**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 
| ý     | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OF THE  SECURITIES EXCHANGE ACT OF 1934**           |
|------------|------------|----------------------------------------------------------------------------------------------------------|
|       | ** ** | ** **                                                                                               |
|       | ** ** | **For the  quarterly period ended March 31, 2005**                                                  |
| ** ** | ** ** | ** **                                                                                               |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from                    to                     **

 

**Commission file number 000-29335**

 

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**WITNESS SYSTEMS, INC.**

(Exact Name of Registrant as Specified in its Charter)

 
| **Delaware**                                                    | ** ** | **23-2518693**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or Other Jurisdiction of Incorporation or  Organization) |       | (I.R.S. Employer Identification No.) |
|                                                            |       |                                 |
| **300 Colonial Center Parkway  Roswell, Georgia**               | ** ** | **30076**                            |
| (Address of Principal Executive Offices)                        |       | (Zip Code)                           |

 

Registrant’s telephone number, including area code **770-754-1900**

 

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Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes  ý  No  o

 

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

 

*Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date.*

 
| **Class**                              | ** ** | **Outstanding at May 2, 2005** |
|----------------------------------------|------------|-------------------------------------|
| Common Stock, par value $.01 per share |       | 26,979,095                          |

 

 

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**WITNESS SYSTEMS, INC.**

 

**FORM 10-Q**

 

**INDEX**

 
| PART I.  | FINANCIAL INFORMATION                                                                                            |   |
|---------------|------------------------------------------------------------------------------------------------------------------|--------|
|          |                                                                                                             |   |
| Item 1.       | Financial Statements:                                                                                            |   |
|          |                                                                                                             |   |
|          | Condensed  Consolidated Balance Sheets at  March 31, 2005 and December 31, 2004 (unaudited)                      |   |
|          |                                                                                                             |   |
|          | Condensed  Consolidated Statements of Operations  for the three months ended March 31, 2005 and 2004 (unaudited) |   |
|          |                                                                                                             |   |
|          | Condensed  Consolidated Statements of Cash Flows  for the three months ended March 31, 2005 and 2004 (unaudited) |   |
|          |                                                                                                             |   |
|          | Notes  to the Condensed Consolidated Financial Statements (unaudited)                                            |   |
|          |                                                                                                             |   |
| Item  2.      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                      |   |
|          |                                                                                                             |   |
| Item  3.      | Quantitative  and Qualitative Disclosures About Market Risk                                                      |   |
|          |                                                                                                             |   |
| Item 4.       | Controls and Procedures                                                                                          |   |
|          |                                                                                                             |   |
| PART II. | OTHER INFORMATION                                                                                                |   |
|          |                                                                                                             |   |
| Item 1.       | Legal Proceedings                                                                                                |   |
|          |                                                                                                             |   |
| Item 6.       | Exhibits                                                                                                         |   |
|          |                                                                                                             |   |
| SIGNATURES    |                                                                                                             |

 

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**PART I.  FINANCIAL INFORMATION**

 

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

 

**WITNESS SYSTEMS,INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(In thousands, exceptshare data)**

**(unaudited)**

 
| ** **                                                                                                                                                                                            | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                            | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                                       |       |                     |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                             |       | $                        | 29,020     |                        | $          | 42,641 |   |
| Investments                                                                                                                                                                                           |       | 2,914                    |       | 33,842                      |       |
| Accounts receivable, net of allowance of $3,929 at March 31,  2005 and $3,250 at December 31, 2004                                                                                          |       | 32,286                   |       | 25,681                      |       |
| Prepaid and other current assets                                                                                                                                                                      |       | 4,723                    |       | 4,118                       |       |
| Total current assets                                                                                                                                                                                  |       | 68,943                   |       | 106,282                     |       |
| Intangible assets , net                                                                                                                                                                               |       | 45,313                   |       | 10,802                      |       |
| Goodwill                                                                                                                                                                                              |       | 35,728                   |       | —                      |       |
| Property and equipment, net                                                                                                                                                                           |       | 7,352                    |       | 6,197                       |       |
| Other assets                                                                                                                                                                                          |       | 2,554                    |       | 1,218                       |       |
|                                                                                                                                                                                                  |       | $                        | 159,890    |                        | $          | 124,499 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                         |       |                     |       |                        |       |
| Current liabilities :                                                                                                                                                                                 |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                                      |       | $                        | 6,851      |                        | $          | 4,454 |   |
| Accrued expenses                                                                                                                                                                                      |       | 20,085                   |       | 16,308                      |       |
| Deferred revenue                                                                                                                                                                                      |       | 24,445                   |       | 25,406                      |       |
| Total current liabilities                                                                                                                                                                             |       | 51,381                   |       | 46,168                      |       |
| Other long-term liabilities                                                                                                                                                                           |       | 3,611                    |       | 3,703                       |       |
| Deferred income tax liabilities , net                                                                                                                                                                 |       | 244                      |       | 254                         |       |
| Total liabilities                                                                                                                                                                                     |       | 55,236                   |       | 50,125                      |       |
| Commitments and contingencies                                                                                                                                                                         |       |                     |       |                        |       |
| Stockholders’ equity:                                                                                                                                                                            |       |                     |       |                        |       |
| Preferred stock, $.01 par value; 10,000,000 shares  authorized; (50,000 shares of which have been designated as Series A  Junior Participating Preferred Stock), no shares issued or outstanding |       | —                   |       | —                      |       |
| Common stock, $.01 par value; 50,000,000 shares  authorized; 26,940,951 and 24,476,289 shares issued and outstanding at March 31,  2005 and December 31, 2004, respectively                 |       | 269                      |       | 245                         |       |
| Additional paid-in capital                                                                                                                                                                            |       | 147,757                  |       | 108,247                     |       |
| Accumulated deficit                                                                                                                                                                                   |       | (48,420                  | )          | (39,060                     | )          |
| Accumulated other comprehensive income                                                                                                                                                                |       | 5,048                    |       | 4,942                       |       |
| Total stockholders’ equity                                                                                                                                                                       |       | 104,654                  |       | 74,374                      |       |
|                                                                                                                                                                                                  |       | $                        | 159,890    |                        | $          | 124,499 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

4

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**WITNESS SYSTEMS,INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands,except per share data)**

**(unaudited)**

 
| ** **                                      | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                      | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Revenue:                                        |       |                                  |       |   |   |
| Product                                         |       | $                                     | 16,368     |   | $ | 13,902 |   |
| Services                                        |       | 24,791                                |       | 19,050 |   |
| Total revenue                                   |       | 41,159                                |       | 32,952 |   |
| Cost of revenue:                                |       |                                  |       |   |   |
| Product                                         |       | 4,332                                 |       | 3,910 |   |
| Services                                        |       | 9,525                                 |       | 7,936 |   |
| Total cost of revenue                           |       | 13,857                                |       | 11,846 |   |
| Gross profit                                    |       | 27,302                                |       | 21,106 |   |
| Operating expenses:                             |       |                                  |       |   |   |
| Selling, general and administrative             |       | 19,913                                |       | 15,539 |   |
| Research and development                        |       | 6,195                                 |       | 4,875 |   |
| Merger-related costs                            |       | 1,659                                 |       | 368 |   |
| Acquired in-process research and development    |       | 9,000                                 |       | — |   |
| Operating (loss) income                         |       | (9,465                                | )          | 324 |   |
| Interest and other income, net                  |       | 138                                   |       | 171 |   |
| (Loss) income before provision for income taxes |       | (9,327                                | )          | 495 |   |
| Provision for income taxes                      |       | 33                                    |       | 25 |   |
| Net (loss) income                               |       | $                                     | (9,360     | ) | $ | 470 |   |
|                                            |       |                                  |       |   |   |
| Net (loss) income per share:                    |       |                                  |       |   |   |
| Basic                                           |       | $                                     | (0.36      | ) | $ | 0.02 |   |
| Diluted                                         |       | $                                     | (0.36      | ) | $ | 0.02 |   |
| Weighted-average common shares outstanding:     |       |                                  |       |   |   |
| Basic                                           |       | 26,261                                |       | 22,462 |   |
| Diluted                                         |       | 26,261                                |       | 25,201 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

5

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**WITNESS SYSTEMS,INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

**(unaudited)**

 
| ** **                                                                                          | ** ** | **Three Months Ended March 31,** | ** **         |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------|--------------------|
| ** **                                                                                          | ** ** | **2005**                              | ** **         | **2004** | ** ** |
| Cash flows from operating activities:                                                               |       |                                  |               |   |   |
| Net (loss) income                                                                                   |       | $                                     |  (9,360  | ) | $ | 470 |   |
| Adjustments to reconcile net (loss) income to net  cash (used in) provided by operating activities: |       |                                  |               |   |   |
| In-process research and development                                                                 |       | 9,000                                 |               | — |   |
| Amortization of intangible assets                                                                   |       | 3,284                                 |               | 1,864 |   |
| Depreciation and amortization of property and  equipment                                            |       | 911                                   |               | 827 |   |
| Provision for doubtful accounts                                                                     |       | 358                                   |               | 220 |   |
| Other non-cash items, net                                                                           |       | 131                                   |               | 102 |   |
| Changes in operating assets and liabilities:                                                        |       |                                  |               |   |   |
| Accounts receivable                                                                                 |       | (5,581                                | )                  | 3,246 |   |
| Prepaid and other assets                                                                            |       | 510                                   |               | 1,488 |   |
| Accounts payable and accrued expenses, including  acquisition related costs                         |       | (4,920                                | )                  | (4,999 | ) |
| Deferred revenue                                                                                    |       | (2,974                                | )                  | 1,054 |   |
| Net cash (used in) provided by operating activities                                                 |       | (8,641                                | )                  | 4,272 |   |
| Cash flows from investing activities:                                                               |       |                                  |               |   |   |
| Capital expenditures                                                                                |       | (1,547                                | )                  | (391 | ) |
| Purchases of investments                                                                            |       | —                                |               | (7,929 | ) |
| Proceeds from maturities of investments                                                             |       | —                                |               | 1,996 |   |
| Proceeds from sales of investments                                                                  |       | 30,885                                |               | 3,646 |   |
| Acquisition of Blue Pumpkin, Inc., net of cash  acquired of $3,728                             |       | (36,272                               | )                  | — |   |
| Net cash used in investing activities                                                               |       | (6,934                                | )                  | (2,678 | ) |
| Cash flows from financing activities:                                                               |       |                                  |               |   |   |
| Proceeds from exercise of stock options                                                             |       | 2,226                                 |               | 3,359 |   |
| Net cash provided by financing activities                                                           |       | 2,226                                 |               | 3,359 |   |
| Effect of exchange rate changes on cash                                                             |       | (272                                  | )                  | 287 |   |
| Net (decrease) increase in cash and cash equivalents                                                |       | (13,621                               | )                  | 5,240 |   |
| Cash and cash equivalents at beginning of period                                                    |       | 42,641                                |               | 21,517 |   |
| Cash and cash equivalents at end of period                                                          |       | $                                     |  29,020       |   | $ | 26,757 |   |
| Supplemental cash flow information:                                                                 |       |                                  |               |   |   |
| Cash paid for interest                                                                              |       | $                                     | 1                  |   | $ | — |   |
| Cash paid for income taxes                                                                          |       | $                                     | 216                |   | $ | 115 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

6

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**WITNESS SYSTEMS, INC. ANDSUBSIDIARIES**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**March 31, 2005**

**(unaudited)**

 

**1.****              Basis of Presentation**

 

***Business***- Witness Systems, Inc. (“Witness” or the “Company”)is a publicly traded company that provides the contact center market acomplete workforce optimization software and services solution that enablesglobal enterprises to capture customer intelligence and improve workforceperformance.  Our****solutions – which playa strategic role in the customer interaction centers of****Global 2000 and small- and medium-sizedbusinesses (“SMBs”) worldwide – also are deployed in Internet Protocol (“IP”) Telephony and back office environments,and throughout the extended enterprise, including branch offices.  Witness Systems’ software is comprised of qualitymonitoring, compliance, high-volume and IP Telephony recording solutions, aswell as workforce management, actionable learning and performance managementapplications. **** The solutions enable organizations to****optimizetheir people, processes and technology throughout the enterprise.  Customers benefit from an integrated businessconsulting, implementation and training methodology that supports a rapiddeployment, enabling them to drive revenue, reduce operational costs, andachieve greater customer retention and loyalty.

 

Our solution set is designed toenhance the quality of customer interactions across multiple communicationsmedia, including the telephone, e-mail and the Internet, and is used primarilyin the organization’s contact center(s). Our enterprise collaboration architecture allows contact centermanagement to share information gathered in the contact center with otherdepartments that service the customer, as well as throughout theorganization.  The result is a proactivemanagement tool for optimizing their customer relationship management (“CRM”),improving communication among departments, and fine-tuning workflow, processesand quality of service from within the contact center and throughout theenterprise.  As a result, we believe ourcustomers are able to generate additional revenue opportunities, improveprofitability, enhance customer retention, reduce employee turnover and improvetheir overall customer service and intelligence.  Using an integrated business consulting,installation and training methodology, we provide services to support an effectiveand rapid deployment of our software that enables organizations to maximizetheir return on an investment in our products and services.  Our software is designed to integrate with avariety of third-party software applications, such as CRM and enterpriseresource planning applications, and with existing telephony and computernetwork hardware and software.  Many ofour customers are companies with an international presence and one or morecontact centers that handle voice and data customer interactions for outboundsales and marketing operations, inbound service/support lines, or both.

 

Weare headquartered in Roswell, Georgia with other offices in the United States,Australia, Brazil, Canada, China, Germany, India, Israel, Japan, Mexico, theNetherlands, South Africa and the United Kingdom. We were originallyincorporated in 1988 in Georgia and were reincorporated in Delaware in 1997.

 

***Principles ofConsolidation and Reclassifications*** - The unaudited interim condensed consolidatedfinancial statements include the financial statements of Witness Systems, Inc.and its wholly-owned subsidiaries.  Allsignificant intercompany balances and transactions have been eliminated inconsolidation.  Certain prior yearamounts have been reclassified to conform to the current presentation.  In particular, prior period informationrelated to auction rate securities in the statements of cash flows wasreclassified, which reduced cash flows from investing activities by $1.2million in the first quarter of 2004. There was no impact on net (loss) income or cash flows from operationsas a result of the reclassification.

 

The financial statements herein have been prepared inaccordance with the requirements of Form 10-Q and, therefore, do notinclude all information and footnotes required by generally accepted accountingprinciples in the United States of America. However, in the opinion of management, all adjustments necessary for afair presentation of the results of operations for the relevant periods havebeen made.  Results for the interimperiods are not necessarily indicative of the results to be expected for theyear.  These financial statements shouldbe read in conjunction with the summary of significant accounting policies andthe notes to the consolidated financial statements included in our Annual Reporton Form 10-K for the fiscal year ended December 31, 2004, filed withthe U.S. Securities and Exchange Commission.

 

7

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***Use of Estimates*** - The preparation of these financialstatements requires us to make certain estimates and judgments that affect ourreported assets, liabilities, revenues and expenses, and our related disclosureof contingent assets and liabilities.  Webase our estimates on historical experience and on various assumptions that webelieve to be reasonable under the circumstances.  Actual results may differ from theseestimates.

 

**2.****              Revenue Recognition and Deferred Revenue**

** **

**We recognize revenue inaccordance with the American Institute of Certified Public Accountants’Statement of Position (“SOP”) 97-2, *Software RevenueRecognition*, and SOP 98-9, *Modification of*SOP 97-2, *Software Revenue Recognition, With Respect toCertain Transactions*. Revenue is primarily derived from licensingsoftware and providing related services including maintenance. Product revenue,which can include software and hardware, is recognized when persuasive evidenceof an agreement exists, delivery of the product has occurred, the fee is fixedor determinable, collection is probable and vendor specific objective evidenceof fair value (“VSOE”) exists to allocate revenue to the undelivered elementsof the arrangement. We report hardware revenue gross in accordance withEmerging Issues Task Force No. 99-19, *Reporting Revenue Gross asa Principal versus Net as an Agent*, because the factors indicatinggross reporting outweigh the factors indicating net reporting. We recognizerevenue using the residual method of accounting when customer orders containmultiple element arrangements, including the sale of licensed software, hardware,maintenance, and professional services. We generally have VSOE for maintenanceand professional services, but not for the software and hardware elements ofthe order. Under the residual method, services revenue, including maintenanceand professional services, is deferred at an amount equal to VSOE until thoseelements are delivered. Consequently, product revenue for the software andhardware may be recognized (i) upon delivery of those products when wehave VSOE for the related maintenance and professional services sold and (ii) atan amount representing the difference between the total order amount and theamount deferred.**

** **

Services revenue includes installation, training,consulting, maintenance and reimbursable travel expenses. Revenue from installation,training and consulting services is recognized upon performance of the relatedservices and is offered and billed as separate elements of contracts.Reimbursable travel expenses revenue is recognized upon incurrence of therelated expenses. The functionality of the software and any hardware sold isnot dependent on installation and training services and customization is notrequired to enable our customers to use our products. Maintenance is offered asa separate element and the majority of contracts include the right tounspecified upgrades on a when-and-if available basis. Maintenance revenue isdeferred and recognized ratably over the term of the related maintenancecontract.

 

Deferred revenue consists of amounts collected fromcustomers for products and services that have not met the criteria for revenuerecognition.

 

**3.****              BluePumpkin Acquisition**

 

On January 24,2005, we acquired Blue Pumpkin Software, Inc. (“Blue Pumpkin”), aprivately held California corporation. With this acquisition, we have extended our workforce optimizationsolution to include advanced workforce management software and servicessolutions including forecasting, scheduling, adherence and planningapplications.  Pursuant to the MergerAgreement and Plan of Reorganization, dated December 16, 2004 (the “Merger”),we paid $40 million in cash which was financed from our existing cash andinvestments, accrued $6.9 million in acquisition costs through March 31,2005 and issued 2.1 million unregistered shares of Witness’ common stockvalued at $37.2 million (measured at the date the stock consideration becamefixed pursuant to the application of a formula specified in the mergeragreement).  Ten percent of the aggregatemerger consideration is being held in escrow until January 24, 2006, oneyear after the closing date of the Merger. The escrow period may be extended in the event that there are pendingclaims that are brought against the escrow fund within such one-year period.  The escrow fund is available to compensateWitness, subject to certain limitations, for losses resulting from, among otherthings, breaches of representations, warranties or covenants in the MergerAgreement and certain pending and potential claims.  In addition, we are currently in negotiationswith an international reseller to acquire its rights to sell Blue Pumpkinproducts in certain geographic territories outside of the U.S.

 

In January 2001, IEXCorporation filed a lawsuit against Blue Pumpkin in the United States DistrictCourt for the Eastern District of Texas, Sherman Division, alleging that BluePumpkin infringed IEX Corporation’s (“IEX”) U.S. Patent No. 6,044,355 (“the‘355 Patent”) by making and selling certain workforce management and callrouting software products, including Blue Pumpkin’s Prime Time Skills and PrimeTime Enterprise products. IEX is seeking to recover actual damages, an award oftreble damages pursuant to 35 U.S.C. § 284, and an award of prejudgmentinterest, costs, and attorney’s fees. IEX is also seeking an injunction againstBlue Pumpkin’s making or selling the products that IEX claims infringe its ‘355Patent. On October 10, 2003, the District Court granted Blue Pumpkin summaryjudgment of non-infringement. That day, the District Court dismissed theremainder of the case. IEX appealed the District Court’s summary judgmentruling to the Court of Appeals for the Federal Circuit. On February 2, 2005,the Federal Circuit reversed-in-part the district court’s summary judgmentruling and remanded the action to the district court for further proceedingsconsistent with the Federal Circuit’s analysis. Blue Pumpkin is not yet on aschedule before the district court. We are unable to assess the impact, if any,on our financial position, results of operations or cash flows.  Certain amounts that may be payable inconnection with this matter remain the responsibility of the former BluePumpkin stockholders pursuant to the terms of the indemnification provisions ofthe Blue Pumpkin acquisition agreement.

 

Wecommenced the consolidation of Blue Pumpkin on January 24, 2005 and theacquisition was accounted for using the purchase method of accounting inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 141,*Business Combinations*.  The following summarizes the total purchaseprice for Blue Pumpkin (in thousands):

 

8

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| Value of Witness’ common stock issued |   | $      | 37,200 |   |
|--------------------------------------------|--------|--------|--------|--------|
| Purchase price (paid in cash)              |   | 40,000 |   |
| Estimated direct transaction costs         |   | 6,900  |   |
|                                       |   | $      | 84,100 |   |

 

Under the purchase methodof accounting, the total estimated purchase price is allocated to Blue Pumpkin’snet tangible and intangible assets based upon their estimated fair value as ofthe date of the acquisition.  Based uponthe estimated purchase price and review of the net assets acquired andliabilities assumed, the preliminary purchase price allocation is as follows(in thousands):

 
| Cash and investments                     |   | $      | 3,700  |   |
|------------------------------------------|--------|--------|--------|--------|
| Other current assets                     |   | 4,400  |   |
| Property and equipment, net              |   | 700    |   |
| Identifiable intangible assets acquired: |   |   |   |
| Acquired technology                      |   | 21,000 |   |
| Customer relationships                   |   | 17,000 |   |
| Goodwill                                 |   | 35,700 |   |
| In-process research and development      |   | 9,000  |   |
| Total assets acquired                    |   | 91,500 |   |
| Current liabilities                      |   | (3,900 | )      |
| Deferred revenue                         |   | (2,200 | )      |
| Restructuring accruals                   |   | (1,300 | )      |
| Total liabilities assumed                |   | (7,400 | )      |
|                                     |   | $      | 84,100 |   |

 

The fair values ofidentifiable intangible assets was determined with the assistance of TaylorConsulting Group, Inc., an independent third-party appraiser using both anincome and a cost approach taking into consideration the nature, risks,historical patterns, economic characteristics, and future considerations of theassets.  As of the closing date of themerger, technological feasibility of the in-process research and development (“IPR&D”)had not been established and the technology had no alternative future use.Accordingly, we charged the value of the IPR&D at the date of theacquisition to expense. The amount of the purchase price allocated to IPR&Dwas based on established valuation techniques used in the software industry.The fair value assigned to the acquired IPR&D was determined using adiscounted cash flow methodology, which discounts expected future cash flows topresent value. The key assumptions used in the valuation include, among others,expected completion date of the in-process projects identified as of theacquisition date, estimated cost to complete the projects, revenuecontributions and expense projections assuming the resulting product hasentered the market, and discount rates based on the risks associated with thedevelopment life cycle of the in-process technology acquired. The discountrates used in the present value calculations are obtained from aweighted-average cost of capital analysis, adjusted upward to account for theinherent uncertainties surrounding the successful development of the IPR&D,the expected profitability levels of such technology, and the uncertainty oftechnological advances that could potentially impact the estimates. We assumethe pricing model for the resulting product of the acquired IPR&D to bestandard within its industry. We did not take into consideration anyconsequential amount of expense reductions from integrating the acquiredIPR&D with other existing in process or completed technology.

 

The key considerationsunderlying the valuation of acquired in-process research and development fromBlue Pumpkin are as follows: a) guidance from the Financial AccountingStandards Board (“FASB”) Statement of Financial Accounting Standards No. 2,*Accounting for Research and DevelopmentCosts*and FASB Interpretation No. 4, *Applicability of FASB Statement No. 2 to Business CombinationsAccounted for by the Purchase Method;*b) percent completed as of theacquisition date; c) estimated costs to date, as well as costs to complete thetechnology; and d) the numerous technical, cost, market, and timing risks weface before the technology becomes technologically feasible.

 

9

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Goodwill of $35.7 millionhas been recorded and represents the excess of the purchase price over the fairvalue of the tangible and other intangible assets acquired less the liabilitiesassumed.  In accordance with Statement ofFinancial Accounting Standards No. 142, *Goodwilland Other Intangible Assets*, goodwill and intangible assets withindefinite useful lives are not amortized, but are tested for impairment atleast annually or as circumstances indicate their value may no longer berecoverable.

 

Supplemental unauditedpro forma information reflecting the acquisition of Blue Pumpkin as if itoccurred on January 1, 2004 is as follows (in thousands, except per share amounts):

 
| ** **                                  | ** ** | **Three months ended  March 31,** | ** ** |
|---------------------------------------------|------------|-----------------------------------|------------|
| ** **                                  | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Total revenues                              |       | $                                 | 42,234     |   | $ | 42,716 |   |
| Net loss                                    |       | $                                 | (11,734    | ) | $ | (4,753 | ) |
| Net loss per share - basic and diluted      |       | $                                 | (0.45      | ) | $ | (0.19 | ) |
| Weighted average shares - basic and diluted |       | 26,261                            |       | 24,593 |   |

 

The above pro formaresults include adjustments for the amortization expense of intangible assetsarising from the acquisition and the reversal of interest income assuming thepurchase was paid from available cash. In addition, the pro forma results do not reflect any adjustments forIPR&D charges and other cost savings and synergies that we believe wouldhave resulted had the acquisition occurred on January 1, 2004.

 

**4.****              Acquisition-Related Restructuring Accruals andMerger-Related Costs**

 

As a result of the BluePumpkin acquisition in January 2005, we recorded $1.3 million in certainacquisition-related restructuring accruals primarily related to personnelreductions.  All such costs met thecriteria for accrual as outlined in EITF No. 95-3, *Recognitionof Liabilities in Connection with a Purchase Business Combination,*andwere included in the assets acquired and liabilities assumed in the purchase ofBlue Pumpkin.  The following tablesummarizes restructuring accrual activities related to all acquisitions (inthousands):

 
| ** **                                | ** ** | **Severance  and Benefits** | ** ** | **Facilities** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|-----------------------------|------------|----------------|------------|-----------|------------|
| Accrual at December 31, 2004         |       | $                           | —     |           | $          | 2,044     |       | $ | 2,044 |   |
| Acquisition-related restructuring accrual |       | 1,300                       |       | —         |       | 1,300     |       |
| Cash payments                             |       | (1,200                      | )          | (52            | )          | (1,252    | )          |
| Foreign exchange translation              |       | —                      |       | (40            | )          | (40       | )          |
| Accrual at March 31, 2005            |       | 100                         |       | 1,952          |       | $         | 2,052      |   |
| Less: Long-term portion                   |       | —                      |       | (1,747         | )          | (1,747    | )          |
| Current portion at March 31, 2005    |       | $                           | 100        |           | $          | 205       |       | $ | 305 |   |

 

The following tablesummarizes all merger-related costs that were charged to expense during thefirst quarter ended March 31, 2005 and 2004 (in thousands):

 
| ** **                             | ** ** | **March 31,** | ** ** |
|----------------------------------------|------------|--------------------|------------|
| ** **                             | ** ** | **2005**           | ** ** | **2004** | ** ** |
| Eyretel:                               |       |               |       |   |   |
| Adjustments to acquisition liabilities |       | $                  | (56        | ) | $ | — |   |
| Bonus expense                          |       | 154                |       | 368 |   |
| Blue Pumpkin:                          |       |               |       |   |   |
| Integration costs                      |       | 1,561              |       | — |   |
|                                   |       | $                  | 1,659      |   | $ | 368 |   |

 

During2005 and 2004, we incurred merger-related costs pertaining to the acquisitionof Blue Pumpkin that closed in January 2005 and the Eyretel acquisition inMarch 2003.  Merger-related coststotaled $1.7 million in the first quarter of 2005 and included $1.6 million ofintegration expenses comprised primarily of costs of transitional Blue Pumpkinemployees and other contractors, travel costs and advertising costs.  Merger-related costs incurred in the first

 

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quarter of 2004 totaled$0.4 million and relatedto the partial accrual of a bonuspayable to Eyretel’s former Chief Executive Officer, now our Chief OperatingOfficer (“COO”).  Our Board of Directors agreedto pay a bonus of £1.0 million to our COO in connection with the Eyretelacquisition and subsequent integration. In March 2004, £0.4 million of this bonus was paid and theremaining balance of £0.6 million (or $1.1 million as of March 31, 2005)was paid in March 2005.

 

**5.****              Net (Loss) Income Per Share**

** **

The following is a reconciliation ofthe numerator and denominator used in the calculation of basic and diluted net(loss) income per share (in thousands, except per share data):

 
| ** **                                                                         | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                               | ** ** | **2004** | ** ** |
|                                                                               |       |                                   |       |   |   |
| Net (loss) income                                                                  |       | $                                      | (9,360     | ) | $ | 470 |   |
| Weighted average shares of common stock and common  stock equivalents outstanding: |       |                                   |       |   |   |
| Basic                                                                              |       | 26,261                                 |       | 22,462 |   |
| Dilutive effect of stock options computed using the  treasury stock method         |       | —                                 |       | 2,739 |   |
| Diluted common shares and share equivalents  outstanding                           |       | 26,261                                 |       | 25,201 |   |
| Net (loss) income per share:                                                       |       |                                   |       |   |   |
| Basic                                                                              |       | $                                      | (0.36      | ) | $ | 0.02 |   |
| Diluted                                                                            |       | $                                      | (0.36      | ) | $ | 0.02 |   |

 

We have excluded all outstanding stock options from thecalculation of diluted net loss per common share for the first quarter of 2005because we reported a loss in this period and all such securities areanti-dilutive.  The total number of shareequivalents excluded from the calculation of historical diluted net loss percommon share for the first quarter of 2005 was 2,862,491 calculated using thetreasury stock method.  In the firstquarter of 2005 and 2004, 41,283 and 1,136,081 stock options, respectively,were excluded from the computation of diluted earnings per share because theyhad exercise prices that exceeded the average fair market value of our commonstock for those periods, and therefore had an anti-dilutive effect.

 

**6.****              Stock-BasedCompensation**

 

Wegenerally do not record compensation expense for options granted to ouremployees because all options granted under our stock option plans have anexercise price equal to the market value of the underlying common stock on thedate of grant.  As permitted under SFAS No. 148,*Accounting for Stock-Based Compensation -Transition and Disclosure*, and SFAS No. 123, *Accounting for Stock-Based Compensation*,we have elected to continue to apply the provisions of Accounting PrinciplesBoard Opinion No. 25, *Accounting forStock Issued to Employees,* and have adopted the disclosurerequirements of SFAS No. 123.  Thefollowing table illustrates the effect on net (loss) income and net (loss)income per share if we had applied the fairvalue method as prescribed by SFAS No. 123 (in thousands, except per sharedata):

 

11

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| ** **                                                                                              | ** ** | **Three months ended  March, 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                              | ** ** | **2005**                           | ** ** | **2004** | ** ** |
|                                                                                                    |       |                               |       |   |   |
| Reported net (loss) income                                                                              |       | $                                  | (9,360     | ) | $ | 470 |   |
| Add back: Stock-based employee compensation expense  included in reported net (loss) income             |       | 15                                 |       | — |   |
| Deduct: Total stock-based compensation expense  determined under fair value based method for all awards |       | (2,863                             | )          | (1,570 | ) |
| Pro forma net loss                                                                                      |       | $                                  | (12,208    | ) | $ | (1,100 | ) |
| Net (loss) income per share:                                                                            |       |                               |       |   |   |
| Reported basic                                                                                          |       | $                                  | (0.36      | ) | $ | 0.02 |   |
| Pro forma basic                                                                                         |       | $                                  | (0.46      | ) | $ | (0.05 | ) |
| Reported diluted                                                                                        |       | $                                  | (0.36      | ) | $ | 0.02 |   |
| Pro forma diluted                                                                                       |       | $                                  | (0.46      | ) | $ | (0.05 | ) |

 

As of March 31, 2005, there were 2.4 million shares available for future grants under our stock option plans.

 

**7.****              Comprehensive (Loss) income**

** **

**Total comprehensive (loss) income and accumulatedother comprehensive income consisted of the following (in thousands):**

** **
| ** **                                           | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                           | ** ** | **2005**                               | ** ** | **2004** | ** ** |
|                                                 |       |                                   |       |   |   |
| Net (loss) income                                    |       | $                                      | (9,360     | ) | $ | 470 |   |
| Other comprehensive (loss) income:                   |       |                                   |       |   |   |
| Change in unrealized net holding loss on investments |       | 1                                      |       | 14 |   |
| Foreign currency translation adjustments             |       | 105                                    |       | 729 |   |
| Total comprehensive (loss) income                    |       | $                                      | (9,254     | ) | $ | 1,213 |   |

 
| ** **                                          | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                |       |                     |       |                        |       |
| Cumulative foreign currency translation adjustments |       | $                        | 5,058      |                        | $          | 4,953 |   |
| Unrealized net holding loss on investments          |       | (10                      | )          | (11                         | )          |
| Total accumulated other comprehensive income        |       | $                        | 5,048      |                        | $          | 4,942 |   |

 

**8.****              IntangibleAssets**

 

The following tables present the components ofintangible assets (in thousands):

 

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| ** **                | ** ** | **March 31, 2005** | ** ** |
|---------------------------|------------|-------------------------|------------|
| ** **                | ** ** | **Gross  Amount**       | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
|                      |       |                    |       |   |   |   |   |
| Acquired technology       |       | $                       | 36,333     |   | $ | (11,566 | ) | $ | 24,767 |   |
| Customer relationships    |       | 19,291                  |       | (1,793 | ) | 17,498 |   |
| Distribution arrangements |       | 4,256                   |       | (1,736 | ) | 2,520 |   |
| Trademarks                |       | 1,213                   |       | (861 | ) | 352 |   |
| Patents                   |       | 281                     |       | (105 | ) | 176 |   |
|                      |       | $                       | 61,374     |   | $ | (16,061 | ) | $ | 45,313 |   |

 
| ** **                | ** ** | **December 31, 2004** | ** ** |
|---------------------------|------------|----------------------------|------------|
| ** **                | ** ** | **Gross  Amount**          | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
|                      |       |                       |       |   |   |   |   |
| Acquired technology       |       | $                          | 15,588     |   | $ | (9,664 | ) | $ | 5,924 |   |
| Customer relationships    |       | 2,336                      |       | (915 | ) | 1,421 |   |
| Distribution arrangements |       | 4,343                      |       | (1,536 | ) | 2,807 |   |
| Trademarks                |       | 1,237                      |       | (789 | ) | 448 |   |
| Patents                   |       | 295                        |       | (93 | ) | 202 |   |
|                      |       | $                          | 23,799     |   | $ | (12,997 | ) | $ | 10,802 |   |

 

Theintangible assets and amortization expenses are subject to foreign currencytranslation adjustments.  Amortization of intangible assets includedin the accompanying condensed consolidated statements of operations is asfollows (in thousands):

 
| ** **                          | ** ** | **Three months ended  March, 31,** | ** ** |
|-------------------------------------|------------|------------------------------------|------------|
| ** **                          | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| Included in:                        |       |                               |       |   |   |
| Cost of product revenue             |       | $                                  | 2,072      |   | $ | 1,409 |   |
| Selling, general and administrative |       | 1,211                              |       | 455 |   |
|                                |       | $                                  | 3,283      |   | $ | 1,864 |   |

 

**9.****              Lineof Credit**

 

In March 2005, we extended the maturity date on our $15.0 million line of credit to March 2006.  At our election, borrowings under the line of credit bear interest at the bank’s prime rate or LIBOR plus 300 basis points.  Borrowings under the revolving line of credit are limited to 85% of eligible accounts receivable, as defined by the agreement.  The revolving line of credit is secured by all of our assets and requires compliance with various covenants, including liquidity ratios and EBITDA requirements, among others.  As of March 31, 2005, we were in compliance with our bank covenants.

 

As of March 31,2005, we had no amounts outstanding under the line of credit and the amountavailable for borrowing was $12.3 million, which was net of outstanding lettersof credit of $2.7 million.  The lettersof credit secure the leases on the corporate headquarters facility and havedecreasing schedules that ultimately expire in 2007.  In addition, we have a £0.3 million letter ofcredit securing our premises in the United Kingdom.

 

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**10.****       Segment and GeographicInformation**

*** ***

 We consider ourselves to be in a single industry segment, specifically licensing and servicing of software applications to the customer interaction recording and analysis market.  Our chief operating decision maker receives financial information by geographic region; however, our operating segments are aggregated into one reportable segment based upon similar economic characteristics, products, services and delivery methods.

 

World-wide revenue basedon customer location is as follows (in thousands):

 
| ** **     | ** ** | **Three months ended  March, 31,** | ** ** |
|----------------|------------|------------------------------------|------------|
| ** **     | ** ** | **2005**                           | ** ** | **2004** | ** ** |
|           |       |                               |       |   |   |
| United States  |       | $                                  | 23,038     |   | $ | 18,578 |   |
| United Kingdom |       | 9,791                              |       | 8,607 |   |
| Rest of world  |       | 8,330                              |       | 5,767 |   |
| Total          |       | $                                  | 41,159     |   | $ | 32,952 |   |

 

The rest of world revenue was derived primarily from customers located in Canada, Australia, India, Japan, China and other countries.  No individual customer accounted for more than 10% of consolidated revenue during the three months ended March 31, 2005 or 2004.

 

Long-lived assets, including intangible assets and goodwill, by geography are as follows (in thousands):

 

 
| ** **     | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------|------------|--------------------------|------------|-----------------------------|------------|
|           |       |                     |       |                        |       |
| United States  |       | $                        | 78,578     |                        | $          | 5,518 |   |
| United Kingdom |       | 7,117                    |       | 8,533                       |       |
| Rest of world  |       | 2,698                    |       | 2,948                       |       |
| Total          |       | $                        | 88,393     |                        | $          | 16,999 |   |

 

**11.****       Recent AccountingPronouncements**

*** ***

In December 2004, the FinancialAccounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”)No. 123R (Revised 2004), *Share-Based Payment*,which requires that the compensation cost relating to share-based paymenttransactions be recognized in financial statements based on alternative fairvalue models. The share-based compensation cost will be measured based on thefair value of the equity or liability instruments issued. We currently disclosepro forma compensation expense quarterly and annually by calculating the stockoption grants’ fair value using the Black-Scholes model. Upon adoption, proforma disclosure will no longer be an alternative. SFAS No. 123R wasoriginally effective for reporting periods that began after June 15,2005.  In April 2005, the SECannounced the adoption of a new rule allowing companies to implement SFAS No. 123Rat the beginning of their next fiscal year that begins after June 15,2005.  We will begin to apply SFAS No. 123Rusing the most appropriate fair value model beginning January 1, 2006. Weare evaluating the requirements under SFAS 123R and expect the adoption to havea significant adverse impact on our results of operations, but not on our cashflows.

 

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

**Thisquarterly report on Form 10-Q contains forward-looking statements that arenot historical facts but rather are based on current expectations, estimatesand projections about our business and industry, and our beliefs andassumptions.  Words such as “anticipates’’,“expects’’, “intends’’, “plans’’, “believes’’, “seeks’’, “estimates’’ andvariations of these words and similar expressions are intended to identifyforward-looking statements.  Thesestatements are not guarantees of future performance and are subject to risks, uncertaintiesand other factors, some of which are beyond our control, are difficult topredict and could cause actual results to differ materially from thoseexpressed or forecasted in the forward-looking statements.  Forward-looking statements that were true atthe time made may ultimately prove to be incorrect or false.  Readers are cautioned not to place unduereliance on forward-looking statements, which reflect our management’s viewonly as of the date of this report. Except as required by law, we undertake no obligation to update anyforward-looking statement, whether as a result of new information, futureevents or otherwise.**

 

Thefollowing Management’s Discussion and Analysis of Financial Condition andResults of Operations should be read in conjunction with the CondensedConsolidated Financial Statements and Notes thereto included elsewhere in thisreport.  Investors should carefullyreview the information contained in this report under the caption “Factors ThatMay Affect Our Future Results and Market Price of Our Stock” beginning on page 24.

 

**Overview**

 

Weprovide the contact center market a complete workforce optimization softwareand services solution that enables global enterprises to capture customerintelligence and improve workforce performance. Our****solutions – which play a strategic role in the customer interaction centers of****Global 2000 and small- and medium-sizedbusinesses (“SMBs”) worldwide – also are deployed in Internet Protocol (“IP”) Telephony and back office environments,and throughout the extended enterprise, including branch offices.  Witness Systems’ software is comprised of qualitymonitoring, compliance, high-volume and IP Telephony recording solutions, aswell as workforce management, actionable learning and performance managementapplications. **** The solutions enable organizations to****optimizetheir people, processes and technology throughout the enterprise.  Customers benefit from an integrated businessconsulting, implementation and training methodology that supports a rapid deployment,enabling them to drive revenue, reduce operational costs, and achieve greatercustomer retention and loyalty.

 

Oursolution set is designed to enhance the quality of customer interactions acrossmultiple communications media, including the telephone, e-mail and theInternet, and is used primarily in the organization’s contact center(s).  Our enterprise collaboration architectureallows contact center management to share information gathered in the contactcenter with other departments that service the customer, as well as throughoutthe organization.  The result is aproactive management tool for optimizing their customer relationship management(“CRM”), improving communication among departments, and fine-tuning workflow,processes and quality of service from within the contact center and throughoutthe enterprise.  As a result, we believeour customers are able to generate additional revenue opportunities, improveprofitability, enhance customer retention, reduce employee turnover and improvetheir overall customer service and intelligence.  Using an integrated business consulting,installation and training methodology, we provide services to support aneffective and rapid deployment of our software that enables organizations tomaximize their return on an investment in our products and services.  Our software is designed to integrate with avariety of third-party software applications, such as CRM and enterpriseresource planning applications, and with existing telephony and computernetwork hardware and software.  Many ofour customers are companies with an international presence and one or morecontact centers that handle voice and data customer interactions for outboundsales and marketing operations, inbound service/support lines, or both.

 

We deriveproduct revenue by licensing software and derive services revenue by providingrelated installation, training, consulting, and maintenance services.  We also derive a relatively small portion ofproduct revenue by selling hardware to customers since our acquisition ofEyretel plc (“Eyretel”) in March 2003. Our business-driven and/or full-time customer interaction recordingsolutions have generated the majority of our product revenue to date.  We sell our products through our direct salesforce and through our indirect sales channels. Our indirect sales channels consist of distributors, resellers, systemsintegrators and Original Equipment Manufacturers (“OEM”).  Distributors and resellers purchase productfrom us at a discount and then resell our products to end-users (or, in thecase of distributors, to other resellers) and referral partners are paid a feefor referring sales leads to us or for assisting us in a sales order.  Systems integrators are information technology(“IT”) consulting service companies

 

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who recommend ourproducts during client engagements. Through OEM agreements, we co-develop products, which are sold by theOEM as part of their portfolio of products.

 

Weplan to grow our product revenue and maintain our competitive position from atechnology perspective through the timely introduction of our new end-to-endworkforce optimization solution. Comprised of pre-packaged software and services, our workforceoptimization solutions feature four functional areas that will be engineered towork optimally together:  qualitymonitoring/contact center recording, workforce management, performancemanagement and e-learning.  In addition,we continue our investment in and commitment to helping customers optimizeworkforce performance in Internet Protocol (“IP”) Telephony environmentsthrough our Voice over Internet Protocol (“VoIP”) solutions, as well as in backoffice environments that impact the customer experience.  All of these solutions are currently offeredto our customers.  Although sales of suchpre-packaged solutions and IP product offerings have not been material to date,we believe that our VoIP product offerings represent a material growth opportunityfor us as the market transitions to an IP technology environment.  In addition, we believe our product offeringscan be marketed toward back-office initiatives for business process monitoring,which represents a new market for us.

 

Weintend to continue to expand our global sales channels by entering into newreseller, distributor, OEM and similar arrangements with key vendors in thecontact center workforce optimization market. During the past year, approximately one-third of our product revenue wasderived from the indirect sales channel. Factors that may impact our ability to grow our product revenue,however, include our ability to remain competitive from a technologyperspective; market acceptance of our new products; our ability to maintain ourproduct pricing integrity; and our ability to expand our global sales channels.

 

Wealso plan to grow our services revenue in concert with our productrevenue.  When our customers license ourproducts, they generally purchase installation, training and one year ofsupport services.  Therefore, as wegenerate product revenue, we also generate related services revenue. Inaddition, our customers generally renew their maintenance contracts with useach year.  Therefore, our maintenancerevenue increases as our customer base increases.  Factors that may influence our ability togrow our services revenue, however, include our ability to continue to increaseproduct revenues and our ability to maintain a high level of customersatisfaction.

 

On January 24,2005, we acquired Blue Pumpkin Software, Inc. (“Blue Pumpkin”), aprivately held California corporation in order to extend our workforceoptimization solution to include advanced workforce management software andservices solutions.  The acquisitionexpands our offerings by adding forecasting, scheduling, adherence and planningapplications. Pursuant to the Merger Agreement and Plan of Reorganization,dated December 16, 2004 (the “Merger”), we paid $40 million in cash,which was financed from our existing cash and investments, and issued2.1 million unregistered shares of Witness common stock valued at$37.2 million.  Ten percent of theaggregate merger consideration is being held in escrow until January 24,2006, one-year after the closing date of the Merger.  The escrow period may be extended in the eventthat there are pending claims that are brought against the escrow fund withinsuch one-year period.  The escrow fund isavailable to compensate Witness, subject to certain limitations, for lossesresulting from, among other things, breaches of representations, warranties orcovenants in the Merger and certain pending and potential claims.

 

In January 2005,the Compensation Committee of our Board of Directors approved awards of stockoptions for approximately 600,000 shares of Witness common stock to certainBlue Pumpkin employees as an inducement to join the Company.  All of these inducement options have anexercise price equal to the market value on the date of grant, subject tostandard provisions for termination, forfeiture and acceleration, and are exercisablefor five years from the date of grant. The inducement options will first become exercisable, as to25 percent of the total amount, after one year from the date of grant, andcommencing 13 months after grant and until the end of the 47th month followinggrant, the options will become exercisable as to an additional two percent permonth and the balance upon the 48th month following grant.

 

We areheadquartered in Roswell, Georgia and have other offices throughout the UnitedStates.  We deliver our products andservices internationally through our offices in Australia, Brazil, Canada,China, Germany, India, Israel, Japan, Mexico, the Netherlands, South Africa andthe United Kingdom.  During 2004, 2003and 2002, 48%, 45% and 25%, respectively, of our revenue was derived fromcustomers outside the United States.  Wehad 595 full-time employees, plus approximately 159 contractors located in theAsia-Pacific region, at March 31, 2005, compared to 603 employees at March 31,2004.  As of March 31, 2005, 195 ofthe 595 full-time employees were located outside the United States.

 

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**CriticalAccounting Policies and Estimates**

 

Thediscussion and analysis of our financial condition and results of operations isbased upon our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America.  The preparation of thesefinancial statements requires us to make certain estimates and judgments thataffect our reported assets, liabilities, revenues and expenses, and our relateddisclosure of contingent assets and liabilities.  On an on-going basis, we re-evaluate ourestimates, including those related to revenue recognition, the collectibilityof receivables, accounting for acquisitions, impairment of long-lived assetsand goodwill, income taxes and stock-based compensation.  We base our estimates on historicalexperience and on various assumptions that we believe to be reasonable underthe circumstances.  Actual results maydiffer from these estimates.  A summaryof our critical accounting policies follows.

 

*Revenue Recognition.*    Werecognize revenue in accordance with the American Institute of Certified PublicAccountants’ Statement of Position (“SOP”) No. 97-2, *Software Revenue Recognition,* and SOP No. 98-9*, Modification of SOP 97-2, Software RevenueRecognition, With Respect to Certain Transactions*.  Revenue is primarily derived from licensingsoftware and providing related services including maintenance.  We also derive a relatively small portion ofproduct revenue by selling hardware to customers since our acquisition ofEyretel.  Product revenue, which includessoftware and hardware, is recognized when persuasive evidence of an arrangementexists, delivery of the product has occurred, the fee is fixed or determinable,collection is probable and vendor specific objective evidence of fair value (“VSOE”)exists to allocate revenue to the undelivered elements of the arrangement. Wereport hardware revenue gross in accordance with Emerging Issues Task Force (“EITF”)No. 99-19, *Reporting Revenue Gross as aPrincipal versus Net as an Agent,* because the factors indicatinggross reporting outweigh the factors indicating net reporting.  We recognize revenue using the residualmethod of accounting since we generally have VSOE for maintenance andprofessional services, but not for the software and hardware elements of theorder.  Under the residual method,services revenue, including maintenance and professional services, is deferredat an amount equal to VSOE until those elements are delivered.  Consequently, product revenue for thesoftware and hardware may be recognized (i) upon delivery of thoseproducts when we have VSOE on the related maintenance and professional servicessold and (ii) at an amount representing the difference between the totalorder amount and the amount deferred. Services revenue includes installation, training, consulting,maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services isrecognized upon performance of the related services and is offered and billedas separate elements of contracts. Reimbursable travel expenses revenue isrecognized upon incurrence of the related expenses.  The functionality of the software and anyhardware sold is not dependent on installation and training services andcustomization is not required to enable our customers to use our products.  Maintenance is offered as a separate elementand the majority of contracts include the right to unspecified upgrades on awhen-and-if available basis.  Maintenancerevenue is deferred and recognized ratably over the term of the relatedcontract.

 

*Allowance for Doubtful Accounts.*    Weperform ongoing evaluations of our customers and continuously monitorcollections and payments and estimate an allowance for doubtful accounts basedon the aging of the underlying receivables, our historical experience and anyspecific customer collection issues that we have identified.  While such credit losses have historicallybeen within our expectations and we believe appropriate reserves have beenestablished, we cannot assure that we will continue to experience the samecredit loss rates that we have experienced in the past or adequately predictfuture credit losses.  If the financialcondition of our customers was to deteriorate and resulted in an impairment oftheir ability to make payments, additional allowances may be required whichwould result in an additional selling, general and administrative expense inthe period such determination is made.

 

Ourrevenue recognition policy is significant because our revenues are a keycomponent of our results of operations. We follow very specific and detailed guidelines, discussed above, inmeasuring revenues; however, certain judgments and estimates affect theapplication of our revenue policy described above.  Further, assessment of collectibility isparticularly critical in determining whether or not revenues should berecognized. We also record provisions for estimated sales allowances on productand service related revenues at the time the related revenues arerecorded.  These estimates are based onhistorical sales and services allowances, analysis of customer credits andother known factors.  If future salescredits prove to be greater than the historical data and the estimates we usedto calculate these provisions, our revenues could be overstated.

 

17

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*Accounting for Acquisitions.*    Accountingfor acquisitions requires management to make judgments and estimates indetermining the purchase price, the fair value of the assets and liabilitiesacquired and merger-related and restructuring expenses.  In recording the Blue Pumpkin acquisition in2005, significant judgment was required in estimating:

 

•                  valuation of deferred revenue,

•                  valuation of intangible assets andacquired in-process research and development,

•                  severance expenses for employeeterminations,

•                  contingent liabilities that existedat the date of acquisition.

 

Changesto purchase price estimates, prior to the completion of the final purchaseprice allocation, are reflected as adjustments to goodwill and/or otheracquired assets.  Subsequent adjustmentsare reflected in our results of operations. In accordance with Statement of Financial Accounting Standards No. 142,*Goodwill and Other Intangible Assets*,goodwill and intangible assets with indefinite useful lives are not amortized,but are tested for impairment at least annually or as circumstances indicatetheir value may no longer be recoverable.

 

*Impairment of Long-Lived Assets.*    Long-livedassets, such as property and equipment and intangible assets, are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable.  All of our intangible assets are amortizedusing the straight-line method.  Usefullives of amortizable intangible assets are reviewed annually with any changesin estimated useful lives being accounted for prospectively over the revisedremaining useful life.  Recoverability ofassets to be held and used would be measured by a comparison of the carryingamount of an asset to the estimated undiscounted future cash flows expected tobe generated by the asset.  If thecarrying amount of an asset exceeds its estimated future cash flows, animpairment charge is recognized in the amount by which the carrying amount ofthe asset exceeds the fair value of the asset. The determination of estimated future cash flows, however, would requiremanagement to make estimates.  Futureevents and changes in circumstances may require us to record a significantimpairment charge in the period in which such events or changes occur.Impairment testing requires considerable analysis and judgment in determiningthe results.  If other assumptions andestimates were used in our evaluations, the results could differ significantly.

 

*Accounting for Income Taxes.*    Weaccount for income taxes in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 109, *Accountingfor Income Taxes*, which requires companies to recognize deferredincome tax assets and liabilities using enacted tax rates for temporarydifferences between the financial reporting and tax bases of recorded assetsand liabilities and expected benefits of utilizing net operating loss andcredit carryforwards.  SFAS No. 109also requires that deferred income tax assets be reduced by a valuationallowance if it is more likely than not that some portion or all of thedeferred income tax assets will not be realized.  We evaluate the realizability of our deferredincome tax assets, primarily resulting from net operating loss and creditcarryforwards, and adjust our valuation allowance, if necessary.

 

Oncewe utilize our net operating loss carryforwards, we would expect our provisionfor income tax expense in future periods to reflect an effective tax rate thatwill be significantly higher than past periods. Furthermore, the utilization of certain net operating loss carryforwardsarising from acquisitions might result in a reduction of the intangible assetsand the recognition of deferred income tax expense.

 

Estimatesand judgments are required in determining our worldwide income tax expense.  In the ordinary course of conducting businessglobally, there are many transactions and calculations whose ultimate taxoutcome cannot be certain.  Although webelieve our estimates and judgments are reasonable, no assurance can be giventhat the final tax outcome of these matters will not be different from what isreflected in our historical income tax provisions and accruals.  Such differences could have a material impacton our income tax provision and operating results in the period in which such adetermination is made.

 

In December 2004,the Financial Accounting Standards Board (“FASB”) issued Staff Position No. FAS 109-2,Accounting*and Disclosure Guidance for theForeign Earnings Repatriation Provision within the American Jobs Creations Actof 2004*.  Corporations areallowed an 85% dividends received deduction in 2004 and 2005 on therepatriation of certain foreign earnings to a U.S. taxpayer, provided certaincriteria are met. Later in 2005, we will complete our evaluation of the effectsof the repatriation provision.  At thistime, the range of possible amounts that may be considered for repatriation, ifany, and the tax effects of these amounts under this provision are unknown.

 

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*Stock-Based Compensation.*    Wegenerally do not record compensation expense for options granted to ouremployees because all options granted under our stock option plans have anexercise price equal to the market value of the underlying common stock on thedate of grant.  As permitted under SFAS No. 148,*Accounting for Stock-BasedCompensation—Transition and Disclosure*, and SFAS No. 123, *Accounting for Stock-Based Compensation*,we have elected to continue to apply the provisions of Accounting PrinciplesBoard Opinion No. 25, *Accounting forStock Issued to Employees,* and have adopted the disclosurerequirements of SFAS No. 123.  Thepro forma disclosures of stock-based compensation include the use of certaininput factors in calculating the fair value of stock option grants, some ofwhich require management to make estimates and use judgment.  In December 2004, the FASB issued SFAS No. 123R(Revised 2004), *Share-Based Payment*,which requires that the compensation cost relating to share-based paymenttransactions be recognized in financial statements based on alternative fairvalue models.  The share-basedcompensation cost will be measured based on the fair value of the equity orliability instruments issued. Upon adoption, pro forma disclosure will nolonger be an alternative.  SFAS No. 123Rwas originally effective for reporting periods that began after June 15,2005.  In April 2005, the SECannounced the adoption of a new rule allowing companies to implement SFAS No. 123Rat the beginning of their next fiscal year that begins after June 15,2005.  We will begin to apply SFAS No. 123Rusing the most appropriate fair value model beginning January 1,2006.  We are evaluating the requirementsunder SFAS 123R and expect the adoption to have a significant adverseimpact on our results of operations, but not on our cash flows.

 

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**Results ofOperations**

 

Thefollowing table sets forth the results of operations for the three months endedMarch 31, 2005 and 2004 expressed as a percentage of total revenue.

 
| ** **                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                       | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Revenue:                                         |       |                              |       |   |   |
| Product                                          |       | 40                                | %          | 42 | % |
| Services                                         |       | 60                                | %          | 58 | % |
| Total  revenue                                   |       | 100                               | %          | 100 | % |
| Cost  of revenue:                                |       |                              |       |   |   |
| Product                                          |       | 11                                | %          | 12 | % |
| Services                                         |       | 23                                | %          | 24 | % |
| Total  cost of revenue                           |       | 34                                | %          | 36 | % |
| Gross  profit                                    |       | 66                                | %          | 64 | % |
| Operating  expenses:                             |       |                              |       |   |   |
| Selling,  general and administrative             |       | 48                                | %          | 47 | % |
| Research  and development                        |       | 15                                | %          | 15 | % |
| Merger-related  costs                            |       | 4                                 | %          | 1 | % |
| Acquired  in-process research and development    |       | 22                                | %          | 0 | % |
| Operating  (loss) income                         |       | -23                               | %          | 1 | % |
| Interest  and other income, net                  |       | 0                                 | %          | 0 | % |
| (Loss)  income before provision for income taxes |       | -23                               | %          | 1 | % |
| Provision  for income taxes                      |       | 0                                 | %          | 0 | % |
| Net  (loss) income                               |       | -23                               | %          | 1 | % |

 

*Impact of Blue Pumpkin Acquisition*

 

The acquisition of Blue Pumpkin in January 2005,increased our reported revenues and expenses in the first quarter of 2005 byapproximately $4 million compared to the same period in 2004.  Operating expenses, expressed as a percentageof total revenue, increased in the first quarter of 2005 compared to the sameperiod in 2004 due to an increase of $9.0 million for the acquired in-processresearch and development costs, the increase of $1.3 million in merger-relatedcosts and additional intangible asset amortization of $1.8 million.

 

*Revenue*

 

Totalrevenue increased 25% in the first quarter of 2005, as compared to the firstquarter of 2004, to $41.2 million.  Theincrease in total revenue can be attributed to both continued growth of ourbusiness and sales and related services derived from our Blue Pumpkinacquisition.  In addition, first quarterof 2005 was adversely affected by a 3% or $1.0 million decrease in hardwarerevenue from the first quarter of 2004. During the first quarter of 2005, we installed an additional 117customer sites and, with the inclusion of Blue Pumpkin, we ended the quarterwith 3,846 installed customer sites as of March 31, 2005 versus approximately2,444 at March 31, 2004.

 

Product revenue includessoftware revenue and hardware revenue. Because hardware sales are incidental to our core business, we areworking towards transitioning our customers to third-party hardware suppliersand, as a result, expect hardware revenue to decline in the future.  Product revenue of $15.1 million, excluding hardware revenue of $1.3 million in thefirst quarter of 2005 (and $2.3 million in the same period in 2004), increased$3.5 million or 30%

 

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in the first quarter of 2005.  Approximately $1.2 million of this increasereflects the revenue from our expanded product line resulting from ouracquisition of Blue Pumpkin which we began consolidating on January 24, 2005.

 

Product revenue as a percentage of total revenue hasbeen decreasing over the previous three years due to increased servicesrevenue, as discussed below. Our product pricing has remained reasonablyconsistent over the previous three years.

 

Newcustomers accounted for 21% and 22%, respectively, of product revenue,excluding hardware revenue, during the first quarter of 2005 and 2004.  We receive follow-on revenue from ourexisting customers when they purchase additional user licenses or licenseadditional applications at existing sites and when they license our products atnew sites.  We expect to continuereceiving the majority of our product revenue from existing customers during2005.

 

Services revenue, consisting of installation,training, consulting, maintenance support and reimbursable travel expenses,increased 30% to $24.8 million in the first quarter of 2005 compared to thefirst quarter of 2004.  This increase wasdue to the installation and training services related to new product sales anddue to customers renewing their maintenance contracts with us therebyincreasing our recurring maintenance revenue stream.  Approximately one-third of the increase inservices revenue in 2005 can be attributed to the Blue Pumpkin acquisitionconsummated January 24, 2005.  Thepercentage of Witness customers that have renewed their maintenance contractswith us has historically exceeded 90%. We believe that maintenance contracts will be renewed at a comparablerate during 2005.  Our services pricinghas remained consistent over the past three years.  We expect services revenue, in absolutedollars, to increase over time due to the compounding effect of renewals ofannual maintenance contracts from existing customer sites and to remain relativelyconstant as a percentage of total revenue, excluding hardware revenue,throughout 2005.

 

*Cost ofRevenue*

 

Total cost of revenue increased 17% to $13.9 millionin the first quarter of 2005 compared to the first quarter of 2004.  Expressedas a percent of revenue, gross profit margins increased to 66% in the firstquarter of 2005 compared to 64% in the same period in 2004.  This increase resulted primarily fromproductivity gains achieved in the professional services organization.  Excluding hardware cost of revenue and theamortization of intangible assets resulting from acquisitions, gross profitmargins increased slightly to 74% in the first quarter of 2005 from 73% in thefirst quarter of 2004.  We expect ourgross profit margin, excluding hardware and amortization of intangible assets,to remain relatively constant throughout 2005.

 

Cost of product revenue consists of amortization ofacquired technology, hardware costs, royalties due to third parties forsoftware components that are embedded in our software applications,amortization of capitalized software development costs and packagingcosts.  Amortization of acquiredtechnology was $1.9 million in the first quarter of 2005 compared to $1.4million in the same period in 2004.  Costof hardware revenue was $1.3 million in the first quarter of 2005 and $2.0million in the same period of 2004.  Wewill continue to incur amortization expense, but expect the cost of hardware todecline as we work towards reducing the amount of hardware sales in the future.  Cost of product revenue, excludingamortization of acquired technology and hardware costs, increased 108% in thefirst quarter of 2005 compared to the same period in 2004.  This increase was due to increased royaltiesdue to third parties for software components that are embedded in our softwareapplications.  Such royalties increasedas a result of an increase in sales of software applications containing thirdparty software components.  The cost ofproduct revenue expressed as a percentage of product revenue, excludinghardware and amortization of intangible assets was 6% and 4% in the firstquarter of 2005 and 2004, respectively. As we develop upgrades of our existing products and add new offerings toour product suite, we may embed third-party technology into our software, whichwould increase the cost of product revenue in the future.

 

Cost of services revenue for installation, training,consulting and maintenance services include personnel costs and relatedexpenses and allocated overhead.  Personnelcosts include salaries, bonuses and benefits. Cost of services revenue increased 20% to $9.5 million in the firstquarter of 2005 compared to the same period in 2004 due primarily to anincrease in the number of employees engaged in customer support servicesprimarily as a result of the Blue Pumpkin acquisition.  Cost of 

 

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services revenue as a percentage of services revenuedecreased to 38% of total services revenue in the first quarter of 2005 from42% in the same period in 2004 due to productivity improvements in theprofessional services group.  Weanticipate that our services margins will remain relatively consistent with2005 throughout the remainder of the year. We expect our customer service organization to continue to grow overtime and, therefore, we anticipate that our cost of services revenue, inabsolute dollars, will increase as we grow our customer base.  During the latter half of 2004, we began expandingour customer support organization in the Asia-Pacific region; however, we havenot incurred any significant incremental costs associated with this initiativein 2005.

 

*OperatingExpenses*

 

*Selling, General andAdministrative.** *Selling, general and administrative(‘‘SG&A’’) expense consists primarily of personnel costs, salescommissions, marketing programs, professional fees, the amortization of certainintangible assets and provisions for bad debt expense.  SG&A expense increased 28% to $19.9 millionin the first quarter of 2005 compared to the same period in 2004 due primarilyto higher amortization expenses and the increased size of our Company due tothe acquisition of Blue Pumpkin.  In2005, we expect SG&A expense to increase in absolute dollars but decreaseas a percentage of total revenue due to anticipated revenue growth.

 

*Research and Development.*   Research and development (‘‘R&D’’)expenses consist primarily of personnel and consulting costs to support productdevelopment, and allocated overhead. R&D costs are generally expensed as incurred and include softwaredevelopment costs incurred prior to the establishment of technologicalfeasibility. Costs incurred subsequent to establishing technologicalfeasibility are capitalized and amortized over their estimated useful lives tocost of product revenue.  As of March 31,2005 and 2004, $0.1 million and $0, respectively, in software development costswere capitalized.  R&D expensesincreased 27% to $6.2 million in the first quarter of 2005 compared to the sameperiod in 2004 due to the increased number of employees engaged in research anddevelopment activities as a result of the Blue Pumpkin acquisition.  We expect total R&D expense to increasein absolute dollars but decrease as a percentage of total revenue during 2005as compared to 2004.

 

*Merger-relatedCosts*. During 2005 and 2004, we incurred merger-related costspertaining to the acquisition of Blue Pumpkin that closed in January 2005 andthe Eyretel acquisition in March 2003. Merger-related costs totaled $1.7 million in the first quarter of 2005and included $1.6 million of Blue Pumpkin integration expenses.

 

Merger-related costsincurred in the first quarter of 2004 totaled $0.4 million and related to the partial accrual of a bonus payable toEyretel’s former Chief Executive Officer, now our Chief Operating Officer (“COO”).  OurBoard of Directors agreed to pay a bonus of £1.0 million to our COO inconnection with the Eyretel acquisition and subsequent integration.  In March 2004, £0.4 million of this bonus waspaid and the remaining balance of £0.6 million (or $1.1 million as of March 31,2005) was paid in March 2005.

 

*Acquired In-Process Research andDevelopment.*  Duringthe first quarter of 2005, we estimated that $9.0 million of the purchase priceof Blue Pumpkin represented acquired in-process research and development (‘‘IPR&D’’)that had not yet reached technological feasibility as defined by SFAS No. 86, *Accounting for the Cost of Computer Software to BeSold, Leased or Otherwise Marketed,*and had no alternative futureuse.  Accordingly, these amounts wereimmediately charged to expense upon consummation of the acquisition.  The value of the IPR&D was determinedwith the assistance of an independent third-party appraiser by utilizing adiscounted cash flow methodology, focusing on the income-producing capabilitiesof the in-process technologies and taking into consideration: stage ofcompletion; complexity of work to date and to complete; anticipated productdevelopment and introduction schedules; forecasted product sales cycles;internal and external risk factors; revenue and operating expense estimates;contributory asset charges, and costs already incurred and the expected coststo complete.

 

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*Interestand Other Income, Net*

 

Interest and other income, net consists primarily ofinterest earned on funds available for investment and foreign currencytransaction gains and losses on settlement of contracts denominated incurrencies other than the local currency. Interest and other income, net decreased slightly to $0.1 million in thefirst quarter of 2005 compared to $0.2 million in the same period in 2004 dueprimarily to decreased interest income resulting from lower investment balancesas a result of the acquisition of Blue Pumpkin. We expect that interest and other income, net will decrease in 2005compared to 2004 due to lower cash and investment balances.

 

*Provisionfor Income Taxes*

 

We recorded a provision for federal alternativeminimum tax and foreign income tax of $33,000 and $25,000, respectively, in thefirst quarter of 2005 and 2004.  As ofDecember 31, 2004, we have net operating loss carryforwards aggregating $31.4million for U.S. tax purposes and $44.4 million for foreign tax purposes.  The provisions for income taxes benefitedfrom the utilization of net operating loss carryforwards from prior years.  However, the utilization of certain netoperating loss carryforwards arising from acquisitions might result in a futurereduction of intangible assets and the recognition of deferred income taxexpense.

 

**Liquidity and Capital Resources**

 

At March 31, 2005, we had $31.9 million in total cashand cash equivalents and investments, compared to $76.5 million at December 31,2004.  Working capital similarlydecreased by $42.5 million from $60.1 million at December 31, 2004 to $17.6million at March 31, 2005.  The cashflows used for operations in the first quarter of 2005 were impacted by $1.7million of merger-related costs, as well as by an increase of accountsreceivable of $6.6 million, which was attributable to the Blue Pumpkinacquisition and an increase in days sales outstanding since December 31,2004.  Deferred revenue decreased by $1.0million due to the timing of collections.

 

Cash flows used ininvesting activities in the first quarter of 2005 were $(6.9) million.  The cash portion of the Blue Pumpkinacquisition ($40.0 million or $36.3 million net of cash equivalents acquired)was funded in part through the sale of investment securities totaling $30.9million.  Capital expenditures were $1.4million during the quarter.

 

Cash flows provided byfinancing activities during the first quarter of 2005 were $2.2 million,representing proceeds from the exercise of stock options.

 

At March 31, 2005, we had $12.3 million availableunder a line of credit, which was net of outstanding letters of credit of $2.7million.  The letters of credit securethe lease on the corporate headquarters facility and have decreasing schedulesthat ultimately expire in 2007.  At ourelection, borrowings under the line of credit bear interest at the bank’s primerate, or LIBOR plus 300 basis points, and are limited to 85% of eligibleaccounts receivable, as defined by the agreement.  The revolving line of credit is secured byall of our assets and requires compliance with various covenants, includingliquidity ratios and EBITDA requirements, among others.  As of March 31, 2005, we were in compliancewith all bank covenants.

 

We anticipate that operating expenses and capitalexpenditures will continue to be a material use of our cash resources.  We currently expect to have total capitalexpenditures of approximately $12.0 million in 2005, including the use ofapproximately $7.0 million of cash to acquire an international reseller, whichis presently in negotiation.  We expectto expend approximately $5.0 million during 2005 on other capital expenditures,including computer equipment and software. We anticipate that our capital expenditures may increase over the nextseveral years as we expand our facilities and acquire equipment to support theexpansion of our research and development activities and internal managementand information systems.  We believe thatour existing cash and investment balances, together with our anticipated cashflows from operations, will be sufficient to meet our working capital andcapital expenditures for at least the next twelve months.  In addition, the availability under our lineof credit may be used to fund working capital requirements or future merger oracquisition transactions.

 

Our shelf registration statement on Form S-3(including subsequent amendments) with the Securities and Exchange Commission (“SEC”)became effective in August 2004.  Theshelf registration allows us to register up to $80 million of securities, whichmay consist of common stock, warrants to purchase our common stock, or both.

 

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The shelf registration statement provides us the ability to raiseequity capital if and when appropriate for our business.  The sale of additional equity securitiescould result in additional dilution to our stockholders.  If cash generated from operations isinsufficient to satisfy our liquidity requirements and we are unable or choosenot to raise additional equity capital or borrow under our line of credit, wemay seek to establish new financing arrangements. We cannot assure that anyfinancing arrangements will be available in sufficient amounts or on acceptableterms.

 

In addition, we are inthe process of registering the 2.1 million shares of our common stock issued tothe Blue Pumpkin shareholders as part of the purchase price.  The registration of these shares requires ourfiling additional information with the SEC and the subsequent order of the SECdeclaring our registration statement effective.

 

*Market Risk*

 

Market risk representsthe risk of loss that may affect us due to adverse changes in financial marketprices and rates.  Our market riskexposure primarily relates to fluctuations in foreign exchange rates and interestrates.  Except for the hedge transactionentered into in connection with the Eyretel acquisition during 2003, we havenot entered into derivative or hedging transactions to manage risk inconnection with foreign exchange fluctuations and have not engaged in anyinterest rate hedging transactions.  Dueto the stabilization of foreign currencies compared to the U.S. dollar, foreigncurrency translations did not contribute significantly to our March 31, 2005operating results compared to those in the same period in 2004.

 

Within our foreign-basedoperations, where transactions may be denominated in foreign currencies, we aresubject to market risk with respect to fluctuations in the relative value ofcurrencies.  Currently, we have foreign-basedoperations in Australia, Brazil, Canada,China, Germany, India, Israel, Japan, Mexico, the Netherlands, South Africa andthe United Kingdom and conduct transactions in either the local currencyof the location or the U.S. dollar.  Weare exposed to adverse movements in foreign currency exchange rates because wetranslate foreign currencies into U.S. dollars for reporting purposes.  Historically, these risks have been minimal,but as our international operations continue to grow, adverse currencyfluctuations could have a material adverse impact on our financialresults.  Net foreign exchange gains and(losses) were $(0.2) million and $0 inthe first quarter of 2005 and 2004, respectively.

 

Exposure to market raterisk for changes in interest rates relates to our investment portfolio.  Our investments are made with capitalpreservation and liquidity as our primary objectives.  We generally hold only high-grade investmentssuch as commercial paper, corporate bonds and U.S. government agencysecurities.  To reduce our balance sheetexposure to variations in asset values, our investment policy guidelinesspecify that we invest in the highest investment grade securities and maintaina weighted average maturity of nine months for our entire portfolio.  Our investment portfolio may containsecurities with maturities of up to three years.  While this minimizes our interest rate riskto asset values, our results are exposed to fluctuations in interest income dueto changes in market rates.

 

**FactorsThat May Affect Our Future Results and Market Price of Our Stock**

 

Our future operatingresults may vary substantially from period to period. The price of our commonstock will fluctuate in the future, and an investment in our common stock issubject to a variety of risks, including, but not limited to, the specificrisks identified below. Inevitably, some investors in our securities willexperience gains while others will experience losses depending on the prices atwhich they purchase and sell our securities. Prospective and existing investorsshould consider the following factors in evaluating our business or aninvestment in our securities.  If any ofthe following or other risks actually occurs, our business, financial conditionand results of operations could be adversely affected.  In that case, the trading price of our commonstock could decline.

 

*Becauseour products have a long sales cycle, it is difficult to plan our expenses andforecast our results; and our operating results may fail to meet investorexpectations, which may adversely affect our stock price.*

 

It typically takes threeto nine months from the time we qualify a sales lead until we sign a salescontract with the customer. As a result, it is difficult for us to predict thequarter in which a particular sale will occur. If our sales cycle unexpectedlylengthens for one or more large orders or a significant number of small orders,it would delay the timing of our revenue, but not the timing of most of ourcorresponding expenses. Lengthening our sales cycle could also increase thetotal cost of a sale due to additional employee time and costs associated withthe sale. Material

 

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changes in our salescycle could cause our quarterly revenue or operating results to be below theexpectations of investors, and the price of our common stock could fallsubstantially.

 

Ourcustomers’ decision process regarding their purchase of our products andservices is relatively long due to several factors, including:

 

•                  thecomplex nature of our products, requiring our need to educate potentialcustomers about the uses and benefits of our products;

•                  competitionfor the corporate resources necessary to finance the purchase andimplementation of our products;

•                  customers’budgeting and purchasing cycles;

•                  theextent of customers’ evaluation and internal approval process often requiredbefore purchasing our products and services; and

•                  delayedpurchases due to announcements of new products or enhancements by ourcompetitors or us.

 

*If our productsand services are not used and accepted by existing and prospective customers,our business and results of operations will be adversely affected.*

 

Themarket for workforce optimization software, including software that records andanalyzes customer interactions and that forecasts and schedules employees, isstill developing. Our success depends on the use and acceptance of our softwareand services by existing and prospective customers. In addition, demand for oursoftware remains uncertain because our existing and potential customers may:

 

•                  notunderstand the benefits of using workforce optimization software generally or,more specifically, software which records and analyzes the interactions betweena business and its customers or which optimizes the forecasting and scheduling of employees;

•                  not achieve favorable results using oursoftware;

•                  experience technical difficulty inimplementing our software;

•                  usealternative methods such as online self-help to solve the same businessproblems our software is intended to address; or

•                  close contact centers.

 

*If we experiencelosses from operations in the future, the market price of our common stock maybe materially and adversely affected.*

 

With the exception of2004 and the first half of 2002, we have historically experienced quarterlylosses from operations.  We will need togenerate sufficient revenue to achieve sustained profitability and avoidincurring losses again in the future.  Asa result of our prior operating losses, we had an accumulated deficit of $48.4million as of March 31, 2005.

 

*Ourquarterly results are difficult to predict and adverse fluctuations inoperating results could cause our stock price to fall.*

 

Our quarterly revenue andoperating results are difficult to predict and could fluctuate significantlyfrom period to period. In particular, we typically derive a significant portionof our software product revenue in each quarter from a small number ofrelatively large orders. The delay or failure to close anticipated sales in aparticular quarter could reduce our revenue in that quarter and subsequentquarters over which revenue for the sale could be recognized. In addition,because our revenue from installation, initial maintenance and trainingservices largely correlates with our product revenue, a decline in productrevenue could also cause a decline in our services revenue in the same quarteror in subsequent quarters. Our quarterly revenue is difficult to forecast forseveral reasons, including the following:

 

•                  changesin demand for our products and services;

•                  afailure by us to develop, market and manage new software, software enhancementsand services that our customers require in a timely manner;

•                  lengtheningof our customers’ budgeting and purchasing cycles;

•                  timingof any acquisitions and related costs;

•                  delaysin installations of our software;

•                  varyingsales and implementation cycles for our products and services from customer tocustomer;

•                  thetendency of customers to delay software until the end of the fiscal quarter;

 

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•                  thefailure of our customers to renew their maintenance service agreements;

•                  thetiming of hiring new services employees and the rate at which these employeesbecome productive; and

•                  thedevelopment and performance of our distribution channels.

 

As a result of these andother factors, we believe that quarter-to-quarter comparisons of our operatingresults may not be a good indicator of our future performance, and you shouldnot rely on them to predict our future performance or the performance of ourstock price. If our revenue or operating results fall below the expectations ofinvestors or securities analysts, the price of our common stock would likelydecline.

 

*We maybe unable to manage and expand our international operations, which mayadversely affect our business and operating results.*

 

We derived $18.1 millionand $14.4 million in the first quarter of 2005 and 2004, respectively, fromcustomers located outside the United States. During 2003, we completed thepurchase of Eyretel plc and significantly expanded our operations outside ofNorth America.  Our operations outside ofthe United States at March 31, 2005, consisted of approximately 195 dedicatedemployees located in Australia, Brazil, Canada, China, Germany, India, Japan,Malaysia, Mexico, the Netherlands, Singapore, South Africa and the UnitedKingdom. We have also established relationships with a number of internationalresellers.

 

Withour acquisition of Blue Pumpkin Software Inc. in January 2005, which also hassales outside of North America, we have expanded our international operations,and we intend to continue to expand our international operations throughadditional acquisitions, internal business expansion and strategic businessrelationships. These efforts require significant management attention andfinancial resources. We may not be able to successfully penetrate internationalmarkets or, if we do, we may not be able to grow or to maintain adequate profitmargins in these markets. Because of the complex nature of our internationalexpansion, it may adversely affect our business and operating results.International expansion and sales are subject to many risks, including thefollowing:

 

•                  limiteddevelopment of an international market for our software and services;

•                  expandingand training our international sales force and support operations;

•                  highercosts of employment in certain international geographies;

•                  difficultiesin producing localized versions of our products;

•                  politicaland economic instability;

•                  potentiallyadverse tax consequences of operating in foreign countries;

•                  importand export restrictions and tariffs;

•                  longerpayment cycles and difficulties in collecting accounts receivable;

•                  currencyfluctuations;

•                  culturaldifferences which may affect workforce performance and sales processes;

•                  difficultiesand expenses associated with complying with a variety of foreign laws; and

•                  unexpectedchanges in regulatory requirements.

 

As we further expand ouroperations outside the United States, we will also face new competitors andcompetitive environments. In addition to the risks associated with our domesticcompetitors, foreign competitors may pose an even greater risk, because theymay possess a better understanding of their local markets and have betterworking relationships with local infrastructure providers and others. Inparticular, because telephone protocols and standards are unique to eachcountry, local competitors will have more experience with, and may have a competitiveadvantage in, these markets. We may not be able to obtain similar levels ofknowledge, which could place us at a significant competitive disadvantage. Inaddition, we have limited experience in developing local language versions ofour products or in marketing our products to international customers. We maynot be able to successfully translate, market, sell, and deliver our productsinternationally.

 

*If weare unable to maintain a productive direct sales force, our business andoperating results could be materially adversely affected.*

 

We believe that ourfuture success will depend on maintaining a productive direct sales force.Historically, it has taken us up to six months to train new sales personnelbefore they reach an acceptable level of productivity.  We cannot assure you that we will be able tocontinue to manage turnover and hire new sales personnel to meet our needs. Ifthe personnel we hire are less qualified than we expect, it may take us moretime to train them before they reach an acceptable level of productivity, whichcould increase our costs and impact our revenue.

 

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*If weare unable to expand the distribution of our products through indirect saleschannels, our business and operating results could be materially adverselyaffected.*

 

Our strategy is tocontinue to increase the proportion of customers served through indirect saleschannels, such as select resellers and a variety of strategic marketingalliances. Product revenue from our indirect sales channel representedapproximately 42% and 41% of total product revenue in the first quarter of 2005and 2004.  We expect revenue from ourindirect sales channel and, accordingly, our dependence on distributionpartners, to increase as we establish relationships with companies to resellour software worldwide. In connection with our acquisition of Blue Pumpkin, weacquired several reseller relationships with provisions that grant theexclusive rights to market some of our products. If we are not successful inremoving these contractual provisions, our ability to grow in the affectedgeographies, including the United Kingdom, may be limited. We cannot assure youthat we will be able to maintain productive relationships with our currentpartners, or that we will be able to establish similar relationships withadditional resellers on a timely basis, if at all.

 

Some resellers with whichwe do business have similar, and often more established, relationships with ourcompetitors, and may recommend the products and services of our competitors tocustomers instead of our software and services. We cannot provide assurancethat these distribution partners will devote adequate resources to selling oursoftware and services or that our resellers may not learn about our productsand the market for our software and services and develop and sell competingproducts and services.  As a result, ourrelationships with resellers could lead to increased competition for us.

 

*Intensecompetition in our business could adversely affect our revenue, profitabilityand market share.*

 

The market for productsthat record customer interactions, forecast and schedule employees, analyzeperformance and/or provide electronic learning is intensely competitive,evolving and is subject to rapid changes in technology. We believe ourprincipal competitors include, but are not limited to:

 

•                  qualitymonitoring suppliers to the contact center industry;

•                  traditionalcall-logging vendors;

•                  workforcemanagement, forecasting and scheduling vendors to the call center industry;

•                  electroniclearning vendors;

•                  businessanalytics vendors;

•                  largetelecom solution providers;

•                  systemsintegrators and consulting firms; and

•                  new,larger and more established entities that may acquire, invest in or form jointventures with providers of recording or performance enhancing softwaresolutions.

 

Many of our current andpotential competitors have longer operating histories, more establishedbusiness relationships, larger customer bases, a broader range of products andservices, greater name recognition and substantially greater financial,technical, marketing, personnel, management, service, support and otherresources than we do. As a result, our current and potential competitors may beable to respond more quickly to new or emerging technologies and changes incustomer requirements, take better advantage of acquisitions and otheropportunities, devote greater resources to marketing and selling their productsand services and adopt more aggressive pricing policies.  We cannot assure you that our current orpotential competitors will not develop products comparable or superior in termsof price and performance features to those developed by us.

 

In addition, many of ourcompetitors market their products through resellers and companies thatintegrate their technology and products with those of the competitor. Theseresellers and technology partners often have strong business relationships withour customers and potential customers. For example, some of our competitorshave better and more long standing relationships than we do with telephoneswitch vendors. Our competitors may use these business relationships to marketand sell their products and compete for potential customers. It is alsopossible that resellers or technology partners may acquire or be acquired byone or more of our competitors, which would further solidify their businessrelationships.

 

We expect thatcompetition will increase as other established and emerging companies enter ourmarket and as new products, services and technologies are introduced. Increasedcompetition may result in price reductions, lower

 

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gross margins and loss ofour market share, any of which could materially and adversely affect ourbusiness, financial condition and results of operations.

 

*Ourheavy reliance on sales of our eQuality Balance and eQuality ContactStoreproducts exposes us to risks of obsolescence due to changes in competitiveproduct offerings.*

 

We have derived asubstantial portion of our product revenues from sales of our eQuality Balanceand eQuality

 

ContactStore software.  We expect revenue from these products tocontinue to account for most of our revenue for the foreseeable future. As aresult, any factors affecting the markets for these products could materiallyand adversely affect our business, financial condition and results ofoperations. We cannot assure you that the market will continue to demand ourcurrent products or that we will be successful in marketing any new or enhancedproducts. If our competitors release new products that are superior to ourproducts in performance or price, demand for our products may decline. Adecline in demand for our products as a result of competition, technologicalchange or other factors would reduce our total revenues and harm our ability tomaintain profitability.

 

*If we fail todevelop new software or improve our existing software, we may not be able toremain competitive.*

 

The markets for ourproducts are characterized by rapidly changing technology, frequent new productintroductions and enhancements, changes in customer demands and evolvingindustry standards. Our existing products could be rendered obsolete if we failto continue to advance our technology. We have also found that thetechnological life cycles of our products are difficult to estimate, partiallybecause of changing demands of our customers. We believe that our futuresuccess will depend on our ability to continue to enhance our current productline while we concurrently develop and introduce new products that keep pacewith competitive and technological developments. These developments require usto continue to make substantial product development investments. Although weare presently developing a number of product enhancements to our productsuites, we cannot assure you that these enhancements will be completed on atimely basis or gain customer acceptance. In addition, failure to develop newsoftware or improve existing software products may impact our ability tomaintain our maintenance renewal rate which could have a material impact on ourrevenue.

 

*If our software developmentactivities in the Asia-Pacific region are not successful, we may not be able tomeet our development schedules*

 

During 2004, we expandedour software development capabilities in the Asia-Pacific region in order tooptimize available research and development resources and better meetdevelopment timeframes. We have limited experience with remote softwaredevelopment activities. Accordingly, there are a number of risks associatedwith this activity, including:

 

•                  delays orproduct errors due to miscommunication between our local developmentorganization and the remote development personnel affected by time, distanceand language differences;

•                  schedulingdelays due to lengthy ramp-up time for our new development personnel;

•                  productsproduced in the Asia-Pacific region that fail to meet our quality requirements;

•                  high voluntarypersonnel turnover; and

•                  foreignemployment and labor laws with which we are not familiar.

 

Ourinability to meet development schedules because of our reliance on developersin the Asia-Pacific region may affect our ability to enhance our currentproduct line or introduce new products, which would have a material adverseaffect on our financial results and could harm our reputation.  The loss of key development personnel couldhave a material adverse effect on our product development process and adverselyaffect future product revenues.

 

*Ourliability to customers may be substantial if our products fail to performproperly.*

 

Our software is used in acomplex operating environment that requires its integration with computer andtelephone networks and other business software applications. If our productsfail to function as required, we may be subject to claims for substantialdamages.  Courts may not enforceprovisions in our contracts that would limit our liability or otherwise protectus from liability for damages. Although we maintain general liability insurancecoverage, including coverage for errors or omissions, this coverage may notcontinue to be available on reasonable terms or in sufficient amounts to coverclaims against us.  In addition, ourinsurer may disclaim coverage as to any future claim.  If claims exceeding the available insurancecoverage are successfully asserted against us, or our insurer imposes premium

 

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increases, largedeductibles or co-insurance requirements on us, our business and results ofoperations could be adversely affected.

 

*Oursoftware may contain undetected errors or “bugs,” resulting in harm to ourreputation and operating results.*

 

Software products as complex as those offered by usmight contain undetected errors or failures when first introduced or when newversions are released.  We cannot assureyou, despite testing by us and by current and prospective customers that errorswill not be found in new products or product enhancements after commercialrelease.  Any errors found may causesubstantial harm to our reputation and result in additional unplanned expensesto remedy any defects as well as a loss in revenue.

 

*If ouradvanced compliance recording applications fail to record 100% of our customers’interactions, we may be subject to liability and our reputation may be harmed.*

 

Our product line includesadvanced compliance recording applications and related services. Many of ourcustomers use these applications to record and store interactions withcustomers to provide back-up and verification of transactions and to guardagainst risks posed by lost or misinterpreted voice communications. Thesecustomers rely on our applications to record, store and retrieve voice data ina timely, reliable and efficient manner. If our applications fail to record100% of our customers’ interactions or our customers are unable to retrieve therecordings when necessary, we may be subject to liability and our reputationmay be harmed.

 

*If weare unable to maintain the security of our systems, our business, financialcondition and operating results could be harmed.*

 

The occurrence orperception of security breaches in the operation of our business or by thirdparties using our products could harm our business, financial condition andoperating results. Our customers use our products to compile and analyze highlysensitive or confidential information. We may come into contact with suchinformation or data when we perform support or maintenance functions for ourcustomers. While we have internal policies and procedures for employeesperforming these functions, the perception that we have improperly handledsensitive, confidential information could have a negative effect on ourbusiness. If, in handling this information, we fail to comply with privacy orsecurity laws, we could incur civil liability to government agencies, customersand individuals whose privacy is compromised. If personal information isreceived or used from sources outside the U.S., we could be subject to civil,administrative or criminal liability under the laws of other countries. Inaddition, while we implement sophisticated security measures, third parties mayattempt to breach our security or inappropriately use our products throughcomputer viruses, electronic break-ins and other disruptions. If successful,confidential information may be improperly obtained and we may be subject tolawsuits and other liability. Any internal or external security breaches couldharm our reputation, and even the perception of security risks, whether or notvalid, could inhibit market acceptance of our products.

 

*Fluctuationsin foreign currency exchange rates could affect our financial results.*

 

We may experience gainsand losses resulting from fluctuations in currency exchange rates. Moreover, inlocations where we price our products in U.S. dollars, our sales could beaffected adversely by declines in foreign currencies relative to the dollar,thereby making our products more expensive in local currencies. In locationswhere we sell our products in local currencies, we could be competitivelyunable to increase our prices to reflect fluctuations in exchange rates. Wecannot predict the impact that future exchange rate fluctuations may have onour results.

 

*Certainprovisions in agreements that we have entered into may expose us to liabilityfor breach that is not limited in amount by the terms of the contract.*

 

Certain contractprovisions, principally confidentiality and indemnification obligations incertain of our license agreements, could expose us to risks of loss that, insome cases, are not limited by contract to a specified maximum amount. If wefail to perform to the standards required by these contracts, we could besubject to additional liability and our business, financial condition andresults of operations could be materially and adversely affected.  There have been no material losses to date asa result of any such contractual provisions.

 

*If wefail to protect our intellectual property, third parties may use our technologyfor their own benefit.*

 

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Our success and abilityto compete depends to a significant degree upon our proprietary technology. Werely on a combination of patent, trade secret, copyright and trademark laws andconfidentiality agreements with employees and third parties to establish andprotect our proprietary rights. These measures may not be sufficient to protectour proprietary rights, and we cannot be certain that third parties will notmisappropriate our technology and use it for their own benefit. Also, most ofthese protections do not preclude our competitors from independently developingproducts with functionality or features substantially equivalent or superior toour software.  Any infringement of ourproprietary rights could negatively impact our future operating results.

 

As of March 31, 2005, wehad nine registered trademarks, two trademark applications pending in the U.S.,eight patents and twenty patent applications pending in the U.S. and ninepatent applications pending internationally. There is no guarantee that ourpending applications will result in issued trademarks or patents or, if issued,that they will provide us with any competitive advantage. We cannot assure youthat we will file further patent or trademark applications, that any futureapplications will be approved, that any existing or future patents, trademarksor copyrights will adequately protect our intellectual property or that anyexisting or future patents, trademarks or copyrights will not be challenged bythird parties.

 

We are aware of certainuses, U.S. trademark registrations, and U.S. trademark applications for our “eQuality”trademark and its variations that predate our use, and the April 2002 issuanceof the U.S. registration for our trademark eQuality®. It is possible that anowner of legal rights resulting from prior use, registrations, or applicationswill bring legal action to challenge our registration of and/or our use of thetrademark eQuality®, and may also seek compensation for damages resulting fromour use this trademark. As a result, we cannot assure you that our registrationof this trademark will be undisturbed, or that this use will not result inliability for trademark infringement, trademark dilution, and/or unfaircompetition.

 

Moreover, the laws ofcertain foreign countries do not protect our intellectual property rights tothe same extent, as do the laws of the United States.  Furthermore, policing the unauthorized use ofour products is difficult, and litigation may be necessary in the future toenforce our intellectual property rights, to protect our trade secrets or todetermine the validity and scope of the proprietary rights of others.  Litigation could result in substantial costsand diversion of resources and could negatively impact our future operatingresults.

 

*Claimsby other companies that our software infringes their intellectual propertycould require us to incur substantial costs or prevent us from selling oursoftware or services.*

 

It is possible that thirdparties will claim that we have infringed their current or future products. Weexpect that we and other participants in our industry will be increasinglysubject to infringement claims as the number of competitors and products grows.Any claims, with or without merit, which is generally uninsurable could betime-consuming, result in costly litigation, require us to reengineer orredevelop our software, cause product shipment delays or require us to enterinto royalty or licensing agreements, any of which could negatively impact ouroperating results. Any efforts to reengineer our software or obtain licensesfrom third parties may not be successful, could be extremely costly and wouldlikely divert valuable management and product development resources. Forexample, depending on the outcome of lawsuits involving Knowlagent, IEX andNICE (as described in Item 1, “Legal Proceedings,” of Part II), we may berequired to enter into royalty and licensing agreements on unfavorable terms,to stop selling or redesign our products at issue, or to pay damages or satisfyindemnification commitments with our customers.

 

Inaddition, we cannot assure you that legal action claiming patent infringementwill not be commenced against us, or that we would prevail in litigation giventhe complex technical issues and inherent uncertainties in patentlitigation.  In addition, users of oursoftware may become subject to claims if our software is alleged to infringethe intellectual property of others. These software users could attempt to holdus responsible for these claims and any resulting harm they suffer. If a patentclaim against us was successful and we could not obtain a license on acceptableterms or license a substitute technology or redesign to avoid infringement, wemay be prevented from distributing our software or required to incursignificant expense and delay in developing non-infringing software.  Such a result would have a material adverseeffect on our business, financial condition and results of operations.

 

*As a result of our acquisition of Blue Pumpkin, weare subject to a pending patent lawsuit, which, if determined adversely to us,may cause our business to suffer.*

 

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In January 2001, IEXCorporation filed a lawsuit against Blue Pumpkin in the United States DistrictCourt for the Eastern District of Texas, Sherman Division, alleging that BluePumpkin infringed IEX Corporation’s (“IEX”) U.S. Patent No. 6,044,355 (the “355Patent”) by making and selling certain workforce management and call routingsoftware products, including Blue Pumpkin’s Prime Time Skills and Prime TimeEnterprise products. IEX is seeking to recover actual damages, an award oftreble damages pursuant to 35 U.S.C. § 284, and an award of prejudgmentinterest, costs, and attorney’s fees. IEX is also seeking an injunction againstBlue Pumpkin’s making or selling the products that IEX claims infringe its “355Patent.” On October 10, 2003, the District Court granted Blue Pumpkin summaryjudgment of non-infringement. That day, the District Court dismissed theremainder of the case. IEX appealed the District Court’s summary judgmentruling to the Court of Appeals for the Federal Circuit. On February 2, 2005,the Federal Circuit reversed-in-part the district court’s summary judgmentruling and remanded the action to the district court for further proceedingsconsistent with the Federal Circuit’s analysis. Blue Pumpkin is not yet on aschedule before the district court.  Weare unable to assess the impact, if any, on our financial position, results ofoperations or cash flows.

 

Regardlessof the merit of this claim, it can be time-consuming and costly. While wecurrently believe that the ultimate outcome of this proceeding will not have amaterial adverse effect on our financial position and results of operations,litigation is subject to inherent uncertainties. If an unfavorable ruling wereto occur, there exists the remote possibility of a material adverse impact onour net income. Our estimate of the potential impact from this legal proceedingon our financial position or results of operations could change in the future.

 

*If we are unableto maintain the compatibility of our software with certain other products andtechnologies, our future business would be adversely affected.*

 

Our software mustintegrate with software and hardware solutions provided by a number of ourexisting and potential competitors. For example, our products must integratewith phone switches made by the telephone switch vendors and computer telephonysoftware applications offered by other software providers. These competitors ortheir business partners could alter their products so that our software nolonger integrates well with them, or they could delay or deny our access to softwarereleases that allow us to timely adapt our software to integrate with theirproducts. If we cannot adapt our software to changes in necessary technology,it may significantly impair our ability to compete effectively, particularly ifour software must integrate with the software and hardware solutions of ourcompetitors.

 

*If ourprofessional services employees do not provide installation serviceseffectively and efficiently, our customers may not use our installationservices or may stop using our software.*

 

Our customers ordinarilypurchase installation, training and maintenance services together with ourproducts. The functionality of our products is not dependent on ourinstallation and training services. We generate a material part of our revenuesfrom these services. We believe that the speed and quality of installationservices are competitive factors in our industry. If our installation servicesare not satisfactory to our customers, the customers may choose not to use ourinstallation services or they may not license our software in the future. As aresult, we would lose licensing and services revenue, and it could harm ourreputation.

 

*We maymake acquisitions or investments that are not successful and that adverselyaffect our ongoing operations.*

 

We may acquire or makeinvestments in companies, products, services and technologies that we believecomplement our business and assist us in quickly bringing new products tomarket. We have limited experience in making acquisitions and investments. As aresult, our ability to identify and evaluate prospects, complete acquisitionsand properly manage the integration of businesses is relatively unproven. If wefail to properly evaluate and execute acquisitions or investments, it may havea material adverse effect on our business and operating results. In making orattempting to make acquisitions or investments, we face a number of risks,including:

 

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•                  identifyingsuitable candidates, performing appropriate due diligence, identifyingpotential liabilities and negotiating acceptable terms;

•                  reducing ourworking capital and hindering our ability to expand or maintain our business,if we make acquisitions using cash;

•                  the potentialdistraction of our management, diversion of our resources and disruption of ourbusiness;

•                  retaining andmotivating key employees of the acquired companies;

•                  managingoperations that are distant from our current headquarters and operations;

•                  entering intogeographic markets in which we have little or no prior experience;

•                  competing foracquisition opportunities with competitors that are larger than we are or havegreater financial and other resources than we have;

•                  accuratelyforecasting the financial impact of a transaction;

•                  assumingliabilities of acquired companies, including litigation related to theoperation of the business prior to the acquisition;

•                  maintaining goodrelations with the customers and suppliers of the acquired company; and

•                  effectivelyintegrating acquired companies and achieving expected synergies.

 

In January 2005, weacquired Blue Pumpkin Software, Inc. We paid $40 million in cash and issued 2.1million shares of our common stock in the Blue Pumpkin acquisition. During thefirst quarter of 2005, senior management was focused on integrating theoperations, product sets and personnel of Blue Pumpkin into our business andproduct offerings.  This acquisitionsignificantly expands our operations and, as a result, the integration processcould divert the attention of our senior management from our existingoperations and other potential business opportunities.

 

Our senior management isfocusing on retaining key employees and maintaining relationships with BluePumpkin’s customers and suppliers. We cannot assure you, however, that we willbe able to retain key employees or preserve Blue Pumpkin’s customer andsupplier relationships. Certain customers simply may not want to continue theirrelationship with the larger combined enterprise.  If we are not successful in integrating BluePumpkin into our operations or are otherwise unable to realize the anticipatedsynergies of the combined companies, our business may suffer.

 

*If weneed additional financing to maintain or expand our business, it may not beavailable on favorable terms, if at all.*

 

Although we believe ourcurrent cash and borrowing capacity will be sufficient to meet our anticipatedcash needs for at least the next 12 months and the foreseeable future, we mayneed additional funds to expand or meet all of our operating needs. If we needadditional financing, we cannot be certain that it will be available to us onfavorable terms, or at all. If we raise additional funds by issuing equitysecurities or convertible debt, the ownership interest of our stockholderscould be significantly diluted, and any additional equity securities we issuemay have rights, preferences or privileges senior to the rights of ourstockholders. Also, the terms of any additional financing we obtain maysignificantly limit our future financing and operating activities. If we needfunds and cannot obtain them on acceptable terms, we may be unable to:

 

•                  develop andenhance our software to remain competitive;

•                  take advantageof future opportunities, such as acquisitions;

•                  respond tochanging customer needs and our competitors’ innovations; or

•                  attract andretain qualified key personnel.

 

Any of these events couldsignificantly harm our business and financial condition and limit our growth.

 

*Ourinability to source hardware could harm our business.*

 

A number of customersexpect us to source hardware to support the implementation of our software. Wedo not intend to continue selling hardware and have transferred the fulfillmentof all hardware orders to third-party distributors. Thus, we are largelydependent on third parties for the supply of hardware components to ourcustomers. If these hardware distributors experience financial, operational orquality assurance difficulties, or if there is any other disruption in ourrelationship, this would adversely impact our business and we would be requiredto locate alternative hardware sources. We are subject to the following risksdue to our hardware distribution system:

 

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•                  cancellations oforders due to unavailability of hardware;

•                  increasedhardware prices, which may make our products less attractive; and

•                  additionaldevelopment expense to modify our products to work with new hardwareconfigurations.

 

Even if we and/or ourdistributors are successful in locating alternative sources of supply,alternative suppliers could increase prices significantly. In addition,alternative components may malfunction or interact with existing components inunexpected ways. The use of new suppliers and the modification of our productsto function with new systems would require testing and may require furthermodifications, which may result in additional expense, diversion of managementattention and other resources, inability to fulfill customer orders or delay infulfillment, reduction in quality and reliability, customer dissatisfaction,and other adverse effects on our reputation, business and operating results.

 

*Failure to achieve and maintaineffective internal controls in accordance with Section 404 of theSarbanes-Oxley Act of 2002 could have a material adverse effect on ourbusiness, operating results and stock price.*

 

The Sarbanes-Oxley Act of2002 imposes new duties on us and our executives, directors, attorneys andindependent registered public accountants. Our efforts to comply with therequirements of Section 404 have resulted in increased general andadministrative expense and a diversion of management time and attention fromrevenue-generating activities to compliance activities, and we expect theseefforts to require the continued commitment of significant resources. If wefail to maintain the adequacy of our internal controls, as such standards aremodified, supplemented or amended from time to time, we may not be able toensure that we can conclude on an ongoing basis that we have effective internalcontrols over financial reporting. Failure to achieve and maintain effectiveinternal controls over financial reporting could result in investigation and/orsanctions by regulatory authorities, and could have a material adverse effecton our business and operating results, investor confidence in our reportedfinancial information, and the market price of our common stock.

 

*Ourstock price has been volatile.*

 

The market price of ourcommon stock has been subject to significant fluctuations in response tovariations in quarterly operating results and other factors. In addition, thestock market has experienced significant volatility that has particularlyaffected the market prices of equity securities of many technology companiesand that often has been unrelated or disproportionate to the operatingperformance of these companies. Any announcement with respect to any adversevariance in revenue or earnings from levels generally expected by securities analystsor investors could have a significant adverse effect on the trading price ofour common stock. In addition, factors such as announcements of technologicalinnovations or new products by us, our competitors or third parties, changingconditions in the customer relationship management software market, changes inthe market valuations of similar companies, loss of a major customer, additionsor departures of key personnel, changes in estimates by securities analysts,announcements of extraordinary events, such as acquisitions or litigation, orgeneral economic conditions may have an adverse effect on the market price ofour common stock.

 

*We issued 2.1 million newshares and granted approximately 600,000 options to purchase shares of ourcommon stock, which will result in dilution to our existing stockholders andmay cause our stock price to decline.*

 

Aspart of the merger consideration in our recent acquisition of Blue Pumpkin, weissued a total of 2.1 million shares of common stock to Blue Pumpkin shareholders,which increased our total outstanding common stock by approximately 8%; we alsoissued options to purchase approximately 600,000 shares of common stock inconnection with the acquisition. The issuance of a significant amount ofadditional shares of common stock results in dilution to our existingshareholders and reduces our earnings per share, which could negatively affectthe market price of our common stock. A significant amount of common stockcoming on the market at any given time could result in a decline in the priceof our common stock or increased volatility.

 

*Ourperformance may be negatively affected by macro-economic or other externalinfluences.*

 

Beginningin 2000, a declining United States economy began to adversely affect theperformance of many businesses, especially within the technology sector.  We are a technology company sellingtechnology-based solutions with total pricing, including software and servicesthat in some cases exceed $1.0 million. Reductions in the capital budgets of our customers and prospectivecustomers had an adverse impact on our ability to sell our solutions.  Until 

 

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late in 2003, we continued toexperience effects from a weak spending environment for information technologyin both the United States and Europe, in the form of delayed and cancelledbuying decisions by customers for our software, services and hardware,deferrals by customers of service engagements previously scheduled and pressureby our customers and competitors to discount our offerings.  If the current improvements now being seen inthe general business climate do not continue, this would likely have a materialadverse effect on our business.

 

*Governmentregulation of telephone and Internet monitoring could cause a decline in theuse of our software, result in increased expenses for us or subject ourcustomers and us to liability.*

 

As the telecommunicationsindustry continues to evolve, state, federal and foreign governments (includingsupranational governmental organizations such as the European Union) mayincreasingly regulate the monitoring of telecommunications and telephone andInternet monitoring and recording products, such as our software. We believethat increases in regulation could come in the form of a number of differentkinds of regulations, including regulations regarding privacy, protection ofpersonal information and employment. For example, the State of Californiarecently enacted the Database Security Breach Act, which requires any businessthat suffers a computer security breach to immediately notify customers inCalifornia if personal information has been compromised. The adoption of anynew regulations or changes to existing regulations could cause a decline in theuse of our software and could result in increased expense for us, particularlyif we are required to modify our software to accommodate these regulations.Moreover, these regulations could subject our customers or us to liability.Whether or not these regulations are adopted, if we do not adequately addressthe privacy concerns of consumers, companies may be hesitant to use oursoftware. If any of these events occur, it could materially and adverselyaffect our business.

 

*If weare unable to attract and retain key personnel, our ability to effectivelymanage and grow our business would suffer.*

 

Our success greatlydepends on our ability to hire, train, retain and motivate qualified personnel,particularly in sales, marketing, research and development, service and support.We face significant competition for individuals with the skills required toperform the services we offer.  If we areunable to attract and retain qualified personnel or if we experience highpersonnel turnover, it could prevent us from effectively managing and expandingour business.

 

Our success also dependsupon the continued service of our executive officers, particularly our Chairmanand Chief Executive Officer, David Gould, and our President and Chief OperatingOfficer, Nick Discombe. We have employment agreements with Mr. Gould and Mr.Discombe and limited non-compete agreements with most of our other executiveofficers. However, any of our executive officers and other employees couldterminate his or her relationship with us at any time. The loss of the servicesof our executive officers or other key personnel, particularly if lost tocompetitors, could materially and adversely affect our business.

 

*Our certificateof incorporation and bylaws, as well as Delaware law, may inhibit a takeover ofour company, which could limit the price investors might be willing to pay forour securities.*

 

Ouramended and restated certificate of incorporation and bylaws, as well asDelaware law, contain provisions that might enable our management to resist atakeover of our company. For example, our stockholders cannot take action bywritten consent or call a special meeting to remove our board ofdirectors.  In addition, our directorsserve for staggered terms, which makes it difficult to remove all our directorsat once.  Further, in October 2002, ourboard of directors approved, and we have implemented, a stockholder rights planwhich has the effect of causing substantial dilution to a person or group thatattempts to acquire us on terms not approved by the board of directors.

 

These anti-takeover provisions might discourage, delayor prevent a change in the control of our company or a change in ourmanagement.  These provisions could alsodiscourage proxy contests and make it more difficult for you and other shareholdersto elect directors and take other corporate actions.  The existence of these provisions could alsolimit the price that investors might be willing to pay in the future for oursecurities.

 

**Item 3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

Information concerning market risk is included in the Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, Item 2 ofPart I of this Report.

 

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### **Item4.  Controls and Procedures**

### ** **

***Evaluation of Disclosure Controls and Procedures***

 

We conducted an evaluation of the effectiveness of theCompany’s disclosure controls and procedures (as defined in Rules 13a-14 and15d-14 under the Securities Exchange Act of 1934), as of the end of the periodcovered by this quarterly report.  Thisevaluation was conducted under the supervision and with the participation ofthe Company’s management, including the Chief Executive Officer and ChiefFinancial Officer.  Based on thisevaluation, as of the quarter ended March 31, 2005, the Company’s ChiefExecutive Officer and Chief Financial Officer have concluded the Company’sdisclosure controls and procedures are effective.  There were no changes in internal controlsover financial reporting that occurred during the period covered by thisquarterly report that have materially affected, or that are reasonably likelyto materially affect, our internal controls over financial reporting.

 

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**PART II.  OTHER INFORMATION**

 

### **Item 1. LegalProceedings**

### ** **

On December 11, 2002, wefiled in the United States District Court for the Northern District of Georgia,Atlanta Division, a lawsuit against Knowlagent, Inc. (“Knowlagent”), which isthe assignee of United States (“U.S.”) Patent Nos. 6,324,282 B1 and 6,459,787B2. Knowlagent has accused our eQuality Now software of infringing the abovepatents. We filed suit seeking a declaration that we did not and do notinfringe either of the two patents listed above, as well as a declaration thatthe above patents are invalid and unenforceable. We also filed a claimrequesting that if the patents are found to be valid, that one of our ownemployees be named the rightful inventor of the patents. We also requestedmonetary damages in an amount equal to the amount that Knowlagent has receivedfrom its use of the above patents. On December 31, 2002, Knowlagent filed itsanswer to our complaint as well as two counterclaims, alleging that we infringeand contribute to the infringement by others of the above patents; Knowlagentseeks both monetary damages and an injunction in connection with itscounterclaim. We are currently in the discovery phase of the lawsuit andbelieve that any adverse outcome would not have a material impact on ourfinancial position, results of operations and cash flows.

 

On July 20, 2004, STSSoftware Systems Ltd. (“STS Software”), a wholly-owned subsidiary of NICESystems, Ltd. (“NICE Ltd.”), filed a patent infringement suit in the U.S.District Court for the Southern District of New York against us (“New YorkAction”).  The New York Action assertsthat our products, including eQuality ContactStore for IP, infringe UnitedStates (“U.S”). Patent No. 6,122,665 (“the ‘665 patent”). On the same day, wefiled a declaratory judgment action against STS Software in the U.S. DistrictCourt for the Northern District of Georgia (“Georgia Action”).  We seek a declaration from the court that wehave not infringed any valid claim of the ‘665 patent. By Order entered December16, 2004, Judge Koeltl of the U.S. District Court for the Southern District ofNew York granted our motion to transfer the New York Action to the NorthernDistrict of Georgia, which has now consolidated the former New York Action withthe Georgia Action.  The case has beenset on a discovery calendar and is at a preliminary stage.  We currently believe that an adverse outcomewould not have a material impact on our financial position, results ofoperations and cash flows.

 

On August 30, 2004, wefiled in the United States District Court for the Northern District of Georgia,Atlanta Division, a lawsuit against NICE Systems, Inc. (“NICE Inc.”), awholly-owned subsidiary of NICE Ltd., alleging patent infringement.  Specifically, we have alleged that NICE products,including the NiceUniverse products that include screen capture andsynchronized screen and voice capture technologies, infringe claims of U.S.Patent Nos. 5,790,798 (“the ‘798 Patent”) and 6,510,220 (“the ‘220 Patent”),both entitled “Method and Apparatus for Simultaneously Monitoring Computer UserScreen and Telephone Activity from a Remote Location.”  We have sought an injunction and moneydamages for NICE’s infringement of these two patents.  NICE Inc. has answered and counterclaimed fordeclaratory judgments of non-infringement and invalidity.  Since then, on February 24, 2005, we filedsuit against NICE Ltd. because of its infringing activities in violation of the‘798 and ‘220 patents, including importation of the accused NICE products.  By order dated April 5, 2005, Judge Pannellhas consolidated the NICE Inc. and NICE Ltd. actions.  The case has been set on a modified discoverycalender after consolidation and is at a preliminary stage.

 

In January 2001, IEXCorporation filed a lawsuit against Blue Pumpkin in the United States DistrictCourt for the Eastern District of Texas, Sherman Division, alleging that BluePumpkin infringed IEX Corporation’s (“IEX”) U.S. Patent No. 6,044,355 (“the ‘355Patent”) by making and selling certain workforce management and call routingsoftware products, including Blue Pumpkin’s Prime Time Skills and Prime TimeEnterprise products. IEX is seeking to recover actual damages, an award oftreble damages pursuant to 35 U.S.C. § 284, and an award of prejudgment interest,costs, and attorney’s fees. IEX is also seeking an injunction against BluePumpkin’s making or selling the products that IEX claims infringe its ‘355Patent. On October 10, 2003, the District Court granted Blue Pumpkin summaryjudgment of non-infringement. That day, the District Court dismissed theremainder of the case. IEX appealed the District Court’s summary judgmentruling to the Court of Appeals for the Federal Circuit. On February 2, 2005,the Federal Circuit reversed-in-part the district court’s summary judgmentruling and remanded the action to the district court for further proceedingsconsistent with the Federal Circuit’s analysis. Blue Pumpkin is not yet on aschedule before the district court. We are unable to assess the impact, if any,on our financial position, results of operations or cash flows.  Certain amounts that may be payable inconnection with this matter remain the responsibility of the former BluePumpkin stockholders pursuant to the terms of the indemnification provisions ofthe Blue Pumpkin acquisition agreement.

 

 

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### **Item 6.  Exhibits**

### ** **

**(a)****                      Exhibits**

 
| 10.1* |   | Seventh Loan Modification Agreement between the  Company and Silicon Valley Bank dated March 10, 2005. |
|-------|--------|--------------------------------------------------------------------------------------------------------|
| 10.2* |   | Form of Executive Stock  Option Grant Certificate                                                      |
| 10.3* |   | Form of Stock Option  Grant Certificate                                                                |
| 23.1* |   | Consent of Independent  Business Valuation Experts                                                     |
| 31.1* |   | Certification of Chief Executive Officer                                                               |
| 31.2* |   | Certification of Chief Financial Officer                                                               |
| 32.1* |   | Certifications Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                              |

 

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* Filed herewith

 

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**(1)   SIGNATURES**

 

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

 

 
| Dated: May 10,  2005 | WITNESS SYSTEMS, INC. |
|----------------------|-----------------------|
|                 |                  |   |
|                 |                  |   |
|                 | BY:                   | /s/  David B. Gould |   |
|                 |                  | DAVID B. GOULD  CHAIRMAN OF THE BOARD AND  CHIEF EXECUTIVE OFFICER  (*PRINCIPAL EXECUTIVE OFFICER)* |
|                 |                  |   |
|                 |                  |   |
|                 | BY:                   | /s/  William F. Evans |   |
|                 |                  | WILLIAM F. EVANS  EXECUTIVE VICE PRESIDENT AND  CHIEF FINANCIAL OFFICER  (*PRINCIPAL FINANCIAL AND ACCOUNTING  OFFICER)* |

 

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