UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

ý		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
		For the quarterly period ended June 30, 2005
		OR
o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
		For the transition period from               to

 

Commission File Number: 0-24081

 

EVOLVING SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware		84-1010843
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)
9777 Pyramid Court, Suite 100 Englewood, Colorado		80112
(Address of principal executive offices)		(Zip Code)
(303) 802-1000
(Registrant’s telephone number)

 

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

 

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

 

As of August 5, 2005 there were 16,049,754 shares outstanding of Registrant’s Common Stock (par value $0.001 per share).

 

 

EVOLVING SYSTEMS, INC.

Quarterly Report on Form 10-Q

June 30, 2005

Table of Contents

 

	PART I – FINANCIAL INFORMATION
Item 1	Financial Statements
	Consolidated Balance Sheets (Unaudited) as of June 30, 2005 and December 31, 2004
	Consolidated Statements of Operations (Unaudited) for the Three and Six Months Ended June 30, 2005 and 2004
	Consolidated Statements of Cash Flows (Unaudited) for the Six Months Ended June 30, 2005 and 2004
	Notes to Unaudited Consolidated Financial Statements
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3	Quantitative and Qualitative Market Risk Disclosures
Item 4	Controls and Procedures
	PART II – OTHER INFORMATION
Item 1	Legal Proceedings
Item 2	Changes in Securities
Item 3	Defaults on Senior Securities
Item 4	Submission of Matters to a Vote of Security Holders
Item 5	Other Information
Item 6	Exhibits
Signature

 

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PART I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

EVOLVING SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands except share data)

(unaudited)

 

		June 30, 2005			December 31, 2004
ASSETS
Current assets:
Cash and cash equivalents		$	4,567		$	11,386
Current portion of restricted cash		100			100
Contract receivables, net of allowance of $44 at June 30, 2005 and December 31, 2004		6,065			11,296
Unbilled work-in-progress		1,467			1,323
Prepaid and other current assets		1,742			1,832
Total current assets		13,941			25,937
Property and equipment, net		2,269			2,563
Intangible assets, net		16,282			19,993
Goodwill		35,596			37,698
Long-term restricted cash		300			300
Total assets		$	68,388		$	86,491
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of notes payable and long-term obligations		$	4,451		$	31
Short-term notes payable		—			4,880
Accounts payable and accrued liabilities		6,125			8,357
Payable to Tertio sellers		—			2,664
Deferred foreign income taxes		128			265
Unearned revenue		10,298			13,083
Total current liabilities		21,002			29,280
Long-term liabilities:
Long-term obligations		88			125
Notes payable, net of current portion		8,336			11,849
Deferred foreign income taxes		3,735			4,642
Total liabilities		33,161			45,896
Commitments and contingencies
Series B convertible redeemable preferred stock; $.001 par value; 966,666 shares issued and outstanding as of June 30, 2005 and December 31, 2004.		11,281			11,281
Stockholders’ equity:
Common stock, $0.001 par value; 25,000,000 shares authorized; 16,037,477 and 15,987,217 shares issued and outstanding as of June 30, 2005 and December 31, 2004, respectively.		16			16
Additional paid-in capital		67,828			67,765
Other comprehensive income (loss)		(600		)	1,994
Accumulated deficit		(43,298		)	(40,461		)
Total stockholders’ equity		23,946			29,314
Total liabilities and stockholders’ equity		$	68,388		$	86,491

 

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

 

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EVOLVING SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands except per share data)

(unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
REVENUE
License fees and services		$	4,741		$	2,383		$	9,822		$	5,602
Customer support		5,185			2,878			9,942			5,425
Total revenue		9,926			5,261			19,764			11,027
COSTS OF REVENUE AND OPERATING EXPENSES
Costs of license fees and services, excluding depreciation and amortization		2,393			1,125			5,369			2,194
Costs of customer support, excluding depreciation and amortization		1,636			1,816			3,667			3,480
Sales and marketing		2,423			901			4,815			1,837
General and administrative		1,481			934			3,982			1,869
Product development		495			241			605			732
Depreciation		384			265			760			539
Amortization		1,395			214			2,816			432
Restructuring and other expenses (recovery)		(3		)	—			(51		)	—
Total costs of revenue and operating expenses		10,204			5,496			21,963			11,083
Loss from operations		(278		)	(235		)	(2,199		)	(56		)
Other income (expense):
Interest income (expense), net		(368		)	67			(758		)	124
Other income (expense), net		(59		)	—			(174		)	—
Total other income (expense), net		(427		)	67			(932		)	124
Income (loss) before income taxes		(705		)	(168		)	(3,131		)	68
Benefit from income taxes		16			—			294			8
Net income (loss)		$	(689	)	$	(168	)	$	(2,837	)	$	76
Basic income (loss) per common share		$	(0.04	)	$	(0.01	)	$	(0.15	)	$	0.00
Diluted income (loss) per common share		$	(0.04	)	$	(0.01	)	$	(0.15	)	$	0.00
Weighted average basic shares outstanding		18,639			15,853			18,619			15,845
Weighted average diluted shares outstanding		18,639			15,853			18,619			17,590

 

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

 

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EVOLVING SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

		Six Months Ended June 30,
		2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)		$	(2,837	)	$	76
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation		760			539
Amortization of intangible assets		2,816			432
Amortization of debt issuance costs		26			—
Interest expense added to debt principal		660			—
Gain on disposal of property and equipment		(12		)	—
Bad debt recovery		—			(21		)
Benefit from foreign deferred income taxes		(920		)	—
Change in operating assets and liabilities:
Contract receivables		5,044			6,743
Unbilled work-in-progress		(53		)	606
Prepaid and other assets		51			(350		)
Accounts payable and accrued liabilities		(1,243		)	(665		)
Unearned revenue		(2,482		)	(2,490		)
Long-term obligations		(20		)	(19		)
Net cash provided by operating activities		1,790			4,851
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment		(529		)	(756		)
Proceeds from sale of property and equipment		18			3
Business combinations, net of cash acquired		(365		)	41
Net cash used in investing activities		(876		)	(712		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Capital lease payments		(15		)	(14		)
Principal payments on notes payable		(4,889		)	—
Payment of amount due to Tertio sellers		(2,616		)	—
Proceeds from the issuance of stock		63			340
Net cash (used in) provided by financing activities		(7,457		)	326
Effect of exchange rate changes on cash		(276		)	(2		)
Net (decrease) increase in cash and cash equivalents		(6,819		)	4,463
Cash and cash equivalents at beginning of period		11,386			17,999
Cash and cash equivalents at end of period		$	4,567		$	22,462
Supplemental disclosure of other cash and non-cash financing transactions:
Interest paid		$	147		$	7

 

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

 

5

 

EVOLVING SYSTEMS, INC.

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

(1)   Basis of Presentation

 

Interim Consolidated Financial Statements. The accompanying consolidated financial statements of Evolving Systems, Inc. (“Evolving Systems” or the “Company”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. However, management believes that the disclosures included in these financial statements are adequate to make the information presented not misleading. The unaudited consolidated financial statements included in this document have been prepared on the same basis as the annual consolidated financial statements, and in management’s opinion, reflect all adjustments, which include normal recurring adjustments, necessary for a fair presentation in accordance with GAAP. The results for the three and six months ended June 30, 2005 are not necessarily indicative of the results that the Company will have for any subsequent quarter or full fiscal year.  These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes to those statements for the year ended December 31, 2004 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

 

Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting period. Estimates have been made by management with respect to the collectibility of accounts receivable, estimates to complete long-term contracts and in establishing the estimated fair values of acquired assets and liabilities. Actual results could differ from these estimates.

 

Foreign Currency Translation. The Company’s foreign subsidiaries use as their functional currency the local currency of the countries in which they operate. Their assets and liabilities are translated into U.S. dollars at the exchange rates in effect at the balance sheet date. Revenues, expenses, and cash flows are translated at the average rates of exchange prevailing during the period. Translation gains and losses are included in comprehensive income (loss) within stockholders’ equity. Realized and unrealized transaction gains and losses resulting from the remeasurement of non-functional currency financial instruments are included in the determination of net income (loss). For the three and six months ended June 30, 2005 transaction gains were approximately $61,000 and $125,000, respectively. For the three and six months ended June 30, 2004, transaction gains (losses) were approximately $1,000 and ($2,000), respectively.

 

Comprehensive Income. The Company’s comprehensive income (loss) is comprised of its net income (loss) and foreign currency translation adjustment.  For the three and six months ended June 30, 2005 total comprehensive loss was approximately $2.2 million and $5.4 million, respectively. For the three and six months ended June 30, 2004, total comprehensive income (loss) was ($177,000) and $69,000, respectively.

 

Principles of Consolidation. The consolidated financial statements include the accounts of the Company and its subsidiaries, all of which are wholly owned.  All significant intercompany transactions and balances have been eliminated.

 

Reclassification. As a result of the significance of the intangible assets and the related amortization expense from the acquisitions of Tertio Telecoms Limited (“Tertio”) and Telecom Software Enterprises LLC. (“TSE”), the Company is now reporting amortization expense as a separate line item on the statements of operations. In quarterly periods prior to December 31, 2004, amortization of intangibles was shown within costs of license fees and services and costs of customer support. Prior period balances have been reclassified to conform with the current period’s presentation.

 

Revenue Recognition. The Company derives revenue from two primary sources: license fees/services and customer support.  We recognize revenue in accordance with Statements of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended and interpreted by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” In addition we have applied the provisions of Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,” which provides further interpretive guidance for public companies on the recognition, presentation and disclosure of revenue in financial statements.

 

The majority of the Company’s license fees and services revenue is generated from fixed-price contracts which provide for both licenses to its software products and services. Revenue under these arrangements, where the services are determined to be essential to the functionality of the delivered software, is recognized using the percentage-of-completion method of accounting, in accordance with SOP 97-2 and SOP 81-1, “Accounting for Long-Term Construction Type Contracts,” once a license agreement has been signed, the fee is fixed or determinable and collectibility is reasonably assured.  The percentage of completion for each contract is estimated based on the ratio of direct labor hours incurred to total estimated direct labor hours.  The estimated percentage of completion on contracts entered into by the Company’s United Kingdom (“U.K.”) subsidiary, Tertio, are based upon the ratio of direct project costs incurred to total estimated direct project costs.  The use of direct project costs approximates what would have resulted had direct labor hours been used since the majority of direct project costs consist of direct labor.  Due to the fact that the estimated direct labor hours and project costs, and changes thereto, can have a significant impact on revenue recognition, these estimates are critical and are reviewed by management regularly. Amounts billed in advance of services being performed are recorded as unearned revenue. Unbilled work-in-progress represents revenue earned but not yet billable under the terms of the fixed-price contracts. All

 

6

 

such amounts are expected to be billed and collected during the succeeding 12 months.

 

In arrangements where the services are not essential to the functionality of the delivered software, the Company recognizes license revenue when a license agreement has been signed, delivery has occurred, the fee is fixed or determinable and collectibility is reasonably assured. Where applicable, fees from multiple element arrangements are unbundled and recorded as revenue as the elements are delivered to the extent that Vendor Specific Objective Evidence (“VSOE”) of the fair value of the undelivered elements exists. If VSOE for the undelivered elements does not exist, fees from such arrangements are deferred until the earlier of the date that VSOE does exist on the undelivered elements or all of the elements have been delivered.

 

Services revenue provided under fixed-price contracts is generally recognized using the proportional performance method of accounting, which is similar to the percentage of completion method described above. Revenue from professional services provided pursuant to time-and-materials based contracts and training services are recognized as the services are performed, as that is when the Company’s obligation to its customers under such arrangements is fulfilled.

 

Customer support and maintenance revenue is generally recognized ratably over the service contract period. When maintenance or training services are bundled with the original license fee arrangement, their fair value, based upon VSOE, is deferred and recognized during the periods such services are provided.

 

The Company may encounter budget and schedule overruns on fixed price contracts caused by increased labor, overhead or material costs. Adjustments to cost estimates are made in the periods in which the facts requiring such revisions become known. Estimated losses, if any, are recorded in the period in which current estimates of total contract revenue and contract costs indicate a loss.

 

(2) Business Combinations

 

Tertio

 

On November 2, 2004, the Company acquired all of the outstanding shares of privately-held, U.K.-based Tertio. Total consideration for Tertio’s net assets determined in accordance with GAAP approximated $40.2 million, consisting of $11.0 million in cash, approximately $15.9 million in seller-financed notes, of which $4.0 million was paid during the first half of 2005, 966,666 shares of Series B Preferred Stock with an estimated fair value of approximately $11.3 million and approximately $2.0 million in estimated transaction-related costs. Of the total purchase price, 10% was deposited in escrow with Wells Fargo Bank, N.A. as escrow agent to secure the sellers’ representations and warranties under the purchase agreement.  Of the funds deposited in escrow, 80% will remain in escrow until November 2, 2005 and the remaining 20% will remain in escrow until November 2, 2007, unless sooner released to the Company in payment of indemnification claims. Both Evolving Systems and Tertio operate on a calendar year. The acquisition was recorded as a purchase business combination and Tertio’s results of operations have been combined with Evolving Systems’ from the acquisition date forward.

 

Tertio’s activation and mediation solutions fit well with elements of the Company’s product portfolio, enabling it to provide activation solutions and strengthening its current network mediation and service assurance offerings.  In addition, the acquisition provides the Company with global reach and a customer base that includes many of the world’s leading communications carriers. The purchase price for Tertio included goodwill because the Company concluded that increased scale may be achieved from a financial, customer and product perspective. In addition, Tertio brought a quality, experienced work force.

 

In January 2005, Tertio changed its name to Evolving Systems Limited and is sometimes referred to in this Form 10-Q as “Evolving Systems U.K.”.

 

TSE

 

On October 15, 2004, the Company acquired all of the outstanding ownership interests in privately-held TSE. Total GAAP consideration for TSE approximated $2.4 million, consisting of $1.5 million in cash, a note payable of $889,000 and approximately $55,000 in transaction-related costs.  The note payable was due and paid on March 31, 2005. Of the total purchase price, $250,000 was deposited in escrow for one year with Wells Fargo Bank, N.A. as escrow agent to secure the sellers’ representations and warranties under the purchase agreement.  The Company agreed to pay additional consideration of up to $3.5 million contingent upon the achievement of certain specified revenue and gross margin results. Up to $2.5 million of the contingent consideration may be payable over a 24 month period from the closing date and additional contingent consideration of up to $1.0 million may be paid through the year 2011 if certain specified sales of TSE products occur. In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 141, the contingent consideration will not be recorded until the contingency is resolved and the additional consideration is distributable. The Company paid $447,000 of contingent consideration recorded at December 31, 2004 during the first quarter of 2005.  During the three and six months ended June 30, 2005, the Company recorded additional contingent consideration and resulting goodwill related to certain specified gross margin results achieved by the sale of TSE products during the period of approximately $182,000 and $238,000. The additional contingent consideration is paid within 45 days of the last day of the quarter in which it is earned. The acquisition was treated as a purchase business combination and the results of TSE’s operations have been combined with Evolving Systems’ from the acquisition date forward. Both Evolving Systems and TSE operate on a calendar year.

 

TSE’s products are sold to U.S. wireline and wireless carriers, and provide for simulation of the nation’s centralized Number Portability Administration Center (“NPAC”) and a testing environment for critical back office systems that carriers use for enabling number portability. Other products in the TSE portfolio are used for enhanced integration between back office Operational Support

 

7

 

Systems (“OSS”).  TSE has installed its products at many of the leading wireless and wireline carriers in North America. By acquiring TSE, the Company has expanded its customer base and extended the set of solutions it offers its Local Number Portability (“LNP”) customers. The primary reason for a valuation which gives rise to goodwill is related to the value the Company placed on the TSE’s solid reputation as a provider of LNP products, the Company’s expectation of new customers and the experienced employees acquired in the TSE acquisition.

 

Pro Forma Financial Information

 

The financial information in the table below summarizes the combined results of operations of Evolving Systems, Inc., TSE and Tertio on a pro forma basis, as though the companies had been combined as of the period presented below.  The impact of the In-Process Research and Development (“IPR&D”) charges associated with the acquisitions has been excluded.  This pro forma financial information is presented for informational purposes only and is not necessarily indicative of the results of operations that would have been achieved had the acquisitions actually taken place as of the beginning of the period presented below.  The following amounts are in thousands, except per share amounts.

 

		Three Months Ended June 30,			Six Months Ended June 30,
		2004			2004
Revenues		$	11,419		$	23,710
Net loss		$	(636	)	$	(699	)
Basic loss per share		$	(0.03	)	$	(0.04	)
Diluted loss per share		$	(0.03	)	$	(0.04	)

 

(3) Goodwill and Intangible Assets

 

The Company has recorded goodwill and intangible assets from its acquisitions of CMS in 2003 and TSE and Tertio in 2004.  In accordance with SFAS No. 142, goodwill is not amortized but is subject to an impairment test at least annually.  Goodwill is assessed on an annual basis for impairment at the reporting unit level by applying a fair-value-based test. Changes in the carrying amounts of goodwill by reporting unit for the six months ended June 30, 2005 are as follows (in thousands):

 

		License and Services				Customer Support			Total Goodwill
Balance as of December 31, 2004		$		20,689		$	17,009		$	37,698
Adjustments to goodwill		(52			)	(67		)	(119		)
Effects of foreign currency exchange rates		(390			)	(321		)	(711		)
Balance as of March 31, 2005		20,247				16,621			36,868
Adjustments to goodwill		(4			)	(152		)	(156		)
Effects of foreign currency exchange rates		(705			)	(411		)	(1,116		)
		$	19,538			$	16,058		$	35,596

 

The Company recorded goodwill adjustments during the six months ended June 30, 2005 related to the finalization of the Tertio purchase price and contingent consideration and resulting goodwill related to certain specified gross margin results achieved by the sale of TSE products during the period. The Company may have additional purchase price adjustments related to Tertio as acquired contingencies are resolved and adjustments related to TSE as contingent consideration is earned.

 

The Company’s annual goodwill impairment test was conducted as of July 31, 2004, and it was determined that goodwill, at that time related solely to the CMS acquisition, was not impaired as of the test date. The Company will continue to monitor the carrying value of the acquired identifiable intangibles and goodwill as it executes on its business plan.  The Company expects to perform its annual required test in the third quarter of 2005.  If the Company determines that a substantial revision to its original financial projections related to the acquisitions is necessary, it is reasonably possible that a review for impairment of the Company’s goodwill and/or related long-lived intangible assets in connection with the annual impairment test, or in future assessments, may indicate that these assets are impaired, and the amount of impairment could be substantial. Additionally, goodwill is assessed for impairment at each reporting period end if certain events have occurred indicating that an impairment may have occurred.

 

Identifiable intangible balances include the cumulative effects of changes in foreign currency exchange rates since the acquisition date and were as follows as of June 30, 2005 (in thousands):

 

		Gross Amount				Accumulated Amortization				Useful Life
Identifiable intangible assets:
Purchased software		$		8,691		$	1,260			5 yrs
Customer contracts		2,079				1,389				1 yr
Purchased licenses		1,335				443				5 yrs
Trademarks and tradenames		1,121				124				6 yrs
Partnerships		1,397				133				7 yrs
Maintenance agreements and related relationships		6,159				1,151				2-7 yrs
		$	20,782			$		4,500

 

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As of December 31, 2004, identifiable intangibles were as follows (in thousands):

 

		Gross Amount			Accumulated Amortization			Estimated Useful Life
Identifiable intangible assets:
Purchased software		$	9,180		$	326		5 yrs
Customer contracts		2,196			305			1 yr
Purchased licenses		1,335			309			5 yrs
Trademarks and tradenames		1,196			33			6 yrs
Business partnerships		1,491			35			7 yrs
Customer relationships		6,403			800			2-7 yrs
		$	21,801		$	1,808

 

Amortization expense of identifiable intangible assets was $1.4 million and $2.8 million for the three and six months ended June 30, 2005, respectively, and $214,000 and $432,000 for the three and six months ended June 30, 2004, respectively.

 

(4)  Earnings Per Common Share

 

Basic earnings per share (“EPS”) is computed by dividing net income or loss available to common stockholders by the weighted average number of shares outstanding during the period, including common stock issuable under participating securities, such as the Series B Convertible, Redeemable Preferred Stock (“Series B Preferred Stock”). Diluted EPS is computed using the weighted average number of shares outstanding, including participating securities, plus all potentially dilutive common stock equivalents. Common stock equivalents consist of stock options, warrants and shares held in escrow. The following is the reconciliation of the numerators and denominators of the basic and diluted EPS computations (in thousands except per share data):

 

		Three Months Ended June 30,				Six Months Ended June 30,
		2005		2004		2005		2004
Weighted average common shares outstanding		16,029		15,853		16,009		15,845
Participating securities		2,610		—		2,610		—
Basic weighted average common shares outstanding		18,639		15,853		18,619		15,845
Effect of dilutive securities - options and warrants		—		—		—		1,745
Diluted weighted average common shares outstanding		18,639		15,853		18,619		17,590

 

Weighted average options to purchase 818,000 and 1.3 million shares of common stock were excluded from the dilutive stock calculation for the three and six months ended June 30, 2005, respectively, as their effect would have been anti-dilutive as a result of the net loss for the period. Weighted average options to purchase 2.8 million and 2.3 million shares of common stock were excluded from the dilutive stock calculation for the three and six months ended June 30, 2005, respectively, because their exercise prices were greater than the average fair value of the Company’s stock for the period.

 

Weighted average options to purchase 2.9 million shares of common stock were excluded from the dilutive stock calculation for the three months ended June 30, 2004, as their effect would have been anti-dilutive as a result of the net loss for the period. Weighted average options to purchase 393,000 shares of common stock were excluded from the dilutive stock calculation for the six months ended June 30, 2004 because their exercise prices were greater than the average fair value of the Company’s stock for the period.

 

The participating securities reflect 966,666 shares of Series B Preferred Stock, convertible into 2.9 million shares of the Company’s common stock, less the 96,667 shares of Series B Preferred Stock, convertible into 290,000 shares of the Company’s common stock, that are held in escrow.  In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 128 “Earnings Per Share”, shares that are contingently issuable are not included in the computation of basic EPS until all necessary conditions have been satisfied (in essence, when issuance of the shares are no longer contingent).

 

(5) Stock-Based Compensation

 

The Company applies the intrinsic-value-based method prescribed by Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for employee stock-based compensation arrangements. Non-employee stock compensation arrangements are accounted for under SFAS No. 123 and Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other than Employees, or in Conjunction with

 

9

 

Selling Goods or Services.”

 

SFAS No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123,” established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As permitted by existing accounting standards, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted only the disclosure requirements of SFAS No. 123, as amended. The following table illustrates the effect on net income (loss) if the fair-value-based method had been applied to all outstanding and unvested awards in each period (in thousands, except per share data):

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
Net income (loss), as reported		$	(689	)	$	(168	)	$	(2,837	)	$	76
Stock based compensation expense under the fair value method		(617		)	(395		)	(1,225		)	(579		)
Pro forma net loss		$	(1,306	)	$	(563	)	$	(4,062	)	$	(503	)
Earnings (loss) per common share as reported:
Basic		$	(0.04	)	$	(0.01	)	$	(0.15	)	$	0.00
Diluted		$	(0.04	)	$	(0.01	)	$	(0.15	)	$	0.00
Pro forma loss per common share:
Basic		$	(0.07	)	$	(0.04	)	$	(0.22	)	$	(0.03	)
Diluted		$	(0.07	)	$	(0.04	)	$	(0.22	)	$	(0.03	)

 

(6) Concentration of Credit Risk

 

For the three and six months ended June 30, 2005, the Company recognized 27% (14% and 13%) and 26% (14% and 12%), respectively, of total revenue from two significant customers (defined as contributing at least 10%), in the telecommunications industry.  For the three months ended June 30, 2004, the Company recognized 70% (20%, 16%, 13%, 11% and 10%) of total revenue from five significant customers, all in the telecommunications industry. For the six months ended June 30, 2004, the Company recognized 68% (23%, 19%, 14% and 12%) of total revenue from four significant customers, all in the telecommunications industry.

 

As of June 30, 2005, two significant customers accounted for approximately 20% (10% and 10%) of contract receivables.  At December 31, 2004, three significant customers accounted for approximately 58% (30%, 17% and 11%) of contract receivables.

 

In the past, and currently, the Company earns a significant portion of its revenue from a small number of customers in the communications industry. This has been mitigated somewhat by the expansion of the Company’s customer base through recent acquisitions. However, the loss of any significant customer, delays in delivery or acceptance of any of our products by a customer, delays in the performance of services for a customer, or delays in collection of customer receivables could be materially harmful to the Company’s business, financial condition, results of operations and cash flows.

 

(7) Notes Payable

 

The Company’s notes payable consist of the following (in thousands):

 

		As of June 30, 2005
Long-term seller financed notes payable, interest at weighted average rate of 11.62%, due in varying quarterly principal installments beginning March 31, 2006, with final maturity on December 31, 2007.		$	12,839
Debt issuance costs		(84		)
Total notes payable		12,755
Less current portion, net		(4,419		)
Long-term debt, excluding current installments, net		$	8,336

 

The Company entered into the long-term seller-financed notes payable (“Long-Term Notes”) on November 2, 2004, in conjunction with the acquisition of Tertio.  From the acquisition date through November 2, 2006, the Long-Term Notes bear interest at 11.0% per annum. From November 2, 2006 through the maturity date of December 31, 2007, the notes will bear interest at 14.0% per annum. For accounting purposes, interest is recognized using an effective rate of 11.62% for the term of the notes. Interest is accrued and added to the principal balance through December 31, 2005, and beginning March 31, 2006, interest is payable in cash on a quarterly basis in addition to the scheduled principal payments. Accrued interest of approximately $889,000 has been added to the

 

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principal balance of the Long-Term Notes from their inception through June 30, 2005. The Long-Term Notes payable may be prepaid at any time without penalty. Beginning in March 2005, if the Company’s quarterly cash balances exceed $7.0 million, the holder of the Long-Term Notes may require a prepayment on the note equal to the amount by which the quarterly cash balance exceeds $7.0 million. Based on its projections of cash balances, the Company believes that these additional payments will not be required through June 30, 2006. The scheduled principal payments on the Long-Term Notes are as follows (in thousands):

 

 

The Long-Term Notes have an effective interest rate of approximately 11.62% and a maturity date of December 31, 2007.  The notes are secured by substantially all of the assets of Evolving Systems and a pledge, subject to certain limitations, of the shares of its subsidiaries.

 

The Long-Term Notes subject the Company to certain affirmative and negative covenants, including a financial covenant indexed to the Company’s computation of EBITDA, as defined. The Company is required to comply with such covenants beginning June 30, 2005 and was in compliance as of that date.

 

The Company also entered into short-term seller financed notes payable on November 2, 2004, in conjunction with the acquisition of Tertio.  The first installments of $2.0 million were paid on March 31, 2005. The final installments of $2.0 million plus accrued interest were paid on June 30, 2005. The short-term seller financed note bore interest at a rate per annum equal to five and one-half percent, due on each of the previously mentioned payment dates.

 

The notes issued in connection with the Tertio acquisition prohibit the Company from declaring dividends to our common stockholders during the term of the notes.

 

(8) Income Taxes

 

The Company recorded a net income tax benefit of $16,000 and $294,000 for the three and six months ended June 30, 2005, respectively. The net benefit during the three and six months ended June 30, 2005 consists of current income tax expense of approximately $436,000 and $626,000, respectively and a deferred tax benefit of $452,000 and $920,000, respectively, both of which are related to the Company’s UK-based operations.

 

In conjunction with the acquisition of Tertio, certain identifiable intangible assets were recorded.  Since the amortization of these identifiable intangibles is not deductible for income tax purposes, a long-term deferred tax liability of $4.6 million was established at the acquisition date for the expected difference between what would be expensed for financial reporting purposes and what would be deductible for income tax purposes. As of June 30, 2005, this deferred tax liability was $3.7 million. This deferred tax liability is carried on the books of the Company’s United Kingdom subsidiary, and has no impact on the Company’s ability to recover its U.S.-based deferred tax assets.

 

In conjunction with the acquisition of Tertio, future revenue under contracts in existence at the acquisition dates was reduced to an amount equal to the Company’s estimated costs to fulfill its obligations under the contracts plus a reasonable profit margin on the Company’s estimated fulfillment effort.  The resulting reduction of future revenue recorded for financial reporting purposes is not deductible for income tax purposes and thus, a current deferred tax liability of approximately $600,000 was established at the acquisition date. As of June 30, 2005, this deferred tax liability was $128,000.  Both of the aforementioned deferred tax liabilities will be recognized as a reduction of current income tax expense as the identifiable intangibles are amortized and the contract revenue is recognized.

 

As of June 30, 2005 and December 31, 2004, the Company continued to maintain a full valuation allowance on its domestic net deferred tax asset due to uncertainties related to the Company’s ability to utilize its domestic deferred tax assets, primarily consisting of certain net operating loss carryforwards, before they expire.  The Company’s assessment of this valuation allowance was made using all available evidence, both positive and negative.  In particular, the Company considered both its historical results and its projections of profitability for the reasonably foreseeable future periods.  The Company’s realization of its recorded net deferred tax assets is dependent on future taxable income and, therefore, the Company cannot conclude that it is more likely than not that it will realize such benefits.  The Company is required to reassess its conclusions regarding the realization of its deferred tax assets at each financial reporting date. It is reasonably possible that future evaluation could result in a conclusion that all or a portion of the valuation allowance is no longer necessary which could have a material impact on the Company’s results of operations and financial position.

 

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(9) Restructuring and Other Expenses

 

In early 2002, management implemented a restructuring plan (the “Plan”) due to the downturn in the U.S. telecommunications industry, the Company’s sharp decline in revenue, the FCC’s delay in ruling on wireless number portability and other factors.  The Plan included workforce reductions, restructuring of the Company’s headquarters building lease, the closure of its satellite field offices and the write down of certain fixed assets, all of which were executed in 2002. At June 30, 2005 and December 31, 2004, the remaining accrual related to the closure of the satellite offices.

 

Closure of satellite offices.  The Company closed all of its satellite field offices during 2002.  Because the costs to sublease or terminate these lease commitments are based on estimates, the Company may incur additional costs related to the satellite office closures.  During the three and six months ended June 30, 2005 the Company recorded a recovery of $3,000 and $48,000 related to the closure of the satellite offices as the actual costs to close these facilities were less than its original estimate.  As of June 30, 2005 approximately $13,000 was included in accounts payable and accrued liabilities, and approximately $1,000 was included in long-term obligations, related to the closure of the satellite offices.

 

The following table summarizes the change in the accrual balance since December 31, 2004 (in thousands):

 

		Closure of Satellite Offices
Accrual balance December 31, 2004		$	79
1st quarter adjustments		(48		)
1st quarter cash payments, net		(15		)
Accrual balance March 31, 2005		16
2nd quarter cash payments		(3		)
Accrual balance June 30, 2005		$	13

 

(10) Segment Information

 

In accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” the Company defines operating segments as components of an enterprise for which separate financial information is available.  This information is reviewed regularly by the chief operating decision-maker, or decision-making group, to evaluate performance and to make operating decisions. The Company has identified its Chief Executive Officer and Chief Financial Officer as its chief operating decision-makers. These chief operating decision makers review revenues by segment and review overall results of operations.

 

The Company currently operates its business as two operating segments based on revenue type: license fees/services revenue and customer support revenue (as shown on the consolidated statements of operations).  License fees and services revenue represents the fees received from the license of software products and those services directly related to the delivery of the licensed products as well as custom development, integration services and time and materials work.  Customer support revenue includes annual support fees, recurring maintenance fees, fees for maintenance upgrades and warranty fees.  Warranty services are typically bundled with a license sale and the related revenue, based on VSOE, is deferred and recognized ratably over the warranty period. With the acquisition of Tertio, the Company now provides products and services on a global basis. In addition, the Company has a product development facility in Bangalore, India.  Total assets by segment have not been specified because the information is not available to the chief operating decision-making group.

 

Segment information is as follows (in thousands):

 

		Three Months Ended June 30,							Six Months Ended June 30,
		2005				2004			2005			2004
Revenue
License fees and services		$		4,741		$	2,383		$	9,822		$	5,602
Customer support		5,185				2,878			9,942			5,425
		9,926				5,261			19,764			11,027
Segment profit, excluding depreciation and amortization
License fees and services		2,348				1,258			4,453			3,408
Customer support		3,549				1,062			6,275			1,945
		5,897				2,320			10,728			5,353
Other operating expenses		4,399				2,076			9,402			4,438
Depreciation and amortization		1,779				479			3,576			971
Restructuring and other		(3			)	—			(51		)	—
Loss from operations		$	(278		)	$	(235	)	$	(2,199	)	$	(56	)

 

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Geographic Regions

 

The Company uses the customer locations as the basis of attributing revenues to individual countries. Financial information relating to the Company’s operations by geographic region is as follows (in thousands):

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
Revenue
United States		$	4,701		$	5,261		$	9,717		$	11,027
Europe, Middle East, Africa and Asia		5,225			—			10,047			—
Total revenues		$	9,926		$	5,261		$	19,764		$	11,027

 

		As of June 30, 2005			As of December 31, 2004
Long-lived assets, net
United States		$	1,239		$	1,563
Europe, Middle East, Africa and Asia		1,030			1,000
Total long-lived assets		$	2,269		$	2,563

 

(11) Commitments and Contingencies

As permitted under Delaware law, the Company has agreements with its officers and directors under which it agrees to indemnify them for certain events or occurrences while the officer or director is, or was serving, at the Company’s request in this capacity. The term of the indemnification period is indefinite. There is no limit on the amount of future payments the Company could be required to make under these indemnification agreements; however, the Company maintains Director and Officer insurance policies, as well as an Employment Practices Liability Insurance Policy, that may enable it to recover a portion of any future amounts paid. As a result of the Company’s insurance policy coverage, it believes the estimated fair value of these indemnification agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of June 30, 2005 and December 31, 2004.

 

The Company enters into standard indemnification terms with its customers, as discussed below, in the ordinary course of business. Because the Company subcontracts some of the development of its deliverables under its customer contracts, the Company could be required to indemnify its customers for work performed by its subcontractors. Depending upon the nature of the customer indemnification, the potential amount of future payments the Company could be required to make under these indemnification agreements may be unlimited. The Company may be able to recover damages from a subcontractor if the indemnification to its customers results from the subcontractor’s failure to perform. To the extent the Company is unable to recover damages from its subcontractors; the Company could be required to reimburse the indemnified party for the full amount. The Company has never incurred costs to defend lawsuits or settle claims relating to indemnification arising out of its subcontractors’ failure to perform. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of June 30, 2005 and December 31, 2004.

 

The Company’s standard license agreements contain a warranty provision that the software will be free of material defects and will operate in accordance with the stated requirements.  The warranty provisions require the Company to cure any defects through any reasonable means.  To date, no claims under the warranty provisions have been brought to the Company’s attention.  The Company’s customers typically purchase annual maintenance services as well and as a matter of course, the Company provides fixes for known defects through the provision of such maintenance services.  As a result, the Company believes the estimated fair value of the warranty provisions in the license agreements in place with its customers is minimal.  Accordingly, the Company has not recorded liabilities for these warranty provisions as of June 30, 2005 and December 31, 2004.

 

The Company’s software arrangements generally include a product indemnification provision that will indemnify and defend a client in actions brought against the client that claim the Company’s products infringe upon a copyright, trade secret, or valid patent. Historically, the Company has not incurred any significant costs related to product indemnification claims. Accordingly, the Company has no liabilities recorded as of June 30, 2005 and December 31, 2004.

 

In relation to the acquisitions of Tertio, TSE and CMS, the Company agreed to indemnify certain parties of and from any losses, actions, claims, damages or liabilities (or actions in respect thereof) resulting from any claim raised by a third party. The Company does not believe that there will be any claims related to these indemnifications. Accordingly, the Company has no liabilities recorded for these agreements as of June 30, 2005 and December 31, 2004.

 

From time to time the Company is involved in various legal proceedings arising in the normal course of business operations. We are not currently involved in any such proceedings.

 

(12) Recent Accounting Pronouncements

 

In December 2004, the FASB issued SFAS No. 123(Revised), “Share-Based Payment.” This statement replaces SFAS No. 123, “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to

 

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Employees.” Under the modified prospective method of adoption, SFAS No. 123(R) requires companies to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees and to record compensation cost for all stock awards granted after the required effective date and to awards modified, repurchased, or cancelled after that date. In addition, the Company is required to record compensation expense (as awards previously granted continue to vest) for the unvested portion of those awards that remain outstanding at the date of adoption. In accordance with adoption provisions released by the SEC, SFAS 123(R) will be effective for the Company on January 1, 2006. Management has not yet determined the impact that SFAS 123(R) will have on its financial position and results of operations, but expects that the stock incentive plans’ pro forma disclosure provides a reasonable measure of the expected annual impact.

 

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

OVERVIEW

 

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are based on current expectations, estimates, and projections about Evolving Systems’ industry, management’s beliefs, and certain assumptions made by management.  Forward-looking statements include our expectations regarding product, services, and maintenance revenue, annual savings associated with the organizational changes effected in prior years, and short- and long-term cash needs.  In some cases, words such as “anticipates”, expects”, “intends”, “plans”, “believes”, “estimates”, variations of these words, and similar expressions are intended to identify forward-looking statements.  The statements are not guarantees of future performance and are subject to certain risks, uncertainties, and assumptions that are difficult to predict; therefore, actual results may differ materially from those expressed or forecasted in any forward-looking statements.  Risks and uncertainties of our business include those set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 under “Risk Factors” on pages 9 through 22 as well as additional risks described in this Form 10-Q.  Unless required by law, we undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events, or otherwise.  However, readers should carefully review the risk factors set forth in other reports or documents the Company files from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form
8-K.

 

Evolving Systems, Inc. (“we”, “our”, “us”) is a provider of mission critical software products and services to communications carriers. We maintain long-standing relationships with many of the largest wireline, wireless and cable communications carriers worldwide. Our customers rely on us to develop, deploy, enhance, maintain and integrate complex, highly reliable software solutions for a range of Operations Support Systems (“OSS”) and Network Support Systems (“NSS”). Included among our more than 40 customers are four of the largest wireline carriers in North America, one of the largest cable companies in North America and three of the world’s 10 largest wireless carriers. We offer software products and solutions in three core areas — numbering solutions that enable carriers to comply with government-mandated requirements regarding number portability and phone number conservation; a service activation solution that is used to activate complex bundles of voice, video and data services; and mediation solutions supporting data collection for both service assurance and billing applications.  Historically, our products have been used to support traditional telephony capabilities; however, today many communications carriers are using our products to support Voice over Internet Protocol (“VoIP”) offerings.

 

The core Evolving Systems portfolio that included ordering and provisioning solutions for Local Number Portability (“LNP”), as well as a number inventory and assignment platform, has recently been expanded, as a result of three acquisitions we made over a period of 12 months from November of 2003 to November of 2004. Through the acquisition of CMS Communications, Inc. (“CMS”) in November 2003 we acquired a network mediation and service assurance solution to add to our product portfolio. Additionally, with the acquisition of Telecom Software Enterprises, LLC (“TSE”) on October 15, 2004 we added LNP and Wireless Number Portability (“WNP”) number ordering and provisioning testing products which provide new OSS system integration capabilities.  Most recently, on November 2, 2004, we acquired Tertio Telecoms Ltd. (“Tertio”), a privately held supplier of OSS software solutions to communication carriers throughout Europe, the Middle East, Africa and Asia, expanding our markets beyond North America.  Tertio’s activation solution, Provident™, and mediation solution Evident™, strengthen our overall product portfolio. Our significantly expanded product and service capabilities now enable us to address a larger portion of our customer’s application needs. Also, as a result of these acquisitions, we have become a company with global reach and a customer base that includes many of the world’s leading communications carriers.  We are positioned as a provider of OSS, NSS and comprehensive systems integration capabilities. These complementary competencies enable us to address and implement solutions across much of a customer’s back office.

 

Company Background

 

Founded in 1985, we initially focused on providing custom software development and professional services to a limited number of telecommunications companies in the United States. In 1996, concurrent with the passage of the Telecommunications Act of 1996 (“the Telecom Act”), we made a strategic decision to add software products to our established professional services offerings. Since that time we have built a strong product portfolio, of which we are best known for our LNP and service activation solutions.

 

Historically, we have helped our customers integrate our products into their existing business process and OSS environments. In 2002, we initiated a restructuring plan, which, in addition to significant operational cost reductions and greater leverage of offshore

 

14

 

development, included the reengineering of our business model to a solutions strategy.  The solutions business model reflects a more balanced mix of services and products, as well as integration and product enhancements for our customers’ back office to meet the specific requirements of each customer. This customer specific effort is complementary to product development investments driven by more traditional marketing efforts. Solutions which include our products, as well as product extensions and integration, are typically licensed to our customers and supported by us. In 2004, our sales reach was expanded to include both direct and indirect sales.  New partnerships with network equipment providers and system integrators to extend our reach to new geographical regions as well as helping us further penetrate our existing territories were achieved during the year.  We have also created packaged products with our channel partners, where we provide the underlying product and our partner provides some or most of the integration services.

 

Critical Accounting Policies

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP. We review the accounting policies we use in reporting our financial results on a regular basis. The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require our judgment in its application.  Our senior management has reviewed these critical accounting policies and related disclosures with our Audit Committee.  We have identified the policies below as critical to our business operations and the understanding of our results of operations.

 

•                  Revenue recognition

 

•                  Allowance for doubtful accounts

 

•                  Income taxes

 

•                  Intangible assets

 

•                  Business combinations

 

•                  Capitalization of internal software development costs

 

For a detailed discussion on the application of these accounting policies, see “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2004.

 

Recent Developments

 

Acquisition of TSE

 

In October 2004, we acquired TSE.  TSE’s VeriPort™ and Verify™ products are sold to United States of America (“U.S.”) wireline and wireless carriers, and provide for simulation of the nation’s centralized Number Portability Administration Center (“NPAC”) and a testing environment for critical back office systems that carriers use for enabling number portability. Other products in the TSE portfolio are used for enhanced integration between back office OSS systems.  TSE has installed its products at several of the leading wireless and wireline carriers in North America. By acquiring TSE, we have expanded our customer base and extended the set of solutions we offer our numbering solutions customers.

 

Acquisition of Tertio

 

In November 2004, we acquired Tertio, our third acquisition in a twelve month period. By acquiring Tertio we became a global company with a customer base that includes many of the world’s largest communication carriers. Tertio’s activation and mediation solutions, Provident and Evident, fit well with elements of our product portfolio, enabling us to provide activation solutions and strengthening our current mediation and service assurance offerings.

 

In January 2005, we changed Tertio’s name to Evolving Systems Limited (“Evolving Systems U.K.”). We also renamed the Provident activation product “Tertio”, to build on the strong recognition of the Tertio brand in the service activation market. The name changes are reflected in this filing where appropriate.

 

Expansion of Offshore Development Subsidiary

 

In February 2004, we formed Evolving Systems Networks India Private Limited, a wholly owned subsidiary of Evolving Systems (“Evolving Systems India”).  For several years, offshore development, through a subcontractor, had been a key aspect of our low-cost, accelerated-deployment strategy. With the formation of Evolving Systems India we now have more control and flexibility and lower costs than with our previous outsourced development, which used an offshore third party contractor. As of June 30, 2005, we had approximately 78 employees in our Indian office with plans for further expansion as demand dictates.

 

Customer Support Revenue Deferral

 

During the first and second quarter of 2004, we deferred the recognition of customer support revenue for one of our largest customers. Under this maintenance arrangement, the customer purchased professional services, specified licensed software upgrades and support services.  Since fair value of the undelivered specified licensed software upgrades did not exist, all of the revenue related

 

15

 

to this contract was deferred until the specified licensed software upgrades were delivered and accepted by the customer.  During the third quarter of 2004, we delivered and obtained acceptance of the specified licensed software upgrades. Since vendor specific objective evidence of fair value existed for all of the remaining undelivered elements in the arrangement, we recognized the residual amount of revenue for all delivered elements at that time.  Our 2005 customer support contract with the same customer did not contain these additional accounting elements, and was not deferred. Accordingly, during the three and six months ended June 30, 2005, we recognized approximately $1.1 million and $2.1 million, respectively of customer support revenue related to this contract.

 

Accelerated Filer Status

 

Companies considered accelerated filers under Securities Exchange Act Rule 12b-2, are required to comply with the internal control reporting and disclosure requirements of Section 404 of the Sarbanes-Oxley Act of 2002, for fiscal years ending on or after November 15, 2004. An accelerated filer is defined as a company that meets the following conditions as of the end of its fiscal year:

 

•                  Its common equity public float was $75 million or more as of the last business day of its most recently completed second fiscal quarter;

 

•                  The company has been subject to the reporting requirements of Section 13(a) or 15(d) of the Exchange Act for a period of at least 12 calendar months;

 

•                  The company has previously filed at least one annual report pursuant to Section 13(a) or 15(d) of the Exchange Act; and

 

•                  The company is not eligible to use Forms 10-KSB and 10-QSB.

 

As of the last business day of our most recently completed second fiscal quarter, June 30, 2005, our common equity public float was less than $75 million, therefore we are not an accelerated filer, as defined in Securities Exchange Act Rule 12b-2, and are not required to comply with the management reporting on internal control over financial reporting for the year ending December 31, 2005. Since we are not an accelerated filer in 2004 we must begin complying with the internal control reporting and disclosure requirements for our fiscal year ending December 31, 2006.

 

Cost Reductions

 

In July 2005, we undertook cost reduction measures that involved a 10% reduction in our workforce, including individuals at all levels of our U.S. and U.K. operations. The efforts around the cost reductions are also designed to better integrate our recent acquisitions. These reductions will save the Company more than $3.0 million annually, with the impact of the savings realized beginning in the fourth quarter of 2005.

 

To meet our long-term goals, including revenue growth, we continue to make investments in our products. We are currently investing in both service activation and number solutions products to expand the number of products that we can offer our newly expanded customer base and internationalize our existing numbering solutions products. These activities will cause product development expenses to increase in future periods compared to prior periods.

 

Results of Operations

 

The following table presents the Company’s consolidated statements of operations reflected as a percentage of total revenue.

 

		Three Months Ended June 30,				Six Months Ended June 30,
		2005		2004		2005		2004
REVENUE
License fees and services		48	%	45	%	50	%	51	%
Customer support		52	%	55	%	50	%	49	%
Total revenue		100	%	100	%	100	%	100	%
COSTS OF REVENUE AND OPERATING EXPENSES
Costs of license fees and services, excluding depreciation and amortization		24	%	21	%	27	%	20	%
Costs of customer support, excluding depreciation and amortization		17	%	35	%	19	%	31	%
Sales and marketing		24	%	17	%	24	%	17	%
General and administrative		15	%	18	%	20	%	17	%
Product development		5	%	4	%	3	%	6	%
Depreciation		4	%	5	%	4	%	5	%
Amortization		14	%	4	%	14	%	4	%
Restructuring and other expenses		—		—		—		—
Total costs of revenue and operating expenses		103	%	104	%	111	%	100	%
Loss from operations		(3	)%	(4	)%	(11	)%	(1	)%
Other income (expense), net		(4	)%	1	%	(5	)%	1	%
Income (loss) before income taxes		(7	)%	(3	)%	(16	)%	1	%
Benefit from income taxes		—		—		2	%	—
Net income (loss)		(7	)%	(3	)%	(14	)%	1	%

 

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The three and six months ended June 30, 2005 compared to the three and six months ended June 30, 2004

 

Revenue

 

Revenue is comprised of license fees/services and customer support.  License fees and services revenue represent the fees we receive from the licensing of our software products and those services directly related to the delivery of the licensed product as well as integration services and time and materials work.  Customer support revenue includes annual support fees, recurring maintenance fees, maintenance upgrades and warranty fees.  Warranty services consist of maintenance services and are typically bundled with a license sale and the related revenue, based on VSOE, is deferred and recognized ratably over the warranty period.  Total revenue was $9.9 million and $5.3 million for the three months ended June 30, 2005 and 2004, respectively, and $19.7 million and $11.0 million for the six months ended June 30, 2005 and 2004, respectively. The following table presents the Company’s revenue by product group (in thousands).

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2005			2004			2005			2004
Numbering solutions		$	3,957		$	4,247		$	7,747		$	9,348
Mediation		1,038			1,014			2,893			1,679
Activation		4,931			—			9,124			—
		$	9,926		$	5,261		$	19,764		$	11,027

 

License Fees and Services

 

License fees and services revenue increased 99% to $4.7 million for the three months ended June 30, 2005, from $2.4 million for the three months ended June 30, 2004.  The increase in license fees and services revenue is due to activation sales related to products acquired in the Tertio acquisition, offset by lower revenue from our number portability and inventory products.  The decline in number portability and inventory products is due to industry consolidation and smaller overall license sales which is reflective of the maturity of the narrowband numbering solutions market in the U.S.

 

License fees and services revenue increased 75% to $9.8 million for the six months ended June 30, 2005, from $5.6 million for the six months ended June 30, 2004.  The increase in license fees and services revenue is primarily due to activation and mediation sales related to products acquired in the Tertio acquisition, offset by lower revenue from our number portability and inventory products.  The decline in number portability and inventory products is due to industry consolidation and smaller overall license sales which is reflective of the maturity of the narrowband numbering solutions market in the U.S.

 

Customer Support

 

Customer support revenue increased 80% to $5.2 million for the three months ended June 30, 2005, from $2.9 million for the three months ended June 30, 2004.  The increase in customer support revenue during the second quarter of 2005 is due to increased revenue related to the support of activation products acquired in the Tertio acquisition as well as increased customer support revenue related to numbering solutions products, partially offset by price reductions in certain customer support contracts. Numbering solutions customer support revenue was lower in the second quarter of 2004 due to a large customer support contract that was deferred until the acceptance of specified upgrades, which occurred during the third quarter of 2004.

 

Customer support revenue increased 83% to $9.9 million for the six months ended June 30, 2005, from $5.4 million for the six months ended June 30, 2004.  The increase in customer support revenue during the first half of 2005 is due to increased revenue related to the support of activation products acquired in the Tertio acquisition as well as increased customer support revenue related to numbering solutions products, partially offset by price reductions in certain customer support contracts. Numbering solutions customer support revenue was lower in the first half of 2004 due to a large customer support contract that was deferred until the acceptance of specified upgrades, which occurred during the third quarter of 2004.

 

Costs of Revenue, Excluding Depreciation and Amortization

 

Costs of revenue, excluding depreciation and amortization, consist primarily of personnel costs, facilities costs, the costs of third-party software and all other direct costs associated with these personnel. Total costs of revenue, excluding depreciation and amortization, were $4.0 million and $2.9 million for the three months ended June 30, 2005 and 2004, respectively and $9.0 million and $5.7 million for the six months ended June 30, 2005 and 2004, respectively.

 

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Costs of License Fees and Services, Excluding Depreciation and Amortization

 

Costs of license fees and services, excluding depreciation and amortization, were $2.4 million and $1.1 million for the three months ended June 30, 2005 and 2004, respectively.  The increase of $1.3 million, or 113%, is due to more projects in delivery as a result of the Tertio acquisition, as well as additional costs related to the U.K. development transition to our off-shore development model which utilizes Evolving Systems India. As a percentage of license fees and services revenue, costs of license fees and services, excluding depreciation and amortization, increased to 50% for the three months ended June 30, 2005 from 47% for the three months ended June 30, 2004.  The increase as a percentage of license fees and services revenues was due to the aforementioned increased costs related to the U.K. development transition to our off-shore development model and the increased costs from Evolving Systems U.K. and TSE which exceeded the increase in revenue during the period.

 

Costs of license fees and services, excluding depreciation and amortization, were $5.4 million and $2.2 million for the six months ended June 30, 2005 and 2004, respectively.  The increase of $3.2 million, or 145%, is due to more projects in delivery as a result of the Tertio acquisition, as well as additional costs related to the U.K. development transition to our off-shore development model which utilizes Evolving Systems India. As a percentage of license fees and services revenue, costs of license fees and services, excluding depreciation and amortization, increased to 55% for the six months ended June 30, 2005 from 39% for the six months ended June 30, 2004.  The increase as a percentage of license fees and services revenues was due to the aforementioned increased costs related to the U.K. development transition to our off-shore development model and the increased costs from Evolving Systems U.K. and TSE which exceeded the increase in revenue during the period.

 

Costs of Customer Support, Excluding Depreciation and Amortization

 

Costs of customer support, excluding depreciation and amortization, were $1.6 million and $1.8 million for the three months ended June 30, 2005 and 2004, respectively.  The decrease of $180,000, or 10%, is due to decreased third party software maintenance fees and savings from the transition to Evolving India from our Indian subcontractor, partially offset by increased hours worked on customer support projects to support products acquired in the Tertio and TSE acquisitions.  Higher 2005 revenue from Evolving Systems U.K. and TSE customer support contracts as well as the deferral of the aforementioned large support contract in 2004 decreased the percentage of costs of customer support revenue, excluding depreciation, as a percentage of revenue from 63% for the three months ended June 30, 2004 to 32% for the three months ended June 30, 2005.

 

Costs of customer support, excluding depreciation and amortization, were $3.7 million and $3.5 million for the six months ended June 30, 2005 and 2004, respectively.  The increase of $187,000, or 5%, is due to increased hours worked on customer support projects to support products acquired in the Tertio and TSE acquisitions, partially offset by decreased third party software maintenance fees and savings from the transition to Evolving India from our Indian subcontractor.  Higher 2005 revenue from Evolving Systems U.K. and TSE customer support contracts as well as the deferral of the aforementioned large support contract in 2004 decreased the percentage of costs of customer support revenue, excluding depreciation, as a percentage of revenue from 64% for the six months ended June 30, 2004 to 37% for the six months ended June 30, 2005.

 

Sales and Marketing

 

Sales and marketing expenses primarily consist of compensation costs, including bonuses and commissions, travel expenses, advertising and occupancy expenses.  Sales and marketing expenses were $2.4 million and $901,000 for the three months ended June 30, 2005 and 2004, respectively. The increase of $1.5 million, or 169%, is due to additional costs from Evolving Systems U.K. and TSE as well as increased expenses in the U.S. related to increased headcount for sales initiatives designed to penetrate new markets.  As a percentage of total revenue, sales and marketing expenses increased to 24% for the three months ended June 30, 2005 from 17% for the three months ended June 30, 2004.  The increase as a percentage of revenue is due to the combination of increased expenses from Evolving Systems U.K. and the increased expenses in the U.S., which exceeded the increase in revenue during the period.

 

Sales and marketing expenses were $4.8 million and $1.8 million for the six months ended June 30, 2005 and 2004, respectively. The increase of $3.0 million, or 162%, is due to additional costs from Evolving Systems U.K. and TSE as well as increased expenses in the U.S. related to increased headcount for sales initiatives designed to penetrate new markets.  As a percentage of total revenue, sales and marketing expenses increased to 24% for the six months ended June 30, 2005 from 17% for the six months ended June 30, 2004.  The increase as a percentage of revenue is due to the combination of increased expenses from Evolving Systems U.K. and the increased expenses in the U.S., which exceeded the increase in revenue during the period.

 

General and Administrative

 

General and administrative expenses consist principally of employee related costs and professional fees for the following departments: facilities, finance, legal, human resources, and executive management.  General and administrative expenses were $1.5 million and $934,000 for the three months ended June 30, 2005 and 2004, respectively.  The increase of $547,000 or 59%, is primarily due to costs from Evolving Systems U.K.  As a percentage of total revenue, general and administrative expenses decreased to 15% for the three months ended June 30, 2005 from 18% for the three months ended June 30, 2004.  The decrease as a percentage of revenue is due to the increase in revenue from Tertio and TSE, partially offset by the combination of increased expenses from Evolving Systems U.K..

 

General and administrative expenses were $4.0 million and $1.9 million for the six months ended June 30, 2005 and 2004, respectively.  The increase of $2.1 million or 113%, is primarily due to costs related to the integration of Tertio, expenses from Evolving Systems U.K. as well as increased expenses in the U.S. related to significantly higher levels of professional fees.  As a percentage of total revenue, general and administrative expenses increased to 20% for the six months ended June 30, 2005 from 17%

 

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for the six months ended June 30, 2004.  The increase as a percentage of revenue is due to the combination of increased expenses from Evolving Systems U.K. and increased professional fees in the U.S., which was greater than the increase in revenue during the period.

 

Product Development

 

Product development expenses consist primarily of employee related costs, offshore development subcontractor expenses and costs to start up our offshore Indian facility.  Product development expenses were $495,000 and $241,000 for the three months ended June 30, 2005 and 2004, respectively. The increase of $254,000, or 105%, is due to costs related to development work on new numbering product ServiceLink™ and additional work on our acquired U.K. products, partially offset by decreased costs in the U.S. as development in 2005 was principally focused on customer specific projects rather than general research and development efforts. Costs for customer-specific projects are reflected as costs of the related revenue.  As a percentage of revenue, product development expenses were 5% for the three months ended June 30, 2005 and 2004.  The costs as a percentage of revenue did not change during the quarter as the aforementioned increased costs were matched by the increase in revenue during the quarter.

 

Product development expenses were $605,000 and $732,000 for the six months ended June 30, 2005 and 2004, respectively. The decrease of $127,000, or 17%, is due to decreased costs in the U.S. as development in 2005 was principally focused on customer specific projects rather than general research and development efforts, partially offset by costs related to development work on Evolving Systems U.K. products. Costs for customer-specific projects are reflected as costs of the related revenue.  As a percentage of revenue, product development expenses were 3% for the six months ended June 30, 2005 and 7% for the six month ended June 30, 2004.  The decrease as a percentage of revenue is primarily due to the increased revenue during the first half of 2005 compared to 2004.

 

Amortization

 

Amortization expense consists of amortization of identifiable intangibles from our acquisitions of CMS, TSE and Tertio. Amortization expense was $1.4 million and $214,000 for the three months ended June 30, 2005 and 2004, respectively.  The increase in amortization expense of $1.2 million or 552% is due to amortization related to identifiable intangibles from the acquisitions of Tertio and TSE.  As a percentage of revenue amortization expense increased to 14% for the three months ended June 30, 2005 from 4% for the three months ended June 30, 2004. The increase as a percentage of revenue is due to the aforementioned increase in expenses which was greater than the increase in revenue during the period.

 

Amortization expense was $2.8 million and $432,000 for the six months ended June 30, 2005 and 2004, respectively.  The increase in amortization expense of $2.4 million or 552% is due to amortization related to identifiable intangibles from the acquisitions of Tertio and TSE.  As a percentage of revenue amortization expense increased to 14% for the six months ended June 30, 2005 from 4% for the six months ended June 30, 2004. The increase as a percentage of revenue is due to the aforementioned increase in expenses which was greater than the increase in revenue during the period.

 

Restructuring and Other Expense

 

During the three and six months ended June 30, 2005, we recorded a restructuring recovery of $3,000 and $51,000 in accordance with the Company’s restructuring plan, as follows:

 

•                  Closure of satellite offices.  We closed all of our satellite field offices during 2002.  Because the costs to sublease or terminate these lease commitments are based on estimates, we may incur additional costs related to the satellite office closures.  During the three and six months ended June 30, 2005 we recorded a recovery of $3,000 and $51,000 related to the closure of the satellite offices as the actual costs to close this facilities were less than our original estimate. As of June 30, 2005 approximately $13,000 was included in accounts payable and accrued liabilities related to the closure of the satellite offices.

 

Other Income (Expense), Net

 

Other income (expense), net, was ($427,000) and $67,000 for the three months ended June 30, 2005 and 2004, respectively.  The expense during 2005 is primarily due to interest expense from the notes payable issued in the acquisition of Tertio.

 

Other income (expense), net, was ($932,000) and $124,000 for the six months ended June 30, 2005 and 2004, respectively.  The expense during 2005 is primarily due to interest expense from the notes payable issued in the acquisitions of TSE and Tertio.

 

Income Taxes

 

The Company recorded a net income tax benefit of $16,000 and $294,000 for the three and six months ended June 30, 2005, respectively. The net benefit during the three and six months ended June 30, 2005 consists of current income tax expense of approximately $436,000 and $626,000, respectively and a deferred tax benefit of $452,000 and $920,000, respectively, both of which are related to the Company’s UK-based operations. For the six months ended June 30, 2005, this represents an 9% effective tax rate, reflecting the blend of the estimated effective tax rate of our domestic pretax income of approximately 2% and the estimated effective tax rate related to our U.K. pretax income of approximately 30%.

 

In conjunction with the acquisition of Tertio, certain identifiable intangible assets were recorded.  Since the amortization of these identifiable intangibles is not deductible for income tax purposes, a long-term deferred tax liability of $4.6 million was established at the acquisition date for the expected difference between what would be expensed for financial reporting purposes and

 

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what would be deductible for income tax purposes. As of June 30, 2005, this deferred tax liability was $3.7 million. This deferred tax liability is carried on the books of the Company’s United Kingdom subsidiary, and has no impact on the Company’s ability to recover its U.S.-based deferred tax assets.

 

In conjunction with the acquisition of Tertio, future revenue under contracts in existence at the acquisition dates was reduced to an amount equal to the Company’s estimated costs to fulfill its obligations under the contracts plus a reasonable profit margin on the Company’s estimated fulfillment effort.  The resulting reduction of future revenue recorded for financial reporting purposes is not deductible for income tax purposes and thus, a current deferred tax liability of approximately $600,000 was established at the acquisition date. As of June 30, 2005, this deferred tax liability was $128,000.  Both of the aforementioned deferred tax liabilities will be recognized as a reduction of current income tax expense as the identifiable intangibles are amortized and the contract revenue is recognized.

 

Liquidity and Capital Resources

 

We have historically financed operations through cash flows from operations and equity transactions.  At June 30, 2005, our principal source of liquidity was $4.6 million in cash and cash equivalents.

 

Net cash provided by operating activities was $1.8 million for the six months ended June 30, 2005. The main factors in the cash provided by operating activities for the three months ended June 30, 2005 were decreases in contract receivables of $5.0 million, interest expense added to debt principal of $660,000 and depreciation and amortization of $3.6 million. Offsetting increases to cash flows from operating activities for the six months ended June 30, 2005 was the net loss of $2.8 million, decreases in accounts payable and accrued liabilities of $1.2 million, unearned revenue of $2.5 million and the deferred foreign income tax benefit of $925,000.

 

Net cash provided by operating activities was $4.9 million for the six months ended June 30, 2004.  The cash generated from operating activities is primarily due to decreases in contract receivables of $6.7 million and unbilled work-in-progress of $606,000 and depreciation and amortization of $971,000.  Offsetting increases to cash flows from operating activities for the six months ended June 30, 2004 were decreases in prepaid and other assets of $350,000, accounts payable and accrued liabilities of $665,000 and unearned revenue of $2.5 million.

 

Net cash used by investing activities during the six months ended June 30, 2005 was $876,000. Cash used by investing activities for the six months ended June 30, 2005 consisted of outflows of $365,000 related to contingent consideration paid to the sellers of TSE, partially offset by inflows related to the settlement of pre-acquisition contingencies from the Tertio acquisition and outflows of $529,000 for capital expenditures primarily related to the Tertio integration.

 

Net cash used by investing activities during the six months ended June 30, 2004 of $712,000 was primarily due to capital expenditures of $756,000 for domestic internal hardware that improved performance and reliability of our product development environment, as well as servers and computers for Evolving Systems India.

 

Financing activities used $7.5 million in cash during the six months ended June 30, 2005. During the first half of 2005, we made payments of $7.5 million on acquisition related notes payable and an acquired dividend payable assumed in the Tertio acquisition. We received proceeds of $63,000 during the six months ended June 30, 2005, from the issuance of approximately 37,000 shares of common stock related to our stock option and employee stock purchase plans.

 

Financing activities provided $326,000 for the six months ended June 30, 2004, related to the exercise of approximately 165,000 stock options.

 

Working capital (deficit) at June 30, 2005 was ($7.1) million compared to ($3.3) million at December 31, 2004. As previously mentioned, we acquired two companies, TSE and Tertio, during the fourth quarter of 2004. We made net payments of approximately $8.0 million during the six months ended June 30, 2005 related to notes payable, an acquired dividend obligation assumed and contingent consideration related to the TSE and Tertio acquisitions. The acquisition of Tertio also includes the issuance of long-term seller-financed notes (“Long-Term Notes”) of approximately $11.9 million of which $4.5 million is due within the next twelve months. We believe that our current cash and cash equivalents, together with anticipated cash flow from operations will be sufficient to meet our working capital and capital expenditure requirements for at least the next twelve months. In making this assessment we considered the following:

 

•                  Our cash and cash equivalents balance at June 30, 2005 of $4.6 million.

 

•                  Our ability to generate positive cash flows from operations. During 2003, 2004 and the six months ended June 30, 2005 we generated cash flows from operations of $6.9 million, $4.3 million and $1.8 million, respectively.

 

•                  Our backlog of approximately $14.5 million, including $3.3 million in license fees and services and $11.2 million in customer support at June 30, 2005.

 

•                  In July 2005, we took steps to reduce our cost structure by reducing our workforce in the U.S. and U.K. by 10%. This will allow us to save more than approximately $3.0 million annually.

 

•                  We believe that we can restructure the Long-Term Notes which would lower the interest rate and extend maturity.

 

•                  Our cash forecast indicates that we will have sufficient liquidity to cover anticipated operating costs as well as debt

 

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