**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

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

**For the quarterly periodended September 30, 2006**

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

**For the transition period from                 to                 **

**CommissionFile Number 000-50954**

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**NESS TECHNOLOGIES, INC.**

**(Exact name of registrant asspecified in its charter)**

| **Delaware**                     |   | **98-0346908**          |
|----------------------------------|--------|-------------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer        |
| incorporation or  organization)  |   | Identification  Number) |

 

**Ness TowerAtidim High-Tech Industrial ParkBuilding 4Tel Aviv 61580, IsraelTelephone: +972 (3) 766-6800**(Addressof registrant’s principal executive offices and registrant’s telephone number,including area code)

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Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  x Yes  o No

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act. (Check one):Large accelerated filer     o     Acceleratedfiler     x      Non-acceleratedfiler     o

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

As of October 31,2006, 36,750,316 shares of common stock, $0.01 par value per share, were outstanding.

 

 

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# **NESS TECHNOLOGIES, INC. AND SUBSIDIARIES**

# **INDEX**

|                                                                                                                         | Page   |
|-------------------------------------------------------------------------------------------------------------------------|--------|
| PART I – FINANCIAL  INFORMATION                                                                                    | 3      |
|                                                                                                                    |   |
| Item  1. Financial Statements                                                                                           | 3      |
|                                                                                                                    |   |
| Condensed Consolidated Balance Sheets – December 31,  2005 and September 30, 2006 (Unaudited)                      | 3      |
| Condensed Consolidated Statements of Income – Three  and nine months ended September 30, 2005 and 2006 (Unaudited) | 5      |
| Condensed  Consolidated Statements of Cash Flows – Nine months ended September 30, 2005  and 2006 (Unaudited)      | 6      |
| Notes  to Interim Condensed Consolidated Financial Statements – September 30, 2006  (Unaudited)                    | 7      |
|                                                                                                                    |   |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations                    | 26     |
|                                                                                                                    |   |
| Overview                                                                                                                | 26     |
| Recent  Developments                                                                                                    | 27     |
| Consolidated  Results of Operations                                                                                     | 27     |
| Three  Months Ended September 30, 2006 Compared to the Three Months Ended September  30, 2005                           | 27     |
| Nine  Months Ended September 30, 2006 Compared to the Nine Months Ended September  30, 2005                             | 29     |
| Results  by Business Segment                                                                                            | 32     |
| Liquidity  and Capital Resources                                                                                        | 33     |
| Forward-Looking  Statements and Risk Factors                                                                            | 35     |
|                                                                                                                    |   |
| Item  3. Quantitative and Qualitative Disclosure about Market Risk                                                      | 35     |
|                                                                                                                    |   |
| Item  4. Controls and Procedures                                                                                        | 36     |
|                                                                                                                    |   |
| Evaluation  of Disclosure Controls and Procedures                                                                       | 36     |
| Changes  in Internal Control                                                                                            | 36     |
|                                                                                                                    |   |
| PART II – OTHER INFORMATION                                                                                        | 37     |
|                                                                                                                    |   |
| Item 1.  Legal Proceedings                                                                                              | 37     |
|                                                                                                                    |   |
| Item 1A. Risk  Factors                                                                                                  | 37     |
|                                                                                                                    |   |
| Item  2. Unregistered Sales of Equity Securities and Use of Proceeds                                                    | 37     |
|                                                                                                                    |   |
| Item  3. Defaults upon Senior Securities                                                                                | 37     |
|                                                                                                                    |   |
| Item  4. Submission of Matters to a Vote of Security Holders                                                            | 37     |
|                                                                                                                    |   |
| Item 5.  Other Information                                                                                              | 37     |
|                                                                                                                    |   |
| Item 6. Exhibits                                                                                                        | 37     |
|                                                                                                                    |   |
| SIGNATURES                                                                                                              | 38     |
|                                                                                                                    |   |
| EXHIBIT INDEX                                                                                                           | 39     |

 

2

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# **PART I – FINANCIAL INFORMATION**

## ***Item 1. Financial Statements***

## **NESSTECHNOLOGIES, INC. AND ITS SUBSIDIARIES**

## **Interim Condensed Consolidated Balance Sheets**

**U.S. dollars inthousands**
| ** **                                                                                                                                              | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                              | ** ** | **2005**              | ** ** | **2006**               | ** ** |
| ** **                                                                                                                                              | ** ** | ** **            | ** ** | **(Unaudited)**        | ** ** |
| ASSETS                                                                                                                                                  |       |                  |       |                   |       |
|                                                                                                                                                    |       |                  |       |                   |       |
| CURRENT ASSETS:                                                                                                                                         |       |                  |       |                   |       |
| Cash  and cash equivalents                                                                                                                              |       | $                     | 33,579     |                   | $          | 40,186 |   |
| Short-term  bank deposits                                                                                                                               |       | 39,561                |       | 4,862                  |       |
| Marketable  securities                                                                                                                                  |       | 2,651                 |       | —                 |       |
| Trade  receivables (net of allowance for doubtful accounts of $2,320 and $2,731 at  December 31, 2005 and September 30, 2006 (unaudited), respectively) |       | 99,097                |       | 103,567                |       |
| Unbilled  receivables                                                                                                                                   |       | 21,500                |       | 39,459                 |       |
| Other  accounts receivable and prepaid expenses                                                                                                         |       | 13,664                |       | 19,459                 |       |
| Inventories  and work in progress                                                                                                                       |       | 2,506                 |       | 888                    |       |
|                                                                                                                                                    |       |                  |       |                   |       |
| Total current  assets                                                                                                                                   |       | 212,558               |       | 208,421                |       |
|                                                                                                                                                    |       |                  |       |                   |       |
| LONG-TERM  ASSETS:                                                                                                                                      |       |                  |       |                   |       |
| Long-term  prepaid expenses                                                                                                                             |       | 4,816                 |       | 6,482                  |       |
| Marketable  securities                                                                                                                                  |       | 32                    |       | 118                    |       |
| Trade  and unbilled receivables                                                                                                                         |       | 7,045                 |       | 12,133                 |       |
| Deferred  income taxes                                                                                                                                  |       | 5,271                 |       | 3,884                  |       |
| Severance  pay fund                                                                                                                                     |       | 35,845                |       | 41,270                 |       |
|                                                                                                                                                    |       |                  |       |                   |       |
| Total long-term  assets                                                                                                                                 |       | 53,009                |       | 63,887                 |       |
|                                                                                                                                                    |       |                  |       |                   |       |
| PROPERTY AND  EQUIPMENT, NET                                                                                                                            |       | 21,308                |       | 25,418                 |       |
|                                                                                                                                                    |       |                  |       |                   |       |
| INTANGIBLE  ASSETS, NET                                                                                                                                 |       | 7,938                 |       | 9,028                  |       |
|                                                                                                                                                    |       |                  |       |                   |       |
| GOODWILL                                                                                                                                                |       | 159,421               |       | 186,324                |       |
|                                                                                                                                                    |       |                  |       |                   |       |
| Total assets                                                                                                                                            |       | $                     | 454,234    |                   | $          | 493,078 |   |

 

 

The accompanying notesare an integral part of the interim condensed consolidated financialstatements.

3

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**NESSTECHNOLOGIES, INC. AND ITS SUBSIDIARIES**

**Interim Condensed ConsolidatedBalance Sheets**

**U.S. dollars inthousands (except share and par value data)**
| ** **                                                                                                                                                                                                          | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                          | ** ** | **2005**              | ** ** | **2006**               | ** ** |
| ** **                                                                                                                                                                                                          | ** ** | ** **            | ** ** | **(Unaudited)**        | ** ** |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                           |       |                  |       |                   |       |
|                                                                                                                                                                                                                |       |                  |       |                   |       |
| CURRENT  LIABILITIES:                                                                                                                                                                                               |       |                  |       |                   |       |
| Short-term bank credit                                                                                                                                                                                              |       | $                     | 21,011     |                   | $          | 25,639 |   |
| Current maturities of long-term debt                                                                                                                                                                                |       | 6,862                 |       | 6,387                  |       |
| Trade payables                                                                                                                                                                                                      |       | 35,259                |       | 28,512                 |       |
| Advances from customers                                                                                                                                                                                             |       | 7,670                 |       | 9,078                  |       |
| Other accounts payable and accrued expenses                                                                                                                                                                         |       | 82,657                |       | 79,410                 |       |
|                                                                                                                                                                                                                |       |                  |       |                   |       |
| Total current  liabilities                                                                                                                                                                                          |       | 153,459               |       | 149,026                |       |
|                                                                                                                                                                                                                |       |                  |       |                   |       |
| LONG-TERM  LIABILITIES:                                                                                                                                                                                             |       |                  |       |                   |       |
| Long-term debt, net of current maturities                                                                                                                                                                           |       | 6,294                 |       | 2,697                  |       |
| Excess of losses over investment in affiliates                                                                                                                                                                      |       | 257                   |       | 480                    |       |
| Accrued severance pay                                                                                                                                                                                               |       | 39,722                |       | 45,295                 |       |
|                                                                                                                                                                                                                |       |                  |       |                   |       |
| Total long-term  liabilities                                                                                                                                                                                        |       | 46,273                |       | 48,472                 |       |
|                                                                                                                                                                                                                |       |                  |       |                   |       |
| COMMITMENTS AND  CONTINGENT LIABILITIES                                                                                                                                                                             |       |                  |       |                   |       |
|                                                                                                                                                                                                                |       |                  |       |                   |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                                                                         |       |                  |       |                   |       |
| Common stock of $0.01 par value -                                                                                                                                                                                   |       |                  |       |                   |       |
| Authorized: 76,500,000 shares at December 31, 2005  and at September 30, 2006 (unaudited);  Issued and outstanding: 34,771,837 shares at December 31, 2005 and 36,267,424  shares at September 30, 2006 (unaudited) |       | 348                   |       | 363                    |       |
| Additional paid-in capital                                                                                                                                                                                          |       | 282,642               |       | 295,019                |       |
| Accumulated other comprehensive loss                                                                                                                                                                                |       | (13,559               | )          | (5,098                 | )          |
| Retained earnings (accumulated deficit)                                                                                                                                                                             |       | (14,929               | )          | 5,296                  |       |
|                                                                                                                                                                                                                |       |                  |       |                   |       |
| Total  stockholders’ equity                                                                                                                                                                                    |       | 254,502               |       | 295,580                |       |
|                                                                                                                                                                                                                |       |                  |       |                   |       |
| Total liabilities and  stockholders’ equity                                                                                                                                                                    |       | $                     | 454,234    |                   | $          | 493,078 |   |

 

The accompanying notesare an integral part of the interim condensed consolidated financialstatements.

4

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**NESSTECHNOLOGIES, INC. AND ITS SUBSIDIARIES**

**Interim Condensed ConsolidatedStatements of Income**

**U.S. dollars inthousands (except per share data)**
| ** **                                    | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                    | ** ** | **(Unaudited)**                                      | ** ** | **(Unaudited)**                                     | ** ** |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Revenues                                      |       | $                                                    | 97,719     |                                                | $          | 119,135 |   | $ | 280,342 |   | $ | 342,791 |   |
| Cost of revenues  (*)                         |       | 69,628                                               |       | 85,095                                              |       | 200,252 |   | 244,792 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Gross profit                                  |       | 28,091                                               |       | 34,040                                              |       | 80,090 |   | 97,999 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Operating  expenses:                          |       |                                                 |       |                                                |       |   |   |   |   |
| Selling and marketing                         |       | 7,081                                                |       | 8,391                                               |       | 21,114 |   | 25,615 |   |
| General and administrative (*)                |       | 13,344                                               |       | 15,489                                              |       | 40,538 |   | 46,845 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Total operating  expenses                     |       | 20,425                                               |       | 23,880                                              |       | 61,652 |   | 72,460 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Operating income                              |       | 7,666                                                |       | 10,160                                              |       | 18,438 |   | 25,539 |   |
| Financial  expenses, net                      |       | (383                                                 | )          | (492                                                | )          | (1,297 | ) | (1,130 | ) |
| Other income  (expenses), net                 |       | (14                                                  | )          | (8                                                  | )          | (10 | ) | 436 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Income before  taxes on income                |       | 7,269                                                |       | 9,660                                               |       | 17,131 |   | 24,845 |   |
| Taxes on income                               |       | 1,252                                                |       | 1,709                                               |       | 2,277 |   | 4,517 |   |
| Equity in net  losses of affiliates           |       | —                                               |       | (13                                                 | )          | (29 | ) | (103 | ) |
| Minority  interests in losses of a subsidiary |       | —                                               |       | —                                              |       | 101 |   | — |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Net income                                    |       | $                                                    | 6,017      |                                                | $          | 7,938 |   | $ | 14,926 |   | $ | 20,225 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Basic net  earnings per share                 |       | $                                                    | 0.17       |                                                | $          | 0.22 |   | $ | 0.43 |   | $ | 0.57 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Diluted net earnings  per share               |       | $                                                    | 0.17       |                                                | $          | 0.22 |   | $ | 0.42 |   | $ | 0.56 |   |

----

(*)   Expenses include stock-based compensation, asfollows:
| ** **                  | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                  | ** ** | **(Unaudited)**                                      | ** ** | **(Unaudited)**                                     | ** ** |
|                        |       |                                                 |       |                                                |       |   |   |   |   |
| Cost of revenues            |       | $                                                    | —     |                                                | $          | — |   | $ | 98 |   | $ | — |   |
| General and  administrative |       | 76                                                   |       | 204                                                 |       | 1,875 |   | 495 |   |
|                             |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |

 

The accompanying notesare an integral part of the interim condensed consolidated financial statements.

5

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**NESSTECHNOLOGIES, INC. AND ITS SUBSIDIARIES**

**Interim Condensed ConsolidatedStatements of Cash Flows**

**U.S. dollars in thousands**
| ** **                                                                                            | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2005**                                            | ** ** | **2006** | ** ** |
| ** **                                                                                            | ** ** | **(Unaudited)**                                     | ** ** |
| Cash flows from  operating activities:                                                                |       |                                                |       |   |   |
| Net income                                                                                            |       | $                                                   | 14,926     |   | $ | 20,225 |   |
| Adjustments required to reconcile net income to net  cash used in operating activities:               |       |                                                |       |   |   |
| Stock-based compensation-related expenses                                                             |       | 2,085                                               |       | 471 |   |
| Equity in net losses of affiliates                                                                    |       | 29                                                  |       | 103 |   |
| Minority interests in losses of a subsidiary                                                          |       | (101                                                | )          | — |   |
| Currency fluctuation of long-term debt                                                                |       | 2,281                                               |       | 353 |   |
| Accrued interest on long-term debt                                                                    |       | (634                                                | )          | (1,347 | ) |
| Depreciation and amortization                                                                         |       | 6,448                                               |       | 8,594 |   |
| Deferred income taxes, net                                                                            |       | (1,412                                              | )          | 1,383 |   |
| Loss on sale of property and equipment                                                                |       | 21                                                  |       | 105 |   |
| Decrease (increase) in trade receivables                                                              |       | (15,561                                             | )          | 2,010 |   |
| Increase in unbilled receivables                                                                      |       | (10,271                                             | )          | (18,554 | ) |
| Increase in other accounts receivable and prepaid  expenses                                           |       | (77                                                 | )          | (5,575 | ) |
| Decrease (increase) in inventories and work in  progress                                              |       | (1,231                                              | )          | 1,824 |   |
| Increase in long-term prepaid expenses                                                                |       | (1,666                                              | )          | (1,026 | ) |
| Decrease in trade payables                                                                            |       | (9,308                                              | )          | (10,049 | ) |
| Increase (decrease) in advances from customers                                                        |       | (3,608                                              | )          | 862 |   |
| Increase (decrease) in other accounts payable and accrued  expenses                                   |       | 8,212                                               |       | (11,352 | ) |
| Tax benefits related to exercise of options                                                           |       | —                                              |       | 628 |   |
| Increase (decrease) in accrued severance pay, net                                                     |       | 598                                                 |       | (103 | ) |
|                                                                                                  |       |                                                |       |   |   |
| Net cash used in  operating activities                                                                |       | (9,269                                              | )          | (11,448 | ) |
|                                                                                                  |       |                                                |       |   |   |
| Cash flows from  investing activities:                                                                |       |                                                |       |   |   |
| Net cash paid for acquisition of consolidated  subsidiaries (a)                                       |       | (4,364                                              | )          | (13,683 | ) |
| Additional payments in connection with acquisitions  of subsidiaries in prior periods                 |       | —                                              |       | (5,162 | ) |
| Acquisition of minority interest in a subsidiary (b)                                                  |       | (114                                                | )          | — |   |
| Proceeds from maturity of short-term bank deposits                                                    |       | —                                              |       | 35,211 |   |
| Proceeds from sale of marketable securities                                                           |       | 387                                                 |       | 2,779 |   |
| Acquisition of available-for-sale marketable  securities                                              |       | (5,202                                              | )          | — |   |
| Proceeds from sale of property and equipment                                                          |       | 149                                                 |       | 597 |   |
| Purchase of property and  equipment and capitalization of software development costs for internal use |       | (6,012                                              | )          | (9,396 | ) |
| Capitalization of software development costs                                                          |       | (1,633                                              | )          | (255 | ) |
|                                                                                                  |       |                                                |       |   |   |
| Net cash provided by  (used in) investing activities                                                  |       | (16,789                                             | )          | 10,091 |   |
|                                                                                                       |            |                                                     |            |  |  |  |  |

 

 

The accompanying notesare an integral part of the interim condensed consolidated financialstatements.

6

----

 

**NESSTECHNOLOGIES, INC. AND ITS SUBSIDIARIES**

**Interim Condensed ConsolidatedStatements of Cash Flows**

**U.S. dollars in thousands**
| ** **                                                    | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                            | ** ** | **2006** | ** ** |
| ** **                                                    | ** ** | **(Unaudited)**                                     | ** ** |
| Cash flows from  financing activities:                        |       |                                                |       |   |   |
| Exercise of options and warrants                              |       | $                                                   | 9,132      |   | $ | 9,376 |   |
| Short-term bank loans and credit, net                         |       | 5,116                                               |       | 1,128 |   |
| Proceeds from long-term debt                                  |       | 21,216                                              |       | — |   |
| Principal payments of long-term debt                          |       | (34,345                                             | )          | (4,038 | ) |
|                                                          |       |                                                |       |   |   |
| Net cash provided by financing activities                     |       | 1,119                                               |       | 6,466 |   |
|                                                          |       |                                                |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents |       | (4,987                                              | )          | 1,498 |   |
|                                                          |       |                                                |       |   |   |
| Increase  (decrease) in cash and cash equivalents             |       | (29,926                                             | )          | 6,607 |   |
| Cash and cash  equivalents at the beginning of the period     |       | 104,229                                             |       | 33,579 |   |
|                                                          |       |                                                |       |   |   |
| Cash and cash  equivalents at the end of the period           |       | $                                                   | 74,303     |   | $ | 40,186 |   |
|                                                          |       |                                                |       |   |   |
| Supplemental  disclosures of cash flows information:          |       |                                                |       |   |   |
|                                                          |       |                                                |       |   |   |
| Cash paid during the period for:                              |       |                                                |       |   |   |
| Interest                                                      |       | $                                                   | 895        |   | $ | 1,384 |   |
| Taxes                                                         |       | $                                                   | 897        |   | $ | 12,715 |   |

 

----

| (a) | *In  conjunction with the acquisitions, the fair values of the assets acquired and  liabilities assumed at the date of the related acquisition were as follows:* |   |   |   |   |   |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|

 
| Working capital  (capital deficiency), net (excluding cash and cash equivalents)      |   | $      | (1,859 | )      | $      | (1,777 | ) |
|---------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|---|
| Long-term assets                                                                      |   | — |   | 519    |   |
| Property and equipment                                                                |   | 2,353  |   | — |   |
| Other assets                                                                          |   | 48     |   | (214   | )      |
| Long-term loans                                                                       |   | (1,601 | )      | 2,488  |   |
| Customer relations and backlog                                                        |   | 680    |   | 14,886 |   |
| Goodwill                                                                              |   | 3,744  |   | 4,773  |   |
| Workforce                                                                             |   | 1,069  |   | (8,225 | )      |
| Accrual for additional consideration to be paid  subsequent to the balance sheet date |   | — |   | — |   |
| Accrued severance pay, net                                                            |   | (70    | )      | $      | 13,683 |   |
| Net cash used in  acquisitions of consolidated subsidiaries                           |   | $      | 4,364  |   | 434    |   |

 
| (b) | *In  conjunction with the acquisition of the minority interest in a subsidiary  during the nine months ended September 30, 2005, the fair values of the  assets acquired and liabilities assumed at the date of acquisition were as  follows:* |   |   |   |   |   |
|-----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|

 
| Minority interest                                          |   | $      | 197    |   | $      | — |   |
|------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|
| Goodwill                                                   |   | 3,196  |   | — |   |
| Customer-related intangible assets                         |   | 139    |   | — |   |
|                                                       |   | 3,532  |   | — |   |
| Issuance of shares                                         |   | (3,418 |   | — |   |
| Net cash used in acquisition of a consolidated  subsidiary |   | $      | 114    |   | $      | — |   |

 

 
| (c) | *Non-cash  financing activity:* |   |   |   |   |   |
|-----|---------------------------------|--------|--------|--------|--------|--------|

 
| Capitalization of redeemable options accrual upon  partial exercise of options |   | $ | — |   | $ | 1,868 |   |
|--------------------------------------------------------------------------------|--------|---|--------|--------|---|-------|--------|

 

 

 

The accompanying notesare an integral part of the interim condensed consolidated financialstatements.

7

----

 

**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notes to Interim Condensed ConsolidatedFinancial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

***Note 1: General***

Ness Technologies, Inc. was incorporated under thelaws of the State of Delaware in March 1999. We operate through oursubsidiaries in Israel, the United States, Europe and Asia.

We are a global provider of information technology (“IT”)services and solutions designed to help clients improve their competitivenessand effectiveness. Our portfolio of solutions and services includes systemintegration and application development, outsourcing, software and consulting,and quality assurance and training. We and our subsidiaries primarily serve thefollowing vertical markets: government and defense, financial services, lifesciences and healthcare, telecommunications and utilities, and independentsoftware vendors.

***Note 2: Significant AccountingPolicies***

##### a.               UnauditedInterim Financial Information

The accompanying condensed consolidated balance sheet as of September30, 2006, the condensed consolidated statements of income for the three andnine months ended September 30, 2005 and 2006, and the condensed consolidatedstatements of cash flows for the nine months ended September 30, 2005 and 2006are unaudited. These unaudited interim condensed consolidated financialstatements have been prepared in accordance with U. S. generally acceptedaccounting principles for interim financial information. In the opinion ofmanagement, the unaudited interim condensed consolidated financial statementsinclude all adjustments of a normal recurring nature necessary for a fairpresentation of our consolidated financial position as of September 30, 2006,our consolidated results of operations for the three and nine months endedSeptember 30, 2005 and 2006, and our consolidated cash flows for the ninemonths ended September 30, 2005 and 2006.

The balance sheet at December 31, 2005 has been derived from theaudited consolidated financial statements at that date but does not include allof the information and footnotes required by U. S. generally acceptedaccounting principles for complete financial statements.

These consolidated financial statements should be read in conjunctionwith the audited consolidated financial statements and accompanying notes forthe year ended December 31, 2005 included in our Annual Report on Form 10-Kfiled with the U.S. Securities and Exchange Commission (“SEC”) on March 15,2006.

Results for the three and nine months ended September 30, 2006 are notnecessarily indicative of results that may be expected for the year endingDecember 31, 2006.

Unless otherwise noted, (1) all references to “dollars” or “$” are toUnited States dollars and all references to “NIS” are to New Israeli Shekelsand (2) all references to shares of our common stock and per share informationhave been adjusted to reflect the 0.7193-for-one reverse stock split effectedon September 20, 2004.

##### b.              Use of estimates

The preparation of financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect the amounts reported in the financial statements andaccompanying notes. Actual results could differ from those estimates.

8

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

##### c.               Financialstatements in U.S. dollars

Our subsidiaries’ transactions are recorded in local currencies. Wehave designated the U.S. dollar as the primary functional currency of ouroperations in the United States, the NIS as the primary functional currency ofour subsidiaries’ operations in Israel, and local currencies as the primaryfunctional currencies of our operations elsewhere. Accordingly, for allsubsidiaries of which the dollar is the functional currency, monetary accountsmaintained in other currencies are re-measured into U.S. dollars, in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 52 “ForeignCurrency Translation.” All transaction gains and losses of the re-measuredmonetary balance sheet items are reflected in the statements of income asfinancial income or expenses, as appropriate.

For those foreign subsidiaries whose functional currency has beendetermined to be their local currency, assets and liabilities are translated atperiod-end exchange rates and statements of income items are translated ataverage exchange rates prevailing during that period. Such translationadjustments are recorded as a separate component of accumulated othercomprehensive income (loss) in stockholders’ equity.

The financial statements of affiliates reported using the equity methodof accounting, whose functional currency has been determined to be their localcurrency, have been translated into dollars. All balance sheet accounts havebeen translated using the exchange rates in effect at the balance sheet date.Statements of income amounts have been translated using the average exchangerate for the period. The resulting aggregate translation adjustments arereported as a separate component of accumulated other comprehensive income(loss) in stockholders’ equity.

##### d.              Principles ofconsolidation

Our consolidated financial statements include the accounts of thecompany and its wholly and majority owned subsidiaries, or the group.Inter-company transactions and balances, including profit from inter-companysales not yet realized outside the group, have been eliminated in consolidation.

##### e.               Acquisition ofsubsidiaries

1.       Ness U.S.A. Inc. (“Ness U.S.A.”)

On November 12, 2004, we filed a Form S-4 Registration Statement inrespect of an exchange offer for the remaining shares of Ness U.S.A. which wedid not already own. The offer commenced on January 31, 2005 and ended onFebruary 28, 2005. 96 of 98 offerees accepted the offer bringing our holdingsin Ness U.S.A. following the offer to 99.9%. On March 1, 2005, we issued260,316 shares to the offerees, for the consideration of $3,532. Theacquisition was accounted for under the purchase method of accounting accordingto SFAS No. 141, “Business Combinations.”

In September 2005, Ness U.S.A. purchased the outstanding shares of NessU.S.A.’s common stock from the remaining two offerees in a private transaction,and it immediately thereafter retired the shares, since which time we have held100% of the shares of common stock of Ness U.S.A.

On January 3, 2006, Ness U.S.A. was merged into Ness Global Services,Inc. Subsequently the surviving company changed its name to Ness USA, Inc.

9

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

Basedupon a valuation of tangible and intangible assets acquired and liabilitiesassumed, we have allocated the total cost of the acquisition to Ness U.S.A.’sassets and liabilities (as of the acquisition date) as follows:

| Cash and cash equivalents                                   |   | $      | 426    |   |
|-------------------------------------------------------------|--------|--------|--------|--------|
| Trade receivables                                           |   | 277    |   |
| Unbilled  receivable                                        |   | 185    |   |
| Other accounts  receivable                                  |   | 64     |   |
| Other long-term  tangible assets                            |   | 20     |   |
| Deferred tax  liability                                     |   | (40    | )      |
| Property and  equipment                                     |   | 18     |   |
| Total tangible  assets acquired                             |   | 950    |   |
|                                                        |   |   |   |
| Customer-related  intangible asset (five years useful life) |   | 139    |   |
| Goodwill                                                    |   | 3,236  |   |
| Total intangible  assets acquired                           |   | 3,375  |   |
|                                                        |   |   |   |
| Total tangible  and intangible assets acquired              |   | 4,325  |   |
|                                                        |   |   |   |
| Accounts payable                                            |   | 148    |   |
| Other accounts  payable                                     |   | 280    |   |
| Related parties,  net                                       |   | 365    |   |
|                                                        |   |   |   |
| Total  liabilities assumed                                  |   | 793    |   |
|                                                        |   |   |   |
| Net assets acquired                                         |   | $      | 3,532  |   |

 

The allocation of the purchase price reflected in the consolidatedbalance sheet is according to a valuation of Ness U.S.A.’s current assets,current liabilities, long-term tangible assets, property and equipment andintangible assets.

2.           Ness Romania

On April 1, 2005, we acquired all of the outstanding shares of RadixCompany SA (“Radix”), a provider of IT services and solutions based in Romania.The purchase price was €4 million, or $5,385, consisting of €2 million paid incash at the closing and €2 million placed in escrow for six months contingenton the verification of the accuracy of certain representations made by thesellers. Additional payments of €1.5 million, or $1,775, were made in April2006 based on achievement of certain revenue and operating income milestones in2005. The additional payments were accrued for and recorded as goodwill in theDecember 31, 2005 consolidated balance sheet. An additional payment of up to €1.5million will be required to be made in April 2007 based on achievement ofcertain revenue and operating income milestones for 2006. Currently, we cannotestimate the probability of achieving the 2006 milestones. Radix became awholly-owned subsidiary of our Dutch subsidiary, Ness Technologies, B.V., and,accordingly, its results of operations have been included in our consolidatedfinancial statements since the acquisition date. Upon completion of theacquisition, Radix Company SA changed its name to Ness Romania.

10

----

 

**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

This acquisition was accounted for under the purchase method of accountingand, accordingly, the purchase price was allocated to the assets acquired andliabilities assumed based on their related fair values. Based upon a valuationof tangible and intangible assets acquired and liabilities assumed, we haveallocated the total cost of the acquisition to Ness Romania’s assets andliabilities (as of the acquisition date, except for goodwill, which was updatedto include the additional payments) as follows: 

| Cash and cash equivalents                    |   | $      | 2,511  |   |
|----------------------------------------------|--------|--------|--------|--------|
| Trade receivables                            |   | 933    |   |
| Inventories                                  |   | 137    |   |
| Deferred tax liability                       |   | (204   | )      |
| Property and equipment                       |   | 2,094  |   |
| Other accounts receivable                    |   | 97     |   |
| Intangible assets:                           |   |   |   |
| Customer relations                           |   | 420    |   |
| Backlog                                      |   | 260    |   |
| Work force                                   |   | 730    |   |
| Goodwill                                     |   | 4,659  |   |
| Total assets acquired                        |   | 11,637 |   |
| Liabilities assumed:                         |   |   |   |
| Accounts payable and other  accrued expenses |   | 1,420  |   |
| Other current liabilities                    |   | 1,506  |   |
| Long-term liabilities                        |   | 1,551  |   |
| Total liabilities assumed                    |   | 4,477  |   |
| Net  assets acquired                         |   | $      | 7,160  |   |

 

The allocation of the purchase price reflected in the consolidatedbalance sheet is according to a valuation of Radix’s current assets, currentliabilities, long-term liabilities, property and equipment and intangibleassets.

The value assigned to the tangible assets, intangible assets andliabilities has been determined as follows:

a.               Radix’s current assets and liabilities were recordedat their carrying amounts. The carrying amounts of the current assets andliabilities were reasonable proxies for their market values due to their short-termmaturity. Property and equipment were presented at current replacement cost.Long-term liabilities are presented at present value of amounts to be paiddetermined at appropriate current interest rates.

b.              The value assigned to the customer-related intangiblesamounted to $680. The fair value of Radix’s customer-related intangibles wasdetermined using the Income Approach.

3.           Ness DM a.s.

On June 1, 2005, we acquired all of the outstanding shares of Efcona.s. (“Efcon”), a provider of IT services and solutions based in the CzechRepublic. The purchase price was €0.6 million, or $738, consisting of €350,000paid at closing and €250,000 paid in July 2005. An additional 

11

----

 

**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

payment of €0.2 million, or $237, was made in February 2006 based onachievement of certain 2005 performance goals. The additional payment wasaccrued for and recorded as goodwill in the December 31, 2005 consolidatedbalance sheet. Efcon became a wholly-owned subsidiary of Ness Czech s.r.o., apart of our Ness Europe group, and, accordingly, its results of operations havebeen included in our consolidated financial statements since the acquisitiondate. Following the acquisition, Efcon changed its name to Ness DM a.s.

This acquisition was accounted for under the purchase method ofaccounting and, accordingly, the purchase price was allocated to the assetsacquired and liabilities assumed based on their related fair values. Based upona valuation of tangible and intangible assets acquired and liabilities assumed,we have allocated the total cost of the acquisition to Ness DM’s assets andliabilities (as of the acquisition date, except for goodwill, which was updatedto include the additional payment) as follows:

| Cash and cash equivalents                    |   | $      | 426    |   |
|----------------------------------------------|--------|--------|--------|--------|
| Trade receivables                            |   | 314    |   |
| Inventories                                  |   | 33     |   |
| Property and equipment                       |   | 212    |   |
| Deferred tax liabilities                     |   | (19    | )      |
| Other accounts receivable                    |   | 446    |   |
| Intangible assets:                           |   |   |   |
| Work force                                   |   | 278    |   |
| Customer relations                           |   | 64     |   |
| Goodwill                                     |   | 253    |   |
| Other                                        |   | 48     |   |
| Total assets acquired                        |   | 2,055  |   |
| Liabilities assumed:                         |   |   |   |
| Accounts payable and other  accrued expenses |   | 442    |   |
| Other current liabilities                    |   | 588    |   |
| Long term liabilities                        |   | 50     |   |
| Total liabilities assumed                    |   | 1,082  |   |
| Net  assets acquired                         |   | $      | 975    |   |

 

The allocation of the purchase price reflected in the consolidatedbalance sheet is according to a valuation of Ness DM’s current assets, currentliabilities, long-term liabilities, property and equipment and intangibleassets.

The value assigned to the tangible assets, intangible assets andliabilities has been determined as follows:

a.               Ness DM’s current assets and liabilities were recordedat their carrying amounts. The carrying amounts of the current assets andliabilities were reasonable proxies for their market values due to theirshort-term maturity. Property and equipment were presented at currentreplacement cost. Long-term liabilities are presented at present value ofamounts to be paid determined at appropriate current interest rates.

b.              The value assigned to the customer-related intangiblesamounted to $64. The fair value of Ness DM’s customer-related intangibles wasdetermined using the Income Approach.

12

----

 

**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

4.           NTR

On September 12, 2005, we acquired all of the outstanding shares ofN.T.R. Holding Ltd. (“NTR”), a provider of IT services and solutions based inIsrael. The purchase price was $1,350. Additional payments of $150 were made inJune 2006 based on achievement of certain 2005 performance goals. Theadditional required payments were accrued for and recorded as goodwill in theDecember 31, 2005 consolidated balance sheet. NTR became a wholly-ownedsubsidiary of Ness A.T., a part of our Ness Israel group, and, accordingly, itsresults of operations have been included in the consolidated financialstatements since September 12, 2005.

This acquisition was accounted for under the purchase method ofaccounting and, accordingly, the purchase price was allocated to the assetsacquired and liabilities assumed based on their related fair values. Based upona valuation of tangible and intangible assets acquired and liabilities assumed,we have allocated the total cost of the acquisition to NTR’s assets andliabilities (as of the acquisition date, except for goodwill, which was updatedto include the additional payments) as follows:

| Cash and cash equivalents                    |   | $      | 173    |   |
|----------------------------------------------|--------|--------|--------|--------|
| Trade receivables                            |   | 408    |   |
| Property and equipment                       |   | 47     |   |
| Deferred tax liability                       |   | (139   | )      |
| Other accounts receivable                    |   | 391    |   |
| Intangible assets:                           |   |   |   |
| Backlog                                      |   | 119    |   |
| Customer relations                           |   | 345    |   |
| Goodwill                                     |   | 889    |   |
| Total assets acquired                        |   | 2,233  |   |
| Liabilities assumed:                         |   |   |   |
| Accounts payable and other  accrued expenses |   | 25     |   |
| Other current liabilities                    |   | 443    |   |
| Long-term liabilities                        |   | 265    |   |
| Total liabilities assumed                    |   | 733    |   |
| Net  assets acquired                         |   | $      | 1,500  |   |

 

The allocation of the purchase price reflected in the consolidatedbalance sheet is according to a valuation of NTR’s current assets, currentliabilities, long-term liabilities, property and equipment and intangible assets.

The value assigned to the tangible assets, intangible assets andliabilities has been determined as follows:

a.               NTR’s current assets and liabilities were recorded attheir carrying amounts. The carrying amounts of the current assets andliabilities were reasonable proxies for their market values due to theirshort-term maturity. Property and equipment were presented at current replacementcost. Long-term liabilities are presented at present value of amounts to bepaid determined at appropriate current interest rates.

13

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

b.              The value assigned to the customer-related intangiblesamounted to $464. The fair value of NTR’s customer-related intangibles wasdetermined using the Income Approach.

5.           Delta

On October 3, 2005, we acquired all the outstanding shares of DeltaElectronic Services a.s. (“Delta”), a provider of IT services and solutions inSlovakia. We acquired the outstanding shares for cash consideration of $8,000and related purchase costs of approximately $115. In addition, as Deltaachieved certain business goals by the end of 2005, we paid an additionalamount of $3,000 during 2006. Upon completion of the acquisition, Delta changedits name to Ness Slovakia, and it operates as a part of Ness Europe. Deltabecame a wholly-owned subsidiary of Ness B.V., a part of the Ness Europe group,and, accordingly, its results of operations have been included in theconsolidated financial statements since October 3, 2005.

This acquisition was accounted for under the purchase method ofaccounting and, accordingly, the purchase price was allocated to the assetsacquired and liabilities assumed based on their related fair values. Based upona valuation of tangible and intangible assets acquired and liabilities assumed,we have allocated the total cost of the acquisition to Delta’s assets andliabilities (as of the acquisition date, except for goodwill, which was updatedto include the additional payment) as follows:

| Cash and cash equivalents                   |   | $      | 2,158  |   |
|---------------------------------------------|--------|--------|--------|--------|
| Trade receivables                           |   | 1,476  |   |
| Property and equipment                      |   | 575    |   |
| Other accounts receivable                   |   | 1,176  |   |
| Deferred tax liabilities                    |   | (564   | )      |
| Intangible  assets:                         |   |   |   |
| Customer relations                          |   | 1,616  |   |
| Backlog                                     |   | 265    |   |
| Workforce                                   |   | 1,290  |   |
| Goodwill                                    |   | 6,408  |   |
| Total assets  acquired                      |   | 14,400 |   |
| Liabilities  assumed:                       |   |   |   |
| Accounts payable and other accrued expenses |   | 1,235  |   |
| Other current liabilities                   |   | 1,925  |   |
| Long-term liabilities                       |   | 125    |   |
| Total  liabilities assumed                  |   | 3,285  |   |
| Net assets acquired                         |   | $      | 11,115 |   |

 

The allocation of the purchase price reflected in the consolidatedbalance sheet is according to a valuation of Delta’s current assets, currentliabilities, long-term liabilities, property and equipment and intangibleassets.

14

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

The value assigned to the tangible assets, intangible assets andliabilities has been determined as follows:

a.               Delta’s current assets and liabilities were recordedat their carrying amounts. The carrying amounts of the current assets andliabilities were reasonable proxies for their market values due to theirshort-term maturity. Property and equipment were presented at currentreplacement cost. Long-term liabilities are presented at present value ofamounts to be paid determined at appropriate current interest rates.

b.              The value assigned to the customer-related intangiblesamounted to $1,881. The fair value of Delta’s customer-related intangibles wasdetermined using the Income Approach.

6.           Innova

On February 28, 2006, we acquired all of the outstanding shares of OlasSoftware Solutions, Inc., d/b/a Innova Solutions (“Innova”), a provider of ITservices and solutions based in the United States and India. We acquired theoutstanding shares for cash consideration of $15,000 and related purchase costsof approximately $249. Additional payments of up to $10,000 are required to bemade in April 2007 and April 2008 based on achievement of certain revenue andoperating income milestones for the years 2006 and 2007, respectively. We haveprovided for a payment of $8,225 related to the milestones of 2006. Currently,we cannot estimate the probability of achieving the milestones of 2007.

Innova became a wholly-owned subsidiary of Ness Technologies, Inc. and,accordingly, its results of operations are included in our consolidatedfinancial statements since the acquisition date. Upon completion of theacquisition, Innova changed its name to Ness Innovative Business Services.

This acquisition was accounted for under the purchase method ofaccounting and, accordingly, the purchase price was allocated to the assetsacquired and liabilities assumed based on their relative fair values. Basedupon a valuation of tangible and intangible assets acquired and liabilitiesassumed, we have allocated the total cost of the acquisition to Innova’s assetsand liabilities (as of the acquisition date) as follows:

| Cash and cash equivalents                                                             |   | $      | 1,566  |   |
|---------------------------------------------------------------------------------------|--------|--------|--------|--------|
| Trade receivables                                                                     |   | 3,527  |   |
| Other accounts receivable                                                             |   | 1,310  |   |
| Property and equipment                                                                |   | 1,233  |   |
| Other long-term assets                                                                |   | 519    |   |
| Intangible assets:                                                                    |   |   |   |
| Customer relations                                                                    |   | 1,848  |   |
| Backlog                                                                               |   | 640    |   |
| Workforce                                                                             |   | 4,773  |   |
| Goodwill                                                                              |   | 14,886 |   |
| Total assets acquired                                                                 |   | 30,302 |   |
| Liabilities assumed:                                                                  |   |   |   |
| Accounts payable and other  accrued expenses                                          |   | 4,606  |   |
| Other current liabilities                                                             |   | 2,008  |   |
| Accrual for additional  consideration to be paid subsequent to the balance sheet date |   | 8,225  |   |
| Long-term liabilities                                                                 |   | 214    |   |
| Total liabilities assumed                                                             |   | 15,053 |   |
| Net  assets acquired                                                                  |   | $      | 15,249 |   |

 

15

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

 

The allocation of the purchase price reflected in the consolidatedbalance sheet is according to a valuation of Innova's current assets, currentliabilities, long-term liabilities, property and equipment, other long-termassets and intangible assets. 

The value assigned to the tangible assets, intangible assets andliabilities has been determined as follows: 

a.               Innova’s current assets and liabilities were recordedat their carrying amounts. The carrying amounts of the current assets andliabilities were reasonable proxies for their market values due to theirshort-term maturity. Property and equipment were presented at currentreplacement cost. Long-term liabilities are presented at present value ofamounts to be paid determined at appropriate current interest rates.

b.              The value assigned to the customer-related intangiblesamounted to $2,488. The fair value of Innova’s customer-related intangibles wasdetermined using the Income Approach. Customer relations is amortized over itsuseful life, estimated as 4.83 years. Backlog is amortized according to itsexpected revenue recognition schedule.

Pro forma information in accordance with SFAS No. 141 has not beenprovided, since the revenues and net income of Ness Innovative BusinessServices were not material in relation to our total consolidated revenues andnet income.

##### f.                 Goodwill

On January 1, 2006, we began segment reporting, and therefore weallocated our goodwill balance as of January 1, 2006 to our reportable segmentsbased on their relative fair value as of that date.

In the nine months ended September 30, 2006, we recordedadditional goodwill resulting from the acquisition of Innova and additionalconsideration to be paid subsequent to the balance sheet date, togetherrepresenting $19,659.

We have elected to perform our annual goodwill impairment test duringthe fourth quarter of the year. No indications of impairment were identifiedduring the three and nine months ended September 30, 2006.

##### g.              Accounting forstock-based compensation

On January 1, 2006, we adopted Statement of Financial AccountingStandards No. 123(R), “Share-Based Payment” (“SFAS 123(R)”) utilizing themodified prospective transition method. SFAS 123(R) requires employee stockoptions to be valued at fair value on the date of grant and charged to expenseover the applicable service period. Under the modified prospective method,compensation expense is recognized for all share-based payments issued on orafter January 1, 2006 and for all share-based payments issued to employeesprior to January 1, 2006 that remain unvested.

Our results of operations for the three and nine months ended September30, 2006 include expenses of $204 and $495, respectively, in operating expenserelated to the adoption of SFAS 123(R). In accordance with the modifiedprospective method, our consolidated financial statements for prior periodshave not been restated to reflect, and do not include, the impact of SFAS 123(R).

16

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** **

**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

Adoption of SFAS 123(R) did not change our accounting for share-basedpayments issued to non-employees.

Prior to the adoption of SFAS 123(R), we accounted for share-basedawards to employees and directors using the intrinsic value method inaccordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accountingfor Stock Issued to Employees.” Additionally, prior to January 1, 2006, weprovided pro forma disclosure amounts in accordance with SFAS No. 148, “Accountingfor Stock-Based Compensation — Transition and Disclosure” (“SFAS No. 148”), asif the fair value method defined by SFAS 123 had been applied to stock-basedcompensation. Under APB Opinion No. 25, the exercise price of stock optionsgranted to employees and directors equaled the fair market value of theunderlying stock at the grant date, therefore, no share-based compensationexpense was recognized in our condensed consolidated statement of income.

SFAS 123(R) requires companies to estimate the fair value ofshare-based awards on the date of grant using an option-pricing model, whereapplicable. Share-based compensation expense recognized in our condensedconsolidated statement of income for the first and second quarters of fiscal2006 includes compensation expense for share-based awards granted (i) prior to,but not yet vested as of, December 31, 2005, based on the grant date fair valueestimated in accordance with the original provisions of SFAS 123, “Accountingfor Stock-Based Compensation” (“SFAS 123”), and (ii) subsequent to December 31,2005, based on the grant date fair value estimated in accordance with the provisionsof SFAS 123(R). We recognize these compensation costs net of a forfeiture rateand recognize the compensation costs for only those shares expected to vest ona straight-line basis over the requisite service period of the award, which isgenerally the option vesting term of three to four years. SFAS 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates. In ourpro forma information required under SFAS 123 for periods prior to fiscal 2006,we accounted for forfeitures as they occurred.

As of September 30, 2006, approximately $218 of total unrecognizedcompensation cost related to stock based compensation is expected to berecognized over a weighted-average period of 2.25 years. The total unrecognizedstock-based compensation cost to be recognized in future periods as ofSeptember 30, 2006 does not consider the effect of stock options that may beissued in subsequent periods.

During the six months ended June 30, 2006, no options were granted.During the three months ended September 30, 2006, we extended the term ofcertain options previously granted to Aharon Fogel, our Chairman of the Board,and Raviv Zoller, our President and CEO, representing 366,262 and 154,323options, respectively, to February 28, 2007, and we granted 26,974 options to aformer employee. Our results of operations include expenses of $195 related tothese modifications.

The fair value for options granted in the three and nine month periodsended September 30, 2005 and the options extended and granted in the threeand nine months ended September 30, 2006 is amortized over their vestingperiods and estimated at the date of grant using the Black-Scholes option pricingmodel with the following weighted average assumptions:
|                           | ** ** | **Three and nine  months ended  September 30, 2005** | ** ** | **Three and nine  months ended  September 30, 2006** | ** ** |
|---------------------------|------------|-------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                | ** ** | **(Unaudited)**                                                               | ** ** | **(Unaudited)**                                                               | ** ** |
| Dividend yield            |       | 0                                                                             | %          | 0                                                                             | %          |
| Expected volatility       |       | 0.38                                                                          |       | 0.31                                                                          |       |
| Risk-free  interest       |       | 4.25                                                                          | %          | 5.15                                                                          | %          |
| Expected life (in  years) |       | 4                                                                             |       | 0.52                                                                          |       |

 

17

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

The pro forma information regarding net income and earnings per sharerequired by SFAS No. 123 has been determined as if we accounted for ourstock-based compensation plans under the fair value method. Had compensationcost for our stock-based compensation plans been determined in accordance withSFAS No. 123, as amended by SFAS No. 148, our net income and earnings per sharewould have been reduced to the pro forma amounts indicated below:
|                                                                | ** ** | **Three months ended  September 30, 2005** | ** ** | **Nine months ended  September 30, 2005** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **(Unaudited)**                                                | ** ** | **(Unaudited)**                                               | ** ** |
| Net income  available to common stock, as reported             |       | $                                                              | 6,017      |                                                          | $          | 14,926 |   |
| Add: Stock-based employee compensation – intrinsic  value |       | 76                                                             |       | 1,973                                                         |       |
| Deduct: Stock-based employee compensation – fair  value   |       | (708                                                           | )          | (4,201                                                        | )          |
| Pro forma net income                                           |       | $                                                              | 5,385      |                                                          | $          | 12,698 |   |
|                                                           |       |                                                           |       |                                                          |       |
| Basic net  earnings per share, as reported                     |       | $                                                              |  0.17 |                                                          | $          | 0.43 |   |
| Diluted net  earnings per share, as reported                   |       | $                                                              |  0.17 |                                                          | $          |  0.42 |   |
|                                                           |       |                                                           |       |                                                          |       |
| Pro forma basic  net earnings per share                        |       | $                                                              |  0.16 |                                                          | $          |  0.37 |   |
| Pro forma diluted net  earnings per share                      |       | $                                                              |  0.15 |                                                          | $          |  0.36 |   |

 

##### h.              Impact ofrecently issued accounting pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”)issued SFAS No. 157, “Fair Value Measurements.” This standard defines fairvalue, establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair value measurements.SFAS No. 157 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007 and interim periods within those fiscalyears. The adoption of SFAS No. 157 is not expected to have a material impacton our financial position, results of operations or cash flows.

In September 2006, the FASB also issued SFAS No. 158, “Employers’Accounting for Defined Benefit Pension and Other Post-Retirement Plans — anAmendment of FASB Statements No. 87, 88, 106 and 132(R).” This standardrequires recognition of the funded status of benefit plans in statements offinancial position. The standard also requires recognition in othercomprehensive income of certain gains and losses that arise during the periodbut are deferred under pension accounting rules; and it modifies the timing ofreporting and adds certain disclosures. The recognition and disclosure elementsof SFAS No. 158 are effective for fiscal years ending after December 15, 2006and the measurement elements are effective for fiscal years ending afterDecember 15, 2008. Management is currently evaluating the effect that theadoption of SFAS No. 158 would have on our financial position and results ofoperations.

In June 2006, the FASB issued Interpretation No. 48, “Accounting forUncertainty in Income Taxes,” (“FIN 48”). FIN 48 creates a single model to addressuncertainty in tax positions. FIN 48 clarifies the accounting for income taxesby prescribing the minimum recognition threshold a tax position is required tomeet before being recognized in the financial statements. FIN 48 also providesguidance on derecognition, measurement, classification, interest and penalties,accounting in interim periods, disclosure and transition. In addition, FIN 48clearly scopes out income taxes from Financial Accounting Standards BoardStatement No. 5, “Accounting for Contingencies.” FIN 48 utilizes a two-stepapproach for evaluating tax positions. Recognition (step one) occurs when anenterprise concludes that a tax position, based solely on its technical merits,is more-likely-than-not to be sustained upon examination. Measurement (steptwo) is only addressed if step one has been satisfied (i.e., the position ismore-likely-than-not to be sustained). FIN 48 applies to all tax positionsrelated to income taxes subject to Financial 

18

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

Accounting Standards Board Statement No. 109, “Accountingfor Income Taxes.” This includes tax positions considered to be “routine” aswell as those with a high degree of uncertainty. Derecognition of a taxposition that was previously recognized would occur when a company subsequentlydetermines that a tax position no longer meets the more-likely-than-notthreshold of being sustained. FIN 48 specifically prohibits the use of avaluation allowance as a substitute for derecognition of tax positions. FIN 48is effective for fiscal years beginning after December 15, 2006. Management isin the process of evaluating the possible impact of the adoption of FIN 48 onour consolidated financial statements.

In March 2006, the FASB issued FASB Statement No. 156, “Accounting forServicing of Financial Assets,” (“FAS 156”) which amends FASB Statement No.140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities.” This statement addresses the recognition andmeasurement of separately recognized servicing assets and liabilities, such asthose common with mortgage securitization activities, and provides an approachto simplify efforts to obtain hedge-like accounting. It also clarifies when anobligation to service financial assets should be separately recognized as aservicing asset or servicing liability and requires that those separatelyrecognized assets or liabilities be initially measured at fair value, ifpracticable. FAS 156 permits an entity to choose either the amortization methodor the fair value method for subsequent measurement and also permits a servicerthat uses derivative financial instruments to offset risks on servicing toreport both the derivative financial instrument and related servicing asset orliability by using a consistent measurement attribute – fair value. Thisstatement shall be effective for all separately recognized servicing assets andliabilities acquired or issued after the beginning of an entity’s first fiscalyear beginning after September 15, 2006, with early adoption permitted.Management believes this statement will not have a material effect on ourconsolidated financial statements.

 In February 2006, the FASBissued FASB Statement No. 155, “Accounting for Hybrid Financial Instruments –an amendment of FASB Statements No. 133 and 140.” This statement amends FASBStatements No. 133, “Accounting for Derivative Instruments and HedgingActivities” (“FAS 133”), and No. 140, “Accounting for Transfers and Servicingof Financial Assets and Extinguishments of Liabilities” (“FAS 140”). Thisstatement allows financial instruments that have embedded derivatives to beaccounted for as a whole (eliminating the need to bifurcate the derivative fromits host) if the holder elects to account for the whole instrument on a fairvalue basis. It also clarifies which interest-only strips and principal-onlystrips are not subject to the requirements of FAS 133; establishes arequirement to evaluate interests in securitized financial assets to identifyinterest that are freestanding derivatives or that are hybrid financialinstruments that contain an embedded derivative requiring bifurcation;clarifies that concentrations of credit risk in the form of subordination arenot embedded derivatives; and amends FAS 140 to eliminate the prohibition on aqualifying special-purpose entity from holding a derivative financialinstrument that pertains to a beneficial interest other than another derivativefinancial instrument. This statement shall be effective for all financialinstruments acquired or issued after the beginning of an entity’s first fiscalyear beginning after September 15, 2006. Management believes this statementwill not have a material effect on our consolidated financial statements.

##### i.                  Reclassification

Certain prior period amounts have been reclassified to conform to thecurrent period presentation.

***Note3: Long-Term Debt***

##### a.               Composition

Our long-term debt is comprised as follows:

19

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**
|                          | ** ** | **December 31,   2005** | ** ** | **September 30,  2006** | ** ** |
|--------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **               | ** ** | ** **                        | ** ** | **(Unaudited)**              | ** ** |
| Banks (1)                |       | $                                 | 11,610     |                         | $          | 8,660 |   |
| Loans from  others       |       | 1,546                             |       | 424                          |       |
|                     |       | 13,156                            |       | 9,084                        |       |
| Less current  maturities |       | 6,862                             |       | 6,387                        |       |
|                     |       | $                                 | 6,294      |                         | $          | 2,697 |   |

 

----

(1)            Thelong-term loans default upon the failure of any of our subsidiaries named asborrowers under the loans to satisfy certain conditions and comply withcovenants. As of December 31, 2005 and September 30, 2006, management believesthat the subsidiaries are in compliance with foregoing conditions. The weightedaverage interest rate on the bank loans as of December 31, 2005 was 6.75% andas of September 30, 2006 was 6.57%.

##### b.              Classification

Classified by currency, linkage terms and interest rates, the totalamount of the liabilities (before deduction of current maturities) is asfollows:
|                         | ** ** | **Interest rate (%)** | ** ** | **Amount**        | ** ** |
|-------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **              | ** ** | **December 31,**      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
| ** **              | ** ** | **2005**              | ** ** | **2006**          | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **              | ** ** | ** **            | ** ** | **(Unaudited)**   | ** ** | ** ** | ** ** | **(Unaudited)** | ** ** |
| In, or linked to dollar |       | 5-6                   |       | 5-6               |       | $ | 2,169 |   | $ | 424 |   |
| In NIS - linked to CPI  |       | 6-8                   |       | 6-8               |       | 10,987 |   | 8,660 |   |
|                    |       |                  |       |              |       | $ | 13,156 |   | $ | 9,084 |   |

 

##### c.               Maturities

The liabilities mature as follows:
| **As of December 31,**  | ** ** | ** ** | ** ** |   |   |                                                         |   |
|-------------------------|------------|------------|------------|--------|--------|--------------------------------------------------------------|--------|
| 2006 (current maturity) |       |       |       |   |   | $         6,862 |   |
| 2007                    |       |       |       |   |   | 4,158                                                        |   |
| 2008                    |       |       |       |   |   | 1,080                                                        |   |
| 2009                    |       |       |       |   |   | 1,056                                                        |   |
|                    |       |       |       |   |   | $       13,156            |   |

 

***Note4: Commitments and Contingent Liabilities***

##### a.               Litigation

There are several outstanding claims filed against our subsidiaries byex-employees and others. Our management believes that the provision in ourconsolidated financial statements and our insurance coverage are adequate tocover probable costs arising from these matters.

One of our Israeli subsidiaries is currently in a dispute with one ofits clients, an Israeli insurance company, regarding the terms and conditionsof a software development contract (the “Contract”). The insurance companyclaims that we have breached the Contract by not timely delivering the requiredsoftware. The insurance company has issued a contract termination notice and isdemanding payment of the amounts 

20

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

paid so far, as well as unspecified damages.Furthermore, termination could affect our reputation and impair our relationswith another client as well as with additional prospects for the software. Webelieve that we have not breached the Contract and that the delays were causedby the insurance company’s actions. The Contract provides for mandatoryarbitration, which has not yet commenced, in which we intend to vigorouslydefend our position. The total scope of the project is approximately $9.0million and the amount paid so far is $5.3 million. We can give no assurance atthe present time of the exposure, if any, for these claims, but we believe thatour liability insurance policy should cover such exposure. Accordingly, weconcluded that no accrual is required in our consolidated financial statementsas of September 30, 2006 in connection with the insurance company’s demandfor repayments of amounts paid to us so far or for unspecified damages. Inaddition, we have not written off amounts we believe the insurance company owesus as of the balance sheet date based on the agreement. If the outcome of thedispute is not in our favor and not in line with our position described above,it may adversely affect our financial position, results of operations and cashflows.

##### b.              Guarantees

Guarantees are contingent commitments issued by us generally toguarantee our performance in different projects to our customers, such astenders. The term of a guarantee generally is equal to the term of the relatedprojects, which can be as short as 30 days or as long as 8 years. The maximumpotential amount of future payments we could be required to make under ourguarantees at December 31, 2005 and September 30, 2006, is $36,168 and $38,525,respectively. Included in these amounts are guaranties provided to the insurancecompany described in Note 4(a) above, which might require us to makefuture payments related to the agreement in the maximum amount of $2,060 as ofSeptember 30, 2006. No accrual was provided in the consolidated financialstatements as of September 30, 2006 in connection with thesecontingencies. We do not hold collateral to support guarantees when deemednecessary.

##### c.               Liens andcharges

To secure our liabilities, we and our subsidiaries recorded fixed andfloating charges on our holdings in subsidiaries, and on our and our subsidiaries’property and equipment and goodwill.

***Note5: Stockholders’ Equity***

##### a.               Redeemableoptions:

Our Executive Committee approved and resolved on August 31, 2004 toprovide to certain optionees (specifically, those who exchanged their optionsin two previously public entities acquired by us for options in Ness) the rightto redeem their options for a cash payment. The grant date occurred during thefourth quarter of 2004.

The redemption right was exercisable from October 1, 2004 until May 31,2006. Each option subject to the redemption right was transferable by theemployee to us for a cash payment linked, at the employee’s sole discretion,either to the Israeli CPI with NIS interest at the rate of 5% per year, or tothe U.S. dollar with U.S. dollar interest at the rate of 6% per year,calculated from the original option grant date of September 23, 1999 or October3, 1999 up to the redemption date. Each of 272,976 options were exercisable toacquire one share of our common stock at a price of $3.49 and were redeemableat the NIS equivalent amount of $10.12 per option as of May 31, 2006. Each of77,382 options were exercisable to acquire one share of our common stock at aprice of $7.45 and were redeemable at the NIS equivalent amount of $7.63 peroption as of May 31, 2006.

We accounted for the rights following the guidance of FIN No. 28, “Accountingfor Stock Appreciation Rights and Other Variable Stock Option or Award Plans,”relating to tandem awards and EITF No. 00-23, “Issues Related to the Accountingfor Stock Compensation under APB No. 25 and FIN No. 44.” Accordingly, once webelieved it was likely that the rights would be exercised in the future, aliability was recorded at the then value of the redemption rights with acorresponding charge to compensation expense.

On May 31, 2006, the redemption value of the redeemable options washigher than the difference between the market price of our shares and thestrike price of the options. We had previously recorded all 

21

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**NESS TECHNOLOGIES, INC. AND ITS SUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

the expected redemption value. The holders of 289,836options preferred to exercise their options and sell their shares and receivefrom us in cash only the difference between the redemption values and theproceeds they received from the sale. The holders of the remaining 60,522options elected to fully redeem the options.

The net cash payment was therefore only $1,485 and the remainingbalance of the previously recorded liability, or $1,868, was classified asequity.

##### b.              Totalcomprehensive income:

|                                                                            | ** ** | **Three months ended  September 30,** | ** **  | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|-------------|-----------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2005**                                             | ** **  | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                                 | ** ** | **(Unaudited)**                                      | ** **  | **(Unaudited)**                                     | ** ** |
| Net income                                                                 |       | $                                                    | 6,017  |                                                | $          | 7,938 |   | $ | 14,926 |   | $ | 20,225 |   |
| Foreign currency  translation adjustments, net                             |       | 255                                                  |        | 4,925                                               |       | (8,956 | ) | 8,460 |   |
| Net unrealized  losses (gains) on available-for-sale marketable securities |       | (86                                                  | )           | 43                                                  |       | (28 | ) | 23 |   |
| Comprehensive income  (loss)                                               |       | $                                                    | 6,186       |                                                | $          | 12,906 |   | $ | 5,942 |   | $ | 28,708 |   |

 

##### c.               Optionexercises:

In the nine months ended September 30, 2006, a total of 1,495,587options were exercised into common stock, including the aforementionedredeemable options, for aggregate consideration of $9,376.

***Note6: Segment Reporting***

Our segment information has been prepared inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterprise andRelated Information.” Operating segments are defined as components of an enterpriseengaging in business activities about which separate financial information isavailable that is evaluated regularly by our chief operating decision-maker indeciding how to allocate resources and assess performance.

At the end of 2005, we completed the reorganization ofour operations into operating segments. Our chief operating decision-maker isour chief executive officer, who evaluates our performance and allocatesresources based on segment revenues and operating profit.

Our operating segments are:

1. **Managed Strategic Services**, which includesIndia-based offshore services as well as system integration and applicationdevelopment and consulting services. Verticals served by this segment are:independent software vendors, life sciences and healthcare and others.

2. **Technologies & Systems Group**, whichincludes system integration and application development, real-time systemsdevelopment, consulting and outsourcing services for the defense, governmentand homeland security vertical, as well as systems for the telecommunicationsvertical.

3. **Ness Europe**, which includes systemintegration and application development, outsourcing and software andconsulting for Eastern European and Western European customers, includingnear-shore services from 

22

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

Eastern Europe forWestern European customers. Verticals served by this segment are: telecommunicationsand utilities, financial services and others.

4. **Ness Israel**, which includes systemintegration and application development, outsourcing, software and consultingand quality assurance and training for customers in Israel within the followingverticals: financial services, government, life sciences and healthcare,manufacturing, retail, transportation and others.

5. **Other**, which comprises operationsrepresenting, individually, less than 10% of our consolidated revenues andoperating profit. These include our operations in the United Kingdom and AsiaPacific as well as the recently acquired Ness Innovative Business Servicesdivision (formerly Innova).

Segment operating profit is defined as income fromoperations excluding unallocated headquarters costs. Expenses included insegment operating profit consist principally of direct selling, general,administrative and delivery costs. Certain general and administrative expensesand a portion of depreciation and amortization are not specifically allocatedto specific segments as management believes they are not directly attributableto any specific segment. Accordingly, these expenses are categorized as “UnallocatedExpenses” and adjusted against our total income from operations. Additionally,our management has determined that it is not practical to allocate certainidentifiable assets by segment, when such assets are used interchangeably amongthe segments.

The table below presents financial information for ourfive reportable segments. Prior period data is presented on a pro forma basis,as we were not organized into SFAS No. 131 operating segments at that time.

|                                        | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                             | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                             | ** ** | **(unaudited)**                                      | ** ** | **(unaudited)**                                     | ** ** |
| **Revenues:**                          |       |                                                 |       |                                                |       |   |   |   |   |
| Managed Strategic Services (MSS)       |       | $                                                    | 18,998     |                                                | $          | 18,935 |   | $ | 60,375 |   | $ | 60,829 |   |
| Technologies & Systems Group (TSG) |       | 12,414                                               |       | 14,538                                              |       | 35,165 |   | 41,958 |   |
| Ness Europe                            |       | 14,624                                               |       | 19,285                                              |       | 36,324 |   | 58,898 |   |
| Ness Israel                            |       | 43,700                                               |       | 50,652                                              |       | 127,570 |   | 138,966 |   |
| Other                                  |       | 7,983                                                |       | 15,725                                              |       | 20,908 |   | 42,140 |   |
|                                   |       | $                                                    | 97,719     |                                                | $          | 119,135 |   | $ | 280,342 |   | $ | 342,791 |   |

 

|                                        | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                             | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                             | ** ** | **(unaudited)**                                      | ** ** | **(unaudited)**                                     | ** ** |
| **Operating  Income (Loss):**          |       |                                                 |       |                                                |       |   |   |   |   |
| Managed Strategic Services (MSS)       |       | $                                                    | 1,770      |                                                | $          | 2,243 |   | $ | 5,122 |   | $ | 7,630 |   |
| Technologies & Systems Group (TSG) |       | 1,869                                                |       | 2,275                                               |       | 4,952 |   | 5,467 |   |
| Ness Europe                            |       | 1,683                                                |       | 1,493                                               |       | 4,165 |   | 5,410 |   |
| Ness Israel                            |       | 4,065                                                |       | 4,621                                               |       | 9,824 |   | 9,158 |   |
| Other                                  |       | 72                                                   |       | 870                                                 |       | (352 |   | 2,465 |   |
| Unallocated Expenses                   |       | (1,793                                               | )          | (1,342                                              |       | (5,273 |   | (4,591 |   |
|                                   |       | $                                                    | 7,666      |                                                | $          | 10,160 |   | $ | 18,438 |   | $ | 25,539 |   |

 

Our total revenues are attributed to geographic areasbased on the location of the end customer.

23

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**NESS TECHNOLOGIES, INC. AND ITS SUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**

The following presents total revenues for the threeand nine month periods ended September 30, 2005 and 2006, and long-lived assetsas of September 30, 2005 and 2006:

|                                                 | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                      | ** ** | **(Unaudited)**                                      | ** ** | **(Unaudited)**                                     | ** ** |
| Revenues from  sales to unaffiliated customers: |       |                                                 |       |                                                |       |   |   |   |   |
| Israel                                          |       | $                                                    | 52,842     |                                                | $          | 60,362 |   | $ | 153,014 |   | $ | 165,864 |   |
| United States                                   |       | 21,222                                               |       | 28,532                                              |       | 65,376 |   | 89,674 |   |
| Europe                                          |       | 17,535                                               |       | 24,970                                              |       | 44,384 |   | 70,849 |   |
| Asia and the Far East                           |       | 4,697                                                |       | 4,178                                               |       | 13,513 |   | 13,138 |   |
| Others                                          |       | 1,423                                                |       | 1,093                                               |       | 4,055 |   | 3,266 |   |
|                                            |       | $                                                    | 97,719     |                                                | $          | 119,135 |   | $ | 280,342 |   | $ | 342,791 |   |

 

|                        | ** ** | **September 30,** | ** ** |
|------------------------|------------|-------------------|------------|
| ** **             | ** ** | **2005**          | ** ** | **2006** | ** ** |
| ** **             | ** ** | **(Unaudited)**   | ** ** |
| Long-lived assets:     |       |              |       |   |   |
| Israel                 |       | $100,636          |       | $109,785 |   |
| United States          |       | 60,140            |       | 82,024 |   |
| Europe                 |       | 7,945             |       | 19,472 |   |
| Asia and the Far  East |       | 8,587             |       | 9,477 |   |
| Others                 |       | 15                |       | 12 |   |
|                   |       | $177,323          |       | $220,770 |   |

 

***Note7: Basic and Diluted Net Earnings per Share***

Basic net earnings per share are computed based on theweighted average number of shares of common stock outstanding during eachperiod. Diluted net earnings per share are computed based on the weightedaverage number of shares of common stock outstanding during each period, plusdilutive potential shares of common stock considered outstanding during theperiod, in accordance with SFAS No. 128, “Earnings per Share.”

The total weighted average number of shares related tothe outstanding options and warrants excluded from the calculations of dilutednet earnings per share, as they would have been anti-dilutive for all periodspresented, was 1,230,265, 1,183,597, 2,203,644, 782,223 and 2,372,532 for theyear ended December 31, 2005, the three months ended September 30, 2005 and2006, and the nine months ended September 30, 2005 and 2006, respectively.

The following table sets forth the computation ofbasic and diluted net earnings per share of common stock (in thousands):

24

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**NESS TECHNOLOGIES, INC. AND ITSSUBSIDIARIES**

**Notesto Interim Condensed Consolidated Financial Statements**

**U.S.dollars in thousands (except share and per share data) (Unaudited)**
|                                                                                                                | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| ** **                                                                                                     | ** ** | **(Unaudited)**                                      | ** ** | **(Unaudited)**                                     | ** ** |
| Numerator:                                                                                                     |       |                                                 |       |                                                |       |   |   |   |   |
| Net income, numerator for basic and diluted per  share                                                         |       | $                                                    | 6,017      |                                                | $          | 7,938 |   | $ | 14,926 |   | $ | 20,225 |   |
|                                                                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Denominator:                                                                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average number of shares of common stock                                                              |       | 34,648                                               |       | 35,910                                              |       | 34,314 |   | 35,471 |   |
| Denominator for basic net earnings per share                                                                   |       | 34,648                                               |       | 35,910                                              |       | 34,314 |   | 35,471 |   |
| Effect of dilutive securities:                                                                                 |       |                                                 |       |                                                |       |   |   |   |   |
| Employee stock options and warrants                                                                            |       | 851                                                  |       | 987                                                 |       | 1,248 |   | 956 |   |
| Denominator for  diluted net earnings per share – adjusted weighted average assuming exercise  of options |       | 35,499                                               |       | 36,897                                              |       | 35,562 |   | 36,427 |   |
|                                                                                                                |            |                                                      |            |                                                     |            |  |  |  |  |  |  |  |  |

 

25

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***Item2. Management’s Discussion and Analysis of Financial Condition and Results ofOperations***

*You should read the followingdiscussion and analysis together with our unaudited consolidated financialstatements and the accompanying notes. This discussion contains forward-lookingstatements, within the meaning of Section 27A of Securities Act of 1933, asamended, Section 21E of the Securities Exchange Act of 1934, as amended, andthe Private Securities Litigation Reform Act of 1995, including statementsregarding our expected financial position, business and financing plans. Thesestatements involve risks and uncertainties. Our actual results could differmaterially from the results described in or implied by these forward-lookingstatements as a result of various factors, including those discussed below andelsewhere in our Annual Report on Form 10-K filed with the SEC on March 15,2006, particularly under the headings “Disclosure Statement” and “Risk Factors.”*

### **Overview**

We are a global provider of information technology, orIT, services and end-to-end business solutions designed to help clients improvetheir competitiveness and effectiveness. End-to-end business solutionsencompass all stages of a client’s business process and incorporate alltechnologies and IT services related to that process. Our portfolio ofsolutions and services includes outsourcing, system integration and applicationdevelopment, software and consulting, and quality assurance and training. Theprimary industries, or verticals, we serve include government and defense,financial services, life sciences and healthcare, telecommunications andutilities, and independent software vendors, or ISVs.

We have operations in 15 countries across NorthAmerica, Europe and Asia. We combine our deep vertical expertise and strongtechnical capabilities to provide a complete range of high quality services ona global scale. By integrating our local and international personnel in focusedbusiness and project teams, our global delivery model leverages our corporateknowledge and experience, intellectual property and global infrastructure todevelop innovative solutions for clients across the geographies and verticalswe serve. We complement this global delivery model with our offshore deliverycapabilities to achieve meaningful cost reductions or other benefits for ourclients.

Our revenues increased to $119.1 million and $342.8million for the three and nine months ended September 30, 2006, respectively,from $97.7 million and $280.3 million for the three and nine months endedSeptember 30, 2005, respectively. Net income increased to $7.9 million and $20.2million for the three and nine months ended September 30, 2006, respectively,from $6.0 million and $14.9 million for the three and nine months endedSeptember 30, 2005, respectively.

Our revenue growth is attributable to a number offactors, including acquisitions we made, increases in the number and size ofprojects for existing clients and the addition of new clients. Our client baseis diverse, and we are not dependent on any single client. In the three andnine months ended September 30, 2006, no client accounted for more than 4% ofour revenues and our largest twenty clients together accounted forapproximately 29% and 33% of our revenues, respectively. For the three and ninemonths ended September 30, 2006, the percentage of our revenues generated fromagencies of the government of Israel was 9%. Existing clients from prior yearsgenerated more than 85% of our revenues in the three and nine months endedSeptember 30, 2006.

Our backlog as of September 30, 2006 was $548 millioncompared to $439 million as of September 30, 2005. This $109 million increasein our backlog was due primarily to new bookings. We achieve backlog throughnew signings of IT services projects and outsourcing contracts, including fornew and repeat customers. We recognize backlog as revenue when we perform theservices related to backlog.

For the three and nine months ended September 30,2006, the percentage of our revenues derived from clients in Israel was 51% and48%, respectively; in the United States, 24% and 26%, respectively; in Europe,21% and 21%, respectively; in Asia and the Far East, 4% and 4%, respectively;and in other countries, 1% and 1%, respectively.

26

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For the three and nine months ended September 30,2006, we derived 42% and 44%, respectively, of our revenues from outsourcing(including offshore development); 33% and 32%, respectively, from systemintegration and application development; 16% and 15%, respectively, fromsoftware and consulting; 7% and 7%, respectively, from quality assurance andtraining; and 2% and 2%, respectively, from our other offerings.

As of September 30, 2006, we had approximately 7,240employees, including approximately 6,365 IT professionals. Of the 7,240employees, approximately 3,380 were in Israel, 2,165 were in India, 500 were inNorth America, 815 were in Europe and 375 were in the Asia Pacific region.

### **RecentDevelopments**

There have been no significant developments since September30, 2006.

### **ConsolidatedResults of Operations**

The following table sets forth the items in ourconsolidated statements of income as a percentage of revenues for the periodspresented.

|                                               | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                             | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenues                                      |       | 100.0                                                | %          | 100.0                                               | %          | 100.0 | % | 100.0 | % |
| Cost of revenues                              |       | 71.3                                                 |       | 71.4                                                |       | 71.4 |   | 71.4 |   |
| Gross profit                                  |       | 28.7                                                 |       | 28.6                                                |       | 28.6 |   | 28.6 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Operating expenses:                           |       |                                                 |       |                                                |       |   |   |   |   |
| Selling and  marketing                        |       | 7.2                                                  |       | 7.0                                                 |       | 7.5 |   | 7.5 |   |
| General and  administrative                   |       | 13.7                                                 |       | 13.0                                                |       | 14.5 |   | 13.7 |   |
| Total operating  expenses                     |       | 20.9                                                 |       | 20.0                                                |       | 22.0 |   | 21.1 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Operating income                              |       | 7.8                                                  |       | 8.5                                                 |       | 6.6 |   | 7.5 |   |
| Financial expenses, net                       |       | (0.4                                                 | )          | (0.4                                                | )          | (0.5 | ) | (0.3 | ) |
| Other income, net                             |       | 0.0                                                  |       | 0.0                                                 |       | 0.0 |   | 0.1 |   |
| Income before taxes on  income                |       | 7.4                                                  |       | 8.1                                                 |       | 6.1 |   | 7.2 |   |
|                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Taxes on income                               |       | 1.3                                                  |       | 1.4                                                 |       | 0.8 |   | 1.3 |   |
| Equity in net losses of  affiliates           |       | —                                               |       | 0.0                                                 |       | 0.0 |   | 0.0 |   |
| Minority interests in  losses of a subsidiary |       | —                                               |       | —                                              |       | 0.0 |   | — |   |
| Net income                                    |       | 6.2                                                  |       | 6.7                                                 |       | 5.3 |   | 5.9 |   |

 

### **ThreeMonths Ended September 30, 2006 Compared to the Three Months Ended September30, 2005**

The following table summarizes certain line items fromour consolidated statements of income (dollars in thousands):

|                  | ** ** | **Three months ended** | ** ** | ** **   | ** ** |
|------------------|------------|----------------------------------|------------|--------------|------------|
| ** **       | ** ** | **September 30,**           | ** ** | **Increase** | ** ** |
| ** **       | ** ** | **2005**                         | ** ** | **2006**     | ** ** | **$** | ** ** | **%** | ** ** |
| ** **       | ** ** | ** **                       | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues         |       | $                                | 97,719     |         | $          | 119,135 |   | 21,416 |   | 21.9 |   |
| Cost of revenues |       | 69,628                           |       | 85,095       |       | 15,467 |   | 22.2 |   |
| Gross profit     |       | $                                | 28,091     |         | $          | 34,040 |   | 5,949 |   | 21.2 |   |
| Gross margin     |       | 28.7                             | %          | 28.6         | %          |   |   |   |   |

 

#### ***Revenues***

Our revenues increased from $97.7 million in the threemonths ended September 30, 2005 to $119.1 million in the three months endedSeptember 30, 2006, representing an increase of $21.4 million, or 21.9%. Asignificant portion of the $13.3 million of revenue growth attributable toacquisitions made in the last twelve months was due

27

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to post-acquisition growth resulting from synergieswith Ness. Of the $21.4 million increase in revenues, $5.0 million representsgrowth in outsourcing and offshore engagements and $16.3 million representsgrowth in our other offerings, comprised of system integration and applicationdevelopment, software and consulting, and quality assurance and training.Revenues from outsourcing and offshore services increased as a result of volumegrowth due to our sales initiatives related to these offerings, including thehiring of key personnel and aligning of our organizational structure. There wasno significant change in our billing rates, or prices, from the three monthsended September 30, 2005 to the three months ended September 30, 2006.

#### ***Cost of revenues***

Our cost of revenues, including salaries, wages andother direct and indirect costs, increased from $69.6 million in the threemonths ended September 30, 2005 to $85.1 million in the three months endedSeptember 30, 2006, representing an increase of $15.5 million, or 22.2%.Approximately $10.2 million of this increase was attributable to acquisitionsmade in the last twelve months, a significant portion of which was due togrowth in our delivery staff needed to support post-acquisition revenue growthresulting from synergies with Ness, and $5.3 million was due to normal growthin our delivery staff needed to support our increased revenues.

#### ***Gross Profit***

Our gross profit (revenues less cost of revenues)increased from $28.1 million in the three months ended September 30, 2005 to$34.0 million in the three months ended September 30, 2006, representing anincrease of $5.9 million, or 21.2 %. The increase was primarily due to ourincrease in revenues. A significant portion of the $3.6 million of gross profitincrease attributable to acquisitions made in the last twelve months was due topost-acquisition revenue growth resulting from synergies with Ness, and $2.3million was related to our other revenue growth. Gross margin for the threemonths ended September 30, 2006 was 28.6%, compared to 28.7% in the threemonths ended September 30, 2005. This decrease in gross margin was notsignificant.

The following table summarizes certain line items fromour consolidated statements of income (dollars in thousands):

|                             | ** ** | **Three months ended  September 30,** | ** ** | **Increase** | ** ** |
|-----------------------------|------------|------------------------------------------------------|------------|--------------|------------|
| ** **                  | ** ** | **2005**                                             | ** ** | **2006**     | ** ** | **$** | ** ** | **%** | ** ** |
| Selling and  marketing      |       | $                                                    | 7,081      |         | $          | 8,391 |   | 1,310 |   | 18.5 |   |
| General and  administrative |       | 13,344                                               |       | 15,489       |       | 2,145 |   | 16.1 |   |
| Total operating  expenses   |       | 20,425                                               |       | 23,880       |       | 3,455 |   | 16.9 |   |
| Operating income            |       | $                                                    | 7,666      |         | $          | 10,160 |   | 2,494 |   | 32.5 |   |

 

#### ***Selling and marketing***

Selling and marketing expenses increased from $7.1million in the three months ended September 30, 2005 to $8.4 million in thethree months ended September 30, 2006, representing an increase of $1.3million, or 18.5%. This increase was due primarily to the inclusion ofmarketing and sales expenses from our acquisitions in the last twelve months,representing $1.2 million and amortization of backlog and customer relationsrelated to acquisitions, representing $0.5 million, offset by a decrease inmarketing and sales expenses in our other units, representing $0.4 million.

#### ***General and administrative***

General and administrative expenses increased from$13.3 million in the three months ended September 30, 2005 to $15.5 million inthe three months ended September 30, 2006, representing an increase of $2.1million, or 16.1%. This increase was due primarily to our acquisitions in thelast twelve months, representing $1.4 million.

#### ***Operating Income***

Operating income increased from $7.7 million in thethree months ended September 30, 2005 to $10.2 million in the three monthsended September 30, 2006, representing an increase of $2.5 million, or 32.5%.The major factors contributing to this increase were the growth in operatingincome of our Managed Strategic Services,

28

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Technologies & Services Group, Ness Israel andOther segments, representing $0.5 million, $0.4 million, $0.6 million and $0.8million, respectively, and a decrease in unallocated expenses, representing$0.5 million, offset by a decrease in the operating income of our Ness Europesegment, representing $0.2 million. See also “—Results by Business Segment.”

The following table summarizes certain line items fromour consolidated statements of income (dollars in thousands):

|                                     | ** ** | **Three months ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|--------------------------|------------|
| ** **                          | ** ** | **2005**                                             | ** ** | **2006**                 | ** ** | **$** | ** ** | **%** | ** ** |
| Operating income                    |       | $                                                    | 7,666      |                     | $          | 10,160 |   | 2,494 |   | 32.5 |   |
| Financial  expenses, net            |       | (383                                                 | )          | (492                     | )          | (109 | ) | 28.5 |   |
| Other expenses,  net                |       | (14                                                  | )          | (8                       | )          | 6 |   | (42.9 | ) |
| Income before  taxes on income      |       | 7,269                                                |       | 9,660                    |       | 2,391 |   | 32.9 |   |
| Taxes on income                     |       | 1,252                                                |       | 1,709                    |       | 457 |   | 36.5 |   |
| Equity in net  losses of affiliates |       | —                                               |       | (13                      | )          | (13 | ) | N/A |   |
| Net income                          |       | $                                                    | 6,017      |                     | $          | 7,938 |   | 1,921 |   | 31.9 |   |

 

#### ***Financial expenses, net***

Financial expenses, net, increased from $0.4 millionin the three months ended September 30, 2005 to $0.5 million in the threemonths ended September 30, 2006, representing an increase of $0.1 million, or28.5%. The increase was insignificant, despite the significant decrease inaverage net cash from $38.2 million to $5.6 million, as a result ofimproved cash management, repayment of relatively expensive loans and effectivehedging of foreign currencies.

#### ***Other expenses, net***

Other expenses, net, decreased from $14,000 in thethree months ended September 30, 2005 to $8,000 in the three months endedSeptember 30, 2006. This change was not significant.

#### ***Taxes on income***

Our taxes on income increased from $1.3 million in thethree months ended September 30, 2005 to $1.7 million in the three months endedSeptember 30, 2006, representing an increase of $0.5 million, or 36.5%. Thisincrease was primarily attributable to the increase in our income before taxes,representing $0.4 million.

#### ***Equity in net losses of affiliates***

Equity in net losses of affiliates increased from zerofor the three months ended September 30, 2005 to $13,000 in the three monthsended September 30, 2006. This change was not significant.

#### ***Net Income***

Net income increased from $6.0 million in the threemonths ended September 30, 2005 to $7.9 million in the three months endedSeptember 30, 2006, representing an increase of $1.9 million, or 31.9%. Theincrease in net income was due primarily to our increase in operating income of$2.5 million, partially offset by our increase in taxes on income of $0.5million.

### **NineMonths Ended September 30, 2006 Compared to the Nine Months Ended September 30,2005**

The following table summarizes certain line items fromour consolidated statements of income (dollars in thousands):

29

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|                  | ** ** | **Nine months ended  September 30,** | ** ** | **Increase** | ** ** |
|------------------|------------|-----------------------------------------------------|------------|--------------|------------|
| ** **       | ** ** | **2005**                                            | ** ** | **2006**     | ** ** | **$** | ** ** | **%** | ** ** |
| Revenues         |       | $                                                   | 280,342    |         | $          | 342,791 |   | 62,449 |   | 22.3 |   |
| Cost of revenues |       | 200,252                                             |       | 244,792      |       | 44,540 |   | 22.2 |   |
| Gross profit     |       | $                                                   | 80,090     |         | $          | 97,999 |   | 17,909 |   | 22.4 |   |
| Gross margin     |       | 28.6                                                | %          | 28.6         | %          |   |   |   |   |

 

#### ***Revenues***

Our revenues increased from $280.3 million in the ninemonths ended September 30, 2005 to $342.8 million in the nine months endedSeptember 30, 2006, representing an increase of $62.4 million, or 22.3%. Asignificant portion of the $42.2 million of revenue growth attributable toacquisitions was due to post-acquisition growth resulting from synergies withNess. Of the $62.4 million increase in revenues, $21.4 million representsgrowth in outsourcing and offshore engagements and $40.9 million representsgrowth in our other offerings, comprised of system integration and applicationdevelopment, software and consulting, and quality assurance and training.Revenues from outsourcing and offshore services increased as a result of volumegrowth due to our sales initiatives related to these offerings, including thehiring of key personnel and aligning of our organizational structure. There wasno significant change in our billing rates, or prices, from the nine monthsended September 30, 2005 to the nine months ended September 30, 2006.

#### ***Cost of revenues***

Our cost of revenues, including salaries, wages andother direct and indirect costs, increased from $200.3 million in the ninemonths ended September 30, 2005 to $244.8 million in the nine months endedSeptember 30, 2006, representing an increase of $44.5 million, or 22.2%.Approximately $30.8 million of this increase was attributable to acquisitionsmade in the last twelve months, a significant portion of which was due togrowth in our delivery staff needed to support post-acquisition revenue growthresulting from synergies with Ness, and $13.7 million was due to normal growth inour delivery staff needed to support our increased revenues.

#### ***Gross Profit***

Our gross profit (revenues less cost of revenues)increased from $80.1 million in the nine months ended September 30, 2005 to$98.0 million in the nine months ended September 30, 2006, representing anincrease of $17.9 million, or 22.4 %. The increase was primarily due to ourincrease in revenues. A significant portion of the $11.9 million of grossprofit increase attributable to acquisitions made in the last twelve months wasdue to post-acquisition revenue growth resulting from synergies with Ness, and$6.0 million was related to our other revenue growth. Gross margin for the ninemonths ended September 30, 2006 was 28.6%, compared to 28.6% in the nine monthsended September 30, 2005.

The following table summarizes certain line items fromour consolidated statements of income (dollars in thousands):

|                             | ** ** | **Nine months ended  September 30,** | ** ** | **Increase** | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|--------------|------------|
| ** **                  | ** ** | **2005**                                            | ** ** | **2006**     | ** ** | **$** | ** ** | **%** | ** ** |
| Selling and  marketing      |       | $                                                   | 21,114     |         | $          | 25,615 |   | 4,501 |   | 21.3 |   |
| General and  administrative |       | 40,538                                              |       | 46,845       |       | 6,307 |   | 15.6 |   |
| Total operating  expenses   |       | 61,652                                              |       | 72,460       |       | 10,808 |   | 17.5 |   |
| Operating income            |       | $                                                   | 18,438     |         | $          | 25,539 |   | 7,101 |   | 38.5 |   |

 

#### ***Selling and marketing***

Selling and marketing expenses increased from $21.1million in the nine months ended September 30, 2005 to $25.6 million in thenine months ended September 30, 2006, representing an increase of $4.5 million,or 21.3%. This increase was due primarily to the inclusion of marketing andsales expenses from our acquisitions in the last twelve months, representing$2.7 million, and amortization of backlog and customer relations related toacquisitions, representing $1.8 million.

30

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#### ***General and administrative***

General and administrative expenses increased from$40.5 million in the nine months ended September 30, 2005 to $46.8 million inthe nine months ended September 30, 2006, representing an increase of $6.3million, or 15.6%. This increase was due primarily to our acquisitions in thelast twelve months, representing $4.1 million, general and administrativeexpenses associated with the reorganization of our Ness Israel segment,representing $1.0 million, and the rollout of long-term retention programs andbonuses, representing $1.0 million, offset by lower stock-based compensationexpenses, representing $1.4 million.

#### ***Operating Income***

Operating income increased from $18.4 million in thenine months ended September 30, 2005 to $25.5 million in the nine months endedSeptember 30, 2006, representing an increase of $7.1 million, or 38.5%. Themajor factors contributing to this increase were the growth in operating incomeof our Managed Strategic Services, Technologies & Services Group, NessEurope and Other segments, representing $2.5 million, $0.5 million, $1.2 millionand $2.8 million, respectively, and a decrease in unallocated expenses,representing $0.7 million, offset by a decrease in the operating income of ourNess Israel segment, representing $0.7 million. See also “—Results by BusinessSegment.”

The following table summarizes certain line items fromour consolidated statements of income (dollars in thousands):

|                                               | ** ** | **Nine months ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------|------------|
| ** **                                    | ** ** | **2005**                                            | ** ** | **2006**                 | ** ** | **$** | ** ** | **%** | ** ** |
| Operating income                              |       | $                                                   | 18,438     |                     | $          | 25,539 |   | 7,101 |   | 38.5 |   |
| Financial  expenses, net                      |       | (1,297                                              | )          | (1,130                   | )          | 167 |   | (12.9 | ) |
| Other income  (expenses), net                 |       | (10                                                 | )          | 436                      |       | 446 |   | N/A |   |
| Income before  taxes on income                |       | 17,131                                              |       | 24,845                   |       | 7,714 |   | 45.0 |   |
| Taxes on income                               |       | 2,277                                               |       | 4,517                    |       | 2,240 |   | 98.4 |   |
| Equity in net  losses of affiliates           |       | (29                                                 | )          | (103                     | )          | (74 | ) | 255.2 |   |
| Minority  interests in losses of a subsidiary |       | 101                                                 |       | —                   |       | (101 | ) | (100.0 | ) |
| Net income                                    |       | $                                                   | 14,926     |                     | $          | 20,225 |   | 5,299 |   | 35.5 |   |

 

#### ***Financial expenses, net***

Financial expenses, net, decreased from $1.3 millionin the nine months ended September 30, 2005 to $1.1 million in the nine monthsended September 30, 2006, representing a decrease of $0.2 million, or 12.9%.The decrease occurred despite the significant decrease in average net cash from$45.1 million to $7.9 million, as a result of improved cashmanagement, repayment of relatively expensive loans and effective hedging offoreign currencies.

#### ***Other income (expenses), net***

Other income (expenses), net, changed from expenses of$10,000 in the nine months ended September 30, 2005 to income of $0.4 millionin the nine months ended September 30, 2006. This increase was primarily due toconsideration received for a third party transaction, representing $0.4million, net of expenses.

#### ***Taxes on income***

Our taxes on income increased from $2.3 million in thenine months ended September 30, 2005 to $4.5 million in the nine months endedSeptember 30, 2006, representing an increase of $2.2 million, or 98.4%. Thisincrease was primarily attributable to the increase in our income before taxes,representing $1.0 million, a lower utilization of tax loss carry forwardscompared to the year-ago period, representing $0.5, and an increase in incomebefore taxes from geographies with higher tax rates as well as from highertaxes on certain revenues and other income, net, together representing $0.7million.

31

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#### ***Equity in net losses of affiliates***

Equity in net losses of affiliates increased from$29,000 for the nine months ended September 30, 2005 to $0.1 million in thenine months ended September 30, 2006. This change was not significant.

#### ***Minority interests in losses of a subsidiary***

Minority interests in losses of a subsidiary changedfrom $0.1 million in the nine months ended September 30, 2005 to zero in thenine months ended September 30, 2006. This change was not significant.

#### ***Net Income***

Net income increased from $14.9 million in the ninemonths ended September 30, 2005 to $20.2 million in the nine months endedSeptember 30, 2006, representing an increase of $5.3 million, or 35.5%. The increasein net income was due primarily to our increase in operating income of $7.1million, our increase in other income, net, of $0.4 million and our decrease infinancial expenses of $0.2 million, partially offset by our increase in taxeson income of $2.2 million.

**Resultsby Business Segment**

Our segment information has been prepared inaccordance with SFAS No. 131, “Disclosures about Segments of an Enterprise andRelated Information.” Operating segments are defined as components of anenterprise engaging in business activities about which separate financialinformation is available that is evaluated regularly by our chief operatingdecision-maker in deciding how to allocate resources and assess performance.

At the end of 2005, we completed the reorganization ofour operations into operating segments. Our chief operating decision-maker isour chief executive officer, who evaluates our performance and allocatesresources based on segment revenues and operating profit.

Our operating segments are:

1.       **Managed Strategic Services**, which includes India-based offshoreservices as well as system integration and application development andconsulting services. Verticals served by this segment are: independent softwarevendors, life sciences and healthcare and others.

2.       **Technologies & Systems Group**, which includes system integration andapplication development, real-time systems development, consulting andoutsourcing services for the defense, government and homeland securityvertical, as well as systems for the telecommunications vertical.

3.       **Ness Europe**, which includes system integration andapplication development, outsourcing and software and consulting for EasternEuropean and Western European customers, including near-shore services fromEastern Europe for Western European customers. Verticals served by this segmentare: telecommunications and utilities, financial services and others.

4.       **Ness Israel**, which includes system integration andapplication development, outsourcing, software and consulting and quality assuranceand training for customers in Israel within the following verticals: financialservices, government, life sciences and healthcare, manufacturing, retail,transportation and others.

5.       **Other**, which comprises operations representing,individually, less than 10% of our consolidated revenues and operating profit.These include our operations in the United Kingdom and Asia Pacific as well asthe recently acquired Ness Innovative Business Services division (formerlyInnova).

Segment operating profit is defined as income fromoperations excluding unallocated headquarters costs. Expenses included insegment operating profit consist principally of direct selling, general,administrative and

32

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delivery costs. Certain general and administrativeexpenses and a portion of depreciation and amortization are not specificallyallocated to specific segments as management believes they are not directlyattributable to any specific segment. Accordingly, these expenses arecategorized as “Unallocated Expenses” and adjusted against our total incomefrom operations. Additionally, our management has determined that it is notpractical to allocate certain identifiable assets by segment, when such assetsare used interchangeably among the segments.

The table below presents financial information for ourfive reportable segments (dollars in thousands). Prior period data is presentedon a pro forma basis, as we were not organized into SFAS No. 131 operatingsegments at that time.
|                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                             | ** ** | **2005**                                                 | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2006** | ** ** |
| **Segment Data:**                      | ** ** | **(unaudited)**                                          | ** ** | **(unaudited)**                                         | ** ** |
| ** **                             | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenues:**                          | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Managed Strategic Services (MSS)bn     |       | $                                                        | 18,998     |                                                    | $          | 18,935 |   | $ | 60,375 |   | $ | 60,829 |   |
| Technologies & Systems Group (TSG) |       | 12,414                                                   |       | 14,538                                                  |       | 35,165 |   | 41,958 |   |
| Ness Europe                            |       | 14,624                                                   |       | 19,285                                                  |       | 36,324 |   | 58,898 |   |
| Ness Israel                            |       | 43,700                                                   |       | 50,652                                                  |       | 127,570 |   | 138,966 |   |
| Other                                  |       | 7,983                                                    |       | 15,725                                                  |       | 20,908 |   | 42,140 |   |
|                                   |       | $                                                        | 97,719     |                                                    | $          | 119,135 |   | $ | 280,342 |   | $ | 342,791 |   |
| **Operating  Income (Loss):**          | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Managed Strategic Services (MSS)       |       | $                                                        | 1,770      |                                                    | $          | 2,243 |   | $ | 5,122 |   | $ | 7,630 |   |
| Technologies & Systems Group (TSG) |       | 1,869                                                    |       | 2,275                                                   |       | 4,952 |   | 5,467 |   |
| Ness Europe                            |       | 1,683                                                    |       | 1,493                                                   |       | 4,165 |   | 5,410 |   |
| Ness Israel                            |       | 4,065                                                    |       | 4,621                                                   |       | 9,824 |   | 9,158 |   |
| Other                                  |       | 72                                                       |       | 870                                                     |       | (352 | ) | 2,465 |   |
| Unallocated Expenses                   |       | (1,793                                                   | )          | (1,342                                                  | )          | (5,273 | ) | (4,591 | ) |
|                                   |       | $                                                        | 7,666      |                                                    | $          | 10,160 |   | $ | 18,438 |   | $ | 25,539 |   |

 

**Liquidityand Capital Resources**

#### ***Overview***

As of September 30, 2006, we had cash, cashequivalents and short-term bank deposits of $45.0 million compared to $73.1million as of December 31, 2005. The funds held at locations outside of theUnited States are for future operating expenses and capital expenditures, andwe have no intention of repatriating those funds. We are not, however,restricted in repatriating those funds back to the United States, if necessary.While we expect that cash generated by our non-U.S. subsidiaries will bereinvested in their respective geographies to support expansion of ourbusiness, to the extent that funds were remitted to the United States in theform of dividend payments, those payments may be subject to withholding taxesin their respective countries, and would be subject to tax in the UnitedStates.

#### ***Cash Flows***

The following table summarizes our cash flows for theperiods presented (dollars in thousands):

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|                                                               | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                    | ** ** | **2005**                                                | ** ** | **2006** | ** ** |
| Net cash used in  operating activities                        |       | $                                                       | (9,269     | ) | $ | (11,448 | ) |
| Net cash  provided by (used in) investing activities          |       | (16,789                                                 | )          | 10,091 |   |
| Net cash  provided by financing activities                    |       | 1,119                                                   |       | 6,466 |   |
| Effect of  exchange rate changes on cash and cash equivalents |       | (4,987                                                  | )          | 1,498 |   |
| Increase  (decrease) in cash and cash equivalents             |       | (29,926                                                 | )          | 6,607 |   |
| Cash and cash  equivalents at the beginning of the period     |       | 104,229                                                 |       | 33,579 |   |
| Cash and cash  equivalents at the end of the period           |       | $                                                       | 74,303     |   | $ | 40,186 |   |

 

*Nine months ended September 30, 2006compared to the nine months ended September 30, 2005*

Net cash used in operating activities was $11.5million in the nine months ended September 30, 2006, compared to $9.3 millionin the nine months ended September 30, 2005. The major factors contributing tothe change were tax payments in the nine months ended September 30, 2006 to theIsraeli Tax Authority related to prior periods, representing $10.5 million, anda greater increase in unbilled receivables, representing $8.3 million,offset by a decrease in trade receivables, representing $17.6 million. Weachieved this significant decrease in trade receivables despite the unusualdelay in the approval of the Israeli government budget in 2006 resulting fromthe Israeli elections. This delay, as well as a shorter delay in the ninemonths ended September 30, 2005, caused our cash flow from operating activitiesto be negative in the first half of each year.

Net cash provided by investing activities was $10.1million in the nine months ended September 30, 2006, compared with net cashused of $16.8 million in the nine months ended September 30, 2005. The majorfactors contributing to the decrease were payments in respect of theacquisitions we made during the first nine months of 2006, representing $14.6million, net of cash acquired, offset by the sale of short-term bank depositsand marketable securities, representing $35.2 million.

Net cash provided by financing activities was $6.5million in the nine months ended September 30, 2006, compared with $1.1 millionin the nine months ended September 30, 2005. The change was primarily due to alower increase in short-term bank loans and credit, net, representing $4.0million, offset by a lower decrease in long-term bank loans and credit, net,representing $9.0 million. In the nine months ended September 30, 2005 and2006, we had positive cash flows from the exercise of options and warrants of$9.1 million and $9.4 million, respectively.

The effect of exchange rate changes on cash and cashequivalents was $1.5 million in the nine months ended September 30, 2006,compared to ($5.0) million in the nine months ended September 30, 2005. Thechange was primarily due to long-term inter-company balances, representing $4.6million.

#### ***Long-term and Short-term Debt***

At September 30, 2006, we had aggregate short-term andlong-term bank and other borrowings of $34.6 million, consisting of variousnotes denominated in dollars and NIS (linked to index) with interest ratesranging from approximately 5.8% to 7.5% and a weighted average interest rate ofapproximately 6.57%, with maturities of one to three years. These aggregatebank borrowings included $8.4 million from Mizrahi Bank, with interest rates of6.4% to 6.5% and maturity of one year; $7.9 million from Israel Discount Bank,with interest rates of approximately 6.4% to 7.5% and maturities of one tothree years; $6.4 million from Bank Leumi, with an interest rate of approximately6.4% and maturity of one year; and $11.9 million from seven other lenders,in amounts ranging from $0.4 million to $2.8 million, with interest ratesof approximately 5.8% to 6.8% and maturities of up to three years. The maximuminterest rate for our NIS index linked borrowings was approximately 7.5%.

At September 30, 2006, we had a net cash position of$10.3 million, compared to $40.7 as of December 31, 2005. Net cash decreasedduring the first nine months of 2006 primarily due to non-recurring uses ofcash, such as payments in respect of acquisitions, representing $18.8 million,net of cash acquired, and tax payments to the Israeli Tax Authority related toprior periods, representing $10.5 million. Despite this reduction in net cash, wehave been able to maintain relatively low financial expenses.

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The shares of two of our Israeli subsidiaries arepledged to Israeli Discount Bank and Bank Hapoalim as security for borrowings.We are currently in the process of canceling the pledges on these shares. Therelevant debt instruments contain customary restrictive covenants relating tothe borrower and our wholly-owned subsidiary Ness A.T. Ltd., including thefollowing:

·                  limitations on incurring debt;

·                  prohibition on pledging assets;

·                  prohibition on distributing dividends;

·                  stockholders’ equity must not be lessthan 30% of its total assets;

·                  EBITDA must not be less than 9.5% ofrevenues and not less than NIS 34 million; and

·                  limitations on merging or transferring assets.

In addition, the Israel Discount Bank agreementrequires that the net cash and liquid assets of the borrower must not be lowerthan $18.0 million. As of September 30, 2006, we are in compliance and expectto remain in compliance with all of our covenants. Our failure to comply withthese covenants could lead to an event of default under the agreementsgoverning some or all of the indebtedness, permitting the applicable lender toaccelerate all borrowings under the applicable agreement and to foreclose onany collateral.

#### ***Anticipated Needs***

We intend to fund future growth through future cashflow from operations, available bank borrowings and the remaining net proceedsof our initial public offering. We believe the remaining balance of theproceeds of our initial public offering, together with borrowings and futurecash flow from operations, will be sufficient to fund continuing operations forthe foreseeable future. In order to achieve our strategic business objectives,we may be required to seek additional financing. For example, futureacquisitions may require additional equity and/or debt financing. In addition,we may require further capital to continue to enhance our infrastructure andfor working capital purposes. These financings may not be available onacceptable terms, or at all.

#### **Forward-LookingStatements and Risk Factors**

This Quarterly Report on Form 10-Q, includingManagement’s Discussion and Analysis of Financial Condition and Results ofOperations, contains forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995. Forward-looking statementsoften are proceeded by words such as “believes,” “expects,” “may,” “anticipates,”“plans,” “intends,” “assumes,” “will” or similar expressions. Forward-lookingstatements reflect management’s current expectations, as of the date of thisreport, and involve certain risks and uncertainties. Our actual results coulddiffer materially from those anticipated in these forward looking statements asa result of various factors. Some of the factors that could cause futureresults to materially differ from the recent results or those projected inforward-looking statements include the “Risk Factors” described in our 2005Annual Report on Form 10-K filed with the SEC on March 15, 2006.

## ***Item 3. Quantitative and QualitativeDisclosure about Market Risk***

We do not engage in trading market-risk instruments orpurchase hedging or “other than trading” instruments that are likely to exposeus to market risk, whether interest rate, commodity price or equity price risk.We have not purchased options or entered into swaps or forward or futurescontracts and do not use derivative financial instruments for speculativetrading purposes.

We have direct operations in 15 different countriesand relationships in many other parts of the world. Our contracts withcustomers are in local currencies or dollars. As a result, we are subject toadverse movements in foreign currency exchange rates in those countries wherewe conduct business. Beginning in the second quarter of 2005, we entered intocertain forward foreign currency exchange contracts to hedge our exposureagainst foreign currencies which differ from the local functional currencies.In the future, we may enter into additional forward foreign currency exchangeor other derivatives contracts to further hedge our exposure to foreigncurrency exchange rates.

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#### ***Item 4. Controls and Procedures***

### **Evaluationof Disclosure Controls and Procedures**

As of the end of the period covered by this report,our chief executive officer and chief financial officer evaluated theeffectiveness of our disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended).Based on their evaluation of our disclosure controls and procedures, our chiefexecutive officer and chief financial officer, with the participation of ourmanagement, have concluded that our disclosure controls and procedures areeffectively designed to ensure that information required to be disclosed by usin the reports that we file or submit under the Securities Exchange Act of1934, as amended, is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms and are operating in an effective manner.

It should be noted that any system of controls,however well designed and operated, can provide only reasonable, and notabsolute, assurance that the objectives of the system are met. In addition, thedesign of any control system is based in part upon certain assumptions aboutthe likelihood of future events. Given these and other inherent limitations ofcontrol systems, there is only reasonable assurance that our controls willsucceed in achieving their stated goals under all potential future conditions.

### **Changesin Internal Control**

As of the end of the period covered by this report,there were no significant changes in our internal controls over financialreporting or in other factors that could significantly affect these controls.

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# **PART II**–**OTHER INFORMATION**

#### ***Item 1. Legal Proceedings***

One of our Israeli subsidiariesis currently in a dispute with one of its clients, an Israeli insurance company,regarding the terms and conditions of a software development contract (the “Contract”).The insurance company claims that we have breached the Contract by not timelydelivering the required software. The insurance company has issued a contracttermination notice and is demanding payment of the amounts paid so far, as wellas unspecified damages. Furthermore, termination could affect our reputationand impair our relations with another client as well as with additionalprospects for the software. We believe that we have not breached the Contractand that the delays were caused by the insurance company’s actions. TheContract provides for mandatory arbitration, which has not yet commenced, inwhich we intend to vigorously defend our position. The total scope of theproject is approximately $9.0 million and the amount paid so far is $5.3million. We can give no assurance at the present time of the exposure, if any,for these claims, but we believe that our liability insurance policy shouldcover such exposure. If the outcome of the dispute is not in our favor and notin line with our position described above, it may adversely affect ourfinancial position, results of operations and cash flows.

 

## ***Item 1A. Risk Factors***

There are no material changes in the risk factorspreviously disclosed in our Annual Report on Form 10-K filed with the SEC onMarch 15, 2006.

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

Not applicable.

## ***Item 3. Defaults upon Senior Securities.***

None.

## ***Item 4. Submission of Matters to a Vote ofSecurity Holders***

None.

## ***Item 5. Other Information***

None.

## ***Item 6. Exhibits***

The following is a list of exhibits filed as part ofthis Form 10-Q:
| Exhibit Number | ** ** | **Description**                                                                                                                                      |
|----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1           |       | Certification of Chief Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
| 31.2           |       | Certification of Chief Financial Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
| 32.1           |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2           |       | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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# **SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, as amended, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.
| NESS TECHNOLOGIES, INC. |             |   |                                           |
|-------------------------|------------------|--------|------------------------------------------------|
| (Registrant)            |             |   |                                           |
|                    |             |   |                                           |
|                    |             |   |                                           |
| Date:                   | November 8, 2006 | By:    | /s/ Raviv  Zoller                              |
|                    |             |   | Raviv Zoller                                   |
|                    |             |   | Chief Executive  Officer, President, Director  |
|                    |             |   | (Principal  executive officer)                 |
|                    |             |   |                                           |
|                    |             |   |                                           |
| Date:                   | November 8, 2006 | By:    | /s/ Ytzhak  Edelman                            |
|                    |             |   | Ytzhak Edelman                                 |
|                    |             |   | Chief Financial  Officer and deputy to the CEO |
|                    |             |   | (Principal  financial and accounting officer)  |
|                         |                  |        |                                                |  |

 

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**EXHIBIT INDEX**
| Exhibit Number | ** ** | **Description**                                                                                                                                      |
|----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1           |       | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
|           |       |                                                                                                                                                 |
| 31.2           |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
|           |       |                                                                                                                                                 |
| 32.1           |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|           |       |                                                                                                                                                 |
| 32.2           |       | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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