-process  research and development |       | —                                |       | 13                                  |       | — |   | 7 |   |
| Selling,  general and administrative |       | 45                                    |       | 45                                  |       | 47 |   | 44 |   |
| Total  operating expenses            |       | 68                                    |       | 83                                  |       | 72 |   | 76 |   |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Operating  income (loss)             |       | —                                |       | (16                                 | )          | (3 | ) | (8 | ) |
| Other  income, net                   |       | 2                                     |       | —                              |       | 2 |   | 1 |   |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Income  (loss) before income taxes   |       | 2                                     |       | (16                                 | )          | (1 | ) | (7 | ) |
| Income tax  (benefit) provision      |       | (1                                    | )          | (1                                  | )          | (1 | ) | — |   |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Net income  (loss)                   |       | 3                                     | %          | (15                                 | )%         | — | % | (7 | )% |

 

***Revenue***

 

***Three Months Ended June 30, 2005and 2004***

 

The following table presents our domestic and international revenue:

 
| ** **                          | ** **   | **Three Months Ended June 30,** | ** ** |
|-------------------------------------|--------------|--------------------------------------|------------|
| ** **                          | ** **   | **2005**                             | ** ** | **2004** | ** ** |
| *** ***                        | *** *** | **(dollars in thousands)**           | ** ** |
|                                |         |                                 |       |   |   |   |   |   |   |
| United  States                      |         | $                                    | 14,852     |   | 80 | % | $ | 15,606 |   | 81 | % |
| International,  principally exports |         | 3,802                                |       | 20 |   | 3,587 |   | 19 |   |
|                                |         |                                 |       |   |   |   |   |   |   |
| Total  revenue                      |         | $                                    | 18,654     |   | 100 | % | $ | 19,193 |   | 100 | % |

 

Revenue in the three months ended June 30, 2005 was $18.7 millioncompared to $19.2 million in the three months ended June 30, 2004, adecrease of $0.5 million or approximately 3%. The decrease in the secondquarter of 2005, compared with the second quarter of 2004 was due to lowersales to original equipment manufacturers and service providers, primarily inNorth America. The reduction in these sales was offset, in part, by highersales to value-added resellers and enterprise customers. The decrease in salesto original equipment manufacturers and service providers was primarily theresult of weakness in our traditional circuit-switched telephone networks, orTDM, voice and data products that we believe was caused by fewerimplementations of this older technology as our customers are anticipating amigration to IP-based technology in the future. In comparison to the threemonths ended June 30, 2004, international revenue in the three monthsended June 30, 2005 increased by $0.2 million due primarily to highersales to Japanese customers of $0.4 million offset, in part, by lower sales toEuropean customers of $0.3 million. 

 

12

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In the three months ended June 30, 2005, revenue from enterprisecustomers accounted for approximately 85% of total revenue, as compared to 83%of total revenue for the three months ended June 30, 2004. The remainingrevenue in each quarter was attributable to service provider customers. Revenuefrom Captaris, Inc. accounted for 19% of total revenue in the three monthsended June 30, 2005 compared to 15% in the three months ended June 30,2004. We expect that revenue from Captaris, Inc. will be greater than 10%of total revenue for the year ended December 31, 2005.

 

In the three months ended June 30, 2005, 28 of our customers eachpurchased over $100,000 of products, in aggregate representing 78% of totalrevenue for the quarter. In the three months ended June 30, 2004, 31 ofour customers each purchased over $100,000 of products, in aggregaterepresenting 75% of total revenue for the quarter. Total customers in thesecond quarter of 2005 increased to approximately 325 from approximately 315 inthe second quarter of 2004.

 

***Six Months Ended June 30, 2005and 2004***

 

The following table presents our domestic and international revenue:

 
| ** **                          | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------|------------|------------------------------------|------------|
| ** **                          | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| ** **                          | ** ** | **(dollars in thousands)**         | ** ** |
|                                |       |                               |       |   |   |   |   |   |   |
| United  States                      |       | $                                  | 28,685     |   | 79 | % | $ | 29,941 |   | 79 | % |
| International,  principally exports |       | 7,819                              |       | 21 |   | 7,945 |   | 21 |   |
|                                |       |                               |       |   |   |   |   |   |   |
| Total  revenue                      |       | $                                  | 36,504     |   | 100 | % | $ | 37,886 |   | 100 | % |

 

Revenue in the six months ended June 30, 2005 was $36.5 millioncompared to $37.9 million in the six months ended June 30, 2004, adecrease of $1.4 million, or approximately 4%. The decrease in the first halfof 2005, compared with the first half of 2004 was due to lower sales tooriginal equipment manufacturers and service providers, primarily in NorthAmerica. The reduction in these sales was offset, in part, by higher sales tovalue-added resellers and enterprise customers. The decrease in sales tooriginal equipment manufacturers and service providers was primarily the resultof the weakness in our TDM voice and data products described above. Incomparison to the six months ended June 30, 2004, international revenue inthe six months ended June 30, 2005 decreased by $0.1 million due primarilyto lower sales to European customers of $0.8 million. The decreases in sales toEuropean customers were offset, in part, by higher sales to Japanese customersof $0.4 million and to Central and Latin American customers of $0.2 million.

 

In the six months ended June 30, 2005, revenue from enterprisecustomers accounted for approximately 86% of total revenue, as compared to 84%of total revenue for the six months ended June 30, 2004. The remainingrevenue in each period was attributable to service provider customers. Revenuefrom Captaris, Inc. accounted for 18% of total revenue in the six monthsended June 30, 2005 compared to 16% in the six months ended June 30, 2004.

 

In the six months ended June 30, 2005, 51 of our customers eachpurchased over $100,000 of products, in aggregate representing 82% of totalrevenue for the period. In the six months ended June 30, 2004, 59 of ourcustomers each purchased over $100,000 of products, in aggregate representing84% of total revenue for the period. Total customers in both the six monthsended June 30, 2005 and June 30, 2004 were approximately 440.

 

***Cost of Product Soldand Gross Profit***

 

***Three Months Ended June 30, 2005and 2004***

 

The following table presents cost of product sold and gross profitinformation:

 
| ** **                                     | ** ** | **Three Months Ended  June 30,** | *** *** |
|------------------------------------------------|------------|---------------------------------------|--------------|
| ** **                                     | ** ** | **2005**                              | ** **   | **2004** | ** ** |
| ** **                                     | ** ** | **(dollars in thousands)**            | ** **   |
|                                           |       |                                  |         |   |   |
| Cost of  product sold                          |       | $                                     | 5,895        |   | $ | 6,306 |   |
| Gross profit                                   |       | $                                     | 12,759       |   | $ | 12,887 |   |
| Gross profit  as a percentage of total revenue |       | 68                                    | %            | 67 | % |

 

13

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The decrease in cost of product sold in the three months ended June 30,2005, compared with the three months ended June 30, 2004 was due primarilyto the lower sales of TDM voice and data products described above. The increasein gross profit as a percentage of total revenue for the three months ended June 30,2005 compared with the three months ended June 30, 2004 is a result of changesin product mix. Gross profit for the third quarter of 2005 is expected to beapproximately 68% to 70% of total revenue.

 

***Six Months Ended June 30, 2005and 2004***

 

The following table presents cost of product sold and gross profitinformation:

 
| ** **                                     | ** ** | **Six Months Ended  June 30,** | *** *** |
|------------------------------------------------|------------|-------------------------------------|--------------|
| ** **                                     | ** ** | **2005**                            | ** **   | **2004** | ** ** |
| ** **                                     | ** ** | **(dollars in thousands)**          | ** **   |
|                                           |       |                                |         |   |   |
| Cost of  product sold                          |       | $                                   | 11,378       |   | $ | 12,274 |   |
| Gross profit                                   |       | $                                   | 25,126       |   | $ | 25,612 |   |
| Gross profit  as a percentage of total revenue |       | 69                                  | %            | 68 | % |

 

The decrease in cost of product sold in the six months ended June 30,2005, compared with the six months ended June 30, 2004 was due primarilyto the lower sales of TDM voice and data products described above. The increasein gross profit as a percentage of total revenue for the six months ended June 30,2005 compared with the six months ended June 30, 2004 is a result of changes inproduct mix.

 

***Operating Expenses***

 

***Three Months Ended June 30, 2005and 2004***

 

The following table presents our operating expenses:

 
| ** **                           | ** ** | **Three Months Ended  June 30,** | *** *** |
|--------------------------------------|------------|---------------------------------------|--------------|
| ** **                           | ** ** | **2005**                              | ** **   | **2004** | ** ** |
| ** **                           | ** ** | **(in thousands)**                    | ** **   |
|                                 |       |                                  |         |   |   |
| Research and  development            |       | $                                     | 4,265        |   | $ | 4,847 |   |
| In-process  research and development |       | —                                |         | 2,490 |   |
| Selling,  general and administrative |       | 8,452                                 |         | 8,711 |   |
|                                 |       |                                  |         |   |   |
| Total  operating expenses            |       | $                                     | 12,717       |   | $ | 16,048 |   |

 

**Research and development expense**

 

Research and development expense represented 23% of revenue in thesecond quarter of 2005, compared with 25% in the second quarter of 2004. The$0.6 million decrease in research and development expenses in the secondquarter of 2005 compared with the second quarter of 2004 was due primarily tolower consulting expenses of $0.4 million and lower salary related expenses of$0.2 million. Our continuing development efforts are focused on software andhardware for traditional circuit-switched telephone networks and IP mediaprocessing products (voice, video, fax and data), network interface products,call control products and signal processing products. Research and developmentexpense for the third quarter of 2005 is expected to be approximately 22% to25% of revenue. 

 

**In-process research and development**

 

We recorded a one-time charge of $2.5 million in the second quarter of2004 for purchased in-process technology related to SnowShore developmentprojects that had not yet reached technological feasibility, had no alternativefuture use, and for which successful development was uncertain at the date ofacquisition. The value of the purchased in-process research and development wascomputed by determining the present value of the project’s future economicbenefits from future revenues net of anticipated costs and expenses. At thetime of the acquisition, the projects were approximately 40% complete. As of June 30,2005, these projects were substantially complete.  

 

14

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**Selling, general and administrative expense**

 

Selling, general and administrative expenses represented 45% of revenuein the second quarters of 2005 and 2004. The $0.3 million decrease in selling,general and administrative expenses in the second quarter of 2005 compared withthe second quarter of 2004 was due primarily to lower salary related expensesof $0.4 million and lower consulting expenses of $0.2 million offset, in part,by increased legal, audit and other professional fees of $0.3 million. Selling,general and administrative expenses for the third quarter of 2005 are expectedto be approximately 38% to 40% of revenue.

 

***Six Months Ended June 30, 2005and 2004***

 

The following table presents our operating expenses:

 
| ** **                           | ** **   | **Six Months Ended  June 30,** | *** *** |
|--------------------------------------|--------------|-------------------------------------|--------------|
| ** **                           | ** **   | **2005**                            | ** **   | **2004** | ** ** |
| *** ***                         | *** *** | **(in thousands)**                  | ** **   |
|                                 |         |                                |         |   |   |
| Research and  development            |         | $                                   | 9,129        |   | $ | 9,332 |   |
| In-process  research and development |         | —                              |         | 2,490 |   |
| Selling,  general and administrative |         | 16,961                              |         | 16,829 |   |
|                                 |         |                                |         |   |   |
| Total  operating expenses            |         | $                                   | 26,090       |   | $ | 28,651 |   |

 

**Research and development expense**

 

Research and development expense represented 25% of revenue in the sixmonths ended June 30, 2005 and June 30, 2004. The $0.2 milliondecrease in research and development expenses in the six months ended June 30,2005 compared with the six months ended June 30, 2004 was due primarily tolower salary related expenses of $0.5 million and reduced spending on productprototypes of $0.1 million offset, in part, by an increase in consultingexpenses of $0.3 million.

 

**In-process research and development**

 

We recorded a one-time charge of $2.5 million in the second quarter of2004 related to the purchase of in-process technology described above.  

 

**Selling, general and administrative expense**

 

Selling, general and administrative expenses represented 47% of revenuein the six months ended June 30, 2005, compared with 44% in the six monthsended June 30, 2004. The $0.1 million increase in selling, general andadministrative expenses in the six months ended June 30, 2005 comparedwith the six months ended June 30, 2004 was due primarily to increasedlegal, audit and other professional fees of $0.6 million, an increase in baddebt expense of $0.2 million and an increase in depreciation expense of $0.1million. The increases in selling, general and administrative expenses wereoffset, in part, by lower salary related expenses of $0.3 million, lower consultingexpenses of $0.3 million and lower facility-related expenses of $0.2 million. 

 

***Other income, net***

 

***Three Months Ended June 30, 2005and 2004***

 

The following table presents our other income,net:

 
| ** **         | ** ** | **Three Months Ended  June 30,** | *** *** |
|--------------------|------------|---------------------------------------|--------------|
| ** **         | ** ** | **2005**                              | ** **   | **2004** | ** ** |
| ** **         |       | **(in thousands)**                    |         |
|               |       |                                  |         |   |   |
| Other  income, net |       | $                                     | 325          |   | $ | 117 |   |
|                    |            |                                       |              |  |  |  |  |

 

The change in other income, net from the three months ended June 30,2004 to the three months ended June 30, 2005 was due primarily to anincrease in interest income. The increase in interest income related to higheraverage interest rates on our marketable debt securities offset, in part, bylower average cash, cash equivalents and marketable debt securities.

 

15

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***Six Months Ended June 30, 2005and 2004***

 

The following table presents our other income,net:

 
| ** **         | ** **   | **Six Months Ended  June 30,** | *** *** |
|--------------------|--------------|-------------------------------------|--------------|
| ** **         | ** **   | **2005**                            | ** **   | **2004** | ** ** |
| *** ***       | *** *** | **(in thousands)**                  | ** **   |
|               |         |                                |         |   |   |
| Other  income, net |         | $                                   | 645          |   | $ | 299 |   |
|                    |              |                                     |              |  |  |  |  |

 

The change in other income, net from the sixmonths ended June 30, 2004 to the six months ended June 30, 2005 wasdue primarily to an increase in interest income. The increase in interestincome related to higher average interest rates on our marketable debtsecurities offset, in part, by lower average cash, cash equivalents andmarketable debt securities.

 

***Income tax (benefit) provision***

 

***Three Months Ended June 30, 2005and 2004***

 

The following table presents our income tax (benefit) provision andeffective tax rate:

 
| ** **                      | ** **   | **Three Months Ended  June 30,** | *** *** |
|---------------------------------|--------------|---------------------------------------|--------------|
| ** **                      | ** **   | **2005**                              | ** **   | **2004** | ** ** |
| *** ***                    | *** *** | **(dollars in thousands)**            | ** **   |
|                            |         |                                  |         |   |   |
| Income tax  (benefit) provision |         | $                                     | (106         | ) | $ | (117 | ) |
| Effective  tax rate             |         | (29                                   | )%           | 4 | % |
|                                 |              |                                       |              |  |  |  |  |

 

The tax benefit in the three months ended June 30, 2005 differedfrom the statutory tax rate as a result of a favorable settlement related tostate tax obligations from prior periods and the release of related reserves.Excluding the impact of this item, the effective tax rate for the three monthsended June 30, 2005 was 41%. The annual effective tax rate for the thirdquarter of 2005 is expected to be approximately 41% to 43%.

 

The tax benefit in the three months ended June 30, 2004 differedfrom the statutory tax rate as a result of the disproportionate relationshipbetween permanent taxable items and our forecasted pre-tax income (loss).Excluding the impact of the in-process research and development charge recordedin the second quarter of 2004, which is not deductible for tax purposes due tothe nature of the SnowShore acquisition, the effective tax rate was 21%.

 

***Six Months Ended June 30, 2005and 2004***

 

The following table presents our income tax (benefit) provision andeffective tax rate:

 
| ** **                      | ** ** | **Six Months Ended  June 30,** | *** *** |
|---------------------------------|------------|-------------------------------------|--------------|
| ** **                      | ** ** | **2005**                            | ** **   | **2004** | ** ** |
| ** **                      | ** ** | **(dollars in thousands)**          | ** **   |
|                            |       |                                |         |   |   |
| Income tax  (benefit) provision |       | $                                   | (304         | ) | $ | 5 |   |
| Effective  tax rate             |       | 95                                  | %            | 0 | % |
|                                 |            |                                     |              |  |  |  |  |

 

The tax benefit in the six months ended June 30, 2005 differedfrom the statutory tax rate as a result of the settlement described aboveoffset by additional tax expense recorded in the first quarter of 2005 thatresulted from the filing of amended tax returns associated with prior periods.Excluding the impact of these items, the effective tax rate for the six monthsended June 30, 2005 was 42%.

 

The tax provision in the six months ended June 30, 2004 differedfrom the statutory tax rate as a result of the disproportionate relationshipbetween permanent taxable items and our forecasted pre-tax income (loss).Excluding the impact of the in-process research and development charge recordedin the second quarter of 2004, which is not deductible for tax purposes due tothe nature of the SnowShore acquisition, the effective tax rate was 2%.

 

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**Liquidityand Capital Resources**

 

***Cash flows for the six months ended June 30,2005 and 2004***

 

Cash from operating activities was $1.3 million in the six months ended June 30,2005. This resulted primarily from our net loss adjusted for non-cash expenses,such as depreciation and amortization, that do not require current expendituresof cash and a decrease in accounts receivable offset, in part, by an increasein inventory. Cash flows from operating activities were $1.9 million in the sixmonths ended June 30, 2004. This resulted primarily from our net lossadjusted for non-cash expenses and a decrease in accounts receivable offset, inpart, by a decrease in current liabilities. 

 

Cash used in investing activities was $3.3 million in the six monthsended June 30, 2005. This resulted from net purchases of marketable debtsecurities of $2.0 million, expenditures for capital equipment of $0.7 millionand the purchase and license of technology for $0.5 million. Cash flows used ininvesting activities were $10.8 million in the six months ended June 30,2004. This resulted from a net decrease in cash of $8.3 million as a result ofthe SnowShore acquisition, net purchases of marketable debt securities of $1.2million, expenditures for capital equipment of $0.7 million and the purchaseand license of technology for $0.6 million. 

 

Cash used in financing activities was $1.7 million in the six monthsended June 30, 2005. This resulted from $2.7 million used to repurchaseshares of our common stock offset, in part, by $1.0 million of proceedsreceived from the sale of common stock to our employees under stock option andemployee stock purchase plans. Cash flows from financing activities were $2.1million in the six months ended June 30, 2004. This resulted from $3.0million of proceeds received from the sale of common stock to our employeesunder stock option and employee stock purchase plans offset, in part, by $0.9million used to repurchase shares of our common stock.

 

***Cash and Cash Liquidity Position***

 

The following table presents our cash and liquidity position as of June 30,2005 and December 31, 2004:

 
| ** **                        | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|-----------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **2005**                   | ** ** | **2004**              | ** ** |
| ** **                        | ** ** | **(dollars in thousands)** | ** ** |
|                              |       |                       |       |                  |       |
| Cash and  cash equivalents        |       | $                          | 14,721     |                  | $          | 18,452 |   |
| Marketable  debt securities       |       | 36,269                     |       | 34,250                |       |
|                              |       |                       |       |                  |       |
| Total                             |       | $                          | 50,990     |                  | $          | 52,702 |   |
|                              |       |                       |       |                  |       |
| Working  capital                  |       | $                          | 54,677     |                  | $          | 56,163 |   |
| Quick ratio                       |       | 3.7                        |       | 3.7                   |       |
| Maximum  available line of credit |       | $                          | 5,000      |                  | $          | 5,000 |   |

 

Cash, cash equivalents and marketable debt securities decreased to $51.0million as of June 30, 2005 from $52.7 million as of December 31,2004. This resulted primarily from the use of $2.7 million to repurchase sharesof our common stock offset, in part, by $1.0 million of proceeds received fromthe sale of common stock to our employees under stock option and employee stockpurchase plans. Working capital decreased by $1.5 million from December 31,2004 to June 30, 2005 for the same reasons.

 

Our quick ratio was 3.7 at June 30, 2005 and December 31,2004. The quick ratio is generally considered to be an indicator of a company’sability to meet its short-term financial obligations. Quick ratio is computedas cash and cash equivalents, marketable debt securities and accountsreceivable divided by current liabilities. 

 

Our line of credit was with a commercial bank and provided for amaximum commitment of $5.0 million through July 29, 2005.  Borrowings under the line of credit wouldhave borne interest at the lender’s prime rate and we paid a commitment fee onunused commitments.  Borrowings under theline of credit were collateralized by a pledge of substantially all of ourassets and the availability of funds under the line of credit was subject tocompliance with certain financial covenants relating to our quick ratio,minimum tangible net worth and other standard reporting requirements.  We are currently in the process of renewingthe line of credit and based on this process we expect to complete the renewalin August 2005 on substantially the same terms as outlined above.  There were no borrowings outstanding underthe line of credit on July 29, 2005, June 30, 2005 or at December 31,2004.  At June 30, 2005,approximately $0.1 million of the line of credit was pledged as security forcertain forward currency contracts.

 

 

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On October 20, 2004, our board of directors authorized a programfor the repurchase of up to 1,000,000 shares of our common stock. Under thisprogram, shares may be repurchased prior to October 19, 2005 and in suchamounts as market conditions warrant, subject to regulatory and otherconsiderations. We plan to use the shares repurchased under this program forgeneral corporate purposes, including our stock option plans, employee stockpurchase plan and other stock benefit plans. We repurchased 211,530 shares forapproximately $2.7 million under this program during the first six months of2005. We repurchased 368,100 shares for approximately $3.4 million under stockrepurchase programs during the year ended December 31, 2004.

 

We expect that our cash and cash equivalents and marketable debtsecurities will meet our needs for at least the next twelve months; however, weare always looking for opportunities to expand our business, which couldinclude acquisitions or organic expansion into new markets. If we find that ourcash and cash equivalent and marketable debt securities are not sufficient, wemay choose to utilize or to seek other sources of financing. If we were to seekfuture equity financings, the terms may be dilutive to our stockholders and maycontain restrictive covenants, which could limit our ability to pursue certaincourses of action. It is possible that, should the need arise, we will not beable to obtain additional financing, or that the financing made available to uswill not be on acceptable terms.

 

***Contractual Obligations and CapitalExpenditures***

 

The following table presents our future contractual obligations andcommercial commitments as of June 30, 2005:

 
| ** **        | ** ** | **Total**          | ** ** | **Remainder  of 2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** |
|-------------------|------------|--------------------|------------|------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
| ** **        | ** ** | **(in thousands)** | ** ** |
|              |       |               |       |                   |       |     |       |     |       |     |       |     |       |           |       |
| Operating  leases |       | $                  | 3,606      |                   | $          | 1,325    |       | $        | 1,110      |     | $          | 389      |       | $              | 389        |   | $ | 275 |   | $ | 118 |   |
|                   |            |                    |            |                        |            |          |            |          |            |          |            |          |            |                |            |  |  |  |  |  |  |  |

 

We have operating lease commitments for our primary office andmanufacturing facilities that expire in 2006. We have operating leasecommitments for our sales and support functions that expire at various datesbetween 2006 and 2010. Some of these leases contain renewal options rangingfrom three to ten years. Certain lease agreements require us to pay all of thebuilding’s taxes, insurance and maintenance costs.

 

We purchased $0.7 million of capital equipment in both the sixmonths ended June 30, 2005 and June 30, 2004. We expect to purchaseapproximately $0.5 million of capital equipment in the remainder of 2005. Inaddition, our leases for certain properties in Needham, Massachusetts willexpire in March 2006, and we are currently assessing alternatives forleasing various available facilities, including our current facilities.Depending on the facility and arrangements that we ultimately select, we may berequired to expend funds for capital improvements beginning in the second halfof 2005. We do not expect that our funding of any such capital improvementswill have a material effect on our cash position.  

 

We have certain inventory purchase commitments that are part of ourordinary course of business. The term of these inventory purchase commitmentstypically do not exceed six months. We do not expect these short-termcommitments to have a material impact on our financial results.

 

***Inflation***

 

The pricing of our products and the costs of our goods can besignificantly affected by current market conditions. Market conditions can beimpacted by inflation; however, we believe that inflation has not had asignificant effect on our operations to date.

 

**Recent Accounting Pronouncement**

 

In December 2004, the FinancialAccounting Standards Board issued Statement of Financial Accounting Standard No. 123(revised 2004), “Share-Based Payment,” or SFAS No. 123(R), which revisesSFAS No. 123, “Accounting for Stock-Based Compensation” and supercedesAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees,” and its related interpretations. In April 2005, the SECannounced the adoption of a rule that defers the effective date of SFAS No. 123(R)to fiscal years beginning after June 15, 2005. We expect to adopt SFAS No. 123(R)using the modified prospective application method. Adoption of SFAS No. 123(R)will increase stock compensation expense. The actual impact on future yearswill depend on a number of factors, including our stock price and the level offuture grants and awards made from our stock-based compensation plans. Wedisclose the pro forma effect on our financial results using a fair value basedapproach in Note 1(f), “Stock-Based Compensation,” to our unaudited condensedconsolidated financial statements. The pro forma effects disclosed are notnecessarily representative of the effects on the results of operations in thefuture for the reasons provided above.

 

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**Factors That May Affect Future Results**

 

The risks and uncertainties described below are those that we currentlybelieve may materially affect us. The trading price of our common stock coulddecline due to any of these factors. You should also refer to the otherinformation in this report, including the consolidated financial statements andrelated notes. Additional risks and uncertainties that we are unaware of, orthat we currently deem immaterial, also may become important factors thataffect us.

 

***Risks Related to OurBusiness***

 

***Downturns in the economy generally, and insectors of the telecommunications industry in particular, make it difficult toanticipate or expand sales.***

 

As a result of the uncertain economic conditions that have affectedmost technology sectors and the telecommunications sector in particular, overthe past few years many of our customers have aggressively sought to increaseefficiency in their supply chains and reduce their inventory levels.Additionally, the slowdown in the telecommunications industry and the resultingdecrease in spending by companies in our target markets have limited the rateof growth of data traffic and the use of the Internet, which are driving theconvergence of data and telephony that we expect will give rise to demand forNew Network applications. The economic downturn adversely affected our businessand operating results for the first two quarters of 2003, and even more so forthe years ended December 31, 2002 and 2001. While economic conditions haveimproved somewhat, if current economic conditions do not continue to improve orif they worsen, we may experience additional adverse effects on our revenue,net income and cash flow. For example, if the rate at which our customers orderproduct decreases, it becomes more likely that our current inventories would beexposed to technological obsolescence, which would require us to reduce thevalue of those inventories on our balance sheet.

 

***If we fail to compete successfully in thehighly competitive telecommunications market, our revenue and profitabilitywill suffer.***

 

The market for telecommunications equipment is highly competitive. Ifwe are unable to differentiate our products from existing and future offeringsof our competitors, and thereby effectively compete in the market fortelecommunications equipment, our operating results could be materiallyadversely affected. Many of our current and potential competitors havesignificantly greater selling and marketing, technical, manufacturing,financial and other resources than we have. We expect our current competitorsto continue to improve the design and performance of their existing productsand to introduce new products and enhancements with improved price andperformance characteristics. New technologies, products or market trends maythreaten our product sales, and we may have to reduce the prices of ourproducts to stay competitive or we may not have the resources required torespond to the new technologies, products or market trends. In addition, newcompetitors may emerge in the markets we serve. An acquisition of, or by, oneof our competitors may result in a substantially strengthened competitor withgreater financial, engineering, manufacturing, marketing and customer serviceand support resources than we have. If our current or future competitors enterinto strategic relationships with leading manufacturers covering productssimilar to those sold or being developed by us, our ability to sell products tothose manufacturers may be adversely affected.

 

Capitalizing on our technology will require a continued high level ofinvestment in research and development, marketing and customer service andsupport. We may be unable, or otherwise fail, to allocate sufficient resourcesto achieve the technological advances necessary to compete successfully withexisting competitors or new entrants.

 

***Internal development efforts by our customersmay adversely affect demand for our products.***

 

Many of our customers and partners, including the large originalequipment manufacturers on which we focus a significant portion of oursales and marketing efforts, have the technical and financial ability to designand produce components replicating or improving on the functionality of most ofour products. These customers often consider in-house development oftechnologies and products as an alternative to doing business with us. Wecannot guarantee that our existing or potential customers will do business withus, rather than attempting to develop similar technology and productsinternally or obtaining technology or products through acquisitions. We cannotbe certain that we will be able to find customers to replace the revenue lostas a result of customers developing technologies or products in-house. Any suchoccurrence could have a material adverse effect on our business, financialcondition or operating results.

 

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***If we fail to develop and sell new orenhanced products for the telecommunications hardware and software market, wewill not be able to compete effectively.***

 

The telecommunications hardware and software market is characterizedby:

 

*•**               *rapidtechnological advances;

*•**               *evolvingindustry standards;

*•**               *changes incustomer requirements;

*•**               *changes inproduct life cycles, including the shortening life cycle of products in themarket;

*•**               *frequent newproduct introductions or innovations;

*•**               *decliningprices;

*•**               *intensecompetition; and

*•**               *evolvingofferings by telecommunications service providers.

 

Our future success depends in large part on our ability to offerproducts that address the sophisticated and varied needs of our current andprospective customers and to respond to technological advances and evolvingindustry standards on a timely and cost-effective basis.

 

The timely development of new or enhanced products is a complex anduncertain process. We intend to continue to invest significantly in product andtechnology development. We may experience design, manufacturing, marketing andother difficulties that could delay or prevent our development, introduction orcommercialization of any new and enhanced products. In particular, developmentof new products may require different engineering skills and experience, whichour current employees may not possess. We also may not be able to incorporatenew technologies on a cost-effective or timely basis, which may result inunexpected expenses. We may not anticipate technological or market trendsaccurately or manage long development cycles successfully. We may be requiredto collaborate with third parties to develop products and may not be able to doso on a timely and cost-effective basis, if at all.

 

The introduction of new or enhanced products also requires that wemanage the transition from older products so as to minimize the disruption tocustomers and ensure that adequate supplies of new products can be delivered tomeet anticipated customer demand. If we are unable to develop new products orenhancements on a timely and cost-effective basis, or if the new products orenhancements that we introduce fail to achieve market acceptance, our abilityto grow our business would be harmed and competitors could achieve greatermarket share.

 

***Our future success will depend in part on thecontinued migration to IP-based networks.***

 

We develop core technology that connects the traditional telephonenetwork, or TDM, to the data network in the fax, enterprise voice and carrierenhanced service markets. In the first half of 2005, we have seen a decline inour traditional TDM voice and data business that we believe was the result ofour customers anticipating a migration to IP-based technology. We anticipatethat the migration to VOIP will generate the need for new enterprise voiceapplication systems that connect to VOIP networks. We also expect that demandfor new fax systems will be driven in part by the transition of many voice networksto VOIP. Moreover, telecommunications carriers are now migrating theirinfrastructure toward IP-based technologies. As a result, our future success maydepend on the timing and extent of the continued migration of our targetmarkets to VOIP and other IP-based networks. This migration is still in arelatively early stage, and the continued migration to VOIP and other IP-basednetworks depends on various factors that are outside of our control, includingconcerns of enterprises and carriers regarding capital outlay requirements aswell as competitive and regulatory issues. If the migration to IP-basednetworks does not occur for these or other reasons, or if it occurs more slowlythan we expect, our operating results may be harmed.

 

***Our revenue could decline significantly if welose a major customer or if a major customer cancels, reduces or delays anorder.***

 

One customer accounted for 18% of our revenue in the first six monthsof 2005 and 18% of our revenue in fiscal 2004. We expect this customer to continue to account for more than 10% of ourtotal revenue. The loss of this or any other major customer or thecancellation, reduction or delay of significant orders from such customers,even if only temporary, could significantly reduce our revenue and cash flowand could harm our reputation in the industry.

 

***Our products typically have long salescycles, causing us to expend significant resources before recognizing revenue.***

 

The length of our sales cycle typically ranges from six to eighteenmonths and varies substantially from customer to customer. Prospectivecustomers generally must commit significant resources to test and evaluate ourproducts and integrate them into larger systems. This evaluation period isoften prolonged due to delays associated with approval processes that typicallyaccompany the design and testing of new communications equipment by ourcustomers.

 

20

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In addition, the rapidly emerging and evolving nature of the markets inwhich we and our customers compete may cause prospective customers to delaytheir purchase decisions as they evaluate new technologies and develop andimplement new systems. During the period in which our customers are evaluatingwhether to place an order with us, we often incur substantial sales andmarketing expenses, without any assurance of future orders or their timing.Even after a customer places an order, the timing of the development andintroduction of the customer’s product, and in particular the timing of implementationof our product into the customer’s product, are controlled by, and can varysignificantly with the needs of, the customer. In some circumstances, thecustomer will not require the product for several months. This continuinguncertainty can complicate our planning processes and reduce the predictabilityof our earnings and cash flows.

 

***Our business and operating results could beadversely affected by downturns in economic conditions in countries outside theUnited States and other risks associated with international operations.***

 

Sales of our products to customers outside the United States accountedfor 21% of our revenue in the six months of 2005 and 20% of our revenue infiscal 2004. We anticipate that international sales will continue to account fora significant portion of our revenue. We are subject to a number of risks as aresult of our international sales, including:

 

*•**               *volatility incurrency exchange rates;

*•**               *political andeconomic instability in other countries;

*•**               *the impositionof trade restrictions, trade barriers, and tariff regulations by foreigngovernments;

*•**               *difficultiesin accounts receivable collections;

*•**               *extendedpayment terms beyond those customarily offered in the United States;

*•**               *compliancewith statutory requirements in many foreign countries;

*•**               *potentiallyadverse tax consequences;

*•**               *difficultiesin managing and/or expanding operations across disparate geographic areas; and

*•**               *interruptionin the delivery of our products.

 

In addition, most countries require technical approvals from theirtelecommunications regulatory agencies for products that operate in conjunctionwith the local telephone system. Obtaining these approvals is generally aprerequisite for sales in a given jurisdiction. Obtaining requisite approvalstakes from two months to a year or more depending on the product and thejurisdiction. In addition, obtaining these requisite approvals may requiremodifications to our products. These or other factors may limit our ability tosell our products in other countries, which could have a material adverseeffect on our business, financial condition and operating results.

 

***Our dependence on sole and single sourcesuppliers and independent manufacturers could result in increased costs ordelays in the manufacture and delivery of our products.***

 

Although we generally use standard parts and components for ourproducts, some key components are purchased from sole or single source vendorsfor which alternative sources are not currently available or are difficult toobtain. Our inability to obtain sufficient quantities of these components mayresult in future delays or reductions in product shipments that could cause usto lose sales, incur additional costs and suffer harm to our reputation. Wecurrently purchase proprietary components from a number of suppliers for whichthere are no direct substitutes.

 

These components could be replaced with alternatives from othersuppliers, but that might require redesign of our products. If such a redesignwere required, we would incur considerable delay and expenses. We currentlyenter into purchase orders with our suppliers for materials based on forecastsof need, but have no guaranteed supply arrangements with these suppliers.

 

In addition, we currently use independent manufacturers to manufactureprinted circuit boards, chassis and subassemblies in accordance with our designand specification. Our reliance on independent manufacturers involves a numberof risks, including the potential for inadequate capacity of, unavailabilityof, or interruptions in access to, process technologies and reduced controlover delivery schedules, manufacturing yields and costs. If our manufacturersare unable or unwilling to continue manufacturing our components in requiredquantities or to our quality expectations, we will have to transfermanufacturing to acceptable alternative manufacturers that we identify, whichcould result in significant delays in shipment of products to customers.Moreover, the manufacture of these components is extremely complex, and our relianceon the suppliers of these components exposes us to potential productiondifficulties and quality variations, which could negatively affect the cost andtimely delivery of our products. We currently enter into purchase orders withindependent manufacturers of materials based on forecasts of need, but have noguaranteed capacity arrangements with these manufacturers. Any significantinterruption in the supply, or degradation in the quality, of any componentcould cause us to lose sales, incur additional costs and suffer harm to ourreputation.

 

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***Defects in our products or problems arisingfrom the use of our products may seriously harm our business and reputation.***

 

Products as complex as ours may contain known and undetected errors,bugs, or other performance problems. Defects are frequently found during theperiod immediately following introduction and initial implementation of newproducts or enhancements to existing products. Although it is our objective toresolve all bugs that we believe would be considered serious by our customersbefore implementation, our products may not be bug-free. We also providewarranties against defects in materials and workmanship on our hardwareproducts for up to five years. Errors, bugs or performance problems couldresult in lost revenue or customer relationships and could be detrimental toour business and reputation generally. In addition, our customers generally useour products together with their own products and products from other vendors.As a result, when problems occur, it may be difficult to identify the source ofthe problem. These problems may cause us to incur significant warranty andrepair costs, divert the attention of our engineering personnel from our productdevelopment efforts and cause significant customer relations problems.

 

***Changes to regulations affecting thetelecommunications or Internet industries could reduce demand for our productsor increase our costs.***

 

Laws and regulations governing telecommunications, electronic commerceand the Internet are emerging, but remain largely unsettled, even in the areaswhere there has been some legislative action. Regulation may focus on, amongother things, assessing access or settlement charges, or imposing tariffs orregulations based on the characteristics and quality of products, either ofwhich could restrict our business or increase our cost of doing business. Anychanges to existing laws or the adoption of new regulations by federal or stateregulatory authorities or any legal challenges to existing laws or regulationsrelating to the telecommunications industry could materially adversely affectthe market for our products. Moreover, our value-added resellers or othercustomers may require us, or we may otherwise deem it necessary or advisable,to alter our products to address actual or anticipated changes in theregulatory environment. Our inability to alter our products or address anyregulatory changes could have a material adverse effect on our business,financial condition or operating results.

 

***Changes in stock option accounting rules mayhave a significant adverse affect on our operating results.***

 

We have a history of using broad based employee stock option programsto hire, incentivize and retain our workforce in a competitive marketplace.Statement of Financial Accounting Standards, or SFAS, No. 123, “Accountingfor Stock-Based Compensation,” allows companies the choice of either using afair value method of accounting for options that would result in expenserecognition for all options granted, or using an intrinsic value method, asprescribed by Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees,” or APB No. 25, with pro forma disclosure ofthe impact on net income (loss) of using the fair value option exerciserecognition method. We have previously elected to apply APB No. 25 andaccordingly, we have not recognized any compensation expense with respect toemployee stock options as long as such options are granted at exercise pricesequal to the fair value of our common stock on the grant date. 

 

In December 2004, the Financial Accounting Standards Board issuedSFAS No. 123(R), which would require all companies to measure compensationcost for all share-based payments, including employee stock options, at fairvalue. This statement is effective for fiscal years beginning after June 15,2005. Adoption of SFAS No. 123(R) will increase stock compensationexpense. The actual impact on future years will depend on a number of factors,including our stock price and the level of future grants and awards made fromour stock-based compensation plans. If we had used the fair value method tomeasure compensation related to stock awards to employees, we would haveincurred additional stock-based compensation expense, net of tax, of $2.0million in the six months ended June 30, 2005 and $5.4 million in fiscal 2004.The pro forma effects for 2005 and 2004 are not necessarily representative ofthe effects on the results of operations in the future.

 

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***Limitations on our ability to adequatelyprotect our proprietary rights may prevent us from retaining our competitiveadvantage and negatively affect our future operating results.***

 

Our success and ability to compete are dependent, in part, upon ourproprietary technology. Taken as a whole, we believe our intellectual propertyrights are significant and any failure to adequately protect the unauthorizeduse of our proprietary rights could result in our competitors offering similarproducts, potentially resulting in loss of a competitive advantage anddecreased revenue. We rely upon a combination of patents, trademark law, tradesecret protections, copyright law and confidentiality agreements withconsultants and third parties to protect our proprietary rights. In addition,we generally require each of our employees to execute a proprietary informationagreement designed to protect our trade secrets, our inventions created in thecourse of employment with us and other proprietary information of our company.Notwithstanding our efforts, third parties may infringe or misappropriate ourproprietary rights. Moreover, effective patent, trademark, copyright or tradesecret protections may not be available in every country in which we operate orintend to operate to the same extent as the laws of the United States. Also, itmay be possible for unauthorized third parties to copy or reverse engineeraspects of our products, develop similar technology independently or otherwiseobtain and use information that we regard as proprietary. Furthermore,detecting unauthorized use of our proprietary rights is difficult. Litigationmay be necessary to enforce our proprietary rights. Such litigation couldresult in the expenditure of significant financial and managerial resources andcould have a material adverse effect on our future operating results.

 

***Intellectual property claims against us canbe costly and negatively affect our business.***

 

In the telecommunications business, there is frequent litigation basedon allegations of patent infringement. As the number of entrants in our marketincreases and the functionality of our products is enhanced and overlaps withthe products of other companies, we may become subject to claims ofinfringement or misappropriation of the intellectual property rights of others.As a result, from time-to-time, third parties may claim exclusive patent orother intellectual property rights to technologies that we use. Although webelieve that we do not face material liability related to infringement of theintellectual property of others, any claims asserting that our productsinfringe or may infringe proprietary rights of third parties, if determinedadversely to us, could have a material adverse effect on our business,financial condition or operating results. Any claims, with or without merit,could be time-consuming, result in costly litigation, divert the efforts of ourengineering and management personnel, cause delays in product shipments orrequire us to enter into royalty or licensing agreements, any of which couldhave a material adverse effect upon our operating results. In any legal actionclaiming patent infringement commenced against us, we cannot assure you that wewould prevail given the complex technical issues and inherent uncertainties inpatent litigation. In the event a claim against us was successful, and we couldnot obtain a license on acceptable terms or license a substitute technology orredesign to avoid infringement, we may be unable to market our affectedproducts. This could have a material adverse effect on our business, financialcondition and operating results.

 

***Certain of our products depend upon thecontinued availability of licensed technology from third parties.***

 

We currently license and will continue to license from third partiescertain technology integral to certain of our products. For example, we haveobtained licenses from third parties for software for certain of our voice andfax products. While we believe that much of this technology is available frommultiple sources, any difficulties in acquiring third-party technologylicenses, or integrating the related third-party technology into our products,could result in delays in product development or upgrades until equivalenttechnology can be identified, licensed and integrated.

 

We may require new licenses in the future as our business grows andtechnology evolves. We cannot assure you that these licenses will continue tobe available to us on commercially reasonable terms, if at all, which couldhave a material adverse effect on our business, financial condition andoperating results.

 

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***We may enter into acquisitions that may bedifficult to integrate, disrupt our business, dilute stockholder value ordivert management attention.***

 

We intend to pursue acquisitions of businesses, technologies andproducts that will complement our existing operations. We cannot assure youthat any acquisition we make in the future will provide us with the benefits weanticipated in entering into the transaction. Acquisitions are typicallyaccompanied by a number of risks, including:

 

•                difficulties inintegrating the operations and personnel of the acquired companies;

•                maintenance ofacceptable standards, controls, procedures and policies; 

•                potentialdisruption of ongoing business and distraction of management; 

•               impairmentof relationships with employees and customers as a result of any integration ofnew management or other personnel; 

•                inability tomaintain relationships with customers of the acquired business; 

•                difficulties inincorporating acquired technology and rights into products and services; 

•                failure to achievethe expected benefits of the acquisition; 

•                unexpectedexpenses resulting from the acquisition; 

•                potential unknownliabilities associated with the acquired businesses; and 

•                unanticipatedexpenses related to acquired technology and its integration into existingtechnology. 

 

In addition, acquisitions may result in the incurrence of debt,restructuring charges and large one-time write-offs, such as write-offs foracquired in-process research and development costs. Acquisitions may alsoresult in goodwill and other intangible assets that are subject to impairmenttests, which could result in future impairment charges. Furthermore, if wefinance acquisitions by issuing convertible debt or equity securities, ourexisting stockholders may be diluted and earnings per share may decrease. 

 

From time-to-time, we may enter into negotiations for acquisitions thatare not ultimately consummated. Those negotiations could result in diversion ofmanagement time and significant out-of-pocket costs. If we fail to evaluate andexecute acquisitions properly, we may not be able to achieve our anticipatedlevel of growth and our business and operating results could be adverselyaffected. 

 

***Recent compliance initiatives will cause usto incur significant increased costs and will require substantial time of ourmanagement.***

 

The Sarbanes-Oxley Act, as well as new rules subsequentlyimplemented by the SEC and the Nasdaq National Market, have imposed various newrequirements on public companies, including requiring changes in corporategovernance practices. Our management and other personnel will need to continueto devote a substantial amount of time to these new compliance initiatives.Moreover, these rules and regulations are increasing our legal andfinancial compliance costs and will make some activities more time-consumingand costly. 

 

In addition, the Sarbanes-Oxley Act requires, among other things, thatwe maintain effective internal controls for financial reporting and disclosurecontrols and procedures. Our ongoing compliance with Section 404 of theSarbanes-Oxley Act will require that we incur substantial accounting expenseand expend significant management efforts. Moreover, if we are not able tocomply with the requirements of Section 404 in a timely manner, or if weor our independent registered public accounting firm identifies deficiencies inour internal controls over financial reporting that are deemed to be materialweaknesses, the market price of our stock could decline and we could be subjectto sanctions or investigations by the Nasdaq, SEC or other regulatoryauthorities, which would require additional financial resources and managementresources. 

 

***If we are unable to attract or retain keypersonnel, we may be unable to operate our business successfully.***

 

Our success depends in large part upon the continued contributions ofour key management, sales, marketing and engineering personnel, many of whomperform important functions and would be difficult to replace. If we lose oneor more members of our senior management team our business and operatingresults would be harmed. We do not have employment contracts with our keypersonnel. There has been significant competition in our industry for qualifiedpersonnel, and, at times, we have experienced difficulty in recruitingqualified personnel. We may not be able to attract and retain the necessarypersonnel to accomplish our business objectives, and we may experienceconstraints that will adversely affect our ability to satisfy customer demandin a timely fashion or to support our customers and operations. Our inabilityto hire qualified personnel on a timely basis, or to retain our key personnel,could materially adversely affect our business, financial condition andoperating results.

 

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***We are subject to environmental andoccupational health and safety regulations that can increase the costs ofoperations or limit our activities.***

 

We are subject to environmental and occupational health and safetyregulations relating to matters such as reductions in the use of harmfulsubstances, comprehensive risk management in manufacturing activities and finalproducts, the use of lead-free soldering, and the recycling of products andpackaging materials. On February 13, 2003 the European Parliament and theCounsel of the European Union published directives on waste electrical andelectronic equipment and on the restriction of the use of certain hazardoussubstances in electrical and electronic equipment. These directives willgenerally require electronics producers after August 2005 to bear the costof collection, treatment, recovery and safe disposal of past and futureproducts from end-users and to ensure after June 2006 that new electricaland electronic equipment does not contain specified hazardous substances. Whilethe cost of these directives to us cannot be determined before regulations areadopted in individual member states of the European Union, it may besubstantial and may divert resources, which could detract from our ability todevelop new products. We may not be able to comply in all cases with applicableenvironmental and other regulations, and if we do not, we may incur remediationcosts or we may not be able to offer our products for sale in certaincountries, which could adversely affect our results.

 

***Risks Related to OurCommon Stock***

 

***Our operating results could fluctuatesignificantly and cause our stock price to be volatile, which may cause thevalue of your investment to decline.***

 

Our operating results could fluctuate in the future due to a variety offactors, many of which are outside of our control. If our operating results donot meet the expectations of securities analysts, the trading price of ourcommon stock could significantly decline. This may cause the value of yourinvestment in our company to decline. In addition, the value of your investmentcould be affected by investor perception of our industry or our prospectsgenerally, independent of our operating performance. Some of the factors thatcould affect our operating results or the market price of our common stockinclude:

 

*•**               *our ability tocope with difficult conditions in the economy in general, and thetelecommunications market in particular;

*•**               *our ability toformulate and implement effective strategies to respond to changing marketrequirements and conditions;

*•**               *cancellationor rescheduling of orders for our products;

*•**              *ourability to collect accounts receivable from customers that have been adverselyaffected by the difficult economic conditions;

*•**               *our ability todevelop, manufacture, market and support our products and product enhancements;

*•**              *thetiming and number of orders for our products, which have historically beenweighted more heavily toward the last month of each quarter and the second andfourth quarters of each year;

*•**              *quarterlyfluctuations in our revenue, which typically is lower in the third quarter dueto customer summer vacation schedules, particularly in Europe, and to a lesserextent in the first quarter of each year;

*•**               *our ability tohire, train and retain key management, sales, marketing and engineeringpersonnel;

*•**               *announcementsor technological innovations by our competitors or in competing technologies;

*•**               *our ability toobtain sufficient supplies of sole or limited source components for ourproducts;

*•**               *a decrease inthe average selling prices of our products;

*•**               *changes incosts of components that we include in our products;

*•**               *the mix ofproducts that we sell; and 

*•**               *anyinterruptions in the flow of our products through our resellers or ourtwo-tiered distribution system.

 

Because of quarterly fluctuations, we believe that quarter-to-quartercomparisons of our operating results are not necessarily meaningful. Moreover,our operating results may not meet our announced guidance or expectations ofequity research analysts or investors, in which case the price of our commonstock could decrease significantly. 

 

In addition, our expense levels are based, in significant part, on ourexpectations as to future revenue and are largely fixed in the short term. As aresult, we may be unable to adjust spending in a timely manner to compensatefor any unexpected shortfall in revenue. Furthermore, we intend to increase ouroperating expenses as we expand our product development, sales and marketing,and administrative organizations. The timing of these increases and the rate atwhich new personnel become productive will affect our operating results, and,in particular, we may incur operating losses in the event of an unexpecteddelay in the rate at which development or sales personnel become productive.Any such revenue shortfall, and the resulting decrease in operating income orincrease in operating loss, could lead to volatility in the price of our commonstock.

 

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***The market price of our common stock may bevolatile, which could lead to losses for individual investors.***

 

Stock markets in general, and the market for technology stocks,including our common stock, in particular, have experienced extreme price andvolume fluctuations that often have been unrelated, or disproportionate, to theoperating performance of those companies. The market for our common stock hasbeen and is likely to continue to be volatile. Many factors could cause thetrading price of our common stock to fluctuate substantially, including thefollowing:

 

*•**              *futureannouncements concerning our business, technology, acquisitions, strategicpartnerships, management, customers or competitors;

*•**              *introductionof new products or changes in product pricing policies by us, our competitorsor our customers;

*•**              *changesin earnings estimates by securities analysts or announcements of results ofoperations that are not aligned with the expectations of analysts andinvestors;

*•**              *changesin market valuations of similar companies;

*•**              *reducedspending for telecommunications hardware and software;

*•**              *theeconomic and competitive conditions in the telecommunications sectors in whichour customers operate; and

*•**              *generaleconomic conditions and stock market trends.

 

In the past, following periods of volatility in the market price of aparticular company’s securities, securities class action litigation has oftenbeen brought against that company. Many technology companies have been subjectto this type of litigation. This type of litigation, if instituted against us,could result in substantial costs and a diversion of our management’s attentionand resources.

 

***Our corporate documents may prevent a changein control or management that stockholders consider desirable.***

 

Our charter and by-laws contain provisions that might enable ourmanagement to resist a takeover of our company. In addition, we haveimplemented a shareholder rights plan. These provisions and our shareholderrights plan could have the effect of delaying, deferring, or preventing achange in control of Brooktrout or a change in our management that stockholdersconsider favorable or beneficial. They could discourage proxy contests and makeit more difficult for stockholders to elect directors and take other corporateactions. They also could limit the price that investors may be willing to payin the future for shares of our common stock.

 

***We may need additional financing in thefuture, and any additional financing may result in restrictions on ouroperations or substantial dilution to our stockholders.***

 

We may need to raise additional funds in the future, for example, todevelop new technologies, support our expansion, respond to competitivepressures, acquire complementary businesses or respond to unanticipatedsituations. We may decide to raise additional funds through public or privatefinancings, strategic relationships or other arrangements. Our ability toobtain debt or equity funding will depend on a number of factors, includingmarket conditions, our operating performance and investor interest. Additionalfunding may not be available to us on acceptable terms or at all. If adequatefunds are not available, we may be required to revise our business plan toreduce expenditures, including curtailing our growth strategies, foregoingacquisitions or reducing our product development efforts. If we succeed inraising additional funds through the issuance of equity or convertiblesecurities, the issuance could result in substantial dilution to existingstockholders. If we raise additional funds through the issuance of debtsecurities or preferred stock, these new securities would have rights,preferences and privileges senior to those of the holders of our common stock.The terms of these securities, as well as any borrowings under our bank line ofcredit agreement, could impose restrictions on our operations.

 

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

 

Market riskrepresents the risk of loss that may affect us due to adverse changes infinancial market prices and rates. Our market risk exposure results primarilyfrom fluctuations in interest rates and foreign currency exchange rates. 

 

***Interest Rate Risks***

 

We invest cash balances in excess of operating requirements inshort-term securities, generally with maturities of 90 days or less on the dateof purchase. These securities consist of U.S. government notes and bonds,commercial paper, and certificates of deposit. We also invest in marketabledebt securities that consist of notes and bonds issued by various federalagencies of the United States, as well as corporate commercial paper, withmaturities greater than 90 days on the date of purchase. If we were toexperience a 1% increase in the effective interest rate, the effect on thecarrying value of marketable debt securities as of June 30, 2005 would bea decrease of approximately $0.2 million. Changes in interest rates and therelated impact on the carrying value of marketable debt securities do notgenerally affect our net income or loss because our securities are consideredavailable-for-sale for accounting purposes and any unrealized gain or loss isdeferred as a component of accumulated other comprehensive income. 

 

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***Foreign Currency Exchange Rate Risks***

 

We generally conduct business in U.S. dollars; however, some of ourinternational sales are denominated in foreign currencies. We also operatesales and support offices located outside of the United States and we incurexpenses that are denominated in foreign currencies. As a result of theseactivities, we are exposed to market risk from changes in foreign currencyexchange rates. The impact of changes in foreign currency exchange rates can bepositive or negative in any period. We manage our exposure to foreign currencymarket risks through regular operating and financing activities. We also makeuse of foreign currency forward exchange contracts to minimize the impact offluctuations in foreign currency exchange rates. We do not enter into foreigncurrency forward exchange contracts for trading purposes. As of June 30,2005, a 10% appreciation or depreciation in foreign currency exchange ratesfrom the prevailing market rates would not have had a material impact on ourresults for the three or six months ended June 30, 2005.

 

**Item 4. Controls and Procedures**

 

***(a) Evaluationof disclosure controls and procedures.***

 

Our management, with the participation of our principal executiveofficer and principal financial and accounting officer, evaluated theeffectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended, or theExchange Act) as of June 30, 2005. In designing and evaluating ourdisclosure controls and procedures, our management recognizes that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving their objectives, and our managementnecessarily applied its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures. Based on this evaluation, our chief executiveofficer and chief financial officer concluded that, as of June 30, 2005,our disclosure controls and procedures were (1) designed to ensure thatmaterial information relating to our company, including our consolidatedsubsidiaries, is made known to our chief executive officer and chief financialofficer by others within those entities, particularly during the period inwhich this report was being prepared and (2) effective, in that theyprovide reasonable assurance that information required to be disclosed by us inthe reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms.

 

***(b) Changes ininternal control over financial reporting.***

 

No change in our internal control over financial reporting (as definedin Rules 13a-15(f) and 15d-15(f) under the Exchange Act)occurred during the fiscal quarter ended June 30, 2005 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

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**PART II– OTHER INFORMATION**

 

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

 

Our repurchases ofequity securities for the second quarter of fiscal 2005 were as follows:

 
| **Period**                               | ** ** | **Total Number of  Shares  Purchased** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Number of  Shares  Purchased as  Part of Publicly  Announced Plans  or Programs (1)** | ** ** | **Maximum  Number of  Shares That May  Yet Be Purchased  Under the Plans  or Programs** | ** ** |
|------------------------------------------|------------|----------------------------------------|------------|-----------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|
|                                     |       |                                   |       |                              |       |                                                                                               |       |                                                                                    |       |
| April 1  – April 30, 2005 |       | —                                 |       | —                            |       | —                                                                                             |       | 506,370                                                                                 |       |
| May 1 –  May 31, 2005     |       | —                                 |       | —                            |       | —                                                                                             |       | 506,370                                                                                 |       |
| June 1  – June 30, 2005   |       | —                                 |       | —                            |       | —                                                                                             |       | 506,370                                                                                 |       |
|                                     |       |                                   |       |                              |       |                                                                                               |       |                                                                                    |       |
| Total                                    |       | —                                 |       | —                            |       | —                                                                                             |       | 506,370                                                                                 |       |

 

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(1) -                 In October 2004, our Board of Directorsauthorized the repurchase of up to 1,000,000 shares of our common stock fromtime-to-time on the open market or in privately negotiated transactions. Theprogram expires in October 2005. From the inception of this program in October 2004through the date of this report, the Company has repurchased 493,630 shares forapproximately $5.2 million.

 

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

 

We held our 2005annual meeting of stockholders on May 5, 2005. At the annual meeting, ourstockholders were asked to consider proposals to:

 

•*        *Elect two class I directors to serve forthree-year terms;

•*        *approve an amendment to our 2001 stockoption and incentive plan increasing the number of shares of common stockissuable under such plan by 400,000 shares, from 1,500,000 shares to 1,900,000shares; 

•*        *ratify the selection of Deloitte &Touche LLP as our independent registered public accounting firm for the 2005fiscal year; and

•*        *transact any other business properlypresented at the meeting.

 

With regard to the election of two class I directors, David L. Chapmanand David W. Duehren were nominated to serve until the 2008 annual meeting ofstockholders. Our other directors whose terms of office continued after theannual meeting are as follows: W. Brook Tunstall (class II director), Robert G.Barrett (class III director) and Eric R. Giler (class III director).

 

At the annual meeting, David L. Chapman was elected as a class Idirector by a vote of 11,180,352 shares of common stock in favor of Mr. Chapman,which was a plurality of the eligible votes, and 710,881 withheld for Mr. Chapman.David W. Duehren was elected as a class I director by a vote of 11,031,329shares of common stock in favor of Mr. Duehren, which was a plurality ofthe eligible votes, and 859,904 withheld for Mr. Duehren.

 

In addition, at the annual meeting, the amendment to our 2001 stockoption and incentive plan to increase the number of shares of common stockissuable under such plan by 400,000 shares, from 1,500,000 shares to 1,900,000 shares, wasapproved by a vote of 4,468,035 shares of common stock in favor, 3,599,377against, 26,576 abstaining, and 3,797,245 broker non-votes.

 

The selection of Deloitte &Touche LLP as our independent registered public accounting firm for the 2005fiscal year was ratified at the annual meeting by a vote of 11,798,741 shares ofcommon stock in favor, 72,629 against, and 19,863 abstaining.

 

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**Item6.  Exhibits**

 
| **Exhibit  No.** | ** ** | **Exhibit**                                                                                                                                                                                                                                                       |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                                                                              |
| 10.1             |       | Brooktrout, Inc. 2001 Stock Option and Incentive Plan, as amended  by Amendment No. 1 thereto, is hereby incorporated by reference from the  Company’s definitive Proxy Statement filed with the SEC on March 30,  2005 (File No. 000-20698). |
|             |       |                                                                                                                                                                                                                                                              |
| 31.1             |       | Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(a) or  15d-14(a), as adopted pursuant to Section 302 of Sarbanes-Oxley Act of  2002 is filed herewith.                                                          |
|             |       |                                                                                                                                                                                                                                                              |
| 31.2             |       | Certification of Principal Financial and Accounting Officer pursuant  to Exchange Act Rules 13a-14(a) or 15d-14(a), as adopted pursuant  to Section 302 of Sarbanes-Oxley Act of 2002 is filed herewith.                                           |
|             |       |                                                                                                                                                                                                                                                              |
| 32.1             |       | Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(b) or  15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of Sarbanes-Oxley Act of 2002 is filed herewith.                     |
|             |       |                                                                                                                                                                                                                                                              |
| 32.2             |       | Certification of Principal Financial and Accounting Officer pursuant  to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002 is  filed herewith.     |

 

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**SIGNATURES**

 

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

 
|   |                | BROOKTROUT, INC. |
|--------|---------------------|------------------|
|   |                |             |   |
| Date:  | August 9, 2005 | By:              | /s/ ERIC R. GILER |
|   |                |             | Eric R. Giler |
|   |                |             | *President* |
|   |                |             | *(Principal  Executive Officer)* |
|   |                |             |   |
|   |                |             |   |
| Date:  | August 9, 2005 | By:              | /s/ ROBERT C. LEAHY |
|   |                |             | Robert C. Leahy |
|   |                |             | *Vice President of  Finance and Operations* |
|   |                |             | *(Principal  Financial and Accounting Officer)* |

 

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**EXHIBIT INDEX**

 
| **Exhibit  No.** | ** ** | **Exhibit**                                                                                                                                                                                                                                                      |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                                                                             |
| 10.1             |       | Brooktrout, Inc. 2001 Stock Option and Incentive Plan, as amended  by Amendment No.1 thereto, is hereby incorporated by reference from the  Company’s definitive Proxy Statement filed with the SEC on March 30,  2005 (File No. 000-20698). |
|             |       |                                                                                                                                                                                                                                                             |
| 31.1             |       | Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(a) or  15d-14(a), as adopted pursuant to Section 302 of Sarbanes-Oxley Act of  2002 is filed herewith.                                                         |
|             |       |                                                                                                                                                                                                                                                             |
| 31.2             |       | Certification of Principal Financial and Accounting Officer pursuant  to Exchange Act Rules 13a-14(a) or 15d-14(a), as adopted pursuant  to Section 302 of Sarbanes-Oxley Act of 2002 is filed herewith.                                          |
|             |       |                                                                                                                                                                                                                                                             |
| 32.1             |       | Certification of Principal Executive Officer pursuant to Exchange Act Rules 13a-14(b) or  15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of Sarbanes-Oxley Act of 2002 is filed herewith.                    |
|             |       |                                                                                                                                                                                                                                                             |
| 32.2             |       | Certification of Principal Financial and Accounting Officer pursuant  to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350,  as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002 is  filed herewith.    |

 

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