**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-K**

**ANNUAL REPORTPURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**
| **(MARK ONE)**                                                                                                                                                                    | ** **                                                                                               |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
| x                                                                                                                                                                                      | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**     |
| **For the Fiscal Year Ended April 30, 2006**                                                                                                                                      |
| **OR**                                                                                                                                                                                 |
| o                                                                                                                                                                                      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
| **For the Transition Period From                          To** |

 

**COMMISSIONFILE NUMBER: 000-26209**

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**DITECH NETWORKS, INC.**

(Exact Name of Registrantas Specified in its Charter)

**DELAWARE**(Stateor Other Jurisdiction of Incorporation or Organization)

**94-2935531**(I.R.S.Employer Identification No.)

**825East Middlefield RoadMountain View, CA 94043(650) 623-1300**(Address,Including Zip Code, of Registrant’s Principal Executive Offices andTelephone Number, Including Area Code)

Securities RegisteredPursuant to Section 12(b) of the Act: **None**

Securities RegisteredPursuant to Section 12(g) of the Act: **Common Stock, $.001 Par Value**

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Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. Yes o No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o No x

Indicate by check markwhether the Registrant (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 x No 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 thebest of the Registrant’s knowledge, in definitive proxy or informationincorporated by reference to Part III of this Form 10-K or anyamendment to this Form 10-K. x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer. or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act).

Large accelerated filer o         Accelerated filer x         Non-accelerated filer o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of the Act).Yes o No x

The aggregate market valueof voting stock held by non-affiliates of the Registrant was approximately$152,934,006 as of October 31, 2005 based upon the closing price on theNasdaq National Market reported for such date. Excludes an aggregate of8,102,703 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 June 23, 2006 was32,466,282 shares.

**DOCUMENTSINCORPORATED BY REFERENCE**

The information required byPart III of this report, to the extent not set forth herein, isincorporated by reference from the Registrant’s definitive proxy statementrelating to the 2006 annual meeting of stockholders, which definitive proxystatement will be filed with the Securities and Exchange Commission within120 days after the fiscal year to which this Report relates.

 

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**DITECH NETWORKS,INC.**

**FORM 10-K**

**INDEX**
|                                                                                                                                           | ** ** | PAGE   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|------------|
| PART I                                                                                                                               |       |
| Item 1—Business                                                                                                                 |       |   | 1          |   |   |
| Item 1A—Risk Factors                                                                                                            |       |   | 14         |   |   |
| Item 1B—Unresolved Staff Comments                                                                                               |       |   | 23         |   |   |
| Item 2—Properties                                                                                                               |       |   | 23         |   |   |
| Item 3—Legal Proceedings                                                                                                        |       |   | 23         |   |   |
| Item 4—Submission of Matters to a Vote of  Security Holders                                                                     |       |   | 23         |   |   |
| PART II                                                                                                                              |       |
| Item 5—Market for Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities  |       |   | 24         |   |   |
| Item 6—Selected  Financial Data                                                                                                 |       |   | 25         |   |   |
| Item 7—Management’s Discussion and Analysis of  Financial Condition and Results of Operations                              |       |   | 27         |   |   |
| Item 7A—Quantitative and Qualitative Disclosure  About Market Risk                                                              |       |   | 44         |   |   |
| Item 8—Financial Statements and Supplementary  Data                                                                             |       |   | 46         |   |   |
| Item 9—Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                                    |       |   | 76         |   |   |
| Item 9A—Controls and Procedures                                                                                                 |       |   | 76         |   |   |
| Item 9B—Other  Information                                                                                                      |       |   | 77         |   |   |
| PART III                                                                                                                             |       |
| Item 10—Directors and Executive Officers of the  Registrant                                                                     |       |   | 78         |   |   |
| Item 11—Executive Compensation                                                                                                  |       |   | 78         |   |   |
| Item 12—Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters               |       |   | 78         |   |   |
| Item 13—Certain Relationships and Related  Transactions                                                                         |       |   | 78         |   |   |
| Item 14—Principal Accountant Fees and Services                                                                                  |       |   | 78         |   |   |
| PART IV                                                                                                                              |       |
| Item 15—Exhibits and Financial Statement  Schedules                                                                             |       |   | 79         |   |   |
| SIGNATURES                                                                                                                                |       |   | 84         |   |   |

 

**Trademarks:**

Ditech and the Fern logo are registered trademarks ofDitech Networks. VQA and PeerPoint are trademarks of Ditech Networks. ThisAnnual Report on Form 10-K also includes trademarks of companiesother than Ditech.

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**Ditech Networks, Inc.**

**Part I**

**Item 1—Business**

*This Annual Reportcontains forward-looking statements that relate to future events or futurefinancial performance. In some cases, forward looking statements can beidentified by terminology such as “may”, “will”, “should”, “expects”, “plans”, “anticipates”,“believes”, “estimates”, “targets”, “predicts”, “intends”, “potential” or “continue”or the negative of such terms or other comparable terminology. These statementsare only predictions. Although we believe that the expectations reflected inthe forward looking statements are reasonable, we cannot guarantee futureresults, levels of activity, performance or achievements. Actual results coulddiffer materially from those anticipated in these forward-looking statements asa result of various factors, including the risks outlined under “Item 1A—RiskFactors” and elsewhere in this Annual Report. All forward-looking statementsincluded in this document are based on information available to us on the datehereof. We assume no obligation to update any such forward-looking statements.*

*Where we use the words “Ditech,”“we” “our” or similar expressions, we are referring to Ditech Networks, Inc.and each of our wholly-owned subsidiaries. Our fiscal year ends on April 30.Consequently, when we refer to a specific fiscal year we are referring to the12 months ended on April 30 of that year. For example, fiscal 2006means the 12 months ended April 30, 2006.*

**General**

Ditech Networks, Inc. is a globaltelecommunications equipment supplier for voice networks. Our solutions enableservice providers to deliver consistently clear, secure, end-to-endcommunications to their customers worldwide. Our voice quality products includeecho cancellers, which are used to effectively eliminate echo, a significantproblem in existing and emerging voice networks. In the second half of 2004, weintroduced a new line of voice quality products that incorporate both echocancellation and a new generation of voice quality enhancement technology calledVoice Quality Assurance (VQA). VQA addresses various voice quality issues inwireline and wireless networks, including a broader spectrum of echo,background noise and inconsistent voice levels. Over the last three fiscalyears, voice quality products, which include our echo cancellation and VQAplatforms, have comprised substantially all of our revenue. Beginning in thesecond half of fiscal 2004 and continuing through fiscal 2006, we have beendeveloping a new platform, the Packet Voice Processor, which represents ourentry into service providers’ Internet Protocol (IP) networks using Voice overInternet Protocol (VoIP) technology. The Packet Voice Processor incorporatesour VQA technology and newly developed Packet Quality Assurance (PQA)technology to address voice quality issues. In addition, we acquired JasomiNetworks, Inc. (Jasomi) in the first quarter of fiscal 2006. Jasomideveloped and sold session border controllers that enable VoIP calls totraverse the network address translation (NAT) and protect networks fromexternal attacks by admitting only authorized sessions, ensuring that reliableVoIP service can be provided to them. Through July 16, 2003, we alsodeveloped and marketed optical subsystem communications products through ourwholly 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 10-K.

We market our products domestically through a directsales force and, to a lesser extent, through distributors. Internationally, wemarket our products through the combination of a direct sales force,value-added resellers, system integrators and agents.

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 1999 

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andchanged its name to Ditech Communications Corporation. In May 2006, DitechCommunications Corporation changed its name to Ditech Networks, Inc.

**Mobile VoiceQuality Market**

***Market Size and Characteristics***

While we supply voiceprocessing products to the wireline network, our primary market is mobileoperators. Mobile networks are currently estimated to have nearly 2.3 billionsubscribers worldwide and recent market research reports indicate that thissubscriber base is still growing at a significant rate. Global System forMobile Communications, commonly referred to as GSM, is the predominanttechnology for mobile communications outside the United States and is growingin popularity domestically. Code-Division Multiple Access, commonly referred toas CDMA, is an alternative mobile technology used primarily in the U.S. andKorea and a number of smaller 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 Center (MSC) with switchingequipment; and (3) Inter MSC network to connect switching sites across thecarrier’s geographical coverage area.

***Service Providers Challenges—Improving Voice Qualityand Lowering Costs***

Voice quality is a key competitive differentiator fortelecommunication service providers. To deliver excellent voice quality,service providers must eliminate a variety of voice anomalies that includehybrid and acoustic echo, background noise, and inconsistent voice levels.

In addition to delivering excellent voice quality,carriers in a fiercely competitive environment are seeking to lower the capitaland operating costs of their voice networks. Service providers are demandingequipment with greater capacity as well as smaller physical size as space inservice provider facilities and central offices becomes more crowded. Serviceproviders are also interested in monitoring voice quality throughout theirnetwork so they can rapidly address quality issues and guarantee Quality ofService to their subscribers.

The need to lower the costof deploying and operating a mobile voice network is even greater in manyinternational markets where carriers are expanding to reach low-incomesubscribers. The Radio Access Network, with nearly 70% of overall equipment andinstallation costs, dominates the cost of deployment in a mobile network. Tolower costs, international carriers are utilizing various forms of voicecompression to reduce radio bandwidth and infrastructure costs. Voice compressionenables carriers to serve more subscribers with less bandwidth. The drawback ofthese compression technologies, however, is that they can degrade voice quality.Therefore, carriers are seeking solutions that enable them to deploy voicecompression while still guaranteeing good voice quality.

***Eliminating Hybrid and Acoustic Echo***

It is important to understand the factors that affectvoice quality in mobile calls. There are two types of echo in networks: HybridEcho and Acoustic Echo. Hybrid Echo is generated within a telecommunicationsnetwork and results from signal reflection at the “hybrid,” commonly the pointwhere two wires of the local network meet the four wires of the long distancenetwork. Echo becomes noticeable whenever the one-time delay of a reboundedvoice signal exceeds 25 milliseconds. If the delay exceeds 32 milliseconds, thequality of the voice call begins to degrade creating an echo, which isreflected back to the person speaking and can become an annoyance during thecall. When these echo problems are present, people describe the effect as theirvoices sounding hollow or like someone talking in a tunnel. Acoustic echo iscaused by the sound generated on the speaker device of a telephone or mobilehandset being reflected from surfaces such as walls, or being conducted by thedevice and then captured by the 

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microphone on the samedevice. Acoustic echo behavior is more diverse since the resulting echo isdriven by the specific physical characteristics of the room and the mechanicalproperties of the device.

Delays, either due to along transmission path, as in a long distance telephone call, or due to thecomplex signal hand-off from one network to another, exacerbate the effect ofecho. As the telecommunications network moves to adopt VoIP, additional delaywill be added to the call transmission path. Therefore, carriers are lookingfor comprehensive, long-range solutions to eliminate echo from their networks.

***Reducing Background Noise and Maintaining ConsistentVoice Levels***

To ensure delivery ofexcellent voice quality, service providers strive to eliminate background noiseand inconsistent voice levels. Background noise is a particularly acute problemin mobile 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. Background noise also affects theperformance of voice transmission in mobile networks that utilize voicecompression, as the noise consumes valuable bandwidth. Inconsistent voicelevels also degrade voice quality in mobile networks. Variations in voicelevels occur when calls are routed between the networks of different serviceproviders, particularly on international calls, resulting in the voice of thespeaker often being too high or too low for comfortable listening.

**Our Voice QualitySolutions**

We design, develop, and market stand-alone andsystem-based voice quality enhancement products for mobile networks throughoutthe world. Our products feature high-capacity, high-availability hardwaresystems coupled with a sophisticated array of voice enhancement and monitoringsoftware to enhance the quality of voice communications.

The key benefits of our voice processing solutionsinclude:

*VoiceQuality Assurance (VQA) technology.**  *Our VQA technology integrates voicequality enhancement features with the some of the latest voice processortechnology to improve the sound quality of voice calls in alltelecommunications networks but especially mobile networks. VQA’s generalfeatures include noise reduction, acoustic echo cancellation, voice levelcontrol, and enhanced listener intelligibility.

*Networkcapacity expansion.*   Our VQA technology enablesmobile carriers to deploy lower-cost, bandwidth-saving compression technologieswhile still maintaining good voice quality. Our VQA technology also enablesmobile carriers to deploy a capacity-saving technology called DTX(Discontinuous Transmission). Human conversations typically occupy a phone call50% of the time for each person. Mobile networks use DTX to stop radiotransmission during silent periods. Background noise renders the process ofdetecting these silent periods more difficult, thus reducing the effectivenessof DTX, increasing radio network traffic and usurping capacity. Our VQAtechnology detects and minimizes this background noise.

*Time-to-marketadvantage.**  *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 voice processing 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, which in turn enable us to invest resources in thedevelopment of additional voice quality algorithms to support the growing needsof the telecommunication and networking marketplace. As a result, we believethat we are able to deliver high 

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performance products tomarket with shorter product development cycles and lower investments in capitalequipment than alternative solutions.

*Lowertotal cost of ownership.**  *Our compact system design allows us to offer voiceprocessing products with some of the highest voice processing capacitiescurrently available based on a seven-foot industry standard equipment racklocated in service providers’ central offices or remote facilities. This highercapacity represents cost and space savings for service providers. Our newergeneration products also offer highly efficient cabling and network equipmentinstallation, saving service providers even more space and installation costs.Our products are designed to allow service providers to remotely download andupgrade software via the Internet without interrupting network service ordispatching a technician to the remote site, which also lowers the cost ofownership.

*Remote monitoring andservice assurance.**  *Ourreal-time monitoring technology, known as Voice Quality Monitoring (VQM),allows remote monitoring of voice quality data in real-time. Service providerscan use this technology to identify problems remotely and address them proactively.We are also able to assist our customers on-line during this process. As aresult, service providers can improve performance levels and monitor voicequality on a consistent basis.

**Our Mobile VoiceQuality Products**

Our voice quality productsare designed to solve voice quality issues, such as echo, background noise andinconsistent voice levels primarily in mobile networks (Our products also servewireline and satellite networks). Our echo cancellation product family includesa mixture of both single and multi-port, stand-alone echo cancellers andseveral broadband, system-based products. In fiscal 2004, we consolidated manyof our previous generation product lines enabling customers to migrate tonewer, lower cost and higher performance platforms. This also enabled us toreduce costs by streamlining on-going development and increasing manufacturingvolumes on fewer hardware components. As part of this consolidation process, weannounced last-buy periods for our 18T1, 18E1, Quad I T1, Quad I E1,BBEC, OC-3, STM-1, SX-30 and SX-24 echo cancellationsystems. We ceased selling these products following last-buy periods ending,depending on the product, between November 2004 and June 2006. Infiscal 2004, we announced the availability of two new voice processing platformfamilies. Unlike our previous products that were designed for echo cancellationonly, the new voice processing platforms are designed to support a largervariety of voice processing algorithms, such as the features in VQA. Theseproducts are the Quad Voice Processor (QVP), with four T1 or E1 interfaces, andthe Broadband Voice Processor-Flex (BVP-Flex) with high capacity any-to-anyinterfaces such as DS-3, STS-1, OC-3 and STM-1. Bothplatforms can be factory configured to support a wide range of computationalpower and can be field upgraded to support the purchase of new softwarefeatures.

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**Our Current MobileVoice**QualityProducts

Thefollowing table summarizes our current mobile voice quality products.
| Product                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                      | ** ** | **Description**                                                                                                                                                                                                                                                                           | ** ** | **Functionality** |
|--------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|
| 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 a wide 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 |

 

**VoIP Market: BorderSolutions and Services Market**

***Market Size and Characteristics***

There is a growing trend of wireline service providerstransitioning away from traditional circuit-switched network infrastructure toVoIP. VoIP offers service providers’ customers an increase in features 

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and functionality whileenabling the service providers to simplify network operations, reduce capitalexpenditures and increase service revenue.

Our primary focus in ourVoIP business is the Border Solutions and Services Market. The “border” is thedemarcation between the local access network and the VoIP core transportnetwork. Carriers are currently deploying key voice processing devices, such assession border controllers and media gateways, at the borders of their VoIPnetworks. These devices translate and process calls originating incircuit-based and packet-based access networks, and pass them into the coreVoIP network for further processing and eventual service delivery to VoIPsubscribers. Sales for all Border network devices, including session bordercontrollers and media gateways, were estimated at $1.2 billion in calendar year2005 and expected to grow to $2.5 billion by calendar year 2006. We believe theVoIP border is emerging as the key location in the network to ensure voicequality and security.

***VoIP Service Provider Challenges***

**Voice Quality**

As carriers seek to move mainstream telephonesubscribers to their new VoIP service, they must offer the same level of voicequality and service these subscribers have been accustomed to with theircircuit-based service. “Toll-quality” service is the industry term fortelephone service that always works and is always high quality. To providetoll-quality service, VoIP carriers must address a number of traditional voicechallenges and additional challenges associated with transporting voice over adata network.

*TraditionalVoice Quality Challenges.*   To become a universal,mainstream service, VoIP must interconnect calls to the wireless and publicswitch networks (PSTN) from which the majority of subscribers originate andreceive phone calls. As VoIP calls are connected to wireless and PSTN networks,call quality can be degraded by the same voice quality issues that affectcircuit-based calls; that is, echo, background noise, and inconsistent voicelevels. In fact, VoIP adds more delay to the transmission path of a call and inmany cases this delay increases the negative effects of these voice anomalies,especially echo.

*PacketLoss, Packet Delay.**  *In the**VoIP network, voice is packetized and transported in abest-available routing method. Packets can be lost or delayed during VoIProuting resulting in degradation of call quality.

*Voice compressiontranslation.*   As VoIP becomes more widelydeployed, carriers will be challenged to support different types of VoIP mediastreams, including compressed voice, or codec, technologies. VoIP carriers,therefore, will seek a means to normalize or translate these codecs before theyare transported into the core network.

**End-to-end ServiceDelivery**

As voice is packetized andtransported within the “open,” best-available routing world of VoIP, carriersmust ensure calls can traverse network boundaries and barriers, includingtraditional data firewalls. End-to-end service delivery, therefore, becomes asignificant challenge to establishing mainstream VoIP service.

**Security**

VoIP represents afundamental change in the way voice is transported. In the circuit-based world,voice is transported over dedicated circuits with dedicated bandwidth allocatedto each call. In VoIP, voice runs on a network originally built to transportdata where no one entity controls the end-to-end path the data travels. Whilethis VoIP data network offers many cost-savings advantages, by its very naturethe VoIP network is more open and prone to some of the same security issuesfaced by users of computers—issues like viruses, spam, and various forms ofnetwork attack and personal identity theft. Therefore, as 

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carriersmove to take advantage of the cost efficiencies of VoIP, they must ensure thattheir networks guarantee a secure environment to VoIP subscribers.

**Our VoIP Solutions**

We design, develop and market systems that ensureservice providers can provide consistently clear, secure, end-to-end VoIPcommunications to their customers throughout the world. Our products featurehigh-capacity, high-availability hardware systems coupled with a sophisticatedarray of voice enhancement and monitoring software to enhance the quality anddelivery of voice communications. Our Packet Voice Processor is currently inbeta stage and we continue to develop features as we review and clarifycustomer requirements. PeerPoint, our session border controller product, iscurrently available.

The key currentlyor planned to be available benefits of our VoIP solutions include:

*Toll-quality voice service.*   OurPacket Voice Processor system incorporates our VQA functionality. The VQAfeatures on the Packet Voice Processor improve voice quality in a call andoffer noise reduction, enhanced voice intelligibility, voice level control andacoustic and hybrid echo cancellation capabilities. Our 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 voice quality enhancement features are currently orplanned to be available in the 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 in an IP network. The Packet Voice Processor is designed toeliminate hybrid echo from end-to-end calls that traverse a PSTN hybridnetwork.

*End-to-endconnectivity.*   Our Packet Voice Processor, whendeployed at the border between networks, supports a wide array of codecs fromthe customer premises or network edge and normalizes incoming codec typesbefore transmission to the IP backbone. This may also eliminate serviceproviders’ need to convert one compressed voice format to another (transcoding)at VoIP service points such as conferencing servers, media servers and voiceportal servers, hence saving the service providers costs and allowing foreasier deployment and integration of additional enhanced VoIP service platformsin the future. The Packet Voice Processor also provides a full suite of VQAtechnology features to ensure the delivery of consistently high voice qualityin VoIP deployments.

*LowerBorder network costs.*   Our Packet Voice Processoris purpose-built to support large-scale, high-capacity voice processing at theVoIP network Border. One equipment bay (7 foot) of our Packet VoiceProcessor, for example, supports 48,000 VoIP sessions. Combined with its sophisticatedarray of voice enhancement and voice monitoring capabilities, deployment of thePacket Voice Processor represents a major capital and operating expense savingsfor VoIP carriers.

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*Secure voice service.*   Thesuccess of any VoIP network depends on being able to make the right connectionswithout having to redefine the infrastructure or compromise security. OurPeerPoint Session Border Controller helps enterprises and carriers connectdiverse equipment, traverse firewalls and network boundaries, reduce bandwidthcosts, and prevent Denial of Service attacks.

**Our VoIP Products**

Because of the high expectations of their customers,VoIP service providers are working to provide a service level that is as goodas, or better than, services offered over traditional circuit-switched networks.Leveraging our VQA technology and new PQA technology, which addresses packetloss and jitter, we believe that our newest product platform, the Packet VoiceProcessor, addresses these voice quality issues. Our Packet Voice Processor iscurrently in beta stage and we sold our first beta unit in the fourth quarterof fiscal 2006.

The success of a voice or video IP network largelydepends on being able to make the right connections without having to redefineinfrastructure or compromise security. Our PeerPoint Session Border Controller,acquired in the Jasomi business transaction, is aimed at enabling enterprisesand carriers to connect diverse equipment, traverse firewalls, operate inenvironments prone to security breaches, reduce bandwidth costs, and preventDenial of Service attacks.

Thefollowing table summarizes our current mobile Voice-over-IP products andcurrently or planned to be available features.
| Product                                     | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             | ** ** | **Description**                                                                                                                                                                                                                        | ** ** | **Functionality** |
|---------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|
| PeerPoint C100 (Session  Border Controller) |       |  

The PeerPoint Session  Border Controller enables enterprises and carriers to connect diverse  equipment, traverse firewalls, operate in environments prone to security breach,  reduce bandwidth costs, and prevent Denial of Service attacks, and is  targeted at both North American and international network operators                                                                                                                                                                                                                                                                     |       |  

·  Session control

·  Security

·  NAT/Firewall traversal

·  Peering                                                                                                                 |
| Packet Voice Processor                      |       | The Packet Voice Processor  delivers packet voice processing for an IP network, offering a comprehensive  set of voice processing features that ensure consistent, clear voice quality  while maximizing carrier service offerings. These features include any-to-any  codec transcoding for wireline and wireless networks, our VQA software suite,  our PQA software suite, and an advanced voice quality monitoring capability.  The carrier-grade system offers scalable VoIP processing with Gigabit  Ethernet connectivity, targeted at both North American and international  network operators |       | ·  48,000 VoIP sessions per 7’ rack

·  Any-to-any codec transcoding

·  Advanced voice quality enhancement

·  Sophisticated voice quality monitoring and  packet quality assurance |

 

 

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**Customers**

*Voiceprocessing customers.**  *Ouractive voice processing customer base has increased to approximately 120customers in fiscal 2006 from 80 customers in fiscal 2005, primarily as aresult of new session border controller customers. While we added new customersin fiscal 2006 and we continued to do business with major North American longdistance companies, the vast majority of our domestic revenue was generatedfrom sales to Verizon Wireless. Verizon Wireless accounted for 79% of our totalworldwide revenue in fiscal 2006 compared to 49% in fiscal 2005. As a result ofNextel’s merger with Sprint, our fiscal 2006 revenue from Nextel was nominalcompared to 37% of our total worldwide revenue in fiscal 2005. Our next fourlargest customers accounted collectively for 9*%*of our total company revenue in fiscal 2006. All of our revenue is fromexternal customers. Our revenue, net income (loss) and total assets for thelast three years are set forth in our financial statements included in Item 8of 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 13 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 approximately87%, 91% and 89%, of our revenue in fiscal 2006, 2005 and 2004, respectively.Virtually all of our long-lived assets are located in the U.S. See “Item 7—Management’sDiscussion and Analysis of Financial Condition and Results of Operations—FutureGrowth and Operating Results Subject to Risk—We May Experience UnforeseenProblems As We Diversify Our International Customer Base, Which Would ImpairOur Ability To Grow Our Business” for a discussion of risks associated withboth domestic and international operations.

*Backlog.**  *Our backlog for voice processingproducts was approximately $18.7 million and $1.3 million as of the firstbusiness day of June 2006 and 2005, respectively. Our backlog consists of (1) ordersconfirmed with a purchase order for product from which we expect to recognizerevenue within 120 days to customers with approved credit status, (2) shipmentsclassified as deferred revenue, which we expect to recognize as revenue within120 days, and (3) deferred maintenance revenue, which we expect torecognize within 120 days. A shipment is classified as deferred revenue when aninstallation is required by the customer. Backlog at June 1, 2006 excludes$6.0 million of orders for which shipment dates are undefined or which extendbeyond 120 days. Because of the generally short cycle between order andshipment, and occasional customer changes in delivery schedules, we do notbelieve that our backlog as of any particular date is necessarily predictive ofactual net sales for any future period.

**Research andDevelopment**

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 2006, 2005 and 2004,were approximately $17.9 million, $15.8 million and $10.7 million,respectively. The increase in spending in fiscal 2006 was largely due toincremental payroll and other compensation expense associated with ouracquisition of Jasomi and the depreciation of lab equipment purchased tosupport our Packet Voice Processor development. The increase in spending infiscal 2005 was primarily due to incremental headcount and outside servicesrequired for the development of our Packet Voice Processor. Our research anddevelopment efforts are driven by market demand and customer feedback. We havecreated a structured process for undertaking all product development projects.Following an assessment of market demand, our research and development teamdevelops a set of functional product specifications based on input from ourproduct management, sales and post-sales organizations. This process isdesigned to provide a framework for defining and addressing the steps, tasksand activities required to bring product concepts and development projects tomarket. As of April 30, 2006, we had 79 employees in Research andDevelopment and we believe that retaining those personnel and 

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recruitingnew personnel, as necessary, will be essential to our continued success. See “Item 1A—RiskFactors” below for a discussion of risks related to timely specification anddevelopment of products for commercial viability.

**Manufacturing**

We operate as a “virtual” manufacturing organizationby relying on contract manufacturers to assemble our voice processing products.Our contractmanufacturers manufacture our products based on rolling forecasts provided byus. The rolling forecasts we submit to our contract manufacturers arebased on our expectations of customer and, in the case of prototypes or labequipment, internal demand. We normally ship to our customers within 7 to 10days of receiving an order. Wegenerally do not own the products or components until they are shipped to us. Incertain circumstances, we may be liable to our contract manufacturers forcarrying and obsolete material charges for excess components purchased based onour forecasts. We perform final test, configuration and shippingfunctions for our voice processing products. Our raw materials are procuredfrom outside suppliers, primarily through our contract manufacturers. Severalcomponents used in our products are sole sourced. We closely monitor suppliesof parts and supplier lead times in an attempt to mitigate the risk ofcomponent availability affecting our ability to deliver product to ourcustomers. In cases where we believe that a particular sole source component istoo critical or expensive to replace and we believe that there may beavailability issues, we have, and will continue to, buy components in excess ofour immediate needs to help mitigate the risk of component shortages in thefuture. In procuring digital signal processors for our echo cancellationproducts, we and our contract manufacturers rely on Texas Instruments as oursole supplier, as our software license agreement with Texas Instrumentsstipulates that we will only use their processors to run the licensed TexasInstruments software. Our future success will depend in significant part on ourability to obtain components on time, at competitive prices, and in sufficientquantities to meet demand. Although we believe that there are currently amplesupplies of components, we have experienced part shortages in prior years,which had a direct impact on revenues and results of operations and we mayexperience such shortages again in the future. See “Item 1A—Risk Factors”below for a discussion of risks related to manufacturing our products.

We are ISO 9001:2000 andISO 14001:1996 certified and require that our contract manufacturers are ISO9000:2000 registered as a condition of qualification. As part of our 14001-certifiedmanagement system and our overall commitment to the environment we areinvestigating the requirements set forth by the RoHS directive, which restrictsthe use of certain hazardous substances in electrical and electronic equipment.Based on some independent industry benchmarking, and guidance offered by the UK’sDepartment of Trade and Industry, we believe that our product,telecommunication network infrastructure equipment, qualifies for thelead-in-solder exemption of the RoHS directive. Consequently, we are pursuingwhat is commonly called “5 of 6” compliance for the July 2006implementation deadline. We will continue to monitor the evolution of the EC/95and related industry activities and will take appropriate compliance action forthose products that we sell into EU countries and territories. Effective January 1,2006, we began shipping Waste Electrical and Electronic Equipment (WEEE)compliant product as referenced in EC/96. We will continue to monitor theevolution of the EC/96 and related industry activities and will takeappropriate compliance actions for those products that we sell into EUcountries and territories.

**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 fiscal2006, we hired 

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marketingpersonnel to focus on product development strategy and brought on additionalsales and marketing personnel through our acquisition of Jasomi. 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, during fiscal 2006 and 2005,we expanded our domestic and international trade show participation to furtherstrengthen our presence in the echo cancellation marketplace, to launch our newPacket Voice Processor and market our PeerPoint C100. See “Item 1A—RiskFactors” below for a discussion of risks related to effectively marketing andselling our products.

**Acquisitions andDispositions**

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 June 30, 2005, we acquired Jasomi for $10.4million in cash plus $7.0 million in non-transferable convertible notes. Inaddition, we transferred $2.0 million into an escrow account to secureindemnification obligations for breaches of representations and warranties madeby Jasomi and certain of its affiliates, and the portion of the escrowedamount, if any, remaining after all claims are made against the escrow, willalso be paid to the former stockholders of Jasomi. We also assumed all of theJasomi stock options outstanding on the date of the closing, which convertedinto options to acquire, in the aggregate, 191,111 shares of Ditech commonstock. In addition, we established a restricted stock plan and issuedrestricted common stock and restricted stock units to Jasomi employees andemployees of a Canadian affiliate of Jasomi in the aggregate amount of 393,212shares of Ditech common stock. We believe the combination of our Packet VoiceProcessor and Jasomi’s session border control technology, which enables VoIPcalls to traverse the network address translation (NAT) and protects networksfrom external attacks by admitting only authorized sessions, thus ensuring thatreliable VoIP service can be provided to them, will enable us to provide acomprehensive solution to carriers’ border service needs. See also Note 6 ofNotes to the Consolidated Financial Statements.

We will continue to lookto acquire companies that meet market attractiveness and strategic fitcriteria. Acquisitions involve numerous risks, which are more fully discussedin “Item 1A—Risk Factors—Acquisitions and Investments May AdverselyAffect 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;

·       Technical support andservice;

·       Completesystem integration and turnkey network delivery;

·       Financing;

·       Credibilityto deliver large scale solutions; and

·       Incumbentnetwork deployments.

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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 thatcompetition will increase in the future.

Our principal competitors for stand-alone****echo and voice quality products in circuit-switchednetworks are NMS Communications Corporation and Tellabs. However, the primarycompetition in the voice processing market comes from voice switchmanufacturers, of which there are several companies competing in this space,the more formidable of which are Nortel, Lucent, Nokia, Ericsson Siemens,Huawei, ZTE and Alcatel. These switch manufacturers do not independently sellecho cancellation products or compete in the open echo cancellation market;however, they integrate echo cancellation functionality within their switchproduct offerings, either as hardware modules or as software running on chips.A widespread adoption of internal echo cancellation solutions could present acompetitive threat to us by eliminating demand for our echo cancellation systemproducts.

Our principalcompetitors in the VoIP space include Sonus Networks, Nortel, Lucent, Alcatel,Cisco, Huawei, Siemens, Audiocodes, Acme Packet, Juniper (Kagoor), manymid-sized companies 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 competitorsand potential competitors have substantially greater name recognition andtechnical, financial, marketing, purchasing and other resources than we do. Asa result, these competitors may be able to respond more quickly to new oremerging technologies or standards and to changes in customer requirements,devote greater resources to the development, promotion and sale of products, ordeliver competitive products at a lower price. We may not be able to competesuccessfully against our current or future competitors. See “Item 1A—RiskFactors” below for a discussion of risks related to resources needed to competeglobally.

**Patents andIntellectual Property Rights**

Our future success will depend, in part, on ourability to protect our intellectual property. We rely primarily onnondisclosure agreements as well as copyright, trademark, trade secret laws,and other methods to protect our proprietary voice processing technologies andprocesses, and in the future we may utilize patents, where applicable andavailable. Nevertheless, such measures may not be adequate to safeguard theproprietary technology underlying our 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 had an initial four-year royalty-free period after which, in March 2006,we (1) extended the royalty-free period through December 31, 2007primarily to support Ditech’s remaining warranty obligation for our end-of-lifeproducts and (2) negotiated new pricing based on the purchase of chipsbundled with the echo software for our current products. We are dependent onthe license of this technology and continued support from Texas Instruments, asit is the fundamental technology incorporated in our echo cancellationproducts.

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 

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patent, copyright, ortrademark protection outside of the U.S. Further, we occasionally incorporatethe intellectual property of our customers into our designs, and we havecertain 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 industryparticipants, such as Lucent, Nortel Networks and certain major universitiesand research laboratories hold substantial inventories of intellectualproperty. This concentration of intellectual property in the hands of a fewmajor entities also poses certain risks to us in seeking to hire qualifiedpersonnel. We have on a few occasions recruited such personnel from suchentities. These entities or others may claim the misappropriation orinfringement of their intellectual property, particularly when and if employeesof these entities leave to work for us. We may not be able to avoid litigationin the future, particularly if new employees join us after having worked for acompeting company. Such litigation could be very expensive to defend,regardless of the merits of the claims, and could have a material adverseeffect on our business, financial condition and results of operations.

**Employees**

As of April 30, 2006,we had 216 employees, 34 of whom were primarily engaged in operations, 79 inresearch and development, 78 in sales, marketing and technical support and 25in 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.

**Available Information**

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.ditechnetworks.com*. Our websiteaddress is provided solely for informational purposes. We do not intend, bythis reference, that our website should be deemed to be part of this AnnualReport. The reports filed with the SEC are also available at www.sec.gov.

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**Item 1A—Risk Factors**

**Future Growth andOperating Results Subject to Risk**

Our business and the value of our stock are subject toa number of risks, which are set out below. If any of these risks actuallyoccur, our business, financial condition or operating results could bematerially adversely affected, which would likely have a corresponding impacton the value of our common stock. These risk factors should be carefullyreviewed.

**WEDEPEND ON A LIMITED NUMBER OF CUSTOMERS, THE LOSS OF ANY ONE OF WHICH COULD CAUSE OUR REVENUE TODECREASE.**

Ourrevenue historically has come from a small number of customers. Our fivelargest customers accounted for approximately 88% of our revenue in fiscal 2006and 91% and 86% of our revenue in fiscal 2005 and 2004, respectively. Ourlargest customer accounted for approximately 79% of our revenue in fiscal 2006.A customer may stop buying our products or significantly reduce its orders forour products for a number of reasons, including the acquisition of a customerby another company, a delay in a scheduled product introduction, completion ofa network expansion or upgrade, or a change in technology or networkarchitecture. If this happens, our revenue could be greatly reduced, whichwould materially and adversely affect our business.

Since the beginning of calendar year 2004, NorthAmerican telecommunication service providers have been involved in a series ofmerger and acquisition activities and some affected telecommunication serviceproviders are still assessing the network technology and deployment plans. Inany merger, product purchases for network deployment may be reviewed, postponedor canceled based on revised plans for technology or network expansion for themerged entity. We believe this is what happened at Nextel when, in December2004, they announced a plan to merge with Sprint. Consequently, our fiscal 2006revenue from Nextel was nominal compared to 37% of our total worldwide revenue,or $34.9 million, in fiscal 2005.

**WEARE RELIANT PRIMARILY ON OUR VOICE QUALITY BUSINESS TO GENERATE REVENUE GROWTHAND PROFITABILITY, WHICHCOULD LIMIT OUR RATE OF FUTURE REVENUE GROWTH.**

We expect that, at least through fiscal 2007, ourprimary business will be the design, development and marketing of voiceprocessing products. However, the relatively small size of the overall echocancellation portion of the voice market, which is where we have derived themajority of our revenue to date, could limit the rate of growth of ourbusiness. In addition, certain telecommunication service providers may utilizedifferent technologies, such as VoIP, which would further limit demand forproducts we sold in fiscal 2006 and 2005, which are deployed in mobile andwireline networks. Although we have begun to distribute for trial our PacketVoice Processor for use in the VoIP market, we generated only nominal revenuein the fourth quarter of fiscal 2006.

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

Our quarterly operating results have fluctuatedsignificantly in the past and may fluctuate in the future as a result ofseveral factors, some of which are outside of our control. If revenue significantlydeclines, as we experienced in the first nine months of fiscal 2006, ouroperating results will be adversely affected because many of our expenses arerelatively fixed. In particular, sales and marketing, research and developmentand general and administrative expenses do not change significantly withvariations in revenue in a quarter. Adverse changes in our operating resultscould adversely affect our stock price. For example, when we announced in May 2005that we expected our revenue for the first quarter of fiscal 2006 would be lessthan half of our revenue in the last quarter of fiscal 2005, our stock pricedropped from a 

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closing price of $12.59just prior to our announcement to a closing price of $7.79 per share on the dayfollowing our announcement.

**OUR REVENUE MAY VARY FROM PERIOD TO PERIOD.**

Factors that couldcause our revenue to fluctuate from 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;

·       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.

Sales of our products typically come from our majorcustomers ordering large quantities when they deploy a switching center.Consequently, we may get one or more large orders in one quarter from acustomer and then no orders in the next quarter. As a result, our revenue mayvary 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 salescycle for our products is typically lengthy. Before ordering our products, ourcustomers perform significant technical evaluations, which typically last up to90 days or more for our base echo cancellation systems and up to 180 days ormore for our newer VQA product offering. Once an order is placed, deliverytimes can vary depending on the product ordered and the timing of installationsor product acceptance may be delayed by our customers. As a result, revenueforecasted for a specific customer for a particular quarter may not occur in thatquarter. Because of the potential large size of our customers’ orders, thiswould adversely affect our revenue for the quarter.

**OUR EXPENSES MAY VARY FROM PERIOD TO PERIOD.**

Many of ourexpenses do not vary with our revenue. Factors that could cause our expenses tofluctuate 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.

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

**IF WE DO NOT SUCCESSFULLY DEVELOP AND INTRODUCE NEWPRODUCTS, OUR PRODUCTS MAY BECOME OBSOLETE WHICH COULD CAUSEOUR SALES TO DECLINE.**

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 sales levels.These risks are of particular concern when a new generation product isintroduced. Although we believe we will meet our product introductiontimetables, there is no guarantee that delays will not occur. We realized ourfirst modest levels of revenue from our new voice quality features, which arebeing offered on our BVP-Flex and Quad Voice Processor (QVP) voice processinghardware platforms, in the fourth quarter of fiscal 2004 and are currentlyexperiencing numerous customer evaluations of these features around the world. Theseevaluations have typically taken longer than we first anticipated. We did,however, generate $3.5 million of revenue in our fourth quarter of fiscal 2006from international customers that purchase the VQA platform. We expect moresignificant levels of revenue from these new features in the first half offiscal 2007 based on our backlog. However, should the product not meet thecustomers’ expectations, the timing of our realization of any revenues from theVQA platform could be delayed or not materialize at all.

The Packet Voice Processor, currently in beta phase,provides voice processing functionality to enable the deployment of end-to-endVoIP services. This is the first packet-based product developed by us. Theproduct may not be accepted in the market due to feature or capabilitiesmis-matches with customer requirements, pricing of the product, or limitationsof our sales and marketing organizations 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, an unexpected drop in demand for our OC-3 product led to thewrite down of $3.5 million of excess inventory in the third quarter of fiscal2002. Although we were eventually able to sell this product after havingwritten it down, there can be no assurances that we will be able to selladditional written-down units 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.Our new and/or existing products may not be able to address evolving demands inthe telecommunications market in a timely or effective way. Even if they do,customers in these markets may purchase or otherwise implement competingproducts.

**WE OPERATE IN AN INDUSTRY EXPERIENCING RAPIDTECHNOLOGICAL CHANGE, WHICH MAY MAKE OUR PRODUCTS 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.

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WE MAY NOT BE ABLE TO RESPOND QUICKLY AND EFFECTIVELYTO THESE RAPID CHANGES.   The emerging nature of these products and theirrapid evolution will require us to continually improve the performance,features and reliability of our products, particularly in response tocompetitive 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 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 MODIFY OURPRODUCTS AS A RESULT OF CHANGES IN INDUSTRY STANDARDS.   The emergence ofnew industry standards, whether through adoption by official standardscommittees or widespread use by service providers, could require us to redesignour products. If such standards become widespread, and our products are not incompliance, our current and potential customers may not purchase our products.The rapid development of new standards increases the risk that our competitorscould develop and introduce new products or enhancements directed at newindustry standards before us.

**ACQUISITIONS ANDINVESTMENTS 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. Acquisitions or investments could result in a number offinancial 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 operationalrisks, 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 limitedprior experience; and

·       potential loss of keyemployees of acquired organizations.

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**WE ANTICIPATE THAT AVERAGE SELLING PRICES FOR OURPRODUCTS WILL DECLINE IN THE FUTURE, WHICH COULD ADVERSELY AFFECT OUR ABILITYTO 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 to increasing competition and ouranticipation that average-selling prices will decrease, we are attempting toreduce manufacturing costs of our new and existing products. If we do notreduce manufacturing costs and average selling prices decrease, our operatingresults will be adversely affected. Manufacturing is currently outsourced toprimarily one contract manufacturer. We believe that our current contractmanufacturing relationship provides us with competitive manufacturing costs forour products. However, if we or this contract manufacturer terminates ourrelationship, or if we otherwise establish new relationships, we may encounterproblems in the transition of manufacturing to another contract manufacturer,which could temporarily increase our manufacturing costs and cause productiondelays.

**IF WE LOSE THE SERVICES OF ANY OF OUR KEY MANAGEMENTOR KEY TECHNICAL PERSONNEL, OR ARE UNABLE TO RETAIN OR ATTRACTADDITIONAL TECHNICAL PERSONNEL, OUR ABILITY TO CONDUCT AND EXPAND OUR BUSINESSCOULD 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 technical employees. However, we may not be able to do so.

**WE FACE INTENSE COMPETITION, WHICH COULD ADVERSELYAFFECT OUR ABILITY TO MAINTAIN OR 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.Certain of our customers also have the ability to internally produce theequipment that they currently purchase from us. In such cases, we also competewith their internal product development capabilities. We expect thatcompetition will increase in the future. We may not have the financialresources, technical expertise or marketing, manufacturing, distribution andsupport capabilities to compete successfully.

We face competition from two direct manufacturers ofstand-alone voice processing products, Tellabs and Natural Microsystems. Theother competition in these markets comes from voice switch manufacturers. Theseswitch manufacturers do not sell voice processing products or compete in thestand-alone voice processing product market, but they integrate voice processingfunctionality within their switches, either as hardware modules or as softwarerunning on chips. A more widespread adoption of internal voice processingsolutions would present an increased competitive threat to us, if the netresult was the elimination of demand for our voice processing system products.

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Many of our competitorsand potential competitors have long-standing relationships with our existingand potential customers, and 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.

**WE DO NOT HAVE THE RESOURCES TO ACT AS A SYSTEMSINTEGRATOR, WHICH MAY BE REQUIRED TO WIN DEALS WITH SOME LARGE U.S. ANDINTERNATIONAL TELECOMMUNICATIONS SERVICES COMPANIES.**

When implementingsignificant technology upgrades, large U.S. and internationaltelecommunications services companies often require one major equipmentsupplier to act as a “systems integrator” (SI) to ensure interoperability ofall the network elements. Normally the SI would provide the most crucialnetwork elements and also take responsibility for the interoperation of theirown equipment with the equipment provided by other suppliers. We are not in aposition to take such a lead SI position and therefore we may have to partnerwith an SI (other, much larger, telecommunication equipment supplier) to have achance to win with certain customers. As a result, we may experience delays inrevenue because it could take a long time to agree to terms with the necessarySI. Moreover, there is no guarantee that we will reach agreement with a SI.

**IF INCUMBENT AND EMERGING COMPETITIVE SERVICEPROVIDERS AND THE TELECOMMUNICATIONS INDUSTRY AS A WHOLE EXPERIENCE ADOWNTURN OR REDUCTION IN GROWTH RATE, THE DEMAND FOR OUR PRODUCTS WILLDECREASE, WHICH WILL ADVERSELY AFFECT OUR BUSINESS.**

Our success will continueto depend in large part on development, expansion and/or upgrade of voice andcommunications networks. We are subject to risks of growth constraints due toour current and planned dependence on U.S. and international telecommunicationsservice providers. In fiscal 2001, for example, we experienced, as did othercompanies in our sector, a slowdown in infrastructure spending by our customers.These potential customers may be constrained for a number of reasons, includingtheir limited capital resources, economic conditions, changes in regulation andmergers or consolidations which we have seen in North America since calendaryear 2004. New service provides (E.g., Skype, Google and Yahoo) are beginningto compete against our traditional customers with new business models that aresubstantially reducing the prices charged to end users. This competition mayforce network operators to reduce capital expenditures.

**WE MAY EXPERIENCE UNFORESEEN PROBLEMS AS WE DIVERSIFYOUR INTERNATIONAL CUSTOMER BASE, WHICH WOULD IMPAIR OUR ABILITY TOGROW 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, mayinvest in markets that ultimately generate little or no revenue, and may incurother unforeseen expenditures related to our international expansion. Despitethese efforts, to date our expansion overseas has met with limited success andthere is no guarantee of future success. As we expand our sales focus fartherinto international markets, we will face new and complex issues that we may nothave faced before, such as expanded risk to currency fluctuations, longerpayment cycles, manufacturing overseas, political or economic instability,potential adverse tax consequences and broadened import/export controls, whichwill put additional strain on our management personnel. In the past, thevast majority 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.

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The number of installationswe will be responsible for may increase as a result of our continuedinternational expansion and recognition of revenue may be dependent onacceptances. 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.

**SOME OF THE KEY COMPONENTS USED IN OUR PRODUCTS ARECURRENTLY AVAILABLE ONLY FROM SOLE SOURCES, THE LOSS OF WHICHCOULD 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 impacts on the cost of ourproducts or require us to find alternative, less expensive components, whichwould have to be designed into our products in an effort to avoid erosion inour product margin.

**WE NOW LICENSE OUR ECHO CANCELLATION SOFTWARE FROMTEXAS INSTRUMENTS, AND IF WE DO NOT RECEIVE THE LEVEL OFSUPPORT WE EXPECT FROM TEXAS INSTRUMENTS, IT COULD ADVERSELY AFFECT OUR ECHOCANCELLATION 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. The license had aninitial four-year royalty-free period after which, in March 2006, we (1) extendedthe royalty-free period through December 31, 2007 primarily to supportDitech’s remaining warranty obligation for our end-of-life products and (2) negotiatednew pricing based on the purchase of chips bundled with the echo software forour current products. Although the licensing agreement has strong guarantees ofsupport for the software used in our products, if Texas Instruments were tobreach that agreement in some fashion, and not deliver complete and timelysupport to us, our success in the echo cancellation systems business could beadversely affected.

**IF TEXAS INSTRUMENTS LICENSES ITS ECHO CANCELLATIONSOFTWARE TO OTHER ECHO CANCELLATION SYSTEMS COMPANIES, THISCOULD INCREASE THE COMPETITIVE PRESSURES ON OUR ECHO CANCELLATION SYSTEMSBUSINESS.**

Under the terms of thesale agreement of our echo cancellation software to Texas Instruments, TexasInstruments was precluded from licensing the software to two specifiedcompetitors for a period of four years from the date of the sale. If TexasInstruments were to license its echo cancellation software to other echocancellation systems companies other than the two specified competitors, orbeginning in April 2006 to either or both of the two specifiedcompetitors, it could increase the level of competition and adversely affectour success in our echo cancellation systems business.

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**SOME SUPPLIERS OF KEY COMPONENTS MAY REDUCE THEIRINVENTORY LEVELS WHICH COULD RESULT IN LONGER LEAD TIMES FORFUTURE COMPONENT PURCHASES AND ANY DELAYS IN FILLING OUR DEMAND MAY REDUCEOR DELAY OUR EXPECTED PRODUCT SHIPMENTS AND REVENUES.**

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 notmeet our total demand. As a result, the scheduled shipment of our OC-3product was delayed, which contributed to our revenue shortfall in thatquarter.

**IF WE ARE UNSUCCESSFUL IN MANUFACTURING PRODUCT THATCOMPLIES WITH ENVIRONMENTAL REQUIREMENTS,IT MAY LIMIT OUR ABILITY TO SELL IN EUROPEAN UNION (EU) COUNTRIES ANDTERRITORIES.**

As part of our 14001-certifiedmanagement system and our overall commitment to the environment we areinvestigating the requirements set forth by the RoHS directive. Based on someindependent industry benchmarking, and guidance offered by the UK’s Departmentof Trade and Industry, we believe that our product, telecommunication networkinfrastructure equipment, qualifies for the lead-in-solder exemption of theRoHS Directive. Consequently, we are pursuing what is commonly called “5 of 6”compliance for the July 2006 implementation deadline. We will continue tomonitor the evolution of the EC/95 and related industry activities and willtake appropriate action for those products that we sell into EU countries andterritories. Moreover, we will continue to monitor the evolution of the EC/96and related industry activities and will take appropriate action for thoseproducts that we sell into EU countries and territories. There is no guaranteethat we will be successful in complying with these evolving environmentalrequirements. If we are unsuccessful in complying with these environmentalrequirements, it would limit our ability to sell into EU countries andterritories.

**OUR ABILITY TO COMPETE SUCCESSFULLY WILL DEPEND, INPART, ON OUR ABILITY TO PROTECT OUR INTELLECTUAL PROPERTYRIGHTS, 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 our intellectualproperty, and we may not have adequate remedies for any such breach. Inaddition, we may not be able to effectively protect our intellectual propertyrights in certain countries. We may, for a variety of reasons, decide not tofile 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 to protect ourintellectual property, our competitors may be able to develop products that areequal or superior to our products without infringing on any of our intellectualproperty rights.

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**WE CURRENTLY ARE, AND IN THE FUTURE MAY BE,SUBJECT TO SECURITIES CLASS ACTION LAWSUITS 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,*Case No. 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. Several similar lawsuits were filed andall of the cases were consolidated into a single action. In addition, ashareholder’s derivative suit was filed against our directors and the same twoexecutive officers, and named Ditech nominally as a defendant, making similarallegations. This shareholder’s derivative suit was subsequently voluntarilydismissed without prejudice, which means that the shareholder is able to refilethe shareholder’s derivative suit at any time. We cannot predict the outcome ofthe lawsuits. If our stock price declines substantially in the future, we maybe the target of similar litigation. The current, and any future, securitieslitigation could result in substantial costs and divert management’s attentionand resources, and could seriously harm our business.

**OUR PRODUCTS EMPLOY TECHNOLOGY THAT MAY INFRINGEON THE PROPRIETARY RIGHTS OF THIRD PARTIES, WHICH MAY EXPOSE US TOLITIGATION.**

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.

**THERE IS RISK THAT WE WILL NOT BE ABLE TO FULLYUTILIZE THE DEFERRED TAX ASSETS RECORDED ON OUR BALANCE SHEET.**

In accordance withStatement of Financial Accounting Standard (SFAS) No. 109, “Accounting forIncome Taxes,” we are required to establish a valuation allowance against ourdeferred tax assets if it is morelikely than not that some portion or all of the deferred tax assets will not berealized. The valuationallowance should be sufficient to reduce the deferred tax asset to the amountthat is more likely than not to be realized. At April 30, 2006, we had$48.8 million in net deferred tax assets, which we believe are realizable basedon the requirements of SFAS 109. However, because we incurred pre-tax losses inthe first and second quarters of fiscal 2006, have shown volatile operatingresults in the past and because there is no guarantee that the amount andtiming of our net profits will be sufficient to fully utilize our deferred taxassets, there is a risk that we will have to record valuation allowances in thefuture. Moreover, there is a risk that unfavorable audits of, for example, taxcredit or NOL carryforwards by government agencies or change of ownershiplimitations (Section 382) may reduce the value of our deferred tax assets.If any of these events were to occur, our financial results for one or moreperiods would be adversely affected.

**BEGINNING MAY 1, 2006, WE WILL BE REQUIRED TORECORD COMPENSATION EXPENSE FOR STOCK OPTIONS. AS A RESULT, OUR FINANCIALRESULTS WILL BE ADVERSELY AFFECTED.**

In December 2004,FASB issued an accounting standard that will require the fair value of allequity-based awards granted to employees be recognized in the statement ofoperations as compensation expense, beginning on May 1, 2006 for ourcompany. The various methods for determining the fair value of stock 

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optionsare based on, among other things, the volatility of the underlying stock. Ourstock price has historically been volatile. Therefore, the adoption of thisaccounting standard will significantly and negatively affect our financialresults and may adversely affect our stock price. Such adoption could alsolimit our ability to continue to use stock options as an incentive andretention tool, which could, in turn, hurt our ability to recruit employees andretain existing employees.

**Item 1B—UnresolvedStaff Comments**

None.

**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 64% 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 July 31, 2011.We believe that the space under the lease is adequate to meet our needs for theforeseeable future. We additionally have leased office space in Calgary, Canadaunder an operating lease expiring on January 31, 2011.

**Item 3—LegalProceedings**

Beginning on June 14, 2005, several purportedclass action lawsuits were 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 complaints allege claims under Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934 against Ditech and its Chief ExecutiveOfficer and Chief Financial Officer in connection with alleged misrepresentationsconcerning VQA orders and the potential effect on Ditech of the merger betweenSprint and Nextel. All of the lawsuits were consolidated into a singleaction entitled*In re Ditech CommunicationsCorp. Securities Litigation,* No. C 05-02406-JSW, and aconsolidated amended complaint was filed on February 2, 2006. Thedefendants moved to dismiss the complaint, and the motion was heard and takenunder submission by the court on June 9, 2006. This matter is at anearly stage; no discovery has taken place and no trial date has been set.

On June 20, 2005, thefirst of two shareholder derivative complaints was filed in the CaliforniaSuperior Court for the County of Santa Clara. Both complaints werepurportedly brought derivatively by shareholders on behalf of Ditech againstseveral executives of Ditech and all members of its board of directors, andnamedDitech as a nominal defendant. The plaintiffs alleged that the defendants breached theirfiduciary duties to Ditech in connection with alleged misrepresentationsconcerning VQA orders and the potential effect on Ditech of the merger betweenSprint and Nextel, that certain of the defendants improperly sold Ditech stockwhile in possession of material nonpublic information, and that the defendants were liableto Ditech for damages as a result thereof. Both lawsuits were consolidated intoa single action entitled*In re DitechCommunications Corp. Derivative Litigation,* No. 105-CV-043429.The defendants filed a demurrer to the consolidated complaint, which was grantedby the court with leave to amend. The plaintiffs elected not to amend thecomplaint, and voluntarily dismissed the action without prejudice on February 14,2006.

**Item 4—Submissionof Matters to a Vote of Security Holders**

Not Applicable.

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**Part II**

**Item 5—Market for Registrant’s Common Equity, RelatedStockholder Matters and Issuer Purchases of Equity Securities**

Ditech’scommon stock is quoted on the Nasdaq Global Market under the symbol “DITC.” Thefollowing 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 2006** | ** ** | **Fiscal 2005** | ** ** |
|----------------|------------|----------------------|------------|----------------------|------------|
| ** **     | ** ** | **High**             | ** ** | **Low**              | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $                    | 12.59      |                 | $          | 6.35 |   | $ | 25.50 |   | $ | 12.94 |   |
| Second Quarter |       | $                    | 8.21       |                 | $          | 6.12 |   | $ | 26.87 |   | $ | 14.65 |   |
| Third Quarter  |       | $                    | 9.25       |                 | $          | 6.17 |   | $ | 23.19 |   | $ | 12.76 |   |
| Fourth Quarter |       | $                    | 10.80      |                 | $          | 8.82 |   | $ | 14.33 |   | $ | 10.65 |   |

 

On June 23, 2006 thelast reported sale price of our common stock as reported on the Nasdaq NationalMarket was $8.46 per share. According to the records of our transfer agent,there were 121 stockholders of record of Ditech’s common stock at June 23,2006. 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.

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**Item 6—SelectedFinancial Data**

Theconsolidated statement of operations data for the years ended April 30,2006, 2005 and 2004, and the consolidated balance sheet data as of April 30,2006 and 2005, have been derived from our audited consolidated financialstatements included in Item 8 of this Annual Report on Form 10-K.The consolidated statement of operations data for the years ended April 30,2003 and 2002, as adjusted to give effect to the discontinued operationspresentation of our optical business, see Note 4 of the Notes to theConsolidated Financial Statements, and the consolidated balance sheet data asof April 30, 2004, 2003 and 2002, have been derived from our consolidatedfinancial statements not included in this Annual Report on Form 10-K.The data set forth below should be read in conjunction with our consolidatedfinancial statements, including the notes thereto, set forth in “Item 8—FinancialStatements and Supplementary Data” of this Annual Report on Form 10-K,and with “Item 7—Management’s Discussion and Analysis of FinancialCondition and Results of Operations” included elsewhere in this Form 10-K.
|                                                                                                           | ** ** | **Years Ended April 30,**                           | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated  Statement of Operations Data:**                                                           | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                                                                                                   |       | $                                                                  | 54,905     |   | $ | 94,055 |   | $ | 69,590 |   | $ | 35,088 |   | $ | 27,214 |   |
| Cost of goods sold                                                                                        |       | 16,368                                                             |       | 22,184 |   | 23,413 |   | 13,543 |   | 15,009 |   |
| Gross profit                                                                                              |       | 38,537                                                             |       | 71,871 |   | 46,177 |   | 21,545 |   | 12,205 |   |
| Operating expenses:                                                                                       |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                                       |       | 18,233                                                             |       | 16,430 |   | 13,168 |   | 12,051 |   | 13,277 |   |
| Research and development                                                                                  |       | 17,884                                                             |       | 15,826 |   | 10,719 |   | 9,952 |   | 14,888 |   |
| General and administrative                                                                                |       | 6,568                                                              |       | 7,244 |   | 5,308 |   | 5,269 |   | 5,980 |   |
| Amortization of  purchased intangible assets                                                              |       | 821                                                                |       | — |   | — |   | — |   | 4,967 |   |
| In-process research and  development                                                                      |       | 700                                                                |       | — |   | — |   | — |   | — |   |
| Amortization of goodwill                                                                                  |       | —                                                             |       | — |   | — |   | — |   | 2,177 |   |
| Restructuring charges                                                                                     |       | —                                                             |       | — |   | 275 |   | — |   | — |   |
| Total operating expenses                                                                                  |       | 44,206                                                             |       | 39,500 |   | 29,470 |   | 27,272 |   | 41,289 |   |
| Income (loss) from  continuing operations                                                                 |       | (5,669                                                             | )          | 32,371 |   | 16,707 |   | (5,727 | ) | (29,084 | ) |
| Other income, net                                                                                         |       | 4,522                                                              |       | 2,430 |   | 1,294 |   | 1,702 |   | 3,701 |   |
| Income (loss) from  continuing operations before income taxes and cumulative effect of accounting  change |       | (1,147                                                             | )          | 34,801 |   | 18,001 |   | (4,025 | ) | (25,383 | ) |
| Provision (benefit) for  income taxes                                                                     |       | 262                                                                |       | (36,100 | ) | 270 |   | — |   | 4,982 |   |
| Income (loss) from  continuing operations before cumulative effect of accounting change                   |       | (1,409                                                             | )          | 70,901 |   | 17,731 |   | (4,025 | ) | (30,365 | ) |
| Discontinued operations:                                                                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Loss from discontinued  operations                                                                        |       | —                                                             |       | — |   | (2,538 | ) | (34,119 | ) | (54,836 | ) |
| Income tax provision  (benefit) from loss on discontinued operations                                      |       | —                                                             |       | — |   | — |   | 129 |   | 128 |   |
| Gain (loss) on  disposition                                                                               |       | 887                                                                |       | 94 |   | (7,142 | ) | — |   | — |   |
| Income tax expense  (benefit) from gain (loss) on disposition                                             |       | 361                                                                |       | (110 | ) | (144 | ) | — |   | — |   |
| Income (loss) from  discontinued operations                                                               |       | 526                                                                |       | 204 |   | (9,536 | ) | (34,248 | ) | (54,964 | ) |
| Cumulative effect of  accounting change                                                                   |       | —                                                             |       | — |   | — |   | (36,837 | ) | — |   |
| Net income (loss)                                                                                         |       | $                                                                  | (883       | ) | $ | 71,105 |   | $ | 8,195 |   | $ | (75,110 | ) | $ | (85,329 | ) |

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| Per share data:                                                                         |   |   |   |   |   |   |   |   |   |   |   |
|-----------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Basic                                                                                   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from  continuing operations before cumulative effect of accounting change |   | $      | (0.04  | )      | $      | 2.12   |   | $      | 0.56   |   | $      | (0.13 | ) | $ | (1.03 | ) |
| Discontinued operations                                                                 |   | 0.01   |   | 0.01   |   | (0.30  | )      | (1.13  | )      | (1.87  | )      |
| Cumulative effect of  accounting change                                                 |   | — |   | — |   | — |   | (1.21  | )      | — |   |
| Net income (loss) per  share attributable to common stockholders                        |   | $      | (0.03  | )      | $      | 2.13   |   | $      | 0.26   |   | $      | (2.47 | ) | $ | (2.90 | ) |
| Diluted                                                                                 |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from  continuing operations before cumulative effect of accounting change |   | $      | (0.04  | )      | $      | 2.02   |   | $      | 0.53   |   | $      | (0.13 | ) | $ | (1.03 | ) |
| Discontinued operations                                                                 |   | 0.01   |   | 0.00   |   | (0.29  | )      | (1.13  | )      | (1.87  | )      |
| Cumulative effect of  accounting change                                                 |   | — |   | — |   | — |   | (1.21  | )      | — |   |
| Net income (loss) per  share attributable to common stockholders                        |   | $      | (0.03  | )      | $      | 2.02   |   | $      | 0.24   |   | $      | (2.47 | ) | $ | (2.90 | ) |
| Number of shares used in  per share calculations:                                       |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                   |   | 32,119 |   | 33,408 |   | 31,734 |   | 30,371 |   | 29,380 |   |
| Diluted                                                                                 |   | 32,119 |   | 35,140 |   | 33,496 |   | 30,371 |   | 29,380 |   |

 
|                                       | ** ** | **April 30,** | ** ** |
|---------------------------------------|------------|--------------------|------------|
| ** **                            | ** ** | **2006**           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Consolidated  Balance Sheet Data:** | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents            |       | $                  | 35,707     |   | $ | 36,781 |   | $ | 45,610 |   | $ | 69,670 |   | $ | 56,959 |   |
| Short-term  investments               |       | 100,325            |       | 98,853 |   | 79,899 |   | 24,825 |   | 48,950 |   |
| Total assets                          |       | 219,313            |       | 209,720 |   | 150,548 |   | 126,441 |   | 203,874 |   |
| Total stockholders’  equity      |       | 198,581            |       | 197,265 |   | 135,400 |   | 116,138 |   | 186,938 |   |
|                                       |            |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The selected financial data for the five years ended April 30,2006 reflects the following:

We amortized goodwill and other intangibles anddeferred stock compensation of an acquisition we made in February 2000until the sale of the underlying software technology at the end of fiscal 2002.In accordance 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.

We disposed of our optical business in July 2003,which resulted in the financial results from our optical business beingreported as a discontinued operation for all periods presented and contributedto our ability to return to positive net income during fiscal 2004.

Following our fiscal 2004 return to profitability, wereversed a valuation allowance on our deferred tax assets, resulting in a $36.1million tax benefit in fiscal 2005.

Following our acquisitionof Jasomi, we wrote off $700,000 of in-process R&D and amortized $821,000of acquired intangible assets in fiscal 2006.

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**Item 7—Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

*Thefollowing discussion and analysis should be read in conjunction with “SelectedFinancial Data” and our Consolidated Financial Statements and Notes theretoincluded elsewhere in this Annual Report on Form 10-K. Thediscussion 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 “Ite  1. Business” regardingthese statements. Our actual results could differ materially from thosediscussed here. See “Item 1A-Risk Factors” for factors that could cause futureresults to differ materially.*

**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.Our products monitor and enhance voice quality and provide security in thedelivery of voice services.  Sinceentering the voice processing market, we have continued to refine our echocancellation products to meet the needs of the ever-changing telecommunicationsmarketplace. Our more recent product introductions have leveraged theprocessing capacity of our newer hardware platforms to offer not only echocancellation but also enhanced VQA features including noise reduction, acousticecho cancellation, voice level control and noise compensation through enhancedvoice intelligibility. Since becoming a public company in June 1999, ourfinancial success has been primarily predicated on the macroeconomicenvironment of U.S. wireline and, more recently, wireless carriers as well asour success in selling to the larger carriers. Since the beginning of calendaryear 2004, large North American telecommunications service providers have engagedin merger and acquisition activity. Such activity largely drove our fiscal 2006revenue decline of 42% as one of our two largest fiscal 2005 U.S. customers wasand continues to be involved in post-merger integration and, consequently,orders from that customer in fiscal 2006 were nominal. Our revenue willcontinue to be heavily influenced by the buying trends of Verizon Wireless, ourlargest customer in fiscal 2006 at 79% of our total worldwide revenue. Ourrevenue also will continue to be primarily generated from sales of ourBVP-Flex, which accounted for 81% of our revenue in fiscal 2006. In an attemptto diversify our customer base, beginning in fiscal 2004 and throughout fiscal2005, we added sales and marketing resources to focus on new large accountopportunities in the United States. In the United States, we believe that ourcontinued focus on voice quality in the competitive wireless services landscapeand the continued expansion of wireless networks will be key factors in addingnew customers and driving our revenue growth. Internationally, we have alsoadded sales resources and invested in customer trials. The development of ourVQA feature set was targeted at the international GSM market. In fiscal 2006,Orascom Telecom Holding (Orascom) became our largest VQA sale to-date, as wellas a step toward our goal of greater customer diversification. While fromfiscal 2005 to fiscal 2006 our international revenue declined from $8.7 millionto $6.9 million, we generated $3.5 million of international revenue in thefourth quarter of fiscal 2006 and we currently have revenue deferrals andorders from which we expect to generate $5-6 million of internationalrevenue in the first quarter of fiscal 2007. We continue to focus oninternational mobile carriers who might best apply our VQA solution.

We expect additional long-term opportunities forgrowth will occur in VoIP-based network deployments as there appears to be agrowing trend of service providers transitioning from traditionalcircuit-switched network infrastructure to VoIP. We have therefore directed themajority of our R&D spending, since the beginning of fiscal 2005, towardsthe development of our Packet Voice Processor, a new platform targetingVoIP-based network deployments. The Packet Voice Processor, currently in itsbeta phase, introduces cost-effective voice format transcoding capabilities andcombines our VQA software and newly developed PQA technology to improve callquality and clarity by eliminating acoustic echo and voice level imbalances andreducing packet loss, delay and jitter. To further develop a presence in theVoIP market, we acquired Jasomi. Jasomi’s currently available PeerPoint C100session border 

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controller enables VoIPcalls to traverse the NAT and protects networks from external attacks byadmitting only authorized sessions, ensuring that reliable VoIP service can beprovided to them. We plan to combine the Packet Voice Processor and sessionborder controller technologies to provide a more comprehensive solution tocarriers’ border services needs. In fiscal 2006, we recognized modest revenuefrom PeerPoint and sold our first Packet Voice Processor beta unit in thefourth quarter.

*Exitof 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 VQA products, and as a result we decided tosell our optical communications business. In July 2003, we completed theprimary step in our planned exit of our optical communications business throughthe sale of a large portion of the assets of the optical communicationsbusiness to JDS Uniphase Corporation (“JDSU”). The assets sold consistedprimarily of inventory, certain specified optical-related equipment andintellectual property rights, which were sold for an aggregate purchase priceof 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 JDSU forany purchased but unused inventory at June 30, 2004, up to $2.0 million,which right expired as of July 31, 2004. JDSU also had indemnificationrights in connection with the performance of certain warranty obligationsrelating to optical products that were sold by us on or prior to July 16,2003.  In fiscal 2004, we recognized$855,000 associated with the level of revenue generated by JDSU since the closeof the sale. 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. Infiscal 2005, income from discontinued operations was due to adjustments neededto reflect actual costs incurred and to recognize a tax benefit due to therelease of our valuation reserve. In June 2006, we and JDSU came to amutual settlement and release whereby JDSU paid us $718,000 and released usfrom our warranty obligation. In addition, in June 2006, we completed theclosure of our international optical operations. See Note 4 of Notes tothe 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.

*AcquisitionHistory.**  *Inthe last five fiscal years, we have completed two acquisitions. In July 2000,we acquired Atmosphere Networks, Inc. to bring then-needed technicalskills to our optical engineering group. In May 2002, we recorded atransitional impairment of the unamortized goodwill balance associated withthis acquisition of $36.8 million, which was reported as a cumulativeeffect of accounting change. In June 2005, we acquired Jasomi, whichdeveloped and sold session border controllers that enable VoIP calls totraverse the NAT and protect networks from external attacks by admitting onlyauthorized sessions, ensuring that reliable VoIP service can be provided tothem. The combination of Ditech’s Packet Voice Processor and Jasomi’s sessionborder control technology may enable Ditech to provide a more comprehensivesolution to carriers’ border service needs. Consideration for the acquisitionincluded $14.8 million in cash, escrow payments, vested options assumed,acquisition costs, and net liabilities assumed plus $7.0 million innon-transferable convertible notes. The payment of the full $7.0 millionprincipal amount of the convertible notes is contingent on the retention of aspecified number of designated employees and is not reflected in the purchaseprice. We additionally issued shares of Ditech 

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restricted stock to newemployees hired as part of the acquisition. See Note 6 of Notes to theConsolidated Financial Statements.

*OurCustomer Base.**  *Historically,the majority of our sales have been to customers in the United States. Thesecustomers accounted for approximately 87%, 91% and 89% of our revenue in fiscal2006, 2005 and 2004, 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 largest customer accounted for approximately 79% of our totalrevenue in fiscal 2006. Our five largest customers accounted for approximately88%, 91% and 86% of our revenue in fiscal 2006, 2005 and 2004, respectively.Consequently, the loss of any one of our largest customers, without anoffsetting increase in revenue from existing or new customers, would have anegative and substantial effect on our business. This customer concentrationrisk was evidenced in fiscal 2006 as revenue was approximately 58% of ourfiscal 2005 revenue primarily due to a lack of orders from one of two largestfiscal 2005 customers. This caused fiscal 2006 to result in a net loss.

*CriticalAccounting Policies and Estimates.**  *The preparation of our financialstatements requires us to make certain estimates and judgments that affect thereported amounts of assets, liabilities, revenue and expenses and relateddisclosures. We evaluate these estimates on an ongoing basis, including thoserelated to our revenue, allowance for bad debts, provisions for inventories,warranties and recovery of deferred income taxes. Estimates are based on ourhistorical experience and other assumptions that we consider reasonable underthe circumstances, the results of which form the basis for making judgmentsabout the carrying value of assets and liabilities that are not readilyapparent from other sources. Actual future results may differ from theseestimates in the event that facts and circumstances vary from our expectations.To the extent there are material differences between our ongoing estimates andthe ultimate actual results, our future results of operations will be affected.We believe that the following critical accounting policies affect the mostsignificant judgments and estimates used in the preparation of our consolidatedfinancial statements.

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 30,2006, we had deferred $12.7 million of revenue. To the extent that we havereceived cash for some or all of a given deferred revenue transaction, wereported it on the Consolidated Balance Sheet as a deferred revenue liability.However, to the extent that we have not collected cash against the deferredrevenue transaction, we reflect the deferred revenue as a reduction in thecorresponding account receivable balance. Of the $12.7 million of revenuedeferred as of April 30, 2006, $12.1 million related to deferralsassociated with installations and $598,000 was associated with maintenancecontracts. In dealing with smaller customers, we closely evaluate the creditrisk of these customers. In those cases where credit risk is deemed to be high,we either mitigate the risk by having the customer post a letter of credit,which we can draw against on a specified date to effectively provide reasonableassurance of collection, or we defer the revenue until customer payment isreceived.

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 

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liquidate on 28 or 35 dayauction cycles, are considered short-term investments. Other investmentsecurities with remaining maturities of one year or more are consideredlong-term investments. Short-term investments currently consist primarily ofcorporate bonds and asset backed securities. We have classified our short-termand long-term investments as available-for-sale securities in the accompanyingconsolidated financial statements. Available-for-sale securities are carried atfair value, with unrealized gains and losses reported in a separate componentof stockholders’ equity. Realized gains and losses and declines in value judgedto be other-than-temporary, if any, on available-for-sale securities areincluded in interest income based on specific identification. Interest onsecurities classified as available-for-sale is also included in interestincome.

Inventory Valuation—In conjunction with our ongoinganalysis of inventory valuation, we are constantly monitoring projected demand ona product by product basis. Based on these projections we evaluate the levelsof allowances required both for inventory on hand, as well as inventory onorder from our contract manufacturer. Although we believe we have beenreasonably successful in identifying allowance requirements in a timely manner,sudden changes in future buying patterns from our customers, either due to ashift in product interest and/or a complete pull back from their expected orderlevels could result in some larger than anticipated write-downs beingrecognized, such as the OC-3 write-down recorded in fiscal 2002. For theOC-3 write-down, the complete pull back from the forecasted demand by theprimary customer for this product resulted in a $3.5 million write-down ofthe OC-3 inventory. However, beginning in 2003, the addition of a fewlarge new customers helped to utilize a large portion of the inventory whichhad been written down and we consequently sold $2.2 million and $455,000 ofwritten-down OC-3 inventory in fiscal 2004 and 2003, respectively. Wesold no additional OC-3 inventory in fiscal 2006 or 2005. However, wesold $634,000 and $911,000 of other previously written-down inventory in fiscal2006 and 2005, respectively. Fiscal 2006 sales of previously written-downinventory had a negligible impact on the fiscal 2006 gross margin as theinventory was sold for approximately its net book value.

Goodwill—Our methodology for allocating a portion ofthe purchase price to goodwill in connection with the purchase of Jasomi wasbased on established valuation techniques in the high-technology communicationsequipment industry. Goodwill was measured as the excess of the cost ofacquisition over the sum of the amounts assigned to tangible and identifiableintangible assets acquired, less liabilities assumed. Goodwill is not amortized.The goodwill recorded in the Condensed Consolidated Balance Sheet as of April 30,2006 was $9.9 million.

Impairment of Long-lived Assets—We evaluate therecoverability of our long-lived assets, including goodwill, on an annual basisor more frequently if indicators of potential impairment arise. Following thecriteria of SFAS 131 “Disclosure about Segments of an Enterprise and RelatedInformation” and SFAS 142 “Goodwill and Other Intangible Assets”, we viewDitech as having a single operating segment and consequently have evaluatedgoodwill and purchased intangible assets for impairment based on an evaluationof the fair value of Ditech as a whole. Ditech’s quoted share price from NASDAQis the basis for measurement of that fair value as Ditech’s marketcapitalization based on share price best represents the amount at which Ditechcould be bought or sold in a current transaction between willing parties.Measurement of an impairment loss for long-lived assets that we expect to holdand use is based on the difference between the fair value and carrying value ofthe asset. Long-lived assets to be disposed of are reported at the lower ofcarrying amount or fair value less costs to sell.

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Accounting for Stock-based Compensation—Statement ofFinancial Accounting Standards No. 123, “Accounting for Stock-basedCompensation,” (“SFAS 123”), encourages, but does not require, companiesto record compensation cost for stock-based compensation plans at fair value.We account for grants of equity instruments to employees using the intrinsicvalue method described in Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” and comply with the disclosure provisions ofSFAS 123. Accordingly, compensation cost for stock options is measured asthe excess, if any, of the quoted market price of Ditech’s stock at the date ofthe grant over the amount an employee must pay to acquire the stock and isrecognized over the vesting period of the related shares. In fiscal 2006, werecorded compensation expense related to the vesting of assumed stock optionsand the restricted stock grants made in connection with the June 30, 2006acquisition of Jasomi. Beginning with the first quarter of fiscal 2007, we willbegin to record compensation cost for stock-based compensation plans at fairvalue in accordance with Statement No. 123(Revised 2004) “Share-BasedPayment” (SFAS 123R), which is discussed below.

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, 2006,we had recorded $1.2 million of accruals related to estimated future warrantycosts. In general, we have been able to closely estimate the level of warrantyexposure on our products, and the level of adjustment required to the reservehas 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 and ournet operating loss and tax credit carryforwards result in deferred tax assetsand liabilities. At least once per quarter, we assess the likelihood that ournet deferred tax assets will be recovered from future taxable income and to theextent we believe that recovery is no longer more likely than not, we establisha valuation allowance. Significant management judgment is required indetermining our provision for income taxes, our deferred tax assets andliabilities and any valuation allowance recorded against our net deferred taxassets.

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 determined that it was more likely than not thatour deferred tax assets would be realized. We therefore released the valuationallowance of $51.6 million in fiscal 2005.

*RecentAccounting Pronouncements.**  *In November 2004, the FASB issued Statement ofFinancial Accounting Standards (SFAS) No. 151, Inventory Costs, whichclarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs, and wasted material. SFAS No. 151 will beeffective for inventory costs incurred during fiscal years beginning after June 15,2005. We do not believe the adoption of SFAS No. 151 will have a materialimpact on our financial statements.

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In December 2004, the FASB issued Statement No. 123(Revised2004) “Share-Based Payment” (SFAS 123R) which requires companies to measure andrecognize compensation expense for all stock-based payments at fair value. SFAS123R is effective for the first annual reporting period beginning after June 15,2005 and, thus, will be effective for us beginning fiscal 2007. In March 2005,the SEC issued Staff Accounting Bulletin (SAB) No. 107 regarding the SEC’sinterpretation of SFAS No. 123R and the valuation of share-based paymentsfor public companies. We are currently evaluating the impact of SFAS 123Rand SAB 107 on our financial position and results of operations. See “Accountingfor Stock-Based Compensation” above for information related to the pro formaeffects on our reported net income (loss) and net income (loss) per share ofapplying the fair value recognition provisions of the previous Statement ofFinancial Accounting Standards (SFAS) 123, “Accounting for Stock-BasedCompensation,” to stock-based employee compensation.

In June 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes, and FASB No. 3, Reporting Accounting Changes inInterim Financial Statements. The Statement applies to all voluntary changes inaccounting principle, and changes the requirements for accounting for andreporting of a change in accounting principle. SFAS 154 requires retrospectiveapplication to prior periods’ financial statements of a voluntary change inaccounting principle unless it is impracticable. It is effective for accountingchanges and corrections of errors made in fiscal years beginning after December 15,2005. Earlier application is permitted for accounting changes and correctionsof errors made occurring in fiscal years beginning after June 1, 2005. Wedo not expect the effect of SFAS 154 will have material impact on ourfinancial statements.

In November 2005, theFinancial Accounting Standards Board (FASB) issued final staff position(FSP) 115-1 and FSP 124-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments” which nullify certainrequirements of Emerging Issues Task Force (EITF) Issue No. 03-1 andsupersede EITF Topic No. D-44. The FSPs provide guidance foridentifying impaired investments and new disclosure requirements forinvestments that are deemed to be temporarily impaired. We do not believe theimpact of adoption of the measurement provisions of the FSPs will have amaterial impact on our financial statements.

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**Results ofOperations**

Thefollowing table sets forth certain items from our consolidated statements ofoperations as a percentage of revenue for the periods indicated:
|                                                                             | ** ** | **Years Ended April 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                                                     |       | 100.0                                    | %          | 100.0 | % | 100.0 | % |
| Cost of goods  sold                                                         |       | 29.8                                     |       | 23.6 |   | 33.6 |   |
| Gross profit                                                                |       | 70.2                                     |       | 76.4 |   | 66.4 |   |
| Operating  expenses:                                                        |       |                                     |       |   |   |   |   |
| Sales and marketing                                                         |       | 33.2                                     |       | 17.5 |   | 18.9 |   |
| Research and development                                                    |       | 32.6                                     |       | 16.8 |   | 15.4 |   |
| General and administrative                                                  |       | 11.9                                     |       | 7.7 |   | 7.6 |   |
| Amortization of purchased intangible assets                                 |       | 1.5                                      |       | — |   | — |   |
| In-process research and development                                         |       | 1.3                                      |       | — |   | — |   |
| Restructuring charge                                                        |       | —                                   |       | — |   | 0.4 |   |
| Total operating expenses                                                    |       | 80.5                                     |       | 42.0 |   | 42.3 |   |
| Income (loss) from continuing operations                                    |       | (10.3                                    | )          | 34.4 |   | 24.0 |   |
| Other income, net                                                           |       | 8.2                                      |       | 2.6 |   | 1.9 |   |
| Income (loss) from continuing operations before  provision for income taxes |       | (2.1                                     | )          | 37.0 |   | 25.9 |   |
| Provision  (benefit) for income taxes                                       |       | 0.5                                      |       | (38.4 | ) | 0.4 |   |
| Income (loss) from continuing operations                                    |       | (2.6                                     | )          | 75.4 |   | 25.5 |   |
| Discontinued operations:                                                    |       |                                     |       |   |   |   |   |
| Loss from discontinued operations                                           |       | —                                   |       | — |   | (3.6 | ) |
| Gain (loss) on disposition                                                  |       | 1.6                                      |       | 0.1 |   | (10.3 | ) |
| Income tax expense (benefit) from gain (loss) on  disposition               |       | 0.6                                      |       | (0.1 | ) | (0.2 | ) |
| Income (loss) from discontinued operations                                  |       | 1.0                                      |       | 0.2 |   | (13.7 | ) |
| Net income (loss)                                                           |       | (1.6                                     | )%         | 75.6 | % | 11.8 | % |

 

***Discussion of Fiscal Years ended April 30, 2006,2005 and 2004***

*Revenue*

| ** ** | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** ** | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** ** | ** ** | **$s in thousands**            | ** ** |
| Revenue    |       | $                                        | 54,905     |                                               | $          | 94,055 |   | $ | 69,590 |   | $ | (39,150 | ) | $ | 24,465 |   |
| % Change   |       |                                     |       |                                               |       |   |   | (41.6 | )% | 35.2 | % |
|            |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The decrease in revenue in fiscal 2006 compared tofiscal 2005 was primarily due to a lack of orders from Nextel, our secondlargest fiscal 2005 customer, and to a level of shipments to our largest fiscal2005 customer, Verizon, more consistent with historical shipments to them.  In December 2004, Nextel announced a planto merge with Sprint. As a result of any merger, product purchases for networkdeployment may be reviewed, postponed or canceled based on revised plans fortechnology or network expansion for the merged entity. We believe this is whathas happened at Nextel and, consequently, our fiscal 2006 revenue from Nextelwas nominal compared to 37% of our total worldwide revenue, or $34.9 million,in fiscal 2005. The increase in revenue in fiscal 2005 compared to fiscal 2004was largely 

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driven by increasedshipments to our then two largest domestic wireless customers, Verizon andNextel, as they continued to expand and update their networks, additional newcustomers and expansion into Asia, Latin America and Canada.

In fiscal 2006, our largest domestic wireless customer,Verizon, accounted for 79% of our total worldwide revenue. In fiscal 2005, ourtwo largest domestic wireless customers accounted for 86% of our totalworldwide revenue. In fiscal 2004, our two largest domestic wireless customersaccounted for 59% of our revenue. Our second largest customer accounted for 3%of our total worldwide revenue in fiscal 2006 while our third largest customeraccounted for 3% of our revenue in fiscal 2005 and 22% of our revenue in fiscal2004.

In fiscal 2006, sales of our Broadband Voice ProcessorFlex (BVP-Flex) accounted for 81% of our revenue. Because the BVP-Flex providesincreased flexibility and easier installation, it has been critical in helpingus to acquire and retain our key domestic strategic customers, most prominentlyVerizon. In fiscal 2004, we introduced our VQA product, which includes our newvoice quality features and is primarily targeted at the international GSMmarket. We expected the sales of VQA products to be higher in the last twofiscal years based on the number of customer trials in which we have beenengaged. While the revenue has been slow to materialize, we continue to believethat VQA presents material revenue opportunities, and we will thereforecontinue to invest in our international infrastructure and in customer trials. Infiscal 2006, $3.5 million of our fourth quarter revenue was generated frominternational customers who, as noted, purchased the VQA platform, and wecurrently have revenue deferrals and orders from which we expect to generate $5-6million of international revenue in the first quarter of fiscal 2007.

Following the success of our BVP-Flex, revenue overthe three fiscal years has been generated largely from domestic sales, whichrepresented 87%, 91% and 89% of our fiscal 2006, 2005 and 2004 revenue,respectively. As noted in the preceding paragraph, our international growth hasprimarily been dependent on our success in selling VQA. While our success inselling to international markets has been limited so far, we expect that in thecoming year, the international portion of our business will begin to grow as apercentage of overall sales as we begin to realize more sales of our VQAapplications.  However, we expect thatour domestic customers will continue to represent the majority of our revenuefor the foreseeable future.

We expect revenue in thefirst quarter of fiscal 2007 to grow 10% compared to the fourth quarter offiscal 2006. Revenue for the remainder of fiscal 2007 will be dependent on oursuccess in adding new customers domestically and internationally, the networktechnology and deployment plans of the North American telecommunication serviceproviders and the market acceptance of our Packet Voice Processor. See ourcautionary language in the first paragraph of “Item 1. Business” regardingforward-looking statements such as the statements made in this and the priortwo paragraphs about our expectations regarding our future revenue, as well asstatements regarding our expectations in each of the categories below.

*Cost of Goods Sold*

| ** **          | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|---------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **          | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **          | ** ** | **$s in thousands**            | ** ** |
| Cost of Goods  Sold |       | $                                        | 16,368     |                                               | $          | 22,184 |   | $ | 23,413 |   | $ | (5,816 | ) | $ | (1,229 | ) |
| % Change            |       |                                     |       |                                               |       |   |   | (26.2 | )% | (5.2 | )% |
|                     |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Cost of goods sold consistsof direct material costs, personnel costs for test and quality assurance, costsof licensed technology incorporated into our products, post-sales installationcosts, provisions for inventory and warranty expenses and other indirect costs.The decrease in cost of goods sold in fiscal 2006 

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wasprimarily driven by the decrease in business volume as compared to fiscal 2005. However, cost of goods sold did notdecrease in direct proportion to the decrease in sales due to (1) thehigher standard cost of the Flex 400 sales in fiscal 2006 relative to thestandard cost of BVP-Flex sales in fiscal 2005 and (2) higher servicecosts due to installations at our largest customer and one of our newinternational customers. The Flex 400 combines echo cancellation technologywith elements of our VQA suite of voice enhancement software to provide qualityenhancement. The decrease in cost of goods sold in fiscal 2005 as compared tofiscal 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 were fullyreserved as of the end of fiscal 2004. Our inventory provisions recorded were$223,000, $972,000 and $3.6 million for fiscal 2006, 2005 and 2004,respectively. Our analysis of gross profit below discusses the other factorsdriving changes in cost of goods sold.

*Gross Margin.*

| ** **     | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|----------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **     | ** ** | **$s in thousands**            | ** ** |
| Gross Profit   |       | $                                        | 38,537     |                                               | $          | 71,871 |   | $ | 46,177 |   | $ | (33,334 | ) | $ | 25,694 |   |
| Gross Margin % |       | 70.2                                     | %          | 76.4                                               | %          | 66.4 | % | (6.2) pts |   | 10.0 pts |   |
|                |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The primary reason for the 6.2 percentage pointdecrease in gross margin in fiscal 2006 was (1) the unfavorable customerand product mix, which included the impact of the higher standard cost of theFlex 400 sales relative to the standard cost of BVP-Flex and lowermargin fiscal 2006 international sales, and (2) higher service costs dueto installations at our largest customer and one of our new internationalcustomers. Those unfavorable changes were partially offset by a combination of higheroverhead utilization and lower manufacturing costs, lower standard productcosts relative to fiscal 2005 and improved warranty and inventory obsolescenceexperience. In fiscal 2006, Ditech sold $634,000 of previously written-downinventory at approximately net book value.

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.

We expect gross margins inthe next quarter to be approximately 70% based on forecasted product andcustomer mix and the impact of increased compensation charges due to recordingstock compensation expense under SFAS 123R. Over the next several quarters, ifwe are successful in international deployment, we expect to experience pricingpressures as we expand the distribution of our products through value-addedresellers and distributors.

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*Sales and Marketing*

| ** **                   | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                   | ** ** | **$s in thousands**            | ** ** |
| Sales and  Marketing Expense |       | $                                        | 18,233     |                                               | $          | 16,430 |   | $ | 13,168 |   | $ | 1,803 |   | $ | 3,262 |   |
| % of Revenue                 |       | 33.2                                     | %          | 17.5                                               | %          | 18.9 | % | 15.7 pts |   | (1.4) pts |   |
|                              |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Sales and marketing expenses primarily consist ofpersonnel costs, including commissions and costs associated with customerservice, travel, trade shows and outside consulting services. Salary andrelated expenses increased $2.1 million in fiscal 2006 compared to fiscal 2005primarily due to employees acquired from Jasomi, incremental hiring ofinternational salespersons, hiring pre- and post-sales engineers to support agreater level of installation activity and the introduction of the Packet VoiceProcessor, and the hiring of a new sales vice president.  Salary and related costs included stock-basedcompensation, convertible debenture amortization and other compensation expenseassociated with the Jasomi acquisition discussed in more detail in “Acquisition-Related Compensation Expense”below. We incurred incremental costs of approximately $491,000 forparticipation in trade shows primarily showcasing our Packet Voice Processorapplications. Travel and related costs increased $376,000 over the prior yeardue to support required for international product evaluations of our VQAapplications. Third party installation expense increased $305,000 compared tofiscal 2005 to support the great level of installation activity. Thoseincreases were partially offset by an increase in absorption of serviceexpenses to cost of sales of $913,000 due to installation support requirementsat our largest customer. We charge post-sales service expenses for field andtechnical phone support to cost of sales and charge pre-sales service expenses toSales and Marketing expense. Amortization of demonstration and field unitspreviously being used in customer demonstrations and trials declined by$404,000 in fiscal 2006. During the first quarter of fiscal 2006, weaggressively pursued the return of this equipment, which was previously beingamortized, when customer demonstrations and trials were completed. Additionally,we reduced our competitor equipment purchases by $208,000. From time-to-time,depending on releases of new products, we may purchase competitor equipment toevaluate performance and features versus to our own products. Finally,primarily as a result of the renegotiation of our headquarters lease, wereduced facilities costs allocated to sales and marketing by $224,000 comparedto fiscal 2005.

Salary and related costs increased $1.7 million infiscal 2005 compared to fiscal 2004 primarily due to incremental hiring ofinternational sales and pre-sales support staff as well as domestic sales andpre-sales support staff focused on specific domestic opportunities. Travelexpense increased $779,000 in fiscal 2005, primarily to support internationalproduct evaluations of our QVP-based VQA products. Finally, outside serviceexpenses increased $733,000 in fiscal 2005 to further support pre-andpost-sales efforts in the field.

We expect that sales andmarketing expenses will increase in fiscal 2007 due to (1) selectiveheadcount increases in sales, marketing and business development, (2) deploymentof more evaluation units primarily to drive demand for and support the VoIPproducts and (3) the cost of agent fees as we sell more of our productinternationally. Additionally, sales and marketing expense will increase infiscal 2007 as a result of increased compensation charges due to recordingstock compensation expense under SFAS 123R.

*Research and Development.*

| ** **                        | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                        | ** ** | **$s in thousands**            | ** ** |
| Research and  Development Expense |       | $                                        | 17,884     |                                               | $          | 15,826 |   | $ | 10,719 |   | $ | 2,058 |   | $ | 5,107 |   |
| % of Revenue                      |       | 32.6                                     | %          | 16.8                                               | %          | 15.4 | % | 15.8 pts |   | 1.4 pts |   |
|                                   |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

36

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Research and development expenses primarily consist ofpersonnel costs, contract consultants, materials and supplies used in thedevelopment of voice processing products. Salary and related costs increased$2.1 million in fiscal 2006 compared to fiscal 2005. The increase in spendingwas primarily associated with engineers hired as part of our acquisition ofJasomi and our research and development efforts for our new packet-based voiceproducts. Our engineering staff grew to 79 employees by the end of fiscal 2006from 62 at the end of fiscal 2005. Salary and related costs included theincremental salaries and stock-based and convertible debenture amortizationassociated with the Jasomi acquisition discussed in more detail in “Acquisition-Related Compensation Expense”below. Depreciation, information technology related costs and maintenance onsoftware and equipment used by the engineering departments accounted for anaggregate increase of $1.1 million in fiscal 2006 due, in large part, to theincreased demands from the larger engineering workforce needed to support ourexisting voice products, as well as our move into packet-based voice productswhich required purchases of lab equipment. Travel related expense increased$287,000 for the year due to increased support of field trials and travelbetween our Canada location and our California headquarters. Those increaseswere partially offset by decreases of $1.2 million in outside service expense. Thatexpense declined based on our stage in Packet Voice Processor development andour hiring of additional regular employees to complete the work. Additionally,facilities expense allocated to research and development declined $285,000 dueto the renegotiation of our headquarters lease.

Salary and related and prototype materials costsincreased $2.1 million and $1.4 million, respectively, in fiscal 2005 comparedto fiscal 2004. 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 the increaseddemands from a larger engineering workforce.

We expect modest increasesin our research and development spending in fiscal 2007 as we have a full yearof Jasomi personnel and as we continue development of the Packet VoiceProcessor. Additionally, research and development expense will increase infiscal 2007 as a result of increased compensation charges due to recordingstock compensation expense under SFAS 123R.

*General and Administrative*

| ** **                          | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|-------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                          | ** ** | **$s in thousands**            | ** ** |
| General and  Administrative Expense |       | $                                        | 6,568      |                                               | $          | 7,244 |   | $ | 5,308 |   | $ | (676 | ) | $ | 1,936 |   |
| % of Revenue                        |       | 11.9                                     | %          | 7.7                                                | %          | 7.6 | % | 4.2 pts |   | 0.1 pts |   |
|                                     |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

General andadministrative expenses primarily consist of personnel costs for corporateofficers, finance and human resources personnel, as well as insurance, legal,accounting and consulting costs. Fiscal 2006 outside services for consultingand audit costs related to Sarbanes-Oxley compliance and taxes declined $1.1million compared to fiscal 2005, primarily because the workload wassignificantly less in the second year of Sarbanes-Oxley compliance. Thosereductions were offset by the cost of legal work related to the class actionlawsuits, which resulted in an increase of $411,000 compared to fiscal 2005.

The fiscal 2005increases in general and administrative spending were largely due to increasedconsulting, professional service costs and audit fees related to Sarbanes-Oxleycompliance work and international expansion, which resulted in an aggregateincrease in spending of over $1.8 million. Additionally, bad debt expense was$250,000 lower in fiscal 2004 due to credits taken in fiscal 2004 for an 

37

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adjustment to our bad debt reserve based on improvedcollection efforts. There were no such adjustments to the reserve in fiscal2005.

We expect a slightincrease in general and administrative expenses in fiscal 2007 due to plannedincreases in variable compensation and audit-related expenses. Additionally,general and administrative expense will increase in fiscal 2007 as a result ofincreased compensation charges due to recording stock compensation expenseunder SFAS 123R.

*Acquisition-RelatedCompensation Expense.*

In fiscal 2006, we recorded compensation expenserelated to the vesting of assumed stock options and the restricted stock grantsmade in connection with the June 30, 2006 acquisition of Jasomi. Deferredstock-based compensation represents the intrinsic value of the unvested portionof options assumed and restricted shares granted to Jasomi employees and isamortized to research and development expense and sales and marketing expenseover the corresponding vesting periods. See Note 6 of Notes to the ConsolidatedFinancial Statements.

Stock-basedcompensation charges included in operating expenses were as follows:

| ** **                | ** ** | **Year ended  April 30, 2006** | ** ** |
|---------------------------|------------|-----------------------------------------------|------------|
| ** **                | ** ** | **$s in thousands**                 | ** ** |
| Sales and  marketing      |       |                                          | $          | 256 |   |   |
| Research and  development |       |                                          | 619        |   |   |
| Total                     |       |                                          | $          | 875 |   |   |

 

For the year ended April 30, 2006, weadditionally recorded compensation expense related to the portion ofconvertible debentures issued to employee-stockholders. The compensationexpense is being amortized to research and development expense and sales andmarketing expense over the lives of the convertible debentures. See Note 6 ofNotes to the Consolidated Financial Statements.

Convertibledebenture amortization included in operating expenses was as follows:

| ** **                | ** ** | **Year ended  April 30, 2006** | ** ** |
|---------------------------|------------|-----------------------------------------------|------------|
| ** **                | ** ** | **$s in thousands**                 | ** ** |
| Sales and  marketing      |       |                                          | $          | 563 |   |   |
| Research and  development |       |                                          | 41         |   |   |
| Total                     |       |                                          | $          | 604 |   |   |

 

*Amortization ofpurchased intangible assets.*

Forthe year ended April 30, 2006, we recorded amortization of purchasedintangible assets related to the Jasomi acquisition. Purchased intangibleassets are being amortized to operating expense over their estimated usefullife which ranges from four to five years. See Note 7 of Notes to theConsolidated Financial Statements.

| ** **                                   | ** ** | **Year ended  April 30, 2006** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                   | ** ** | **$s in thousands**                 | ** ** |
| Amortization of  purchased intangible assets |       |                                          | $          | 821 |   |   |
| % of revenue                                 |       |                                          | 1.5        | % |   |

 

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*In-process research and development.*

| ** **                           | ** ** | **Year ended  April 30, 2006** | ** ** |
|--------------------------------------|------------|-----------------------------------------------|------------|
| ** **                           | ** ** | **$s in thousands**                 | ** ** |
| In-process  research and development |       |                                          | $          | 700 |   |   |
| % of revenue                         |       |                                          | 1.3        | % |   |

 

Infiscal 2006, we incurred a charge for in-process research and development (“inprocess R&D”) acquired as part of our acquisition of Jasomi. The amount ofthe purchase price for Jasomi allocated to in-process R&D was* *determined through establishedvaluation techniques common in the high-technology communications equipmentindustry. In-process R&D is expensed upon acquisition because technologicalfeasibility has not been established and no future alternative uses exist.

Invaluing in-process R&D, cash flows were based on estimates from our andJasomi’s management and from various public, financial and industry sources. Weprojected net revenue to grow through calendar 2008 and decline thereafterbased on the rate of technology changes in the industry, product life cyclesand various projects’ stages of development. We estimated cost of goods soldand operating expenses, including research and development expenses andselling, general and administrative expenses, as a percentage of revenue basedon historical averages and forward-looking projections. We also included in theprojections estimated costs to bring projects to technological feasibility andcosts associated with activities undertaken to correct errors or keep productsupdated (also referred to as “maintenance” research and development). We basedthe tax expense on statutory Federal and California tax rates.

Webased the percentage of completion of in-process projects on an averaging of(1) expenses incurred to-date compared to the total estimated developmentcosts for each project, (2) time incurred to-date and remaining time tocomplete each project and (3) milestone-based percent completeestimates.  The in-process projectspertained to general enhancements to PeerPoint software, combining of NAT andPeering capability, increasing throughput capability, enhancing the interfaceand developing a Denial of Service module. The average percentage complete forthe in-process projects was 56% as of the date of the acquisition. At the time of the acquisition, weestimated that these development efforts would be completed in nine months atan estimated cost of approximately $740,000. As of April 30, 2006, theremaining estimated cost to complete the project is approximately $400,000,primarily because the project to increase throughput capacity will be part ofan integrated PeerPoint and Packet Voice Processor solution instead of astand-alone solution as originally planned.

The 30% cost of capital used to discount estimatedcash flows reflects the estimated time to complete the projects and the levelof risk involved.

*Restructuring*

| ** **    | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|---------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **    | ** ** | **$s in thousands**            | ** ** |
| Restructuring |       | $                                        | —     |                                               | $          | — |   | $ | 275 |   | $ | — |   | $ | (275 | ) |
| % of Revenue  |       | 0.0                                      | %          | 0.0                                                | %          | 0.4 | % | 0.0 pts |   | (0.4) pts |   |
|               |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The restructuring charge recognized in fiscal 2004 wasattributable to the elimination of redundant general corporate level costs,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 lossprovision of $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** | ** ** |
|-------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **        | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **        | ** ** | **$s in thousands**            | ** ** |
| Other Income, Net |       | $                                        | 4,522      |                                               | $          | 2,430 |   | $ | 1,294 |   | $ | 2,092 |   | $ | 1,136 |   |
| % of Revenue      |       | 8.2                                      | %          | 2.6                                                | %          | 1.9 | % | 5.6 pts |   | 0.7 pts |   |
|                   |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net consists of interest income on ourinvested cash and cash equivalent and investment balances, offset by a nominalamount of foreign exchange losses. The increase in other income, net in fiscal2006 compared to 2005 was primarily attributable to higher interest income, dueto a significant improvement in the return on our invested cash. The increasein fiscal 2005 compared to 2004 was also primarily attributable to higherinterest income, due to our larger invested cash balance and an improvement inthe return on our invested cash as interest rates began to increase.

Our fiscal 2007 interestincome will be dependent on our cash balances and the movement of U.S. interestrates.

*Income Taxes, Continuing Operations*

| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Income Taxes,  Continuing Operations |       | $                                        | 262        |                                               | $          | (36,100 | ) | $ | 270 |   | $ | 36,362 |   | $ | (36,370 | ) |
| % of Revenue                         |       | 0.5                                      | %          | (38.4                                              | )%         | 0.4 | % | 38.9 pts |   | (38.8) pts |   |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Income taxes consist of federal, state and foreignincome taxes. The tax provision (benefit) for fiscal 2006 resulted in aneffective tax rate of (23%). The effective tax rate for the year was adverselyaffected by non-deductible Jasomi acquisition-related charges, including ourinability to deduct for tax purposes (1) in-process R&D relatedto the acquisition of Jasomi and (2) convertible debenture amortization,and the correction of a $1.1 million error in the balance of a deferred taxasset related to a California R&D tax credit. The error originated in thesecond quarter of fiscal 2005 at the time Ditech released its valuationallowance on deferred tax assets and was corrected in the fourth quarter offiscal 2006. After conducting a thorough analytical review on materiality,which was brought to the attention of and discussed with the audit committee,Management believes that such amounts are not material to previously reportedfinancial statements. Those items were partially offset by the reversal of $1.2million of reserves on deferred tax assets primarily associated with aCalifornia R&D tax credit position under audit by California’s FranchiseTax Board. In April 2006, Ditech reached an agreement with the FranchiseTax Board regarding its tax credit positions and consequently revisedassociated reserves.

The benefit in fiscal 2005 includes the reversal ofour valuation allowance against all of our deferred tax assets. In fiscal 2005,we concluded that it was more likely than not that we would realize the benefitrelated to our deferred tax assets. Accordingly, we reduced the valuationallowance against the assets and recorded a tax benefit to continuingoperations of $36.7 million. The recognition of the deferred tax assets had noimpact on our fiscal 2005 cash flows. Partially offsetting the tax benefitrecorded was income tax expense associated with income earned by our foreignsubsidiaries and state and federal alternative minimum tax totaling $595,000 infiscal 2005.

The income taxesincurred in fiscal 2004 were due to providing alternative minimum taxes on ourdomestic operations.

We expect the effective tax rate to be at a morenormalized rate of approximately 40% in fiscal 2007.

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*Income (Loss) from Discontinued Operations*

| ** **                                                    | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **$s in thousands**            | ** ** |
| Loss from  discontinued operations                            |       | $                                        | —     |                                               | $          | — |   | $ | (2,538 | ) | $ | — |   | $ | 2,538 |   |
| Gain (loss) on  disposition                                   |       | 887                                      |       | 94                                                 |       | (7,142 | ) | 793 |   | 7,236 |   |
| Income tax  expense (benefit) from gain (loss) on disposition |       | 361                                      |       | (110                                               | )          | (144 | ) | (471 | ) | (34 | ) |
| Income (loss)  from discontinued operations                   |       | $                                        | 526        |                                               | $          | 204 |   | $ | (9,536 | ) | $ | 322 |   | $ | 9,740 |   |
| % of Revenue                                                  |       | 1.0                                      | %          | 0.2                                                | %          | (13.7 | )% | 0.8 pts |   | 13.9 pts |   |

 

The fiscal 2004 loss from discontinued operationsincludes remaining spending on optical communications marketing and developmentafter our announcement to exit the optical business in May 2003 and theelimination of substantially all optical costs effective July 2003. As alloperations related to our optical business ceased in fiscal 2004, we did nothave further losses from this discontinued operation in fiscal 2005 or 2006.

In June 2006, we came to a mutual settlement andrelease with JDSU whereby JDSU paid us $718,000. We had recorded receivables of$534,000 such that the net financial gain from the settlement was $184,000. Aspart of the settlement, JDSU additionally released us from our warrantyobligation, which resulted in the release of $514,000 of our warrantyliability. In addition, in June 2006, we completed the closure of ourinternational optical operations and, as a result, reversed our remaining$189,000 of reserves related to the closure. Net of $361,000 of tax expense,the transactions resulted in a $526,000 gain from disposal of our discontinuedoperations. This gain on disposition was not reflected in our press release ofMay 25, 2006 announcing our fiscal 2006 financial results, because thesettlement had not occurred prior to that time.

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.Subsequent adjustments to the loss resulted in an incremental loss ofapproximately $100,000 and were included in the total loss from disposal of ourdiscontinued optical operations of $7.0 million for fiscal 2004 in theConsolidated Statement of Operations.

We have currently completed the wind up of our opticaloperations such that we expect no financial impact in fiscal 2007. SeeNote 4 of Notes to the Consolidated Financial Statements.

**Liquidity andCapital Resources**

As of April 30, 2006, we had cash and cashequivalents of $35.7 million as compared to $36.8 million atApril 30, 2005. Additionally, we had $100.3 million of short-terminvestments as of April 30, 2006 compared to $98.9 million ofshort-term investments as of April 30, 2005.

We have satisfied themajority of our liquidity requirements through cash flow generated fromoperations, funds received upon exercise of stock options and the proceeds fromour initial and follow-on public offerings in fiscal 2000.

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*Cash flows from Operating Activities*

| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Cash Flow from  Operating Activities |       | $                                        | 14,485     |                                               | $          | 33,136 |   | $ | 21,219 |   | $ | (18,651 | ) | $ | 11,917 |   |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

Our cash flow from operations generally follows ourprofitability trend of ($1.0) million, $71.1 million (inclusive of a $36.1non-cash tax benefit from the release of a valuation allowance on our deferredtax assets) and $8.2 million for fiscal 2006, 2005 and 2004, respectively.Through a combination of reducing accounts receivable and increasing deferredrevenue, we generated $15.2 million of cash in fiscal 2006. Compared to fiscal2004, 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.

We expect to see positivecash flows from operations in the coming year based on projected revenuegrowth. We expect, however, increases in accounts receivable as we sell moreproduct internationally, as international customers typically have longerpayment terms, and increases in operating expenses and inventory levels as weinvest to grow our VoIP product sales.

*Cash flows from Investing Activities*

| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Cash Flow from  Investing Activities |       | $                                        | (16,760    | )                                                  | $          | (17,088 | ) | $ | (56,328 | ) | $ | 328 |   | $ | 39,240 |   |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The change in cash flows from investing activities isdue to three key events. First, in fiscal 2004, we changed our investingstrategy to include short-term and long-term investments designed to improveour overall return on invested funds, which accounted for the majority of thecash used in fiscal 2004 and 2005, but had little impact in fiscal 2006 as wehad limited proceeds from operating and financing activities to invest inshort-term securities. Second, we used $12.6 million of cash in fiscal 2006 toacquire Jasomi (See Note 6 of Notes to the Consolidated FinancialStatements). Finally, partially offsetting our use of cash in fiscal 2004 wasthe collection of purchase price installments from the sale of our echocancellation software technology of $3.5 million and the collection of proceedsfrom the sale of our optical business 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 and in fiscal 2006 we had no proceedsfrom the optical business.

We plan to continue toinvest in capital assets related to new product features and to support ourefforts to sell our VoIP products. In the first quarter of fiscal 2007, $3.0million of the convertible debentures mature and will be paid in cash.

*Cash flows from Financing Activities*

| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                 | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Cash Flow from  Financing Activities |       | $                                        | 1,201      |                                               | $          | (24,877 | ) | $ | 11,049 |   | $ | 26,078 |   | $ | (35,926 | ) |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The cash flow used infinancing activities in fiscal 2005 was largely due to the repurchase of sharesof common stock, as discussed below, partially offset by funds received fromstock option exercises. We 

42

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repurchasedno common stock in fiscal 2006 or 2004. Stock option activity in fiscal 2004and the first half of fiscal 2005 was particularly high following the trend inour stock price over that same period. The limited level of option activity infiscal 2006 was largely due to a large portion of the options beingout-of-the-money or only marginally in-the-money due to the decline in ourstock price.

*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.

*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 approximately 61,000square feet of space in the two buildings that form our Mountain View,California headquarters. In September 2005, we renegotiated our MountainView, California lease, which extended the lease term through July 31,2011 and reduced the rent cost. We additionally have leased office space inCalgary, Canada, primarily for R&D operations, under an operating leaseexpiring January 31, 2011.

Our contractual commitments, by year in which theybecome due, are as follows:

|                                                           | ** ** | **Payments due by period** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations (in thousands)** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **2 to 3  years** | ** ** | **4 to 5  years** | ** ** | **Over 5  years** | ** ** |
| Operating leases                                          |       | $                                         | 4,801      |   |   | $ | 1,054 |   |   | $ | 2,192 |   | $ | 1,555 |   |   | $ | — |   |   |
| Purchase  commitments                                     |       | 6,152                                     |       |   | 6,152 |   |   | — |   | — |   |   | — |   |   |
| Convertible notes                                         |       | 3,150                                     |       |   | 3,150 |   |   | — |   | — |   |   | — |   |   |
| Total                                                     |       | $                                         | 14,103     |   |   | $ | 10,356 |   |   | $ | 2,192 |   | $ | 1,555 |   |   | $ | — |   |   |
|                                                           |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Jasomi acquisition consideration included $7.0 millionin non-transferable convertible notes, divided into two tranches with principalamounts of $3.0 million and $4.0 million, respectively. The $3.0 million notesmature on June 30, 2006, as no holder elected to extend or convert thenotes. Ditech has not made any indemnification claims, nor have a sufficientnumber of designated employees left the employment of Ditech to cause areduction in the principal amounts of the notes, and so the full $3.0 millionof the first tranche of notes, plus interest accrued at 5%, will be paid on orafter June 30, 2006 upon surrender of the notes. The $4.0 million noteseither mature or convert into Ditech common stock at the election of the holdertwo years from the closing date. The payment of the full $4.0 million principalamount of the second tranche of convertible notes is contingent on (1) theretention of a specified number of designated employees and (2) the amountof any indemnification claims made by Ditech for breaches of representations,warranties and covenants, and so is not reflected in the table above. The notesbear an interest rate of 5%, payable on maturity or conversion, and areconvertible at $9.84 per share.

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 millionline of credit, 

43

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whichexpires in July 2006. The ability to fund our operations beyond the nexttwo fiscal years will be dependent on the overall demand of telecommunicationsproviders for new capital equipment. Should our customers significantly reducetheir purchases of our products compared to current levels of purchases, wecould need to find additional sources of cash during fiscal 2008 or be forcedto reduce our spending levels to protect our cash reserves.

**Off-Balance SheetArrangements**

As of April 30, 2006,we did not have any off-balance-sheet arrangements, as defined inItem 303(a)(4)(ii) of SEC Regulation S-K.

**Item 7A—Quantitativeand 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 investment portfolios. Our cash, cash equivalents,and short-term investments are primarily maintained at four major financialinstitutions in the United States. As of April 30, 2006, we did not holdany derivative instruments. The primary objective of our investment activitiesis the preservation of principal while maximizing investment income andminimizing risk, and we attempt to achieve this by diversifying our portfolioin a variety of highly rated investment securities that have limited terms tomaturity. We do not hold any instruments for trading purposes.

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. Short-term investments consistprimarily of corporate bonds and asset backed securities. Short-terminvestments are maintained at three major financial institutions, areclassified as available-for-sale, and are recorded on the accompanyingConsolidated Balance Sheets at fair value. If we sell our short-terminvestments prior to their maturity, we may incur a charge to operations in theperiod the sale took place. In fiscal 2006, 2005 and 2004, we realized no gainsor losses on our short-term investments.

Thefollowing table presents the hypothetical changes in fair values of ourinvestments as of April 30, 2006, 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**     | ** ** | ** **                          | ** ** | **Valuation of Securities Given**     | ** ** |
|-------------------|------------|------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------------------------|------------|
| ** **        | ** ** | **an Interest Rate Decrease of** | ** ** | ** **                          | ** ** | **an Interest Rate Increase of** | ** ** |
|                   | ** ** | **X Basis Points**                         | ** ** | **Fair Value as of** | ** ** | **X Basis Points**                         | ** ** |
| ** **        | ** ** | **(150 BPS)**                                   | ** ** | **(100 BPS)**                  | ** ** | **(50 BPS)**                                    | ** ** | **April 30, 2006** | ** ** | **50 BPS** | ** ** | **100 BPS** | ** ** | **150 BPS** | ** ** |
| Total investments |       | $                                                    | 100,325    |                                | $          | 100,325                                              |       | $ | 100,325 |   |   | $ | 100,325 |   |   | $ | 100,325 |   | $ | 100,325 |   | $ | 100,325 |   |
|                   |            |                                                      |            |                                     |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**     | ** ** | ** **                          | ** ** | **Valuation of Securities Given**     | ** ** |
|-------------------|------------|------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------------------------|------------|
| ** **        | ** ** | **an Interest Rate Decrease of** | ** ** | ** **                          | ** ** | **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 

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remaining life of theinvestments, which shifts are representative of the historical movements in theFederal Funds 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, 2006 and 2005 (in thousands). Carryingvalue approximates fair value.
|                            | ** ** | **April 30, 2006** | ** ** | **April 30, 2005**    | ** ** |
|----------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **Carrying  Value**          | ** ** | **Average  Interest Rate** | ** ** | **Carrying  Value** | ** ** | **Average  Interest Rate** | ** ** |
| Cash and cash  equivalents |       | $                            | 35,707     |                            |       | 3.59 | % |   | $ | 36,781 |   |   | 1.62 | % |   |
| Short-term  investments    |       | 100,325                      |       |                            | 4.67       |   |   | 98,853 |   |   | 2.97 |   |   |
| Long-term  investments     |       | —                       |       |                            | —     |   |   | — |   |   | — |   |   |
| Total                      |       | $                            | 136,032    |                            |       | 4.39 | % |   | $ | 135,634 |   |   | 2.61 | % |   |

 

In fiscal 2006, ourreturn on our cash and cash equivalents ranged from 2.8% to 4.6% and ouraverage return for the year was 3.4% while our return on short-term investmentsranged from 1.7% to 4.9% and our average return for the year was 3.8%.

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—Financial Statements and SupplementaryData**

**DITECH NETWORKS,INC.**

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**
|                                                          | **Page** | ** ** |
|----------------------------------------------------------|----------|------------|
| Report  of Independent Registered Public Accounting Firm |     | 47         |   |   |
| Consolidated  Balance Sheets                             |     | 49         |   |   |
| Consolidated Statements of Operations                    |     | 50         |   |   |
| Consolidated Statements of Stockholders’ Equity     |     | 51         |   |   |
| Consolidated Statements of Cash Flows                    |     | 52         |   |   |
| Notes to Consolidated Financial Statements               |     | 53         |   |   |
| Supplementary Financial Data (unaudited)                 |     | 76         |   |   |

** **

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**Reportof Independent Registered Public Accounting Firm**

**To the Board of Directors and Stockholders of**Ditech Networks, Inc.:

We have completedintegrated audits of Ditech Networks, Inc.’s 2006 and 2005 consolidatedfinancial statements and of its internal control over financial reporting as ofApril 30, 2006 and an audit of its 2004 consolidated financial statementsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Our opinions, based on our audits, are presented below.

*Consolidatedfinancial statements and financial statement schedule*

In our opinion, theconsolidated financial statements listed in the index appearing under Item15(a)(1) present fairly, in all material respects, the financial positionof Ditech Networks, Inc. and its subsidiaries at April 30, 2006 and2005, and the results of their operations and their cash flows for each of thethree years in the period ended April 30, 2006 in conformity withaccounting principles generally accepted in the United States of America. Inaddition, in our opinion, the financial statement schedule listed in the indexappearing under Item 15(a)(2) presents fairly, in all material respects,the information set forth therein when read in conjunction with the relatedconsolidated financial statements. These financial statements and financialstatement schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements andfinancial statement schedule based on our audits. We conducted our audits ofthese statements in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit of financialstatements includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

*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, 2006 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 30,2006, 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 and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we consider necessary in the circumstances. We believe thatour audit provides a reasonable basis for our opinions.

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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, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (ii) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (iii) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

/s/ PRICEWATERHOUSECOOPERS LLP

PricewaterhouseCoopers LLPSan Jose, CaliforniaJune 28, 2006

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**DITECH NETWORKS,INC.**

**CONSOLIDATEDBALANCE SHEETS**

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

 
|                                                                                                                                                               | ** ** | **April 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                    | ** ** | **2006**           | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                    | ** ** | ** **         | ** ** | ** ** | ** ** |
| Current assets:                                                                                                                                               |       |               |       |   |   |
| Cash and cash equivalents                                                                                                                                     |       | $                  | 35,707     |   | $ | 36,781 |   |
| Short-term investments                                                                                                                                        |       | 100,325            |       | 98,853 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $306 and $344 at April 30, 2006 and 2005, respectively                                   |       | 5,276              |       | 9,318 |   |
| Inventories                                                                                                                                                   |       | 8,318              |       | 5,732 |   |
| Deferred income taxes                                                                                                                                         |       | 2,923              |       | 4,836 |   |
| Other current assets                                                                                                                                          |       | 2,664              |       | 1,561 |   |
| Total current assets                                                                                                                                          |       | 155,213            |       | 157,081 |   |
| Property and  equipment, net                                                                                                                                  |       | 4,740              |       | 4,937 |   |
| Goodwill                                                                                                                                                      |       | 9,913              |       | — |   |
| Purchased  intangibles, net                                                                                                                                   |       | 3,379              |       | — |   |
| Deferred income  taxes                                                                                                                                        |       | 45,852             |       | 46,771 |   |
| Other assets                                                                                                                                                  |       | 216                |       | 931 |   |
| Total assets                                                                                                                                                  |       | $                  | 219,313    |   | $ | 209,720 |   |
| **LIABILITIES**                                                                                                                                               |       |               |       |   |   |
| Current liabilities:                                                                                                                                          |       |               |       |   |   |
| Accounts payable                                                                                                                                              |       | $                  | 1,576      |   | $ | 2,166 |   |
| Accrued expenses                                                                                                                                              |       | 7,090              |       | 8,505 |   |
| Deferred revenue                                                                                                                                              |       | 10,951             |       | 202 |   |
| Income taxes payable                                                                                                                                          |       | 471                |       | 1,582 |   |
| Total current liabilities                                                                                                                                     |       | 20,088             |       | 12,455 |   |
| Long term accrued expenses                                                                                                                                    |       | 644                |       | — |   |
| Commitments and contingencies (Note 8)                                                                                                                        |       |               |       |   |   |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                 |       |               |       |   |   |
| Preferred stock, $0.001 par value: 5,000 shares  authorized and none issued and outstanding at April 30, 2006 and 2005                                   |       | —             |       | — |   |
| Common stock,  $0.001 par value: 200,000 shares authorized and 32,375 and 31,998 shares  issued and outstanding at April 30, 2006 and 2005, respectively |       | 32                 |       | 32 |   |
| Additional  paid-in capital                                                                                                                                   |       | 291,329            |       | 287,036 |   |
| Accumulated  deficit                                                                                                                                          |       | (90,640            | )          | (89,757 | ) |
| Deferred  stock-based compensation                                                                                                                            |       | (2,137             | )          | — |   |
| Other  comprehensive loss                                                                                                                                     |       | (3                 | )          | (46 | ) |
| Total stockholders’ equity                                                                                                                               |       | 198,581            |       | 197,265 |   |
| Total liabilities  and stockholders’ equity                                                                                                              |       | $                  | 219,313    |   | $ | 209,720 |   |

 

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

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**DITECH NETWORKS,INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(inthousands, except per share data)**
|                                                                                             | ** ** | **Years ended April 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                                                                                     |       | $                                        | 54,905     |   | $ | 94,055 |   | $ | 69,590 |   |
| Cost of goods sold                                                                          |       | 16,368                                   |       | 22,184 |   | 23,413 |   |
| Gross profit                                                                                |       | 38,537                                   |       | 71,871 |   | 46,177 |   |
| Operating expenses:                                                                         |       |                                     |       |   |   |   |   |
| Sales and marketing                                                                         |       | 18,233                                   |       | 16,430 |   | 13,168 |   |
| Research and development                                                                    |       | 17,884                                   |       | 15,826 |   | 10,719 |   |
| General and  administrative                                                                 |       | 6,568                                    |       | 7,244 |   | 5,308 |   |
| Amortization of  purchased intangible assets                                                |       | 821                                      |       | — |   | — |   |
| In-process research and  development                                                        |       | 700                                      |       | — |   | — |   |
| Restructuring charge                                                                        |       | —                                   |       | — |   | 275 |   |
| Total operating expenses                                                                    |       | 44,206                                   |       | 39,500 |   | 29,470 |   |
| Income (loss) from  continuing operations                                                   |       | (5,669                                   | )          | 32,371 |   | 16,707 |   |
| Other income (expense):                                                                     |       |                                     |       |   |   |   |   |
| Interest income                                                                             |       | 4,551                                    |       | 2,446 |   | 1,237 |   |
| Other income (expense),  net                                                                |       | (29                                      | )          | (16 | ) | 57 |   |
| Total other income                                                                          |       | 4,522                                    |       | 2,430 |   | 1,294 |   |
| Income (loss) from  continuing operations before provision (benefit) for income taxes  |       | (1,147                                   | )          | 34,801 |   | 18,001 |   |
| Provision (benefit) for  income taxes                                                       |       | 262                                      |       | (36,100 | ) | 270 |   |
| Income (loss) from  continuing operations                                                   |       | (1,409                                   | )          | 70,901 |   | 17,731 |   |
| Discontinued operations:                                                                    |       |                                     |       |   |   |   |   |
| Loss from discontinued  operations                                                          |       | —                                   |       | — |   | (2,538 | ) |
| Gain (loss) on  disposition                                                                 |       | 887                                      |       | 94 |   | (7,142 | ) |
| Income tax expense  (benefit) from gain (loss) on disposition                               |       | 361                                      |       | (110 | ) | (144 | ) |
| Income (loss) from  discontinued operations                                                 |       | 526                                      |       | 204 |   | (9,536 | ) |
| Net income (loss)                                                                           |       | $                                        | (883       | ) | $ | 71,105 |   | $ | 8,195 |   |
| Per share data:                                                                             |       |                                     |       |   |   |   |   |
| Basic:                                                                                      |       |                                     |       |   |   |   |   |
| Net income (loss) from  continuing operations                                               |       | $                                        | (0.04      | ) | $ | 2.12 |   | $ | 0.56 |   |
| Income (loss) from  discontinued operations                                                 |       | 0.01                                     |       | 0.01 |   | (0.30 | ) |
| Net income (loss)                                                                           |       | $                                        | (0.03      | ) | $ | 2.13 |   | $ | 0.26 |   |
| Diluted:                                                                                    |       |                                     |       |   |   |   |   |
| Net income (loss) from  continuing operations                                               |       | $                                        | (0.04      | ) | $ | 2.02 |   | $ | 0.53 |   |
| Income (loss) from  discontinued operations                                                 |       | 0.01                                     |       | 0.00 |   | (0.29 | ) |
| Net income (loss)                                                                           |       | $                                        | (0.03      | ) | $ | 2.02 |   | $ | 0.24 |   |
| Number of shares used in per share calculations:                                            |       |                                     |       |   |   |   |   |
| Basic                                                                                       |       | 32,119                                   |       | 33,408 |   | 31,734 |   |
| Diluted                                                                                     |       | 32,119                                   |       | 35,140 |   | 33,496 |   |

 

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

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**DITECH NETWORKS,INC.**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**(in thousands)**

| ** **                                                                | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**   | ** ** | ** **              | ** ** | ** **        | ** ** | **Other**  | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|------------------|------------|-------------------------|------------|-------------------|------------|------------|------------|------------|------------|
| ** **                                                                | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **(Accumulated** | ** ** | **Deferred Stock** | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                                | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**      | ** ** | **Deficit)**            | ** ** | **Compensation**  | ** ** | **Income** | ** ** | **Total**  | ** ** |
| **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 |   |
| Issuance of stock  under employee stock plans                             |       |                  | 256        |        |       |             | —     |                    |       |              | 1,201      |       |       |       | —     |   |   |   | — |   |   |   | — |   |   | 1,201 |   |
| Assumed unvested  options in Jasomi acquisition                           |       |                  | —     |        |       |             | —     |                    |       |              | 689        |       |       |       | —     |   |   |   | (689 | ) |   |   | — |   |   | — |   |
| Assumed vested  options in Jasomi acquisition                             |       |                  | —     |        |       |             | —     |                    |       |              | 483        |       |       |       | —     |   |   |   | — |   |   |   | — |   |   | 483 |   |
| Restricted stock  issued                                                  |       |                  | 121        |        |       |             | —     |                    |       |              | 2,552      |       |       |       | —     |   |   |   | (2,552 | ) |   |   | — |   |   | — |   |
| Amortization of  stock-based compensation                                 |       |                  | —     |        |       |             | —     |                    |       |              | (37        | )          |       |       | —     |   |   |   | 912 |   |   |   | — |   |   | 875 |   |
| Reversal of  deferred compensation due to terminations                    |       |                  | —     |        |       |             | —     |                    |       |              | (192       | )          |       |       | —     |   |   |   | 192 |   |   |   | — |   |   | — |   |
| Tax benefit from  exercise of stock options                               |       |                  | —     |        |       |             | —     |                    |       |              | 190        |       |       |       | —     |   |   |   | — |   |   |   | — |   |   | 190 |   |
| Reclassification  of deferred tax asset                                   |       |                  | —     |        |       |             | —     |                    |       |              | (593       | )          |       |       | —     |   |   |   | — |   |   |   | — |   |   | (593 | ) |
| Other comprehensive income (loss):                                        |       |                  |       |        |       |             |       |                    |       |              |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized loss on  available for sale investment securities              |       |                  | —     |        |       |             | —     |                    |       |              | —     |       |       |       | —     |   |   |   | — |   |   |   | 43 |   |   | 43 |   |
| Net loss                                                                  |       |                  | —     |        |       |             | —     |                    |       |              | —     |       |       |       | (883       | ) |   |   | — |   |   |   | — |   |   | (883 | ) |
| Total  comprehensive loss                                                 |       |                  |       |        |       |             |       |                    |       |              |       |       |       |       |       |   |   |   |   |   |   |   |   |   |   | (840 | ) |
| **Balances,  April 30, 2006**                                        |       |                  | 32,375     |        |       |             | $          | 32                      |       |              |       | $          | 291,329    |       |       |   | $ | (90,640 | ) |   |   | $ | (2,137 | ) |   |   | $ | (3 | ) |   | $ | 198,581 |   |

 

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

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**DITECH NETWORKS,INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(inthousands)**
|                                                                                                     | ** ** | **Years ended April 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                                               |       |                                     |       |   |   |   |   |
| Net income (loss)                                                                                   |       | $                                        | (883       | ) | $ | 71,105 |   | $ | 8,195 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |                                     |       |   |   |   |   |
| Non-cash effect of  discontinued operations                                                         |       | (526                                     | )          | 344 |   | 6,229 |   |
| Depreciation and  amortization                                                                      |       | 3,509                                    |       | 2,770 |   | 2,920 |   |
| Decrease in provision  for doubtful accounts                                                        |       | (38                                      | )          | — |   | (250 | ) |
| Loss on disposal of  property and equipment                                                         |       | 22                                       |       | 192 |   | — |   |
| Tax benefit from  exercise of stock options                                                         |       | 190                                      |       | 15,645 |   | — |   |
| Deferred income taxes                                                                               |       | 1,161                                    |       | (51,607 | ) | — |   |
| Amortization of deferred  stock compensation                                                        |       | 875                                      |       | — |   | — |   |
| Amortization of  purchased intangibles                                                              |       | 821                                      |       | — |   | — |   |
| Amortization of Jasomi  contingent consideration                                                    |       | 604                                      |       | — |   | — |   |
| In-process research and  development                                                                |       | 700                                      |       | — |   | — |   |
| Other                                                                                               |       | 95                                       |       | 203 |   | 58 |   |
| Changes in assets and liabilities:                                                                  |       |                                     |       |   |   |   |   |
| Accounts receivable                                                                                 |       | 4,546                                    |       | (2,774 | ) | (45 | ) |
| Inventories                                                                                         |       | (2,586                                   | )          | 223 |   | 565 |   |
| Other current assets                                                                                |       | (1,086                                   | )          | (109 | ) | (14 | ) |
| Income taxes                                                                                        |       | (1,115                                   | )          | (118 | ) | (143 | ) |
| Accounts payable                                                                                    |       | (1,086                                   | )          | (88 | ) | (200 | ) |
| Accrued expenses and  other                                                                         |       | (1,355                                   | )          | (402 | ) | 1,575 |   |
| Deferred revenue                                                                                    |       | 10,637                                   |       | (2,248 | ) | 2,329 |   |
| Net cash provided by  operating activities                                                          |       | 14,485                                   |       | 33,136 |   | 21,219 |   |
| Cash flows from investing activities:                                                               |       |                                     |       |   |   |   |   |
| Purchases of property  and equipment                                                                |       | (2,555                                   | )          | (3,461 | ) | (2,052 | ) |
| Purchase of available  for sale investments                                                         |       | (50,300                                  | )          | (74,071 | ) | (83,050 | ) |
| Sales and maturities of  available for sale investments                                             |       | 48,777                                   |       | 59,902 |   | 22,897 |   |
| Proceeds from sale of  echo software technology and related assets                                  |       | —                                   |       | — |   | 3,500 |   |
| Collection of note  receivable and related interest                                                 |       | —                                   |       | — |   | 834 |   |
| Proceeds from sale of  discontinued optical business                                                |       | —                                   |       | 542 |   | 1,793 |   |
| Acquisition of Jasomi,  net of cash received                                                        |       | (12,636                                  | )          | — |   | — |   |
| Additions to other  assets                                                                          |       | (46                                      | )          | — |   | (250 | ) |
| Net cash used in  investing activities                                                              |       | (16,760                                  | )          | (17,088 | ) | (56,328 | ) |
| Cash flows from financing activities:                                                               |       |                                     |       |   |   |   |   |
| Repurchase of common  stock                                                                         |       | —                                   |       | (35,000 | ) | (6 | ) |
| Proceeds from employee  stock plan issuances                                                        |       | 1,201                                    |       | 10,123 |   | 11,055 |   |
| Net cash provided by  (used in) financing activities                                                |       | 1,201                                    |       | (24,877 | ) | 11,049 |   |
| Net decrease in cash and  cash equivalents                                                          |       | (1,074                                   | )          | (8,829 | ) | (24,060 | ) |
| Cash and cash  equivalents, beginning of year                                                       |       | 36,781                                   |       | 45,610 |   | 69,670 |   |
| Cash and cash equivalents, end of year                                                              |       | $                                        | 35,707     |   | $ | 36,781 |   | $ | 45,610 |   |

 

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

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**DITECH NETWORKS,INC.**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**1.   ORGANIZATIONAND NATURE OF BUSINESS**

Ditech Networks, Inc.(the “Company” or “Ditech”) designs, develops and markets telecommunicationsequipment for use in wireline, wireless, satellite and IP telecommunicationsnetworks. The Company’s products enhance and monitor voice quality and providesecurity in the delivery of voice services. The Company has established adirect sales force that sells its products in the U.S. and internationally. In addition,the Company is expanding its use of value added resellers and distributors inan effort to broaden its sales channels, and this expanded use of value addedresellers and distributors has occurred primarily in the Company’sinternational markets.

**2.   SUMMARY OFSIGNIFICANT 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*

Certain previouslyreported amounts have been reclassified to conform to the current yearclassification.

*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 expensesduring the 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.

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*Allowance forDoubtful 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 two tofive 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.

*Cash and CashEquivalents*

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 four majorU.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. At April 30, 2006,short-term investments consist primarily of corporate bonds and asset backedsecurities. The primary objective of the Company’s investment activities is thepreservation of principal while maximizing investment income and minimizingrisk, and management attempts to achieve this by diversifying its portfolio in avariety of highly rated investment securities that have limited terms tomaturity. Management has classified the Company’s short-term investments asavailable-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.

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*Fair Value ofFinancial Investments*

Carrying amounts ofcertain of the Company’s financial instruments, including cash and cashequivalents, accounts receivable, and accounts payable, are considered toapproximate fair value based on their short time to maturity.

*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 andEquipment*

Property and equipmentare stated at cost and are depreciated using the straight-line method overtheir estimated useful lives, which differ by asset category:

·       Furniture &fixtures:  5 years

·       Equipment:  2 **- **5 years

·       Software:  3 years

·       Leaseholdimprovements:  Shorter of 5 years or remaining 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.

*Goodwill*

The Company’s methodologyfor allocating a portion of the purchase price to goodwill in connection withthe purchase of Jasomi Networks Inc. (“Jasomi”) was based on establishedvaluation techniques in the high-technology communications equipment industry.Goodwill was measured as the excess of the cost of acquisition over the sum ofthe amounts assigned to tangible and identifiable intangible assets acquiredless liabilities assumed. Goodwill is not amortized. The goodwill recorded inthe Condensed Consolidated Balance Sheet as of April 30, 2006 was $9.9million.

*Impairment ofLong-lived Assets*

The Company evaluates therecoverability of its long-lived assets, including goodwill, on an annual basisor more frequently if indicators of potential impairment arise. Following thecriteria of SFAS 131 “Disclosure about Segments of an Enterprise andRelated Information” and SFAS 142 “Goodwill and Other Intangible Assets”,the Company views Ditech as having a single operating segment and consequentlyhas evaluated goodwill and purchased intangible assets for impairment based onan evaluation of the fair value of Ditech as a whole. Ditech’s quoted shareprice from NASDAQ is the basis for measurement of that fair value as Ditech’smarket capitalization based on share price best represents the amount at whichthe Company could be bought or sold in a current transaction between willingparties. Measurement of an impairment loss for long-lived assets that theCompany expects to hold and use is based on the difference between the fairvalue and carrying value of the asset. Long-lived assets to be disposed of arereported at the lower of carrying amount or fair value less costs to sell.

*Certain Risks andConcentrations*

The Company’s products are concentrated in thetelecommunications equipment industry, which is highly competitive and rapidlychanging. Revenue from the Company’s products is concentrated with a 

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relatively limited numberof customers. One customer accounted for 79% of net revenue in fiscal 2006. Twocustomers accounted for 49% and 37% of net revenue in fiscal 2005. Threecustomers accounted for 37%, 23% and 22% of net revenue in fiscal 2004. Netrevenue from customers outside the United States, which was primarilydenominated in U.S. dollars, was 13%, 9% and 11% in fiscal 2006, 2005 and 2004,respectively. The Company’s gross accounts receivable were concentrated withtwo customers at April 30, 2006 (representing 48% and 23% of receivables)and April 30, 2005 (representing 52% and 20% of receivables). The Companyperforms ongoing credit evaluations of its customers’ financial condition andgenerally requires no collateral from its customers. The Company maintains anallowance for doubtful accounts receivable based on the expected collectibilityof accounts receivable.

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 itbelieves that it is more likely than not that the deferred tax assets will notbe recovered.

*Foreign CurrencyTranslation*

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.

*ComprehensiveIncome (Loss)*

The comprehensive income(loss) for fiscal 2006, 2005 and 2004 was ($840,000), $71,097,000 and$8,077,000 and included the impact of foreign currency translation adjustmentsrelated to the Company’s international operations, if any, and unrealized gainsand losses on available for sale investment securities, net of tax.

*Earnings per Share*

Basic earnings per share is calculated based on theweighted average number of shares of common stock outstanding during the periodless shares subject to repurchase, which are considered contingently issuableshares. Diluted earnings per share is calculated based on the weighted averagenumber of shares of common stock and common stock equivalents outstanding,including the dilutive effect of stock options, 

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using the treasury stockmethod and common stock subject to repurchase. Diluted loss per share forfiscal 2006 is calculated excluding the effects of all common stockequivalents, as their effect would be anti-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,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Historical net income  (loss):                           |       |                                     |       |   |   |   |   |
| Income (loss) from continuing operations                 |       | $                                        | (1,409     | ) | $ | 70,901 |   | $ | 17,731 |   |
| Income (loss) from discontinued operations               |       | 526                                      |       | 204 |   | (9,536 | ) |
| Net income (loss)                                        |       | $                                        | (883       | ) | $ | 71,105 |   | $ | 8,195 |   |
| Basic income  (loss) per share:                          |       |                                     |       |   |   |   |   |
| Weighted average shares of common stock outstanding      |       | 32,121                                   |       | 33,410 |   | 31,737 |   |
| Less stock subject to repurchase                         |       | (2                                       | )          | (2 | ) | (3 | ) |
| Shares used in calculation of basic per share  numbers   |       | 32,119                                   |       | 33,408 |   | 31,734 |   |
| Income (loss) from continuing operations                 |       | $                                        | (0.04      | ) | $ | 2.12 |   | $ | 0.56 |   |
| Income (loss) from discontinued operations               |       | 0.01                                     |       | 0.01 |   | (0.30 | ) |
| Net income (loss) per share                              |       | $                                        | (0.03      | ) | $ | 2.13 |   | $ | 0.26 |   |
| Diluted income  (loss) per share:                        |       |                                     |       |   |   |   |   |
| Shares used in calculation of basic per share  numbers   |       | 32,117                                   |       | 33,408 |   | 31,734 |   |
| Shares subject to repurchase                             |       | 2                                        |       | 2 |   | 3 |   |
| Dilutive effect of stock plans                           |       | —                                   |       | 1,730 |   | 1,759 |   |
| Shares used in calculation of diluted per share  numbers |       | 32,119                                   |       | 35,140 |   | 33,496 |   |
| Income (loss) from continuing operations                 |       | $                                        | (0.04      | ) | $ | 2.02 |   | $ | 0.53 |   |
| Loss from discontinued operations                        |       | 0.01                                     |       | — |   | (0.29 | ) |
| Net income (loss)  per share                             |       | $                                        | (0.03      | ) | $ | 2.02 |   | $ | 0.24 |   |

 

The computation of dilutednet income (loss) per share excluded the following number of options, as theireffect was anti-dilutive: 1,521,000 shares in fiscal 2006, 179,000 shares infiscal 2005 and 325,000 shares in fiscal 2004. Included in the fiscal 2006anti-dilutive shares are the weighted average effect of the potentialconversion to common stock of $7.0 million of convertible notes issued as partof the Jasomi acquisition that either mature or convert into Ditech commonstock at the election of the holder. As of April 30, 2006, the notespotentially converted to a maximum of 782,139 shares of common stock (See alsoNote 6).

*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.

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The Company recorded $3.2 million of deferredstock-based compensation expense associated with unvested stock options assumedas part of the Company’s acquisition of Jasomi and a restricted stock planoffered to former Jasomi employees hired by the Company. In fiscal 2006, theCompany recorded $875,000 of stock-based compensation expense related to theassumed unvested stock options and restricted stock plan.

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 30,2006, 2005 and 2004 would have been adjusted to the pro forma amounts indicatedin the following table (in thousands, except per share amounts):

| ** **                                                                                                              | ** ** | **April 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                              | ** ** | **2006**           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income (loss)  as reported                                                                                          |       | $                  | (883       | ) | $ | 71,105 |   | $ | 8,195 |   |
| Add: Stock-based  compensation expense included in reported net income (loss), net of  applicable tax effects           |       | 518                |       | — |   | — |   |
| Deduct:  Stock-based compensation determined under the fair value method for all stock  awards, net of applicable taxes |       | (5,640             | )          | (8,089 | ) | (9,362 | ) |
| Pro forma net income (loss)                                                                                             |       | $                  | (6,005     | ) | $ | 63,016 |   | $ | (1,167 | ) |
| Diluted net income (loss) attributable to common  stockholders per share:                                               |       |               |       |   |   |   |   |
| As reported                                                                                                             |       | $                  | (0.03      | ) | $ | 2.02 |   | $ | 0.24 |   |
| Pro forma                                                                                                               |       | $                  | (0.19      | ) | $ | 1.79 |   | $ | (0.03 | ) |

 

*Recent AccountingPronouncements*

In November 2004, the FASB issued Statement ofFinancial Accounting Standards (SFAS) No. 151, Inventory Costs, whichclarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs, and wasted material. SFAS No. 151 will beeffective for inventory costs incurred during fiscal years beginning after June 15,2005. The Company does not believe the adoption of SFAS No. 151 will havea material impact on its financial statements.

In December 2004, the FASB issued Statement No. 123(Revised 2004) “Share-Based Payment” (SFAS 123R) which requires companies tomeasure and recognize compensation expense for all stock-based payments at fairvalue. SFAS 123R is effective for the first annual reporting period beginningafter June 15, 2005 and, thus, will be effective for the Company beginningin fiscal 2007. In March 2005, the SEC issued Staff Accounting Bulletin(SAB) No. 107 regarding the SEC’s interpretation of SFAS No. 123R andthe valuation of share-based payments for public companies. The Company iscurrently evaluating the impact of SFAS 123R and SAB 107 on itsfinancial position 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,” tostock-based employee compensation.

In June 2005, the FASB issued SFAS No. 154,Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20,Accounting Changes*,* and FASB No. 3,Reporting Accounting Changes in Interim Financial Statements. The Statementapplies to all voluntary changes in accounting principle, and changes therequirements for accounting for and reporting of a change in accountingprinciple. SFAS 154 requires retrospective application to prior periods’financial statements of a voluntary 

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change in accountingprinciple unless it is impracticable. It is effective for accounting changesand corrections of errors made in fiscal years beginning after December 15,2005. Earlier application is permitted for accounting changes and correctionsof errors made occurring in fiscal years beginning after June 1, 2005. TheCompany does not expect the effect of SFAS 154 will have material impact on itsfinancial statements.

In November 2005, theFinancial Accounting Standards Board (FASB) issued final staff position(FSP) 115-1 and FSP 124-1, “The Meaning of Other-Than-TemporaryImpairment and Its Application to Certain Investments” which nullify certainrequirements of Emerging Issues Task Force (EITF) Issue No. 03-1 andsupersede EITF Topic No. D-44. The FSPs provide guidance foridentifying impaired investments and new disclosure requirements forinvestments that are deemed to be temporarily impaired. The Company does notbelieve the impact of adoption of the measurement provisions of the FSPs willhave a material impact on its financial statements.

**3.   BALANCE SHEETACCOUNTS**

Inventories:   Inventoriescomprised (in thousands):

| ** **       | ** ** | **April 30,** | ** ** |
|------------------|------------|--------------------|------------|
| ** **       | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Raw materials    |       | $                  | 2,125      |   | $ | 667 |   |
| Work in progress |       | —             |       | 72 |   |
| Finished goods   |       | 6,193              |       | 4,993 |   |
| Total            |       | $                  | 8,318      |   | $ | 5,732 |   |

 

In fiscal 2004 the Company benefited from the sale ofpreviously written-down OC-3 inventory with an original cost of$2.2 million but no carrying value. In fiscal 2006 and 2005, the Companysold $634,000 and $911,000, respectively, of other previously written-downinventory at approximately net book values.

Investments:   The following table summarizes the Company’s investments as of April 30,2006 (in thousands):

| ** **               | ** ** | ** ** | ** ** | **Gross Unrealized ** | ** ** | **Gross Unrealized ** | ** ** | ** **          | ** ** |
|--------------------------|------------|------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------|------------|
| ** **               | ** ** | **Cost**   | ** ** | **Gains**                       | ** ** | **Losses**                      | ** ** | **Fair Value** | ** ** |
| Corporate notes          |       | $          | 75,903     |                            |       | $                               | —     |                |       |   | $ | (3 | ) |   | $ | 75,900 |   |
| Asset backed  securities |       | 24,425     |       |                            | —     |                            |       |                | —     |   |   | 24,425 |   |
| Total                    |       | $          | 100,328    |                            |       | $                               | —     |                |       |   | $ | (3 | ) |   | $ | 100,325 |   |

 

Thefollowing table summarizes the Company’s investments as of April 30, 2005(in thousands):

| ** **                   | ** ** | ** ** | ** ** | **Gross Unrealized ** | ** ** | **Gross Unrealized ** | ** ** | ** **          | ** ** |
|------------------------------|------------|------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------|------------|
| ** **                   | ** ** | **Cost**   | ** ** | **Gains**                       | ** ** | **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 |   |   |
| Certificates of  deposit     |       | 5,613      |       |                            | —     |                            |       |                | —     |   |   |   | 5,613 |   |   |
| Total                        |       | $          | 98,899     |                            |       | $                               | —     |                |       |   | $ | (46 | ) |   |   | $ | 98,853 |   |   |

 

Included in corporate notes and asset backedsecurities are $72.4 million and $71.9 million of auction rate securities at April 30,2006 and 2005, respectively. For the years ended April 30, 2006 and 2005,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, 2006 and 2005, net unrealized holding losses 

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of $3,000 and $46,000 wereincluded in other comprehensive income in the accompanying Consolidated BalanceSheets, net of any related tax effect.

Thefollowing table summarizes the maturities of the Company’s investments as of April 30,2006 (in thousands):

| ** **          | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
|---------------------|------------|----------|------------|---------------------|------------|
| Less than one  year |       | $        | 100,328    |                | $          | 100,325 |   |
| Total               |       | $        | 100,328    |                | $          | 100,325 |   |

 

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 |   |   |
| Total               |       | $        | 98,899     |                |       | $ | 98,853 |   |   |

 

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 or35 day auction cycles.

Propertyand Equipment:   Property and equipment comprised (in thousands):

| ** **                                       | ** ** | **April 30,** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|
| ** **                                       | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Furniture and  fixtures                          |       | $                  | 1,659      |   | $ | 1,625 |   |
| Equipment                                        |       | 12,570             |       | 10,948 |   |
| Leasehold  improvements                          |       | 1,375              |       | 1,173 |   |
| Computer software                                |       | 3,435              |       | 3,205 |   |
|                                             |       | 19,039             |       | 16,950 |   |
| Less: accumulated  depreciation and amortization |       | (14,299            | )          | (12,013 | ) |
| Total                                            |       | $                  | 4,740      |   | $ | 4,937 |   |

 

AccruedExpenses:   Accrued expenses comprised (in thousands):

| ** **                     | ** ** | **April 30,** | ** ** |
|--------------------------------|------------|--------------------|------------|
| ** **                     | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Accrued employee  related      |       | $                  | 4,303      |   | $ | 3,831 |   |
| Accrued warranty               |       | 1,157              |       | 2,010 |   |
| Accrued  restructuring charges |       | 28                 |       | 228 |   |
| Accrued  professional services |       | 504                |       | 561 |   |
| Other accrued  expenses        |       | 1,098              |       | 1,875 |   |
| Total                          |       | $                  | 7,090      |   | $ | 8,505 |   |

* *

*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 retained its warrantyobligations for optical products sold by the Company prior to 

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July 16, 2003. However,as part of the agreement reached in June 2006 between JDSU and theCompany, JDSU released the Company of its remaining warranty obligations. Consequently,the Company reversed approximately $514,000 of its warranty liability in thefourth quarter of fiscal 2006.

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.

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,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2006**                                | ** ** | **2005** | ** ** |
| Balance as of the  beginning of the fiscal period                                                                      |       | $                                       | 2,010      |   | $ | 1,980 |   |
| Provision for  warranties issued during fiscal period                                                                  |       | 124                                     |       | 515 |   |
| Warranty costs  incurred during fiscal period                                                                          |       | (363                                    | )          | (459 | ) |
| Other adjustments  to the liability (including changes in estimates for pre-existing  warranties) during fiscal period |       | (614                                    | )          | (26 | ) |
| Balance as of the  end of the fiscal period                                                                            |       | $                                       | 1,157      |   | $ | 2,010 |   |

* *

*Guaranteesand 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, theCompany indemnified Texas Instruments for various matters. In April 2004,the indemnifications to Texas Instruments lapsed without a material cost to theCompany.

As permitted or requiredunder Delaware law and to the maximum extent allowable under that law, theCompany has certain obligations to indemnify its current and former officersand directors for certain events or occurrences while the officer or directoris, or was serving at the Company’s request in such capacity. Theseindemnification obligations are valid as long as the director or officer actedin good faith and in a manner that a person reasonably believed to be in or notopposed to the best interests of the Company, and, with respect to any criminalaction or proceeding, had no reasonable cause to believe his or her conduct wasunlawful. The maximum potential amount of future payments the Company could berequired to make under these indemnification obligations is unlimited; however,the Company has a director and officer insurance policy that limits the Company’sexposure and enables the Company to recover a portion of any future amounts paid.As a result of the Company’s insurance policy coverage, the Company believesthe estimated fair value of these indemnification obligations is minimal.

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**4.   DISCONTINUEDOPERATIONS**

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 was 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.

During fiscal 2004, the Company recognized $855,000associated with the level of revenue generated by JDSU since the close of thesale and a $144,000 tax benefit associated with the year-to-date loss fromdisposal, which benefit offset the domestic tax provision recognized fromcontinuing operations. The incremental sales proceeds and the tax benefit wereoffset by incremental loss accruals associated with closure of the Company’sinternational optical operations and an estimated loss provision associatedwith its indemnification of inventory purchased by JDSU which aggregated$1.1 million. The net effect of these items was reported as an incrementalnet loss on disposal of discontinued operations in the Consolidated Statementof Operations.

The gain (loss) on disposition in fiscal 2005 was dueto adjustments needed to reflect actual costs incurred and included an $110,000income tax benefit related to the reversal of a valuation reserve on deferredtax assets.

In June 2006, the Company came to a mutualsettlement and release with JDSU whereby JDSU paid Ditech $718,000. The Companyhad recorded receivables of $534,000 such that the net financial gain from thesettlement was $184,000. As part of the settlement, JDSU additionally releasedthe Company from its warranty obligation, which resulted in the release of$514,000 of its warranty liability. In addition, in June 2006, the Companycompleted the closure of its international optical operations and, as a result,reversed its remaining $189,000 of reserves related to the closure. Net of$361,000 of tax expense, the transactions resulted in a $526,000 gain fromdisposal of the Company’s discontinued operations. This gain on disposition wasnot reflected in the Company’s press release of May 25, 2006 announcing theCompany’s fiscal 2006 financial results, because the settlement had notoccurred prior to that time.

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 30,2006, 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.

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Certaininformation with respect to the discontinued optical communications business’operations is summarized below (in thousands):

| ** **                             | ** ** | **Year ended April 30,** | ** ** |
|----------------------------------------|------------|-----------------------------------------|------------|
| ** **                             | ** ** | **2004**                                | ** ** |
| Revenue                                |       |                                    | $          | 1,656 |   |   |
| Gross profit  (loss)                   |       |                                    | 269        |   |   |
| Operating  expenses                    |       |                                    | 2,807      |   |   |
| Operating loss                         |       |                                    | (2,538     | ) |   |
| Income tax  provision                  |       |                                    | —     |   |   |
| Net loss from  discontinued operations |       |                                    | $          | (2,538 | ) |   |

 

Thefollowing table shows the components of the gain from the disposal of theCompany’s discontinued operations (in thousands):

| ** **                                   | ** ** | **Year ended April 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| Proceeds from  sale                          |       | $                                       | 184        |   | $ | (55 | ) | $ | 2,926 |   |
| Less: Net book  value of assets sold         |       | —                                  |       | — |   | 4,671 |   |
| Transaction costs                            |       | —                                  |       | (68 | ) | 221 |   |
| Gain on sale                                 |       | 184                                     |       | 13 |   | (1,966 | ) |
| Costs to exit  remainder of optical business |       | (703                                    | )          | (81 | ) | 5,176 |   |
| Income from disposition                      |       | 887                                     |       | 94 |   | (7,142 | ) |
| Income tax  expense (benefit)                |       | 361                                     |       | (110 | ) | (144 | ) |
| Net income (loss)  from disposition          |       | $                                       | 526        |   | $ | 204 |   | $ | (6,998 | ) |

 

The income from disposition in fiscal 2006, asdescribed above, was due to (1) reaching a final mutual settlement andrelease with JDSU in June 2006 whereby JDSU paid the Company $718,000 andreleased it from its warranty obligation and (2) completing the closureits international optical operations. The income from disposition in fiscal2005 was due to adjustments needed to reflect actual costs incurred andincluded an $110,000 income tax benefit related to the reversal of a valuationreserve on deferred tax assets. The costs of exiting the optical business infiscal 2004 included severance and related costs for optical employees nothired by JDSU of $1.6 million, impairment of optical assets not acquiredby JDSU of $2.6 million, other exit costs associated with closure ofinternational optical subsidiaries of $530,000 and losses associated withabandonment of facility leases related to the Company’s UK and Australian opticaldevelopment operations of $497,000.

As of April 30, 2006,the Company has resolved all contingencies related to closing the opticalbusiness.

**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.

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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.

*WorkforceReduction.**  *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.

*LeaseLoss 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 the restructuringcharge line, when the Company made the decision to begin using the space again.The reversal was predicated on the significant changes that had occurred in theCompany’s business since the first quarter of fiscal 2004 when the originaldecision was made to abandon the space. At the time of the original provision,the Company was projecting what it viewed as good (20%) revenue growth duringfiscal 2004, based on the Company’s client base and the overall state of thetelecommunications industry. However, with fiscal 2004 revenue growthapproximating 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 ofApril 2004, all of the costs associated with the severance and relatedbenefits and the lease costs while the facility was abandoned had been paid.

**6.   BUSINESSCOMBINATION**

On June 30, 2005, the Company acquired privately-heldJasomi. Jasomi developed and sold session border controllers, which enablesVoIP calls to traverse the network address translation (NAT) and protectsnetworks from external attacks by admitting only authorized sessions, ensuringthat reliable 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 VoIP carriers’ borderservice needs.

The acquisition consideration paid totaled $14.8million and included a cash payment of $10.4 million that was paid at closing,an additional $2.0 million in cash that was placed in escrow, with theremainder consisting of the assumption of vested stock options, acquisition costsand net liabilities assumed. The escrowed cash shall be available to satisfyany claims for indemnification that Ditech may make for certain breaches ofrepresentations, warranties and covenants set forth in the acquisitionagreements and any remaining and available amount in such escrow shall bedistributed to the former Jasomi stockholders two years from the acquisitiondate. In addition, further acquisition consideration not yet recorded included$7.0 million in non-transferable convertible notes, divided into two trancheswith principal amounts of $3.0 million and $4.0 million, respectively. The$3.0 million first tranche of notes were to either mature or convert intoDitech common stock on the date one year or, at the election of the holder, twoyears from the closing date, and were contingent on the retention of aspecified number of designated employees. As of June 2006, no holderelected to extend or convert the $3.0 million first tranche of notes and Ditechhas not made any indemnification claims, nor have a sufficient number ofdesignated employees left the 

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employment of Ditech tocause a reduction in the principal amounts of the notes. Consequently, the full$3.0 million of the first tranche of notes, plus interest at 5%, will be paidon or after June 30, 2006 upon surrender of the notes. The $4.0 millionsecond tranche of notes either mature or convert into Ditech common stock atthe election of the holder two years from the closing date. The notes bear aninterest rate of 5%, payable on maturity or conversion, and are convertible at$9.84 per share. The payment of the full $4.0 million principal amount of theconvertible notes is contingent on the retention of a specified number ofdesignated employees. In accordance with Statement of Financial AccountingStandards No. 141 (SFAS 141), the Company did not record the $7.0million as acquisition consideration as, at the closing date of theacquisition, the Company believed the retention of the designated employees wasnot assured beyond a reasonable doubt. At the time the contingencies aresatisfied and the notes are paid or converted to Ditech common stock, theCompany will record the amounts due to the former non-employee Jasomistockholders, if any, as goodwill. The portion of the notes that have beenissued to employee-stockholders, totaling $947,000, is being amortized ascompensation expense over the remaining life of each note. In fiscal 2006, theCompany recorded $604,000 of compensation expense related to the notes. The$604,000 is included in accrued expenses and long-term accrued expenses as of April 30,2006.

Ditech also (1) assumed Jasomi unvested stockoptions outstanding on the date of the closing, which converted into options tobuy 112,343 shares of the Company’s common stock, and (2) issued to Jasomiemployees restricted stock and restricted stock units for an aggregate of393,212 shares of the Company’s common stock. The intrinsic value of theunvested options assumed and restricted shares granted to Jasomi employees havebeen recorded as deferred stock-based compensation and are being amortized ascompensation expense over the remaining respective vesting periods. Therestricted stock has a three year vesting schedule while the unvested optionsassumed typically have a ten year term and a four year vesting period.

The 78,768 vested stock options assumed, at anintrinsic value of $483,000, have been recorded as part of the purchaseconsideration.

The Company allocated the purchase price to in-processresearch and development (“in-process R&D”), goodwill and intangiblesthrough established valuation techniques in the high-technology communicationsequipment industry. In-process R&D was expensed at the time of theacquisition because technological feasibility was not established and no futurealternative use existed.

In valuing in-process R&D, cash flow projectionswere based on estimates from Ditech and Jasomi management and from variouspublic, financial and industry sources. The Company expected net revenue togrow through calendar 2008 and decline thereafter based on the rate oftechnology changes in the industry, product life cycles and various projects’stages of development. The Company estimated cost of goods sold and operatingexpenses, including research and development expenses and selling, general andadministrative expenses, as a percentage of revenue based on historicalaverages and forward-looking projections. The Company also included in theprojections estimated costs to bring projects to technological feasibility andcosts associated with activities undertaken to correct errors or keep productsupdated (also referred to as “maintenance” research and development). TheCompany based tax expense on statutory Federal and California tax rates.

The Company based the percentage of completion ofin-process projects on an averaging of (2) expenses incurred to-datecompared to the total estimated development costs for each project, (2) timeincurred to-date and remaining time to complete each project and (3) milestone-basedpercent complete estimates. The in-process projects pertained to generalenhancements to PeerPoint software, combining of NAT and Peering capability,increasing throughput capability, enhancing the interface and developing aDenial of Service module. The average percentage complete for the in-processprojects was 56% as of the date of the acquisition. At the time of the acquisition, it wasestimated that these development efforts would be completed in nine months atan estimated cost of approximately $740,000. As of April 30, 2006, 

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theremaining estimated cost to complete the project is approximately $400,000,primarily because the project to increase throughput capacity will be part ofan integrated PeerPoint and Packet Voice Processor solution instead of astand-alone solution as originally planned.

The 30% cost of capital used to discount estimatedcash flows reflects the estimated time to complete the projects and the levelof risk involved.

Thepreliminary consideration paid for Jasomi was comprised of (in thousands):

| Cash                     |   | $     | 12,449 |   |
|--------------------------|--------|-------|--------|--------|
| Vested options  assumed  |   | 483   |   |
| Acquisition costs        |   | 706   |   |
| Net liabilities  assumed |   | 1,175 |   |
| Total  consideration     |   | $     | 14,813 |   |

 

Thepreliminary purchase price of Jasomi was allocated as follows (in thousands):

| In-process  research and development    |   | $      | 700    |   |
|-----------------------------------------|--------|--------|--------|--------|
| Other intangible assets  consisting of: |   |   |   |
| Core technology                         |   | 2,900  |   |
| Customer relationships                  |   | 1,100  |   |
| Trade name and trademarks               |   | 200    |   |
| Goodwill                                |   | 9,913  |   |
| Total purchase  price                   |   | $      | 14,813 |   |

 

The consideration paid and purchase price noted aboveare preliminary due to the $7.0 in outstanding convertible notes that arecurrently excluded from the purchase price.

Goodwill originating from the Jasomi acquisition willnot be amortized. Purchased intangible assets are being amortized on astraight-line basis over a period of four to five years.

In fiscal 2006, the Company recorded $875,000 ofcompensation expense related to assumed unvested stock options and a restrictedstock plan. The $2.1 million remaining balance of deferred stock-basedcompensation is reflected as a component of Stockholders’ Equity.

Since July 1, 2005,the results of operations of Jasomi have been included in the Company’sconsolidated statements of operations. Pro forma results of operations have notbeen presented, as the effect of this acquisition was not material.

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**7.   GOODWILLAND PURCHASED INTANGIBLES**

Thecarrying value of intangible assets acquired in the Jasomi business combinationis as follows (in thousands):

| ** **                      | ** ** | **Fiscal 2006** | ** ** |
|---------------------------------|------------|----------------------|------------|
| ** **                      | ** ** | **Gross Value** | ** ** | **Accumulated  Amortization** | ** ** | **Impairment** | ** ** | **Net Value** | ** ** |
| **Purchased Intangible Assets** |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Core technology                 |       |                 | $          | 2,900 |   |   |   | $ | (605 | ) |   |   | $ | — |   |   |   | $ | 2,295 |   |   |
| Customer relationships          |       |                 | 1,100      |   |   |   | (183 | ) |   |   | — |   |   |   | 917 |   |   |
| Trade name and trademarks       |       |                 | 200        |   |   |   | (33 | ) |   |   | — |   |   |   | 167 |   |   |
| Goodwill                        |       |                 | 9,913      |   |   |   | — |   |   |   | — |   |   |   | 9,913 |   |   |
| Total                           |       |                 | $          | 14,113 |   |   |   | $ | (821 | ) |   |   | $ | — |   |   |   | $ | 13,292 |   |   |

 

In fiscal 2006, the Company recorded $821,000 ofamortization of Jasomi acquisition-related intangible assets.

Estimatedfuture amortization expense of purchased intangible assets as of April 30,2006 is as follows:

| ** ** | ** ** | **Years ended April 30,** | ** ** |
|------------|------------|------------------------------------------|------------|
| 2007       |       |                                     | $          | 985 |   |   |
| 2008       |       |                                     | 985        |   |   |
| 2009       |       |                                     | 985        |   |   |
| 2010       |       |                                     | 381        |   |   |
| 2011       |       |                                     | 43         |   |   |
| Thereafter |       |                                     | —     |   |   |
|       |       |                                     | $          | 3,379 |   |   |

 

Otherintangible assets included as a component of Other Assets, comprised (inthousands):

| ** **        | ** ** | **Fiscal 2006** | ** ** | **Fiscal 2005**          | ** ** |
|-------------------|------------|----------------------|------------|-------------------------------|------------|
| ** **        | ** ** | **Gross  Value**     | ** ** | **Accumulated  Amortization** | ** ** | **Net  Value** | ** ** | **Gross  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Value** | ** ** |
| Software licenses |       | $                    | 3,239      |                          |       | $ | (3,219 | ) |   |   | $ | 20 |   |   | $ | 3,199 |   |   | $ | (2,458 | ) |   | $ | 741 |   |
|                   |            |                      |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Amortization expense related to software licenses was$761,000, $838,000 and $865,000, respectively, in fiscal 2006, 2005 and 2004.

The $20,000 remaining bookvalue of software licenses is expected to be amortized in fiscal 2007.

**8.   COMMITMENTSAND CONTINGENCIES**

*Leases*

The Company leases its principal office facilities inMountain View, California under a non-cancelable operating lease expiring on July 31, 2011.As part of the extension of the Mountain View, California lease term in September 2005,the landlord provided $442,000 for tenant improvements. This was recorded inaccrued expenses and is being amortized over the remaining term of the lease asa reduction in rent expense. The Company is responsible for taxes, insuranceand maintenance expenses related to the leased facilities. The Company additionallyhas leased office space in Calgary, Canada under an operating lease expiring onJanuary 31, 2011. The Company also has operating leases on other officesand certain office equipment.

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At April 30, 2006, future minimum payments underthe leases are as follows (in thousands):

| ** ** | ** ** | **Years ended April 30,** | ** ** |
|------------|------------|------------------------------------------|------------|
| 2007       |       |                                     | $          | 1,054 |   |   |
| 2008       |       |                                     | 1,080      |   |   |
| 2009       |       |                                     | 1,112      |   |   |
| 2010       |       |                                     | 1,200      |   |   |
| 2011       |       |                                     | 355        |   |   |
| Thereafter |       |                                     | —     |   |   |
|       |       |                                     | $          | 4,801 |   |   |

 

Rent expense under allleases for the years ended April 30, 2006, 2005 and 2004, was $1,610,000,$2,268,000 and $2,311,000, respectively. Included in these rent amounts was$71,000 in fiscal 2004 which was related to rent at the Company’s internationaloptical operations and has been reflected in discontinued operations and $254,000in fiscal 2004 which is included in the restructuring charge.

*Credit Facility*

Effective September 2005,the Company renewed its $2.0 million operating line of credit agreementwith its bank. The renewed line of credit expires on July 31, 2006. Advancesunder the line bear interest at the rate of prime plus 0.25%. The renewed lineof credit, which expires on July 31, 2006, carries the same basic terms asthe original line of credit and financial covenants related to minimumeffective tangible net worth and cash and cash equivalent and short-terminvestment balances. As of April 30, 2006, the Company had no borrowingsoutstanding under the line of credit.

*Legal Proceedings*

Beginning on June 14, 2005, several purportedclass action lawsuits were 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 complaints allege claims under Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934 against Ditech and its Chief ExecutiveOfficer and Chief Financial Officer in connection with alleged misrepresentationsconcerning VQA orders and the potential effect on Ditech of the merger betweenSprint and Nextel. All of the lawsuits were consolidated into a singleaction entitled*In re Ditech CommunicationsCorp. Securities Litigation,* No. C 05-02406-JSW, and aconsolidated amended complaint was filed on February 2, 2006. Thedefendants moved to dismiss the complaint, and the motion was heard and takenunder submission by the court on June 9, 2006. This matter is at anearly stage; no discovery has taken place and no trial date has been set.

On June 20, 2005, the first of two shareholderderivative complaints was filed in the California Superior Court for the Countyof Santa Clara. Both complaints were purportedly brought derivativelyby shareholders on behalf of Ditech against several executives of Ditech andall members of its board of directors, and named Ditech as a nominal defendant. Theplaintiffs alleged that the defendants breached their fiduciary duties to Ditech inconnection with alleged misrepresentations concerning VQA orders and thepotential effect on Ditech of the merger between Sprint and Nextel, that certainof the defendants improperly sold Ditech stock while in possession of materialnonpublic information, and that the defendants were liable to Ditech for damages as aresult thereof. Both lawsuits were consolidated into a single action entitled*In re Ditech Communications Corp. DerivativeLitigation,* No. 105-CV-043429. The defendants fileda demurrer to the consolidated complaint, which was granted by the court with leave toamend. The plaintiffs elected not to amend the complaint, and voluntarily dismissedthe action withoutprejudice on February 14, 2006.

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The Company cannot predictthe outcome of the lawsuits at this time and has made no provisions forpotential losses from these lawsuits.

**9.   SALE OFECHO 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 February 2000, were hired by TexasInstruments. Additionally, in connection with the sale, Ditech received, at nocost, a license from Texas Instruments and Telogy Networks, Inc., a whollyowned subsidiary of Texas Instruments, to use the existing echo cancellationand voice enhancement software and any enhancements in Ditech’s products for aperiod of four years. A value of $3.0 million was assigned to this fouryear license period, which value was amortized to cost of goods sold over thefour year term ending in April 2006. After the initial four-yearroyalty-free period ending in April 2006, the Company (1) extendedthe royalty-free period through December 31, 2007 primarily to supportDitech’s remaining warranty obligation for its end-of-life products and (2) negotiatednew pricing based on the purchase of chips bundled with the echo software forthe Company’s current products.

**10.   PREFERREDSTOCK**

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 30,2006, 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.

**11.   STOCKHOLDERS’EQUITY**

**Employee EquityPlans**

*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 30,2006. Employees who participate in an offering period can have up to 10% oftheir earnings withheld or 1,400 shares per offering period, whichever is less,pursuant to the Purchase Plan. The amount withheld will then be used topurchase shares of the common stock on specified dates determined by the Board.The price of common stock purchased under the Purchase Plan will be equal to85% of the lower of the fair market value of the common stock on the commencementdate of each offering period or on the specified purchase date. In fiscal 2006,2005 and 2004, shares purchased under the plan totaled 131,665, 65,602 and175,310 shares, respectively. As of April 30, 2006, 227,718 shares remainavailable for issuance under the Purchase Plan.

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*Stock Option andRestricted Stock 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 under these plans are substantially consistentwith non-statutory options granted under the 1997 and 1998 plans. Shares issuedthrough early option exercises are subject to the Company’s right of repurchaseat the original exercise price. The number of shares subject to repurchasegenerally decreases by 25% of the option shares one year after the grant date,and thereafter, ratably over 36 months. As of April 30, 2006, noshares were subject to repurchase.

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.

On June 30, 2005, the Company acquired Jasomi andassumed all outstanding stock options that had been granted under the JasomiNetworks 2001 Stock Plan (the “Jasomi Plan”). The option shares under theJasomi Plan were converted into 191,111 options to purchase Ditech commonstock. The calculation of the conversion of option shares was determined usingthe approximate fair market values of the Jasomi and Ditech common stock priceswithin a one-week period up to the date of the acquisition. After June 30,2005, no new options are permitted to be granted under the Jasomi Plan. Theoptions granted under this plan are substantially consistent with the terms ofoptions granted under Ditech’s stock option plans.

In connection with the acquisition of Jasomi on June 30,2005, a new equity plan was adopted and approved by the Board of Directors. The2005 New Recruit Stock Plan allows for up to 500,000 shares of restricted stockand restricted stock units to be granted to newly hired employees. The JasomiCanada employees hired by Ditech received shares with a vesting schedule of 1/3of the shares vesting on the first anniversary of the acquisition date, and theremaining vesting in eight (8) successive equal quarterly installmentsover the two (2)-year period measured from the first anniversary of the closingdate. The shares were granted at no cost to the employees. As of April 30,2006, 130,664 shares remain available for issuance under the 2005 New RecruitStock Plan.

In November of 2005 the Board also adopted the2005 New Recruit Stock Option Plan. A total of 200,000 shares were approved forissuance as non-qualified stock options to new hired employees only. 

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The terms of the plan aresubstantially consistent with the non-qualified stock options granted under theCompany’s other stock option plans, except that the plan does not allow theearly exercise of stock options. In February of 2006, another 300,000shares were approved and added to the reserve in connection with the hiring ofthe new vice president of worldwide sales. As of April 30, 2006, there isa reserve of 500,000 shares under the plan.

All options under theoption plans described above have a ten-year term.

**Directors StockOption Plan**

In March 1999, theCompany adopted the 1999 Non-Employee Directors’ Stock Option Plan. Under thisstock option plan an aggregate of 650,000 shares are reserved as of April 30,2006. Options granted under the plan have a 5-year term. One-time initialautomatic grants 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.

**Stock OptionExchange Program**

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, 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 |   |   |
| Reservation of shares             |       |                                      | 500        |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Assumed outstanding options  |       |                                      |       |                         |       |   | 191 |   |   | $0.36 |   |   | 68 |   |   |   | $ | 0.36 |   |   |
| Options granted                   |       |                                      | (2,272     | )                            |       |   | 2,272 |   |   | $ | 6.45 - $10.78 |   |   | 15,844 |   |   |   | $ | 6.97 |   |   |
| Options exercised                 |       |                                      | —     |                         |       |   | (125 | ) |   | $ | 0.36 - $  8.76 |   |   | (403 | ) |   |   | $ | 3.24 |   |   |
| Options canceled                  |       |                                      | 201        |                         |       |   | (212 | ) |   | $ | 0.36 - $79.50 |   |   | (3,807 | ) |   |   | $ | 17.98 |   |   |
| Balances,  April 30, 2006    |       |                                      | 837        |                         |       |   | 6,929 |   |   | $ | 0.36 - $76.00 |   |   | $ | 55,099 |   |   |   | $ | 7.95 |   |   |

 

Optionsoutstanding and exercisable at April 30, 2006 (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** | ** ** |
| $  0.36  - $  2.85      |       |                         | 546        |                       |       |                                           | $          | 2.04 |   |   |   | 5.67 |   |   |   | 521 |   |   |   | $ | 2.02 |   |   |
| $  2.92  - $  6.45      |       |                         | 527        |                       |       |                                           | $          | 3.86 |   |   |   | 6.34 |   |   |   | 498 |   |   |   | $ | 3.71 |   |   |
| $  6.49                           |       |                         | 1,659      |                       |       |                                           | $          | 6.49 |   |   |   | 9.17 |   |   |   | 1,659 |   |   |   | $ | 6.49 |   |   |
| $  6.75  - $  8.56      |       |                         | 619        |                       |       |                                           | $          | 7.23 |   |   |   | 5.20 |   |   |   | 604 |   |   |   | $ | 7.19 |   |   |
| $  8.76                           |       |                         | 1,634      |                       |       |                                           | $          | 8.76 |   |   |   | 7.42 |   |   |   | 1,634 |   |   |   | $ | 8.76 |   |   |
| $  8.82  - $10.35                 |       |                         | 1,099      |                       |       |                                           | $          | 9.26 |   |   |   | 6.32 |   |   |   | 715 |   |   |   | $ | 9.40 |   |   |
| $10.78 - $18.75                             |       |                         | 780        |                       |       |                                           | $          | 13.69 |   |   |   | 8.22 |   |   |   | 779 |   |   |   | $ | 13.69 |   |   |
| $21.92 - $76.00                             |       |                         | 65         |                       |       |                                           | $          | 23.74 |   |   |   | 3.41 |   |   |   | 65 |   |   |   | $ | 23.74 |   |   |
| $  0.36  - $76.00                 |       |                         | 6,929      |                       |       |                                           | $          | 7.95 |   |   |   | 7.30 |   |   |   | 6,475 |   |   |   | $ | 7.92 |   |   |
|                                             |            |                              |            |                            |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The estimated weighted average fair value of optionsgranted during fiscal years 2006, 2005 and 2004 was $4.22, $8.84 and $5.52 pershare, respectively. The estimated weighted average fair value of sharesgranted under the Employee Stock Purchase Plan was $3.14, $6.39 and $0.58 infiscal 2006, 2005 and 2004, respectively.

The fair value of optionsgranted under the Company’s stock option plans during fiscal 2006, 2005 and2004 was estimated on the date of grant using the Black-Scholes option pricingmodel. The model utilized the multiple option approach with the followingweighted average assumptions: no dividend yield, expected volatility of 82%,87% and 91% in fiscal 2006, 2005 and 2004, respectively, risk-free interestrates 

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of4.11%, 3.40% and 2.38% in fiscal 2006, 2005 and 2004, respectively, andexpected life of four years for the option plans. The Employee Stock PurchasePlan used the following weighted average assumptions: no dividend yield,expected volatility of 93%, 73% and 58% in fiscal 2006, 2005 and 2004,respectively, risk-free interest rates of 4.45%, 2.44% and 1.63% infiscal 2006, 2005 and 2004, respectively, and expected life of six months.Forfeitures are recognized as they occur.

**Stock RepurchaseProgram**

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 purchase price of the shares of theCompany’s common stock repurchased was reflected as a reduction toshareholders’ equity. In accordance with Accounting Principles Board OpinionNo. 6, “Status of Accounting Research Bulletins,” the Company allocatedthe purchase price of the repurchased shares as a reduction to retainedearnings, common stock and additional paid-in capital.

**12.   INCOMETAXES**

Theprovisions for income taxes reflected in the statements of operations for theyears ended April 30 consisted of (in thousands):

| ** **     | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------|------------|----------|------------|----------|------------|----------|------------|
| Current:       |       |     |       |     |       |     |       |
| Federal        |       | $        | 4          |     | $          | 496      |       | $ | 76 |   |
| State          |       | (1,171   | )          | 153      |       | —   |       |
| Foreign        |       | 71       |       | (54      | )          | 50       |       |
| Total current  |       | $        | (1,096     | )        | $          | 595      |       | $ | 126 |   |
| Deferred:      |       |     |       |     |       |     |       |
| Federal        |       | $        | 168        |     | $          | (28,708  | )          | $ | — |   |
| State          |       | 1,190    |       | (8,097   | )          | —   |       |
| Total deferred |       | 1,358    |       | (36,805  | )          | —   |       |
| Total          |       | $        | 262        |     | $          | (36,210  | )          | $ | 126 |   |

 

Because the Company had a full valuation allowanceagainst its deferred tax assets due to uncertainty surrounding the realizationof the benefit of such assets, there was no deferred tax provision in fiscal2004. In fiscal 2005, based on the level of historical taxable income andprojections for future taxable income over the periods that the Company’sdeferred tax assets are deductible, the Company determined that it was morelikely than not that certain of its deferred tax assets were expected to berealized and therefore released $51.6 million of valuation allowance. Thereversal of the valuation allowance and other adjustments to the deferred taxassets resulted in the recognition of income tax benefits to continuingoperations and discontinued operations of $36.7 million and $110,000,respectively, in fiscal 2005. In addition, the Company recognized a credit of$14.8 million to additional paid-in capital for the portion of the deferred taxasset attributable to benefits from the exercise of employee stock options. Asof April 30, 2006 and 2005, the Company had no valuation allowance againstits deferred tax assets.

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Thecomponents of the Company’s deferred tax assets and liabilities at April 30consisted of (in thousands):

| ** **                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets  (liabilities):                  |       |     |       |     |       |
| Uniform capitalization                               |       | $        | 1,402      |     | $          | 905 |   |
| Depreciation                                         |       | 300      |       | 312      |       |
| Inventory reserves                                   |       | 1,335    |       | 1,827    |       |
| Other reserves and accruals                          |       | 1,434    |       | 2,017    |       |
| Purchased technology, goodwill and other intangibles |       | 677      |       | 2,198    |       |
| Tax credits                                          |       | 8,483    |       | 10,121   |       |
| Net operating losses                                 |       | 35,144   |       | 34,227   |       |
| Total deferred tax assets                            |       | 48,775   |       | 51,607   |       |
| Less valuation  allowance                            |       | —   |       | —   |       |
| Net deferred tax  assets                             |       | $        | 48,775     |     | $          | 51,607 |   |

 

As of April 30, 2006, the Company has federal andstate tax net operating loss carryforwards of approximately $87.7 millionand $62.5 million, respectively, available to offset future taxable incomeand has federal and state tax credit carryforwards of approximately $5.9million and $3.8 million, respectively. The net operating loss and tax creditcarryforwards expire between 2007 and 2026 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$13.2 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:

| ** **                                                                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| 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  in-process R&D and other acquisition related amortization |       | (46.3    | )          |     |       |     |       |
| Non-deductible  goodwill and other intangible amortization                    |       | —   |       | —   |       | 3.8      |       |
| Other permanent  differences                                                  |       | (7.1     | )          | —   |       | —   |       |
| Correction of  California R&D tax credit error                            |       | (100.3   | )          | —   |       | —   |       |
| True-up  adjustments to deferred tax assets                                   |       | (11.4    | )          | —   |       | —   |       |
| Reversal of  reserves associated with California R&D tax credit position  |       | 101.5    |       | —   |       | —   |       |
| Valuation  allowance                                                          |       | —   |       | (146.2   | )          | (39.8    | )          |
| Other                                                                         |       | —   |       | 1.9      |       | (3.2     | )          |
| Effective tax  rate                                                           |       | (22.9    | )%         | (103.6   | )%         | 1.5      | %          |

 

The tax provision(benefit) for fiscal 2006 resulted in an effective tax rate of (23%). Theeffective tax rate for the year was adversely affected by non-deductible Jasomiacquisition-related charges, including the Company’s inability to deduct fortax purposes (1) in-process R&D related to the acquisition of Jasomiand (2) convertible debenture amortization, and the correction of a $1.1million error in the balance of a deferred tax asset related to a CaliforniaR&D tax credit. The error originated in the second quarter of fiscal 2005at the time the Company released its valuation allowance on deferred tax assetsand was corrected in the fourth quarter of fiscal 2006. After conducting athorough analytical review on materiality, which was brought to the attentionof and discussed with the audit committee, management believes that 

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suchamounts are not material to previously reported financial statements. Thoseitems were partially offset by the reversal of $1.2 million of reserves ondeferred tax assets primarily associated with a California R&D tax creditposition under audit by California’s Franchise Tax Board. In April 2006,the Company reached an agreement with the Franchise Tax Board regarding its taxcredit positions and consequently revised associated reserves. The agreementdid not result in the assessment of additional tax.

**13.   REPORTABLESEGMENTS AND GEOGRAPHIC INFORMATION**

As a result of the Company exiting the opticalcommunications business in the first quarter of fiscal 2004, that segment isnow being reported as a discontinued operation in the consolidated statementsof operations for all periods presented. As such, the Company currentlyoperates in a single segment, voice quality products, and segment data will nolonger be reported.

TheCompany’s revenue from external customers by geographic region, based on shipto destination, was as follows (in thousands):

| ** **                 | ** ** | **Years ended April 30,** | ** ** |
|----------------------------|------------|------------------------------------------|------------|
| ** **                 | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| USA                        |       | $                                        | 47,992     |   | $ | 85,337 |   | $ | 61,916 |   |
| Asia Pacific               |       | 983                                      |       | 2,155 |   | 1,348 |   |
| Canada                     |       | 2,056                                    |       | 3,292 |   | 1,914 |   |
| Latin America              |       | 595                                      |       | 1,345 |   | 547 |   |
| Europe/Middle  East/Africa |       | 3,279                                    |       | 1,926 |   | 3,865 |   |
| Total                      |       | $                                        | 54,905     |   | $ | 94,055 |   | $ | 69,590 |   |

 

TheCompany’s long lived assets by geographic region were as follows (inthousands):

| ** **    | ** ** | **As of April 30,** | ** ** |
|---------------|------------|------------------------------------|------------|
| ** **    | ** ** | **2006**                           | ** ** | **2005** | ** ** |
| USA           |       | $                                  | 4,320      |   | $ | 4,896 |   |
| Canada        |       | 395                                |       | — |   |
| Rest of World |       | 25                                 |       | 41 |   |
| Total         |       | $                                  | 4,740      |   | $ | 4,937 |   |

 

**14.   PROFITSHARING 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 2006, 2005 and 2004 of $58,000, $49,000 and $45,000,respectively.

**15.   RELATEDPARTY 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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**16.   SUPPLEMENTAL CASH FLOW INFORMATION**

| ** **                                    | ** ** | **Years ended April 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                    | ** ** | **(in thousands)**                  | ** ** |
| Operating:                                    |       |                                     |       |   |   |   |   |   |   |   |   |
| Interest paid                                 |       | $                                        | —     |   |   | $ | 6 |   |   |   | $ | 11 |   |   |
| Income taxes paid                             |       | 191                                      |       |   | 53 |   |   |   | 64 |   |   |
| Non-cash  financing and investing activities: |       |                                     |       |   |   |   |   |   |   |   |   |
| Deferred stock  compensation                  |       | 3,049                                    |       |   | — |   |   |   | — |   |   |
|                                               |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

**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 2006** | ** ** | **Fiscal 2005** | ** ** |
|-------------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                                | ** ** | **First  Quarter**   | ** ** | **Second  Quarter**  | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenue                                   |       | $                    | 10,347     |                 | $          | 10,523 |   | $ | 13,995 |   | $ | 20,040 |   | $ | 25,540 |   | $ | 24,253 |   | $ | 21,310 |   | $ | 22,952 |   |
| Gross profit                              |       | $                    | 7,188      |                 | $          | 7,354 |   | $ | 9,715 |   | $ | 14,280 |   | $ | 19,136 |   | $ | 18,954 |   | $ | 16,522 |   | $ | 17,259 |   |
| Income (loss)  from continuing operations |       | $                    | (1,931     | )                    | $          | (1,392 | ) | $ | (67 | ) | $ | 1,981 |   | $ | 10,115 |   | $ | 46,078 |   | $ | 7,113 |   | $ | 7,595 |   |
| Net income (loss)                         |       | $                    | (1,931     | )                    | $          | (1,392 | ) | $ | (67 | ) | $ | 2,507 |   | $ | 10,605 |   | $ | 45,770 |   | $ | 7,136 |   | $ | 7,595 |   |
| Basic per share  data                     |       |                 |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations  |       | $                    | (0.06      | )                    | $          | (0.04 | ) | $ | (0.00 | ) | $ | 0.06 |   | $ | 0.30 |   | $ | 1.35 |   | $ | 0.21 |   | $ | 0.24 |   |
| Net income (loss)                         |       | $                    | (0.06      | )                    | $          | (0.04 | ) | $ | (0.00 | ) | $ | 0.08 |   | $ | 0.32 |   | $ | 1.34 |   | $ | 0.21 |   | $ | 0.24 |   |
| Diluted per share  data                   |       |                 |       |                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations  |       | $                    | (0.06      | )                    | $          | (0.04 | ) | $ | (0.00 | ) | $ | 0.06 |   | $ | 0.28 |   | $ | 1.28 |   | $ | 0.20 |   | $ | 0.23 |   |
| Net income (loss)                         |       | $                    | (0.06      | )                    | $          | (0.04 | ) | $ | (0.00 | ) | $ | 0.07 |   | $ | 0.30 |   | $ | 1.27 |   | $ | 0.20 |   | $ | 0.23 |   |

 

The quarterly financialdata for the two years ended April 30, 2006 reflects a $35.8 millionbenefit from the release of a valuation allowance on the Company’s deferred taxassets 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**

*Limitations ofDisclosure Controls and Procedures and Internal Control Over FinancialReporting*

It should be noted that acontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control system aremet. For example, controls can be circumvented by a person’s individual acts,by collusion of two or more people or by management override of the control.Because a cost-effective control system can only provide reasonable assurancethat the objectives of the control system are met, misstatements due to erroror fraud may occur and not be detected.

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*Disclosure Controlsand Procedures*

We maintain disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) that aredesigned to provide reasonable assurance that that information required to bedisclosed in the reports we file or submit under the Exchange Act is recorded,processed, summarized, and reported within the time periods specified in theSecurities and Exchange Commission rules and forms, and that suchinformation is accumulated and communicated to management, including our chiefexecutive officer and chief financial officer, as appropriate to allow timely decisionsregarding required disclosure.

We carried out anevaluation, under the supervision and with the participation of management,including our Chief Executive Officer and our Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures. Based on this evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that, as of April 30, 2006, our disclosurecontrols and procedures were effective to provide reasonable assurance that theinformation required to be disclosed by us in reports that we file or submitunder the Exchange Act, is recorded, processed, summarized and reported withinthe time periods specified in Securities and Exchange Commission rules andforms, and that such information is accumulated and communicated to management,including our chief executive officer and chief financial officer, asappropriate to allow timely decisions regarding required disclosure.

*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, 2006. 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.*Ourmanagement has concluded that, as of April 30, 2006, our internal controlover financial reporting was effective based on these criteria.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of April 30, 2006 has been audited by PricewaterhouseCoopersLLP, the independent registered public accounting firm that audited ourfinancial statements included in this Annual Report on Form 10-K. PricewaterhouseCoopersLLP has issued an attestation report on management’s assessment of our internalcontrol over financial reporting, which is included at the beginning of Item 8herein.

*Changes in InternalControl over Financial Reporting.*

During the fourth quarterof 2006, there have been no changes in our internal control over financialreporting that have material affected, or were reasonably likely to materiallyaffect, our internal control over financial reporting.

**Item 9B—OtherInformation**

Not applicable.

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**Part III**

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

*Directors.**  *Information concerning ourDirectors is incorporated by reference to the section entitled “Proposal 1—Electionof Directors” contained in our definitive Proxy Statement with respect to ourAnnual Meeting of Stockholders to be filed with the Securities and ExchangeCommission not later than August 28, 2006 in connection with thesolicitation of proxies for the Company’s Annual Meeting of Stockholders to beheld September 15, 2006 (the “Proxy Statement”).

*ExecutiveOfficers.**  *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 concerning compliancewith Section 16(a) of the Securities Act of 1934 is set forth in thesection entitled “Section 16(a) Beneficial Ownership ReportingCompliance” contained in our Proxy Statement and is incorporated herein byreference.

*Code of Business Conductand Ethics.**  *Theinformation required by this Item with respect to our code of conduct andethics is incorporated herein by reference from the section captioned “Proposal 1—Electionof Directors—Code of Business Conduct and Ethics” contained in the ProxyStatement.

**Item 11—ExecutiveCompensation**

The information requiredby this Item is set forth in the Proxy Statement under the captions “Compensationof Directors”, “Compensation of Executive Officers” and “Compensation CommitteeInterlocks and Insider Participation.” Such information is incorporated hereinby reference.

**Item 12—Security Ownership of Certain BeneficialOwners 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.

78

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**Part IV**

**Item 15—Exhibitsand Financial Statement Schedule**

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

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

Referenceis made to the Index to Consolidated Financial Statements of Ditech Networks, Inc.under Item 8 in Part II of this Form 10-K.

***(2)****         ***Financial StatementSchedule**

**Schedule IIValuation and Qualifying Accounts(in thousands)**
|                                                | ** ** | **Balance at  Beginning of Year** | ** ** | **Additions** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------|------------|---------------|------------|----------------|------------|--------------------------------------------|------------|
| Year ended  April 30, 2004                |       |                                             |       |          |       |           |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts(1)             |       |                                             | $          | 811           |       |           |       | $                                          | —     |   |   |   | $ | (407 | ) |   |   | $ | 404 |   |   |
| Provision for excess and obsolete inventory(2) |       |                                             | $          | 12,823        |       |           |       | $                                          | 3,648      |   |   |   | $ | (4,948 | ) |   |   | $ | 11,523 |   |   |
| 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 | ) |   |   | $ | — |   |   |
| Year ended  April 30, 2006                |       |                                             |       |          |       |           |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts(1)             |       |                                             | $          | 344           |       |           |       | $                                          | 28         |   |   |   | $ | (66 | ) |   |   | $ | 306 |   |   |
| Provision for excess and obsolete inventory(2) |       |                                             | $          | 4,487         |       |           |       | $                                          | 98         |   |   |   | $ | (1,306 | ) |   |   | $ | 3,279 |   |   |
| Valuation  allowance on deferred tax assets(3) |       |                                             | $          | —        |       |           |       | $                                          | —     |   |   |   | $ | — |   |   |   | $ | — |   |   |

----

(1)          The deductions to theallowance for bad debts included $61,000 of deductions for the write off ofoptical customer receivables in fiscal 2004. There were no deductions in 2006or 2005 related to optical receivables.

(2)          The additions to theprovision for excess and obsolete inventory included $20,000 of additions foroptical inventory, which expense charges have been reported as a component ofthe loss from discontinued operations for fiscal 2004. There were no provisionsfor optical inventory in fiscal 2005 or 2006. The fiscal 2005 provision of $1.5million included $555,000 of field and evaluation unit amortization, which wascharged to sales and marketing expense. The deductions to the provision forexcess and obsolete inventory included $150,000, $4.7 million and $2.7million of deductions for optical inventory in fiscal 2006, 2005 and 2004,respectively. Approximately $634,000 of the $1.3 million of fiscal 2006deductions related to the sale of previously written-down inventory. The largededuction activity in fiscal 2005 and 2004 related to the scrapping of excessand obsolete optical components primarily for our Titanium optical switchproduct that was abandoned in fiscal 2003. The fiscal 2004 deduction activitywas also related to a lesser degree to the sale of inventory to JDSU as part ofour exiting the optical business.

(3)          Based on the level ofhistorical taxable income and projections for future taxable income over theperiods that the Company’s deferred tax assets are deductible, the Companydetermined that it was 

79

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more likely thannot that certain of its deferred tax assets were expected to be realized andtherefore released its valuation allowance on deferred tax assets in fiscal2005.

*(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.
| Exhibtit            | ** ** | ** **                                                                                                                                                                                                    | ** ** | **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(29) |       | 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     |       | Bylaws of Ditech, as amended and restated on March  28, 2002                                                                                                                                                  |
|   4.1     |       | Reference is made to Exhibits 3.1 and 3.2                                                                                                                                                                     |
|   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)(24)         |       | 1999 Non-Employee Directors' Stock Option Plan, as  amended                                                                                                                                                   |
| 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 Networks, Inc. 2001 Stock Plan                                                                                                                                                                         |
| 10.12(8)(13)        |       | Employment Letter, dated April 25, 2002 between  Ditech and Lee House                                                                                                                                         |
| 10.13(8)(23)        |       | Compensation Arrangements with Named Executive  Officers                                                                                                                                                      |
| 10.14(8)(22)        |       | Compensation Arrangements with Non-Employee  Directors                                                                                                                                                        |
| 10.15(8)(27)        |       | 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                                                                                                                  |
| 10.22(8)(21)        |       | 2005 New Recruit Stock Option Plan                                                                                                                                                                            |
| 10.23(8)(26)        |       | Form of Stock Option Agreement under the 2005 New  Recruit Stock Option Plan                                                                                                                                  |

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| 10.26(3)     |   | Second Lease Amendment, dated February 15, 2000,  between Ditech and Middlefield-Bernardo Associates LLC                                      |
|--------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------|
| 10.27(25)    |   | Fourth Amendment to Lease Agreement dated July 31,  2005, between Middlefield II LLC and Ditech                                               |
| 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                                                            |
| 10.36(8)(21) |   | Offer Letter, executed February 4, 2006, between  Ditech and Gary Testa                                                                       |
| 10.37(28)    |   | Amendment No. 2 to TELOGY SOFTWARE LICENSE AGREEMENT  between Ditech Communications Corporation and Texas Instruments Incorporated            |
| 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)   Incorporatedby reference from the exhibit with corresponding number from Ditech's Report onForm 8-K, filed April 30, 2002 (Commission File No. 000-26209).

(2)   Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed July 30, 2003 (Commission File No. 000-26209).

(3)   Incorporatedby reference from the exhibit with corresponding number from Ditech's AnnualReport on Form 10-K for the fiscal year ended April 30, 2000, filedJuly 31, 2000 (Commission File No. 000-26209).

(4)   Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed May 22, 2006 (Commission File No. 000-26209).

(5)   Incorporatedby reference from the exhibit with corresponding number from Ditech's AnnualReport on Form 10-K for the fiscal year ended April 30, 2002, filed July 29,2002 (Commission File No. 000-26209).

(6)   Incorporatedby reference from the exhibit with corresponding title from Ditech's Current Reporton Form 8-K, filed March 30, 2001 (Commission File No. 000-26209).

(7)   Incorporatedby reference from the exhibits with corresponding descriptions from Ditech'sRegistration Statement (No. 333-75063), declared effective on June 9,1999.

(8)   Managementcontract or compensatory plan or arrangement.

(9)   Confidentialtreatment has been granted as to a portion of this exhibit. The confidentialportion of such exhibit has been omitted and filed separately with theCommission.

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(10) Incorporatedby reference from the exhibit with the corresponding exhibit number fromDitech's Quarterly Report on Form 10-Q for the quarter ending July 31, 1999(Commission File No. 000-26209).

(11) Incorporatedby reference from the exhibit with the corresponding title from Ditech'sQuarterly Report on Form 10-Q for the quarter ending July 31, 2002, filedAugust 29, 2002 (Commission File No. 000-26209).

(12) Incorporatedby reference from the exhibit with the corresponding title from Ditech'sQuarterly Report on Form 10-Q for the quarter ending October 31, 2002, filedDecember 16, 2002 (Commission File No. 000-26209).

(13) Incorporatedby reference from the exhibit with the corresponding title from Ditech'sQuarterly Report on Form 10-Q for the quarter ending January 31, 2003, filedMarch 14, 2003 (Commission File No. 000-26209).

(14) Incorporatedby reference to the exhibit with the corresponding title from Ditech's TenderOffer Statement on Schedule TO, filed February 19, 2003 (Commission File No.000-26209).

(15) Incorporatedby reference to the exhibit with the corresponding title from Ditech'sRegistration Statement on Form S-8 (Commission File No. 333-110821), filedNovember 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, filedSeptember 15, 2003 (Commission File No. 000-26209).

(17) Incorporatedby reference from the exhibit with the corresponding number from Ditech'sQuarterly Report on Form 10-Q for the quarter ended October 31, 2003, filedDecember 8, 2003 (Commission File No. 000-26209).

(18) Incorporatedby reference to the exhibit with the corresponding title from Ditech's RegistrationStatement on Form S-8 (Commission File No. 333-120278), filed November 8, 2004.

(19) Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed September 22, 2004 (Commission File No. 000-26209).

(20) Incorporatedby reference to the exhibit with the corresponding title from Ditech'sRegistration Statement on Form S-8 (Commission File No. 333-126302), filed June30, 2005.

(21) Incorporatedby reference to the exhibit with the corresponding title from Ditech's CurrentReport on Form 8-K, filed February 9, 2006 (Commission File No. 000-26209).

(22) Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed August 1, 2005 (Commission File No. 000-26209).

(23) Incorporatedby reference from the exhibits with corresponding titles from Ditech's CurrentReports on Form 8-K, filed August 1, 2005 and May 22, 2006 (Commission File No.000-26209).

(24) Incorporatedby reference from such plan filed with Ditech's Proxy Statement filed August16, 2005 (Commission File No. 000-26209).

(25) Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed September 23, 2005 (Commission File No. 000-26209).

(26) Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed November 15, 2005 (Commission File No. 000-26209).

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(27) Incorporatedby reference to the exhibit with the corresponding title from Ditech’s RegistrationStatement on Form S-8 (Commission No. 333-126292), filed June 28,2005.

(28) Confidentialtreatment has been requested for portions of this exhibit.

(29) Incorporatedby reference from the exhibit with corresponding number from Ditech's AnnualReport on Form 10-K for the fiscal year ended April 30, 2005, filedJuly 14, 2005 (Commission File No. 000-26209).

*(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 NETWORKS, INC.                                                                                    |
|--------------------|--------|--------|--------|----------------------------------------------------------------------------------------------------------|
| June 30, 2006 |   | 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       |       | June 30, 2006 |
| Timothy K. Montgomery       |           | Chairman of the Board of  Directors           |       |               |
|                             |           | (principal executive  officer)                |       |               |
| /s/ WILLIAM J. TAMBLYN      |           | Executive Vice  President and                 |       | June 30, 2006 |
| William J. Tamblyn          |           | Chief Financial Officer                       |       |               |
|                             |           | (principal financial and  accounting officer) |       |               |
| /s/ GREGORY M. AVIS         |           | Director                                      |       | June 30, 2006 |
| Gregory M. Avis             |           |                                          |       |               |
| /s/ EDWIN L. HARPER         |           | Director                                      |       | June 30, 2006 |
| Edwin L. Harper             |           |                                          |       |               |
| /s/ WILLIAM A. HASLER       |           | Director                                      |       | June 30, 2006 |
| William A. Hasler           |           |                                          |       |               |
| /s/ ANDREI M. MANOLIU, PHD  |           | Director                                      |       | June 30, 2006 |
| Andrei M. Manoliu, Phd |           |                                          |       |               |
| /s/ DAVID M. SUGISHITA      |           | Director                                      |       | June 30, 2006 |
| David M. Sugishita          |           |                                          |       |               |

 

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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(29) |       | 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     |       | Bylaws of Ditech, as amended and restated on March  28, 2002                                                                                                                                                  |
|   4.1     |       | Reference is made to Exhibits 3.1 and 3.2                                                                                                                                                                     |
|   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)(24)         |       | 1999 Non-Employee Directors' Stock Option Plan, as  amended                                                                                                                                                   |
| 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 Networks, Inc. 2001 Stock Plan                                                                                                                                                                         |
| 10.12(8)(13)        |       | Employment Letter, dated April 25, 2002 between  Ditech and Lee House                                                                                                                                         |
| 10.13(8)(23)        |       | Compensation Arrangements with Named Executive  Officers                                                                                                                                                      |
| 10.14(8)(22)        |       | Compensation Arrangements with Non-Employee  Directors                                                                                                                                                        |
| 10.15(8)(27)        |       | 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                                                                                                                  |
| 10.22(8)(21)        |       | 2005 New Recruit Stock Option Plan                                                                                                                                                                            |
| 10.23(8)(26)        |       | Form of Stock Option Agreement under the 2005 New  Recruit Stock Option Plan                                                                                                                                  |
| 10.26(3)            |       | Second Lease Amendment, dated February 15, 2000,  between Ditech and Middlefield-Bernardo Associates LLC                                                                                                      |
| 10.27(25)           |       | Fourth Amendment to Lease Agreement dated July 31,  2005, between Middlefield II LLC and Ditech                                                                                                               |
| 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                                                                                                                     |

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| 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                                                            |
| 10.36(8)(21) |   | Offer Letter, executed February 4, 2006, between  Ditech and Gary Testa                                                                       |
| 10.37(28)    |   | Amendment No. 2 to TELOGY SOFTWARE LICENSE AGREEMENT  between Ditech Communications Corporation and Texas Instruments Incorporated            |
| 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)   Incorporatedby reference from the exhibit with corresponding number from Ditech's Report onForm 8-K, filed April 30, 2002 (Commission File No. 000-26209).

(2)   Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed July 30, 2003 (Commission File No. 000-26209).

(3)   Incorporatedby reference from the exhibit with corresponding number from Ditech's AnnualReport on Form 10-K for the fiscal year ended April 30, 2000, filed July 31,2000 (Commission File No. 000-26209).

(4)   Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed May 22, 2006 (Commission File No. 000-26209).

(5)   Incorporatedby reference from the exhibit with corresponding number from Ditech's AnnualReport on Form 10-K for the fiscal year ended April 30, 2002, filed July 29,2002 (Commission File No. 000-26209).

(6)   Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed March 30, 2001 (Commission File No. 000-26209).

(7)   Incorporatedby reference from the exhibits with corresponding descriptions from Ditech'sRegistration Statement (No. 333-75063), declared effective on June 9,1999.

(8)   Managementcontract or compensatory plan or arrangement.

(9)   Confidentialtreatment has been granted as to a portion of this exhibit. The confidentialportion of such exhibit has been omitted and filed separately with theCommission.

(10) Incorporatedby reference from the exhibit with the corresponding exhibit number fromDitech's Quarterly Report on Form 10-Q for the quarter ending July 31, 1999(Commission File No. 000-26209).

(11) Incorporatedby reference from the exhibit with the corresponding title from Ditech'sQuarterly Report on Form 10-Q for the quarter ending July 31, 2002, filedAugust 29, 2002 (Commission File No. 000-26209).

(12) Incorporatedby reference from the exhibit with the corresponding title from Ditech'sQuarterly Report on Form 10-Q for the quarter ending October 31, 2002, filedDecember 16, 2002 (Commission File No. 000-26209).

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(13) Incorporatedby reference from the exhibit with the corresponding title from Ditech'sQuarterly Report on Form 10-Q for the quarter ending January 31, 2003, filedMarch 14, 2003 (Commission File No. 000-26209).

(14) Incorporatedby reference to the exhibit with the corresponding title from Ditech's TenderOffer Statement on Schedule TO, filed February 19, 2003 (Commission File No.000-26209).

(15) Incorporatedby reference to the exhibit with the corresponding title from Ditech'sRegistration Statement on Form S-8 (Commission File No. 333-110821), filedNovember 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, filedSeptember 15, 2003 (Commission File No. 000-26209).

(17) Incorporatedby reference from the exhibit with the corresponding number from Ditech'sQuarterly Report on Form 10-Q for the quarter ended October 31, 2003, filedDecember 8, 2003 (Commission File No. 000-26209).

(18) Incorporatedby reference to the exhibit with the corresponding title from Ditech's RegistrationStatement on Form S-8 (Commission File No. 333-120278), filed November 8, 2004.

(19) Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed September 22, 2004 (Commission File No. 000-26209).

(20) Incorporatedby reference to the exhibit with the corresponding title from Ditech'sRegistration Statement on Form S-8 (Commission File No. 333-126302), filed June30, 2005.

(21) Incorporatedby reference to the exhibit with the corresponding title from Ditech's CurrentReport on Form 8-K, filed February 9, 2006 (Commission File No. 000-26209).

(22) Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed August 1, 2005 (Commission File No. 000-26209).

(23) Incorporatedby reference from the exhibits with corresponding titles from Ditech's CurrentReports on Form 8-K, filed August 1, 2005 and May 22, 2006 (Commission File No. 000-26209).

(24) Incorporatedby reference from such plan filed with Ditech's Proxy Statement filed August 16,2005 (Commission File No. 000-26209).

(25) Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed September 23, 2005 (Commission File No. 000-26209).

(26) Incorporatedby reference from the exhibit with corresponding title from Ditech's CurrentReport on Form 8-K, filed November 15, 2005 (Commission File No. 000-26209).

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

(28) Confidentialtreatment has been requested for portions of this exhibit.

(29) Incorporatedby reference from the exhibit with corresponding number from Ditech's AnnualReport on Form 10-K for the fiscal year ended April 30, 2005, filed July 14,2005 (Commission File No. 000-26209).

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