** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

----

 

**FORM 10-Q**

 

----

 
| **ý**                                                                                                                                              | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                              | ** ** | ** **                                                                                               |
| **FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2005**                                                                                               |
| ** **                                                                                                                                              | ** ** | ** **                                                                                               |
| **Or**                                                                                                                                                  |
| ** **                                                                                                                                              | ** ** | ** **                                                                                               |
| **o**                                                                                                                                                   | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                              | ** ** | ** **                                                                                               |
| **FOR THE TRANSITION PERIOD FROM                    TO** |

 

**Commissionfile number 0-51118**

 

**SoftBrands, Inc.**

(Exact name of registrant asspecified in its charter)

 
| **DELAWARE**                                                             | ** ** | **41-2021446**                            |
|--------------------------------------------------------------------------|------------|-------------------------------------------|
| (State or  other jurisdiction of  incorporation or organization)         |       | (I.R.S.  Employer  Identification Number) |
| ** **                                                               | ** ** | ** **                                |
| **Two Meridian Crossings, Suite 800  Minneapolis, Minnesota 55423** |
| (Address of  principal executive offices)                                |
| ** **                                                               | ** ** | ** **                                |
| **(612) 851-1500**                                                  |
| (Registrant’s  telephone number, including area code)               |

 

----

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days.    YES   ý     NO  o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer.

Large accelerated filer   o                                                       Acceleratedfiler   o                                    Non-acceleratedfiler   ý

 

Indicate by checkmark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).     YES   o      NO   ý

The number of shares of the registrant’s common stock outstanding as ofJanuary 31, 2006 was 40,110,000.

 

 

----

 

**Form 10-Q**

**Index**

 
| Part I.  | Financial Information                                                                             |   |
|---------------|---------------------------------------------------------------------------------------------------|--------|
| Item 1.       | Financial Statements                                                                              |   |
|          | Consolidated Balance Sheets at December 31, 2005 and September 30,  2005                |   |
|          | Consolidated Statements of Operations for the three months ended December 31,  2005 and 2004 |   |
|          | Consolidated Statements of Cash Flows for the three months ended December 31,  2005 and 2004 |   |
|          | Notes to Consolidated Financial Statements                                                        |   |
| Item 2.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations       |   |
| Item 3.       | Quantitative and Qualitative Disclosures About Market Risk                                        |   |
| Item 4.       | Controls and Procedures                                                                           |   |
|          |                                                                                              |   |
| Part II. | Other  Information                                                                                |   |
| Item  1.      | Legal  Proceedings                                                                                |   |
| Item  1A.     | Risk  Factors                                                                                     |   |
| Item 2.       | Unregistered Sales of Equity Securities and Use of Proceeds.                                      |   |
| Item 3.       | Defaults Upon Senior Securities                                                                   |   |
| Item 4.       | Submission of Matters to a Vote of Security Holders                                               |   |
| Item  5.      | Other  Information                                                                                |   |
| Item 6.       | Exhibits                                                                                          |   |
| Signatures    |                                                                                              |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

2

----

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. Financial Statements**

 

**SoftBrands, Inc.**

**ConsolidatedBalance Sheets**

**inthousands, except share and per share data**

**(unaudited)**

 
| ** **                                                                                                                                                                        | ** ** | **December 31,  2005** | ** ** | **September 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| ** **                                                                                                                                                                        | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| **Assets**                                                                                                                                                                        | ** ** | ** **                  | ** ** | ** **                   | ** ** |
| Current  assets                                                                                                                                                                   |       |                        |       |                         |       |
| Cash and  cash equivalents                                                                                                                                                        |       | $                           | 13,812     |                         | $          | 16,034 |   |
| Accounts  receivable, net                                                                                                                                                         |       | 5,998                       |       | 5,363                        |       |
| Prepaid  expenses and other current assets                                                                                                                                        |       | 1,500                       |       | 1,134                        |       |
| Total  current assets                                                                                                                                                             |       | 21,310                      |       | 22,531                       |       |
|                                                                                                                                                                              |       |                        |       |                         |       |
| Furniture,  fixtures and equipment, net                                                                                                                                           |       | 1,994                       |       | 1,986                        |       |
| Restricted  cash                                                                                                                                                                  |       | 654                         |       | 648                          |       |
| Goodwill                                                                                                                                                                          |       | 23,532                      |       | 22,947                       |       |
| Intangible  assets, net                                                                                                                                                           |       | 4,049                       |       | 3,783                        |       |
| Other long-term  assets                                                                                                                                                           |       |                        |       | 6                            |       |
| Total assets                                                                                                                                                                      |       | $                           | 51,539     |                         | $          | 51,901 |   |
|                                                                                                                                                                              |       |                        |       |                         |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                    |       |                        |       |                         |       |
| Current  liabilities                                                                                                                                                              |       |                        |       |                         |       |
| Current portion  of long-term debt and capital leases                                                                                                                             |       | $                           | 154        |                         | $          | 260 |   |
| Accounts  payable                                                                                                                                                                 |       | 1,257                       |       | 2,240                        |       |
| Accrued  expenses                                                                                                                                                                 |       | 4,232                       |       | 5,707                        |       |
| Accrued  restructuring costs                                                                                                                                                      |       | 183                         |       | 203                          |       |
| Deferred  revenue                                                                                                                                                                 |       | 17,440                      |       | 15,355                       |       |
| Other  current liabilities                                                                                                                                                        |       | 1,383                       |       | 1,352                        |       |
| Total  current liabilities                                                                                                                                                        |       | 24,649                      |       | 25,117                       |       |
|                                                                                                                                                                              |       |                        |       |                         |       |
| Other long-term  liabilities                                                                                                                                                      |       | 268                         |       | 292                          |       |
| Total  liabilities                                                                                                                                                                |       | 24,917                      |       | 25,409                       |       |
|                                                                                                                                                                              |       |                        |       |                         |       |
| Stockholders’  equity                                                                                                                                                        |       |                        |       |                         |       |
| Series A  Convertible Preferred Stock, $0.01 par value; 300,000 shares authorized; no  shares issued or outstanding                                                          |       |                        |       |                         |       |
| Series B  Convertible Preferred Stock, $0.01 par value; 4,331,540 shares authorized,  issued and outstanding; liquidation value of $4,591                                    |       | 5,068                       |       | 5,068                        |       |
| Series C  Convertible Preferred Stock, $0.01 par value; 20,027 shares authorized,  18,000 shares issued and outstanding; liquidation value of $18,000 plus unpaid  dividends |       | 15,065                      |       | 15,065                       |       |
| Common  stock, $0.01 par value; 110,000,000 shares authorized; 40,071,500 and 40,030,000  shares issued and outstanding, respectively                                             |       | 401                         |       | 400                          |       |
| Additional  paid-in capital                                                                                                                                                       |       | 173,552                     |       | 173,756                      |       |
| Accumulated  other comprehensive loss                                                                                                                                             |       | (1,333                      | )          | (1,893                       | )          |
| Accumulated  deficit                                                                                                                                                              |       | (166,131                    | )          | (165,904                     | )          |
| Total  stockholders’ equity                                                                                                                                                  |       | 26,622                      |       | 26,492                       |       |
| Total  liabilities and stockholders’ equity                                                                                                                                  |       | $                           | 51,539     |                         | $          | 51,901 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

3

----

 

**SoftBrands, Inc.**

**Consolidated Statements of Operations**

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

 
| ** **                                                         | ** ** | **Three Months Ended**      | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                         | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|                                                               |       |                        |       |   |   |
| **Revenue**                                                        | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Software  licenses                                                 |       | $                           | 2,357      |   | $ | 2,297 |   |
| Maintenance                                                        |       | 10,505                      |       | 11,133 |   |
| Professional  services                                             |       | 3,355                       |       | 3,179 |   |
| Third-party  software and hardware                                 |       | 525                         |       | 668 |   |
| Total  revenue                                                     |       | 16,742                      |       | 17,277 |   |
|                                                               |       |                        |       |   |   |
| **Cost of  revenues**                                              |       |                        |       |   |   |
| Software  licenses                                                 |       | 983                         |       | 1,120 |   |
| Maintenance                                                        |       | 3,248                       |       | 3,533 |   |
| Professional  services                                             |       | 3,040                       |       | 2,586 |   |
| Third-party  software and hardware                                 |       | 342                         |       | 445 |   |
| Total cost  of revenues                                            |       | 7,613                       |       | 7,684 |   |
| Gross profit                                                       |       | 9,129                       |       | 9,593 |   |
|                                                               |       |                        |       |   |   |
| **Operating  expenses**                                            |       |                        |       |   |   |
| Selling,  general and administrative                               |       | 7,511                       |       | 7,427 |   |
| Research and  product development                                  |       | 2,439                       |       | 2,002 |   |
|                                                               |       |                        |       |   |   |
| Total  operating expenses                                          |       | 9,950                       |       | 9,429 |   |
| Operating  income (loss)                                           |       | (821                        | )          | 164 |   |
|                                                               |       |                        |       |   |   |
| Interest  expense                                                  |       | (4                          | )          | (1,003 | ) |
| Other  income, net                                                 |       | 85                          |       | 273 |   |
| Loss from  continuing operations before provision for income taxes |       | (740                        | )          | (566 | ) |
|                                                               |       |                        |       |   |   |
| Provision  for (benefit from) income taxes                         |       | (87                         | )          | 100 |   |
| Loss from  continuing operations                                   |       | (653                        | )          | (666 | ) |
|                                                               |       |                        |       |   |   |
| **Discontinued  operations**                                       |       |                        |       |   |   |
| Income from  discontinued operations, net of tax                   |       | 426                         |       |   |   |
| Net loss                                                           |       | (227                        | )          | (666 | ) |
|                                                               |       |                        |       |   |   |
| Preferred  stock dividends                                         |       | 273                         |       |   |   |
|                                                               |       |                        |       |   |   |
| **Net loss  applicable to common shareholders**                    |       | $                           | (500       | ) | $ | (666 | ) |
|                                                               |       |                        |       |   |   |
| **Basic  and diluted earnings (loss) per common share**            |       |                        |       |   |   |
| Continuing  operations                                             |       | $                           | (0.02      | ) | $ | (0.02 | ) |
| Discontinued  operations                                           |       | $                           | 0.01       |   |   |   |
| Net loss                                                           |       | $                           | (0.01      | ) | $ | (0.02 | ) |
|                                                               |       |                        |       |   |   |
| **Weighted  average basic and diluted shares outstanding**         |       | 40,042                      |       | 40,030 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements

 

4

----

 

**SoftBrands, Inc.**

**Consolidated Statements of Cash Flows**

**inthousands**

**(unaudited)**

 
| ** **                                                                                                        | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                        | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
| **Cash flow from operating activities**                                                                           | ** ** | ** **             | ** ** | ** ** | ** ** |
| Loss from continuing operations                                                                                   |       | $                      | (653       | ) | $ | (666 | ) |
| Adjustments to reconcile loss from  continuing operations to net cash provided by (used in) continuing operations |       |                   |       |   |   |
| Depreciation and amortization                                                                                     |       | 1,407                  |       | 1,464 |   |
| Stock-based compensation expense                                                                                  |       | 348                    |       |   |   |
| Noncash interest expense                                                                                          |       |                   |       | 271 |   |
| Foreign currency transaction gains                                                                                |       | (52                    | )          | (271 | ) |
| Provision for doubtful accounts                                                                                   |       | 3                      |       | 69 |   |
| Change in operating assets and liabilities,  net of effect of acquisitions and divestitures                       |       |                   |       |   |   |
| Accounts receivable                                                                                               |       | (570                   | )          | 300 |   |
| Prepaid expenses and other current assets                                                                         |       | (273                   | )          | (259 | ) |
| Accounts payable                                                                                                  |       | (996                   | )          | (194 | ) |
| Accrued expenses                                                                                                  |       | (865                   | )          | (863 | ) |
| Accrued restructuring costs                                                                                       |       | (20                    | )          | (179 | ) |
| Deferred revenue                                                                                                  |       | 2,203                  |       | 1,353 |   |
| Other current liabilities                                                                                         |       | (48                    | )          | (196 | ) |
| Other long-term assets and liabilities                                                                            |       | (24                    | )          | (161 | ) |
| Net cash provided by operating activities                                                                         |       | 460                    |       | 668 |   |
| **Cash flow from investing activities**                                                                           |       |                   |       |   |   |
| Purchases of furniture, fixtures and  equipment                                                                   |       | (215                   | )          | (111 | ) |
| Capitalized software development costs                                                                            |       |                   |       | (60 | ) |
| Investments in acquisitions                                                                                       |       | (1,907                 | )          |   |   |
| Net cash used in investing activities                                                                             |       | (2,122                 | )          | (171 | ) |
| **Cash flow from financing activities**                                                                           |       |                   |       |   |   |
| Repayment of long-term debt and capital  leases                                                                   |       | (105                   | )          | (131 | ) |
| Proceeds on issuance of common stock                                                                              |       | 76                     |       |   |   |
| Preferred stock dividends                                                                                         |       | (408                   | )          |   |   |
| Net cash used in financing activities                                                                             |       | (437                   | )          | (131 | ) |
| Effect of exchange rates on cash balances                                                                         |       | (123                   | )          | (385 | ) |
| Change in cash and cash equivalents                                                                               |       | (2,222                 | )          | (19 | ) |
| **Cash and cash equivalents**                                                                                     |       |                   |       |   |   |
| Beginning of period                                                                                               |       | 16,034                 |       | 9,719 |   |
| End of period                                                                                                     |       | $                      | 13,812     |   | $ | 9,700 |   |

 

The accompanying notes are anintegral part of these consolidated financial statements.

 

5

----

 

**SoftBrands, Inc.**

**Notes to Consolidated Financial Statements**

**(unaudited)**

 

**1.****                                      Basisof Presentation**

 

The unaudited consolidated financial statements included herein reflectall adjustments, in the opinion of management, necessary to fairly state theconsolidated financial position, results of operations and cash flows ofSoftBrands, Inc. (the “Company”) for the periods presented. Theseadjustments consist of normal, recurring items unless otherwise noted. The preparationof financial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts therein. Due to the inherentuncertainty involved in making estimates, actual results in future periods maydiffer from those estimates. The results of operations for the quarter ended December 31, 2005are not necessarily indicative of the results to be expected for any subsequentquarter or for the entire fiscal year ending September 30, 2006.These statements do not contain certain information included in the Company’sannual financial statements and notes. The accompanying interim consolidatedfinancial statements should be read in conjunction with the financialstatements and related notes included in the Company’s Report on Form 10-Kas filed with the Securities and Exchange Commission (“SEC”) on December 20,2005.

 

 

**2.****                                     ****Stock-Based Compensation**

 

On December 13, 2001, the Company’s Board of Directors andshareholders approved the SoftBrands, Inc. 2001 Stock Incentive Plan,which has a total of 12,400,000 shares of the Company’s common stock reservedfor issuance under options, including incentive stock options (“ISOs”) andother stock options, restricted stock awards, stock appreciation rights,dividend rights and other stock-based awards thereunder.  The planprovides that employees, directors and consultants are eligible to receiveawards thereunder, that the Compensation Committee of the Board of Directors isauthorized to establish the terms of such awards, as long as, in the case ofISOs, the term does not exceed ten years from the date of grant, and that theexercise price of the options not be less than fair value on the date ofgrant.  Through December 31, 2005, 6,175,235 of the options grantedhad become exercisable.  In the fiscalquarter ending December 31, 2005 the Company’s Compensation Committee forthe first time approved equity awards to management employees which consistedof restricted stock units (“RSUs”) and stock appreciation rights (“SARs”).

 

Effective October 1, 2005 the Company adopted the fair valuemethod of accounting for stock-based compensation arrangements in accordancewith Financial Accounting Standards Board (“FASB”) Statement No123R, *Share-Based Payment*(“SFAS No. 123(R)”),using the modified prospective method of transition. Under the provisions ofSFAS No. 123(R), the estimated fair value of share based awards grantedunder the 2001 Stock Incentive Plan is recognized as compensation expense overthe vesting period. Using the modified prospective method, compensation expenseis recognized beginning with the effective date of adoption of SFAS No. 123(R)for all share based payments (i) granted after the effective date ofadoption and (ii) granted prior to the effective date of adoption and thatremain unvested on the date of adoption.

 

Prior to October 1, 2005, the Company accounted for stock-basedemployee compensation plans using the intrinsic value method of accounting inaccordance with Accounting Principles Board Opinion No. 25,*Accounting for Stock Issued to Employees*(“APB25”), and its related interpretations. Under the provisions of APB 25, nocompensation expense was recognized when stock options were granted withexercise prices equal to or greater than market value on the date of grant.

 

The Company recorded $348,000, or $0.01 per share of total stock-basedcompensation expense for the three-month period ended December 31, 2005 asrequired by the provisions of SFAS No. 123(R). The stock-basedcompensation expense is calculated on a straight-line basis over the vestingperiods of the related options. This charge had no impact on the Company’sreported cash flows. For the three-month period ended December 31, 2004,the Company recorded no stock compensation expense pursuant to APB 25.  The allocation of the stock-basedcompensation expense for the three months ended December 31, 2005 is asfollows:

 

6

----

 
| **Thousands**                                 | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|------------|------------|
| ** **                                    | ** ** | ** ** | ** ** |
| Cost of  revenue                              |       | $          | 23         |   |
| Selling,  general and administrative expenses |       | 303        |       |
| Research and  Development                     |       | 22         |       |
| Total                                         |       | $          | 348        |   |

 

Under the modified prospective method of transition under SFAS No. 123(R),the Company is not required to restate its prior period financial statements toreflect expensing of share-based compensation under SFAS No. 123(R).Therefore, the results as of December 31, 2005 are not directly comparableto the same period in the prior year.

 

As required by SFAS No. 123(R), the Company has presented proforma disclosures of its net loss and net loss per share for the prior yearperiod assuming the estimated fair value of the options granted prior to October 1,2005 was amortized to expense over the option-vesting period as illustrated below.

 
| ** **                                                                                             | ** ** | **Three Months Ended**      | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| **Thousands**                                                                                          | ** ** | **December 31,  2004** | ** ** |
| ** **                                                                                             | ** ** | ** **                  | ** ** |
| Net loss, as  reported                                                                                 |       | $                           | (666       | ) |
| Less total  stock-based compensation expense determined under fair value based method for  all rewards |       | (277                        | )          |
| Pro forma  net loss                                                                                    |       | $                           | (943       | ) |
|                                                                                                   |       |                        |       |
| Basic and diluted  loss per common share                                                               |       |                        |       |
| As reported                                                                                            |       | $                           | (0.02      | ) |
| Pro forma                                                                                              |       | $                           | (0.02      | ) |
|                                                                                                        |            |                             |            |  |  |

 

For purposes of the disclosure in the foregoing table and for purposesof determining estimated fair value under SFAS No. 123(R), the Company hascomputed the estimated fair values of all share-based compensation using theBlack-Scholes option pricing model and has applied the assumptions set forth inthe following table.  In the fourthquarter of 2005, the Company changed the expected life of options granted from10 years to 5 years based on a study of comparable companies and to reflectanticipated increased marketability and trading volume of the Company’s commonstock.   The previous estimated life of 10 years was used because,prior to March 15, 2005, when the Company’s registration under Section 12(g) ofthe Securities Exchange Act of 1934 became effective, options had a seven yearcliff vesting period.  Under initial terms of the options, vesting wasaccelerated on March 15, 2005 and now vest over three-to-four year terms.  The approved listing and trading ofSoftBrands, Inc. common shares on the American Stock Exchange effective December 27,2005 was also taken into consideration when determining the expected life ofoptions.

 
| ** **        | ** ** | **Risk-Free  Interest Rate** | ** ** | **Dividend  Yield** | ** ** | **Volatility  Factor** | ** ** | **Weighted-  Average Option  Life (Years)** | ** ** |
|-------------------|------------|------------------------------|------------|---------------------|------------|------------------------|------------|---------------------------------------------|------------|
|              |       |                         |       |                |       |                   |       |                                        |       |
| Fiscal Year  2006 |       | 4.41                         | %          | 0                   | %          | 80                     | %          | 5                                           |       |
| Fiscal Year  2005 |       | 4.09                         | %          | 0                   | %          | 80                     | %          | 9.5                                         |       |

 

The Black-Scholes option-pricing model requires the input of highlysubjective assumptions. Management will continue to assess the

 

7

----

 

assumptions and methodologies used to calculate estimated fair value ofshare-based compensation. Circumstances may change and additional data maybecome available over time, which result in changes to these assumptions andmethodologies, which could materially impact the Company’s fair valuedetermination.

 

A summary of option activity under the 2001 Stock Incentive Plan as of December 31,2005, and changes during the three-month period then ended is presented below.

 

**Summary Details for Stock Options Granted under the2001 Stock Incentive Program**

 
| ** **                                       | ** ** | **Number of  Options** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Weighted-Average  Remaining Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|----------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------|------------|
|                                             |       |                   |       |                                   |       |                                                      |       |                            |       |
| Outstanding  Balance, September 30, 2005    |       | 10,257,500             |       | $                                      | 2.20       |                                                      |       |                            |       |   |
| Granted                                          |       | 145,500                |       | $                                      | 1.88       |                                                      |       |                            |       |   |
| Exercised                                        |       | (41,500                | )          | $                                      | 1.50       |                                                      |       |                            |       |   |
| Forfeited                                        |       | (252,626               | )          | $                                      | 1.51       |                                                      |       |                            |       |   |
| Outstanding  Balance, December 31, 2005     |       | 10,108,874             |       | $                                      | 2.21       |                                                      | 7.0        |                            | $          | 2,601,629 |   |
|                                             |       |                   |       |                                   |       |                                                      |       |                            |       |
| Exercisable  shares as of December 31, 2005 |       | 6,175,235              |       | $                                      | 2.48       |                                                      | 6.0        |                            | $          | 924,348 |   |

 

The weighted-average, grant-date fair value of options granted duringthe three-month period ended December 31, 2005 was $1.23.  The total intrinsic value of optionsexercised during the three-month period ended December 31, 2005 was $17,335.  The fair value of vested options during thequarter is $127,750.

 

A summary of the status of the Company unvested shares as of December 31,2005, and changes during the three-month period then ended is presented below.

 

**Unvested Stock Options Issued Under the 2001 StockIncentive Program**

 
| ** **                                 | ** ** | **Nonvested   Shares** | ** ** | **Weighted-Average   Grant-Date   Fair Value** | ** ** |
|--------------------------------------------|------------|------------------------|------------|------------------------------------------------|------------|
|                                       |       |                   |       |                                           |       |
| Unvested  Balance, September 30, 2005 |       | 4,180,804              |       | $                                              | 1.07       |   |
| Granted                                    |       | 145,500                |       | $                                              | 1.23       |   |
| Vested                                     |       | (143,539               | )          | $                                              | 0.89       |   |
| Forfeited                                  |       | (249,126               | )          | $                                              | 1.05       |   |
| Unvested  Balance, December 31, 2005  |       | 3,933,639              |       | $                                              | 1.07       |   |

 

As of December 31, 2005, there was $2,217,296 of totalunrecognized compensation expense related to stock option arrangements grantedunder the 2001 Stock Incentive Plan. This expense is expected to be recognizedover a weighted-average period of 2 years.

 

**Restricted Stock Units and Stock AppreciationRights**

 

On December 29, 2005, the Company’s Compensation Committeeapproved equity awards to management employees under the SoftBrands, Inc.2001 Stock Incentive Program.  To better optimize the cost of the Company’sequity incentives under SFAS 123(R), the awards consisted of restricted stockunits (“RSUs”) and stock appreciation rights (“SARs”) rather than stockoptions.  In total, the Committee granted RSUs to acquire 362,000 sharesof common stock, and SARs with respect to 237,500 shares of common stock.

 

Each of the RSU grants generally vest and require SoftBrands to issueto the employee 25% of the shares subject to the grant on

 

8

----

 

the first, second, third and fourth annual anniversaries of the date ofgrant, provided the employee remains an employee of the Company or a subsidiaryon those dates.  Each of the SAR grants also vest on the first, second,third and fourth anniversaries of the date of grant with respect to 25% of theshares, provided the employee remains employed with the Company or a subsidiaryon that date, and expire on the fifth anniversary of the date of grant. The SARs entitle the employee, once vested and exercised, to receive shares ofSoftBrands common stock having a value on the date of exercise equal to the excessof the fair market value of the shares on the date of exercise over the fairmarket value of the shares on the date of grant.  Using the Black-Scholes valuation model, thefair market value of these grants is $1.27 per share, with an exercise price of$2.13 per share.  As of December 31,2005, there was $302,432 of total unrecognized compensation expense related tothese SARs.

 

**3.****                                      NetIncome (Loss) Per Share**

 

Net income (loss) per share is computed under the provisions of SFAS No. 128,*Earning per Share*.  Basic earnings per share is computed usingnet income (loss) available to common shareholders and the weighted averagenumber of shares outstanding.  Basicearnings per share from continuing operations is computed using income (loss)from continuing operations available to common shareholders (adjusted forpreferred stock dividends) and the weighted average number of sharesoutstanding. Diluted earnings per share reflects the weighted average number ofshares outstanding plus any potentially dilutive shares outstanding during theperiod, calculated using the “treasury stock” method.  In accordance with EITF 03-6, *Participating Securities and the Two-Class Method under FASBStatement No. 128*, the Company’s Series B ConvertiblePreferred Stock and Series C Preferred Stock is considered in both thebasic and diluted earnings per share calculations, subject to the applicableantidilution provisions.

 

For the three months ended December 31, 2005 and 2004, 4,331,540shares of Series B Convertible Preferred Stock and 18,000 shares of Series CConvertible Preferred Stock were not considered in the calculation of basicearnings per share because the Company had net losses, and based on thecontractual terms, holders of neither the Series B Convertible PreferredStock nor the Series C Convertible Preferred Stock have the obligation toshare in the losses of the Company.

 

For the three months ended December 31, 2005 and 2004, thefollowing securities were not considered in the calculation of diluted earningsper share because the Company had net losses and to do so would have beenantidilutive:

 

| ** **                                 | ** ** | **Securities outstanding** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|
| ** **                                 | ** ** | **at December 31,**   | ** ** |
| ** **                                 | ** ** | **2005**                   | ** ** | **2004** | ** ** |
|                                       |       |                       |       |   |   |
| Series B  Convertible Preferred Stock |       | 4,331,540                  |       | 4,331,540 |   |
| Series C  Convertible Preferred Stock |       | 18,000                     |       |   |   |
| Stock  Options and Warrants                |       | 16,147,546                 |       | 15,935,300 |   |

 

**4.****                                      DiscontinuedOperations**

 

Upon re-assignment of a lease to a third party in the Europe, MiddleEast and Africa (“EMEA”) region during the first quarter, the Company reversedan accrual in the amount of $655,000. This accrual was the remaining obligation from the Former Parent, andhad been included in accrued expenses on the Company’s balance sheet.  The benefit is recorded as income fromdiscontinued operations and is shown net of income taxes of $229,000

 

The details of the Company’s relationship with the Former Parent aremore fully described in the Company’s Report on Form 10-K filed with theSEC on December 20, 2005.

 

**5.****                                      RestructuringRelated Charges**

 

The following table presents a summary of the Company’s restructuringactivities during the quarter ended December 31, 2005 and the year ended September 30,2005:

 
| **Thousands**                       | ** ** | **Employee   Severance and   Termination   Costs** | ** ** | **Lease   Commitments** | ** ** | **Total**  | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                          | ** ** | ** **                                         | ** ** | ** **              | ** ** | ** ** | ** ** |
| Balance at September 30,  2004 |       | $                                                  | 466        |                    | $          | 748        |       | $ | 1,214 |   |
| Adjustments  and reversals          |       | (81                                                | )          | (180                    | )          | (261       | )          |
| Cash  payments and other (1)        |       | (182                                               | )          | (568                    | )          | (750       | )          |
| Balance at September 30,  2005 |       | 203                                                |       |                    |       | 203        |       |
| Cash  payments and other (1)        |       | (20                                                | )          |                    |       | (20        | )          |
| Balance at December 31,  2005  |       | $                                                  | 183        |                    | $          | —     |       | $ | 183 |   |

 

----

(1)                                  Theimpact of foreign currency translation is included with cash payments.

 

The discussion of the Company’s restructuring activities included belowis organized by the period of initiation of the different restructuring planstogether with related subsequent activity.

 

9

----

 

During the year ended September 30, 2004, the Company ceasedusing two international facilities and recorded restructuring charges of$981,000 for lease costs that were to continue. Of this amount, $728,000 was taken during the first quarter of fiscalyear 2004.  These charges are anextension of the September 2003 restructuring program (see below) andreflect the Company’s desire to consolidate certain of its hospitality and manufacturingoperations.  These costs were reversed inthe second quarter of fiscal year 2005 with the closing of leased space in ourEMEA region.  There were no morerestructuring based lease commitments as of September 30, 2005.

 

On September 30, 2003, the Company announced a restructuring andreorganization plan that primarily affected the Hospitality segment.  The plan’s near-term focus was to supportcurrent customers’ needs and return the business to profitability.  All product strategies and investmentdecisions were re-assessed.  As a result,certain development projects were deferred or cancelled while other projectswere afforded focused efforts to complete. The plan included the closure or consolidation of several offices invarious U.S. and international locations and the elimination of approximately120 positions.  The initial restructuringcharges related to this program were taken in September 2003.  An additional restructuring charge of$490,000 was taken during the year ended September 30, 2004, primarily foradditional employee severance related to the remaining 30 identifiedpositions and contract terminations.  Asof September 30, 2005, the remaining balance of this plan was$33,000.  During the quarter ended December 31,2005, the Company made cash severance payments of $18,000.  At December 31, 2005, the remainingemployee severance accrual for this program was $15,000, all of which iscontinued carryover from regions outside of the U.S.

 

In December 2001, the Company instituted a restructuring plan toalign its cost structure with its business plan.  Under the restructuring plan, the Companyreduced its workforce by approximately 20%, or 153 positions throughout theorganization.  In addition to theemployee termination costs, charges were taken related to excess leased spaceat two of the Company’s facilities.  Inconjunction with the restructuring related charges, the Company estimatedfuture sublease income to offset the liability. During the year ended September 30, 2004, due to the Company’sinability to negotiate acceptable sublease terms at one of the facilities,additional restructuring charges of $470,000 were taken.  In September 2004, Company managementmade the strategic decisions to utilize both of the leased spaces previouslyconsidered excess, and the remaining restructuring accrual of $991,000 waseliminated and a restructuring benefit was recorded.  The most significant portion of this reversalrelates to previously unused space at the Company’s headquarters in theU.S.  Following the initiation of certainkey business partnerships and the related staff increase, the Company chose toutilize the unused space for development, training and general office space.

 

In conjunction with the acquisition of Fourth Shift Corporation in April 2001,the Company assumed accrued restructuring liabilities related to employeetermination costs and facility consolidation. At December 31, 2005, $167,000 of this restructuring liability wasremaining, and is required for special one-time retirement benefits that theCompany is obligated to pay for three former employees.

 

**6.****                                      ComprehensiveIncome (loss)**

 

Total comprehensive income was $333,000 for the quarter ended December 31,2005, compared to the comprehensive loss of $1,288,000 for the quarter ended December 31,2004.  Comprehensive loss differs fromnet loss due to foreign currency translation adjustments.

 

**7.****                                      Acquisition**

 

Effective October 1,2005, the Company acquired all of the outstanding shares of Infra BusinessSolutions, GmbH (“Infra”), a privately held German software company that is areseller and development partner of SAP Business One, for $2.3 milliondollars.  The purchase price includescash, warrants to purchase 200,000 shares of our common stock valued at$227,000 and closing costs.  Theacquisition gives the Company presence in Germany and the ability to use Infra’sestablished channel partners to introduce Fourth Shift Edition for SAP BusinessOne to the German market.  As a result ofthe acquisition of Infra, the Company acquired $1.4 million of identifiableintangible assets that have estimated useful lives of three to four years, andare being amortized using straight-line and accelerated methods.  The allocation of the intangibles ispreliminary and the actual allocation could differ when the final valuation iscomplete.  The fair market value of theidentifiable intangible assets purchased included Infra’s software productInfra:Net, a production planning system sold to small- to medium-sizedmanufacturers in the German, Swiss and Austrian markets at $676,000,non-contractual customer relationships are valued at $282,000, the licensingand royalty agreement at $25,000 and the value assigned to employment contractsat $376,000.  Goodwill of $585,000 wasassigned to the manufacturing operating segment.  The following table summarizes thepreliminary allocation of the purchase price to the estimated fair values ofthe assets acquired and liabilities assumed:

 

10

----

 
| Current  assets                 |   | $         | 413,000   |   |
|---------------------------------|--------|-----------|-----------|--------|
| Furniture  and fixtures         |   | 26,000    |      |
| Other  non-current assets       |   | 15,000    |      |
| Identifiable  intangible assets |   | 1,359,000 |      |
| Goodwill                        |   | 585,000   |      |
| Total assets  acquired          |   | 2,398,000 |      |
|                            |   |      |      |
| Current  liabilities            |   | 111,000   |      |
| Net assets  acquired            |   | $         | 2,287,000 |   |

 

The results of operations of Infra areincluded in the Company’s consolidated statements of operations since the dateof the acquisition.  The pro forma impactof the Infra acquisition was not significant to the results of the Company forthe three months ended December 31, 2005 or 2004.

 

**8.****                                      Goodwilland Intangible Assets**

 

The Company assesses goodwill for impairment under the annualrequirement of SFAS No. 142, *Goodwilland Other Intangible Assets,* or when impairment indicatorsarise.  The Company’s September 30, 2005 annual assessment resultedin no impairments.

 

There was an increase of $585,000 to goodwill during the quarter ended December 31,2005, which was due entirely to the Infra acquisition in October.

 

Intangible assets, net were comprised of the following at December 31,2005 and September 30, 2005:

 
| ** **                        | ** ** | **December 31, 2005**    | ** ** | **September 30, 2005**    | ** ** |
|-----------------------------------|------------|-------------------------------|------------|--------------------------------|------------|
| **Thousands**                     | ** ** | **Gross   Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net   Carrying   Amount** | ** ** | **Gross   Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net   Carrying   Amount** | ** ** |
|                              |       |                          |       |                           |       |   |   |   |   |   |   |   |   |
| Acquired  technology              |       | $                             | 21,095     |                           | $          | (18,101 | ) | $ | 2,994 |   | $ | 20,436 |   | $ | (17,168 | ) | $ | 3,268 |   |
| Capitalized  software development |       | 1,094                         |       | (701                           | )          | 393 |   | 1,094 |   | (610 | ) | 484 |   |
| Other                             |       | 930                           |       | (268                           | )          | 662 |   | 252 |   | (221 | ) | 31 |   |
| Intangible  assets                |       | $                             | 23,119     |                           | $          | (19,070 | ) | $ | 4,049 |   | $ | 21,782 |   | $ | (17,999 | ) | $ | 3,783 |   |

 

Total amortization of intangibles was $1.1 million and $1.1 million forthe quarters ended December 31, 2005 and 2004, respectively.  Based on the intangibles at December 31,2005, estimated amortization expense for each of the next four years is asfollows:

 

| **Year Ending September 30 (thousands)** | ** ** | ** ** | ** ** |
|-----------------------------------------------|------------|------------|------------|
| Remainder of  fiscal year 2006                |       | $          | 2,151      |   |
| 2007                                          |       | 1,338      |       |
| 2008                                          |       | 484        |       |
| 2009                                          |       | 76         |       |
|                                          |       | $          | 4,049      |   |

 

**9.****                                      SegmentInformation**

 

The Company discloses segments in accordance with SFAS No. 131, *Disclosures about Segments of an Enterprise andRelated Information*, which established standards for disclosure offinancial information related to operating segments of the Company, as well asdisclosure requirements for customer and geographic information.  SFAS No. 131 defines an operatingsegment as a component of a company for which operating results are reviewedregularly by the chief operating decision-

 

11

----

 

maker to determine resource allocation and assess performance.  The Company has two reportable segments underthe guidelines of SFAS No. 131: manufacturing and hospitality. Manufacturing and hospitality derive their revenues from licensingproprietary software systems; providing customer support, training, consultingand installation services related to software; and through the resale ofcomplementary third-party software licenses and hardware.

 

Financial information by segment is summarized in the followingtable.  Total assets are not allocated tomanufacturing and hospitality for internal reporting purposes.

 
| ** **     | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------|------------|------------------------------------------|------------|
| ** **     | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| **Thousands**  | ** ** | **Revenue**                              | ** ** | **Operating  Income (Loss)** | ** ** | **Revenue** | ** ** | **Operating Income  (Loss)** | ** ** |
| ** **     | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Manufacturing  |       | $                                        | 12,680     |   | $ | 3,723 |   | $ | 12,421 |   | $ | 3,658 |   |
| Hospitality    |       | 4,062                                    |       | 246 |   | 4,856 |   | 459 |   |
| Corporate      |       |                                     |       | (4,790 | ) |   |   | (3,953 | ) |
|           |       |                                     |       |   |   |   |   |   |   |
| Total  Company |       | $                                        | 16,742     |   | $ | (821 | ) | $ | 17,277 |   | $ | 164 |   |

 

----

*NM: Percentage not meaningful

 
| ** **                             | ** ** | **Three Months Ended December 31,** | ** ** |
|----------------------------------------|------------|------------------------------------------|------------|
| ** **                             | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| **Thousands**                          | ** ** | **Manufacturing**                        | ** ** | **Hospitality** | ** ** | **Total** | ** ** | **Manufacturing** | ** ** | **Hospitality** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Geography:**                         |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Americas                               |       | $                                        | 7,283      |   | $ | 1,414 |   | $ | 8,697 |   | $ | 7,655 |   | $ | 1,822 |   | $ | 9,477 |   |
| Europe,  Middle East & Africa |       | 3,558                                    |       | 1,923 |   | 5,481 |   | 3,103 |   | 2,374 |   | 5,477 |   |
| Asia Pacific                           |       | 1,839                                    |       | 725 |   | 2,564 |   | 1,663 |   | 660 |   | 2,323 |   |
|                                   |       | $                                        | 12,680     |   | $ | 4,062 |   | $ | 16,742 |   | $ | 12,421 |   | $ | 4,856 |   | $ | 17,277 |   |

 

12

----

 

**ITEM2.**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*The following discussion of our financialcondition and results of operations should be read together with the financialstatements and related notes, which are included elsewhere in this Form 10-Q.  This discussion contains forward-lookingstatements based upon current expectations that involve risks anduncertainties.  Our actual results maydiffer materially from those anticipated in these forward-looking statements asa result of various factors, including those set forth in more detail in the “Forward-LookingStatements” section below.  Weundertake no obligation to update any information in our forward-lookingstatements.*

 

**Business Overview**

** **

SoftBrands, Inc.provides enterprise software and support solutions to approximately 4,500customers in more than 60 countries.  We are organized into two reportablesegments:  manufacturing and hospitality. Our manufacturing business designs, develops and sells enterpriseresource planning software and services to mid-sized manufacturingconcerns.  Our principal products in this segment include***Fourth Shift Edition for SAPBusiness One,***our newest productthat is sold with SAP’s Business One product suite to medium-sizedmanufacturers and to plants or divisions of multinational enterprises; ***Fourth Shift*****,** our core manufacturing enterprisesoftware solution aimed at small- to mid-sized manufacturers;***evolution***, asoftware system designed to serve niche manufacturing markets that isparticularly suitable for ‘converter’ manufacturers; and***Demand Stream***, alean enterprise automation software system that was introduced in 2003.  Our hospitality business designs, developsand sells software and services that support the enterprise information managementneeds of hotels and resorts.  Principal products in the hospitalitysegment include***Medallion***, a windows-based property management system designedprimarily for medium-service independent hotels and hotel chains;***PORTfolio***, acomprehensive client/server hotel system for both the front- and back-officeoperations of single-site and multi-property hotels; and***RIO***, a leisuremanagement system that supports the activities of spas, health clubs andresorts.  Because much of ouradministrative and support staff provides services to both segments, we alsoreport in this Management’s Discussion unallocated corporate expenses as partof a “Corporate” segment.

 

Wederive revenue in both of our manufacturing and hospitality segments throughsale of licenses to use our software products, and through providing servicesrequired to maintain our products, to install and implement our products, andin some cases to customize or create extensions for our products.  Onoccasion we also sell hardware products of third-party vendors on adistribution basis for the convenience of our customers and sell licenses tothird-party software programs.  Our software license revenue is heavilyinfluenced by the timing of customer purchases and installations, and the termsunder which we sell software licenses.  Our software maintenance revenue,which currently constitutes a majority of our revenue, is derived primarilyfrom one-year contracts that require payment at the beginning of the contractterm and under which we recognize revenue ratably over the one-year contractperiod.  Our other services revenue is normally recognized over the timeservices are performed.

 

**InfraAcquisition**

 

Effective October 1,2005, we acquired all of the outstanding shares of Infra Business Solutions, GmbH,a privately held German software company that is a reseller and developmentpartner of SAP Business One, for $2.3 million dollars.  The purchase price consisted of cash pluswarrants to purchase 200,000 shares of our common stock.  Based upon preliminary results of anassessment provided by an independent consultant, we assigned $343,000 of thepurchase price to the value of net tangible assets acquired, $1.4 million toidentifiable intangible assets, and $585,000 to goodwill.  The fair market value of the identifiableintangible assets purchased included Infra’s software product Infra:Net, aproduction planning system sold to small- to medium-sized manufacturers in theGerman, Swiss and Austrian markets at $676,000, non-contractual customerrelationships are valued at $282,000, the licensing and royalty agreement at$25,000 and the employment contracts at $376,000.

 

**Critical Accounting Policies and Estimates**

 

The preparation of the financial information contained in this Form 10-Qrequires our management to make estimates and judgments that affect thereported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  Our management evaluates these estimates onan ongoing basis, including those related to revenue recognition, the valuationallowance for deferred tax assets, the valuation of our accounts receivable,the valuation of our intangible assets, including goodwill and the recording ofrestructuring charges.  Except withrespect to changes in the manner in which we account for share basedcompensation, as discussed below, there have been no material changes to thecritical accounting policies as discussed in greater detail in the Management’sDiscussion and Analysis of Financial Condition and Results of Operationscontained in our Form 10-K as filed with the SEC on December 20,2005.

 

*Stock-Based Compensation.  During* the firstquarter of 2006, we adopted the fair value method of accounting for stock-based

 

13

----

 

compensation using the modified prospective method of transition asoutlined in Financial Accounting Standards Board Statement No. 123R, *Share-Based Payment* (“SFAS No. 123R”). Under SFAS No. 123R,the estimated fair value of stock-based compensation, including stock optionsgranted under our 2001 Stock Incentive Plan, is recognized as compensationexpense. The estimated fair value of stock options is expensed on astraight-line basis over the expected term of the grant.  Prior to October 1, 2005, we accountedfor stock-based employee compensation plans using the intrinsic value method ofaccounting in accordance with Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*(“APB 25”), and itsrelated interpretations. Under the provision of APB 25, no compensation expensewas recognized when stock options were granted with exercise prices equal to orgreater than market value on the date of grant. Under the modified prospective method of transition that we adopted, compensationexpense is recognized beginning with the effective date of adoption for allstock-based payments (i) granted after the effective date of adoption and (ii) grantedprior to the effective date of adoption and that remain unvested on the date ofadoption. Under the modified prospective method of transition, we are notrequired to restate our prior period financial statements to reflect expensingof stock-based compensation under SFAS No. 123R. Therefore the three-monthresults of December 31, 2005 are not directly comparable to the sameperiod in the prior year.  Under SFAS No. 123R,we use the Black Scholes pricing model to estimate the fair value of thestock-based compensation as of the grant date. The Black-Scholes model by itsdesign is highly complex, and dependent upon key data inputs estimated bymanagement. The primary data input with the greatest degree of subjectivejudgment are the estimated lives of the stock-based awards and the estimatedvolatility of our stock price. The Black-Scholes model is highly sensitive tochanges in these two data inputs. Beginning in the fourth quarter of fiscal2005, we changed the estimated life of stock options granted from 10 years to 5years based on a study of comparable companies and to reflect anticipatedincreased marketability and trading volume of our common stock.  We based our estimate of expected volatilityfor fiscal year 2006 on daily historical trading data of our common stock. Forfiscal year 2005, we based our volatility estimate under the same method asfiscal year 2006. We selected the historical method primarily because we havenot identified a more reliable or appropriate method to predict futurevolatility. See Note 2, Accounting for Stock-Based Compensation, to ourfinancial statements for more information about the adoption of SFAS No. 123(R).

 

**Results of Operations**

 

For the quarter ended December 31, 2005,we reported total revenue of $16.7 million and a net loss of $227,000, or $0.01per share, compared to total revenue of $17.3 million and a net loss of$666,000, or $0.02 per share, for the same period in 2004.    Loss from continuing operations was$653,000 for the quarter ended December 31, 2005 compared to $666,000 forthe quarter ended December 31, 2004. The change in the loss from continuing operations includes a favorablechange due to the absence of interest expense in the quarter ended December 31,2005 from the Senior Notes that were repaid in August 2005, while weincurred $1.0 million of interest expenses from those Notes in the quarterended December 31, 2004.  Thisfavorable impact was offset somewhat by $348,000 of additional expense incurredin the December 31, 2005 quarter, but not the December 31, 2004quarter, as a result of the adoption of SFAS No. 123(R).

 

14

----

 

The following table summarizes revenue andoperating results by reportable segment for the quarters ended December 31,2005 and 2004:

 
| ** **     | ** ** | **Three Months Ended December 31,** | ** ** | ** **                   | ** ** | ** **   | ** ** |
|----------------|------------|------------------------------------------|------------|------------------------------|------------|--------------|------------|
| ** **     | ** ** | **2005**                                 | ** ** | **2004**                     | ** ** | **% Change** | ** ** |
| **Thousands**  | ** ** | **Revenue**                              | ** ** | **Operating  Income (Loss)** | ** ** | **Revenue**  | ** ** | **Operating Income  (Loss)** | ** ** | **Revenue** | ** ** | **Operating Income (Loss)** | ** ** |
| ** **     | ** ** | ** **                               | ** ** | ** **                   | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Manufacturing  |       | $                                        | 12,680     |                         | $          | 3,723        |       | $ | 12,421 |   | $ | 3,658 |   | 2.1 | % | 1.8 | % |
| Hospitality    |       | 4,062                                    |       | 246                          |       | 4,856        |       | 459 |   | (16.4 | )% | (46.4 | )% |
| Corporate      |       |                                     |       | (4,790                       | )          |         |       | (3,953 | ) |   |   | 21.2 | % |
|           |       |                                     |       |                         |       |         |       |   |   |   |   |   |   |
| Total  Company |       | $                                        | 16,742     |                         | $          | (821         | )          | $ | 17,277 |   | $ | 164 |   | (3.1 | )% | NM | * |

 

----

*NM:Percentage not meaningful

 

Total revenue decreased 3.1% in the 2005 quarter and reflects a 2.1%increase for manufacturing offset by a 16.4% decrease for hospitality.  See below for a more detailed discussion ofchanges in revenue by reportable segment, revenue type and geography.  Operating income in the manufacturing groupincreased by 1.8%, primarily through cost controls.  The corporate group loss increased by 21.2%,due in large part to increased marketing efforts.  Hospitality operating income decreased 46.4%at the operating income line, due to declining maintenance revenue**. **

 

**Revenue. **The following table summarizes revenue byreportable segment, revenue type and geography for the quarters ended December 31, 2005and 2004:

 
|  

** **                    | ** ** | **Three Months Ended December 31,** | ** ** | ** **      | ** ** | ** **   | ** ** | ** **        | ** ** |
|---------------------------------------|------------|------------------------------------------|------------|-----------------|------------|--------------|------------|-------------------|------------|
| ** **                            | ** ** | **2005**                                 | ** ** | **2004**        | ** ** | **% change** | ** ** |
| **Thousands**                         | ** ** | **Manufacturing**                        | ** ** | **Hospitality** | ** ** | **Total**    | ** ** | **Manufacturing** | ** ** | **Hospitality** | ** ** | **Total** | ** ** | **Manufacturing** | ** ** | **Hospitality** | ** ** | **Total** | ** ** |
|                                  |       |                                     |       |            |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |
| **Revenue Type:**                     |       |                                     |       |            |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |
| Software licenses                     |       | $                                        | 1,759      |            | $          | 598          |       | $                 | 2,357      |   | $ | 1,808 |   | $ | 489 |   | $ | 2,297 |   | (2.7 | )% | 22.3 | % | 2.6 | % |
| Maintenance                           |       | 7,862                                    |       | 2,643           |       | 10,505       |       | 7,587             |       | 3,546 |   | 11,133 |   | 3.6 | % | (25.5 | )% | (5.6 | )% |
| Professional services                 |       | 2,790                                    |       | 565             |       | 3,355        |       | 2,659             |       | 520 |   | 3,179 |   | 4.9 | % | 8.7 | % | 5.5 | % |
| Third-party software and hardware     |       | 269                                      |       | 256             |       | 525          |       | 367               |       | 301 |   | 668 |   | (26.7 | )% | (15.0 | )% | (21.4 | )% |
|                                  |       | $                                        | 12,680     |            | $          | 4,062        |       | $                 | 16,742     |   | $ | 12,421 |   | $ | 4,856 |   | $ | 17,277 |   | 2.1 | % | (16.4 | )% | (3.1 | )% |
|                                  |       |                                     |       |            |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |
| **Geography:**                        |       |                                     |       |            |       |         |       |              |       |   |   |   |   |   |   |   |   |   |   |
| Americas                              |       | $                                        | 7,283      |            | $          | 1,414        |       | $                 | 8,697      |   | $ | 7,655 |   | $ | 1,822 |   | $ | 9,477 |   | (4.9 | )% | (22.4 | )% | (8.2 | )% |
| Europe, Middle East & Africa |       | 3,558                                    |       | 1,923           |       | 5,481        |       | 3,103             |       | 2,374 |   | 5,477 |   | 14.7 | % | (19.0 | )% | 0.1 | % |
| Asia Pacific                          |       | 1,839                                    |       | 725             |       | 2,564        |       | 1,663             |       | 660 |   | 2,323 |   | 10.6 | % | 9.8 | % | 10.4 | % |
|                                  |       | $                                        | 12,680     |            | $          | 4,062        |       | $                 | 16,742     |   | $ | 12,421 |   | $ | 4,856 |   | $ | 17,277 |   | 2.1 | % | (16.4 | )% | (3.1 | )% |
|                                       |            |                                          |            |                 |            |              |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

*Manufacturing segment:*  Total manufacturing revenue increased by$259,000 or 2.1%.  License revenuedeclined 2.7% in manufacturing as a result of weak sales of our core FourthShift product in the Americas region, where customers delayed projects.  This soft performance in the Americas morethan offset good performance in our other two regions.  License revenue in the quarter includes twonew customer contracts for our Fourth Shift Edition for SAP Business Onesolution. Maintenance revenues in manufacturing increased 3.6 % first quarter2006.  Revenue generated from our newservice offerings more than offset normal customer attrition.  These new services include remote systemadministration, and business

 

15

----

 

process management.  Professionalservices revenue increased $131,000 or 4.9% due to new revenue from ouracquisition of Infra in Germany. Geographically, Europe, Middle East & Africa (EMEA) regionexperienced organic license and maintenance growth and generated increasedrevenue from the Infra acquisition.  TheAsia Pacific region reported increases in license and maintenance revenue asthe strength of the Chinese economy continues and our customers demand increasedproduct and services.  The Americasregion suffered from delayed projects resulting in lower license revenue.

 

*Hospitality segment:*  Total hospitality segment revenue decreasedby $794,000 or 16.4% driven by reduced maintenance revenue.  License revenue increased due to therecognition of $205,000 of previously deferred revenue in the Asia Pacificregion.  The 25.5% decrease inhospitality maintenance revenue was primarily due to continued attrition ofmaintenance related to legacy systems that are being phased out by customers.  Although we plan to partially offset thisattrition with revenue from new sales of our Medallion and Portfolio products,sales of those products are not yet to the level necessary to compensate forthe attrition.  Provided we aresuccessful in meeting our new account sales objectives, we expect relativelyflat hospitality maintenance revenue for the remainder of the year.  Geographically, hospitality revenue decreasesare driven by the loss of maintenance revenue with EMEA and Asia Pacificregions experiencing greater attrition due to the higher base of customersusing legacy products.

 

**GrossMargin. **The following table summarizes gross profit as apercentage of revenue, or gross margin percentages, by reportable segment andrevenue type for the quartersended December 31, 2005 and 2004:

 
| ** **                         | ** ** | **Three Months Ended December 31,** | ** ** |
|------------------------------------|------------|------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                         | ** ** | **Manufacturing**                        | ** ** | **Hospitality** | ** ** | **Total** | ** ** | **Manufacturing** | ** ** | **Hospitality** | ** ** | **Total** | ** ** |
| ** **                         | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software  licenses                 |       | 47.9                                     | %          | 88.8 | % | 58.3 | % | 51.5 | % | 50.1 | % | 51.2 | % |
|                               |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Maintenance                        |       | 77.2                                     | %          | 44.9 | % | 69.1 | % | 77.6 | % | 48.4 | % | 68.3 | % |
|                               |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Professional  services             |       | 10.8                                     | %          | 2.3 | % | 9.4 | % | 21.9 | % | 1.9 | % | 18.7 | % |
|                               |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Third-party  software and hardware |       | 18.2                                     | %          | 52.3 | % | 34.9 | % | 25.1 | % | 43.5 | % | 33.4 | % |
|                               |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| **Total**                          | ** ** | **57.3**                                 | **%**      | **45.9** | **%** | **54.5** | **%** | **60.3** | **%** | **43.3** | **%** | **55.5** | **%** |

 

Overall gross margin percentage decreased to 54.5% in the first quarterof 2006 from 55.5% in the first quarter of 2005.   The manufacturing segment’s software licensegross margin percentage remained relatively flat year over year.  Cost of license revenue consists ofamortization of acquired software, the amortization of capitalized costs forinternally developed software, and the cost of third-party software embedded insome of our products.  Amortization isrelatively fixed while royalty costs to third parties can fluctuate dependingon product mix.  The manufacturingsegment’s maintenance gross profit percentage also remained stable, due to acontinued effort in cost savings, as we saw less revenue in the Americasregion, but an increase in both the EMEA and APAC regions.  In addition, we are starting to recognizemore cost savings resulting from our support center in Bangalore, India, whichbecame fully operational in late 2004. The support center has grown from fourteen people in December 2004to thirty-one people in December 2005, and is now providing world-widesupport.  The significant drop in themanufacturing professional services margin is due to moving several projectsinto the second quarter that were anticipated to occur in the first quarter ofthe 2006 fiscal year, thereby reducing utilization rates of full timeconsultants.

 

The decline in hospitality maintenance gross margin percentage is dueto a large decline in maintenance revenue which was not yet offset by a similardecline in related costs.  Althoughhospitality cost of maintenance revenue decreased by $374,000, this did notfully compensate for the even larger revenue decline.  We also expect that hospitality maintenancegross margin percentages will benefit from our support center in Bangalore,India, as this location is now fully operational and from greater efficienciesas we begin generating more maintenance revenue on Medallion andPortfolio.  We did experience some growthin the hospitality professional services in connection with new Medallioninstallations with the release of Medallion 6.0 in January 2005.  We anticipate improvement in hospitalityprofessional services gross margin percentage from custom development projectsthat have commenced and on which we will recognize revenue as work iscompleted.  In our European operations,the professional services gross profit percentage saw a moderate improvementover last year, as the first quarter of fiscal 2005 was adversely affected bythe requirement to utilize consulting resources in nonbillable product upgradetesting

 

16

----

 

activities.

 

**Operating Expenses. **The following table summarizes operatingexpenses for the quarters ended December 31, 2005 and 2004:

 
| ** **                       | ** ** | **Three Months Ended December 31,** | ** ** | ** **              | ** ** |
|----------------------------------|------------|------------------------------------------|------------|-------------------------|------------|
| ** **                       | ** ** | **2005**                                 | ** ** | **2004**                | ** ** | ** ** | ** ** |
| **Thousands**                    | ** ** | ** **                               | ** ** | **% of Total  Revenue** | ** ** | ** ** | ** ** | **% of Total  Revenue** | ** ** | **% Change** | ** ** |
| ** **                       | ** ** | ** **                               | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| General and administrative       |       | $                                        | 4,723      |                    | 28.2       | % | $ | 4,837 |   | 28.0 | % | (2.4 | )% |
| Selling and marketing            |       | 2,788                                    |       | 16.7                    | %          | 2,590 |   | 15.0 | % | 7.6 | % |
| Research and product development |       | 2,439                                    |       | 14.6                    | %          | 2,002 |   | 11.6 | % | 21.8 | % |
| Total operating expenses         |       | $                                        | 9,950      |                    | 59.4       | % | $ | 9,429 |   | 54.6 | % | 5.5 | % |

 

Operating expenses increased slightly quarter over quarter in dollarsand as a percentage of revenue.  Ourgeneral and administrative expense decreased by approximately $114,000primarily because of higher external professional fees associated with theinternal control documentation project in the first quarter of 2005, but onwhich we recorded only $165,000 in the first quarter of 2006.  This was partially offset by the recognitionof approximately $288,000 of stock option expense in the first quarter of thisyear, which was not recorded in previous years. 

 

In addition, we expanded several of our selling and marketing efforts,stepped up demand generation activities in both business groups, increasedbusiness development efforts to support strategic partnerships, expansion inGermany, and corporate communications in support of our recent listing with theAmerican Stock Exchange. 

 

Research and product development expense was higher in the firstquarter of 2006 as we now report the expenses from the recently acquired InfraBusiness Solutions, GmbH, along with a continued effort to improve certainhospitality products.  Research anddevelopment expenses for hospitality were 17.9% of hospitality revenue duringfirst quarter of fiscal 2006 compared with 12.5% for the first quarter of 2005,due to a 16.4% decline in revenue, along with the recording of stock optionexpenses for the quarter, resulted in an increase in research and developmentas a percentage of revenue.  Research anddevelopment expenses for manufacturing were 13.4% of revenue in the quarterended December 31, 2005 and 11.3% of manufacturing revenue in quarterended December 31, 2004.

 

We made cash payments of $83,000 during the quarter ended December 31,2004 related to employee severance and $96,000 related to leasecommitments.  In the quarter ended December 31,2005, we made cash payments of $21,000 related to employee severance.  A balance of $183,000 of accruedrestructuring charges remained at December 31, 2005.  

 

**Non-Operating Items and other. **The following table summarizes non-operatingincome and expenses for the quarters ended December 31, 2005 and 2004, aswell as our tax provision and discontinued operations:

 
| ** **                                       | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **December 31,**  | ** ** |
| **Thousands**                                    | ** ** | **2005**               | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | ** **             | ** ** | ** ** | ** ** |
| Interest  expense                                |       | $                      | 4          |   | $ | 1,003 |   |
| Other  income, net                               |       | 85                     |       | 273 |   |
| Provision  for (benefit from) income taxes       |       | (87                    | )          | 100 |   |
| Income from  discontinued operations, net of tax |       | 426                    |       |   |   |
|                                                  |            |                        |            |  |  |  |  |

 

Interest expense incurred in the first quarter of fiscal year 2005 wasrelated to long-term institutional debt which was repaid in August 2005.  It included cash interest expense,amortization of capitalized financing costs and debt accretion of an originalissue discount.  

 

17

----

 

Other income, net, primarily consists of the effect of changes inforeign exchange rates on intercompany payables denominated in U.S.dollars.  Of the $85,000 of other income,net reflected on our consolidated statement of operations for the three monthsended December 31, 2005; approximately $46,000 was due to the impact ofthe weakening of foreign currencies against the U.S. dollar.  We also recorded interest income of$62,000.  We do not currently utilize anyderivative security instruments or engage in any hedging activities.

 

We recognized a tax benefit in continuing operations in the threemonths ended December 31, 2005, to the extent that income fromdiscontinued operations has been offset by current period losses fromcontinuing operations.  The benefit isstated net of amounts for our estimated domestic federal, state andinternational tax liabilities.  Our taxprovision fluctuates due to the mix of forecasted results between domesticoperations and our international subsidiaries. Also, we have not recorded certain income tax benefits in either of theperiods presented due to continued uncertainty regarding our ability to realizeour deferred tax assets.

 

Upon re-assignment of a leaseto a third party by the landlord during the first quarter of fiscal 2006, wereversed a $655,000 accrual.  Thisaccrual was the remaining obligation from the Former Parent.  The benefit is recorded as income fromdiscontinued operations and is shown net of income taxes of $229,000.  The reversal of this obligation resulted inincome from discontinued operations of $426,000, net of income tax.

 

# **Liquidity and Capital Resources**

#  

# **As of December 31, 2005, we had $13.8 million of cash and cashequivalents and $654,000 of restricted cash. Our working capital deficit (current assets less current liabilities),increased to $3.3 million at December 31, 2005 from $2.6 million at September 30,2005.  This increase in working capitaldeficit is due to the $2.1 million increase in deferred revenue.  It is common to see our deferred revenueincrease drastically during the first quarter, and even the second quarter, asannual maintenance contracts are renewed. Deferred revenue was $17.4 million at December 31, 2005, comparedwith $15.3 million at September 30, 2005. These deferred revenue obligations are typically satisfied forsubstantially less than the carrying value. Deferred maintenance revenues comprise the majority of our deferredrevenues and our cost to perform these revenues has recently been between 30%and 35% of total maintenance revenue. Our most significant source of operating cash flows is derived fromlicense, maintenance and service fees. Our primary uses of cash from operating activities are for employeecosts, third-party costs for services and the cost of our facilities.**

#  

# **Cash Flows from Operating Activities. **Wegenerated $460,000 of cash from operating activities in the quarter ended December 31,2005, a decrease of $208,000 from the $668,000 of cash generated in operatingactivities from the comparable period a year ago.  This change is comprised by a $13,000decrease in our loss from continuing operations as well as an increase of$173,000 in our non-cash expenses, offset by a reduction of $394,000 in ouroperating assets and liabilities.

#  

# **We had $1.7 million of non-cash expenses in the quarter ended December 31,2005, which included $1.4 million of depreciation and amortization, and$348,000 of stock-based compensation, offset by a modest foreign currency gainof $52,000.  This compares to non-cashexpenses of $1.5 million in the prior year, including $1.5 million of depreciationand amortization, $271,000 for non-cash interest, $271,000 for foreign currencytransaction gains, and a benefit of $69,000 from provision for doubtfulaccounts.**

#  

# **Changes in operating assets and liabilities produced a usage of $593,000million in the quarter ended December 31, 2005 as compared to a $199,000use in the prior year. The most significant cash flow changes in the currentyear’s quarter relate to cash used to finance an increase of $570,000 inaccounts receivable in the first quarter of 2006 compared to a $300,000decrease in accounts receivable in the same period in 2005.  It is typical for accounts receivable toincrease in the first quarter due to an increase in sales at the calendaryear-end.  We generated $2.2 million incash in the quarter ended December 31, 2005 from deferred revenue,compared with $1.4 million in cash generated from deferred revenue in thequarter ended December 31, 2004. Strong collection of annual maintenance contracts is common in December,and generally continues into the early months of the calendar year.  It is typical for accounts receivable toincrease in the first quarter due to an increase in sales at the calendaryear-end.  We used $996,000 of cash toreduce accounts payable in the first quarter of 2006, as compared to a usage of$194,000 in the same quarter of the previous year, due to the timing of cashdisbursements.   **

#  

# **We believe that increased profitability and effective working capitalmanagement will yield continued cash generation from operating activities infiscal 2006.**

#  

# **Cash Flows from Investing Activities.****We used $2.1 million of cash ininvesting activities during the quarter ended December 31, 2005 and$171,000 for the quarter ended December 31, 2004.  We recorded approximately $1.9 million ininvestments in acquisitions, and approximately $215,000 of expenditures toupgrade and replace some of our internal computer hardware and otherequipment.  We had limited expendituresfor acquired technology or other intangible assets, reflecting the strategyfollowing the September 2003 restructuring plan to focus hospitalitydevelopment efforts on existing products and existing customers.  We expect investing activities in theremainder of fiscal 2006 to consist primarily of

 

18

----

 

# **internal technology and system upgrades.**

#  

# **Cash Flows from Financing Activities. **We used$437,000 of cash in financing activities in the quarter ended December 31,2005 and $131,000 in the quarter ended December 31, 2004 primarily relatedto payments for debt incurred in connection with acquisitions, as well as$408,000 in preferred stock dividends, offset by $76,000 of proceeds onissuance of common stock.

#  

# **Commitmentsand Capital Adequacy.**  As of December 31, 2005, our primarycommitments are for leased office space in Minneapolis, Minnesota; Wichita,Kansas; Reading, England; Tianjin, China; and Sydney, Australia and payments onthe long-term debt and lease obligations.

#  

# **We believe that cash flows from operations, expected to improve with2006 results, together with our cash and cash equivalents, will be sufficientto meet our commitments and our cash requirements for at least the next twelvemonths. **

#  

**Forward-Looking Statements**

 

Our Form 10-Q contains a number ofstatements about our future operations. We make statements regarding anticipated product introductions, changesin markets, customers and customer order rates, expenditures in research anddevelopment, growth in revenue, taxation levels, the effects of pricing, andthe growth in our foreign operations, all of which represent our expectationsand beliefs about future events.  Insome cases, you can identify forward-looking statements by terminology such as “may,”“will,” “should,” “could,” “expect,” “intend,” “plan,” “anticipate,” “believe,”“estimate,” “predict,” “potential,” “continue” or similar words andexpressions.  These statements are onlypredictions and involve known and unknown risks, uncertainties and otherfactors that may cause our or our industry’s actual results, level of activity,performance or achievements to be materially different from those expressed orimplied by these forward-looking statements. The factors that may cause our operations to vary materially from thosecontemplated by our forward-looking statements are described in detail in our Form 10-Kdated December 20, 2005, and include:

 

•                  Economicand market conditions.

 

•                  Downturnsin the hospitality or manufacturing markets.

 

•                  Our increasingdependence upon our relationship with SAP.

 

•                  Thedifficulty encountered in generating significant new software license sales inmature markets.

 

•                  Increasingdependence on products that are not currently widely accepted and that wecannot be certain will be widely accepted.

 

•                  Therisks related to our substantial international operations and sales.

 

•                  Theunpredictability of our operating results because of the sales cycle of ourproducts.

 

•                  Theneed to continue to develop new products and enhance our current products inresponse to technological changes and competing products.

 

•                  Thedependence of our revenue on renewal of maintenance agreements by ourcustomers.

 

•                  Thepossibility that we may not be able to recognize revenue when we deliverproducts.

 

•                  Theeffect of our anti-takeover defenses on possible acquisition proposals.

 

•                  Thegreater size and brand recognition of a number of our competitors.

 

•                  Theeffect of a change, effective for periods beginning after October 1, 2005,in accounting for stock options and other stock based benefits on our reportedoperating results.

 

•                  Ourdependence on third-party vendors for some of the software technology used inour products.

 

•                  Ourpotential exposure to intellectual property disputes.

 

•                  Ourdependence on current management.

 

•                  Ourprevious status and association as a subsidiary of AremisSoft Corporation.

 

19

----

 

•                  Ourability to maintain an effective system of internal controls.

 

•                  Ourability to raise capital with acceptable pricing and terms should we choose todo so.

 

**ITEM 3. QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

There were no material changes in market risk for the Company in theperiod covered by this report. See the Company’s Form 10-K as filed withthe SEC on December 20, 2005, for a discussion of market risk for theCompany.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

*Evaluation of Disclosure Controls andProcedures.*  As required by Rule 13a-15(b) underthe Securities Exchange Act of 1934, as amended, we conducted an evaluationunder the supervision and with the participation of our management, includingthe Chief Executive Officer and the Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures as of the end of theperiod covered by this report.  Based on that evaluation and because ofthe material weaknesses in internal control over financial reporting discussedbelow, the Chief Executive Officer and the Chief Financial Officer concludedthat our disclosure controls and procedures were not effective in ensuring thatall information required to be disclosed in reports that we file or submitunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in the SEC rules and forms and that suchinformation is accumulated and communicated to our management, including our ChiefExecutive Officer and Chief Financial Officer, in a manner that allows timelydecisions regarding required disclosure.  Notwithstanding the materialweaknesses discussed below, the Company’s management has concluded that thefinancial statements included in this Form 10-Q fairly present in allmaterial respects the Company’s financial position, results of operations andcash flows for the periods presented in conformity with generally acceptedaccounting principles.

 

*Changes in Internal Control over FinancialReporting.*  Except as noted below, there were nochanges in our internal control over financial reporting that occurred duringthe quarter ended December 31, 2005 that materially affected, or that arereasonably likely to materially affect, our internal control over financialreporting.

 

Although we have not yet been required to assess and report on theeffectiveness of our internal control over financial reporting, we haveconcluded that we did not maintain effective internal controls over accountingfor income taxes required under SFAS No. 109.  Specifically, we didnot maintain effective controls to ensure that the tax accounting wasaccurately presented for unique transactions and situations or that the relatedtax accounting was appropriately reviewed to ensure compliance with generallyaccepted accounting principles.  This control deficiency resulted in therestatement of our interim and annual consolidated financial statements for theyear ended September 30, 2004, and the interim consolidated financialstatements during fiscal year 2005 (the quarters ended December 31, 2004and March 31, 2005).  This control deficiency could result in amisstatement to the tax provision and related tax accounts and disclosures inthe financial statements that would result in a material misstatement in theannual or interim financial statements that would not be prevented ordetected.  Accordingly, management determined that this control deficiencyrepresents a material weakness in internal control over financial reporting asof December 31, 2005.

 

We did not maintain effective controls over the period-end financialreporting process to ensure that our June 30, 2005 Form 10-Q wasoriginally filed accurately.  Specifically, in our rushed attempt tocorrect the income tax accounting for 2004 by the filing deadline in thecontext of the aforementioned control deficiency we filed our June 30,2005 Form 10-Q prior to completion of the usual review controls andprocedures.  The Form 10-Q as originally filed contained errors inthe cash flow statement, the restatement footnote and MD&A sectionsregarding the restatement.  This control deficiency resulted in the needto amend our June 30, 2005 Form 10-Q.  This control deficiencycould result in a misstatement to the aforementioned disclosures in thefinancial statements that would result in a material misstatement in the annualor interim financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency represents amaterial weakness in internal control over financial reporting as of December 31,2005.

 

The tax accounting restatement and restatement of the June 30,2005 Form 10-Q had no impact on net loss, net cash provided by operatingactivities and total stockholders’ equity as previously reported for the fiscalyears ended September 30, 2004 or 2005.

 

*Plans for Remediation.* In response, we implemented a more in-depth and comprehensive process toaccount for income taxes and brought in external resources with greatertaxation expertise in order to remediate the material weakness discussed above.To further improve our internal control over financial reporting; we conductadditional research, we are increasing our

 

20

----

 

internal knowledge base with expanded training and education, we reviewunique and specialized transactions on a contemporaneous basis, we added anadditional level of management personnel to the review process and haveestablished a formal technical accounting review process.  The reviewprocess gives specific consideration to accounting and income tax implicationsof significant discrete period non-routine transactions, such as, but notlimited to, acquisitions of businesses or assets or dispositions of businessesor assets. Although we have implemented the remediation procedures as describedabove, we cannot yet assert that the remediation is effective as we have nothad sufficient time to test the operating effectiveness of the newlyimplemented controls.

 

By implementing internal control improvements, we expect to remediatethese material weaknesses in internal control over financial reporting before September 30,2006, which is the date with respect to which our management, and ourindependent registered public accounting firm, must first report on theeffectiveness of our internal control over financial reporting under the Section 404provisions of the Sarbanes-Oxley Act.

 

Internal control over financial reporting, no matter how well designed,has inherent limitations.  Therefore, even those systems determined to beeffective can provide only reasonable assurance with respect to financialstatement preparation and presentation.  We will continue to improve thedesign and effectiveness of our disclosure controls and procedures and internalcontrol over financial reporting to the extent necessary in the future toprovide our senior management with timely access to such material information,and to correct any deficiencies that we may discover in the future.

 

**PART II. OTHER INFORMATION**

 

**Item 1—Legal Proceedings**

 

We are periodically engaged in litigation in the ordinary course ofbusiness, including litigation seeking return of software licensing andservicing fees.  We do not believe thatany of such litigation is material to our ongoing operations.

 

**Item 1A – Risk Factors**

 

Reference is made to the factors set forth under the caption “Forward-LookingStatements” in Part I, Item 2 of this Form 10-Q, which are incorporated hereinby reference.

 

**Item 2—Unregistered Sales of EquitySecurities and Use of Proceeds**.

 

Not applicable.

 

**Item 3—Default Upon Senior Securities**

 

Not applicable.

 

**Item 4—Submission of Matters to a Vote ofSecurity Holders**

 

Not applicable.

 

**Item 5—Other Information**

 

Not applicable.

 

**Item 6—Exhibits**

 

10.1                           Form of SoftBrands, Inc. StockAward Agreement

 

10.2                           Form of SoftBrands, Inc. StockAppreciation Right Agreement

 

10.3                           Executive Compensation Plan for Randal B. Tofteland

 

10.4                           Executive Compensation Plan for David G. Latzke

 

10.5                           Executive Compensation Plan for Ralf Suerken

 

10.6                           Executive Compensation Plan for Steven VanTassel

 

31.1                           Certification Pursuant to Section 302 of the Sarbanes-Oxley Act –Randal B. Tofteland.

 

21

----

 

31.2                           Certification Pursuant to Section 302 of the Sarbanes-Oxley Act –David G. Latzke.

 

32                                    CertificationPursuant to Section 906 of the Sarbanes-OxleyAct of 2002

 

22

----

 

**SIGNATURES**

 

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

 

 
| Date: February 14, 2006 |                  |                                                                                                                |
|------------------------------|-----------------------|---------------------------------------------------------------------------------------------------------------------|
|                         |                  |                                                                                                                |
|                         | SoftBrands, Inc. |
|                         |                  |                                                                                                                |
|                         | By:                   | /s/ DAVID G. LATZKE                                                                                                 |   |
|                         |                  | David G. Latzke*Senior Vice President and Chief Financial Officer*(principal financial and accounting officer) |
|                              |                       |                                                                                                                     |  |  |

 

----

 

**EXHIBIT INDEX**

 
| **EXHIBIT  NUMBER** | ** ** | **DESCRIPTION OF DOCUMENTS**                                                                      |
|---------------------|------------|---------------------------------------------------------------------------------------------------|
|                |       |                                                                                              |
| 10.1                |       | Form of SoftBrands, Inc.  Stock Award Agreement                                         |
|                |       |                                                                                              |
| 10.2                |       | Form of SoftBrands, Inc.  Stock Appreciation Right Agreement                            |
|                |       |                                                                                              |
| 10.3                |       | Executive Compensation Plan for  Randal B. Tofteland                                              |
|                |       |                                                                                              |
| 10.4                |       | Executive Compensation Plan for  David G. Latzke                                                  |
|                |       |                                                                                              |
| 10.5                |       | Executive Compensation Plan for  Ralf Suerken                                                     |
|                |       |                                                                                              |
| 10.6                |       | Executive Compensation Plan for  Steven VanTassel                                                 |
|                |       |                                                                                              |
| 31.1                |       | Certification Pursuant to Section 302  of the Sarbanes-Oxley Act – Randal B. Tofteland. |
|                |       |                                                                                              |
| 31.2                |       | Certification Pursuant to Section 302  of the Sarbanes-Oxley Act – David G. Latzke.     |
|                |       |                                                                                              |
| 32                  |       | Certification Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                     |

 

----