**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 June 30, 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 markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes  ý  No  o

 

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

 

*Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.*

 
| **Class**                              | ** ** | **Outstanding at August 8, 2005** |
|----------------------------------------|------------|-----------------------------------|
| Common Stock, par value $.01 per share |       | 27,436,390                        |

 

 

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**WITNESS SYSTEMS, INC.**

 

**FORM 10-Q**

 

**INDEX**

 
| PART I.    | FINANCIAL INFORMATION                                                                                       |   |
|------------|-------------------------------------------------------------------------------------------------------------|--------|
|       |                                                                                                        |   |
| Item 1.    | Financial Statements:                                                                                       |   |
|       |                                                                                                        |   |
|       | Condensed Consolidated  Balance Sheets at June 30, 2005 and December 31, 2004                               |   |
|       |                                                                                                        |   |
|       | Condensed Consolidated  Statements of Operations for the three and six months ended June 30, 2005 and  2004 |   |
|       |                                                                                                        |   |
|       | Condensed Consolidated  Statements of Cash Flows for the six months ended June 30, 2005 and 2004            |   |
|       |                                                                                                        |   |
|       | Notes to the Condensed  Consolidated Financial Statements                                                   |   |
|       |                                                                                                        |   |
| 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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###### **PART1: FINANCIAL INFORMATION**

###### ** **

**Item1.   Financial Statements**

 

**WITNESS SYSTEMS, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

**(unaudited)**

 
| ** **                                                                                                                                                                                        | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|------------|------------------|------------|
| ** **                                                                                                                                                                                        | ** ** | **2005**     | ** ** | **2004**         | ** ** |
| **ASSETS**                                                                                                                                                                                        | ** ** | ** **   | ** ** | ** **       | ** ** |
| Current assets:                                                                                                                                                                                   |       |         |       |             |       |
| Cash and cash  equivalents                                                                                                                                                                        |       | $            | 29,982     |             | $          | 42,641 |   |
| Investments                                                                                                                                                                                       |       | 984          |       | 33,842           |       |
| Accounts  receivable, net of allowance of $4,485 at June 30, 2005 and $3,250 at  December 31, 2004                                                                                                |       | 34,428       |       | 25,681           |       |
| Prepaid and  other current assets                                                                                                                                                                 |       | 4,362        |       | 4,118            |       |
| Total current  assets                                                                                                                                                                             |       | 69,756       |       | 106,282          |       |
| Intangible  assets, net                                                                                                                                                                           |       | 43,781       |       | 10,802           |       |
| Goodwill                                                                                                                                                                                          |       | 40,481       |       | —           |       |
| Property and  equipment, net                                                                                                                                                                      |       | 7,404        |       | 6,197            |       |
| Other assets                                                                                                                                                                                      |       | 2,952        |       | 1,218            |       |
|                                                                                                                                                                                              |       | $            | 164,374    |             | $          | 124,499 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                     |       |         |       |             |       |
| Current  liabilities:                                                                                                                                                                             |       |         |       |             |       |
| Accounts payable                                                                                                                                                                                  |       | $            | 7,451      |             | $          | 4,454 |   |
| Accrued expenses                                                                                                                                                                                  |       | 16,705       |       | 16,308           |       |
| Deferred revenue                                                                                                                                                                                  |       | 28,896       |       | 25,406           |       |
| Total current  liabilities                                                                                                                                                                        |       | 53,052       |       | 46,168           |       |
| Other long-term  liabilities                                                                                                                                                                      |       | 3,365        |       | 3,703            |       |
| Deferred income  tax liabilities, net                                                                                                                                                             |       | 238          |       | 254              |       |
| Total  liabilities                                                                                                                                                                                |       | 56,655       |       | 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; 27,249,556 and 24,476,289  shares issued and outstanding at June 30, 2005 and December 31, 2004,  respectively                       |       | 273          |       | 245              |       |
| Additional  paid-in capital                                                                                                                                                                       |       | 150,628      |       | 108,247          |       |
| Accumulated  deficit                                                                                                                                                                              |       | (47,841      | )          | (39,060          | )          |
| Accumulated other  comprehensive income                                                                                                                                                           |       | 4,659        |       | 4,942            |       |
| Total  stockholders’ equity                                                                                                                                                                  |       | 107,719      |       | 74,374           |       |
|                                                                                                                                                                                              |       | $            | 164,374    |             | $          | 124,499 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

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**WITNESSSYSTEMS, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(Inthousands, except per share data)**

**(unaudited)**

 
| ** **                                       | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                       | ** ** | **2005**                        | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                         |       |                            |       |                          |       |   |   |   |   |
| Product                                          |       | $                               | 18,918     |                          | $          | 14,138 |   | $ | 35,286 |   | $ | 28,040 |   |
| Services                                         |       | 27,253                          |       | 20,280                        |       | 52,044 |   | 39,330 |   |
| Total revenue                                    |       | 46,171                          |       | 34,418                        |       | 87,330 |   | 67,370 |   |
| Cost of revenue:                                 |       |                            |       |                          |       |   |   |   |   |
| Product                                          |       | 4,928                           |       | 3,714                         |       | 9,260 |   | 7,624 |   |
| Services                                         |       | 10,784                          |       | 8,363                         |       | 20,309 |   | 16,299 |   |
| Total cost of  revenue                           |       | 15,712                          |       | 12,077                        |       | 29,569 |   | 23,923 |   |
| Gross profit                                     |       | 30,459                          |       | 22,341                        |       | 57,761 |   | 43,447 |   |
| Operating  expenses:                             |       |                            |       |                          |       |   |   |   |   |
| Selling, general  and administrative             |       | 21,505                          |       | 15,702                        |       | 41,418 |   | 31,241 |   |
| Research and  development                        |       | 6,892                           |       | 4,963                         |       | 13,087 |   | 9,838 |   |
| Merger-related  and integration costs            |       | 925                             |       | 155                           |       | 2,584 |   | 523 |   |
| Acquired  in-process research and development    |       | —                          |       | —                        |       | 9,000 |   | — |   |
| Operating income  (loss)                         |       | 1,137                           |       | 1,521                         |       | (8,328 | ) | 1,845 |   |
| Interest and  other income, net                  |       | 56                              |       | 137                           |       | 194 |   | 308 |   |
| Income (loss)  before provision for income taxes |       | 1,193                           |       | 1,658                         |       | (8,134 | ) | 2,153 |   |
| Provision for  income taxes                      |       | 617                             |       | 144                           |       | 650 |   | 169 |   |
| Net income  (loss)                               |       | $                               | 576        |                          | $          | 1,514 |   | $ | (8,784 | ) | $ | 1,984 |   |
|                                             |       |                            |       |                          |       |   |   |   |   |
| Net income  (loss) per share:                    |       |                            |       |                          |       |   |   |   |   |
| Basic                                            |       | $                               | 0.02       |                          | $          | 0.07 |   | $ | (0.33 | ) | $ | 0.09 |   |
| Diluted                                          |       | $                               | 0.02       |                          | $          | 0.06 |   | $ | (0.33 | ) | $ | 0.08 |   |
| Weighted-average  common shares outstanding:     |       |                            |       |                          |       |   |   |   |   |
| Basic                                            |       | 27,078                          |       | 23,013                        |       | 26,669 |   | 22,737 |   |
| Diluted                                          |       | 29,676                          |       | 26,108                        |       | 26,669 |   | 26,259 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

**(unaudited)**

 
| ** **                                                                                           | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                           | ** ** | **2005**                      | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                                                | ** ** | ** **                    | ** ** | ** ** | ** ** |
| Net (loss)  income                                                                                   |       | $                             | (8,784     | ) | $ | 1,984 |   |
| 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                                                                   |       | 7,239                         |       | 3,568 |   |
| Depreciation and  amortization of property and equipment                                             |       | 1,895                         |       | 1,652 |   |
| Provision for accounts  receivable                                                                   |       | 1,977                         |       | 417 |   |
| Other non-cash  items, net                                                                           |       | 160                           |       | 211 |   |
| Changes in  operating assets and liabilities:                                                        |       |                          |       |   |   |
| Accounts  receivable                                                                                 |       | (8,988                        | )          | 2,713 |   |
| Prepaid and  other assets                                                                            |       | 294                           |       | 478 |   |
| Accounts payable  and accrued expenses                                                               |       | (1,506                        | )          | (5,078 | ) |
| Deferred revenue                                                                                     |       | 515                           |       | 2,492 |   |
| Acquisition and  related costs                                                                       |       | (3,772                        | )          | (3,444 | ) |
| Net cash (used  in) provided by operating activities                                                 |       | (1,970                        | )          | 4,993 |   |
| Cash flows from  investing activities:                                                               |       |                          |       |   |   |
| Capital  expenditures                                                                                |       | (2,608                        | )          | (1,308 | ) |
| Purchases of  investments                                                                            |       | —                        |       | (27,532 | ) |
| Proceeds from  maturities of investments                                                             |       | —                        |       | 3,000 |   |
| Proceeds from  sales of investments                                                                  |       | 32,968                        |       | 15,187 |   |
| Acquisition of  Blue Pumpkin, Inc., net of cash acquired of $3,728                                   |       | (41,241                       | )          | — |   |
| Acquisition of  Optimis, net of cash acquired of $1,287                                              |       | (4,341                        | )          | — |   |
| Net cash used in  investing activities                                                               |       | (15,222                       | )          | (10,653 | ) |
| Cash flows from  financing activities:                                                               |       |                          |       |   |   |
| Proceeds from  exercise of stock options and employee stock purchase plan                            |       | 4,974                         |       | 6,852 |   |
| Repayments on  long term debt                                                                        |       | (128                          | )          | — |   |
| Net cash  provided by financing activities                                                           |       | 4,846                         |       | 6,852 |   |
| Effect of  exchange rate changes on cash                                                             |       | (313                          | )          | 1,320 |   |
| Net (decrease)  increase in cash and cash equivalents                                                |       | (12,659                       | )          | 2,512 |   |
| Cash and cash  equivalents at beginning of period                                                    |       | 42,641                        |       | 21,517 |   |
| Cash and cash  equivalents at end of period                                                          |       | $                             | 29,982     |   | $ | 24,029 |   |
| Supplemental  cash flow information:                                                                 |       |                          |       |   |   |
| Cash paid for  interest                                                                              |       | $                             | 13         |   | $ | — |   |
| Cash paid for  income taxes                                                                          |       | $                             | 358        |   | $ | 142 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

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**WITNESS SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**June 30, 2005**

**(unaudited)**

 

**1.**     Basis of Presentation

** **

***Business***- Witness Systems, Inc. (“Witness”) is a publiclytraded company that provides the contact center market a completeworkforce optimization software and services solution that enables globalenterprises 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 – are also deployed in Internet Protocol (“IP”) Telephony and back office environments,and throughout the extended enterprise, including branch offices.  Witness 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 to enhance the quality ofcustomer interactions across multiple communications media, including thetelephone, e-mail and the Internet, and are used primarily in the organization’scontact center(s).  Our enterprisecollaboration architecture allows contact center management to shareinformation gathered in the contact center with other departments that servicethe customer, as well as throughout the organization.  The result is a proactive management tool foroptimizing their customer relationship management (“CRM”), improvingcommunication among departments, and fine-tuning workflow, processes andquality 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, installationand training methodology, we provide services to support an effective and rapiddeployment of our software that enables organizations to maximize their returnon an investment on our products and services. Our software is designed to integrate with a variety of third-partysoftware applications, such as CRM and enterprise resource planningapplications, and with existing telephony and computer network hardware andsoftware.  Many of our customers arecompanies with an international presence and one or more contact centers thathandle voice and data customer interactions for outbound sales and marketingoperations, inbound service/support lines, or both.

 

We are headquartered in Roswell,Georgia with other offices in the United States, Australia, Brazil, Canada,China, Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africaand the United Kingdom. We were originally incorporated in 1988 in Georgia andwere reincorporated in Delaware in 1997.

 

***Principles of Consolidation andReclassifications*** -The unaudited interim condensed consolidated financial statements include thefinancial statements of Witness Systems, Inc. and its wholly-ownedsubsidiaries.  All significantintercompany balances and transactions have been eliminated in consolidation.  Certain prior year amounts have beenreclassified to conform to the current year presentation.  In particular, prior period informationrelated to auction rate securities in the statement of cash flows wasreclassified, which impacted cash flows from investing activities by $(3.2) millionfor the six month period ended June 30, 2004. There was no impact on net income or cash flow from operations as aresult of the reclassification.

 

Thefinancial statements herein have been prepared in accordance with therequirements of Form 10-Q and, therefore, do not include all information andfootnotes required by generally accepted accounting principles in the UnitedStates of America.  However, in theopinion of management, all adjustments necessary for a fair presentation of theresults of operations for the relevant periods have been made.  Results for the interim periods are notnecessarily indicative of the results to be expected for the year.  These financial statements should be read inconjunction with the summary of significant accounting policies and the notesto the consolidated financial statements included in our Annual Report on Form10-K for the year ended December 31, 2004, filed with the U.S. Securities andExchange Commission.

 

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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, revenue 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 DeferredRevenue

** **

**We recognize revenue in accordance with the American Institute ofCertified Public Accountants’ Statement of Position (“SOP”) 97-2, *Software Revenue Recognition*, and SOP 98-9, *Modification of* SOP 97-2, *SoftwareRevenue Recognition, With Respect to Certain Transactions*. Revenueis primarily derived from licensing software and providing related servicesincluding maintenance. Product revenue, which can include software andhardware, is recognized when persuasive evidence of an agreement exists,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. TheCompany reports hardware revenue gross in accordance with Emerging Issues TaskForce No. 99-19, *Reporting Revenue Gross as a Principalversus Net as an Agent*, because the factors indicating grossreporting outweigh the factors indicating net reporting. We recognize revenueusing the residual method of accounting when customer orders contain multipleelement arrangements, including the license of software, the sale of 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 its fair valueuntil those elements are delivered. Consequently, product revenue for thesoftware and hardware may be recognized (i) upon delivery of those productswhen we have VSOE for the related maintenance and professional services soldand (ii) at an amount representing the difference between the total orderamount and the amount deferred.**

** **

Servicesrevenue includes installation, training, consulting, maintenance andreimbursable travel expenses. Revenue from installation, training andconsulting services is recognized upon performance of the related services andis offered and billed as separate elements of contracts. Reimbursable travelexpenses revenue is recognized upon incurrence of the related expenses. Thefunctionality of the software and any hardware sold is not dependent oninstallation and training services and customization is not required to enableour 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. Maintenance revenue is deferred and recognizedratably over the term of the related maintenance contract.

 

Deferredrevenue consists of amounts collected from customers for products and servicesthat have not met the criteria for revenue recognition.

 

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

 

On January 24, 2005, weacquired Blue Pumpkin Software, Inc. (“Blue Pumpkin”), a privately heldCalifornia corporation.  With thisacquisition, we have extended our workforce optimization solution to includeadvanced workforce management software and services solutions includingforecasting, scheduling, adherence and planning applications.  Pursuant to the Merger Agreement and Plan ofReorganization, dated December 16, 2004 (the “Merger Agreement”), we paid $40million in cash which was financed from our existing cash and investments andissued 2.1 million shares of Witness’ common stock valued at $37.2 million(measured at the date the stock consideration became fixed pursuant to theapplication of a formula specified in the merger agreement).  On May 24, 2005, the shares issued in connectionwith the acquisition were registered for resale with the Securities andExchange Commission.  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 event that there are pendingclaims that are brought against the escrow fund within such one-yearperiod.  The escrow fund is available tocompensate Witness, subject to certain limitations, for losses resulting from,among other things, breaches of representations, warranties or covenants in theMerger Agreement and certain pending and potential claims.

 

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

 

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interest, costs, and attorney’s fees. IEX is also seeking an injunctionagainst Blue Pumpkin’s making or selling the products that IEX claims infringeits ‘355 Patent. On October 10, 2003, the District Court granted Blue Pumpkinsummary judgment of non-infringement and dismissed the remainder of the case.IEX then appealed the District Court’s summary judgment ruling to the Court ofAppeals for the Federal Circuit. On February 2, 2005, the Federal Circuitreversed-in-part the district court’s summary judgment ruling and remanded theaction to the district court for further proceedings consistent with theFederal Circuit’s analysis. Blue Pumpkin is on a schedule before the districtcourt that is likely to result in a January 2006 trial, unless the case isresolved on summary judgment. We are unable to assess the impact, if any, onour financial position, results of operations or cash flows.

 

We commenced theconsolidation of Blue Pumpkin on January 24, 2005 and the acquisition wasaccounted for using the purchase method of accounting in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 141, *Business Combinations*.  The following summarizes the total purchaseprice for Blue Pumpkin (in thousands):

 

| Value of Witness  Systems, Inc. common stock issued |   | $      | 37,200 |   |
|-----------------------------------------------------|--------|--------|--------|--------|
| Cash consideration                                  |   | 40,000 |   |
| Direct  acquisition costs                           |   | 5,600  |   |
|                                                |   | $      | 82,800 |   |

 

Under the purchase method of accounting, the totalpurchase price is allocated to Blue Pumpkin’s net tangible and intangibleassets based upon their estimated fair value as of the date of the acquisitionwith any amount paid in excess of the fair value of the net assets recorded asgoodwill. Based upon the purchase price and review of the net assets acquiredand liabilities assumed, the purchase price allocation, is as follows (inthousands):

 

| Cash and  investments                     |   | $      | 3,700  |   |
|-------------------------------------------|--------|--------|--------|--------|
| Other current  assets                     |   | 3,200  |   |
| Property and  equipment, net              |   | 700    |   |
| Identifiable  intangible assets acquired: |   |   |   |
| Acquired  technology                      |   | 21,000 |   |
| Customer  relationships                   |   | 17,000 |   |
| Goodwill                                  |   | 35,100 |   |
| In-process  research and development      |   | 9,000  |   |
| Total assets  acquired                    |   | 89,700 |   |
| Current  liabilities                      |   | (3,400 | )      |
| Deferred revenue                          |   | (2,000 | )      |
| Restructuring  accruals                   |   | (1,500 | )      |
| Total  liabilities assumed                |   | (6,900 | )      |
|                                      |   | $      | 82,800 |   |

 

The fair values of identifiableintangible assets was determined with the assistance of Taylor ConsultingGroup, Inc., an independent third-party appraiser using both an income and acost approach taking into consideration the nature, risks, historical patterns,economic characteristics, and future considerations of the assets.  As of the closing date of the merger,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 a discountedcash flow methodology, which discounts expected future cash flows to presentvalue. 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 the

 

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inherent uncertainties surrounding the successfuldevelopment of the IPR&D, the expected profitability levels of suchtechnology, and the uncertainty of technological advances that couldpotentially impact the estimates. We assume the pricing model for the resultingproduct of the acquired IPR&D to be standard within its industry. We didnot take into consideration any consequential amount of expense reductions fromintegrating the acquired IPR&D with other existing in process or completedtechnology.

 

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”) SFAS No. 2, *Accounting for Researchand Development Costs* 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 we facebefore the technology becomes technologically feasible.

 

Goodwill of $35.1 million hasbeen 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 SFAS 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.

 

Supplemental unaudited pro formainformation reflecting the acquisition of Blue Pumpkin as if it occurred onJanuary 1, 2004 is as follows (in thousands, except per share amounts):

 
| ** **                             | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                             | ** ** | **2005**                        | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total revenues                         |       | $                               | 46,171     |                          | $          | 43,741 |   | $ | 88,405 |   | $ | 86,457 |   |
| Net income  (loss)                     |       | $                               | 576        |                          | $          | 271 |   | $ | (2,158 | ) | $ | (4,482 | ) |
| Net income  (loss) per share - basic   |       | $                               | 0.02       |                          | $          | 0.01 |   | $ | (0.08 | ) | $ | (0.18 | ) |
| Net income  (loss) per share - diluted |       | $                               | 0.02       |                          | $          | 0.01 |   | $ | (0.08 | ) | $ | (0.18 | ) |
| Weighted average  shares - basic       |       | 27,078                          |       | 25,113                        |       | 26,844 |   | 24,837 |   |
| Weighted average  shares - diluted     |       | 29,676                          |       | 28,208                        |       | 26,844 |   | 24,837 |   |

 

The above pro forma results include adjustments forthe amortization expense of intangible assets arising from the acquisition andthe reversal of interest income assuming the purchase was paid from availablecash.  In addition, the pro forma resultsdo not reflect any adjustments for IPR&D charges and cost savings and synergiesthat we believe would have resulted had the acquisition occurred on January 1,2004.

 

**4.****    OptimisAcquisition**

 

On May 23, 2005, we acquired Optimis Group Limited(“Optimis”), a UK-based provider of workforce optimization software solutions.Blue Pumpkin owned a minority interest in an operating subsidiary of Optimis,the balance of which was acquired through the Optimis acquisition.  We paid $5.2 million in cash, which wasfinanced from our existing cash and investments.  Ten percent of the aggregate mergerconsideration is being held in escrow until May 23, 2006, one year after theclosing date of the Merger.  The escrowperiod may be extended in the event that there are pending claims that arebrought 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.

 

We commenced theconsolidation of Optimis on May 23, 2005 and the acquisition was accounted forusing the purchase method of accounting in accordance with SFAS No. 141, *Business Combinations*.  The following summarizes the total purchaseprice for Optimis (in thousands):

 

9

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| Cash and other  consideration       |   | $   | 5,200  |   |
|-------------------------------------|--------|-----|--------|--------|
| Estimated direct  acquisition costs |   | 700 |   |
|                                |   | $   | 5,900  |   |

 

Under the purchase method of accounting, the totalestimated purchase price is allocated to Optimis’ net tangible and intangibleassets based upon their estimated fair value as of the date of the acquisitionwith any amount paid in excess of the fair value of the net assets recorded asgoodwill.. Based upon the estimated purchase price and review of the net assetsacquired and liabilities assumed, the preliminary purchase price allocation, isas follows (in thousands):

 

| Cash and  investments      |   | $      | 1,300  |   |
|----------------------------|--------|--------|--------|--------|
| Other current  assets      |   | 1,300  |   |
| Other long term  assets    |   | 100    |   |
| Customer  relationships    |   | 2,500  |   |
| Goodwill                   |   | 5,300  |   |
| Total assets  acquired     |   | 10,500 |   |
| Current  liabilities       |   | (2,400 | )      |
| Restructuring  accruals    |   | (1,000 | )      |
| Deferred revenue           |   | (1,200 | )      |
| Total  liabilities assumed |   | (4,600 | )      |
|                       |   | $      | 5,900  |   |

 

Thefair values of identifiable intangible assets was determined using both anincome and a cost approach taking into consideration the nature, risks,historical patterns, economic characteristics, and future considerations of theassets.

 

**5.****     Acquisition-Related Restructuring Accruals andMerger-Related and Integration Costs**

 

Asa result of the Blue Pumpkin and Optimis acquisitions during the first sixmonths of 2005, we recorded $2.3 million in certain acquisition-relatedrestructuring accruals primarily related to personnel reductions.  All such costs met the criteria for accrualas outlined in EITF No. 95-3, *Recognition of Liabilitiesin Connection with a Purchase Business Combination*, and wereincluded in the assets acquired and liabilities assumed in the purchases ofBlue Pumpkin and Optimis.  The followingtable summarizes restructuring accrual activities related to all acquisitions(in thousands):

 
| ** **                                   | ** ** | **Severance  and Benefits** | ** ** | **Facilities** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|----------------|------------|-----------|------------|
| Accrual at  December 31, 2004                |       | $                           | —     |           | $          | 2,044     |       | $ | 2,044 |   |
| Acquisition-related  restructuring provision |       | 1,949                       |       | 352            |       | 2,301     |       |
| Cash payments                                |       | (1,728                      | )          | (102           | )          | (1,830    | )          |
| Foreign exchange  translation                |       | (27                         | )          | (90            | )          | (117      | )          |
| Accrual at June  30, 2005                    |       | 194                         |       | 2,204          |       | 2,398     |       |
| Less: Long-term  portion                     |       | —                      |       | (1,598         | )          | (1,598    | )          |
| Current portion  at June 30, 2005            |       | $                           | 194        |           | $          | 606       |       | $ | 800 |   |

 

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The following table summarizes all merger-related andintegration costs (in thousands):

 
| ** **                              | ** ** | **Three months ended June** | ** ** | **Six months ended June** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|---------------------------|------------|
| ** **                              | ** ** | **2005**                    | ** ** | **2004**                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Eyretel:                                |       |                        |       |                      |       |   |   |   |   |
| Adjustments to  acquisition liabilities |       | $                           | —     |                      | $          | — |   | $ | (56 | ) | $ | — |   |
| Bonus expense                           |       | —                      |       | 155                       |       | 155 |   | 523 |   |
| Blue Pumpkin and  Optimis:              |       |                        |       |                      |       |   |   |   |   |
| Integration  costs                      |       | 925                         |       | —                    |       | 2,485 |   | — |   |
|                                    |       | $                           | 925        |                      | $          | 155 |   | $ | 2,584 |   | $ | 523 |   |

 

During 2005 and 2004, we incurred merger-related andintegration costs pertaining to the acquisitions of Blue Pumpkin and Optimisthat closed in 2005 and the Eyretel acquisition in 2003.  Merger-related and integration costs totaled$2.6 million in the first half of 2005 and included $2.5 million of integrationexpenses comprised primarily of costs of transitional employees and othercontractors, travel costs, legal costs and advertising costs.  Merger-related and integration costs incurredin the first half of 2004 totaled $0.5 million and related to the partialaccrual of a bonus payable to Eyretel’s former Chief Executive Officer, now ourChief 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.

 

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

 

The following is asummary of the calculation of basic and diluted net income (loss) per share (inthousands, except per share data):

 
| ** **                                                                         | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                               |       |                             |       |                           |       |   |   |   |   |
| Net income  (loss)                                                                 |       | $                                | 576        |                           | $          | 1,514 |   | $ | (8,784 | ) | $ | 1,984 |   |
| Weighted average  shares of common stock and common stock equivalents outstanding: |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                              |       | 27,078                           |       | 23,013                         |       | 26,669 |   | 22,737 |   |
| Dilutive effect  of stock options computed using the treasury stock method         |       | 2,598                            |       | 3,095                          |       | — |   | 3,522 |   |
| Diluted common  shares and share equivalents outstanding                           |       | 29,676                           |       | 26,108                         |       | 26,669 |   | 26,259 |   |
| Net income  (loss) per share:                                                      |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                              |       | $                                | 0.02       |                           | $          | 0.07 |   | $ | (0.33 | ) | $ | 0.09 |   |
| Diluted                                                                            |       | $                                | 0.02       |                           | $          | 0.06 |   | $ | (0.33 | ) | $ | 0.08 |   |

 

We have excluded all outstandingstock options from the calculation of diluted net loss per common share for thesix month period ended June 30, 2005 because we reported a loss in this periodand all such securities are anti-dilutive. The total number of share equivalents excluded from the calculation ofhistorical diluted net loss per common share for the six month period endedJune 30, 2005 was 2,730,424 calculated using the treasury stock method.  For the three and six months ended June 30,2005, stock options of 398,948 and 41,283, respectively, were excluded from thecomputation of diluted earnings per share compared to 778,850 and 1,014,514,respectively for the same year ago periods because they had exercise pricesthat exceeded the average fair market value of our common stock for thoseperiods, and therefore had an anti-dilutive effect.

 

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***7.***    Stock-Based Compensation

*** ***

We generally do notrecord compensation expense for options granted to our employees because alloptions granted under our stock option plans have an exercise price equal tothe market value of the underlying common stock on the date of grant.  As permitted under SFAS No. 148, *Accounting for Stock-Based Compensation - Transitionand Disclosure*, and SFAS No. 123, *Accountingfor Stock-Based Compensation*, we have elected to continue to applythe provisions of Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees,*and have adopted the disclosure requirements of SFAS No. 123.  The following table illustrates the effect onnet income (loss) and net income (loss) per share if we had applied the fair value method as prescribed by SFAS No. 123 (inthousands, except per share data):

 
| ** **                                                                                               | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| Reported net  income (loss)                                                                              |       | $                                | 576        |                           | $          | 1,514 |   | $ | (8,784 | ) | $ | 1,984 |   |
| Add back:  Stock-based employee compensation expense included in reported net income  (loss)             |       | 15                               |       | —                         |       | 30 |   | — |   |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards |       | (3,385                           | )          | (2,053                         | )          | (6,248 | ) | (3,624 | ) |
| Pro forma net  (loss)                                                                                    |       | $                                | (2,794     | )                              | $          | (539 | ) | $ | (15,002 | ) | $ | (1,640 | ) |
| Net income  (loss) per share:                                                                            |       |                             |       |                           |       |   |   |   |   |
| Reported basic                                                                                           |       | $                                | 0.02       |                           | $          | 0.07 |   | $ | (0.33 | ) | $ | 0.09 |   |
| Pro forma basic                                                                                          |       | $                                | (0.10      | )                              | $          | (0.02 | ) | $ | (0.56 | ) | $ | (0.07 | ) |
| Reported diluted                                                                                         |       | $                                | 0.02       |                           | $          | 0.06 |   | $ | (0.33 | ) | $ | 0.08 |   |
| Proforma diluted                                                                                         |       | $                                | (0.10      | )                              | $          | (0.02 | ) | $ | (0.56 | ) | $ | (0.07 | ) |

 

As of June 30, 2005, there were 1.3 million shares available for future grants under our stock option plans.

 

**8.**     Comprehensive Income (Loss)

 

**Totalcomprehensive (loss) income and accumulated other comprehensive incomeconsisted of the following (in thousands):**

 
| ** **                                                   | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                   | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income  (loss)                                           |       | $                                | 576        |                           | $          | 1,514 |   | $ | (8,784 | ) | $ | 1,984 |   |
| Other  comprehensive income (loss):                          |       |                             |       |                           |       |   |   |   |   |
| Change in net  unrealized holding gain (loss) on investments |       | 14                               |       | (180                           | )          | 15 |   | (166 | ) |
| Foreign currency  translation adjustments                    |       | (403                             | )          | (287                           | )          | (298 | ) | 442 |   |
| Total  comprehensive (loss) income                           |       | $                                | 187        |                           | $          |  1,047 |   | $ |  (9,067 | ) | $ |  2,260 |   |

 

| ** **                                           | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
|                                                 |       |               |       |                   |       |
| Cumulative  foreign currency translation adjustments |       | $                  | 4,655      |                   | $          | 4,953 |   |
| Unrealized net  holding gain (loss) on investments   |       | 4                  |       | (11                    | )          |
| Total  accumulated other comprehensive income        |       | $                  | 4,659      |                   | $          | 4,942 |   |

 

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**9.****     IntangibleAssets**

 

Thefollowing tables present the components of intangible assets (in thousands):

 
| ** **                 | ** ** | **June 30, 2005** | ** ** |
|----------------------------|------------|-------------------|------------|
| ** **                 | ** ** | **Gross  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
|                       |       |              |       |   |   |   |   |
| Acquired  technology       |       | $                 | 35,826     |   | $ | (13,559 | ) | $ | 22,267 |   |
| Customer  relationships    |       | 21,726            |       | (2,986 | ) | $ | 18,740 |   |
| Distribution  arrangements |       | 4,293             |       | (1,962 | ) | $ | 2,331 |   |
| Trademarks                 |       | 1,166             |       | (912 | ) | $ | 254 |   |
| Patents                    |       | 308               |       | (119 | ) | $ | 189 |   |
|                       |       | $                 | 63,319     |   | $ | (19,538 | ) | $ | 43,781 |   |

 
| ** **                 | ** ** | **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 |   |

 

The intangible assets andamortization expenses are subject to foreign currency translation adjustments.  Amortizationof intangible assets included in the accompanying condensed consolidatedstatements of operations is as follows (in thousands):

 

| ** **                           | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                           | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                 |       |                             |       |                           |       |   |   |   |   |
| Included in:                         |       |                             |       |                           |       |   |   |   |   |
| Cost of product  revenue             |       | $                                | 2,384      |                           | $          | 1,350 |   | $ | 4,456 |   | $ | 2,758 |   |
| Selling, general  and administrative |       | 1,572                            |       | 355                            |       | 2,783 |   | 810 |   |
|                                 |       | $                                | 3,956      |                           | $          | 1,705 |   | $ | 7,239 |   | $ | 3,568 |   |

 

**10.****  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 June 30, 2005, we were in compliance with our bank covenants.

 

As of June 30, 2005, wehad no amounts outstanding under the line of credit and the amount availablefor borrowing was $12.7 million, which was net of outstanding letters of creditof $2.3 million.  The letters of credit

 

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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.

 

***11.***  Segment and Geographic Information

 

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 annual revenue based on customer locationis as follows (in thousands):

 

| ** **     | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **     | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|           |       |                             |       |                           |       |   |   |   |   |
| United States  |       | $                                | 23,360     |                           | $          | 17,878 |   | $ | 46,398 |   | $ | 35,843 |   |
| United Kingdom |       | 13,879                           |       | 8,898                          |       | 23,670 |   | 17,519 |   |
| Rest of World  |       | 8,932                            |       | 7,642                          |       | 17,262 |   | 14,008 |   |
|           |       | $                                | 46,171     |                           | $          | 34,418 |   | $ | 87,330 |   | $ | 67,370 |   |

 

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 and six months ended June 30, 2005 or 2004.

 

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

 

| ** **     | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------|------------|--------------------|------------|------------------------|------------|
|           |       |               |       |                   |       |
| United States  |       | $                  | 76,103     |                   | $          | 5,518 |   |
| United Kingdom |       | 12,981             |       | 8,533                  |       |
| Rest of world  |       | 2,582              |       | 2,948                  |       |
| Total          |       | $                  | 91,666     |                   | $          | 16,999 |   |

 

**12.****  Recent Accounting Pronouncements**

 

In December 2004, the Financial Accounting StandardsBoard issued Statement of Financial Accounting Standards (“SFAS”) No. 123R(Revised 2004), *Share-Based Payment*, whichrequires 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 (see above). Uponadoption, pro forma disclosure will no longer be an alternative. SFAS No. 123Rwas originally effective for reporting periods that began after June 15,2005.  In April 2005, the SEC announced theadoption of a new rule allowing companies to implement SFAS No. 123R at thebeginning of their next fiscal year that begins after June 15, 2005.  We will begin to apply SFAS No. 123R usingthe most appropriate fair value model beginning January 1, 2006. We areevaluating the requirements under SFAS 123R and expect the adoption to have asignificant adverse impact on our results of operations, but will not impactour cash flows.

 

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

 

This quarterly report on Form 10-Q containsforward-looking statements that are not historical facts but rather are basedon current expectations, estimates and projections about our business andindustry, and our beliefs and assumptions. Words such as “anticipates’’, “expects’’, “intends’’, “plans’’,“believes’’, “seeks’’, “estimates’’ and variations of these words and similarexpressions are intended to identify forward-looking statements.  These statements are not guarantees of futureperformance and are subject to risks, uncertainties and other factors, some ofwhich are beyond our control, are difficult to predict and could cause actualresults to differ materially from those expressed or forecasted in theforward-looking statements. Forward-looking statements that were true at the time made mayultimately prove to be incorrect or false. Readers are cautioned not to place undue reliance on forward-lookingstatements, which reflect our management’s view only as of the date of thisreport.  Except as required by law, weundertake no obligation to update any forward-looking statement, whether as aresult of new information, future events or otherwise.

 

The following Management’sDiscussion and Analysis of Financial Condition and Results of Operations shouldbe read in conjunction with the Condensed Consolidated Financial Statements andNotes thereto included elsewhere in this report.  Investors should carefully review theinformation contained in this report under the caption “Factors That May AffectOur Future Results and Market Price of Our Stock” beginning on page 24.

 

**Overview**

 

We provide the contactcenter market a complete workforce optimization software and services solutionthat enables global enterprises to capture customer intelligence and improveworkforce performance.  Our****solutions – which playa strategic role in the customer interaction centers of****Global 2000 and small- and medium-sizedbusinesses (“SMBs”) worldwide are deployed in Internet Protocol (“IP”) Telephony and back office environments,and throughout the extended enterprise, including branch offices.  WitnessSystems, Inc. (“Witness”) softwareis comprised of quality monitoring, compliance, high-volume and IP Telephonyrecording solutions, as well as workforce management, actionable learning andperformance management applications. **** The solutionsenable organizations to****optimize their 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 isdesigned to enhance the quality of customer interactions across multiplecommunications media, including the telephone, e-mail and the Internet, and areused 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 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 (“ERP”) applications, and with existing telephony andcomputer network hardware and software. Many of our customers are companies with an international presence andone or more contact centers that handle voice and data customer interactionsfor outbound sales and marketing operations, inbound service/support lines, orboth.

 

We derive product revenueby licensing software and derive services revenue by providing relatedinstallation, training, consulting, and maintenance services.  We also derive a relatively small portion ofproduct revenue by selling hardware to customers.  Since our acquisition of Eyretel plc (“Eyretel”)in 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 informationtechnology (“IT”) consulting service companies who recommend

 

15

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

 

We intend to continue toexpand our global sales channels by entering into new reseller, distributor,OEM and similar arrangements with key vendors in the contact center workforceoptimization market.  During the pastyear, approximately one-third of our product revenue was derived from theindirect sales channel.

 

We plan to grow ourproduct revenue and maintain our competitive position from a technologyperspective through the timely introduction of new products, such aspre-packaged solutions, which add capabilities such as performance analysis ande-learning management to our core quality monitoring and workforce managementsolutions. These solutions, as well as recording products that we offer forVoice over Internet Protocol (“VoIP”) environments, are currently offered toour customers.  Although sales of suchpre-packaged solutions have not been material to date, we believe that our VoIPproduct offerings represent a material growth opportunity for us as the markettransitions to an Internet protocol (“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. 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.

 

We also plan to grow ourservices revenue in concert with our product revenue.  When our customers license our products, theygenerally purchase installation, training and one year of support services.  Therefore, as we generate product revenue, wealso generate related services revenue. In addition, our customers generallyrenew their maintenance contracts with us each year.  Therefore, our maintenance revenue increasesas our customer base increases.  Factorsthat may influence our ability to grow our services revenue, however, includeour ability to continue to increase product revenues and our ability tomaintain a high level of customer satisfaction.

 

On January 24, 2005, weacquired Blue Pumpkin Software, Inc. (“Blue Pumpkin”), a privately heldCalifornia corporation.  With thisacquisition, we have extended our workforce optimization solution to includeadvanced workforce management software and services solutions includingforecasting, scheduling, adherence and planning applications.  Pursuant to the Merger Agreement and Plan ofReorganization, dated December 16, 2004 (the “Merger Agreement”), we paid $40million in cash which was financed from our existing cash and investments andissued 2.1 million shares of Witness’ common stock valued at $37.2 million(measured at the date the stock consideration became fixed pursuant to theapplication of a formula specified in the merger agreement).  On May 24, 2005, the shares issued in connectionwith the acquisition were registered for resale with the Securities andExchange Commission.  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 event that there are pendingclaims that are brought against the escrow fund within such one-yearperiod.  The escrow fund is available tocompensate Witness, subject to certain limitations, for losses resulting from,among other things, breaches of representations, warranties or covenants in thepurchase agreement and certain pending and potential claims.

 

On May 23, 2005, weacquired Optimis Group Limited (“Optimis”), a UK-based provider of workforceoptimization software solutions.  BluePumpkin owned a minority interest in an operating subsidiary of Optimis, thebalance of which was acquired through the Optimis acquisition.  We paid $5.2 million in cash which wasfinanced from our existing cash and investments.  Ten percent of the aggregate mergerconsideration is being held in escrow for one year after the closing date ofthe Merger.  The escrow period may beextended in the event that there are pending claims that are brought againstthe escrow fund within such period.  Theescrow fund is available to compensate Witness, subject to certain limitations,for losses resulting from, among other things, breaches of representations,warranties or covenants in the Merger Agreement and certain pending andpotential claims.

 

In 2005, theCompensation Committee of our Board of Directors approved stock option awardsfor approximately 650,000 shares of Witness common stock to certain BluePumpkin and Optimis 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 the grant, subject tostandard provisions for termination, forfeiture and acceleration, and areexercisable for five years from the date of grant.  The inducement options will first becomeexercisable, as to 25 percent of the total amount, after one year from thedate of grant, and commencing 13 months after grant and until the end ofthe 47th month following grant, the options will become exercisable as to anadditional two percent per month and the balance upon the 48th month followinggrant.

 

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We are headquartered inRoswell, Georgia and have other offices throughout the United States.  We deliver our products and servicesinternationally through our offices in Australia, Brazil, Canada, China,Germany, India, Japan, Mexico, the Netherlands, Singapore, South Africa and theUnited Kingdom.  During 2004, 2003 and2002, 48%, 45% and 25%, respectively, of our revenue was derived from customersoutside the United States.  At June 30,2005, we had 604 full-time employees, excluding approximately 169 contractorslocated in the Asia-Pacific region, compared to 470 employees at June 30,2004.  As of June 30, 2005, 199 of the604 full-time employees were located outside the United States.

 

**CriticalAccounting Policies and Estimates**

 

The discussion andanalysis of our financial condition and results of operations is based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America.  The preparation of these financial statementsrequires us to make certain estimates and judgments that affect our reportedassets, liabilities, revenue and expenses, and our related disclosure ofcontingent assets and liabilities.  On anon-going basis, we re-evaluate our estimates, including those related torevenue recognition, the collectibility of receivables, accounting foracquisitions, impairment of long-lived assets, income taxes and stock-basedcompensation.  We base our estimates onhistorical experience and on various assumptions that we believe to bereasonable under the circumstances. Actual results may differ from these estimates.  A summary of our critical accounting policiesfollows.

 

*RevenueRecognition.*  We recognize revenue in accordance withthe American Institute of Certified Public Accountants’ Statement of Position (“SOP”)No. 97-2, *Software Revenue Recognition,*and SOP No. 98-9*, Modification of SOP97-2, Software Revenue Recognition, 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 its fair value 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.

 

*Allowancefor Doubtful Accounts.*  We perform ongoingevaluations of our customers and continuously monitor collections and paymentsand estimate an allowance for doubtful accounts based on the aging of theunderlying receivables, our historical experience and any specific customercollection issues that we have identified. While such credit losses have historically been within our expectationsand we believe appropriate reserves have been established, we cannot assurethat we will continue to experience the same credit loss rates that we haveexperienced in the past or adequately predict future credit losses.  If the financial condition of our customerswere to deteriorate and resulted in an impairment of their ability to makepayments, additional allowances may be required which would result in an additional selling,general and administrative expense in the period such determination is made.

 

Our revenue recognitionpolicy is significant because our revenues are a key component of our resultsof operations.  We follow very specificand detailed guidelines, discussed above, in measuring revenues; however,certain judgments and estimates affect the application of our revenue policydescribed above.  Further, assessment of

 

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collectibility is particularly critical in determining whether or notrevenues should be recognized in the current market environment.  We also record provisions for estimated salesallowances on product and service related revenues at the time the relatedrevenues are recorded.  These estimatesare based on historical sales and services allowances, analysis of customercredits and other known factors.  Iffuture sales credits prove to be greater than the historical data and theestimates we used to calculate these provisions, our revenues could beoverstated.

 

*Accountingfor Acquisitions.*  Accounting for acquisitionsrequires management to make judgments and estimates in determining the purchaseprice, the fair value of the assets and liabilities acquired and merger-relatedand integration expenses.  In recordingthe Blue Pumpkin and Optimis acquisitions in 2005, significant judgment wasrequired in estimating:

 

•      valuation ofdeferred revenue,

•      valuation ofintangible assets and acquired in-process research and development,

•      severanceexpenses for employee terminations,

•      otherliabilities existing at the time of acquisition.

 

Changes to purchase priceestimates, prior to the completion of the final purchase price allocation, arereflected as adjustments to goodwill and/or other acquired assets.  Subsequent adjustments are reflected in ourresults of operations.  In accordancewith Statement of Financial Accounting Standards (“SFAS”) 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.

 

*Impairmentof Long-Lived Assets.*  Long-lived assets, such asproperty and equipment and intangible assets, are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable.  Allof our intangible assets are amortized using the straight-line method.  Useful lives of amortizable intangible assetsare reviewed annually with any changes in estimated useful lives beingaccounted for prospectively over the revised remaining useful life.  Recoverability of assets to be held and usedwould be measured by a comparison of the carrying amount of an asset to theestimated undiscounted future cash flows expected to be generated by the asset.  If the carrying amount of an asset exceeds itsestimated future cash flows, an impairment charge is recognized in the amountby which the carrying amount of the asset exceeds the fair value of theasset.  The determination of estimatedfuture cash flows, however, would require management to make estimates.  Future events and changes in circumstancesmay require us to record a significant impairment charge in the period in whichsuch events or changes occur. Impairment testing requires considerable analysisand judgment in determining the results. If other assumptions and estimates were used in our evaluations, theresults could differ significantly.

 

*Accountingfor Income Taxes.*  We account for income taxes inaccordance with SFAS No. 109, *Accountingfor Income Taxes*, which requires companies to recognize deferredincome tax assets and liabilities for temporary differences between thefinancial reporting and tax bases of recorded assets and liabilities and theexpected benefits of net operating loss and credit carryforwards.  SFAS No. 109 requires that deferredincome tax assets be reduced by a valuation allowance if it is more likely thannot that some portion or all of the deferred income tax assets will not berealized.  We evaluate the realizabilityof our deferred income taxassets, primarily resulting from net operating loss and credit carryforwards,and adjust our valuation allowance, if necessary.

 

Once we utilize our netoperating loss carryforwards, we would expect our provision for income taxexpense in future periods to reflect an effective tax rate that will besignificantly higher than past periods. Furthermore, the utilization of certain net operating loss carryforwardsarising from acquisitions will result in a reduction of the valuation allowancefor the deferred income tax assets and intangible assets.

 

Estimates and judgmentsare 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 DisclosureGuidance for the Foreign Earnings Repatriation Provision within the AmericanJobs*

 

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*CreationsAct of 2004*. Corporations are allowed an 85% dividends received deduction in 2004 and2005 on the repatriation of certain foreign earnings to a U.S. taxpayer,provided certain criteria are met. Management does not believe it willrepatriate any material amount of earnings in 2005.  The range of possible amounts that are currentlybeing considered for repatriation is between $0 and $.4 million and the taxeffects of these amounts are insignificant.

 

*Stock-BasedCompensation.*  We generally do not recordcompensation expense for options granted to our employees because all optionsgranted under our stock option plans have an exercise price equal to the marketvalue of the underlying common stock on the date of grant.  As permitted under SFAS No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure*, and SFAS No. 123, *Accounting for Stock-Based Compensation*, we have elected tocontinue to apply the provisions of Accounting Principles Board OpinionNo. 25, *Accounting for Stock Issued toEmployees,* and have adopted the disclosure requirements of SFASNo. 123.  The pro forma disclosuresof stock-based compensation include the use of certain input factors incalculating the fair value of stock option grants, some of which requiremanagement to make estimates and use judgment. In December 2004, the FASB issued SFAS No. 123R (Revised2004), *Share-Based Payment*, whichrequires 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.  We will beginto apply SFAS No. 123R using the most appropriate fair value model beginningJanuary 1, 2006.  We are evaluating therequirements under SFAS 123R and expect the adoption to have a significantadverse impact 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 and sixmonths ended June 30, 2005 and 2004 expressed as a percentage of total revenue.

 
| ** **                                              | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                              | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue:                                                |       |                             |       |                           |       |   |   |   |   |
| Product                                                 |       | 41                               | %          | 41                             | %          | 40 | % | 42 | % |
| Services                                                |       | 59                               | %          | 59                             | %          | 60 | % | 58 | % |
| Total revenue                                           |       | 100                              | %          | 100                            | %          | 100 | % | 100 | % |
| Cost of revenue:                                        |       |                             |       |                           |       |   |   |   |   |
| Product                                                 |       | 11                               | %          | 11                             | %          | 11 | % | 11 | % |
| Services                                                |       | 23                               | %          | 24                             | %          | 23 | % | 24 | % |
| Total cost of  revenue                                  |       | 34                               | %          | 35                             | %          | 34 | % | 36 | % |
| Gross profit                                            |       | 66                               | %          | 65                             | %          | 66 | % | 64 | % |
| Operating  expenses:                                    |       |                             |       |                           |       |   |   |   |   |
| Selling, general  and administrative                    |       | 47                               | %          | 46                             | %          | 47 | % | 46 | % |
| Research and  development                               |       | 15                               | %          | 14                             | %          | 15 | % | 15 | % |
| Merger-related  and integration costs                   |       | 2                                | %          | 0                              | %          | 3 | % | 1 | % |
| Acquired in-process  research and development           |       | 0                                | %          | 0                              | %          | 10 | % | 0 | % |
| Operating income  (loss)                                |       | 2                                | %          | 4                              | %          | -10 | % | 3 | % |
| Interest and  other income, net                         |       | 0                                | %          | 0                              | %          | 0 | % | 0 | % |
| Income (loss)  income before provision for income taxes |       | 2                                | %          | 4                              | %          | -10 | % | 3 | % |
| Provision for  income taxes                             |       | 1                                | %          | 0                              | %          | 1 | % | 0 | % |
| Net income  (loss)                                      |       | 1                                | %          | 4                              | %          | -10 | % | 3 | % |

 

*Impact of Blue Pumpkin and OptimisAcquisitions*

 

The acquisition of Blue Pumpkin and Optimis in 2005increased our reported revenues in the six months ended June 30, 2005 by anestimated $12 million compared to the same period in 2004.  Operating expenses, expressed as a percentageof total revenue, increased in the six months ended June 30, 2005 compared tothe same period in 2004 due to the aforementioned acquisitions, $9.0 million inacquired in-process research and development costs, an increase of $2.1 millionin merger-related and integration costs and additional intangible assetamortization of $3.7 million.

 

*Revenue*

 

Totalrevenue increased 34% in the second quarter of 2005, as compared to the secondquarter of 2004, to $46.2 million.  Theincrease in total revenue can be attributed to both continued growth of ourbusiness and sales and related services derived from our Blue Pumpkinacquisition, which expanded our workforce optimization solution.  Total revenue increased 30% in the first halfof 2005 as compared to the same year ago period due to increases in product andservices revenue.

 

Product revenue includessoftware revenue and hardware revenue. Because hardware sales are incidental to our business, we are workingtowards transitioning our customers to third-party hardware suppliers and, as aresult, expect hardware revenue to decline in the future.  For the three and six months ended June 30,2005, hardware

 

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revenue was $1.9 million and $3.2 million,respectively, compared to $2.0 million and $4.3 million, respectively, during2004.  Software revenue for the three andsix months ended June 30, 2005 increased 40% and 35%, respectively, as comparedto the same year ago periods. More than half of the increase in software revenue growth in 2005 isattributed to our expanded product line resulting from our acquisitions of BluePumpkin and Optimis which we began consolidating during 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 relativelyconsistent over the previous three years.

 

Newcustomers accounted for 18% and 19%, respectively, of product revenue,excluding hardware revenue, during the second 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. During the second quarter of 2005, we installed an additional 133customer sites and, with the inclusion of Blue Pumpkin, we ended the quarterwith 3,979 installed customer sites as of June 30, 2005 versus approximately2,549 at June 30, 2004.

 

Services revenue, consisting of installation,training, consulting, maintenance support and reimbursable travel expenses,increased 34% and 32% in the three and six months ended June 30, 2005,respectively, as compared to the same year ago periods.  This increase was due to the installation andtraining services related to new product sales and due to customers renewingtheir maintenance contracts with us thereby increasing our recurringmaintenance revenue stream.  The BluePumpkin and Optimis acquisitions during 2005 accounted for approximately 10% ofthe increase in services revenue in 2005. The percentage of Witness customers that have renewed their maintenancecontracts with us has historically exceeded 90%.  We believe that maintenance contracts will berenewed at a comparable rate during 2005. Our services pricing has remained consistent over the past threeyears.  We expect services revenue, inabsolute dollars, to increase over time due to the compounding effect ofrenewals of annual maintenance contracts from existing customer sites and to remainrelatively constant as a percentage of total revenue, excluding hardwarerevenue, throughout 2005.

 

*Cost ofRevenue*

 

Total cost of revenue increased 30% and 24% in thethree and six months ended June 30, 2005, respectively, as compared to the sameyear ago periods.  Expressed as a percent of revenue,gross profit margins increased to 66% for the three and six months ended June30, 2005 as compared to 65% and 64%, respectively, for the same year agoperiods.  This increase resultedprimarily from productivity gains achieved in the professional servicesorganization.  Excluding hardware cost ofrevenue and the amortization of intangible assets resulting from acquisitions,gross profit margins have remained consistent at 75% in the first half of 2005and 2004.  We expect our gross profitmargin, excluding hardware and amortization of intangible assets, to continueto remain relatively constant throughout 2005.

 

Cost of product revenueconsists of amortization of acquired technology, hardware costs, royalties dueto third parties for software components that are embedded in our softwareapplications, amortization of capitalized software development costs andpackaging costs.  For the three and six months ended June 30,2005, amortization of acquired technology of $2.4 million and $4.4 million,respectively, increased 77% and 62%, respectively as compared to the same yearago periods.  For the three and sixmonths ended June 30, 2005, cost of hardware revenue of $1.9 million and $3.2million, respectively, decreased 0% and 19%, respectively, as compared to thesame year ago periods.  We willcontinue to incur amortization expense, but expect the cost of hardware todecline as we work towards reducing the amount of hardware sales in thefuture.  For the three and six monthsended June 30, 2005, cost of productrevenue, excluding amortization of acquired technology and hardware costs, of $.6 million and $1.6million, respectively, increased 36% and82%, respectively, as compared to the same year ago periods.  This increase was due to increasedroyalties due to third parties for software components that are embedded in oursoftware applications.  Such royaltiesincreased as a result of an increase in sales of software applicationscontaining third party software components. For the three and six months ended June 30, 2005, expressed as apercentage of product revenue and excluding hardware and amortization ofintangible assets, the cost of product revenue, was 3% and 4%, respectively, ascompared to 3% for the same year ago periods. As we develop upgrades of our existing products and

 

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add new offerings to our product suite, we may embed third-partytechnology into our software, which would increase the cost of product revenuein the future.

 

Cost of services revenue for installation, training,consulting and maintenance services include personnel costs and relatedexpenses and allocated overhead. Personnel costs include salaries, bonuses and benefits and allocated overhead.  Cost of services revenue increased 29% and25% in the three and six months ended June 30, 2005, respectively, as comparedto the same year ago periods due primarily to an increase in the number ofemployees engaged in customer support services mainly as a result of the BluePumpkin and Optimis acquisitions.  Costof services revenue as a percentage of services revenue was 40% in the secondquarter of 2005, compared to 41% in the second quarter of 2004.  We anticipate that our services margins willremain relatively constant throughout 2005. 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.

 

*OperatingExpenses*

 

*Selling, General and Administrative.** *Selling, general and administrativeexpense (‘‘SG&A’’) consists primarily of personnel costs, salescommissions, marketing programs, professional fees, the amortization of certainintangible assets and provisions for bad debt expense. For the three and six months ended June 30, 2005, SG&A expense of$21.5 million and $41.4 million, respectively, increased 37% and 33%,respectively as compared to the same year ago periods.  This increase is due primarily tohigher amortization expenses and the increased size of our Company due toacquisitions of Blue Pumpkin and Optimis. In 2005, we expect SG&A expense to increase in absolute dollars butdecrease as a percentage of total revenue due to anticipated revenue growth ascompared to the same period in 2004.

 

*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 June 30,2005, we reported $37 thousand in capitalized but unamortized softwaredevelopment costs was capitalized. R&D expenses increased 39% and 33% in the three and six months endedJune 30, 2005, respectively, as compared to the same year ago periods due to theincreased number of employees engaged in research and development activities asa result of the Blue Pumpkin acquisition. We expect total R&D expense to increase in absolute dollars butdecrease as a percentage of total revenue during 2005 as compared to 2004.

 

*Merger-relatedand Integration Costs*. We incurred merger-related andintegration costs of $2.6 million in the first half of 2005, primarily BluePumpkin and Optimis integration expenses. Merger-related and integration costs incurred in the first half of 2004totaled $0.5 million and related to the final accrualof a bonus payable to Eyretel’s former Chief Executive Officer.  Merger-related and integration costs arecomprised primarily of costs of transitional employees and other contractors,travel costs, legal costs and advertising costs.

 

*Acquired In-Process Research andDevelopment Charges.* During the first quarter of 2005, we estimated that $9.0 million of thepurchase price of Blue Pumpkin represented acquired in-process research anddevelopment (‘‘IPR&D’’) that had not yet reached technological feasibilityas defined by SFAS No. 86, *Accounting forthe Cost of Computer Software to Be Sold, Leased or Otherwise Marketed,*andhad no alternative future use. Accordingly, these amounts were immediately charged to expense uponconsummation of the acquisition.  Thevalue of the IPR&D was calculated with the assistance of an independentthird-party appraiser by utilizing a discounted cash flow methodology, focusingon the income-producing capabilities of the in-process technologies and takinginto consideration: stage of completion; complexity of work to date and tocomplete; anticipated product development and introduction schedules;forecasted product sales cycles; internal and external risk factors; revenueand operating expense estimates; contributory asset charges, and costs alreadyincurred and the expected costs to 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 59% and 37% in the three andsix months ended June 30, 2005, respectively, as compared to the same year agoperiods due primarily to decreased interest income resulting from lowerinvestment balances as a result of the acquisitions of Blue Pumpkin andOptimis.  We expect that interest andother income, net will decrease in 2005 compared to 2004 due to lower cash andinvestment balances.

 

*Provisionfor Income Taxes*

 

We recorded a provision for income tax of $0.7 millionand $0.2 million, respectively, during the six months ended June 30, 2005 and2004.  The provision is comprised of U.S.federal alternative minimum income tax, expense relating to the utilization ofpurchased net operating loss carryforwards and foreign income tax, primarilyfrom withholding.  At December 31, 2004,we had net operating loss carryforwards aggregating $31.4 million for U.S. taxpurposes and $44.4 million for foreign tax purposes.  The provision for income taxes in 2005 and2004 benefited from the utilization of net operating loss carryforwards fromprior years.  However, the utilization ofcertain net operating loss carryforwards arising from acquisitions results in areduction of intangible assets and the recognition of income taxes.

 

### **Liquidity and Capital Resources**

 

At June 30, 2005, we had $31million in total cash and cash equivalents and investments, compared to $76.5million at December 31, 2004.  Workingcapital also decreased by $43.4 million from $60.1 million at December 31, 2004to $16.7 million at June 30, 2005.  Thesedecreases in cash and working capital were primarily due to the acquisitions ofBlue Pumpkin and Optimis in 2005.

 

Cash flows used in operatingactivities in the first half of 2005 was $2.0 million compared to $5.0 millionin cash provided by operating activities in the first half of 2004.  The cash flows used in operations in thefirst half of 2005 were impacted by $2.6 million of merger-related andintegration costs, as well as by an increase in accounts receivable of $9.0million, of which $3.1 million was attributable to the Blue Pumpkin and Optimisacquisitions.  We made cash payments of$1.8****million and $1.1 million inmerger-related and integration costs during the first half of 2005 and 2004,respectively.  We expect to payapproximately $.250****million inadditional accrued merger-related and integration costs throughout theremainder of 2005.  Our accountsreceivables days sales outstanding (“DSO”) at June 30, 2005 was 66 days,unchanged from December 31, 2004.  Weexpect our DSO to remain in the mid to high 60 day range throughout theremainder of the year.

 

Cash flows used ininvesting activities in the first half of 2005 were $15.2 million compared to$10.7 million in the same year ago period, which was attributed primarily tothe acquisitions of Blue Pumpkin and Optimis. The cash portion of the Blue Pumpkin acquisition ($40.0 million or $36.3million net of cash and cash equivalents acquired) was funded in part throughthe sale of investment securities totaling $30.9 million.  We paid $5.2 million for Optimis (or $4.0million net of cash and cash equivalents acquired). Capital expenditures in thefirst half of 2005 were $2.6 million, compared to $1.3 million in the first sixmonths of 2004.

 

Cash flows provided byfinancing activities during the first half of 2005 were $4.8 million ascompared to $6.9 million during the first half of 2004 and represents proceedsfrom the exercise of stock options.

 

At June 30, 2005, we had$12.7 million available under a line of credit, which was net of outstandingletters of credit of $2.3 million.  Theletters of credit secure the lease on the corporate headquarters facility andhave decreasing schedules that ultimately expire in 2007.  At our election, borrowings under the line ofcredit bear interest at the bank’s prime rate, or LIBOR plus 300 basis pointsand are limited to 85% of eligible accounts receivable, as defined by theagreement.  The revolving line of creditis secured by all of our assets and requires compliance with various covenants,including liquidity ratios and tangible net worth requirements, amongothers.  As of June 30, 2005, we were incompliance with all bank covenants.

 

We anticipate that operatingexpenses and capital expenditures will continue to be a material use of ourcash resources.  We currently expect tohave total capital expenditures of approximately $5 million in 2005, primarily

 

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consisting of purchases of computer equipment and software.  We anticipate that our capital expendituresmay increase over the next several years as we expand our facilities andacquire equipment to support the expansion of our research and developmentactivities and internal management and information systems.  We believe that our existing cash andinvestment balances, together with our anticipated cash flows from operations,will be sufficient to meet our working capital and capital expenditures for atleast the next twelve months.  Inaddition, the availability under our line of credit may be used to fund workingcapital requirements or future merger or acquisition transactions.

 

Our shelf registrationstatement on Form S-3 (including subsequent amendments) with the Securities andExchange Commission (“SEC”) became effective in August 2004.  The shelf registration allows us to registerup to $80 million of securities, which may consist of common stock, warrants topurchase our common stock, or both.  The shelf registration statement provides us the ability to raise equity capital if and when appropriate forour business. The sale of additional equitysecurities could 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 registered 2.1 million shares of our common stock issuedto the Blue Pumpkin shareholders in the second quarter of 2005.

 

*Market Risk*

 

Market risk represents the risk of loss that mayaffect us due to adverse changes in financial market prices and rates.  Our market risk exposure primarily relates tofluctuations in foreign exchange rates and interest rates.  Except for the hedge transaction entered intoin connection with the Eyretel acquisition during 2003, we have not enteredinto derivative or hedging transactions to manage risk in connection withforeign exchange fluctuations and have not engaged in any interest rate hedgingtransactions.

 

We areexposed to adverse movements in foreign currency exchange rates because wetranslate foreign currencies into U.S. dollars for reporting purposes.  Foreign currency translations did notcontribute significantly to our June 30, 2005 operating results compared tothose in the same period in 2004. However, due to the relative strengthening of the US dollar compared tothe British pound Sterling and certain other currencies since May 2005, wecurrently expect that revenue reported in the second half of 2005 may benegatively impacted by $1million to $2 million.

 

Within our foreign-basedoperations, where transactions may be denominated in foreign currencies, we arealso subject to market risk, especially when those operations conducttransactions in currencies other than the local currency.  As our international operations continue togrow, adverse currency fluctuations could have a material adverse impact on ourfinancial results.  Net foreign exchangegains and (losses) were $(0.3) million and $0million in the first half of 2005 and 2004, respectively.

 

Exposure to market rate risk for changes in interestrates relates to our investment portfolio. Our investments are made with capital preservation and liquidity as ourprimary objectives.  We generally holdonly high-grade investments such as commercial paper, corporate bonds and U.S.government agency securities.  To reduceour balance sheet exposure to variations in asset values, our investment policyguidelines specify that we invest in the highest investment grade securitiesand maintain a weighted average maturity of nine months for our entireportfolio.  Our investment portfolio maycontain securities 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.

 

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*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 investor expectations,which may adversely affect our stock price.*

 

It typically takes three to nine months from the timewe qualify a sales lead until we sign a sales contract with the customer. As aresult, it is difficult for us to predict the quarter in which a particularsale will occur. If our sales cycle unexpectedly lengthens for one or morelarge orders or a significant number of small orders, it would delay the timingof our revenue, but not the timing of most of our corresponding expenses.Lengthening of our sales cycle could also increase the total cost of a sale dueto additional employee time and costs associated with the sale. Materialchanges in our sales cycle could cause our quarterly revenue or operatingresults to be below the expectations of investors, and the price of our commonstock could fall substantially.

 

Our customers’ decision process regarding theirpurchase of our products and services is relatively long due to severalfactors, 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 ourproducts and services are not used and accepted by existing and prospectivecustomers, our business and results of operations will be adversely affected.*

 

The market for workforce optimization software,including software that records and analyzes customer interactions and thatforecasts and schedules employees, is still developing. Our success depends onthe use and acceptance of our software and services by existing and prospectivecustomers. In addition, demand for our software remains uncertain because ourexisting 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 schedulingof employees;

•      notachieve favorable results using our software;

•      experiencetechnical difficulty in implementing our software;

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

•      closecontact centers.

 

*If weexperience losses from operations in the future, the market price of our commonstock may be materially and adversely affected.*

 

Throughout much of our history, we have experiencedlosses from operations. As a result of our prior operating losses, we had anaccumulated deficit of $47.8 million as of June 30, 2005. We need togenerate sufficient revenue to achieve sustained profitability and avoidincurring losses again in the future.

 

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

 

Our quarterly revenue and operating results aredifficult to predict and could fluctuate significantly from period to period.In particular, we typically derive a significant portion of our softwareproduct revenue toward the end of each quarter and 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 and training services largely correlateswith our product revenue, a decline in product revenue could also cause adecline in our professional services revenue in

 

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the same quarter or in subsequent quarters. Our quarterly revenue isdifficult to forecast for several 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 purchases until the end of the fiscalquarter;

 

•      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 and other factors, we believethat quarter-to-quarter comparisons of our operating results may not be a goodindicator of our future performance, and you should not rely on them to predictour future performance or the performance of our stock price. If our revenue oroperating results fall below the expectations of investors or securitiesanalysts, the price of our common stock would likely decline.

 

*We may beunable to manage and expand our international operations, which may adverselyaffect our business and operating results.*

 

We derived revenues of $40.9 million and $31.5 millionin the first half of 2005 and 2004, respectively, from customers locatedoutside the United States.  Ouroperations outside of the United States at June 30, 2005, consisted of officeslocated in Australia, Brazil, Canada, China, Germany, India, Japan, Malaysia,Mexico, the Netherlands, Singapore, South Africa and the United Kingdom. Wehave also established relationships with a number of international resellers.

 

With our acquisitions of Optimis in May 2005 and BluePumpkin in January 2005, both of which have sales outside of North America, wehave expanded our international operations, and we intend to continue to expandour international operations through additional acquisitions, internal businessexpansion and strategic business relationships. These efforts requiresignificant management attention and financial resources. We may not be able tosuccessfully penetrate international markets or, if we do, we may not be ableto grow or to maintain adequate profit margins in these markets. Because of thecomplex nature of our international expansion, it may adversely affect ourbusiness and operating results. International expansion and sales are subjectto many risks, including the following:

 

•      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;

 

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•      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 our operations outside the UnitedStates, we will also face new competitors and competitive environments. Inaddition to the risks associated with our domestic competitors, foreigncompetitors may pose an even greater risk, because they may possess a betterunderstanding of their local markets and have better working relationships withlocal infrastructure providers and others. In particular, because telephoneprotocols and standards are unique to each country, local competitors will havemore experience with, and may have a competitive advantage in, these markets.We may not be able to obtain similar levels of knowledge, which could place us ata significant competitive disadvantage. In addition, we have limited experiencein developing local language versions of our products or in marketing ourproducts to international customers. We may not be able to successfullytranslate, market, sell, and deliver our products internationally.

 

*If we areunable to maintain a productive direct sales force, our business and operatingresults could be materially adversely affected.*

 

We believe that our future success will depend onmaintaining a productive direct sales force. Historically, it has taken us upto six months to train new sales personnel before they reach an acceptablelevel of productivity. We have also experienced difficulty in recruiting salespersonnel with experience in computer and telephone integration technologies.We cannot assure you that we will be able to continue to manage turnover andhire new sales personnel to meet our needs. If the personnel we hire are lessqualified than we expect, it may take us more time to train them before theyreach an acceptable level of productivity, which could increase our costs andimpact our revenue.

 

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

 

Our strategy is to continue to increase the proportionof customers served through indirect sales channels, such as select resellersand a variety of strategic marketing alliances. Product revenue from ourindirect sales channel represented approximately 39% and 34% of total productrevenue in the first half of 2005 and 2004, respectively. We expect revenuefrom our indirect sales channel and, accordingly, our dependence ondistribution partners, to increase as we establish relationships with companiesto resell our software worldwide. We cannot assure you that we will be able tomaintain productive relationships with our current partners, or that we will beable to establish similar relationships with additional resellers on a timelybasis, if at all.

 

Some resellers with which we do business have similar,and often more established, relationships with our competitors, and mayrecommend the products and services of our competitors to customers instead ofour software and services. We cannot provide assurance that these distributionpartners will devote adequate resources to selling our software and services orthat our resellers may not learn about our products and the market for oursoftware and services and develop and sell competing products and services. Asa result, our relationships with resellers could lead to increased competitionfor us.

 

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

 

The market for products that record customer interactions,forecast and schedule employees, analyze performance and/or provide electroniclearning is intensely competitive, evolving and is subject to rapid changes intechnology. We believe our principal competitors include, but are not limitedto:

 

•      qualitymonitoring suppliers to the contact center industry;

 

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•      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 and potential competitors havelonger operating histories, more established business relationships, largercustomer bases, a broader range of products and services, greater namerecognition and substantially greater financial, technical, marketing,personnel, management, service, support and other resources than we do. As aresult, our current and potential competitors may be able to respond morequickly to new or emerging technologies and changes in customer requirements,take better advantage of acquisitions and other opportunities, devote greaterresources to marketing and selling their products and services and adopt moreaggressive pricing policies. We cannot assure you that our current or potentialcompetitors will not develop products comparable or superior in terms of priceand performance features to those developed by us.

 

In addition, many of our competitors market theirproducts through resellers and companies that integrate their technology andproducts with those of the competitor. These resellers and technology partnersoften have strong business relationships with our customers and potentialcustomers. For example, some of our competitors have better and more longstanding relationships than we do with telephone switch vendors. Ourcompetitors may use these business relationships to market and sell theirproducts and compete for potential customers. It is also possible thatresellers or technology partners may acquire or be acquired by one or more ofour competitors, which would further solidify their business relationships.

 

We expect that competition will increase as otherestablished and emerging companies enter our market and as new products,services and technologies are introduced. Increased competition may result inprice reductions, lower gross margins and loss of market share, any of whichcould materially and adversely affect our business, financial condition andresults of operations.

 

*Our heavyreliance on sales of our eQuality Balance and eQuality ContactStore productsexposes us to risks of obsolescence due to changes in competitive productofferings.*

 

We have derived a substantial portion of our productrevenues from sales of our eQuality Balance and eQuality ContactStore software.We expect revenue from these products to continue to account for a significantportion of our revenue for the foreseeable future. As a result, any factorsaffecting the markets for these products could materially and adversely affectour business, financial condition and results of operations. We cannot assureyou that the market will continue to demand our current products or that wewill be successful in marketing any new or enhanced products. If ourcompetitors release new products that are superior to our products inperformance or price, demand for our products may decline. A decline in demandfor our products as a result of competition, technological change or otherfactors would reduce our total revenues and harm our ability to maintainprofitability.

 

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

 

The markets for our products are characterized byrapidly changing technology, frequent new product introductions and enhancements,changes in customer demands and evolving industry standards. Our existingproducts could be rendered obsolete if we fail to continue to advance ourtechnology. We have also found that the technological life cycles of ourproducts are difficult to estimate, partially because of changing demands ofour customers. We believe that our future success will depend on our ability tocontinue to enhance our current product line while we concurrently develop andintroduce new products that keep pace with competitive and technological

 

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developments. These developments require us to continue to makesubstantial product development investments. Although we are presentlydeveloping a number of product enhancements to our product suites, we cannotassure you that these enhancements will be completed on a timely basis or gaincustomer acceptance. In addition, failure to develop new software or improveexisting software products may impact our ability to maintain our maintenancerenewal rate which could have a material impact on our revenue.

 

*If oursoftware development activities in the Asia-Pacific region are not successful,we may not be able to meet our development schedules.*

 

During 2004, we expanded our software developmentcapabilities in the Asia-Pacific region in order to optimize available researchand development resources and better meet development timeframes. We havelimited experience with remote software development activities. Accordingly,there are a number of risks associated with this activity, including:

 

•      delaysor product 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;

 

•      highvoluntary personnel turnover; and

 

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

 

Our inability to meet development schedules because ofour reliance on developers in the Asia-Pacific region may affect our ability toenhance our current product line or introduce new products, which would have amaterial adverse affect on our financial results and could harm our reputation.The loss of key development personnel could have a material adverse effect onour product development process and adversely affect future product revenues.

 

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

 

Our software is used in a complex operatingenvironment that requires its integration with computer and telephone networksand other business software applications. If our products fail to function asrequired, we may be subject to claims for substantial damages. Courts may notenforce provisions in our contracts that would limit our liability or otherwiseprotect us from liability for damages. Although we maintain general liabilityinsurance coverage, including coverage for errors or omissions, this coveragemay not continue to be available on reasonable terms or in sufficient amountsto cover claims against us. In addition, our insurer may disclaim coverage asto any future claim. If claims exceeding the available insurance coverage aresuccessfully asserted against us, or our insurer imposes premium increases,large deductibles or co-insurance requirements on us, our business and resultsof operations 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 assure you, despite testing by us and bycurrent and prospective customers, that errors will not be found in newproducts or product enhancements after commercial release. Any errors found maycause substantial harm to our reputation and result in additional unplannedexpenses to 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.*

 

Through our acquisition of Eyretel, we have extendedour product line to include advanced compliance recording applications andrelated services. Many of our Eyretel customers use these applications torecord and store interactions with customers to provide back-up and verificationof transactions and to guard against risks posed by lost or misinterpretedvoice communications. These customers rely on our applications to record, storeand retrieve voice data in a timely, reliable and efficient manner. If ourapplications fail to record 100% of our customers’

 

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interactions or our customers are unable to retrieve the recordingswhen necessary, we may be subject to liability and our reputation may beharmed.

 

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

 

The occurrence or perception of security breaches inthe operation of our business or by third parties using our products could harmour business, financial condition and operating results. Our customers use ourproducts to compile and analyze highly sensitive or confidential information.We may come into contact with such information or data when we perform supportor maintenance functions for our customers. While we have internal policies andprocedures for employees performing these functions, the perception that wehave improperly handled sensitive, confidential information could have anegative effect on our business. If, in handling this information, we fail tocomply with privacy or security laws, we could incur civil liability togovernment agencies, customers and individuals whose privacy is compromised. Ifpersonal information is received or used from sources outside the U.S., wecould be subject to civil, administrative or criminal liability under the lawsof other countries. In addition, while we implement sophisticated securitymeasures, third parties may attempt to breach our security or inappropriatelyuse our products through computer viruses, electronic break-ins and otherdisruptions. If successful, confidential information may be improperly obtainedand we may be subject to lawsuits and other liability. Any internal or externalsecurity breaches could harm our reputation, and even the perception ofsecurity risks, whether or not valid, could inhibit market acceptance of ourproducts.

 

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

 

We may experience gains and losses resulting fromfluctuations in currency exchange rates. Moreover, in locations where we priceour products in U.S. dollars, our sales could be affected adversely by declinesin foreign currencies relative to the dollar, thereby making our products moreexpensive in local currencies. In locations where we sell our products in localcurrencies, we could be competitively unable to increase our prices to reflectfluctuations in exchange rates. We cannot predict the impact that futureexchange rate fluctuations may have on our results.

 

*Certain provisionsin agreements that we have entered into may expose us to liability for breachthat is not limited in amount by the terms of the contract.*

 

Certain contract provisions, principallyconfidentiality and indemnification obligations in certain of our licenseagreements, could expose us to risks of loss that, in some cases, are notlimited by contract to a specified maximum amount. If we fail to perform to thestandards required by these contracts, we could be subject to additionalliability and our business, financial condition and results of operations couldbe materially and adversely affected. There have been no material losses todate as a result of any such contractual provisions.

 

*If we failto protect our intellectual property, third parties may use our technology fortheir own benefit.*

 

Our success and ability to compete depends to asignificant degree upon our proprietary technology. We rely on a combination ofpatent, trade secret, copyright and trademark laws and confidentialityagreements with employees and third parties to establish and protect ourproprietary rights. These measures may not be sufficient to protect ourproprietary 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 our proprietary rights could negativelyimpact our future operating results.

 

As of June 30, 2005, we had eight registeredtrademarks, two trademark applications pending in the U.S., eight patents andnineteen patent applications pending in the U.S. and nine patent applicationspending internationally. There is no guarantee that our pending applicationswill result in issued trademarks or patents or, if issued, that they willprovide us with any competitive advantage. We cannot assure you that we willfile further patent or trademark applications, that any future applicationswill be approved, that any existing or future patents, trademarks or copyrightswill adequately protect our intellectual property or that any existing orfuture patents, trademarks or copyrights will not be challenged by thirdparties.

 

We are aware of certain uses, U.S. trademarkregistrations, and U.S. trademark applications for our “eQuality”

 

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trademark and its variations that predate our use, and theApril 2002 issuance of the U.S. registration for our trademark eQuality®.It is possible that an owner of legal rights resulting from prior use,registrations, or applications will bring legal action to challenge ourregistration of and/or our use of the trademark eQuality®, and may also seekcompensation for damages resulting from our use this trademark. As a result, wecannot assure you that our registration of this trademark will be undisturbed,or that this use will not result in liability for trademark infringement, trademarkdilution, and/or unfair competition.

 

Moreover, the laws of certain foreign countries do notprotect our intellectual property rights to the same extent as do the laws ofthe United States. Furthermore, policing the unauthorized use of our products isdifficult, and litigation may be necessary in the future to enforce ourintellectual property rights, to protect our trade secrets or to determine thevalidity and scope of the proprietary rights of others. Litigation could resultin substantial costs and diversion of resources and could negatively impact ourfuture operating results.

 

*Claims byother companies that our software infringes their intellectual property couldrequire us to incur substantial costs or prevent us from selling our softwareor services.*

 

It is possible that third parties will claim that wehave infringed their current or future products. We expect that we and otherparticipants in our industry will be increasingly subject to infringementclaims as the number of competitors and products grows. Any claims, with orwithout merit, which are generally uninsurable could be time-consuming, resultin costly litigation, require us to reengineer or redevelop our software, causeproduct shipment delays or require us to enter into royalty or licensingagreements, any of which could negatively impact our operating results. Anyefforts to reengineer our software or obtain licenses from third parties maynot be successful, could be extremely costly and would likely divert valuablemanagement and product development resources. For example, depending on theoutcome of lawsuits involving Knowlagent, IEX and NICE (as described in Item 1,“Legal Proceedings”, of Part II), we may be required to enter into royalty andlicensing agreements on unfavorable terms, to stop selling or redesign ourproducts at issue, and to pay damages and satisfy indemnification commitmentswith our customers.

 

In addition, we cannot assure you that legal actionclaiming patent infringement will not be commenced against us, or that we wouldprevail in litigation given the complex technical issues and inherentuncertainties in patent litigation. In addition, users of our software maybecome subject to claims if our software is alleged to infringe theintellectual property of others. These software users could attempt to hold usresponsible 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 aresult would have a material adverse effect on our business, financialcondition and results of operations.

 

*If we areunable to maintain the compatibility of our software with certain otherproducts and technologies, our future business would be adversely affected.*

 

Our software must integrate with software and hardwaresolutions provided by a number of our existing and potential competitors. Forexample, our products must integrate with phone switches made by the telephoneswitch vendors and computer telephony software applications offered by othersoftware providers. These competitors or their business partners could altertheir products so that our software no longer integrates well with them, orthey could delay or deny our access to software releases that allow us totimely adapt our software to integrate with their products. If we cannot adaptour software to changes in necessary technology, it may significantly impairour ability to compete effectively, particularly if our software must integratewith the software and hardware solutions of our competitors.

 

*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 ordinarily purchase installation,training and maintenance services together with our products. The functionalityof our products is not dependent on our installation and training services. Wegenerate a material part of our revenues from these services. We believe thatthe speed and quality of installation services are competitive factors in ourindustry. If our installation services are not satisfactory to our customers,the customers may choose not to use our installation services or they may notlicense our software in the future. As a result, we would lose licensing andservices revenue, and it could harm our reputation.

 

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

 

We may acquire or make investments in companies,products, services and technologies that we believe complement our business andassist us in quickly bringing new products to market. We have limitedexperience in making acquisitions and investments. As a result, our ability toidentify and evaluate prospects, complete acquisitions and properly manage theintegration of businesses is relatively unproven. If we fail to properlyevaluate and execute acquisitions or investments, it may have a materialadverse effect on our business and operating results. In making or attemptingto make acquisitions or investments, we face a number of risks, including:

 

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

•      reducingour working capital and hindering our ability to expand or maintain ourbusiness, if we make acquisitions using cash;

•      thepotential distraction of our management, diversion of our resources anddisruption of our business;

•      retainingand motivating key employees of the acquired companies;

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

•      enteringinto geographic markets in which we have little or no prior experience;

•      competingfor acquisition opportunities with competitors that are larger than we are orhave greater 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;

•      maintaininggood relations with the customers and suppliers of the acquired company; and

•      effectivelyintegrating acquired companies and achieving expected synergies.

 

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

 

Although we believe our current cash and borrowingcapacity will be sufficient to meet our anticipated cash needs for at least thenext 12 months and the foreseeable future, we may need additional funds toexpand or meet all of our operating needs. If we need additional financing, wecannot be certain that it will be available to us on favorable terms, or atall. If we raise additional funds by issuing equity securities or convertibledebt, the ownership interest of our stockholders could be significantlydiluted, and any additional equity securities we issue may have rights,preferences or privileges senior to the rights of our stockholders. Also, theterms of any additional financing we obtain may significantly limit our futurefinancing and operating activities. If we need funds and cannot obtain them onacceptable terms, we may be unable to:

 

•      developand enhance our software to remain competitive;

•      takeadvantage of future opportunities, such as acquisitions;

•      respondto changing customer needs and our competitors’ innovations; or

•      attractand retain qualified key personnel.

 

Any of these events could significantly harm ourbusiness and financial condition and limit our growth.

 

*Ourinability to source hardware could harm our business.*

 

A number of customers expect us to source hardware tosupport the implementation of our software. We are working towards reducing theamount of hardware sales in the future and have transferred the fulfillment ofhardware orders to third-party distributors. Thus, we are largely dependent onthird parties for the supply of hardware components to our customers. If thesehardware distributors experience financial, operational or quality assurance difficulties,or if there is any other disruption in our relationships, we may be required tolocate alternative hardware sources. We are subject to the following risks dueto our hardware distribution system:

 

•      cancellationsof orders due to unavailability of hardware;

 

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

 

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

 

Even if we and/or our distributors are successful inlocating alternative sources of supply, alternative suppliers could increaseprices significantly. In addition, alternative components may malfunction orinteract with existing components in unexpected ways. The use of new suppliersand the modification of our products to function with new systems would requiretesting and may require further modifications, which may result in additionalexpense, diversion of management attention and other resources, inability to fulfillcustomer orders or delay in fulfillment, reduction in quality and reliability,customer dissatisfaction, and other adverse effects on our reputation, businessand operating results.

 

*Failure toachieve and maintain effective internal controls in accordance withSection 404 of the Sarbanes-Oxley Act of 2002 could have a materialadverse effect on our business, operating results and stock price.*

 

The Sarbanes-Oxley Act of 2002 imposes new duties onus and our executives, directors, attorneys and independent registered publicaccountants. Our efforts to comply with the requirements of Section 404have resulted in increased general and administrative expense and a diversionof management time and attention from revenue-generating activities to complianceactivities, and we expect these efforts to require the continued commitment ofsignificant resources. We completed the initial implementation of Section 404during the year ended December 31, 2004 and reported no material weaknesses ininternal controls. However, if we fail to maintain the adequacy of our internalcontrols, as such standards are modified, supplemented or amended from time totime, we may not be able to ensure that we can conclude on an ongoing basisthat we have effective internal controls over financial reporting. Failure toachieve and maintain effective internal controls over financial reporting couldresult in investigation and/or sanctions by regulatory authorities, and couldhave a material adverse effect on our business and operating results, investorconfidence in our reported financial information, and the market price of ourcommon stock.

 

*Our stockprice has been volatile.*

 

The market price of our common stock has been subjectto significant fluctuations in response to variations in quarterly operatingresults and other factors. In addition, the stock market has experiencedsignificant volatility that has particularly affected the market prices ofequity securities of many technology companies and that often has beenunrelated or disproportionate to the operating performance of these companies.Any announcement with respect to any adverse variance in revenue or earningsfrom levels generally expected by securities analysts or investors could have asignificant adverse effect on the trading price of our common stock. Inaddition, factors such as announcements of technological innovations or newproducts by us, our competitors or third parties, changing conditions in thecustomer relationship management software market, changes in the marketvaluations of similar companies, loss of a major customer, additions ordepartures 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 issued2.1 million new shares and granted approximately 650,000 options topurchase shares of our common stock in connection with acquisitions in 2005,which will result in dilution to our existing stockholders and may cause ourstock price to decline.*

 

As part of the merger consideration in our acquisitionof Blue Pumpkin in January 2005, we issued a total of 2.1 million sharesof common stock to Blue Pumpkin shareholders, which increased our totaloutstanding common stock by approximately 8%; we also issued employee stockoptions to purchase approximately 650,000 shares of common stock in connectionwith this acquisition and the acquisition of Optimis in May 2005. The issuanceof a significant amount of additional shares of common stock results indilution to our existing shareholders and reduces our earnings per share, whichcould negatively affect the market price of our common stock. A significantamount of common stock coming on the market at any given time could result in adecline in the price of our common stock or increased volatility.

 

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

 

Beginning in 2000, a declining United States economy beganto adversely affect the performance of many businesses, especially within thetechnology sector. Reductions in the capital budgets of our customers andprospective customers have an adverse impact on our ability to sell oursolutions. Until late in 2003, we continued to experience effects from a weakspending environment for information technology in both the United States and

 

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Europe, in the form of delayed and cancelled buying decisions bycustomers for our software, services and hardware, deferrals by customers ofservice engagements previously scheduled and pressure by our customers andcompetitors to discount our offerings. If the current improvements now beingseen in the general business climate do not continue, this would likely have amaterial adverse 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 telecommunications industry continues toevolve, state, federal and foreign governments (including supranationalgovernmental organizations such as the European Union) may increasinglyregulate the monitoring of telecommunications and telephone and Internetmonitoring and recording products, such as our software. We believe thatincreases in regulation could come in the form of a number of different kindsof regulations, including regulations regarding privacy, protection of personalinformation and employment. For example, the State of California recentlyenacted the Database Security Breach Act, which requires any business thatsuffers 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 our software.If any of these events occur, it could materially and adversely affect ourbusiness.

 

*If we areunable to attract and retain key personnel, our ability to effectively manageand grow our business would suffer.*

 

Our success greatly depends on our ability to hire,train, retain and motivate qualified personnel, particularly in sales,marketing, research and development, service and support. We face significantcompetition for individuals with the skills required to perform the services weoffer. If we are unable to attract and retain qualified personnel or if weexperience high personnel turnover, it could prevent us from effectivelymanaging and expanding our business.

 

Our success also depends upon the continued service ofour executive officers, particularly our Chairman and Chief Executive Officer,David Gould, and our President and Chief Operating Officer, Nick Discombe. Wehave employment agreements with Mr. Gould and Mr. Discombe andlimited non-compete agreements with most of our other executive officers.However, any of our executive officers and other employees could terminate hisor her relationship with us at any time. The loss of the services of ourexecutive officers or other key personnel, particularly if lost to competitors,could materially and adversely affect our business.

 

*Ourcertificate of incorporation and bylaws, as well as Delaware law, may inhibit atakeover of our company, which could limit the price investors might be willingto pay for our securities.*

 

Our amended and restated certificate of incorporationand bylaws, as well as Delaware law, contain provisions that might enable ourmanagement to resist a takeover of our company. For example, our stockholderscannot take action by written consent or call a special meeting to remove ourboard of directors. In addition, our directors serve for staggered terms, whichmakes it difficult to remove all our directors at once. Further, inOctober 2002, our board of directors approved, and we have implemented, astockholder rights plan which has the effect of causing substantial dilution toa person or group that attempts to acquire us on terms not approved by theboard 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 also discourage proxy contests and make itmore difficult for you and other shareholders to elect directors and take othercorporate actions. The existence of these provisions could also limit the pricethat investors might be willing to pay in the future for our securities.

 

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

 

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

 

The Company conducted an evaluation of theeffectiveness of the Company’s disclosure controls and procedures (as definedin Rules 13a-15 and 15d-15 under the Securities Exchange Act of 1934), as ofthe end of the period covered by this quarterly report.  This evaluation was conducted under thesupervision and with the participation of the Company’s management, includingthe Chief Executive Officer and Chief Financial Officer.  Based on this evaluation, as of the quarterended June 30, 2005, the Company’s Chief Executive Officer and Chief FinancialOfficer have concluded the Company’s disclosure controls and procedures areeffective.  There were no changes ininternal controls over financial reporting that occurred during the periodcovered by this quarterly report that have materially affected, or that arereasonably likely to materially affect, our internal controls over financialreporting.

 

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**PART II.  OTHER INFORMATION**

 

### **Item 1. LegalProceedings**

 

On December 11, 2002, we filed in the United StatesDistrict Court for the Northern District of Georgia, Atlanta Division, alawsuit against Knowlagent, Inc. (“Knowlagent”), which is the assignee ofUnited States (“U.S.”) Patent Nos. 6,324,282 B1 and 6,459,787 B2. Knowlagenthas accused our eQuality Now software of infringing the above patents. We filedsuit seeking a declaration that we did not and do not infringe either of thetwo patents listed above, as well as a declaration that the above patents areinvalid and unenforceable. We also filed a claim requesting that if the patentsare found to be valid, that one of our own employees be named the rightfulinventor of the patents. We also requested monetary damages in an amount equalto the amount that Knowlagent has received from its use of the above patents.On December 31, 2002, Knowlagent filed its answer to our complaint as well astwo counterclaims, alleging that we infringe and contribute to the infringementby others of the above patents; Knowlagent seeks both monetary damages and aninjunction in connection with its counterclaim. On June 6, 2005, the Court helda claim construction hearing and issued a claim construction order on June 8,2005.  We are currently in the discoveryphase of the lawsuit and believe that any adverse outcome would not have amaterial impact on our financial position, results of operations and cashflows.

 

On July 20, 2004, STS Software Systems Ltd. (“STSSoftware”), a wholly-owned subsidiary of NICE Systems, Ltd. (“NICE Ltd.”),filed a patent infringement suit in the U.S. District Court for the SouthernDistrict of New York against us (“New York Action”).  The New York Actionasserts that our products, including eQuality ContactStore for IP, infringeUnited States (“U.S”). Patent No. 6,122,665 (“the ‘665 patent”). On the sameday, we filed a declaratory judgment action against STS Software in the U.S.District Court for the Northern District of Georgia (“Georgia Action”). We seek a declaration from the court that we have not infringed any valid claimof the ‘665 patent. By Order entered December 16, 2004, Judge Koeltl of theU.S. District Court for the Southern District of New York granted our motion totransfer the New York Action to the Northern District of Georgia, which has nowconsolidated the former New York Action with the Georgia Action. On July7, 2005, the Court also granted STS leave to amend its complaint to add threepatents to the dispute, namely: U.S. Patent Nos. 6,865,604; 6,871,229; and6,880,004 (respectively, “the ‘604 patent,” “the ‘229 patent,” and “the ‘604patent”; collectively, “the STS patents”).  We answered the first amendedcomplaint and asserted counterclaims on July 29, 2005, collectively throughwhich we deny infringement of any valid claim of the STS patents and seek adeclaration to that effect. The case has been set on a discovery calendar andis 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, we filed in the United States DistrictCourt for the Northern District of Georgia, Atlanta Division, a lawsuit againstNICE Systems, Inc. (“NICE Inc.”), a wholly-owned subsidiary of NICE Ltd.,alleging patent infringement.  Specifically, we have alleged that NICEproducts, 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 aninjunction and money damages for NICE’s infringement of these twopatents.  NICE Inc. has answered and counterclaimed for declaratoryjudgments of non-infringement and invalidity.  Since then, on February 24,2005, we filed suit against NICE Ltd. because of its infringing activities inviolation of the ‘798 and ‘220 patents, including importation of the accusedNICE products.  By order dated April 5, 2005, Judge Pannell hasconsolidated the NICE Inc. and NICE Ltd. actions.  The case has been seton a modified discovery calender after consolidation and is at a preliminarystage.

 

In January 2001, IEX Corporation filed a lawsuitagainst Blue Pumpkin in the United States District Court for the EasternDistrict of Texas, Sherman Division, alleging that Blue Pumpkin infringed IEXCorporation’s (“IEX”) U.S. Patent No. 6,044,355 (“the ‘355 Patent”) by makingand selling certain workforce management and call routing software products,including Blue Pumpkin’s Prime Time Skills and Prime Time Enterprise products.IEX is seeking to recover actual damages, an award of treble damages pursuantto 35 U.S.C. § 284, and an award of prejudgment interest, costs, and attorney’sfees. IEX is also seeking an injunction against Blue Pumpkin’s making orselling the products that IEX claims infringe its ‘355 Patent. On October 10,2003, the District Court granted Blue Pumpkin summary judgment ofnon-infringement and dismissed the remainder of the case. IEX then appealed theDistrict Court’s summary judgment ruling to the Court of Appeals for theFederal Circuit. On February 2, 2005, the Federal Circuit reversed-in-part thedistrict court’s summary judgment ruling and remanded the action to thedistrict court for further proceedings consistent with the Federal Circuit’sanalysis. Blue Pumpkin is on a schedule before the

 

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district court that is likely to result in a January 2006 trial, unlessthe case is resolved on summary judgment. We are unable to assess the impact, if any, on our financial position,results of operations or cash flows.

 

### **Item6.  Exhibits and Reports on Form 8-K**

 

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

 
| 10.1* |   | Eighth 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                                                               |
| 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**

 

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

 

 
| Dated:  August 8, 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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