**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

**FORM 10-K**

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

**(MARK ONE)**

**x**                                 ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the Fiscal Year Ended April 30, 2007**

**OR**

**o**                                   TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the Transition PeriodFrom                        To                        **

**COMMISSION FILE NUMBER: 000-26209**

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****

**DITECH NETWORKS, INC.**

(ExactName of Registrant as Specified in its Charter)

| **DELAWARE**                                                     |   | **94-2935531**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization) |   | (I.R.S. Employer  Identification No.) |

 

**825East Middlefield RoadMountain View, CA 94043(650) 623-1300**

(Address,Including Zip Code, of Registrant’s Principal Executive Offices andTelephone Number, Including Area Code)

SecuritiesRegistered Pursuant to Section 12(b) of the Act:

| **Title of Each Class**        | ** ** | **Name of  Each Exchange on Which Registered** |
|--------------------------------|------------|------------------------------------------------|
| Common Stock,  $.001 Par Value |       | The NASDAQ Stock  Market, Inc                  |

 

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Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes o No x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act. Yes o No x

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of the Registrant’s knowledge, in definitive proxy or informationincorporated by reference to Part III of this Form 10-K or anyamendment to this Form 10-K. x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer. (See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct).

Large accelerated filer o            Acceleratedfiler x            Non-acceleratedfiler o

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

Theaggregate market value of voting stock held by non-affiliates of the Registrantwas approximately $166,858,667 as of October 31, 2006 based upon theclosing price on the Nasdaq Global Market reported for such date. Excludes anaggregate of 11,490,126 shares of common stock held by officers and directorsand by each person known by the registrant to own 5% or more of the outstandingcommon stock. Exclusion of shares held by any such person should not beconstrued to indicate that a determination has been made that such personpossesses the power, directly or indirectly, to direct or cause the directionof the management or policies of the registrant, or that such person iscontrolled by or under common control with the registrant.

Thenumber of shares outstanding of the Registrant’s Common Stock as of July 3,2007 was 33,200,275 shares.

**DOCUMENTS INCORPORATED BY REFERENCE**

Theinformation required by Part III of this report, to the extent not setforth herein, is incorporated by reference from the Registrant’s definitiveproxy statement relating to the 2007 annual meeting of stockholders, which definitiveproxy statement will be filed with the Securities and Exchange Commissionwithin 120 days after the fiscal year to which this Report relates.

 

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**DITECH NETWORKS,INC.**

**FORM 10-K**

**INDEX**

|                                                                                                                                      | ** ** | **PAGE** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I                                                                                                                          |       |
| Item 1—Business                                                                                                            |       | 1        |       |
| Item 1A—Risk Factors                                                                                                       |       | 13       |       |
| Item 1B—Unresolved Staff  Comments                                                                                         |       | 23       |       |
| Item 2—Properties                                                                                                          |       | 23       |       |
| Item 3—Legal Proceedings                                                                                                   |       | 23       |       |
| Item 4—Submission of  Matters to a Vote of Security Holders                                                                |       | 24       |       |
| PART II                                                                                                                         |       |
| Item 5—Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |       | 25       |       |
| Item 6—Selected Financial Data                                                                                             |       | 27       |       |
| Item 7—Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |       | 29       |       |
| Item 7A—Quantitative  and Qualitative Disclosure About Market Risk                                                         |       | 47       |       |
| Item 8—Financial  Statements and Supplementary Data                                                                        |       | 49       |       |
| Item 9—Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                               |       | 81       |       |
| Item 9A—Controls and  Procedures                                                                                           |       | 81       |       |
| Item 9B—Other Information                                                                                                  |       | 82       |       |
| PART III                                                                                                                        |       |
| Item 10—Directors,  Executive Officers and Corporate Governance                                                            |       | 82       |       |
| Item 11—Executive  Compensation                                                                                            |       | 83       |       |
| Item 12—Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                   |       | 83       |       |
| Item 13—Certain  Relationships and Related Transactions, and Director Independence                                         |       | 83       |       |
| Item 14—Principal  Accountant Fees and Services                                                                            |       | 83       |       |
| PART IV                                                                                                                         |       |
| Item 15—Exhibits and  Financial Statement Schedules                                                                        |       | 84       |       |
| SIGNATURES                                                                                                                           |       | 85       |       |

 

**Trademarks:**

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

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**Ditech Networks, Inc.**

**Part I**

**Item 1—Business**

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

*Where we use the words “Ditech,”“we,” “our” or similar expressions, we are referring to Ditech Networks, Inc.and each of our wholly-owned subsidiaries. Our fiscal year ends on April 30.Consequently, when we refer to a specific fiscal year we are referring to the12 months ended on April 30 of that year. For example, fiscal 2007means the 12 months ended April 30, 2007.*

**General**

Ditech Networks, Inc. is a globaltelecommunications equipment supplier for voice networks. Our solutions enableservice providers to deliver consistently clear, secure, end-to-endcommunications to their customers worldwide. Our voice quality products includeecho cancellers, which are used to effectively eliminate echo, a significantproblem in existing and emerging voice networks. In the second half of fiscal2004, we introduced a new line of voice quality products that incorporate bothecho cancellation and a new generation of voice quality enhancement technology calledVoice Quality Assurance (VQA). VQA addresses various voice quality issues inwireline and wireless networks, including a broader spectrum of echo,background noise and inconsistent voice levels. In the second half of calendar2006, we introduced the ability to accurately measure and report on audioimpairments, a product called Experience Intelligence (EXi). Over the lastthree fiscal years, voice quality products, which include our echo cancellationand VQA platforms, have comprised substantially all of our revenue. Beginningin the second half of fiscal 2004 and continuing through fiscal 2007, we havebeen developing a new platform, the Packet Voice Processor, which representsour entry into service providers’ Internet Protocol (IP) networks using Voiceover Internet Protocol (VoIP) technology. The Packet Voice Processorincorporates our VQA and EXi technology as well as Packet Quality Assurance(PQA) technology to address voice quality issues specific to packet networks.In addition, we acquired Jasomi Networks, Inc. (Jasomi) in the firstquarter of fiscal 2006. Jasomi developed and sold session border controllersthat enable VoIP calls to traverse the network address translation (NAT) andprotect networks from external attacks by admitting only authorized sessions,ensuring that reliable VoIP service can be provided to them. We market ourproducts domestically through a direct sales force and, to a lesser extent,through distributors. Internationally, we market our products through thecombination of a direct sales force, value-added resellers, system integratorsand agents.

Ditech was originallyincorporated as Phone Info., Inc. in July 1983 and subsequentlychanged its name to Automated Call Processing Corporation, Inc. In March 1997,Automated Call Processing Corporation sold portions of its business and mergedwith its wholly owned subsidiary, and the surviving entity was renamed DitechCorporation. Ditech Corporation reincorporated in Delaware in April 1999and changed its name to Ditech Communications Corporation. In May 2006,Ditech Communications Corporation changed its name to Ditech Networks, Inc.

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**Mobile VoiceQuality Market**

***Market Size and Characteristics***

While we supply voiceprocessing products to the wireline network, our primary market is mobileoperators. Mobile networks are currently estimated to have over 2.5 billionsubscribers worldwide and recent market research reports indicate that thissubscriber base is still growing at a significant rate. Global System forMobile Communications, commonly referred to as GSM, is the predominanttechnology for mobile communications outside the United States and is growingin popularity domestically. Code-Division Multiple Access, commonly referred toas CDMA, is an alternative mobile technology used primarily in the U.S. andKorea and a number of smaller networks in other parts of the world. Mobilenetworks are composed of three distinct types of equipment: (1) RadioAccess Network (Cellular towers, base station with radio equipment, backhaulequipment and lines to carry traffic back to the switching site and the basestation controllers); (2) Mobile Switching Center (MSC) with switchingequipment; and (3) Inter MSC network to connect switching sites across thecarrier’s geographical coverage area.

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

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

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

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

***Eliminating Hybrid and Acoustic Echo***

It is important to understand the factors that affectvoice quality in mobile calls. There are two types of echo in networks: HybridEcho and Acoustic Echo. Hybrid Echo is generated within a telecommunicationsnetwork and results from signal reflection at the “hybrid,” commonly the pointwhere two wires of the local network meet the four wires of the long distancenetwork. Echo becomes noticeable whenever the one-time delay of a reboundedvoice signal exceeds 25 milliseconds. If the delay exceeds 32 milliseconds, thequality of the voice call begins to degrade creating an echo, which is reflectedback to the person speaking and can become an annoyance during the call. Whenthese echo problems are present, people describe the effect as their voicessounding hollow or like someone talking in a tunnel. Acoustic echo is caused bythe sound generated on the speaker device of a telephone or mobile handsetbeing reflected from surfaces such as walls, or being conducted by the deviceand then captured by the microphone on the same device. Acoustic echo behavioris more diverse since the resulting echo is driven by the specific physicalcharacteristics of the room and the mechanical properties of the device.

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

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

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

**Our Mobile VoiceQuality Solutions**

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

The key technologies that we have developed and use inour voice processing solutions are:

*VoiceQuality Assurance (VQA) technology.  **Our VQA technology integrates voicequality enhancement features with some of the latest voice processor technologyto improve the sound quality of voice calls in all telecommunications networksbut especially mobile networks. VQA’s general features include noise reduction,acoustic echo cancellation, voice level control, and enhanced listenerintelligibility.*

*PacketQuality Assurance (PQA) technology:**  *Our PQA technology mitigates the effect of lostpackets on packet networks by intelligently replacing lost packets.

*ExperienceIntelligence (EXi) technology:**  *OurEXi technology provides detailed visibility into voice impairments that enter anetwork. EXi enables a service provider to better manage their overall qualitylevels.

The key benefits of our voice processing solutionsinclude:

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

*CodecTranscoding:*   The ability to run different voicecompression schemes (codecs) within a network allows a provider to optimize thequality versus bandwidth tradeoff. We provide an extensive list of codecs thatcan be used in conjunction with both VQA and EXi on VoIP networks.

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*Time-to-marketadvantage.**  *Ourcore technology uses intelligent software algorithms, which are a sophisticatedprocess or set of rules for our software to address an array of voicequality problems, running on off-the-shelf electronic integrated circuits anddigital signal processors. Competitive voice processing solutions usingapplication specific integrated circuits are more expensive to design, requiremore development time and are difficult to upgrade. Our approach leveragesrapid technological advances in the commercial integrated circuit and digitalsignal processor industries, which in turn enable us to invest resources in thedevelopment of additional voice quality algorithms to support the growing needsof the telecommunication and networking marketplace. As a result, we believethat we are able to deliver high performance products to market with shorterproduct development cycles and lower investments in capital equipment thanalternative solutions.

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

*Remote monitoring andservice assurance.**  *Ourreal-time monitoring technology, known as Experience Intelligence (EXi), allowsremote monitoring of voice quality data in real-time. Service providers can usethis technology to identify problems remotely and address them proactively. Weare also able to assist our customers on-line during this process. As a result,service providers can improve performance levels and monitor voice quality on aconsistent basis.

**Our Mobile VoiceQuality Products**

Our voice quality productsare designed to solve voice quality issues, such as echo, background noise andinconsistent voice levels primarily in mobile networks. Our products also servewireline and satellite networks. Our echo cancellation product family includesa mixture of both single and multi-port, stand-alone echo cancellers andseveral broadband, system-based products. In fiscal 2004, we consolidated manyof our previous generation product lines enabling customers to migrate tonewer, lower cost and higher performance platforms. This also enabled us to reducecosts by streamlining on-going development and increasing manufacturing volumeson fewer hardware components. As part of this consolidation process, weannounced last-buy periods for our 18T1, 18E1, Quad I T1, Quad I E1,BBEC, OC-3, STM-1, SX-30 and SX-24 echo cancellationsystems. We ceased selling these products following last-buy periods ending,depending on the product, between November 2004 and June 2006. Infiscal 2004, we announced the availability of two new voice processing platformfamilies. Unlike our previous products that were designed for echo cancellationonly, the new voice processing platforms are designed to support a largervariety of voice processing algorithms, such as the features in VQA and EXi.These products are the Quad Voice Processor (QVP), with four T1 or E1interfaces, and the Broadband Voice Processor-Flex (BVP-Flex) with highcapacity any-to-any interfaces such as DS-3, STS-1, OC-3 andSTM-1. Both platforms can be factory configured to support a wide rangeof digital signal processor, or DSP, computational levels and can be fieldupgraded to support the purchase of new software features. Over 95% of ourrevenue over the last three fiscal years has been generated by sales of ourmobile voice quality products.

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**Our Current Mobile Voice**Quality Products

Thefollowing table summarizes our current mobile voice quality products.

| Product                          | ** ** | ** **                                                                                                                                                                                                                                                                                      | ** ** | **Description**                                                                                                                                                                                                                                                              | ** ** | **Functionality** |
|----------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|
| Broadband Voice   Processor-Flex |       |                                                                                                                                                                                                                                                                                            |       |                                                                                                                                                                                                                                                                         |
| (BVP-Flex)                       |       | Broadband Voice  Processor System with flexible resource cards that permit up to six times the  computational power of the previous generation BVP platform with continued  support for a wide range of interface support, targeted at both North  American and international network operators |       | ·  Supports up to 2016 channels per system,

·  Three systems per shelf 

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

·  Supports hybrid echo, full VQA features and  EXi in a variety of hardware and software configurations |
| Quad II T1                       |       | Single module  including four independent T1 echo cancellers supporting North American  markets                                                                                                                                                                                                 |       | ·  Hybrid Echo Cancellation and built-in voice  enhancement technology 

·  Cancels 480 T1 lines per rack                                                                                                                                                |
| Quad II E1                       |       | Single module  including four independent E1 echo cancellers supporting international  markets and North American gateway applications                                                                                                                                                          |       | ·  Hybrid Echo Cancellation and built-in voice  enhancement technology 

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

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

·  Processes 480 E1 lines per rack          |

 

**VoIP Market: Border Solutions and Services Market**

***MarketCharacteristics***

There is a growing trend of wireline service providerstransitioning away from traditional circuit-switched network infrastructure toVoIP. VoIP offers service providers’ customers an increase in features andfunctionality while enabling the service providers to simplify networkoperations, reduce capital expenditures and increase service revenue.

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Our primary focus in ourVoIP business is the Border Solutions and Services Market. The “border” is thedemarcation between the local access network and the VoIP core transportnetwork. Carriers are currently deploying key voice processing devices, such assession border controllers and media gateways, at the borders of their VoIPnetworks. These devices translate and process calls originating incircuit-based and packet-based access networks, and pass them into the coreVoIP network for further processing and eventual service delivery to VoIPsubscribers. We believe the VoIP border is emerging as the key location in thenetwork to ensure voice quality and security.

***VoIP Service Provider Challenges***

**Voice Quality**

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

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

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

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

**End-to-end ServiceDelivery**

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

**Security**

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

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**Our VoIP Solutions**

We design, develop andmarket systems that ensure service providers can provide consistently clear,secure, end-to-end VoIP communications to their customers throughout the world.Our products feature high-capacity, high-availability hardware systems coupledwith a sophisticated array of voice enhancement and monitoring software toenhance the quality and delivery of voice communications. Our Packet VoiceProcessor began production shipments in first half of fiscal 2007 and wecontinue to develop features as we review and clarify customer requirements.PeerPoint, our session border controller product, is currently available.

The key currently orplanned to be available benefits of our VoIP solutions include:

*Toll-quality voiceservice.*   Our Packet Voice Processor systemincorporates our VQA, PQA, EXi, and codec transcoding functionality. The VQAfeatures on the Packet Voice Processor improve voice quality in a call andoffer noise reduction, enhanced voice intelligibility, voice level control andacoustic and hybrid echo cancellation capabilities. Our PQA features addressquality issues specific to VoIP calls such as packet loss, delay and jitter,and reduce the effects of these impairments to improve call quality andclarity. The following voice quality enhancement features are currentlyavailable in the Packet Voice Processor:

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

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

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

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

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

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

*End-to-end connectivity.*   OurPacket Voice Processor, when deployed at the border between networks, supportsa wide array of codecs from the customer premises or network edge andnormalizes incoming codec types before transmission to the IP backbone. Thismay also eliminate service providers’ need to convert one compressed voiceformat to another (transcoding) at VoIP service points such as conferencingservers, media servers and voice portal servers, hence saving the serviceproviders costs and allowing for easier deployment and integration ofadditional enhanced VoIP service platforms in the future. The Packet VoiceProcessor also provides a full suite of VQA technology features to ensure thedelivery of consistently high voice quality in VoIP deployments.

*Lower Border network costs.*   OurPacket Voice Processor is purpose-built to support large-scale, high-capacityvoice processing at the VoIP network Border. One equipment bay (7 foot) ofour Packet Voice Processor, for example, supports up to 48,000 VoIP sessions,depending on feature configuration. Combined with its sophisticated array ofvoice enhancement and voice monitoring capabilities, deployment of the PacketVoice Processor represents a major capital and operating expense savings forVoIP carriers.

*Securevoice service.*   The success of any VoIP networkdepends on being able to make the right connections without having to redefinethe infrastructure or compromise security. Our PeerPoint Session BorderController helps enterprises and carriers connect diverse equipment, traversefirewalls and network boundaries, reduce bandwidth costs, and mitigate someDenial of Service attacks.

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**Our VoIP Products**

Because of the high expectations of their customers,VoIP service providers are working to provide a service level that is as goodas, or better than, services offered over traditional circuit-switchednetworks. Leveraging our VQA technology and new PQA technology, which addressespacket loss and jitter, we believe that our newest product platform, the PacketVoice Processor, addresses these voice quality issues. Our PVP began productionshipment in early fiscal 2007.

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

Thefollowing table summarizes our current mobile Voice-over-IP products andcurrently available features.

| Product                         | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **Description**                                                                                                                                                                                                                               | ** ** | **Functionality** |
|---------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|
| PeerPoint C100 (Session  Border |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |       |                                                                                                                                                                                                                                          |
| Controller)                     |       | The PeerPoint Session Border Controller enables  enterprises and carriers to connect diverse equipment, traverse firewalls,  operate in environments prone to security breach, reduce bandwidth costs, and  mitigate some Denial of Service attacks, and is targeted at both North American  and international network operators                                                                                                                                                                                                                                                                   |       | ·  Session control

·  Security

·  NAT/Firewall traversal

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

·  Any-to-many codec transcoding

·  Advanced voice quality enhancement

·  Sophisticated voice quality monitoring and  packet quality assurance |

 

**Customers**

While we added new customers in fiscal 2007 andcontinued to do business with major North American long distance companies, thevast majority of our domestic revenue was generated from sales to VerizonWireless. Verizon Wireless accounted for 64% of our total worldwide revenue infiscal 2007 compared to 79% in fiscal 2006. Our other customer that accountedfor greater than 10% of revenue in fiscal 2007 was Orascom Telecom and itsaffiliates, which accounted for 14% of our fiscal 2007 revenue. As a result ofNextel’s merger with Sprint, our fiscal 2007 and 2006 revenue from Nextel wasnominal compared to 37% of our total worldwide revenue in fiscal 2005. Our nextthree largest customers 

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accounted collectively for10*%* of our total company revenuein fiscal 2007. All of our revenue is from external customers.

We market our products, both domestically andinternationally; information by geographic region with respect to revenues fromexternal customers and long-lived assets, is set forth in Note 12 of theNotes to our Consolidated Financial Statements included in Item 8 of thisAnnual Report on Form 10-K and is incorporated by reference here.Historically, the majority of our sales have been to customers in the U.S.These customers accounted for approximately 71%, 87%, and 91%, of our revenuein fiscal 2007, 2006, and 2005, respectively. Virtually all of our long-livedassets are located in the U.S. See “Item 1A—Risk Factors—We May ExperienceUnforeseen Problems As We Diversify Our International Customer Base, WhichWould Impair Our Ability To Grow Our Business” for a discussion of risksassociated with both domestic and international operations.

*Backlog.**  *Our backlog for voice processingproducts was approximately $7.0 million and $18.7 million as of the firstbusiness day of June 2007 and 2006, respectively. Our backlog consists of (1) ordersconfirmed with a purchase order for product from which we expect to recognizerevenue within 120 days to customers with approved credit status, (2) shipmentsclassified as deferred revenue, which we expect to recognize as revenue within120 days, and (3) deferred maintenance revenue, which we expect torecognize within 120 days. A shipment may be classified as deferred revenue fora variety of reasons including, but not limited to, concerns overcollectibility or contractual terms when installation is provided. Backlog at June 1,2007 and 2006 excludes $6.9 million and $6.0 million, respectively, of ordersfor which shipment dates are undefined or which extend beyond 120 days. Becauseof the generally short cycle between order and shipment, and occasionalcustomer changes in delivery schedules, we do not believe that our backlog asof any particular date is necessarily predictive of actual net sales for anyfuture period. However, when backlog levels entering a fiscal quarter are lowrelative to the forecast revenue for that quarter, it places greater relianceon generating new orders during that fiscal quarter to meet our revenuetargets.

**Research andDevelopment**

Our engineers arededicated to and focused on designing and developing next generation voiceprocessing products for both circuit-switched and VoIP networks. Our researchand development expenses for fiscal 2007, 2006, and 2005, were approximately$20.8 million, $17.9 million, and $15.8 million, respectively. Theincrease in spending in fiscal 2007 was largely due to incremental payroll dueto increases in engineering headcount and stock compensation expense associatedwith the adoption of SFAS 123R in fiscal 2007. Our research and developmentefforts are driven by market demand and customer feedback. We have created astructured process for undertaking all product development projects. Followingan assessment of market demand, our research and development team develops aset of functional product specifications based on input from our productmanagement, sales and post-sales organizations. This process is designed toprovide a framework for defining and addressing the steps, tasks and activitiesrequired to bring product concepts and development projects to market. As of April 30,2007, we had 86 employees in Research and Development and we believe thatretaining those personnel and recruiting new personnel, as necessary, will beessential to our continued success. See “Item 1A—Risk Factors” below for adiscussion of risks related to timely specification and development of productsfor commercial viability.

**Manufacturing**

We operate as a “virtual” manufacturing organizationby relying on contract manufacturers to assemble our voice processing products.The vast majority of our products are currently manufactured by a singlecontract manufacturer whomanufactures our products based on rolling forecasts provided by us. Therolling forecasts we submit to our contract manufacturers are based on ourexpectations of customer demand, or in the case of prototypes or lab equipment,internal demand. We generally donot own the products or components until they are shipped to us. In certaincircumstances, we may be liable to our 

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contractmanufacturers for carrying and obsolete material charges for excess componentspurchased based on our forecasts. We perform final test, configurationand shipping functions for our voice processing products. Our raw materials areprocured from outside suppliers, primarily through our contract manufacturers.Several components used in our products are sole sourced. We closely monitorsupplies of parts and supplier lead times in an attempt to mitigate the risk ofcomponent availability affecting our ability to deliver product to ourcustomers. In cases where we believe that a particular sole source component istoo critical or expensive to replace and we believe that there may beavailability issues, we have, and will continue to, buy components in excess ofour immediate needs to help mitigate the risk of component shortages in thefuture. In procuring digital signal processors for our echo cancellationproducts, we and our contract manufacturers rely on Texas Instruments as oursole supplier, as our software license agreement with Texas Instrumentsstipulates that we will only use their processors to run the licensed TexasInstruments software. Our future success will depend in significant part on ourability to obtain components on time, at competitive prices, and in sufficientquantities to meet demand. Although we believe that there are currently amplesupplies of components, we have experienced part shortages in prior years,which had a direct impact on revenues and results of operations and we mayexperience shortages again in the future. See “Item 1A—Risk Factors” belowfor a discussion of risks related to manufacturing our products.

We are ISO 9001:2000 andISO 14001:2004 certified and we encourage our contract manufacturers andstrategic partners to be ISO 9000:2000 registered. As part of our 14001-certifiedmanagement system and our overall commitment to the environment we haveinvestigated the requirements set forth by the RoHS directive, which restrictsthe use of certain hazardous substances in electrical and electronic equipment.Based on some independent industry benchmarking, and guidance offered by the UK’sDepartment of Trade and Industry, we have designed our product,telecommunication network infrastructure equipment, to comply under thelead-in-solder exemption, commonly known as the “5 of 6” compliant of the RoHS directive. We have also completed ourinvestigation in support of the China RoHS initiative. We expect to becompliant with that initiative by December 1, 2007.  We will continue to monitor the evolution ofthe EC/95 and related industry activities and will take appropriate complianceaction for those products that we sell into EU countries and territories.Effective January 1, 2006, we began shipping Waste Electrical andElectronic Equipment (WEEE) compliant product as referenced in EC/96. We willcontinue to monitor the evolution of the EC/96 and related industry activitiesand will take appropriate compliance actions for those products that we sellinto EU countries and territories.

**Sales and Marketing**

We primarily rely on ourdirect sales force to sell our voice processing products domestically and on acombination of a direct sales force, value-added resellers, distributors andsales agents internationally. We have continued to expand our network ofvalue-added resellers, distributors, and sales agents that sell our productsinternationally, and continued to enhance our web site marketing. Over the lastthree fiscal years, we have continued to increase our sales and marketingspending as we have invested in sales and marketing headcount, pre- andpost-sales support staff and trade shows. The focus of this increased spendinghas been to increase our international presence and to promote the introductionof our new VoIP products. See “Item 1A—Risk Factors” below for adiscussion of risks related to effectively marketing and selling our products.

**Acquisitions andDispositions**

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

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On June 30, 2005, we acquired Jasomi for $10.4million in cash plus $7.0 million in non-transferable convertible notes. In thefirst quarter of fiscal 2007, the first $3.0 million of convertible notes werepaid off and the remaining balance of $4.0 million was paid off in the firstquarter of fiscal 2008. In addition, in connection with the acquisition wetransferred $2.0 million into an escrow account to secure indemnificationobligations for breaches of representations and warranties made by Jasomi andcertain of its affiliates, and this escrowed amount was also paid to the formerstockholders of Jasomi in the first quarter of fiscal 2008. We also assumed allof the Jasomi stock options outstanding on the date of the closing, whichconverted into options to acquire an aggregate of 191,111 shares of Ditechcommon stock. In addition, we established a restricted stock plan and issuedrestricted common stock and restricted stock units to Jasomi employees andemployees of a Canadian affiliate of Jasomi in the aggregate amount of 393,212shares of Ditech common stock. We believe the combination of our Packet VoiceProcessor and Jasomi’s session border control technology, which enables VoIPcalls to traverse the network address translation (NAT) and protects networksfrom external attacks by admitting only authorized sessions, thus ensuring thatreliable VoIP service can be provided to them, will enable us to provide acomprehensive solution to carriers’ border service needs. See also Note 5 ofNotes to the Consolidated Financial Statements.

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

**Competition**

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

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

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

·       Ease of product deploymentand installation;

·       Technical support andservice;

·       Completesystem integration and turnkey network delivery;

·       Financing;

·       Credibilityto deliver large scale solutions;

·       Incumbentnetwork deployments; and

·       Handsetbased voice processing.

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

Our principal competitors for stand-alone****echo and voice quality products in circuit-switchednetworks are NMS Communications Corporation and Tellabs. However, the primarycompetition in the voice processing market comes from voice switchmanufacturers, of which there are several companies competing in this space,the more formidable of which are Nortel, Alcatel-Lucent, Nokia, Ericsson,Siemens-Nokia, Huawei and ZTE. These switch manufacturers do not independentlysell echo cancellation products or compete in the open echo cancellationmarket; however, they integrate echo cancellation 

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functionality within theirswitch product offerings, either as hardware modules or as software running onchips. A widespread adoption of internal echo cancellation solutions couldpresent a competitive threat to us by eliminating demand for our echocancellation system products.

Our principalcompetitors in the VoIP space include Sonus Networks, Nortel, Alcatel-Lucent,Cisco, Siemens-Nokia, Audiocodes, Acme Packet, Juniper (Kagoor), Nextone, manymid-sized companies and other startups that offer session border controllerproducts. Large OEMs that offer media gateway products such as Nortel,Alcatel-Lucent and Cisco are also potential competitors as our packet productsare deployed in networks where equipment from these suppliers is already in thenetwork and where we may affect the long-term incremental deployment of theirproducts.

Many of our competitorsand potential competitors have substantially greater name recognition andtechnical, financial, marketing, purchasing and other resources than we do. Asa result, these competitors may be able to respond more quickly to new oremerging technologies or standards and to changes in customer requirements,devote greater resources to the development, promotion and sale of products, ordeliver competitive products at a lower price. We may not be able to competesuccessfully against our current or future competitors. See “Item 1A—RiskFactors” below for a discussion of risks related to resources needed to competeglobally.

**Patents andIntellectual Property Rights**

Our future success will depend, in part, on ourability to protect our intellectual property. We rely primarily onnondisclosure agreements as well as copyright, trademark, trade secret laws,and other methods to protect our proprietary voice processing technologies andprocesses. However, where it is applicable and when we deem it appropriate, wehave and will file for protection under patent laws. Nevertheless, thesemeasures may not be adequate to safeguard the proprietary technology underlyingour voice quality products.

In connection with the sale of our echo cancellationintellectual property to Texas Instruments in April 2002, we secured along-term license of the echo cancellation software from Texas Instruments. Thelicense had an initial four-year royalty-free period after which, in March 2006,we (1) extended the royalty-free period for certain legacy DSPs purchasedfrom TI through December 31, 2007 primarily to support our remainingwarranty obligation for our end-of-life products and (2) negotiated newpricing based on the purchase of DSPs bundled with the echo software for ourcurrent products. We are dependent on the license of this technology andcontinued support from Texas Instruments, as it is the fundamental technologyincorporated in our echo cancellation products.

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

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

A few industryparticipants, such as Lucent, Nortel Networks and certain major universitiesand research laboratories hold substantial inventories of intellectualproperty. This concentration of intellectual property in the hands of a fewmajor entities also poses certain risks to us in seeking to hire qualifiedpersonnel. We have on a few occasions recruited personnel from these entities.These entities or others may claim the misappropriation or infringement oftheir intellectual property, particularly when and if employees of theseentities leave to work for us. We may not be able to avoid litigation in thefuture, particularly if new employees join us after having worked for acompeting company. Litigation could be very expensive to defend, regardless of themerits of the claims, and could have a material adverse effect on our business,financial condition and results of operations.

**Employees**

As of April 30, 2007,we had 224 employees, 36 of whom were primarily engaged in operations, 86 inresearch and development, 81 in sales, marketing and technical support and 21in finance and administration. Our employees are not represented by anycollective bargaining agreement, and we have not experienced a work stoppage.We believe our employee relations are good.

**AvailableInformation**

You may obtain a free copyof our Annual Report on Form 10-K, Quarterly Reports on Form 10-Qand current reports on Form 8-K and any amendments to those reports,which we make available as soon as reasonably practicable after our filing orfurnishing of these reports with or to the SEC, through our website at *www.ditechnetworks.com*. Our websiteaddress is provided solely for informational purposes. We do not intend, bythis reference, that our website should be deemed to be part of this AnnualReport. The reports filed with the SEC are also available at www.sec.gov.

**Item 1A—RiskFactors**

**Future Growth andOperating Results Subject to Risk**

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

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**WE DEPEND ON A LIMITED NUMBER OF CUSTOMERS, THE LOSSOF ANY ONE OF WHICH COULD CAUSE OUR REVENUE TO DECREASE.**

Our revenue historicallyhas come from a small number of customers. Our five largest customers accountedfor approximately 88% of our revenue in fiscal 2007, and 88% and 91% of ourrevenue in fiscal 2006 and 2005, respectively. Our largest customer accountedfor approximately 64% of our revenue in fiscal 2007 and 79% of our revenue infiscal 2006. A customer may stop buying our products or significantly reduceits orders for our products for a number of reasons, including the acquisitionof a customer by another company, a delay in a scheduled product introduction,completion of a network expansion or upgrade, or a change in technology ornetwork architecture. If this happens, our revenue could be greatly reduced,which would materially and adversely affect our business.

Since the beginning ofcalendar year 2004, North American telecommunication service providers havebeen involved in a series of merger and acquisition activities and someaffected telecommunication service providers are still assessing the networktechnology and deployment plans. In any merger, product purchases for networkdeployment may be reviewed, postponed or canceled based on revised plans fortechnology or network expansion for the merged entity. We believe this is whathappened at Nextel when, in December 2004, they announced a plan to mergewith Sprint. Consequently, our fiscal 2007 and 2006 revenue from Nextel wasnominal compared to 37% of our total worldwide revenue, or $34.9 million, infiscal 2005.

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

We expect that, at leastthrough fiscal 2008, our primary business will be the design, development andmarketing of voice processing products. However, the relatively small size ofthe overall echo cancellation portion of the voice market, which is where wehave derived the majority of our revenue to date, could limit the rate ofgrowth of our business. In addition, certain telecommunication serviceproviders may utilize different technologies, such as VoIP, which would furtherlimit demand for products we sold in fiscal 2007 and 2006, which are deployedin mobile and wireline networks. Although we have begun to distribute ourPacket Voice Processor for use in the VoIP market, we have generated onlymodest levels of revenue in fiscal 2007. We have continued to expand our trial activityaround the PVP.

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

Our quarterly operatingresults have fluctuated significantly in the past and may fluctuate in thefuture as a result of several factors, some of which are outside of ourcontrol. If revenue significantly declines, as we experienced in the first ninemonths of fiscal 2006, our operating results will be adversely affected becausemany of our expenses are relatively fixed. In particular, sales and marketing,research and development and general and administrative expenses do not changesignificantly with variations in revenue in a quarter. Adverse changes in our operatingresults could adversely affect our stock price. For example, when we announcedin May 2005 that we expected our revenue for the first quarter of fiscal2006 would be less than half of our revenue in the last quarter of fiscal 2005,our stock price dropped from a closing price of $12.59 just prior to ourannouncement to a closing price of $7.79 per share on the day following ourannouncement. More recently, we have experienced delays in customers finalizingcontracts and/or issuing purchase orders, which have resulted in revenuesslipping out of the quarter in which we had expected to recognize them. Thisresulted in a revenue shortfall in the second and fourth quarters of fiscal2007 and in both cases we experienced a 10% - 15% drop in our stock pricefollowing the announcement of these revenue shortfalls.

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**OURREVENUE MAY VARY FROM PERIOD TO PERIOD, WHICH WOULD SUBSTANTIALLY AFFECTOUR NET INCOME.**

Factorsthat could cause our revenue to fluctuate from period to period include:

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

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

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

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

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

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

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

·       competitivepricing pressures;

·       variationsin the mix of products offered by us; and

·       variationsin our sales or distribution channels.

Sales of our products typically come from our majorcustomers ordering large quantities when they deploy a switching center.Consequently, we may get one or more large orders in one quarter from acustomer and then no orders in the next quarter. As a result, our revenue mayvary significantly from quarter to quarter, which would substantially impactour net income.

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

In addition, the salescycle for our products is typically lengthy. Before ordering our products, ourcustomers perform significant technical evaluations, which typically last up to90 days or more for our base echo cancellation systems and up to 180 days ormore for our newer VQA and PVP product offerings. Once an order is placed,delivery times can vary depending on the product ordered and the timing ofinstallations or product acceptance may be delayed by our customers. As a result,revenue forecasted for a specific customer for a particular quarter may bedelayed until very late in the quarter or may not even occur in that quarter.  Further, in a fiscal quarter for which weenter the quarter with a small backlog relative to our revenue target, we areat heightened risk for the factors noted above as we are more dependent on thegeneration of new orders within the quarter to meet the revenue targets.Because of the potential large size of our customers’ orders, this wouldadversely affect our revenue for the quarter.

**OUR EXPENSES MAY VARYFROM PERIOD TO PERIOD.**

Many of ourexpenses do not vary with our revenue. Factors that could cause our expenses tofluctuate from period to period include:

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

·       thetiming and extent of our research and development efforts;

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

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·       thetiming of personnel hiring.

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

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

We operate in an industrythat experiences rapid technological change, and if we do not successfullydevelop and introduce new products and our existing products become obsoletedue to product introductions by competitors, our revenues will decline. Even ifwe are successful in developing new products, we may not be able tosuccessfully produce or market our new products in commercial quantities, orincrease our overall sales levels. These risks are of particular concern when anew generation product is introduced. Although we believe we will meet ourproduct introduction timetables, there is no guarantee that delays will notoccur. For example, we realized our first modest levels of revenue from our newvoice quality features, which are offered on our BVP-Flex and Quad VoiceProcessor (QVP) voice processing hardware platforms, in the fourth quarter offiscal 2004 and are currently experiencing numerous customer evaluations ofthese features around the world. These evaluations have typically taken longerthan we anticipated. Although we have experienced our first full year ofsubstantial revenue from our VQA products, there is no guarantee that our VQA productswill continue to meet the expectations of new potential customers and thetiming of our realization of any additional revenues from the VQA platformcould be delayed or not materialize at all.

The Packet VoiceProcessor, which has only experienced modest levels of production shipments todate, provides voice processing functionality to enable the deployment of end-to-endVoIP services. This is the first packet-based product developed by us. Theproduct may not achieve broad market acceptance due to feature or capabilitiesmis-matches with customer requirements, pricing of the product, or limitationsof our sales and marketing organizations to properly interact with customers tocommunicate the benefits of the product.

We have in the pastexperienced, and in the future may experience, unforeseen delays in thedevelopment of our new products. For example, an unexpected drop in demand forour OC-3 product led to the write down of $3.5 million of excessinventory in the third quarter of fiscal 2002. Although we were eventually ableto sell this product after having written it down, there can be no assurancesthat we will be able to sell additional written-down units in the future.

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

**WEOPERATE IN AN INDUSTRY EXPERIENCING RAPID TECHNOLOGICAL CHANGE, WHICH MAY MAKEOUR PRODUCTS OBSOLETE.**

Ourfuture success will depend on our ability to develop, introduce and marketenhancements to our existing products and to introduce new products in a timelymanner to meet our customers’ requirements. The markets we target arecharacterized by:

·       rapidtechnological developments;

·       frequentenhancements to existing products and new product introductions;

·       changesin end user requirements; and

·       evolvingindustry standards.

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

WE MAY NEED TO MODIFYOUR PRODUCTS AS A RESULT OF CHANGES IN INDUSTRY STANDARDS.   Theemergence of new industry standards, whether through adoption by officialstandards committees or widespread use by service providers, could require usto redesign our products. If these standards become widespread, and ourproducts are not in compliance, our current and potential customers may notpurchase our products. The rapid development of new standards increases therisk that our competitors could develop and introduce new products orenhancements directed at new industry standards before us.

**ACQUISITIONS ANDINVESTMENTS MAY ADVERSELY AFFECT OUR BUSINESS.**

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

·       potentiallydilutive issuances of equity securities;

·       largeone-time write-offs;

·       reducedcash balances and related interest income;

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

·       theincurrence of debt and contingent liabilities; and

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

Furthermore,acquisitions involve numerous operational risks, including:

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

·       diversionof management’s attention from other business concerns;

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

·       risksof entering geographic and business markets in which we have no or limitedprior experience; and

·       potential loss of keyemployees of acquired organizations.

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**WE ANTICIPATE THAT AVERAGE SELLING PRICES FOR OURPRODUCTS WILL DECLINE IN THE FUTURE, WHICH COULD ADVERSELY AFFECT OUR ABILITYTO BE PROFITABLE.**

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

In order to respond toincreasing competition and our anticipation that average-selling prices willdecrease, we are attempting to reduce manufacturing costs of our new andexisting products. If we do not reduce manufacturing costs and average sellingprices decrease, our operating results will be adversely affected.

**WE USE PRIMARILY ONE CONTRACT MANUFACTURER TOMANUFACTURE OUR PRODUCTS, AND IF WE LOSE THE SERVICES OF THIS MANUFACTURER THENWE COULD EXPERIENCE INCREASED MANUFACTURING COSTS AND PRODUCTION DELAYS**

Manufacturing is currentlyoutsourced to primarily one contract manufacturer. We believe that our currentcontract manufacturing relationship provides us with competitive manufacturingcosts for our products. However, if we or this contract manufacturer terminatesour relationship, or if we otherwise establish new relationships, we mayencounter problems in the transition of manufacturing to another contractmanufacturer, which could temporarily increase our manufacturing costs andcause production delays.

**IF WE LOSE THE SERVICES OF ANY OF OUR KEY MANAGEMENTOR KEY TECHNICAL PERSONNEL, OR ARE UNABLE TO RETAIN OR ATTRACT ADDITIONALTECHNICAL PERSONNEL, OUR ABILITY TO CONDUCT AND EXPAND OUR BUSINESS COULD BEIMPAIRED.**

We depend heavily on keymanagement and technical personnel for the conduct and development of ourbusiness and the development of our products. However, there is no guaranteethat if we lost the services of one or more of these people for any reason,that it would not adversely affect our ability to conduct and expand ourbusiness and to develop new products. We believe that our future success willdepend in large part upon our continued ability to attract, retain and motivatehighly skilled technical employees. However, we may not be able to do so. Forexample, our current chief executive officer will be retiring, and we are in theprocess of searching for a new executive officer. If we are not able to hire anew chief executive officer with the skills and industry experience that weneed, our business will suffer.

**WE FACE INTENSE COMPETITION, WHICH COULD ADVERSELYAFFECT OUR ABILITY TO MAINTAIN OR INCREASE SALES OF OUR PRODUCTS.**

The markets for our products are intenselycompetitive, continually evolving and subject to rapid technological change. Wemay not be able to compete successfully against current or future competitors.Certain of our customers also have the ability to internally produce theequipment that they currently purchase from us. In these cases, we also competewith their internal product development capabilities. We expect thatcompetition will increase in the future. We may not have the financialresources, technical expertise or marketing, manufacturing, distribution andsupport capabilities to compete successfully.

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

Many of our competitorsand potential competitors have long-standing relationships with our existingand potential customers, and have substantially greater name recognition andtechnical, financial and marketing resources than we do. These competitors mayundertake more extensive marketing campaigns, adopt more aggressive pricingpolicies and devote substantially more resources to developing new productsthan we will.

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

When implementingsignificant technology upgrades, large U.S. and international telecommunicationsservices companies often require one major equipment supplier to act as a “systemsintegrator” (SI) to ensure interoperability of all the network elements.Normally the SI would provide the most crucial network elements and also takeresponsibility for the interoperation of their own equipment with the equipmentprovided by other suppliers. We are not in a position to take such a lead SIposition and therefore we may have to partner with an SI (other, much larger,telecommunication equipment supplier) to have a chance to win with certaincustomers. As a result, we may experience delays in revenue because it couldtake a long time to agree to terms with the necessary SI. Moreover, there is noguarantee that we will reach agreement with a SI.

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

Our success will continueto depend in large part on development, expansion and/or upgrade of voice andcommunications networks. We are subject to risks of growth constraints due toour current and planned dependence on U.S. and international telecommunicationsservice providers. In fiscal 2001, for example, we experienced, as did othercompanies in our sector, a slowdown in infrastructure spending by ourcustomers. These potential customers may be constrained for a number ofreasons, including their limited capital resources, economic conditions,changes in regulation and mergers or consolidations which we have seen in NorthAmerica since calendar year 2004. New service provides (E.g., Skype, Google andYahoo) are beginning to compete against our traditional customers with new businessmodels that are substantially reducing the prices charged to end users. Thiscompetition may force network operators to reduce capital expenditures.

**WE MAY EXPERIENCE UNFORESEEN PROBLEMS AS WEDIVERSIFY OUR INTERNATIONAL CUSTOMER BASE, WHICH WOULD IMPAIR OUR ABILITY TOGROW OUR BUSINESS.**

Historically, we have sold mostly to customers inNorth America. We are continuing to execute on our plans to expand ourinternational presence through the establishment of new relationships withestablished international value-added resellers and distributors. However, wemay still be required to hire additional personnel for the overseas market, mayinvest in markets that ultimately generate little or no revenue, and may incurother unforeseen expenditures related to our international expansion. Despitethese efforts, to 

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date our expansionoverseas has met with success in only a few markets and there is no guaranteeof future success. As we expand our sales focus farther into internationalmarkets, we will face new and complex issues that we may not have faced before,such as expanded risk to currency fluctuations, longer payment cycles,manufacturing overseas, political or economic instability, potential adversetax consequences and broadened import/export controls, which will putadditional strain on our management personnel. In the past, the vastmajority of our international sales have been denominated in U.S. dollars;however, in the future, we may be forced to denominate a greater amount ofinternational sales in foreign currencies.

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

**SOME OF THE KEY COMPONENTS USED IN OUR PRODUCTS ARECURRENTLY AVAILABLE ONLY FROM SOLE SOURCES, THE LOSS OF WHICH COULD DELAYPRODUCT SHIPMENTS.**

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

Resulting delays orreductions in product shipments could damage customer relationships, and wecould lose customers and orders. Additionally, because these suppliers are thesole source of these components, we are at risk that adverse increases in theprice of these components could have negative impacts on the cost of ourproducts or require us to find alternative, less expensive components, whichwould have to be designed into our products in an effort to avoid erosion inour product margin.

**WE NOW LICENSE OUR ECHO CANCELLATION SOFTWARE FROMTEXAS INSTRUMENTS, AND IF WE DO NOT RECEIVE THE LEVEL OF SUPPORT WE EXPECT FROMTEXAS INSTRUMENTS, IT COULD ADVERSELY AFFECT OUR ECHO CANCELLATION SYSTEMSBUSINESS.**

In April 2002, wesold our echo cancellation software technology and future revenue streams fromour licenses of acquired technology to Texas Instruments, in return for cashand a long-term license of the echo cancellation software. The license had aninitial four-year royalty-free period after which, in March 2006, we (1) extendedthe royalty-free period through December 31, 2007 for certain legacy DSPspurchased from TI primarily to support our remaining warranty obligation forour end-of-life products and (2) negotiated new pricing based on thepurchase of DSPs bundled with the echo software for our current products. Althoughthe licensing agreement has strong guarantees of support for the software usedin our products, if Texas Instruments were to breach that agreement in somefashion, and not deliver complete and timely support to us, our success in theecho cancellation systems business could be adversely affected.

**IF TEXAS INSTRUMENTS LICENSES ITS ECHO CANCELLATIONSOFTWARE TO OTHER ECHO CANCELLATION SYSTEMS COMPANIES, THIS COULD INCREASE THECOMPETITIVE PRESSURES ON OUR ECHO CANCELLATION SYSTEMS BUSINESS.**

If Texas Instrumentslicenses its echo cancellation software that it acquired from us in April 2002to other echo cancellation systems companies, it could increase the level ofcompetition and adversely affect our success in our echo cancellation systemsbusiness.

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**SOME SUPPLIERS OF KEY COMPONENTS MAY REDUCE THEIRINVENTORY LEVELS WHICH COULD RESULT IN LONGER LEAD TIMES FOR FUTURE COMPONENTPURCHASES AND ANY DELAYS IN FILLING OUR DEMAND MAY REDUCE OR DELAY OUREXPECTED PRODUCT SHIPMENTS AND REVENUES.**

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

**IF WE ARE UNSUCCESSFUL IN MANUFACTURING PRODUCTS THATCOMPLY WITH ENVIRONMENTAL REQUIREMENTS, IT MAY LIMIT OUR ABILITY TO SELLIN REGIONS ADOPTING THESE REQUIREMENTS.**

As part of our 14001-certifiedmanagement system and our overall commitment to the environment we areinvestigating the requirements set forth by the RoHS directive. Based on someindependent industry benchmarking, and guidance offered by the UK’s Departmentof Trade and Industry, we believe that our product, telecommunication networkinfrastructure equipment, qualifies for the lead-in-solder exemption of theRoHS Directive. Consequently, we are have obtained what is commonly called “5of 6” compliance.  We will continue tomonitor the evolution of the EC/95 and related industry activities and willtake appropriate action for those products that we sell into EU countries andterritories. Moreover, we will continue to monitor the evolution of the EC/96and related industry activities elsewhere in the world and will takeappropriate action for those products that we sell into regions adopting newenvironmental standards. There is no guarantee that we will be successful incomplying with these evolving environmental requirements. If we areunsuccessful in complying with these environmental requirements, it would limitour ability to sell into territories adopting new environmental requirements.

**OUR ABILITY TO COMPETE SUCCESSFULLY WILL DEPEND, INPART, ON OUR ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, WHICH WE MAY NOTBE ABLE TO PROTECT.**

We may rely on acombination of patents, trade secrets, copyright and trademark laws,nondisclosure agreements and other contractual provisions and technicalmeasures to protect our intellectual property rights. Nevertheless, thesemeasures may not be adequate to safeguard the technology underlying ourproducts. In addition, employees, consultants and others who participate in thedevelopment of our products may breach their agreements with us regarding ourintellectual property, and we may not have adequate remedies for any suchbreach. In addition, we may not be able to effectively protect our intellectualproperty rights in certain countries. We may, for a variety of reasons, decidenot to file for patent, copyright or trademark protection outside of the UnitedStates. We also realize that our trade secrets may become known through othermeans not currently foreseen by us. Notwithstanding our efforts to protect ourintellectual property, our competitors may be able to develop products that areequal or superior to our products without infringing on any of our intellectualproperty rights.

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**WE CURRENTLY ARE, AND IN THE FUTURE MAY BE,SUBJECT TO SECURITIES CLASS ACTION LAWSUITS DUE TO DECREASES IN OUR STOCKPRICE.**

We are at risk of being subject to securities classaction lawsuits if our stock price declines substantially. Securities classaction litigation has often been brought against a company following a declinein the market price of its securities. For example, in May 2005, weannounced that we expected our first quarter fiscal 2006 revenue to beapproximately one half of our last quarter fiscal 2005 revenue, and our stockprice declined dramatically. On June 14, 2005, a lawsuit entitled*Richard E. Jaffe v. Ditech Communications Corp.,Timothy K. Montgomery and William J. Tamblyn,* Case No. C 0502406 was filed in the United States District Court for the Northern Districtof California, purportedly on behalf of a class of investors who purchasedDitech’s stock between August 25, 2004 and May 26, 2005. Thecomplaint alleges claims under Sections 10(b) and 20(a) of theSecurities Exchange Act of 1934 against Ditech and our Chief ExecutiveOfficer and Chief Financial Officer. Several similar lawsuits were filed andall of the cases were consolidated into a single action.

In addition, a shareholder’s derivative suit was filedagainst our directors and the same two executive officers, and named Ditechnominally as a defendant, making similar allegations. This shareholder’sderivative suit was subsequently voluntarily dismissed without prejudice, whichmeans that the shareholder is able to refile the shareholder’s derivative suitat any time.

We cannot predict theoutcome of the lawsuits. If our stock price declines substantially in thefuture, we may be the target of similar litigation. The current, and anyfuture, securities litigation could result in substantial costs and divertmanagement’s attention and resources, and could seriously harm our business.

**WE CURRENTLY ARE, AND IN THE FUTURE MAY BE,SUBJECT TO ADDITIONAL SECURITIES LAWSUITS.**

We are at risk of beingsubject to other lawsuits as a result of being a public company. Four actionshave been filed purportedly as derivative actions on behalf of Ditech Networksagainst certain of our current and former officers and directors. Thecomplaints allege that between 1999 and 2001 a number of stock option grantswere backdated, and that as a result the defendants breached their fiduciaryduties to Ditech Networks and violated provisions of federal securities lawsand California statutory and common law. The complaints also allege that someof our officers and former officers were unjustly enriched. These lawsuitscould result in substantial costs and divert management’s attention andresources, and thus could seriously harm our business.

**WE HAVE ANNOUNCED A STOCK REPURCHASE WHICH, IF FULLYCOMPLETED, WILL SIGNIFICANTLY DECREASE OUR CASH RESOURCES AND MAY IMPAIROUR ABILITY TO ACQUIRE OR DEVELOP ADDITIONAL TECHNOLOGIES.**

We have announced that weintend to repurchase up to $60 million of our common stock. If we complete thisrepurchase then we will have significantly less cash resources, which mayinhibit our ability to acquire companies or technologies, or develop newtechnologies, that we believe would be beneficial to our company and ourstockholders. Further, if we experience a downturn in our business, we may needto rely on our cash reserves to fund our business during the period of thedownturn which, if prolonged and severe, we may not be able to do.

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

Although we do not believethat our products infringe the proprietary rights of any third parties, thirdparties may still assert infringement or invalidity claims (or claims forindemnification resulting from infringement claims) against us. If made, theseassertions could materially adversely affect our business, 

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financialcondition and results of operations. In addition, irrespective of the validityor the successful assertion of these claims, we could incur significant costsin defending against these claims.

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

In accordance withStatement of Financial Accounting Standard (SFAS) No. 109, “Accounting forIncome Taxes,” we are required to establish a valuation allowance against ourdeferred tax assets if it is morelikely than not that some portion or all of the deferred tax assets will not berealized. The valuationallowance should be sufficient to reduce the deferred tax asset to the amountthat is more likely than not to be realized. At April 30, 2007, we had$45.8 million in net deferred tax assets, which we believe are realizable basedon the requirements of SFAS 109. However, because we have had volatileoperating results in the past and because there is no guarantee that the amountand timing of our future net profits will be sufficient to fully utilize ourdeferred tax assets, there is a risk that we will have to record valuationallowances in the future. Moreover, there is a risk that unfavorable audits of,for example, tax credit or NOL carryforwards by government agencies or changeof ownership limitations (Section 382) may reduce the value of ourdeferred tax assets. If any of these events were to occur, our financialresults for one or more periods would be adversely affected.

**Item 1B—UnresolvedStaff Comments**

None.

**Item 2—Properties**

Our principal offices andfacilities are currently located in two leased buildings totaling approximately61,000 square feet in Mountain View, California. Of the space occupied,approximately 65% is used for manufacturing and research and development andthe balance is used for office space for sales and marketing and general andadministrative functions. The term of the lease expires on July 31, 2011.We believe that the space under the lease is adequate to meet our needs for theforeseeable future. We additionally have leased office space in Calgary, Canadaunder an operating lease expiring on January 31, 2011.

**Item 3—LegalProceedings**

Beginning on June 14, 2005, several purportedclass action lawsuits were filed in the United States District Court for theNorthern District of California, purportedly on behalf of a class of investorswho purchased Ditech’s stock between August 25, 2004 and May 26,2005. The complaints allege claims under Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934 against Ditech and its Chief ExecutiveOfficer and Chief Financial Officer in connection with alleged misrepresentationsconcerning VQA orders and the potential effect on Ditech of the merger betweenSprint and Nextel. All of the lawsuits were consolidated into a singleaction entitled*In re Ditech CommunicationsCorp. Securities Litigation,* No. C 05-02406-JSW, and aconsolidated amended complaint was filed on February 2, 2006. Thedefendants moved to dismiss the complaint, and by order dated August 10, 2006, the court granted thedefendants’ motion and dismissed the complaint with leave to amend. Defendantsfiled their Second Amended Complaint on September 11, 2006. Defendantsagain moved to dismiss, and by order dated March 22, 2007, the courtdismissed the Second Amended Complaint with leave to amend. Plaintiffs filedtheir Third Amended Complaint on April 23, 2007. On May 14, 2007,Defendant again moved to dismiss. This latest motion has been set for a hearing on August 19,2007. This matter is at an early stage; no discovery has taken place and notrial date has been set.

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On August 23, 2006, August 25, 2006, and November 3,2006, three actions were filed in United States District Court for the NorthernDistrict of California (Case Nos. C06-05157, C06-05242, and C06-6877)purportedly as derivative actions on behalf of Ditech against certain of Ditech’scurrent and former officers and directors alleging that between 1999 and 2001certain stock option grants were backdated; that these options were notproperly accounted for; and that as a result false and misleading financialstatements were filed. These three actions have been consolidated under casenumber C06-05157. On December 1, 2006, a fourth derivative complaintmaking similar allegations against many of the same defendants was filed inCalifornia Superior Court for the County of Santa Clara (Case No.106-CV-075695).On April 19, 2007, the California Superior Court granted Ditech’s motionto stay the state court action pending the outcome of the federal consolidatedactions.

The defendants named inthe derivative actions are Timothy Montgomery, Gregory Avis, Edwin Harper,William Hasler, Andrei Manoliu, David Sugishita, William Tamblyn, Caglan Aras,Toni Bellin, Robert DeVincenzi, James Grady, Lee House, Serge Stepanoff, GaryTesta, Lowell Trangsrud, Kenneth Jones, Pong Lim, Glenda Dubsky, Ian Wright,and Peter Chung. These derivative complaints raise claims under Section 10(b) and10b-5 of the Securities Exchange Act, Section 14(a) of theSecurities Act, and California Corporations Code Section 25403, as well ascommon law claims for breach of fiduciary duty, unjust enrichment, waste ofcorporate assets, gross mismanagement, constructive fraud, and abuse of control.The plaintiffs seek remedies including money damages, disgorgement of profits,accounting, rescission, and punitive damages. With respect to the consolidatedfederal actions, the plaintiffs filed an amended consolidated complaint on March 2,2007, adding new allegations regarding another stock option grant. On April 2,2007, Ditech moved to dismiss the amended complaint based on plaintiffs’failure to make a demand on the board before bringing suit. On the same day,the individual defendants moved to dismiss the amended complaint for failure tostate a claim. On June 8, 2007, the Court heard oral argument on bothmotions. The Court has not yet issued a decision in either motion. Theseactions are in their preliminary stages; no discovery has taken place and notrial date has been set.

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

Not Applicable.

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**Part II**

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

**Market Information**

Ditech’scommon stock is quoted on the NASDAQ Global Market (formerly the NasdaqNational Market) under the symbol “DITC.” The following table shows the highand low sale prices per share of our common stock as reported on the NASDAQGlobal Market for the periods indicated:

| ** **     | ** ** | **Fiscal 2007** | ** ** | **Fiscal 2006** | ** ** |
|----------------|------------|----------------------|------------|----------------------|------------|
| ** **     | ** ** | **High**             | ** ** | **Low**              | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $                    | 11.44      |                 | $          | 7.62 |   | $ | 12.59 |   | $ | 6.35 |   |
| Second Quarter |       | $                    | 9.35       |                 | $          | 7.44 |   | $ | 8.21 |   | $ | 6.12 |   |
| Third Quarter  |       | $                    | 8.95       |                 | $          | 6.59 |   | $ | 9.25 |   | $ | 6.17 |   |
| Fourth Quarter |       | $                    | 8.87       |                 | $          | 7.09 |   | $ | 10.80 |   | $ | 8.82 |   |

 

On July 3, 2007 thelast reported sale price of our common stock as reported on the NASDAQ GlobalMarket was $8.18 per share.

**Holders**

According to the recordsof our transfer agent, there were 112 stockholders of record of Ditech’scommon stock at July 3, 2007. Because many of our shares of common stockare held by brokers and other institutions on behalf of stockholders, we areunable to estimate the total number of stockholders represented by these recordholders.

**Dividend Policy**

We have never declared orpaid any cash dividend on our capital stock and do not anticipate, at thistime, paying any cash dividends on our capital stock in the near future.

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**Stock PerformanceGraph(1)**

The following graph showsthe total stockholder return of an investment of $100 in cash on April 30, 2002for (i) our Common Stock; (ii) the NASDAQ Composite Index (U.S.) and (iii) theNASDAQ Telecommunications Index. All values assume reinvestments of the fullamount of all dividends.

**COMPARISONOF 5 YEAR CUMULATIVE TOTAL RETURN***

**Among Ditech Networks, Inc., The NASDAQ CompositeIndexAnd The NASDAQ Telecommunications Index**

*                    $100Invested on 4/30/02 in stock or index-including reinvestment of dividends.Fiscal year ending April 30.

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(1)          This section is not “solicitingmaterial,” is not deemed “filed” with the SEC and is not to be incorporated byreference in any filing of Ditech Networks under the 1933 Act or 1934 Act,whether made before or after the date hereof and irrespective of any generalincorporation language in any such filing.

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**Item6—Selected Financial Data**

Theconsolidated statement of operations data for the fiscal years ended April 30,2007, 2006 and 2005, and the consolidated balance sheet data as of April 30,2007 and 2006, have been derived from our audited consolidated financialstatements included in Item 8 of this Annual Report on Form 10-K.The consolidated statement of operations data for the fiscal years ended April 30,2004 and 2003, as adjusted to give effect to the discontinued operationspresentation of our optical business, see Note 4 of the Notes to theConsolidated Financial Statements, and the consolidated balance sheet data asof April 30, 2005, 2004, and 2003, have been derived from our consolidatedfinancial statements not included in this Annual Report on Form 10-K.The data set forth below should be read in conjunction with our consolidatedfinancial statements, including the notes thereto, set forth in “Item 8—FinancialStatements and Supplementary Data” of this Annual Report on Form 10-K,and with “Item 7—Management’s Discussion and Analysis of FinancialCondition and Results of Operations” included elsewhere in this Form 10-K.

| ** **                                                                                                    | ** ** | **Years Ended April 30,**                           | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                                    | ** ** | **2007**                                                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003(1)** | ** ** |
| ** **                                                                                                    | ** ** | **(in thousands, except per share data)** | ** ** |
| ** **                                                                                                    | ** ** | ** **                                                         | ** ** | **(as restated)** | ** ** |
| **Consolidated Statement of  Operations  Data:**                                                              |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Revenue                                                                                                       |       | $                                                                  | 84,004     |   | $ | 54,905 |   | $ | 94,055 |   | $ | 69,590 |   |   | $ | 35,088 |   |   |
| Cost of goods  sold                                                                                           |       | 27,140                                                             |       | 16,368 |   | 22,184 |   | 23,413 |   |   | 13,543 |   |   |
| Gross profit                                                                                                  |       | 56,864                                                             |       | 38,537 |   | 71,871 |   | 46,177 |   |   | 21,545 |   |   |
| Operating  expenses:                                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                                           |       | 24,496                                                             |       | 18,233 |   | 16,430 |   | 13,168 |   |   | 12,105 |   |   |
| Research and development                                                                                      |       | 20,835                                                             |       | 17,884 |   | 15,826 |   | 10,719 |   |   | 9,978 |   |   |
| General and administrative                                                                                    |       | 8,534                                                              |       | 6,568 |   | 7,244 |   | 5,308 |   |   | 5,269 |   |   |
| Amortization of purchased intangible assets                                                                   |       | 985                                                                |       | 821 |   | — |   | — |   |   | — |   |   |
| In-process research and development                                                                           |       | —                                                             |       | 700 |   | — |   | — |   |   | — |   |   |
| Restructuring charges                                                                                         |       | —                                                             |       | — |   | — |   | 275 |   |   | — |   |   |
| Total operating expenses                                                                                      |       | 54,850                                                             |       | 44,206 |   | 39,500 |   | 29,470 |   |   | 27,352 |   |   |
| Income (loss) from continuing operations                                                                      |       | 2,014                                                              |       | (5,669 | ) | 32,371 |   | 16,707 |   |   | (5,807 | ) |   |
| Other income, net                                                                                             |       | 6,689                                                              |       | 4,522 |   | 2,430 |   | 1,294 |   |   | 1,702 |   |   |
| Income (loss) from continuing operations before  income taxes and cumulative effect of accounting change |       | 8,703                                                              |       | (1,147 | ) | 34,801 |   | 18,001 |   |   | (4,105 | ) |   |
| Provision  (benefit) for income taxes                                                                         |       | 3,385                                                              |       | 262 |   | (36,100 | ) | 270 |   |   | — |   |   |
| Income (loss) from continuing operations before  cumulative effect of accounting change                       |       | 5,318                                                              |       | (1,409 | ) | 70,901 |   | 17,731 |   |   | (4,105 | ) |   |
| Discontinued operations:                                                                                      |       |                                                               |       |   |   |   |   |   |   |   |   |   |   |
| Loss from discontinued operations                                                                             |       | —                                                             |       | — |   | — |   | (2,538 | ) |   | (34,191 | ) |   |
| Income tax provision (benefit) from loss on  discontinued operations                                          |       | —                                                             |       | — |   | — |   | — |   |   | 129 |   |   |
| Gain (loss) on disposition                                                                                    |       | —                                                             |       | 887 |   | 94 |   | (7,142 | ) |   | — |   |   |
| Income tax expense (benefit) from gain (loss) on  disposition                                            |       | —                                                             |       | 361 |   | (110 | ) | (144 | ) |   | — |   |   |
| Income (loss)  from discontinued operations                                                                   |       | —                                                             |       | 526 |   | 204 |   | (9,536 | ) |   | (34,320 | ) |   |
| Cumulative effect of accounting change                                                                        |       | —                                                             |       | — |   | — |   | — |   |   | (36,837 | ) |   |
| Net income (loss)                                                                                             |       | $                                                                  | 5,318      |   | $ | (883 | ) | $ | 71,105 |   | $ | 8,195 |   |   | $ | (75,262 | ) |   |

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| Per share data                                                                          |   |   |   |   |   |   |   |   |   |   |   |   |   |
|-----------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Basic                                                                                   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from  continuing operations before cumulative effect of accounting change |   | $      | 0.16   |   | $      | (0.04  | )      | $      | 2.12   |   | $      | 0.56   |   |   | $ | (0.14 | ) |   |
| Discontinued operations                                                                 |   | — |   | 0.01   |   | 0.01   |   | (0.30  | )      |   | (1.13  | )      |   |
| Cumulative effect of  accounting change                                                 |   | — |   | — |   | — |   | — |   |   | (1.21  | )      |   |
| Net income (loss) per  share attributable to common stockholders                   |   | $      | 0.16   |   | $      | (0.03  | )      | $      | 2.13   |   | $      | 0.26   |   |   | $ | (2.48 | ) |   |
| Diluted                                                                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from  continuing operations before cumulative effect of accounting change |   | $      | 0.16   |   | $      | (0.04  | )      | $      | 2.02   |   | $      | 0.53   |   |   | $ | (0.14 | ) |   |
| Discontinued operations                                                                 |   | — |   | 0.01   |   | 0.00   |   | (0.29  | )      |   | (1.13  | )      |   |
| Cumulative effect of  accounting change                                                 |   | — |   | — |   | — |   | — |   |   | (1.21  | )      |   |
| Net income (loss) per  share attributable to common stockholders                   |   | $      | 0.16   |   | $      | (0.03  | )      | $      | 2.02   |   | $      | 0.24   |   |   | $ | (2.48 | ) |   |
| Number of shares used in per share calculations:                                        |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                                                                   |   | 32,579 |   | 32,119 |   | 33,408 |   | 31,734 |   |   | 30,371 |   |   |
| Diluted                                                                                 |   | 34,020 |   | 32,119 |   | 35,140 |   | 33,496 |   |   | 30,371 |   |   |

 

| ** **                           | ** ** | **Years Ended April 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Consolidated Balance Sheet Data:** |       |                                     |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents           |       | $                                        | 34,074     |   | $ | 35,707 |   | $ | 36,781 |   | $ | 45,610 |   | $ | 69,670 |   |
| Short-term investments               |       | 100,465                                  |       | 100,325 |   | 98,853 |   | 79,899 |   | 24,825 |   |
| Total assets                         |       | 226,384                                  |       | 219,313 |   | 209,720 |   | 150,548 |   | 126,441 |   |
| Total stockholders’ equity      |       | 211,945                                  |       | 198,581 |   | 197,265 |   | 135,400 |   | 116,138 |   |
|                                      |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          In response to a numberof derivative complaints filed against us surrounding our stock optionpractices, we, with the assistance of outside counsel, conducted an internalreview of the circumstances surrounding the stock option grants identified inthe derivative complaints as well as certain of our historical stock optionpractices. The internal review identified administrative items that werenon-material errors of approximately $1.0 million in stock-based compensationexpense for certain prior periods. The fiscal 2003 financial results reflectthe adjustment of $0.1 million to operating expense and $0.1 million todiscontinued operations. See Note 2 of Notes to the Consolidated FinancialStatements.

The selected financial data for the five years ended April 30,2007 reflects the following:

In accordance with SFAS 142, we ceased amortizinggoodwill and wrote off $36.8 million of goodwill in fiscal 2003.

In September 2002, we discontinued thedevelopment and marketing of our optical switch product, which resulted in asignificant decline in the level of optical losses subsequent to that point intime.

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

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

Following our acquisition of Jasomi, we wrote off $0.7million of in-process R&D in fiscal 2006 and amortized $1.0 million and$0.8 million of acquired intangible assets in fiscal 2007 and 2006,respectively.

In accordance withStatement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment, we began recognizing stock-based compensation expensebased on the fair value of equity instruments granted to employees beginning infiscal 2007. As a result, fiscal 2007 operating results include stock basedcompensation charges of $0.4 million, $2.7 million, $2.0 million and $1.1million in cost of goods sold, sales and marketing, research and developmentand general and administrative expenses, respectively. See Note 2 of Notes to theConsolidated Financial Statements.

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

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

**Overview**

We design, develop and market telecommunications equipmentfor use in canceling echo and enhancing voice quality in voice calls overwireline, wireless and internet protocol (IP) telecommunications networks. Ourproducts monitor and enhance voice quality and provide security in the deliveryof voice services. Since entering the voice processing market, we havecontinued to refine our echo cancellation products to meet the needs of theever-changing telecommunications marketplace. Our more recent productintroductions have leveraged the processing capacity of our newer hardwareplatforms to offer not only echo cancellation but also enhanced VQA featuresincluding noise reduction, acoustic echo cancellation, voice level control andnoise compensation through enhanced voice intelligibility. Since becoming a publiccompany in June 1999, our financial success has been primarily predicatedon the macroeconomic environment of U.S. wireline and, more recently, wirelesscarriers as well as our success in selling to the larger carriers. Since thebeginning of calendar year 2004, large North American telecommunicationsservice providers have engaged in merger and acquisition activity. Thisactivity largely drove our fiscal 2006 revenue decline of 42% as one of our twolargest fiscal 2005 U.S. customers was involved in post-merger integration and,consequently, orders from that customer in fiscal 2006 were nominal. Ourrevenue will continue to be heavily influenced by the buying trends of VerizonWireless, our largest customer in fiscal 2007 at 64% of our total worldwiderevenue. Our revenue also will continue to be primarily generated from sales ofour BVP-Flex, which accounted for 59% of our revenue in fiscal 2007. In anattempt to diversify our customer base, beginning in fiscal 2004 and throughoutfiscal 2005, we added sales and marketing resources to focus on new largeaccount opportunities in the United States. In the fourth quarter of fiscal2007, we signed a contract with one of these large domestic carriers andrealized our first revenue shipments. In the United States, we believe that ourcontinued focus on voice quality in the competitive wireless services landscapeand the continued expansion of wireless networks will be key factors in addingnew customers and driving our revenue growth. Internationally, we have alsoadded sales resources and invested in customer trials. The development of ourVQA feature set was targeted at the international GSM market. In fiscal 2006,Orascom Telecom Holding (Orascom) became our largest VQA customer to-date. Wewere able to add other international customers during fiscal 2007 making fiscal2007 our most geographically diverse revenue base and continuing ouradvancement toward our goal of greater 

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customer diversification. Wecontinue to focus on international mobile carriers who might best apply our VQAsolution.

We expect additional long-term opportunities forgrowth will occur in VoIP-based network deployments as there appears to be agrowing trend of service providers transitioning from traditionalcircuit-switched network infrastructure to VoIP. We have therefore directed themajority of our R&D spending, since the beginning of fiscal 2005, towardsthe development of our Packet Voice Processor, a new platform targetingVoIP-based network deployments. The Packet Voice Processor introduces cost-effectivevoice format transcoding capabilities and combines our VQA software and newlydeveloped PQA technology to improve call quality and clarity by eliminatingacoustic echo and voice level imbalances and reducing packet loss, delay andjitter. To further develop a presence in the VoIP market, we acquired Jasomi inJune 2005. Jasomi’s currently available PeerPoint C100 session bordercontroller enables VoIP calls to traverse the NAT and protects networks fromexternal attacks by admitting only authorized sessions, ensuring that reliableVoIP service can be provided to them. We are continuing to work on theintegration of the Packet Voice Processor and session border controllertechnologies to provide a more comprehensive solution to carriers’ borderservices needs. In fiscal 2007, we have continued to recognize modest revenuefrom PeerPoint and have sold modest levels of our Packet Voice Processor.

*Exitof Optical Business.**  *InMay 2003, we announced a change to our strategic direction. We decided tofocus all of our assets in continuing to grow our voice processing business,including our echo cancellation and VQA products, and as a result we decided tosell our optical communications business. In July 2003, we completed theprimary step in our planned exit of our optical communications business throughthe sale of a large portion of the assets of the optical communicationsbusiness to JDS Uniphase Corporation (“JDSU”). The assets sold consistedprimarily of inventory, certain specified optical-related equipment andintellectual property rights, which were sold for an aggregate purchase priceof up to approximately $6.5 million in cash, of which (a) approximately$1.4 million was paid to us at closing, (b) $0.2 million to be paidto us one year from the closing (subject to reduction in the event anysuccessful indemnification claims are made against us), and (c) up to anadditional $4.9 million to be paid to us, which is comprised of up to $0.9million based on the level of inventory consumed by JDSU, and up to$4.0 million based on revenues generated by the optical business acquiredby JDSU through June 30, 2005, if any. Additionally, JDSU had the right torequire us to reimburse JDSU for any purchased but unused inventory at June 30,2004, up to $2.0 million, which right expired as of July 31, 2004. JDSUalso had indemnification rights in connection with the performance of certainwarranty obligations relating to optical products that were sold by us on orprior to July 16, 2003. In fiscal 2004, we recognized $0.9 millionassociated with the level of revenue generated by JDSU since the close of thesale. The proceeds were substantially offset by increased loss accrualsassociated with exiting our international optical operations and an estimatedloss provision associated with our indemnification of the realizable value ofthe inventory purchased by JDSU. The net effect of these items was reported asan incremental net loss on disposition of discontinued operations in fiscal2004 of $1.1 million in the Consolidated Statement of Operations. Infiscal 2005, income from discontinued operations was due to adjustments neededto reflect actual costs incurred and to recognize a tax benefit due to therelease of our valuation reserve. In June 2006, we and JDSU came to amutual settlement and release whereby JDSU paid us $0.7 million and released usfrom our warranty obligation. In addition, in June 2006, we completed theclosure of our international optical operations. See Note 4 of Notes tothe Consolidated Financial Statements.

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

*AcquisitionHistory.**  *Inthe last five fiscal years, we have completed one acquisition. In June 2005,we acquired Jasomi, which developed and sold session border controllers thatenable VoIP calls to traverse the NAT and protect networks from externalattacks by admitting only authorized sessions, ensuring that 

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reliable VoIP service canbe provided to them. The integration of our Packet Voice Processor and Jasomi’ssession border control technology may enable Ditech to provide a morecomprehensive solution to carriers’ border service needs. Consideration for theacquisition included $14.8 million in cash, escrow payments, vestedoptions assumed, acquisition costs, and net liabilities assumed plus $7.0million in non-transferable convertible notes. The payment of the full$7.0 million principal amount of the convertible notes is contingent onthe retention of a specified number of designated employees and is broken intotwo tranches. The conditions of the first tranche were met in June 2006 atwhich point $3.0 million was paid and reflected as an adjustment to thepurchase price. The second tranche of $4.0 million was paid in July 2007,after the conditions related to that tranche were met. The second tranche isnot reflected in the purchase price as of April 30, 2007. We additionallyissued shares of Ditech restricted stock to new employees hired as part of theacquisition. See Note 5 of Notes to the Consolidated Financial Statements.

*OurCustomer Base.**  *Historically,the majority of our sales have been to customers in the United States.These customers accounted for approximately 71%, 87%, and 91% of our revenue infiscal 2007, 2006 and 2005, respectively. However, sales to some of our U.S.customers may result in our products purchased by these customers eventuallybeing deployed internationally, especially in the case of any originalequipment manufacturer that distributes overseas. To date, the vast majority ofour international sales have been export sales and denominated in U.S. dollars.We expect that as we expand shipments of our newer voice processing products,which are targeted at GSM networks, international revenue will begin to becomea larger percentage of our overall revenue.

Our revenue historically has come from a small numberof customers. Our largest customer accounted for approximately 64% of our totalrevenue in fiscal 2007. Our five largest customers accounted for approximately88%, 88%, and 91% of our revenue in fiscal 2007, 2006 and 2005, respectively.Consequently, the loss of any one of our largest customers, without anoffsetting increase in revenue from existing or new customers, would have anegative and substantial effect on our business. This customer concentrationrisk was evidenced in fiscal 2006 as revenue was approximately 58% of ourfiscal 2005 revenue primarily due to a lack of orders from one of our twolargest fiscal 2005 customers. This caused fiscal 2006 to result in a net loss.

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

Revenue Recognition—In applying our revenuerecognition and allowance for doubtful accounts policies, the level of judgmentis generally relatively limited, as the vast majority of our revenue has beengenerated by a handful of customers. These customers are some of the largestwire-line and wireless carriers in the United States and our relationships withthem are documented in contracts, which clearly highlight potential revenuerecognition issues, such as passage of title and risk of loss. As of April 30,2007, we had deferred $6.1 million of revenue. To the extent that we havereceived cash for some or all of a given deferred revenue transaction, wereported it on the Consolidated Balance Sheet as a deferred revenue liability.However, to the extent that we have not collected cash related to the deferredrevenue 

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transaction, we reflectthe deferred revenue as a reduction in the corresponding account receivablebalance. Of the $6.1 million of revenue deferred as of April 30,2007, $4.0 million related to deferrals associated primarily with installationsand $2.1 million was associated with maintenance contracts. In dealing withsmaller customers, we closely evaluate the credit risk of these customers. Inthose cases where credit risk is deemed to be high, we either mitigate the riskby having the customer post a letter of credit, which we can draw against on aspecified date to effectively provide reasonable assurance of collection, or wedefer the revenue until customer payment is received.

Investments—Investment securities that have maturitiesof more than three months at the date of purchase but remaining maturities ofless than one year and auction rate securities, which we are able to liquidateon 28 or 35 day auction cycles, we consider short-term investments. We considerother investment securities with remaining maturities of one year or more aslong-term investments. Short-term investments currently consist primarily ofcorporate bonds and asset backed securities. We have classified our short-termand long-term investments as available-for-sale securities in the accompanyingconsolidated financial statements. We carry available-for-sale securities atfair value, with unrealized gains and losses reported in a separate componentof stockholders’ equity. We include realized gains and losses and declines invalue judged to be other-than-temporary, if any, on available-for-salesecurities in other income based on specific identification. We includeinterest on securities classified as available-for-sale in interest income.

Inventory Valuation—In conjunction with our ongoinganalysis of inventory valuation, we are constantly monitoring projected demandon a product by product basis. Based on these projections we evaluate thelevels of allowances required both for inventory on hand, as well as inventoryon order from our contract manufacturer. Although we believe we have beenreasonably successful in identifying allowance requirements in a timely manner,sudden changes in future buying patterns from our customers, either due to ashift in product interest and/or a complete pull back from their expected orderlevels could result in some larger than anticipated write-downs beingrecognized, such as the OC-3 write-down recorded in fiscal 2002. For theOC-3 write-down, the complete pull back from the forecasted demand by theprimary customer for this product resulted in a $3.5 million write-down ofthe OC-3 inventory. However, beginning in 2003, the addition of a fewlarge new customers helped to utilize a large portion of the inventory whichhad been written down and we consequently sold $2.2 million and $0.5 million ofwritten-down OC-3 inventory in fiscal 2004 and 2003, respectively. Wesold no additional OC-3 inventory in fiscal 2007, 2006 or 2005. However,we sold $0.3 million, $0.6 million and $0.9 million of other previouslywritten-down inventory in fiscal 2007, 2006 and 2005, respectively. Fiscal 2006sales of previously written-down inventory had a negligible impact on thefiscal 2006 gross margin as we sold the inventory for approximately its netbook value.

Goodwill—Our methodology for allocating a portion ofthe purchase price to goodwill in connection with the purchase of Jasomi wasbased on established valuation techniques in the high-technology communicationsequipment industry. We measure goodwill as the excess of the cost ofacquisition over the sum of the amounts assigned to tangible and identifiableintangible assets acquired, less liabilities assumed. We do not amortizegoodwill. The goodwill recorded in the Consolidated Balance Sheet as of April 30,2007 was $12.6 million.

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

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evaluate the recoverabilityof our amortizable purchased intangible assets based on an estimate of theundiscounted cash flows resulting from the use of the related asset group andits eventual disposition. The asset group represents the lowest level for whichcash flows are largely independent of cash flows of other assets andliabilities. We base measurement of an impairment loss for long-lived assetsthat we expect to hold and use on the difference between the fair value andcarrying value of the asset. We report long-lived assets to be disposed of atthe lower of carrying amount or fair value less costs to sell.

Accounting for Stock-based Compensation—On May 1,2006, we adopted Statement of Financial Accounting Standards No. 123(revised 2004), Share-Based Payment,(“SFAS 123R”) which requires the measurement and recognition ofcompensation expense for all stock-based payment awards made to employees anddirectors including employee stock options, restricted stock, restricted stockunits (“RSUs”) and employee stock purchases under our employee stock purchaseplan based on estimated fair values. SFAS 123R supersedes the previousaccounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”),as allowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”).In March 2005, the Securities and Exchange Commission issued StaffAccounting Bulletin No. 107 (“SAB 107”) relating toSFAS 123R, which provided further guidance related to the application ofSFAS 123R for public companies. We have applied the provisions of SAB 107in conjunction with our adoption of SFAS 123R.

Cost of Warranty—At the time that we recognizerevenue, we accrue for the estimated costs of the warranty we offer on ourproducts. We currently offer hardware warranties on our products ranging fromtwo to five years and one year software warranties. The warranty generallyprovides that we will repair or replace any defective product and providesoftware bug fixes within the term of the warranty. We base our accrual for theestimated warranty on our historical experience and expectations of futureconditions. To the extent we experience increased warranty claim activity orincreased costs associated with servicing those claims, we may revise ourestimated warranty accrual to reflect these additional exposures, which wouldresult in a decrease in gross profits. As of April 30, 2007, we hadrecorded $0.8 million of accruals related to estimated future warranty costs.In general, we have been able to closely estimate the level of warrantyexposure on our products, and the level of adjustment required to the reservehas been relatively insignificant, except for the last two fiscal years whereinwe have reversed warranty accruals established in prior years due either to acontractual release from our warranty obligation of $0.5 million associatedwith changes in estimates attributable to exiting our optical business, whichwas reported as an adjustment to discontinued operations in fiscal 2006, or dueto a customer electing not to pursue a recall of a potentially defectivecomponent in fiscal 2007, resulting in a $0.4 million reversal. See Note 3of the Notes to the Consolidated Financial Statements.

Accounting for Income Taxes—We are subject to incometaxes in both the United States and certain other foreign jurisdictions.Significant judgment is required in evaluating our tax positions anddetermining our provision for income taxes.

During the ordinary course of business, there arecertain transactions and calculations for which the ultimate tax determinationis uncertain. We establish reserves for tax-related uncertainties based onestimates of whether, and the extent to which, additional taxes and interestwill be due. We establish these reserves when, despite our belief that our taxreturn positions are fully supportable, we believe that certain positions arelikely to be challenged and may not be fully sustained on review by taxauthorities. We adjust these reserves in light of changing facts andcircumstances, such as the closing of a tax audit or the refinement of anestimate. Although we believe our reserves are reasonable, no assurance can begiven that the final tax outcome of these matters will not be different fromthat which is reflected in our historical income tax provisions and accruals.To the extent that the final tax outcome of these matters is different than theamounts recorded, these differences will impact the provision for income taxesin the period in which such determination is made. The provision for incometaxes includes the impact of reserve provisions and changes to reserves that weconsider appropriate, as well as the related net interest.

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Significant judgment is also required in determiningany valuation allowance recorded against deferred tax assets. In assessing theneed for a valuation allowance, we consider all available evidence includingpast operating results, estimates of future taxable income, and the feasibilityof tax planning strategies. Currently, we do not have a valuation allowance onany of our deferred tax assets (see the discussion on tax net operating lossesand research credit carryforward amounts). In the event that we change ourdetermination as to the amount of deferred tax assets that can be realized, wewill establish a valuation allowance with a corresponding impact to theprovision for income taxes in the period in which such determination is made.

We estimate our actual current tax exposure togetherwith our temporary differences resulting from differing treatment of items suchas valuationallowances for bad debts and inventory, for tax and accounting purposes. Thesetemporary differences, in conjunction with net operating loss and tax creditcarryforwards, result in deferred tax assets and liabilities. Of our $45.8million deferred tax assets at April 30, 2007, $27.7 million and $9.9million, respectively, are associated with net operating loss and tax creditcarryforwards. The remaining $8.2 million of deferred tax assets are associatedwith temporary differences. At least once per quarter, we assess the likelihoodthat our net deferred tax assets will be recovered from future taxable incomeand to the extent we believe that recovery is no longer more likely than not, weestablish a valuation allowance. Significant management judgment is required indetermining our provision for income taxes, our deferred tax assets andliabilities and any valuation allowance recorded against our net deferred taxassets. On an annual basis, or more frequently if warranted by adverse changesin our business, we review income projections to ensure that our pre-tax incomeis sufficient to recover our deferred tax assets. We specifically review thetiming of our pre-tax income in relation to the expiration of our net operatingloss carryforwards and tax credits. On a quarterly basis, we review theexpiration dates of our net operating loss carryforwards that we believe to beat near-term risk. In addition, we complete a study on the impact of Section 382of the Internal Revenue Code on at least a semi-annual basis to determinewhether a change in ownership may limit the value of our net operating losscarryforwards. However, as noted in “Item 1A—Risk Factors,” there are risks toour future financial performance and the financial impact of the risks may bedifficult to anticipate. Consequently, there is a possibility that we may notmeet the minimum level of U.S. pre-tax income to utilize our net operating losscarryforwards such that all or a portion of our deferred tax assets will becomeimpaired. In order to evaluate the sensitivity of possible impairment, weapplied a hypothetical 10% decrease to future pre-tax income. This hypotheticaldecrease would not result in the impairment of our deferred tax assets.

Beginning in fiscal 2002, we determined that avaluation allowance against our then existing deferred tax asset position wasnecessary. We based this decision on the fact that in the fourth quarter of2002, we generated sufficient operating losses on a tax basis to fully recoverall taxes paid in prior years. In addition, our expectations of limitedprofitability, if any, due to the softness in the telecommunication industryduring fiscal 2003, combined with the significant tax losses generated by thesale of our echo cancellation software technology led us to conclude that therecovery of our deferred tax assets was no longer more likely than not. In thesecond quarter of 2005, based on the level of historical taxable incomeand projections for future taxable income over the periods that our deferredtax assets are deductible, we determined that it was more likely than not thatour deferred tax assets would be realized. We therefore released the valuationallowance of $51.6 million in fiscal 2005.

Our effective tax ratesdiffer from the statutory rate primarily due to stock-based compensation,research and experimentation tax credits, state taxes, tax impact of foreignoperations, and changes in the state tax rate as it relates to certain deferredtax assets specifically for California purposes only. The state tax ratechanged with respect to this deferred tax asset as a result of our filing taxreturns in additional other states. The effective tax rate was 38.9%, (22.9)%,and (103.6)% for fiscal 2007, 2006, and 2005, respectively. We are notcurrently under audit by any tax jurisdiction. We regularly assess thelikelihood of 

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adverseoutcomes resulting from these examinations to determine the adequacy of ourprovision for income taxes.

*Recent Accounting Pronouncements.*

In July 2006, the FASB issued Interpretation No. 48,“*Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109.*” Interpretation 48 clarifies theaccounting for uncertainty in income taxes recognized in an entity’s financialstatements in accordance with Statement 109 and prescribes a recognitionthreshold and measurement attribute for financial statement disclosure of taxpositions taken or expected to be taken on a tax return. Additionally,Interpretation 48 provides guidance on derecognition, classification, interestand penalties, accounting in interim periods, disclosure and transition. Interpretation48 is effective for fiscal years beginning after December 15, 2006, withearly adoption permitted. We will adopt Interpretation 48 in the first quarterof fiscal 2008 and are currently evaluating whether adoption will have amaterial effect on our overall results of operations or financial position.

In September 2006, the FASB issued Statement No. 157,*Fair Value Measurements* (“SFAS 157”).SFAS 157 defines fair value, establishes a framework and guidance regarding themethods for measuring fair value, and expands related disclosures about thosemeasurements. SFAS 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007, and interim periods withinthose fiscal years. We are currently assessing the impact that SFAS 157 willhave on our results of operations and financial position.

In February 2007, theFASB issued Statement No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities—including an amendment to FAS 115*(“SFAS159”). SFAS 159 allows entities to choose, at specified election dates, tomeasure eligible financial assets and liabilities at fair value in situationsin which they are not otherwise required to be measured at fair value. If acompany elects the fair value option for an eligible item, changes in that item’sfair value in subsequent reporting periods must be recognized in current earnings.SFAS 159 also establishes presentation and disclosure requirements designed todraw comparison between entities that elect different measurement attributesfor similar assets and liabilities. SFAS 159 is effective for fiscal yearsbeginning after November 15, 2007. We are currently assessing the impactthat SFAS 159 will have on our results of operations and financial position.

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**Results ofOperations**

The following table setsforth certain items from our consolidated statements of operations as a percentageof revenue for the periods indicated:

*Results of Operations*

| ** **                                                                  | ** ** | **Years Ended April 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                  | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue                                                                     |       | 100.0                                    | %          | 100.0 | % | 100.0 | % |
| Cost of goods  sold                                                         |       | 32.3                                     |       | 29.8 |   | 23.6 |   |
| Gross profit                                                                |       | 67.7                                     |       | 70.2 |   | 76.4 |   |
| Operating expenses:                                                         |       |                                     |       |   |   |   |   |
| Sales and marketing                                                         |       | 29.2                                     |       | 33.2 |   | 17.5 |   |
| Research and development                                                    |       | 24.8                                     |       | 32.6 |   | 16.8 |   |
| General and administrative                                                  |       | 10.2                                     |       | 11.9 |   | 7.7 |   |
| Amortization of purchased intangible assets                                 |       | 1.2                                      |       | 1.5 |   | — |   |
| In-process research and development                                         |       | —                                   |       | 1.3 |   | — |   |
| Total operating expenses                                                    |       | 65.4                                     |       | 80.5 |   | 42.0 |   |
| Income (loss) from continuing operations                                    |       | 2.3                                      |       | (10.3 | ) | 34.4 |   |
| Other income, net                                                           |       | 8.0                                      |       | 8.2 |   | 2.6 |   |
| Income (loss) from continuing operations before  provision for income taxes |       | 10.3                                     |       | (2.1 | ) | 37.0 |   |
| Provision  (benefit) for income taxes                                       |       | 4.0                                      |       | 0.5 |   | (38.4 | ) |
| Income (loss) from continuing operations                                    |       | 6.3                                      |       | (2.6 | ) | 75.4 |   |
| Discontinued  operations:                                                   |       |                                     |       |   |   |   |   |
| Gain (loss) on disposition                                                  |       | —                                   |       | 1.6 |   | 0.1 |   |
| Income tax expense (benefit) from gain (loss) on  disposition               |       | —                                   |       | 0.6 |   | (0.1 | ) |
| Income (loss) from discontinued operations                                  |       | —                                   |       | 1.0 |   | 0.2 |   |
| Net income (loss)                                                           |       | 6.3                                      | %          | (1.6 | )% | 75.6 | % |

 

***Discussion of Fiscal Years ended April 30, 2007,2006, and 2005***

*Revenue*

| ** ** | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)   from Prior Year** | ** ** |
|------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| ** ** | ** ** | **2007**                                 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** ** | ** ** | **$s in thousands**            | ** ** |
| Revenue    |       | $                                        | 84,004     |                                                     | $          | 54,905 |   | $ | 94,055 |   | $ | 29,099 |   | $ | (39,150 | ) |
| % Change   |       |                                     |       |                                                     |       |   |   | 53.0 | % | (41.6 | )% |
|            |            |                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

The increase in revenue in fiscal 2007 compared tofiscal 2006 was driven, in part, by increased shipments to our domesticwireless customers, primarily Verizon, as they continued to expand and updatetheir networks. However, the largest impact on our year-over-year revenuegrowth was the growth in our international revenues. International revenuesgrew by approximately $17.2 million, largely driven by new customers in theMiddle East and Latin America regions. The decrease in revenue in fiscal 2006compared to fiscal 2005 was primarily due to a lack of orders from Nextel, oursecond largest fiscal 2005 customer, and to a level of shipments to our largestfiscal 2005 customer, Verizon, more consistent with historical shipments tothem. In December 2004, Nextel announced a plan to merge with Sprint. As aresult of any merger, product purchases for network deployment may be reviewed,postponed or canceled based on 

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revised plans fortechnology or network expansion for the merged entity. We believe this is whathas happened at Nextel and, consequently, our fiscal 2006 revenue from Nextelwas nominal compared to 37% of our total worldwide revenue, or$34.9 million, in fiscal 2005.

In fiscal 2007, our largest customer, Verizon, adomestic wireless carrier, accounted for 64% of our total worldwide revenue, ascompared to 79% in fiscal 2006 and 49% in 2005. Our second largest customer infiscal 2007 and 2006 was Orascom Telecom, an international carrier thataccounted for 14% and 3% of worldwide revenue, respectively. Nextel, our secondlargest customer in 2005, accounted for 37% of worldwide revenue.

In fiscal 2007 and 2006, sales of our Broadband VoiceProcessor Flex (BVP-Flex) accounted for 59% and 81% of our revenue,respectively. Because the BVP-Flex provides increased flexibility and easierinstallation, it has been critical in helping us to acquire and retain our keydomestic strategic customers, most prominently Verizon. In fiscal 2004, weintroduced our VQA product, which includes our new voice quality features andis primarily targeted at the international GSM market. Although we expected thesales of VQA products to be higher in the fiscal 2006 and 2005 based on thenumber of customer trials in which we were engaged, we did not realizesignificant growth in revenue from this product until very late in fiscal 2006and throughout fiscal 2007. During fiscal 2007, sales of our VQA productaccounted for approximately 20% of our worldwide revenue. While the revenue hasbeen slow to materialize, we continue to believe that VQA presents materialrevenue opportunities, and we will therefore continue to invest in ourinternational infrastructure and in customer trials.

Following the success of our BVP-Flex, revenue overthe three fiscal years has been generated largely from domestic sales, whichrepresented 71%, 87%, and 91% of our fiscal 2007, 2006 and 2005 revenue,respectively. As noted in the preceding paragraph, our international growth hasprimarily been dependent on our success in selling VQA. Although fiscal 2007represents our most successful year of selling to international markets, weexpect that in the coming year the international portion of our business willcontinue to grow as a percentage of overall sales as we realize more sales ofour VQA applications. However, we expect that our domestic customers willcontinue to represent the majority of our revenue for the foreseeable future.

Revenue levels for fiscal2008 will be dependent on our success in adding new customers domestically andinternationally, the network technology and deployment plans of the NorthAmerican telecommunication service providers and the market acceptance of ourPacket Voice Processor. See “Item 1A-Risk Factors” for discussions ofrisks related to customer concentration and other factors, which could impactthe timing and level of revenue.

See our cautionary languagein the first paragraph of “Item 1. Business” regarding forward-lookingstatements such as the statements made in the prior paragraphs about ourexpectations regarding our future revenue, as well as statements regarding ourexpectations in each of the categories below.

*Cost of Goods Sold*

| ** **          | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)   from Prior Year** | ** ** |
|---------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **          | ** ** | **2007**                                 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **          | ** ** | **$s in thousands**            | ** ** |
| Cost of Goods  Sold |       | $                                        | 27,140     |                                                     | $          | 16,368 |   | $ | 22,184 |   | $ | 10,772 |   | $ | (5,816 | ) |
| % Change            |       |                                     |       |                                                     |       |   |   | 65.8 | % | (26.2 | )% |
|                     |            |                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

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Cost of goods sold consists of direct material costs,personnel costs for test and quality assurance, costs of licensed technologyincorporated into our products, post-sales installation costs, provisions forinventory and warranty expenses and other indirect costs. The increase in costof goods sold in fiscal 2007 as compared to fiscal 2006 was largely due to theincrease in business volume. However, cost of goods sold did not increase indirect proportion with the increase in revenue due to: (1) the inclusionof $0.4 million of costs associated with stock compensation charges pursuant toSFAS 123R in fiscal 2007, and (2) the customer/product mix which was moreheavily weighted to lower margin international customers and products, as wellas the other factors discussed in the discussion of gross margin below. 

The decrease in cost ofgoods sold in fiscal 2006 was primarily driven by the decrease in businessvolume as compared to fiscal 2005. However, cost of goods sold did not decreasein direct proportion to the decrease in sales due to (1) the higherstandard cost of the Flex 400 sales in fiscal 2006 relative to the standardcost of BVP-Flex sales in fiscal 2005 and (2) higher service costs due toinstallations at our largest customer and one of our new internationalcustomers. The Flex 400 combines echo cancellation technology with elements ofour VQA suite of voice enhancement software to provide quality enhancement. Ourinventory provisions recorded were $0.3 million, $0.2 million, and $1.0 millionfor fiscal 2007, 2006, and 2005, respectively. Our analysis of gross profitbelow discusses the other factors driving changes in cost of goods sold.

*Gross Margin*

| ** **     | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)   from Prior Year** | ** ** |
|----------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **     | ** ** | **2007**                                 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **     | ** ** | **$s in thousands**            | ** ** |
| Gross Profit   |       | $                                        | 56,864     |                                                     | $          | 38,537 |   | $ | 71,871 |   | $ | 18,327 |   | $ | (33,334 | ) |
| Gross Margin % |       | 67.7                                     | %          | 70.2                                                     | %          | 76.4 | % | (2.5) pts |   | (6.2) pts |   |
|                |            |                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

As discussed above, the primary reasons for the 2.5percentage point decline in gross margin in fiscal 2007 from fiscal 2006 werethe inclusion of approximately $0.4 million of stock compensation, due toadoption of SFAS 123R in fiscal 2007, and the customer/product mix, which washeavily impacted by an increased percentage of our revenues being derived fromlower margin international markets. Partially offsetting the negative impactsof the international revenue mix was an increase, albeit still a relativelyminor percentage of our overall revenue, in higher margin maintenance revenue. Alsoimpacting gross margin unfavorably was an increase in the level of installationservice spending to support both our international and domestic customer growth.Partially offsetting these net negative factors on gross margin was thecessation of amortization of the technology asset established upon the sale ofour core echo cancellation technology in fiscal 2002. This resulted in a grossprofit improvement of approximately $0.7 million in fiscal 2007.  Fiscal2007 gross margin also benefited from the sale of approximately $0.3 million ofpreviously written-down inventory and the reversal of approximately $0.4million of warranty reserves due to the favorable resolution of a potentialrecall of a defective component in one of our older products with a pastcustomer.

The primary reasons for the 6.2 percentage pointdecrease in gross margin in fiscal 2006 from fiscal 2005 were (1) theunfavorable customer and product mix, which included the impact of the higherstandard cost of the Flex 400 sales relative to the standard cost of BVP-Flexand lower margin fiscal 2006 international sales, and (2) higher servicecosts due to installations at our largest customer and one of our newinternational customers. Those unfavorable changes were partially offset by acombination of higher overhead utilization and lower manufacturing costs, lowerstandard product costs relative to fiscal 2005 and improved warranty andinventory obsolescence experience. In fiscal 2006, we sold $0.6 million ofpreviously written-down inventory at approximately net book value.

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We expect gross margins inthe fiscal 2008 to be approximate those experienced in fiscal 2007 based onforecasted product and customer mix and the impact of continued compensationcharges due to recording stock compensation expense pursuant to SFAS 123R. Overthe next several quarters, if we are successful in international deployment, weexpect to experience continued pricing pressures as we expand the distributionof our products through value-added resellers and distributors.

*Sales and Marketing*

| ** **                   | ** ** | ** **                               | ** ** | ** **                    | ** ** | ** ** | ** ** | **Increase/(Decrease)** | ** ** |
|------------------------------|------------|------------------------------------------|------------|-------------------------------|------------|------------|------------|-------------------------|------------|
| ** **                   | ** ** | **Years ended April 30,** | ** ** | **from Prior Year** | ** ** |
| ** **                   | ** ** | **2007**                                 | ** ** | **2006**                      | ** ** | **2005**   | ** ** | **2007**                | ** ** | **2006** | ** ** |
| ** **                   | ** ** | **$s in thousands**            | ** ** |
| Sales and  Marketing Expense |       | $                                        | 24,496     |                          | $          | 18,233     |       | $                       | 16,430     |   | $ | 6,263 |   | $ | 1,803 |   |
| % of Revenue                 |       | 29.2                                     | %          | 33.2                          | %          | 17.5       | %          | (4.0) pts               |       | 15.7 pts |   |
|                              |            |                                          |            |                               |            |            |            |                         |            |  |  |  |  |  |  |  |

 

Sales and marketing expenses primarily consist ofpersonnel costs, including commissions and costs associated with customerservice, travel, trade shows and outside consulting services. Salary andrelated expenses increased $2.3 million in fiscal 2007 compared to fiscal 2006primarily due to incremental hiring of domestic personnel and marketingpersonnel to support introduction of our VoIP product offerings, and pre- andpost-sales engineers to support a greater level of installation activity andour VoIP products. Fiscal 2007 salary and related costs included stock-basedcompensation associated with adoption of SFAS 123R, which contributed anadditional $2.5 million of the increase in spending in fiscal 2007. The otherkey increases were attributable to: (1) a $0.7 million increase in agentfees associated with international sales growth; (2) a $0.4 millionincrease in travel costs related to increased customer contacts related tointernational expansion and expansion of our PVP trials; and (3) a $0.4million increase in amortization of field demonstration and evaluation systemsassociated with the protracted nature of customer evaluations of our VQA andVoIP products. 

Salary and related expenses increased $2.1 million infiscal 2006 compared to fiscal 2005 primarily due to employees acquired fromJasomi, incremental hiring of international salespersons, hiring pre- andpost-sales engineers to support a greater level of installation activity andthe introduction of the Packet Voice Processor, and the hiring of a new salesvice president. Salary and related costs included the incremental salaries andstock-based and convertible debenture amortization associated with the Jasomiacquisition discussed in more detail in “Acquisition-RelatedCompensation Expense” below. We incurred incremental costs ofapproximately $0.5 million for participation in trade shows primarilyshowcasing our Packet Voice Processor applications. Travel and related costsincreased $0.4 million over the prior year due to support required forinternational product evaluations of our VQA applications. Third partyinstallation expense increased $0.3 million compared to fiscal 2005 to supportthe great level of installation activity. Those increases were partially offsetby an increase in absorption of service expenses to cost of sales of $0.9million due to installation support requirements at our largest customer.

We expect that our salesand marketing expenses in fiscal 2008 will be relatively consistent with thelevel experienced in fiscal 2007 due to anticipated stability in the level ofstaffing across the sales, marketing and service organizations and a moretargeted marketing program, the savings from which should substantially offsetincreased variable compensation and agent fees tied to anticipated increases insales levels. 

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*Research and Development*

| ** **                        | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)   from Prior Year** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                        | ** ** | **2007**                                 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                        | ** ** | **$s in thousands**            | ** ** |
| Research and  Development Expense |       | $                                        | 20,835     |                                                     | $          | 17,884 |   | $ | 15,826 |   | $ | 2,951 |   | $ | 2,058 |   |
| % of Revenue                      |       | 24.8                                     | %          | 32.6                                                     | %          | 16.8 | % | (7.8) pts |   | 15.8 pts |   |
|                                   |            |                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

Research and development expenses primarily consist ofpersonnel costs, contract consultants, materials and supplies used in thedevelopment of voice processing products. The increase in spending in fiscal2007 was largely driven by salary and related costs which increased $1.7million due to increases in headcount in the engineering area and meritincreases and $1.3 million associated with stock compensation charges attributableto the adoption of SFAS 123R in fiscal 2007. In addition to these increases, weexperienced increases in outside service costs to supplement headcount demandsand increased deprecation expense associated with increase lab equipment tosupport new product design and test and increased headcount levels totaling$0.6 million. The latter increases were substantially offset by a reduction inspending on consumable materials due to the later stage of development of ourproducts in fiscal 2007 as compared to fiscal 2006.

Salary and related costs increased $2.1 million infiscal 2006 compared to fiscal 2005. The increase in spending was primarilyassociated with engineers hired as part of our acquisition of Jasomi and ourresearch and development efforts for our new packet-based voice products.Salary and related costs included the incremental salaries and stock-based andconvertible debenture amortization associated with the Jasomi acquisitiondiscussed in more detail in “Acquisition-RelatedCompensation Expense” below. Depreciation, information technologyrelated costs and maintenance on software and equipment used by the engineeringdepartments accounted for an aggregate increase of $1.1 million in fiscal 2006due, in large part, to the increased demands from the larger engineeringworkforce needed to support our existing voice products, as well as our moveinto packet-based voice products which required purchases of lab equipment.Travel related expense increased $0.3 million for the year due to increased supportof field trials and travel between our Canada location and our Californiaheadquarters. Those increases were partially offset by decreases of $1.2million in outside service expense. That expense declined based on our stage inPacket Voice Processor development and our hiring of additional regularemployees to complete the work. Additionally, facilities expense allocated toresearch and development declined $0.3 million due to the renegotiation of ourheadquarters lease.

We expect modest increasesin our research and development spending in fiscal 2008 as we developvariations of our PVP product for use in emerging wireless networks, which willresult in increases in headcount, outside services and consumed materials. 

*General and Administrative*

| ** **                          | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|-------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | **2007**                                 | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                          | ** ** | **$s in thousands**            | ** ** |
| General and  Administrative Expense |       | $                                        | 8,534      |                                               | $          | 6,568 |   | $ | 7,244 |   | $ | 1,966 |   | $ | (676 | ) |
| % of Revenue                        |       | 10.2                                     | %          | 11.9                                               | %          | 7.7 | % | (1.7) pts |   | 4.2 pts |   |
|                                     |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

General andadministrative expenses primarily consist of personnel costs for corporateofficers, finance and human resources personnel, as well as insurance, legal,accounting and consulting costs. The increase in fiscal 2007 spending islargely due to the adoption of SFAS 123R, which resulted in $1.1 million ofstock compensation. The increase was also impacted by other salary relatedcosts, which increased due 

40

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to increased headcount and annual merit increases totalingapproximately $0.5 million and a $0.3 million increase in professional fees attributableto the various legal matters that we are currently addressing.

The decrease in fiscal 2006 spending over fiscal 2005spending is largely due to fiscal 2006 outside services for consulting andaudit costs related to Sarbanes-Oxley compliance and taxes declining $1.1million compared to fiscal 2005, primarily because the workload wassignificantly less in the second year of Sarbanes-Oxley compliance. Thosereductions were offset by the cost of legal work related to the class actionlawsuits, which resulted in an increase of $0.4 million compared to fiscal2005.

We expect a slightincrease in general and administrative expenses in fiscal 2008 due to plannedincreases in base pay and variable compensation and professional fees. 

*Acquisition-RelatedCompensation Expense*

In fiscal 2006, we recorded compensation expenserelated to the vesting of assumed stock options and the restricted stock grantsmade in connection with the June 30, 2006 acquisition of Jasomi. Deferredstock-based compensation represents the intrinsic value of the unvested portionof options assumed and restricted shares granted to Jasomi employees and isamortized to research and development expense and sales and marketing expenseover the corresponding vesting periods. See Note 5 of Notes to the ConsolidatedFinancial Statements.

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

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

 

In fiscal 2007, we adopted SFAS 123R, which replacedthe above compensation charges associated with our acquisition of Jasomi andalso introduced compensation charges for all equity-based employee programs.Compensation charges related to the Jasomi acquisition are now embedded in thestock compensation charges reported in the sales and marketing and research anddevelopment lines, discussed below.  

In fiscal 2007 and 2006, we recorded compensationexpense related to the portion of convertible debentures issued toemployee-stockholders. We are amortizing the compensation expense to researchand development expense and sales and marketing expense over the lives of theconvertible debentures. See Note 5 of Notes to the Consolidated FinancialStatements.

Convertibledebenture amortization included in operating expenses was as follows: 

| ** **                | ** ** | **Years ended  April 30** | ** ** |
|---------------------------|------------|-------------------------------------|------------|
| ** **                | ** ** | **2007**                            | ** ** | **2006** | ** ** |
| Sales and  marketing      |       | $                                   | 339        |   | $ | 563 |   |
| Research and  development |       | 25                                  |       | 41 |   |
| Total                     |       | $                                   | 364        |   | $ | 604 |   |

 

*Amortization of purchasedintangible assets*

Forthe years ended April 30, 2007 and 2006, we recorded amortization ofpurchased intangible assets related to the Jasomi acquisition. We areamortizing purchased intangible assets to operating expense over 

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their estimated useful life which ranges from four tofive years. See Note 6 of Notes to the Consolidated Financial Statements. 

| ** **                                   | ** ** | **Years ended  April 30** | ** ** |
|----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                   | ** ** | **2007**                            | ** ** | **2006** | ** ** |
| Amortization of  purchased intangible assets |       | $                                   | 985        |   | $ | 821 |   |
| % of revenue                                 |       | 1.2                                 | %          | 1.5 | % |
|                                              |            |                                     |            |  |  |  |  |

 

*In-process research and development*

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

 

In fiscal 2006, we incurred a charge for in-processresearch and development (“in process R&D”) acquired as part of ouracquisition of Jasomi. The amount of the purchase price for Jasomi allocated toin-process R&D was* *determinedthrough established valuation techniques common in the high-technologycommunications equipment industry. In-process R&D is expensed uponacquisition because technological feasibility has not been established and nofuture alternative uses exist.

In valuing in-process R&D, cash flows were basedon estimates from our and Jasomi’s management and from various public,financial and industry sources. We projected net revenue to grow throughcalendar 2008 and decline thereafter based on the rate of technology changes inthe industry, product life cycles and various projects’ stages of development.We estimated cost of goods sold and operating expenses, including research anddevelopment expenses and selling, general and administrative expenses, as apercentage of revenue based on historical averages and forward-lookingprojections. We also included in the projections estimated costs to bringprojects to technological feasibility and costs associated with activitiesundertaken to correct errors or keep products updated (also referred to as “maintenance”research and development). We based the tax expense on statutory Federal andCalifornia tax rates.

We based the percentage of completion of in-processprojects on an averaging of (1) expenses incurred to-date compared to thetotal estimated development costs for each project, (2) time incurredto-date and remaining time to complete each project and (3) milestone-basedpercent complete estimates. The in-process projects pertained to generalenhancements to PeerPoint software, combining of NAT and Peering capability,increasing throughput capability, enhancing the interface and developing aDenial of Service module. The average percentage complete for the in-processprojects was 56% as of the date of the acquisition. At the time of the acquisition, weestimated that these development efforts would be completed in nine months atan estimated cost of approximately $0.7 million. As of April 30, 2007, theremaining estimated cost to complete the project is approximately $0.4 million,primarily due to other projects taking higher priority in fiscal 2007 resultingin most of the development related to the last element of the in-process projectsslipping into fiscal 2008.

The 30% cost of capitalused to discount estimated cash flows reflects the estimated time to completethe projects and the level of risk involved.

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*Other Income, Net*

| ** **        | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)   from Prior Year** | ** ** |
|-------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **        | ** ** | **2007**                                 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **        | ** ** | **$s in thousands**            | ** ** |
| Other Income, Net |       | $                                        | 6,689      |                                                     | $          | 4,522 |   | $ | 2,430 |   | $ | 2,167 |   | $ | 2,092 |   |
| % of Revenue      |       | 8.0                                      | %          | 8.2                                                      | %          | 2.6 | % | (0.2) pts |   | 5.6 pts |   |
|                   |            |                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

Other income, net consists of interest income on ourinvested cash and cash equivalent and investment balances, offset by a nominalamount of foreign exchange losses. The increase in other income, net in fiscal2007 compared to 2006 was primarily attributable to higher interest income, dueto a significant improvement in the return on our invested cash and larger averageinvested balances in fiscal 2007. The increase in fiscal 2006 compared to 2005was also primarily attributable to higher interest income, due to our largerinvested cash balance and an improvement in the return on our invested cash asinterest rates began to increase.

Our fiscal 2008 interestincome will be dependent on our cash balances and the movement of U.S. interestrates.

*Income Taxes, Continuing Operations*

| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)   from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Income Taxes,  Continuing Operations |       | $                                        | 3,385      |                                                     | $          | 262 |   | $ | (36,100 | ) | $ | 3,123 |   | $ | 36,362 |   |
| % of Revenue                         |       | 4.0                                      | %          | 0.5                                                      | %          | (38.4 | )% | 3.5 pts |   | 38.9 pts |   |
|                                      |            |                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

Income taxes consist of federal, state and foreignincome taxes. The tax provision for fiscal 2007 resulted in an effective taxrate of 39%. The effective tax rate differs from the statutory rate primarilydue to stock-based compensation expense, research and experimentation taxcredits, state taxes, tax impact of foreign operations and changes in the statetax rate as it relates to certain deferred tax assets specifically forCalifornia purposes only.

The tax provision (benefit) for fiscal 2006 resultedin an effective tax rate of (23%). The effective tax rate for the year wasadversely affected by non-deductible Jasomi acquisition-related charges,including our inability to deduct for tax purposes (1) in-processR&D related to the acquisition of Jasomi and (2) convertible debentureamortization, and the correction of a $1.1 million error in the balance of adeferred tax asset related to a California R&D tax credit. The errororiginated in the second quarter of fiscal 2005 at the time we released ourvaluation allowance on deferred tax assets and was corrected in the fourthquarter of fiscal 2006. After conducting a thorough analytical review onmateriality, which was brought to the attention of and discussed with the auditcommittee, management believes that these amounts are not material to previouslyreported financial statements. Those items were partially offset by thereversal of $1.2 million of reserves on deferred tax assets primarilyassociated with a California R&D tax credit position under audit byCalifornia’s Franchise Tax Board. In April 2006, we reached an agreementwith the Franchise Tax Board regarding our tax credit positions andconsequently revised associated reserves.

The benefit in fiscal 2005 includes the reversal ofour valuation allowance against all of our deferred tax assets. In fiscal 2005,we concluded that it was more likely than not that we would realize the benefitrelated to our deferred tax assets. Accordingly, we reduced the valuationallowance against the assets and recorded a tax benefit to continuing operationsof $36.7 million. The recognition of the deferred tax assets had no impact onour fiscal 2005 cash flows. Partially offsetting the tax benefit recorded wasincome 

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tax expenseassociated with income earned by our foreign subsidiaries and state and federalalternative minimum tax totaling $0.6 million in fiscal 2005.

We expect the effective tax rate to be at a morenormalized rate of approximately 40% in fiscal 2008.

*Income (Loss) from Discontinued Operations*

| ** **                                                         | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)   from Prior Year** | ** ** |
|--------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2007**                                 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                         | ** ** | **$s in thousands**            | ** ** |
| Gain (loss) on  disposition                                        |       |                                     | $          | —                                                   |       |   | $ | 887 |   | $ | 94 |   | $ | (887 | ) | $ | 793 |   |
| Income tax  expense (benefit) from gain (loss) on disposition |       |                                     | —     |                                                     |       | 361 |   | (110 | ) | (361 | ) | (471 | ) |
| Income (loss)  from discontinued operations                        |       |                                     | $          | —                                                   |       |   | $ | 526 |   | $ | 204 |   | $ | (526 | ) | $ | 322 |   |
| % of Revenue                                                       |       |                                     | —     | %                                                        |       | 1.0 | % | 0.2 | % | (1.0) pts |   | 0.8 pts |   |

 

In June 2006, we came to a mutual settlement andrelease with JDSU whereby JDSU paid us $0.7 million. We had recordedreceivables of $0.5 million such that the net financial gain from thesettlement was $0.2 million. As part of the settlement, JDSU additionallyreleased us from our warranty obligation, which resulted in the release of $0.5million of our warranty liability. In addition, in June 2006, we completedthe closure of our international optical operations and, as a result, reversedour remaining $0.2 million of reserves related to the closure. Net of $0.4million of tax expense, the transactions resulted in a $0.5 million gain fromdisposal of our discontinued operations. In fiscal 2006, we completed the windup of our optical operations, resulting in no financial impact fromdiscontinued operations in fiscal 2007. See Note 4 of Notes to theConsolidated Financial Statements.

The $0.1 million gain ondisposition in fiscal 2005 was due to adjustments needed to reflect actualcosts incurred. The loss on disposition in fiscal 2004 reflects the aggregateloss of $6.9 million realized in the first quarter of fiscal 2004 upon thesale of the optical technology, inventory and certain fixed assets to JDSU,along with other exit costs associated with abandoning that portion of theoptical business not acquired by JDSU. Subsequent adjustments to the lossresulted in an incremental loss of approximately $0.1 million and were includedin the total loss from disposal of our discontinued optical operations of$7.0 million for fiscal 2004 in the Consolidated Statement of Operations.As all operations related to our optical business ceased in fiscal 2004, we didnot have further losses from this discontinued operation in fiscal 2005, 2006or 2007.

**Liquidity and Capital Resources**

As of April 30, 2007,we had cash and cash equivalents of $34.0 million as compared to$35.7 million at April 30, 2006 and $36.8 million as of April 30,2005. Additionally, we had $100.4 million of short-term investments as of April 30,2007 compared to $100.3 million of short-term investments as of April 30,2006 and $98.9 million as of April 30, 2005.

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

*Cash flows fromOperating Activities*

| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)   from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                 | ** ** | **2006**                                                 | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Cash Flow from Operating  Activities |       | $                                        | 2,475      |                                                     | $          | 14,485 |   | $ | 33,136 |   | $ | (12,010 | ) | $ | (18,651 | ) |
|                                      |            |                                          |            |                                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

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Our cash flow from operations generally follows ourprofitability trend of $5.3 million, ($0.9) million, and $71.1 million(inclusive of a $36.1 non-cash tax benefit from the release of a valuationallowance on our deferred tax assets) for fiscal 2007, 2006 and 2005,respectively. The difference in cash flow from operations in fiscal 2007 and profitabilityis largely due to the growth in inventory in the fourth quarter of fiscal 2007due to lower than anticipated revenue levels in the quarter. The improved cashflow from operations in fiscal 2006 as compared to profitability was due to acombination of reducing accounts receivable due to improved collections andmore linear sales patterns in fiscal 2006 and increasing deferred revenue dueto several shipments near the end of the year which required deferraltreatment, which resulted in $15.2 million of operating cash flow.

We expect to see positivecash flows from operations in the coming year based on projected revenuegrowth. We expect, however, increases in accounts receivable as we sell moreproduct internationally, as international customers typically have longerpayment terms, and increases in operating expenses partially offset by areduction of inventory that grew in the fourth quarter of fiscal 2007.

*Cash flows from Investing Activities*

| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                 | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Cash Flow from  Investing Activities |       | $                                        | (5,973     | )                                                  | $          | (16,760 | ) | $ | (17,088 | ) | $ | 10,787 |   | $ | 328 |   |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The change in cash flows from investing activities isdue to three key events. First, in fiscal 2004, we changed our investingstrategy to include short-term and long-term investments designed to improveour overall return on invested funds, which accounted for the majority of thecash used in 2005, but had little impact in fiscal 2006 and 2007 as we hadlimited proceeds from operating and financing activities to invest inshort-term securities. Second, we used $2.7 million of cash in fiscal 2007 and$12.6 million of cash in fiscal 2006 related to the acquisition of Jasomi (SeeNote 5 of Notes to the Consolidated Financial Statements). In fiscal 2005,we collected proceeds from the sale of our optical business and other minorsales of optical equipment of only $0.5 million and in fiscal 2007 and 2006 wehad no proceeds from the optical business.

We plan to continue toinvest in capital assets related to new product features and to support ourefforts to sell our VoIP products. In the first quarter of fiscal 2008, $4.0 millionof the convertible debentures mature and were paid in cash upon surrender ofthe notes.

*Cash flows from Financing Activities*

| ** **                           | ** ** | **Years ended April 30,** | ** ** | **Increase/(Decrease)  from Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                 | ** ** | **2006**                                           | ** ** | **2005** | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **$s in thousands**            | ** ** |
| Cash Flow from  Financing Activities |       | $                                        | 1,865      |                                               | $          | 1,201 |   | $ | (24,877 | ) | $ | 664 |   | $ | 26,078 |   |
|                                      |            |                                          |            |                                                    |            |  |  |  |  |  |  |  |  |  |  |  |

 

The limited cash flow fromfinancing activities in fiscal 2007 and 2006 was due to the limited level ofoption activity during those years largely due to a large portion of theoptions being out-of-the-money or only marginally in-the-money due to thedecline in our stock price. The cash flow used in financing activities infiscal 2005 was largely due to the repurchase of shares of common stock, asdiscussed below, partially offset by funds received from stock optionexercises. We repurchased no common stock in fiscal 2007 or 2006. Stock optionactivity in the first half of fiscal 2005 was particularly high following thetrend in our stock price over that same period.

45

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*Stock RepurchasePrograms*

In December 2004, our Board of Directorsauthorized the repurchase of up to $35 million of common stock under a stockrepurchase program. During fiscal 2005, we repurchased and retired 2,516,660shares of our common stock at an average price of $13.91 per share for anaggregate purchase price of $35 million. Consequently, we are notauthorized to repurchase additional shares under the stock repurchase programapproved in December of 2004.

The aggregate purchase price of the shares of ourcommon stock repurchased was reflected as a reduction to shareholders’ equity.In accordance with Accounting Principles Board Opinion No. 6, “Status ofAccounting Research Bulletins,” we allocated the purchase price of therepurchased shares as a reduction to retained earnings, common stock andadditional paid-in capital.

On June 13, 2007, ourBoard of Directors authorized the repurchase of up to $60 million of commonstock under a stock repurchase program. We do not expect to begin repurchasingany stock until at least the second quarter of fiscal 2008.

*Commitments*

We have no material commitments other than obligationsunder operating leases, particularly our facility leases, and normal purchasesof inventory, capital equipment and operating expenses, such as materials forresearch and development and consulting. We currently occupy approximately61,000 square feet of space in the two buildings that form our Mountain View,California headquarters. In September 2005, we renegotiated our MountainView, California lease, which extended the lease term through July 31,2011 and reduced the rent cost. We additionally have leased office space inCalgary, Canada, primarily for R&D operations, under an operating leaseexpiring January 31, 2011.

Ourcontractual commitments, by year in which they become due, are as follows:

| ** **                                                | ** ** | **Payments due by period** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations (in thousands)** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 year** | ** ** | **2 to 3  years** | ** ** | **4 to 5  years** | ** ** | **Over 5  years** | ** ** |
| Operating leases                                          |       | $                                         | 4,815      |   |   | $ | 1,091 |   |   | $ | 2,275 |   | $ | 1,449 |   |   | $ | — |   |   |
| Purchase  commitments                                     |       | 11,331                                    |       |   | 11,331 |   |   | — |   | — |   |   | — |   |   |
| Convertible notes                                         |       | 4,400                                     |       |   | 4,400 |   |   | — |   | — |   |   | — |   |   |
| Total                                                     |       | $                                         | 20,546     |   |   | $ | 16,822 |   |   | $ | 2,275 |   | $ | 1,449 |   |   | $ | — |   |   |
|                                                           |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Jasomi acquisition consideration included $7.0 millionin non-transferable convertible notes, divided into two tranches with principalamounts of $3.0 million and $4.0 million, respectively. The $3.0 million ofnotes plus interest accrued at 5% was paid in the first quarter of fiscal 2007.The $4.0 million of notes mature on June 30, 2007, as no holder elected toextend or convert the notes. We have not made any indemnification claims, norhave a sufficient number of designated employees left our employment, to causea reduction in the principal amounts of the notes, and so the full $4.0 millionof the second tranche of notes, plus interest accrued at 5%, were paid in cashduring the first quarter of fiscal 2008 upon surrender of the notes.

We believe that we will beable to satisfy our cash requirements for at least the next two years from ourexisting cash and short-term investments. We currently expect to renew our$2 million line of credit, which expires in July 2007. The ability tofund our operations beyond the next two fiscal years will be dependent on theoverall demand of telecommunications providers for new capital equipment.Should our customers significantly reduce their purchases of our productscompared to current levels of purchases, we could need to find additionalsources of cash during fiscal 2009 or be forced to reduce our spending levelsto protect our cash reserves.

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**Off-Balance SheetArrangements**

As of April 30, 2007,we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii)of SEC Regulation S-K.

**Item 7A—Quantitativeand Qualitative Disclosures About Market Risk**

Our exposure to market risk due to changes in thegeneral level of United States interest rates relates primarily to our cashequivalents and short-term investment portfolios. Our cash, cash equivalents,and short-term investments are primarily maintained at four major financialinstitutions in the United States. As of April 30, 2007 and 2006, we didnot hold any derivative instruments. The primary objective of our investmentactivities is the preservation of principal while maximizing investment incomeand minimizing risk, and we attempt to achieve this by diversifying ourportfolio in a variety of highly rated investment securities that have limitedterms to maturity. We do not hold any instruments for trading purposes.

Investmentsecurities that have maturities of more than three months at the date ofpurchase but current maturities of less than one year and auction ratesecurities, which management is able to liquidate on 28 or 35 day auctioncycles, are considered short-term investments. Short-term investments consistprimarily of corporate bonds and asset backed securities. Short-terminvestments are maintained at three major financial institutions, areclassified as available-for-sale, and are recorded on the accompanying ConsolidatedBalance Sheets at fair value. If we sell our short-term investments prior totheir maturity, we may incur a charge to operations in the period the sale tookplace. In fiscal 2007, 2006 and 2005, we realized no gains or losses on ourshort-term investments.

The following tablepresents the hypothetical changes in fair values of our investments as of April 30,2007, based on a discounted cash flow calculation over the remaining term ofeach investment, that are sensitive to changes in interest rates (dollars inthousands):

| ** **        | ** ** | **Valuation of Securities Given  an Interest Rate Decrease of   X Basis Points** | ** ** | **Fair Value as of** | ** ** | **Valuation of Securities Given  an Interest Rate Increase of   X Basis Points** | ** ** |
|-------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **        | ** ** | **(150 BPS)**                                                                                                                 | ** ** | **(100 BPS)**                  | ** ** | **(50 BPS)**                                                                                                                  | ** ** | **April 30, 2007** | ** ** | **50 BPS** | ** ** | **100 BPS** | ** ** | **150 BPS** | ** ** |
| ** **        | ** ** | **$s in thousands**                                                                                                      | ** ** |
| Total investments |       | $                                                                                                                                  | 100,465    |                                | $          | 100,465                                                                                                                            |       | $ | 100,465 |   |   | $ | 100,465 |   |   | $ | 100,465 |   | $ | 100,465 |   | $ | 100,465 |   |
|                   |            |                                                                                                                                    |            |                                     |            |                                                                                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thefollowing table presents the hypothetical changes in fair values of ourinvestments as of April 30, 2006, based on a discounted cash flowcalculation over the remaining term of each investment, that are sensitive tochanges in interest rates (dollars in thousands):

| ** **         | ** ** | **Valuation of Securities Given**     | ** ** | ** **                          | ** ** | **Valuation of Securities Given**     | ** ** |
|--------------------|------------|------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------------------------|------------|
| ** **         | ** ** | **an Interest Rate Decrease of** | ** ** | ** **                          | ** ** | **an Interest Rate Increase of** | ** ** |
| ** **         | ** ** | **X Basis Points**                         | ** ** | **Fair Value as of** | ** ** | **X Basis Points**                         | ** ** |
| ** **         | ** ** | **(150 BPS)**                                   | ** ** | **(100 BPS)**                  | ** ** | **(50 BPS)**                                    | ** ** | **April 30, 2006** | ** ** | **50 BPS** | ** ** | **100 BPS** | ** ** | **150 BPS** | ** ** |
| Total  investments |       | $                                                    | 100,325    |                                | $          | 100,325                                              |       | $ | 100,325 |   |   | $ | 100,325 |   |   | $ | 100,325 |   | $ | 100,325 |   | $ | 100,325 |   |
|                    |            |                                                      |            |                                     |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

These instruments are not leveraged. The modelingtechnique used measures the change in fair values arising from selectedpotential changes in interest rates. Market changes reflect immediatehypothetical parallel shifts in the yield curve of plus or minus 50 basispoints (BPS), 100 BPS, and 150 BPS over the remaining life of the investments,which shifts are representative of the historical movements in the FederalFunds Rate. 100 BPS equals 1%.

47

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Thefollowing table presents our cash equivalents and short-term and long-terminvestments subject to interest rate risk and their related weighted averageinterest rates as of April 30, 2007 and 2006 (in thousands). Carryingvalue approximates fair value.

| ** **                 | ** ** | **April 30, 2007** | ** ** | **April 30, 2006**          | ** ** |
|----------------------------|------------|------------------------------|------------|---------------------------------------|------------|
| ** **                 | ** ** | **Carrying   Value**    | ** ** | **Average   Interest Rate** | ** ** | **Carrying   Value** | ** ** | **Average   Interest Rate** | ** ** |
| Cash and cash  equivalents |       | $                            | 34,074     |                                  |       | 4.19 | % |   | $ | 35,707 |   |   | 3.59 | % |   |
| Short-term  investments    |       | 100,465                      |       |                                  | 5.25       | % |   | 100,325 |   |   | 4.67 | % |   |
| Long-term  investments     |       | —                       |       |                                  |       |   |   | — |   |   | — |   |   |
| Total                      |       | $                            | 134,539    |                                  |       | 4.98 | % |   | $ | 136,032 |   |   | 4.39 | % |   |

 

In fiscal 2007, ourreturn on our cash and cash equivalents ranged from 1.0% to 5.1% and ouraverage return for the year was 4.2% while our return on short-term investmentsranged from 5.2% to 5.3% and our average return for the year was 5.3%.

To date, the vastmajority of our sales have been denominated in U.S. dollars. As only a smallamount of foreign invoices are paid in currencies other than the U.S. dollar,our foreign exchange risk is considered immaterial to our consolidatedfinancial position, results of operations or cash flows.

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**Item 8—FinancialStatements and Supplementary Data**

**DITECH NETWORKS,INC.**

**INDEX TOCONSOLIDATED FINANCIAL STATEMENTS**
|                                                          | ** ** | **Page** |
|----------------------------------------------------------|------------|----------|
| Report of Independent  Registered Public Accounting Firm |       |     | 50 |
| Consolidated Balance Sheets                              |       |     | 52 |
| Consolidated Statements of  Operations                   |       |     | 53 |
| Consolidated Statements of  Stockholders’ Equity    |       |     | 54 |
| Consolidated Statements of  Cash Flows                   |       |     | 55 |
| Notes to Consolidated  Financial Statements              |       |     | 56 |
| Supplementary  Financial Data (unaudited)                |       |     | 81 |

 

49

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**Report ofIndependent Registered Public Accounting Firm**

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

We have completedintegrated audits of Ditech Networks, Inc.’s consolidated financialstatements and of its internal control over financial reporting as of April 30,2007 in accordance with the standards of the Public Company AccountingOversight Board (United States). Our opinions, based on our audits, arepresented below.

*Consolidatedfinancial statements and financial statement schedule*

In our opinion, the consolidated financialstatements listed in the index appearing under Item 8 present fairly, inall material respects, the financial position of Ditech Networks, Inc. andits subsidiaries at April 30, 2007 and 2006, and the results of theiroperations and their cash flows for each of the three years in the period endedApril 30, 2007 in conformity with accounting principles generally acceptedin the United States of America. In addition, in our opinion, the financialstatement schedule appearing under Item 15(a)(2) presents fairly, in allmaterial respects, the information set forth therein when read in conjunctionwith the related consolidated financial statements. These financial statementsand financial statement schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements and financial statement schedule based on our audits. We conductedour audits of these statements in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement. An audit offinancial statements includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

As discussed in Note 2 to the consolidated financialstatements, the Company has restated its accumulated deficit balance andadditional paid-in-capital balance as of April 30, 2004.

Also as discussed in Note2 to the consolidated financial statements, effective May 1, 2006, theCompany changed its method of accounting for stock-based compensation inaccordance with Statement of Financial Accounting Standard No. 123(revised 2004), “Share-Based Payment”.

*Internal controlover financial reporting*

Also, in our opinion, management’s assessment,included in Management’s Report on Internal Control over Financial Reportingappearing under Item 9A, that the Company maintained effective internal controlover financial reporting as of April 30, 2007 based on criteriaestablished in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO), is fairly stated, in all material respects, basedon those criteria. Furthermore, in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of April 30,2007, based on criteria established in *InternalControl—Integrated Framework* issued by the COSO. The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express opinions onmanagement’s assessment and on the effectiveness of the Company’s internalcontrol over financial reporting based on our audit. We conducted our audit ofinternal control over financial reporting in accordance with the standards ofthe Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether effective internal control over financial reporting was maintained inall material respects. An audit of internal control over financial reportingincludes obtaining 

50

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an understanding ofinternal control over financial reporting, evaluating management’s assessment,testing and evaluating the design and operating effectiveness of internalcontrol, and performing such other procedures as we consider necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinions.

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

Becauseof its inherent limitations, internal control over financial reporting may notprevent or detect misstatements. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.
| /s/ PRICEWATERHOUSECOOPERS LLP |
|-------------------------------------|
| PricewaterhouseCoopers  LLP         |
| San Jose,  California               |
| July 16,  2007                 |

 

51

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**DITECH NETWORKS,INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(in thousands, except pershare data)**

| ** **                                                                                                                                                     | ** ** | **April 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                     | ** ** | **2007**           | ** ** | **2006** | ** ** |
| ** **                                                                                                                                                     | ** ** | ** **         | ** ** | **as restated(1)** | ** ** |
| **ASSETS**                                                                                                                                                     |       |               |       |   |   |   |   |
| Current assets:                                                                                                                                                |       |               |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                                                     |       | $                  | 34,074     |   |   | $ | 35,707 |   |   |
| Short-term investments                                                                                                                                         |       | 100,465            |       |   | 100,325 |   |   |
| Accounts receivable, net  of allowance for doubtful accounts of $373 and $306 at April 30,  2007 and 2006, respectively                              |       | 10,324             |       |   | 5,276 |   |   |
| Inventories                                                                                                                                                    |       | 13,353             |       |   | 8,318 |   |   |
| Deferred income taxes                                                                                                                                          |       | 5,936              |       |   | 2,923 |   |   |
| Other current assets                                                                                                                                           |       | 1,262              |       |   | 2,664 |   |   |
| Total current assets                                                                                                                                           |       | 165,414            |       |   | 155,213 |   |   |
| Property and equipment,  net                                                                                                                                   |       | 5,781              |       |   | 4,740 |   |   |
| Goodwill                                                                                                                                                       |       | 12,637             |       |   | 9,913 |   |   |
| Purchased intangibles,  net                                                                                                                                    |       | 2,394              |       |   | 3,379 |   |   |
| Deferred income taxes                                                                                                                                          |       | 39,892             |       |   | 45,852 |   |   |
| Other assets                                                                                                                                                   |       | 266                |       |   | 216 |   |   |
| Total assets                                                                                                                                                   |       | 226,384            |       |   | 219,313 |   |   |
| **LIABILITIES**                                                                                                                                                |       |               |       |   |   |   |   |
| Current liabilities:                                                                                                                                           |       |               |       |   |   |   |   |
| Accounts payable                                                                                                                                               |       | $                  | 2,659      |   |   | $ | 1,576 |   |   |
| Accrued expenses                                                                                                                                               |       | 7,148              |       |   | 7,090 |   |   |
| Deferred revenue                                                                                                                                               |       | 3,424              |       |   | 10,951 |   |   |
| Income taxes payable                                                                                                                                           |       | 803                |       |   | 471 |   |   |
| Total current liabilities                                                                                                                                      |       | 14,034             |       |   | 20,088 |   |   |
| Long term accrued  expenses                                                                                                                                    |       | 405                |       |   | 644 |   |   |
| Commitments and contingencies (Note 8)                                                                                                                         |       |               |       |   |   |   |   |
| **STOCKHOLDERS’  EQUITY**                                                                                                                                 |       |               |       |   |   |   |   |
| Preferred stock, $0.001  par value: 5,000 shares authorized and none issued and outstanding at  April 30, 2007 and 2006                              |       | —             |       |   | — |   |   |
| Common stock, $0.001 par  value: 200,000 shares authorized and 33,044 and  32,375 shares issued and outstanding at April 30, 2007 and 2006,  respectively |       | 32                 |       |   | 32 |   |   |
| Additional paid-in  capital                                                                                                                                    |       | 298,279            |       |   | 292,373 |   |   |
| Accumulated deficit                                                                                                                                            |       | (86,366            | )          |   | (91,684 | ) |   |
| Deferred stock-based  compensation                                                                                                                             |       | —             |       |   | (2,137 | ) |   |
| Other comprehensive loss                                                                                                                                       |       | —             |       |   | (3 | ) |   |
| Total stockholders’  equity                                                                                                                               |       | 211,945            |       |   | 198,581 |   |   |
| Total liabilities and stockholders’ equity                                                                                                                |       | $                  | 226,384    |   |   | $ | 219,313 |   |   |

----

(1)          See Note 2 of Notes tothe Consolidated Financial Statements for adjustments to stockholders’ equity.

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

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**DITECH NETWORKS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

| ** **                                                                                 | ** ** | **Years ended April 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue                                                                                    |       | $                                        | 84,004     |   | $ | 54,905 |   | $ | 94,055 |   |
| Cost of goods sold(1)                                                                      |       | 27,140                                   |       | 16,368 |   | 22,184 |   |
| Gross profit                                                                               |       | 56,864                                   |       | 38,537 |   | 71,871 |   |
| Operating expenses:                                                                        |       |                                     |       |   |   |   |   |
| Sales and marketing(1)                                                                     |       | 24,496                                   |       | 18,233 |   | 16,430 |   |
| Research and  development(1)                                                               |       | 20,835                                   |       | 17,884 |   | 15,826 |   |
| General and  administrative(1)                                                             |       | 8,534                                    |       | 6,568 |   | 7,244 |   |
| Amortization of  purchased intangible assets                                               |       | 985                                      |       | 821 |   | — |   |
| In-process research and  development                                                       |       | —                                   |       | 700 |   | — |   |
| Total operating expenses                                                                   |       | 54,850                                   |       | 44,206 |   | 39,500 |   |
| Income (loss) from  continuing operations                                                  |       | 2,014                                    |       | (5,669 | ) | 32,371 |   |
| Other income (expense):                                                                    |       |                                     |       |   |   |   |   |
| Interest income                                                                            |       | 6,707                                    |       | 4,551 |   | 2,446 |   |
| Other income (expense),  net                                                               |       | (18                                      | )          | (29 | ) | (16 | ) |
| Total other income                                                                         |       | 6,689                                    |       | 4,522 |   | 2,430 |   |
| Income (loss) from  continuing operations before provision (benefit) for income taxes |       | 8,703                                    |       | (1,147 | ) | 34,801 |   |
| Provision (benefit) for  income taxes                                                      |       | 3,385                                    |       | 262 |   | (36,100 | ) |
| Income (loss) from  continuing operations                                                  |       | 5,318                                    |       | (1,409 | ) | 70,901 |   |
| Discontinued operations:                                                                   |       |                                     |       |   |   |   |   |
| Gain on disposition                                                                        |       | —                                   |       | 887 |   | 94 |   |
| Income tax expense  (benefit) from gain on disposition                                     |       | —                                   |       | 361 |   | (110 | ) |
| Income from discontinued  operations                                                       |       | —                                   |       | 526 |   | 204 |   |
| Net income (loss)                                                                          |       | $                                        | 5,318      |   | $ | (883 | ) | $ | 71,105 |   |
| Per share data                                                                             |       |                                     |       |   |   |   |   |
| Basic                                                                                      |       |                                     |       |   |   |   |   |
| Net income (loss) from  continuing operations                                              |       | $                                        | 0.16       |   | $ | (0.04 | ) | $ | 2.12 |   |
| Net income from  discontinued operations                                                   |       | —                                   |       | 0.01 |   | 0.01 |   |
| Net income (loss)                                                                          |       | $                                        | 0.16       |   | $ | (0.03 | ) | $ | 2.13 |   |
| Diluted                                                                                    |       |                                     |       |   |   |   |   |
| Net income (loss) from  continuing operations                                              |       | $                                        | 0.16       |   | $ | (0.04 | ) | $ | 2.02 |   |
| Net income from  discontinued operations                                                   |       | 0.00                                     |       | 0.01 |   | 0.00 |   |
| Net income (loss)                                                                          |       | $                                        | 0.16       |   | $ | (0.03 | ) | $ | 2.02 |   |
| Number of shares used in per share calculations:                                           |       |                                     |       |   |   |   |   |
| Basic                                                                                      |       | 32,579                                   |       | 32,119 |   | 33,408 |   |
| Diluted                                                                                    |       | 34,020                                   |       | 32,119 |   | 35,140 |   |

----

(1)          Stock-basedcompensation expense was as follows for the periods:

| Cost of Sales               |   | $     | 370    |   | $      | — |   | $ | — |   |
|-----------------------------|--------|-------|--------|--------|--------|--------|--------|---|--------|--------|
| Sales and marketing         |   | 2,714 |   | 256    |   | — |   |
| Research and development    |   | 1,951 |   | 619    |   | — |   |
| General and  administrative |   | 1,124 |   | — |   | — |   |

 

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

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**DITECH NETWORKS,INC.**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**(inthousands)**

| ** **                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | ** **              | ** ** | ** **              | ** ** | ** **        | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|-------------------------|------------|-------------------------|------------|-------------------|------------|-----------------|------------|------------|------------|
| ** **                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**          | ** ** | ** **              | ** ** | ** **        | ** ** | **Other**       | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | **Common Stock** | ** ** | **Paid-In** | ** ** | **Accumulated**         | ** ** | **Deferred Stock** | ** ** | **Comprehensive** | ** ** | ** **      | ** ** |
| ** **                                                        | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**             | ** ** | **Deficit**             | ** ** | **Compensation**  | ** ** | **Income**      | ** ** | **Total**  | ** ** |
| ** **                                                        | ** ** | ** **            | ** ** | ** **  | ** ** | **as restated(1)** | ** ** | **as restated(1)** | ** ** | ** **        | ** ** | ** **      | ** ** | ** ** | ** ** |
| **Balances, April 30, 2004, restated**                       |       |                  | 32,915     |        |       |                    | $          | 33                      |       |              |       | $               | 282,234    |       |       |   | $ | (146,829 | ) |   |   | $ | — |   |   |   | $ | (38 | ) |   | $ | 135,400 |   |
| Issuance of stock under employee stock plans                 |       |                  | 1,600      |        |       |                    | 2          |                    |       |              | 10,121     |            |       |       | —     |   |   |   | — |   |   |   | — |   |   | 10,123 |   |
| Repurchase of common stock                                        |       |                  | (2,517     | )           |       |                    | (3         | )                       |       |              | (19,920    | )               |       |       | (15,077    | ) |   |   | — |   |   |   | — |   |   | (35,000 | ) |
| Tax benefit from exercise of stock options                        |       |                  | —     |        |       |                    | —     |                    |       |              | 15,645     |            |       |       | —     |   |   |   | — |   |   |   | — |   |   | 15,645 |   |
| Other comprehensive  income (loss):                               |       |                  |       |        |       |                    |       |                    |       |              |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized loss on available for sale investment  securities |       |                  | —     |        |       |                    | —     |                    |       |              | —     |            |       |       | —     |   |   |   | — |   |   |   | (8 | ) |   | (8 | ) |
| Net income                                                        |       |                  | —     |        |       |                    | —     |                    |       |              | —     |            |       |       | 71,105     |   |   |   | — |   |   |   | — |   |   | 71,105 |   |
| Total comprehensive income                                        |       |                  |       |        |       |                    |       |                    |       |              |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   | 71,097 |   |
| **Balances, April 30, 2005**                                 |       |                  | 31,998     |        |       |                    | 32         |                    |       |              | 288,080    |            |       |       | (90,801    | ) |   |   | — |   |   |   | (46 | ) |   | 197,265 |   |
| Issuance of stock under employee stock plans                 |       |                  | 256        |        |       |                    | —     |                    |       |              | 1,201      |            |       |       | —     |   |   |   | — |   |   |   | — |   |   | 1,201 |   |
| Assumed unvested options in Jasomi acquisition                    |       |                  | —     |        |       |                    | —     |                    |       |              | 689        |            |       |       | —     |   |   |   | (689 | ) |   |   | — |   |   | — |   |
| Assumed vested options in Jasomi acquisition                      |       |                  | —     |        |       |                    | —     |                    |       |              | 483        |            |       |       | —     |   |   |   | — |   |   |   | — |   |   | 483 |   |
| Restricted stock issued                                           |       |                  | 121        |        |       |                    | —     |                    |       |              | 2,552      |            |       |       | —     |   |   |   | (2,552 | ) |   |   | — |   |   | — |   |
| Amortization of stock-based compensation                          |       |                  | —     |        |       |                    | —     |                    |       |              | (37        | )               |       |       | —     |   |   |   | 912 |   |   |   | — |   |   | 875 |   |
| Reversal of deferred compensation due to  terminations       |       |                  | —     |        |       |                    | —     |                    |       |              | (192       | )               |       |       | —     |   |   |   | 192 |   |   |   | — |   |   | — |   |
| Tax benefit from exercise of stock options                        |       |                  | —     |        |       |                    | —     |                    |       |              | 190        |            |       |       | —     |   |   |   | — |   |   |   | — |   |   | 190 |   |
| Reclassification of deferred tax asset                            |       |                  | —     |        |       |                    | —     |                    |       |              | (593       | )               |       |       | —     |   |   |   | — |   |   |   | — |   |   | (593 | ) |
| Other  comprehensive income (loss):                               |       |                  |       |        |       |                    |       |                    |       |              |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Unrealized loss on available for sale investment  securities |       |                  | —     |        |       |                    | —     |                    |       |              | —     |            |       |       | —     |   |   |   | — |   |   |   | 43 |   |   | 43 |   |
| Net loss                                                          |       |                  | —     |        |       |                    | —     |                    |       |              | —     |            |       |       | (883       | ) |   |   | — |   |   |   | — |   |   | (883 | ) |
| Total comprehensive income                                        |       |                  |       |        |       |                    |       |                    |       |              |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   | (840 | ) |
| **Balances, April 30, 2006**                                 |       |                  | 32,375     |        |       |                    | 32         |                    |       |              | 292,373    |            |       |       | (91,684    | ) |   |   | (2,137 | ) |   |   | (3 | ) |   | 198,581 |   |
| Issuance of stock under employee  stock plans                     |       |                  | 376        |        |       |                    | —     |                    |       |              | 1,865      |            |       |       | —     |   |   |   | — |   |   |   | — |   |   | 1,865 |   |
| Restricted stock issued                                           |       |                  | 293        |        |       |                    | —     |                    |       |              | —     |            |       |       | —     |   |   |   | — |   |   |   | — |   |   | — |   |
| Reclassification upon adoption of FAS123R                         |       |                  | —     |        |       |                    | —     |                    |       |              | (2,137     | )               |       |       | —     |   |   |   | 2,137 |   |   |   | — |   |   | — |   |
| Stock-based compensation expense under FAS123R                    |       |                  | —     |        |       |                    | —     |                    |       |              | 6,178      |            |       |       | —     |   |   |   | — |   |   |   | — |   |   | 6,178 |   |
| Other comprehensive income                                        |       |                  |       |        |       |                    |       |                    |       |              |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| (loss):                                                           |       |                  |       |        |       |                    |       |                    |       |              |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   | — |   |
| Unrealized loss on available for                                  |       |                  |       |        |       |                    |       |                    |       |              |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   | — |   |
| sale investment securities                                   |       |                  | —     |        |       |                    | —     |                    |       |              | —     |            |       |       | —     |   |   |   | — |   |   |   | 3 |   |   | 3 |   |
| Net income                                                        |       |                  | —     |        |       |                    | —     |                    |       |              | —     |            |       |       | 5,318      |   |   |   | — |   |   |   | — |   |   | 5,318 |   |
| Total comprehensive income                                        |       |                  |       |        |       |                    |       |                    |       |              |       |            |       |       |       |   |   |   |   |   |   |   |   |   |   | 5,321 |   |
| **Balances,  April 30, 2007**                                |       |                  | 33,044     |        |       |                    | $          | 32                      |       |              |       | $               | 298,279    |       |       |   | $ | (86,366 | ) |   |   | $ | — |   |   |   | $ | — |   |   | $ | 211,945 |   |

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(1)              See Note 2 of Notes to the Consolidated FinancialStatements for adjustments to stockholders’ equity.

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

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**DITECH NETWORKS,INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(inthousands)**

| ** **                                                                                          | ** ** | **Years ended April 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Cash flows from operating activities:                                                               |       |                                     |       |   |   |   |   |
| Net income (loss)                                                                                   |       | $                                        | 5,318      |   | $ | (883 | ) | $ | 71,105 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |                                     |       |   |   |   |   |
| Non-cash effect of  discontinued operations                                                         |       | —                                   |       | (526 | ) | 344 |   |
| Depreciation and  amortization                                                                      |       | 2,716                                    |       | 3,509 |   | 2,770 |   |
| Provision for doubtful  accounts                                                                    |       | 67                                       |       | (38 | ) | — |   |
| Loss on disposal of  property and equipment                                                         |       | —                                   |       | 22 |   | 192 |   |
| Tax benefit from  exercise of stock options                                                         |       | —                                   |       | 190 |   | 15,645 |   |
| Deferred income taxes                                                                               |       | 2,947                                    |       | 1,161 |   | (51,607 | ) |
| Amortization of deferred  stock compensation                                                        |       |                                     |       | 875 |   | — |   |
| Stock-based compensation  expense                                                                   |       | 6,159                                    |       | — |   | — |   |
| Payment of  employee-investor portion of convertible debentures                                     |       | (408                                     | )          | — |   | — |   |
| Amortization of  purchased intangibles                                                              |       | 985                                      |       | 821 |   | — |   |
| Amortization of  employee-investor portion of convertible debentures                                |       | 364                                      |       | — |   | — |   |
| Amortization of Jasomi  contingent consideration                                                    |       | —                                   |       | 604 |   | — |   |
| In-process research and  development                                                                |       | —                                   |       | 700 |   | — |   |
| Other                                                                                               |       | —                                   |       | 95 |   | 203 |   |
| Changes in assets and liabilities:                                                                  |       |                                     |       |   |   |   |   |
| Accounts receivable                                                                                 |       | (5,115                                   | )          | 4,546 |   | (2,774 | ) |
| Inventories                                                                                         |       | (5,013                                   | )          | (2,586 | ) | 223 |   |
| Other current assets                                                                                |       | 684                                      |       | (1,086 | ) | (109 | ) |
| Income taxes                                                                                        |       | 332                                      |       | (1,115 | ) | (118 | ) |
| Accounts payable                                                                                    |       | 1,083                                    |       | (1,086 | ) | (88 | ) |
| Accrued expenses and  other                                                                         |       | (117                                     | )          | (1,355 | ) | (402 | ) |
| Deferred revenue                                                                                    |       | (7,527                                   | )          | 10,637 |   | (2,248 | ) |
| Net cash provided by  operating activities                                                          |       | 2,475                                    |       | 14,485 |   | 33,136 |   |
| Cash flows from investing activities:                                                               |       |                                     |       |   |   |   |   |
| Purchases of property  and equipment                                                                |       | (3,689                                   | )          | (2,555 | ) | (3,461 | ) |
| Purchase of available  for sale investments                                                         |       | (49,200                                  | )          | (50,300 | ) | (74,071 | ) |
| Sales and maturities of  available for sale investments                                             |       | 49,060                                   |       | 48,777 |   | 59,902 |   |
| Proceeds from sale of  discontinued optical business                                                |       | 698                                      |       | — |   | 542 |   |
| Acquisition of Jasomi,  net of cash received                                                        |       | (2,724                                   | )          | (12,636 | ) | — |   |
| Additions to other  assets                                                                          |       | (118                                     | )          | (46 | ) | — |   |
| Net cash used in  investing activities                                                              |       | (5,973                                   | )          | (16,760 | ) | (17,088 | ) |
| Cash flows from financing activities:                                                               |       |                                     |       |   |   |   |   |
| Repurchase of common  stock                                                                         |       | —                                   |       | — |   | (35,000 | ) |
| Proceeds from employee  stock plan issuances                                                        |       | 1,865                                    |       | 1,201 |   | 10,123 |   |
| Net cash provided by  (used in) financing activities                                                |       | 1,865                                    |       | 1,201 |   | (24,877 | ) |
| Net decrease in cash and  cash equivalents                                                          |       | (1,633                                   | )          | (1,074 | ) | (8,829 | ) |
| Cash and cash  equivalents, beginning of year                                                       |       | 35,707                                   |       | 36,781 |   | 45,610 |   |
| Cash and cash equivalents, end of year                                                              |       | $                                        | 34,074     |   | $ | 35,707 |   | $ | 36,781 |   |

 

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

 

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**DITECH NETWORKS,INC.**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**1.**                 ORGANIZATIONAND NATURE OF BUSINESS

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

**2.**                 SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES

*Principles ofConsolidation and Basis of Presentation*

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

In May 2003, the Company announced its intentionto exit the optical communications portion of its business. In July 2003,the Company executed a sale of a substantial portion of the assets used in theoptical business. As a result, the optical business has been presented as adiscontinued operation in the Consolidated Statements of Operations for allperiods presented. See Note 4 for a further discussion of the discontinuedoperations.

Certain items in theconsolidated financial statements for the years ended April 30, 2005 and April 30,2006 have been reclassified to conform to classifications used in the currentfiscal year.

*Use of Estimates*

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

*Revenue Recognition*

The Company generally recognizes product revenue,including shipping charges, when: persuasive evidence of a definitive agreementexists; shipment to the customer has occurred; title and all risks and rewardsof ownership have passed to the customer; acceptance terms, if any have beenfulfilled; no significant contractual obligations remain outstanding; the feeis fixed or determinable; and collection is reasonably assured.

In the event that a shipment transaction does not meetall of the criteria for revenue recognition it is recorded as deferred revenuein our Consolidated Balance Sheet. To the extent that the Company has receivedcash for some or all of a given deferred revenue transaction, the Companyreports it on the Consolidated Balance Sheet as a deferred revenue liability.However, to the extent that the Company has not collected cash related to thedeferred revenue transaction, the Company reflects the deferred revenue as areduction in the corresponding account receivable balance.

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The Company recordstransaction-based taxes including, but not limited to, sales, use, value added,and excise taxes, on a net basis in its consolidated statements of operations.

*Cost of Goods Sold*

Cost of goods sold iscomprised primarily of material, labor including share-based compensation,overhead, shipping costs, warranty and inventory write-downs.

*Allowance forDoubtful Accounts*

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

*Warranties*

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

*Research andDevelopment*

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

*Cash and CashEquivalents*

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

*Investments*

Investment securities thathave maturities of more than three months at the date of purchase but remainingmaturities of less than one year and auction rate securities, which managementis able to liquidate on 28 or 35 day auction cycles, are considered short-terminvestments. Other investment securities with remaining maturities of one yearor more are considered long-term investments. At April 30, 2007,short-term investments consist primarily of corporate bonds and asset backedsecurities. The primary objective of the Company’s investment activities is thepreservation of principal while maximizing investment income and minimizingrisk, and management attempts to achieve this by diversifying its portfolio ina variety of highly rated investment securities that have limited terms tomaturity. Management has classified the Company’s short-term investments asavailable-for-sale securities in the accompanying consolidated financialstatements. Available-for-sale securities are carried at fair value, withunrealized gains and losses reported in a separate component of stockholders’equity. Realized 

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gainsand losses and declines in value judged to be other-than-temporary, if any, onavailable-for-sale securities are included in other income based on specificidentification. Interest on securities classified as available-for-sale is alsoincluded in interest income.

*Fair Value ofFinancial Investments*

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

*Inventories*

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

*Property andEquipment*

Property andequipment are stated at cost and are depreciated using the straight-line methodover their estimated useful lives, which differ by asset category:

·       Furniture &fixtures: 5 years

·       Equipment: 2 -** **5 years

·       Software: 3 years

·       Leaseholdimprovements: Shorter of 5 years or remaining lease period

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

*Goodwill*

The Company’s methodologyfor allocating a portion of the purchase price to goodwill in connection withthe purchase of Jasomi Networks, Inc. (“Jasomi”) was based on establishedvaluation techniques in the high-technology communications equipment industry.Goodwill was measured as the excess of the cost of acquisition over the sum ofthe amounts assigned to tangible and identifiable intangible assets acquiredless liabilities assumed. Goodwill is not amortized. The goodwill recorded inthe Condensed Consolidated Balance Sheet as of April 30, 2007 was $12.6million.

*Impairment ofLong-lived Assets*

The Company evaluates therecoverability of its long-lived assets, including goodwill, on an annual basisor more frequently if indicators of potential impairment arise. Following thecriteria of SFAS 131 “Disclosure about Segments of an Enterprise andRelated Information” and SFAS 142 “Goodwill and Other Intangible Assets”,the Company views itself as having a single operating segment and consequentlyhas evaluated goodwill and purchased intangible assets for impairment based onan evaluation of the fair value of Ditech as a whole. Ditech’s quoted shareprice from NASDAQ is the basis for measurement of that fair value as Ditech’smarket capitalization based on share price best represents the amount at whichthe Company could be bought or sold in a current transaction between willingparties. The Company evaluates the recoverability of its amortizable purchasedintangible assets based on an estimate of the undiscounted cash flows resultingfrom the use of the related asset group and its eventual disposition. The assetgroup represents the lowest level for which cash flows are largely independentof cash flows of other assets and liabilities. Measurement of an impairmentloss for long-lived assets that the Company expects to 

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hold anduse is based on the difference between the fair value and carrying value of theasset. Long-lived assets to be disposed of are reported at the lower ofcarrying amount or fair value less costs to sell.

*Certain Risks andConcentrations*

The Company’s products are concentrated in thetelecommunications equipment industry, which is highly competitive and rapidlychanging. Revenue from the Company’s products is concentrated with a relativelylimited number of customers. One customer accounted for 64%, 79% and 49% ofrevenue in fiscal 2007, 2006 and 2005, respectively. The second largestcustomer in fiscal 2007 and 2006, an international customer, accounted for 14%and 3% of net revenue, respectively. The second largest customer in fiscal2005, a domestic carrier, accounted for 37% of net revenue. Net revenue fromcustomers outside the United States, which was primarily denominated in U.S.dollars, was 29%, 13%, and 9% in fiscal 2007, 2006 and 2005, respectively. TheCompany’s gross accounts receivable were concentrated with two customers at April 30,2007 (representing 34% and 27% of receivables) and April 30, 2006(representing 48% and 23% of receivables). The Company performs ongoing creditevaluations of its customers’ financial condition and generally requires nocollateral from its customers. The Company maintains an allowance for doubtfulaccounts receivable based on the expected collectibility of accountsreceivable.

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

*Income Taxes*

Income tax expense isbased on pretax financial accounting income. Deferred tax assets andliabilities are recognized for the expected tax consequences of temporarydifferences between the tax bases of assets and liabilities and their reportedamounts. Valuation allowances are recorded to reduce deferred tax assets to theamount that will more likely than not be realized. Currently, no valuationallowance is recorded against any of the deferred tax assets. The Companyregularly examines factors that would create an issue with respect to therealization of such deferred tax assets (e.g. limitation to net operating lossand research credit utilization as a result of changes of ownership pursuant toInternal Revenue Code Section 382).

*Foreign CurrencyTranslation*

The functional currency ofall of the Company’s current foreign subsidiaries is the U.S. dollar.Translation adjustments resulting from remeasuring the foreign currencydenominated financial statements of subsidiaries into the U.S. dollar areincluded in operations. Gains or losses resulting from transactions denominatedin currency other than the functional currency are recorded in net income(loss).

*ComprehensiveIncome (Loss)*

Comprehensive income(loss) for fiscal 2007, 2006 and 2005 was $5,321,000, ($840,000), and$71,097,000 and included the impact of unrealized gains and losses on availablefor sale investment securities, net of tax.

*Computation ofIncome (Loss) per Share*

Basic net income (loss) per share is calculated basedon the weighted average number of shares of common stock outstanding during theperiod less shares subject to repurchase, which are considered contingentlyissuable shares. Diluted net income per share is calculated based on theweighted average 

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number of shares of commonstock and potentially dilutive securities outstanding, including the dilutiveeffect of stock options, using the treasury stock method, and common stocksubject to repurchase. Under the treasury stock method, the amount that theemployee must pay for exercising stock options, the amount of compensation costfor future services that the Company has not yet recognized, and the amount oftax benefit that would be recorded in additional paid-in capital when the awardbecomes deductible are assumed to be used to repurchase shares. Also includedin diluted shares for the year ended April 30, 2007 is the weightedaverage effect of the potential conversion to common stock of $4.0 million ofconvertible notes issued as part of the Jasomi Networks, Inc. (“Jasomi”)acquisition. These notes either mature or convert into the Company’s commonstock at the election of the holder. At April, 2007, the notes potentiallyconvert to a maximum of 447,000 shares of common stock (See also Note 5). Dilutedloss per share for the year ended April 30, 2006 is calculated excludingthe effects of all potentially dilutive securities, as their effect would beanti-dilutive.

Areconciliation of the numerator and denominator used in the calculation of thehistorical basic and diluted net income (loss) per share follows (in thousands,except per share amounts):

| ** **                                          | ** ** | **Years Ended April 30,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                          | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| Historical net income  (loss):                      |       |                                     |       |   |   |   |   |
| Income (loss) from continuing operations            |       | $                                        | 5,318      |   | $ | (1,409 | ) | $ | 70,901 |   |
| Income (loss) from discontinued operations          |       | —                                   |       | 526 |   | 204 |   |
| Net income (loss)                                   |       | $                                        | 5,318      |   | $ | (883 | ) | $ | 71,105 |   |
| Basic income  (loss) per share:                     |       |                                     |       |   |   |   |   |
| Weighted average shares of common stock outstanding |       | 32,579                                   |       | 32,121 |   | 33,410 |   |
| Less stock subject to repurchase                    |       | —                                   |       | (2 | ) | (2 | ) |
| Shares used in calculation of basic per share       |       | 32,579                                   |       | 32,119 |   | 33,408 |   |
| Income (loss) from continuing operations            |       | $                                        | 0.16       |   | $ | (0.04 | ) | $ | 2.12 |   |
| Income from discontinued operations                 |       | —                                   |       | 0.01 |   | 0.01 |   |
| Net income (loss) per share                         |       | $                                        | 0.16       |   | $ | (0.03 | ) | $ | 2.13 |   |
| Diluted income  (loss) per share:                   |       |                                     |       |   |   |   |   |
| Shares used in calculation of basic per share       |       | 32,579                                   |       | 32,117 |   | 33,408 |   |
| Shares subject to repurchase                        |       | —                                   |       | 2 |   | 2 |   |
| Dilutive effect of stock plans                      |       | 994                                      |       | — |   | 1,730 |   |
| Dilutive effect of convertible debentures           |       | 447                                      |       | — |   | — |   |
| Shares used in calculation of diluted per share     |       | 34,020                                   |       | 32,119 |   | 35,140 |   |
| Income (loss) from continuing operations            |       | $                                        | 0.16       |   | $ | (0.04 | ) | $ | 2.02 |   |
| Income from discontinued operations                 |       | —                                   |       | 0.01 |   | — |   |
| Net income (loss)  per share                        |       | $                                        | 0.16       |   | $ | (0.03 | ) | $ | 2.02 |   |

 

The computation of dilutednet income (loss) per share excluded the following number of shares underlyingoptions, as their effect was anti-dilutive: 3,752,000 shares in fiscal 2007,1,521,000 shares in fiscal 2006, and 179,000 shares in fiscal 2005. Included inthe fiscal 2006 anti-dilutive shares are the weighted average effects of thepotential conversion to common stock of $7.0 million of convertible notesissued as part of the Jasomi acquisition that either mature or convert intoDitech common stock at the election of the holder. As of April 30, 2006,the notes potentially converted into a maximum of 782,139 shares of commonstock (See also Note 5).

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*Accounting forStock-Based Compensation*

On May 1, 2006, the Company adopted Statement ofFinancial Accounting Standard No. 123 (revised 2004), Share-Based Payment, (“SFAS 123R”)which requires the measurement and recognition of compensation expense for allstock-based payment awards made to employees and directors including employeestock options, restricted stock, restricted stock units (“RSUs”) and employeestock purchases under the Company’s Employee Stock Purchase Plan based onestimated fair values. SFAS 123R supersedes the previous accounting underAccounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), asallowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”).In March 2005, the Securities and Exchange Commission issued StaffAccounting Bulletin No. 107 (“SAB 107”) relating toSFAS 123R. The Company has applied the provisions of SAB 107 inconjunction with its adoption of SFAS 123R.

The Company adopted SFAS 123R using the modifiedprospective transition method, which requires the application of the accountingstandard as of May 1, 2006, the first day of the Company’s fiscal year2007. The Company’s Consolidated Financial Statements as of and for the yearended April 30, 2007 reflect the impact of SFAS 123R. In accordancewith the modified prospective transition method, the Company’s ConsolidatedFinancial Statements for periods prior to fiscal 2007 have not been restated toreflect, and do not include, the impact of SFAS 123R.

SFAS 123R requires companies to estimate the fairvalue of stock-based payment awards on the date of grant using anoption-pricing model. The Company uses the Black-Scholes option-pricing modelto determine the fair-value of stock based awards under SFAS 123R,consistent with that used for pro forma disclosures under SFAS 123. Thevalue of the portion of the award that is ultimately expected to vest isrecognized as expense over the requisite service periods in the Company’sconsolidated statement of operations.

Stock-based compensation expense recognized in theCompany’s consolidated statement of operations for the year ended April, 2007included compensation expense for stock-based payment awards granted prior to,but not yet vested as of, April 30, 2006 based on the grant date fairvalue estimated in accordance with the provisions of SFAS 123 andcompensation expense for the stock-based payment awards granted subsequent to April 30,2006 based on the grant date fair value estimated in accordance with theprovisions of SFAS 123R. In conjunction with the adoption of SFAS 123R,the Company changed its accounting policy of attributing the fair value ofstock-based compensation to expense from the accelerated multiple-optionapproach, to the straight-line single-option approach. Compensation expense forall stock-based payment awards expected to vest that were granted on or priorto April 30, 2006 will continue to be recognized using the acceleratedattribution method. Compensation expense for all stock-based payment awardsexpected to vest that were granted or modified subsequent to April 30,2006 is recognized on a straight-line basis. SFAS 123R requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. In theCompany’s pro forma information required under SFAS 123 for the periodsprior to fiscal 2007, the Company accounted for forfeitures as they occurred.

Prior to the adoption of SFAS 123R, the Companyaccounted for grants of equity instruments to employees using the intrinsicvalue method described in Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (APB 25) and complied with the disclosureprovisions of SFAS 123. Accordingly, compensation cost for stock optionsrecorded in the Company’s consolidated statement of operations was measured asthe excess, if any, of the quoted market price of the Company’s stock at thedate of the grant over the amount an employee was required to pay to acquirethe stock and was recognized over the vesting period of the related shares. TheCompany recorded $3.2 million of deferred stock-based compensation expenseassociated with unvested stock options assumed as part of the Company’sacquisition of Jasomi and a restricted stock plan offered to former Jasomi employeeshired by 

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the Company. In fiscal2006, the Company recorded $875,000 of stock-based compensation expense relatedto the assumed unvested stock options and restricted stock plan.

As a resultof adopting SFAS 123R, stock-based compensation expense recognized during theyear ended April, 2007 totaled approximately $6.2 million ($3.9 million net oftaxes), or approximately a $0.12 per share decrease to basic and dilutednet income per common share, and consisted of stock option, restricted stockunit and restricted stock expense. A contra-equity balance of $2.1 million in “Deferredstock compensation” on the Consolidated Balance Sheet was reversed, upon theadoption of SFAS 123R, to “Additional paid-in capital” as of May 1, 2006.

Prior tothe adoption of SFAS 123R, the Company presented all tax benefits of deductionsresulting from the exercise of stock options as an operating cash flow, inaccordance with Emerging Issues Task Force (“EITF”) Issue No. 00-15,*Classification in the Statement of CashFlows of the Income Tax**BenefitReceived by a Company upon Exercise of a Nonqualified Employee Stock Option*.SFAS 123R requires the Company to reflect the tax savings resulting from taxdeductions in excess of expense reflected in its financial statements as a financingcash flow.

If theCompany had applied the fair value recognition provisions of SFAS 123, theCompany’s net income (loss) for the years ended April 30, 2006 and 2005would have been adjusted to the pro forma amounts indicated in the followingtable (in thousands, except per share amounts):

| ** **                                                                                                                   | ** ** | **April 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                   | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Net income (loss)  as reported                                                                                               |       | $                  | (883       | ) | $ | 71,105 |   |
| Add: Stock-based  compensation expense included in reported net income (loss), net of  applicable tax effects           |       | 518                |       | — |   |
| Deduct: Stock-based  compensation determined under the fair value method for all stock  awards, net of applicable taxes |       | (5,640             | )          | (8,089 | ) |
| Pro forma net income (loss)                                                                                                  |       | $                  | (6,005     | ) | $ | 63,016 |   |
| Basic net income  (loss) per share:                                                                                          |       |               |       |   |   |
| As reported                                                                                                                  |       | $                  | (0.03      | ) | $ | 2.13 |   |
| Pro forma                                                                                                                    |       | $                  | (0.19      | ) | $ | 1.89 |   |
| Diluted net  income (loss) per share:                                                                                        |       |               |       |   |   |
| As reported                                                                                                                  |       | $                  | (0.03      | ) | $ | 2.02 |   |
| Pro forma                                                                                                                    |       | $                  | (0.19      | ) | $ | 1.79 |   |

 

In response to a number of derivative complaints filedagainst it surrounding its stock option practices, the Company, with theassistance of outside counsel, conducted an internal review of thecircumstances surrounding the stock option grants identified in the derivativecomplaints as well as certain of the Company’s historical stock optionpractices. The internal review identified non-material administrative errors ofapproximately $1.0 million in stock-based compensation expense in a few stockoption awards which, due to the administrative errors, were incorrectlyrecorded in our financial statements. The internal review uncovered no evidenceof intentional misconduct. The stock compensation expense was determined basedon the difference in the intrinsic value per option on the new measurement dateversus on the original measurement date (determined by the difference of the optionprice and the closing price per share) multiplied by the number of sharesunderlying the options.

As aresult of revising the accounting measurement date for these stock optiongrants, the Company identified errors which aggregated approximately $1.0million, related to stock-based compensation expenses incurred in fiscal year2000 through fiscal year 2003. The impact of these errors, net of tax, was to 

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decrease net income or increase net loss by $74,000,$255,000, $563,000 and $152,000 for fiscal year 2000 through fiscal year 2003,respectively. While these errors were not material to any previously filedfinancial statements, the Company concluded that correcting the aggregate errorof approximately $1.0 million would be material to its consolidated statementof operations for fiscal 2007, and accordingly, prior period accumulateddeficit and additional paid-in-capital balances have been restated to recordthe cumulative non-cash stock-based compensation expense in this Form 10-K.Additional paid-in-capital and accumulated deficit were adjusted as of April 30,2004, 2005 and 2006 as follows (in thousands):

| ** **                 | ** ** | **April 30, 2004** | ** ** | **April 30, 2005** | ** ** | **April 30, 2006** | ** ** |
|----------------------------|------------|------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                 | ** ** | **As Reported**         | ** ** | **As Restated**         | ** ** | **As Reported**         | ** ** | **As Restated** | ** ** | **As Reported** | ** ** | **As Restated** | ** ** |
| Additional paid-in-capital |       |                         | $          | 281,190                      |       |                         |       | $ | 282,234 |   |   |   | $ | 287,036 |   |   |   | $ | 288,080 |   |   |   | $ | 291,329 |   |   |   | $ | 292,373 |   |   |
| Accumulated deficit        |       |                         | $          | (145,785                     | )          |                         |       | $ | (146,829 | ) |   |   | $ | (89,757 | ) |   |   | $ | (90,081 | ) |   |   | $ | (90,640 | ) |   |   | $ | (91,684 | ) |   |

 

***Recent Accounting Pronouncements***

In July 2006, the FASB issued Interpretation No. 48,“*Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109.*” Interpretation 48 clarifies theaccounting for uncertainty in income taxes recognized in an entity’s financialstatements in accordance with Statement 109 and prescribes a recognitionthreshold and measurement attribute for financial statement disclosure of taxpositions taken or expected to be taken on a tax return. Additionally,Interpretation 48 provides guidance on derecognition, classification, interestand penalties, accounting in interim periods, disclosure and transition. Interpretation48 is effective for fiscal years beginning after December 15, 2006, withearly adoption permitted. The Company has started the review process and isplanning to adopt in the first quarter of fiscal 2008. The Company is currentlyevaluating whether the adoption of Interpretation 48 will have a materialeffect on its overall results of operations or financial position.

In September 2006, the FASB issued Statement No. 157,*Fair Value Measurements* (“SFAS 157”).SFAS 157 defines fair value, establishes a framework and guidance regarding themethods for measuring fair value, and expands related disclosures about thosemeasurements. SFAS 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007, and interim periods withinthose fiscal years. The Company is currently assessing the impact that SFAS 157will have on its results of operations and financial position.

In February 2007, theFASB issued Statement No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities—including an amendment to FAS 115*(“SFAS159”). SFAS 159 allows entities to choose, at specified election dates, tomeasure eligible financial assets and liabilities at fair value in situationsin which they are not otherwise required to be measured at fair value. If acompany elects the fair value option for an eligible item, changes in that item’sfair value in subsequent reporting periods must be recognized in currentearnings. SFAS 159 also establishes presentation and disclosure requirementsdesigned to draw comparison between entities that elect different measurementattributes for similar assets and liabilities. SFAS 159 is effective for fiscalyears beginning after November 15, 2007. The Company is currentlyassessing the impact that SFAS 159 will have on its results of operations andfinancial position.

**3.**                 BALANCESHEET ACCOUNTS

Inventories:   Inventoriescomprised (in thousands):

| ** **     | ** ** | **April 30,** | ** ** |
|----------------|------------|--------------------|------------|
| ** **     | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Raw Materials  |       | $                  | 3,104      |   | $ | 2,125 |   |
| Finished Goods |       | 10,249             |       | 6,193 |   |
| Total          |       | $                  | 13,353     |   | $ | 8,318 |   |

 

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In fiscal 2007 and 2006,the Company sold $337,000 and $634,000, respectively, of previouslywritten-down inventory at approximately net book values.

Investments:   Thefollowing table summarizes the Company’s investments as of April 30, 2007(in thousands):

| ** **               | ** ** | **Cost** | ** ** | **Gross   Unrealized  Gains** | ** ** | **Gross   Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|--------------------------|------------|----------|------------|------------------------------------|------------|-------------------------------------|------------|---------------------|------------|
| Corporate notes          |       | $        | 86,490     |                               |       | $                                   | —     |                |       |   | $ | — |   |   | $ | 86,490 |   |
| Asset backed  securities |       | 13,975   |       |                               | —     |                                |       |                | —     |   |   | $ | 13,975 |   |
| Total                    |       | $        | 100,465    |                               |       | $                                   | —     |                |       |   | $ | — |   |   | $ | 100,465 |   |

 

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

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

 

Included in corporate notes and asset backedsecurities are $39.8 million and $72.4 million of auction rate securities at April 30,2007 and 2006, respectively. For the years ended April 30, 2007, 2006 and2005, no gains or losses were realized on the sale of short-term and long-terminvestments as the Company has not sold investments prior to their maturitydates. As of April 30, 2007 and 2006, net unrealized holding losses of $0and $3,000 were included in accumulated other comprehensive income (loss) inthe accompanying Consolidated Balance Sheets, net of any related tax effect.

As of April 30, 2007 and 2006, all investmentshad maturities of less than one year. Auction rate securities are included inthe less than one year category as they are intended to meet the short-termworking capital needs of the Company and the Company can sell or roll them overon 28 or 35 day auction cycles.

Propertyand Equipment:   Property andequipment comprised (in thousands): 

| ** **                                       | ** ** | **April 30,** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|
| ** **                                       | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Furniture and fixtures                           |       | $                  | 1,904      |   | $ | 1,659 |   |
| Equipment                                        |       | 14,223             |       | 12,570 |   |
| Leasehold improvements                           |       | 1,634              |       | 1,375 |   |
| Computer software                                |       | 4,828              |       | 3,435 |   |
|                                             |       | 22,589             |       | 19,039 |   |
| Less: accumulated  depreciation and amortization |       | (16,808            | )          | (14,299 | ) |
| Total                                            |       | $                  | 5,781      |   | $ | 4,740 |   |

 

AccruedExpenses:   Accrued expenses comprised (inthousands):

| ** **                | ** ** | **April 30,** | ** ** |
|---------------------------|------------|--------------------|------------|
| ** **                | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Accrued employee  related |       | $                  | 4,837      |   | $ | 4,303 |   |
| Accrued warranty          |       | 754                |       | 1,157 |   |
| Other accrued  expenses   |       | 1,557              |       | 1,630 |   |
| Total                     |       | $                  | 7,148      |   | $ | 7,090 |   |

 

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*Warranties.*   TheCompany provides for future warranty costs upon shipment of its products. Thespecific terms and conditions of those warranties may vary depending on theproduct sold, the customer and the country in which it does business. However,the Company’s hardware warranties generally start from the shipment date andcontinue for a period of two to five years while the software warranty isgenerally ninety days to one year. As part of the sale of the Company’s opticalbusiness to JDS Uniphase (“JDSU”), see Note 4, the Company retained itswarranty obligations for optical products sold by the Company prior to July 16,2003. However, as part of the agreement reached in June 2006 between JDSUand the Company, JDSU released the Company of its remaining warrantyobligations. Consequently, the Company reversed approximately $514,000 of itswarranty liability in the fourth quarter of fiscal 2006.

Because the Company’s products are manufactured to astandardized specification and products are internally tested to thesespecifications prior to shipment, the Company historically has experiencedminimal warranty costs. Factors that affect the Company’s warranty liabilityinclude the number of installed units, historical experience and management’sjudgment regarding anticipated rates of warranty claims and cost per claim. TheCompany assesses the adequacy of its recorded warranty liabilities everyquarter and makes adjustments to the liability, if necessary. In fiscal 2007,the Company reversed approximately $395,000 due to the favorable resolution ofa potential recall of a defective component in one of the Company’s olderproducts sold to a past customer.

Changesin the warranty liability, which is included as a component of “Accruedexpenses” on the Consolidated Balance Sheet, were as follows (in thousands):

| ** **                                                                                                             | ** ** | **Year ended April 30,**            | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **   2007    ** | ** ** | **   2006    ** | ** ** |
| Balance as of the  beginning of the fiscal period                                                                      |       |                                               | $          | 1,157 |   |   |   | $ | 2,010 |   |   |
| Provision for  warranties issued during the fiscal period                                                              |       |                                               | 103        |   |   |   | 124 |   |   |
| Warranty costs  incurred during the fiscal period                                                                      |       |                                               | (111       | ) |   |   | (363 | ) |   |
| Other adjustments  to the liability (including changes in estimates for pre-existing warranties)  during fiscal period |       |                                               | (395       | ) |   |   | (614 | ) |   |
| Balance as of the end of  the fiscal period                                                                            |       |                                               | $          | 754 |   |   |   | $ | 1,157 |   |   |

 

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

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

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recovera portion of any future amounts paid. As a result of the Company’s insurancepolicy coverage, the Company believes the estimated fair value of theseindemnification obligations is minimal.

**4.**   DISCONTINUEDOPERATIONS

On July 16, 2003, the Company completed theprimary step in the planned exit of its optical communications business throughthe sale of a large portion of the assets of its optical communicationsbusiness to JDSU, pursuant to an Asset Purchase Agreement (the “PurchaseAgreement”). The assets sold consisted primarily of inventory, certainspecified optical-related equipment and intellectual property rights, whichwere sold for an aggregate purchase price of up to approximately$6.5 million in cash, of which (i) approximately $1.4 millionwas paid to the Company at closing, (ii) $225,000 was to be paid to theCompany one year from the closing (subject to reduction in the event anysuccessful indemnification claims were made against the Company), and (iii) upto an additional $4.9 million was to be paid to the Company, which wascomprised of up to $900,000 based on the level of inventory consumed by JDSU,and up to $4.0 million based on revenues generated by the optical businessacquired by JDSU through June 30, 2005, if any. Additionally, JDSU had theright to require the Company to reimburse JDSU for any purchased but unusedinventory at June 30, 2004, up to $2.0 million, which right expiredas of July 31, 2004. JDSU also was provided indemnification rights inconnection with the performance of certain warranty obligations relating tooptical products that were sold by the Company on or prior to July 16,2003.

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

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

In June 2006, the Company came to a mutualsettlement and release with JDSU whereby JDSU paid Ditech $718,000. The Companyhad recorded receivables of $534,000 such that the net gain from the settlementwas $184,000. As part of the settlement, JDSU additionally released the Companyfrom its warranty obligation, which resulted in the release of $514,000 of itswarranty liability. In addition, in June 2006, the Company completed theclosure of its international optical operations and, as a result, reversed itsremaining $189,000 of reserves related to the closure. Net of $361,000 of taxexpense, the transactions resulted in a $526,000 gain from disposal of theCompany’s discontinued operations.

Subsequent to the sale to JDSU, the Companyaggressively pursued the disposition, through sale, sublease or abandonment, ofassets not included in the Purchase Agreement and the facility leases for theCompany’s Australian and United Kingdom optical research facilities. As of April 30,2006, the Company had disposed of all optical assets not acquired by JDSU andhad negotiated out of the leases for the Australian and United Kingdom opticalresearch facilities. As a result of exiting the optical business, the Company’sConsolidated Statements of Operations reflect the optical business as adiscontinued operation for all periods presented.

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

| ** **                                   | ** ** | **Year ended April 30,** | ** ** |
|----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                   | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Proceeds from  sale                          |       |                                    | $          | — |   |   | $ | 184 |   | $ | (55 | ) |
| Less: Net book  value of assets sold         |       |                                    | —     |   |   | — |   | — |   |
| Transaction costs                            |       |                                    | —     |   |   | — |   | (68 | ) |
| Gain on sale                                 |       |                                    | —     |   |   | 184 |   | 13 |   |
| Costs to exit  remainder of optical business |       |                                    | —     |   |   | (703 | ) | (81 | ) |
| Income from disposition                      |       |                                    | —     |   |   | 887 |   | 94 |   |
| Income tax  expense (benefit)                |       |                                    | —     |   |   | 361 |   | (110 | ) |
| Net income (loss)  from disposition          |       |                                    | $          | — |   |   | $ | 526 |   | $ | 204 |   |

 

The income from disposition in fiscal 2006, asdescribed above, was due to (1) reaching a final mutual settlement andrelease with JDSU in June 2006 whereby JDSU paid the Company $718,000 andreleased it from its warranty obligation and (2) completing the closureits international optical operations. The income from disposition in fiscal2005 was due to adjustments needed to reflect actual costs incurred andincluded an $110,000 income tax benefit related to the reversal of a valuationreserve on deferred tax assets.

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

**5.**   BUSINESSCOMBINATION

On June 30, 2005, the Company acquiredprivately-held Jasomi. Jasomi developed and sold session border controllers,which enables VoIP calls to traverse the network address translation (NAT) andprotects networks from external attacks by admitting only authorized sessions,ensuring that reliable VoIP service can be provided to them. The combination ofDitech’s Packet Voice Processor and Jasomi’s session border control technologymay enable Ditech to provide a comprehensive solution to VoIP carriers’ borderservice needs.

The acquisition consideration paid totaled $14.8million and included a cash payment of $10.4 million that was paid at closing,an additional $2.0 million in cash that was placed in escrow, with theremainder consisting of the assumption of vested stock options, acquisitioncosts and net liabilities assumed. The escrowed cash shall be available tosatisfy any claims for indemnification that Ditech may make for certainbreaches of representations, warranties and covenants set forth in theacquisition agreements and any remaining and available amount in such escrowshall be distributed to the former Jasomi stockholders two years from theacquisition date. In addition, further acquisition consideration not yetrecorded included $7.0 million in non-transferable convertible notes, dividedinto two tranches with principal amounts of $3.0 million and $4.0 million,respectively. The $3.0 million first tranche of notes were to either mature orconvert into Ditech common stock on the date one year or, at the election ofthe holder, two years from the closing date, and were contingent on theretention of a specified number of designated employees. As of  the deadline in June 2006, no holderelected to extend or convert the $3.0 million first tranche of notes and Ditechhad not made any indemnification claims, nor have a sufficient number ofdesignated employees left the employment of Ditech to cause a reduction in theprincipal amounts of the notes. Consequently, the full $3.0 million of thefirst tranche of notes, plus interest at 5%, was paid in the first quarter offiscal 2007, upon surrender of the notes. The $4.0 million second tranche ofnotes either mature or convert into Ditech common stock at the election of theholder two years from the closing date. The notes bear an interest rate of 5%,payable on maturity or conversion, and are convertible at $9.84 per 

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share. The payment of thefull $4.0 million principal amount of the convertible notes is contingent onthe retention of a specified number of designated employees. In accordance withStatement of Financial Accounting Standards No. 141 (SFAS 141), theCompany did not record the $7.0 million as acquisition consideration as, at theclosing date of the acquisition, the Company believed the retention of thedesignated employees was not assured beyond a reasonable doubt. At the time thecontingencies are satisfied and the notes are paid or converted to Ditechcommon stock, the Company will record the amounts due to the former non-employeeJasomi stockholders, if any, as goodwill. The portion of the notes that havebeen issued to employee-stockholders, totaling $947,000, is being amortized ascompensation expense over the remaining life of each note. In fiscal 2007 and2006 , the Company recorded $364,000 and $604,000, respectively, ofcompensation expense related to the notes. The accrued compensation  is included in accrued expenses as of April 30,2007.

Ditech also (1) assumed Jasomi unvested stockoptions outstanding on the date of the closing, which converted into options tobuy 112,343 shares of the Company’s common stock, and (2) issued to Jasomiemployees restricted stock and restricted stock units for an aggregate of393,212 shares of the Company’s common stock. The intrinsic value of theunvested options assumed and restricted shares granted to Jasomi employees wereinitially recorded as deferred stock-based compensation and were beingamortized as compensation expense over the remaining respective vestingperiods. Upon adoption of SFAS 123R on May 1, 2006, the unamortizeddeferred compensation balance was reversed against additional paid-in capital. Therestricted stock has a three year vesting schedule while the unvested optionsassumed typically have a ten year term and a four year vesting period.

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

The Company allocated the purchase price to in-processresearch and development (“in-process R&D”), goodwill and identifiedintangibles through established valuation techniques in the high-technologycommunications equipment industry. In-process R&D was expensed at the timeof the acquisition because technological feasibility was not established and nofuture alternative use existed.

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

The Company based the percentage of completion ofin-process projects on an averaging of (1) expenses incurred to-datecompared to the total estimated development costs for each project, (2) timeincurred to-date and remaining time to complete each project and (3) milestone-basedpercent complete estimates. The in-process projects pertained to generalenhancements to PeerPoint software, combining of NAT and Peering capability,increasing throughput capability, enhancing the interface and developing aDenial of Service module. The average percentage complete for the in-processprojects was 56% as of the date of the acquisition. At the time of the acquisition, it wasestimated that these development efforts would be completed in nine months atan estimated cost of approximately $740,000. As of April 30, 2007, theremaining estimated cost to complete the project was approximately $400,000,primarily due to other projects taking higher priority in fiscal 2007 resultingin most of the development related to the last element of the in-processprojects slipping into fiscal 2008, primarily because the project to increase 

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throughputcapacity was to be part of an integrated PeerPoint and Packet Voice Processorsolution instead of a stand-alone solution as originally planned.

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

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

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

 

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

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

 

The consideration paid and purchase price noted aboveare preliminary due to the $7.0 million of convertible notes that were initially excluded from the purchase price. Uponpayment of the $3.0 million first tranche of the note in the first quarter offiscal 2007, an additional $2.7 million was added to goodwill.

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

In fiscal 2006, the Company recorded $875,000 ofcompensation expense related to assumed unvested stock options and therestricted stock plan.

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

**6.**   GOODWILLAND PURCHASED INTANGIBLES

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

| ** **                      | ** ** | **Fiscal 2007** | ** ** |
|---------------------------------|------------|----------------------|------------|
| ** **                      | ** ** | **Gross  Value**     | ** ** | **Accumulated  Amortization** | ** ** | **Impairment** | ** ** | **Net Value** | ** ** |
| **Purchased Intangible Assets** | ** ** | ** **           | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Core technology                 |       | $                    | 2,900      |   |   | $ | (1,330 | ) |   |   | $ | — | ** ** |   |   | $ | 1,570 | ** ** |   |
| Customer relationships          |       | 1,100                |       |   | (403 | ) |   |   | — | ** ** |   |   | 697 | ** ** |   |
| Trade name and trademarks       |       | 200                  |       |   | (73 | ) |   |   | — | ** ** |   |   | 127 | ** ** |   |
| Goodwill                        |       | 12,637               |       |   | — |   |   |   | — | ** ** |   |   | 12,637 | ** ** |   |
| Total                           |       | $                    | 16,837     |   |   | $ | (1,806 | ) |   |   | $— | ** ** |   |   | $ | 15,031 | ** ** |   |
|                                 |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

In fiscal 2007 and 2006, the Company recorded $985,000and $821,000, respectively, of amortization of Jasomi acquisition-relatedintangible assets.

Estimatedfuture amortization expense of purchased intangible assets as of April 30,2007 is as follows:

| ** **          | ** ** | **Years ended April 30,** | ** ** |
|---------------------|------------|------------------------------------------|------------|
| 2008                |       |                                     | $          | 985 |   |   |
| 2009                |       |                                     | 985        |   |   |
| 2010                |       |                                     | 381        |   |   |
| 2011                |       |                                     | 43         |   |   |
| 2012 and thereafter |       |                                     | —     |   |   |
|                |       |                                     | $          | 2,394 |   |   |

 

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

| ** **        | ** ** | **Fiscal 2007** | ** ** | **Fiscal 2006**          | ** ** |
|-------------------|------------|----------------------|------------|-------------------------------|------------|
| ** **        | ** ** | **Gross  Value**     | ** ** | **Accumulated  Amortization** | ** ** | **Net Value** | ** ** | **Gross  Value** | ** ** | **Accumulated  Amortization** | ** ** | **Net Value** | ** ** |
| Software licenses |       | $                    | 3,359      |                          |       | $ | (3,287 | ) |   |   | $ | 72 |   |   | $ | 3,239 |   |   | $ | (3,219 | ) |   |   | $ | 20 |   |   |
|                   |            |                      |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Amortization expense related to software licenses was$287,000, $761,000, and $838,000, respectively, in fiscal 2007, 2006 and 2005.

The $72,000 remaining bookvalue of software licenses is expected to be amortized in fiscal 2008.

**7.**                 COMMITMENTSAND CONTINGENCIES

*Leases*

The Company leases its principal office facilities inMountain View, California under a non-cancelable operating lease expiring onJuly 31, 2011. As part of the extension of the Mountain View,California lease term in September 2005, the landlord provided $442,000for tenant improvements. This was recorded in accrued expenses and is beingamortized over the remaining term of the lease as a reduction in rent expense.The Company is responsible for taxes, insurance and maintenance expensesrelated to the leased facilities. The Company additionally has leased officespace in Calgary, Canada under an operating lease expiring on January 31,2011. The Company also has operating leases on other offices and certain officeequipment.

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At April 30,2007, future minimum payments under the leases are as follows (in thousands):

| ** ** | ** ** | **Years ended April 30, 2007** | ** ** |
|------------|------------|----------------------------------------------------|------------|
| 2008       |       |                                               | $          | 1,091 |   |   |
| 2009       |       |                                               | 1,112      |   |   |
| 2010       |       |                                               | 1,163      |   |   |
| 2011       |       |                                               | 1,173      |   |   |
| 2012       |       |                                               | 276        |   |   |
| Thereafter |       |                                               | —     |   |   |
|       |       |                                               | $          | 4,815 |   |   |

 

Rent expense under allleases for the years ended April 30, 2007, 2006 and 2005, was $1,511,000$1,610,000, and $2,268,000, respectively.

*Credit Facility*

Effective September 2006,the Company renewed its $2.0 million operating line of credit agreementwith its bank. The renewed line of credit expires on July 31, 2007.Advances under the line bear interest at the rate of prime plus 0.25%. Therenewed line of credit carries the same basic terms as the original line ofcredit and financial covenants related to minimum effective tangible net worthand cash and cash equivalent and short-term investment balances. As of April 30,2007, the Company had no borrowings outstanding under the line of credit.

*Legal Proceedings*

Beginning on June 14, 2005, several purportedclass action lawsuits were filed in the United States District Court for theNorthern District of California, purportedly on behalf of a class of investorswho purchased Ditech’s stock between August 25, 2004 and May 26,2005. The complaints allege claims under Sections 10(b) and 20(a) ofthe Securities Exchange Act of 1934 against Ditech and its Chief ExecutiveOfficer and Chief Financial Officer in connection with alleged misrepresentationsconcerning VQA orders and the potential effect on Ditech of the merger between Sprintand Nextel. All of the lawsuits were consolidated into a single actionentitled*In re Ditech Communications Corp.Securities Litigation,* No. C 05-02406-JSW, and aconsolidated amended complaint was filed on February 2, 2006. Thedefendants moved to dismiss the complaint, and by order dated August 10, 2006, the court granted thedefendants’ motion and dismissed the complaint with leave to amend. Defendantsfiled their Second Amended Complaint on September 11, 2006. Defendantsagain moved to dismiss, and by order dated March 22, 2007, the courtdismissed the Second Amended Complaint with leave to amend. Plaintiffs filedtheir Third Amended Complaint on April 23, 2007. On May 14, 2007,Defendant again moved to dismiss. This latest motion has been set for a hearing on August 19,2007. This matter is at an early stage; no discovery has taken place and notrial date has been set.

On June 20, 2005, the first of two shareholderderivative complaints was filed in the California Superior Court for the Countyof Santa Clara. Both complaints were purportedly brought derivativelyby shareholders on behalf of Ditech against several executives of Ditech andall members of its board of directors, and named Ditech as a nominal defendant. Theplaintiffs alleged that the defendants breached their fiduciary duties to Ditech inconnection with alleged misrepresentations concerning VQA orders and thepotential effect on Ditech of the merger between Sprint and Nextel, thatcertain of the defendants improperly sold Ditech stock while in possession ofmaterial nonpublic information, and that the defendants were liable to Ditech for damages as aresult thereof. Both lawsuits were consolidated into a single action entitled*In re Ditech Communications Corp. DerivativeLitigation,* No. 105-CV-043429. The defendants fileda demurrer to the consolidated complaint, which was granted by the court with leave to 

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amend. The plaintiffs elected not to amend thecomplaint, and voluntarily dismissed the action without prejudice on February 14,2006.

On August 23, 2006, August 25, 2006, and November 3,2006, three actions were filed in United States District Court for the NorthernDistrict of California (Case Nos. C06-05157, C06-05242, and C06-6877)purportedly as derivative actions on behalf of the Company against certain ofthe Company’s current and former officers and directors alleging that between1999 and 2001 certain stock option grants were backdated; that these optionswere not properly accounted for; and that as a result false and misleadingfinancial statements were filed. These three actions have been consolidatedunder case number C06-05157. On December 1, 2006, a fourthderivative complaint making similar allegations against many of the samedefendants was filed in California Superior Court for the County of Santa Clara(Case No.106-CV-075695). On April 19, 2007, the CaliforniaSuperior Court granted the Company’s motion to stay the state court actionpending the outcome of the federal consolidated actions.

The defendants named in the derivative actions areTimothy Montgomery, Gregory Avis, Edwin Harper, William Hasler, AndreiManoliu, David Sugishita, William Tamblyn, Caglan Aras, Toni Bellin,Robert DeVincenzi, James Grady, Lee House, Serge Stepanoff, Gary Testa, LowellTrangsrud, Kenneth Jones, Pong Lim, Glenda Dubsky, Ian Wright, and Peter Chung.These derivative complaints raise claims under Section 10(b) and 10b-5of the Securities Exchange Act, Section 14(a) of the Securities Act,and California Corporations Code Section 25403, as well as common lawclaims for breach of fiduciary duty, unjust enrichment, waste of corporateassets, gross mismanagement, constructive fraud, and abuse of control. Theplaintiffs seek remedies including money damages, disgorgement of profits,accounting, rescission, and punitive damages. With respect to the consolidatedfederal actions,  the plaintiffs filed anamended consolidated complaint on March 2, 2007, adding new allegationsregarding another stock option grant. On April 2, 2007, the Company movedto dismiss the amended complaint based on plaintiffs’ failure to make a demandon the board before bringing suit. On the same day, the individual defendantsmoved to dismiss the amended complaint for failure to state a claim. On June 8,2007, the Court heard oral argument on both motions. The Court has not yetissued a decision in either motion. These actions are in their preliminarystages; no discovery has taken place and no trial date has been set.

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

**8.**                 SALEOF ECHO CANCELLATION TECHNOLOGY

On April 16, 2002,the Company sold its echo cancellation and voice enhancement softwaretechnology, the associated product licenses and all of the related assets toTexas Instruments for an aggregate price of $26.8 million. In connectionwith the sale, Ditech received, at no cost, a license from Texas Instrumentsand Telogy Networks, Inc., a wholly owned subsidiary of Texas Instruments,to use the existing echo cancellation and voice enhancement software and anyenhancements in Ditech’s products for a period of four years. A value of$3.0 million was assigned to this four year license period, which valuewas amortized to cost of goods sold over the four year term ending in April 2006.After the initial four-year royalty-free period ending in April 2006, theCompany (1) extended the royalty-free period for certain legacy digitalsignal processors (“DSPs”)  purchasedfrom TI through December 31, 2007 primarily to support Ditech’s remainingwarranty obligation for its end-of-life products and (2) negotiated newpricing based on the purchase of DSP bundled with the echo software for theCompany’s current products.

**9.**                 PREFERREDSTOCK

Ditech is authorized to issue, from time to time, inone or more series, 5,000,000 shares of preferred stock at a $0.001 par value.The Board of Directors may determine the rights, preferences, privileges and 

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restrictions granted orimposed upon any series of preferred stock. As of April 30, 2007, nopreferred stock was outstanding.

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

**10.**          STOCKHOLDERS’EQUITY

**Employee EquityPlans**

*Employee StockPurchase Plan*

In March and April 1999,the Board adopted, and the stockholders approved, the Company’s 1999 EmployeeStock Purchase Plan (the “Purchase Plan”) under which an aggregate of1,816,666 shares of common stock has been reserved as of April 30,2007. Employees who participate in the one-year offering period can have up to15% of their earnings withheld for the purchase of up to a maximum of 700shares per six-month purchase period pursuant to the Purchase Plan. The amountwithheld will then be used to purchase shares of common stock on specifieddates determined by the Board. The price of common stock purchased under thePurchase Plan will be equal to 85% of the lower of the fair market value of thecommon stock on the commencement date of the offering or end date of thepurchase period. In fiscal 2007, 2006 and 2005, 159,361, 131,665 and 65,602shares, respectively, were purchased under the Purchase Plan. As of April 30,2007, 468,357 shares remain available for issuance under the Purchase Plan.

*Stock Option andRestricted Stock Plans*

The Company’s 1997 Stock Option Plan serves as thesuccessor equity incentive program to the Company’s 1987 Stock Option Plan andthe Supplemental Stock Option Plan (the “Predecessor Plans”). All outstandingstock options under the Predecessor Plans continue to be governed by the termsand conditions of the 1997 Stock Option Plan. The Company reserved4,000,000 shares of common stock for issuance under the 1997 Stock OptionPlan. Under the 1997 Stock Option Plan, the Board of Directors could grantincentive or non-statutory stock options at a price not less than 100% or 85%,respectively, of fair market value of common stock, as determined by the Boardof Directors, at grant date. In November 1998, the Company adoptedits 1998 Stock Option Plan and determined not to grant any further optionsunder its 1997 Stock Option Plan. The Company has reserved a total of4,856,082 shares of common stock for issuance under the 1998 Stock OptionPlan, under terms similar to those of the 1997 Stock Option Plan. During fiscal2000, the Company adopted two non-statutory stock option plans under which atotal of 1,350,000 shares were reserved for issuance. The terms ofnon-statutory options granted under these plans are substantially consistentwith non-statutory options granted under the 1997 and 1998 plans. Shares issuedthrough early option exercises are subject to the Company’s right of repurchaseat the original exercise price. The number of shares subject to repurchasegenerally decreases by 25% of the option shares one year after the grant date,and thereafter, ratably over 36 months. As of April 30, 2007, noshares were subject to repurchase.

On July 25, 2000, the Company purchased the netassets of Atmosphere Networks, and assumed all outstanding stock options thathad been granted under the Atmosphere Networks 1997 Stock Plan (the “AtmospherePlan”). The option shares under the Atmosphere Plan were converted into 122,236options to purchase the Company’s common stock. The calculation of theconversion of option shares was determined using the approximate fair marketvalues of the Atmosphere Networks and the Company’s 

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common stock prices withina one-week period up to the date of the acquisition. After July 25, 2000,no new options are permitted to be granted under the Atmosphere Plan. Theoptions granted under this plan are substantially consistent with the terms ofoptions granted under the Company’s stock option plans.

In August 2000, the Board of Directors adoptedthe 2000 Non-Qualified Stock Plan. A total of 5,000,000 shares werereserved under this plan as of April 30, 2006. The terms of optionsgranted under this plan are substantially consistent with options granted underthe 1997 and 1998 plans.  In September 2006,the Board of Directors amended the 2000 Non-Qualified Stock Plan and re-namedit the 2006 Equity Incentive Plan, as described below. The 2006 EquityIncentive Plan allows for the grant of other types of equity awards, includingrestricted stock and restricted stock units.

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

In connection with the acquisition of Jasomi on June 30,2005, the Board of Directors adopted the 2005 New Recruit Stock Plan. This planallows for up to 500,000 shares of restricted stock and restricted stock unitsto be granted to newly hired employees. The Jasomi Canada employees hired bythe Company received shares with a vesting schedule of 1/3 of the sharesvesting on the first anniversary of the acquisition date, and the remainingvesting in eight (8) successive equal quarterly installments over the two(2)-year period measured from the first anniversary of the closing date. As of April 30,2007, 175,861 shares remain available for issuance under the 2005 New RecruitStock Plan.

In November of 2005 the Board also adopted the2005 New Recruit Stock Option Plan. A total of 200,000 shares were approved forissuance as non-qualified stock options to new hired employees only. The termsof the plan are substantially consistent with the non-qualified stock optionsgranted under the Company’s other stock option plans, except that the plan doesnot allow the early exercise of stock options. In February of 2006,another 300,000 shares were approved and added to the reserve in connectionwith the hiring of the new vice president of worldwide sales. As of April 30,2007, there is a reserve of 500,000 shares under the plan.

In September 2006, the Board of Directors amendedthe 2000 Non-Qualified Stock Plan and re-named it the 2006 Equity IncentivePlan, reserving an additional 2,000,000 shares. As a result of the increase, atotal of 7,000,000 shares have been reserved under this plan as ofApril 30, 2007. The terms of non-statutory options granted under this planare substantially consistent with non-statutory options granted under the 2000plan. However, the new plan allows for the grant of other types of equityawards, including restricted stock and restricted stock units. Restricted stockand restricted stock units generally vest over four years with 25% vestingafter the first year and the remaining shares vesting ratably every six monthsthereafter.

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

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*Directors StockOption Plan*

In March 1999, the Company adopted the 1999Non-Employee Directors’ Stock Option Plan. Under this stock option plan anaggregate of 650,000 shares have been reserved as of April 30, 2007. Optionsgranted under the plan have a 5-year term. Currently, one-time initialautomatic grants of 35,000 shares each are made upon a director’s initialappointment and are subject to annual vesting over a four-year period. Annualautomatic grants of 10,000 shares each are made on the date of each annualmeeting of stockholders to each incumbent director (provided they have servedas a director for at least six months) and are fully vested at the grant date.

Activityunder the stock plans referenced above was as follows (in thousands, exceptlife and exercise price amounts):

| ** **                                             | ** ** | ** **                                | ** ** | **Outstanding Options** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------|------------|
| ** **                                             | ** ** | **Shares Available  For Grant** | ** ** | **Number  of Shares**   | ** ** | **Exercise  Price** | ** ** | **Aggregate  Price** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| Balances,  April 30, 2004                         |       |                                      | 2,020      |                         |       |   | 5,724 |   |   | $ | 0.41 - $79.50 |   |   | $ | 42,456 |   |   |   | $ | 7.42 |   |   |   |   |   |   |
| Reservation of  shares                                 |       |                                      | 1,000      |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options granted                                        |       |                                      | (853       | )                            |       |   | 853 |   |   | $ | 10.85 - $21.92 |   |   | 12,110 |   |   |   | $ | 14.20 |   |   |   |   |   |   |
| Options exercised                                      |       |                                      | —     |                         |       |   | (1,534 | ) |   | $ | 0.41 - $18.07 |   |   | (9,279 | ) |   |   | $ | 6.05 |   |   |   | $ | 20,007 |   |   |
| Options forfeited                                      |       |                                      | 221        |                         |       |   | (221 | ) |   | $ | 1.77 - $17.68 |   |   | (1,304 | ) |   |   | $ | 5.91 |   |   |   |   |   |   |
| Options expired                                        |       |                                      | 20         |                         |       |   | (20 | ) |   | $ | 2.85 - $76.00 |   |   | (586 | ) |   |   | $ | 28.31 |   |   |   |   |   |   |
| Balances,  April 30, 2005                         |       |                                      | 2,408      |                         |       |   | 4,802 |   |   | $ | 0.41 - $79.50 |   |   | 43,397 |   |   |   | $ | 9.04 |   |   |   |   |   |   |
| Reservation of  shares                                 |       |                                      | 1,000      |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Restricted stock  and restricted stock units issued    |       |                                      | (369       | )                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Assumed  outstanding options                           |       |                                      |       |                         |       |   | 191 |   |   | $  0.36 |   |   | 68 |   |   |   | $ | 0.36 |   |   |   |   |   |   |
| Options granted                                        |       |                                      | (2,272     | )                            |       |   | 2,272 |   |   | $ | 6.45 - $10.78 |   |   | 15,844 |   |   |   | $ | 6.97 |   |   |   |   |   |   |
| Options exercised                                      |       |                                      | —     |                         |       |   | (125 | ) |   | $ | 0.36 - $  8.76 |   |   | (403 | ) |   |   | $ | 3.24 |   |   |   | $ | 608 |   |   |
| Options forfeited                                      |       |                                      | 119        |                         |       |   | (130 | ) |   | $ | 0.36 - $17.68 |   |   | (1,275 | ) |   |   | $ | 9.79 |   |   |   |   |   |   |
| Options expired                                        |       |                                      | 82         |                         |       |   | (82 | ) |   | $ | 2.85 - $79.50 |   |   | (2,532 | ) |   |   | $ | 31.09 |   |   |   |   |   |   |
| Balances,  April 30, 2006                         |       |                                      | 968        |                         |       |   | 6,928 |   |   | $ | 0.36 - $76.00 |   |   | 55,099 |   |   |   | $ | 7.95 |   |   |   |   |   |   |
| Reservation of  shares                                 |       |                                      | 2,000      |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Restricted stock  and restricted stock units issued    |       |                                      | (292       | )                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Restricted stock  and restricted stock units forfeited |       |                                      | 74         |                         |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Options granted                                        |       |                                      | (837       | )                            |       |   | 837 |   |   | $ | 6.62 - $  8.46 |   |   | 6,211 |   |   |   | $ | 7.41 |   |   |   |   |   |   |
| Options exercised                                      |       |                                      | —     |                         |       |   | (217 | ) |   | $ | 0.36 - $  8.76 |   |   | (940 | ) |   |   | $ | 4.33 |   |   |   | $ | 791 |   |   |
| Options forfeited                                      |       |                                      | 258        |                         |       |   | (258 | ) |   | $ | 0.36 - $18.75 |   |   | (1,971 | ) |   |   | $ | 8.55 |   |   |   |   |   |   |
| Options expired                                        |       |                                      | 267        |                         |       |   | (267 | ) |   | $ | 6.49 - $76.00 |   |   | (2,936 | ) |   |   | $ | 10.08 |   |   |   |   |   |   |
| Balances, April 30,  2007                         |       |                                      | 2,438      |                         |       |   | 7,023 |   |   | $ | 0.36 - $24.69 |   |   | 55,463 |   |   |   | $ | 7.90 |   |   |   |   |   |   |

 

| ** **                                 | ** ** | **Number of   Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Aggregate  Fair Value** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|--------------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|-----------------------------------------------------|------------|
| 2007                                       |       |                             |       |                                       |       |                            |       |                           |       |                                                |       |   |   |   |   |   |   |   |   |   |   |
| Fully vested and  expected to vest options |       |                             | 6,509      |                                       |       |                            | $          | 7.91                           |       |                                                |       | $ | 9,914 |   |   |   |   |   |   |   | 6.32 |   |   |
| Options vested during  the period          |       |                             | 4,955      |                                       |       |                            | $          | 7.92                           |       |                                                |       | $ | 7,776 |   |   |   | $ | 26,922 |   |   |   | 5.62 |   |   |
|                                            |            |                                  |            |                                            |            |                                 |            |                                |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Sharesavailable for grant include shares from the 2005 New Recruit Stock Plan and the2006 Equity Incentive Plan that may be issued as either stock options,restricted stock or restricted stock units. Shares issued under the 2006 EquityIncentive Plan as stock bonus awards, stock purchase awards, stock unit awards,or other stock awards in which the issue price is less than the fair marketvalue on 

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the date of grant of the award count as the issuanceof 1.3 shares for each share of common stock issued pursuant to these awardsfor purposes of the share reserve.

Optionsoutstanding and exercisable at April 30, 2007 (in thousands, except life andexercise price amounts):

| ** **                              | ** ** | **Options Outstanding** | ** ** | ** **                 | ** ** | **Options Exercisable**                   | ** ** |
|-----------------------------------------|------------|------------------------------|------------|----------------------------|------------|------------------------------------------------|------------|
| **Range of Exercise  Prices** | ** ** | ** **                   | ** ** | **Number of  Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** | **Weighted Average Remaining  Contractual Life (in Years)** | ** ** | **Number of Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
| $  0.36  - $  4.13  |       |                         | 788        |                       |       |                                           | $          | 2.50 |   |   |   | 4.70 |   |   |   | 766 |   |   |   | $ | 2.56 |   |   |
| $  4.19  - $  6.45  |       |                         | 154        |                       |       |                                           | $          | 5.71 |   |   |   | 6.28 |   |   |   | 106 |   |   |   | $ | 5.38 |   |   |
| $  6.49                       |       |                         | 1,481      |                       |       |                                           | $          | 6.49 |   |   |   | 8.10 |   |   |   | 829 |   |   |   | $ | 6.49 |   |   |
| $  6.62  - $  7.22  |       |                         | 1,230      |                       |       |                                           | $          | 7.18 |   |   |   | 7.03 |   |   |   | 559 |   |   |   | $ | 7.16 |   |   |
| $  7.77 -  $  8.56  |       |                         | 185        |                       |       |                                           | $          | 8.31 |   |   |   | 7.79 |   |   |   | 63 |   |   |   | $ | 8.33 |   |   |
| $  8.76                       |       |                         | 1340       |                       |       |                                           | $          | 8.76 |   |   |   | 6.28 |   |   |   | 1,282 |   |   |   | $ | 8.76 |   |   |
| $  8.82  - $  9.59  |       |                         | 795        |                       |       |                                           | $          | 8.98 |   |   |   | 5.17 |   |   |   | 529 |   |   |   | $ | 9.02 |   |   |
| $  9.62  - $13.37             |       |                         | 866        |                       |       |                                           | $          | 12.15 |   |   |   | 6.59 |   |   |   | 661 |   |   |   | $ | 12.00 |   |   |
| $14.45 - $24.69                         |       |                         | 183        |                       |       |                                           | $          | 17.62 |   |   |   | 3.99 |   |   |   | 159 |   |   |   | $ | 17.88 |   |   |
| $  0.36  - $24.69             |       |                         | 7,022      |                       |       |                                           | $          | 7.90 |   |   |   | 6.51 |   |   |   | 4,954 |   |   |   | $ | 7.92 |   |   |
|                                         |            |                              |            |                            |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Restrictedstock and restricted stock units outstanding at April 30, 2007 (inthousands, except life):

| ** **                                                                           | ** ** | **Restricted Stock and Restricted Stock Units Outstanding** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                                                                           | ** ** | **Number of  Shares or  Units**                                                 | ** ** | **Weighted Average  Grant Date Fair  Value** | ** ** | **Aggregate Intrinsic  Value** | ** ** | **Weighted Average  Remaining  Contractual Term** | ** ** |
| Nonvested  restricted stock and restricted stock units, April 30, 2006     |       |                                                                                      | 369        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Restricted stock  and restricted stock units granted                                 |       |                                                                                      | 227        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Restricted stock  and restricted stock  units vested                                 |       |                                                                                      | (191       | ) |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Restricted stock  and restricted stock units forfeited                               |       |                                                                                      | (72        | ) |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Nonvested  restricted stock and restricted stock units, April 30, 2007          |       |                                                                                      | 333        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Fully vested and  expected to vest restricted stock and restricted stock units  |       |                                                                                      | 303        |   |   |   | $ | — |   |   |   | $ | 2,313 |   |   |   | 2.7 |   |   |
| Fully vested  restricted stock and restricted stock units currently exercisable |       |                                                                                      | —     |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
|                                                                                      |            |                                                                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

For the year ended April 30, 2007, the totalintrinsic value of restricted stock and restricted stock units (“RSUs”) vestedwas $1.6 million and the total fair value of shares vested was $1.2 million.

As of April 30, 2007, approximately $6.2 millionof total unrecognized compensation cost related to stock options and restrictedstock/RSUs is expected to be recognized over a weighted-average period of1.9 years for options and 2.7 years for restricted stock and restrictedstock units.

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Thekey assumptions used in the fair value model and the resulting estimates ofweighted-average fair value per share used to record stock-based compensationin fiscal 2007 under SFAS 123R and for proforma disclosures under SFAS 123 infiscal 2006 and 2005 for options granted and for employee stock purchases underthe ESPP during those periods are as follows:

| ** **                                                                           | ** ** | **Years ended April 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                           | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Stock options:**                                                                   | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Dividend yield(1)                                                                    |       | —                                   |       | — |   | — |   |
| Volatility  factor(2)                                                                |       | 0.69                                     |       | 0.82 |   | 0.87 |   |
| Risk-free  interest rate(3)                                                          |       | 4.5                                      | %          | 4.1 | % | 3.4 | % |
| Expected life  (years)(4)                                                            |       | 4.9                                      |       | 4.0 |   | 4.0 |   |
| Weighted average  fair value of options granted during the period                    |       | $                                        | 4.48       |   | $ | 4.22 |   | $ | 8.84 |   |
| **Employee  stock purchase plan:(5)**                                                | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Dividend yield(1)                                                                    |       | —                                   |       | — |   | — |   |
| Volatility  factor(2)                                                                |       | .46                                      |       | 0.93 |   | 0.73 |   |
| Risk-free  interest rate(3)                                                          |       | 5.0                                      | %          | 4.5 | % | 2.4 | % |
| Expected life (years)(4)                                                             |       | .71                                      |       | 0.50 |   | 0.50 |   |
| Weighted average  fair value of employee stock purchases during the period |       | $                                        | 2.24       |   | $ | 3.14 |   | $ | 6.39 |   |
| **Restricted  stock and restricted stock units:**                                    | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted average fair  value of restricted stock and RSUs granted during the period  |       | $                                        | 7.37       |   | $ | 6.49 |   | $ | n/a |   |

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(1)          The Company has nohistory or expectation of paying dividends on its common stock.

(2)          The Company estimatesthe volatility of its common stock at the date of grant based on the historicvolatility of its common stock for a term consistent with the expected life ofthe awards affected at the time of grant.

(3)          The risk-free interestrate is based on the U.S. Treasury yield for a term consistent with theexpected life of the awards in affect at the time of grant.

(4)          The expected life ofstock options granted under the Plans is based on historical exercise patterns,which the Company believes are representative of future behavior. The expectedlife of grants under the Purchase Plan represents the amount of time remainingin the 12-month offering window.

(5)          Assumptionsfor the Purchase Plan relate to the most recent enrollment period. Enrollmentis currently permitted in May and November of each year.

**Stock RepurchaseProgram**

In December 2004, the Company’s Board of Directorsauthorized the repurchase of up to $35 million of common stock under a stockrepurchase program. The repurchase program was implemented to invest availablefunds. During fiscal 2005, the Company repurchased and retired 2,516,660 sharesof its common stock at an average price of $13.91 per share for an aggregatepurchase price of $35 million. Consequently, the Company is not authorized torepurchase additional shares under the stock repurchase program approved in December of2004.

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

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**11.**   INCOMETAXES

Theprovisions for income taxes reflected in the statements of operations for theyears ended April 30:

| ** **     | ** ** | **2007**                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|-------------------------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **$s in thousands** | ** ** |
| Current:       |       |                          |       |     |       |     |       |
| Federal        |       | $                             | 315        |     | $          | 4        |       | $ | 496 |   |
| State          |       | 119                           |       | (1,171   | )          | 153      |       |
| Foreign        |       | 4                             |       | 71       |       | (54      | )          |
| Total Current  |       | $                             | 438        |     | $          | (1,096   | )          | $ | 595 |   |
| Deferred:      |       |                          |       |     |       |     |       |
| Federal        |       | $                             | 2,854      |     | $          | 168      |       | $ | (28,708 | ) |
| State          |       | 93                            |       | 1,190    |       | (8,097   | )          |
| Total Deferred |       | 2,947                         |       | 1,358    |       | (36,805  | )          |
| Total          |       | $                             | 3,385      |     | $          | 262      |       | $ | (36,210 | ) |

 

In fiscal 2005, based on the level of historicaltaxable income and projections for future taxable income over the periods thatthe Company’s deferred tax assets are deductible, the Company determined thatit was more likely than not that certain of its deferred tax assets wereexpected to be realized and therefore released $51.6 million of valuationallowance. The reversal of the valuation allowance and other adjustments to thedeferred tax assets resulted in the recognition of income tax benefits tocontinuing operations and discontinued operations of $36.7 million and$110,000, respectively, in fiscal 2005. In addition, the Company recognized acredit of $14.8 million to additional paid-in capital for the portion of thedeferred tax asset attributable to benefits from the exercise of employee stockoptions. As of April 30, 2007, 2006 and 2005, the Company had no valuationallowance against its deferred tax assets.

Thecomponents of the Company’s deferred tax assets and liabilities at April 30consisted of

| ** **                                           | ** ** | **2007**                      | ** ** | **2006** | ** ** |
|------------------------------------------------------|------------|-------------------------------|------------|----------|------------|
| ** **                                           | ** ** | **$s in thousands** | ** ** |
| Deferred tax assets  (liabilities):                  |       |                          |       |     |       |
| Uniform capitalization                               |       | $                             | 1,728      |     | $          | 1,402 |   |
| Depreciation                                         |       | 385                           |       | 300      |       |
| Inventory reserves                                   |       | 1,341                         |       | 1,335    |       |
| Other reserves and accruals                          |       | 1,474                         |       | 1,434    |       |
| Stock-based compensation under SFAS 123R             |       | 2,171                         |       | —   |       |
| Purchased technology, goodwill and other intangibles |       | 1,117                         |       | 677      |       |
| Tax credits                                          |       | 9,894                         |       | 8,483    |       |
| Net operating losses                                 |       | 27,718                        |       | 35,144   |       |
| Total deferred  tax assets                           |       | $                             | 45,828     |     | $          | 48,775 |   |

 

As of April 30, 2007, the Company has federal andstate tax net operating loss carryforwards of approximately $73.6 millionand $36.4 million, respectively. If not utilized, the federal netoperating loss carryforwards will begin to expire in fiscal 2016, and the statenet operating loss carry forwards will begin to expire in fiscal 2010. As of April 30,2007, the Company had federal and state tax credit carryforwards ofapproximately $6.6 million and $4.8 million, respectively.

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TheCompany’s effective tax rate differs from the U.S. federal statutory income taxrate for the years ended April 30, principally due to the following:

| ** **                                                                         | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Tax Provision  (benefit) at federal statutory rate                                 |       | 35.0     | %          | 35.0     | %          | 35.0     | %          |
| State taxes, net  of federal benefit                                               |       | 6.0      |       | 5.7      |       | 5.7      |       |
| Non-deductible  in-process R&D and other acquisition related amortization |       | —   |       | (46.3    | )          | —   |       |
| Other permanent  differences                                                       |       | 4.3      |       | (7.1     | )          | —   |       |
| Correction of  California R&D tax credit error                                 |       | —   |       | (100.3   | )          | —   |       |
| True-up  adjustments to deferred tax assets                                        |       | —   |       | (11.4    | )          | —   |       |
| Reversal of  reserves associated with California R&D tax credit position  |       | —   |       | 101.5    |       | —   |       |
| Research Credit                                                                    |       | (11.1    | )          |     |       |     |       |
| Valuation  allowance                                                               |       | —   |       | —   |       | (146.2   | )          |
| Other                                                                              |       | 4.7      |       | —   |       | 1.9      |       |
| Effective tax  rate                                                                |       | 38.9     | %          | (22.9    | )%         | (103.6   | )%         |

 

The tax provision (benefit) for fiscal 2006 resultedin an effective tax rate of (23%). The effective tax rate for the year wasadversely affected by non-deductible Jasomi acquisition-related charges,including the Company’s inability to deduct for tax purposes (1) in-processR&D related to the acquisition of Jasomi and (2) convertible debentureamortization, and the correction of a $1.1 million error in the balance of adeferred tax asset related to a California R&D tax credit. The errororiginated in the second quarter of fiscal 2005 at the time the Companyreleased its valuation allowance on deferred tax assets and was corrected inthe fourth quarter of fiscal 2006. After conducting a thorough analyticalreview on materiality, which was brought to the attention of and discussed withthe audit committee, management believes that such amounts are not material topreviously reported financial statements. Those items were partially offset bythe reversal of $1.2 million of reserves on deferred tax assets primarilyassociated with a California R&D tax credit position under audit byCalifornia’s Franchise Tax Board. In April 2006, the Company reached anagreement with the Franchise Tax Board regarding its tax credit positions andconsequently revised associated reserves. The agreement did not result in theassessment of additional tax.

The Company’s income taxes payable for federal, state,and foreign purposes have been reduced by the tax benefits from employee stockoptions. The Company receives an income tax benefit calculated as thedifference between the fair market value of the stock issued at the time ofexercise and the option price, tax effected. The net tax benefits from employeestock option transactions were $0.2 million, and $15.6 million for fiscal 2006,and 2005, respectively, and were reflected as an increase to additional paid-incapital in the Consolidated Balance Sheet only for 2006 and 2005. The Companydid not record a benefit to the Consolidated Statements of Shareholders’ Equityfor fiscal 2007 as a result of electing to use FAS 109 ordering with respect toreduction to the current tax provision. Accordingly, the net operating lossescarryforward from pre-2007 years were utilized first to offset thecurrent taxes payable prior to the impact of current year tax benefits fromemployee stock options.

The Company’s federal income tax returns are notcurrently under examination for any year.

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**12.   REPORTABLESEGMENTS AND GEOGRAPHIC INFORMATION**

The Company currently operates in a single segment,voice quality products.

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

| ** **          | ** ** | **2007**                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------|------------|-------------------------------|------------|----------|------------|----------|------------|
| ** **          | ** ** | **$s in thousands** | ** ** |
| USA                 |       | $                             | 59,806     |     | $          | 47,992   |       | $ | 85,337 |   |
| Asia Pacific        |       | 960                           |       | 983      |       | 2,155    |       |
| Canada              |       | 2,233                         |       | 2,056    |       | 3,292    |       |
| Latin America       |       | 4,905                         |       | 595      |       | 1,345    |       |
| Middle  East/Africa |       | 15,329                        |       | 1,519    |       | —   |       |
| Europe              |       | 771                           |       | 1,760    |       | 1,926    |       |
| Total               |       | $                             | 84,004     |     | $          | 54,905   |       | $ | 94,055 |   |

 

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

| ** **    | ** ** | **As of April 30,** | ** ** |
|---------------|------------|------------------------------------|------------|
| ** **    | ** ** | **2007**                           | ** ** | **2006** | ** ** |
| USA           |       | $                                  | 5,379      |   | $ | 4,320 |   |
| Canada        |       | 395                                |       | 395 |   |
| Rest of World |       | 7                                  |       | 25 |   |
| Total         |       | $                                  | 5,781      |   | $ | 4,740 |   |

 

**13.**   PROFITSHARING PLAN

The Company maintains a401(k) profit sharing plan for all eligible employees. Employees maycontribute to the Plan based on statutory limits. Any Company contributions areat the discretion of the Board of Directors. The Company made contributions tothe Plan during fiscal 2007, 2006, and 2005, of $68,000, $58,000, and $49,000,respectively.

**14.**   SUPPLEMENTAL CASHFLOW INFORMATION

| ** **        | ** ** | **Years ended April 30,** | ** ** |
|-------------------|------------|------------------------------------------|------------|
| ** **        | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **        | ** ** | **$s in thousands**            | ** ** |
| Operating:        |       |                                     |       |   |   |   |   |   |   |   |   |
| Interest paid     |       |                                     | $          | — |   |   | $ | — |   |   | $ | 6 |   |   |
| Income taxes paid |       |                                     | 93         |   |   | 191 |   |   | 53 |   |   |
|                   |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 

**15.**   SUBSEQUENTEVENTS

On June 13, 2007, the Company’s Board ofDirectors approved the repurchase of approximately $60 million of the Company’sshares of common stock The Company does not plan to commence repurchasing theshares until the second quarter of fiscal 2008.

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**SUPPLEMENTARY FINANCIAL DATA (unaudited)**

| ** **                                | ** ** | **Fiscal 2007**                                               | ** ** | **Fiscal 2006** | ** ** |               |
|-------------------------------------------|------------|--------------------------------------------------------------------|------------|----------------------|------------|--------------------|
| ** **                                | ** ** | **First  Quarter**                                                 | ** ** | **Second  Quarter**  | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter(1)** | ** ** |
| ** **                                | ** ** | **(in thousands, except per share data)** | ** ** |                 |
| Revenue                                   |       | $                                                                  | 21,619     |                 | $          | 21,098             |   | $ | 22,078 |   | $ | 19,209 |   | $ | 10,347 |   | $ | 10,523 |   | $ | 13,995 |   |   | $ | 20,040 |   |   |
| Gross profit                              |       | $                                                                  | 15,063     |                 | $          | 14,283             |   | $ | 14,102 |   | $ | 13,416 |   | $ | 7,188 |   | $ | 7,354 |   | $ | 9,715 |   |   | $ | 14,280 |   |   |
| Income (loss)  from continuing operations |       | $                                                                  | 1,523      |                 | $          | 1,071              |   | $ | 2,007 |   | $ | 717 |   | $ | (1,931 | ) | $ | (1,392 | ) | $ | (67 | ) |   | $ | 1,981 |   |   |
| Net income (loss)                         |       | $                                                                  | 1,523      |                 | $          | 1,071              |   | $ | 2,007 |   | $ | 717 |   | $ | (1,931 | ) | $ | (1,392 | ) | $ | (67 | ) |   | $ | 2,507 |   |   |
| Basic per share  data                     |       |                                                               |       |                 |       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations  |       | $                                                                  | 0.05       |                 | $          | 0.03               |   | $ | 0.06 |   | $ | 0.02 |   | $ | (0.06 | ) | $ | (0.04 | ) | $ | 0.00 |   |   | $ | 0.06 |   |   |
| Net income (loss)                         |       | $                                                                  | 0.05       |                 | $          | 0.03               |   | $ | 0.06 |   | $ | 0.02 |   | $ | (0.06 | ) | $ | (0.04 | ) | $ | 0.00 |   |   | $ | 0.08 |   |   |
| Diluted per share  data                   |       |                                                               |       |                 |       |               |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income (loss) from continuing operations  |       | $                                                                  | 0.04       |                 | $          | 0.03               |   | $ | 0.06 |   | $ | 0.02 |   | $ | (0.06 | ) | $ | (0.04 | ) | $ | 0.00 |   |   | $ | 0.06 |   |   |
| Net income (loss)                         |       | $                                                                  | 0.04       |                 | $          | 0.03               |   | $ | 0.06 |   | $ | 0.02 |   | $ | (0.06 | ) | $ | (0.04 | ) | $ | 0.00 |   |   | $ | 0.07 |   |   |
|                                           |            |                                                                    |            |                      |            |                    |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          Thequarterly data reflects the treatment of the Company’s optical business, whichwas sold in July 2003, as a discontinued operation. See Note 4 of theNotes to the Consolidated Financial Statements.

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

Not Applicable.

**Item 9A—Controlsand Procedures**

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

It should be noted that acontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. For example, controls can be circumvented by a person’s individualacts, by collusion of two or more people or by management override of thecontrol. Because a cost-effective control system can only provide reasonableassurance that the objectives of the control system are met, misstatements dueto error or fraud may occur and not be detected.

*Disclosure Controlsand Procedures*

We maintain disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”)) that are designed toprovide reasonable assurance that that information required to be disclosed inthe reports we file or submit under the Exchange Act is recorded, processed,summarized, and reported within the time periods specified in the Securitiesand Exchange Commission rules and forms, and that such information isaccumulated and communicated to management, including our chief executiveofficer and chief financial officer, as appropriate to allow timely decisionsregarding required disclosure.

We carried out anevaluation, under the supervision and with the participation of management,including our chief executive officer and our chief financial officer, of theeffectiveness of the design and 

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operationof our disclosure controls and procedures. Based on this evaluation, our chiefexecutive officer and chief financial officer concluded that, as of April 30,2007, our disclosure controls and procedures were effective to providereasonable assurance that the information required to be disclosed by us inreports that we file or submit under the Exchange Act, is recorded, processed,summarized and reported within the time periods specified in Securities andExchange Commission rules and forms, and that such information isaccumulated and communicated to management, including our chief executiveofficer and chief financial officer, as appropriate to allow timely decisionsregarding required disclosure.

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

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rules 13a-15(f) and 15d-15(f). Undersupervision and with the participation of our management, including TimothyMontgomery, our principal executive officer, and William Tamblyn, our principalfinancial officer, we conducted an evaluation of the effectiveness of ourinternal control over financial reporting as of April 30, 2007. In makingthis assessment, our management used the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission (COSO) in *Internal Control—Integrated Framework.*Ourmanagement has concluded that, as of April 30, 2007, our internal controlover financial reporting was effective based on these criteria.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of April 30, 2007 has been audited by PricewaterhouseCoopersLLP, the independent registered public accounting firm that audited ourfinancial statements included in this Annual Report on Form 10-K.PricewaterhouseCoopers LLP has issued an attestation report on management’sassessment of our internal control over financial reporting, which is includedat the beginning of Item 8 herein.

*Changes in InternalControl over Financial Reporting.*

During the fourth quarterof 2007, there have been no changes in our internal control over financialreporting that have material affected, or were reasonably likely to materiallyaffect, our internal control over financial reporting.

**Item 9B—OtherInformation**

None.

**Part III**

**Item 10—Directors,Executive Officers and Corporate Governance**

*Directors.**  *Information concerning ourDirectors, including with respect to procedures by which security holders mayrecommend nominees to our Board of Directors and with respect to thecomposition of our Audit Committee, is incorporated herein by reference to thesection entitled “Proposal 1—Election of Directors” contained in our definitiveProxy Statement with respect to our Annual Meeting of Stockholders to be filedwith the Securities and Exchange Commission not later than August 28, 2006in connection with the solicitation of proxies for the Company’s 2007 AnnualMeeting of Stockholders (the “Proxy Statement”).

*ExecutiveOfficers.**  *Informationconcerning our Executive Officers is set forth under the section entitled “ExecutiveOfficers of the Registrant” in the Proxy Statement and is incorporated hereinby reference.

*Section 16(a) BeneficialOwnership Reporting Compliance.**  *Information concerning compliancewith Section 16(a) of the Securities Act of 1934 is set forth in thesection entitled “Section 16(a) Beneficial 

82

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Ownership ReportingCompliance” contained in our Proxy Statement and is incorporated herein by reference.

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

**Item 11—ExecutiveCompensation**

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

**Item 12—Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

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

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

**Item 13—CertainRelationships and Related Transactions, and Director Independence**

The information required by this Item with respect tobeneficial ownership of our common stock is set forth in the Proxy Statementunder the heading “Certain Relationships and Related Transactions.” Suchinformation is incorporated herein by reference.

The information requiredby this Item with respect to the independence of our Directors is set forth inthe Proxy Statement in the section entitled “Proposal 1—Election of Directors”.Such information is incorporated herein by reference.

**Item 14—PrincipalAccountant Fees and Services**

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

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**Part IV**

**Item 15—Exhibitsand Financial Statement Schedules**

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

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

Reference is made to theIndex to Consolidated Financial Statements of Ditech Networks, Inc. underItem 8 in Part II of this Form 10-K, which is incorporatedby reference here.

***(2)****         *Financial Statement Schedule

**Schedule IIValuation and Qualifying Accounts(in thousands)**

| ** **                                      | ** ** | **Balance at  Beginning of Year** | ** ** | **Additions** | ** ** | **Deductions** | ** ** | **Balance at  End of Year** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------|------------|---------------|------------|----------------|------------|--------------------------------------------|------------|
| Year ended April 30,  2005                 |       |                                             |       |          |       |           |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts(1)              |       |                                             | $          | 404           |       |           |       | $                                          | —     |   |   |   | $ | (60 | ) |   |   | $ | 344 |   |   |
| Provision for excess and obsolete inventory(2)  |       |                                             | $          | 11,523        |       |           |       | $                                          | 1,526      |   |   |   | $ | (8,562 | ) |   |   | $ | 4,487 |   |   |
| Valuation allowance on deferred tax assets(3)   |       |                                             | $          | 52,229        |       |           |       | $                                          | 3,382      |   |   |   | $ | (55,611 | ) |   |   | $ | — |   |   |
| Year ended  April 30, 2006                 |       |                                             |       |          |       |           |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts(1)              |       |                                             | $          | 344           |       |           |       | $                                          | 28         |   |   |   | $ | (66 | ) |   |   | $ | 306 |   |   |
| Provision for excess and obsolete inventory(2)  |       |                                             | $          | 4,487         |       |           |       | $                                          | 98         |   |   |   | $ | (1,306 | ) |   |   | $ | 3,279 |   |   |
| Year ended  April 30, 2007                 |       |                                             |       |          |       |           |       |                                       |       |   |   |   |   |   |   |   |   |
| Allowance for doubtful accounts(1)              |       |                                             | $          | 306           |       |           |       | $                                          | 80         |   |   |   | $ | (13 | ) |   |   | $ | 373 |   |   |
| Provision for  excess and obsolete inventory(2) |       |                                             | $          | 3,279         |       |           |       | $                                          | 1,143      |   |   |   | $ | (1,127 | ) |   |   | $ | 3,295 |   |   |

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(1)          There were no deductionsin 2007, 2006 or 2005 related to optical receivables.

(2)          There were no provisionsfor optical inventory in fiscal 2007, 2006 or 2005. The fiscal 2007 provisionof $1.1 million included $835,000 of field and evaluation unit amortization,which was charged to operating expense. The deductions to the provision forexcess and obsolete inventory included $0, $150,000, and $4.7 million ofdeductions for optical inventory in fiscal 2007, 2006 and 2005, respectively.Approximately $288,000 of fiscal 2007 and $634,000 of fiscal 2006 deductionsrelated to the sale of previously written-down inventory at its carrying value.The large deduction activity in fiscal 2005 related to the scrapping of excessand obsolete optical components primarily for our Titanium optical switch productthat was abandoned in fiscal 2003.

(3)          Based on the level ofhistorical taxable income and projections for future taxable income over theperiods that the Company’s deferred tax assets are deductible, the Companydetermined that it was more likely than not that certain of its deferred taxassets were expected to be realized and therefore released its valuationallowance on deferred tax assets in fiscal 2005.

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

See the Exhibit Index which follows the signaturepage of this Annual Report on Form 10-K, which is incorporatedherein by reference.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                    |   |   | DITECH NETWORKS, INC.                                                    |
|--------------------|--------|--------|-------------------------------------------------------------------------------|
| July 16, 2007 | By:    |   | /s/  TIMOTHY K. MONTGOMERY                                                    |
|               |   |   | Timothy K.  Montgomery*President, Chief Executive Officer, and Director* |

 

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

|                                  | **Signatures** | ** **                                    | ** ** | ** **         | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|----------------------------------|----------------|-----------------------------------------------|------------|--------------------|-----------|------------|------------|------------|----------|------------|
| /s/ TIMOTHY K. MONTGOMERY        |           | President, Chief  Executive Officer and       |       | July 16, 2007 |
| Timothy K. Montgomery       |           | Director                                      |       |               |
|                             |           | (principal executive  officer)                |       |               |
| /s/ WILLIAM J. TAMBLYN           |           | Executive Vice  President and                 |       | July 16, 2007 |
| William J. Tamblyn          |           | Chief Financial Officer                       |       |               |
|                             |           | (principal financial and  accounting officer) |       |               |
| /s/ GREGORY M. AVIS              |           | Director                                      |       | July 16, 2007 |
| Gregory M. Avis             |           |                                          |       |               |
| /s/ EDWIN L. HARPER              |           | Chairman of the  Board of Directors           |       | July 16, 2007 |
| Edwin L. Harper             |           |                                          |       |               |
| /s/ WILLIAM A. HASLER            |           | Director                                      |       | July 16, 2007 |
| William A. Hasler           |           |                                          |       |               |
| /s/ ANDREI M. MANOLIU, PHD       |           | Director                                      |       | July 16, 2007 |
| Andrei M. Manoliu, PhD |           |                                          |       |               |
| /s/ DAVID M. SUGISHITA           |           | Director                                      |       | July 16, 2007 |
| David M. Sugishita          |           |                                          |       |               |

 

85

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**Exhibit Index**
| Exhibit             | ** ** | ** **                                                                                                                                                                                                                    | ** ** | **Description   of document** |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|
|   2.1(1)  |       | Asset Purchase  Agreement, dated as of April 16, 2002, by and between Ditech and Texas  Instruments                                                                                                                      |
|   2.2(2)  |       | Asset Purchase  Agreement, dated as of July 16, 2003, by and between Ditech and JDSU.                                                                                                                                    |
|   2.3(29) |       | Agreement and Plan of  Merger, dated as of June 6, 2005, among Ditech, Spitfire Acquisition  Corp., Jasomi Networks, Inc., Jasomi Networks (Canada), Inc.,  Daniel Freedman, Cullen Jennings and Todd Simpson. |
|   3.1(4)  |       | Restated Certificate of  Incorporation of Ditech                                                                                                                                                                              |
|   3.2(28) |       | Bylaws of Ditech, as  amended and restated on March 28, 2002                                                                                                                                                             |
|   4.1     |       | Reference is made to  Exhibits 3.1 and 3.2                                                                                                                                                                                    |
|   4.2(7)  |       | Specimen Stock  Certificate                                                                                                                                                                                                   |
|   4.3(6)  |       | Rights Agreement, dated  as of March 26, 2001 among Ditech Communications Corporation and Wells  Fargo Bank Minnesota, N.A.                                                                                              |
|   4.4(6)  |       | Form of Rights  Certificate                                                                                                                                                                                              |
| 10.1(7)             |       | Lease Agreement, dated  August 18, 1998, between Ditech and Lincoln-Whitehall Pacific, LLC, as  amended January 25, 1999                                                                                            |
| 10.2(7)(8)          |       | 1997 Stock Option Plan                                                                                                                                                                                                        |
| 10.3(8)(18)         |       | 1998 Amended and  Restated Stock Option Plan                                                                                                                                                                                  |
| 10.4(8)(15)         |       | 1999 Employee Stock  Purchase Plan                                                                                                                                                                                            |
| 10.5(8)(24)         |       | 1999 Non-Employee  Directors’ Stock Option Plan, as amended                                                                                                                                                              |
| 10.6(7)(8)          |       | Employment Agreement,  dated October 3, 1997, as amended September 15, 1998, between  Ditech and Timothy Montgomery                                                                                                 |
| 10.7(8)(14)         |       | 1999 Non-Officer Equity  Incentive Plan                                                                                                                                                                                       |
| 10.8(5)(8)          |       | Employment Offer, dated  June 19, 2001, between Ditech and Lowell Trangsrud                                                                                                                                              |
| 10.9(8)(11)         |       | Employment Offer, dated  as of April 30, 2002, between Ditech and Sandeep Pombra                                                                                                                                         |
| 10.10(12)           |       | Loan and Security  Agreement, dated August 7, 2002, by and between Ditech and Comerica  Bank-California                                                                                                                  |
| 10.11(8)(20)        |       | Jasomi  Networks, Inc. 2001 Stock Plan                                                                                                                                                                                   |
| 10.12(8)(13)        |       | Employment Letter, dated  April 25, 2002 between Ditech and Lee House                                                                                                                                                    |
| 10.13(8)            |       | Cash Compensation  Arrangements with Executive Officers                                                                                                                                                                       |
| 10.14(8)            |       | Cash Compensation  Arrangements with Non-Employee Directors                                                                                                                                                                   |
| 10.15(8)(27)        |       | 2005 New Recruit Stock  Plan                                                                                                                                                                                                  |
| 10.16(7)(8)         |       | Form of Indemnity  Agreement to be entered between Ditech and each of its current executive  officers and directors                                                                                                      |
| 10.18(7)            |       | Stock Purchase  Agreement, dated as of September 15, 1997 between Ditech and William  Hasler                                                                                                                             |
| 10.19(7)(8)         |       | Form of option agreement  under the 1997 Stock Option Plan                                                                                                                                                               |
| 10.20(7)(8)         |       | Form of option  agreement under the 1998 Stock Option Plan                                                                                                                                                               |
| 10.21(9)(10)        |       | Patent License  Agreement, dated as of August 13, 1999, between Ditech and Antec  Corporation                                                                                                                            |
| 10.22(8)(21)        |       | 2005 New Recruit Stock  Option Plan                                                                                                                                                                                           |
| 10.23(8)(26)        |       | Form of Stock  Option Agreement under the 2005 New Recruit Stock Option Plan                                                                                                                                             |
| 10.26(3)            |       | Second Lease Amendment,  dated February 15, 2000, between Ditech and Middlefield-Bernardo  Associates LLC                                                                                                                |
| 10.27(25)           |       | Fourth Amendment to Lease  Agreement dated July 31, 2005, between Middlefield II LLC and Ditech                                                                                                                          |
| 10.28(8)(12)        |       | 2000 Non-Qualified Stock  Option Plan                                                                                                                                                                                         |
| 10.31(1)(9)         |       | Software License  Agreement, dated as of April 16, 2002, by and between Ditech and Telogy                                                                                                                                |
| 10.32(9)(16)        |       | Amendment No. 1 to  Telogy Software License between Ditech Communications Corporation and Texas  Instruments Incorporated, dated May 21, 2003                                                                       |

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| 10.33(17)     |   | First Amendment to Loan  and Security Agreement dated August 28, 2003 between Ditech  Communications Corporation and Comerica Bank-California |
|---------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.34(8)(17)  |   | Employment Agreement,  dated September 16, 2003, between Ditech Communications Corporation and  Jim H. Grady                                  |
| 10.35(8)(19)  |   | Form of option  agreement under the 1999 Non-Employee Directors’ Stock Option Plan                                                       |
| 10.36(8)(21)  |   | Offer Letter, executed  February 4, 2006, between Ditech and Gary Testa                                                                       |
| 10.37(28)(35) |   | Amendment No. 2 to  TELOGY SOFTWARE LICENSE AGREEMENT between Ditech Communications Corporation  and Texas Instruments Incorporated           |
| 10.38(8)(30)  |   | 2006 Equity Incentive Plan                                                                                                                         |
| 10.39(8)(31)  |   | Change In Control  Severance Benefit Plan                                                                                                          |
| 10.40(8)(32)  |   | Form of Stock  Option Agreement to be Used for Grants of Stock Options Under the Ditech  Networks, Inc. 2006 Equity Incentive Plan       |
| 10.41(8)(33)  |   | 2006 Equity Incentive  Plan Restricted Stock Award Agreement                                                                                       |
| 10.42(8)(33)  |   | 2006 Equity Incentive  Plan Restricted Stock Unit Award Agreement                                                                                  |
| 10.43(8)(34)  |   | Transition and Retirement Agreement, dated May 8, 2007,  between Timothy K. Montgomery and Ditech Networks, Inc.                         |
| 10.44(8)      |   | Amendment to Relocation  Arrangement with Gary Testa, dated May 16, 2007                                                                      |
| 10.45(8)      |   | Relocation Arrangement  with Todd Simpson, dated May 9, 2007                                                                                  |
| 21.1          |   | Subsidiaries of Ditech  Networks, Inc.                                                                                                        |
| 23.1          |   | Consent of  PricewaterhouseCoopers LLP                                                                                                             |
| 31.1          |   | Certification by Chief  Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                          |
| 31.2          |   | Certification by Chief  Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                          |
| 32.1          |   | Certification Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                                                      |

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(1)          Incorporated byreference from the exhibit with corresponding number from Ditech’s Report on Form 8-K,filed April 30, 2002 (Commission File No. 000-26209).

(2)          Incorporated byreference from the exhibit with corresponding title from Ditech’s Current Reporton Form 8-K, filed July 30, 2003 (Commission File No. 000-26209).

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

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

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

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

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

(8)          Management contract orcompensatory plan or arrangement.

(9)          Confidential treatmenthas been granted as to a portion of this exhibit. The confidential portion ofsuch exhibit has been omitted and filed separately with the Commission.

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(10) Incorporated by reference from the exhibit with the correspondingexhibit number from Ditech’s Quarterly Report on Form 10-Q for thequarter ending July 31, 1999 (Commission File No. 000-26209).

(11) Incorporated by reference from the exhibit with the correspondingtitle from Ditech’s Quarterly Report on Form 10-Q for the quarterending July 31, 2002, filed August 29, 2002 (Commission File No. 000-26209).

(12) Incorporated by reference from the exhibit with the correspondingtitle from Ditech’s Quarterly Report on Form 10-Q for the quarterending October 31, 2002, filed December 16, 2002 (Commission File No. 000-26209).

(13) Incorporated by reference from the exhibit with the correspondingtitle from Ditech’s Quarterly Report on Form 10-Q for the quarterending January 31, 2003, filed March 14, 2003 (Commission File No. 000-26209).

(14) Incorporated by reference to the exhibit with the correspondingtitle from Ditech’s Tender Offer Statement on Schedule TO, filed February 19,2003 (Commission File No. 000-26209).

(15) Incorporated by reference to Appendix B to Ditech’s Amendment No. 1to Proxy Statement (Commission File No. 333-110821), filed August 9,2006.

(16) Incorporated by reference from the exhibit with the correspondingnumber from Ditech’s Quarterly Report on Form 10-Q for the quarter endedJuly 31, 2003, filed September 15, 2003 (Commission File No. 000-26209).

(17) Incorporated by reference from the exhibit with the correspondingnumber from Ditech’s Quarterly Report on Form 10-Q for the quarterended October 31, 2003, filed December 8, 2003 (Commission File No. 000-26209).

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

(19) Incorporated by reference from the exhibit with corresponding titlefrom Ditech’s Current Report on Form 8-K, filed September 22,2004 (Commission File No. 000-26209).

(20) Incorporated by reference to the exhibit with the correspondingtitle from Ditech’s Registration Statement on Form S-8 (CommissionFile No. 333-126302), filed June 30, 2005.

(21) Incorporated by reference to the exhibit with the correspondingtitle from Ditech’s Current Report on Form 8-K, filed February 9,2006 (Commission File No. 000-26209).

(22) Incorporated by reference from the exhibit with corresponding titlefrom Ditech’s Current Report on Form 8-K, filed August 1, 2005(Commission File No. 000-26209).

(23) Incorporated by reference from the exhibits with correspondingtitles from Ditech’s Current Reports on Form 8-K, filed August 1,2005 and May 22, 2006 (Commission File No. 000-26209).

(24) Incorporated by reference from such plan filed with Ditech’s ProxyStatement filed August 16, 2005 (Commission File No. 000-26209).

(25) Incorporated by reference from the exhibit with corresponding titlefrom Ditech’s Current Report on Form 8-K, filed September 23,2005 (Commission File No. 000-26209).

(26) Incorporated by reference from the exhibit with corresponding titlefrom Ditech’s Current Report on Form 8-K, filed November 15,2005 (Commission File No. 000-26209).

(27) Incorporated by reference to the exhibit with the correspondingtitle from Ditech’s Registration Statement on Form S-8 (Commission No. 333-126292),filed June 28, 2005.

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(28) Incorporated by reference from the exhibit with corresponding numberfrom Ditech’s Annual Report on Form 10-K for the fiscal year ended April 30,2006, filed July 7, 2006 (Commission File No. 000-26209).

(29) Incorporated by reference from the exhibit with corresponding numberfrom Ditech’s Annual Report on Form 10-K for the fiscal year ended April 30,2005, filed July 14, 2005 (Commission File No. 000-26209).

(30) Incorporated by reference from such plan filed with Ditech’s ProxyStatement filed August 2, 2006 (Commission File No. 000-26209).

(31) Incorporated by reference from the exhibit with corresponding titlefrom Ditech’s Current Report on Form 8-K, filed August 22, 2006(Commission File No. 000-26209).

(32) Incorporated by reference from the exhibit with corresponding titlefrom Ditech’s Current Report on Form 8-K, filed September 21,2006 (Commission File No. 000-26209).

(33) Incorporated by reference from the exhibit with corresponding titlefrom Ditech’s Quarterly Report on Form 10-Q, filed March 12,2007 (Commission File No. 000-26209).

(34) Incorporated by reference from the exhibit with corresponding titlefrom Ditech’s Current Report on Form 8-K, filed May 10, 2007(Commission File No. 000-26209).

(35) Confidential treatment has been requested as to a portion of thisexhibit. The confidential portion of such exhibit has been omitted and filedseparately with the Commission.

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