**UNITED STATES********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 the  quarterly period ended September 30, 2003**                    |
|                                                                      |
| **OR**                                                                    |
|                                                                      |
|                                                                      | **o**      |   | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                      |
| **For the  transition period from ________________ to ________________.** |

 

**Commission File No.: 000-20698**

 

**BROOKTROUT, INC.**

(ExactName of Registrant as Specified in Its Charter)

 

| **MASSACHUSETTS**                                                                 |   | **04-2814792**                        |
|-----------------------------------------------------------------------------------|--------|---------------------------------------|
| (State  or Other Jurisdiction of Incorporation or  Organization)                  |   | (I.R.S.  Employer Identification No.) |
|                                                                              |   |                                  |
| **250 FIRST  AVENUE, NEEDHAM, MASSACHUSETTS 02494**                               |
| (Address  of Principal Executive Offices) (Zip Code)                              |
|                                                                              |   |                                  |
| Registrant’s  Telephone Number, Including Area Code: **(781) 449-4100** |

 

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý       No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes ý       No o

 

As of October 31, 2003, 12,451,328 shares of commonstock, $.01 par value per share, were outstanding.

 

 

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**BROOKTROUT, INC.FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2003**

 

**TABLE OF CONTENTS**

 
|                             |                                                                                                                                                       |   | **Page** |
|----------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|
| **PART I FINANCIAL INFORMATION** |                                                                                                                                                       |   |
| Item 1.                          | Condensed Consolidated Financial Statements                                                                                                                |   | 1        |
|                             | Unaudited  Condensed Consolidated Balance Sheets as of September 30, 2003 and December  31, 2002                                                           |   | 1        |
|                             | Unaudited Condensed Consolidated Statements  of Operations for the Three and Nine Months Ended September 30, 2003 and  September 30, 2002                  |   | 2        |
|                             | Unaudited Condensed Consolidated Statements  of Comprehensive Income (Loss) for the Three and Nine Months Ended September  30, 2003 and September 30, 2002 |   | 3        |
|                             | Unaudited  Condensed Consolidated Statements of Cash Flows for the Nine Months Ended  September 30, 2003 and September 30, 2002                            |   | 4        |
|                             | Notes to Unaudited Condensed Consolidated  Financial Statements                                                                                            |   | 5        |
| Item 2.                          | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                                |   | 11       |
|                             | Overview                                                                                                                                                   |   | 11       |
|                             | Application of Critical Accounting Policies                                                                                                                |   | 11       |
|                             | Discontinued Operations                                                                                                                                    |   | 13       |
|                             | Results of Operations                                                                                                                                      |   | 14       |
|                             | Liquidity and Capital Resources                                                                                                                            |   | 18       |
|                             | Recent  Accounting Pronouncements                                                                                                                          |   | 19       |
|                             | Factors That May Affect Future Results                                                                                                                     |   | 20       |
| Item 3.                          | Quantitative and Qualitative Disclosures  About Market Risk                                                                                                |   | 26       |
| Item 4.                          | Controls and Procedures                                                                                                                                    |   | 27       |
|                             |                                                                                                                                                       |   |     |
|                             |                                                                                                                                                       |   |     |
| **PART II OTHER INFORMATION**    |                                                                                                                                                       |   |
| Item 6.                          | Exhibits and Reports on Form 8-K                                                                                                                           |   | 28       |
|                             | Signatures                                                                                                                                                 |   | 29       |
|                             | Exhibit  Index                                                                                                                                             |   | 30       |

 

“BROOKTROUT,” the “NEW NETWORK,” and the“PARTNER ACCESS NETWORK PROGRAM” are trademarks or registered trademarks ofBrooktrout, Inc.

 

ii

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**PART I****FINANCIALINFORMATION**

 

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

 

**BROOKTROUT, INC.UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS***(in thousands, except share and per share data)*

* *
|                                                                                                                                               |   | **September  30,  2003** |   | **December  31,  2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-------------------------|--------|
| **Assets**                                                                                                                                         |   |                     |   |                    |   |
| Current assets:                                                                                                                                    |   |                     |   |                    |   |
| Cash and cash equivalents                                                                                                                          |   | $                        | 14,845 |                    | $      | 23,685 |   |
| Marketable debt securities, available for sale                                                                                                     |   | 35,027                   |   | 18,103                  |   |
| Accounts receivable (less allowance for doubtful accounts and sales  returns of $1,203 at September 30, 2003 and $1,679 at December 31, 2002) |   | 9,284                    |   | 8,853                   |   |
| Inventory                                                                                                                                          |   | 4,492                    |   | 6,797                   |   |
| Income tax receivable                                                                                                                              |   | 201                      |   | 6,236                   |   |
| Deferred tax assets                                                                                                                                |   | 4,436                    |   | 3,856                   |   |
| Prepaid expenses                                                                                                                                   |   | 913                      |   | 1,137                   |   |
|                                                                                                                                               |   |                     |   |                    |   |
| Total current assets                                                                                                                               |   | 69,198                   |   | 68,667                  |   |
|                                                                                                                                               |   |                     |   |                    |   |
| Equipment and furniture, net                                                                                                                       |   | 2,463                    |   | 3,404                   |   |
| Deferred tax assets                                                                                                                                |   | 9,341                    |   | 9,341                   |   |
| Intangible assets, net                                                                                                                             |   | 6,263                    |   | 7,412                   |   |
| Other assets                                                                                                                                       |   | 1,002                    |   | 1,511                   |   |
|                                                                                                                                               |   |                     |   |                    |   |
| Total assets                                                                                                                                       |   | $                        | 88,267 |                    | $      | 90,335 |   |
|                                                                                                                                               |   |                     |   |                    |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                     |   |                     |   |                    |   |
| Current liabilities:                                                                                                                               |   |                     |   |                    |   |
| Accounts payable                                                                                                                                   |   | $                        | 4,034  |                    | $      | 5,715 |   |
| Accrued expenses                                                                                                                                   |   | 6,127                    |   | 5,104                   |   |
| Accrued compensation and commissions                                                                                                               |   | 2,027                    |   | 2,141                   |   |
| Accrued warranty costs                                                                                                                             |   | 1,095                    |   | 1,060                   |   |
| Customer deposits                                                                                                                                  |   | 866                      |   | 883                     |   |
| Net liabilities related to discontinued operations                                                                                                 |   | 59                       |   | 125                     |   |
|                                                                                                                                               |   |                     |   |                    |   |
| Total current liabilities                                                                                                                          |   | 14,208                   |   | 15,028                  |   |
|                                                                                                                                               |   |                     |   |                    |   |
| Deferred rent                                                                                                                                      |   | 159                      |   | 209                     |   |
|                                                                                                                                               |   |                     |   |                    |   |
| Total liabilities                                                                                                                                  |   | 14,367                   |   | 15,237                  |   |
|                                                                                                                                               |   |                     |   |                    |   |
| Commitments and contingencies (Note 8)                                                                                                             |   |                     |   |                    |   |
|                                                                                                                                               |   |                     |   |                    |   |
| Stockholders’ equity:                                                                                                                         |   |                     |   |                    |   |
| Preferred stock, $1.00 par value; authorized 100,000 shares; issued  and outstanding, none                                                         |   | —                   |   | —                  |   |
| Common stock, $0.01 par value; authorized 40,000,000 shares; issued  12,593,212 at September 30, 2003 and 12,532,810 at December 31, 2002          |   | 126                      |   | 125                     |   |
| Additional paid-in capital                                                                                                                         |   | 64,399                   |   | 64,170                  |   |
| Accumulated other comprehensive loss                                                                                                               |   | (26                      | )      | (64                     | )      |
| Notes receivable — officers                                                                                                                   |   | (11,741                  | )      | (11,760                 | )      |
| Retained earnings                                                                                                                                  |   | 24,939                   |   | 26,387                  |   |
| Treasury stock, 260,386 shares at September 30, 2003 and 255,384  shares at December 31, 2002, at cost                                             |   | (3,797                   | )      | (3,760                  | )      |
|                                                                                                                                               |   |                     |   |                    |   |
| Total stockholders’ equity                                                                                                                    |   | 73,900                   |   | 75,098                  |   |
|                                                                                                                                               |   |                     |   |                    |   |
| Total liabilities and stockholders’ equity                                                                                                    |   | $                        | 88,267 |                    | $      | 90,335 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

1

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

 
|                                                           |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|----------------------------------------------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                                                           |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
| Revenue                                                        |   | $                                      | 19,446 |                                  | $      | 18,510 |   | $ | 52,370 |   | $ | 55,730 |   |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Costs and expenses:                                            |   |                                   |   |                                  |   |   |   |   |   |
| Cost of product sold                                           |   | 6,680                                  |   | 8,223                                 |   | 19,280 |   | 25,753 |   |
| Research and development                                       |   | 4,455                                  |   | 4,576                                 |   | 13,868 |   | 15,703 |   |
| Selling, general and administrative                            |   | 7,503                                  |   | 6,937                                 |   | 22,337 |   | 21,952 |   |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Total costs and expenses                                       |   | 18,638                                 |   | 19,736                                |   | 55,485 |   | 63,408 |   |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Operating income (loss)                                        |   | 808                                    |   | (1,226                                | )      | (3,115 | ) | (7,678 | ) |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Other income (expense), net:                                   |   |                                   |   |                                  |   |   |   |   |   |
| Gain on sale of investment                                     |   | 499                                    |   | —                                |   | 499 |   | — |   |
| Interest income, net and other                                 |   | 172                                    |   | 175                                   |   | 617 |   | 765 |   |
| Total other income (expense), net                              |   | 671                                    |   | 175                                   |   | 1,116 |   | 765 |   |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Income (loss) before income taxes                              |   | 1,479                                  |   | (1,051                                | )      | (1,999 | ) | (6,913 | ) |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Income tax provision (benefit)                                 |   | 562                                    |   | (422                                  | )      | (551 | ) | (2,884 | ) |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Income (loss) from continuing operations                       |   | 917                                    |   | (629                                  | )      | (1,448 | ) | (4,029 | ) |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Gain on disposal of discontinued operations, net of income tax |   | —                                 |   | 147                                   |   | — |   | 227 |   |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Net income (loss)                                              |   | $                                      | 917    |                                  | $      | (482 | ) | $ | (1,448 | ) | $ | (3,802 | ) |
|                                                           |   |                                   |   |                                  |   |   |   |   |   |
| Income (loss) from continuing operations per common share:     |   |                                   |   |                                  |   |   |   |   |   |
| Basic                                                          |   | $                                      | 0.07   |                                  | $      | (0.05 | ) | $ | (0.12 | ) | $ | (0.33 | ) |
| Diluted                                                        |   | 0.07                                   |   | (0.05                                 | )      | (0.12 | ) | (0.33 | ) |
| Net income (loss) per common share:                            |   |                                   |   |                                  |   |   |   |   |   |
| Basic                                                          |   | $                                      | 0.07   |                                  | $      | (0.04 | ) | $ | (0.12 | ) | $ | (0.31 | ) |
| Diluted                                                        |   | 0.07                                   |   | (0.04                                 | )      | (0.12 | ) | (0.31 | ) |
| Weighted average shares outstanding:                           |   |                                   |   |                                  |   |   |   |   |   |
| Basic                                                          |   | 12,325                                 |   | 12,244                                |   | 12,298 |   | 12,220 |   |
| Diluted                                                        |   | 12,870                                 |   | 12,244                                |   | 12,298 |   | 12,220 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

2

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**BROOKTROUT, INC.UNAUDITED CONDENSED CONSOLIDATED STATEMENTSOFCOMPREHENSIVE INCOME (LOSS)***(in thousands)*

 
|                                                                              |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|-----------------------------------------------------------------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                                                                              |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
| Net income (loss)                                                                 |   | $                                      | 917    |                                  | $      | (482 | ) | $ | (1,448 | ) | $ | (3,802 | ) |
| Unrealized (losses) gains on marketable debt securities, net of  applicable taxes |   | (11                                    | )      | 8                                     |   | 38 |   | 4 |   |
| Comprehensive income (loss)                                                       |   | $                                      | 906    |                                  | $      | (474 | ) | $ | (1,410 | ) | $ | (3,798 | ) |

 

Seenotes to unaudited condensed consolidated financial statements.

 

3

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

 
|                                                                             |   | **Nine  Months Ended September 30,** |   |
|----------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                             |   | **2003**                             |   | **2002** |   |
| **Cash  flows from operating activities:**                                       |   |                                 |   |   |   |
| Net loss                                                                         |   | $                                    | (1,448 | ) | $ | (3,802 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities: |   |                                 |   |   |   |
| Loss on disposal of discontinued operations                                      |   | —                               |   | 469 |   |
| Deferred income taxes                                                            |   | —                               |   | (696 | ) |
| Depreciation and amortization                                                    |   | 2,510                                |   | 3,191 |   |
| Amortization of acquired and licensed software                                   |   | 516                                  |   | 876 |   |
| Inventory obsolescence expense                                                   |   | 599                                  |   | 3,646 |   |
| Gain on sale of investment                                                       |   | (499                                 | )      | — |   |
| Increase (decrease) in cash from changes in:                                     |   |                                 |   |   |   |
| Accounts receivable                                                              |   | (442                                 | )      | 679 |   |
| Inventory                                                                        |   | 1,706                                |   | 1,281 |   |
| Prepaid expenses and other assets                                                |   | 5,704                                |   | 1,602 |   |
| Current liabilities                                                              |   | (907                                 | )      | (2,832 | ) |
|                                                                             |   |                                 |   |   |   |
| Cash flows from operating activities                                             |   | 7,739                                |   | 4,414 |   |
|                                                                             |   |                                 |   |   |   |
| **Cash  flows from investing activities:**                                       |   |                                 |   |   |   |
| Expenditures for equipment and furniture                                         |   | (419                                 | )      | (481 | ) |
| Proceeds from the sale of an investment                                          |   | 499                                  |   | — |   |
| Sales and maturities of marketable debt securities                               |   | 7,956                                |   | 16,555 |   |
| Purchases of marketable debt securities                                          |   | (24,826                              | )      | (9,778 | ) |
|                                                                             |   |                                 |   |   |   |
| Cash flows from investing activities                                             |   | (16,790                              | )      | 6,296 |   |
|                                                                             |   |                                 |   |   |   |
| **Cash  flows from financing activities:**                                       |   |                                 |   |   |   |
| Proceeds from the sale of common stock                                           |   | 211                                  |   | 180 |   |
|                                                                             |   |                                 |   |   |   |
| Cash flows from financing activities                                             |   | 211                                  |   | 180 |   |
|                                                                             |   |                                 |   |   |   |
| (Decrease) increase in cash and cash equivalents                                 |   | (8,840                               | )      | 10,890 |   |
| Cash and cash equivalents, beginning of period                                   |   | 23,685                               |   | 22,425 |   |
|                                                                             |   |                                 |   |   |   |
| Cash and cash equivalents, end of period                                         |   | $                                    | 14,845 |   | $ | 33,315 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

4

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**BROOKTROUT, INC.**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

**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 hardware andsoftware 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. Prior to February 8, 2001, theCompany was organized and reported the results of its operations in thefollowing three business segments: Brooktrout Technology, Inc.(“Brooktrout Technology”), Brooktrout Software, Inc. (“BrooktroutSoftware”), and Interspeed, Inc. (“Interspeed”). These segments weredifferentiated based upon the products provided to the marketplace, thecustomers served, and the distribution channels utilized. Two of these segmentshave been discontinued and are classified as discontinued operations for theperiods presented in these condensed consolidated financial statements. Forfurther discussion of discontinued operations, please see the Company’s AnnualReport on Form 10-K for the year ended December 31, 2002.  Following thediscontinuance of the Brooktrout Software and Interspeed segments, theCompany’s operations consist of one reportable segment, Brooktrout Technology.Disclosures included herein pertain to the Company’s continuing operationsunless noted otherwise.

 

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

 

Accountingpolicies, methods and estimates are an integral part of the condensedconsolidated financial statements and are based upon management’s currentjudgments. These policies, methods, and estimates affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenue andexpenses during the reporting periods. The judgments made by management arebased on knowledge and experience with regard to past and current events andassumptions about future events that are believed to be reasonable under thecircumstances. The Company’s management evaluates these estimates andassumptions and adjusts them if expectations concerning events, includingfuture events, affecting them differ markedly from management’s currentjudgments.

 

***(c) Basis of Presentation and Principles ofConsolidation***

 

The accompanying unaudited condensed consolidated financial statementshave been prepared by the Company pursuant to the rules and regulations of theSecurities and Exchange Commission regarding interim financial reporting. Theseunaudited condensed consolidated financial statements should be read inconjunction with the audited consolidated financial statements included in theCompany’s Annual Report on Form 10-K for the fiscal year ended December31, 2002.

 

Theaccompanying unaudited condensed consolidated financial statements have beenprepared on the same basis as the audited consolidated financial statements andinclude all adjustments, consisting only of normal recurring adjustments,necessary for a fair presentation of the interim periods presented. Thecondensed consolidated financial statements include the accounts of the Companyand its wholly owned subsidiaries. All significant intercompany balances andtransactions have been eliminated in consolidation. The operating resultsfor the interim periods presented are not necessarily indicative of the resultsthat could be expected for the full year.

 

***(d) Revenue Recognition***

 

Revenuefrom product sales is recognized upon shipment to the customer (whichconstitutes delivery), provided that persuasive evidence of an arrangementexists, the fee is fixed or determinable, and collection is reasonably assured.To the extent that one or more of these conditions are not met, which hasoccurred from time to time, revenue is deferred until such time as all fourcriteria are met. Revenue from sales to certain distributors is recognized on a“sell-through” basis, that is, when the distributors report to the Company thatresale of the product

 

5

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**BROOKTROUT, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

to the ultimate customer ofthe distributor in question 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. The Companyrecords a provision for estimated sales returns and allowances on product salesin the same period as the related revenue is recorded. These estimates arebased on historical sales returns, analysis of credit memo data and other knownfactors.

 

***(e) Warranties***

 

TheCompany provides warranties on its products for periods of up to five years.Provisions are made at the time revenue is recognized for the cost offulfilling these commitments. Actual costs of fulfilling these warrantyobligations have been within amounts estimated and provided.  At September30, 2003 and December 31, 2002, the Company’s accrued warranty obligation was$1.1 million.

 

***(f) Concentration of Credit Risk***

 

TheCompany sells its products to various customers in the high technologyindustry. The Company generally requires no collateral. To reduce credit risk,the Company performs credit evaluations of its customers. The Company maintainsallowances for doubtful accounts for estimated losses resulting from itscustomers’ inability to make required payments. At September 30, 2003 andDecember 31, 2002, 23% of the Company’s accounts receivable were from onecustomer.  For these same periods, 10% and 13% of the Company’s accountsreceivable, respectively, were from a second customer, while 11% and 7% of theCompany’s accounts receivable, respectively, were from a third customer.

 

TheCompany has one customer that generates more than 10% of total revenue. Thiscustomer accounted for approximately 20% and 13% of revenue for the threemonths ended September 30, 2003 and 2002, respectively. For the nine monthsended September 30, 2003 and 2002, this customer accounted for approximately17% and 14% of revenue, respectively.

 

***(g) Stock-Based Compensation***

 

TheCompany uses the intrinsic value method to measure compensation expenseassociated with the grants of stock options or awards to employees. The Companyaccounts for stock options and awards to non-employees using the fair valuemethod.

 

Underthe intrinsic value method, compensation associated with stock awards toemployees is determined as the excess, if any, of the current fair value of theunderlying common stock on the date compensation is measured over the price anemployee must pay to exercise the award. The measurement date for employeeawards 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.

 

Hadthe Company used the fair value method to measure compensation related to stockawards to employees, reported income (loss) from continuing operations and lossper share would have been as follows:

 
| **(in  thousands, except per share data)**             |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|--------------------------------------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                                                   |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
|                                                   |   |                                   |   |                                  |   |   |   |   |   |
| Income (loss) from  continuing operations, as reported |   | $                                      | 917    |                                  | $      | (629 | ) | $ | (1,448 | ) | $ | (4,029 | ) |
| Stock-based compensation  recorded                     |   | —                                 |   | —                                |   | — |   | — |   |
| Pro forma stock-based  compensation, net of tax        |   | (1,232                                 | )      | (938                                  | )      | (3,431 | ) | (2,852 | ) |
|                                                   |   |                                   |   |                                  |   |   |   |   |   |
| Loss from continuing  operations, pro forma            |   | $                                      | (315   | )                                     | $      | (1,567 | ) | $ | (4,879 | ) | $ | (6,881 | ) |
|                                                   |   |                                   |   |                                  |   |   |   |   |   |   |   |   |   |
| Basic loss per common  share                           |   | $                                      | (.03   | )                                     | $      | (.13 | ) | $ | (.40 | ) | $ | (.56 | ) |
| Diluted loss per common  share                         |   | $                                      | (.03   | )                                     | $      | (.13 | ) | $ | (.40 | ) | $ | (.56 | ) |

 

6

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**BROOKTROUT, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

Forpurposes of determining the disclosures provided above, the fair value ofoptions on their grant date is measured using the Black-Scholes option-pricingmodel. Key assumptions used to apply this pricing model were as follows:

 
|                                     |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|------------------------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                                     |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
| Risk-free interest rate                  |   | 3.0                                    | %      | 4.3                                   | %      | 3.0 | % | 4.3 | % |
| Expected life of option  grants (years)  |   | 5.4                                    |   | 4.3                                   |   | 5.4 |   | 4.3 |   |
| Expected volatility of  underlying stock |   | 86                                     | %      | 65                                    | %      | 86 | % | 65 | % |

 

Theestimated weighted average fair value of option grants made during the threemonths ended September 30, 2003 and 2002 was $5.10 and $2.90, respectively, peroption.  The estimated weighted average fair value of option grants madeduring the nine months ended September 30, 2003 and 2002 was $4.89 and $2.66,respectively, per option.

 

Fromtime to time, the Company receives shares of its common stock as payment forthe exercise price of stock options.  Inthe nine months ended September 30, 2003, $0.04 million worth of common stockwas received from an employee in payment for the exercise price of thisemployee’s stock option.  These sharesof common stock were added to our treasury share balance.  The employee had held the shares tenderedfor at least six months prior to the transaction, and accordingly, nocompensation charge was required.

 

***(h) Earnings Per Share***

 

Basicearnings per common share is computed using the weighted average number ofcommon shares outstanding during each period. Diluted earnings per common shareis calculated by dividing the net income (loss) by the sum of the weightedaverage number of common shares outstanding and all additional common sharesthat would have been outstanding if potentially dilutive securities had beenissued, using the treasury method, if such shares have a dilutive effect.  For the three months ended September 30,2003, the weighted average shares used for computing diluted earnings per shareincluded 545,000 shares which represent the additional potentially dilutivecommon shares that would have been outstanding if exercised as of that dateusing the treasury method.

 

Stock options to purchase 1,559,303 shares and 3,920,627 shares wereexcluded from the computation of diluted earnings per share in the three andnine months ended September 30, 2003, respectively, because of theiranti-dilutive effect.  Stock options to purchase 3,531,200 shares wereexcluded from the computation of diluted earnings per share in both the threeand nine months ended September 30, 2002, because of their anti-dilutiveeffect.

 

***(i) Reclassifications***

 

Certainamounts in the 2002 unaudited condensed consolidated financial statements havebeen reclassified to conform to the 2003 presentation.

 

**2. Marketable Debt Securities**

 

TheCompany has classified all of its marketable debt securities asavailable-for-sale. Because these securities are available for immediate sale,they have been classified as current assets in the accompanying condensedconsolidated balance sheets.  There were no material realized orunrealized gains recognized during the three and nine months ended September30, 2003 and 2002.  As of both September 30, 2003 and December 31, 2002,the remaining maturities of debt securities ranged from one month toapproximately two years.

 

Marketabledebt securities consisted of the following:

 
|                                               |   | **Amortized  Cost** |   | **Market  Value** |   |
|----------------------------------------------------|--------|---------------------|--------|-------------------|--------|
|                                               |   | **(in  thousands)** |   |
| September  30, 2003:                               |   |                |   |              |   |
| U.S. government notes and  bonds                   |   | $                   | 17,847 |              | $      | 17,881 |   |
| Corporate debt securities  and foreign investments |   | 17,106              |   | 17,146            |   |
|                                               |   |                |   |              |   |
| Total                                              |   | $                   | 34,953 |              | $      | 35,027 |   |
|                                               |   |                |   |              |   |
| December  31, 2002:                                |   |                |   |              |   |
| U.S. government notes and  bonds                   |   | $                   | 7,520  |              | $      | 7,532 |   |
| Corporate debt securities  and foreign investments |   | 10,644              |   | 10,571            |   |
|                                               |   |                |   |              |   |
| Total                                              |   | $                   | 18,164 |              | $      | 18,103 |   |

 

7

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**BROOKTROUT, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

**3. Inventory**

 

Thecomponents of inventory, net of reserves, are as follows:

 
|            |   | **September  30,  2003** |   | **December  31,  2002** |   |
|-----------------|--------|--------------------------|--------|-------------------------|--------|
|            |   | **(in  thousands)**      |   |
| Raw materials   |   | $                        | 828    |                    | $      | 1,076 |   |
| Work in process |   | 422                      |   | 740                     |   |
| Finished goods  |   | 3,242                    |   | 4,981                   |   |
|            |   |                     |   |                    |   |
| Total           |   | $                        | 4,492  |                    | $      | 6,797 |   |

 

Thefollowing is a rollforward of reserves provided for inventory obsolescence:

 
|                              |   | **Nine  months ended September 30,** |   |
|-----------------------------------|--------|--------------------------------------|--------|
|                              |   | **2003**                             |   | **2002** |   |
|                              |   | **(in  thousands)**                  |   |
| Balance, beginning of the  period |   | $                                    | 3,909  |   | $ | 6,591 |   |
| Provisions                        |   | 599                                  |   | 3,646 |   |
| Write offs                        |   | (421                                 | )      | (609 | ) |
|                              |   |                                 |   |   |   |
| Balance, end of period            |   | $                                    | 4,087  |   | $ | 9,628 |   |

 

**4. Intangible Assets**

 

Intangibleassets consisted of the following:

 
|                            |   | **September  30,  2003** |   | **December  31,  2002** |   |
|---------------------------------|--------|--------------------------|--------|-------------------------|--------|
|                            |   | **(in  thousands)**      |   |
| Acquired technology             |   | $                        | 12,038 |                    | $      | 12,038 |   |
| Customer base                   |   | 1,264                    |   | 1,264                   |   |
| In-place workforce              |   | 972                      |   | 972                     |   |
| Trademarks                      |   | 301                      |   | 301                     |   |
|                            |   |                     |   |                    |   |
| Total intangible assets         |   | 14,575                   |   | 14,575                  |   |
| Less: accumulated  amortization |   | (8,312                   | )      | (7,163                  | )      |
|                            |   |                     |   |                    |   |
| Intangible assets, net          |   | $                        | 6,263  |                    | $      | 7,412 |   |

 

Intangibleasset amortization expense was $0.4 million for both the three months endedSeptember 30, 2003 and 2002.  Intangible asset amortization expense was$1.2 million for both the nine months ended September 30, 2003 and 2002. The Company has adopted Statement of Financial Accounting Standards (“SFAS”)No. 142, “Goodwill and Other Intangible Assets.”  Included in intangible assets are amounts allocated to in-placeworkforce, which SFAS No. 142 requires be reclassified to goodwill; such assetswere fully amortized prior to January 1, 2002, and as a result, no adjustmentsor reclassifications were recorded.  All intangibles carried on thebalance sheet are being amortized.

 

8

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**BROOKTROUT, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

**5. Valuation and Qualifying Accounts**

 

***Allowances for doubtful accounts and salesreturns:***

 

TheCompany’s allowance for doubtful accounts and sales returns was $1.2 millionand $1.8 million as of September 30, 2003 and 2002, respectively.  Thefollowing is a rollforward of allowances provided for doubtful accounts andsales returns:

 
|                                    |   | **Nine  months ended September 30,** |   |
|-----------------------------------------|--------|--------------------------------------|--------|
|                                    |   | **2003**                             |   | **2002** |   |
|                                    |   | **(in  thousands)**                  |   |
| Balance, beginning of the  period       |   | $                                    | 1,679  |   | $ | 2,074 |   |
| Provisions                              |   | (261                                 | )      | (81 | ) |
| Write offs, payments  issued, and other |   | (215                                 | )      | (223 | ) |
|                                    |   |                                 |   |   |   |
| Balance, end of period                  |   | $                                    | 1,203  |   | $ | 1,770 |   |

 

***Accrued warranty costs:***

 

The Company’s accrued warranty costs liability was $1.1 millionand $0.5 million as of September 30, 2003 and 2002, respectively. The followingis a rollforward of accrued warranty costs:

 
|                              |   | **Nine  months ended September 30,** |   |
|-----------------------------------|--------|--------------------------------------|--------|
|                              |   | **2003**                             |   | **2002** |   |
|                              |   | **(in  thousands)**                  |   |
| Balance, beginning of the  period |   | $                                    | 1,060  |   | $ | 789 |   |
| Provisions for claims             |   | 134                                  |   | (113 | ) |
| Claims incurred                   |   | (99                                  | )      | (207 | ) |
|                              |   |                                 |   |   |   |
| Balance, end of period            |   | $                                    | 1,095  |   | $ | 469 |   |

 

**6. Gainon Sale of Investment**

 

On July 21, 2003, the Company completed the sale of approximately135,000 shares of Network Engines, Inc. (“NEI”) common stock at prices rangingfrom $3.70 to $3.75 per share (net of commissions).  The Company had acquired these shares in early July 2003 throughthe exercise of a warrant with NEI at a price of $0.0733 per share.  The one-time gain on the sale of thisinvestment was $0.5 million and the net proceeds are being invested inaccordance with the Company’s cash management guidelines.

 

**7. Product Sales Information**

 

Brooktrout’sproducts are sold for applications in the New Network and for applications inToday’s Network. Today’s Network involves core technologies and platforms thatare primarily used in business premise products such as fax, LAN fax, and voicemail. The New Network applications expand the capabilities of communicationsnetworks to allow data, voice and fax information to be distributed usingpacket-based data networks, such as the Internet, for portions of the transmissionand also allow information to be distributed using the traditionalcircuit-switched telephone network. For the three months ended September 30,2003, sales of products for use in the New Network accounted for approximately35% of total revenue as compared to approximately 38% of total revenue for thethree months ended September 30, 2002. For both the nine months endedSeptember 30, 2003 and 2002, sales of products for use in the New Networkaccounted for approximately 36% of total revenue.  Other than the revenuedata described above, the Company does not maintain separate financialinformation related to its New Network and Today’s Network products.

 

9

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**BROOKTROUT, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)**

 

**8. Commitments and Contingencies**

 

Fromtime to time, the Company is a party to legal and other actions, which mayinclude allegations of patent infringement made against us and/or ourcustomers, that arise in the normal course of business. The Company, takinginto account advice of counsel, does not currently believe the eventual outcomeof any such pending or potential matters, including matters in which we have anobligation on behalf of our customers, will have a material effect on theCompany’s consolidated financial condition or results of operations.

 

**9. Subsequent Events**

 

OnOctober 16, 2003, the Company announced that its Board of Directors hadauthorized the repurchase of up to 1,000,000 shares of the Company’s commonstock from time to time on the open market or in privately negotiatedtransactions.  Under the program, sharesmay be repurchased prior to October 15, 2004 and in such amounts as marketconditions warrant, and subject to regulatory and other considerations.  The Company plans to use the repurchasedshares for general corporate purposes including the Company’s stock optionplans, employee stock purchase plan and other stock benefit plans.  As of October 31, 2003, the Company has notrepurchased any shares under the plan.

 

10

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

 

*The following discussion should be read in conjunction withthe condensed consolidated financial statements and related notes appearingelsewhere in this quarterly report and in our Annual Report on Form 10-K forthe year ended December 31, 2002. The discussion contains forward-lookingstatements that involve known and unknown risks and uncertainties, includingthose set forth below under “Factors That May Affect Future Results.”*

 

**Overview**

 

Wedevelop hardware and software platforms that original equipment manufacturers,or OEMs, developers and corporate information technology managers build intotheir communications systems. Customers incorporate our products intoapplications, systems and services that allow voice, fax and data to bedistributed over both Internet protocol, or IP, packet-based networks, which werefer to as the New Network, and the traditional circuit-based telephonenetwork. We supply products for media processing, network interface, callcontrol and signal processing, including protocols that allow Internet andtraditional telephony systems to communicate.

 

Wemeasure our operating success using both financial and market metrics. Thefinancial metrics include revenue, gross margin, operating expenses, and incomefrom continuing operations, as well as working capital and cash provided byoperating activities. Other key metrics include the total number of enterpriseand service provider customers, customers whose purchases exceed $100,000, andthe portion of our revenue that is generated by the sales of products forapplications in the New Network. Our long-term business model stresses ourcommitment to establishing and maintaining close customer relationships and tocontinuing to develop innovative products.

 

Themost significant trend that has impacted our business has been the unfavorableeconomic conditions affecting the communications sector. This had resulted in adecrease in our revenue in the first two quarters of 2003 and for the fiscalyears 2002 and 2001, compared to prior periods. Sales of products, particularlyfor applications in the New Network, to OEMs for use by large serviceproviders had declined most significantly. In response to the revenuedecreases, we implemented expense control programs to reduce operatingexpenses, while at the same time, we have continued to invest in developingproducts that we believe our customers will need when the economyimproves.  While the third quarter of2003 revenue exceeded third quarter of 2002 revenue, and while we expectrevenue in the fourth quarter of 2003 to exceed the revenue in the fourthquarter of 2002, we believe it is too early to determine whether this will besustainable.

 

Despitethese uncertain economic conditions, we have been able to increase our cash andmarketable debt securities balances to $49.9 million at September 30, 2003 from$26.0 million at December 31, 2000. This was accomplished primarilythrough income tax refunds, operating expense reductions, inventory reductions,and the sale of a business segment.  If current economic conditionscontinue for an extended period of time or worsen, we may experience adverseeffects on our business, operating results, and cash and marketable debtsecurities balances.

 

**Applicationof Critical Accounting Policies**

 

Management’sdiscussion and analysis of financial condition and results of operations isbased upon our condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America applicable to interim financial information. We makeestimates and assumptions in the preparation of the condensed consolidatedfinancial statements that affect the reported amounts of assets andliabilities, revenue and expenses, and the related disclosures of contingentassets and liabilities. These estimates form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. We base our estimates and judgments on historicalexperience and on various other assumptions that we believe are reasonableunder the circumstances. However, actual results may differ from theseestimates under different assumptions or conditions.

 

Thefollowing critical accounting policies require the use of significant judgmentand estimates in the preparation of the condensed consolidated financialstatements. This listing is not a comprehensive list of all of our

 

11

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significant accountingpolicies. For further information regarding the application of these and otheraccounting policies, see Note 1 to the condensed consolidated financialstatements in Part I, Item 1 of this report.

 

RevenueRecognition

 

Revenuefrom product sales is recognized upon shipment to the customer (whichconstitutes delivery), provided that persuasive evidence of an arrangementexists, the fee is fixed or determinable, and collection is reasonably assured.In determining when to recognize revenue we often are required to exercisejudgment. To the extent that one or more of these criteria are not met, whichhas occurred from time to time, revenue is deferred until such time as all fourconditions are satisfied. We record a provision for estimated sales returns andallowances on product sales in the same period as the related revenue isrecorded. These estimates are based on historical sales returns, analysis ofcredit memo data and other known factors. Actual results could differ fromthese estimates and could therefore impact our results of operations and cashflows.

 

Allowancesfor Doubtful Accounts

 

Accountsreceivable are reduced by an allowance for amounts that may becomeuncollectible in the future. The estimated allowance for doubtful accounts isbased primarily on a specific analysis of accounts in the receivable portfolioand a general reserve based on the aging of receivables. While managementbelieves the allowance to be adequate, if the financial condition of ourcustomers were to deteriorate, resulting in impairment of their ability to makepayments, additional allowances may be required and could materially impact ourfinancial position and results of operations.

 

InventoryAllowances

 

We evaluate our inventories for estimated excess quantities andobsolescence. This evaluation includes analyses of sales levels by product andprojections of anticipated future demand. In addition, we assessthe impact of changing technology on our inventory-on-hand. We provide reservesfor inventories that are considered excess or obsolete. If future demand ormarket conditions are less favorable than our projections, additional inventoryreserves may be required and would be reflected in cost of sales in the periodin which the revision is made. If future demand or market conditions are morefavorable and products for which reserves have been provided become moremarketable and are sold, our gross margin could improve.  These actions could impact both our resultsof operations and our cash flows.

 

IntangibleAssets

 

Wereview our intangible assets for impairment periodically and whenever events orchanges in circumstances indicate that the carrying value may not berecoverable. The evaluation of the recoverability of our intangible assetsincludes assumptions regarding estimated future undiscounted cash flowsassociated with these assets and other factors. If these estimates or assumptionschange in the future, we may be required to record impairment charges for theseassets. Such an impairment charge would impact the results of operations, butwould not directly impact our cash flows.  All of our remaining netintangible assets are being amortized, with original useful lives ofapproximately five to ten years.

 

DeferredTax Assets

 

Weassess the carrying value of our deferred tax assets to determine if it is morelikely than not that we will be able to generate sufficient future taxableincome in certain tax jurisdictions in order to realize these assets. Whennecessary, we have reduced the deferred tax asset to its estimated realizablevalue by recording a valuation allowance. This assessment requires us to makeestimates and assumptions about our future profitability. In determining thecarrying value of the deferred tax assets as of September 30, 2003, we areassuming profitability in the future and that it is more likely than not thatwe will be able to realize these assets. This assumption is based in part uponour history of profitability and our profitability in the three months endedSeptember 30, 2003. If current economic conditions deteriorate or futureresults of operations are less than expected, future assessments may result ina determination that all or a portion of the remaining deferred tax assets arenot realizable. As a result, we may

 

12

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need to establish additionalvaluation allowances for all or a portion of the deferred tax assets, which mayhave a material adverse effect on our results of operations.

 

AccruedWarranty Costs

 

Weaccrue for warranty costs based on historical trends in product return ratesand the expected material and labor costs to provide warranty services. If wewere to experience an increase in warranty claims compared with our historicalexperience, or if costs of servicing warranty claims were greater than theexpectation on which the accrual had been based, our gross margins could beadversely affected.

 

**DiscontinuedOperations**

 

Priorto February 8, 2001, we were organized and reported the results of ouroperations in three operating segments, Brooktrout Technology, BrooktroutSoftware, and Interspeed. On February 8, 2001, our board of directors adoptedformal plans to discontinue our Brooktrout Software and Interspeed segments. Wehave accounted for these businesses as discontinued operations.  Thesebusinesses were substantially disposed of prior to December 31, 2001, andadjustments recorded in 2002 primarily reflect additional proceeds and changesin estimates to the amounts recorded related to gains or losses ondisposal.  There are no operating activities related to discontinuedoperations included in our condensed consolidated financial statements ineither 2002 or 2003.

 

13

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**Results ofOperations**

 

Thefollowing discussion focuses on our results from continuing operations for thethree and nine months ended September 30, 2003 and 2002. The table below setsforth certain condensed consolidated statements of operations data as apercentage of total revenue for the periods presented.

 
|                                      |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|-------------------------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                                      |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
| Domestic revenue                          |   | 81                                     | %      | 74                                    | %      | 78 | % | 78 | % |
| International revenue                     |   | 19                                     |   | 26                                    |   | 22 |   | 22 |   |
| Total revenue                             |   | 100                                    |   | 100                                   |   | 100 |   | 100 |   |
| Cost of product sold                      |   | 34                                     |   | 44                                    |   | 37 |   | 46 |   |
| Gross margin                              |   | 66                                     |   | 56                                    |   | 63 |   | 54 |   |
| Operating expenses:                       |   |                                   |   |                                  |   |   |   |   |   |
| Research and development                  |   | 23                                     |   | 25                                    |   | 26 |   | 28 |   |
| Selling, general and  administrative      |   | 39                                     |   | 38                                    |   | 43 |   | 40 |   |
| Total operating expenses                  |   | 62                                     |   | 63                                    |   | 69 |   | 68 |   |
| Operating income (loss)                   |   | 4                                      |   | (7                                    | )      | (6 | ) | (14 | ) |
| Other income (expense),  net              |   | 4                                      |   | 1                                     |   | 2 |   | 2 |   |
| Income (loss) before  income taxes        |   | 8                                      |   | (6                                    | )      | (4 | ) | (12 | ) |
| Income tax provision  (benefit)           |   | 3                                      |   | (3                                    | )      | (1 | ) | (5 | ) |
| Income (loss) from  continuing operations |   | 5                                      | %      | (3                                    | )%     | (3 | )% | (7 | )% |

 

***Revenue***

 

*Three Months Ended September 30, 2003 and 2002*

 

Thefollowing table presents our domestic and international revenue:

 
|                                       |   | **Three  Months Ended September 30,** |   |
|--------------------------------------------|--------|---------------------------------------|--------|
|                                       |   | **2003**                              |   | **2002** |   |
|                                       |   | **(dollars  in thousands)**           |   |
| Domestic revenue                           |   | $                                     | 15,768 |   | 81 | % | $ | 13,783 |   | 74 | % |
| International revenue,  principally export |   | 3,678                                 |   | 19 |   | 4,727 |   | 26 |   |
|                                       |   |                                  |   |   |   |   |   |   |   |
| Total revenue                              |   | $                                     | 19,446 |   | 100 | % | $ | 18,510 |   | 100 | % |

 

Revenuefor the three months ended September 30, 2003 increased by $0.9 millioncompared to the three months ended September 30, 2002.  Sales to domesticOEMs and enterprise customers increased by 15%.  We believe that this increased demand is the result ofstrengthening economic conditions in the communications marketplace during thethird quarter of 2003.   International revenue for the three months endedSeptember 30, 2003 was similar to the revenue generated in previous quarters of2003.  In comparison to the three monthsended September 30, 2002, international revenue decreased by $0.1 million dueto favorable foreign exchange rates and decreased by approximately $1.1 milliondue to a reduction in sales volume.  Thelarger than usual revenue total during the third quarter of 2002 was due toseveral customers purchasing product for significant one-time projects.

 

Ourproducts are sold for applications in the New Network and for applications inToday’s Network. Today’s Network involves core technologies and platforms thatare primarily used in business premise products such as fax, LAN fax, and voicemail. The New Network applications expand the capabilities of communicationsnetworks to allow data, voice and fax information to be distributed using packet-baseddata networks, such as the Internet, for portions of the transmission and alsoallow information to be distributed using the traditional circuit-switchedtelephone network.  Revenue from sales of products for applications in theNew Network for the three months ended

 

14

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September 30, 2003 decreasedby $0.1 million compared to the three months ended September 30, 2002. This revenue decrease was attributable to weakness in both the serviceprovider and enterprise segments.  New Network revenue was approximately35% of total revenue for the three months ended September 30, 2003, as comparedto 38% of total revenue in the three months ended September 30, 2002.

 

*Nine Months Ended September 30, 2003 and 2002*

 

Thefollowing table presents our domestic and international revenue:

 
|                                       |   | **Nine  Months Ended September 30,** |   |
|--------------------------------------------|--------|--------------------------------------|--------|
|                                       |   | **2003**                             |   | **2002** |   |
|                                       |   | **(dollars  in thousands)**          |   |
| Domestic revenue                           |   | $                                    | 40,911 |   | 78 | % | $ | 43,450 |   | 78 | % |
| International revenue,  principally export |   | 11,459                               |   | 22 |   | 12,280 |   | 22 |   |
|                                       |   |                                 |   |   |   |   |   |   |   |
| Total revenue                              |   | $                                    | 52,370 |   | 100 | % | $ | 55,730 |   | 100 | % |

 

Revenuefor the nine months ended September 30, 2003 decreased by $3.4 million comparedto the nine months ended September 30, 2002.  Year to date sales todomestic OEMs and enterprise customers decreased primarily due to the economicconditions in the communications marketplace, as well as world events thataffected product demand in the first three months of 2003.  For the ninemonths ended September 30, 2003, international revenue declined by $1.3 millionas sales to Pacific Rim and European customers were less than the correspondingperiod of 2002. This revenue decline was partially offset by favorable foreigncurrency exchange rates that increased revenue in 2003 by approximately $0.5million.

 

Asdiscussed above, our products are sold for applications in the New Network andfor applications in Today’s Network. Revenue from sales of products forapplications in the New Network for the nine months ended September 30, 2003decreased by $1.1 million compared to the nine months ended September 30,2002.  This revenue decrease was attributable to weakness in serviceprovider segment offset by relative strength in the enterprise segment. New Network revenue was at approximately 36% of total revenue for both the ninemonths ended September 30, 2003 and September 30, 2002.

 

***Cost of Product Sold and Gross Margin***

 

*Three Months Ended September 30, 2003 and 2002*

 

Thefollowing table presents cost of product sold and gross margin information:

 
|                 |   | **Three  Months Ended September 30,** |   |
|----------------------|--------|---------------------------------------|--------|
|                 |   | **2003**                              |   | **2002** |   |
|                 |   | **(dollars  in thousands)**           |   |
| Cost of product sold |   | $                                     | 6,680  |   | $ | 8,223 |   |
| Gross profit         |   | $                                     | 12,766 |   | $ | 10,287 |   |
| Gross margin         |   | 66                                    | %      | 56 | % |

 

Thedecrease in cost of product sold in the three months ended September 30, 2003compared to the corresponding period in 2002 was primarily the result of directmaterial cost reductions achieved from using new manufacturing subcontractorsand due to reduced inventory obsolescence expense.  Obsolescence expensedecreased by $1.7 million, primarily due to reduced levels of excess inventoryof service provider product in the three months ended September 30, 2003. Thesefactors, along with a shift in product mix to higher margin products,contributed to a significant improvement in gross margin percentages in thethird quarter of 2003 compared to the third quarter of 2002.

 

15

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*Nine Months Ended September 30, 2003 and 2002*

 

Thefollowing table presents cost of product sold and gross margin information:

 
|                 |   | **Nine  Months Ended September 30,** |   |
|----------------------|--------|--------------------------------------|--------|
|                 |   | **2003**                             |   | **2002** |   |
|                 |   | **(dollars  in thousands)**          |   |
| Cost of product sold |   | $                                    | 19,280 |   | $ | 25,753 |   |
| Gross profit         |   | $                                    | 33,090 |   | $ | 29,977 |   |
| Gross margin         |   | 63                                   | %      | 54 | % |

 

Thedecrease in cost of product sold in the nine months ended September 30, 2003compared to the corresponding period in 2002 was primarily the result of directmaterial cost reductions achieved from using new manufacturing subcontractors,combined with decreased product sales.  In addition, inventoryobsolescence expense decreased by $3.0 million, primarily due to reduced levelsof excess inventory of service provider product in the nine months endedSeptember 30, 2003. These factors, along with a shift in product mix to highermargin products, contributed to a significant improvement in gross marginpercentages in the nine months ended September 30, 2003 compared to the ninemonths ended September 30, 2002.

 

***Operating Expenses***

 

*Three Months Ended September 30, 2003 and 2002*

 

Thefollowing table presents our operating expenses:

 
|                                 |   | **Three  Months Ended  September 30,** |   |
|--------------------------------------|--------|----------------------------------------|--------|
|                                 |   | **2003**                               |   | **2002** |   |
|                                 |   | **(in  thousands)**                    |   |
| Research and development             |   | $                                      | 4,455  |   | $ | 4,576 |   |
| Selling, general and  administrative |   | 7,503                                  |   | 6,937 |   |
|                                 |   |                                   |   |   |   |
| Total operating expenses             |   | $                                      | 11,958 |   | $ | 11,513 |   |

 

Researchand development expense

 

Researchand development expense represented 23% of total revenue in the three monthsended September 30, 2003, compared with 25% of total revenue in thecorresponding period in 2002. The $0.1 million decrease in 2003 was primarilythe result of reduced consulting and contract labor expenses, decreaseddepreciation expense, and decreased spending on new product prototypes, offsetby a slight increase in equipment and maintenance costs.  Our continuingdevelopment efforts are focused on hardware and software for media processingproducts (voice, fax and data), network interface products, call controlproducts and signal processing products.

 

Selling,general and administrative expense

 

Selling,general and administrative expense represented 39% of total revenue for thethree months ended September 30, 2003 compared with 38% of total revenue in thecorresponding period of 2002.  The $0.6million increase was primarily due to increases in expenses associated with thePartner Access Network Program, a marketing program providing financialassistance for the porting of approved applications, access to lab facilitiesworldwide, sales leads, technical training and support, and co-op fundedmarketing support.

 

*Nine Months Ended September 30, 2003 and 2002*

 

Thefollowing table presents our operating expenses:

 
|                                 |   | **Nine  Months Ended  September 30,** |   |
|--------------------------------------|--------|---------------------------------------|--------|
|                                 |   | **2003**                              |   | **2002** |   |
|                                 |   | **(in  thousands)**                   |   |
| Research and development             |   | $                                     | 13,868 |   | $ | 15,703 |   |
| Selling, general and  administrative |   | 22,337                                |   | 21,952 |   |
|                                 |   |                                  |   |   |   |
| Total operating expenses             |   | $                                     | 36,205 |   | $ | 37,655 |   |

 

16

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Researchand development expense

 

Researchand development expense represented 26% of total revenue in the nine monthsended September 30, 2003, compared with 28% of total revenue in thecorresponding period in 2002. The $1.8 million decrease in 2003 was primarilythe result of reduced consulting and contract labor expenses, decreasedspending on new product prototypes and decreased depreciation expense. Ourcontinuing development efforts are focused on hardware and software for mediaprocessing products (voice, fax and data), network interface products, callcontrol products and signal processing products.

 

Selling,general and administrative expense

 

Selling,general and administrative expense represented 43% of total revenue for thethree months ended September 30, 2003 compared with 40% of total revenue in thecorresponding period of 2002.  The $0.4million increase in selling, general and administrative expense from the ninemonths ended September 30, 2002 to the corresponding period of 2003 wasprimarily due to increases in professional fees and marketing expensesassociated with the Partner Access Network Program, and increases in employeehealth insurance premiums.  Theseexpense increases were partially offset by decreased depreciation expense andreduced spending for variable incentive compensation.

 

***Other income (expense), net***

 

*Three and Nine Months Ended September 30, 2003 and 2002*

 

Theincrease in other income (expense), net, to $0.7 million in the three monthsended September 30, 2003 from $0.2 million in the corresponding three monthperiod in 2002, and to $1.1 million in the nine months ended September 30, 2003from $0.8 million in the corresponding nine month period in 2002 was the resultof a $0.5 million one-time gain on sale of investment in July 2003 resultingfrom the sale of securities acquired from the exercise of stock purchasewarrants, offset by a decline in short-term interest rates.

 

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

 

*Three and Nine Months Ended September 30, 2003 and 2002*

 

Thefollowing table presents our income tax provision (benefit) and effective taxrate for the three months ended September 30, 2003 and 2002:

 
|                            |   | **Three  Months Ended  September 30,** |   |
|---------------------------------|--------|----------------------------------------|--------|
|                            |   | **2003**                               |   | **2002** |   |
|                            |   | **(dollars  in thousands)**            |   |
| Income tax provision  (benefit) |   | $                                      | 562    |   | $ | (422 | ) |
| Effective tax rate              |   | 38                                     | %      | (40 | )% |
|                                 |        |                                        |        |  |  |  |  |

 

Thefollowing table presents our income tax benefit and effective tax rate for thenine months ended September 30, 2003 and 2002:

 
|               |   | **Nine  Months Ended  September 30,** |   |
|--------------------|--------|---------------------------------------|--------|
|               |   | **2003**                              |   | **2002** |   |
|               |   | **(dollars  in thousands)**           |   |
| Income tax benefit |   | $                                     | (551   | ) | $ | (2,884 | ) |
| Effective tax rate |   | (28                                   | )%     | (42 | )% |
|                    |        |                                       |        |  |  |  |  |

 

The Company has recorded anincome tax provision in the three months ended September 30, 2003, versus anincome tax benefit in the nine months ended September 30, 2003, as a result ofearning a pre-tax profit.  The reductionin the effective tax rate for the nine months ended September 30, 2003 relativeto the corresponding period

 

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in 2002, was primarily due a decrease in theloss before income taxes and also due to a limitation of, and correspondingreduction in, the research and development tax credit that we can utilize in2003.

 

**Liquidityand Capital****Resources**

 

Cashflows for the nine months ended September 30, 2003 and 2002

 

Netcash provided by operating activities was $7.7 million in the nine months endedSeptember 30, 2003. This primarily resulted from tax refunds of$6.0 million and reductions in inventory, offset by a decrease in currentliabilities.  Cash provided by operating activities was $4.4 millionin the nine months ended September 30, 2002. This primarily resulted fromincome tax refunds of $4.4 million and reductions in inventory, offset by adecrease in current liabilities.

 

Netcash used in investing activities was $16.8 million in the nine monthsended September 30, 2003. This primarily resulted from net purchases ofmarketable debt securities of $16.9 million. Net cash provided byinvesting activities was $6.3 million in the nine months ended September30, 2002. This primarily resulted from net sales of marketable debt securitiesof $6.8 million.

 

Netcash provided by financing activities was $0.2 million in both the nine monthsended September 30, 2003 and 2002, primarily attributable to proceeds from thesale of common stock under the our employee stock purchase plan.  From time to time, the Company receivesshares of its common stock as payment for the exercise price of stockoptions.  In the nine months endedSeptember 30, 2003, $0.04 million worth of common stock was received from anemployee in payment for the exercise price of this employee's stock option.  These shares of common stock were added toour treasury share balance.  Theemployee had held the shares tendered for at least six months prior to thetransaction, and accordingly, no compensation charge was required.

 

ContractualObligations and Capital Expenditures

 

Thefollowing table presents our future contractual obligations and commercialcommitments as of September 30, 2003:

 
|             |   | **Total**           |   | **Remainder  of 2003** |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **Thereafter** |   |
|------------------|--------|---------------------|--------|------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|
|             |   | **(in  thousands)** |   |
| Operating leases |   | $                   | 7,273  |                   | $      | 740      |   | $        | 3,006  |     | $      | 2,062    |   | $              | 786    |   | $ | 211 |   | $ | 468 |   |
|                  |        |                     |        |                        |        |          |        |          |        |          |        |          |        |                |        |  |  |  |  |  |  |  |

 

Wehave operating lease commitments for our primary office and manufacturingfacilities that expire between 2004 and 2006. In addition, we lease officespace for sales and support functions that expire beyond 2006. Certain leaseagreements require us to pay all of the building’s taxes, insurance andmaintenance costs.

 

Wepurchased $0.4 million and $0.5 million of capital equipment in the nine monthsended September 30, 2003 and September 30, 2002, respectively.  We currently have no material commitmentsfor additional capital expenditures. We have certain inventory purchasecommitments that are part of our ordinary course of business in which theproduct delivery dates range from one month to three months into thefuture.  We do not expect these short term commitments to have a materialadverse impact on our financial results.

 

Wehad no long-term debt as of September 30, 2003 or November 7, 2003.

 

Cashand Cash Liquidity Position

 

Thefollowing table presents our cash and liquidity position as of September 30,2003 and December 31, 2002:

 
|                              |   | **September  30,  2003**    |   | **December  31,  2002** |   |
|-----------------------------------|--------|-----------------------------|--------|-------------------------|--------|
|                              |   | **(dollars  in thousands)** |   |
| Cash and cash equivalents         |   | $                           | 14,845 |                    | $      | 23,685 |   |
| Marketable debt securities        |   | 35,027                      |   | 18,103                  |   |
| Total                             |   | $                           | 49,872 |                    | $      | 41,788 |   |
|                              |   |                        |   |                    |   |
| Working capital                   |   | $                           | 54,990 |                    | $      | 53,639 |   |
| Quick ratio                       |   | 4.16                        |   | 3.37                    |   |
| Maximum available line of  credit |   | $                           | 5,000  |                    | $      | 5,000 |   |

 

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Cash,cash equivalents and marketable debt securities increased to $49.9 millionas of September 30, 2003 from $41.8 million as of December 31, 2002,primarily due to a $6.0 million tax refund and a net cash inflow from otheroperating activities of $2.2 million in the first nine months of2003. Working capital increased by $1.4 million from December 31,2002 to September 30, 2003. This increase was the result of a reduction inaccounts payable balances along with a $0.5 million increase in total currentassets.  Our quick ratio improved from3.37 at December 31, 2002 to 4.16 at September 30, 2003, due primarily to a 19%increase in cash, cash equivalents, and marketable debt securities whilecurrent liabilities decreased modestly.

 

Wehave a $5.0 million working capital line of credit available from acommercial bank. Any borrowings would bear interest at the lender’s prime rate.The line of credit is secured by a pledge of substantially all of our assets.Availability of funds under this line of credit is subject to compliance withcertain financial covenants relating to its quick ratio, minimum tangible networth, and other standard reporting requirements. As of September 30, 2003,letters of credit issued against the existing line totaled $1.0 million,representing the collateral required for certain lease obligations. Other thanthe issuance of letters of credit and using the credit line to secureimmaterial foreign currency forward contracts, there have been no borrowingsunder the line during the past three years. The line of credit expires on July29, 2005.

 

InOctober 2003, the we announced that our Board of Directors had authorized therepurchase of up to 1,000,000 shares of the our common stock from time to timeon the open market or in privately negotiated transactions.  This program will be funded by our existingand future cash and marketable debt securities balances.  As of October 31, 2003, we have notrepurchased any shares under the plan.

 

Webelieve that our cash and cash equivalents and marketable debt securities arelikely to meet our needs for the foreseeable future.  Though we do notexpect to make any major capital expenditures in 2003, we are always lookingfor opportunities to expand the business, which could include acquisitions ororganic expansion into new markets.  If we find that our cash and cashequivalents, marketable debt securities and funds available from our bank lineof credit are not sufficient, we may choose to utilize or to seek other sourcesof financing. If we were to seek future equity financings, the terms may bedilutive to our stockholders and may contain restrictive covenants, which couldlimit our ability to pursue certain courses of action. It is possible that,should the need arise, we will not be able to obtain additional financing, orthat the financing made available to us will not be on acceptable terms.

 

Thepricing of our products and the costs of our goods can be significantlyaffected by current market conditions. Market conditions can be impacted byinflation; however, we believe that inflation has not had a significant effecton our operations to date.

 

**RecentAccounting****Pronouncements**

 

Wehave adopted Statement of Financial Accounting Standards (“SFAS”) No. 146,“Accounting for Costs Associated with Exit or Disposal Activities.”  Thispronouncement is effective for exit or disposal activities that are initiatedafter December 31, 2002, and requires these costs to be recognized whenthe liability is incurred and not at project initiation. The adoption of SFASNo. 146 has not had an impact on our operations or financial positionsince there have been no exit or disposal activities in the periods presented.

 

InJanuary 2003, the Emerging Issues Task Force (“EITF”) issued EITF 00-21,“Accounting for Revenue Arrangements with Multiple Deliverables”. EITF 00-21addresses the issues of how to determine whether an arrangement involvingmultiple deliverables contains more than one unit of accounting and howarrangement consideration should be measured and allocated to the separateunits of accounting in the arrangement. EITF 00-21 does not change otherwise applicablerevenue recognition criteria. EITF 00-21 is effective for revenue arrangementsentered into in fiscal periods beginning after June 15, 2003. The adoption ofEITF 00-21 has not had a material impact on the Company’s operations orfinancial position.

 

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** **

**FactorsThat May Affect Future Results**

 

Therisks and uncertainties described below are those that we currently believe maymaterially affect us.  The trading price of our common stock could declinedue to any of these factors.  You should also refer to the otherinformation in this report, including the condensed consolidated financialstatements and related notes, and information included in our Annual Report onForm 10-K for the year ended December 31, 2002.  Additional risks anduncertainties that we are unaware of, or that we currently deem immaterial,also may become important factors that affect us.

 

**Risks Related to Our Business**

 

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

 

Asa result of the uncertain economic conditions affecting most technology sectorsand the telecommunications sector in particular, many of our customers areseeking aggressively to increase efficiency in their supply chains and reducetheir inventory levels. Additionally, the slowdown in the telecommunicationsindustry and the resulting decrease in spending by companies in our targetmarkets have reduced the rate of growth of data traffic and the use of theInternet, which are driving the convergence of data and telephony that weexpect will give rise to demand for New Network applications. The economicdownturn has adversely affected our business and operating results, including areduction in revenue of $3.4 million for the nine months ended September 30,2003, or 6%, compared to the nine months ended September 30, 2002, and $9.8million, or 16%, compared to the nine months ended September 30, 2001. Ifcurrent economic conditions continue for an extended period of time or worsen,we may experience additional adverse effects on our revenue, net income andcash flow. For example, if the rate at which our customers order productdecreases, it becomes more likely that our current inventories would be exposedto technological obsolescence, which would require us to reduce the value ofthose inventories on our balance sheet.

 

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

 

Themarket for telecommunications equipment is highly competitive. If we are unableto differentiate our products from existing and future offerings of ourcompetitors, and thereby effectively compete in the market for telecommunicationsequipment, our operating results could be materially adversely affected. Manyof our current and potential competitors have significantly greater selling andmarketing, technical, manufacturing, financial, and other resources. We expectour current competitors to continue to improve the design and performance oftheir existing products and to introduce new products and enhancements withimproved price and performance characteristics. Our product sales may bethreatened by new technologies, products or market trends, and we may have toreduce the prices of our products to stay competitive. 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.

 

Capitalizingon our technology will require a continued high level of investment in researchand development, marketing, and customer service and support. We may be unable,or otherwise fail, to allocate sufficient resources to achieve thetechnological advances necessary to compete successfully with existingcompetitors or new entrants.

 

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

 

Manyof our customers, including the large OEMs on which we focus a significantportion of our sales and marketing efforts, have the technical and financialability to design and produce components replicating or improving on thefunctionality of most of our products. These customers often consider in-housedevelopment of technologies and products as an alternative to doing businesswith us. We cannot assure you that our existing or potential customers will dobusiness with us, rather than attempting to develop similar technology andproducts internally or obtaining technology or products through acquisitions.We cannot be certain that we will be able to find

 

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customers to replace therevenue lost as a result of customers developing technologies or productsin-house. Any such occurrence could have a material adverse effect on ourbusiness, financial condition or operating results.

 

***If we fail to develop and sell new or enhancedproducts for the telecommunications hardware and software market, we will notbe able to compete effectively.***

 

Thetelecommunications hardware and software market is characterized by:

 

•                  rapid technological advances;

 

•                  evolving industry standards;

 

•                  changes in customer requirements and productlife cycles;

 

•                  frequent new product introductions;

 

•                  declining prices;

 

•                  intense competition; and

 

•                  evolving offerings by telecommunicationsservice providers.

 

Ourfuture success depends in large part on our ability to offer products thataddress the sophisticated and varied needs of our current and prospectivecustomers and to respond to technological advances and evolving industrystandards on a timely and cost-effective basis.

 

Thetimely development of new or enhanced products is a complex and uncertainprocess. 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. We may also not be able toincorporate new technologies on a cost-effective or timely basis, which mayresult in unexpected expenses. We may not anticipate technological or markettrends accurately or manage long development cycles successfully. We may berequired to collaborate with third parties to develop products and may not beable to do so on a timely and cost-effective basis, if at all.

 

Theintroduction of new or enhanced products also requires that we manage thetransition from older products so as to minimize the disruption to customersand ensure that adequate supplies of new products can be delivered to meetanticipated 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 revenue could decline significantly ifwe lose a major customer or if a major customer cancels, reduces or delays anorder.***

 

Onecustomer accounted for 17% of our revenue in the nine months ended September30, 2003 and for 14% of our revenue in the nine months ended September 30,2002. The loss of this or any other major customer or the cancellation,reduction or delay of significant orders from such customers, even if onlytemporary, could significantly reduce our revenue and cash flow and could harmour reputation in the industry.

 

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

 

Althoughwe generally use standard parts and components for our products, some keycomponents are purchased from sole or single source vendors for whichalternative sources are not currently available or are difficult to obtain. Ourinability to obtain sufficient quantities of these components may result infuture delays or reductions

 

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in product shipments thatcould cause us to lose sales, incur additional costs and suffer harm to ourreputation. We currently purchase proprietary components from a number ofsuppliers for which there are no direct substitutes.

 

Thesecomponents could be replaced with alternatives from other suppliers, but thatmight require redesign of our products. If such a redesign were required, wewould incur considerable delay and expenses. We currently enter into purchaseorders with our suppliers for materials based on forecasts of need, but have noguaranteed supply arrangements with these suppliers.

 

Inaddition, we currently use a number of 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 have identified,which could result in significant delays in shipment of products to customers.Moreover, the manufacture of these components is extremely complex, and ourreliance on the suppliers of these components exposes us to potentialproduction difficulties and quality variations, which could negatively affectthe cost and timely delivery of our products. We currently enter into purchaseorders with independent manufacturers of materials based on forecasts of need,but have no guaranteed capacity arrangements with these manufacturers. Anysignificant interruption in the supply, or degradation in the quality, of anycomponent could cause us to lose sales, incur additional costs and suffer harmto our reputation.

 

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

 

Productsas complex as ours may contain known and undetected errors, bugs, or otherperformance problems. Defects are frequently found during the periodimmediately following introduction and initial implementation of new productsor enhancements to existing products. Although it is our objective to resolveall bugs that we believe would be considered serious by our customers beforeimplementation, our products may not be bug-free. We also provide warrantiesagainst defects in materials and workmanship on our hardware products for fiveyears. Errors, bugs or performance problems, however, could result in lostrevenue or customer relationships and could be detrimental to our business andreputation generally. In addition, our customers generally use our productstogether with their own products and products from other vendors. As a result,when problems occur, it may be difficult to identify the source of the problem.These problems may cause us to incur significant warranty and repair costs,divert the attention of our engineering personnel from our product developmentefforts 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 federalor state regulatory authorities or any legal challenges to existing laws orregulations relating to the telecommunications industry could materiallyadversely affect the market for our products. Moreover, our value-addedresellers or other customers may require, or we may otherwise deem it necessaryor advisable, for us to alter our products to address actual or anticipatedchanges in the regulatory environment. Our inability to alter our products oraddress any regulatory changes could have a material adverse effect on ourbusiness, financial condition or operating results.

 

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

 

Oursuccess and ability to compete are dependent, in part, upon our proprietarytechnology. Taken as a whole, we believe our intellectual property rights aresignificant and any failure to adequately protect the unauthorized use

 

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of our proprietary rightscould result in our competitors offering similar products, potentiallyresulting in loss of a competitive advantage and decreased revenue. We relyupon a combination of patents, trademark law, trade secret protections,copyright law and confidentiality agreements with consultants and third partiesto protect our proprietary rights. Notwithstanding our efforts, third partiesmay infringe or misappropriate our proprietary rights. In addition, wegenerally 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.Moreover, effective patent, trademark, copyright or trade secret protectionsmay not be available in every country in which we operate or intend to operateto the same extent as the laws of the United States. Also, it may be possiblefor unauthorized third parties to copy or reverse engineer aspects of ourproducts, develop similar technology independently or otherwise obtain and useinformation that we regard as proprietary. Furthermore, detecting unauthorizeduse of our proprietary rights is difficult. Litigation may be necessary toenforce our proprietary rights. Such litigation could result in the expenditureof significant financial and managerial resources and could have a materialadverse 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. If any legal actionclaiming patent infringement is commenced against us, we cannot assure you thatwe would prevail in such litigation given the complex technical issuesand inherent uncertainties in patent litigation. In the event a claim againstus was successful, and we could not obtain a license on acceptable terms orlicense a substitute technology or redesign to avoid infringement, we may beunable to market our affected products. This could have a material adverseeffect on our business, financial condition and operating results.

 

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

 

Wecurrently license and will continue to license certain technology integral tocertain of our products from third parties. For example, we have obtainedlicenses from third parties for software for certain of our voice and fax products.While we believe that much of this technology is available from multiplesources, any difficulties in acquiring third-party technology licenses, orintegrating the related third-party technology into our products, could resultin delays in product development or upgrades until equivalent technology can beidentified, licensed and integrated.

 

Wemay require new licenses in the future as our business grows and technologyevolves. We cannot assure you that these licenses will continue to be availableto us on commercially reasonable terms, if at all, which could have a materialadverse effect on our business, financial condition and operating results.

 

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

 

Oursuccess depends in large part upon the continued contributions of our keymanagement, sales, marketing, and engineering personnel, many of whom performimportant functions and would be difficult to replace. If we lose one or moremembers of our senior management team our business and operating results wouldbe harmed. We do not have employment contracts with our key personnel. Therehas been significant competition in our industry for qualified personnel, and,at times, we have experienced difficulty in recruiting qualified personnel. Wemay not be able to attract and retain the necessary personnel to accomplish ourbusiness objectives, and we may experience constraints that will adverselyaffect our ability to satisfy customer demand in a timely fashion or to supportour

 

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customers and operations.Our inability to hire qualified personnel on a timely basis, or to retain ourkey personnel, could materially adversely affect our business, financialcondition and operating results.

 

***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.

 

Inaddition, the rapidly emerging and evolving nature of the markets in which weand our customers compete may cause prospective customers to delay their purchasedecisions as they evaluate new technologies and develop and implement newsystems. During the period in which our customers are evaluating whether toplace an order with us, we often incur substantial sales and marketingexpenses, without any assurance of future orders or their timing. Even after acustomer places an order, the timing of the development, introduction andimplementation of the customer’s product or service using our product iscontrolled by, and can vary significantly with the needs of, the customer. Insome circumstances, the customer will not require the product for severalmonths. This continuing uncertainty can complicate our planning processes andreduce the predictability of 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.***

 

Salesof our products to customers outside the United States accounted for 22% of ourrevenue in the nine months ended September 30, 2003. We anticipate thatinternational sales will continue to account for a significant portion of ourrevenue. Because of our dependence upon international sales, we are subject toa number of risks, including volatility in currency exchange rates, politicaland economic instability in other countries, the imposition of trade and tariffregulations by foreign governments, difficulties in accounts receivablecollections, extended payment terms beyond those customarily offered in theUnited States, potentially adverse tax consequences, and the difficulties inmanaging and/or expanding operations across disparate geographic areas. Inaddition, most countries require technical approvals from their telecommunicationsregulatory agencies for products that operate in conjunction with the localtelephone system. Obtaining these approvals is generally a prerequisite forsales in a given jurisdiction. Obtaining requisite approvals takes from twomonths to a year or more depending on the product and the jurisdiction. Theseor other factors may limit our ability to sell our products in other countries,which could have a material adverse effect on our business, financial conditionand operating results.

 

***We may seek to expand through acquisitionsof complementary businesses, and we may not be able to successfully integrateacquired companies.***

 

We may seek to acquire complementary companies in the future. Inaddition to the difficulties we may face in identifying and consummatingacquisitions, we will also be required to integrate and consolidate anyacquired businesses or assets with our existing operations. Managing anacquired business entails numerous operational and financial risks, includingdifficulties in integrating disparate administrative, accounting and finance,and information systems, difficulties in assimilating acquired operations andnew personnel, diversion of management’s attention from other businessconcerns, and potential loss of key employees or customers of any acquiredoperations. Accordingly, we may be unable to successfully identify, consummateand integrate future acquisitions or operate acquired businessesprofitably.  If we are unable to integrate successfully an acquiredcompany, our future growth may suffer, and our results of operations could beharmed.

 

**Risks Related to Our Financial Results**

 

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

 

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Ouroperating results could fluctuate in the future due to a variety of factors,many of which are outside of our control. If our operating results do not meetthe expectations of securities analysts, the trading price of our common stockcould significantly decline. This may cause the value of your investment in ourcompany to decline. In addition, the value of your investment could be affectedby investor perception of our industry or our prospects generally, independentof our operating performance. Some of the factors that could affect ouroperating results or the market price of our common stock include:

 

•                  our ability to cope with difficult conditionsin the economy in general, and the telecommunications market in particular;

 

•                  our ability to formulate and implementeffective strategies to respond to changing market requirements and conditions;

 

•                  cancellation or rescheduling of orders forour products;

 

•                  our ability to collect accounts receivable fromcustomers that have been adversely affected by the difficult economicconditions;

 

•                  our ability to develop, manufacture, marketand support our products and product enhancements;

 

•                  the timing and number of orders for ourproducts, which have historically been weighted more heavily toward the lastmonth of each quarter and the second and fourth quarters of each year;

 

•                  we typically experience lower revenue in thethird quarter, due to customer summer vacation schedules, particularly inEurope, and to a lesser extent, the first quarter of each year;

 

•                  our ability to hire, train and retain keymanagement, sales, marketing and engineering personnel;

 

•                  announcements or technological innovations byour competitors or in competing technologies;

 

•                  our ability to obtain sufficient supplies ofsole or limited source components for our products;

 

•                  a decrease in the average selling prices ofour products;

 

•                  changes in costs of components that weinclude in our products;

 

•                  the mix of products that we sell;

 

•                  any interruptions in the flow of our productsthrough our resellers or our two-tiered distribution system; and

 

•                  a decrease in the demand for our commonstock.

 

Dueto these and other factors, revenue, expenses and operating results could varysignificantly in the future, and period-to-period comparisons should not berelied upon as indications of future performance.

 

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

 

Stockmarkets in general, and the market for technology stocks, including our commonstock, in particular, have experienced extreme price and volume fluctuationsthat often have been unrelated, or disproportionate, to the operatingperformance of those companies. The market for our common stock has been and islikely to continue to be volatile. Many factors could cause the trading priceof our common stock to fluctuate substantially, including the following:

 

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•                  future announcements concerning our business,technology, acquisitions, strategic partnerships, management, customers orcompetitors;

 

•                  introduction of new products or changes inproduct pricing policies by us, our competitors or our customers;

 

•                  changes in earnings estimates by securitiesanalysts or announcements of results of operations that are not aligned withthe expectations of analysts and investors;

 

•                  changes in market valuations of similarcompanies;

 

•                  reduced spending for telecommunicationshardware and software;

 

•                  the economic and competitive conditions inthe telecommunications sectors in which our customers operate; and

 

•                  general economic conditions and stock markettrends.

 

Inthe past, following periods of volatility in the market price of a particularcompany’s securities, securities class action litigation has often been broughtagainst that company. Many technology companies have been subject to this typeof litigation. This type of litigation, if instituted against us, could resultin substantial costs and a diversion of our management’s attention andresources.

 

***Our corporate documents may prevent achange in control or management that stockholders consider desirable.***

 

Ourcharter and by-laws contain provisions that might enable our management toresist a takeover of our company. In addition, our board of directors hasadopted a shareholder rights plan. These provisions and our shareholder rightsplan could have the effect of delaying, deferring, or preventing a change incontrol of Brooktrout or a change in our management that stockholders considerfavorable or beneficial. They could discourage proxy contests and make it moredifficult for you and other stockholders to elect directors and take othercorporate actions. They also could limit the price that investors may bewilling to pay in 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.***

 

Wemay need to raise additional funds in the future, for example, to develop newtechnologies, support our expansion, respond to competitive pressures, acquirecomplementary businesses or respond to unanticipated situations. We may try toraise additional funds through public or private financings, strategicrelationships or other arrangements. Our ability to obtain debt or equityfunding will depend on a number of factors, including market conditions, ouroperating performance and investor interest. Additional funding may not beavailable to us on acceptable terms or at all. If adequate funds are notavailable, we may be required to revise our business plan to reduceexpenditures, 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 debt securitiesor preferred stock, these new securities would have rights, preferences andprivileges senior to those of the holders of our common stock. The terms ofthese securities, as well as any borrowings under our bank line of creditagreement, could impose restrictions on our operations.

 

**Item 3****. Quantitative and Qualitative Disclosures AboutMarket Risk**

 

Ourexposure to market risk from changes in interest rates and currency exchangerates has not changed materially from our exposure at December 31, 2002.  Please refer to our Annual Report on Form10-K for the year ended December 31, 2002 for more information.

 

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

 

Our management, with the participation of our chief executive officerand chief financial officer, evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theExchange Act) as of September 30, 2003.  Based on this evaluation, ourchief executive officer and chief financial officer concluded that, as ofSeptember 30, 2003, our disclosure controls and procedures were (1) designed toensure that material information relating to our company, including ourconsolidated subsidiaries, is made known to our chief executive officerand chief financial officer by others within those entities, particularlyduring the period in which this report was being prepared and (2) effective, inthat they provide reasonable assurance that information required to be disclosedby us in the reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSEC’s rules and forms.

 

Nochange in our internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscalquarter ended September 30, 2003 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

# ** **

# **27**

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# **PART II OTHER INFORMATION**

 
| **Item 6****.** | **Exhibits and  Reports on Form 8-K** |
|-----------------|--------------------------------------------|
|            |                                       |   |
| (a)             |                                       | Exhibits |
|            |                                       |   |
| 3.1             |                                       | Restated  Articles of Organization of Brooktrout, Inc. are hereby incorporated by  reference from Exhibit 3.1 to Annual Report on Form 10-K for the fiscal year  ended December 31, 1999 filed with the SEC on March 30, 2000 (File No.  000-20698). |
|            |                                       |   |
| 3.2             |                                       | Articles  of Amendment to the Restated Articles of Organization of Brooktrout, Inc. are  hereby incorporated by reference from Exhibit 3.2 to Annual Report on Form  10-K for the fiscal year ended December 31, 1999 filed with the SEC on March  30, 2000 (File No. 000-20698). |
|            |                                       |   |
| 3.3             |                                       | Articles  of Amendment to the Restated Articles of Organization of Brooktrout, Inc. are  hereby incorporated by reference from Exhibit 3.3 to Amendment No. 2 to the  quarterly report on Form 10-Q/A for the fiscal quarter ended June 30, 2000  filed with the SEC on November 17, 2000 (File No. 000-20698). |
|            |                                       |   |
| 3.4             |                                       | Amended  and Restated By-laws of Brooktrout, Inc. are hereby incorporated by reference  from Exhibit 3.4 to Annual Report on Form 10-K for the fiscal year ended  December 31, 2001 filed with the SEC on March 25, 2002 (File No. 000-20698). |
|            |                                       |   |
| 31.1            |                                       | Certification  of Chief Executive Officer pursuant to Exchange Act Rules 13a-14 or 15d-14,  as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002. |
|            |                                       |   |
| 31.2            |                                       | Certification  of Chief Financial Officer pursuant to Exchange Act Rules 13a-14 or 15d-14,  as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002. |
|            |                                       |   |
| 32.1            |                                       | Certification  of Chief 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. |
|            |                                       |   |
| 32.2            |                                       | Certification  of Chief Financial 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. |
|            |                                       |   |
| (b)             |                                       | Reports  on Form 8-K |

 

OnJuly 16, 2003, we filed a current report on Form 8-K, dated July 16, 2003,furnishing under Item 12 our press release announcing financial results for thequarter ended June 30, 2003.

 

OnOctober 16, 2003, we filed a current report on Form 8-K, dated October 16,2003, filing under Item 5 our press release announcing the authorization of astock repurchase program and furnishing under Item 12 our press releaseannouncing financial results for the quarter ended September 30, 2003.

 

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**SIGNATURES**

 

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

 
|                    | **BROOKTROUT, INC.** |
|-------------------------|---------------------------|
|                    |                      |   |
| Date:  November 7, 2003 | By:                       | /s/ ERIC R. GILER |
|                    |                      | Eric R. Giler*President  (Principal Executive Officer)* |
|                    |                      |   |
| Date:  November 7, 2003 | 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**

 
| 3.1    |   | Restated  Articles of Organization of Brooktrout, Inc. are hereby incorporated by  reference from Exhibit 3.1 to Annual Report on Form 10-K for the fiscal year  ended December 31, 1999 filed with the SEC on March 30, 2000 (File No.  000-20698).                                                            |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                            |
| 3.2    |   | Articles  of Amendment to the Restated Articles of Organization of Brooktrout, Inc. are  hereby incorporated by reference from Exhibit 3.2 to Annual Report on Form  10-K for the fiscal year ended December 31, 1999 filed with the SEC on March  30, 2000 (File No. 000-20698).                               |
|   |   |                                                                                                                                                                                                                                                                                                            |
| 3.3    |   | Articles  of Amendment to the Restated Articles of Organization of Brooktrout, Inc. are  hereby incorporated by reference from Exhibit 3.3 to Amendment No. 2 to the  quarterly report on Form 10-Q/A for the fiscal quarter ended June 30, 2000  filed with the SEC on November 17, 2000 (File No. 000-20698). |
|   |   |                                                                                                                                                                                                                                                                                                            |
| 3.4    |   | Amended  and Restated By-laws of Brooktrout, Inc. are hereby incorporated by reference  from Exhibit 3.4 to Annual Report on Form 10-K for the fiscal year ended  December 31, 2001 filed with the SEC on March 25, 2002 (File No. 000-20698).                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                            |
| 31.1   |   | Certification  of Chief Executive Officer pursuant to Exchange Act Rules 13a-14 or 15d-14,  as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                            |
| 31.2   |   | Certification  of Chief Financial Officer pursuant to Exchange Act Rules 13a-14 or 15d-14,  as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                            |
| 32.1   |   | Certification  of Chief 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.                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                            |
| 32.2   |   | Certification  of Chief Financial 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.                                                                                                                 |

 

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