**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-K**

**FOR ANNUAL AND TRANSITION REPORTS PURSUANT TOSECTIONS 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**(MARK ONE)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe Fiscal Year Ended April 30, 2005**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe Transition Period From                                    To                                     **

**COMMISSIONFILE NUMBER: 000-26209**

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| DITECH COMMUNICATIONS CORPORATION                                                                                                         |
|-------------------------------------------------------------------------------------------------------------------------------------------|
| (Exact Name of Registrant as Specified in its  Charter)                                                                                   |
| **DELAWARE**                                                                                                                              |
| (State or Other Jurisdiction of Incorporation or  Organization)                                                                           |
| **94-2935531**                                                                                                                            |
| (I.R.S. Employer Identification No.)                                                                                                      |
| **825  East Middlefield Road**                                                                                                            |
| **Mountain View, CA 94043**                                                                                                               |
| **(650) 623-1300**                                                                                                                   |
| (Address, Including Zip Code, of Registrant’s Principal  Executive Offices and Telephone Number, Including Area Code) |
| Securities Registered  Pursuant to Section 12(b) of the Act:**None**                                                            |
| Securities Registered  Pursuant to Section 12(g) of the Act:**Common Stock, $.001 Par Value**                                   |

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Indicate by check mark whether theRegistrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes xNo o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof the Registrant’s knowledge, in definitive proxy or information incorporatedby reference to Part III of this Form 10-K or any amendment tothis Form 10-K. x

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

The aggregate market valueof voting stock held by non-affiliates of the Registrant was approximately$484,679,899 as of October 31, 2004 based upon the closing price on theNasdaq National Market reported for such date. Excludes an aggregate of13,197,461 shares of common stock held by officers and directors and by eachperson known by the registrant to own 5% or more of the outstanding commonstock. Exclusion of shares held by any such person should not be construed toindicate that a determination has been made that such person possesses thepower, directly or indirectly, to direct or cause the direction of themanagement or policies of the registrant, or that such person is controlled byor under common control with the registrant.

The number of sharesoutstanding of the Registrant’s Common Stock as of July 1, 2005 was32,063,904 shares.

**DOCUMENTSINCORPORATED BY REFERENCE**

Theinformation required by Part III of this report, to the extent not setforth herein, is incorporated by reference from the Registrant’s definitiveproxy statement relating to the annual meeting of stockholders to be held September 16,2005, which definitive proxy statement will be filed with the Securities andExchange Commission within 120 days after the fiscal year to which thisReport relates.

 

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**DITECH COMMUNICATIONS CORPORATIONFORM 10-KINDEX**
|                                                                                                                                      | ** ** | ** ** | **PAGE** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------|----------|------------|
| PART I                                                                                                                          |       |       |     |
| Item 1—Business                                                                                                            |       | 1          |     |
| Item 2—Properties                                                                                                          |       | 13         |     |
| Item 3—Legal Proceedings                                                                                                   |       | 13         |     |
| Item 4—Submission of  Matters to a Vote of Security Holders                                                                |       | 13         |     |
| PART II                                                                                                                         |       |       |     |
| Item 5—Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |       | 14         |     |
| Item 6—Selected Financial Data                                                                                             |       | 15         |     |
| Item 7—Management’s  Discussion and Analysis of Financial Condition and Results of Operations                    |       | 17         |     |
| Item 7A—Quantitative  and Qualitative Disclosure About Market Risk                                                         |       | 39         |     |
| Item 8—Financial  Statements and Supplementary Data                                                                        |       | 41         |     |
| Item 9—Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                          |       | 69         |     |
| Item 9A—Controls and  Procedures                                                                                           |       | 69         |     |
| Item 9B—Other Information                                                                                                  |       | 69         |     |
| PART III                                                                                                                        |       |       |     |
| Item 10—Directors and  Executive Officers of the Registrant                                                                |       | 70         |     |
| Item 11—Executive  Compensation                                                                                            |       | 70         |     |
| Item 12—Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                   |       | 70         |     |
| Item 13—Certain  Relationships and Related Transactions                                                                    |       | 70         |     |
| Item 14—Principal  Accountant Fees and Services                                                                            |       | 70         |     |
| PART IV                                                                                                                         |       |       |     |
| Item 15—Exhibits and  Financial Statement Schedules                                                                        |       | 71         |     |
| SIGNATURES                                                                                                                           |       | 75         |     |
|                                                                                                                                      |            |            |          |            |  |

 

**Trademarks:**

Ditech and the Wave Design logo are registeredtrademarks of Ditech Communications Corporation. VQA is a trademark of DitechCommunications Corporation. This Annual Report on Form 10-K alsoincludes trademarks of companies other than Ditech.

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**Ditech Communications Corporation**

**Part I**

**Item 1—Business**

*This Annual Report contains forward-lookingstatements that relate to future events or future financial performance. Insome cases, forward looking statements can be identified by terminology such as“may”, “will”, “should”, “expects”, “plans”, “anticipates”, “believes”, “estimates”,“targets”, “predicts”, “intends”, “potential” or “continue” or the negative ofsuch terms or other comparable terminology. These statements are onlypredictions. Although we believe that the expectations reflected in the forwardlooking statements are reasonable, we cannot guarantee future results, levelsof activity, performance or achievements. Actual results could differmaterially from those anticipated in these forward-looking statements as aresult of various factors, including the risks outlined under “Item7—Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Future Growth and Operating Results Subject to Risk” and elsewherein this Annual Report. All forward-looking statements included in this documentare based on information available to us on the date hereof. We assume noobligation to update any such forward-looking statements.*

*Where we use the words “Ditech,” “we” “our” or similarexpressions, we are referring to Ditech Communications Corporation and each ofour wholly-owned subsidiaries. Our fiscal year ends on April 30. Consequently,when we refer to a specific fiscal year we are referring to the 12 months endedon April 30 of that year. For example, fiscal 2005 means the 12 monthsended April 30, 2005.*

**General**

Ditech is a global telecommunications equipmentsupplier for voice networks. Our voice processing products include our echocancellers, which are used to effectively eliminate echo, a significant problemin existing and emerging voice networks. Our echo cancellers have been ourprimary source of revenue to date. Our voice quality products, introduced inthe second half of fiscal 2004, not only provide our customers with ourtraditional echo cancellation features, but also incorporate Voice QualityAssurance (VQA) features, which address issues such as background noise andother voice quality issues in wireline and wireless communications. Throughoutthe second half of fiscal 2004 and all of fiscal 2005, we developed a newproduct, the Packet Voice Processor, which represents our entry into serviceproviders’ Internet Protocol (IP) networks using Voice-over-Internet-Protocol(VoIP) technology. We currently anticipate that the Packet Voice Processor willbe available for trial in the first quarter of fiscal 2006. Through July 16,2003, we also developed and marketed optical subsystem communications productsthrough our wholly owned subsidiary, Altamar Networks, Inc. However, on July 16,2003, we completed the sale of our optical subsystem communications businessand have therefore presented the optical business as discontinued operations inthis Annual Report on Form-10K.

We market our products domestically through a directsales force and, to a lesser extent, through distributors. Internationally, wemarket our products through a direct sales force, value-added resellers, systemintegrators and distributors.

Ditech was originallyincorporated as Phone Info., Inc. in July 1983 and subsequentlychanged its name to Automated Call Processing Corporation, Inc. In March 1997,Automated Call Processing Corporation sold portions of its business and mergedwith its wholly owned subsidiary, and the surviving entity was renamed DitechCorporation. Ditech Corporation reincorporated in Delaware in April 1999and changed its name to Ditech Communications Corporation. Through July 16,2003, Ditech developed and marketed optical subsystem communications productsthrough its subsidiary, Altamar Networks, which was formed in February 2001.The mailing address for Ditech is 825 East Middlefield Road, Mountain View,California USA 94043. The Ditech general telephone number is 650-623-1300.

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**Voice Quality Market**

***Wireline, Wirelessand Satellite Networks***

Voice quality is a key competitive differentiator fortelecommunication service providers. One of the primary challenges faced byservice providers in delivering quality voice communication is the eliminationof echo. Echo results from signal reflection at the “hybrid,” commonly thepoint where two wires of the local network meet the four wires of the longdistance network. The hybrid is not completely efficient in carrying theelectrical energy from the four-wire network to the two-wire network and a certainamount of electrical energy or voice signal is reflected back from the hybridtowards the speaker. Echo becomes noticeable whenever the one-time delay of arebounded voice signal exceeds 25 milliseconds. If the delay exceeds 32milliseconds, the quality of the voice call begins to degrade creating an echo,which is reflected back to the person speaking and can become an annoyanceduring the call. When these echo problems are present, people describe theeffect as their voices sounding hollow or like someone talking in a tunnel.Delays, either due to a long transmission path, as in a long distance telephonecall, or due to the complex signal hand-off from one network to another, forinstance in digital wireless or satellite voice calls, exacerbate the effect ofecho. Therefore, most long distance, digital wireless and satellite callsrequire echo cancellation. Delays are also introduced as intelligent processingequipment, such as network switch interconnects, are increasingly incorporatedinto voice networks. Digital processing of voice signals requires time tocompress and decompress and route signals through networks. As there is agreater shift towards Voice-over-IP, which is a means of packaging voicesignals into units of digital data for efficient transmission, these processingdelays will continue to increase.

In addition to dealing with the problem of echo,service providers also desire to address the problems of background noise andhigh and low voice levels. Background noise is a particularly acute problem inwireless voice networks, where users are attempting to use their wirelesshandset in noisy environments, such as in an airport terminal, on a noisystreet or in a crowded restaurant. Variations in sound levels occur when voicecalls are routed between the networks of different service providers,particularly on international calls, resulting in the voice of the speakeroften being too high or too low for comfortable listening. Background noisealso affects the performance of voice transmission in compressed environmentsas noise consumes valuable transmission bandwidth, particularly intransmissions over the air as used in wireless networks.

To address these voice quality problems, serviceproviders deploy voice quality enhancement and echo cancellation technologiesthat are designed to quickly analyze all voice channels and implementcounter-measures to solve a variety of voice problems present. When an echosignal is detected, the echo canceller cancels the echo. Voice qualityenhancement technology detects and cancels background noise as well as raisesor lowers the voice signal for more comfortable listening.

Service providers aredemanding equipment with greater capacity as well as smaller physical size asspace in service provider facilities and central offices becomes more crowded.In addition, due to intense competition, service providers are expandingnetwork services offered to consumers. In order to compete successfully, theymust deliver these services reliably and under the strict time-to-market andcost constraints demanded by consumers. We believe that our echo cancellationand VQA features, which address these market pressures, are poised to gainshare in the market.

***IP Networks***

There appears to be agrowing trend of service providers transitioning away from traditionalcircuit-switched network infrastructure to VoIP. VoIP offers service providers’customers an increase in features and functionality while enabling the serviceproviders to simplify network operations, reduce capital expenditures andincrease service revenue. These service providers must address the same voicequality challenges as those using traditional circuit-switched networks as wellas the additional challenges of 

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packetloss, packet delay and packet jitter. Moreover, echo, voice level variation andbackground noise are all compounded in a network based on VoIP technology. Becauseof the high expectations of their customers, service providers are working toprovide a service level that is as good as or better than services offered overtraditional circuit-switched networks. Leveraging our VQA technology and newPacket Quality Assurance (PQA) technology that addresses packet loss andjitter, we believe that our newest product, the Packet Voice Processor, whichwe expect to begin customer trials in the first quarter of fiscal 2006,addresses these voice quality issues.

**Call Traffic Management**

***Mobile Networks***

Mobile networks worldwide currently have in excess ofone billion subscribers and recent market research reports indicate that thissubscriber base is growing at a rate where it is likely to exceed two billionin the next four years. GSM is the predominant technology for mobilecommunications outside the United States and is growing in popularitydomestically. CDMA is an alternative mobile technology used primarily in theUSA and Korea with a smaller number of networks in other parts of the world. Mobilenetworks are composed of three distinct types of equipment: (1) RadioAccess Network (Cellular towers, base station with radio equipment, backhaulequipment and lines to carry traffic back to the switching site and the basestation controllers); (2) Mobile Switching Centers (MSC) with switchingequipment; and (3) Inter MSC network to connect switching sites across thecarrier’s geographical coverage area.

As the number of subscribers increases, serviceproviders must either add more radio equipment to base stations in existingcells, provided sufficient spectrum is available, or sub-divide cells ifsufficient radio spectrum is not available, or in the worst case acquireadditional licensed radio spectrum. The high rate of subscriber growth, coupledwith limitations in capital budgets, radio spectrum licenses and limitedability to spend on capital equipment against low average revenue per user incertain geographical regions of the world, have led wireless service providersto seek alternate means to reduce the cost of network capacity expansion.

Mobile networks utilize compression technologies toreduce bandwidth consumption (and therefore radio access equipment cost) on theradio access portion of the network. In GSM, the widely available voicecompression technologies include Full Rate (FR), Half-Rate (HR), Enhanced FullRate (EFR) and Adaptive Multi-Rate (AMR) voice encoder and decoders (vocoders).FR and HR vocoders are the most widely available, followed by EFR and AMR,which have recently begun deployment. While HR vocoders use half of thebandwidth of FR and EFR vocoders, mobile service providers prefer to use FR vocodersdue to their higher subjective voice quality. Many mobile service providersactivate the usage of HR vocoders only during peak periods to satisfy hightraffic demand, albeit at lower voice quality.

Human conversationstypically occupy a phone call 50% of the time for each person. Mobile networksutilize this to stop radio transmission during silent periods using atechnology called DTX (Discontinuous Transmission). Background noise rendersthe process of detecting these silent periods more difficult, thus reducing theeffectiveness of DTX, increasing radio network traffic and usurping capacity.

We believe that our VQAtechnology can improve the subjective quality of calls utilizing HR vocoders,such that the calls sound as good as, or better than FR calls that do not useour VQA technology. VQA technology also reduces background noise, thus enablingthe downlink DTX functionality built into the mobile network to function moreeffectively. Therefore, mobile operators in need of capacity growth can utilizeHR vocoders in a greater portion of calls, and increase their DTX performance,to increase their overall network capacity without resorting to the purchase ofadditional radio equipment. Depending on the growth rate of the network andrange of deployment required, we believe our VQA solution can reduce the totalcost of capacity expansion by up to 75%.

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***IP Networks***

Voice quality is not the only challenge facing serviceproviders that deploy VoIP technology. With the transition to an IP network,calls are routed through multiple networks and, as a result, service providersare challenged to support different types of VoIP media streams, or datacompression algorithms (codecs), as well as various payload sizes. Serviceproviders who adopted VoIP technology early chose to standardize their networkswith the use of a single voice codec, most notably ITU-T G.711. While thisapproach offers a first step to deploying VoIP, it does not take advantage ofincreased channel densities, lower bandwidth requirements and enhanced voicequality made available with different voice codecs. With the increased demandfor additional voice channels, service providers are beginning to supportmultiple compressed codecs throughout their networks.

Our Packet VoiceProcessor, deployed at the border between networks, supports a wide array ofcodecs from the customer premises or network edge and normalizes incoming codectypes before transmission to the IP backbone. This may also eliminate serviceproviders’ need to convert one compressed audio format to another (transcoding)at VoIP service points such as conferencing servers, media servers and voiceportal servers, hence saving the service providers money and allowing foreasier deployment and integration of additional enhanced VoIP service platformsin the future.

**Our Voice Quality Solutions**

***Over Wireline,Wireless and Satellite Networks***

We design, develop and market stand-alone andsystem-based voice quality enhancement and echo cancellation products forwireline, wireless and satellite networks throughout the world. Our productsuse a software architecture coupled with one of the latest commerciallyavailable digital signal processors to cancel echo and enhance the quality ofvoice communications. In April 2002, we sold our echo cancellationsoftware technology and transferred the majority of the echo cancellationsoftware development group to Texas Instruments. We maintain a softwaredevelopment group for our VQA technology for voice processing features. We aredependent on Texas Instruments for our hybrid echo cancellation softwaredevelopment. We have entered into a license relationship with TexasInstruments, which provides that Texas Instruments will continue to support ourecho cancellation software development needs for at least the next year. Wehave developed an internal group of software engineers who have been developingthe majority of our voice quality features. We believe our approach enables usto offer echo cancellation products with some of the highest capacity currentlycommercially available.

The key benefits of our voice processing solutionsinclude:

*Time-to-market advantage.  *Ourcore technology uses intelligent software algorithms, which are a sophisticatedprocess or set of rules for our software to address an array of voicequality problems, running on off-the-shelf electronic integrated circuits anddigital signal processors. Competitive echo cancellation solutions usingapplication specific integrated circuits are more expensive to design, requiremore development time and are difficult to upgrade. Our approach leveragesrapid technological advances in the commercial integrated circuit and digitalsignal processor industries. As a result, we believe that we are able todeliver high performance products to market with shorter product developmentcycles and lower investments in capital equipment than alternative solutions.

*Lower total cost of ownership.  *Ourcompact design allows us to offer voice processing products with some of thehighest echo canceling capacities currently available based on a seven-footindustry standard equipment rack located in service providers’ central officesor remote facilities. This higher capacity represents cost and space savingsfor service providers. Our newer generation products also offer more efficientcabling and network equipment installation, saving service providers even morespace and installation costs. Our products are designed to allow serviceproviders to remotely download and upgrade 

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software via the Internetwithout interrupting network service or dispatching a technician to the remotesite, which also lowers the cost of ownership.

*Remote monitoring and serviceassurance.  *Our real-time monitoring technology, knownas reflectometry, allows remote monitoring of real-time performance data.Service providers can use this technology to identify problems remotely andaddress them proactively. We are also able to assist our customers on-lineduring this process. As a result, service providers can improve performancelevels and monitor voice quality on a consistent basis.

*VoiceQuality Assurance technology.  *Our VQA softwareintegrates voice quality enhancement features with the latest voice processortechnology to improve the sound quality of voice calls in noisy environments.VQA forms the foundation of a wide range of advanced voice enhancement productsthat we believe will help service providers optimize the voice quality of theircommunications networks. VQA’s general features include noise reduction,acoustic echo cancellation, level control and noise compensation throughenhanced voice intelligibility.

***Over IP Networks***

We believe that our Packet Voice Processor willimprove the end-to-end voice quality of VoIP networks. We anticipate that ourPacket Voice Processor will be available for trials in the first quarter offiscal 2006.

Our Packet Voice Processor supports a wide array ofcodecs such as G.711, G.723.1, G.729 and others from the customer premises ornetwork edge and normalizes incoming codec types before transmission to the IPbackbone. This may also eliminate service providers’ need to perform conversionof one compressed audio format to another (transcoding) at VoIP service pointssuch as conferencing servers, media servers and voice portal servers, hencesaving the service providers money and allowing for easier deployment andintegration of additional enhanced VoIP service platforms in the future.

The VQA features onthe Packet Voice Processor improve the quality of the voice in a call and offernoise reduction, enhanced voice intelligibility, voice level control andacoustic and hybrid echo cancellation capabilities. Its PQA features addressquality issues specific to VoIP calls such as packet loss, delay and jitter,and reduce the effects of these impairments to improve call quality andclarity. The following VQA features are currently or planned to be available inthe Packet Voice Processor:

·       Acousticecho control. Addresses echo problems that are common in VoIP networks due topoor acoustic isolation between the speaker and the microphone of a user’sdevice.

·       Adaptivenoise cancellation. Provides a noise reduction algorithm that removes the noisecomponents of a call.

·       Enhancedvoice intelligibility. Improves the quality of speech that has been impaireddue to encoding and decoding of voice calls using compressed VoIP codecs.

·       Automaticlevel control. Detects and adjusts for voice level imbalances caused byconnections between different VoIP endpoint devices.

·       Intelligentpacket restoration. Reconstructs missing packets within a VoIP packet streamusing a predictive speech model.

·       Hybridecho cancellation. The echo that occurs at the 2-wire to 4-wireconversion point in a PSTN network becomes even more noticeable when packetdelay is added from an IP network. The Packet Voice Processor eliminates hybridecho bi-directionally from end-to-end calls that traverse a PSTN hybridnetwork.

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**Our Voice Quality Products**

Our voice quality products are designed to solve echoand other voice quality issues, such as background noise and voice levels, inwireline, wireless and satellite networks. Our echo cancellation product familyincludes a mixture of both single and multi-port, stand-alone echo cancellersas well as several broadband, system-based products. In fiscal 2004, weconsolidated many of our previous generation product lines to streamline on-goingdevelopment, migrate customers to newer, lower cost and higher performanceplatforms, and to increase manufacturing volumes on fewer hardware components.As part of this consolidation process, we announced last-buy periods for our18T1, 18E1, Quad I T1, Quad I E1, BBEC, OC-3 and STM-1 echocancellation systems. We have ceased selling these products as both general andcertain contractually mandated last-buy periods ended in the first half offiscal 2005. In fiscal 2004, we announced the availability of two new voiceprocessing platform families. Unlike our previous products that were designedfor echo cancellation only, the new voice processing platforms are designed tosupport a larger variety of voice processing algorithms, such as the featuresin VQA. These products are the Quad Voice Processor (QVP), with four T1 or E1interfaces, and the Broadband Voice Processor-Flex (BVP-Flex) with highcapacity any-to-any interfaces such as DS-3, STS-1, OC-3 andSTM-1. Both platforms can be factory configured to support a wide rangeof computational power and can be field upgraded to support the purchase of newsoftware features.

Our voice quality product family shares several commonadvantages:

*High capacity.  *Ourvoice processing platforms are competitive with the capacity of other currentlycommercially available competitive products.

*Remote software updates.  *Withour products, the latest software updates for bug fixes can be downloadedremotely and incorporated into our products without taking the productsoff-line and interrupting service.

*International TelecommunicationsUnion (“ITU”) standards.  *Our products are targeted tobe compliant with ITU standards. As a member of the ITU, we activelyparticipate in establishing the evolving global standards.

*Warranty.  *Wecurrently offer a two- to five-year hardware warranty and a one year softwarewarranty on our products, depending on the platform purchased and contractualrequirements.

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**Our Current Voice**Quality Products

Thefollowing table summarizes our current product offerings.
| Product                        | ** ** | ** **                                                                                                                                                                                                                                                                                                          | ** ** | **Description**                                                                                                                                                                                                                                                             | ** ** | **Functionality** |
|--------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|
| SX-24                          |       | Single port echo canceller for use at T-1 (1.544  Mb/s) transmission rate supporting North American markets                                                                                                                                                                                                         |       | ·  Basic echo cancellation functionality, plus  it supports our voice enhancement software suite of enhancement products  previously only available on Quad and higher generation echo cancellers                                                                 |
| Quad II T1                     |       | Single module including  four independent T1 echo cancellers supporting North American markets                                                                                                                                                                                                                      |       | ·  Hybrid  Echo Cancellation and built-in voice enhancement technology Cancels 480 T1  lines per rack                                                                                                                                                             |
| Quad II E1                     |       | Single module including  four independent E1 echo cancellers supporting international markets and  North American gateway applications                                                                                                                                                                              |       | ·  Hybrid  Echo Cancellation and built-in voice enhancement technology Cancels 480 E1  lines per rack                                                                                                                                                             |
| Quad Voice Processor           |       |                                                                                                                                                                                                                                                                                                                |       |                                                                                                                                                                                                                                                                        |
| (QVP)—T1                  |       | Narrowband Voice Processor with four independent T1  voice processing modules that support both hybrid echo cancellation and the  extensive suite of VQA software                                                                                                                                                   |       | ·  High capability voice enhancement technology  with industry leading algorithms for noise reduction, level control, acoustic  echo control and noise compensation through enhanced voice intelligibility

·  Processes 480 T1 lines per rack          |
| Quad Voice Processor           |       |                                                                                                                                                                                                                                                                                                                |       |                                                                                                                                                                                                                                                                        |
| (QVP)—E1                  |       | Narrowband Voice Processor with four independent E1  voice processing modules that support both hybrid echo cancellation and the  extensive suite of VQA software                                                                                                                                                   |       | ·  High capability voice enhancement technology  with industry leading algorithms for noise reduction, level control, acoustic  echo control and noise compensation through enhanced voice intelligibility

·  Processes 480 E1 lines per rack          |
| Broadband Voice Processor-Flex |       |                                                                                                                                                                                                                                                                                                                |       |                                                                                                                                                                                                                                                                        |
| (BVP-Flex)                     |       | Broadband Voice  Processor System with flexible resource cards that permit up to six times the  computational power of the previous generation BVP platform with continued  support for the industry’s widest range of interface support, targeted at  both North American and international network operators |       | ·  Supports up to 2016 channels per system,

·  Three systems per shelf

·  Transmux capability for OC-3/STM1/DS-3/STS1  

·  Supports both hybrid echo and full VQA  features in a variety of hardware and software configurations |

** **

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**Customers**

*Voice processing customers.  *Ouractive voice processing customer base has remained relatively constant atapproximately 80 customers in fiscal 2005 and 2004. Although we have addedseveral new customers in fiscal 2005, they essentially have replaced customersthat are no longer in business or that have not purchased anything from us inthe past year. Although we continued to do business with major North Americanlong distance companies during fiscal 2005, the vast majority of our domesticecho revenue in fiscal 2005 was generated by some of the largest domesticwireless carriers, including Verizon Wireless and Nextel. Revenue from echocancellation sales remains highly concentrated. In fiscal 2005, our largestecho cancellation customer, Verizon Wireless, accounted for 49% of our totalrevenue and Nextel accounted for 37% of our total revenue. However, as a resultof Nextel’s merger with Sprint, we expect that revenue from Nextel will bedramatically lower than fiscal 2005 levels for at least the first quarter offiscal 2006. Our next three largest echo customers accounted collectively for 5*%* of our total company revenue in fiscal2005. All of our revenue is from external customers. Our revenue, net income(loss) and total assets for the last three years are set forth in our financialstatements included in Item 8 of this Annual Report on Form 10-K.

We market our products, both domestically andinternationally; information by geographic region with respect to revenues fromexternal customers and long-lived assets, is set forth in Note 12 of theNotes to our Consolidated Financial Statements included in Item 8 of thisAnnual Report on Form 10-K. Historically, the majority of our saleshave been to customers in the U.S. These customers accounted for approximately91%, 89% and 84%, of our revenue in fiscal 2005, 2004 and 2003, respectively.Virtually all of our long-lived assets are located in the U.S. See “Item7—Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Future Growth and Operating Results Subject to Risk—We May ExperienceUnforeseen Problems As We Diversify Our International Customer Base, WhichWould Impair Our Ability To Grow Our Business” for a discussion of risksassociated with both domestic and international operations.

*Backlog.  *Ourbacklog for voice processing products was approximately $1.3 million and$16.9 million as of the first business day of June 2005 and 2004,respectively. Our backlog consists of (1) orders confirmed with a purchaseorder for products to be shipped within 120 days to customers withapproved credit status, (2) shipments classified as deferred revenue,which we expect to recognize as revenue within 120 days, and (3) deferredmaintenance revenue. Backlog at June 1, 2005 excludes $4.5 million of ordersfor which shipment dates are uncertain or which extend beyond 120 days. Becauseof the generally short cycle between order and shipment, and occasionalcustomer changes in delivery schedules, we do not believe that our backlog asof any particular date is necessarily indicative of actual net sales for anyfuture period.

**Research and Development**

We have engineeringdepartments dedicated to and focused on designing and developing nextgeneration voice processing products for both circuit-switched and VoIPnetworks. Our research and development expenses for fiscal 2005, 2004 and 2003,were approximately $15.8 million, $10.7 million and$10.0 million, respectively. The increase in spending in fiscal 2005 wasprimarily due to development of the hardware and software of our new PacketVoice Processor. Our research and development efforts are driven by marketdemand and customer feedback. We have created a structured process forundertaking all product development projects. Following an assessment of marketdemand, our research and development team develops a set of functional productspecifications based on input from our product management, sales and post—salesorganizations. This process is designed to provide a framework for defining andaddressing the steps, tasks and activities required to bring product conceptsand development projects to market. As of April 30, 2005, we have 62employees in Research and Development and we 

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believethat retaining those personnel and recruiting new personnel, as necessary, willbe essential to our continued success.

**Manufacturing**

We operate as a “virtual”manufacturing organization by relying on contract manufacturers to assemble ourvoice processing products. We perform final test, configuration and shippingfunctions for our voice processing products. We are ISO 9001:2000 and ISO14001:1996 certified and require that our contract manufacturers have ISO9000:2000 registration as a condition of qualification. Our raw materials areprocured from outside suppliers, primarily through our contract manufacturers.There are several components used in our products which are sole sourced. Weattempt to closely monitor supplies of parts and supplier lead times in anattempt to mitigate the risk of component availability affecting our ability todeliver product to our customers. In cases where we believe that a particularsole source component is too critical or expensive to replace and we believethat there may be availability issues, we have and will continue to buycomponents in excess of our immediate needs to help mitigate the risk ofcomponent shortages in the future. In procuring digital signal processors forour echo cancellation products, we and our contract manufacturers rely on TexasInstruments as our sole supplier, as our software license agreement with TexasInstruments stipulates that we will only use their processors to run thelicensed Texas Instruments software. Our future success will depend insignificant part on our ability to obtain components on time, at competitiveprices, and in sufficient quantities to meet demand. Although we believe thatthere are currently ample supplies of components, we have experienced partshortages in prior years, which had a direct impact on revenues and results ofoperations and may experience such shortages again in the future. See “Item7—Management’s Discussion and Analysis of Financial Condition and Results ofOperations—Future Growth and Operating Results Subject to Risk” below for adiscussion of risks related to manufacturing our products.

**Sales and Marketing**

We primarily rely on ourdirect sales force to sell our voice processing products domestically and on acombination of a direct sales force, value-added resellers, distributors andsales agents internationally. We have continued to expand our network ofvalue-added resellers, distributors, and sales agents that sell our productsinternationally, and continued to enhance our web site marketing. In fiscal2005, we hired additional international sales and pre- and post-sales supportstaff as well as domestic sales and pre- and post-sales support staff focusedon specific domestic opportunities. In addition, in fiscal 2005 we expanded ourdomestic and international trade show participation to further strengthen ourpresence in the echo cancellation marketplace and to launch our new PacketVoice Processor.

**Acquisitions and Dispositions**

Our strategy is to increase new product developmentboth through internal staffing and when potential acquisitions provide us witha critical new product and/or a decided time-to-market advantage, throughacquisitions.

On April 16,2002, we sold our echo cancellation software intellectual property and allrights to future revenue streams from our existing software licenses to thirdparty network equipment manufacturers to Texas Instruments in exchange for cashand a license for the echo cancellation software used in our products. Thistransaction and license agreement with Texas Instruments reflects a strategicdecision to bolster and focus all of our echo-cancellation resources to competein the echo cancellation systems business, where historically we have generatedthe vast majority of our revenues and profits. Under the terms of theagreement, we received a total of $26.8 million, of which$18.3 million of cash was received on the closing date of the sale,$5.0 million was paid to us in April 2003 and the final$3.5 million was paid to us in April 2004. In addition, we secured along-term license of the echo cancellation software from Texas 

9

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Instruments, which is used in our echo cancellationsystems. The license has an initial four-year free royalty period, after whichthe royalty rate will be set based on a preferred customer pricing formulastipulated in the sale agreement. With this transaction and licensing agreementwith Texas Instruments, we believe we have maintained the advantage of theecho-cancellation software component of our product, while increasing the fundsavailable to develop new products.

Prior to July 2003, in addition to being engagedin the voice processing business, we had been engaged in the opticalcommunications business. On May 22, 2003, after careful review, weannounced a change to our strategic direction. As of that date we decided tofocus all of our assets on continuing to grow our voice processing business,and as a result we decided to sell our optical subsystem business. In July 2003,we completed the primary step in the planned exit of our optical communicationsbusiness through the sale of a large portion of the assets of the opticalcommunications business to JDS Uniphase Corporation (“JDSU”). The assets soldconsisted primarily of inventory, certain specified optical-related equipmentand intellectual property rights, which were sold for an aggregate purchaseprice of up to approximately $6.5 million in cash, of which (a) approximately$1.4 million was paid to us at closing, (b) $225,000 will be paid tous one year from the closing (subject to reduction in the event any successfulindemnification claims are made against us), and (c) up to an additional$4.9 million to be paid to us, which is comprised of up to $900,000 basedon the level of inventory consumed by JDSU, and up to $4.0 million basedon revenues generated by the optical business acquired by JDSU through June 30,2005, if any. Additionally, JDSU had indemnification rights for any purchasedbut unused inventory at June 30, 2004, up to $2.0 million, a rightwhich expired on July 31, 2004. JDSU also has indemnification rights inconnection with the performance of certain warranty obligations relating tooptical products that were sold by us on or prior to July 16, 2003. We andJDSU are currently evaluating the remaining obligations of each party, but havenot reached agreement on what the remaining obligations are. However, we do notexpect that the outcome of these discussions will have a material affect on ourfinancial statements. During fiscal 2004, we recognized $855,000 associatedwith the level of revenue generated by JDSU since the close of the sale and atax benefit of $144,000, which benefit partially offsets the tax provision fromcontinuing operations. However, these incremental proceeds were substantiallyoffset by increased loss accruals associated with exiting our internationaloptical operations and an estimated loss provision associated with a possibleindemnification of the realizable value of the inventory purchased by JDSU. Thenet effect of these items was reported as an incremental net loss ondisposition of discontinued operations of $1.1 million in fiscal 2004 inthe Consolidated Statement of Operations. In fiscal 2005, income fromdiscontinued operations was due to adjustments needed to reflect actual costsincurred and to recognize a tax benefit from the release of our valuationreserve. See Note 4 of Notes to the Consolidated Financial Statements.

On June 6, 2005, we announced an agreement andplan of merger to acquire privately-held Jasomi Networks, Inc., and on June 30,2005 we closed this acquisition. The merger consideration was $10.7 million incash plus $7.0 million in non-transferable convertible notes. In addition,Ditech put an additional $2.0 million into an escrow to secure indemnificationobligations for breaches of representations and warranties made by Jasomi andcertain of its affiliates, and the portion of the escrowed amount, if any,remaining after all claims are made against the escrow, will also be paid tothe former stockholders of Jasomi. Ditech also assumed all of the Jasomi stockoptions outstanding on the date of the closing, which converted into options toacquire, in the aggregate, 191,111 shares of Ditech common stock. In addition,Ditech established a restricted stock plan and issued restricted common stockand restricted stock units to Jasomi employees and employees of a Canadianaffiliate of Jasomi in the aggregate amount of 423,267 shares of Ditech commonstock. Jasomi develops and sells session border controllers, which enable VoIPcalls to traverse the Network Address Translation (NAT) and firewall devices incustomers’ networks, ensuring that reliable VoIP service can be provided tothem. We believe the combination of our Packet Voice Processor and Jasomi’ssession border control technology will enable us to provide a comprehensivesolution to carriers’ border services needs.

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We will continue to lookto acquire companies that meet market attractiveness and strategic fitcriteria. Acquisitions involve numerous risks, which are more fully discussedin “Item 7—Management’s Discussion and Analysis of Financial Condition andResults of Operations—Future Growth and Operating Results Subject toRisk-Acquisitions and Investments May Adversely Affect Our Business.”

**Competition**

The markets for ourproducts are intensely competitive, continually evolving and subject to rapidtechnological change. We believe that rapid product introductions with priceperformance advantages are critical competitive factors. We believe ourproducts also face competition in the following areas:

·       Product features andenhancements (including improvements in product performance, reliability, size,compatibility and scalability);

·       Cost of ownership(including ease-of-installation and cost of maintenance);

·       Ease of product deploymentand installation; and

·       Technical support andservice.

Although we believe that we currently competefavorably with respect to all of these factors, we may not have the financialresources, technical expertise or marketing, manufacturing, distribution andsupport capabilities to compete successfully in the future. We expect that competitionwill increase in the future.

Our principal competitors for echo and voice qualityproducts in circuit-switched networks are NMS Communications Corporation, whichpurchased Lucent’s echo cancellation business in October 2001, andTellabs. The other competition in the voice processing market comes from voiceswitch manufacturers, of which there are at least six companies competing inthis space, the more formidable of which are Nortel, Lucent, Nokia andEricsson. These switch manufacturers do not sell echo cancellation products orcompete in the open echo cancellation market, but they integrate echocancellation functionality within their switches, either as hardware modules oras software running on chips. A widespread adoption of internal echo cancellationsolutions could present a competitive threat to us if this eliminates demandfor our echo cancellation system products.

Our principalcompetitors in the VoIP space include Sonus Networks, Audiocodes, Acme Packet,Juniper (Kagoor) and other startups that offer session border controllerproducts. Large OEMs that offer media gateway products such as Nortel, Lucentand Cisco are also potential competitors as our packet products are deployed innetworks where equipment from these suppliers is already in the network andwhere we may affect the long-term incremental deployment of their products.

Many of our competitors and potential competitors havesubstantially greater name recognition and technical, financial, marketing,purchasing and other resources than we do. As a result, these competitors maybe able to respond more quickly to new or emerging technologies or standardsand to changes in customer requirements, to devote greater resources to thedevelopment, promotion and sale of products, or to deliver competitive productsat a lower price. We may not be able to compete successfully against ourcurrent or future competitors.

Existing and potentialcustomers are also our current and potential competitors. These companies maydevelop or acquire competitive products or technologies in the future andthereby reduce or cease their purchases from us. In addition, we believe thatthe size of suppliers will be an increasingly important part of purchasers’decision-making criteria in the future. We may not be able to grow rapidly andtherefore not compete successfully with our existing or new competitors. Inaddition, competitive pressures faced by us may result in lower prices for ourproducts, loss of market share, or reduced gross margins, any of which could materiallyand adversely affect our business, financial condition and results ofoperations.

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**Patentsand Intellectual Property Rights**

Our future success will depend, in part, on ourability to protect our intellectual property. We rely primarily on nondisclosureagreements as well as copyright, trademark, trade secret laws, and othermethods to protect our proprietary voice processing technologies and processes,and in the future we may utilize patents, where available. Nevertheless, suchmeasures may not be adequate to safeguard the proprietary technology underlyingour voice quality products.

In connection with the sale of our echo cancellationintellectual property to Texas Instruments in April 2002, we secured along-term license of the echo cancellation software from Texas Instruments. Thelicense has an initial four-year free royalty period, after which the licensecan be renewed at a royalty rate to be set based on a preferred customerpricing formula stipulated in the sales agreement. We are dependent on thelicense of this technology and continued support from Texas Instruments, as itis the fundamental technology incorporated in our echo cancellation products.

We generally enter into confidentiality agreementswith our employees and strategic partners, and generally control access to anddistribution of our documentation and other proprietary information. Despitethese precautions, it may be possible for a third party to copy or otherwiseobtain and use our products or technology without authorization or developsimilar technology independently. In addition, effective patent, copyright,trademark and trade secret protection may be unavailable or limited outside ofthe U.S., Europe and Japan. We may not be able to obtain any meaningfulintellectual property protection in such countries and territories.Additionally, we may, for a variety of reasons, decide not to file for patent,copyright, or trademark protection outside of the U.S. Further, we occasionallyincorporate the intellectual property of our customers into our designs, and wehave certain obligations with respect to the non-use and non-disclosure of suchintellectual property. However, the steps taken by us to preventmisappropriation or infringement of the intellectual property of our company orour customers may not be successful. Moreover, litigation may be necessary inthe future to enforce our intellectual property rights, to protect our tradesecrets or to determine the validity and scope of proprietary rights of others,including our customers. Such litigation could result in substantial costs anddiversion of our resources and could have a material adverse effect on ourbusiness, financial condition and results of operations.

The telecommunications equipment industry ischaracterized by vigorous protection and pursuit of intellectual propertyrights. In the future, we may receive notices of claims of infringement ofother parties’ proprietary rights. We may not prevail in actions alleginginfringement of third-party patents. In addition, in a patent or trade secretaction, an injunction could issue against us, requiring that we withdrawcertain products from the market or necessitating that certain products offeredfor sale or under development be redesigned. We have also entered into certainindemnification obligations in favor of our customers and strategic partnersthat could be triggered upon an allegation or finding of our infringement ofother parties’ proprietary rights. Irrespective of the validity or successfulassertion of such claims, we would likely incur significant costs and diversionof our resources with respect to the defense of such claims, which could alsohave a material adverse effect on our business, financial condition and resultsof operations. To address any potential claims or actions asserted against us,we may seek to obtain a license under a third party’s intellectual propertyrights. Under such circumstances, a license may not be available oncommercially reasonable terms, if at all.

A few industry participants, such as Lucent, NortelNetworks and certain major universities and research laboratories holdsubstantial inventories of intellectual property. This concentration ofintellectual property in the hands of a few major entities also poses certainrisks to us in seeking to hire qualified personnel. We have on a few occasionsrecruited such personnel from such entities. These entities or others may claimthe misappropriation or infringement of their intellectual property,particularly when and if employees of these entities leave to work for us. Wemay not be able to avoid litigation in the future, particularly if newemployees join us after having worked for a competing company. 

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Suchlitigation could be very expensive to defend, regardless of the merits of theclaims, and could have a material adverse effect on our business, financialcondition and results of operations.

**Employees**

As of April 30, 2005,we had 184 employees, 35 of whom were primarily engaged in operations, 62 inresearch and development, 64 in sales, marketing and technical support and 23in finance and administration. Our employees are not represented by anycollective bargaining agreement, and we have not experienced a work stoppage.We believe our employee relations are good.

**AvailableInformation**

You may obtain a free copyof our Annual Report on Form 10-K, Quarterly Reports on Form 10-Qand current reports on Form 8-K and any amendments to those reports,which we make available as soon as reasonably practicable after our filing orfurnishing of these reports with or to the SEC, through our website at *www.ditechcom.com*. Our website address isprovided solely for informational purposes. We do not intend, by thisreference, that our website should be deemed to be part of this Annual Report.

**Item 2—Properties**

Our principal offices andfacilities are currently located in two leased buildings totaling approximately61,000 square feet in Mountain View, California. Of the space occupied,approximately 67% is used for manufacturing and research and development andthe balance is used for office space for sales and marketing and general andadministrative functions. The term of the lease expires on June 30, 2006.Although we believe that the space under the combined leases is adequate tomeet our needs at least until the lease expires, we have begun exploring themarket to determine what we will do when our lease expires in June 2006.

**Item 3—LegalProceedings**

On June 14, 2005, alawsuit entitled *Richard E. Jaffe v. DitechCommunications Corp., Timothy K. Montgomery and William J. Tamblyn,*CaseNo. C 05 02406 was filed in the United States District Court for theNorthern District of California, purportedly on behalf of a class of investorswho purchased Ditech’s stock between August 25, 2004 and May 26,2005. The complaint alleges claims under Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934 against Ditech and our Chief ExecutiveOfficer and Chief Financial Officer. We expect that several similar lawsuitswill subsequently be filed in the same court, and that all of the cases will beconsolidated into a single action. This matter is at an early stage; no leadplaintiff has been selected, no response to the complaint has been filed, nodiscovery has taken place and no trial date has been set. Ditech and theindividual defendants intend to take all appropriate actions to defend thesuit.

On June 20, 2005, ashareholder’s derivative complaint, entitled *Kerlin v.Montgomery, et al.,* Case No 105CV043429, was filed in theCalifornia Superior Court for the County of Santa Clara. The complaint ispurportedly brought derivatively by a shareholder on behalf of Ditech againstseveral executives of Ditech and all members of its board of directors, andnames Ditech as a nominal defendant. Plaintiff alleges that the defendantsbreached their fiduciary duties to Ditech in connection with allegedmisrepresentations concerning VQA orders and the potential effect on Ditech ofthe merger between Sprint and Nextel, that certain of the defendants improperlysold Ditech stock while in possession of material nonpublic information, andthat the defendants are liable to Ditech for damages as a result thereof. Thedefendants intend to take all appropriate action in connection with the defenseof the litigation.

**Item4—Submission of Matters to a Vote of Security Holders**

Not Applicable.

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**Part II**

**Item5—Market for Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities**

Ditech’scommon stock is quoted on the Nasdaq National Market under the symbol “DITC.”The following table shows the high and low closing sale prices per share of ourcommon stock as reported on the Nasdaq National Market for the periodsindicated:
| ** **     | ** ** | **Fiscal 2005** | ** ** | **Fiscal 2004** | ** ** |
|----------------|------------|----------------------|------------|----------------------|------------|
| ** **     | ** ** | **High**             | ** ** | **Low**              | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $                    | 25.50      |                 | $          | 12.94 |   | $ | 6.70 |   | $ | 3.55 |   |
| Second Quarter |       | $                    | 26.87      |                 | $          | 14.65 |   | $ | 11.90 |   | $ | 5.15 |   |
| Third Quarter  |       | $                    | 23.19      |                 | $          | 12.76 |   | $ | 24.80 |   | $ | 10.50 |   |
| Fourth Quarter |       | $                    | 14.33      |                 | $          | 10.65 |   | $ | 22.75 |   | $ | 14.05 |   |

 

On July 1, 2005 thelast reported sale price of our common stock as reported on the Nasdaq NationalMarket was $6.45 per share. According to the records of our transfer agent,there were 128 stockholders of record of Ditech’s common stock at July 1,2005. Because many of our shares of common stock are held by brokers and otherinstitutions on behalf of stockholders, we are unable to estimate the totalnumber of stockholders represented by these record holders.

**Dividend Policy**

We have never declared orpaid any cash dividend on our capital stock and do not anticipate, at thistime, paying any cash dividends on our capital stock in the near future. Wecurrently intend to retain any future earnings for use in our business orfuture acquisitions.

**Stock Repurchase Program**

In December 2004, ourBoard of Directors authorized the repurchase of up to $35 million of commonstock under a stock repurchase program. During the fourth quarter of fiscal2005, we repurchased and retired 981,160 shares of our common stock at anaverage price of $13.70 per share for an aggregate purchase price of $13.4million. From the inception of the program in December 2004 through February 14,2005, we repurchased and retired an aggregate of 2,516,660 shares of our commonstock at an average price of $13.91 per share for an aggregate purchase priceof $35 million. Consequently, we are not authorized to repurchase additionalshares under the stock repurchase program subsequent to February 14, 2005.The following table provides a month-to-month summary of the stock purchaseactivity during the fourth quarter of fiscal 2005:
| Period                         | ** ** | ** ** | ** ** | **TOTAL  NUMBER OF  SHARES PURCHASED** | ** ** | **AVERAGE  PRICE PAID  PER SHARE** | ** ** | **   TOTAL NUMBER OF     SHARES PURCHASED   AS PART OF  PUBLICLY ANNOUNCED  PROGRAMS** | ** ** | **MAXIMUM  DOLLAR VALUE OF  SHARES THAT  MAY YET BE  PURCHASED  UNDER THE  PROGRAMS** | ** ** |
|--------------------------------|------------|------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
| Month #1                       |       |       |       |                                             |       |                                         |       |                                                                                                                                                    |       |                                                                                                                |       |   |   |   |   |   |   |
| February 1, 2005  through |       |       |       |                                             |       |                                         |       |                                                                                                                                                    |       |                                                                                                                |       |   |   |   |   |   |   |
| February 28, 2005         |       |       | 981,160    |                                             |       |                                         | $          | 13.70                                                                                                                                                   |       |                                                                                                                |       | 981,160 |   |   |   | $ | — |   |   |
| Month #2                       |       |       |       |                                             |       |                                         |       |                                                                                                                                                    |       |                                                                                                                |       |   |   |   |   |   |   |
| March 1, 2005 through     |       |       |       |                                             |       |                                         |       |                                                                                                                                                    |       |                                                                                                                |       |   |   |   |   |   |   |
| March 31, 2005            |       |       | —     |                                             |       |                                         | —     |                                                                                                                                                    |       |                                                                                                                | —     |   |   |   | — |   |   |
| Month #3                       |       |       |       |                                             |       |                                         |       |                                                                                                                                                    |       |                                                                                                                |       |   |   |   |   |   |   |
| April 1, 2005 through     |       |       |       |                                             |       |                                         |       |                                                                                                                                                    |       |                                                                                                                |       |   |   |   |   |   |   |
| April 30, 2005            |       |       | —     |                                             |       |                                         | —     |                                                                                                                                                    |       |                                                                                                                | —     |   |   |   | — |   |   |
| Total                          |       |       | 981,160    |                                             |       |                                         | $          | 13.70                                                                                                                                                   |       |                                                                                                                |       | 981,160 |   |   |   | $ | — |   |   |

 

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The information requiredto be described in a footnote to this table is included in the paragraphimmediately preceding this table, which information is incorporated byreference here.

**Item6—Selected Financial Data**

The consolidated statementof operations data for the years ended April 30, 2005, 2004 and 2003, andthe consolidated balance sheet data as of April 30, 2005 and 2004, havebeen derived from our audited consolidated financial statements included inItem 8 of this Annual Report on Form 10-K. The consolidated statement ofoperations data for the years ended April 30, 2002 and 2001, as adjustedto give effect to the discontinued operations presentation of our opticalbusiness, See Note 4 of the Notes to the Consolidated FinancialStatements, and the consolidated balance sheet data as of April 30, 2003,2002 and 2001, have been derived from our consolidated financial statements notincluded in this Annual Report on Form 10-K. The data set forth belowshould be read in conjunction with our consolidated financial statements,including the notes thereto, set forth in “Item 8—Financial Statements and SupplementaryData” of this Annual Report on Form 10-K, and with “Item 7—Management’sDiscussion and Analysis of Financial Condition and Results of Operations”included elsewhere in this Form 10-K.
| ** **                                                                                                | ** ** | **Years Ended April 30,**                           | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                                | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statement of Operations Data:**                                                            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Revenue                                                                                                   |       | $                                                                  | 94,055     |   | $ | 69,590 |   | $ | 35,088 |   | $ | 27,214 |   | $ | 104,683 |   |
| Cost of goods  sold                                                                                       |       | 22,184                                                             |       | 23,413 |   | 13,543 |   | 15,009 |   | 31,031 |   |
| Gross profit                                                                                              |       | 71,871                                                             |       | 46,177 |   | 21,545 |   | 12,205 |   | 73,652 |   |
| Operating expenses:                                                                                       |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                                       |       | 16,430                                                             |       | 13,168 |   | 12,051 |   | 13,277 |   | 10,873 |   |
| Research and development                                                                                  |       | 15,826                                                             |       | 10,719 |   | 9,952 |   | 14,888 |   | 17,097 |   |
| General and administrative                                                                                |       | 7,244                                                              |       | 5,308 |   | 5,269 |   | 5,980 |   | 6,463 |   |
| Restructuring charge                                                                                      |       | —                                                             |       | 275 |   | — |   | — |   | — |   |
| Amortization of goodwill and other acquisition related  intangible assets                            |       | —                                                             |       | — |   | — |   | 7,144 |   | 7,454 |   |
| Total operating expenses                                                                                  |       | 39,500                                                             |       | 29,470 |   | 27,272 |   | 41,289 |   | 41,887 |   |
| Income (loss) from  continuing operations                                                                 |       | 32,371                                                             |       | 16,707 |   | (5,727 | ) | (29,084 | ) | 31,765 |   |
| Other income, net                                                                                         |       | 2,430                                                              |       | 1,294 |   | 1,702 |   | 3,701 |   | 4,853 |   |
| Income (loss)  from continuing operations before income taxes and cumulative effect of  accounting change |       | 34,801                                                             |       | 18,001 |   | (4,025 | ) | (25,383 | ) | 36,618 |   |
| Provision  (benefit) for income taxes                                                                     |       | (36,100                                                            | )          | 270 |   | — |   | 4,982 |   | 14,647 |   |
| Income (loss)  from continuing operations before cumulative effect of accounting change                   |       | 70,901                                                             |       | 17,731 |   | (4,025 | ) | (30,365 | ) | 21,971 |   |
| Discontinued operations:                                                                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Loss from discontinued operations                                                                         |       | —                                                             |       | (2,538 | ) | (34,119 | ) | (54,836 | ) | (23,570 | ) |
| Income tax provision (benefit) from loss on  discontinued operations                                      |       | —                                                             |       | — |   | 129 |   | 128 |   | (3,695 | ) |
| Gain (loss) on disposition                                                                                |       | 94                                                                 |       | (7,142 | ) | — |   | — |   | — |   |
| Income tax benefit from gain (loss) on disposition                                                        |       | (110                                                               | )          | (144 | ) | — |   | — |   | — |   |
| Income (loss) from  discontinued operations                                                               |       | 204                                                                |       | (9,536 | ) | (34,248 | ) | (54,964 | ) | (19,875 | ) |
| Cumulative effect of  accounting change                                                                   |       | —                                                             |       | — |   | (36,837 | ) | — |   | — |   |
| Net income (loss)                                                                                         |       | 71,105                                                             |       | 8,195 |   | (75,110 | ) | (85,329 | ) | 2,096 |   |
|                                                                                                           |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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| Per share data:                                                                         |   |   |   |   |   |   |   |   |   |   |   |
|-----------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Basic                                                                                   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations before  cumulative effect of accounting change |   | $      | 2.12   |   | $      | 0.56   |   | $      | (0.13  | )      | $      | (1.03 | ) | $ | 0.78 |   |
| Discontinued operations                                                                 |   | 0.01   |   | (0.30  | )      | (1.13  | )      | (1.87  | )      | (0.71  | )      |
| Cumulative effect of accounting change                                                  |   | — |   | — |   | (1.21  | )      | — |   | — |   |
| Net income (loss) per share attributable to common  stockholders                        |   | $      | 2.13   |   | $      | 0.26   |   | $      | (2.47  | )      | $      | (2.90 | ) | $ | 0.07 |   |
| Diluted                                                                                 |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations before  cumulative effect of accounting change |   | $      | 2.02   |   | $      | 0.53   |   | $      | (0.13  | )      | $      | (1.03 | ) | $ | 0.72 |   |
| Discontinued operations                                                                 |   | 0.00   |   | (0.29  | )      | (1.13  | )      | (1.87  | )      | (0.65  | )      |
| Cumulative effect of accounting change                                                  |   | — |   | — |   | (1.21  | )      | — |   | — |   |
| Net income (loss) per share attributable to common  stockholders                        |   | $      | 2.02   |   | $      | 0.24   |   | $      | (2.47  | )      | $      | (2.90 | ) | $ | 0.07 |   |
| Number of shares used in per share calculations:                                        |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                   |   | 33,408 |   | 31,734 |   | 30,371 |   | 29,380 |   | 28,145 |   |
| Diluted                                                                                 |   | 35,140 |   | 33,496 |   | 30,371 |   | 29,380 |   | 30,512 |   |

 
| ** **                            | ** ** | **April 30,** | ** ** |
|---------------------------------------|------------|--------------------|------------|
| ** **                            | ** ** | **2005**           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| **Consolidated Balance Sheet  Data:** |       |               |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents            |       | $                  | 36,781     |   | $ | 45,610 |   | $ | 69,670 |   | $ | 56,959 |   | $ | 62,932 |   |
| Short-term  investments               |       | 98,853             |       | 79,899 |   | 24,825 |   | 48,950 |   | 47,200 |   |
| Total assets                          |       | 209,720            |       | 150,548 |   | 126,441 |   | 203,874 |   | 262,019 |   |
| Long-term debt                        |       | —             |       | — |   | — |   | — |   | — |   |
| Total stockholders’  equity      |       | 197,265            |       | 135,400 |   | 116,138 |   | 186,938 |   | 250,729 |   |
|                                       |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The selected financialdata for the five years ended April 30, 2005 reflects the impacts of ouracquisition and disposition activities over this period of time. The keyimpacts include amortization of goodwill and other intangibles and deferredstock compensation of an acquisition we made in February 2000 until thesale of the underlying software technology at the end of fiscal 2002. Inaccordance with SFAS 142, we ceased amortizing goodwill and wrote off $36.8million of goodwill in fiscal 2003. In September 2002, we discontinued thedevelopment and marketing of our optical switch product, which resulted in asignificant decline in the level of optical losses subsequent to that point intime. In addition, the selected financial data also reflects the disposition ofour optical business in July 2003, which resulted in the financial resultsfrom our optical business being reported as a discontinued operation for allperiods presented and contributed to our ability to return to positive netincome during fiscal 2004.

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**Item 7—Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

*The following discussion and analysis should be readin conjunction with “Selected Financial Data” and our Consolidated FinancialStatements and Notes thereto included elsewhere in this Annual Report on Form 10-K.The discussion in this Annual Report on Form 10-K containsforward-looking statements that involve risks and uncertainties, such asstatements of our plans, objectives, expectations and intentions. See ourcautionary language in the first paragraph of “Item 1. Business” regardingthese statements. Our actual results could differ materially from thosediscussed here. See “Future Growth and Operating Results Subject to Risk” atthe end of this Item 7 for factors that could cause future results to differmaterially.*

**Overview**

We design, develop and market telecommunicationsequipment for use in canceling echo and enhancing voice quality in voice callsover wireline, wireless and Internet Protocol (IP) telecommunications networks.As a result of announcing our intention to exit our optical communicationsbusiness and completion of the sale of a substantial portion of assets used inour optical business in the first quarter of fiscal 2004, our continuing operationsare currently focused solely on our voice processing products, including ourlong-standing echo cancellation products. Our initial entrance into the voiceprocessing market was focused on echo cancellation. Since entering the voiceprocessing market, we have continued to refine our echo cancellation productsto meet the needs of the ever-changing telecommunications marketplace. Our morerecent product introductions have leveraged off the processing capacity of ournewer hardware platforms to offer not only echo cancellation but also new VoiceQuality Assurance (VQA) features including noise reduction, acoustic echocancellation, voice level control and noise compensation through enhanced voiceintelligibility. We are currently selling our seventh generation echocancellation product, which began production shipments in the third quarter offiscal 2004. The majority of our R&D spending in fiscal 2005 was directedtoward the development of our Packet Voice Processor, a new product targetingVoice-over-Internet-Protocol (VoIP) based network deployments.  The Packet Voice Processor introduces costeffective voice format transcoding capabilities and combines our Voice QualityAssurance (VQA) software and newly developed Packet Quality Assurance (PQA)technology to improve call quality and clarity by eliminating acoustic echo andvoice level imbalances and reducing packet loss, delay and jitter.

Since becoming apublic company in June 1999, our financial success has been primarilypredicated on the success of the domestic wire-line and more recently wirelesscarriers. During fiscal 2000 and the first half of fiscal 2001, we benefitedfrom the rapid expansion in domestic wire-line infrastructure spending tosupport increasing demand expectations due to customer growth and theexpectations of increased demand from internet traffic. In the latter half offiscal 2001, as the promise of the internet’s growth waned we, along withvirtually every other telecommunications equipment supplier, experienced asignificant decline in revenue due to a dramatic decline in infrastructurespending by domestic carriers. Over the last four years, wire-line carriershave experienced a modest recovery in spending while wireless carriers haveexperienced more rapid growth. However, beginning in calendar year 2004, NorthAmerican telecommunication service providers began a series of merger andacquisition activities and the affected telecommunications service providersare still assessing the network technology and deployment plans. We expect sucha trend will affect our near term revenue, as our revenue will continue to beheavily influenced by the buying trends of Verizon Wireless and Nextel, twolarge domestic wireless carriers that are our two largest customers, one ofwhich is involved in post-merger integration. In an attempt to reduce ourreliance on our two large domestic customers, beginning in fiscal 2004 andthroughout fiscal 2005, we added sales and marketing resources to increase ourpresence and our VQA trial activity in the international marketplace and tofocus on new large account opportunities in the United States. We also expectthat long-term opportunities for growth will occur in VoIP based networkdeployments as there appears to be a growing trend of service providerstransitioning away from traditional circuit-switched network 

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infrastructureto VoIP. Our Packet Voice Processor targets these VoIP based networks. Weexpect to begin to trial our new Packet Voice Processor in the first quarter offiscal 2006.

*Exit of Optical Business.  *InMay 2003, we announced a change to our strategic direction. We decided tofocus all of our assets in continuing to grow our voice processing business,including our echo cancellation and new VQA features, and as a result wedecided to sell our optical communications business. In July 2003, wecompleted the primary step in our planned exit of our optical communicationsbusiness through the sale of a large portion of the assets of the opticalcommunications business to JDS Uniphase Corporation (“JDSU”). The assets soldconsisted primarily of inventory, certain specified optical-related equipmentand intellectual property rights, which were sold for an aggregate purchaseprice of up to approximately $6.5 million in cash, of which (a) approximately$1.4 million was paid to us at closing, (b) $225,000 to be paid to usone year from the closing (subject to reduction in the event any successfulindemnification claims are made against us), and (c) up to an additional$4.9 million to be paid to us, which is comprised of up to $900,000 basedon the level of inventory consumed by JDSU, and up to $4.0 million basedon revenues generated by the optical business acquired by JDSU through June 30,2005, if any. Additionally, JDSU had the right to require us to reimburse JDSUfor any purchased but unused inventory at June 30, 2004, up to $2.0million, which right expired as of July 31, 2004. JDSU also hasindemnification rights in connection with the performance of certain warrantyobligations relating to optical products that were sold by us on or prior to July 16,2003. We and JDSU are currently evaluating the remaining obligations of eachparty, but have not reached agreement on what the remaining obligations are.  In fiscal 2004, we recognized $855,000associated with the level of revenue generated by JDSU since the close of thesale. The proceeds were substantially offset by increased loss accrualsassociated with exiting our international optical operations and an estimatedloss provision associated with our indemnification of the realizable value ofthe inventory purchased by JDSU. The net effect of these items was reported asan incremental net loss on disposition of discontinued operations in fiscal2004 of $1.1 million in the Consolidated Statement of Operations. In fiscal2005, income from discontinued operations was due to adjustments needed toreflect actual costs incurred and to recognize a tax benefit due to the releaseof our valuation reserve. No additional revenue was recognized from the sale toJDSU. See Note 4 of Notes to the Consolidated Financial Statements.

We have sold or abandoned all of the assets notpurchased by JDSU. As a result of exiting the optical business, ourConsolidated Statements of Operations reflect the optical business as adiscontinued operation for all periods presented. See Note 4 of Notes tothe Consolidated Financial Statements.

*Acquisition History.  *Sincecompleting our initial public offering in June 1999, we have completedthree acquisitions. At the time we made each of these acquisitions, they weremade to bring needed technical skills into our research and development groupsto aid in new product introductions. The most recent, significant acquisitionwas in July 2000, when we acquired Atmosphere Networks, Inc. to bringneeded technical skills to our optical engineering group. The total value ofthe acquisition was approximately $82 million, which was accounted forusing purchase accounting. In May 2002, we recorded a transitionalimpairment of the unamortized goodwill balance associated with this acquisitionof $36.8 million, which has been reported as a cumulative effect ofaccounting change. In June 2005, we announced that we acquired JasomiNetworks, Inc., for $19.7 million in cash and convertible notes plusassumed outstanding Jasomi stock options and issued shares of Ditech restrictedstock to new employees assumed in the merger. See Note 16 of Notes to theConsolidated Financial Statements.

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*Our Customer Base.  *Historicallythe majority of our sales have been to customers in the United States. Thesecustomers accounted for approximately 91%, 89% and 84% of our revenue in fiscal2005, 2004 and 2003, respectively. However, sales to some of our U.S. customersmay result in our products purchased by these customers eventually beingdeployed internationally, especially in the case of any original equipmentmanufacturer that distributes overseas. To date, the vast majority of ourinternational sales have been export sales and denominated in U.S. dollars. Weexpect that as we expand shipments of our newer voice processing products,which are targeted at GSM networks, international revenue will begin to becomea larger percentage of our overall revenue.

Our revenue historically has come from a small numberof customers. Our two largest customers accounted for approximately 86% of ourtotal revenue in fiscal 2005. Our five largest customers accounted forapproximately 91%, 86% and 81% of our revenue in fiscal 2005, 2004 and 2003,respectively. Consequently, the loss of any one of these customers, without anoffsetting increase in revenue from existing or new customers, would have anegative and substantial effect on our business. For example, due to the decreasein projected purchases by one of our largest customers, we announced that weexpect our first quarter fiscal 2006 revenue to be less than half of our fourthquarter fiscal 2005 revenue. This announcement had a dramatic negative effecton our stock price.

*Critical Accounting Policies andEstimates.  *The preparation of our financial statementsrequires us to make certain estimates and judgments that affect the reportedamounts of assets, liabilities, revenue and expenses and related disclosures.We evaluate these estimates on an ongoing basis, including those related to ourrevenue, allowance for bad debts, provisions for inventories, warranties andrecovery of deferred income taxes. Estimates are based on our historicalexperience and other assumptions that we consider reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying value of assets and liabilities that are not readily apparent fromother sources. Actual future results may differ from these estimates in theevent that facts and circumstances vary from our expectations. To the extentthere are material differences between our ongoing estimates and the ultimateactual results, our future results of operations will be affected. We believethat the following critical accounting policies affect the most significantjudgments and estimates used in the preparation of our consolidated financialstatements.

Revenue Recognition—In applying our revenuerecognition and allowance for doubtful accounts policies, the level of judgmentis generally relatively limited, as the vast majority of our revenue has beengenerated by a handful of customers. These customers are some of the largestwire-line and wireless carriers in the United States and our relationships withthem are documented in contracts, which clearly highlight potential revenuerecognition issues, such as passage of title and risk of loss. As of April 30,2005, we had deferred $255,000 of revenue. To the extent that we have receivedcash for some or all of a given deferred revenue transaction, we reported it onthe Consolidated Balance Sheet as a deferred revenue liability. However, to theextent that we have not collected cash against the deferred revenuetransaction, we reflect the deferred revenue as a reduction in thecorresponding account receivable balance. Of the $255,000 of revenue deferredas of April 30, 2005, the majority related to deferrals associated withmaintenance contracts. In dealing with smaller customers, we closely evaluatethe credit risk of these customers. In those cases where credit risk is deemedto be high, we either mitigate the risk by having the customer post a letter ofcredit, which we can draw against on a specified date to effectively providereasonable assurance of collection, or we defer the revenue until customerpayment is received.

Investments—Investment securities that have maturitiesof more than three months at the date of purchase but remaining maturities ofless than one year and auction rate securities, which we are able to liquidateon 28 or 35 day auction cycles, are considered short-term investments. Otherinvestment securities with remaining maturities of one year or more areconsidered long-term investments. Short-term and long-term investments consistprimarily of U.S. Government securities and corporate bonds, as well as,commercial paper, asset backed securities and certificates of deposit. We haveclassified our short-term 

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and long-term investmentsas available-for-sale securities in the accompanying consolidated financialstatements. Available-for-sale securities are carried at fair value, withunrealized gains and losses reported in a separate component of stockholders’equity. Realized gains and losses and declines in value judged to beother-than-temporary, if any, on available-for-sale securities are included ininterest income based on specific identification. Interest on securitiesclassified as available-for-sale is also included in interest income.

Inventory Valuation Allowances—In conjunction with ourongoing analysis of inventory valuation allowances, we are constantlymonitoring projected demand on a product by product basis. Based on theseprojections we evaluate the levels of allowances required both for inventory onhand, as well as inventory on order from our contract manufacturer. Although webelieve we have been reasonably successful in identifying allowancerequirements in a timely manner, sudden changes in future buying patterns fromour customers, either due to a shift in product interest and/or a complete pullback from their expected order levels could result in some larger thananticipated write-downs being recognized, such as the OC-3 write-down recordedin fiscal 2002. For the OC-3 write-down, the complete pull back from theforecasted demand by the primary customer for this product resulted in a$3.5 million write-down of the OC-3 inventory. However, in 2003 theaddition of a few large new customers helped to utilize a large portion of theinventory which had been written down, resulting in approximately$2.2 million and $455,000 of previously written down OC-3 inventory beingsold in fiscal 2004 and 2003, respectively. We sold no additional OC-3inventory in fiscal 2005.

Cost of Warranty—At the time that we recognizerevenue, we accrue for the estimated costs of the warranty we offer on ourproducts. We currently offer hardware warranties on our products ranging fromtwo to five years and one year software warranties. The warranty generallyprovides that we will repair or replace any defective product and providesoftware bug fixes within the term of the warranty. Our accrual for theestimated warranty is based on our historical experience and expectations offuture conditions. To the extent we experience increased warranty claimactivity or increased costs associated with servicing those claims, we mayrevise our estimated warranty accrual to reflect these additional exposures,which would result in a decrease in gross profits. As of April 30, 2005,we had recorded $2.0 million of accruals related to estimated futurewarranty costs. In general, we have been able to closely estimate the level ofwarranty exposure on our products, and the level of adjustment required to thereserve has been relatively insignificant. See Note 3 of the Notes to theConsolidated Financial Statements.

Accounting for Income Taxes—We estimate our actualcurrent tax exposure together with our temporary differences resulting fromdiffering treatment of items such as valuation allowances for bad debts andinventory, for tax and accounting purposes. These temporary differences, inconjunction with net operating loss and tax credit carryforwards, result indeferred tax assets and liabilities. At least once per quarter, we assess thelikelihood that our net deferred tax assets will be recovered from future taxableincome and to the extent we believe that recovery is no longer more likely thannot, we establish a valuation allowance. Significant management judgment isrequired in determining our provision for income taxes, our deferred tax assetsand liabilities and any valuation allowance recorded against our net deferredtax assets.

Beginning in fiscal 2002, we determined that avaluation allowance against our then existing deferred tax asset position wasnecessary. We based this decision on the fact that in the fourth quarter of2002, we generated sufficient operating losses on a tax basis to fully recoverall taxes paid in prior years. In addition, our expectations of limitedprofitability, if any, due to the softness in the telecommunication industryduring fiscal 2003, combined with the significant tax losses generated by thesale of our echo cancellation software technology led us to conclude that therecovery of our deferred tax assets was no longer more likely than not. In thesecond quarter of 2005, based on the level of historical taxable incomeand projections for future taxable income over the periods that our deferredtax assets are deductible, we 

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determined that it wasmore likely than not that our deferred tax assets would be realized. Wetherefore released the valuation allowance of $51.6 million in fiscal 2005.

*Recent Accounting Pronouncements.  *InMarch 2004, the Financial Accounting Standards Board (FASB) approvedthe consensus reached on the Emerging Issues Task Force (EITF) Issue No. 03-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.” EITF 03-1 provides guidance for identifying impairedinvestments and new disclosure requirements for investments that are deemed tobe temporarily impaired. On September 30, 2004, the FASB issued a finalstaff position (FSP) EITF Issue 03-1-1 that delays the effective datefor the measurement and recognition guidance included in paragraphs 10through 20 of EITF 03-1. Quantitative and qualitative disclosures requiredby EITF 03-1 remain unchanged by the staff position. We do not believe theimpact of adoption of the measurement provisions of the EITF will besignificant to our overall results of operations or financial position.

In November 2004, the FASB issued Statement of FinancialAccounting Standards (SFAS) No. 151,*Inventory Costs*, which clarifies the accounting for abnormal amountsof idle facility expense, freight, handling costs, and wasted material. SFAS No. 151will be effective for inventory costs incurred during fiscal years beginningafter June 15, 2005. We do not believe the adoption of SFAS No. 151will have a material impact on our financial statements.

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statement No. 123R, “Share-BasedPayment” (SFAS 123R), which requires companies to measure and recognizecompensation expense for all stock-based payments at fair value. SFAS 123R iseffective for the first annual reporting period beginning after June 15,2005 and, thus, will be effective for us beginning in fiscal 2007. We arecurrently evaluating the impact of SFAS 123R on our financial position andresults of operations. See “Accounting for Stock-Based Compensation” in Note 2of the Condensed Consolidated Financial Statements for information related tothe pro forma effects on our reported net income (loss) and net income (loss)per share of applying the fair value recognition provisions of the previousStatement of Financial Accounting Standards (SFAS) 123, “Accounting forStock-Based Compensation,” to stock-based employee compensation.

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**Results of Operations**

Thefollowing table sets forth certain items from our consolidated statements ofoperations as a percentage of revenue for the periods indicated:
| ** **                                                                                                             | ** ** | **Years Ended April 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue                                                                                                                |       | 100.0                               | %          | 100.0 | % | 100.0 | % |
| Cost of goods  sold                                                                                                    |       | 23.6                                |       | 33.6 |   | 38.6 |   |
| Gross profit                                                                                                           |       | 76.4                                |       | 66.4 |   | 61.4 |   |
| Operating  expenses:                                                                                                   |       |                                |       |   |   |   |   |
| Sales and marketing                                                                                                    |       | 17.5                                |       | 18.9 |   | 34.3 |   |
| Research and development                                                                                               |       | 16.8                                |       | 15.4 |   | 28.4 |   |
| General and administrative                                                                                             |       | 7.7                                 |       | 7.6 |   | 15.0 |   |
| Restructuring charge                                                                                                   |       | —                              |       | 0.4 |   | — |   |
| Total operating expenses                                                                                               |       | 42.0                                |       | 42.3 |   | 77.7 |   |
| Income (loss) from continuing operations                                                                               |       | 34.4                                |       | 24.0 |   | (16.3 | ) |
| Other income, net                                                                                                      |       | 2.6                                 |       | 1.9 |   | 4.9 |   |
| Income (loss) from continuing operations before  provision for income taxes and cumulative effect of accounting change |       | 37.0                                |       | 25.9 |   | (11.4 | ) |
| Provision  (benefit) for income taxes                                                                                  |       | (38.4                               | )          | 0.4 |   | — |   |
| Income (loss) from continuing operations before  cumulative effect of accounting change                                |       | 75.4                                |       | 25.5 |   | (11.4 | ) |
| Discontinued operations:                                                                                               |       |                                |       |   |   |   |   |
| Loss from discontinued operations                                                                                      |       | —                              |       | (3.6 | ) | (97.2 | ) |
| Income tax provision from loss on discontinued  operations                                                             |       | —                              |       | — |   | 0.4 |   |
| Gain (loss) on disposition                                                                                             |       | 0.1                                 |       | (10.3 | ) | — |   |
| Income tax benefit from gain (loss) on disposition                                                                     |       | (0.1                                | )          | (0.2 | ) | — |   |
| Income (loss) from discontinued operations                                                                             |       | 0.2                                 |       | (13.7 | ) | (97.6 | ) |
| Cumulative effect of accounting change                                                                                 |       | —                              |       | — |   | (105.0 | ) |
| Net income (loss)                                                                                                      |       | 75.6                                | %          | 11.8 | % | (214.0 | )% |

 

***Discussion of Fiscal Years ended April 30, 2005,2004 and 2003***

*Revenue*
| ** ** | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** ** | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** ** | ** ** | **$s in thousands**                      | ** ** |
| Revenue    |       | $                                        | 94,055     |                                               | $          | 69,590 |   | $ | 35,088 |   | $ | 24,465 |   | $ | 34,502 |   |
|            |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in revenue in the last two years waslargely driven by the addition of new customers, increased shipments to our twolargest domestic wireless customers as they continued to expand and updatetheir networks and, to a lesser extent, the expansion of our internationalcustomer base in Asia, Latin America and Canada. We believe that theintroduction of our Broadband Voice Processor Flex (“BVP-Flex”) EchoCancellation System in the third quarter of fiscal 2004 was critical in drivingour revenue growth over the last two years.

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In fiscal 2005, our largest two domestic wirelesscustomers accounted for 86% of our revenue compared to 59% of the revenue infiscal 2004 and 64% of the revenue in fiscal 2003. Our third largest domesticcustomer accounted for 3% of our revenue in fiscal 2005, 22% of our revenue infiscal 2004 and 7% of our revenue in fiscal 2003.

In fiscal 2005, sales of our Broadband Voice ProcessorFlex Echo Cancellation System, introduced in the third quarter of fiscal 2004,accounted for 79% of our revenue.  Salesof VQA products running on both our BVP Flex and QVP platforms accounted for$2.4 million, or 3%, of our revenue, primarily in the second half of the year,and included a $753,000 sale to Nextel Brazil. We expected the sales of VQAproducts to be higher based on an order from an Asian customer and acceptancefrom some customers that had been evaluating the product. However, shipment ofour VQA product to that Asian customer did not materialize in fiscal 2005 as weexpected and customer acceptance of VQA product being trialed elsewhere istaking longer than anticipated. Revenue growth in fiscal 2004 was largelydriven by sales of our BVP system, which accounted for 58% of our revenuecompared to 30% in 2003. The BVP Flex system, despite the fact that it did notbegin production shipment until late in the third quarter of fiscal 2004,accounted for 22% of our revenue in fiscal 2004. Fiscal 2004 also saw the firstrevenue from our new QVP voice product, which includes our new voice qualityfeatures and is primarily targeted to the international GSM market.  We believe that the introduction of newproducts during fiscal 2004 and 2005 was a key contributor to acquiring andretaining our key strategic customers, as these new products have providedincreased flexibility and easier installation for our customers.

Geographically, revenueover the three fiscal years has been generated largely from domestic sales,which represented 91%, 89% and 84% of our fiscal 2005, 2004 and 2003 revenue,respectively. The increase in the percentage of domestic sales over the threeyears was largely due to the growth in sales of our echo cancellation productsto the domestic wireless telecommunications providers outpacing the growth inour international customer base. While domestic sales continue to be thelargest portion of our geographic revenue mix, we have begun to experience anincreasing year-over-year trend in international revenue in terms of absolutedollar volume. The relatively flat trend in domestic geographic concentrationis largely being driven by the rate of growth in demand from our major domesticcustomers keeping pace with the growth in the smaller international portion ofour business. Although we have successfully added customers internationally,the size of their order levels does not compare with that of our major domesticcustomers. While our success in selling to international markets has beenlimited so far, we expect that in the coming year, the international portion ofour business will begin to grow as a percentage of overall sales as we begin torealize more sales of our VQA applications. However, we expect that ourdomestic customers will continue to represent the majority of our revenue forthe foreseeable future. We expect revenue in the first quarter of fiscal 2006to be in the range of $10-11 million primarily due to a decline in shipments toone of our customers that was one of our two largest customers in fiscal 2005and to a more normal level of shipments to our other large customer, from whichwe generated our highest-ever historical quarterly sales in the fourth quarterof fiscal 2005. Revenue for the remainder of fiscal 2006 will be dependent onour success in adding new customers internationally, the network technology anddeployment plans of the North American telecommunication service providers and,in the latter part of the fiscal year, the market acceptance of our new PacketVoice Processor. See our cautionary language in the first paragraph of “Item 1.Business” regarding forward-looking statements such as the statements made inthis paragraph about our expectations regarding our future revenue, as well asstatements regarding our expectations in each of the categories below.

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*Cost of Goods Sold*
| ** **          | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|---------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **          | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **          | ** ** | **$s in thousands**                      | ** ** |
| Cost of Goods  Sold |       | $                                        | 22,184     |                                               | $          | 23,413 |   | $ | 13,543 |   | $ | (1,229 | ) | $ | 9,870 |   |
|                     |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Cost of goods soldconsists of direct material costs, personnel costs for test and qualityassurance, costs of licensed technology incorporated into our products, post-salesinstallation costs, provisions for inventory and warranty expenses and otherindirect costs. The decrease in cost of goods sold in fiscal 2005 as comparedto fiscal 2004, despite 35% higher revenue, was primarily due to favorablecustomer and product mixes and a $2.7 million reduction in the inventoryprovision as substantially all of our older slower moving products had beenfully reserved in fiscal 2004. The increase in cost of goods sold in fiscal2004 as compared to fiscal 2003 was in large part driven by increased unitsales of our echo cancellation products, which contributed to a$6.7 million increase over fiscal 2003. The other major factor impactingthe increase in costs in 2004 was the write-off of $1.0 million ofmaterials that were deemed too expensive or impractical to refurbish and anincrease of approximately $1.2 million in the level of installation costsdue to increased shipments and an increase in the level of installation supportrequested by our customers. Our inventory provisions were $972,000,$3.6 million and $3.9 million for fiscal 2005, 2004 and 2003,respectively.  Our analysis of grossprofit below discusses the other factors driving changes in cost of goods sold.

*Gross Margin.*
| ** **     | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|----------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **     | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **     | ** ** | **$s in thousands**            | ** ** |
| Gross Profit   |       | $                                        | 71,871     |                                               | $          | 46,177 |   | $ | 21,545 |   | $ | 25,694 |   | $ | 24,632 |   |
| Gross Margin % |       | 76.4                                     | %          | 66.4                                               | %          | 61.4 | % | 10.0 pts |   | 5.0 pts |   |
|                |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The primary factor contributing to the 10.0 percentagepoint increase in gross margin in fiscal 2005 was our favorable customer andproduct mix, as fiscal 2005 was heavily dominated by our BVP Flex products,which have a higher overall gross margin than the products sold in fiscal 2004.Shipments to our largest customer from fiscal 2004 had a somewhat lower marginthan shipments to our largest customer in fiscal 2005. Margins were alsofavorably impacted by the limited levels of excess and obsolete provisions, asvirtually all of the product inventory identified as end of life near the endof fiscal 2004 was written down in fiscal 2004 leaving only minor levels ofinventory other than our current QVP and BVP Flex products. Partiallyoffsetting the fiscal 2005 gross margin increases were lower sales ofpreviously written down inventory. In fiscal 2005, we sold $911,000 ofpreviously written down BVP and Quad inventory compared to $2.2 million ofpreviously written-down OC-3 product in fiscal 2004.

The fiscal 2004 gross margin increased 5.0 percentagepoints compared to fiscal 2003 primarily for two reasons. First, due to theaddition of several new OC-3 customers in fiscal 2003, we began to sellpreviously written-down OC-3 product, which resulted in a benefit of$2.2 million in fiscal 2004 compared to $455,000 in fiscal 2003,increasing gross margin by 1.9 percentage points. The other key factor in theimprovement in gross margin in fiscal 2004 was the effect of our relativelyfixed manufacturing overhead costs. As these costs were relatively fixed overthe period while revenue was steadily improving, we saw an improvement in ouroverall gross margin.

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We expect that the previously noted decline in saleslevels in the first quarter of fiscal 2006 while manufacturing costs remainrelatively fixed will result in overall gross margins of 67-69%. Over the nextseveral quarters, we expect the price we charge our international customerswill decline as we expand the distribution of our products through, value-addedresellers and distributors.

*Sales and Marketing*
| ** **                   | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                   | ** ** | **$s in thousands**            | ** ** |
| Sales and  Marketing Expense |       | $                                        | 16,430     |                                               | $          | 13,168 |   | $ | 12,051 |   | $ | 3,262 |   | $ | 1,117 |   |
| % of Revenue                 |       | 17.5                                     | %          | 18.9                                               | %          | 34.3 | % | (1.4) pts |   | (15.4) pts |   |
|                              |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Sales and marketing expenses primarily consist ofpersonnel costs, including commissions and costs associated with customerservice, travel, trade shows and outside consulting services. The increase insales and marketing expenses in fiscal 2005 compared to fiscal 2004 was partlydue to increases in salary and related costs, which increased $1.7 million infiscal 2005, primarily due to incremental hiring of international sales andpre-sales support staff as well as domestic sales and pre-sales support stafffocused on specific domestic opportunities. Travel expense increased $779,000in fiscal 2005, primarily to support international product evaluations of ourQVP-based products. Finally, outside service expenses increased $733,000 infiscal 2005 to further support pre-and post-sales efforts in the field.

Sales and marketingexpenses began to trend up during fiscal 2004 as we expanded our efforts tointroduce our QVP products internationally and commissions related to revenuethat grew 98% year-over-year.

We expect that sales andmarketing expenses will increase slightly in fiscal 2006 as we launch our new PacketVoice Processor.

*Research and Development.*
| ** **                        | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **$s in thousands**            | ** ** |
| Research and  Development Expense |       | $                                        | 15,826     |                                               | $          | 10,719 |   | $ | 9,952 |   | $ | 5,107 |   | $ | 767 |   |
| % of Revenue                      |       | 16.8                                     | %          | 15.4                                               | %          | 28.4 | % | 1.4 pts |   | (13.0) pts |   |
|                                   |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Research and development expenses primarily consist ofpersonnel costs, contract consultants, materials and supplies used in thedevelopment of voice processing products. The increase in spending in fiscal 2005as compared to fiscal 2004 was partly related to increased salary and relatedcosts of $2.1 million and increased consulting and prototype materials costs of$1.4 million. These increases in spending were primarily associated with thedevelopment of our new Packet Voice Processor. Our engineering staff grew to 62employees by the end of fiscal 2005 from 51 at the end of fiscal 2004. Additionally,depreciation, allocations of facilities and information technology relatedcosts and maintenance on software and equipment used by the engineeringdepartments increased $1.4 million. This was due, in large part, to theincreased demands from a larger engineering workforce.

In fiscal 2004 compared to fiscal 2003, the largestincrease was tied to increased headcount and related costs, as our engineeringstaff grew from 43 employees at the end of fiscal 2003 to 51 employees at theend of fiscal 2004. In addition, depreciation expense increased $150,000 due toincreased levels of lab equipment to support voice processing productdevelopment.

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We expect slight increasesin our research and development spending due to the Jasomi Networks, Inc.acquisition and further development of the Packet Voice Processor.

*General and Administrative*
| ** **                          | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|-------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                          | ** ** | **$s in thousands**            | ** ** |
| General and  Administrative Expense |       | $                                        | 7,244      |                                               | $          | 5,308 |   | $ | 5,269 |   | $ | 1,936 |   | $ | 39 |   |
| % of Revenue                        |       | 7.7                                      | %          | 7.6                                                | %          | 15.0 | % | 0.1 pts |   | (7.4) pts |   |
|                                     |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

General and administrative expenses primarily consistof personnel costs for corporate officers, finance and human resourcespersonnel, as well as insurance, legal, accounting and consulting costs.

The fiscal 2005increases in general and administrative spending were largely due to increased consulting,professional service costs and audit fees related to Sarbanes-Oxley compliancework and international expansion, which resulted in an aggregate increase inspending of over $1.8 million. Additionally, bad debt expense was $250,000lower in fiscal 2004 due to credits taken in fiscal 2004 for an adjustment toour bad debt reserve based on improved collection efforts. There were no suchadjustments to the reserve in fiscal 2005.

The somewhat higherlevels of spending in fiscal 2004 compared to 2003 were due in large part to a$425,000 increase in salaries and related expense due to hiring and financialperformance-driven bonuses and $140,000 of initial spending related tointernational expansion and Sarbanes-Oxley compliance. Those spending increaseswere mostly offset by a $275,000 reduction in bad debt expense due to creditstaken in fiscal 2004 based on an improvement in our customer collectionexperience, $145,000 lower annual report costs and the elimination of cheapstock amortization, which resulted in a $145,000 reduction in expense.

We expect general andadministrative expenses to decline slightly in fiscal 2006 as our second yearof Sarbanes-Oxley compliance will require less use of outside resources.

*Restructuring*
| ** **    | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|---------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **    | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **    | ** ** | **$s in thousands**            | ** ** |
| Restructuring |       | $                                        | —     |                                               | $          | 275 |   | $ | — |   | $ | (275 | ) | $ | 275 |   |
| % of Revenue  |       | 0.0                                      | %          | 0.4                                                | %          | 0.0 | % | (0.4) pts |   | 0.4 pts |   |
|               |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

*RestructuringCharge.  *The restructuring charge recognized in fiscal2004 was attributable to the elimination of redundant general corporate levelcosts, personnel and facilities, which were impacted as a result of exiting theoptical business, but did not qualify for inclusion in discontinued operations.These costs included $21,000 of severance and related benefits and a lossprovision associated with the abandonment of a portion of our Mountain Viewfacilities of $254,000. As a result, the fiscal year reflects a net loss provisionof $275,000 related to our building and employee severance costs.

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*Other Income, Net*
| ** **        | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|-------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **        | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **        | ** ** | **$s in thousands**            | ** ** |
| Other Income, Net |       | $                                        | 2,430      |                                               | $          | 1,294 |   | $ | 1,702 |   | $ | 1,136 |   | $ | (408 | ) |
| % of Revenue      |       | 2.6                                      | %          | 1.9                                                | %          | 4.9 | % | 0.7 pts |   | (3.0) pts |   |
|                   |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net consists of interest income on ourinvested cash and cash equivalent and investment balances, offset by a nominalamount of interest and other expense. The increase in fiscal 2005 compared to2004 was primarily attributable to higher interest income, due to our largerinvested cash balance and an improvement in the return on our invested cash asinterest rates have begun to increase. The decrease in other income in fiscal2004 compared to 2003, net was primarily attributable to lower interest ratesreducing earnings on our invested balances.

Our 2006 interest incomewill be dependent on our cash balances and the movement of U.S. interest rates.

*Income Taxes, Continuing Operations*
| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Income Taxes,  Continuing Operations |       | $                                        | (36,100    | )                                                  | $          | 270 |   | $ | — |   | $ | (36,370 | ) | $ | 270 |   |
| % of Revenue                         |       | (38.4                                    | )%         | 0.4                                                | %          | 0.0 | % | (38.8) pts |   | 0.4 pts |   |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

*Income Taxes.  *Incometaxes consist of federal, state and foreign income taxes. The benefit in fiscal2005 includes the reversal of our valuation allowance against all of ourdeferred tax assets. In fiscal 2005, we concluded that it was more likely thannot that we would realize the benefit related to our deferred tax assets.Accordingly, we reduced the valuation allowance against the assets and recordeda tax benefit to continuing operations of $36.7 million. The majority of thevaluation allowance was released in the second quarter of 2005, based on thelevel of historical taxable income and projections for future taxable incomeover the periods that our deferred tax assets are deductible The remainder ofthe valuation allowance was released over the third and fourth quarters. Therecognition of the deferred tax assets had no impact on our fiscal 2005 cashflows. Partially offsetting the tax benefit recorded was income tax expenseassociated with income earned by our foreign subsidiaries and state and federalalternative minimum tax totaling $595,000 in fiscal 2005.

The income taxesincurred in fiscal 2004 were due to providing alternative minimum taxes on ourdomestic operations. There was no tax provision for continuing operations infiscal 2003 due to our loss.

We expect the effective tax rate to be approximately39% in fiscal 2006.

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*Income (Loss) from Discontinued Operations*
| ** **                                                 | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                 | ** ** | **$s in thousands**            | ** ** |
| Loss from  discontinued operations                         |       | $                                        | —     |                                               | $          | (2,538 | ) | $ | (34,119 | ) | $ | 2,538 |   | $ | 31,581 |   |
| Income tax  provision from loss on discontinued operations |       | —                                   |       | —                                             |       | 129 |   | — |   | 129 |   |
| Gain (loss) on  disposition                                |       | 94                                       |       | (7,142                                             | )          | — |   | 7,236 |   | (7,142 | ) |
| Income tax  benefit from gain (loss) on  disposition       |       | (110                                     | )          | (144                                               | )          | — |   | (34 | ) | 144 |   |
| Income (loss)  from discontinued operations                |       | 204                                      |       | (9,536                                             | )          | (34,248 | ) | 9,740 |   | 24,712 |   |
| % of Revenue                                               |       | 0.2                                      | %          | (13.7                                              | )%         | (97.6 | )% | 13.9 pts |   | 83.9 pts |   |
|                                                            |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The reduction of the loss in our discontinued opticalbusiness in fiscal 2004 as compared to fiscal 2003 was due in large part toreductions in spending subsequent to September 2002, when we discontinuedour optical system product development. As a result, there was a significantdecline in spending on salaries and materials in fiscal 2004. In addition,fiscal 2004 also benefited from reduced spending on optical communicationsmarketing and development after our announcement to exit the optical businessin May 2003 and the elimination of substantially all optical costs effectiveJuly 2003. As all operations related to our optical business ceased infiscal 2004, we did not have further losses from this discontinued operation infiscal 2005.

The $94,000 gain on disposition in fiscal 2005 was dueto adjustments needed to reflect actual costs incurred. The loss on dispositionin fiscal 2004 reflects the aggregate loss of $6.9 million realized in thefirst quarter of fiscal 2004 upon the sale of the optical technology, inventoryand certain fixed assets to JDSU, along with other exit costs associated withabandoning that portion of the optical business not acquired by JDSU. Subsequentadjustments to the loss resulted in an incremental loss of approximately$100,000 and were included in the total loss from disposal of our discontinuedoptical operations of $7.0 million for fiscal 2004 in the ConsolidatedStatement of Operations.

We expect that theonly future discontinued operations activity will be associated with finalresolution of the contingent consideration and resolution of indemnificationobligations between JDSU and us, as well as final wind up costs ofinternational optical operations. See Note 4 of Notes to the CondensedConsolidated Financial Statements.

*CumulativeEffect of Accounting Change.  *The $36.8 millioncumulative effect of an accounting change reported in fiscal 2003 representsthe transitional impairment loss for previously recorded goodwill associatedwith our acquisition of Atmosphere, which we recorded in connection with our adoptionof SFAS 142 effective May 1, 2002. There were no accounting changesin fiscal 2005 or 2004.

**Stock-Based Compensation**

Associated with the acquisition of Atmosphere on July 25,2000, we recorded $2.4 million of deferred compensation related tounvested options assumed in the acquisition. This deferred compensation wasamortized to research and development expense over the remaining vesting termsof the assumed options, which became fully vested in the first quarter offiscal 2003. In connection with the acquisition of Atmosphere, we issuednonqualified stock options for approximately 750,000 shares of our common stockat a price equal to a 50% discount from the market value of the stock on itsgrant date of August 1, 2000. The discount was recorded as deferredcompensation of $17.3 million in August 2000. Subsequent to recordingthis deferred compensation in August 2000, the gross amount of deferredcompensation was reduced from time to time for the impact of optioncancellations due to employee terminations. Due to the 

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cancellation of allremaining options from this August 2000 grant, as part of our optionexchange program as described below, the remaining deferred compensation of$1.2 million was recognized in the fourth quarter of fiscal 2003 and nofurther amortization of this deferred compensation occurred in fiscal 2005 or2004. As this deferred compensation was solely attributable to opticaloperations, the amortization expense has been included in the loss fromdiscontinued operations for all years presented. The Atmosphere-relateddeferred compensation expense totaled approximately $3.1 million in fiscal2003.

In February 2003, wecommenced a voluntary stock option exchange program for our employees,including officers. We implemented this program in order to align employee andstockholder interests while sustaining high levels of performance during thethen stagnant economic period. A large number of our employees’ stock optionexercise prices were significantly higher than the current market price of Ditechcommon stock and, in an effort to motivate and retain our employees, our Boardapproved this stock option exchange program. Under this program, eligibleemployees were offered the opportunity to exchange certain outstanding stockoptions with exercise prices of $20.00 or more for new replacement optionspursuant to the terms of the program. The original options exchanged werecanceled on March 19, 2003. On September 23, 2003, we issued optionsto purchase a total of 165,730 shares of common stock, representing 25% of thenumber of shares originally subject to options exchanged for those individualsstill employed by us on September 23, 2003. (See Note 10 of Notes tothe Consolidated Financial Statements).

**Liquidity and Capital Resources**

As of April 30,2005, we had cash and cash equivalents of $36.8 million as compared to$45.6 million at April 30, 2004. Additionally, we had$98.9 million of short-term investments and no long-term investments as ofApril 30, 2005, compared to $79.9 million of short-term and $5.0 millionof long-term investments as of April 30, 2004.

Since March 1997, wehave satisfied the majority of our liquidity requirements through cash flowgenerated from operations, funds received upon exercise of stock options andthe proceeds from our initial and follow-on public offerings in fiscal 2000.

*Cash flows from Operating Activities*
| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **$s in thousands**                      | ** ** |
| Cash Flow from Operating  Activities |       | $                                        | 33,136     |                                               | $          | 21,219 |   | $ | (12,363 | ) | $ | 11,917 |   | $ | 33,582 |   |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The improvement in ourcash flow from operations reflects the overall improvement in our operatingresults due in large part to increased product shipments. In addition, ourexiting the optical communications business in the first quarter of fiscal 2004also favorably impacted our operating results in fiscal 2004 by dramaticallyreducing the level of spending we had previously invested in this product line.In fiscal 2005, we increased our spending as we invested in our new PacketVoice Processor, international expansion and focused domestic opportunities, aswell as Sarbanes-Oxley compliance. The combination of revenue growth, theelimination of our optical communications business and leveraged spendinggrowth has contributed to our return to profitability and positive cash flowsfrom operating activities in fiscal 2005 and 2004. Compared to fiscal 2004,fiscal 2005 showed growth in accounts receivable, which increased due tosomewhat unfavorable sales linearity in the fourth quarter of fiscal 2005, andreductions in deferred revenue. Although we expect to see positive cash flowsfrom operations in the coming year, they may not be in the same ratio to incomefrom continuing operations before the provision for income taxes as fiscal2005, largely due to expected increases in accounts receivable as we enter newcustomer markets internationally, which may prolong payment terms somewhat, andas we introduce our new Packet Voice Processor products, which may increaseinventory levels.

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*Cash flows from Investing Activities*
| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Cash Flow from  Investing Activities |       | $                                        | (17,088    | )                                                  | $          | (31,978 | ) | $ | 173 |   | $ | 14,890 |   | $ | (32,151 | ) |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The change in the trend of cash flows from investingactivities is due to two key events. First, in fiscal 2004, we changed ourinvesting strategy to include short-term and long-term investments designed toimprove our overall return on invested funds, which accounted for the majorityof the cash used in fiscal 2004 and 2005. Partially offsetting this use of cashin fiscal 2004 and contributing to the positive cash flows from investingactivities in fiscal 2003 was the collection of proceeds from the sale of ourecho cancellation software technology in fiscal 2002 and collection of therelated purchase price installments in fiscal 2003 and 2004 of$5.0 million and $3.5 million in fiscal 2005 and 2004, respectively,and to a lesser degree the collection of sales proceeds from the sale of ouroptical business in fiscal 2004 of $1.8 million. In fiscal 2005, wecollected proceeds from the sale of our optical business and other minor salesof optical equipment of only $542,000.

Our acquisition of JasomiNetworks, Inc. on June 30, 2005 used approximately $12.7 million ofcash in fiscal 2006. (See Note 16 of Notes to the Consolidated FinancialStatements). We also plan to continue to invest in capital assets related tonew product introductions and to support our efforts to sell new productsinternationally.

*Cash flows from Financing Activities*
| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                 | ** ** | **2004**                                           | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Cash Flow from  Financing Activities |       | $                                        | (24,877    | )                                                  | $          | 11,049 |   | $ | 776 |   | $ | (35,926 | ) | $ | 10,273 |   |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in cash flow from financing activities infiscal 2005 as compared to fiscal 2004 was largely due to the repurchase ofshares of common stock, as discussed below, partially offset by funds receivedfrom stock option exercises. Stock option activity in the first half of fiscal2005 was particularly high following the trend in our stock price over thatsame period.

The increase in cash flow from financing activities infiscal 2004 as compared to fiscal 2003 was primarily due to funds received uponstock option exercises. The stock option activity in fiscal 2004 was largelydue to option exercises by employees impacted by the restructuring of ouroptical business prior to the cancellation of those options, as well as optionsexercised by existing employees.

*Stock RepurchaseProgram*

In December 2004, our Board of Directorsauthorized the repurchase of up to $35 million of common stock under a stockrepurchase program. During fiscal 2005, we repurchased and retired 2,516,660shares of our common stock at an average price of $13.91 per share for anaggregate purchase price of $35 million. Consequently, we are not authorized torepurchase additional shares under the stock repurchase program.

The aggregate purchaseprice of the shares of our common stock repurchased was reflected as areduction to shareholders’ equity. In accordance with Accounting PrinciplesBoard Opinion No. 6, “Status of Accounting Research Bulletins,” weallocated the purchase price of the repurchased shares as a reduction toretained earnings, common stock and additional paid-in capital.

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*Commitments*

We have no material commitments other than obligationsunder operating leases, particularly our facility leases, and normal purchasesof inventory, capital equipment and operating expenses, such as materials forresearch and development and consulting. We currently occupy approximately61,000 square feet of space in the two buildings that form our Mountain View,California headquarters. This facility lease expires in June 2006.

Ourcontractual commitments, by year in which they become due, are as follows:
| ** **                                                | ** ** | **Payments due by period** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations (in thousands)** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **1 to 3  years** | ** ** | **3 to 5   years ** | ** ** | **Over 5  years** | ** ** |
| Operating leases                                          |       | $                                         | 2,421      |   |   | $ | 2,013 |   |   | $ | 408 |   |   | $ | — |   |   |   | $ | — |   |   |
| Purchase  commitments                                     |       | 7,054                                     |       |   | 7,054 |   |   | — |   |   | — |   |   |   | — |   |   |
| Total                                                     |       | $                                         | 9,475      |   |   | $ | 9,067 |   |   | $ | 408 |   |   | $ | — |   |   |   | $ | — |   |   |
|                                                           |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In addition, as part of the optical sale agreementwith JDSU, JDSU had the right to require us to indemnify JDSU for any purchasedbut unused inventory at June 30, 2004, up to $2.0 million, and certaincosts incurred by JDSU in connection with the performance of certain warrantyobligations relating to optical products that we sold prior to July 16,2003. We and JDSU are currently evaluating the remaining obligations of eachparty, but have not reached agreement on what the remaining obligations are.

We believe that we will beable to satisfy our cash requirements for at least the next two years from ourexisting cash and short-term investments. We currently expect to renew our$2 million line of credit, which expires in July 2005. The ability tofund our operations beyond the next two fiscal years will be dependent on theoverall demand of telecommunications providers for new capital equipment.Should our customers significantly reduce their purchases of our productscompared to current levels of purchases, we could need to find additionalsources of cash during fiscal 2008 or be forced to reduce our spending levelsto protect our cash reserves.

**Off-Balance SheetArrangements**

As of April 30, 2005, we didnot have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii)of SEC Regulation S-K.

**FutureGrowth and Operating Results Subject to Risk**

Our business and the valueof our stock are subject to a number of risks, which are set out below. If anyof these risks actually occur, our business, financial condition or operatingresults could be materially adversely affected, which would likely have acorresponding impact on the value of our common stock. These risk factorsshould be carefully reviewed.

**WEDEPEND ON A LIMITED NUMBER OF CUSTOMERS FOR OUR PRODUCTS, THE LOSS OF ANY ONEOF WHICH COULD CAUSE OUR REVENUE TO DECREASE.**

Our revenue historically has come from a small numberof customers. Our five largest customers accounted for approximately 91%, 86%and 81% of our revenue in fiscal 2005, 2004 and 2003, respectively. Our twolargest customers accounted for 49% and 37%, respectively, of our revenue infiscal 2005. A customer may stop buying our products or significantly reduceits orders for our products for a number of reasons, including the acquisitionof a customer by another company, financial difficulties or a delay in ascheduled product introduction. If this happens, our revenue could be greatlyreduced, which would materially and adversely affect our business.

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Due to continuingdifficult economic conditions, many operators in the telecommunicationsindustry have experienced financial difficulties, which have impacted theircapital expenditures and, in some cases, resulted in their filing forbankruptcy or being acquired by other operators. In calendar year 2004, NorthAmerican telecommunication service providers began a series of merger andacquisition activities and the affected telecommunication service providers arestill assessing the network technology and deployment plans. In any merger,product purchases for network deployment may be reviewed, postponed or canceledbased on revised plans for technology or network expansion for the mergedentity, which we believe has happened at Nextel, leading to the majority of ourprojected decline in first quarter of fiscal 2006 revenue. If this situationoccurs at other customers, it may result in the delay of product purchases orthe loss of those customers.

**WEARE RELIANT SOLELY ON OUR VOICE QUALITY BUSINESS TO GENERATE REVENUE GROWTH ANDPROFITABILITY, WHICH COULD LIMIT OUR RATE OF FUTURE REVENUE GROWTH.**

We expect that, at leastthrough fiscal 2006, our sole business will be the design, development andmarketing of voice processing products. However, the relatively small size ofthe overall echo cancellation portion of the voice market, which is where wehave derived the majority of our revenue to date, could limit the rate ofgrowth of our business. In addition, certain telecommunication serviceproviders may utilize different technologies, such as VoIP, which would furtherlimit demand for products we sold in fiscal 2005, which are deployed inwireline networks. Although we expect to begin to trial our Packet VoiceProcessor for use in the VoIP market in the first quarter of fiscal 2006, we donot expect to generate meaningful revenue in fiscal 2006.

**OUROPERATING RESULTS HAVE FLUCTUATED SIGNIFICANTLY IN THE PAST, AND WE ANTICIPATETHAT THEY MAY CONTINUE TO DO SO IN THE FUTURE, WHICH COULD ADVERSELYAFFECT OUR STOCK PRICE.**

Our quarterly operatingresults have fluctuated significantly in the past and may fluctuate in thefuture as a result of several factors, some of which are outside of ourcontrol. If revenue significantly declines in a quarter, as we experienced inthe second half of fiscal 2001, again in the second quarter of fiscal 2002 andas we expect to experience in the first quarter of fiscal 2006, our operatingresults will be adversely affected because many of our expenses are relativelyfixed. In particular, sales and marketing, research and development and generaland administrative expenses do not change significantly with variations inrevenue in a quarter. Adverse changes in our operating results could adverselyaffect our stock price. For example, when we announced in May 2005 that weexpected our revenue for the first quarter of fiscal 2006 would be less thanhalf of our revenue in the last quarter to fiscal 2005, our stock price droppedfrom a closing price of $12.59 just prior to our announcement to a closingprice of $7.79 per share on the day following our announcement.

OUR REVENUE MAY VARYFROM PERIOD TO PERIOD.   Factors that could cause our revenue to fluctuatefrom period to period include:

·       changesin capital spending in the telecommunications industry and larger macroeconomictrends;

·       thetiming or cancellation of orders from, or shipments to, existing and newcustomers;

·       theloss of, or a significant decline in orders from, a customer;

·       delaysoutside of our control in obtaining necessary components from our suppliers;

·       delaysoutside of our control in the installation of products for our customers;

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·       thetiming of new product and service introductions by us, our customers, ourpartners or our competitors;

·       delaysin timing of revenue recognition, due to new contractual terms with customers;

·       competitivepricing pressures;

·       variationsin the mix of products offered by us; and

·       variationsin our sales or distribution channels.

In particular, sales of our echo cancellation productstypically come from our major customers ordering large quantities when theydeploy a switching center. Consequently, we may get one or more large orders inone quarter from a customer and then no orders in the next quarter. As aresult, our revenue may vary significantly from quarter to quarter.

Our customers may delay or rescind orders for ourexisting products in anticipation of the release of our or our competitors’ newproducts, due to merger and acquisition activity or if they are unable to putcredit facilities in place. Further, if our or our competitors’ new productssubstantially replace the functionality of our existing products, our existingproducts may become obsolete, which could result in inventory write-downs,and/or we could be forced to sell them at reduced prices or even at a loss.

In addition, the sales cycle for our products istypically lengthy. Before ordering our products, our customers performsignificant technical evaluations, which typically last up to 90 days or morefor our base echo cancellation systems and up to 180 days or more for our newerVQA product offering. Once an order is placed, delivery times can varydepending on the product ordered. As a result, revenue forecasted for aspecific customer for a particular quarter may not occur in that quarter.Because of the potential large size of our customers’ orders, this wouldadversely affect our revenue for the quarter.

OUR EXPENSES MAY VARYFROM PERIOD TO PERIOD.   Manyof our expenses do not vary with our revenue. Factors that could cause ourexpenses to fluctuate from period to period include:

·       theextent of marketing and sales efforts necessary to promote and sell ourproducts;

·       thetiming and extent of our research and development efforts;

·       theavailability and cost of key components for our products; and

·       thetiming of personnel hiring.

If we incur suchadditional expenses in a quarter in which we do not experience increasedrevenue, our operating results would be adversely affected.

**IF WEDO NOT SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS, OUR PRODUCTS MAY BECOMEOBSOLETE.**

We operate in an industry that experiences rapidtechnological change, and if we do not successfully develop and introduce newproducts and our existing products become obsolete due to product introductionsby competitors, our revenues will decline. Even if we are successful indeveloping new products, we may not be able to successfully produce or marketour new products in commercial quantities, or increase our overall saleslevels. These risks are of particular concern when a new generation product isintroduced. Although we believe we will achieve our product introduction dates,there is no guarantee that they will not be delayed. The recent productintroductions, which are of greatest significance, are our new voice qualityfeatures, which are being offered on our BVP-Flex and QVP voice processinghardware platforms. We are currently experiencing numerous customer evaluationsof these features around the world and realized our first modest levels ofrevenue from these new products in the fourth quarter of fiscal 2004. Theseevaluations are taking longer than we first anticipated. We expect moresignificant levels 

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of revenue from these newfeatures in fiscal 2006. However, should the customer evaluation process becomefurther protracted or the product not meet the customers’ expectations, thetiming of our realization of any revenues from these new products could bedelayed or not materialize at all.

In the first quarter of fiscal 2006, we will begin totrial our Packet Voice Processor, a new product targeting VoIP based networkdeployments. The Packet Voice Processor provides voice processing functionalityto enable the deployment of end-to-end VoIP services. This is the first packetbased product developed by us. The product may not be accepted in the marketdue to feature or capabilities mis-matches with customer requirements, pricingof the product, inadequately developed technical capabilities, or limitationsof our sales and marketing force to properly interact with customers tocommunicate the benefits of the product.

We have in the past experienced, and in the future mayexperience, unforeseen delays in the development of our new products. Forexample, in fiscal 2002, sales of our fourth generation echo cancellers and ourbroadband system generated the majority of our echo revenue while sales of ourfifth generation, OC-3 echo cancellation system fell short of ourexpectations due to a sudden decline in projected demand in the third quarterof fiscal 2002 from our primary targeted customer for this product, Qwest. Thisunexpected drop in demand for the OC-3 product led to the write down of$3.5 million of excess inventory in the third quarter of fiscal 2002. Althoughwe were eventually able to sell this product after having written it down,there can be no assurances that we will be able to sell additional written-downunits in the future.

We must devote asubstantial amount of resources in order to develop and achieve commercialacceptance of our new products; most recently, our Packet Voice Processor andour voice quality features offered on our BVP-Flex and QVP hardware platforms. Ournew and/or existing products may not be able to address evolving demands in thetelecommunications market in a timely or effective way. Even if they do,customers in these markets may purchase or otherwise implement competingproducts.

**WE OPERATEIN AN INDUSTRY EXPERIENCING RAPID TECHNOLOGICAL CHANGE, WHICH MAY MAKE OURPRODUCTS OBSOLETE.**

Our future successwill depend on our ability to develop, introduce and market enhancements to ourexisting products and to introduce new products in a timely manner to meet ourcustomers’ requirements. The markets we target are characterized by:

·       rapidtechnological developments;

·       frequentenhancements to existing products and new product introductions;

·       changesin end user requirements; and

·       evolvingindustry standards.

WE MAY NOT BE ABLE TO RESPOND QUICKLY ANDEFFECTIVELY TO THESE RAPID CHANGES.   The emerging nature of these productsand their rapid evolution will require us to continually improve theperformance, features and reliability of our products, particularly in responseto competitive product offerings. We may not be able to respond quickly andeffectively to these developments. The introduction or market acceptance ofproducts incorporating superior technologies or the emergence of alternativetechnologies and new industry standards could render our existing products, aswell as our products currently under development, obsolete and unmarketable. Inaddition, we may have only a limited amount of time to penetrate certainmarkets, and we may not be successful in achieving widespread acceptance of ourproducts before competitors offer products and services similar or superior toour products. We may fail to anticipate or respond on a cost-effective andtimely basis to technological developments, changes in industry standards orend user requirements. We may also experience significant 

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delays in productdevelopment or introduction. In addition, we may fail to release new productsor to upgrade or enhance existing products on a timely basis.

WE MAY NEED TO MODIFYOUR PRODUCTS AS A RESULT OF CHANGES IN INDUSTRY STANDARDS.   The emergence of new industrystandards, whether through adoption by official standards committees orwidespread use by service providers, could require us to redesign our products.If such standards become widespread, and our products are not in compliance,our current and potential customers may not purchase our products. The rapiddevelopment of new standards increases the risk that our competitors coulddevelop and introduce new products or enhancements directed at new industrystandards before us.

**ACQUISITIONSAND INVESTMENTS MAY ADVERSELY AFFECT OUR BUSINESS.**

From time to time,we review acquisition and investment prospects that would complement ourexisting product offerings, augment our market coverage, secure supplies ofcritical materials or enhance our technological capabilities. For example, in June 2005we acquired Jasomi Networks, Inc. Acquisitions or investments could resultin a number of financial consequences, including:

·       potentiallydilutive issuances of equity securities;

·       largeone-time write-offs;

·       reducedcash balances and related interest income;

·       higherfixed expenses which require a higher level of revenues to maintain grossmargins;

·       theincurrence of debt and contingent liabilities; and

·       amortizationexpenses related to other acquisition related intangible assets and impairmentof goodwill.

Furthermore,acquisitions involve numerous operational risks, including:

·       difficultiesin the integration of operations, personnel, technologies, products and theinformation systems of the acquired companies;

·       diversionof management’s attention from other business concerns;

·       diversionof resources from our existing businesses, products or technologies;

·       risksof entering geographic and business markets in which we have no or limited priorexperience; and

·       potential loss of keyemployees of acquired organizations.

**IF WELOSE THE SERVICES OF ANY OF OUR KEY MANAGEMENT OR KEY TECHNICAL PERSONNEL, ORARE UNABLE TO RETAIN OR ATTRACT ADDITIONAL TECHNICAL PERSONNEL, OUR ABILITY TOCONDUCT AND EXPAND OUR BUSINESS COULD BE IMPAIRED.**

We depend heavily on keymanagement and technical personnel, for the conduct and development of ourbusiness and the development of our products. However, there is no guaranteethat if we lost the services of one or more of these people for any reason,that it would not adversely affect our ability to conduct and expand ourbusiness and to develop new products. We believe that our future success willdepend in large part upon our continued ability to attract, retain and motivatehighly skilled employees. However, we may not be able to do so.

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**WEANTICIPATE THAT AVERAGE SELLING PRICES FOR OUR PRODUCTS WILL DECLINE IN THEFUTURE, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO BE PROFITABLE.**

We expect that the price we can charge our customersfor our products will decline as new technologies become available, as weexpand the distribution of products through value-added resellers anddistributors internationally and as competitors lower prices either as a resultof reduced manufacturing costs or a strategy of cutting margins to achieve ormaintain market share. If this occurs, our operating results will be adverselyaffected. We expect price reductions to be more pronounced due to our plannedexpansion internationally. While we intend to reduce our manufacturing costs inan attempt to maintain our margins and to introduce enhanced products withhigher selling prices, we may not execute these programs on schedule. Inaddition, our competitors may drive down prices faster or lower than ourplanned cost reduction programs. Even if we can reduce our manufacturing costs,many of our operating costs will not decline immediately if revenue decreasesdue to price competition.

In order to respond toincreasing competition and our anticipation that average-selling prices willdecrease, we are attempting to reduce manufacturing costs of our new andexisting products. If we do not reduce manufacturing costs and average sellingprices decrease, our operating results will be adversely affected.Manufacturing is currently outsourced to primarily one contract manufacturer.We believe that our current contract manufacturing relationship provides uswith competitive manufacturing costs for our products. However, if we or thiscontract manufacturer terminates our relationship, or if we otherwise establishnew relationships, we may encounter problems in the transition of manufacturingto another contract manufacturer, which could temporarily increase ourmanufacturing costs and cause production delays.

**WEFACE INTENSE COMPETITION, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO MAINTAINOR INCREASE SALES OF OUR PRODUCTS.**

The markets for our products are intenselycompetitive, continually evolving and subject to rapid technological change. Wemay not be able to compete successfully against current or future competitors,including our customers. Certain of our customers also have the ability tointernally produce the equipment that they currently purchase from us. In suchcases, we also compete with their internal product development capabilities. Weexpect that competition will increase in the future. We may not have thefinancial resources, technical expertise or marketing, manufacturing,distribution and support capabilities to compete successfully.

We face competition fromtwo major direct manufacturers of stand-alone voice processing products,Tellabs and Natural Microsystems. The other competition in these markets comesfrom voice switch manufacturers. These manufacturers do not sell voiceprocessing products or compete in the stand-alone voice processing productmarket, but they integrate voice processing functionality within theirswitches, either as hardware modules or as software running on chips. A morewidespread adoption of internal voice processing solutions would present anincreased competitive threat to us, if the net result was the elimination ofdemand for our voice processing system products. With the downturn in spendingin the telecommunications industry, service providers appear to be exploringthese alternative sources of voice processing more thoroughly, while they waitfor more robust capital spending budgets to return. If our customers decide todesign these alternative sources of voice processing functionality into theirfuture network expansion, it could adversely impact the speed and duration ofour sales recovery.

Most of our competitorsand potential competitors have substantially greater name recognition andtechnical, financial and marketing resources than we do. Such competitors mayundertake more extensive marketing campaigns, adopt more aggressive pricingpolicies and devote substantially more resources to developing new productsthan we will.

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**WENOW LICENSE OUR ECHO CANCELLATION SOFTWARE FROM TEXAS INSTRUMENTS, AND IF WE DONOT RECEIVE THE LEVEL OF SUPPORT WE EXPECT FROM TEXAS INSTRUMENTS, IT COULDADVERSELY AFFECT OUR ECHO CANCELLATION SYSTEMS BUSINESS.**

In April 2002, wesold our echo cancellation software technology and future revenue streams fromour licenses of acquired technology to Texas Instruments, in return for cashand a long-term license of the echo cancellation software. Although thelicensing agreement has strong guarantees of support for the software used inour products, if Texas Instruments were to breach that agreement in somefashion, and not deliver complete and timely support to us, our success in theecho cancellation systems business could be adversely affected.

**IFTEXAS INSTRUMENTS LICENSES ITS ECHO CANCELLATION SOFTWARE TO OTHER ECHOCANCELLATION SYSTEMS COMPANIES, THIS COULD INCREASE THE COMPETITIVE PRESSURESON OUR ECHO CANCELLATION SYSTEMS BUSINESS.**

Under the terms of thesale agreement of our echo cancellation software to Texas Instruments, TexasInstruments is precluded from licensing the software to other echo cancellationsystems companies for a period of two years from the date of the sale and totwo specified competitors for a period of four years from the date of sale. IfTexas Instruments were to license its echo cancellation software to other echocancellation systems companies now that the two year period has expired, it couldincrease the level of competition and adversely affect our success in our echocancellation systems business.

**IFINCUMBENT AND EMERGING COMPETITIVE SERVICE PROVIDERS AND THE TELECOMMUNICATIONSINDUSTRY AS A WHOLE EXPERIENCE ANOTHER DOWNTURN OR REDUCTION IN GROWTH RATE,THE DEMAND FOR OUR PRODUCTS WILL DECREASE, WHICH WILL ADVERSELY AFFECT OURBUSINESS.**

We have experienced, ashave other companies in our sector, a slowdown in infrastructure spending byour customers. This trend of lower capital spending in the telecommunicationsindustry contributed to the decline in our revenues, beginning in the secondhalf of fiscal 2001, and although we have experienced some level of recovery insales to these customers, sales have not fully recovered to the levels we sawprior to the decline in fiscal 2001. Our success will continue to depend inlarge part on development, expansion and/or upgrade of voice and communicationsnetworks. We are subject to risks of growth constraints due to our current andplanned dependence on domestic and international telecommunications serviceproviders. These potential customers may be constrained for a number ofreasons, including their limited capital resources, economic conditions,changes in regulation and mergers or consolidations which we have seen in NorthAmerica since calendar year 2004.

**SOMEOF THE KEY COMPONENTS USED IN OUR PRODUCTS ARE CURRENTLY AVAILABLE ONLY FROMSOLE SOURCES, THE LOSS OF WHICH COULD DELAY PRODUCT SHIPMENTS.**

We rely on certain suppliers as the sole source ofcertain key components that we use in our products. For example, we rely onTexas Instruments as the sole source supplier for the digital signal processorsused in our echo cancellation and voice enhancement products. We have noguaranteed supply arrangements with our suppliers. Any extended interruption inthe supply of these components would affect our ability to meet scheduleddeliveries of our products to customers. If we are unable to obtain asufficient supply of these components, we could experience difficulties inobtaining alternative sources or in altering product designs to use alternativecomponents.

Resulting delays orreductions in product shipments could damage customer relationships, and wecould lose customers and orders. Additionally, because these suppliers are thesole source of these components, we are at risk that adverse increases in theprice of these components could have negative 

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impactson the cost of our products or require us to find alternative, less expensivecomponents, which would have to be designed into our products in an effort toavoid erosion in our product margin.

**SOMESUPPLIERS OF KEY COMPONENTS MAY REDUCE THEIR INVENTORY LEVELS WHICH COULDRESULT IN LONGER LEAD TIMES FOR FUTURE COMPONENT PURCHASES AND ANY DELAYS INFILLING OUR DEMAND MAY REDUCE OR DELAY OUR EXPECTED PRODUCT SHIPMENTS ANDREVENUES.**

Although we believe thereare currently ample supplies of components for our products, it is possiblethat in the near-term component manufacturers may reduce their inventory levelsand require firm orders before they manufacture components. This reduction instocking levels could lead to extended lead times in the future. If we areunable to procure our planned quantities of materials from all prospectivesuppliers, and if we cannot use alternative components, we could experiencerevenue delays or reductions and potential harm to customer relationships. Anexample of this risk occurred in the third quarter of fiscal 2001 as twosuppliers supplying us with components used in our OC-3 product did not meetour total demand. As a result, the schedule shipment of our OC-3 productwas delayed, which contributed to our revenue shortfall in that quarter.

**WE MAY EXPERIENCEUNFORESEEN PROBLEMS AS WE DIVERSIFY OUR INTERNATIONAL CUSTOMER BASE, WHICHWOULD IMPAIR OUR ABILITY TO GROW OUR BUSINESS.**

Historically, we have sold mostly to customers inNorth America. We are continuing to execute on our plans to expand ourinternational presence through the establishment of new relationships withestablished international value-added resellers and distributors. However, wemay still be required to hire additional personnel for the overseas market, aswe have seen over the last couple of quarters, and may incur other unforeseenexpenditures related to our international expansion. Despite these efforts, todate our planned expansion overseas has met with limited success and there isno guarantee of future success. As we expand our sales focus farther intointernational markets, we will face new and complex issues that we may not havefaced before, such as expanded risk to currency fluctuations, longer paymentcycles, manufacturing overseas, political or economic instability, potentialadverse tax consequences and broadened import/export controls, which will putadditional strain on our management personnel. In the past, the vastmajority of our international sales have been denominated in U.S. dollars;however, in the future, we may be forced to denominate a greater amount ofinternational sales in foreign currencies.

Additionally, the numberof installations we will be responsible for may increase as a result of ourcontinued international expansion and recognition of revenue may be dependenton acceptances. In addition, we may not be able to establish more relationshipswith international value-added resellers and distributors. If we do not, ourability to increase sales could be materially impaired.

**OURABILITY TO COMPETE SUCCESSFULLY WILL DEPEND, IN PART, ON OUR ABILITY TO PROTECTOUR INTELLECTUAL PROPERTY RIGHTS, WHICH WE MAY NOT BE ABLE TO PROTECT.**

We may rely on acombination of patents, trade secrets, copyright and trademark laws,nondisclosure agreements and other contractual provisions and technicalmeasures to protect our intellectual property rights. Nevertheless, suchmeasures may not be adequate to safeguard the technology underlying ourproducts. In addition, employees, consultants and others who participate in thedevelopment of our products may breach their agreements with us regarding ourintellectual property, and we may not have adequate remedies for any suchbreach. In addition, we may not be able to effectively protect our intellectualproperty rights in certain countries. We may, for a variety of reasons, decidenot to file for patent, copyright or trademark protection outside of the UnitedStates. We also realize that our trade secrets may become known through othermeans not currently foreseen by us. Notwithstanding our efforts 

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toprotect our intellectual property, our competitors may be able to developproducts that are equal or superior to our products without infringing on anyof our intellectual property rights.

**WECURRENTLY ARE, AND IN THE FUTURE MAY BE, SUBJECT TO SECURITIES CLASS ACTIONLAWSUITS DUE TO DECREASES IN OUR STOCK PRICE.**

We are at risk of beingsubject to securities class action lawsuits if our stock price declinessubstantially. Securities class action litigation has often been broughtagainst a company following a decline in the market price of its securities.For example, in May 2005, we announced that we expected our first quarterfiscal 2006 revenue to be approximately one half of our last quarter fiscal2005 revenue, and our stock price declined dramatically. On June 14, 2005,a lawsuit entitled *Richard E. Jaffe v.Ditech Communications Corp., Timothy K. Montgomery and William J. Tamblyn,*CaseNo. C 05 02406 was filed in the United States District Court for theNorthern District of California, purportedly on behalf of a class of investorswho purchased Ditech’s stock between August 25, 2004 and May 26,2005. The complaint alleges claims under Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934 against the Ditech and our Chief ExecutiveOfficer and Chief Financial Officer. We expect that several similar lawsuitswill subsequently be filed in the same court, and that all of the cases will beconsolidated into a single action. In addition, a shareholder’s derivative suithas been filed against our directors and the same two executive officers, andhas named Ditech nominally as a defendant, making similar allegations. Wecannot predict the outcome of the lawsuits. If our stock price declinessubstantially in the future, we may be the target of similar litigation. Thecurrent, and any future, securities litigation could result in substantialcosts and divert management’s attention and resources, and could seriously harmour business.

**OURPRODUCTS EMPLOY TECHNOLOGY THAT MAY INFRINGE ON THE PROPRIETARY RIGHTS OFTHIRD PARTIES, WHICH MAY EXPOSE US TO LITIGATION.**

Although we do not believethat our products infringe the proprietary rights of any third parties, thirdparties may still assert infringement or invalidity claims (or claims forindemnification resulting from infringement claims) against us. Such assertionscould materially adversely affect our business, financial condition and resultsof operations. In addition, irrespective of the validity or the successfulassertion of such claims, we could incur significant costs in defending againstsuch claims.

**Item7A—Quantitative and Qualitative Disclosures About Market Risk**

Our exposure to market risk due to changes in thegeneral level of United States interest rates relates primarily to our cashequivalents and short-term and long-term investment portfolios. Our cash, cashequivalents, and short-term and long-term investments are primarily maintainedat four major financial institutions in the United States. As of April 30,2005, we did not hold any derivative instruments. The primary objective of ourinvestment activities is the preservation of principal while maximizinginvestment income and minimizing risk, and we attempt to achieve this bydiversifying our portfolio in a variety of highly rated investment securitiesthat have limited terms to maturity. We do not hold any instruments for tradingpurposes.

Investmentsecurities that have maturities of more than three months at the date ofpurchase but current maturities of less than one year and auction ratesecurities, which management is able to liquidate on 28 or 35 day auctioncycles, are considered short-term investments. Other investment securities withremaining maturities of one year or more are considered long-term investments.Short-term and long-term investments consist primarily of U.S. Government securitiesand corporate bonds, as well as, commercial paper, asset backed securities andcertificates of deposit. Short-term and long-term investments are maintained atthree major financial institutions, are classified as available-for-sale, andare recorded on the accompanying Consolidated Balance Sheets at fair value. Ifwe sell our short-term or long-term 

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investments prior to their maturity, we may incur acharge to operations in the period the sale took place. In fiscal 2005, 2004and 2003, we realized no gains or losses on our short- or long-terminvestments.

Thefollowing table presents the hypothetical changes in fair values of ourinvestments as of April 30, 2005, based on a discounted cash flowcalculation over the remaining term of each investment, that are sensitive tochanges in interest rates. (dollars in thousands):
| ** **        | ** ** | **Valuation of Securities Given  an Interest Rate Decrease of** | ** ** | ** **                          | ** ** | **Valuation of Securities Given  an Interest Rate Increase of** | ** ** |
|-------------------|------------|----------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|
| ** **        | ** ** | **X Basis Points**                                                                       | ** ** | **Fair Value as of** | ** ** | **X Basis Points**                                                                       | ** ** |
| ** **        | ** ** | ** (150 BPS) **                                                                     | ** ** | ** (100 BPS) **      | ** ** | **(50 BPS)**                                                                                  | ** ** | **April 30, 2005** | ** ** | **50 BPS** | ** ** | **100 BPS** | ** ** | **150 BPS** | ** ** |
| Total investments |       |                                                                                               | $          | 98,949                              |       |                                                                                               |       | $ | 98,917 |   |   | $ | 98,885 |   |   | $ | 98,853 |   |   | $ | 98,820 |   | $ | 98,785 |   | $ | 98,753 |   |
|                   |            |                                                                                                    |            |                                     |            |                                                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

These instruments are not leveraged. The modelingtechnique used measures the change in fair values arising from selectedpotential changes in interest rates. Market changes reflect immediatehypothetical parallel shifts in the yield curve of plus or minus 50 basispoints (BPS), 100 BPS, and 150 BPS over the remaining life of the investments,which shifts are representative of the historical movements in the FederalFunds Rate.

Thefollowing table presents our cash equivalents and short-term and long-terminvestments subject to interest rate risk and their related weighted averageinterest rates as of April 30, 2005 and 2004 (in thousands). Carryingvalue approximates fair value.
| ** **                 | ** ** | **April 30, 2005** | ** ** | **April 30, 2004**    | ** ** |
|----------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Carrying  Value**          | ** ** | **Average  Interest Rate** | ** ** | **Carrying  Value** | ** ** | **Average  Interest Rate** | ** ** |
| Cash and cash  equivalents |       | $                            | 36,781     |                            |       | 1.62 | % |   | $ | 45,610 |   |   | 0.78 | % |   |
| Short-term  investments    |       | 98,853                       |       |                            | 2.97       |   |   | 79,899 |   |   | 1.18 |   |   |
| Long-term  investments     |       | —                       |       |                            | —     |   |   | 4,996 |   |   | 1.75 |   |   |
| Total                      |       | $                            | 135,634    |                            |       | 2.61 | % |   | $ | 130,505 |   |   | 1.06 | % |   |

 

In fiscal 2005, ourreturn on our cash and cash equivalents ranged from 0.9% to 2.7% and ouraverage return for the year was 1.7% while our return on short- and long-terminvestments ranged from 1.1% to 3.6% and our average return for the year was2.0%.

To date, the vast majority of our sales have beendenominated in U.S. dollars. As only a small amount of foreign invoices arepaid in currencies other than the U.S. dollar, our foreign exchange risk isconsidered immaterial to our consolidated financial position, results ofoperations or cash flows.

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**Item 8—FinancialStatements and Supplementary Data**

**DITECH COMMUNICATIONS CORPORATIONINDEX TO CONSOLIDATED FINANCIAL STATEMENTS**
|                                                          | ** ** | **Page** | ** ** |
|----------------------------------------------------------|------------|----------|------------|
| Report of Independent  Registered Public Accounting Firm |       |     | 42         |   |   |
| Consolidated Balance Sheets                              |       |     | 44         |   |   |
| Consolidated Statements of  Operations                   |       |     | 45         |   |   |
| Consolidated Statements of  Stockholders’ Equity    |       |     | 46         |   |   |
| Consolidated Statements of  Cash Flows                   |       |     | 47         |   |   |
| Notes to Consolidated Financial  Statements              |       |     | 48         |   |   |
| Supplementary Financial Data  (unaudited)                |       |     | 68         |   |   |

 

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**Report of Independent Registered Public AccountingFirm**

**Tothe Board of Directors and Stockholders ofDitech Communications Corporation:**

We have completed anintegrated audit of Ditech Communications Corporation’s 2005 consolidatedfinancial statements and of its internal control over financial reporting as ofApril 30, 2005 and audits of its 2004 and 2003 consolidated financialstatements in accordance with the standards of the Public Company AccountingOversight Board (United States). Our opinions, based on our audits, arepresented below.

*Consolidatedfinancial statements and financial statement schedule*

In our opinion, the consolidated financial statementslisted in the index appearing under Item 15(a)(1) present fairly, inall material respects, the financial position of Ditech CommunicationsCorporation and its subsidiaries at April 30, 2005 and 2004, and theresults of their operations and their cash flows for each of the three years inthe period ended April 30, 2005 in conformity with accounting principlesgenerally accepted in the United States of America. In addition, in ouropinion, the financial statement schedule listed in the index appearing underItem 15(a)(2) presents fairly, in all material respects, the informationset forth therein when read in conjunction with the related consolidatedfinancial statements. These financial statements and financial statementschedule are the responsibility of the Company’s management. Our responsibilityis to express an opinion on these financial statements and financial statementschedule based on our audits. We conducted our audits of these statements inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit of financial statements includes examining, ona test basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for ouropinion.

As discussed in Note 2 tothe consolidated financial statements, effective May 1, 2002, the Companychanged its method of accounting for goodwill in accordance with Statement ofFinancial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”

*Internal controlover financial reporting*

Also, in our opinion, management’s assessment,included in Management’s Report on Internal Control over Financial Reportingappearing under Item 9A, that the Company maintained effective internal controlover financial reporting as of April 30, 2005 based on criteriaestablished in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of April 30,2005, based on criteria established in *InternalControl—Integrated Framework* issued by the COSO. The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express opinions onmanagement’s assessment and on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit. We conducted our audit ofinternal control over financial reporting in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects. An audit of internal control over financial reportingincludes obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing 

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and evaluating the designand operating effectiveness of internal control, and performing such otherprocedures as we consider necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, in reasonabledetail, accurately and fairly reflect the transactions and dispositions of theassets of the company; (ii) provide reasonable assurance that transactionsare recorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance withauthorizations of management and directors of the company; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of the company’s assets that could have amaterial effect on the financial statements.

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.
| /s/ PRICEWATERHOUSECOOPERS  LLP |   |
|--------------------------------------|--------|
|                                 |   |
| San Jose, California                 |   |
| July 11, 2005                   |   |

 

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**DITECH COMMUNICATIONS CORPORATIONCONSOLIDATED BALANCE SHEETS(in thousands, except per share data)**
| ** **                                                                                                                                                    | ** ** | **April 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                    | ** ** | **2005**           | ** ** | **2004** | ** ** |
| **ASSETS**                                                                                                                                                    |       |               |       |   |   |
| Current assets:                                                                                                                                               |       |               |       |   |   |
| Cash and cash equivalents                                                                                                                                     |       | $                  | 36,781     |   | $ | 45,610 |   |
| Short-term investments                                                                                                                                        |       | 98,853             |       | 79,899 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $344 and $404 at April 30, 2005 and 2004, respectively                                   |       | 9,318              |       | 6,544 |   |
| Inventories                                                                                                                                                   |       | 5,732              |       | 5,955 |   |
| Deferred income taxes                                                                                                                                         |       | 4,836              |       | — |   |
| Other current assets                                                                                                                                          |       | 1,561              |       | 2,168 |   |
| Total current assets                                                                                                                                          |       | 157,081            |       | 140,176 |   |
| Long-term  investments                                                                                                                                        |       | —             |       | 4,996 |   |
| Property and  equipment, net                                                                                                                                  |       | 4,937              |       | 3,603 |   |
| Deferred income  taxes                                                                                                                                        |       | 46,771             |       | — |   |
| Other assets                                                                                                                                                  |       | 931                |       | 1,773 |   |
| Total assets                                                                                                                                                  |       | $                  | 209,720    |   | $ | 150,548 |   |
| **LIABILITIES**                                                                                                                                               |       |               |       |   |   |
| Current liabilities:                                                                                                                                          |       |               |       |   |   |
| Accounts payable                                                                                                                                              |       | $                  | 2,166      |   | $ | 2,123 |   |
| Accrued expenses                                                                                                                                              |       | 8,505              |       | 8,885 |   |
| Deferred revenue                                                                                                                                              |       | 202                |       | 2,450 |   |
| Income taxes payable                                                                                                                                          |       | 1,582              |       | 1,690 |   |
| Total liabilities                                                                                                                                             |       | 12,455             |       | 15,148 |   |
| Commitments and contingencies (Note 7)                                                                                                                        |       |               |       |   |   |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                 |       |               |       |   |   |
| Preferred stock, $0.001 par value: 5,000 shares  authorized and none issued and outstanding at April 30, 2005 and 2004                                   |       | —             |       | — |   |
| Common stock,  $0.001 par value: 200,000 shares authorized and 31,998 and 32,915 shares  issued and outstanding at April 30, 2005 and 2004, respectively |       | 32                 |       | 33 |   |
| Additional  paid-in capital                                                                                                                                   |       | 287,036            |       | 281,190 |   |
| Accumulated  deficit                                                                                                                                          |       | (89,757            | )          | (145,785 | ) |
| Other  comprehensive loss                                                                                                                                     |       | (46                | )          | (38 | ) |
| Total stockholders’ equity                                                                                                                               |       | 197,265            |       | 135,400 |   |
| Total liabilities  and stockholders’ equity                                                                                                              |       | $                  | 209,720    |   | $ | 150,548 |   |

 

The accompanying notes are an integral part of these consolidated financial statements

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**DITECH COMMUNICATIONS CORPORATIONCONSOLIDATED STATEMENTS OFOPERATIONS(in thousands, except per share data)**
| ** **                                                                                                                        | ** ** | **Years ended April 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                                        | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenue                                                                                                                           |       | $                                        | 94,055     |   | $ | 69,590 |   | $ | 35,088 |   |
| Cost of goods sold                                                                                                                |       | 22,184                                   |       | 23,413 |   | 13,543 |   |
| Gross profit                                                                                                                      |       | 71,871                                   |       | 46,177 |   | 21,545 |   |
| Operating expenses:                                                                                                               |       |                                     |       |   |   |   |   |
| Sales and  marketing                                                                                                              |       | 16,430                                   |       | 13,168 |   | 12,051 |   |
| Research and  development                                                                                                         |       | 15,826                                   |       | 10,719 |   | 9,952 |   |
| General and  administrative                                                                                                       |       | 7,244                                    |       | 5,308 |   | 5,269 |   |
| Restructuring  charge                                                                                                             |       | —                                   |       | 275 |   | — |   |
| Total operating expenses                                                                                                          |       | 39,500                                   |       | 29,470 |   | 27,272 |   |
| Income (loss) from  continuing operations                                                                                         |       | 32,371                                   |       | 16,707 |   | (5,727 | ) |
| Other income (expense):                                                                                                           |       |                                     |       |   |   |   |   |
| Interest income                                                                                                                   |       | 2,446                                    |       | 1,237 |   | 1,712 |   |
| Other income  (expense), net                                                                                                      |       | (16                                      | )          | 57 |   | (10 | ) |
| Total other income                                                                                                                |       | 2,430                                    |       | 1,294 |   | 1,702 |   |
| Income (loss) from  continuing operations before provision (benefit) for income taxes and  cumulative effect of accounting change |       | 34,801                                   |       | 18,001 |   | (4,025 | ) |
| Provision  (benefit) for income taxes                                                                                             |       | (36,100                                  | )          | 270 |   | — |   |
| Income (loss) from  continuing operations before cumulative effect of accounting change                                           |       | 70,901                                   |       | 17,731 |   | (4,025 | ) |
| Discontinued operations:                                                                                                          |       |                                     |       |   |   |   |   |
| Loss from  discontinued operations                                                                                                |       | —                                   |       | (2,538 | ) | (34,119 | ) |
| Income tax  provision from loss on discontinued operations                                                                        |       | —                                   |       | — |   | 129 |   |
| Gain (loss) on  disposition                                                                                                       |       | 94                                       |       | (7,142 | ) | — |   |
| Income tax benefit  from gain (loss) on disposition                                                                               |       | (110                                     | )          | (144 | ) | — |   |
| Income (loss) from  discontinued operations                                                                                       |       | 204                                      |       | (9,536 | ) | (34,248 | ) |
| Cumulative effect  of accounting change                                                                                           |       | —                                   |       | — |   | (36,837 | ) |
| Net income (loss)                                                                                                                 |       | $                                        | 71,105     |   | $ | 8,195 |   | $ | (75,110 | ) |
| Per share data:                                                                                                                   |       |                                     |       |   |   |   |   |
| Basic:                                                                                                                            |       |                                     |       |   |   |   |   |
| Net income (loss)  from continuing operations before cumulative effect of accounting change                                       |       | $                                        | 2.12       |   | $ | 0.56 |   | $ | (0.13 | ) |
| Income (loss) from  discontinued operations                                                                                       |       | 0.01                                     |       | (0.30 | ) | (1.13 | ) |
| Cumulative effect  of accounting change                                                                                           |       | —                                   |       | — |   | (1.21 | ) |
| Net income (loss)                                                                                                                 |       | $                                        | 2.13       |   | $ | 0.26 |   | $ | (2.47 | ) |
| Diluted:                                                                                                                          |       |                                     |       |   |   |   |   |
| Net income (loss)  from continuing operations before cumulative effect of accounting change                                       |       | $                                        | 2.02       |   | $ | 0.53 |   | $ | (0.13 | ) |
| Income (loss) from  discontinued operations                                                                                       |       | 0.00                                     |       | (0.29 | ) | (1.13 | ) |
| Cumulative effect  of accounting change                                                                                           |       | —                                   |       | — |   | (1.21 | ) |
| Net income (loss)                                                                                                                 |       | $                                        | 2.02       |   | $ | 0.24 |   | $ | (2.47 | ) |
| Number of shares used in per share calculations:                                                                                  |       |                                     |       |   |   |   |   |
| Basic                                                                                                                             |       | 33,408                                   |       | 31,734 |   | 30,371 |   |
| Diluted                                                                                                                           |       | 35,140                                   |       | 33,496 |   | 30,371 |   |

 

The accompanying notes are an integral part of these consolidated financial statements

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**DITECH COMMUNICATIONS CORPORATIONCONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY(in thousands)**
| ** **                                                                | ** ** | **Common Stock** | ** ** | ** Additional   Paid-In** | ** ** | **Retained  Earnings  (Accumulated** | ** ** | **Deferred Stock** | ** ** | **Other  Comprehensive** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------------------|------------|--------------------------------------|------------|-------------------------|------------|--------------------------|------------|------------|------------|
| ** **                                                                | ** ** | **Shares**            | ** ** | **Amount**                          | ** ** | **Capital**                          | ** ** | **Deficit)**            | ** ** | **Compensation**         | ** ** | **Income** | ** ** | **Total** | ** ** |
| **Balances,  April 30, 2002**                                        |       | 30,118                |       |                                | 30         |                                 |       |                    | 272,136    |                     |       |       | (78,870    | ) |   |   | (6,358 | ) |   |   | — |   |   | 186,938 |   |
| Issuance of stock  under employee stock plans                        |       | 362                   |       |                                | —     |                                 |       |                    | 776        |                     |       |       | —     |   |   |   | — |   |   |   | — |   |   | 776 |   |
| Adjustment to  deferred compensation for stock option cancellations  |       | —                |       |                                | —     |                                 |       |                    | (2,904     | )                        |       |       | —     |   |   |   | 2,904 |   |   |   | — |   |   | — |   |
| Amortization of  deferred stock compensation                              |       | —                |       |                                | —     |                                 |       |                    | —     |                     |       |       | —     |   |   |   | 3,454 |   |   |   | — |   |   | 3,454 |   |
| Other comprehensive income (loss):                                        |       |                  |       |                                |       |                                 |       |                    |       |                     |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Translation gain  on international operations                             |       | —                |       |                                | —     |                                 |       |                    | —     |                     |       |       | —     |   |   |   | — |   |   |   | $ | 80 |   |   | 80 |   |
| Net loss                                                                  |       | —                |       |                                | —     |                                 |       |                    | —     |                     |       |       | (75,110    | ) |   |   | — |   |   |   | — |   |   | (75,110 | ) |
| Total  comprehensive loss                                                 |       |                  |       |                                |       |                                 |       |                    |       |                     |       |       |       |   |   |   |   |   |   |   |   |   |   | (75,030 | ) |
| **Balances,  April 30, 2003**                                        |       | 30,480                |       |                                | 30         |                                 |       |                    | 270,008    |                     |       |       | (153,980   | ) |   |   | — |   |   |   | 80 |   |   | 116,138 |   |
| Issuance of stock  under employee stock plans                        |       | 2,435                 |       |                                | 3          |                                 |       |                    | 11,052     |                     |       |       | —     |   |   |   | — |   |   |   | — |   |   | 11,055 |   |
| Repurchase of  common stock                                               |       |                  |       |                                |       |                                 |       |                    | (6         | )                        |       |       |       |   |   |   |   |   |   |   |   |   |   | (6 | ) |
| Stock compensation  on modification of options to employees hired by JDSU |       | —                |       |                                | —     |                                 |       |                    | 136        |                     |       |       | —     |   |   |   | — |   |   |   | — |   |   | 136 |   |
| Other comprehensive income (loss):                                        |       |                  |       |                                |       |                                 |       |                    |       |                     |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Translation loss  on international operations                             |       | —                |       |                                | —     |                                 |       |                    | —     |                     |       |       | —     |   |   |   | — |   |   |   | (80 | ) |   | (80 | ) |
| Unrealized loss on  available for sale investment  securities        |       | —                |       |                                | —     |                                 |       |                    | —     |                     |       |       | —     |   |   |   | — |   |   |   | (38 | ) |   | (38 | ) |
| Net income                                                                |       | —                |       |                                | —     |                                 |       |                    | —     |                     |       |       | 8,195      |   |   |   | — |   |   |   | — |   |   | 8,195 |   |
| Total  comprehensive  income                                              |       |                  |       |                                |       |                                 |       |                    |       |                     |       |       |       |   |   |   |   |   |   |   |   |   |   | 8,077 |   |
| **Balances,  April 30, 2004**                                        |       | 32,915                |       |                                | $          | 33                                   |       |                    |       | $                        | 281,190    |       |       |   | $ | (145,785 | ) |   |   | $ | — |   |   |   | $ | (38 | ) |   | $ | 135,400 |   |
| Issuance of stock  under employee stock plans                        |       | 1,600                 |       |                                | 2          |                                 |       |                    | 10,121     |                     |       |       | —     |   |   |   | — |   |   |   | — |   |   | 10,123 |   |
| Repurchase of  common stock                                               |       | (2,517                | )          |                                | (3         | )                                    |       |                    | (19,920    | )                        |       |       | (15,077    | ) |   |   | — |   |   |   | — |   |   | (35,000 | ) |
| Tax benefit from  exercise of stock options                          |       | —                |       |                                | —     |                                 |       |                    | 15,645     |                     |       |       | —     |   |   |   | — |   |   |   | — |   |   | 15,645 |   |
| Other comprehensive  income (loss):                                       |       |                  |       |                                |       |                                 |       |                    |       |                     |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized loss on  available for sale investment  securities        |       | —                |       |                                | —     |                                 |       |                    | —     |                     |       |       | —     |   |   |   | — |   |   |   | (8 | ) |   | (8 | ) |
| Net income                                                                |       | —                |       |                                | —     |                                 |       |                    | —     |                     |       |       | 71,105     |   |   |   | — |   |   |   | — |   |   | 71,105 |   |
| Total  comprehensive  income                                              |       |                  |       |                                |       |                                 |       |                    |       |                     |       |       |       |   |   |   |   |   |   |   |   |   |   | 71,097 |   |
| **Balances,  April 30, 2005**                                        |       | 31,998                |       |                                | $          | 32                                   |       |                    |       | $                        | 287,036    |       |       |   | $ | (89,757 | ) |   |   | $ | — |   |   |   | $ | (46 | ) |   | $ | 197,265 |   |

 

The accompanying notes are an integral part of these consolidated financial statements

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**DITECH COMMUNICATIONS CORPORATIONCONSOLIDATED STATEMENTS OFCASH FLOWS(in thousands)**
| ** **                                                                                          | ** ** | **Years ended April 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash flows from operating activities:                                                               |       |                                     |       |   |   |   |   |
| Net income (loss)                                                                                   |       | $                                        | 71,105     |   | $ | 8,195 |   | $ | (75,110 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |                                     |       |   |   |   |   |
| Loss from discontinued  operations                                                                  |       | 344                                      |       | 6,229 |   | — |   |
| Depreciation and  amortization                                                                      |       | 2,770                                    |       | 2,920 |   | 5,371 |   |
| Increase (decrease) in  provision for doubtful accounts                                             |       | —                                   |       | (250 | ) | 100 |   |
| Loss on disposal of  property and equipment                                                         |       | 192                                      |       | — |   | 61 |   |
| Tax benefit from  exercise of stock options                                                         |       | 15,645                                   |       | — |   | — |   |
| Deferred income taxes                                                                               |       | (51,607                                  | )          | — |   | — |   |
| Amortization of deferred  stock compensation                                                        |       | —                                   |       | — |   | 3,270 |   |
| Impairment of goodwill                                                                              |       | —                                   |       | — |   | 36,837 |   |
| Restructuring costs and  other special charges                                                      |       | —                                   |       | — |   | 8,975 |   |
| Other                                                                                               |       | 203                                      |       | 58 |   | 80 |   |
| Changes in assets and liabilities:                                                                  |       |                                     |       |   |   |   |   |
| Accounts receivable                                                                                 |       | (2,774                                   | )          | (45 | ) | (1,080 | ) |
| Inventories                                                                                         |       | 223                                      |       | 565 |   | (678 | ) |
| Other current assets                                                                                |       | (109                                     | )          | (14 | ) | 451 |   |
| Income taxes                                                                                        |       | (118                                     | )          | (143 | ) | 16,241 |   |
| Accounts payable                                                                                    |       | (88                                      | )          | (200 | ) | (1,377 | ) |
| Accrued expenses and  other                                                                         |       | (402                                     | )          | 1,575 |   | (2,725 | ) |
| Deferred revenue                                                                                    |       | (2,248                                   | )          | 2,329 |   | (2,779 | ) |
| Net cash provided by  (used in) operating activities                                                |       | 33,136                                   |       | 21,219 |   | (12,363 | ) |
| Cash flows from investing activities:                                                               |       |                                     |       |   |   |   |   |
| Purchases of property  and equipment                                                                |       | (3,461                                   | )          | (2,052 | ) | (4,754 | ) |
| Purchase of available  for sale investments                                                         |       | (74,071                                  | )          | (83,050 | ) | (67,650 | ) |
| Sales and maturities of  available for sale investments                                             |       | 59,902                                   |       | 22,897 |   | 91,775 |   |
| Proceeds from sale of  echo software technology and related assets                                  |       | —                                   |       | 3,500 |   | 5,000 |   |
| Collection of note  receivable and related interest                                                 |       | —                                   |       | 834 |   | — |   |
| Proceeds from sale of  discontinued optical business                                                |       | 542                                      |       | 1,793 |   | — |   |
| Additions to other  assets                                                                          |       | —                                   |       | (250 | ) | (73 | ) |
| Net cash provided by  (used in) investing activities                                                |       | (17,088                                  | )          | (56,328 | ) | 24,298 |   |
| Cash flows from financing activities:                                                               |       |                                     |       |   |   |   |   |
| Repurchase of common  stock                                                                         |       | (35,000                                  | )          | (6 | ) | — |   |
| Proceeds from employee  stock plan issuances                                                        |       | 10,123                                   |       | 11,055 |   | 776 |   |
| Net cash provided by  (used in) financing activities                                                |       | (24,877                                  | )          | 11,049 |   | 776 |   |
| Net increase (decrease)  in cash and cash equivalents                                               |       | (8,829                                   | )          | (24,060 | ) | 12,711 |   |
| Cash and cash  equivalents, beginning of year                                                       |       | 45,610                                   |       | 69,670 |   | 56,959 |   |
| Cash and cash equivalents, end of year                                                              |       | $                                        | 36,781     |   | $ | 45,610 |   | $ | 69,670 |   |

 

The accompanying notes are an integral part of these consolidated financial statements

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**DITECH COMMUNICATIONS CORPORATIONNOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**1.   ORGANIZATIONAND NATURE OF BUSINESS**

Ditech CommunicationsCorporation (the “Company” or “Ditech”) designs, develops and marketstelecommunications equipment for use in canceling echo and enhancing voicequality in voice calls over wireline, wireless, satellite and IPtelecommunications networks. The Company has established a direct sales forcethat sells its products in the U.S. and internationally. In addition, theCompany is expanding its use of value added resellers, distributors andoriginal equipment manufacturers in an effort to broaden its sales channels,and this expanded use of value added resellers, distributors and originalequipment manufacturers has occurred primarily in the Company’s internationalmarkets.

**2.   SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

*Principles ofConsolidation and Basis of Presentation*

The consolidated financial statements include theaccounts of the Company and all of its wholly owned subsidiaries. Allsignificant intercompany balances and transactions have been eliminated.

In May 2003, theCompany announced its intention to exit the optical communications portion ofits business. In July 2003, the Company executed a sale of a substantialportion of the assets used in the optical business. As a result, the opticalbusiness has been presented as a discontinued operation in the ConsolidatedStatements of Operations for all periods presented. See Note 4 for afurther discussion of the discontinued operations.

*Reclassifications*

The Company had historically classified auction ratesecurities as cash equivalents if the period between interest rate resets was90 days or less, which was based on the Company’s ability to either liquidateits holdings or roll its investment over to the next reset period. As a resultof re-evaluating the classification of its auction rate securities, the Companyhas reclassified amounts previously classified as cash equivalents toshort-term investments in the consolidated balance sheet as of April 30,2004 and 2003. Such auction rate securities investments are intended to meetthe short-term working capital needs of the Company and, as noted, are highlyliquid investments that the Company can sell or roll over on 28 or 35 day auctioncycles. In addition, the Company has reported gross purchases and sales ofthose auction rate securities investments in the consolidated statements ofcash flows for fiscal 2004 and 2003 to conform to the current period’spresentation.

Thefollowing table summarizes the impact of the auction rate securitiesreclassification for the last three years (in thousands):
| ** **           | ** ** | **Pre-reclassification**                   | ** ** | **Post-reclassification**   | ** ** |
|----------------------|------------|--------------------------------------------|------------|-----------------------------|------------|
| ** **           | ** ** | **Cash & Cash  Equivalents** | ** ** | **Short-term  Investments** | ** ** | **Cash & Cash  Equivalents** | ** ** | **Short-term  Investments** | ** ** |
| April 30,  2004 |       |                                       | $          | 94,785                      |       |   |   | $ | 30,724 |   |   |   | $ | 45,610 |   |   |   | $ | 79,899 |   |   |
| April 30,  2003 |       |                                       | $          | 94,495                      |       |   |   | $ | — |   |   |   | $ | 69,670 |   |   |   | $ | 24,825 |   |   |
| April 30, 2002  |       |                                       | $          | 105,909                     |       |   |   | $ | — |   |   |   | $ | 56,959 |   |   |   | $ | 48,950 |   |   |

 

Inorder to conform to the fiscal 2005 presentation, the Company also changedamounts previously reported for the gross trading activities of its investmentsfor fiscal 2004 and 2003. This reclassification resulted in a net increase incash used in investing activities of $24.4 million in fiscal 2004 and a net 

48

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increase in cash provided by investing activities of$24.1 million in fiscal 2003.  Thefollowing table summarizes the amounts reclassified in gross investment tradingactivities (in thousands):
| ** **                            | ** ** | **Pre-reclassification**                                            | ** ** | **Post-reclassification**                                                             | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **Purchase of Available for  Sale Investments** | ** ** | **Sales and Maturities of  Available for  Sale Investments** | ** ** | **Purchase of Available for  Sale Investments** | ** ** | **Sales and Maturities of  Available for  Sale Investments** | ** ** |
| Year Ended  April 30, 2004  |       |                                                                | $          | (42,975                                                                               | )          |   |   | $ | 7,172 |   |   |   | $ | (83,050 | ) |   |   | $ | 22,897 |   |   |
| Year Ended April 30, 2003   |       |                                                                | $          | —                                                                                |       |   |   | $ | — |   |   |   | $ | (67,650 | ) |   |   | $ | 91,775 |   |   |

 

*Use of Estimates*

The preparation offinancial statements in conformity with generally accepted accountingprinciples in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expenses duringthe reporting period. Actual results could differ from those estimates.

*Revenue Recognition*

The Company generallyrecognizes product revenue, including shipping charges, when: persuasiveevidence of a definitive agreement exists; shipment to the customer hasoccurred; title and all risks and rewards of ownership have passed to thecustomer; acceptance terms, if any have been fulfilled; no significantcontractual obligations remain outstanding; the fee is fixed or determinable;and collection is reasonably assured.

*Cost of Goods Sold*

Cost of goods sold iscomprised primarily of material, labor, overhead, shipping costs, warranty andinventory write-downs.

*Allowance for Doubtful Accounts*

The Company maintains anallowance for doubtful accounts for estimated losses resulting from theinability of its customers to make required payments. The Company evaluates thetrends in customers’ payment patterns, including review of specific delinquentaccounts, changes in business conditions and external communications availableabout customers to estimate the level of allowance that is needed to addresspotential losses that the Company may incur due to the customer’s inability topay. Accounts are considered delinquent, or past due, if they have not beenpaid within the terms provided on the invoice. Delinquent account balances arewritten off after management has determined that the likelihood of collectionis not probable.

*Warranties*

The Company currentlyoffers a hardware warranty on all of its products with terms ranging from twoto five years and a one year software warranty. The warranty generally providesthat the Company will repair or replace any defective product and providesoftware bug fixes within the warranty period. A provision for the estimatedfuture cost of warranty is made at the time product revenue is recognized,based on the Company’s experience and expectations of future conditions.

*Research andDevelopment*

Research and developmentcosts include salaries and salary-related expenses, outside consulting,facilities, consumable materials and allocated corporate costs, which areexpensed as incurred.

49

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*Cash and Cash Equivalents*

The Company considers allhighly liquid investments purchased with an original maturity of three monthsor less to be cash equivalents. Management believes that the financialinstitutions in which it maintains such deposits are financially sound and,accordingly, minimal credit risk exists with respect to these deposits.Substantially all of the Company’s cash and cash equivalents are held by fourmajor U.S. financial institutions.

*Investments*

Investment securities thathave maturities of more than three months at the date of purchase but remainingmaturities of less than one year and auction rate securities, which managementis able to liquidate on 28 or 35 day auction cycles, are considered short-terminvestments. Other investment securities with remaining maturities of one yearor more are considered long-term investments. Short-term and long-terminvestments consist primarily of U.S. Government securities and corporatebonds, as well as, commercial paper, asset backed securities and certificatesof deposit. Management has classified the Company’s short-term and long-terminvestments as available-for-sale securities in the accompanying consolidatedfinancial statements. Available-for-sale securities are carried at fair value,with unrealized gains and losses reported in a separate component ofstockholders’ equity. Realized gains and losses and declines in value judged tobe other-than-temporary, if any, on available-for-sale securities are includedin interest income based on specific identification. Interest on securitiesclassified as available-for-sale is also included in interest income.

*Fair Value of Financial Instruments*

Carrying amounts ofcertain of the Company’s financial instruments, including cash and cashequivalents, accounts receivable, and accounts payable are considered toapproximate fair value based upon comparable market information available atthe respective balance sheet dates.

*Inventories*

Inventories are stated atthe lower of standard cost or market. Standard cost approximates cost asdetermined by using the first-in, first-out (FIFO) method. Appropriateconsideration is given to obsolescence, excessive levels, deterioration andother factors in evaluating net realizable value.

*Property and Equipment*

Propertyand equipment are stated at cost and are depreciated using the straight-linemethod over their estimated useful lives, which differ by asset category:

·       Furniture &fixtures:  5 years

·       Equipment:  2 - 5 years

·       Software:  3 years

·       Leaseholdimprovements:  Shorter of 5 years orremaining lease period

Upon disposal, the assetsand related accumulated depreciation are removed from the Company’s accounts,and the resulting gains or losses are reflected in the statements ofoperations.

*Intangible Assets*

The excess of the costover the fair value of net assets of purchased businesses was recorded asgoodwill and prior to adoption of SFAS 142 was amortized on a straight-linebasis over its estimated useful life, generally five years or less. The cost ofother acquired intangibles was amortized on a straight-line basis over theirestimated useful lives, generally five years or less. Effective May 1,2002, the Company adopted the provisions of SFAS 142, which required theCompany to cease amortization of goodwill and 

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performa transitional impairment analysis of its goodwill and other acquisitionrelated intangible assets as of the date of adoption. See Note 6 for a detaileddiscussion of the consequences of adoption of this standard.

*Long-lived Assets*

The Company periodicallyevaluates the recoverability of its long-lived assets and an impairment loss isrecorded when an asset’s carrying value exceeds its estimated undiscountedfuture cash flows.

*Certain Risks and Concentrations*

The Company’s products areconcentrated in the telecommunications equipment industry, which is highlycompetitive and rapidly changing. Revenue from the Company’s products isconcentrated with a relatively limited number of customers. Two customersaccounted for 49% and 37% of net revenue for fiscal 2005. Three customersaccounted for 37%, 23% and 22% of net revenue during fiscal 2004. Two customersaccounted for 53% and 12% of net revenues for fiscal 2003. Net revenue fromcustomers outside the United States, which were primarily denominated in U.S.dollars, was 9%, 11% and 16% in fiscal 2005, 2004 and 2003, respectively. TheCompany’s gross accounts receivable were concentrated with two customers at April 30,2005 (representing 52% and 20% of receivables) and April 30, 2004(representing 77% and 11% of receivables). The Company performs ongoing creditevaluations of its customers’ financial condition and generally requires nocollateral from its customers. The Company maintains an allowance for doubtfulaccounts receivable based on the expected collectibility of accountsreceivable.

A significant component ofone of the Company’s products is purchased from a sole supplier. If the Companywere unable to obtain the component at prices reasonable to the Company, itwould experience delays in redesigning the product to function with a componentfrom an alternative supplier. The Company relies on one manufacturer for theassembly of the majority of the Company’s products. The Company may experiencedelays if it were to shift production to an alternative supplier.

*Income Taxes*

Income taxes are accountedfor under the liability method. Under this method, deferred income taxes arerecognized for temporary differences and operating loss carryforwards anddeferred tax liabilities are recognized for taxable temporary differences byapplying enacted statutory rates applicable to future years to differencesbetween the financial statement carrying amounts and the tax basis of existingassets and liabilities. The effect on deferred taxes of a change in tax ratesis recognized in income in the period that includes the enactment date. TheCompany establishes valuation allowances on its deferred tax assets when it believesthat it is more likely than not that the deferred tax assets will not berecovered.

*Foreign Currency Translation*

The functional currency ofall of the Company’s current foreign subsidiaries is the U.S. dollar. Translationadjustments resulting from remeasuring the foreign currency denominatedfinancial statements of subsidiaries into the U.S. dollar are included inoperations. The functional currency of the Company’s international opticalresearch offices, which were discontinued in the first quarter of fiscal 2004,was the local currency. Adjustments resulting from translating the foreigncurrency financial statements of those international optical research officeswere included as a separate component of other comprehensive income (loss). Gainsor losses resulting from transactions denominated in currency other than thefunctional currency were recorded in net income (loss). Upon closure of theinternational optical research offices, the cumulative translation adjustmentassociated with those subsidiaries was realized as part of the discontinuedoperations in fiscal 2004.

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*Comprehensive Income (Loss)*

The comprehensive income(loss) for fiscal 2005, 2004 and 2003 was $71,097,000, $8,077,000 and$(75,030,000) and included the impact of foreign currency translationadjustments related to the Company’s international operations, if any, andunrealized gains and losses on available for sale investment securities, net oftax.

*Earnings per Share*

Basic earnings per shareis calculated based on the weighted average number of shares of common stockoutstanding during the period less shares subject to repurchase, which areconsidered contingently issuable shares. Diluted earnings per share iscalculated based on the weighted average number of shares of common stock andcommon stock equivalents outstanding, including the dilutive effect of stockoptions, using the treasury stock method and common stock subject torepurchase. Diluted loss per share for fiscal 2003 is calculated excluding theeffects of all common stock equivalents, as their effect would beanti-dilutive.

Areconciliation of the numerator and denominator used in the calculation of thehistorical basic and diluted net income (loss) per share follows (in thousands,except per share amounts):
| ** **                                                                              | ** ** | **Years Ended April 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| Historical net income (loss):                                                           |       |                                     |       |   |   |   |   |
| Income (loss) from  continuing operations before cumulative effect of accounting change |       | $                                        | 70,901     |   | $ | 17,731 |   | $ | (4,025 | ) |
| Income (loss) from  discontinued operations                                             |       | 204                                      |       | (9,536 | ) | (34,248 | ) |
| Cumulative effect of  accounting change                                                 |       | —                                   |       | — |   | (36,837 | ) |
| Net income (loss)                                                                       |       | $                                        | 71,105     |   | $ | 8,195 |   | $ | (75,110 | ) |
| Basic income (loss) per share:                                                          |       |                                     |       |   |   |   |   |
| Weighted average shares  of common stock outstanding                                    |       | 33,410                                   |       | 31,737 |   | 30,390 |   |
| Less stock subject to repurchase                                                        |       | (2                                       | )          | (3 | ) | (19 | ) |
| Shares used in  calculation of basic per share numbers                                  |       | 33,408                                   |       | 31,734 |   | 30,371 |   |
| Income (loss) from  continuing operations before cumulative effect of accounting change |       | $                                        | 2.12       |   | $ | 0.56 |   | $ | (0.13 | ) |
| Income (loss) from  discontinued operations                                             |       | 0.01                                     |       | (0.30 | ) | (1.13 | ) |
| Cumulative effect of  accounting change                                                 |       | —                                   |       | — |   | (1.21 | ) |
| Net income (loss) per  share                                                            |       | $                                        | 2.13       |   | $ | 0.26 |   | $ | (2.47 | ) |
| Diluted income (loss) per share:                                                        |       |                                     |       |   |   |   |   |
| Shares used in  calculation of basic per share numbers                                  |       | 33,408                                   |       | 31,734 |   | 30,371 |   |
| Shares subject to  repurchase                                                           |       | 2                                        |       | 3 |   | — |   |
| Dilutive effect of stock  plans                                                         |       | 1,730                                    |       | 1,759 |   | — |   |
| Shares used in  calculation of diluted per share numbers                                |       | 35,140                                   |       | 33,496 |   | 30,371 |   |
| Income (loss) from  continuing operations before cumulative effect of accounting change |       | $                                        | 2.02       |   | $ | 0.53 |   | $ | (0.13 | ) |
| Loss from discontinued  operations                                                      |       | —                                   |       | (0.29 | ) | (1.13 | ) |
| Cumulative effect of  accounting change                                                 |       | —                                   |       | — |   | (1.21 | ) |
| Net income (loss) per share                                                             |       | $                                        | 2.02       |   | $ | 0.24 |   | $ | (2.47 | ) |

 

The computation of dilutednet income (loss) per share excluded the following number of options, as theireffect was anti-dilutive: 179,000 shares in fiscal 2005, 325,000 shares infiscal 2004 and 6,576,000 shares in fiscal 2003.

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*Accounting forStock-Based Compensation*

Statement of Financial Accounting Standards No. 123,“Accounting for Stock-based Compensation,” (“SFAS 123”), encourages, butdoes not require, companies to record compensation cost for stock-basedcompensation plans at fair value. The Company accounts for grants of equityinstruments to employees using the intrinsic value method described inAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees” and complies with the disclosure provisions of SFAS 123.Accordingly, compensation cost for stock options is measured as the excess, ifany, of the quoted market price of the Company’s stock at the date of the grantover the amount an employee must pay to acquire the stock and is recognizedover the vesting period of the related shares.

The Company recorded deferred stock compensationassociated with its fiscal 2000 and 2001acquisitions. Prior to the sale of theecho cancellation software technology, the deferred stock compensationassociated with the fiscal 2000 acquisition was amortized to research anddevelopment expense over the vesting period of the options (see Note 10).As the deferred stock compensation related to the fiscal 2001 acquisition wassolely attributable to the Company’s optical business, it has been reflected inthe loss from discontinued operations for fiscal 2003. There was noamortization expense for either of these acquisitions in fiscal 2004 or 2005,as the deferred amounts had been fully amortized by the end of fiscal 2003. Amortizationexpense related to the fiscal 2000 and 2001 acquisitions totaled$3.1 million in fiscal 2003.

TheCompany applies Accounting Principles Board Opinion No. 25 and relatedInterpretations in accounting for its stock option plans. If compensation costfor the Company’s stock option plan had been determined based on the fair valueat the grant dates for awards under those plans consistent with the method ofSFAS 123, the Company’s net income (loss) for the years ended April 30,2005, 2004 and 2003 would have been adjusted to the pro forma amounts indicatedin the following table (in thousands, except per share amounts):
| ** **                                                                                                              | ** ** | **April 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                              | ** ** | **2005**           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss)  as reported                                                                                          |       | $                  | 71,105     |   | $ | 8,195 |   | $ | (75,110 | ) |
| Add: Stock-based  compensation expense included in reported net income (loss), net of  applicable tax effects           |       | —             |       | — |   | 3,230 |   |
| Deduct:  Stock-based compensation determined under the fair value method for all stock  awards, net of applicable taxes |       | (8,089             | )          | (9,362 | ) | (13,308 | ) |
| Pro forma net income (loss)                                                                                             |       | $                  | 63,016     |   | $ | (1,167 | ) | $ | (85,188 | ) |
| Diluted net income (loss) attributable to common  stockholders  per share:                                              |       |               |       |   |   |   |   |
| As reported                                                                                                             |       | $                  | 2.02       |   | $ | 0.24 |   | $ | (2.47 | ) |
| Pro forma                                                                                                               |       | $                  | 1.79       |   | $ | (0.03 | ) | $ | (2.80 | ) |

 

*Recent AccountingPronouncements*

In March 2004, the Financial Accounting StandardsBoard (FASB) approved the consensus reached on the Emerging Issues TaskForce (EITF) Issue No. 03-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments.” EITF 03-1 providesguidance for identifying impaired investments and new disclosure requirementsfor investments that are deemed to be temporarily impaired. On September 30,2004, the FASB issued a final staff position (FSP) EITF Issue 03-1-1that delays the effective date for the measurement and recognition guidanceincluded in paragraphs 10 through 20 of EITF 03-1. Quantitative andqualitative disclosures required by EITF 03-1 remain unchanged by the 

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staff position. TheCompany does not believe the impact of adoption of the measurement provisionsof the EITF will be significant to its overall results of operations orfinancial position.

In November 2004, the FASB issued Statement ofFinancial Accounting Standards (SFAS) No. 151,*Inventory Costs*, which clarifies the accounting forabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial. SFAS No. 151 will be effective for inventory costs incurredduring fiscal years beginning after June 15, 2005. The Company does notbelieve the adoption of SFAS No. 151 will have a material impact on itsfinancial statements.

In December 2004, theFinancial Accounting Standards Board (FASB) issued Statement No. 123R, “Share-BasedPayment” (SFAS 123R), which requires companies to measure and recognizecompensation expense for all stock-based payments at fair value. SFAS 123R iseffective for the first annual reporting period beginning after June 15,2005 and, thus, will be effective for the Company beginning fiscal 2007. TheCompany is currently evaluating the impact of SFAS 123R on its financialposition and results of operations. See “Accounting for Stock-BasedCompensation” for information related to the pro forma effects on the Company’sreported net income (loss) and net income (loss) per share of applying the fairvalue recognition provisions of the previous Statement of Financial AccountingStandards (SFAS) 123, “Accounting for Stock-Based Compensation,” to stock-basedemployee compensation.

**3.**   BALANCESHEET ACCOUNTS

Inventories:   Inventoriescomprised (in thousands):
| ** **       | ** ** | **April 30,** | ** ** |
|------------------|------------|--------------------|------------|
| ** **       | ** ** | **2005**           | ** ** | **2004** | ** ** |
| Raw materials    |       | $                  | 667        |   | $ | 1,527 |   |
| Work in progress |       | 72                 |       | 46 |   |
| Finished goods   |       | 4,993              |       | 4,382 |   |
| Total            |       | $                  | 5,732      |   | $ | 5,955 |   |

 

During the third quarter of fiscal 2002, the Companyrecorded an inventory write-down, including purchase commitments, totaling$3.5 million related to additional excess inventory for one of its echocancellation products, the OC-3. This write-down was due to a sudden andsignificant decline in the forecasted demand from the Company’s primarycustomer for the product during that quarter, and was calculated in accordancewith the Company’s policy. Due to stronger than anticipated demand for OC-3product in the latter part of fiscal 2003, the Company benefited from the saleof previously written-down OC-3 inventory with an original cost of$2.2 million in fiscal 2004 and $455,000 in fiscal 2003 but no carryingvalue. In fiscal 2005, the Company sold $911,000 of previously written-downQuad and BVP inventory.

Investments:   Thefollowing table summarizes the  Company’sinvestments as of April 30, 2005 (in thousands):
| ** **                   | ** ** | **Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | ** Fair Value ** | ** ** |
|------------------------------|------------|----------|------------|----------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| U.S. government  obligations |       | $        | 8,337      |                             |       | $                                 | —     |                            |       |   | $ | (25 | ) |   |   | $ | 8,312 |   |   |
| Corporate notes              |       | 55,255   |       |                             | —     |                              |       |                            | (17        | ) |   |   | 55,238 |   |   |
| Asset backed  securities     |       | 29,694   |       |                             | —     |                              |       |                            | (4         | ) |   |   | 29,690 |   |   |
| Commercial paper             |       | —   |       |                             | —     |                              |       |                            | —     |   |   |   | — |   |   |
| Certificates of  deposit     |       | 5,613    |       |                             | —     |                              |       |                            | —     |   |   |   | 5,613 |   |   |
| Total                        |       | $        | 98,899     |                             |       | $                                 | —     |                            |       |   | $ | (46 | ) |   |   | $ | 98,853 |   |   |

 

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Thefollowing table summarizes the Company’s investments as of April 30, 2004(in thousands):
| ** **                   | ** ** | **Cost** | ** ** | **Gross Unrealized  Gains** | ** ** | **Gross Unrealized  Losses** | ** ** | ** Fair Value ** | ** ** |
|------------------------------|------------|----------|------------|----------------------------------|------------|-----------------------------------|------------|---------------------------------|------------|
| U.S. government  obligations |       | $        | 10,806     |                             |       | $                                 | 2          |                            |       |   | $ | (12 | ) |   |   | $ | 10,796 |   |   |
| Corporate notes              |       | 40,311   |       |                             | —     |                              |       |                            | (26        | ) |   |   | 40,285 |   |   |
| Asset backed  securities     |       | 26,550   |       |                             | 1          |                              |       |                            | (3         | ) |   |   | 26,548 |   |   |
| Commercial paper             |       | 2,997    |       |                             | —     |                              |       |                            | —     |   |   |   | 2,997 |   |   |
| Certificates of  deposit     |       | 4,269    |       |                             | —     |                              |       |                            | —     |   |   |   | 4,269 |   |   |
| Total                        |       | $        | 84,933     |                             |       | $                                 | 3          |                            |       |   | $ | (41 | ) |   |   | $ | 84,895 |   |   |

 

Included in corporate notes and asset backed securitiesare $71.9 million and $49.2 million of auction rate securities at April 30,2005 and 2004, respectively. For the years ended April 30, 2005 and 2004,no gains or losses were realized on the sale of short-term and long-terminvestments as the Company has not sold investments prior to their maturitydates. As of April 30, 2005 and 2004, net unrealized holding losses of$46,000 and $38,000 were included in other comprehensive income in theaccompanying Consolidated Balance Sheets, net of any related tax effect.

Thefollowing table summarizes the maturities of the Company’s investments as of April 30,2005 (in thousands):
| ** **          | ** ** | **Cost** | ** ** | ** Fair Value ** | ** ** |
|---------------------|------------|----------|------------|---------------------------------|------------|
| Less than one  year |       | $        | 98,899     |                            |       | $ | 98,853 |   |   |
| Due in 1-2 years    |       | —   |       |                            | —     |   |   |
| Total               |       | $        | 98,899     |                            |       | $ | 98,853 |   |   |

 

Thefollowing table summarizes the maturities of the Company’s investments as of April 30,2004 (in thousands):
| ** **          | ** ** | **Cost** | ** ** | ** Fair Value ** | ** ** |
|---------------------|------------|----------|------------|---------------------------------|------------|
| Less than one  year |       | $        | 79,927     |                            |       | $ | 79,899 |   |   |
| Due in 1-2 years    |       | 5,006    |       |                            | 4,996      |   |   |
| Total               |       | $        | 84,933     |                            |       | $ | 84,895 |   |   |

 

Auction rate securities are included in the less thanone year category as they are intended to meet the short-term working capitalneeds of the Company and the Company can sell or roll them over on 28 or 35 dayauction cycles.

Propertyand Equipment:   Property and equipment comprised (in thousands):
| ** **                                       | ** ** | **April 30,** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|
| ** **                                       | ** ** | **2005**           | ** ** | **2004** | ** ** |
| Furniture and  fixtures                          |       | $                  | 1,625      |   | $ | 1,600 |   |
| Equipment                                        |       | 10,948             |       | 8,076 |   |
| Leasehold  improvements                          |       | 1,173              |       | 1,061 |   |
| Computer software                                |       | 3,205              |       | 2,788 |   |
|                                             |       | 16,950             |       | 13,525 |   |
| Less: accumulated  depreciation and amortization |       | (12,013            | )          | (9,922 | ) |
| Total                                            |       | $                  | 4,937      |   | $ | 3,603 |   |

 

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Acquiredamortized intangible assets, which are included as a component of Other Assets,comprised (in thousands):
| ** **        | ** ** | **April 30, 2005**       | ** ** |
|-------------------|------------|------------------------------------|------------|
| ** **        | ** ** | **Gross Carrying Value** | ** ** | **Accumulated Amortization** | ** ** |
| Software licenses |       |                               | $          | 3,199 |   |   |   | $ | (2,458 | ) |   |
|                   |            |                                    |            |  |  |  |  |  |  |  |  |

 
| ** **        | ** ** | **April 30, 2004**       | ** ** |
|-------------------|------------|------------------------------------|------------|
| ** **        | ** ** | **Gross Carrying Value** | ** ** | **Accumulated Amortization** | ** ** |
| Software licenses |       |                               | $          | 3,199 |   |   |   | $ | (1,621 | ) |   |
|                   |            |                                    |            |  |  |  |  |  |  |  |  |

 

The optical intangible assets net book value as of July 2003of $217,000 was recorded as a loss on disposal in the Consolidated Statement ofOperations after the optical business was discontinued in fiscal 2004.

Amortization expense related to these assets was$838,000, $865,000 and $1.0 million, respectively, in fiscal 2005, 2004 and2003.

The remaining book value of software licenses of$741,000 is expected to be fully amortized in fiscal 2006.

AccruedExpenses:   Accrued expenses comprised (in thousands):
| ** **                     | ** ** | **April 30,** | ** ** |
|--------------------------------|------------|--------------------|------------|
| ** **                     | ** ** | **2005**           | ** ** | **2004** | ** ** |
| Accrued employee  related      |       | $                  | 3,831      |   | $ | 3,883 |   |
| Accrued warranty               |       | 2,010              |       | 1,980 |   |
| Accrued  restructuring charges |       | 228                |       | 1,064 |   |
| Accrued  professional services |       | 561                |       | 217 |   |
| Other accrued expenses         |       | 1,875              |       | 1,741 |   |
| Total                          |       | $                  | 8,505      |   | $ | 8,885 |   |

 

*Warranties  *TheCompany provides for future warranty costs upon shipment of its products. Thespecific terms and conditions of those warranties may vary depending on theproduct sold, the customer and the country in which it does business. However,the Company’s hardware warranties generally start from the shipment date andcontinue for a period of two to five years while the software warranty isgenerally one year. As part of the sale of the Company’s optical business toJDS Uniphase (“JDSU”), see Note 4, the Company has retained its warrantyobligations for optical products sold by the Company prior to July 16,2003.

Because the Company’s products are manufactured to astandardized specification and products are internally tested to thesespecifications prior to shipment, the Company historically has experiencedminimal warranty costs. Factors that affect the Company’s warranty liabilityinclude the number of installed units, historical experience and management’sjudgment regarding anticipated rates of warranty claims and cost per claim. TheCompany assesses the adequacy of its recorded warranty liabilities everyquarter and makes adjustments to the liability, if necessary.

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Changesin the warranty liability, which is included as a component of “Accruedexpenses” on the Consolidated Balance Sheet, were as follows (in thousands):
| ** **                                                                                                             | ** ** | **Year ended April 30,**                              | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** |
| Balance as of the  beginning of the fiscal period                                                                      |       |                                                                 | $          | 1,980 |   |   |   | $ | 1,588 |   |   |
| Provision for  warranties issued during fiscal period                                                                  |       |                                                                 | 515        |   |   |   | 898 |   |   |
| Warranty costs  incurred during fiscal period                                                                          |       |                                                                 | (459       | ) |   |   | (526 | ) |   |
| Other adjustments  to the liability (including changes in estimates for pre-existing warranties)  during fiscal period |       |                                                                 | (26        | ) |   |   | 20 |   |   |
| Balance as of the  end of the fiscal period                                                                            |       |                                                                 | $          | 2,010 |   |   |   | $ | 1,980 |   |   |

 

*Guarantees and Indemnifications.  *Asis customary in the Company’s industry, and as required by law in the U.S. andcertain other jurisdictions, certain of the Company’s contracts provideremedies to its customers, such as defense, settlement, or payment of judgmentfor intellectual property claims related to the use of the Company’s products.From time to time, the Company indemnifies customers against combinations oflosses, expenses, or liabilities arising from various trigger events related tothe sale and the use of the Company’s products and services. In addition, fromtime to time the Company also provides protection to customers against claimsrelated to undiscovered liabilities, additional product liability orenvironmental obligations. In the Company’s experience, claims made under suchindemnifications are rare.

In connection with the sale of the Company’s echocancellation software technology to Texas Instruments in April 2002 andthe sale of the Company’s optical business to JDSU in July 2003, theCompany indemnified Texas Instruments and JDSU for various matters. In April 2004,the indemnifications to Texas Instruments lapsed without a material cost to theCompany. The Company believes the estimated fair value of the indemnificationsmade to JDSU will not have a material affect on future operations.

As permitted or required under Delaware law and to themaximum extent allowable under that law, the Company has certain obligations toindemnify its current and former officers and directors for certain events oroccurrences while the officer or director is, or was serving at the Company’srequest in such capacity. These indemnification obligations are valid as longas the director or officer acted in good faith and in a manner that a personreasonably believed to be in or not opposed to the best interests of theCompany, and, with respect to any criminal action or proceeding, had noreasonable cause to believe his or her conduct was unlawful. The maximumpotential amount of future payments the Company could be required to make underthese indemnification obligations is unlimited; however, the Company has adirector and officer insurance policy that limits the Company’s exposure andenables the Company to recover a portion of any future amounts paid. As aresult of the Company’s insurance policy coverage, the Company believes theestimated fair value of these indemnification obligations is minimal.

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**4.   DISCONTINUED OPERATIONS**

On July 16, 2003, the Company completed theprimary step in the planned exit of its optical communications business throughthe sale of a large portion of the assets of its optical communicationsbusiness to JDSU, pursuant to an Asset Purchase Agreement (the “PurchaseAgreement”). The assets sold consisted primarily of inventory, certainspecified optical-related equipment and intellectual property rights, whichwere sold for an aggregate purchase price of up to approximately $6.5 millionin cash, of which (i) approximately $1.4 million was paid to theCompany at closing, (ii) $225,000 to be paid to the Company one year fromthe closing (subject to reduction in the event any successful indemnificationclaims are made against the Company), and (iii) up to an additional$4.9 million to be paid to the Company, which is comprised of up to$900,000 based on the level of inventory consumed by JDSU, and up to$4.0 million based on revenues generated by the optical business acquiredby JDSU through June 30, 2005, if any. Additionally, JDSU had the right torequire the Company to reimburse JDSU for any purchased but unused inventory atJune 30, 2004, up to $2.0 million, which right expired as of July 31,2004. JDSU also has indemnification rights in connection with the performanceof certain warranty obligations relating to optical products that were sold bythe Company on or prior to July 16, 2003. The Company and JDSU arecurrently evaluating the remaining obligations of each party. However, theCompany does not expect that the outcome of these discussions will have amaterial affect on its financial statements. During fiscal 2004, the Companyrecognized $855,000 associated with the level of revenue generated by JDSUsince the close of the sale and a $144,000 tax benefit associated with theyear-to-date loss from disposal, which benefit offset the domestic taxprovision recognized from continuing operations. The incremental sales proceedsand the tax benefit were offset by incremental loss accruals associated withclosure of the Company’s international optical operations and an estimated lossprovision associated with its indemnification of inventory purchased by JDSUwhich aggregated $1.1 million. The net effect of these items was reportedas an incremental net loss on disposal of discontinued operations in theConsolidated Statement of Operations. The gain (loss) on disposition in fiscal2005 was due to adjustments needed to reflect actual costs incurred andincluded a $110,000 income tax benefit related to the reversal of a valuationreserve on deferred tax assets.

Subsequent to the sale to JDSU, the Companyaggressively pursued the disposition, through sale, sublease or abandonment, ofassets not included in the Purchase Agreement and the facility leases for theCompany’s Australian and United Kingdom optical research facilities. As of April 30,2005, the Company had disposed of all optical assets not acquired by JDSU andhad negotiated out of the leases for the Australian and United Kingdom opticalresearch facilities. As a result of exiting the optical business, the Company’sConsolidated Statements of Operations reflect the optical business as adiscontinued operation for all periods presented.

Certaininformation with respect to the discontinued optical communications business’operations is summarized below (in thousands):
| ** **                             | ** ** | **Year ended April 30,** | ** ** |
|----------------------------------------|------------|-----------------------------------------|------------|
| ** **                             | ** ** | **2004**                                | ** ** | **2003** | ** ** |
| Revenue                                |       | 1,656                                   |       | 12,286 |   |
| Gross profit  (loss)                   |       | 269                                     |       | (180 | ) |
| Operating  expenses                    |       | 2,807                                   |       | 33,939 |   |
| Operating loss                         |       | (2,538                                  | )          | (34,119 | ) |
| Income tax  provision                  |       | —                                  |       | 129 |   |
| Net loss from  discontinued operations |       | (2,538                                  | )          | (34,248 | ) |

 

The results of the optical business for the year endedApril 30, 2003 include a restructuring charge and loss associated withimpaired assets of $6.8 million related to the discontinuation of theCompany’s optical system level product. This charge was included in the opticalbusiness’ operating expenses. In addition, the 

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Company recognized aninventory write-down of $4.2 million related to the optical product, whichwrite-down was included in cost of goods sold and resulted in a negative grossmargin in fiscal 2003.

Thefollowing table shows the components of the gain (loss) from the disposal ofthe Company’s discontinued operations (in thousands):
| ** **                                   | ** ** | **Year ended April 30,**                  | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                   | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| Proceeds from  sale                          |       |                                                     | $          | (55 | ) |   |   | 2,926 |   |   |
| Less: Net book  value of assets sold         |       |                                                     | —     |   |   |   | 4,671 |   |   |
| Transaction costs                            |       |                                                     | (68        | ) |   |   | 221 |   |   |
| Gain (loss) on  sale                         |       |                                                     | 13         |   |   |   | (1,966 | ) |   |
| Costs to exit  remainder of optical business |       |                                                     | (81        | ) |   |   | 5,176 |   |   |
| Income (loss) on  disposition                |       |                                                     | 94         |   |   |   | (7,142 | ) |   |
| Income tax  benefit                          |       |                                                     | (110       | ) |   |   | (144 | ) |   |
| Net income (loss) on  disposition            |       |                                                     | 204        |   |   |   | (6,998 | ) |   |

 

The costs of exiting theoptical business in fiscal 2004 included severance and related costs foroptical employees not hired by JDSU of $1.6 million, impairment of opticalassets not acquired by JDSU of $2.6 million, other exit costs associatedwith closure of international optical subsidiaries of $530,000 and lossesassociated with abandonment of facility leases related to the Company’s UK andAustralian optical development operations of $497,000. The income ondisposition in fiscal 2005 was due to adjustments needed to reflect actualcosts incurred and included a $110,000 income tax benefit related to thereversal of a valuation reserve on deferred tax assets. As of April 30,2005, the Company has resolved all loss contingencies related to closing theoptical business with the exception of certain matters related to the closureof one of the Company’s international optical operations, for which the Companyhas accrued $228,000. The Company expects to resolve this matter within thenext fiscal year.

**5.   RESTRUCTURINGAND OTHER SPECIAL CHARGES**

As a result of the Company’s decision to exit theoptical communications business in the first quarter of fiscal 2004, theCompany incurred certain restructuring charges associated with general coststhat did not qualify for discontinued operations treatment. The restructuringwas designed to reduce the level of certain general costs that were deemedexcess as a result of the Company’s decision to exit its optical business andincluded a loss reserve for excess leased space in the Company’s Mountain View,California headquarters and severance of certain corporate level employees.

As a result of this restructuring, the Companyrecorded restructuring charges of $275,000, which have been classified asoperating expenses. The following paragraphs provide detailed information oneach of the components of the restructuring charges, which were recorded in thefirst quarter of fiscal 2004.

*Workforce Reduction.  *Therestructuring resulted in the termination of two employees whose focus wasprimarily corporate in nature. The workforce reductions were substantiallycompleted in the first quarter of fiscal 2004. The Company recorded a workforcereduction charge of approximately $21,000 relating to severance pay andcontinuation of certain fringe benefits for the impacted employees.

*Lease Loss Provision.  *TheCompany initially recorded a $995,000 restructuring charge associated with theabandonment of excess leased space in its Mountain View headquarters. Thecharge was based on the monthly rental and related costs on the abandoned spaceof approximately 11,000 square feet less the anticipated sublease income thatthe Company hoped to derive from the space based on current market conditionsin the Mountain View area and impairment of leasehold improvements associatedwith the abandoned space. In March 2004, the then remaining portion of theloss provision for the building of $741,000 was reversed back through therestructuring charge line, when the Company made the decision to 

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begin using the spaceagain. The reversal was predicated on the significant changes that had occurredin the Company’s business since the first quarter of fiscal 2004 when theoriginal decision was made to abandon the space. At the time of the originalprovision, the Company was projecting what it viewed as good (20%) revenuegrowth during fiscal 2004, based on the Company’s client base and the overallstate of the telecommunications industry. However, with fiscal 2004 revenuegrowth approximating almost 100% growth over fiscal 2003, almost five times theCompany’s plan at the beginning of the year and an expectation that the Companywould see modest growth again in fiscal 2005, coupled with incremental hiringrequirements to begin development of the Company’s next generation voiceproducts, the headcount and therefore space demands far exceeded the Company’sexpectations. As a result, fiscal 2004 reflects a net loss provision of$254,000 related to the Company’s facility lease.

As of the end of April 2004,all of the costs associated with the severance and related benefits and thelease costs while the facility was abandoned had been paid.

**6.   ACCOUNTING FOR GOODWILL**

Thechanges in the carrying amount of goodwill for the year ended April 30,2003 are as follows (in thousands):
| Balance as of  May 1, 2002                           |   | $       | 35,998 |   |
|-----------------------------------------------------------|--------|---------|--------|--------|
| Reclassification  of acquisition related intangible asset |   | 839     |   |
| Cumulative effect  of accounting change                   |   | (36,837 | )      |
| Balance as of  April 30, 2003                        |   | $       | — |   |

 

The reclassification of the acquisition relatedintangible asset primarily relates to the net book value of the workforce intangible,as it no longer met the definition of a discrete intangible asset under theprovisions of SFAS 142. This reclassification was made as part of theCompany’s adoption of SFAS 142.

The Company performed atransitional impairment test of its goodwill and intangible assets as of May 1,2002. Due to the continuing soft telecommunications market and the depressedvalues of telecommunications equipment provider stocks, the Company recorded atransitional goodwill impairment loss of $36.8 million which was recordedas a cumulative effect of an accounting change in the Company’s ConsolidatedStatement of Operations for the first quarter of fiscal 2003. The fair value ofthe optical reporting unit giving rise to the transitional impairment loss wasestimated using a combination of the expected present value of future cashflows and a market value approach.

**7.   COMMITMENTS AND CONTINGENCIES**

*Leases*

The Company leases its principal office facilities inMountain View, California under a non-cancelable operating lease expiring in June 2006.The Company is responsible for taxes, insurance and maintenance expensesrelated to the leased facilities. Presently, there is no option for renewal ofthe lease on the Company’s Mountain View facilities. The Company also hasoperating leases on certain office equipment.

At April 30,2005, future minimum payments under the leases are as follows (in thousands):
| ** ** | ** ** | **Years ended April 30,** | ** ** |
|------------|------------|------------------------------------------|------------|
| 2006       |       |                                     | $          | 2,013 |   |   |
| 2007       |       |                                     | 374        |   |   |
| 2008       |       |                                     | 34         |   |   |
|       |       |                                     | $          | 2,421 |   |   |

 

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Rent expense under allleases for the years ended April 30, 2005, 2004 and 2003, was $2,268,000,$2,311,000 and $2,752,000, respectively. Included in these rent amounts was$71,000 and $255,000 in fiscal 2004 and 2003, respectively, which was relatedto rent at the Company’s international optical operations and has beenreflected in discontinued operations and $254,000 in fiscal 2004 which isincluded in the restructuring charge.

*Credit Facility*

Effective August 25,2004, the Company renewed its $2.0 million operating line of creditagreement with its bank. The renewed line of credit expires on July 31,2005. Advances under the line bear interest at the rate of prime plus 0.25%.The credit facility is collateralized by the Company’s current and futureaccounts receivable and inventory. The credit facility provides for certainfinancial covenants, including but not limited to: minimum tangible net worthof $75 million plus 50% of all proceeds from the sale of subordinated debtor equity securities subsequent to August 7, 2002; and minimum unrestrictedcash of at least $20 million. The facility also restricts the payment ofdividends and limits the Company’s ability to dispose of all or substantiallyall of its assets or to merge with another company. As of April 30, 2005,the Company had no borrowings outstanding under the line of credit.

*Legal Proceedings*

On June 14, 2005, a lawsuit entitled *Richard E. Jaffe v. Ditech Communications Corp.,Timothy K. Montgomery and William J. Tamblyn,*Case No. C 0502406 was filed in the United States District Court for the Northern Districtof California, purportedly on behalf of a class of investors who purchasedDitech’s stock between August 25, 2004 and May 26, 2005. Thecomplaint alleges claims under Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934 against the Company and its Chief ExecutiveOfficer and Chief Financial Officer. The Company expects that several similarlawsuits will subsequently be filed in the same court, and that all of thecases will be consolidated into a single action. This matter is at an earlystage; no lead plaintiff has been selected, no response to the complaint hasbeen filed, no discovery has taken place and no trial date has been set. TheCompany and the individual defendants intend to take all appropriate actions todefend the suit.

On June 20, 2005, a shareholder’s derivativecomplaint, entitled *Kerlin v. Montgomery, etal.,* Case No 105CV043429, was filed in the CaliforniaSuperior Court for the County of Santa Clara. The complaint is purportedlybrought derivatively by a shareholder on behalf of the Company against severalexecutives of the Company and all members of its board of directors, and namesthe Company as a nominal defendant. The plaintiff alleges that the defendantsbreached their fiduciary duties to the Company in connection with allegedmisrepresentations concerning VQA orders and the potential effect on theCompany of the merger between Sprint and Nextel, that certain of the defendantsimproperly sold the Company stock while in possession of material nonpublicinformation, and that the defendants are liable to the Company for damages as aresult thereof. The defendants intend to take all appropriate action inconnection with the defense of the litigation.

The Company cannot predictthe outcome of the lawsuits.

**8.   SALEOF ECHO CANCELLATION TECHNOLOGY**

On April 16, 2002,the Company sold its echo cancellation and voice enhancement softwaretechnology, the associated product licenses and all of the related assets to TIfor an aggregate price of $26.8 million. Of the total price,$18.3 million was paid in cash on the closing, $5 million wasreceived in April 2003 on the first anniversary of the closing date andthe balance of $3.5 million was collected in April 2004. Concurrentwith the closing of the sale, all of the individuals employed in the echocancellation software group, including those individuals assumed as part of theTelinnovation acquisition in 

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February 2000,were hired by Texas Instruments. Additionally, in connection with the sale,Ditech received, at no cost, a license from Texas Instruments and TelogyNetworks, Inc., a wholly owned subsidiary of Texas Instruments, to use theexisting echo cancellation and voice enhancement software and any enhancementsin Ditech’s products for a period of four years. A value of $3.0 millionwas assigned to this four year license period, which value is being amortizedto cost of goods sold over the four year term. After this initial four yearperiod expires, Ditech can license the software technology on a per unit royaltyformula based on the most favorable rates offered by Texas Instruments to othercustomers.

**9.   PREFERRED STOCK**

Ditech is authorized to issue, from time to time, inone or more series, 5,000,000 shares of preferred stock at a $0.001 par value.The Board of Directors may determine the rights, preferences, privileges andrestrictions granted or imposed upon any series of preferred stock. As of April 30,2005, no preferred stock was outstanding.

In March 2001, theCompany’s Board of Directors adopted a Preferred Share Purchase Rights Plandesigned to enable Ditech stockholders to realize the full value of theirinvestment and to provide for fair and equal treatment for all Ditechstockholders in the event that an unsolicited attempt is made to acquireDitech. Under the Plan, stockholders will receive one right to purchaseone-thousandth of a share of newly designated Series A JuniorParticipating Preferred Stock of Ditech at an initial exercise price of $75.00for each outstanding share of Ditech common stock held at the close of businesson April 16, 2001. The rights expire on March 25, 2011.

**10.   STOCKHOLDERS’ EQUITY**

*Employee StockPurchase Plan*

In March and April 1999,the Board adopted, and the stockholders approved, the Company’s 1999 EmployeeStock Purchase Plan (the “Purchase Plan”) under which an aggregate of1,416,666 shares of common stock has been reserved as of April 30,2005. Employees who participate in an offering period can have up to 10% oftheir earnings withheld pursuant to the Purchase Plan. The amount withheld willthen be used to purchase shares of the common stock on specified datesdetermined by the Board. The price of common stock purchased under the PurchasePlan will be equal to 85% of the lower of the fair market value of the commonstock on the commencement date of each offering period or on the specifiedpurchase date. In fiscal 2005, 2004 and 2003, shares purchased under the plantotaled 65,602, 175,310 and 332,048 shares, respectively. As of April 30,2005, 359,383 shares remain available for issuance under the Purchase Plan.

*Stock Option Plans*

The Company’s 1997 Stock Option Plan serves as thesuccessor equity incentive program to the Company’s 1987 Stock Option Plan andthe Supplemental Stock Option Plan (the “Predecessor Plans”). All outstandingstock options under the Predecessor Plans continue to be governed by the termsand conditions of the 1997 Stock Option Plan. The Company reserved4,000,000 shares of common stock for issuance under the 1997 Stock OptionPlan. Under the 1997 Stock Option Plan, the Board of Directors could grantincentive or non-statutory stock options at a price not less than 100% or 85%,respectively, of fair market value of common stock, as determined by the Boardof Directors, at grant date. In November 1998, the Company adopted its1998 Stock Option Plan and determined not to grant any further options underits 1997 Stock Option Plan. The Company has reserved a total of4,856,082 shares of common stock for issuance under the 1998 Stock OptionPlan, under terms similar to those of the 1997 Stock Option Plan. During fiscal2000, the Company adopted two non-statutory stock option plans under which atotal of 1,350,000 shares were reserved for issuance. The terms ofnon-statutory options granted 

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under these plans aresubstantially consistent with non-statutory options granted under the 1997 and1998 plans.

On July 25, 2000, the Company purchased the netassets of Atmosphere Networks, and assumed all outstanding stock options thathad been granted under the Atmosphere Networks 1997 Stock Plan (the “AtmospherePlan”). The option shares under the Atmosphere Plan were converted into 122,236options to purchase Ditech common stock. The calculation of the conversion ofoption shares was determined using the approximate fair market values of theAtmosphere Networks and Ditech common stock prices within a one-week period upto the date of the acquisition. After July 25, 2000, no new options arepermitted to be granted under the Atmosphere Plan. The options granted underthis plan are substantially consistent with the terms of options granted underDitech’s stock option plans.

In August 2000, the Board of Directors adoptedthe 2000 Non-Qualified Stock Plan. A total of 5,000,000 shares have beenreserved under this stock option plan as of April 30, 2005. The terms ofnon-statutory options granted under this plan are substantially consistent withnon-statutory options granted under the 1997 and 1998 plans.

All options under all option plans described above areimmediately exercisable and have a ten-year term. Shares issued through earlyoption exercises are subject to the Company’s right of repurchase at theoriginal exercise price. The number of shares subject to repurchase generallydecreases by 25% of the option shares one year after the grant date, andthereafter, ratably over 36 months. As of April 30, 2005, 1,776 shareswere subject to repurchase.

In March 1999, the Company adopted the 1999Non-Employee Directors’ Stock Option Plan. Under this stock option plan anaggregate of 650,000 shares are reserved as of April 30, 2005.Options granted under the plan have a 5-year term. One-time initial automaticgrants of 50,000 shares each are made upon a director’s initialappointment and are subject to annual vesting over a four-year period. Annualautomatic grants of 10,000 shares each are made on the date of each annualmeeting of stockholders to each incumbent director (provided they have servedas a director for at least six months) and are fully vested at the grant date.

In February 2003, the Company commenced a stockoption exchange program, which allowed its employees with outstanding optionsunder certain specified stock option plans with an exercise price of $20.00 ormore per share, to exchange, pursuant to the terms of the exchange program,their qualifying outstanding options, for replacement options to be issued on September 23,2003.

The exchange was conducted on a one-for-four (1:4)basis; thus a participating employee would receive replacement options covering25% of the number of shares subject to the original options surrendered forcancellation. On March 19, 2003, employees surrendered for cancellationoptions to purchase a total of 1,193,719 shares.

On September 23, 2003, the Company grantedoptions for the purchase of 165,730 shares of its common stock pursuant to theoption exchange program at an exercise price equal to the market value of theCompany’s stock on that day of $10.35 per share. The decline in the number ofshares granted under the option exchange program from that originally eligiblewas due to employee terminations that occurred primarily in the first quarterof fiscal 2004 as a result of exiting the optical communications business andthe related restructuring.

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Activityunder the stock option plans referenced above was as follows (in thousands,except per share amounts):
| ** **                     | ** ** | ** **                                | ** ** | **Outstanding Options** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|------------------------------|------------|
| ** **                     | ** ** | **Shares Available  For Grant** | ** ** | **Number of  Shares**   | ** ** | **Exercise Price** | ** ** | **Aggregate Price** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| Balances,  May 1, 2002    |       |                                      | 1,636      |                         |       |   | 6,450 |   |   | $ |  0.41 - $85.75 |   |   | $ | 119,470 |   |   |   | $ | 18.52 |   |   |
| Reservation of shares          |       |                                      | 2,100      |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options granted                |       |                                      | (2,984     | )                            |       |   | 2,984 |   |   | $ |  1.23 - $  2.92 |   |   | 8,135 |   |   |   | $ | 2.73 |   |   |
| Options exercised              |       |                                      | —     |                         |       |   | (31 | ) |   | $ |  0.41 - $  2.92 |   |   | (51 | ) |   |   | $ | 1.65 |   |   |
| Options canceled               |       |                                      | 2,443      |                         |       |   | (2,827 | ) |   | $ |  1.48 - $85.75 |   |   | (86,594 | ) |   |   | $ | 30.62 |   |   |
| Balances, April 30, 2003  |       |                                      | 3,195      |                         |       |   | 6,576 |   |   | $ |  0.41 - $79.50 |   |   | 40,960 |   |   |   | $ | 6.23 |   |   |
| Reservation of shares          |       |                                      | 250        |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options granted                |       |                                      | (2,400     | )                            |       |   | 2,400 |   |   | $ |  4.13 - $18.75 |   |   | 21,600 |   |   |   | $ | 9.00 |   |   |
| Options exercised              |       |                                      | —     |                         |       |   | (2,260 | ) |   | $ |  0.41 - $14.45 |   |   | (10,808 | ) |   |   | $ | 4.78 |   |   |
| Options canceled               |       |                                      | 975        |                         |       |   | (992 | ) |   | $ |  1.77 - $76.00 |   |   | (9,296 | ) |   |   | $ | 9.37 |   |   |
| Balances, April 30, 2004  |       |                                      | 2,020      |                         |       |   | 5,724 |   |   | $ |  0.41 - $79.50 |   |   | 42,456 |   |   |   | $ | 7.42 |   |   |
| Reservation of shares          |       |                                      | 1,000      |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options granted                |       |                                      | (853       | )                            |       |   | 853 |   |   | $ | 10.85 - $21.92 |   |   | 12,110 |   |   |   | $ | 14.20 |   |   |
| Options exercised              |       |                                      | —     |                         |       |   | (1,534 | ) |   | $ |   0.41 - $18.07 |   |   | (9,279 | ) |   |   | $ | 6.05 |   |   |
| Options canceled               |       |                                      | 241        |                         |       |   | (241 | ) |   | $ |   1.77 - $76.00 |   |   | (1,890 | ) |   |   | $ | 7.84 |   |   |
| Balances,  April 30, 2005 |       |                                      | 2,408      |                         |       |   | 4,802 |   |   | $ |   0.41 - $79.50 |   |   | $ | 43,397 |   |   |   | $ | 9.04 |   |   |

 

Optionsoutstanding and exercisable at April 30, 2005 (in thousands, except lifeand per share amounts):
| ** **                                  | ** ** | **Options Outstanding** | ** ** | ** **                 | ** ** | **Options Exercisable**                   | ** ** |
|---------------------------------------------|------------|------------------------------|------------|----------------------------|------------|------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average Remaining  Contractual Life (in Years)** | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $  0.41  - $  6.75      |       |                         | 921        |                       |       |                                           | $          | 3.03 |   |   |   | 6.46 |   |   |   | 871 |   |   |   | $ | 3.06 |   |   |
| $  7.12  - $  8.56      |       |                         | 546        |                       |       |                                           | $          | 7.20 |   |   |   | 5.87 |   |   |   | 546 |   |   |   | $ | 7.20 |   |   |
| $  8.76                           |       |                         | 1,660      |                       |       |                                           | $          | 8.76 |   |   |   | 8.42 |   |   |   | 1,660 |   |   |   | $ | 8.76 |   |   |
| $  8.82  - $10.85                 |       |                         | 723        |                       |       |                                           | $          | 9.42 |   |   |   | 5.49 |   |   |   | 723 |   |   |   | $ | 9.42 |   |   |
| $11.73 - $79.50                             |       |                         | 952        |                       |       |                                           | $          | 16.09 |   |   |   | 8.49 |   |   |   | 952 |   |   |   | $ | 16.09 |   |   |
| $  0.41  - $79.50                 |       |                         | 4,802      |                       |       |                                           | $          | 9.04 |   |   |   | 7.33 |   |   |   | 4,752 |   |   |   | $ | 9.11 |   |   |
|                                             |            |                              |            |                            |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The estimated weighted average fair value of optionsgranted during fiscal years 2005, 2004 and 2003 was $8.84, $5.52 and $1.93 pershare, respectively. The estimated weighted average fair value of sharesgranted under the Employee Stock Purchase Plan was $6.39, $0.58 and $0.76 infiscal 2005, 2004 and 2003, respectively.

The fair value of options granted under the Company’sstock option plans during fiscal 2005, 2004 and 2003 was estimated on the dateof grant using the Black-Scholes option pricing model. The model utilized themultiple option approach with the following weighted average assumptions: nodividend yield, expected volatility of 87%, 91% and 107% in fiscal 2005, 2004and 2003, respectively, risk-free interest rates of 3.40%, 2.38% and 3.08% infiscal 2005, 2004 and 2003, respectively, and expected life of four years forthe option plans. The Employee Stock Purchase Plan used the following weightedaverage assumptions: no dividend yield, expected volatility of 73%, 58% and 77%in fiscal 2005, 2004 and 2003, respectively, risk-free interest rates of 2.44%,1.63% and 1.77% in fiscal 2005, 2004 and 2003, respectively, and expected lifeof six months. Forfeitures are recognized as they occur.

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During fiscal 1999, theCompany granted options to certain employees under the 1997 Stock Plan and 1998Stock Option Plan with exercise prices below the deemed fair market value ofthe Company’s common stock at the date of grant. In accordance with the requirementsof APB 25, the Company has recorded deferred compensation for the differencebetween the exercise price of the stock options and the fair market value ofthe Company’s shares at the date of grant. This deferred compensation has beenamortized to expense over the period during which the options becomeexercisable, generally four years. At April 30, 1999, the Company hadrecorded deferred compensation related to these options in the total amount of$1.3 million, of which $142,000 had been amortized to general andadministrative expense during 2003. The gross amount of deferred compensationwas additionally reduced from time to time for option cancellations due toemployee terminations. The deferred compensation was fully amortized duringfiscal 2003.

In connection with theacquisition of Atmosphere Networks, the Company issued nonqualified stockoptions for approximately 750,000 shares of our common stock at a priceequal to a 50% discount from the market value of the stock on its grant date ofAugust 1, 2000. The discount was recorded as deferred compensation of$17.3 million in August 2000. The gross amount of deferredcompensation was reduced from time to time for option cancellations due toemployee terminations. As part to the stock option exchange program undertakenin the fourth quarter of fiscal 2003, discussed above, all remaining sharesunder option from this option grant were canceled. As such, all remainingdeferred compensation that existed as of the closing date of the tender periodwas recognized as expense in the fourth quarter of fiscal 2003. In fiscal 2003,$3.1 million of this deferred compensation was amortized and included in theloss from discontinued operations as it was solely attributable to the Company’soptical operations.

*Stock Repurchase Program*

In December 2004, the Company’s Board ofDirectors authorized the repurchase of up to $35 million of common stock undera stock repurchase program. The repurchase program was implemented to investavailable funds. During fiscal 2005, the Company repurchased and retired2,516,660 shares of its common stock at an average price of $13.91 per sharefor an aggregate purchase price of $35 million. Consequently, the Company isnot authorized to repurchase additional shares under the stock repurchaseprogram.

The aggregate purchaseprice of the shares of the Company’s common stock repurchased was reflected asa reduction to shareholders’ equity. In accordance with Accounting PrinciplesBoard Opinion No. 6, “Status of Accounting Research Bulletins,” theCompany allocated the purchase price of the repurchased shares as a reductionto retained earnings, common stock and additional paid-in capital.

**11.   INCOMETAXES**

Theprovisions for income taxes reflected in the statements of operations for theyears ended April 30 consisted of (in thousands):
| ** **     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------|------------|----------|------------|----------|------------|----------|------------|
| Current:       |       |     |       |     |       |     |       |
| Federal        |       | $        | 496        |     | $          | 76       |       | $ | — |   |
| State          |       | 153      |       | —   |       | —   |       |
| Foreign        |       | (54      | )          | 50       |       | 129      |       |
| Total current  |       | $        | 595        |     | $          | 126      |       | $ | 129 |   |
| Deferred:      |       |     |       |     |       |     |       |
| Federal        |       | (28,708  | )          | —   |       | —   |       |
| State          |       | (8,097   | )          | —   |       | —   |       |
| Total deferred |       | (36,805  | )          | —   |       | —   |       |
| Total          |       | $        | (36,210    | )        | $          | 126      |       | $ | 129 |   |

 

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The deferred tax provisions for fiscal 2004 and 2003reflect the tax effects of changes in the amounts of temporary differencesduring each year, offset by the establishment of a full valuation allowanceagainst the net deferred tax asset position, due to uncertainty surrounding therealization of the benefit of such assets. In the second quarter of 2005,based on the level of historical taxable income and projections for futuretaxable income over the periods that the Company’s deferred tax assets aredeductible, the Company determined that it was more likely than not that certainof its deferred tax assets were expected to be realized and therefore released$50.3 million of valuation allowance. The reversal of the valuation allowanceand subsequent corresponding adjustments to the deferred tax assets resulted inthe recognition of income tax benefits to continuing operations anddiscontinued operations of $36.7 million and $110,000, respectively, in fiscal2005. In addition, the Company recognized a credit of $14.8 million toadditional paid-in capital for the portion of the deferred tax assetattributable to benefits from the exercise of employee stock options. As of April 30,2005, the Company has no remaining valuation allowance.

Thecomponents of the Company’s deferred tax assets and liabilities at April 30consisted of (in thousands):
| ** **                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax  assets (liabilities):                  |       |     |       |     |       |
| Uniform capitalization                               |       | $        | 905        |     | $          | 677 |   |
| Depreciation                                         |       | 312      |       | 267      |       |
| Inventory reserves                                   |       | 1,827    |       | 4,691    |       |
| Other reserves and accruals                          |       | 2,017    |       | 2,203    |       |
| Purchased technology, goodwill and other intangibles |       | 2,198    |       | 868      |       |
| Tax credits                                          |       | 10,121   |       | 7,545    |       |
| Net operating losses                                 |       | 34,227   |       | 35,978   |       |
| Total deferred tax assets                            |       | 51,607   |       | 52,229   |       |
| Less valuation  allowance                            |       | —   |       | (52,229  | )          |
| Net deferred tax  assets                             |       | $        | 51,607     |     | $          | — |   |

 

As of April 30, 2005, the Company has federal andstate tax net operating loss carryforwards of approximately $88.1 millionand $59.5 million, respectively, available to offset future taxable incomeand has federal and state tax credit carryforwards of approximately $5.9 millionand $3.7 million, respectively. The net operating loss and tax creditcarryforwards expire between 2007 and 2025 if not utilized. The Company’s taxnet operating loss and tax credit carryforwards include federal and state netoperating loss carryforwards of approximately $27.2 million and$14.3 million, respectively, which may be subject to limitations createdunder internal revenue section 382.

TheCompany’s effective tax rate differs from the U.S. federal statutory income taxrate for the years ended April 30, principally due to the following:
| ** **                                                 | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Tax provision  (benefit) at federal statutory rate         |       | 35.0     | %          | 35.0     | %          | (35.0    | )%         |
| State taxes, net  of federal benefit                       |       | 5.7      |       | 5.7      |       | (5.7     | )          |
| Non-deductible  goodwill and other intangible amortization |       | —   |       | 3.8      |       | 3.2      |       |
| Valuation  allowance                                       |       | (146.2   | )          | (39.8    | )          | 37.4     |       |
| Other, including  non-deductible expenses                  |       | 1.9      |       | (3.2     | )          | 0.4      |       |
| Effective tax  rate                                        |       | (103.6   | )%         | 1.5      | %          | 0.3      | %          |

 

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**12.   REPORTABLESEGMENTS AND GEOGRAPHIC INFORMATION**

As a result of the Company exiting the optical communicationsbusiness in the first quarter of fiscal 2004, that segment is now beingreported as a discontinued operation in the consolidated statements ofoperations for all periods presented. As such, the Company currently operatesin a single segment, voice quality products, and segment data will no longer bereported.

TheCompany’s revenue from external customers by geographic region, based on shipto destination, was as follows (in thousands):
| ** **    | ** ** | **Years ended April 30,** | ** ** |
|---------------|------------|------------------------------------------|------------|
| ** **    | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| USA           |       | $                                        | 85,337     |   | $ | 61,916 |   | $ | 29,305 |   |
| Asia Pacific  |       | 2,155                                    |       | 1,348 |   | 1,382 |   |
| Canada        |       | 3,292                                    |       | 1,914 |   | 1,926 |   |
| Latin America |       | 1,345                                    |       | 547 |   | 572 |   |
| Europe        |       | 1,926                                    |       | 3,865 |   | 1,903 |   |
| Total         |       | $                                        | 94,055     |   | $ | 69,590 |   | $ | 35,088 |   |

 

TheCompany’s long lived assets by geographic region were as follows (inthousands):
| ** **     | ** ** | **As of April 30,** | ** ** |
|----------------|------------|------------------------------------|------------|
| ** **     | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| USA            |       | $                                  | 4,896      |   | $ | 3,552 |   |
| United Kingdom |       | 37                                 |       | 51 |   |
| Asia Pacific   |       | 4                                  |       | — |   |
| Total          |       | $                                  | 4,937      |   | $ | 3,603 |   |

 

**13.   PROFIT SHARING PLAN**

The Company maintains a401(k) profit sharing plan for all eligible employees. Employees maycontribute to the Plan based on statutory limits. Any Company contributions areat the discretion of the Board of Directors. The Company made contributions tothe Plan during fiscal 2005, 2004 and 2003 of $49,000, $45,000 and $70,000,respectively.

**14.   RELATED PARTY TRANSACTION**

In October 2001, theCompany advanced its Vice President of Optical Sales $750,000 under a securednote receivable agreement. The note, which was classified as other long-termassets on the balance sheet, was due with interest at the rate of 4.59% on November 1,2004. The note was full recourse and secured by an investment account owned bythe Vice President of Optical Sales, which had more than $750,000 of debt andequity instruments. The note and all accrued interest was repaid by the VicePresident in the first quarter of fiscal 2004.

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**15.   SUPPLEMENTALCASH FLOW INFORMATION**
| ** **                                   | ** ** | **Years ended April 30,** | ** ** |
|----------------------------------------------|------------|------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                   | ** ** | **(in thousands)**                       | ** ** |
| Operating:                                   |       |                                     |       |   |   |   |   |
| Interest paid                                |       | $                                        | 6          |   | $ | 11 |   | $ | 11 |   |
| Income taxes paid                            |       | 53                                       |       | 64 |   | 50 |   |
| Non-cash financing and investing activities: |       |                                     |       |   |   |   |   |
| Deferred stock compensation                  |       | —                                   |       | — |   | (2,904 | ) |
|                                              |            |                                          |            |  |  |  |  |  |  |  |

 

**16.   SUBSEQUENT EVENT**

On June 30, 2005, the Company acquiredprivately-held Jasomi Networks, Inc. for approximately $19.7 million.  The merger consideration is divided into $7.0million in non-transferable convertible notes, divided into two tranches withprincipal amounts of $3.0 million and $4.0 million, respectively, $10.7 millioncash at closing, and $2.0 million was placed into escrow for two years to bedistributed to the Jasomi stockholders, less any amounts retained by Ditech asindemnification for breaches of representations, warranties and covenants setforth in the acquisition agreements. Ditech also assumed all of the Jasomi USstock options outstanding on the date of the closing, which converted intooptions to buy 191,111 shares of the Company’s common stock, plus established arestricted stock plan and issued 423,267 shares of restricted common stock toJasomi US employees. Jasomi Networks, Inc. develops and sells sessionborder controllers, which enable VoIP calls to traverse the network addresstranslation (NAT) and firewall devices in customers’ networks, ensuring thatreliable VoIP service can be provided to them. The combination of Ditech’sPacket Voice Processor and Jasomi’s session border control technology mayenable Ditech to provide a comprehensive solution to carriers’ border servicesneeds.

**SUPPLEMENTARYFINANCIAL DATA (unaudited)**

Thefollowing quarterly data reflects the treatment of the Company’s opticalbusiness, which was sold in July 2003, as a discontinued operation. SeeNote 4 of the Notes to the Consolidated Financial Statements (inthousands, except per share data).
| ** **                                | ** ** | **Fiscal 2005** | ** ** | **Fiscal 2004** | ** ** |
|-------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                | ** ** | **First  Quarter**   | ** ** | **Second  Quarter**  | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenue                                   |       | $                    | 25,540     |                 | $          | 24,253 |   | $ | 21,310 |   | $ | 22,952 |   | $ | 10,717 |   | $ | 14,487 |   | $ | 21,303 |   | $ | 23,083 |   |
| Gross profit                              |       | $                    | 19,136     |                 | $          | 18,954 |   | $ | 16,522 |   | $ | 17,259 |   | $ | 6,963 |   | $ | 9,550 |   | $ | 14,042 |   | $ | 15,622 |   |
| Income (loss)  from continuing operations |       | $                    | 10,115     |                 | $          | 46,078 |   | $ | 7,113 |   | $ | 7,595 |   | $ | (516 | ) | $ | 2,926 |   | $ | 6,830 |   | $ | 8,491 |   |
| Net income (loss)                         |       | $                    | 10,605     |                 | $          | 45,770 |   | $ | 7,136 |   | $ | 7,595 |   | $ | (9,925 | ) | $ | 2,893 |   | $ | 6,925 |   | $ | 8,302 |   |
| Basic per share  data                     |       |                 |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations  |       | $                    | 0.30       |                 | $          | 1.35 |   | $ | 0.21 |   | $ | 0.24 |   | $ | (0.02 | ) | $ | 0.09 |   | $ | 0.21 |   | $ | 0.26 |   |
| Net income (loss)                         |       | $                    | 0.32       |                 | $          | 1.34 |   | $ | 0.21 |   | $ | 0.24 |   | $ | (0.32 | ) | $ | 0.09 |   | $ | 0.21 |   | $ | 0.25 |   |
| Diluted per share  data                   |       |                 |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations  |       | $                    | 0.28       |                 | $          | 1.28 |   | $ | 0.20 |   | $ | 0.23 |   | $ | (0.02 | ) | $ | 0.09 |   | $ | 0.20 |   | $ | 0.24 |   |
| Net income (loss)                         |       | $                    | 0.30       |                 | $          | 1.27 |   | $ | 0.20 |   | $ | 0.23 |   | $ | (0.32 | ) | $ | 0.09 |   | $ | 0.20 |   | $ | 0.24 |   |

 

The quarterly financialdata for the two years ended April 30, 2005 reflects (1) a $9.4 million chargefrom the discontinuation and disposition of the Company’s optical business inthe first quarter of fiscal 

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2004 and(2) a $35.8 million benefit from the release of a valuation allowance on theCompany’s deferred tax assets in the second quarter of fiscal 2005.

**Item 9—Changesin and Disagreements with Accountants on Accounting and Financial Disclosure**

Not Applicable.

**Item 9A—Controlsand Procedures**

*Disclosure Controlsand Procedures*

We carried out anevaluation, under the supervision and with the participation of management, includingour Chief Executive Officer and our Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based onthis evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that, as of April 30, 2005, our disclosure controls andprocedures were effective at the reasonable assurance level for gathering,analyzing and disclosing information we are required to disclose in the reportswe file under the Exchange Act, within the time periods specified in theSecurities and Exchange Commission’s rules and forms. It should be notedthat a control system, no matter how well conceived and operated, can provideonly reasonable, not absolute, assurance that the objectives of the controlsystem are met. For example, controls can be circumvented by a person’sindividual acts, by collusion of two or more people or by management overrideof the control. Because a cost-effective control system can only providereasonable assurance that the objectives of the control system are met,misstatements due to error or fraud may occur and not be detected.

*Management’s Reporton Internal Control over Financial Reporting.*

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rules 13a-15(f) and 15d-15(f).Under supervision and with the participation of our management, includingTimothy Montgomery, our principal executive officer, and William Tamblyn, ourprincipal financial officer, we conducted an evaluation of the effectiveness ofour internal control over financial reporting as of April 30, 2005. Inmaking this assessment, our management used the criteria set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO) in *Internal Control*—*Integrated Framework.*Our management hasconcluded that, as of April 30, 2005, our internal control over financialreporting was effective based on these criteria.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of April 30, 2005 has been audited by PricewaterhouseCoopersLLP, the independent registered public accounting firm that audited ourfinancial statements included in this Annual Report on Form 10-K.PricewaterhouseCoopers LLP has issued an attestation report on management’sassessment of our internal control over financial reporting, which is included atthe beginning of Item 8 herein.

*Changes in InternalControl over Financial Reporting.*

During the fourth quarterof 2005, there have been no significant changes in our internal control overfinancial reporting that have material affected, or were reasonably likely tomaterially affect, our internal control over financial reporting.

**Item 9B—Other Information**

Not applicable.

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**Part III**

**Item 10—Directorsand Executive Officers of the Registrant**

*Directors.  *Informationconcerning our Directors is incorporated by reference to the section entitled “Proposal1—Election of Directors” contained in our definitive Proxy Statement with respectto our Annual Meeting of Stockholders to be filed with the Securities andExchange Commission not later than August 28, 2005 in connection with thesolicitation of proxies for the Company’s Annual Meeting of Stockholders to beheld September 16, 2005 (the “Proxy Statement”).

*Executive Officers.  *Informationconcerning our Executive Officers is set forth under the section entitled “ExecutiveOfficers of Ditech” in the Proxy Statement and is incorporated herein byreference.

*Section 16(a) BeneficialOwnership Reporting Compliance.  *Information concerningcompliance with Section 16(a) of the Securities Act of 1934 is setforth in the section entitled “Section 16(a) Beneficial OwnershipReporting Compliance” contained in our Proxy Statement and is incorporatedherein by reference

*Code ofBusiness Conduct and Ethics.  *The information requiredby this Item with respect to our code of conduct and ethics is incorporatedherein by reference from the section captioned “Proposal 1—Election ofDirectors-Code of Business Conduct and Ethics” contained in the ProxyStatement.

**Item 11—Executive Compensation**

The information requiredby this Item is set forth in the Proxy Statement under the captions “Compensationof Executive Officers” and “Compensation Committee Interlocks and InsiderParticipation.” Such information is incorporated herein by reference.

**Item 12—SecurityOwnership of Certain Beneficial Owners and Management**and Related Stockholder Matters

The information required by this Item with respect tosecurity ownership of beneficial owners and management is set forth in theProxy Statement under the caption, “Security Ownership of Certain BeneficialOwners and Management.” Such information is incorporated herein by reference.

The information requiredby this Item with respect to securities authorized for issuance under ourequity compensation plans is set forth in the Proxy Statement under the caption“Equity Compensation Plan Information.” Such information is incorporated hereinby reference.

**Item 13—CertainRelationships and Related Transactions**

The information requiredby this Item is set forth in the Proxy Statement under the heading “CertainRelationships and Related Transactions.” Such information is incorporatedherein by reference.

**Item 14—PrincipalAccountant Fees and Services**

The information required by this Item is set forth inthe Proxy Statement under the Proposal entitled “Ratification of Selection ofIndependent Registered Public Accounting Firm.” Such information isincorporated herein by reference.

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**Part IV**

**Item 15—Exhibitsand Financial Statement Schedules**

*(a)**         *The following documents are filed as partof this Form 10-K:

***(1)****         ***Financial Statements**

Reference is made to theIndex to Consolidated Financial Statements of Ditech Communications Corporationunder Item 8 in Part II of this Form 10-K.

***(2)****         ***Financial StatementSchedules**

**Schedule II**

**Valuation andQualifying Accounts**

**(in thousands)**
| ** **                                     | ** ** | **Balance at  Beginning of Year** | ** ** | ** Additions ** | ** ** | ** Deductions ** | ** ** | **Balance at  End of Year** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
| Year ended  April 30, 2003                |       |                                             |       |                      |       |                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts(1)             |       |                                             | $          | 740                       |       |                       |       | $                                          | 100        |   |   |   | $ | (29 | ) |   |   | $ | 811 |   |   |
| Provision for excess and obsolete inventory(2) |       |                                             | $          | 5,357                     |       |                       |       | $                                          | 8,328      |   |   |   | $ | (2,393 | ) |   |   | $ | 11,292 |   |   |
| Valuation allowance on deferred tax assets(3)  |       |                                             | $          | 33,058                    |       |                       |       | $                                          | 14,451     |   |   |   | $ | — |   |   |   | $ | 47,509 |   |   |
| Year ended  April 30, 2004                |       |                                             |       |                      |       |                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts(1)             |       |                                             | $          | 811                       |       |                       |       | $                                          | —     |   |   |   | $ | (407 | ) |   |   | $ | 404 |   |   |
| Provision for excess and obsolete inventory(2) |       |                                             | $          | 11,292                    |       |                       |       | $                                          | 3,648      |   |   |   | $ | (4,948 | ) |   |   | $ | 9,992 |   |   |
| Valuation allowance on deferred tax assets(3)  |       |                                             | $          | 47,509                    |       |                       |       | $                                          | 4,720      |   |   |   | $ | — |   |   |   | $ | 52,229 |   |   |
| Year ended April 30, 2005                 |       |                                             |       |                      |       |                       |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts(1)             |       |                                             | $          | 404                       |       |                       |       | $                                          | —     |   |   |   | $ | (60 | ) |   |   | $ | 344 |   |   |
| Provision for excess and obsolete inventory(2) |       |                                             | $          | 11,523                    |       |                       |       | $                                          | 1,526      |   |   |   | $ | (8,562 | ) |   |   | $ | 4,487 |   |   |
| Valuation  allowance on deferred tax assets(3) |       |                                             | $          | 52,229                    |       |                       |       | $                                          | 3,382      |   |   |   | $ | (55,611 | ) |   |   | $ | — |   |   |

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(1)*         *The additions to the allowance for baddebts included $76,000 of additions for optical customers, which expensecharges have been reported as a component of the loss from discontinuedoperations for fiscal 2003. There were no provisions related to opticalcustomers in fiscal 2005 or 2004. The deductions to the allowance for bad debtsincluded $61,000 of deductions for the write off of optical customerreceivables in fiscal 2004. There were no deductions in 2005 or 2003 related tooptical receivables.

(2)*         *The additions to the provision for excessand obsolete inventory included $20,000 and $4.4 million of additions foroptical inventory, which expense charges have been reported as a component ofthe loss from discontinued operations for fiscal 2004 and 2003, respectively.The provision in fiscal 2003 was related to incremental write-downs associatedwith our abandonment of the optical switch product in fiscal 2003. There wereno provisions for optical inventory in fiscal 2005. The fiscal 2005 provisionof $1.5 million included $555,000 of field and evaluation unit amortization,which was charged to sales and marketing expense. The deductions to theprovision for excess and obsolete inventory included $4.7 million,$2.7 million and $260,000 of deductions for inventory in fiscal 2005, 2004and 2003, respectively, related to our optical switch product that wasabandoned in fiscal 2003. The fiscal 2004 deduction activity was also relatedto a lesser degree to the sale of inventory to JDSU as part of our exiting theoptical business.

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(3)*         *Based on the level of historical taxableincome and projections for future taxable income over the periods that theCompany’s deferred tax assets are deductible, the Company determined that itwas more likely than not that certain of its deferred tax assets were expectedto be realized and therefore released its valuation allowance on deferred taxassets in the second quarter of fiscal 2005.

***(3)****         ***Exhibits**

Theexhibits listed below are required by Item 601 of Regulation S-K. Eachmanagement contract or compensatory plan or arrangement required to be filed asan exhibit to this Form 10-K has been identified.
| Exhibit      | ** ** | ** **                                                                                                                                                                                                                    | ** ** | **Description of document** |
|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|
| 2.1(1)       |       | Asset Purchase Agreement, dated as of April 16,  2002, by and between Ditech and Texas Instruments                                                                                                                       |
| 2.2(2)       |       | Asset Purchase Agreement, dated as of July 16,  2003, by and between Ditech and JDSU.                                                                                                                                    |
| 2.3          |       | Agreement and Plan of Merger, dated as of  June 6, 2005, among Ditech, Spitfire Acquisition Corp., Jasomi  Networks, Inc., Jasomi Networks (Canada), Inc., Daniel Freedman,  Cullen Jennings and Todd Simpson. |
| 3.1(4)       |       | Restated Certificate of Incorporation of Ditech                                                                                                                                                                               |
| 3.2(5)       |       | Bylaws of Ditech, as amended and restated on  March 28, 2002                                                                                                                                                             |
| 3.3(6)       |       | Certificate of Designation of Series A Junior  Participating Preferred Stock                                                                                                                                             |
| 4.1          |       | Reference is made to Exhibits 3.1, 3.2 and 3.3                                                                                                                                                                                |
| 4.2(7)       |       | Specimen Stock Certificate                                                                                                                                                                                                    |
| 4.3(6)       |       | Rights Agreement, dated as of March 26, 2001  among Ditech Communications Corporation and Wells Fargo Bank Minnesota, N.A.                                                                                               |
| 4.4(6)       |       | Form of Rights Certificate                                                                                                                                                                                               |
| 10.1(7)      |       | Lease Agreement, dated August 18, 1998, between  Ditech and Lincoln-Whitehall Pacific, LLC, as amended January 25, 1999                                                                                             |
| 10.2(7)(8)   |       | 1997 Stock Option Plan                                                                                                                                                                                                        |
| 10.3(8)(18)  |       | 1998 Amended and Restated Stock Option Plan                                                                                                                                                                                   |
| 10.4(8)(15)  |       | 1999 Employee Stock Purchase Plan                                                                                                                                                                                             |
| 10.5(8)(15)  |       | 1999 Non-Employee Directors’ Stock Option Plan                                                                                                                                                                           |
| 10.6(7)(8)   |       | Employment Agreement, dated October 3, 1997, as  amended September 15, 1998, between Ditech and Timothy Montgomery                                                                                                  |
| 10.7(8)(14)  |       | 1999 Non-Officer Equity Incentive Plan                                                                                                                                                                                        |
| 10.8(5)(8)   |       | Employment Offer, dated June 19, 2001, between  Ditech and Lowell Trangsrud                                                                                                                                              |
| 10.9(8)(11)  |       | Employment Offer, dated as of April 30, 2002,  between Ditech and Sandeep Pombra                                                                                                                                         |
| 10.10(12)    |       | Loan and Security Agreement, dated August 7,  2002, by and between Ditech and Comerica Bank-California                                                                                                                   |
| 10.11(8)(20) |       | Jasomi 2001 Stock Plan                                                                                                                                                                                                        |
| 10.12(8)(13) |       | Employment Letter, dated April 25, 2002 between  Ditech and Lee House                                                                                                                                                    |
| 10.13(8)     |       | Compensation Arrangements with Executive Officers                                                                                                                                                                             |
| 10.14(8)     |       | Compensation Arrangements with Non-Employee  Directors                                                                                                                                                                        |
| 10.15(8)(21) |       | 2005 New Recruit Stock Plan                                                                                                                                                                                                   |
| 10.16(7)(8)  |       | Form of Indemnity Agreement to be entered  between Ditech and each of its current executive officers and directors                                                                                                       |
| 10.18(7)     |       | Stock Purchase Agreement, dated as of  September 15, 1997 between Ditech and William Hasler                                                                                                                              |
| 10.19(7)(8)  |       | Form of option agreement under the 1997 Stock  Option Plan                                                                                                                                                               |
| 10.20(7)(8)  |       | Form of option agreement under the 1998 Stock  Option Plan                                                                                                                                                               |
| 10.21(9)(10) |       | Patent License Agreement, dated as of  August 13, 1999, between Ditech and Antec Corporation                                                                                                                             |

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| 10.26(3)     |   | Second Lease Amendment, dated February 15,  2000, between Ditech and Middlefield-Bernardo Associates LLC                                           |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.28(8)(12) |   | 2000 Non-Qualified Stock Option Plan                                                                                                                    |
| 10.31(1)(9)  |   | Software License Agreement, dated as of  April 16, 2002, by and between Ditech and Telogy                                                          |
| 10.32(9)(16) |   | Amendment No. 1 to Telogy Software License  between Ditech Communications Corporation and Texas Instruments Incorporated,  dated May 21, 2003 |
| 10.33(17)    |   | First Amendment to Loan and Security Agreement dated  August 28, 2003 between Ditech Communications Corporation and Comerica  Bank—California |
| 10.34(8)(17) |   | Employment Agreement, dated September 16, 2003,  between Ditech Communications Corporation and Jim H. Grady                                        |
| 10.35(8)(19) |   | Form of option agreement under the 1999  Non-Employee Directors’ Stock Option Plan                                                            |
| 21.1         |   | Subsidiaries of Ditech Communications Corporation                                                                                                       |
| 23.1         |   | Consent of PricewaterhouseCoopers LLP                                                                                                                   |
| 31.1         |   | Certification by Chief Executive Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                                                |
| 31.2         |   | Certification by Chief Financial Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                                                |
| 32.1         |   | Certification Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                           |

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(1)*         *Incorporated by reference from theexhibit with corresponding number from Ditech’s Report on Form 8-K,filed April 30, 2002.

(2)*         *Incorporated by reference from theexhibit with corresponding title from Ditech’s Current Report on Form 8-K,filed July 30, 2003.

(3)*         *Incorporated by reference from theexhibit with corresponding number from Ditech’s Annual Report on Form 10-Kfor the fiscal year ended April 30, 2000, filed July 31, 2000.

(4)*         *Incorporated by reference from theexhibit with corresponding number from Ditech’s Quarterly Report on Form 10-Qfor the quarter ended October 31, 2000, filed December 13, 2000.

(5)*         *Incorporated by reference from theexhibit with corresponding number from Ditech’s Annual Report on Form 10-Kfor the fiscal year ended April 30, 2002, filed July 29, 2002.

(6)*         *Incorporated by reference from theexhibit with corresponding title from Ditech’s Current Report on Form 8-K,filed March 30, 2001.

(7)*         *Incorporated by reference from theexhibits with corresponding descriptions from Ditech’s Registration Statement (No. 333-75063),declared effective on June 9, 1999.

(8)*         *Management contract or compensatory planor arrangement.

(9)*         *Confidential treatment has been grantedas to a portion of this exhibit. The confidential portion of such exhibit hasbeen omitted and filed separately with the Commission.

(10)*  *Incorporated by reference from the exhibit withthe corresponding exhibit number from Ditech’s Quarterly Report on Form 10-Qfor the quarter ending July 31, 1999.

(11)*  *Incorporated by reference from the exhibit withthe corresponding title from Ditech’s Quarterly Report on Form 10-Qfor the quarter ending July 31, 2002, filed August 29, 2002.

(12)*  *Incorporated by reference from the exhibit withthe corresponding title from Ditech’s Quarterly Report on Form 10-Qfor the quarter ending October 31, 2002, filed December 16, 2002.

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(13)*  *Incorporated by reference from the exhibit withthe corresponding title from Ditech’s Quarterly Report on Form 10-Qfor the quarter ending January 31, 2003, filed March 14, 2003.

(14)*  *Incorporated by reference to the exhibit withthe corresponding title from Ditech’s Tender Offer Statement on Schedule TO,filed February 19, 2003.

(15)*  *Incorporatedby reference to the exhibit with the corresponding title from Ditech’sRegistration Statement on Form S-8 (No. 333-110821), filed November 26,2003.

(16)*  *Incorporatedby reference from the exhibit with the corresponding number from Ditech’sQuarterly Report on Form 10-Q for the quarter ended July 31, 2003,filed September 15, 2003.

(17)*  *Incorporated by reference from the exhibit withthe corresponding number from Ditech’s Quarterly Report on Form 10-Q forthe quarter ended October 31, 2003, filed December 8, 2003.

(18)*  *Incorporated by reference to the exhibit withthe corresponding title from Ditech’s Registration Statement on Form S-8 (No. 333-120278),filed November 8, 2004.

(19)*  *Incorporated by reference from the exhibit withcorresponding title from Ditech’s Current Report on Form 8-K, filed September 22,2004.

(20)*  *Incorporatedby reference to the exhibit with the corresponding title from Ditech’sRegistration Statement on Form S-8 (No. 333-126302), filed June 30,2005.

(21)*  *Incorporatedby reference to the exhibit with the corresponding title from Ditech’sRegistration Statement on Form S-8 (No. 333-126292), filed June 28,2005.

*(b)**         *See item 15(a)(3) above.

*(c)**          *Financial Statement Schedules

See item 15(a)(2) above.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                    | DITECH COMMUNICATIONS  CORPORATION |
|--------------------|------------------------------------|
| July 13, 2005 | By:                                | /s/  TIMOTHY k. MONTGOMERY |
|               |                               | Timothy K.  Montgomery |
| * *           |                               | *President,  Chief Executive Officer, and Chairman of the Board of Directors* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities and on the dates indicated.

|                             | **Signatures** | ** **                                   | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-----------------------------|----------------|----------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/  TIMOTHY K. MONTGOMERY  |           | President, Chief  Executive Officer and      |       | July 13,  2005 |
| Timothy K.  Montgomery      |           | Chairman of the Board of Directors           |       |                |
|                        |           | (principal executive officer)                |       |                |
| /s/  WILLIAM J. TAMBLYN     |           | Executive Vice President  and                |       | July 13,  2005 |
| William J.  Tamblyn         |           | Chief Financial Officer (principal financial |       |                |
|                        |           | and accounting officer)                      |       |                |
| /s/  GREGORY M. AVIS        |           | Director                                     |       | July 13,  2005 |
| Gregory M. Avis             |           |                                         |       |                |
| /s/  EDWIN L. HARPER        |           | Director                                     |       | July 13,  2005 |
| Edwin L. Harper             |           |                                         |       |                |
| /s/  WILLIAM A. HASLER      |           | Director                                     |       | July 13,  2005 |
| William A. Hasler           |           |                                         |       |                |
| /s/  ANDREI M. MANOLIU, Phd |           | Director                                     |       | July 13,  2005 |
| Andrei M.  Manoliu, Phd     |           |                                         |       |                |
| /s/  DAVID M. SUGISHITA     |           | Director                                     |       | July 13,  2005 |
| David M.  Sugishita         |           |                                         |       |                |

 

75

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**Exhibit Index**
| Exhibit      | ** ** | ** **                                                                                                                                                                                                                    | ** ** | **Description of document** |
|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|
| 2.1(1)       |       | Asset Purchase Agreement, dated as of April 16,  2002, by and between Ditech and Texas Instruments                                                                                                                       |
| 2.2(2)       |       | Asset Purchase Agreement, dated as of July 16,  2003, by and between Ditech and JDSU.                                                                                                                                    |
| 2.3          |       | Agreement and Plan of Merger, dated as of  June 6, 2005, among Ditech, Spitfire Acquisition Corp., Jasomi  Networks, Inc., Jasomi Networks (Canada), Inc., Daniel Freedman,  Cullen Jennings and Todd Simpson. |
| 3.1(4)       |       | Restated Certificate of Incorporation of Ditech                                                                                                                                                                               |
| 3.2(5)       |       | Bylaws of Ditech, as amended and restated on  March 28, 2002                                                                                                                                                             |
| 3.3(6)       |       | Certificate of Designation of Series A Junior  Participating Preferred Stock                                                                                                                                             |
| 4.1          |       | Reference is made to Exhibits 3.1, 3.2 and 3.3                                                                                                                                                                                |
| 4.2(7)       |       | Specimen Stock Certificate                                                                                                                                                                                                    |
| 4.3(6)       |       | Rights Agreement, dated as of March 26, 2001  among Ditech Communications Corporation and Wells Fargo Bank Minnesota, N.A.                                                                                               |
| 4.4(6)       |       | Form of Rights Certificate                                                                                                                                                                                               |
| 10.1(7)      |       | Lease Agreement, dated August 18, 1998, between  Ditech and Lincoln-Whitehall Pacific, LLC, as amended January 25, 1999                                                                                             |
| 10.2(7)(8)   |       | 1997 Stock Option Plan                                                                                                                                                                                                        |
| 10.3(8)(18)  |       | 1998 Amended and Restated Stock Option Plan                                                                                                                                                                                   |
| 10.4(8)(15)  |       | 1999 Employee Stock Purchase Plan                                                                                                                                                                                             |
| 10.5(8)(15)  |       | 1999 Non-Employee Directors’ Stock Option Plan                                                                                                                                                                           |
| 10.6(7)(8)   |       | Employment Agreement, dated October 3, 1997, as  amended September 15, 1998, between Ditech and Timothy Montgomery                                                                                                  |
| 10.7(8)(14)  |       | 1999 Non-Officer Equity Incentive Plan                                                                                                                                                                                        |
| 10.8(5)(8)   |       | Employment Offer, dated June 19, 2001, between  Ditech and Lowell Trangsrud                                                                                                                                              |
| 10.9(8)(11)  |       | Employment Offer, dated as of April 30, 2002,  between Ditech and Sandeep Pombra                                                                                                                                         |
| 10.10(12)    |       | Loan and Security Agreement, dated August 7,  2002, by and between Ditech and Comerica Bank-California                                                                                                                   |
| 10.11(8)(20) |       | Jasomi 2001 Stock Plan                                                                                                                                                                                                        |
| 10.12(8)(13) |       | Employment Letter, dated April 25, 2002 between  Ditech and Lee House                                                                                                                                                    |
| 10.13(8)     |       | Compensation Arrangements with Executive Officers                                                                                                                                                                             |
| 10.14(8)     |       | Compensation Arrangements with Non-Employee  Directors                                                                                                                                                                        |
| 10.15(8)(21) |       | 2005 New Recruit Stock Plan                                                                                                                                                                                                   |
| 10.16(7)(8)  |       | Form of Indemnity Agreement to be entered  between Ditech and each of its current executive officers and directors                                                                                                       |
| 10.18(7)     |       | Stock Purchase Agreement, dated as of  September 15, 1997 between Ditech and William Hasler                                                                                                                              |
| 10.19(7)(8)  |       | Form of option agreement under the 1997 Stock  Option Plan                                                                                                                                                               |
| 10.20(7)(8)  |       | Form of option agreement under the 1998 Stock  Option Plan                                                                                                                                                               |
| 10.21(9)(10) |       | Patent License Agreement, dated as of  August 13, 1999, between Ditech and Antec Corporation                                                                                                                             |
| 10.26(3)     |       | Second Lease Amendment, dated February 15,  2000, between Ditech and Middlefield-Bernardo Associates LLC                                                                                                                 |
| 10.28(8)(12) |       | 2000 Non-Qualified Stock Option Plan                                                                                                                                                                                          |
| 10.31(1)(9)  |       | Software License Agreement, dated as of  April 16, 2002, by and between Ditech and Telogy                                                                                                                                |
| 10.32(9)(16) |       | Amendment No. 1 to Telogy Software License  between Ditech Communications Corporation and Texas Instruments Incorporated,  dated May 21, 2003                                                                       |
| 10.33(17)    |       | First Amendment to Loan and Security Agreement dated  August 28, 2003 between Ditech Communications Corporation and Comerica  Bank—California                                                                       |

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| 10.34(8)(17) |   | Employment Agreement, dated September 16, 2003,  between Ditech Communications Corporation and Jim H. Grady |
|--------------|--------|------------------------------------------------------------------------------------------------------------------|
| 10.35(8)(19) |   | Form of option agreement under the 1999  Non-Employee Directors’ Stock Option Plan                     |
| 21.1         |   | Subsidiaries of Ditech Communications Corporation                                                                |
| 23.1         |   | Consent of PricewaterhouseCoopers LLP                                                                            |
| 31.1         |   | Certification by Chief Executive Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002         |
| 31.2         |   | Certification by Chief Financial Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002         |
| 32.1         |   | Certification Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                    |

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(1)          Incorporated byreference from the exhibit with corresponding number from Ditech’s Report on Form 8-K,filed April 30, 2002.

(2)*         *Incorporated by reference from theexhibit with corresponding title from Ditech’s Current Report on Form 8-K,filed July 30, 2003.

(3)*         *Incorporated by reference from theexhibit with corresponding number from Ditech’s Annual Report on Form 10-Kfor the fiscal year ended April 30, 2000, filed July 31, 2000.

(4)*         *Incorporated by reference from theexhibit with corresponding number from Ditech’s Quarterly Report on Form 10-Qfor the quarter ended October 31, 2000, filed December 13, 2000.

(5)*         *Incorporated by reference from theexhibit with corresponding number from Ditech’s Annual Report on Form 10-Kfor the fiscal year ended April 30, 2002, filed July 29, 2002.

(6)*         *Incorporated by reference from the exhibitwith corresponding title from Ditech’s Current Report on Form 8-K,filed March 30, 2001.

(7)*         *Incorporated by reference from theexhibits with corresponding descriptions from Ditech’s Registration Statement (No. 333-75063),declared effective on June 9, 1999.

(8)*         *Management contract or compensatory planor arrangement.

(9)*         *Confidential treatment has been grantedas to a portion of this exhibit. The confidential portion of such exhibit hasbeen omitted and filed separately with the Commission.

(10)*  *Incorporated by reference from the exhibit withthe corresponding exhibit number from Ditech’s Quarterly Report on Form 10-Qfor the quarter ending July 31, 1999.

(11)*  *Incorporated by reference from the exhibit withthe corresponding title from Ditech’s Quarterly Report on Form 10-Qfor the quarter ending July 31, 2002, filed August 29, 2002.

(12)*  *Incorporated by reference from the exhibit withthe corresponding title from Ditech’s Quarterly Report on Form 10-Qfor the quarter ending October 31, 2002, filed December 16, 2002.

(13)*  *Incorporated by reference from the exhibit withthe corresponding title from Ditech’s Quarterly Report on Form 10-Qfor the quarter ending January 31, 2003, filed March 14, 2003.

(14)*  *Incorporated by reference to the exhibit withthe corresponding title from Ditech’s Tender Offer Statement on Schedule TO,filed February 19, 2003.

(15)*  *Incorporatedby reference to the exhibit with the corresponding title from Ditech’sRegistration Statement on Form S-8 (No. 333-110821),filed November 26, 2003.

(16)*  *Incorporatedby reference from the exhibit with the corresponding number from Ditech’sQuarterly Report on Form 10-Q for the quarter ended July 31,2003, filed September 15, 2003.

(17)*  *Incorporated by reference from the exhibit withthe corresponding number from Ditech’s Quarterly Report on Form 10-Qfor the quarter ended October 31, 2003, filed December 8, 2003.

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(18)*  *Incorporated by reference to the exhibit withthe corresponding title from Ditech’s Registration Statement on Form S-8(No. 333-120278), filed November 8, 2004.

(19)*  *Incorporated by reference from the exhibit withcorresponding title from Ditech’s Current Report on Form 8-K, filed September 22,2004.

(20)*  *Incorporatedby reference to the exhibit with the corresponding title from Ditech’sRegistration Statement on Form S-8 (No. 333-126302),filed June 30, 2005.

(21)*  *Incorporatedby reference to the exhibit with the corresponding title from Ditech’sRegistration Statement on Form S-8 (No. 333-126292),filed June 28, 2005.

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