**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 June 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 o       No ý

 

As of July 31, 2003,12,324,507 shares of common stock, $.01 par value per share, wereoutstanding.

 

 

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**BROOKTROUT, INC.**

**FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2003**

 

**TABLE OF CONTENTS**

 
|        |                                                                                                                                   | **Page** |
|-------------|----------------------------------------------------------------------------------------------------------------------------------------|----------|
| **PART I**  | **FINANCIAL INFORMATION**                                                                                                              |     |
| Item  1.    | Condensed  Consolidated Financial Statements                                                                                           | 1        |
|        | Unaudited  Condensed Consolidated Balance Sheets as of June 30, 2003 and December 31, 2002                                             | 1        |
|        | Unaudited  Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30,  2003 and June 30, 2002         | 2        |
|        | Unaudited  Condensed Consolidated Statements of Comprehensive Loss for the Three and Six Months Ended June 30, 2003 and  June 30, 2002 | 3        |
|        | Unaudited  Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2003 and June 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                                            | 13       |
|        | Overview                                                                                                                               | 13       |
|        | Application  of Critical Accounting Policies                                                                                           | 14       |
|        | Discontinued  Operations                                                                                                               | 15       |
|        | Results  of Operations                                                                                                                 | 16       |
|        | Liquidity and Capital  Resources                                                                                                       | 21       |
|        | Recent Accounting  Pronouncements                                                                                                      | 23       |
|        | Factors That May  Affect Future Results                                                                                                | 23       |
| Item  3.    | Quantitative  and Qualitative Disclosures About Market Risk                                                                            | 32       |
| Item 4.     | Controls and Procedures                                                                                                                | 32       |
|        |                                                                                                                                   |     |
| **PART II** | **OTHER INFORMATION**                                                                                                                  |     |
| Item  4.    | Submission  of Matters to a Vote of Security Holders                                                                                   | 33       |
| Item 6.     | Exhibits and Reports on Form 8-K                                                                                                       | 33       |
|        | Signatures                                                                                                                             | 35       |
|        | Exhibit Index                                                                                                                          | 36       |

 

“BROOKTROUT,” the “NEWNETWORK,” and the “PARTNER ACCESS NETWORK PROGRAM” are trademarks or registeredtrademarks of Brooktrout, Inc.

 

ii

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**PARTI FINANCIAL INFORMATION**

 

**Item 1.****Condensed ConsolidatedFinancial Statements**

 

**BROOKTROUT, INC.**

**UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS**

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

 
|                                                                                                                                          |   | **June  30,  2003** |   | **December  31,  2002** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
| **Assets**                                                                                                                                    |   |                |   |                    |   |
| Current assets:                                                                                                                               |   |                |   |                    |   |
| Cash and cash equivalents                                                                                                                     |   | $                   | 16,811 |                    | $      | 23,685 |   |
| Marketable debt securities, available for sale                                                                                                |   | 28,992              |   | 18,103                  |   |
| Accounts receivable (less allowances for doubtful accounts and sales  returns of $1,238 at June 30, 2003 and $1,679at December 31, 2002) |   | 7,981               |   | 8,853                   |   |
| Inventory                                                                                                                                     |   | 5,581               |   | 6,797                   |   |
| Income tax receivable                                                                                                                         |   | 201                 |   | 6,236                   |   |
| Deferred tax assets                                                                                                                           |   | 4,993               |   | 3,856                   |   |
| Prepaid expenses                                                                                                                              |   | 1,052               |   | 1,137                   |   |
|                                                                                                                                          |   |                |   |                    |   |
| Total current assets                                                                                                                          |   | 65,611              |   | 68,667                  |   |
|                                                                                                                                          |   |                |   |                    |   |
| Equipment and furniture, net                                                                                                                  |   | 2,697               |   | 3,404                   |   |
| Deferred tax assets                                                                                                                           |   | 9,341               |   | 9,341                   |   |
| Intangible assets, net                                                                                                                        |   | 6,646               |   | 7,412                   |   |
| Other assets                                                                                                                                  |   | 1,185               |   | 1,511                   |   |
|                                                                                                                                          |   |                |   |                    |   |
| Total assets                                                                                                                                  |   | $                   | 85,480 |                    | $      | 90,335 |   |
|                                                                                                                                          |   |                |   |                    |   |
| **Liabilities and Stockholders’ Equity**                                                                                                 |   |                |   |                    |   |
| Current liabilities:                                                                                                                          |   |                |   |                    |   |
| Accounts payable                                                                                                                              |   | $                   | 2,918  |                    | $      | 5,715 |   |
| Accrued expenses                                                                                                                              |   | 5,532               |   | 5,104                   |   |
| Accrued compensation and commissions                                                                                                          |   | 1,918               |   | 2,141                   |   |
| Accrued warranty costs                                                                                                                        |   | 1,075               |   | 1,060                   |   |
| Customer deposits                                                                                                                             |   | 880                 |   | 883                     |   |
| Net liabilities related to discontinued operations                                                                                            |   | 61                  |   | 125                     |   |
|                                                                                                                                          |   |                |   |                    |   |
| Total current liabilities                                                                                                                     |   | 12,384              |   | 15,028                  |   |
|                                                                                                                                          |   |                |   |                    |   |
| Deferred rent                                                                                                                                 |   | 172                 |   | 209                     |   |
|                                                                                                                                          |   |                |   |                    |   |
| Total liabilities                                                                                                                             |   | 12,556              |   | 15,237                  |   |
|                                                                                                                                          |   |                |   |                    |   |
| Commitments and contingencies (Note 9)                                                                                                        |   |                |   |                    |   |
|                                                                                                                                          |   |                |   |                    |   |
| 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  12,573,401 at June 30, 2003 and 12,532,810at December 31, 2002           |   | 126                 |   | 125                     |   |
| Additional paid-in capital                                                                                                                    |   | 64,348              |   | 64,170                  |   |
| Accumulated other comprehensive loss                                                                                                          |   | (15                 | )      | (64                     | )      |
| Notes receivable — officers                                                                                                              |   | (11,760             | )      | (11,760                 | )      |
| Retained earnings                                                                                                                             |   | 24,022              |   | 26,387                  |   |
| Treasury stock, 260,386 shares at June 30, 2003 and 255,384 shares at  December 31, 2002, at cost                                             |   | (3,797              | )      | (3,760                  | )      |
|                                                                                                                                          |   |                |   |                    |   |
| Total stockholders’ equity                                                                                                               |   | 72,924              |   | 75,098                  |   |
|                                                                                                                                          |   |                |   |                    |   |
| Total liabilities and stockholders’ equity                                                                                               |   | $                   | 85,480 |                    | $      | 90,335 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

1

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**BROOKTROUT, INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

*(in thousands, except per share data)*

 
|                                                                                    |   | **Three  Months Ended June 30,** |   | **Six  Months Ended June 30,** |   |
|-----------------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                                    |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Revenue                                                                                 |   | $                                | 17,390 |                           | $      | 18,798 |   | $ | 32,924 |   | $ | 37,220 |   |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Costs and expenses:                                                                     |   |                             |   |                           |   |   |   |   |   |
| Cost of product sold                                                                    |   | 6,270                            |   | 8,732                          |   | 12,600 |   | 17,530 |   |
| Research and development                                                                |   | 4,827                            |   | 5,508                          |   | 9,413 |   | 11,127 |   |
| Selling, general and administrative                                                     |   | 7,565                            |   | 7,534                          |   | 14,834 |   | 15,015 |   |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Total costs and expenses                                                                |   | 18,662                           |   | 21,774                         |   | 36,847 |   | 43,672 |   |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Operating loss                                                                          |   | (1,272                           | )      | (2,976                         | )      | (3,923 | ) | (6,452 | ) |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Other income, net                                                                       |   | 245                              |   | 369                            |   | 445 |   | 590 |   |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Loss before income taxes                                                                |   | (1,027                           | )      | (2,607                         | )      | (3,478 | ) | (5,862 | ) |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Income tax (benefit)                                                                    |   | (325                             | )      | (1,095                         | )      | (1,113 | ) | (2,462 | ) |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Loss from continuing operations                                                         |   | (702                             | )      | (1,512                         | )      | (2,365 | ) | (3,400 | ) |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Gain on disposal of discontinued operations, net of income tax benefit  of $785 in 2002 |   | —                           |   | —                         |   | — |   | 80 |   |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Net loss                                                                                |   | $                                | (702   | )                              | $      | (1,512 | ) | $ | (2,365 | ) | $ | (3,320 | ) |
|                                                                                    |   |                             |   |                           |   |   |   |   |   |
| Loss per common share:                                                                  |   |                             |   |                           |   |   |   |   |   |
| Loss from continuing operations, basic and diluted                                      |   | $                                | (0.06  | )                              | $      | (0.12 | ) | $ | (0.19 | ) | $ | (0.28 | ) |
| Net loss, basic and diluted                                                             |   | $                                | (0.06  | )                              | $      | (0.12 | ) | $ | (0.19 | ) | $ | (0.27 | ) |
| Weighted average shares outstanding, basic and diluted                                  |   | 12,286                           |   | 12,209                         |   | 12,284 |   | 12,208 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

2

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**BROOKTROUT, INC.**

**UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF**

**COMPREHENSIVELOSS**

*(in thousands)*

 
|                                                                              |   | **Three  Months Ended June 30,** |   | **Six  Months Ended June 30,** |   |
|-----------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                              |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Net loss                                                                          |   | $                                | (702   | )                              | $      | (1,512 | ) | $ | (2,365 | ) | $ | (3,320 | ) |
| Unrealized gains (losses) on marketable debt securities, net of  applicable taxes |   | 2                                |   | 12                             |   | 49 |   | (4 | ) |
| Comprehensive loss                                                                |   | $                                | (700   | )                              | $      | (1,500 | ) | $ | (2,316 | ) | $ | (3,324 | ) |

 

Seenotes to unaudited condensed consolidated financial statements.

 

3

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**BROOKTROUT, INC.**

**UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS**

**OF CASHFLOWS**

*(in thousands)*

 
|                                                                             |   | **Six  Months Ended June 30,** |   |
|----------------------------------------------------------------------------------|--------|--------------------------------|--------|
|                                                                             |   | **2003**                       |   | **2002** |   |
| **Cash flows from operating activities:**                                        |   |                           |   |   |   |
| Net loss                                                                         |   | $                              | (2,365 | ) | $ | (3,320 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities: |   |                           |   |   |   |
| Loss on disposal of discontinued operations                                      |   | —                         |   | 705 |   |
| Depreciation and amortization                                                    |   | 1,732                          |   | 2,195 |   |
| Amortization of acquired and licensed software                                   |   | 333                            |   | 726 |   |
| Deferred income taxes                                                            |   | —                         |   | (785 | ) |
| Inventory obsolescence expense                                                   |   | 527                            |   | 1,825 |   |
| Increase (decrease) in cash from changes in:                                     |   |                           |   |   |   |
| Accounts receivable                                                              |   | 861                            |   | (56 | ) |
| Inventory                                                                        |   | 689                            |   | 2,113 |   |
| Prepaid expenses and other assets                                                |   | 5,004                          |   | 1,785 |   |
| Current liabilities                                                              |   | (2,718                         | )      | (506 | ) |
|                                                                             |   |                           |   |   |   |
| Cash flows from operating activities                                             |   | 4,063                          |   | 4,682 |   |
|                                                                             |   |                           |   |   |   |
| **Cash flows from investing activities:**                                        |   |                           |   |   |   |
| Expenditures for equipment and furniture                                         |   | (259                           | )      | (292 | ) |
| Sales and maturities of marketable debt securities                               |   | 7,263                          |   | 7,582 |   |
| Purchases of marketable debt securities                                          |   | (18,083                        | )      | (4,277 | ) |
|                                                                             |   |                           |   |   |   |
| Cash flows from investing activities                                             |   | (11,079                        | )      | 3,013 |   |
|                                                                             |   |                           |   |   |   |
| **Cash flows from financing activities:**                                        |   |                           |   |   |   |
| Proceeds from the sale of common stock                                           |   | 142                            |   | 179 |   |
|                                                                             |   |                           |   |   |   |
| Cash flows from financing activities                                             |   | 142                            |   | 179 |   |
|                                                                             |   |                           |   |   |   |
| Increase (decrease) in cash and cash equivalents                                 |   | (6,874                         | )      | 7,874 |   |
| Cash and cash equivalents, beginning of period                                   |   | 23,685                         |   | 22,425 |   |
|                                                                             |   |                           |   |   |   |
| Cash and cash equivalents, end of period                                         |   | $                              | 16,811 |   | $ | 30,299 |   |

 

Seenotes to unaudited condensed consolidated financial statements.

 

4

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**BROOKTROUT, INC.**

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

 

**1. Descriptionof Business and Summary of Significant Accounting 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 the discontinuance of theBrooktrout Software and Interspeed segments, the Company’s operations consistof one reportable segment, Brooktrout Technology. Disclosures included hereinpertain to the Company’s continuing operations unless noted otherwise.

 

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

 

Accounting policies, methodsand estimates are an integral part of the condensed consolidated financialstatements and are based upon management’s current judgments. These policies,methods, and estimates affect the reported amounts of assets and liabilitiesand disclosure of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenue and expenses duringthe reporting periods. The judgments made by management are based on knowledgeand experience with regard to past and current events and assumptions aboutfuture events that are believed to be reasonable under the circumstances. TheCompany’s management evaluates these estimates and assumptions and adjusts themif expectations concerning events, including future events, affecting themdiffer markedly from management’s current judgments.

 

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

 

Theaccompanying unaudited condensed consolidated financial statements have beenprepared by the Company pursuant to the rules and regulations of the Securitiesand Exchange Commission regarding interim financial reporting. These unauditedcondensed consolidated financial statements should be read in conjunction withthe audited consolidated financial statements included in the Company’s AnnualReport on Form 10-K for the fiscal year ended December 31, 2002.

 

5

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The accompanying unauditedcondensed consolidated financial statements have been prepared on the samebasis as the audited consolidated financial statements and include alladjustments, consisting only of normal recurring adjustments, necessary for afair presentation of the interim periods presented. The condensed consolidatedfinancial statements include the accounts of the Company and its wholly ownedsubsidiaries. All significant intercompany balances and transactions have beeneliminated in consolidation. The operating results for the interim periodspresented are not necessarily indicative of the results that could be expectedfor the full year.

 

***(d) Revenue Recognition***

 

Revenue from product sales isrecognized upon shipment to the customer (which constitutes delivery), providedthat persuasive evidence of an arrangement exists, the fee is fixed ordeterminable, and collection is reasonably assured. To the extent that one ormore of these conditions are not met, which has occurred from time to time,revenue is deferred until such time as all four criteria are met. Revenue fromsales to certain distributors is recognized on a “sell-through” basis, that is,when the distributors report to the Company that resale of the product to theultimate customer of the distributor in question has occurred. If the Companyreceives a payment from a customer prior to meeting all of the revenuerecognition criteria, the payment is recorded as a customer deposit or deferredrevenue. The Company records 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.

 

***(e) Warranties***

 

The Company provideswarranties on its products for periods of up to five years. Provisions are madeat the time revenue is recognized for the cost of fulfilling these commitments.Actual costs of fulfilling these warranty obligations have been within amountsestimated and provided.  At June 30,2003 and December 31, 2002, the Company’s warranty obligation was $1.1 million.

 

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

 

The Company sells itsproducts to various customers in the high technology industry. The Companygenerally requires no collateral. To reduce credit risk, the Company performscredit evaluations of its customers. The Company maintains allowances fordoubtful accounts for estimated losses resulting from its customers’ inabilityto make required payments. At June 30, 2003 and December 31, 2002, 18% and 23%,respectively, of the Company’s accounts receivable were from one customer.  For these same periods, 8% and 13% of theCompany's accounts receivable, respectively, were from a different customer.

 

The Company has one customerthat generates more than 10% of total revenue. This customer accounted forapproximately 17% and 15% of revenue for the three months ended June 30, 2003and 2002, respectively. For the six months ended June 30, 2003 and 2002, thiscustomer accounted for approximately 16% and 14% of revenue, respectively.

 

6

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***(g) Inventory***

 

Inventory is carried at thelower of cost or market. Cost is determined using the first-in, first-outmethod. The Company reduces the value of its inventory for estimatedobsolescence or unmarketable inventory equal to the difference between the costof inventory and the estimated realizable value based upon assumptions aboutfuture demand and market conditions.

 

***(h) Income Taxes***

 

Deferred tax assets andliabilities are recognized for the estimated future tax consequencesattributable to the differences between the carrying value of existing assetsand liabilities and their respective tax bases and for operating loss andcredit carry forwards. These assets and liabilities are measured using theenacted tax rates and laws that are expected to be in effect at the time thedifferences are expected to reverse. The Company believes that it is morelikely than not that future operations will generate sufficient taxable incometo realize the majority of the deferred tax assets. Valuation allowances areprovided to the extent that recoverability of tax assets is unlikely.

 

***(i) Stock-Based Compensation***

 

The Company uses theintrinsic value method to measure compensation expense associated with thegrants of stock options or awards to employees. The Company accounts for stockoptions and awards to non-employees using the fair value method.

 

Under the intrinsic valuemethod, compensation associated with stock awards to employees is determined asthe excess, if any, of the current fair value of the underlying common stock onthe date compensation is measured over the price an employee must pay toexercise the award. The measurement date for employee awards is generally thedate of grant. Under the fair value method, compensation associated with stockawards to non-employees is determined based on the estimated fair value of theaward itself, measured using either current market data or an establishedoption pricing model. The measurement date for non-employee awards is generallythe date that performance of certain services is complete.

 

Had the Company used the fairvalue method to measure compensation related to stock awards to employees,reported loss from continuing operations and loss per share would have been asfollows:

 
| **(in thousands, except per share  data)**     |   | **Three  Months Ended June 30,** |   | **Six  Months Ended June 30,** |   |
|------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                           |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                           |   |                             |   |                           |   |   |   |   |   |
| Loss from continuing operations, as reported   |   | $                                | (702   | )                              | $      | (1,512 | ) | $ | (2,365 | ) | $ | (3,400 | ) |
| Stock-based compensation recorded              |   | —                           |   | —                         |   | — |   | — |   |
| Pro forma stock-based compensation, net of tax |   | (952                             | )      | (1,059                         | )      | (1,888 | ) | (1,946 | ) |
|                                           |   |                             |   |                           |   |   |   |   |   |
| Loss from continuing operations, pro forma     |   | $                                | (1,654 | )                              | $      | (2,571 | ) | $ | (4,253 | ) | $ | (5,346 | ) |
|                                           |   |                             |   |                           |   |   |   |   |   |
| Basic and diluted loss per common share        |   | $                                | (.13   | )                              | $      | (.21 | ) | $ | (.35 | ) | $ | (.44 | ) |

 

7

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For purposesof determining the disclosures provided above, the fair value of options ontheir grant date is measured using the Black/Scholes option-pricing model. Keyassumptions used to apply this pricing model were as follows:

 
|                                    |   | **Three  Months Ended  June 30,** |   | **Six  Months Ended  June 30,** |   |
|-----------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                    |   | **2003**                          |   | **2002**                        |   | **2003** |   | **2002** |   |
| Risk-free interest rate                 |   | 2.5                               | %      | 4.3                             | %      | 2.5 | % | 4.3 | % |
| Expected life of option grants (years)  |   | 5.5                               |   | 4.3                             |   | 5.5 |   | 4.3 |   |
| Expected volatility of underlying stock |   | 88                                | %      | 65                              | %      | 88 | % | 65 | % |

 

The estimated weightedaverage fair value of option grants made during the three months ended June 30,2003 and 2002 was $4.10 and $2.61, respectively, per option.  The estimated weighted average fair value ofoption grants made during the six months ended June 30, 2003 and 2002 was $3.84and $2.66, respectively, per option.

 

The estimated weightedaverage fair value per share of grants made under the Company’s Employee StockPurchase Plan during the six months ended June 30, 2003 and 2002 was $0.70 and$0.95.  This value was computed using anexpected life of six months for the option feature present in the PurchasePlan, with the following key assumptions:

 
|                                    |   | **Three  Months Ended  June 30,** |   | **Six  Months Ended  June 30,** |   |
|-----------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                    |   | **2003**                          |   | **2002**                        |   | **2003** |   | **2002** |   |
| Risk-free interest rate                 |   | 1.0                               | %      | 4.3                             | %      | 1.0 | % | 4.3 | % |
| Expected volatility of underlying stock |   | 49                                | %      | 65                              | %      | 49 | % | 65 | % |

 

***(j) Earnings Per Share***

 

Basic earnings per commonshare is computed using the weighted average number of common sharesoutstanding during each period. Diluted earnings per common share is calculatedby dividing the net loss by the sum of the weighted average number of commonshares outstanding and all additional common shares that would have beenoutstanding if potentially dilutive securities had been issued, using thetreasury method.

 

Stock options to purchase3,500,534 shares were excluded from the computation of diluted earnings pershare in the three and six months ended June 30, 2003.  Stock options to purchase 3,539,221 shareswere excluded from the computation of diluted earnings per share in the threeand six months ended June 30, 2002. These options were excluded from the calculation as to include themwould have been antidilutive.

 

8

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***(k) Reclassifications***

 

Certain amounts in the 2002unaudited condensed consolidated financial statements have been reclassified toconform to the 2003 presentation.

 

**2.Marketable Debt Securities**

 

The Company has classifiedall of its marketable debt securities as available-for-sale. Because thesesecurities are available for immediate sale, they have been classified ascurrent assets in the accompanying consolidated balance sheets.  There were no material realized orunrealized gains recognized during the three and six months ended June 30, 2003and 2002.  As of both June 30, 2003 andDecember 31, 2002, the remaining maturities of debt securities ranged from onemonth to approximately two years.

 

Marketable debt securitiesconsisted of the following:

 
|                            |   | **Amortized  Cost** |   | **Market  Value** |   |
|---------------------------------|--------|---------------------|--------|-------------------|--------|
|                            |   | **(in  thousands)** |   |
| June 30, 2003:                  |   |                |   |              |   |
| U.S. government notes and bonds |   | $                   | 12,799 |              | $      | 12,825 |   |
| Corporate debt securities       |   | 16,104              |   | 16,167            |   |
|                            |   |                |   |              |   |
| Total                           |   | $                   | 28,903 |              | $      | 28,992 |   |
|                            |   |                |   |              |   |
| December 31, 2002:              |   |                |   |              |   |
| U.S. government notes and bonds |   | $                   | 7,520  |              | $      | 7,532 |   |
| Corporate debt securities       |   | 10,644              |   | 10,571            |   |
|                            |   |                |   |              |   |
| Total                           |   | $                   | 18,164 |              | $      | 18,103 |   |

 

**3. Inventory**

 

The components of inventory,net of reserves, consisted of the following:

 
|            |   | **June  30,  2003** |   | **December  31,  2002** |   |
|-----------------|--------|---------------------|--------|-------------------------|--------|
|            |   | **(in  thousands)** |   |
| Raw materials   |   | $                   | 1,066  |                    | $      | 1,076 |   |
| Work in process |   | 719                 |   | 740                     |   |
| Finished goods  |   | 3,796               |   | 4,981                   |   |
|            |   |                |   |                    |   |
| Total           |   | $                   | 5,581  |                    | $      | 6,797 |   |

 

The following is arollforward of reserves provided for inventory obsolescence:

 
|                             |   | **Six  months ended June 30,** |   |
|----------------------------------|--------|--------------------------------|--------|
|                             |   | **2003**                       |   | **2002** |   |
|                             |   | **(in  thousands)**            |   |
| Balance, beginning of the period |   | $                              | 3,909  |   | $ | 6,591 |   |
| Provisions                       |   | 527                            |   | 1,825 |   |
| Write offs                       |   | (297                           | )      | 24 |   |
|                             |   |                           |   |   |   |
| Balance, end of period           |   | $                              | 4,139  |   | $ | 8,440 |   |

 

9

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**4.Intangible Assets**

 

Intangible assets consistedof the following:

 
|                           |   | **June  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 |   | (7,929              | )      | (7,163                        | )      |
|                           |   |                |   |                          |   |
| Intangible assets, net         |   | $                   | 6,646  |                          | $      | 7,412 |   |

 

Intangibleasset amortization expense was $0.4 million for both the three months endedJune 30, 2003 and 2002.  Intangibleasset amortization expense was $0.8 million for both the six months ended June30, 2003 and 2002.  Included inintangible assets are amounts allocated to in-place workforce, which SFAS No.142 requires be reclassified to goodwill; such assets were fully amortizedprior to January 1, 2002, and as a result, no adjustments or reclassificationswere required.  There are no intangiblescarried on the balance sheet that are not being amortized.

 

**5****. Valuation and QualifyingAccounts**

 

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

 

The Company’sallowance for doubtful accounts and sales returns was $1.2 million and $2.0million as of June 30, 2003 and 2002, respectively.  The following is a rollforward of allowances provided fordoubtful accounts and sales returns:

 
|                             |   | **Six  months ended June 30,** |   |
|----------------------------------|--------|--------------------------------|--------|
|                             |   | **2003**                       |   | **2002** |   |
|                             |   | **(in  thousands)**            |   |
| Balance, beginning of the period |   | $                              | 1,679  |   | $ | 2,074 |   |
| Provisions                       |   | (167                           | )      | 161 |   |
| Write offs and payments issued   |   | (274                           | )      | (226 | ) |
|                             |   |                           |   |   |   |
| Balance, end of period           |   | $                              | 1,238  |   | $ | 2,009 |   |

 

***Accrued warranty costs:***

 

The Company’s accruedwarranty costs liability was $1.1 million and $0.6 million as of June 30,2003 and 2002, respectively. The following is a rollforward of the accruedwarranty costs:

 

10

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|                             |   | **Six  months ended June 30,** |   |
|----------------------------------|--------|--------------------------------|--------|
|                             |   | **2003**                       |   | **2002** |   |
|                             |   | **(in  thousands)**            |   |
| Balance, beginning of the period |   | $                              | 1,060  |   | $ | 789 |   |
| Provisions for claims            |   | 74                             |   | (19 | ) |
| Costs incurred                   |   | (59                            | )      | (126 | ) |
|                             |   |                           |   |   |   |
| Balance, end of period           |   | $                              | 1,075  |   | $ | 644 |   |

 

**6. Bank Lineof Credit**

 

The Companyhas a line of credit under which it can borrow up to $5.0 million. Anyamounts borrowed under the line of credit bear interest at the lender’s primerate. The line of credit is secured by a pledge of substantially all of theassets of the Company. The Company is required to be in compliance with certainfinancial covenants relating to its quick ratio, minimum tangible net worth,and other standard reporting requirements. As of June 30, 2003, letters of credit issued against the Company’sexisting line totaled $1.0 million, representing the collateral requiredfor certain lease obligations. Other than the issuance of letters of credit andusing the credit line to secure immaterial foreign currency forward contracts,there have been no borrowings under the line during the past three years. Theline of credit expires on July 29, 2005.

 

**7.Income Taxes**

 

The Company’stax provision in 2003 is based on the estimated effective tax rate for the fullyear.  The Company’s effective tax rateon continuing operations was 32% for the three and six months ended June 30,2003 and 42% for the three and six months ended June 30, 2002.  The reduction in the income tax rate for thethree and six months ended June 30, 2003 was primarily due to a limitation of,and corresponding reduction in, the research and development tax credit thatthe Company can utilize in 2003. During the six months ended June 30, 2003, theCompany received federal income tax refunds totaling $6.0 million relatedto the carryback of 2002 net operating losses and tax credits.

 

**8. ProductSales Information**

 

Brooktrout’s products aresold for applications in the New Network and for applications in Today’sNetwork. Today’s Network involves core technologies and platforms that areprimarily 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 thetransmission and also allow information to be distributed using the traditionalcircuit-switched telephone network. For the three months ended June 30, 2003,sales of products for use in the New Network accounted for approximately 35% oftotal revenue as compared to 36% of total revenue for the three months endedJune 30, 2002. For the six months ended June 30, 2003, sales of productsfor use in the New Network accounted for approximately 36% of total revenue ascompared to 35% of total revenue for the six months ended June 30,2002.  Other than the

 

11

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revenue data described above, the Company doesnot maintain separate financial information related to its New Network andToday’s Network products.

 

**9.Commitments and Contingencies**

 

*Contingencies*—From time to time, the Company is a party to legal and other actions,which may include 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.

 

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

 

*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**

 

We develop hardware andsoftware platforms that original equipment manufacturers, or OEMs, developersand corporate information technology managers build into their communicationssystems. Customers incorporate our products into applications, systems andservices that allow voice, fax and data to be distributed over both Internetprotocol, or IP, packet-based networks, which we refer to as the New Network,and the traditional circuit-based telephone network. We supply products formedia processing, network interface, call control and signal processing,including protocols that allow Internet and traditional telephony systems tocommunicate.

 

We measure our operatingsuccess using both financial and market metrics. The financial metrics include revenue,gross margin, operating expenses, income from continuing operations and cashprovided by operating activities. Other key metrics include the total number ofenterprise and service provider customers, customers whose purchases exceed$100,000, and the portion of our revenue that is generated by the sales ofproducts for applications in the New Network. Our long-term business modelstresses our commitment to establishing and maintaining close customerrelationships and to continuing to develop innovative products.

 

The most significant trendthat has impacted our business has been the unfavorable economic conditionsaffecting the communications sector. This has resulted in a decrease in ourrevenue in the first two quarters of 2003 and for the fiscal years 2002 and2001, compared to prior periods. Sales of products, particularly forapplications in the New Network, to OEMs for use by large serviceproviders have 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 economy improves.

 

Despite these difficulteconomic conditions, we have been able to increase our cash and marketable debtsecurities balances to $45.8 million at June 30, 2003 from $26.0 millionat December 31, 2000. This was accomplished primarily through income taxrefunds, operating expense reductions, and the sale of a business segment.  If current economic conditions continue foran extended period of time or worsen, we may experience adverse effects on ourbusiness, operating results, and cash and marketable debt securities balances.

 

13

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**Applicationof Critical Accounting Policies**

 

Management’s discussion andanalysis of financial condition and results of operations is based upon ourcondensed consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America applicable to interim financial information. We make estimates andassumptions in the preparation of the condensed consolidated financialstatements that affect the reported amounts of assets and liabilities, revenueand expenses, and the related disclosures of contingent assets and liabilities.These estimates form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources. We baseour estimates and judgments on historical experience and on various otherassumptions that we believe are reasonable under the circumstances. However,actual results may differ from these estimates under different assumptions orconditions.

 

The following criticalaccounting policies require the use of significant judgment and estimates inthe preparation of the condensed consolidated financial statements. Thislisting is not a comprehensive list of all of our 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

 

Revenue from product sales isrecognized upon shipment to the customer (which constitutes delivery), providedthat persuasive evidence of an arrangement exists, the fee is fixed ordeterminable, and collection is reasonably assured. In determining when torecognize revenue we often are required to exercise judgment. To the extentthat one or more of these criteria are not met, which has occurred from time totime, revenue is deferred until such time as all four conditions are satisfied.We record 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. Actual results could differ from these estimates and could thereforeimpact our results of operations and cash flows.

 

Allowancesfor Doubtful Accounts

 

Accounts receivable arereduced by an allowance for amounts that may become uncollectible in thefuture. The estimated allowance for doubtful accounts is based primarily on aspecific analysis of accounts in the receivable portfolio and a general reservebased on the aging of receivables. While management believes the allowance tobe adequate, if the financial condition of our customers were to deteriorate,resulting in impairment of their ability to make payments, additionalallowances may be required and could materially impact our financial positionand results of operations.

 

InventoryAllowances

 

We evaluate our inventoriesfor estimated excess quantities and obsolescence. This evaluation includesanalyses of sales levels by product and projections of future demand. In

 

14

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addition, we assess the impact of changingtechnology on our inventory-on-hand. We provide reserves for inventories thatare considered excess or obsolete. If future demand or market conditions areless favorable than our projections, additional inventory reserves may berequired and would be reflected in cost of sales in the period in which therevision is made. These actions could impact both our results of operations andour cash flows.

 

IntangibleAssets

 

We review our intangibleassets for impairment periodically and whenever events or changes incircumstances indicate that the carrying value may not be recoverable. Theevaluation of the recoverability of our intangible assets includes assumptionsregarding estimated future undiscounted cash flows associated with these assetsand other factors. If these estimates or assumptions change in the future, wemay be required to record impairment charges for these assets. Such animpairment charge would impact the results of operations, but would notdirectly impact our cash flows.  All ofour remaining net intangible assets are being amortized, with original usefullives of approximately five to ten years.

 

DeferredTax Assets

 

We assess the carrying valueof our deferred tax assets to determine if it is more likely than not that wewill be able to generate sufficient future taxable income in certain taxjurisdictions in order to realize these assets. When necessary, we have reducedthe deferred tax asset to its estimated realizable value by recording avaluation allowance. This assessment requires us to make estimates andassumptions about our future profitability. In determining the carrying valueof the deferred tax assets as of June 30, 2003, we are assuming profitabilityin the future and that it is more likely than not that we will be able torealize these assets. This assumption is based in part upon our history ofprofitability. If current economic conditions deteriorate or future results ofoperations are less than expected, future assessments may result in adetermination that all or a portion of the remaining deferred tax assets arenot realizable. As a result, we may need to establish additional valuationallowances for all or a portion of the deferred tax assets, which may have amaterial adverse effect on our results of operations.

 

AccruedWarranty Costs

 

We accrue for warranty costsbased on historical trends in product return rates and the expected materialand labor costs to provide warranty services. If we were to experience anincrease in warranty claims compared with our historical experience, or ifcosts of servicing warranty claims were greater than the expectation on whichthe accrual had been based, our gross margins could be adversely affected.

 

**Discontinued Operations**

 

Prior to February 8,2001, we were organized and reported the results of our operations in threeoperating segments, Brooktrout Technology, Brooktrout Software, and Interspeed.On February 8, 2001, our board of directors adopted formal plans todiscontinue our Brooktrout Software and Interspeed segments. We have accountedfor these businesses as discontinued

 

15

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operations. These businesses were substantially disposed of prior to December 31,2001, and adjustments recorded in 2002 primarily reflect additional proceedsand changes in estimates to the amounts recorded related to gains or losses ondisposal.  There are no operatingactivities related to discontinued operations included in our condensedconsolidated financial statements in either 2002 or 2003.

 

**Results of Operations**

 

The following discussionfocuses on our results from continuing operations for the three and six monthsended June 30, 2003 and 2002. The table below sets forth certain condensedconsolidated statements of operations data as a percentage of total revenue forthe periods presented.

 
|                                |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-------------------------------------|--------|-----------------------------------|--------|---------------------------------|--------|
|                                |   | **2003**                          |   | **2002**                        |   | **2003** |   | **2002** |   |
| Domestic revenue                    |   | 80                                | %      | 81                              | %      | 76 | % | 80 | % |
| International revenue               |   | 20                                |   | 19                              |   | 24 |   | 20 |   |
| Total revenue                       |   | 100                               |   | 100                             |   | 100 |   | 100 |   |
| Cost of product sold                |   | 36                                |   | 46                              |   | 38 |   | 47 |   |
| Gross margin                        |   | 64                                |   | 54                              |   | 62 |   | 53 |   |
| Operating expenses:                 |   |                              |   |                            |   |   |   |   |   |
| Research and development            |   | 28                                |   | 30                              |   | 29 |   | 30 |   |
| Selling, general and administrative |   | 43                                |   | 40                              |   | 45 |   | 40 |   |
| Total operating expenses            |   | 71                                |   | 70                              |   | 74 |   | 70 |   |
| Operating loss                      |   | (7                                | )      | (16                             | )      | (12 | ) | (17 | ) |
| Other income, net                   |   | 1                                 |   | 2                               |   | 1 |   | 1 |   |
| Loss before income taxes            |   | (6                                | )      | (14                             | )      | (11 | ) | (16 | ) |
| Income tax (benefit)                |   | (2                                | )      | (6                              | )      | (4 | ) | (7 | ) |
| Loss from continuing operations     |   | (4                                | )%     | (8                              | )%     | (7 | )% | (9 | )% |

 

***Revenue***

 

*Three Months Ended June 30, 2003 and 2002*

 

The following table presentsour domestic and international revenue:

 
|                                      |   | **Three  Months Ended June 30,** |   |
|-------------------------------------------|--------|----------------------------------|--------|
|                                      |   | **2003**                         |   | **2002** |   |
|                                      |   | **(dollars  in thousands)**      |   |
| Domestic revenue                          |   | $                                | 13,861 |   | 80 | % | $ | 15,155 |   | 81 | % |
| International revenue, principally export |   | 3,529                            |   | 20 |   | 3,643 |   | 19 |   |
|                                      |   |                             |   |   |   |   |   |   |   |
| Total revenue                             |   | $                                | 17,390 |   | 100 | % | $ | 18,798 |   | 100 | % |
|                                           |        |                                  |        |  |  |  |  |  |  |  |  |  |  |

 

16

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Revenue forthe three months ended June 30, 2003 decreased by $1.4 million compared to thethree months ended June 30, 2002.  Salesto domestic OEMs and enterprise customers decreased primarily due to theeconomic conditions in the communications marketplace.  International revenue decreased slightly to$3.5 million primarily as a result of a reduction in Euro-denominated salesoffset by favorable foreign currency exchange rates.

 

Brooktrout’s products aresold for applications in the New Network and for applications in Today’sNetwork. Today’s Network involves core technologies and platforms that areprimarily 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 thetransmission and also allow information to be distributed using the traditionalcircuit-switched telephone network.  Revenuefrom sales of products for applications in the New Network for the three monthsended June 30, 2003 decreased by $0.7 million compared to the three monthsended June 30, 2002.  This revenuedecrease was attributable to weakness in both the service provider andenterprise segments.  New Networkrevenue was approximately 35% of total revenue for the three months ended June30, 2003, as compared to 36% of total revenue in the three months endedJune 30, 2002.

 

*Six Months Ended June 30, 2003 and 2002*

 

The following table presentsour domestic and international revenue:

 
|                                      |   | **Six  Months Ended June 30,** |   |
|-------------------------------------------|--------|--------------------------------|--------|
|                                      |   | **2003**                       |   | **2002** |   |
|                                      |   | **(dollars  in thousands)**    |   |
| Domestic revenue                          |   | $                              | 25,143 |   | 76 | % | $ | 29,667 |   | 80 | % |
| International revenue, principally export |   | 7,781                          |   | 24 |   | 7,553 |   | 20 |   |
|                                      |   |                           |   |   |   |   |   |   |   |
| Total revenue                             |   | $                              | 32,924 |   | 100 | % | $ | 37,220 |   | 100 | % |

 

Revenue forthe six months ended June 30, 2003 decreased by $4.3 million compared to thesix months ended June 30, 2002. Sales to domestic OEMs and enterprise customers decreased primarily dueto recent world events and the economic conditions in the communicationsmarketplace.  International revenueincreased by $0.2 million, primarily as a result of favorable foreign currencyexchange rates.

 

As discussed above,Brooktrout’s products are sold for applications in the New Network and forapplications in Today’s Network. Revenue from sales of products forapplications in the New Network for the six months ended June 30, 2003decreased by $1.0 million compared to the six months ended June 30, 2002.  This revenue decrease was attributable toweakness in both the service provider and enterprise segments.  New Network revenue was at approximately 36%of total revenue for the six months ended June 30, 2003, as compared to35% of total revenue in the six months ended June 30, 2002.

 

17

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

 

*ThreeMonths Ended June 30, 2003 and 2002*

 

The following table presentscost of product sold and gross margin information:

 
|                 |   | **Three  Months Ended June 30,** |   |
|----------------------|--------|----------------------------------|--------|
|                 |   | **2003**                         |   | **2002** |   |
|                 |   | **(dollars  in thousands)**      |   |
| Cost of product sold |   | $                                | 6,270  |   | $ | 8,732 |   |
| Gross profit         |   | $                                | 11,120 |   | $ | 10,066 |   |
| Gross margin         |   | 64                               | %      | 54 | % |

 

The decrease in cost ofproduct sold from the three months ended June 30, 2002 to the correspondingperiod in 2003 was primarily the result of direct material cost reductionsachieved from using new manufacturing subcontractors and of reduced inventoryobsolescence expense.  Obsolescenceexpense decreased by $0.8 million, primarily due to reduced levels of excessinventory of service provider product in the three months ended June 30, 2003.These factors, along with a shift in product mix to higher margin products,contributed to a significant improvement in gross margin percentages in thesecond quarter of 2003 compared to the second quarter of 2002.

 

*Six MonthsEnded June 30, 2003 and 2002*

 

The following table presentscost of product sold and gross margin information:

 
|                 |   | **Six  Months Ended June 30,** |   |
|----------------------|--------|--------------------------------|--------|
|                 |   | **2003**                       |   | **2002** |   |
|                 |   | **(dollars  in thousands)**    |   |
| Cost of product sold |   | $                              | 12,600 |   | $ | 17,530 |   |
| Gross profit         |   | $                              | 20,324 |   | $ | 19,690 |   |
| Gross margin         |   | 62                             | %      | 53 | % |

 

The decrease in cost ofproduct sold from the six months ended June 30, 2002 to the correspondingperiod in 2003 was primarily the result of direct material cost reductionsachieved from using new manufacturing subcontractors, combined with decreasedproduct sales.  In addition, inventoryobsolescence expense decreased by $1.3 million, primarily due to reduced levelsof excess inventory of service provider product in the six months ended June30, 2003. These factors, along with a shift in product mix to higher marginproducts, contributed to a significant improvement in gross margin percentagesin the six months ended June 30, 2003 compared to the six months ended June 30,2002.

 

***Operating Expenses***

 

*ThreeMonths Ended June 30, 2003 and 2002*

 

The following table presentsour operating expenses:

 

18

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|                                |   | **Three  Months Ended June 30,** |   |
|-------------------------------------|--------|----------------------------------|--------|
|                                |   | **2003**                         |   | **2002** |   |
|                                |   | **(in  thousands)**              |   |
| Research and development            |   | $                                | 4,827  |   | $ | 5,508 |   |
| Selling, general and administrative |   | 7,565                            |   | 7,534 |   |
|                                |   |                             |   |   |   |
| Total operating expenses            |   | $                                | 12,392 |   | $ | 13,042 |   |

 

Researchand development expense

 

Research and developmentexpense represented 28% of total revenue in the three months ended June 30,2003, compared with 30% of total revenue in the corresponding period in 2002.The $0.7 million decrease in 2003 was primarily the result of reducedconsulting and contract labor expenses, decreased spending on new productprototypes, and reduced equipment and maintenance costs.  Our continuing development efforts arefocused on hardware and software for media processing products (voice, fax anddata), network interface products, call control products and signal processingproducts.

 

Selling,general and administrative expense

 

Selling, general andadministrative expense for the three months ended June 30, 2003 was similar tothe expense for the corresponding period of 2002.  Increases in professional fees as well as marketing expensesassociated with the Partner Access Network Program were partially offset byexpense decreases in bad debt expense as a result of improved collections ofaccounts receivable, along with decreased depreciation expense and reducedspending for variable incentive compensation.

 

*Six MonthsEnded June 30, 2003 and 2002*

 

The following table presentsour operating expenses:

 
|                                |   | **Six  Months Ended June 30,** |   |
|-------------------------------------|--------|--------------------------------|--------|
|                                |   | **2003**                       |   | **2002** |   |
|                                |   | **(in  thousands)**            |   |
| Research and development            |   | $                              | 9,413  |   | $ | 11,127 |   |
| Selling, general and administrative |   | 14,834                         |   | 15,015 |   |
|                                |   |                           |   |   |   |
| Total operating expenses            |   | $                              | 24,247 |   | $ | 26,142 |   |

 

Researchand development expense

 

Research and development expenserepresented 29% of total revenue in the six months ended June 30, 2003,compared with 30% of total revenue in the corresponding period in 2002. The$1.7 million decrease in 2003 was primarily the result of reduced consultingand contract labor expenses, decreased spending on new product prototypes, andreduced variable incentive compensation and depreciation expenses. Ourcontinuing development efforts are focused on hardware and software formedia processing products (voice, fax and data), network interface products,call control products and signal processing products.

 

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Selling,general and administrative expense

 

The slight decrease inselling, general and administrative expense from the six months ended June 30,2002 to the corresponding period of 2003 was primarily due to a decrease in baddebt expense as a result of improved collections of accounts receivable, alongwith decreased depreciation expense and reduced spending for variable incentivecompensation.  These expense decreaseswere partially offset by increases in professional fees, marketing expensesassociated with the Partner Access Network Program, and increases in employeehealth insurance premiums.

 

***Other income, net***

 

*Three andSix Months Ended June 30, 2003 and 2002*

 

The decrease in other income,net, from $0.4 million in the three months ended June 30, 2002 to $0.2 millionin the corresponding three month period in 2003 and from $0.6 million in thesix months ended June 30, 2002 to $0.4 million in the corresponding six monthperiod in 2003 was the result of a decline in short-term interest rates, whichoffset the favorable impact of increased cash and marketable debt securitiesbalances.

 

***Income tax benefit***

 

*Three andSix Months Ended June 30, 2003 and 2002*

 

The following table presentsour income tax benefit and effective tax rate for the three months ended June30, 2003 and 2002:

 
|               |   | **Three  Months Ended June 30,** |   |
|--------------------|--------|----------------------------------|--------|
|               |   | **2003**                         |   | **2002** |   |
|               |   | **(dollars  in thousands)**      |   |
| Income tax benefit |   | $                                | (325   | ) | $ | (1,095 | ) |
| Effective tax rate |   | (32                              | )%     | (42 | )% |
|                    |        |                                  |        |  |  |  |  |

 

The following table presentsour income tax benefit and effective tax rate for the six months ended June 30,2003 and 2002:

 
|               |   | **Six  Months Ended June 30,** |   |
|--------------------|--------|--------------------------------|--------|
|               |   | **2003**                       |   | **2002** |   |
|               |   | **(dollars  in thousands)**    |   |
| Income tax benefit |   | $                              | (1,113 | ) | $ | (2,462 | ) |
| Effective tax rate |   | (32                            | )%     | (42 | )% |
|                    |        |                                |        |  |  |  |  |

 

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The reduction in theeffective tax rate for the three and six months ended June 30, 2003 relative tothe corresponding periods in 2002, was primarily due to a limitation of, andcorresponding reduction in, the research and development tax credit that we canutilize in 2003.

 

**Liquidityand Capital Resources**

 

Cashflows for the six months ended June 30, 2003 and 2002

 

Net cash provided by operatingactivities was $4.1 million in the six months ended June 30, 2003. Thisprimarily resulted from tax refunds of $6.0 million and reductions inaccounts receivable that were offset by a decrease in current liabilities.  Cash provided by operating activities was$4.7 million in the six months ended June 30, 2002. This primarilyresulted from income tax refunds of $4.4 million and reductions in inventory,offset by a decrease in current liabilities.

 

Net cash used in investingactivities was $11.1 million in the six months ended June 30, 2003. Thisprimarily resulted from net purchases of marketable debt securities of$10.8 million. Net cash provided by investing activities was$3.0 million in the six months ended June 30, 2002. This primarily resultedfrom net sales of marketable debt securities of $3.3 million.

 

Net cashprovided by financing activities was $0.1 million and $0.2 million in the sixmonths ended June 30, 2003 and 2002, respectively, primarily attributable toproceeds from the sale of common stock under the Company’s Employee StockPurchase Plan.

 

ContractualObligations and Capital Expenditures

 

The following table presentsour future contractual obligations and commercial commitments as of June 30,2003:

 
|             |   | **Total**           |       | **2003** |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **Thereafter** |   |
|------------------|--------|---------------------|------------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|
|             |   | **(in  thousands)** | ** ** |
| Operating leases |   | $                   | 7,738      |     | $      | 1,338    |   | $        | 2,922  |     | $      | 2,053    |   | $              | 777    |   | $ | 202 |   | $ | 446 |   |
|                  |        |                     |            |          |        |          |        |          |        |          |        |          |        |                |        |  |  |  |  |  |  |  |

 

We haveoperating lease commitments for our primary office and manufacturing facilitiesthat expire between 2003 and 2006. In addition, we lease office space for salesand support functions that expire beyond 2006. Certain lease agreements requireus to pay all of the building’s taxes, insurance and maintenance costs.

 

We purchased $0.3 million ofcapital equipment in both the six months ended June 30, 2003 and June 30, 2002.We currently have no material commitments for additional capital expenditures.We have certain inventory purchase commitments that are part of our ordinarycourse of business in which the product delivery dates range from one month tothree months into the future.  We do notexpect these short term commitments to have a material adverse impact on ourfinancial results.

 

We had no long-term debt asof June 30, 2003 or August 7, 2003.

 

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Cashand Cash Requirements

 

The following table presentsour cash and cash requirements as of June 30, 2003 and December 31, 2002:

 
|                             |   | **June  30,  2003**         |   | **December  31,  2002** |   |
|----------------------------------|--------|-----------------------------|--------|-------------------------|--------|
|                             |   | **(dollars  in thousands)** |   |
| Cash and cash equivalents        |   | $                           | 16,811 |                    | $      | 23,685 |   |
| Marketable debt securities       |   | 28,992                      |   | 18,103                  |   |
| Total                            |   | $                           | 45,803 |                    | $      | 41,788 |   |
|                             |   |                        |   |                    |   |
| Working capital                  |   | $                           | 53,227 |                    | $      | 53,639 |   |
| Quick ratio                      |   | 4.34                        |   | 3.37                    |   |
| Maximum available line of credit |   | $                           | 5,000  |                    | $      | 5,000 |   |

 

Cash, cash equivalents andmarketable debt securities increased to $45.8 million as of June 30,2003 from $41.8 million as of December 31, 2002, primarily due to a $6.0million tax refund, offset by a cash outflow from other operating activities of$1.9 million in the first six months of 2003. Working capital decreased by$0.4 million from December 31, 2002 to June 30, 2003. This decrease wasthe result of a reduced accounts payable balance corresponding with reducedinventory purchases, offset by a decrease in income tax receivable. Our quick ratioimproved from 3.37 at December 31, 2002 to 4.34 at June 30, 2003, due primarilyto a reduction of current liabilities by 18%, from $15.0 million as ofDecember 31, 2002 to $12.4 million as of June 30, 2003, while weincreased our total cash and marketable debt securities balances due primarilyto the $6.0 million tax refund.

 

We have a$5.0 million working capital line of credit available from a commercialbank. Any borrowings would bear interest at the lender’s prime rate. The lineof 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 June 30, 2003, lettersof 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 secure immaterialforeign currency forward contracts, there have been no borrowings under theline during the past three years. The line of credit expires on July 29, 2005.

 

We believe that our cash andcash equivalents and marketable debt securities are likely to meet our needsfor the foreseeable future.  Though wedo not expect to make any major capital expenditures in 2003, we are alwayslooking for opportunities to expand the business, which could includeacquisitions or organic expansion into new markets.  If we find that our cash and cash equivalents, marketable debtsecurities and funds available from our bank line of credit are not sufficient,we may choose to utilize or to seek other sources of financing. If we were toseek future equity financings, the terms may be dilutive to our stockholdersand may contain restrictive covenants, which could limit our ability to pursuecertain courses of action. It is possible that, should the need arise, we willnot be able to obtain additional financing, or that the financing madeavailable to us will not be on acceptable terms.

 

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The pricing of our productsand the costs of our goods can be significantly affected by current marketconditions. Market conditions can be impacted by inflation; however, we believethat inflation has not had a significant effect on our operations to date.

 

**RecentAccounting Pronouncements**

 

We haveadopted Statement of Financial Accounting Standards (“SFAS”) No. 146,“Accounting for Costs Associated with Exit or Disposal Activities.”  This pronouncement is effective for exit ordisposal activities that are initiated after December 31, 2002, andrequires these costs to be recognized when the liability is incurred and not atproject initiation. The adoption of SFAS No. 146 has not had an impact onour operations or financial position since there have been no exit or disposalactivities in the periods presented.

 

**FactorsThat May Affect Future Results**

 

The risks and uncertaintiesdescribed below are those that we currently believe may materially affectus.  The trading price of our commonstock could decline due to any of these factors.  You should also refer to the other information in this report,including the condensed consolidated financial statements and related notes,and information included in our Annual Report on Form 10-K for the year endedDecember 31, 2002.  Additional risks anduncertainties that we are unaware of, or that we currently deem immaterial, alsomay become important factors that affect us.

 

**Risks Related to Our Business**

 

***Downturns in the economy generally, and in sectors of thetelecommunications industry in particular, make it difficult to anticipate orexpand sales.***

 

As a result of theunfavorable economic conditions affecting most technology sectors and thetelecommunications sector in particular, many of our customers are seekingaggressively to increase efficiency in their supply chains and reduce theirinventory levels. Additionally, the slowdown in the telecommunications industryand the resulting decrease in spending by companies in our target markets havereduced the rate of growth of data traffic and the use of the Internet, whichare driving the convergence of data and telephony that we expect will give riseto demand for New Network applications. The economic downturn has adverselyaffected our business and operating results, including a reduction in revenueof $4.3 million for the six months ended June 30, 2003, or 12%, compared to thesix months ended June 30, 2002, and $12.0 million, or 27%, compared to the sixmonths ended June 30, 2001. If current economic conditions continue for anextended period of time or worsen, we may experience additional adverse effectson our revenue, net income and cash flow. For example, as the rate at which ourcustomers order products decreases, it becomes more likely that our currentinventories will be exposed to technological obsolescence, which would requireus to reduce the value of those inventories on our balance sheet.

 

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***If we fail to compete successfully in the highly competitivetelecommunications market, our revenue and profitability will suffer.***

 

The market fortelecommunications equipment is highly competitive. If we are unable to differentiateour products from existing and future offerings of our competitors, and therebyeffectively compete in the market for telecommunications equipment, ouroperating results could be materially adversely affected. Many of our currentand potential competitors have significantly greater selling and marketing,technical, manufacturing, financial, and other resources. We expect our currentcompetitors to continue to improve the design and performance of their existingproducts and to introduce new products and enhancements with improved price andperformance characteristics. Our product sales may be threatened by newtechnologies, products or market trends, and we may have to reduce the pricesof our products to stay competitive. In addition, new competitors may emerge inthe markets we serve. An acquisition of, or by, one of our competitors mayresult in a substantially strengthened competitor with greater financial,engineering, manufacturing, marketing, and customer service and supportresources than we have. If our current or future competitors enter intostrategic relationships with leading manufacturers covering products similar tothose sold or being developed by us, our ability to sell products to thosemanufacturers may be adversely affected.

 

Capitalizing on ourtechnology will require a continued high level of investment in research anddevelopment, marketing, and customer service and support. We may be unable, orotherwise fail, to allocate sufficient resources to achieve the technological advancesnecessary to compete successfully with existing competitors or new entrants.

 

***Internal development efforts by our customers may adversely affectdemand for our products.***

 

Many of our customers,including the large OEMs on which we focus a significant portion of our salesand marketing efforts, have the technical and financial ability to design andproduce components replicating or improving on the functionality of most of ourproducts. These customers often consider in-house development of technologiesand products as an alternative to doing business with us. We cannot assure youthat our existing or potential customers will do business with us, rather thanattempting to develop similar technology and products internally or obtainingtechnology or products through acquisitions. We cannot be certain that we willbe able to find customers to replace the revenue lost as a result of customersdeveloping technologies or products in-house. Any such occurrence could have amaterial adverse effect on our business, financial condition or operatingresults.

 

***If we fail to develop and sell new or enhanced products for thetelecommunications hardware and software market, we will not be able to competeeffectively.***

 

The telecommunicationshardware and software market is characterized by:

 

•                  rapid technological advances;

 

•                  evolving industry standards;

 

•                  changes in customer requirements;

 

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•                  frequent new product introductions;

 

•                  declining prices;

 

•                  intense competition; and

 

•                  evolving offerings by telecommunicationsservice providers.

 

Our future success depends inlarge part on our ability to offer products that address the sophisticated andvaried needs of our current and prospective customers and to respond to technologicaladvances and evolving industry standards on a timely and cost-effective basis.

 

The timely development of newor enhanced products is a complex and uncertain process. We intend to continueto invest significantly in product and technology development. We mayexperience design, manufacturing, marketing and other difficulties that coulddelay or prevent our development, introduction or commercialization of any newand enhanced products. We may also not be able to incorporate new technologieson a cost-effective or timely basis, which may result in unexpected expenses.We may not anticipate technological or market trends accurately or manage longdevelopment cycles successfully. We may be required to collaborate with thirdparties to develop products and may not be able to do so on a timely andcost-effective basis, if at all.

 

The introduction of new orenhanced products also requires that we manage the transition from olderproducts so as to minimize the disruption to customers and ensure that adequatesupplies of new products can be delivered to meet anticipated customer demand.If we are unable to develop new products or enhancements on a timely andcost-effective basis, or if the new products or enhancements that we introducefail to achieve market acceptance, our ability to grow our business would beharmed and competitors could achieve greater market share.

 

***Our revenue could decline significantly if we lose a major customer orif a major customer cancels, reduces or delays an order.***

 

One customer accounted for16% of our revenue in the six months ended June 30, 2003 and for 14% of ourrevenue in the six months ended June 30, 2002. The loss of this or any othermajor customer or the cancellation, reduction or delay of significant ordersfrom such customers, even if only temporary, could significantly reduce ourrevenue and cash flow and could harm our reputation in the industry.

 

***Our dependence on sole and single source suppliers and independentmanufacturers could result in increased costs or delays in the manufacture anddelivery of our products.***

 

Although we generally usestandard parts and components for our products, some key components arepurchased from sole or single source vendors for which alternative sources arenot currently available or are difficult to obtain. Our inability to obtainsufficient quantities of these components may result in future delays orreductions in product shipments that could cause us to lose sales, incuradditional costs and suffer harm to our reputation. We currently purchaseproprietary components from a number of suppliers for which there are no directsubstitutes.

 

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These components could bereplaced with alternatives from other suppliers, but that might requireredesign of our products. If such a redesign were required, we would incurconsiderable delay and expenses. We currently enter into purchase orders withour suppliers for materials based on forecasts of need, but have no guaranteedsupply arrangements with these suppliers.

 

In addition, we currently usea number of independent manufacturers to manufacture printed circuit boards,chassis and subassemblies in accordance with our design and specification. Ourreliance on independent manufacturers involves a number of risks, including thepotential for inadequate capacity of, unavailability of, or interruptions inaccess to, process technologies, and reduced control over delivery schedules,manufacturing yields and costs. If our manufacturers are unable or unwilling tocontinue manufacturing our components in required quantities or to our qualityexpectations, we will have to transfer manufacturing to acceptable alternativemanufacturers that we have identified, which could result in significant delaysin shipment of products to customers. Moreover, the manufacture of thesecomponents is extremely complex, and our reliance on the suppliers of thesecomponents exposes us to potential production difficulties and qualityvariations, which could negatively affect the cost and timely delivery of ourproducts. We currently enter into purchase orders with independentmanufacturers of materials based on forecasts of need, but have no guaranteedcapacity arrangements with these manufacturers. Any significant interruption inthe supply, or degradation in the quality, of any component could cause us tolose sales, incur additional costs and suffer harm to our reputation.

 

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

 

Products as complex as oursmay contain known and undetected errors, bugs, or other performance problems.Defects are frequently found during the period immediately followingintroduction and initial implementation of new products or enhancements toexisting products. Although it is our objective to resolve all bugs that webelieve would be considered serious by our customers before implementation, ourproducts may not be bug-free. We also provide warranties against defects inmaterials and workmanship on our hardware products for five years. Errors, bugsor performance problems, however, could result in lost revenue or customerrelationships and could be detrimental to our business and reputationgenerally. In addition, our customers generally use our products together withtheir own products and products from other vendors. As a result, when problemsoccur, it may be difficult to identify the source of the problem. Theseproblems may cause us to incur significant warranty and repair costs, divertthe attention of our engineering personnel from our product development effortsand cause significant customer relations problems.

 

***Changes to regulations affecting the telecommunications or Internetindustries could reduce demand for our products or increase our costs.***

 

Laws and regulationsgoverning telecommunications, electronic commerce and the Internet areemerging, but remain largely unsettled, even in the areas where there has beensome legislative action. Regulation may focus on, among other things, assessingaccess or settlement charges, or imposing tariffs or regulations based on thecharacteristics and quality of products, either of which could restrict ourbusiness or increase our cost of doing business. Any changes to

 

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existing laws or the adoptionof new regulations by federal or state regulatory authorities or any legalchallenges to existing laws or regulations relating to the telecommunicationsindustry could materially adversely affect the market for our products.Moreover, our value-added resellers or other customers may require, or we mayotherwise deem it necessary or advisable, for us to alter our products toaddress actual or anticipated changes in the regulatory environment. Ourinability to alter our products or address any regulatory changes could have amaterial adverse effect on our business, financial condition or operatingresults.

 

***Limitations on our ability to adequately protect our proprietary rightsmay prevent us from retaining our competitive advantage and negatively affectour future operating results.***

 

Our success and ability tocompete are dependent, in part, upon our proprietary technology. Taken as awhole, we believe our intellectual property rights are significant and anyfailure to adequately protect the unauthorized use 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 can be costly and negativelyaffect our business.***

 

In the telecommunicationsbusiness, there is frequent litigation based on allegations of patentinfringement. As the number of entrants in our market increases and thefunctionality of our products is enhanced and overlaps with the products ofother companies, we may become subject to claims of infringement ormisappropriation of the intellectual property rights of others. As a result,from time to time, third parties may claim exclusive patent or otherintellectual property rights to technologies that we use. Although we believethat 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

 

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litigation given the complextechnical issues and inherent uncertainties in patent litigation. In the eventa claim against us was successful, and we could not obtain a license onacceptable terms or license a substitute technology or redesign to avoidinfringement, we may be unable to market our affected products. This could havea material adverse effect on our business, financial condition and operatingresults.

 

***Certain of our products depend upon the continued availability oflicensed technology from third parties.***

 

We currently license and willcontinue to license certain technology integral to certain of our products fromthird parties. For example, we have obtained licenses from third parties forsoftware for certain of our voice and fax products. While we believe that muchof this technology is available from multiple sources, any difficulties inacquiring third-party technology licenses, or integrating the relatedthird-party technology into our products, could result in delays in productdevelopment or upgrades until equivalent technology can be identified, licensedand integrated.

 

We may require new licensesin the future as our business grows and technology evolves. We cannot assureyou that these licenses will continue to be available to us on commerciallyreasonable terms, if at all, which could have a material adverse effect on ourbusiness, financial condition and operating results.

 

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

 

Our success depends in largepart upon the continued contributions of our key management, sales, marketing,and engineering personnel, many of whom perform important functions and wouldbe difficult to replace. If we lose one or more members of our seniormanagement team our business and operating results would be harmed. We do nothave employment contracts with our key personnel. There has been significantcompetition in our industry for qualified personnel, and, at times, we haveexperienced difficulty in recruiting qualified personnel. We may not be able toattract and retain the necessary personnel to accomplish our businessobjectives, and we may experience constraints that will adversely affect ourability to satisfy customer demand in a timely fashion or to support ourcustomers and operations. Our inability to hire qualified personnel on a timelybasis, or to retain our key personnel, could materially adversely affect ourbusiness, financial condition and operating results.

 

***Our products typically have long sales cycles, causing us to expendsignificant resources before recognizing revenue.***

 

The length of our sales cycletypically ranges from six to eighteen months and varies substantially fromcustomer to customer. Prospective customers generally must commit significantresources to test and evaluate our products and integrate them into largersystems. This evaluation period is often prolonged due to delays associatedwith approval processes that typically accompany the design and testing of newcommunications equipment by our customers.

 

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In addition, the rapidlyemerging and evolving nature of the markets in which we and our customerscompete may cause prospective customers to delay their purchase decisions asthey evaluate new technologies and develop and implement new systems. During theperiod in which our customers are evaluating whether to place an order with us,we often incur substantial sales and marketing expenses, without any assuranceof future orders or their timing. Even after a customer places an order, thetiming of the development, introduction and implementation of the customer’sproduct or service using our product is controlled by, and can varysignificantly with the needs of, the customer. In some circumstances, thecustomer will not require the product for several months. This continuinguncertainty can complicate our planning processes and reduce the predictabilityof our earnings and cash flows.

 

***Our business and operating results could be adversely affected bydownturns in economic conditions in countries outside the United States andother risks associated with international operations.***

 

Sales of our products tocustomers outside the United States accounted for 24% of our revenue in the sixmonths ended June 30, 2003. We anticipate that international sales will continueto account for a significant portion of our revenue. Because of our dependenceupon international sales, we are subject to a number of risks, includingvolatility in currency exchange rates, political and economic instability inother countries, the imposition of trade and tariff regulations by foreigngovernments, difficulties in accounts receivable collections, extended paymentterms beyond those customarily offered in the United States, potentiallyadverse tax consequences, and the difficulties in managing operations acrossdisparate geographic areas. In addition, most countries require technicalapprovals from their telecommunications regulatory agencies for products thatoperate in conjunction with the local telephone system. Obtaining these approvalsis generally a prerequisite for sales in a given jurisdiction. Obtainingrequisite approvals takes from two months to a year or more depending on theproduct and the jurisdiction. These or other factors may limit our ability tosell our products in other countries, which could have a material adverseeffect on our business, financial condition and operating results.

 

***We may seek to expand through acquisitions of complementary businesses,and we may not be able to successfully integrate acquired companies.***

 

We may seek to acquirecomplementary companies in the future. In addition to the difficulties we mayface in identifying and consummating acquisitions, we will also be required tointegrate and consolidate any acquired businesses or assets with our existingoperations. Managing an acquired business entails numerous operational andfinancial risks, including difficulties in integrating disparateadministrative, accounting and finance, and information systems, difficultiesin assimilating acquired operations and new personnel, diversion ofmanagement’s attention from other business concerns, and potential loss of keyemployees or customers of any acquired operations. Accordingly, we may beunable to successfully identify, consummate and integrate future acquisitionsor operate acquired businesses profitably. If we are unable to

 

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integrate successfully anacquired company, our future growth may suffer, and our results of operationscould be harmed.

 

**Risks Related to Our Financial Results**

 

***Our operating results could fluctuate significantly and cause our stockprice to be volatile, which may cause the value of your investment to decline.***

 

Our operating results couldfluctuate in the future due to a variety of factors, many of which are outsideof our control. If our operating results do not meet the expectations ofsecurities analysts, the trading price of our common stock could significantlydecline. This may cause the value of your investment in our company to decline.In addition, the value of your investment could be affected by investorperception of our industry or our prospects generally, independent of ouroperating performance. Some of the factors that could affect our operatingresults 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 for ourproducts;

 

•                  our ability to collect accounts receivablefrom customers 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;

 

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•                  a decrease in the average selling prices ofour products;

 

•                  changes in costs of components that we includein 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 common stock.

 

Due to these and otherfactors, revenue, expenses and operating results could vary significantly inthe future, and period-to-period comparisons should not be relied upon asindications of future performance.

 

***The market price of our common stock may be volatile, which could leadto losses for individual investors.***

 

Stock markets in general, andthe market for technology stocks, including our common stock, in particular,have experienced extreme price and volume fluctuations that often have beenunrelated, or disproportionate, to the operating performance of thosecompanies. The market for our common stock has been and is likely to continueto be volatile. Many factors could cause the trading price of our common stockto fluctuate substantially, including the following:

 

•                  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 in thetelecommunications sectors in which our customers operate; and

 

•                  general economic conditions and stock markettrends.

 

In the past, followingperiods of volatility in the market price of a particular company’s securities,securities class action litigation has often been brought against that company.Many technology companies have been subject to this type of litigation. Thistype of litigation, if instituted against us, could result in substantial costsand a diversion of our management’s attention and resources.

 

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***Our corporate documents may prevent a change in control or managementthat stockholders consider desirable.***

 

Our charter and by-lawscontain provisions that might enable our management to resist a takeover of ourcompany. In addition, our board of directors has adopted a shareholder rightsplan. These provisions and our shareholder rights plan could have the effect ofdelaying, deferring, or preventing a change in control of Brooktrout or achange in our management that stockholders consider favorable or beneficial. Theycould discourage proxy contests and make it more difficult for you and otherstockholders to elect directors and take other corporate actions. They alsocould limit the price that investors may be willing to pay in the future forshares of our common stock.

 

***We may need additional financing in the future, and any additionalfinancing may result in restrictions on our operations or substantial dilutionto our stockholders.***

 

We may need to raiseadditional funds in the future, for example, to develop new technologies,support our expansion, respond to competitive pressures, acquire complementarybusinesses or respond to unanticipated situations. We may try to raiseadditional funds through public or private financings, strategic relationshipsor other arrangements. Our ability to obtain debt or equity funding will dependon a number of factors, including market conditions, our operating performanceand investor interest. Additional funding may not be available to us onacceptable terms or at all. If adequate funds are not available, we may berequired to revise our business plan to reduce expenditures, includingcurtailing our growth strategies, foregoing acquisitions or reducing ourproduct development efforts. If we succeed in raising additional funds throughthe issuance of equity or convertible securities, the issuance could result insubstantial dilution to existing stockholders. If we raise additional fundsthrough the issuance of debt securities or preferred stock, these newsecurities would have rights, preferences and privileges senior to those of theholders of our common stock. The terms of these securities, as well as anyborrowings under our bank line of credit agreement, could impose restrictionson our operations.

 

**Item 3. Quantitative and QualitativeDisclosures About Market Risk**

 

Our exposureto market risk from changes in interest rates and currency exchange rates hasnot changed materially from our exposure at December 31, 2002.

 

**Item 4.Controls and Procedures**

 

Ourmanagement, with the participation of our chief executive officer and chieffinancial officer, evaluated the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act)as of June 30, 2003.  Based on thisevaluation, our chief executive officer and chief financial officer concludedthat, as of June 30, 2003, our disclosure controls and procedures were (1)designed to ensure that material information relating to our company, includingour consolidated subsidiaries, is made known to our chief executive

 

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officer and chief financialofficer by others within those entities, particularly during the period inwhich this report was being prepared and (2) effective, in that they providereasonable assurance that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms.

 

No changein our internal control over financial reporting (as defined in Rules 13a-15(f)and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter endedJune 30, 2003 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

# **PART II OTHER INFORMATION**

 

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

 

We held our 2003 annualmeeting of stockholders on May 14, 2003. At the annual meeting, ourstockholders were asked to consider proposals to elect one Class II director toserve for a three-year term; to approve an amendment to increase the number ofshares of common stock issuable under our employee stock purchase plan from487,500 to 687,500; and to transact any other business properly presented atthe meeting.

 

With regard to the electionof one Class II director, W. Brooke Tunstall was nominated to serve until the2006 annual meeting.  Our other directors whose terms of office continuedafter the annual meeting are as follows:  Robert G. Barrett (Class IIIdirector), David L. Chapman (Class I director), David W. Duehren (Class Idirector), and Eric R. Giler (Class III director).

 

At the annual meeting, by avote of 11,023,639 votes of common stock in favor of W. Brooke Tunstall, aplurality of the eligible votes, and 386,730 votes withheld for Mr. Tunstall,Mr. Tunstall was elected as a Class II director.

 

Also at the annual meeting,by a vote of 10,576,056 votes in favor, in excess of a majority of eligiblevotes, with 358,591 votes against and 475,722 votes abstaining, the amendmentto increase the number of shares of common stock issuable under our employeestock purchase plan from 487,500 to 687,500 was approved.

 

## **Item6**. 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                                                                        |

 

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|   | 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 and 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 and 15d-14,  as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                            |
| 32.1   | Certification  of Chief Executive Officer pursuant to 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 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of Sarbanes-Oxley Act of 2002.                                                                                                                                                                |
|   |                                                                                                                                                                                                                                                                                                            |
| (b)    | Reports on  Form 8-K                                                                                                                                                                                                                                                                                       |

 

On April 16, 2003, we fileda current report on Form 8-K, dated April 16, 2003, furnishing under Item 12our press release announcing financial results for the quarter ended March 31,2003.

 

On July 16,2003, we filed a current report on Form 8-K, dated July 16, 2003, furnishingunder Item 12 our press release announcing financial results for the quarterended June 30, 2003.

 

34

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
|                  | **BROOKTROUT, INC.** |
|-----------------------|---------------------------|
|                  |                      |   |   |
| Date: August  7, 2003 | By:                       | /s/ ERIC R. GILER |   |
|                  |                      | Eric R. Giler*President  (Principal Executive Officer)* |   |
|                  |                      |   |   |
|                  |                      |   |   |
| Date: August  7, 2003 | By:                       | /s/ ROBERT C. LEAHY |   |
|                  |                      | Robert C. Leahy*Vice President of Finance and Operations  (Principal Financial and Accounting Officer)* |   |

 

35

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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 and 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 and 15d-14,  as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                            |
| 32.1   |   | Certification  of Chief Executive Officer pursuant to 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 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of Sarbanes-Oxley Act of 2002.                                                                                                                                                                |

 

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