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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549



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FORM 10-Q



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|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the quarterly period ended September 30, 2005



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from  to



Commission file number 0-22158



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NetManage, Inc.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Delaware                                                       |  | 77-0252226                       
|(State or other jurisdiction of Incorporation or organization) |  | (IRS employer identification no.)



20883 Stevens Creek
Boulevard

Cupertino, California 95014

(Address of principal executive offices, including zip code)



(408) 973-7171

(Registrants telephone number, including area code)



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90
days.    YES  x    NO ̈



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



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



Number of shares of registrants common stock outstanding as of October 26, 2005: 9,343,217



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##### Table of Contents

NetManage, Inc.



Table of Contents



|         |  |                                                                                                                                                |  |         
|-------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------- |  | --------
|         |  |                                                                                                                                                |  | Page No.
|PART I.  |  | FINANCIAL INFORMATION                                                                                                                          |  |         
|         |  |                                                                                                                                               
|Item 1.  |  | Financial Statements (Unaudited)                                                                                                               |  |         
|         |  |                                                                                                                                               
|         |  | Condensed Consolidated Balance Sheets at September 30, 2005 and December 31, 2004                                                              |  | 3       
|         |  |                                                                                                                                               
|         |  | Condensed Consolidated Statements of Operations for the three and nine month periods ended September 30, 2005 and September 30, 2004           |  | 4       
|         |  |                                                                                                                                               
|         |  | Condensed Consolidated Statements of Comprehensive Income for the three and nine month periods ended September 30, 2005 and September 30, 2004 |  | 5       
|         |  |                                                                                                                                               
|         |  | Condensed Consolidated Statements of Cash Flows for the nine month periods ended September 30, 2005 and September 30, 2004                     |  | 6       
|         |  |                                                                                                                                               
|         |  | Notes to Condensed Consolidated Financial Statements                                                                                           |  | 7       
|         |  |                                                                                                                                               
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                                          |  | 16      
|         |  |                                                                                                                                               
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                                                                                     |  | 34      
|         |  |                                                                                                                                               
|Item 4.  |  | Controls and Procedures                                                                                                                        |  | 34      
|         |  |                                                                                                                                               
|PART II. |  | OTHER INFORMATION                                                                                                                              |  |         
|         |  |                                                                                                                                               
|Item 1.  |  | Legal Proceedings                                                                                                                              |  | 35      
|         |  |                                                                                                                                               
|Item 2.  |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                                                    |  | 35      
|         |  |                                                                                                                                               
|Item 3.  |  | Defaults upon Senior Securities                                                                                                                |  | 35      
|         |  |                                                                                                                                               
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                                                            |  | 35      
|         |  |                                                                                                                                               
|Item 5.  |  | Other Information                                                                                                                              |  | 35      
|         |  |                                                                                                                                               
|Item 6.  |  | Exhibits                                                                                                                                       |  | 35      
|         |  |                                                                                                                                               
|         |  | Signatures                                                                                                                                     |  | 36      





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##### Table of Contents

NETMANAGE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

(Unaudited)



|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                                                            |  | September 30, 2005 |          |   | December 31, 2004 |  
|ASSETS                                                                                                                                                                      |  |                    |          |   |                   |   |          |  
|Current assets:                                                                                                                                                             |  |                    |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                                                                   |  | $                  | 9,664    |   |                   | $ | 19,570   |  
|Short-term investments                                                                                                                                                      |  |                    | 11,467   |   |                   |   | 219      |  
|Accounts receivable, net of allowances of $287 and $883, respectively                                                                                                       |  |                    | 6,639    |   |                   |   | 15,780   |  
|Prepaid expenses and other current assets                                                                                                                                   |  |                    | 1,202    |   |                   |   | 2,608    |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Total current assets                                                                                                                                                        |  |                    | 28,972   |   |                   |   | 38,177   |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Property and equipment, at cost:                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Computer software and equipment                                                                                                                                             |  |                    | 1,528    |   |                   |   | 1,101    |  
|Furniture and fixtures                                                                                                                                                      |  |                    | 2,775    |   |                   |   | 2,687    |  
|Leasehold improvements and other                                                                                                                                            |  |                    | 710      |   |                   |   | 988      |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|                                                                                                                                                                            |  |                    | 5,013    |   |                   |   | 4,776    |  
|Less accumulated depreciation                                                                                                                                               |  |                    | (2,101   | ) |                   |   | (1,546   | )
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Net property and equipment                                                                                                                                                  |  |                    | 2,912    |   |                   |   | 3,230    |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Goodwill                                                                                                                                                                    |  |                    | 3,667    |   |                   |   | 3,667    |  
|Other intangibles, net                                                                                                                                                      |  |                    | 1,779    |   |                   |   | 2,376    |  
|Long-term investments                                                                                                                                                       |  |                    | 1,895    |   |                   |   |         |  
|Other long-term assets                                                                                                                                                      |  |                    | 60       |   |                   |   | 384      |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Total assets                                                                                                                                                                |  | $                  | 39,285   |   |                   | $ | 47,834   |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                        |  |                    |          |   |                   |   |          |  
|Current liabilities:                                                                                                                                                        |  |                    |          |   |                   |   |          |  
|Accounts payable                                                                                                                                                            |  | $                  | 986      |   |                   | $ | 2,763    |  
|Accrued liabilities                                                                                                                                                         |  |                    | 1,341    |   |                   |   | 2,992    |  
|Accrued payroll and related expenses                                                                                                                                        |  |                    | 2,215    |   |                   |   | 3,612    |  
|Deferred revenue                                                                                                                                                            |  |                    | 11,327   |   |                   |   | 17,517   |  
|Income taxes payable                                                                                                                                                        |  |                    | 1,030    |   |                   |   | 1,433    |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Total current liabilities                                                                                                                                                   |  |                    | 16,899   |   |                   |   | 28,317   |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Long-term liabilities:                                                                                                                                                      |  |                    |          |   |                   |   |          |  
|Deferred revenue                                                                                                                                                            |  |                    | 708      |   |                   |   | 1,757    |  
|Other long-term liabilities                                                                                                                                                 |  |                    | 776      |   |                   |   | 786      |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Total long-term liabilities                                                                                                                                                 |  |                    | 1,484    |   |                   |   | 2,543    |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Total liabilities                                                                                                                                                           |  |                    | 18,383   |   |                   |   | 30,860   |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Commitments and contingencies (Note 4)                                                                                                                                      |  |                    |          |   |                   |   |          |  
|Stockholders equity:                                                                                                                                                       |  |                    |          |   |                   |   |          |  
|Preferred stock, $0.01 par value-Authorized-1,000,000 shares. No shares issued and outstanding                                                                              |  |                    |         |   |                   |   |         |  
|Common stock, $0.01 par value-Authorized-36,000,000 shares. Issued-11,417,988 and 11,275,373 shares, respectively. Outstanding-9,341,140 and
9,198,525 shares, respectively |  |                    | 114      |   |                   |   | 113      |  
|Treasury stock, at cost-2,076,848 shares                                                                                                                                    |  |                    | (20,804  | ) |                   |   | (20,804  | )
|Additional paid in capital                                                                                                                                                  |  |                    | 181,545  |   |                   |   | 180,968  |  
|Accumulated deficit                                                                                                                                                         |  |                    | (136,311 | ) |                   |   | (139,418 | )
|Accumulated other comprehensive loss                                                                                                                                        |  |                    | (3,642   | ) |                   |   | (3,885   | )
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Total stockholders equity                                                                                                                                                  |  |                    | 20,902   |   |                   |   | 16,974   |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                                                                  |  | $                  | 39,285   |   |                   | $ | 47,834   |  
|                                                                                                                                                                            |  |                    |          |   |                   |   |          |  



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



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NETMANAGE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)



|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------ |  | ------------------------------- | ----- | - | ------------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                 |  | Three Months EndedSeptember 30, |       |   | Nine Months EndedSeptember 30, |  
|                                                 |  | 2005                            |       |   | 2004                           |   |        | 2005 |  |   | 2004   |  
|Net revenues:                                    |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|License fees                                     |  | $                               | 3,614 |   |                                | $ | 4,813  |      |  | $ | 12,743 |   |  | $ | 13,570 |  
|Services                                         |  |                                 | 6,334 |   |                                |   | 6,820  |      |  |   | 19,992 |   |  |   | 20,939 |  
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total net revenues                               |  |                                 | 9,948 |   |                                |   | 11,633 |      |  |   | 32,735 |   |  |   | 34,509 |  
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Cost of revenues:                                |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|License fees                                     |  |                                 | 237   |   |                                |   | 369    |      |  |   | 855    |   |  |   | 1,115  |  
|Services                                         |  |                                 | 798   |   |                                |   | 920    |      |  |   | 2,444  |   |  |   | 2,717  |  
|Amortization of developed technology             |  |                                 | 70    |   |                                |   | 336    |      |  |   | 210    |   |  |   | 923    |  
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total cost of revenues                           |  |                                 | 1,105 |   |                                |   | 1,625  |      |  |   | 3,509  |   |  |   | 4,755  |  
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Gross margin                                     |  |                                 | 8,843 |   |                                |   | 10,008 |      |  |   | 29,226 |   |  |   | 29,754 |  
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Operating expenses:                              |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Research and development                         |  |                                 | 1,658 |   |                                |   | 1,722  |      |  |   | 5,388  |   |  |   | 5,247  |  
|Sales and marketing                              |  |                                 | 4,431 |   |                                |   | 5,663  |      |  |   | 15,350 |   |  |   | 16,404 |  
|General and administrative                       |  |                                 | 1,994 |   |                                |   | 1,951  |      |  |   | 6,582  |   |  |   | 7,011  |  
|Restructuring charges                            |  |                                 | 29    |   |                                |   | 32     |      |  |   | (63    | ) |  |   | (106   | )
|Amortization and impairment of intangible assets |  |                                 | 158   |   |                                |   | 150    |      |  |   | 388    |   |  |   | 449    |  
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Total operating expenses                         |  |                                 | 8,270 |   |                                |   | 9,518  |      |  |   | 27,645 |   |  |   | 29,005 |  
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Income from operations                           |  |                                 | 573   |   |                                |   | 490    |      |  |   | 1,581  |   |  |   | 749    |  
|Interest income and other, net                   |  |                                 | 239   |   |                                |   | 40     |      |  |   | 501    |   |  |   | 72     |  
|Gain on sale of investments                      |  |                                 | 2     |   |                                |   |       |      |  |   | 35     |   |  |   |       |  
|Foreign currency transaction gains (losses)      |  |                                 | (94   | ) |                                |   | 293    |      |  |   | (269   | ) |  |   | (66    | )
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Income before income taxes                       |  |                                 | 720   |   |                                |   | 823    |      |  |   | 1,848  |   |  |   | 755    |  
|Provision (benefit) for income taxes             |  |                                 | (884  | ) |                                |   | (40    | )    |  |   | (1,259 | ) |  |   | 66     |  
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net income                                       |  | $                               | 1,604 |   |                                | $ | 863    |      |  | $ | 3,107  |   |  | $ | 689    |  
|                                                 |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Net income per share:                            |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Basic                                            |  | $                               | 0.17  |   |                                | $ | 0.10   |      |  | $ | 0.33   |   |  | $ | 0.08   |  
|Diluted                                          |  | $                               | 0.17  |   |                                | $ | 0.09   |      |  | $ | 0.32   |   |  | $ | 0.07   |  
|Weighted average common shares:                  |  |                                 |       |   |                                |   |        |      |  |   |        |   |  |   |        |  
|Basic                                            |  |                                 | 9,341 |   |                                |   | 8,895  |      |  |   | 9,288  |   |  |   | 8,843  |  
|Diluted                                          |  |                                 | 9,598 |   |                                |   | 9,189  |      |  |   | 9,668  |   |  |   | 9,395  |  



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





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NETMANAGE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)



|                                                     |  |                                 |       |   |                                |   |      |      |  |   |       |   |  |   |      |  
|---------------------------------------------------- |  | ------------------------------- | ----- | - | ------------------------------ | - | ---- | ---- |  | - | ----- | - |  | - | ---- | -
|                                                     |  | Three Months EndedSeptember 30, |       |   | Nine Months EndedSeptember 30, |  
|                                                     |  | 2005                            |       |   | 2004                           |   |      | 2005 |  |   | 2004  |  
|Net income                                           |  | $                               | 1,604 |   |                                | $ | 863  |      |  | $ | 3,107 |   |  | $ | 689  |  
|Other comprehensive income (loss):                   |  |                                 |       |   |                                |   |      |      |  |   |       |   |  |   |      |  
|Change in unrealized (gain) loss on investments, net |  |                                 | (1    | ) |                                |   | (28  | )    |  |   | (47   | ) |  |   | (69  | )
|Foreign currency translation adjustments, net        |  |                                 | 120   |   |                                |   | (394 | )    |  |   | 290   |   |  |   | (179 | )
|                                                     |  |                                 |       |   |                                |   |      |      |  |   |       |   |  |   |      |  
|Total comprehensive income                           |  | $                               | 1,723 |   |                                | $ | 441  |      |  | $ | 3,350 |   |  | $ | 441  |  
|                                                     |  |                                 |       |   |                                |   |      |      |  |   |       |   |  |   |      |  



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





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##### Table of Contents

NETMANAGE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                                  |  |                                |         |   |      |   |        |  
|--------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------ | -
|                                                                                  |  | Nine months endedSeptember 30, |        
|                                                                                  |  | 2005                           |         |   | 2004 |  
|Cash flows from operating activities:                                             |  |                                |         |   |      |   |        |  
|Net income                                                                        |  | $                              | 3,107   |   |      | $ | 689    |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                                |         |   |      |   |        |  
|Depreciation and amortization                                                     |  |                                | 1,454   |   |      |   | 2,118  |  
|(Gain) loss on disposal of property, plant and equipment                          |  |                                | (1      | ) |      |   | 13     |  
|Provision (reversal) of doubtful accounts and returns                             |  |                                | (237    | ) |      |   | 93     |  
|Stock compensation expense                                                        |  |                                | 24      |   |      |   | 458    |  
|Liquidation of dormant entities                                                   |  |                                |        |   |      |   | (426   | )
|Gain on sale of investments                                                       |  |                                | (35     | ) |      |   |       |  
|Non-cash impairment charge                                                        |  |                                | 43      |   |      |   |       |  
|Changes in operating assets and liabilities:                                      |  |                                |         |   |      |   |        |  
|Accounts receivable                                                               |  |                                | 9,016   |   |      |   | 7,783  |  
|Prepaid expenses and other current assets                                         |  |                                | 1,233   |   |      |   | 404    |  
|Other assets                                                                      |  |                                | 224     |   |      |   | (74    | )
|Accounts payable                                                                  |  |                                | (1,718  | ) |      |   | (168   | )
|Accrued liabilities, payroll and payroll-related expenses                         |  |                                | (2,739  | ) |      |   | (2,844 | )
|Deferred revenue                                                                  |  |                                | (6,771  | ) |      |   | (1,777 | )
|Income taxes payable                                                              |  |                                | (394    | ) |      |   | 147    |  
|Other long-term liabilities                                                       |  |                                | (9      | ) |      |   | 12     |  
|                                                                                  |  |                                |         |   |      |   |        |  
|Net cash provided by operating activities                                         |  |                                | 3,197   |   |      |   | 6,428  |  
|                                                                                  |  |                                |         |   |      |   |        |  
|Cash flows from investing activities:                                             |  |                                |         |   |      |   |        |  
|Purchases of investments                                                          |  |                                | (38,294 | ) |      |   | (136   | )
|Proceeds from sales and maturities of investments                                 |  |                                | 25,175  |   |      |   | 37     |  
|Purchases of property and equipment                                               |  |                                | (616    | ) |      |   | (1,483 | )
|Acquisition related costs                                                         |  |                                | (66     | ) |      |   |       |  
|                                                                                  |  |                                |         |   |      |   |        |  
|Net cash used in investing activities                                             |  |                                | (13,801 | ) |      |   | (1,582 | )
|                                                                                  |  |                                |         |   |      |   |        |  
|Cash flows from financing activities:                                             |  |                                |         |   |      |   |        |  
|Proceeds from sale of common stock                                                |  |                                | 620     |   |      |   | 813    |  
|                                                                                  |  |                                |         |   |      |   |        |  
|Effect of exchange rate changes on cash                                           |  |                                | 78      |   |      |   | 58     |  
|                                                                                  |  |                                |         |   |      |   |        |  
|Net increase (decrease) in cash and cash equivalents                              |  |                                | (9,906  | ) |      |   | 5,717  |  
|Cash and cash equivalents, beginning of period                                    |  |                                | 19,570  |   |      |   | 20,160 |  
|                                                                                  |  |                                |         |   |      |   |        |  
|Cash and cash equivalents, end of period                                          |  | $                              | 9,664   |   |      | $ | 25,877 |  
|                                                                                  |  |                                |         |   |      |   |        |  



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





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##### Table of Contents

NETMANAGE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



1. Interim financial data



The accompanying interim unaudited condensed consolidated financial statements of NetManage, Inc. (the Company) have been prepared in
accordance with accounting principles generally accepted in the United States of America (generally accepted accounting principles) for interim financial information and in accordance with the instructions to Form 10-Q and Rule 10-01 of
Regulation S-X. Accordingly, they do not contain all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying unaudited condensed
consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation. Actual results for fiscal year 2005 could differ materially from those reported in this
quarterly report on Form 10-Q. The Company believes the results of operations for interim periods are subject to fluctuation and may not be an indicator of future financial performance. The financial statements should be read in conjunction with the
audited financial statements and notes thereto, included in the Companys annual report on Form 10-K for the year ended December 31, 2004, as filed with the Securities and Exchange Commission (the SEC).



2. Summary of significant accounting policies



Principles of consolidation



The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated.



Use of estimates



The preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, disclosures of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those
estimates.



Foreign currency translation, foreign exchange contracts and
comprehensive income



The functional currency of the
Companys foreign subsidiaries is the local currency. Gains and losses resulting from the translation of the foreign subsidiaries financial statements are included in accumulated other comprehensive loss and reported as a separate
component of stockholders equity. Gains and losses resulting from foreign currency transactions are included in net income.



The Company currently does not enter into financial instruments for either trading or speculative purposes. There were no forward foreign exchange
contracts used during the three and nine month periods ended September 30, 2005 and 2004.



Total comprehensive income is comprised of net income and other comprehensive earnings such as foreign currency translation gains or losses and unrealized gains or losses on marketable securities.



Cash and cash equivalents



Cash and cash equivalents includes all money deposited with financial
institutions that can be withdrawn without notice and all short-term, highly liquid investments that are readily convertible to cash.



Investments



The Company accounts for its investments under the provisions of the Financial Accounting Standards Boards (FASB) Statement of Financial Accounting
Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. Under SFAS No. 115, the Companys investments are classified as either available-for-sale or held-to maturity securities. All
available-for-sale securities are reported at fair value, with unrealized gains and losses, net of tax, reported in the condensed consolidated balance sheet as Accumulated other comprehensive loss. Held-to-maturity investments are valued
using the amortized cost method.



Beginning in the third
quarter of 2005, the Company converted a portion of its cash and cash equivalents to longer term securities. The following table summarizes the Companys cash, cash equivalents, short-term and long-term investments as of September 30, 2005
(in thousands):



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|                                                 |  |               |        |   |                 |   |                  |  |   |           |   |  |   |        |  
|------------------------------------------------ |  | ------------- | ------ | - | --------------- | - | ---------------- |  | - | --------- | - |  | - | ------ | -
|                                                 |  | AmortizedCost |        |   | UnrealizedGains |   | UnrealizedLosses |  |   | FairValue |  
|Cash and cash equivalents:                       |  |               |        |   |                 |   |                  |  |   |           |   |  |   |        |  
|Cash                                             |  | $             | 4,701  |   |                 | $ |                 |  | $ |          |   |  | $ | 4,701  |  
|Cash equivalents                                 |  |               | 4,963  |   |                 |   |                 |  |   | (1        | ) |  |   | 4,962  |  
|                                                 |  |               |        |   |                 |   |                  |  |   |           |   |  |   |        |  
|Total cash and cash equivalents                  |  | $             | 9,664  |   |                 | $ |                 |  | $ | (1        | ) |  | $ | 9,663  |  
|                                                 |  |               |        |   |                 |   |                  |  |   |           |   |  |   |        |  
|Held-to-maturity investments:                    |  |               |        |   |                 |   |                  |  |   |           |   |  |   |        |  
|Time deposits                                    |  | $             | 50     |   |                 | $ |                 |  | $ |          |   |  | $ | 50     |  
|Corporate bonds                                  |  |               | 11,880 |   |                 |   |                 |  |   | (26       | ) |  |   | 11,854 |  
|Taxable municipal bonds                          |  |               | 733    |   |                 |   |                 |  |   | (2        | ) |  |   | 731    |  
|Government bonds                                 |  |               | 2,271  |   |                 |   |                 |  |   | (3        | ) |  |   | 2,268  |  
|Commercial paper                                 |  |               | 749    |   |                 |   |                 |  |   |          |   |  |   | 749    |  
|                                                 |  |               |        |   |                 |   |                  |  |   |           |   |  |   |        |  
|Total investments                                |  | $             | 15,683 |   |                 | $ |                 |  | $ | (31       | ) |  | $ | 15,652 |  
|Less amounts classified as cash equivalents      |  |               | (2,321 | ) |                 |   |                 |  |   | 1         |   |  |   | (2,320 | )
|Less amounts classified as long-term investments |  |               | (1,895 | ) |                 |   |                 |  |   | 5         |   |  |   | (1,890 | )
|                                                 |  |               |        |   |                 |   |                  |  |   |           |   |  |   |        |  
|Total short-term investments                     |  | $             | 11,467 |   |                 | $ |                 |  | $ | (25       | ) |  | $ | 11,442 |  
|                                                 |  |               |        |   |                 |   |                  |  |   |           |   |  |   |        |  



At December 31,
2004, the fair value of the time deposit investments, which had original maturities in excess of 90 days, approximated amortized cost and, as such, gross unrealized holding gains and losses were not material. The fair value of the available-for-sale
securities was determined based on quoted market prices at the reporting dates for those instruments. The following table summarizes the Companys cash, cash equivalents and short-term investments as of December 31, 2004 (in thousands):



|                                     |  |               |       
|------------------------------------ |  | ------------- | ------
|                                     |  | AmortizedCost
|Cash and cash equivalents:           |  |               |       
|Cash                                 |  | $             | 4,686 
|Cash equivalents, money market funds |  |               | 14,884
|                                     |  |               |       
|Total cash and cash equivalents      |  | $             | 19,570
|                                     |  |               |       
|Short-term investments:              |  |               |       
|KANA Software, Inc. (1)              |  | $             | 77    
|Time deposits                        |  | $             | 142   
|                                     |  |               |       
|Total short-term investments         |  | $             | 219   
|                                     |  |               |       

---

|(1) | The Company sold its minority interest of less than 1% in KANA Software Inc., a publicly traded company, in the quarter ended June 30, 2005. Shares in KANA Software Inc., were
held as available for sale investments and included an unrealized gain of $47,000 at December 31, 2004.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The contractual maturity dates for securities as of September 30, 2005 are $16.4 million in less than one year and $1.9 million in one to two years.



Goodwill and other intangible assets, net



Effective January 1, 2002, the Company adopted SFAS No. 142,
Goodwill and Other Intangibles. Under SFAS No. 142, goodwill is no longer subject to amortization. Rather, SFAS No. 142 requires that intangible assets deemed to have an indefinite useful life be reviewed for impairment upon
adoption of SFAS No. 142 and at least annually thereafter.



Intangible assets with determinable useful lives are amortized on a straight-line basis over their estimated useful lives ranging from two to five years. In connection with the acquisition of Librados, Inc. in October 2004, the Company
recorded an intangible asset related to employment contracts for certain individuals. In the quarter ended September 30, 2005, these individuals terminated employment with the Company and the remaining unamortized value of the related
intangible asset of $43,000 was expensed. The following table provides a summary of the carrying amounts of other intangible assets that will continue to be amortized (in thousands):



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##### Table of Contents

|                                           |  |                    |       |   |                   |   |       |  
|------------------------------------------ |  | ------------------ | ----- | - | ----------------- | - | ----- | -
|                                           |  | September 30, 2005 |       |   | December 31, 2004 |  
|Carrying amount of:                        |  |                    |       |   |                   |   |       |  
|Developed technology                       |  | $                  | 1,400 |   |                   | $ | 1,400 |  
|Employment contracts                       |  |                    |      |   |                   |   | 79    |  
|Non-compete contracts                      |  |                    | 721   |   |                   |   | 721   |  
|Trade names                                |  |                    | 300   |   |                   |   | 300   |  
|                                           |  |                    |       |   |                   |   |       |  
|Gross carrying amount of other intangibles |  |                    | 2,421 |   |                   |   | 2,500 |  
|Less accumulated amortization:             |  |                    |       |   |                   |   |       |  
|Developed technology                       |  |                    | (257  | ) |                   |   | (47   | )
|Employment contracts                       |  |                    |      |   |                   |   | (7    | )
|Non-compete contracts                      |  |                    | (330  | ) |                   |   | (60   | )
|Trade names                                |  |                    | (55   | ) |                   |   | (10   | )
|                                           |  |                    |       |   |                   |   |       |  
|Net carrying amount of other intangibles   |  | $                  | 1,779 |   |                   | $ | 2,376 |  
|                                           |  |                    |       |   |                   |   |       |  



The carrying amount
and accumulated amortization as of September 30, 2005 and December 31, 2004 have been adjusted to exclude intangibles that were fully amortized as of September 30, 2005 and December 31, 2004, respectively.



The remaining net carrying amount of other intangibles is scheduled to be
amortized as follows (in thousands):



|                  |  |                      |      
|----------------- |  | -------------------- | -----
|Year              |  | Amortization Expense
|Remainder of 2005 |  | $                    | 176  
|2006              |  |                      | 640  
|2007              |  |                      | 340  
|2008              |  |                      | 340  
|2009              |  |                      | 283  
|                  |  |                      |      
|                  |  | $                    | 1,779
|                  |  |                      |      



The aggregate
amortization expense for the three and nine month periods ended September 30, 2005 was $0.2 million and $0.6 million, respectively. The aggregate amortization expense for the three and nine month periods ended September 30, 2004 was $0.5
million and $1.4 million, respectively.



Accrued liabilities



Accrued liabilities at September 30, 2005 and
December 31, 2004 consisted of the following (in thousands):



|                                   |  |                    |       |                   |   |      
|---------------------------------- |  | ------------------ | ----- | ----------------- | - | -----
|Description                        |  | September 30, 2005 |       | December 31, 2004
|Current restructuring (see Note 3) |  | $                  | 45    |                   | $ | 302  
|Other accruals                     |  |                    | 1,296 |                   |   | 2,690
|                                   |  |                    |       |                   |   |      
|Total accrued liabilities          |  | $                  | 1,341 |                   | $ | 2,992
|                                   |  |                    |       |                   |   |      



Long-term liabilities



Long-term liabilities at September 30, 2005 and
December 31, 2004 consisted of the following (in thousands):



|                                     |  |                   |       |                  |   |      
|------------------------------------ |  | ----------------- | ----- | ---------------- | - | -----
|Description                          |  | September 30,2005 |       | December 31,2004
|Long-term restructuring (see Note 3) |  | $                 | 341   |                  | $ | 394  
|Long-term other                      |  |                   | 435   |                  |   | 392  
|Long-term deferred revenue           |  |                   | 708   |                  |   | 1,757
|                                     |  |                   |       |                  |   |      
|Total long-term liabilities          |  | $                 | 1,484 |                  | $ | 2,543
|                                     |  |                   |       |                  |   |      



Concentrations of credit risk



Financial instruments, which potentially subject the
Company to concentrations of credit risk, consist principally of cash investments and trade receivables. The Company has a cash investment policy that limits the amount of credit exposure to any one issuer and restricts placement of these
investments to issuers evaluated as less than creditworthy. Concentrations of credit risk



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##### Table of Contents

with respect to trade receivables are limited due to the large number of customers comprising the Companys customer
base and their dispersion across many different industries and geographies. There were no customers that accounted for 10% or more of consolidated net revenues in the three month period ended September 30, 2005 and for the nine month periods
ended September 30, 2005 and 2004. One customer accounted for approximately 23% of consolidated revenues in the three month period ended September 30, 2004.



Net income per share



Basic net income per share data has been computed using the weighted-average number of shares of common stock outstanding during the indicated periods.
Diluted net income per share data has been computed using the weighted-average number of shares of common stock and potential dilutive common shares. Potential dilutive common shares include dilutive shares issuable upon the exercise of outstanding
common stock options computed using the treasury stock method.



For the three and nine month periods ended September 30, 2005 and 2004, potentially dilutive securities, consisting of applicable stock options, are as shown in the following table.



|                            |  |                                 |  |                                |  |         |  |        
|--------------------------- |  | ------------------------------- |  | ------------------------------ |  | ------- |  | -------
|                            |  | Three Months EndedSeptember 30, |  | Nine Months EndedSeptember 30,
|                            |  | 2005                            |  | 2004                           |  | 2005    |  | 2004   
|Potentially dilutive shares |  | 256,905                         |  | 294,474                        |  | 380,001 |  | 552,154



The following table
sets forth the computation of basic and diluted net income per share for the three and nine month periods ended September 30, 2005 and 2004 (in thousands, except per share amounts):



|                                                                                    |  |                                 |       |                                |   |       |  |      |       |  |   |      
|----------------------------------------------------------------------------------- |  | ------------------------------- | ----- | ------------------------------ | - | ----- |  | ---- | ----- |  | - | -----
|                                                                                    |  | Three Months EndedSeptember 30, |       | Nine Months EndedSeptember 30,
|                                                                                    |  | 2005                            |       | 2004                           |   | 2005  |  | 2004
|Net income                                                                          |  | $                               | 1,604 |                                | $ | 863   |  | $    | 3,107 |  | $ | 689  
|                                                                                    |  |                                 |       |                                |   |       |  |      |       |  |   |      
|Shares used to compute basic net income per share                                   |  |                                 | 9,341 |                                |   | 8,895 |  |      | 9,288 |  |   | 8,843
|Potentially dilutive shares used to compute net income per share on a diluted basis |  |                                 | 257   |                                |   | 294   |  |      | 380   |  |   | 552  
|                                                                                    |  |                                 |       |                                |   |       |  |      |       |  |   |      
|Shares used to compute diluted net income per share                                 |  |                                 | 9,598 |                                |   | 9,189 |  |      | 9,668 |  |   | 9,395
|                                                                                    |  |                                 |       |                                |   |       |  |      |       |  |   |      
|Net income per share:                                                               |  |                                 |       |                                |   |       |  |      |       |  |   |      
|Basic                                                                               |  | $                               | 0.17  |                                | $ | 0.10  |  | $    | 0.33  |  | $ | 0.08 
|Diluted                                                                             |  | $                               | 0.17  |                                | $ | 0.09  |  | $    | 0.32  |  | $ | 0.07 



Income taxes



The Company accounts for income taxes under the liability method. Under
the liability method, deferred tax assets and liabilities are determined based on differences between the financial reporting and tax basis of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when
the differences are expected to reverse. The Company is required to adjust its deferred tax liabilities in the period when tax rates or the provisions of the income tax laws change. Valuation allowances are established when necessary to reduce
deferred tax assets to amounts that, more likely than not, are expected to be realized.



As part of the process of preparing its condensed consolidated financial statements, the Company is required to estimate its income taxes in each of the jurisdictions in which the Company operates. This process
involves estimating the Companys actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in
deferred tax assets and liabilities, which are included in the Companys condensed consolidated balance sheet. The Company must then assess the likelihood that its deferred tax assets will be recovered from future taxable income and to the
extent the Company believes that recovery is not likely, it must establish a valuation allowance. To the extent the Company establishes a valuation allowance, or the allowance in a period changes, the amount recognized as a provision for income
taxes in the Condensed Consolidated Statements of Operations could change.



The income tax benefit of $884,000, for the three month period ended September 30, 2005, primarily relates to a favorable tax adjustment in Germany of $479,000, the reversal of reserves of $418,000 in connection
with the favorable outcome of a tax audit in a foreign subsidiary, offset in part by an international tax expense of $13,000. The income tax benefit of $40,000 for the three month



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##### Table of Contents

period ended September 30, 2004 includes an international tax benefit of $24,000 and a U.S. state tax benefit of
$16,000. The income tax benefit of $1.3 million for the nine month period ended September 30, 2005 includes favorable tax adjustments in Germany of $936,000, the reversal of reserves of $418,000, offset in part by an international tax expense
of $91,000 and a U.S. state tax expense of $4,000. The income tax provision of $66,000 for the nine months ended September 30, 2004 consists of an international tax expense of $54,000 and a U.S. state tax expense of $12,000.



Accounting for stock based compensation



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock
Based Compensation-Transition and Disclosure-An Amendment of FASB Statement No. 123, which provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation.
In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect
of the method used on reported results.



SFAS No. 123,
Accounting for Stock-Based Compensation,encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the fair value of the
award which is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees,whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the
amount an employee must pay to acquire the stock. Stock options issued under the Companys stock option plans have no intrinsic value at the grant date. Accordingly, under APB Opinion No. 25, no compensation cost is recognized. The Company
has elected to continue with the method of accounting prescribed in APB Opinion No. 25 and, as a result, must provide pro forma disclosures of net income and net income per share and other disclosures as if the fair value based method of
accounting had been applied. Had compensation cost for the Companys outstanding stock options been determined based on the fair value at the grant dates for awards under those plans consistent with the method prescribed by SFAS No. 123,
the Companys net income and earnings per share would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data):



|                                                                                                              |  |                                 |       |   |                                |   |       |      |  |   |       |   |  |   |       |  
|------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ----- | - | ------------------------------ | - | ----- | ---- |  | - | ----- | - |  | - | ----- | -
|                                                                                                              |  | Three Months EndedSeptember 30, |       |   | Nine Months EndedSeptember 30, |  
|                                                                                                              |  | 2005                            |       |   | 2004                           |   |       | 2005 |  |   | 2004  |  
|Net income as reported                                                                                        |  | $                               | 1,604 |   |                                | $ | 863   |      |  | $ | 3,107 |   |  | $ | 689   |  
|Less: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                                 | (153  | ) |                                |   | (199  | )    |  |   | (609  | ) |  |   | (630  | )
|                                                                                                              |  |                                 |       |   |                                |   |       |      |  |   |       |   |  |   |       |  
|Pro forma net income                                                                                          |  | $                               | 1,451 |   |                                | $ | 664   |      |  | $ | 2,498 |   |  | $ | 59    |  
|                                                                                                              |  |                                 |       |   |                                |   |       |      |  |   |       |   |  |   |       |  
|Weighted average common shares:                                                                               |  |                                 |       |   |                                |   |       |      |  |   |       |   |  |   |       |  
|Basic                                                                                                         |  |                                 | 9,341 |   |                                |   | 8,895 |      |  |   | 9,288 |   |  |   | 8,843 |  
|Diluted                                                                                                       |  |                                 | 9,598 |   |                                |   | 9,189 |      |  |   | 9,668 |   |  |   | 9,395 |  
|Basic income per share, as reported                                                                           |  | $                               | 0.17  |   |                                | $ | 0.10  |      |  | $ | 0.33  |   |  | $ | 0.08  |  
|Diluted income per share, as reported                                                                         |  | $                               | 0.17  |   |                                | $ | 0.09  |      |  | $ | 0.32  |   |  | $ | 0.07  |  
|Basic income per share, pro forma                                                                             |  | $                               | 0.16  |   |                                | $ | 0.07  |      |  | $ | 0.27  |   |  | $ | 0.01  |  
|Diluted income per share, pro forma                                                                           |  | $                               | 0.15  |   |                                | $ | 0.07  |      |  | $ | 0.26  |   |  | $ | 0.01  |  



The fair value of each
option granted is estimated on the date of grant using the Black-Scholes model with the following assumptions used for grants during the applicable periods:



|                        |  |                                      |  |                                      |  |                                      |  |                                    
|----------------------- |  | ------------------------------------ |  | ------------------------------------ |  | ------------------------------------ |  | -----------------------------------
|                        |  | Three Months EndedSeptember 30, 2005 |  | Three Months EndedSeptember 30, 2004 |  | Nine Months Ended September 30, 2005 |  | Nine Months EndedSeptember 30, 2004
|Volatility              |  | 41.51%                               |  | 71.03%                               |  | 39.32%                               |  | 83.63%                             
|Risk-free interest rate |  | 3.88-4.20%                           |  | 3.23-3.27%                           |  | 3.56-4.20%                           |  | 2.63-3.27%                         
|Dividend yield          |  | 0.00%                                |  | 0.00%                                |  | 0.00%                                |  | 0.00%                              
|Expected term           |  | 3-4 monthsbeyond vest date           |  | 3-4 monthsbeyond vest date           |  | 3-4 monthsbeyond vest date           |  | 3-4 monthsbeyond vest date         



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Revenue recognition



The Company derives revenue primarily from two sources: (1) product revenue, which includes software license and
royalty revenue, and (2) support and services revenue, which includes software maintenance and consulting. The Company licenses its software products on either a perpetual or term basis. The term based arrangements are primarily for a period of
12 months. The Company licenses its software in object code format and in some cases in source code format. The Company applies the provisions of the American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2,
Software Revenue Recognition, and related amendments and interpretations to all transactions involving the licensing of software products.



The Company recognizes revenue from the sale of software licenses to end users and resellers when the following criteria are met: persuasive evidence of
an arrangement exists, the product has been delivered, the fee is fixed and determinable, and collection of the resulting receivable is reasonably assured. Delivery occurs when the product is delivered to a common carrier or when a soft-key has been
transmitted to the customer.



Product licenses are sold,
without the right of return, except for distributor inventory rotation of old or excess product. Certain of the Companys sales are made to domestic distributors under agreements allowing rights of return and price protection on unsold
merchandise. Accordingly, the Company defers recognition of such sales until the distributor sells the merchandise. The Company recognizes sales to international distributors upon shipment, provided all other revenue recognition criteria have been
met. The Company gives rebates to customers on a limited basis. These rebates are presented in its Condensed Consolidated Statement of Operations as a reduction of revenue.



At the time of the transaction, the Company assesses whether the fee associated with its revenue transactions is fixed and
determinable and whether or not collection is reasonably assured. The Company assesses whether the fee is fixed and determinable based on the payment terms associated with the transaction. If a significant portion of a fee is due after normal
payment terms, the Company accounts for the fee as not being fixed and determinable. In these cases, it recognizes revenue as the fees become due.



The Company assesses the ability to collect on a number of factors, including past transaction history with the customer and the credit-worthiness of the
customer. If the Company determines that collection of a fee is not reasonably assured, it recognizes revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash.



For sales, except those completed over the Internet, the Company uses either
a binding purchase order or equivalent customer commitment or signed license agreement as evidence of an arrangement. For sales over the Internet, the Company uses a credit card authorization as evidence of an arrangement. Sales through the
Companys distributors are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction-by-transaction basis.



For arrangements with multiple elements (for example, software and undelivered maintenance and support), the Company
allocates revenue to each element of the arrangement using the residual value method based on vendor-specific objective evidence (VSOE) of the fair value of the undelivered elements. This means that revenue from the arrangement equivalent to the
fair value of the undelivered elements is deferred until such elements are delivered. Fair values for the ongoing maintenance and support obligations are generally based upon separate sales of renewal maintenance contracts to other customers or upon
maintenance renewal rates quoted in the sales contracts. Fair value of services, such as training or consulting, is based upon separate sales by the Company of these services to other customers. However, if an arrangement includes an acceptance
provision, acceptance occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.



Service revenues are derived from providing the Companys customers with software updates for existing software products, user documentation, and
technical support under annual service agreements. These revenues are recognized ratably over the terms of such agreements. If such services are included in the initial licensing fee, the value of the services determined based on VSOE of fair value
is unbundled and recognized ratably over the related service period. Service revenues derived from consulting and training are deferred and recognized when the services are performed and collection is deemed probable. To date, consulting revenue has
not been significant.



Recent accounting pronouncements



In December 2004, the Financial Accounting Standards
Board issued SFAS 123 (revised 2004), Share-Based Payment (SFAS 123R). SFAS 123R eliminates the alternative of applying the intrinsic value measurement provisions of APB Opinion No. 25 to stock compensation awards issued to
employees. Rather, the new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period
during which an employee is required to provide services in exchange for the award, known as the requisite service period which is usually the vesting period.



12



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The Company has not yet quantified the effects of the adoption of SFAS 123R, but anticipates that the new
standard may result in significant stock-based compensation expense. The pro forma effects on net income and earnings per share if the Company had applied the fair value recognition provisions of the original SFAS 123 on stock compensation awards
(rather than applying the intrinsic value measurement provisions of APB Opinion No. 25) are disclosed above. Although such pro forma effects of applying SFAS 123 may be indicative of the effects of adopting SFAS 123R, the provisions of these
two statements differ in some important respects. The actual effects of adopting SFAS 123R will be dependent on numerous factors including, but not limited to, the valuation model chosen by the Company to value stock-based awards; the assumed award
forfeiture rate, the accounting policies adopted concerning the method of recognizing the fair value of awards over the requisite service period; and the transition method (as described below) chosen for adopting SFAS 123R.



SFAS 123R will be effective for the Companys fiscal year beginning
January 1, 2006, and requires the use of the Modified Prospective Application Method. Under this method SFAS 123R will be applied to new awards and to awards modified, repurchased, or cancelled after the effective date. Additionally,
compensation cost for the portion of awards for which the requisite service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining requisite services are rendered. The
compensation cost relating to unvested awards at the date of adoption shall be based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS 123. In addition, companies may apply the Modified
Retrospective Application Method. This method may be applied to all prior years for which the original SFAS 123 was effective or only to prior interim periods in the year of initial adoption. If the Modified Retrospective Application Method is
applied, financial statements for prior periods shall be adjusted to give effect to the fair-value-based method of accounting for awards on a consistent basis with the pro forma disclosures required for those periods under the original SFAS 123.



3. Restructuring of operations



On January 31, 2003, the Company announced a restructuring of its
operations in response to the sluggish North American and European economies. The Company concluded that it was necessary to refocus its operations and reduce its operating expenses and, as part of the restructuring, reduced its workforce in excess
of 30%.



The Company anticipates that the execution of the
restructuring actions will require total cash expenditures of $2.9 million, which is expected to be funded from operations and existing cash balances. As of September 30, 2005, the Company had incurred net costs totaling $2.9 million related to
the restructuring, which required $2.8 million in cash expenditures. The remaining reserve related to this restructuring of $58,000 is included in accrued liabilities and long-term liabilities as of September 30, 2005.



The following table lists the components of the January 2003 restructuring
reserve for the nine month period ended September 30, 2005 (in thousands):



|                                                         |  |               |      |   |                  |   |     |       |  |   |      |  
|-------------------------------------------------------- |  | ------------- | ---- | - | ---------------- | - | --- | ----- |  | - | ---- | -
|                                                         |  | EmployeeCosts |      |   | ExcessFacilities |   |     | Total | 
|Balance at December 31, 2004                             |  | $             | 205  |   |                  | $ | 82  |       |  | $ | 287  |  
|Reserve utilized in nine months ended September 30, 2005 |  |               | (205 | ) |                  |   | (24 | )     |  |   | (229 | )
|                                                         |  |               |      |   |                  |   |     |       |  |   |      |  
|Balance at September 30, 2005                            |  | $             |     |   |                  | $ | 58  |       |  | $ | 58   |  
|                                                         |  |               |      |   |                  |   |     |       |  |   |      |  



On August 8,
2002, the Company announced a restructuring of its operations designed to re-align its core business functions and reduce operating expenses. As part of the restructuring, the Company reduced its workforce by approximately 26%. As of
September 30, 2005, the Company has recorded a total restructuring expense, net of adjustments, of $3.3 million. The Company anticipated that the execution of the restructuring actions would require total cash expenditures of $3.0 million,
which was to be funded from internal operations and existing cash balances. As of September 30, 2005, $3.0 million was paid.



The following table lists the components of the August 2002 restructuring reserve for the nine month period ended September 30, 2005 (in thousands):



|                                                         |  |                  |     |  
|-------------------------------------------------------- |  | ---------------- | --- | -
|                                                         |  | ExcessFacilities |    
|Balance at December 31, 2004                             |  | $                | 40  |  
|Net change in estimate recorded in restructuring expense |  |                  | 9   |  
|Reserve utilized in nine months ended September 30, 2005 |  |                  | (49 | )
|                                                         |  |                  |     |  
|Balance at September 30, 2005                            |  | $                |    |  
|                                                         |  |                  |     |  



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In August 1998, following the acquisition of FTP Software Inc. (FTP), the Company initiated a plan to
restructure its worldwide operations as a result of business conditions and in connection with the integration of the operations of FTP. The remaining reserve related to this restructuring at September 30, 2005 of $328,000 is included in
accrued liabilities and long-term liabilities.



The following
table lists the components of the FTP restructuring reserve for the nine month period ended September 30, 2005 (in thousands):



|                                                         |  |                   |      |  
|-------------------------------------------------------- |  | ----------------- | ---- | -
|                                                         |  | Excess Facilities |     
|Balance at December 31, 2004                             |  | $                 | 369  |  
|Change in estimate recorded in restructuring expense     |  |                   | 115  |  
|Reserve utilized in nine months ended September 30, 2005 |  |                   | (156 | )
|                                                         |  |                   |      |  
|Balance at September 30, 2005                            |  | $                 | 328  |  
|                                                         |  |                   |      |  



4. Commitments and contingencies



Legal proceedings



On November 22, 1999, Kenneth Fisher (Relator) filed a
complaint alleging violations of the False Claims Act, 31 U.S.C. § 3729 et seq., against the Company and its affiliates Network Software Associates, Inc., or NSA, and NetSoft Inc., or NetSoft, in the United States District Court of the District
of Columbia. This action was previously reported in the Legal Proceedings section of the Companys quarterly report Form 10-Q for the period ended March 31, 2005 (incorporated herein by reference). On July 20, 2005, in
response to a motion filed jointly by all defendants, the court dismissed Relators claims without prejudice. The dismissal was based on Relators inability to retain substitute counsel within the timeframe specified by the Court.



The Company may be contingently liable with respect to certain
asserted and unasserted claims that arise during the normal course of business. Management believes the impact, if any, resulting from these matters would not have a material impact on the Companys financial statements.



Leases



Facilities and equipment are leased under non-cancelable operating leases expiring on various dates through the year 2011.
The Company does not have any capital leases. As of September 30, 2005, future minimum rental and lease payments, net of any sublease income, under non-cancelable operating leases are as follows:



|                 |  |                                                           |        |                   |   |                 |  |                 |       |                     |   |       |  |   |      
|---------------- |  | --------------------------------------------------------- | ------ | ----------------- | - | --------------- |  | --------------- | ----- | ------------------- | - | ----- |  | - | -----
|                 |  | Amount of Commitment Expiration Per Period (in thousands)
|                 |  | Total                                                     |        | 12 months or less |   | 13 to 24 months |  | 25 to 36 months |       | More than 36 months
|Operating leases |  | $                                                         | 11,336 |                   | $ | 2,371           |  | $               | 2,146 |                     | $ | 2,055 |  | $ | 4,764
|                 |  |                                                           |        |                   |   |                 |  |                 |       |                     |   |       |  |   |      



Other



As an element of its standard commercial terms, the Company includes an
indemnification clause in its software licensing agreements that indemnifies the licensee against liability and damages (including legal defense costs) arising from any claims of patent, copyright, trademark, or trade secret infringement by its
software. The Companys indemnification limitation is the cost to defend any third party claim brought against its customers, and to the maximum, a refund of the purchase price. To date, the Company has not experienced any claims related to its
indemnification provisions and therefore has not established an indemnification loss reserve.



5. Related party transactions



On May 28, 2003, the Company entered into an independent contractor services agreement with Dr. Shelley Harrison, a director of the Company, pursuant to which Dr. Harrison received compensation in consideration for
consultancy and advisory services he provided the Company over a two-year period. In connection with his entering into the agreement, Dr. Harrison resigned from the Companys Audit Committee effective May 28, 2003. The terms of the
agreement required the Company to pay Dr. Harrison a fixed fee of $138,000 per year, and a one time grant to Dr. Harrison of an option to purchase 150,000 shares, inclusive of 3,200 shares Dr. Harrison was eligible to receive under
the 1993 Directors Plan for 2003 and 2004 and 146,800 shares from the 1999 Plan, at an exercise price of $1.92 per share (which represents the quoted market price of the stock at the date of grant). The option vested on a



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monthly basis over the two-year term of the agreement. The option expires five years from the date of issuance. The fair value of the 146,800 options from
the 1999 Plan was determined using the Black-Scholes option pricing model with the following assumptions: stock price $2.95-$9.65; no dividends; risk free interest rate of 2.00%-3.72%; volatility of 38%-99%; and a contractual life of five years. The
fair value of the option was subject to change over the vesting period of the option based on changes in the underlying assumptions (variable award accounting). The contract with Dr. Harrison expired on May 28, 2005.



For the nine months ended September 30, 2005, the Company has recorded
$24,000, as a result of the stock options awarded to Dr. Harrison, in compensation expense under this agreement based on an aggregate option fair value of $687,000. For the three months ended September 30, 2004, the Company recorded a
credit of $73,000, as a result of the stock options awarded to Dr. Harrison, to compensation expense under this agreement. For the nine months ended September 30, 2004, the Company recorded $458,000, as a result of the stock options
awarded to Dr. Harrison, in compensation expense under this agreement. For the nine month period ended September 30, 2005, the Company recorded total aggregate cash and non-cash compensation of $82,000 related to this arrangement under
General and Administrative expense in the Condensed Consolidated Statements of Operations.



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Item 2  Managements discussion and analysis of financial condition and results of operations.



Some of the statements contained in this Managements discussion and analysis of financial condition and results of operations section of this
Form 10-Q are forward-looking statements, including, but not limited to, those specifically identified as such, that involve risks and uncertainties, including those set forth below under the heading Factors that may affect our future results
and financial condition and elsewhere in this report. The statements contained in this Managements discussion and analysis of financial condition and results of operations section of this Form 10-Q that are not purely historical are
forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act, including, without limitation, statements regarding our expectations, beliefs, intentions or strategies regarding the
future. These statements involve known and unknown risks, uncertainties and other factors, which may cause our actual results to differ materially from those implied by the forward-looking statements. In some cases, you can identify forward-looking
statements by terminology such as may, will, should, expects, plans, anticipates, believes, estimates, predicts, potential, or
continue or the negative of these terms or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity,
performance or achievements. All forward-looking statements included in this Managements discussion and analysis of financial condition and results of operations section of this Form 10-Q are based on information available to us on the date
hereof, and we assume no obligation to update any such forward-looking statements.



Overview



We develop and market software and
service solutions that are designed to enable our customers to access and leverage the considerable investment they have in their corporate business applications, processes and data. Our business is focused on providing a broad spectrum of personal
computer, browser-based and server-based software products and tools. These products allow our customers to access and leverage applications, business processes and data on IBM and IBM compatible mainframe computers, IBM mid-range computers such as
the iSeries, in packaged applications, middleware and databases such as SAP, Siebel, Oracle and PeopleSoft, amongst others, and on UNIX and Microsoft based servers. We provide support, maintenance, and technical consultation services to our
customers in association with the products we develop and market. We provide applications and management consultancy to our customers primarily in association with the server-based products we deliver that are designed to allow customers to develop
and deploy new web-based applications and services.



Four
important industry trends have strong influences on our business strategy:



| | 1. | the adoption of electronic commerce by major corporations worldwide and the increasing acceptance of these approaches in mid-sized companies;
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------



| | 2. | the continuing development of the Internet, intranets and extranets for delivery of mission-critical business applications in large and mid-sized companies;
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 3. | the desire on the part of corporations to make business processes and information broadly accessible internally and externally to their employees and business partners; and
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 4. | the continued mobilization of users of personal computers and the proliferation of wireless and handheld devices requiring corporate system access on a global basis.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



The growth of the Internet has also been matched
by an increase in the use of mobile computing allowing users to access a companys computer systems from remote locations within the confines of an organizations security and access-control policies. As the Internet continues to grow, the
number of different communication and inter-networking options required by major corporations to support their businesses is also increasing. The number and type of mobile computing and communication devices now includes wireless handheld devices,
personal digital assistants (PDAs), Internet and Web-enabled cellular phones and smartphones. We anticipate that these trends will continue to accelerate over the next several years.



We believe that our customers require a single set of solutions that address the traditional need for host access combined
with the need for the presentation of existing corporate systems with a Web application look and feel, and the delivery of existing corporate processes and transactions as reusable programmatic components such as Web services. In assessing the
change in the marketplace, we have focused our sales and marketing efforts on meeting the changing needs of our customers. Our products are designed and built to incorporate reusable components and technologies and to utilize common underlying
services such as user management, system management, security, auditing and reporting. Several technologies are employed to provide solutions; these include traditional fat client or desktop solutions; thin client or browser-based solutions; zero
footprint or server-based solutions and application adapter or connector technologies. Within this marketplace, we believe the trend is away from desktop solutions and toward zero footprint solutions. We believe this movement is primarily driven by
a desire to reduce the total cost of ownership associated with deploying and maintaining these solutions. We also believe that a major element of our customer base will deploy a mixture of all types of solutions.



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The market is also made up of a number of products that allow organizations to reduce costs or increase
revenue by allowing them, or their business partners, to interact via the Internet with corporate business applications that are the backbone of their business processes. A primary example of this kind of solution is found in self-service call
center applications. Companies are building solutions that allow customers to determine order status over the Internet without involving a customer support representative. This approach simultaneously minimizes staffing costs and improves customer
service. Our products assist our customers in building solutions that quickly transform corporate applications into Web-based solutions.



Application of critical accounting policies



Our discussion and analysis of our financial condition and results of operations are based on our condensed consolidated financial statements which have
been prepared in conformity with generally accepted accounting principles in the United States of America. Our preparation of these condensed consolidated financial statements requires us to make judgments and estimates that affect the reported
amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of net revenues and expenses during the reporting period. We base our estimates on historical
experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from such estimates under different assumptions or conditions. The following summarizes other critical accounting
policies used in preparing our condensed consolidated financial statements:



Revenue Recognition: We derive revenue primarily from two sources: (1) product revenue, which includes software license and royalty revenue, and (2) support and services revenue, which includes
software maintenance and consulting. We license our software products both on a perpetual and term basis. Our term based arrangements are primarily for a period of 12 months. We also license our software in both source code and object code format.
We apply the provisions of the AICPA Statement of Position 97-2, Software Revenue Recognition, and related amendments and interpretations to all transactions involving the licensing of software products.



We recognize revenue from the sale of software licenses to end users and
resellers when the following criteria are met: persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed and determinable and collection of the resulting receivable is reasonably assured. Delivery occurs when the
product is delivered to a common carrier or when a soft-key has been transmitted to our customer.



Product licenses are sold without the right of return, except for distributor inventory rotation of old or excess product. Certain of our sales are made
to domestic distributors under agreements allowing rights of return and price protection on unsold merchandise. Accordingly, we defer recognition of such sales until the distributor sells the merchandise. We recognize sales to international
distributors upon shipment, provided all other revenue recognition criteria as mentioned above have been met. We give rebates to customers on a limited basis. These rebates are presented in our Condensed Consolidated Statement of Operations as a
reduction of revenue.



At the time of the transaction, we
assess whether the fee associated with our revenue transactions is fixed and determinable and whether or not collection is reasonably assured. We assess whether the fee is fixed and determinable based on the payment terms associated with the
transaction. If a significant portion of a fee is due after our normal payment terms, we account for the fee as not being fixed and determinable. In these cases, we recognize revenue as the fees become due.



We assess ability to collect based on a number of factors, including past
transaction history with the customer and the credit-worthiness of the customer. If we determine that collection of a fee is not reasonably assured, we recognize revenue at the time collection becomes reasonably assured, which is generally upon
receipt of cash.



For sales, except those completed over the
Internet, we use either a binding purchase order or equivalent customer commitment or signed license agreement as evidence of a contractual arrangement. For sales over the Internet, we use a credit card authorization as evidence of an arrangement.
Sales through our distributors are evidenced by a master agreement governing the relationship together with binding purchase orders on a transaction-by-transaction basis.



For arrangements with multiple elements (for example, software and undelivered maintenance and support), we allocate revenue
to each element of the arrangement using the residual value method based on vendor-specific objective evidence (VSOE) of the fair value of the undelivered elements. This means that revenue from the arrangement equivalent to the fair value of the
undelivered elements is deferred until such elements are delivered. Fair values for the ongoing maintenance and support obligations are generally based upon separate sales of renewal maintenance contracts to other customers or upon maintenance
renewal rates quoted in the sales contracts. Fair value of services, such as training or consulting, is based upon separate sales by us of these services to other customers. However, if an arrangement includes an acceptance provision, acceptance
occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.



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Service revenues are derived from providing our customers with software updates for existing software
products, user documentation and technical support, under annual service agreements. These revenues are recognized ratably over the terms of such agreements. If such services are included in the initial licensing fee, the value of the services
determined based on VSOE of fair value is unbundled and recognized ratably over the related service period. Service revenues derived from consulting and training are deferred and recognized when the services are performed and collection is deemed
probable. To date, consulting revenue has not been significant.



Allowance for doubtful accounts, sales returns and rebates: In establishing our sales return and rebate allowance, we must make estimates of potential future product returns related to current period product revenue, including
analyzing historical returns, current economic trends, and changes in customer demand and acceptance of our products. We apply significant judgment in connection with assessing whether or not our accounts receivable are collectible. We analyze
historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms. Our accounts receivable balance was $6.6 million and $15.8 million, net of our allowance for doubtful
accounts, sales returns, and rebate reserves of $0.3 million and $0.9 million as of September 30, 2005 and December 31, 2004, respectively.



Restructuring reserves: We accrue for restructuring costs when we make a commitment to a firm exit plan that specifically identifies all
significant actions to be taken in conjunction with our response to a change in our strategic plan, product demand, expense structure or other factors such as the date we cease using a facility. We reassess our prior restructuring accruals on a
quarterly basis to reflect changes in the costs of our restructuring activities, and we record new restructuring accruals as commitments are made. Estimates are based on anticipated costs of such restructuring activities and are subject to change.
Our restructuring reserves balance was $0.4 million and $0.7 million as of September 30, 2005 and December 31, 2004, respectively.



Accounting for income taxes: As part of the process of preparing our condensed consolidated financial statements, we are required to estimate our
income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue,
for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our Condensed Consolidated Balance Sheet. We must then assess the likelihood that our deferred tax assets will be recovered
from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within
the tax provision in the Condensed Consolidated Statement of Operations.



Valuation of long-lived and intangible assets and goodwill: We believe that the accounting estimate related to asset impairment is a critical accounting estimate because: (1) it is highly
susceptible to change from period to period as it requires us to make assumptions about future revenues over the life of our software products and services; and (2) the impact that recognizing an impairment has on the assets reported on our
Condensed Consolidated Balance Sheet and the net income (loss) reported in our Condensed Consolidated Statement of Operations could be material.



Our assumptions about future revenues and sales volumes require significant judgment because actual sales prices and volumes have fluctuated significantly
in the past and are expected to continue to do so. In estimating future revenues, we use our sales performance, planned levels of product development, planned new product launches, our internal budgets and industry market estimates of planned market
size and growth rates to assist us.



We assess the carrying
value of identifiable intangibles and long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We assess the carrying value of goodwill whenever events or changes in circumstances
indicate that the carrying value may not be recoverable and at a minimum, annually. SFAS No. 142, Goodwill and Other Intangible Assets requires that if the fair value of a companys individual reporting unit is less than the
reported value of the individual reporting unit, an asset impairment charge must be recognized in the financial statements. The amount of the impairment is calculated by subtracting the fair value of the asset from the carrying value of the asset.
We measure impairment based on a projected discounted cash flow method using a discount rate determined by management to be commensurate with the risk inherent in our current business model.



Factors we consider important which could trigger an impairment review
include the following:



| |  |  | significant underperformance relative to expected historical or projected future operating results;
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | significant changes in the manner of our use of the acquired assets or the strategy for our overall business;
| | - |  | -------------------------------------------------------------------------------------------------------------



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| |  |  | significant negative industry or economic trends; and
| | - |  | -----------------------------------------------------



| |  |  | our market capitalization relative to net book value.
| | - |  | -----------------------------------------------------



Recent accounting pronouncement:In December 2004, the Financial Accounting Standards Board issued SFAS 123 (revised 2004), Share-Based
Payment (SFAS 123R). SFAS 123R eliminates the alternative of applying the intrinsic value measurement provisions of APB Opinion No. 25 to stock compensation awards issued to employees. Rather, the new standard requires
enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to
provide services in exchange for the award, known as the requisite service period which is usually the vesting period.



We have not yet quantified the effects of the adoption of SFAS 123R, but anticipate that the new standard may result in significant stock-based
compensation expense. The pro forma effects on net income and earnings per share if we had applied the fair value recognition provisions of the original SFAS 123 on stock compensation awards (rather than applying the intrinsic value measurement
provisions of APB Opinion No. 25) are disclosed in our Notes to Condensed Consolidated Financial Statements. Although such pro forma effects of applying SFAS 123 may be indicative of the effects of adopting SFAS 123R, the provisions of these
two statements differ in some important respects. The actual effects of adopting SFAS 123R will be dependent on numerous factors including, but not limited to, the valuation model chosen by us to value stock-based awards; the assumed award
forfeiture rate, the accounting policies adopted concerning the method of recognizing the fair value of awards over the requisite service period; and the transition method (as described below) chosen for adopting SFAS 123R.



SFAS 123R will be effective for NetManages fiscal year beginning
January 1, 2006, and requires the use of the Modified Prospective Application Method. Under this method SFAS 123R will be applied to new awards and to awards modified, repurchased, or cancelled after the effective date. Additionally,
compensation cost for the portion of awards for which the requisite service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining requisite services are rendered. The
compensation cost relating to unvested awards at the date of adoption shall be based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS 123. In addition, companies may apply the Modified
Retrospective Application Method. This method may be applied to all prior years for which the original SFAS 123 was effective or only to prior interim periods in the year of initial adoption. If the Modified Retrospective Application Method is
applied, financial statements for prior periods shall be adjusted to give effect to the fair-value-based method of accounting for awards on a consistent basis with the pro forma disclosures required for those periods under the original SFAS 123.



Results of operations



During the past several years, we have implemented initiatives designed to
control costs and reduce operating expenses, including the discontinuance of low revenue-generating products and the implementation of worldwide restructurings of our operations.



Our net revenues for the three and nine month periods ended September 30, 2005 declined approximately 14% and 5%,
respectively from the comparative periods in the prior year. We believe this in large part is related to the cautious IT spending environment, both in North America and Europe which affected both license fees and service revenues. Additionally, one
customer in the third quarter of 2004 represented 23% of consolidated net revenues while no customer represented more than 10% of consolidated net revenues in the third quarter of 2005. The nine months ended September 30, 2005 includes revenue
from our acquisition of Librados which was completed in October 2004. Accordingly there are no revenues from the sale of Librados products in the nine months ended September 30, 2004. Net income for the three and nine month periods ended
September 30, 2005 were impacted by favorable tax benefits of $884,000 and $1.3 million, respectively, and by a net reduction in the allowance for doubtful accounts of $369,000 and $182,000, respectively, which resulted primarily from strong
collection efforts during the third quarter.



Because we
generally ship software products within a short period after receipt of an order, we do not have a material backlog of unfilled orders, and revenues in any quarter are substantially dependent on orders booked in that quarter. Our operating expense
levels are based, in part, on our expectation of future revenues and, to a large extent, are fixed. Our operating expenses, excluding restructuring charges for the three and nine month periods ended September 30, 2005, decreased 13% and 5%,
respectively from the comparative periods in the prior year, and may fluctuate as a percentage of net revenues on a quarterly basis.



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NetManage has recorded a number of restructuring charges in the past, designed to re-align our core
business functions, improve operating efficiencies and reduce costs, as described in Note 3 to Condensed Consolidated Financial Statements  Restructuring of operations.



Three months ended September 30, 2005 compared to September 30, 2004 (in thousands):



|                                                  |  |                                  |        |      |      |   |        |        |  |   |        |   |  |       |  
|------------------------------------------------- |  | -------------------------------- | ------ | ---- | ---- | - | ------ | ------ |  | - | ------ | - |  | ----- | -
|                                                  |  | Three months ended September 30, |       
|                                                  |  | 2005                             |        |      | 2004 |   |        | Change | 
|Net revenues                                      |  |                                  |        |      |      |   |        |        |  |   |        |   |  |       |  
|License fees                                      |  | $                                | 3,614  |      |      | $ | 4,813  |        |  | $ | (1,199 | ) |  | -25   | %
|Services                                          |  |                                  | 6,334  |      |      |   | 6,820  |        |  |   | (486   | ) |  | -7    | %
|                                                  |  |                                  |        |      |      |   |        |        |  |   |        |   |  |       |  
|Total net revenues                                |  |                                  | 9,948  |      |      |   | 11,633 |        |  |   | (1,685 | ) |  | -14   | %
|As a percentage of net revenues:                  |  |                                  |        |      |      |   |        |        |  |   |        |   |  |       |  
|License fees                                      |  |                                  | 36.3   | %    |      |   | 41.4   | %      |  |   |        |   |  |       |  
|Services                                          |  |                                  | 63.7   | %    |      |   | 58.6   | %      |  |   |        |   |  |       |  
|                                                  |  |                                  |        |      |      |   |        |        |  |   |        |   |  |       |  
|Total net revenues                                |  |                                  | 100.0  | %    |      |   | 100.0  | %      |  |   |        |   |  |       |  
|Gross margin-license fees                         |  | $                                | 3,377  |      |      | $ | 4,444  |        |  | $ | (1,067 | ) |  | -24   | %
|Gross margin-services                             |  |                                  | 5,536  |      |      |   | 5,900  |        |  |   | (364   | ) |  | -6    | %
|Gross margin-amortization of developed technology |  |                                  | (70    | )    |      |   | (336   | )      |  |   | 266    |   |  | -79   | %
|                                                  |  |                                  |        |      |      |   |        |        |  |   |        |   |  |       |  
|Total gross margin                                |  | $                                | 8,843  |      |      | $ | 10,008 |        |  | $ | (1,165 | ) |  | -12   | %
|As a percentage of net revenues:                  |  |                                  |        |      |      |   |        |        |  |   |        |   |  |       |  
|Gross margin-license fees                         |  |                                  | 33.9   | %    |      |   | 38.2   | %      |  |   |        |   |  |       |  
|Gross margin-services                             |  |                                  | 55.6   | %    |      |   | 50.7   | %      |  |   |        |   |  |       |  
|Gross margin-amortization of developed technology |  |                                  | -0.7   | %    |      |   | -2.9   | %      |  |   |        |   |  |       |  
|                                                  |  |                                  |        |      |      |   |        |        |  |   |        |   |  |       |  
|Total gross margin                                |  |                                  | 88.8   | %    |      |   | 86.0   | %      |  |   |        |   |  |       |  
|Research and development                          |  | $                                | 1,658  |      |      | $ | 1,722  |        |  | $ | (64    | ) |  | -4    | %
|As a percentage of net revenues:                  |  |                                  | 16.7   | %    |      |   | 14.8   | %      |  |   |        |   |  |       |  
|Sales and marketing                               |  | $                                | 4,431  |      |      | $ | 5,663  |        |  | $ | (1,232 | ) |  | -22   | %
|As a percentage of net revenues:                  |  |                                  | 44.5   | %    |      |   | 48.7   | %      |  |   |        |   |  |       |  
|General and administrative                        |  | $                                | 1,994  |      |      | $ | 1,951  |        |  | $ | 43     |   |  | 2     | %
|As a percentage of net revenues:                  |  |                                  | 20.0   | %    |      |   | 16.8   | %      |  |   |        |   |  |       |  
|Restructuring charge, net                         |  | $                                | 29     |      |      | $ | 32     |        |  | $ | (3     | ) |  | -9    | %
|As a percentage of net revenues:                  |  |                                  | 0.3    | %    |      |   | 0.3    | %      |  |   |        |   |  |       |  
|Amortization and impairment of intangibles        |  | $                                | 158    |      |      | $ | 150    |        |  | $ | 8      |   |  | 5     | %
|As a percentage of net revenues:                  |  |                                  | 1.6    | %    |      |   | 1.3    | %      |  |   |        |   |  |       |  
|Interest income (expense) and other, net          |  | $                                | 239    |      |      | $ | 40     |        |  | $ | 199    |   |  | 498   | %
|As a percentage of net revenues:                  |  |                                  | 2.4    | %    |      |   | 0.3    | %      |  |   |        |   |  |       |  
|Gain on sale of investments                       |  | $                                | 2      |      |      | $ |       |        |  | $ | 2      |   |  |      | %
|As a percentage of net revenues:                  |  |                                  | 0.0    | %    |      |   | 0.0    | %      |  |   |        |   |  |       |  
|Foreign currency transaction gains (losses)       |  | $                                | (94    | )    |      | $ | 293    |        |  | $ | (387   | ) |  | -132  | %
|As a percentage of net revenues:                  |  |                                  | -0.9   | %    |      |   | 2.5    | %      |  |   |        |   |  |       |  
|Provision (benefit) for income taxes              |  | $                                | (884   | )    |      | $ | (40    | )      |  | $ | (844   | ) |  | 2,110 | %
|As a percentage of net revenues:                  |  |                                  | -122.8 | %(1) |      |   | -4.9   | %(2)   |  |   |        |   |  |       |  
|Net income                                        |  | $                                | 1,604  |      |      | $ | 863    |        |  | $ | 741    |   |  | 86    | %
|As a percentage of net revenues:                  |  |                                  | 16.1   | %    |      |   | 7.4    | %      |  |   |        |   |  |       |  

---

|(1) | The tax benefit for the three month period ended September 30, 2005 was a result of a favorable outcome of a foreign tax audit, a favorable foreign tax adjustment and by the
consolidated tax loss position.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The tax benefit for the three month period ended September 30, 2004 was a result of favorable foreign and state adjustments and by the consolidated tax loss position.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------

[Additional columns below]



20



---

##### Table of Contents

Nine months ended September 30, 2005 compared to September 30, 2004 (in thousands):



|                                                  |  |                                 |        |       |      |   |        |        |  |   |        |   |  |        |  
|------------------------------------------------- |  | ------------------------------- | ------ | ----- | ---- | - | ------ | ------ |  | - | ------ | - |  | ------ | -
|                                                  |  | Nine months ended September 30, |       
|                                                  |  | 2005                            |        |       | 2004 |   |        | Change | 
|Net revenues                                      |  |                                 |        |       |      |   |        |        |  |   |        |   |  |        |  
|License fees                                      |  | $                               | 12,743 |       |      | $ | 13,570 |        |  | $ | (827   | ) |  | -6     | %
|Services                                          |  |                                 | 19,992 |       |      |   | 20,939 |        |  |   | (947   | ) |  | -5     | %
|                                                  |  |                                 |        |       |      |   |        |        |  |   |        |   |  |        |  
|Total net revenues                                |  |                                 | 32,735 |       |      |   | 34,509 |        |  |   | (1,774 | ) |  | -5     | %
|As a percentage of net revenues:                  |  |                                 |        |       |      |   |        |        |  |   |        |   |  |        |  
|License fees                                      |  |                                 | 38.9   | %     |      |   | 39.3   | %      |  |   |        |   |  |        |  
|Services                                          |  |                                 | 61.1   | %     |      |   | 60.7   | %      |  |   |        |   |  |        |  
|                                                  |  |                                 |        |       |      |   |        |        |  |   |        |   |  |        |  
|Total net revenues                                |  |                                 | 100.0  | %     |      |   | 100.0  | %      |  |   |        |   |  |        |  
|Gross margin-license fees                         |  | $                               | 11,888 |       |      | $ | 12,455 |        |  | $ | (567   | ) |  | -5     | %
|Gross margin-services                             |  |                                 | 17,548 |       |      |   | 18,222 |        |  |   | (674   | ) |  | -4     | %
|Gross margin-amortization of developed technology |  |                                 | (210   | )     |      |   | (923   | )      |  |   | 713    |   |  | -77    | %
|                                                  |  |                                 |        |       |      |   |        |        |  |   |        |   |  |        |  
|Total gross margin                                |  | $                               | 29,226 |       |      | $ | 29,754 |        |  | $ | (528   | ) |  | -2     | %
|As a percentage of net revenues:                  |  |                                 |        |       |      |   |        |        |  |   |        |   |  |        |  
|Gross margin-license fees                         |  |                                 | 36.3   | %     |      |   | 36.1   | %      |  |   |        |   |  |        |  
|Gross margin-services                             |  |                                 | 53.6   | %     |      |   | 52.8   | %      |  |   |        |   |  |        |  
|Gross margin-amortization of developed technology |  |                                 | -0.6   | %     |      |   | -2.7   | %      |  |   |        |   |  |        |  
|                                                  |  |                                 |        |       |      |   |        |        |  |   |        |   |  |        |  
|Total gross margin                                |  |                                 | 89.3   | %     |      |   | 86.2   | %      |  |   |        |   |  |        |  
|Research and development                          |  | $                               | 5,388  |       |      | $ | 5,247  |        |  | $ | 141    |   |  | 3      | %
|As a percentage of net revenues:                  |  |                                 | 16.5   | %     |      |   | 15.2   | %      |  |   |        |   |  |        |  
|Sales and marketing                               |  | $                               | 15,350 |       |      | $ | 16,404 |        |  | $ | (1,054 | ) |  | -6     | %
|As a percentage of net revenues:                  |  |                                 | 46.9   | %     |      |   | 47.5   | %      |  |   |        |   |  |        |  
|General and administrative                        |  | $                               | 6,582  |       |      | $ | 7,011  |        |  | $ | (429   | ) |  | -6     | %
|As a percentage of net revenues:                  |  |                                 | 20.1   | %     |      |   | 20.3   | %      |  |   |        |   |  |        |  
|Restructuring charge, net                         |  | $                               | (63    | )     |      | $ | (106   | )      |  | $ | 43     |   |  | -41    | %
|As a percentage of net revenues:                  |  |                                 | -0.2   | %     |      |   | -0.3   | %      |  |   |        |   |  |        |  
|Amortization and impairment of intangibles        |  | $                               | 388    |       |      | $ | 449    |        |  | $ | (61    | ) |  | -14    | %
|As a percentage of net revenues:                  |  |                                 | 1.2    | %     |      |   | 1.3    | %      |  |   |        |   |  |        |  
|Interest income (expense) and other, net          |  | $                               | 501    |       |      | $ | 72     |        |  | $ | 429    |   |  | 596    | %
|As a percentage of net revenues:                  |  |                                 | 1.5    | %     |      |   | 0.2    | %      |  |   |        |   |  |        |  
|Gain on sale of investments                       |  | $                               | 35     |       |      | $ |       |        |  | $ | 35     |   |  |       | %
|As a percentage of net revenues:                  |  |                                 | 0.1    | %     |      |   |       | %      |  |   |        |   |  |        |  
|Foreign currency transaction losses               |  | $                               | (269   | )     |      | $ | (66    | )      |  | $ | (203   | ) |  | 308    | %
|As a percentage of net revenues:                  |  |                                 | -0.8   | %     |      |   | -0.2   | %      |  |   |        |   |  |        |  
|Provision (benefit) for income taxes              |  | $                               | (1,259 | )     |      | $ | 66     |        |  | $ | (1,325 | ) |  | -2,008 | %
|As a percentage of net revenues:                  |  |                                 | -68.1  | % (1) |      |   | 8.7    | % (2)  |  |   |        |   |  |        |  
|Net income                                        |  | $                               | 3,107  |       |      | $ | 689    |        |  | $ | 2,418  |   |  | 351    | %
|As a percentage of net revenues:                  |  |                                 | 9.5    | %     |      |   | 2.0    | %      |  |   |        |   |  |        |  

---

|(1) | The tax benefit for the nine month period ended September 30, 2005 was a result of a favorable outcome of a foreign tax audit, favorable foreign tax adjustments and by the
consolidated tax loss position.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | The effective tax rate for the nine month period ended September 30, 2004 was a result of the consolidated tax loss position.
|--- | -----------------------------------------------------------------------------------------------------------------------------



Net revenues



Net revenues decreased 14% for the three months ended September 30, 2005 as compared to the same period in 2004. The
decrease in net revenues resulted from a decrease in license fees of $1.2 million, or 25% and a decline in services revenues of $486,000, or 7%. License fees represented 36% and 41% of our net revenues in the third quarters of 2005 and 2004,
respectively. The decrease in our license fees for the three months ended September 30, 2005 was primarily the result of fewer license transactions in North America which we believe relates to the cautious IT spending environment offset in part
by the inclusion of sales of our new Librados adapter products. Additionally, one customer in the third quarter of 2004 represented 23% of consolidated net revenues while no customer represented more than 10% of consolidated net revenues in the
third quarter of 2005.



21



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##### Table of Contents

Our net revenues for the nine month period ended September 30, 2005 were down 5% compared to the
same period ended September 30, 2004. License fees declined $827,000, or 6% compared to the same period in 2004. Services revenues declined $947,000, or 5% during that period. License fees represented 39% of our net revenues in both the nine
months ended September 30, 2005 and 2004. The decrease in our license fees for the nine months ended September 30, 2005 was offset in part by the inclusion of sales of our new Librados adapter products. Librados was acquired on
October 22, 2004.



We have operations worldwide, with
sales offices located in the United States, Europe, Canada, and Israel. Revenues outside of North America (United States and Canada) as a percentage of net revenues were 32% and 25% for the three months ended September 30, 2005 and 2004,
respectively and were 30% and 26% of net revenues for each of the nine month periods ended September 30, 2005 and 2004, respectively.



There were no customers that accounted for 10% or more of consolidated net revenues in the three month period ended September 30, 2005 and for the
nine month periods ended September 30, 2005 and 2004. There was one customer that accounted for approximately 23% of consolidated net revenues in the three month period ended September 30, 2004.



Gross margin



Gross margin decreased $1.2 million and $528,000 for the three and nine month periods ended September 30, 2005,
respectively as compared to the same periods in 2004, primarily because of the reduction in net revenues offset in part by the reduction in expense related to developed technology and license and services cost of revenues. Gross margin increased as
a percentage of net revenues to 89% from 86% for each of the three and nine month periods ended September 30, 2005, respectively as compared to the same periods in 2004, primarily because of the reduction in expense related to developed
technology and license and services cost of revenues.



Gross
margin for license fees as a percentage of net revenues was 34% for the three month period ended September 30, 2005 compared to 38% in the three months ended September 30, 2004, and was 36% for both the nine month periods ended
September 30, 2005 and 2004. The decrease for the three month period ended September 30, 2005 resulted primarily from the reduction in license fees offset in part by the reduction in cost of revenues for license fees. The gross margin for
services increased to 56% of net revenues for the three month period ended September 30, 2005 from 51% for the same period in 2004, and increased slightly to 54% of net revenues for the nine month period ended September 30, 2005 from 53%
for the same period in 2004 due to the reduction in related services costs offset in part by the reduction in services revenues of 5% and the reduction in licenses fees.



Gross margin for license fees as a percentage of license fees increased to 93% from 92% for the three and nine month periods
ended September 30, 2005 and 2004, respectively. The increase of 1% for the three and nine month periods ended September 30, 2005 is a result of lower cost of revenues for license fees offset in part by the reduction in license fees.



Gross margin for services as a percentage of services revenues
was 87% for both the three month periods ended September 30, 2005 and 2004, and increased to 88% for the nine month period ended September 30, 2005 from 87% for the nine month period ended September 30, 2004. The increase of 1% for
the nine month period ended September 30, 2005 as compared to the same period in 2004 is the result of the reduction in cost of revenues for services offset in part by the reduction in services revenues of 5%.



Research and development



Research and development, or R&D, expenses consist primarily of salaries
and benefits, occupancy, travel expenses, and fees paid to outside consultants. R&D expenses decreased $64,000, or 4% and increased $141,000, or 3% for the three and nine month periods ended September 30, 2005, respectively as compared to
the same periods in 2004. The increase in R&D expenses for the nine month period ended September 30, 2005 is primarily a result of additional costs related to the Librados adapter product line.



Software development costs are accounted for in accordance with SFAS
No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, under which we are required to capitalize software development costs after technological feasibility is established which we define as a
working model and further define as a beta version of the software. The establishment of technological feasibility and the ongoing assessment of the recoverability of these costs requires considerable judgment by us with respect to certain external
factors, including, but not limited to, anticipated future gross product revenue, estimated economic life, and changes in technology. Costs that do not qualify for capitalization are charged to R&D expense when incurred. We did not capitalize
any software development costs in the nine month periods ended September 30, 2005 or 2004.



22



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##### Table of Contents

Sales and marketing



Sales and marketing expenses consist primarily of salaries and commissions of sales personnel, salaries of marketing
personnel, advertising and promotional expenses, and occupancy and related costs. Sales and marketing expenses decreased $1.2 million, or 22% and decreased $1.1 million, or 6%, for the three and nine month periods ended September 30, 2005,
respectively as compared to the same periods in 2004. The decrease in sales and marketing expenses is primarily a result of lower personnel, commissions and other costs of approximately $0.8 million and $0.9 million respectively and the net release
of excess doubtful accounts reserves of $0.4 million and $0.2 million, respectively, due to a reduction in gross trade receivables and improved collections.



General and administrative



General and administrative, or G&A, expenses consist primarily of salaries, benefits, accounting, travel, legal, and occupancy expenses. G&A
expenses increased $43,000, or 2% and decreased $429,000, or 6% for the three and nine month periods ended September 30, 2005, respectively as compared to the same periods in 2004. The reduction in G&A expense for the nine month period
ended September 30, 2005 compared to the same period in 2004 resulted primarily because of lower stock option compensation expense and occupancy costs.



Restructuring charges



Restructuring charges consist of adjustments made to restructuring accruals made in previous periods. Restructuring charges decreased $3,000, and
increased $43,000, for the three and nine month periods ended September 30, 2005, respectively as compared to the same periods in 2004. The changes in restructuring charges for the nine months ended September 30, 2005 related primarily to
the reversal of a severance reserve which management determined was no longer needed and the effect of fluctuations in exchange rates on currencies in which remaining liabilities are denominated.



Amortization and impairment of intangible assets



Amortization expense was $115,000 and $150,000 for the three month periods
ended September 30, 2005 and 2004, respectively and $345,000 and $449,000 for the nine month periods ended September 30, 2005 and 2004, respectively. Amortization expense for the nine month periods ended September 30, 2005 related
solely to the acquisition of Librados. In connection with the acquisition of Librados, Inc. in October 2004, the Company recorded an intangible asset related to employment contracts for certain individuals. In the quarter ended September 30,
2005, these individuals terminated employment with the Company and the remaining unamortized value of the related intangible asset of $43,000 was expensed. Amortization of other intangibles is recorded on a straight-line basis over an estimated
useful life from two years to five years.



Interest income (expense) and
other, net



Interest income and other, net was
$239,000 and $40,000 for the three month periods ended September 30, 2005 and 2004, respectively and $501,000 and $72,000 for the nine month periods ended September 30, 2005 and 2004, respectively. During the three and nine month periods
ended September 30, 2005 we received interest of $99,000 and $211,000, respectively primarily associated with refunds of taxes paid in Germany. The interest income was not previously recorded as receipt was not certain and therefore the benefit
was recorded in the quarter, and the nine month period of receipt. During the three month period ended September 30, 2005 we invested in short term and long-term investments with greater yields than previously obtained in money market cash
accounts. The interest income received from money market and other investments during the three month periods ended September 30, 2005 and 2004 was $160,000 and $39,000, respectively. For the nine month periods ended September 30, 2005 and
2004, interest income from money market and investments was $310,000 and $90,000, respectively. During the three and nine month periods ended September 30, 2005, we incurred a one-time interest expense of $20,000 related to a tax obligation in
France. For the nine month period ended September 30, 2004, we incurred interest expense of $24,000, also related to a tax obligation in France. For the three and nine month periods ended September 30, 2004 we recorded other income of
$1,000 and $6,000 respectively. Our cash, cash equivalents, and short-term and long-term investments at September 30, 2005 and December 31, 2004 are as follows (in thousands):



|                                       |  |                   |        |                  |   |       
|-------------------------------------- |  | ----------------- | ------ | ---------------- | - | ------
|Description                            |  | September 30,2005 |        | December 31,2004
|Cash and cash equivalents              |  | $                 | 9,964  |                  | $ | 19,570
|Short-term investments                 |  |                   | 11,467 |                  |   | 219   
|Long-term investments                  |  |                   | 1,895  |                  |   |      
|                                       |  |                   |        |                  |   |       
|Cash, cash equivalents and investments |  | $                 | 23,326 |                  | $ | 19,789
|                                       |  |                   |        |                  |   |       



23



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##### Table of Contents

Foreign currency transaction gains (losses)



Foreign currency transaction gains (losses) were $(94,000) and $293,000 for the three month periods ended September 30,
2005 and 2004, respectively and were $(269,000) and $(66,000) for the nine month periods ended September 30, 2005 and 2004, respectively. Except as noted, transaction gains and losses are attributable to fluctuations related primarily to the
Israeli shekel (Shekel) in relation to the U.S. dollar (USD), the British pound (Pound) and the Euro. For the three and nine month periods ended September 30, 2005 and 2004, the relationship of the Shekel to the USD, the Pound and the Euro was
as follows:



|               |  |                                 |   |  |                                |   |  |      |   |  |      |  
|-------------- |  | ------------------------------- | - |  | ------------------------------ | - |  | ---- | - |  | ---- | -
|               |  | Three months endedSeptember 30, |   |  | Nine months endedSeptember 30, |  
|               |  | 2005                            |   |  | 2004                           |   |  | 2005 |   |  | 2004 |  
|USD % Change   |  | 0.7                             | % |  | -0.6                           | % |  | 6.1  | % |  | 2.4  | %
|Pound % Change |  | -1.7                            | % |  | -0.5                           | % |  | -2.9 | % |  | 4.2  | %
|Euro % Change  |  | 0.5                             | % |  | 2.1                            | % |  | -6.3 | % |  | 1.3  | %



Provision for income taxes



Income taxes recorded include primarily international
taxes and U.S. state taxes. The income tax benefit of $884,000 for the three month period ended September 30, 2005 resulted primarily from a favorable tax adjustment in Germany of $479,000, the reversal of reserves of $418,000 in connection
with the favorable outcome of a tax audit in a foreign subsidiary, offset in part by an international tax expense of $13,000. The income tax benefit of $40,000 for the three month period ended September 30, 2004 includes an international tax
benefit of $24,000 and a U.S. state tax benefit of $16,000. The income tax benefit of $1.3 million for the nine month period ended September 30, 2005 includes the favorable tax adjustments in Germany of $936,000, the reversal of reserves of
$418,000, offset in part by an international tax expense of $91,000 and a U.S. state tax expense of $4,000. The income tax provision of $66,000 for the nine months ended September 30, 2004 consists of an international tax expense of $54,000 and
a U.S. state tax expense of $12,000. Our effective tax benefit rate for the three and nine month periods ended September 30, 2005 was, respectively, -122.8% and -68.1% due to the consolidated tax loss position, the tax refunds in Germany
received in the second and third quarters of 2005, and the release of international tax provision.



Disclosures about market risk



Disclosures about market risk can be found below, under Item 3Quantitative and qualitative disclosures about market risk.



Liquidity and capital resources



|                                                                                       |  |                    |       |  
|-------------------------------------------------------------------------------------- |  | ------------------ | ----- | -
|                                                                                       |  | September 30, 2005 |      
|                                                                                       |  | (in millions)      |      
|Cash and cash equivalents                                                              |  | $                  | 9.7   |  
|Short-term investments                                                                 |  |                    | 11.5  |  
|Long-term investments                                                                  |  |                    | 1.9   |  
|Net cash provided by operating activities for the nine months ended September 30, 2005 |  |                    | 3.2   |  
|Net cash used in investing activities for the nine months ended September 30, 2005     |  |                    | (13.8 | )
|Net cash provided by financing activities for the nine months ended September 30, 2005 |  |                    | 0.6   |  



Since our inception,
our operations have been financed primarily through cash provided by operations and sales of capital stock. Our primary financing activities to date consist of our initial and secondary public stock offerings and private preferred stock issuances,
which aggregated net proceeds to us of approximately $72.5 million. Over the past several years, domestic and international economic events have negatively impacted our ability to generate sufficient cash to offset our cash outflows. We have taken a
number of measures to reverse this trend including restructuring our organization, reducing our operating expenses through the closing of excess facilities, subleasing excess facility space, and carefully monitoring our discretionary expenses. Our
business has been and will be dependent upon the spending of our customers and their respective IT organizations.



During the nine month period ended September 30, 2005, our aggregate cash, cash equivalents, short-term and long-term investments increased from
$19.8 million to $23.0 million. This increase was due primarily to collection of receivables of $9.0 million reduced by purchases of property and equipment and the net reduction of accounts payables, accrued liabilities and payroll expenses of $5.1
million.



24



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##### Table of Contents

At September 30, 2005, we had working capital of $12.0 million. We believe that our current cash
balance and future operating cash flows will be sufficient to meet our working capital needs, capital expenditure requirements and complete currently identified projects and planned objectives for at least the next 12 months.



If our credit rating was to change materially, it could impact our ability to
enter into transactions with new and existing customers and subsequently have an impact on our cash position. We do not anticipate a material change in our credit rating or rating outlook.



Contractual obligations



A table of our contractual obligations as of September 30, 2005 is
included in Note 4 to Condensed Consolidated Financial StatementsCommitments and contingencies.



Off-balance sheet arrangements



As of September 30, 2005, we did not engage in any off-balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K promulgated by the Commission under the Securities Exchange Act of 1934, as
amended. We do not have external debt financing. We do not issue or purchase derivative instruments or use our stock as a form of liquidity.



Critical accounting policies



Reference is made to Critical Accounting Policies included in our Annual Report on Form 10-K for the year ended December 31, 2004 as
filed with the SEC on March 22, 2005. As of the date of the filing of this Quarterly Report, we have not identified any critical accounting policies other than those discussed in our Annual Report for the year ended December 31, 2004.



Factors that may affect our future results and financial condition



Our business is subject to a number of risks and
uncertainties. You should carefully consider the risks described below, in addition to the other information contained in this Report and in our other filings with the SEC. The risks and uncertainties described below are not the only ones facing our
company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also affect our business operations. If any of these risks actually occur, our business, financial condition or results of operations
could be seriously harmed. In that event, the market price for our common stock could decline and you may lose part or all of your investment.



Our operating results have fluctuated significantly in the past and may continue to do so in the future, which could cause our stock price to decline.



We have experienced, and expect to experience in
future periods, significant fluctuations in operating results that may be caused by many factors including, among others:



| |  |  | general economic conditions, in particular, the slowdown of purchases of information technology due to current economic conditions in North America and internationally;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in the demand for our products;
| | - |  | ---------------------------------------



| |  |  | introduction or enhancements to our products and those of our competitors;
| | - |  | --------------------------------------------------------------------------



| |  |  | technological changes in computer networking;
| | - |  | ---------------------------------------------



| |  |  | competitive pricing pressures;
| | - |  | ------------------------------



| |  |  | market acceptance of new products;
| | - |  | ----------------------------------



| |  |  | customer order deferrals in anticipation of new products and product enhancements;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | the size and timing of individual product orders;
| | - |  | -------------------------------------------------



| |  |  | mix of international and domestic revenues;
| | - |  | -------------------------------------------



| |  |  | mix of distribution channels through which our products are sold;
| | - |  | -----------------------------------------------------------------



25



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##### Table of Contents

| |  |  | loss of, or failure to enter into, strategic alliances to develop or promote our products;
| | - |  | ------------------------------------------------------------------------------------------



| |  |  | quality control of our products;
| | - |  | --------------------------------



| |  |  | changes in our operating expenses;
| | - |  | ----------------------------------



| |  |  | personnel changes;
| | - |  | ------------------



| |  |  | foreign currency exchange rates;
| | - |  | --------------------------------



| |  |  | seasonality; and
| | - |  | ----------------



| |  |  | adverse business conditions in specific industries.
| | - |  | ---------------------------------------------------



In addition, our acquisition of complementary businesses, products or technologies has in the past caused and may continue to cause fluctuations in our
operating results due to in-process research and development charges, the amortization of acquired intangible assets, and integration costs recorded in connection with acquisitions.



Since we generally ship software products within a short period of time after receipt of an order, we do not typically have
a material backlog of unfilled orders, and our revenues in any one quarter are substantially dependent on orders booked in that quarter and particularly in the last month of that quarter. Our expenses are based in part on our expectations as to
future revenues and to a large extent are fixed. Therefore, we may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Accordingly, any significant shortfall in demand for our products in relation to
our expectations or any material delay of customer orders would have an almost immediate adverse impact on our operating results and on our ability to achieve profitability.



As a result, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and
should not be relied upon as indications of future performance. Fluctuations in our operating results have caused, and may in the future cause us to perform below the expectations of public market analysts and investors. If our operating results
fall below market expectations, the price of our common stock may fall.



We have only been profitable in one year since 1995 and may never achieve profitability in the future which would weaken our financial condition.



With the exception of the net income reported for 2004, we have not achieved profitability on an annual basis since 1995 and
we may never obtain sufficient revenues to sustain profitability in any future period. In addition, we cannot be certain that we can increase profitability, particularly to the extent that we face price competition. As a result, we will need to
generate significant revenues to attain profitability. Increasing competition may cause our prices to decline, which would harm our operating results. We anticipate that the prices for our software products may decline over the next few years. We
expect to face increased competition in markets where we sell our products, which will make it more difficult to increase or maintain our prices and profit margins. If anticipated increases in sales volume do not keep pace with anticipated pricing
pressures, our revenues would decline and our business could be harmed. Despite our efforts to introduce enhancements to our products, we may not be successful in maintaining our pricing.



We rely significantly on third parties for sales of our products and our revenues could decline significantly with little or no
notice.



We rely significantly on our independent
distributors and value-added resellers for certain elements of the marketing and distribution of our products. The agreements in place with these organizations are generally non-exclusive, of limited duration, are terminable with little or no notice
by either party and generally do not contain minimum purchase requirements. There can be no assurance that we will be able to attract or retain distributors and resellers who will be able to market our products effectively. These distributors of our
products are not within our control and generally represent competing product lines of other companies in addition to our products. There can be no assurance that these organizations will give a high priority to the marketing of our products, and
they may give a higher priority to the products of our competitors.



Furthermore, our results of operations can also be materially adversely affected by changes in the inventory strategies of our resellers, which can occur rapidly and may not be related to end-user demand. As part of our continued strategy
of selling through multiple distribution channels, we expect to continue using indirect distribution channels, particularly value-added resellers and system integrators, in addition to distributors and original equipment manufacturers. Indirect
sales may grow as a percentage of both domestic and total net revenues during 2005 and beyond, as a result of acquisitions or increased market penetration. Any material increase in our indirect sales as a percentage of revenues may adversely affect
our average selling prices and gross margins due to lower unit costs that are typically charged when selling through indirect channels. There can be no assurance that we will be able to attract or retain resellers and distributors who will be able
to market our products effectively, qualified to provide timely and



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cost-effective customer support and service, or will continue to represent our products. If we are unable to recruit or retain important resellers or
distributors or if they decrease their sales of our products, we may suffer a material adverse effect on our business, financial condition or results of operations.



We have undergone significant restructurings, which may have a material adverse effect on our operating results.



We have undertaken restructurings of our operations in the past. These
restructuring plans involved reductions in our worldwide workforce and the consolidation of certain of our sales, customer support, and research and development operations. We have also had to write-down assets as part of the restructuring effort
that lowered our operating results. These restructuring plans may not be successful and may not improve future operating results. We may also be required to implement additional restructuring plans in the future.



We may not be able to successfully make acquisitions of or investments in other
companies or technologies which could limit our future growth and access to technology.



We have limited experience in acquiring or making investments in companies, technologies or services. We regularly evaluate product and technology
acquisition opportunities and anticipate that we may make additional acquisitions in the future if we determine that an acquisition would further our corporate strategy. Acquisitions in our industry are particularly difficult to assess because of
the rapidly changing technological standards in our industry. If we make any acquisitions, we will be required to assimilate the personnel, operations and products of the acquired business and train, retain and motivate key personnel from the
acquired business. However, the key personnel of the acquired business may decide not to work for us. In addition we may not be successful in the integration of product lines and customers of an acquired company. Moreover, if the operations of an
acquired company or business do not meet our expectations, we may be required to restructure the acquired business, or write-off the value of some or all of the assets of the acquired business. No assurance can be given that any acquisition by us
will or will not occur, that if an acquisition does occur, that it will not materially and adversely affect us or that any such acquisition will be successful in enhancing our business.



We are dependent upon our key management and employees for our future success and few of our key managers and employees are obligated
to stay with us.



Our success depends in part on our
ability to attract and retain key senior management and certain other personnel. Many of our key employees are employed on an at-will basis. If any of our key employees left or were unable to work and we were unable to find a suitable replacement,
then our business, financial condition and results from operations could be materially harmed.



We face significant competition and competition in our market is likely to increase and could harm our business.



The markets for our products are intensely competitive and characterized by rapidly changing technology, evolving industry standards, consolidation
amongst competitors, price erosion, changes in customers needs, and frequent new product introductions. We anticipate continued growth and competition in our industry and the entrance of new competitors into our markets, and accordingly, the
markets for our products will remain intensely competitive. We expect that competition will increase in the near term and that our primary long-term competitors may not yet have entered the market. Several key factors contribute to the continued
growth of our marketplaces including the proliferation of Microsoft Windows client server technology and the continued implementation of web-based access to corporate mainframe and mid-range computer systems. Our connectivity software products
compete with major computer and communication systems vendors, including Microsoft, IBM, BEA, Computer Associates International, Inc. and Sun Microsystems, Inc., as well as smaller networking software companies such as Jacada Ltd., and Seagull
Holding HV. We also face competition from makers of terminal emulation software such as AttachmateWRQ, and with respect to adapter products, we face competition from iWay Software and Attunity Ltd.



Many of our current competitors have, and many of our future competitors may
have, substantially greater financial, technical, sales, marketing and other resources, in addition to greater name recognition and a larger customer base than us. The markets for our products are characterized by significant price competition and
we anticipate that we will face increasing pricing pressures from our competitors in the future. In addition, our current and future competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements
than we can. Increased competition could result in price reductions, fewer customer orders, reduced gross profit margins and loss of market share, any of which could harm our business.



Furthermore, our competitors could seek to expand their product offerings by designing and selling products using technology
that could render obsolete or adversely affect sales of our products. These developments may adversely affect sales of our products either by directly affecting customer-purchasing decisions or by causing potential customers to delay their purchases
of our products.



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We have connectivity and integration products which are similar to some products marketed by Microsoft. Microsoft is expected to increase development of such
products, especially in the enterprise integration and application connectivity markets, which could have a material adverse effect on our business, financial condition or results of operations. In addition, the enterprise integration and
connectivity markets are going through and are expected to continue to go through a period of consolidation, merger and acquisition. Consolidation of the integration and connectivity market could have a material adverse effect on our business,
financial condition or results of operations.



If we fail to manage
technological change, respond to consumer demands or evolving industry standards or if we fail to enhance our products interoperability with the products of our customers, demand for our products will decrease and our business will suffer.



From time to time, many of our customers have delayed
purchase decisions due to confusion in the marketplace relating to rapidly changing technology and product introductions. To maintain or improve our position in this industry, we must successfully develop, introduce, and market new products and
product enhancements on a timely and cost-effective basis. We have experienced difficulty from time to time in developing and introducing new products and enhancing existing products, in a manner which satisfies customer requirements and changing
market demands. Any failure by us to anticipate or respond adequately to changes in technology and customer preferences, or any significant delays in product development or introduction, could have a material adverse effect on our business,
financial condition, and results of operations. The failure to develop products or product enhancements incorporating new functionality on a timely basis could cause customers to delay purchase of our current products or cause customers to purchase
products from our competitors; either situation would adversely affect our business, financial condition, and results of operations. We may not be successful in developing new products or enhancing our existing products on a timely basis, and any
new products or product enhancements developed by us may not achieve market acceptance. In addition, we incorporate software and other technologies owned by third parties and as a result, we are dependent upon such third parties ability to
enhance their current products, to develop new products that will meet changing customer needs on a timely and cost-effective basis, and to respond to emerging industry standards and other technological changes.



We depend upon technology licensed from third parties, and if we do not maintain these
license arrangements we will not be able to ship many of our products and our business will be seriously harmed.



Certain of our products incorporate software and other technologies developed and maintained by third parties. We license these technologies from third
parties under agreements with a limited duration and we may not be able to maintain these license arrangements. If we fail to maintain our license arrangements or find suitable replacements, we would not be able to ship many of our products and our
business would be materially harmed. For example, we have a license agreement with Dartcom Incorporated, renewable annually, for Power TCP Telnet and Power TCP VT320, which we use in our OnWeb product line. There can be no assurance that we would be
able to replace the functionality provided by the third-party technologies currently offered in conjunction with our products if those technologies become unavailable to us or obsolete or incompatible with future versions of our products or market
standards.



We depend upon the compatibility of our products with
applications operating on Microsoft Windows to sell our products.



A significant portion of our net revenues have been derived from the sales of products that provide inter-networking applications for the Microsoft Windows environment and are marketed primarily to Windows users. As a
result, sales of certain of our products would be negatively impacted by developments adverse to Microsoft Windows products. As well, if competing technologies such as Linux are successful in negatively impacting Microsofts success, our
ability to sell our products would be further limited. In addition, our strategy of developing products based on the Windows operating environment is substantially dependent on our ability to gain pre-release access to, and to develop expertise in,
current and future Windows developments by Microsoft. We have no agreement with Microsoft giving us pre-release access to future Windows products. If we are unable to gain such access our ability to develop new products compatible with future
Windows release in a timely manner could be harmed. Also, we have products which are similar to functionality included in some Microsoft products. Microsoft is expected to increase development of such products, which could have a material adverse
effect on our business, financial condition or results of operations.



We
depend upon the compatibility of our products with applications operating on UNIX platforms to sell our products.



A small percentage of our net revenues have been derived from the sales of products that provide inter-networking applications for UNIX environments,
including Linux and Solaris and are marketed primarily to the Fortune 1000 companies running UNIX platforms as their servers. As a result, sales of certain of our products would be negatively impacted by developments adverse to UNIX products or
developments in the Open Source community based around Linux adverse to our own Linux-based products. In addition, our strategy of developing products based on the UNIX operating environment is substantially dependent on our ability to gain
pre-release access to, and to develop expertise in, current and future UNIX developments by various companies including



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IBM, Hewlett-Packard and Sun. No agreement exists between developers of UNIX operating systems and us to provide
pre-release access to future UNIX products. If we are unable to gain such access our ability to develop new products compatible with future UNIX product releases in a timely manner could be harmed.



The loss of any of our strategic relationships would make it more difficult to keep
pace with evolving industry standards and to design products that appeal to the marketplace.



Our future success depends on our ability to maintain and enter into new strategic alliances and OEM relationships to develop necessary products or
technologies, to expand our distribution channels or to jointly market or gain market awareness for our products. We currently rely on strategic relationships, such as those with Microsoft to provide us with state of the art technology, assist us in
integrating our products with leading industry applications and help us make use of economies of scale in manufacturing and distribution. However, we do not have written agreements with many of our strategic partners and cannot ensure these
relationships will continue for a significant period of time. Many of our agreements with these partners are informal and may be terminated by them at any time. There can be no assurance that we will be successful in maintaining current alliances or
developing new alliances and relationships or that such alliances and relationships will achieve their intended purposes.



We may be subject to product returns, product liability claims and reduced sales because of defects in our products which could reduce our revenues and otherwise
adversely affect our financial results.



Software
products as complex as those offered by us may contain undetected errors or failures when first introduced or as new versions are released. The likelihood of errors is higher when a new product is introduced or when new versions or enhancements are
released. Errors may also arise as a result of defects in third-party products or components, which are incorporated, into our products. There can be no assurance that, despite testing by us and by current and potential customers, errors will not be
found in new products or product enhancements after commencement of commercial shipments, which could result in loss of or delay in market acceptance. We may be required to devote significant financial resources and personnel to correct any defects.
Known or unknown errors or defects that affect the operation of our products could result in the following, any of which could have a material adverse effect on our business, financial condition, and results of operations:



| |  |  | delay or loss of revenues;
| | - |  | --------------------------



| |  |  | cancellation of a purchase order or contract due to defects;
| | - |  | ------------------------------------------------------------



| |  |  | diversion of development resources;
| | - |  | -----------------------------------



| |  |  | damage to our reputation;
| | - |  | -------------------------



| |  |  | failure of our products to achieve market acceptance;
| | - |  | -----------------------------------------------------



| |  |  | increased service and warranty costs; and
| | - |  | -----------------------------------------



| |  |  | litigation costs.
| | - |  | -----------------



Although some of our licenses with customers contain provisions designed to limit our exposure to potential product failure to perform claims, these
contractual limitations on liability may not be enforceable or may only limit, rather than eliminate potential liability. In addition, our insurance may not be adequate to cover our losses in the event of a claim resulting from defects in our
products and may not be available to us in the future.



Our business
depends upon licensing our intellectual property, and if we fail to protect our proprietary rights, our business could be harmed.



Our ability to compete depends substantially upon our internally developed proprietary technology. We rely primarily on a combination of patent, copyright
and trademark laws, trade secrets, confidentiality procedures, and contractual provisions to protect our proprietary rights. We seek to protect our software, documentation and other written materials under trade secret and copyright laws and
contractual confidentiality agreements, which afford only limited protection, and, to a lesser extent, patent laws. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain
and use information that we regard as proprietary. Policing unauthorized use of our products and technology is difficult and, while we are unable to determine the extent to which piracy of our software products exists, software piracy can be
expected to be a persistent problem. There can be no assurance that our means of protecting our proprietary rights will be adequate, or our competitors will not independently develop similar technology. In selling a portion of our products, we rely
primarily on click-wrap licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of certain jurisdictions.



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In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the
laws of the United States. If we are not successful in protecting our intellectual property, our business could be substantially harmed.



We rely upon our patents, trademarks, copyrights and trade secrets to protect our proprietary rights, but they may be only of limited value as we may not be able to
prevent misappropriation of our technology.



There can
be no assurance that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology. In addition, the number of patents applied and granted for software inventions is
increasing. Despite any precautions which we have taken:



| |  |  | laws and contractual restrictions may not be sufficient to prevent misappropriation of our technology or deter others from developing similar technologies;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | other companies may claim common law trademark rights based upon state or foreign law which precede our federal registration of such marks; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | current federal laws that prohibit software copying provide only limited protection from software pirates, and effective trademark, copyright and trade secret protection
may be unavailable or limited in certain foreign countries.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our pending patent applications may never be issued, and even if issued, may provide us with little protection.



We regard the protection of patentable inventions as important to our business. However, it is possible that:



| |  |  | our pending patent applications may not result in the issuance of patents;
| | - |  | --------------------------------------------------------------------------



| |  |  | our patents may not be broad enough to protect our proprietary rights;
| | - |  | ----------------------------------------------------------------------



| |  |  | any issued patent could be successfully challenged by one or more third parties, which could result in our loss of the right to prevent others from exploiting the inventions claimed
in those patents;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | current and future competitors may independently develop similar technology, duplicate our products or design around any of our patents; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | effective patent protection, if any, may not be available in every country in which we do business.
| | - |  | ---------------------------------------------------------------------------------------------------



If we are not successful in asserting our patent rights, our business could be substantially harmed. At the present time, we
have one patent pending and 12 patents issued from the U.S. Patent Office.



We have received notices of claims that may result in litigation and we may become involved in costly and time-consuming litigation over proprietary rights.



Substantial litigation regarding intellectual property rights exists in our industry. We expect that software in our
industry may be increasingly subject to third party infringement claims as the number of competitors grows and the functionality of products in different areas of the industry overlaps. Third parties may currently have, or may eventually be issued,
patents that would be infringed by our products or technology. We cannot be certain that any of these third parties will not make a claim of infringement against us with respect to our products and technology. We have received, and may receive in
the future, communications from third parties asserting that our products infringe, or may infringe, the proprietary rights of third parties seeking indemnification against such infringement or indicating that we may be able to obtain a license from
such third parties. Any claims or actions asserted against us could result in the expenditure of significant financial resources and the diversion of managements time and efforts. In addition, litigation in which we are accused of infringement
may cause product shipment delays, require us to develop non-infringing technology or require us to enter into royalty or license agreements even before the issue of infringement has been decided on the merits. If any litigation were not to be
resolved in our favor, we could become subject to substantial damage claims and be prohibited from using the technology at issue without a royalty or license agreement. These royalty or license agreements, if required, might not be available on
acceptable terms, or at all, and could result in significant costs and harm our business. If a successful claim of infringement is made against us and we cannot develop non-infringing technology or license the infringed or similar technology on a
timely and cost-effective basis, our business could be significantly harmed.



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Our business is subject to risks from international operations such as legal uncertainty, tariffs, trade barriers
and political and economic instability which could restrict our ability to compete effectively.



We derived approximately 32% and 25% of our net revenues from sales outside of North America (United States and Canada) for each of the three month
periods ended September 30, 2005 and 2004, respectively. While we expect that international sales will continue to account for a significant portion of our net revenues, there can be no assurance that we will be able to maintain or increase
international market demand for our products or that our sales offices and distributors will be able to effectively meet that demand. Risks inherent in our international business activities generally include, among others:



| |  |  | unexpected changes in regulatory requirements;
| | - |  | ----------------------------------------------



| |  |  | legal uncertainty, particularly regarding intellectual property rights and protection;
| | - |  | --------------------------------------------------------------------------------------



| |  |  | costs and risks of localizing products for foreign countries;
| | - |  | -------------------------------------------------------------



| |  |  | longer accounts receivable payment cycles;
| | - |  | ------------------------------------------



| |  |  | language barriers in business discussions;
| | - |  | ------------------------------------------



| |  |  | cultural differences in the negotiation of contracts and conflict resolution;
| | - |  | -----------------------------------------------------------------------------



| |  |  | time zone differences;
| | - |  | ----------------------



| |  |  | the limitations imposed by U.S. export laws (see Government Regulation and Legal Uncertainties below);
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | changes in markets caused by a variety of political, social and economic factors;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | tariffs and other trade barriers;
| | - |  | ---------------------------------



| |  |  | difficulties in managing international operations;
| | - |  | --------------------------------------------------



| |  |  | currency exchange rate fluctuations;
| | - |  | ------------------------------------



| |  |  | potentially adverse tax consequences;
| | - |  | -------------------------------------



| |  |  | repatriation of earnings; and
| | - |  | -----------------------------



| |  |  | the burdens of complying with a wide variety of foreign laws.
| | - |  | -------------------------------------------------------------



Many of our customers are subject to many of the risks described above. These factors may have an adverse effect on our international sales and,
consequently, on our business, financial condition or results of operations.



Terrorist attacks and threats or actual war could adversely affect our operating results and the price of our common stock.



The terrorist attacks in the United States, the United States response to these attacks, the current instability in Iraq, and the related impact in
consumer confidence and economic weakness have had an adverse impact on our operations. Any escalation in these events or similar future events may disrupt our operations or those of our customers. These events have had and may continue to have an
adverse impact on the United States and world economies in general and consumer confidence and spending in particular, which has and could continue to harm our sales. Any of these events could increase volatility in the United States and worldwide
financial markets and economies, which could harm our stock price and may limit the capital resources available to us and our customers. This could have a significant impact on our operating results, revenues and costs and may result in increased
volatility in the market price of our common stock and on the future price of our common stock.



It may be difficult to raise needed capital in the future, which could significantly harm our business by limiting our ability to grow or make acquisitions.



We may require substantial additional capital to finance growth,
acquisitions and fund ongoing operations in future years. Our capital requirements will depend on many factors including, among other things:



| |  |  | our results of operations;
| | - |  | --------------------------



| |  |  | acceptance of and demand for our products;
| | - |  | ------------------------------------------



| |  |  | the number and timing of any acquisitions and the cost of these acquisitions;
| | - |  | -----------------------------------------------------------------------------



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| |  |  | the costs of developing new products;
| | - |  | -------------------------------------



| |  |  | the costs associated with our refocusing on core products and technologies; and
| | - |  | -------------------------------------------------------------------------------



| |  |  | the extent to which we invest in new technology and research and development projects.
| | - |  | --------------------------------------------------------------------------------------



Although our current business plan does not foresee the need for further financing activities to fund our operations for the
foreseeable future, due to risks and uncertainties in the marketplace as well as a potential of pursuing further acquisitions, we may need to raise additional capital. If we issue additional stock to raise capital, current percentage ownership in
NetManage would be diluted. If we raise capital through debt; our debt servicing costs will increase. Additional financing may not be available when needed and, if such financing is available, it may not be available on terms favorable to us.



Because of their significant stock ownership, our officers and directors
can exert significant control over our future direction.



As of October 26, 2005, our officers, directors and entities affiliated with them, in the aggregate, beneficially owned approximately 2.1 million shares, or 23% of the outstanding common stock. These stockholders, if acting
together, would be able to exert significant influence on all matters requiring approval by our stockholders, including the election of directors, the approval of mergers or other business combination transactions or a sale of all or substantially
all of our assets.



Certain provisions of our stock option plan, our
stockholder rights plan and our certificate of incorporation and bylaws make changes of control difficult even if they would be beneficial to stockholders.



Our 1992 Stock Option Plan and our 1999 Non-statutory Stock Option Plan provide that, in the event of a change of control of
NetManage, all options outstanding under those plans would become fully vested and exercisable for at least 10 days prior to the consummation of such change of control transaction. These accelerations of vesting provisions would increase the cost to
any potential acquirer and could have the effect of deterring or reducing the per share price paid to purchase NetManage.



In addition, our board of directors has the authority without any further vote or action on the part of the stockholders to issue up to 1,000,000 shares
of preferred stock and to determine the price, rights, preferences, privileges and restrictions of the preferred stock. This preferred stock, if it is ever issued, may have preference over and harm the rights of the holders of our common stock.
Although the issuance of this preferred stock will provide us with flexibility in connection with possible acquisitions and other corporate purposes, the issuance of the preferred stock may make it more difficult for a third party to acquire a
majority of our outstanding voting stock. We currently have no plans to issue preferred stock.



Our certificate of incorporation and bylaws include provisions that may have the effect of deterring an unsolicited offer to purchase our stock. In addition, we have implemented a stockholder rights plan that could
deter or at least make it significantly more expensive for an unsolicited offer to purchase our stock. These provisions, coupled with the provisions of the Delaware General Corporation Law, may delay or impede a merger, tender offer or proxy contest
involving us. Furthermore, our board of directors is divided into three classes, only one of which is elected each year. Directors are only capable of being removed by the affirmative vote of two thirds or greater of all classes of voting stock.
These factors may further delay or prevent a change of control.



We face
risks from the uncertainties of current and future governmental regulation which could have a negative impact on our ability to operate our business.



We are not currently subject to direct regulation by any government agency, other than regulations applicable to businesses generally, and there are
currently few laws or regulations directly applicable to access to or commerce on the Internet. However, due to the increasing popularity and use of the Internet, it is possible that various laws and regulations may be adopted with respect to the
Internet, covering issues such as user privacy, pricing and characteristics and quality of products and services. The adoption of any such laws or regulations may decrease the growth of the Internet, which could in turn decrease the demand for our
products, increase our cost of doing business or otherwise have an adverse effect on our business, financial condition or results of operations. Moreover, the applicability to the Internet of existing laws governing issues such as property
ownership, libel and personal privacy is uncertain. Further, due to the encryption technology contained in certain of our products, such products are subject to U.S. export controls. There can be no assurance that such export controls, either in
their current form or as may be subsequently enacted, will not limit our ability to distribute products outside of the United States or electronically. While we take precautions against unlawful exportation, there can be no assurance that
inadvertent violations will not occur, and the global nature of the Internet makes it virtually impossible to effectively control the distribution of our products. In addition, future federal or state legislation or regulation may further limit
levels of encryption or authentication technology. Any such export restriction, new legislation or regulation or unlawful exportation could have a material adverse effect on our business, financial condition, or results of operations.



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Our acquisitions may have a material adverse effect on our operating results and financial condition.



We acquired Librados, Inc. in the fourth quarter of
2004 and have made a number of acquisitions in the last ten years. These acquisitions were motivated by various factors, including the desire to obtain new technologies, expand and enhance our product offerings, expand our customer base, attract key
personnel, and strengthen our presence in the international and OEM marketplaces. Product and technology acquisitions entail numerous risks, including:



| |  |  | the diversion of managements attention away from day-to-day operations;
| | - |  | ------------------------------------------------------------------------



| |  |  | difficulties in the assimilation of acquired operations and personnel (such as sales, engineering, and customer support);
| | - |  | -------------------------------------------------------------------------------------------------------------------------



| |  |  | the integration of acquired products with existing product lines;
| | - |  | -----------------------------------------------------------------



| |  |  | the failure to realize anticipated benefits of cost savings and synergies;
| | - |  | --------------------------------------------------------------------------



| |  |  | the loss of customers;
| | - |  | ----------------------



| |  |  | undisclosed liabilities;
| | - |  | ------------------------



| |  |  | adverse effects on reported operating results;
| | - |  | ----------------------------------------------



| |  |  | the amortization of acquired intangible assets;
| | - |  | -----------------------------------------------



| |  |  | the loss of key employees; and
| | - |  | ------------------------------



| |  |  | the difficulty of presenting a unified corporate image.
| | - |  | -------------------------------------------------------



Standards for compliance with section 404 of the Sarbanes-Oxley Act of 2002 are complex, and if we fail to comply in a timely manner, our business could be harmed
and our stock price could decline.



Rules adopted by
the SEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 require annual assessment of our internal control over financial reporting, and attestation of our assessment by our independent registered public accountants. We anticipate that
this requirement will first apply to our Annual Report on Form 10-K for the fiscal year ending December 31, 2007. The standards that must be met for management to assess the internal controls over financial reporting as effective are complex,
and require significant documentation, testing and possible remediation to meet the detailed standards. We may encounter problems or delays in completing activities necessary to make an assessment of our internal controls over financial reporting.
In addition, the attestation process by our independent registered public accountants is new and we may encounter problems or delays in completing the implementation of any requested improvements and receiving an attestation of our assessment by our
independent registered public accountants. If we cannot assess our internal controls over financial reporting as effective, or our independent registered public accountants are unable to provide an unqualified attestation report on such assessment,
investor confidence and share value may be negatively impacted.



Increased costs associated with corporate governance compliance may significantly impact the results of our operations.



Changing laws, regulations, and standards relating to corporate governance, public disclosure, and compliance practices, including the Sarbanes-Oxley Act
of 2002, new SEC regulations, and NASDAQ National Market rules, are creating uncertainty for companies such as ours in understanding and complying with these laws, regulations, and standards. As a result of this uncertainty and other factors,
devoting the necessary resources to comply with evolving corporate governance and public disclosure standards may result in increased general and administrative expenses and a diversion of management time and attention to compliance activities. We
also expect these developments to increase our legal compliance and financial reporting costs. In addition, these developments may make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be
required to accept reduced coverage or incur substantially higher costs to obtain such coverage. Moreover, we may not be able to comply with these new rules and regulations on a timely basis.



These developments could make it more difficult for us to retain qualified
members of our board of directors or executive officers. We are presently evaluating and monitoring regulatory developments and cannot estimate the timing and magnitude of additional costs we may incur as a result. To the extent these costs are
significant, our general and administrative expenses are likely to increase.



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Item 3  Quantitative and qualitative disclosures about market risk.



Disclosures about market risk



Interest rate risk



Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We place our investments with high credit quality
issuers and, by policy, limit our credit exposure with any one issuer. As stated in our policy, we are averse to principal loss, and seek to preserve our invested funds by limiting default risk, liquidity risk, and territory risk.



We mitigate default and liquidity risks by investing only in high credit
quality securities, and by positioning our portfolio to respond appropriately to a significant reduction in the credit rating of any investment issuer or guarantor. To ensure portfolio liquidity the portfolio includes only marketable securities with
active secondary or resale markets.



Foreign currency risk



We are exposed to foreign currency exchange rate risk inherent in our
sales commitments, anticipated sales, anticipated purchases and assets and liabilities in currencies other than the U.S. dollar. We transact business in approximately six foreign currencies worldwide, of which the most significant to our operations
are the Euro, the Canadian dollar, the Israeli shekel, and the British pound. For most currencies, we are the net receiver of foreign currencies and therefore benefit from a weaker U.S. dollar and are adversely affected by a stronger U.S. dollar
relative to those foreign currencies in which we transact significant amounts of business. The net results of the transaction gains or losses appear in the line entitled foreign currency transaction gains (losses) in the Condensed Consolidated
Statements of Operations. At the end of each period, the translation of Condensed Consolidated Balance Sheets from local currency to the group currency appear in the Condensed Consolidated Statements of Comprehensive Income under the foreign
currency translation adjustments line.



The following table
presents the potential impact on cash flow of changes in exchange rates as noted (in thousands):



|                           |  |                                              |        |   |            |   |      |            |  |   |            |   |  |            |      |   |  |   |      |  
|-------------------------- |  | -------------------------------------------- | ------ | - | ---------- | - | ---- | ---------- |  | - | ---------- | - |  | ---------- | ---- | - |  | - | ---- | -
|                           |  | Cash flow impact on change in exchange rates |       
|                           |  | Fair Value as ofSeptember 30, 2005           |        |   | -15%Change |   |      | -10%Change |  |   | +10%Change |   |  | +15%Change |     
|Accounts receivable(1)     |  | $                                            | 6,639  |   |            | $ | (453 | )          |  | $ | (285       | ) |  | $          | 233  |   |  | $ | 335  |  
|Accounts payable(1)        |  |                                              | (986   | ) |            |   | 73   |            |  |   | 46         |   |  |            | (38  | ) |  |   | (54  | )
|Inter-company with U.S.(2) |  |                                              | (2,014 | ) |            |   | 518  |            |  |   | 326        |   |  |            | (267 | ) |  |   | (383 | )

---

|(1) | The offset entry for this change in exchange rates would be to Accumulated other comprehensive loss in the Condensed Consolidated Balance Sheets.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | This assumes the change in exchange rates applies only to the relationship between the U.S. dollar and the local currency as of September 30, 2005 and that there is no change
in rates between the various non U.S. dollar currencies. The offset entry for this change in exchange rates would be to Foreign currency transaction gains (losses) in the Condensed Consolidated Statements of Operations.
|--- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Item 4. Controls and procedures



Evaluation of disclosure controls and procedures.



As of the end of the period covered by this filing, we performed an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of
the effectiveness of the design and operation of the Companys disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act. An internal control system
is designed to provide reasonable, but not absolute, assurance that the objectives of the control system are met, including, but not limited to, ensuring that transactions are properly authorized, assets are safeguarded against unauthorized or
improper use and transactions are properly recorded and reported. Following that evaluation, our management, including the Chief Executive Officer and Chief Financial Officer, concluded that based on the evaluation, the design and operation of the
Companys disclosure controls and procedures were effective at that time to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with
generally accepted accounting principles.



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Changes in internal controls.



There have been no changes in our internal controls during the most recent fiscal quarter covered by this report, or in any
other factors that could affect these controls, including any corrective actions with regard to significant deficiencies and material weaknesses, that have affected or are reasonably likely to materially affect our internal control over financial
reporting during our most recent fiscal quarter covered by this report.



PART II  OTHER INFORMATION



Item 1. Legal Proceedings



On November 22, 1999, Kenneth Fisher (Realtor) filed a complaint alleging violations of the False Claims Act, 31 U.S.C. § 3729 et seq., against the Company and its affiliates Network Software Associates, Inc., or NSA,
and NetSoft Inc., or NetSoft, in the United States District Court of the District of Columbia. This action was previously reported in the Legal Proceedings section of the Companys quarterly report Form 10-Q for the period
ended March 31, 2005 (incorporated herein by reference). On July 20, 2005, in response to a motion filed jointly by all defendants, the court dismissed Relators claims without prejudice. The dismissal was
based on Relators inability to retain substitute counsel within the timeframe specified by the Court.



The Company may be contingently liable with respect to certain asserted and unasserted claims that arise during the normal course of business. Management
believes the impact, if any, resulting from these matters would not have a material impact on the Companys financial statements.



Item 2. Unregistered Sales of Equity Securities and Use of Proceeds



We made no repurchases of our common stock during the three month period ended September 30, 2005. In addition, we made no sales of unregistered
securities during the three month period ended September 30, 2005.



Item 3. Defaults upon Senior Securities



Not applicable



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



Not applicable



Item 5. Other Information



We file electronically with the SEC our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K pursuant to Section 13(a) or 15(d) of the 1934 Act. The public may read or copy any materials we file
with the SEC at the SECs Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet
site that contains reports, proxy and information statements, and other information statements, and other information regarding issuers that file electronically with the SEC. The address of that site is http:// www.sec.gov.



Item 6. Exhibits



|     |  |                                                                                                                                                                           
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|31.1 |  | Certification of Chief Executive Officer pursuant to Rule 13a-14(a).                                                                                                      
|     | 
|31.2 |  | Certification of Chief Financial Officer pursuant to Rule 13a-14(a).                                                                                                      
|     | 
|32.1 |  | Chief Executive Officer and Chief Financial Officer Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



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SIGNATURES



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



|                       |  |                              |  |                                                                                                                                                      |  | 
|---------------------- |  | ---------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------- |  | 
|                       |  | NETMANAGE, INC. (Registrant)
|                       |  |                             
|DATE: October 31, 2005 |  | By:                          |  | /s/ Michael R. Peckham                                                                                                                              
|                       |  |                              |  | Michael R. Peckham                                                                                                                                  
|                       |  |                              |  | Chief Financial Officer, Senior Vice President, Finance and Secretary(On behalf of the registrant and as Principal Financial and Accounting Officer)



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EXHIBIT INDEX



|               |  |                                                                                                                                                                           
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                               
|31.1           |  | Certification of Chief Executive Officer pursuant to Rule 13a-14(a).                                                                                                      
|               | 
|31.2           |  | Certification of Chief Financial Officer pursuant to Rule 13a-14(a).                                                                                                      
|               | 
|32.1           |  | Chief Executive Officer and Chief Financial Officer Certification pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley act of 2002.



37