10-Q 1 jd12-12_10q.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 31, 2005 or [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-30121 ULTICOM, INC. (Exact name of registrant as specified in its charter) New Jersey 22-2050748 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1020 Briggs Rd. Mt. Laurel, NJ 08054 (Address of principal executive offices) (Zip Code) (856) 787-2700 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last report) 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. [X] Yes [ ] No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). [X] Yes [ ] No Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No The number of shares of Common Stock, no par value, outstanding as of December 1, 2005 was 43,281,649 TABLE OF CONTENTS ----------------- PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. Page ---- 1. Condensed Consolidated Balance Sheets as of January 31, 2005 and October 31, 2005 2 2. Condensed Consolidated Statements of Income for the Three and Nine-Month Periods ended October 31, 2004 and 2005 3 3. Condensed Consolidated Statements of Cash Flows for the Nine-Month Periods ended October 31, 2004 and 2005 4 4. Notes to Condensed Consolidated Financial Statements 5 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. 10 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. 25 ITEM 4. CONTROLS AND PROCEDURES. 26 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. 27 ITEM 6. EXHIBITS. 27 SIGNATURES 28 ii FORWARD-LOOKING STATEMENTS From time to time, Ulticom, Inc. (together with its subsidiaries, the "Company") makes forward-looking statements. Forward-looking statements include financial projections, statements of plans and objectives for future operations, statements of future economic performance, and statements of assumptions relating thereto. Forward-looking statements are often identified by future or conditional words such as "will," "plans," "expects," "intends," "believes," "seeks," "estimates," or "anticipates" or by variations of such words or by similar expressions. The Company may include forward-looking statements in its periodic reports to the Securities and Exchange Commission on Forms 10-K, 10-Q, and 8-K, in its annual report to shareholders, in its proxy statements, in its press releases, in other written materials, and in statements made by employees to analysts, investors, representatives of the media, and others. By their very nature, forward-looking statements are subject to uncertainties, both general and specific, and risks exist that predictions, forecasts, projections and other forward-looking statements will not be achieved. Actual results may differ materially due to a variety of factors including, without limitation, those discussed under "Certain Trends and Uncertainties" and elsewhere in this report. Investors and others should carefully consider these factors and other uncertainties and events, whether or not the statements are described as forward-looking. Forward-looking statements made by the Company are intended to apply only at the time they are made, unless explicitly stated to the contrary. Moreover, whether or not stated in connection with a forward-looking statement, the Company makes no commitment to revise or update any forward-looking statements in order to reflect events or circumstances after the date any such statement is made. If the Company were in any particular instance to update or correct a forward-looking statement, investors and others should not conclude that the Company will make additional updates or corrections thereafter. 1 PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. ULTICOM, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA)
JANUARY 31, OCTOBER 31, 2005* 2005 ----- ---- (UNAUDITED) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 19,372 $ 21,186 Short-term investments 227,300 243,747 Accounts receivable, net 11,062 11,798 Inventories 1,286 936 Prepaid expenses and other current assets 3,558 7,465 ----------- ----------- Total current assets 262,578 285,132 Property and equipment, net 2,274 2,926 Investments 5,375 -- Other assets 1,765 2,025 ----------- ----------- Total assets $ 271,992 $ 290,083 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable and accrued expenses $ 11,966 $ 11,356 Deferred revenue 4,462 3,091 ----------- ----------- Total current liabilities 16,428 14,447 ----------- ----------- SHAREHOLDERS' EQUITY: Undesignated stock, no par value, 10,000,000 shares authorized, no shares issued and outstanding -- -- Common stock, no par value, 200,000,000 shares authorized, 43,101,804 and 43,268,392 shares issued and outstanding -- -- Additional paid-in capital 216,490 217,702 Retained earnings 39,840 55,084 Accumulated other comprehensive income (loss) (766) 2,850 ----------- ----------- Total shareholders' equity 255,564 275,636 ----------- ----------- Total liabilities and shareholders' equity $ 271,992 $ 290,083 =========== ===========
* The Condensed Consolidated Balance Sheet as of January 31, 2005 has been summarized from the Company's audited Consolidated Balance Sheet as of that date. The accompanying notes are an integral part of these financial statements. 2 ULTICOM, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE DATA)
NINE MONTHS ENDED THREE MONTHS ENDED OCTOBER 31, OCTOBER 31, OCTOBER 31, OCTOBER 31, 2004 2005 2004 2005 ---- ---- ---- ---- Sales $ 46,310 $ 44,453 $ 17,034 $ 15,255 Cost of sales 10,786 11,122 3,749 4,307 ---------- --------- --------- --------- Gross profit 35,524 33,331 13,285 10,948 Operating expenses: Research and development 7,918 9,344 2,573 2,961 Selling, general and administrative 13,246 12,134 4,304 4,217 ---------- --------- --------- --------- Income from operations 14,360 11,853 6,408 3,770 Interest and other income, net 2,130 5,849 996 2,987 ---------- --------- --------- --------- Income before income tax provision 16,490 17,702 7,404 6,757 Income tax provision (benefit) 5,444 2,458 2,537 (935) ---------- --------- --------- --------- Net income $ 11,046 $ 15,244 $ 4,867 $ 7,692 ========== ========= ========= ========= Earnings per share: Basic $ 0.26 $ 0.35 $ 0.11 $ 0.18 ========== ========= ========= ========= Diluted $ 0.25 $ 0.35 $ 0.11 $ 0.17 ========== ========= ========= =========
The accompanying notes are an integral part of these financial statements. 3 ULTICOM, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (IN THOUSANDS)
NINE MONTHS ENDED OCTOBER 31, OCTOBER 31, 2004 2005 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 11,046 $ 15,244 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,149 1,166 Deferred income tax provision 2,453 63 Realized gain on sale of investments - (875) Changes in operating assets and liabilities: Accounts receivable, net (2,404) (736) Inventories (623) 350 Prepaid expenses and other current assets 3,011 (4,134) Accounts payable and accrued expenses (870) (360) Deferred revenue (465) (1,371) Other, net (52) (347) ---------- ---------- Net cash provided by operating activities 13,245 9,000 ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of property and equipment (1,053) (1,818) Maturities and sales (purchases) of investments, net (8,312) (6,330) ---------- ---------- Net cash used in investing activities (9,365) (8,148) ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock in connection with exercise of stock options and employee stock purchase plan 5,076 962 ---------- ---------- Net cash provided by financing activities 5,076 962 ---------- ---------- NET INCREASE IN CASH AND CASH EQUIVALENTS 8,956 1,814 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 6,316 19,372 ---------- ---------- CASH AND CASH EQUIVALENTS, END OF PERIOD $ 15,272 $ 21,186 ========== ==========
The accompanying notes are an integral part of these financial statements. 4 ULTICOM, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES COMPANY BUSINESS AND BACKGROUND - Ulticom, Inc. (together with its subsidiaries, the "Company"), a New Jersey corporation and a majority-owned subsidiary of Comverse Technology, Inc. ("CTI"), designs, develops, markets, licenses, and supports service enabling signaling software for fixed, mobile, and Internet communications software and hardware for use in the communications industry. BASIS OF PRESENTATION - The accompanying financial information should be read in conjunction with the financial statements, including the notes thereto, for the year ended January 31, 2005. The condensed consolidated financial information included herein is unaudited; however, such information reflects all adjustments (consisting solely of normal recurring adjustments), which are, in the opinion of management, necessary for a fair statement of results for the interim periods. The results of operations for the three-month and nine-month periods ended October 31, 2005 are not necessarily indicative of the results to be expected for the full year. RECLASSIFICATIONS - Certain prior period amounts have been reclassified to conform to the manner of presentation in the current year. In connection with the preparation of the Company's Annual Report on Form 10-K for the year ended January 31, 2005, the Company concluded that it was appropriate to classify investments in Auction Rate Securities ("ARS") as short-term investments. ARS generally have long-term stated maturities; however, these investments have characteristics similar to short-term investments because at pre-determined intervals, generally every 7 to 90 days, there is a new auction process at which these securities are reset to current interest rates. Previously, such investments had been classified as cash and cash equivalents due to their liquidity and pricing reset feature. Accordingly, the Company has revised the classification to report these securities as short-term investments in the Condensed Consolidated Balance Sheets. The Company reclassified approximately $171,940,000 of investments in ARS as of October 31, 2004, that were previously included in cash and cash equivalents to short-term investments. The Company also reclassified accrued interest related to investments in ARS of approximately $191,000 as of October 31, 2004, from cash and cash equivalents to prepaid expenses and other current assets. The Company has also revised the presentation of the Consolidated Statements of Cash Flows for the period ended October 31, 2004 to reflect the purchases and sales of ARS as investing activities rather than as a component of cash and cash equivalents, which is consistent with the presentation for the period ended October 31, 2005. In the previously reported Consolidated Statements of Cash Flows for the period ended October 31, 2004, net cash used in investing activities related to these short-term investments of approximately $49,691,000 were included in cash and cash equivalents and net cash used in operating activities related to prepaid expenses and other current assets of approximately $43,000 were also included in cash and cash equivalents. This change in classification did not materially affect previously reported cash flows from operations, and did not change previously reported cash flows from financing activities in the Consolidated Statements of Cash Flows or previously reported Consolidated Statements of Operations for any period. 5 SALES - Sales for the nine-month periods ended October 31, 2004 and 2005 consisted of product revenues of approximately $41,367,000 and $38,428,000, respectively, and service revenues of approximately $4,943,000 and $6,025,000, respectively. Sales for the three-month periods ended October 31, 2004 and 2005 consisted of product revenues of approximately $15,240,000 and $13,294,000, respectively, and service revenues of approximately $1,794,000 and $1,961,000, respectively. GAIN ON SETTLEMENT - During the nine-month period ended October 31, 2005, the Company recorded a gain of approximately $828,000 resulting from the settlement of a breach of contract claim. The Company has recorded the settlement as a reduction of selling, general and administrative expenses during the nine-month period ended October 31, 2005. STOCK-BASED EMPLOYEE COMPENSATION - The Company accounts for stock options under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. Accordingly, no stock-based employee compensation cost is reflected in net income for any periods, as all options granted have an exercise price at least equal to the market value of the underlying common stock on the date of grant. Refer to Recent Accounting Pronouncements later in this Note for a description of pending changes to this accounting treatment. Pro forma information regarding net income (loss) and net earnings (loss) per share is required by Statement of Financial Accounting Standards ("SFAS") No. 123, "Accounting for Stock-Based Compensation". Under SFAS No. 123, the Company estimated the fair value of employee stock options utilizing the Black-Scholes option valuation model, using appropriate assumptions, as required under accounting principles generally accepted in the United States of America. The Black-Scholes model was developed for use in estimating the fair value of traded options and does not consider the non-traded nature of employee stock options, vesting and trading restrictions, lack of transferability or the ability of employees to forfeit the options prior to expiry. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the recommended models are under evaluation to provide a reliable single measure of the fair value of the Company's employee stock options. 6 The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation for the nine-month and the three-month periods ended October 31, 2004 and 2005:
NINE MONTHS ENDED THREE MONTHS ENDED OCTOBER 31, OCTOBER 31, 2004 2005 2004 2005 ---- ---- ---- ---- Net income, as reported $ 11,046 $ 15,244 $ 4,867 $ 7,692 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (2,293) (1,575) (746) (508) --------- --------- --------- --------- Pro forma net income $ 8,753 $ 13,669 $ 4,121 $ 7,184 ========= ========= ========= ========= Earnings per share: Basic - as reported $ 0.26 $ 0.35 $ 0.11 $ 0.18 Basic - pro forma $ 0.21 $ 0.32 $ 0.10 $ 0.17 Diluted - as reported $ 0.25 $ 0.35 $ 0.11 $ 0.17 Diluted - pro forma $ 0.20 $ 0.31 $ 0.09 $ 0.16
COMPREHENSIVE INCOME - For the nine-month periods ended October 31, 2004 and 2005, total comprehensive income was approximately $11.0 million and $18.9 million, respectively and for the three-month periods ended October 31, 2004 and 2005 was approximately $5.2 million and $8.1 million, respectively. The elements of comprehensive income include net income, unrealized gains/losses on available for sale securities, and foreign currency translation adjustments. INCOME TAX PROVISION (BENEFIT) - During the three-month period ended October 31, 2005, the Company recorded approximately $3.0 million favorable tax benefit related to the reversal of tax reserves previously established for certain business credits, the reconciliation of the book provision to prior year tax return, and the related impact to interest income. 7 EARNINGS PER SHARE - For the nine-month and three-month periods ended October 31, 2004 and 2005, the computation of basic earnings per share is based on the weighted average number of outstanding common shares. Diluted earnings per share further assumes the issuance of common shares for all dilutive potential common shares outstanding (consisting entirely of stock options). The shares used in the computations are as follows: NINE MONTHS ENDED THREE MONTHS ENDED OCTOBER 31, OCTOBER 31, 2004 2005 2004 2005 ---- ---- ---- ---- (In thousands) Basic 42,435 43,190 42,713 43,256 Diluted 43,740 44,178 44,114 44,204 In computing diluted earnings per share, 861,317 and 812,371 options to purchase shares of common stock were excluded from the computations for the nine-month periods ended October 31, 2004 and 2005, respectively, and 827,324 and 810,755 options to purchase shares of common stock were excluded from the computations for the three-month periods ended October 31, 2004 and 2005, respectively. These options were excluded because the exercise prices of such options were greater than the average market price of the Company's common stock during the respective periods. RELATED PARTY TRANSACTIONS - The Company sells products and provides services to other subsidiaries of CTI. For the nine-month periods ended October 31, 2004 and 2005, sales to related parties were approximately $4.5 million and $4.2 million, respectively, and for the three-month periods ended October 31, 2004 and 2005, sales to related parties were approximately $1.7 million and $2.1 million, respectively. As of January 31, 2005 and October 31, 2005, amounts due from subsidiaries of CTI were approximately $1.4 million and $0.9 million, respectively, and are recorded within accounts receivable, net. The Company has a corporate services agreement with CTI. Under this agreement, CTI provides the Company various administrative and consulting services. The Company has agreed to pay to CTI a quarterly fee of $150,000, payable in arrears at the end of each fiscal quarter, in consideration for all services provided by CTI during such fiscal quarter. The Company was charged $450,000 and $150,000, respectively, in each of the nine-month and three-month periods ended October 31, 2004 and 2005 for services provided by CTI. In addition, the Company has agreed to reimburse CTI for any out-of-pocket expenses incurred, if any, by CTI in providing the services. The agreement is currently in effect until January 31, 2006 and extends for additional twelve-month periods unless terminated by either party. LEGAL PROCEEDINGS - The Company does not believe that it is currently party to any pending legal actions that could reasonably be expected to have a material adverse effect on its business, financial condition and results of operations. 8 RECENT ACCOUNTING PRONOUNCEMENTS - In December 2004, the Financial Accounting Standards Board ("FASB") issued SFAS No. 123 (revised 2004), "Share-Based Payment", ("SFAS No.123(R)") which revises SFAS No. 123 and supersedes APB No. 25. In April 2005, the Securities and Exchange Commission ("SEC") amended Regulation S-X to modify the date for compliance with SFAS No. 123(R). The provisions of SFAS No. 123(R) must be applied beginning with the first interim or annual reporting period of the first fiscal year beginning on or after June 15, 2005, which for the Company is February 1, 2006 (the "Effective Date"). SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. Pro forma disclosure of the income statement effects of share-based payments is no longer an alternative. Beginning on the Effective Date, the Company must (i) expense all options granted after the Effective Date over the applicable vesting period, and (ii) expense the non-vested portions of existing option grants going forward over their remaining vesting period. Compensation expense for the non-vested portions of existing option grants as of the Effective Date will be recorded based on the fair value of the awards previously calculated in developing the pro forma disclosures in accordance with the provisions of SFAS No. 123. Under SFAS No. 123(R), the Company is required to adopt a fair value-based method for measuring the compensation expense related to employee stock and stock options awards, which will lead to substantial additional compensation expense. Any such expense, although it will not affect the Company's cash flows, will have a material negative impact on the Company's reported results of operations. In March 2004, the Emerging Issues Task Force ("EITF") of the FASB reached a consensus on EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," which provides additional guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. In November 2005, the FASB released FASB Staff Position FAS 115-1 and FAS 124-1 (the "FSP"), which reverts to other-than-temporary impairment guidance that predated the original effective date of Issue 03-1; that said, the FSP carries forward other elements of Issue 03-1. The FSP applies to reporting periods beginning after December 15, 2005. The Company is currently evaluating the impact of the FSP; however, the adoption of the FSP in its current form is not expected to have a material effect on the Company's consolidated financial statements. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. INTRODUCTION Ulticom designs, develops, markets, licenses, and supports service enabling signaling software for fixed, mobile, and Internet communications. These products are sold to network equipment manufacturers, application developers, and service providers who include the Company's products within their products. Signalware sales consist of software licenses, interface boards, training, and support revenues. In certain limited circumstances, the Company sells Signalware development services under fixed-fee arrangements with its customers. New customers begin development of applications and services by purchasing the appropriate Signalware development kit, which includes a development software license, an interface board, cables, training, a one-year development support plan, and documentation. At deployment, the customer generally purchases one or more deployment licenses, additional interface boards, and an annual deployment maintenance and support plan, which is typically renewed annually for the life of the installation. CRITICAL ACCOUNTING POLICIES There have been no material changes to the critical accounting policies and estimates as disclosed in the Annual Report on Form 10-K for the year ended January 31, 2005. 10 Results of Operations Summary of Results Consolidated results of operations in dollars and as a percentage of sales for each of the nine-month and three-month periods ended October 31, 2004 and 2005 were as follows:
Nine Months ended (in thousands, except percentages) (Unaudited) October 31, % of October 31, % of % 2004 sales 2005 sales Variance variance ---- ----- ---- ----- -------- -------- Sales $ 46,310 100% $ 44,453 100% $(1,857) (4)% Cost of sales 10,786 23% 11,122 25% 336 3% --------- ------ --------- ------ -------- ------ Gross profit 35,524 77% 33,331 75% (2,193) (6)% Operating expenses: Research and development 7,918 17% 9,344 21% 1,426 18% Selling, general and administrative 13,246 29% 12,134 27% (1,112) (8)% --------- ------ --------- ------ -------- ------ Income from operations 14,360 31% 11,853 27% (2,507) (17)% Interest and other income, net 2,130 5% 5,849 13% 3,719 175% --------- ------ --------- ------ -------- ------ Income before income tax provision (benefit) 16,490 36% 17,702 40% 1,212 7% Income tax provision (benefit) 5,444 12% 2,458 6% (2,986) (55)% --------- ------ --------- ------ -------- ------ Net income $ 11,046 24% $ 15,244 34% $ 4,198 38% ========= ====== ========= ====== ======== ====== Effective tax rate 33% 14%
** TABLE CONTINUED **
Three Months ended (in thousands, except percentages) (Unaudited) October 31, % of October 31, % of % 2004 sales 2005 sales Variance variance ---- ----- ---- ----- -------- -------- Sales $ 17,034 100% $ 15,255 100% $(1,779) (10)% Cost of sales 3,749 22% 4,307 28% 558 15 % --------- ------ --------- ------ -------- ------ Gross profit 13,285 78% 10,948 72% (2,337) (18)% Operating expenses: Research and development 2,573 15% 2,961 19% 388 15 % Selling, general and administrative 4,304 25% 4,217 28% (87) (2)% --------- ------ --------- ------ -------- ------ Income from operations 6,408 38% 3,770 25% (2,638) (41)% Interest and other income, net 996 6% 2,987 20% 1,991 200 % --------- ------ --------- ------ -------- ------ Income before income tax provision (benefit) 7,404 43% 6,757 44% (647) (9)% Income tax provision (benefit) 2,537 15% (935) (6)% (3,472) (137)% --------- ------ --------- ------ -------- ------ Net income $ 4,867 29% $ 7,692 50% $ 2,825 58 % ========= ====== ========= ====== ======== ====== Effective tax rate 34% (14)%
** TABLE COMPLETE ** 11 NINE-MONTH AND THREE-MONTH PERIODS ENDED OCTOBER 31, 2005 COMPARED WITH NINE-MONTH AND THREE-MONTH PERIODS ENDED OCTOBER 31, 2004 SALES. Sales for the nine-month and three-month periods ended October 31, 2005 decreased by approximately $1.9 million, or approximately 4%, and approximately $1.8 million, or approximately 10%, to approximately $44.5 million and approximately $15.3 million, respectively, when compared with the nine-month and three-month periods ended October 31, 2004. The dollar decrease is primarily attributable to a lower volume of product sales and deployments by our customers of our Signalware products, which is partially offset by higher services revenues from new and existing deployments of our Signalware products. Sales to international customers represented approximately 71% and 77%, respectively, of sales for the nine-month and three-month periods ended October 31, 2005 and approximately 77% and 75%, respectively, of sales for the nine-month and three-month periods ended October 31, 2004. COST OF SALES. Cost of sales for the nine-month period ended October 31, 2005 increased by approximately $0.3 million, or approximately 3%, to approximately $11.1 million, when compared with the nine-month period ended October 31, 2004. The dollar increase is primarily attributable to increased material and production costs of approximately $0.2 million and personnel-related and other costs of approximately $0.1 million, when compared with the corresponding 2004 period. Gross margins (expressed as a percentage of sales) decreased to approximately 75% for the nine-month period ended October 31, 2005 from approximately 77% for the corresponding 2004 period. The percentage decrease is primarily due to increased sales of lower margin products, which may continue in future quarters. Cost of sales for the three-month period ended October 31, 2005 increased by approximately $0.6 million, or approximately 15%, to approximately $4.3 million, when compared with the three-month period ended October 31, 2004. The dollar increase is primarily attributable to increased material and production costs of approximately $0.3 million and personnel-related and other costs of approximately $0.3 million, when compared with the corresponding 2004 period. Gross margins (expressed as a percentage of sales) decreased to approximately 72% for the three-month period ended October 31, 2005 from approximately 78% for the corresponding 2004 period. The percentage decrease is primarily due to increased sales of lower margin products, which may continue in future quarters. RESEARCH AND DEVELOPMENT. Research and development expenses for the nine-month period ended October 31, 2005 increased by approximately $1.4 million, or approximately 18%, to approximately $9.3 million, and as a percentage of sales, increased to approximately 21% from approximately 17%, when compared with the nine-month period ended October 31, 2004. The dollar increase is primarily attributable to higher personnel-related and other costs of approximately $1.4 million, when compared with the corresponding 2004 period. Research and development expenses for the three-month period ended October 31, 2005 increased by approximately $0.4 million, or approximately 15%, to approximately $3.0 million, and as a percentage of sales, increased to approximately 19% from approximately 15%, when compared with the three-month period ended October 31, 2004. The dollar increase is primarily attributable to higher personnel-related and other costs of approximately $0.4 million, when compared with the corresponding 2004 period. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses for the nine-month period ended October 31, 2005 decreased by approximately $1.1 million, or approximately 8%, to approximately $12.1 million, and as a percentage of sales, decreased to approximately 27% from approximately 29%, when compared with the nine-month period ended October 31, 2004. The dollar decrease is primarily attributable to a decrease of 12 approximately $0.7 million in professional services fees related to a gain of approximately $0.8 million resulting from the settlement of a breach of contract claim, approximately $0.4 million in sales commission costs and approximately $0.4 million in personnel-related costs, which is partially offset by an increase in travel and other miscellaneous costs of approximately $0.3 million and marketing costs of approximately $0.1 million, when compared with the corresponding 2004 period. Selling, general and administrative expenses for the three-month period ended October 31, 2005 decreased by approximately $0.1 million, or approximately 2%, to approximately $4.2 million, and as a percentage of sales, increased to approximately 28% from approximately 25%, when compared with the three-month period ended October 31, 2004. The dollar decrease is primarily attributable to a decrease of approximately $0.1 million in personnel-related and other costs, when compared with the corresponding 2004 period. INTEREST AND OTHER INCOME, NET. Interest and other income, net for the nine-month period ended October 31, 2005 increased by approximately $3.7 million, or approximately 175%, to approximately $5.8 million, when compared with the nine-month period ended October 31, 2004. The dollar increase is a result of higher interest income earned on investments of approximately $2.0 million, realized gains of approximately $0.9 million on the sale of equity investments, reduction of interest expense and other income of $0.5 million, and lower realized losses of approximately $0.3 million when compared with the corresponding 2004 period. Interest and other income, net for the three-month period ended October 31, 2005 increased by approximately $2.0 million, or approximately 200%, to approximately $3.0 million, when compared with the three-month period ended October 31, 2004. The dollar increase is a result of higher interest income earned on investments of approximately $0.8 million, realized gains of approximately $0.9 million on the sale of equity investments, and reduction of interest expense of approximately $0.4 million related to tax benefits recorded during the period, which is partially offset by foreign currency losses of approximately $0.1 million, when compared with the corresponding 2004 period. INCOME TAX PROVISION (BENEFIT). Provision for income taxes for the nine-month period ended October 31, 2005 decreased by approximately $3.0 million, or approximately 55%, to approximately $2.5 million, when compared with the nine-month period ended October 31, 2004. Provision for income taxes for the three-month period ended October 31, 2005 decreased by approximately $3.5 million, or approximately 137%, to approximately $(0.9) million, when compared with the three-month period ended October 31, 2004. During the three-month period ended October 31, 2005, the Company recorded approximately $2.6 million favorable tax benefit related to the reversal of tax reserves previously established for certain business credits and the reconciliation of the book provision to prior year tax return. The Company's overall effective tax rate was approximately 14% and (14)%, respectively, for the nine-month and three-month periods ended October 31, 2005 and approximately 33% and 34%, respectively, for the nine-month and three-month periods ended October 31, 2004. Excluding the effect of the tax adjustments noted above, the Company's overall effective tax rate was 29% for the nine-month period ended October 31, 2005. NET INCOME. Net income for the nine-month period ended October 31, 2005 increased by approximately $4.2 million, or approximately 38%, to approximately $15.2 million, and as a percentage of sales, increased to approximately 34% from approximately 24%, when compared with the nine-month period ended October 31, 2004. Net income for the three-month period ended October 31, 2005 increased by approximately $2.8 million, or approximately 58%, to approximately $7.7 million, and as a percentage of sales, increased to approximately 50% from approximately 29%, when compared with the three-month period ended October 31, 2004. The changes are primarily attributable to the factors described above. 13 LIQUIDITY AND CAPITAL RESOURCES The Company had working capital at October 31, 2005 and January 31, 2005 of approximately $270.7 million and $246.2 million, respectively. At October 31, 2005 and January 31, 2005, the Company had cash and cash equivalents and short-term investments of approximately $264.9 million and $246.7 million, respectively. Operations for the nine-month periods ended October 31, 2005 and 2004, after adjustment for non-cash items, provided cash of approximately $16.5 million and $14.6 million, respectively. During such periods, other changes in operating assets and liabilities used cash of approximately $7.5 million and $1.4 million, respectively. Investing activities for the nine-month periods ended October 31, 2005 and 2004 used cash of approximately $8.1 million and $9.4 million, respectively. These amounts include (i) purchases of property and equipment of approximately $1.8 million and $1.1 million, respectively; and (ii) net maturities and sales (purchases) of investments, of approximately $6.3 million and $8.3 million, respectively. Financing activities for the nine-month periods ended October 31, 2005 and 2004 provided cash of approximately $1.0 million and $5.1 million, respectively, related to proceeds from the issuance of common stock in connection with the exercise of stock options and employee stock purchase plan. Although there are no present commitments or agreements with respect to acquisitions of other businesses, products or technologies, the Company may in the future pursue such transactions to expand its business and the products and services it offers. Any material acquisition may require the Company to utilize cash reserves or to incur debt or issue equity securities. Any equity financing may dilute existing shareholders, and debt financing, if available, may involve significant restrictive covenants. The Company cannot assure that such financing will be extended on terms acceptable to the Company or at all. In addition, there can be no assurance as to whether or when any acquired business would contribute positive operating results commensurate with the associated investment. The Company believes that its existing cash balances will be sufficient to meet anticipated cash needs for working capital, capital expenditures and other activities for the foreseeable future. Thereafter, if current sources are not sufficient to meet the Company's needs, it may seek debt or equity financing. CERTAIN TRENDS AND UNCERTAINTIES The Company's business is particularly dependent on, and the Company derives substantially all of its revenue from, the communications industry, which appears to be emerging from a challenging capital spending environment. Although the capital spending environment in the communications industry has improved, business conditions currently are weaker than in prior quarters and if capital spending and technology purchasing by the Company's customers does not 14 continue to improve or if they decline, revenue may stagnate or decrease, and the Company's operating results will be adversely affected. Because a significant proportion of the Company's sales occur in the late stages of a quarter, a delay, cancellation or other factor resulting in the postponement or cancellation of a sale may cause the Company to miss its financial projections, which may not be discernible until the end of a financial reporting period. Future results may differ materially from recent results and past reported results should not be considered as an indication of future performance. For these reasons and the risk factors outlined below, it has been and continues to be very difficult for the Company to accurately forecast future revenues and operating results. The success of the Company's business is dependent upon, in part, the development of new products and services, the acceptance of these new products and services by communication service providers and other customers and the corresponding risks associated with the development, marketing, and adoption of these new products as discussed below. In the past, communication service providers have reduced their actual and planned expenditures to expand their networks and delayed and reduced the deployment of services. A number of communication service providers still report the existence of conditions of excess capacity in certain markets and have delayed the planned introduction of new services. The Company's sales to equipment manufacturers and application developers who supply the communications industry have been adversely affected by the past slowdown of infrastructure purchases by communication service providers and by declines in technology expenditures. While there has recently been an increase in such purchases, the return of diminished purchases may have an adverse effect on the Company's future results. In addition to loss of revenue, a return to weakness in the communications industry will affect the Company's business by increasing the risks of credit or business failures of suppliers, customers or distributors, by delays and defaults in customer or distributor payments, and by price reductions instituted by competitors to retain or acquire market share. While the Company's plan of operations is predicated, in part, on a recovery in expenditures by equipment manufacturers, application developers and communication service providers, the Company could experience deterioration in its operating results, and may determine to modify its plan for future operations in the absence of such recovery, which may include, among other things, reductions in its workforce. A limited number of customers have contributed a significant percentage of the Company's revenues; with 66% of the Company's sales derived from only three customers for the nine-month period ended October 31, 2005. The Company anticipates that its operating results in any given period will continue to depend significantly upon revenues from a small number of customers. The deferral or loss of one or more significant orders from any of these customers could have a material adverse effect on the Company's business and operating results. To the extent that the Company's customer base consolidates as a result of the announcements of several mergers in the communications industry, the Company may have an increased dependence on a few customers who may be able to exert increased pressure on the Company's prices and contractual terms in general. Consolidation also may result in the loss of both existing and potential customers of the Company. 15 The communications industry continues to undergo significant change as a result of deregulation and privatization worldwide, reducing restrictions on competition in the industry. The Company believes that existing competitors will continue to present substantial competition, and that other companies, many with considerably greater financial, marketing and sales resources than the Company, may enter the markets for the Company's products. In addition, the Company may lose sales to companies operating in regions such as India and China as a result of pricing competition because of their lower operating costs. Moreover, as the Company enters into new markets as a result of its own research and development efforts or acquisitions, it is likely to encounter new competitors. The Company's products are dependent upon their ability to operate on new and existing hardware and operating systems of other companies. Any modifications to the Company's software needed to adapt to these hardware and operating systems may prove to be costly, time-consuming and may not be successful. Undetected defects could result in lost sales, adverse publicity and other claims against the Company. The Company's new product offerings may not properly integrate into existing platforms and the failure of new product offerings to be accepted by the market could have a material adverse effect on the Company's business, results of operations, and financial condition. The communications industry is subject to rapid technological change. The introduction of new technologies in the communications market, including the delay in the adoption of such new technologies, and new alternatives for the delivery of services are having, and can be expected to continue to have, a profound effect on competitive conditions in the market and the success of market participants, including the Company. The Company's continued success will depend on the ability to correctly anticipate technological trends, to react quickly and effectively to such trends and to enhance its existing product line and to introduce new products on a timely and cost-effective basis. As a result, the life cycle of the Company's product line is difficult to estimate. In addition, changing industry and market conditions may dictate strategic decisions to restructure some business units and discontinue others. Discontinuing a business unit or product line may result in the Company recording accrued liabilities for special charges, such as costs associated with a reduction in workforce. These strategic decisions could result in changes to determinations regarding a product's useful life and the recoverability of the carrying basis of certain assets. The Company's products are designed to support Signaling System #7 ("SS7"), SIGTRAN, SIP, and Diameter protocols. If future networks do not utilize these protocols, and the Company is unable to adapt its products to work with other appropriate signaling protocols, its products will become less competitive or obsolete. A reduction in the demand for these products could adversely affect the Company's business and operating results. The Company's competitors may be able to develop more quickly or adapt faster to new or emerging technologies and changes in customer requirements, or devote greater resources to the development, promotion and sale of their products. Some of the Company's competitors have longer operating histories, larger customer bases, longer standing relationships with customers, greater name recognition and significantly greater financial, technical, marketing, customer service, public relations, distribution and other resources. New competitors continue to emerge, which may create pricing pressure and reduce the Company's market share. In addition, some of the Company's customers, may in the future, decide to internally develop their own solutions instead of purchasing them from the Company. Increased competition could force the Company to lower its prices or take other actions to differentiate its products. 16 In order to increase the Company's revenues, the Company will need to attract additional customers on an ongoing basis. In addition, since the Company's products have long sales cycles that typically range from six to twelve months, the Company's ability to forecast the timing and amount for specific sales is limited. The loss or deferral of one or more significant sales could have a material adverse effect on the Company's operating results in any fiscal quarter, especially if there are significant sales and marketing expenses associated with the deferred or lost sales. The Company's software products are primarily sold to equipment manufacturers and application developers, who integrate its products with their products and sell them to communications service providers. The success of the Company's business and operating results is dependent upon its channel and marketing relationships with these manufacturers and developers and the successful development and deployment of their products. If the Company cannot successfully establish channel and marketing relationships with leading equipment manufacturers and application developers or maintain these relationships on favorable terms, or the Company's sales channels are affected by economic weakness, the Company's business and operating results may be adversely affected. The Company intends to continue to make significant investment in its business, and to examine opportunities for growth. These activities may involve significant expenditures and obligations that cannot readily be curtailed or reduced if anticipated growth in demand for the associated products does not materialize or is delayed. The impact of these decisions on future financial results cannot be predicted with assurance, and the Company's commitment to growth may increase its vulnerability to downturns in its markets, technology changes and shifts in competitive conditions. Currently, the Company accounts for employee stock options in accordance with Accounting Principles Board ("APB") Opinion No. 25 and related Interpretations, which provide that any compensation expense relative to employee stock options be measured based on intrinsic value of the stock options. As a result, when options are priced at or above fair market value of the underlying common stock on the date of the grant, as currently is the Company's practice, the Company incurs no compensation expense. In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 123 (Revised 2004), "Share-Based Payment", ("SFAS No. 123(R)") which revises SFAS No. 123 and supersedes APB Opinion No. 25. In April 2005, the SEC amended Regulation S-X to modify the date for compliance with SFAS No. 123(R). The provisions of SFAS No. 123(R) must be applied beginning with the first interim or annual reporting period of the first fiscal year beginning on or after June 15, 2005, which for the Company is February 1, 2006 (the "Effective Date"). SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant, and to be expensed over the applicable vesting period. Pro forma disclosure of the income statement effects of share-based payments is no longer an alternative. Beginning on the Effective Date, the Company must (i) expense all options granted after the Effective Date over the applicable vesting period, and (ii) expense the non-vested portions of existing option grants going forward over their remaining vesting period. Compensation expense for the non-vested portions of existing option grants as of the Effective Date will be recorded based on the fair value of the awards previously calculated in developing the pro forma disclosures in accordance with the provisions of SFAS No. 123. Under SFAS No. 123(R), the Company is required to adopt a fair value-based method for measuring the compensation expense related to employee stock and stock options awards, which will lead to substantial additional compensation expense. Any such expense, although it will not affect the Company's cash flows, will have a material negative impact on the Company's reported results of operations. 17 The Company's products involve sophisticated technology that perform critical functions to highly demanding standards. If the Company's current or future products develop operational problems, the Company may incur fees and penalties in connection with such problems, which could have a material adverse effect on the Company. The Company offers complex products that may contain undetected defects or errors, particularly when first introduced or as new versions are released. The Company may not discover such defects, errors or operational problems until after a product has been released and used by the customer. Significant costs may be incurred to correct undetected defects, errors or operational problems in the Company's products and these defects, errors or operational problems could result in future lost sales. Defects, errors or operational problems in the Company's products also may result in product liability claims, which could cause adverse publicity and impair their market acceptance. The Company's recent growth in certain areas has strained its managerial and operational resources. The Company's continued growth may further strain its resources, which could hurt its business and results of operations. There can be no assurance that the Company's managers will be able to manage growth effectively. To manage future growth, the Company's management must continue to improve the Company's operational, IT and financial systems, procedures and controls and expand, train, retain and manage its employee base. If the Company's systems, procedures and controls are inadequate to support its operations, the Company's expansion could slow or come to a halt, and it could lose its opportunity to gain significant market share. Any inability to manage growth effectively could materially harm the Company's business, results of operations and financial condition. The Company continues to examine opportunities for growth through merger and acquisitions. Mergers and acquisitions may result in use of the Company's cash resources, amortization expenses related to intangible assets, and issuances of equity securities, which may result in a dilution of existing stockholders, and the Company may be negatively impacted by the assumption of liabilities of the merged or acquired company. Mergers and acquisitions could expose the Company to a number of risks including: o the impact of known potential liabilities or unknown liabilities associated with the acquired companies; o the difficulty of assimilating the operations, personnel and customers of the acquired companies into the Company's operations and business; o the potential disruption of the Company's ongoing business and distraction of management; o the difficulty of integrating acquired technology and rights into the Company's services and unanticipated expenses related to such integration; o the failure to successfully develop acquired technology, resulting in the impairment of amounts currently capitalized as intangible assets; o the potential for patent, trademark and other intellectual property infringement claims against the acquired company; 18 o the impairment of relationships with customers and partners of the acquired companies or the Company's customers and partners as a result of the integration of acquired operations; o the impairment of relationships with employees of the acquired companies or the Company's employees as a result of integration of new management personnel; o the difficulty of integrating the acquired company's accounting, management information, human resources and other administrative systems into existing administrative, financial and managerial controls and reporting systems and procedures; o the need to implement required controls, procedures and policies at private companies which, prior to acquisition, lacked such controls, procedures and policies; o in the case of foreign acquisitions, uncertainty regarding the impact of foreign laws and regulations, currency risks and the particular economic, political and regulatory risks associated with specific countries and the difficulty integrating operations and systems as a result of language, cultural, systems and operational differences; o the potential inheritance of the acquired companies' past financial statements with their associated risks; o the difficulty of achieving the anticipated synergies from the combined businesses, including marketing, product integration, distribution, product development and other synergies; o the potential need to write-down the goodwill of any such transaction in subsequent periods, resulting in charges to operations; and/or o possibly failing to retain the acquired or merged companies' key employees and customers. In addition, the Company may not be able to identify future suitable merger or acquisition candidates, and even if the Company does identify suitable candidates, it may not be able to make these transactions on commercially acceptable terms, or at all. The Company's business is subject to evolving corporate governance and public disclosure regulations that have increased both costs and the risk of noncompliance, which could have an adverse effect on the Company's common stock price. Because the Company's common stock is publicly traded on the Nasdaq stock market, the Company is subject to rules and regulations promulgated by a number of governmental and self-regulated organizations, including the SEC, Nasdaq and the Public Company Accounting Oversight Board, which monitors the accounting practices of public companies. Many of these regulations have only recently been enacted, and continue to evolve, making compliance more difficult and uncertain. In addition, the Company's efforts to comply with these new regulations have resulted in, and are likely to continue to result in, increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. In particular, Section 404 of Sarbanes-Oxley Act of 2002 and related regulations required the Company to include a management assessment of its internal control over financial reporting and auditor attestation of that assessment in its annual report for the Company's fiscal year ending January 31, 2005. While the Company has 19 asserted, in the management assessment of its internal control over financial reporting filed with the Company's Annual Report on Form 10-K, that the Company's internal control over financial reporting is effective as of January 31, 2005 and that no material weaknesses have been identified, the Company must continue to monitor and assess the internal control over financial reporting. The Company cannot provide any assurances that material weaknesses will not be discovered in the future. If, in the future, the Company's management identifies one or more material weaknesses in the internal control over financial reporting that remain unremediated, the Company will be unable to assert that such internal control over financial reporting is effective. If the Company is unable to assert that the internal control over financial reporting is effective for any given reporting period (or if the Company's auditors are unable to attest that the management's report is fairly stated or are unable to express an opinion on the effectiveness of the internal control over financial reporting), the Company could lose investor confidence in the accuracy and completeness of the Company's financial reports, which could have an adverse effect on the Company's common stock price. The effort regarding Section 404 has required, and continues to require, the commitment of significant financial and managerial resources. Changes in existing accounting or taxation rules or practices, new accounting pronouncements or taxation rules or new interpretations of existing accounting principles could have a significant adverse effect on the Company's results of operations and may affect the Company's reported financial results. The Company has made and continues to make significant investments in the areas of sales and marketing, and research and development. The Company's research and development activities include ongoing significant investment in the development of additional features and functionality for its products, including products based on emerging open standards for Internet protocols that facilitate the convergence of voice and data networks. The success of these initiatives will be dependent upon, among other things, the emergence of a market for these types of products and their acceptance by existing and new customers. The Company believes that expenditures on these initiatives are necessary to enhance its products in order to remain competitive, provide future growth opportunities and to maintain the Company's presence in the market. The Company's product initiatives reflect the Company's continuing analysis of the future demand for new products and services, and the Company from time to time is required to reprioritize or otherwise modify its product plans based on such analysis. The Company's business may be adversely affected by its failure to correctly anticipate the emergence of a market demand for certain products or services, or delays or changes in the evolution of market opportunities. If a sufficient market does not emerge for new or enhanced products developed by the Company, or the Company is not successful in marketing such products, the Company's continued growth could be adversely affected and its investment in those products may be lost. Geopolitical, economic and military conditions could directly affect the Company's operations. The outbreak of diseases, such as severe acute respiratory syndrome ("SARS") or avian flu, have curtailed and may in the future curtail travel to and from certain countries. Restrictions on travel to and from these and other regions on account of additional incidents of diseases, such as SARS or avian flu could have a material adverse effect on the Company's business, results of operations, and financial condition. The continued threat of terrorism around the world and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to the Company's business. To the extent that such disruptions result in delays or cancellations of customer orders, the manufacture or shipment of the Company's products, the Company's business, operating results and financial condition could be materially and adversely affected. More recently, the United States military involvement in overseas operations including, for example, the war in Iraq and other armed conflicts throughout the world, could have a material adverse effect on the Company's business, results of operations, and financial condition. 20 The Company is a highly automated business and a disruption or failure of its systems in the event of a catastrophic event, such as a major earthquake, tsunami or other natural disaster, cyber-attack or terrorist attack could cause delays in completing sales and providing services. A catastrophic event that results in the destruction or disruption of any of the Company's critical business systems could severely affect its ability to conduct normal business operations and, as a result, the financial condition and operating results could be adversely affected. "Hackers" and others have, in the past, created a number of computer viruses or otherwise initiated "denial of service" attacks on computer networks and systems. The Company's information technology infrastructure is regularly subject to various attacks and intrusion efforts of differing seriousness and sophistication. If such "hackers" are successful, confidential information, including passwords, financial information, or other personal information may be improperly obtained and the Company may be subject to lawsuits and other liability. Even if the Company is not held liable, a security breach could harm the Company's reputation. Even the perception of security risks, whether or not valid, could inhibit market acceptance of the Company's products and could harm the Company's business, financial condition and operating results. While the Company diligently maintains its information technology infrastructure and continuously implements protections against such viruses, electronic break-ins, disruptions or intrusions, if the defensive measures fail or should similar defensive measures by the Company's customers fail, the Company's business could be materially and adversely affected. The Company currently derives a majority of its total sales from customers outside of the United States. International transactions involve particular risks, including political decisions affecting tariffs and trade conditions, rapid and unforeseen changes in economic conditions in individual countries, difficulty in enforcing intellectual property rights, turbulence in foreign currency and credit markets, and increased costs resulting from lack of proximity to the customer. In addition, legal uncertainties regarding liability, compliance with local laws and regulations, local taxes, labor laws, employee benefits, currency restrictions, difficulty in accounts receivable collection, longer collection periods and other requirements may have a negative impact on the Company's operating results. Unforeseen changes in the regulatory environment, including, but not limited to changes in product requirements also may have an impact on the Company's revenues, operations and/or costs in any given part of the world. New manufacturing requirements for the Company's products could require the Company to redesign or find alternatives to such products, resulting in delays and possibly lost sales. In August 2005, the European Parliament Directive 2002/96/EC (dated 27 January 2003) on Waste Electrical and Electronic Equipment Directive (the "WEEE Directive") became effective in the European Union. The WEEE Directive requires producers of certain electrical and electronic equipment to be financially responsible for the future disposal costs of this equipment sold within the European Union. In July 2006, the Restriction of the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (the "RoHS Directive") will become effective in the European Union. The RoHS Directive restricts the use of certain hazardous substances, including mercury, lead, cadmium, hexavalent chromium, and certain flame retardants, in the construction of component parts of certain electrical and electronic equipment sold within the European Union. The Company is currently assessing the applicability of 21 these Directives, and has begun implementing the WEEE Directive and making preparations and arrangements to comply with the RoHS Directive, in each case, to the extent applicable to the hardware contained in its solutions. As part of this process, the Company will need to ensure that it has a supply of compliant components from its suppliers. Ensuring compliance with these directives and integrating compliance activities with suppliers will result in additional costs to the Company and may result in disruptions to operations. The Company cannot currently estimate the extent of such additional costs or potential disruptions. However, to the extent that any such costs or disruptions are substantial, the Company's financial results could be materially and adversely affected. All of the Company's products are of US origin and are classified under the US export regulations such that currently no licenses are required to export to the countries with which the Company currently conducts business. In the future, the Company may be required to obtain export licenses and other authorizations from applicable governmental authorities for certain countries within which it conducts business and to comply with applicable export control laws generally. The failure to receive any required license or authorization would hinder the Company's ability to sell its products and could adversely affect the Company's business, results of operations, financial condition, and could subject the Company to civil and criminal penalties. Export laws and regulations are revised from time to time and can be extremely complex in their application. If the Company is found not to have complied with applicable export control laws, the Company may be penalized by, among other things, having its ability to receive export licenses curtailed or eliminated. The Company's failure to comply with applicable export laws would hinder its ability to sell its products and could materially and adversely affect its business, financial condition and results of operations. International sales are predominately denominated in United States dollars and the Company has not been exposed to material fluctuations in foreign currency exchange rates related to sales. However, the Company expects that in future periods, a greater portion of international sales may be denominated in currencies other than the United States dollar, which could expose it to losses and gains on foreign currency transactions. The Company does have certain expenses denominated in foreign currency. From time to time, the Company may choose to limit its exposure by utilizing hedging strategies. There can be no assurance that any such hedging strategies that the Company undertakes would be successful in avoiding exchange rate losses. Because the Company relies on a limited number of independent manufacturers to produce boards for its products, if these manufacturers experience financial, operational or other difficulties, the Company may experience disruptions to its product supply. The Company may not be able to find alternate manufacturers that meet its requirements and existing or alternative sources for boards may not continue to be available at favorable prices. The Company also relies on a limited number of suppliers for its board components and it does not have any long-term supply agreements. Thus, if there is a shortage of supply for these components, the Company may experience an interruption in its product supply. The Company's success is dependent on recruiting and retaining key management and highly skilled technical, managerial, sales, and marketing personnel. The market for highly skilled personnel remains very competitive. The Company has in the past and may in the future experience difficulty in recruiting or retaining qualified personnel due to, among other reasons, the market demand or constraints on the Company's ability to use equity compensation due to recent changes in accounting rules. The Company's ability to attract and retain employees also may be affected by cost control actions, which in the past and may again in the future, include reductions in the Company's workforce and the associated reorganization of operations. If the costs of attracting and retaining qualified personnel increase significantly, the Company's financial results could be materially and adversely affected. 22 While the Company generally requires employees, independent contractors and consultants to execute non-competition and confidentiality agreements, the Company's intellectual property or proprietary rights could be infringed or misappropriated, which could result in expensive and protracted litigation. The Company relies on a combination of patent, copyright, trade secret and trademark law to protect its technology. Despite the Company's efforts to protect its intellectual property and proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use its products or technology. Effectively policing the unauthorized use of the Company's products is time-consuming and costly, and there can be no assurance that the steps taken by the Company will prevent misappropriation of its technology, particularly in foreign countries where in many instances the local laws or legal systems do not offer the same level of protection as in the United States. If others claim that the Company's products infringe their intellectual property rights, the Company may be forced to seek expensive licenses, reengineer its products, engage in expensive and time-consuming litigation or stop marketing its products. The Company attempts to avoid infringing known proprietary rights of third parties in its product development efforts. The Company does not, however, regularly conduct comprehensive patent searches to determine whether the technology used in its products infringes patents held by third parties. There are many issued patents, as well as patent applications in the fields, in which the Company is engaged. Because patent applications in the United States are not publicly disclosed until published or issued, applications may have been filed which relate to the Company's software and products. If the Company were to discover that its products violated or potentially violated third-party proprietary rights, it might not be able to continue offering these products without obtaining licenses for those products or without substantial reengineering of the products. Any reengineering effort may not be successful and the Company cannot be certain as to whether such licenses would be available. Even if such licenses were available, the Company cannot be certain that any licenses would be offered to the Company on commercially reasonable terms. While the Company occasionally files patent applications, it cannot be assured that patents will be issued on the basis of such applications or that, if such patents are issued, they will be sufficiently broad to protect its technology. In addition, the Company cannot be assured that any patents issued to it will not be challenged, invalidated or circumvented. Substantial litigation regarding intellectual property rights exists in the communications industry, and the Company expects that its products may be increasingly subject to third-party infringement claims as the number of competitors in its industry segments grows and the functionality of software products in different industry segments overlaps. In addition, the Company has agreed to indemnify customers in certain situations should it be determined that its products infringe on the proprietary rights of third parties. Any third-party infringement claims could be time consuming to defend, result in costly litigation, divert management's attention and resources, cause product and service delays or require the Company to enter into royalty or licensing agreements. Any royalty or licensing arrangements, if required, may not be available on terms acceptable to the Company, if at all. A successful claim of infringement against the Company and its failure or inability to license the infringed or similar technology could have a material adverse effect on its business, financial condition and results of operations. 23 The Company holds a large proportion of its net assets in short-term investments. Such investments subject the Company to the risks inherent in the capital markets generally, and to the performance of other businesses over which it has no direct control. Given the relatively high proportion of the Company's liquid assets relative to its overall size, the results of its operations are materially affected by the results of the Company's capital management and investment activities and the risks associated with those activities. In addition, although interest rates have risen recently, low interest rates have in the past and may in the future have an adverse impact on the Company's results of operations. Comverse Technology, Inc. ("CTI") beneficially owns a majority of the Company's outstanding shares of common stock. Consequently, CTI effectively controls the outcome of all matters submitted for shareholder action, including the composition of the Company's board of directors and the approval of significant corporate transactions. Through its representation on the Company's board of directors, CTI has a controlling influence on the Company's management, direction and policies, including the ability to appoint and remove officers. As a result, CTI may cause the Company to take actions that may not be aligned with the Company's interests or those of its other shareholders. For example, CTI may prevent or delay any transaction involving a change in control of the Company or in which the Company's shareholders might receive a premium over the prevailing market price for their shares. The Company issues stock options as a key component of its overall compensation. There is growing pressure on public companies from shareholders generally and various organizations to reduce the rate at which companies, including the Company, issue stock options to employees, which may make it more difficult to obtain shareholder approval of equity compensation plans when required. In addition, FASB has adopted changes to generally accepted accounting principles ("GAAP") that will require the Company to adopt a different method of determining the compensation expense for its employee stock options and employee stock purchase plan beginning in the first quarter of fiscal year 2006. As a result, the Company has terminated its employee stock purchase plan. In addition, the Company believes expensing stock options will increase shareholder pressure to limit future option grants and could make it more difficult for the Company to grant stock options to employees in the future. As a result, the Company may lose top employees to non-public, start-up companies or may generally find it more difficult to attract, retain and motivate employees, either of which could materially and adversely affect the Company's business, results of operations and financial condition. The Company's operating results have fluctuated in the past and may do so in the future. The trading price of the Company's shares has been affected by the factors disclosed herein as well as prevailing economic and financial trends and conditions in the public securities markets. Share prices of companies in technology-related industries, such as the Company, tend to exhibit a high degree of volatility, which at times is unrelated to the operating performance of a company. The announcement of financial results that fall short of the results anticipated by the public markets could have an immediate and significant negative effect on the trading price of the Company's shares in any given period. Such shortfalls may result from events that are beyond the Company's immediate control, can be unpredictable and, since a significant proportion of the Company's sales during each fiscal quarter tend to occur in the latter stages of the quarter, may not be discernible until the end of a financial reporting period. These factors may contribute to the volatility of the trading value of its shares regardless of the Company's long-term prospects. The trading price of the Company's shares may also be affected by developments, including reported financial results and fluctuations in trading prices of the shares of other publicly-held companies in the communications industry in general, and the Company's business segment in particular, which may not have any direct relationship with the Company's business or prospects. 24 The Company has not declared or paid any cash dividends on its common stock and currently does not expect to pay cash dividends in the near future. Consequently, any economic return to a shareholder may be derived, if at all, from appreciation in the price of the Company's common stock, and not as a result of dividend payments. In addition, the Company's board of directors has the authority to cause the Company to issue, without vote or action of the Company's shareholders up to 10,000,000 shares of undesignated stock, and has the ability to divide such undesignated shares into one or more classes of common or preferred stock and to further divide any classes of preferred stock into series. Any such series of preferred stock could contain dividend rights, conversion rights, voting rights, terms of redemption, redemption prices, liquidation preferences or other rights superior to the rights of holders of its common stock. The Company's board of directors has no present intention of issuing any such preferred series, but reserves the right to do so in the future. The Company is also authorized to issue, without shareholder approval, common stock under certain circumstances. The issuance of either preferred or common stock could have the effect of making it more difficult for a person to acquire, or could discourage a person from seeking to acquire, control of the Company. If this occurs, investors could lose the opportunity to receive a premium on the sale of their shares in a change of control transaction. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company is exposed to market risk from changes in interest rates. Various financial instruments held by the Company are sensitive to changes in interest rates. Interest rate changes could result in an increase or decrease in interest income as well as in gains or losses in the market value of the Company's debt security investments due to differences between the market interest rates and rates at the date of purchase of these investments. The Company places its cash investments with high credit-quality financial institutions and currently invests primarily in money market funds placed with major banks and financial institutions, Auction Rate Securities, corporate and municipal short and medium-term notes, asset-backed securities, and United States government and United States government corporation and agency obligations and/or mutual funds investing in the like. The Company has investment guidelines relative to diversification and maturities designed to maintain safety and liquidity. As of January 31, 2005, the Company had cash and cash equivalents totaling approximately $19,372,000 and had short-term investments totaling approximately $227,300,000. If, during the year ended January 31, 2006, average short-term interest rates increase or decrease by 50 basis points relative to average rates realized during the year ended January 31, 2005, the Company's projected interest income from cash and cash equivalents and short-term investments would increase or decrease by approximately $1,233,000, assuming a similar level of investments in the year ended January 31, 2006. 25 Due to the short-term nature of the Company's cash and cash equivalents, the carrying value approximates market value and are not generally subject to price risk due to fluctuations in interest rates. The Company's short-term investments are subject to price risk due to fluctuations in interest rates. Neither a 10% increase nor decrease in prices would have a material effect on the Company's consolidated financial statements. All short-term investments are considered to be available-for-sale, accounted for at fair value, with resulting unrealized gains or losses reported as a separate component of shareholders' equity. If these available-for-sale securities experience declines in fair value that are considered other-than-temporary, an additional loss would be reflected in net income (loss) in the period when the subsequent impairment becomes apparent. See Note 2 of the financial statements in the Company's Annual Report on Form 10-K for the year ended January 31, 2005 for more information regarding the Company's short-term investments. ITEM 4. CONTROLS AND PROCEDURES. (a) The Company's management evaluated, with the participation of the Company's principal executive and principal financial officers, the effectiveness of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")), as of October 31, 2005. Based on their evaluation, the Company's principal executive and principal financial officers concluded that the Company's disclosure controls and procedures were effective as of October 31, 2005. (b) There has been no change in the Company's internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Company's fiscal quarter ended October 31, 2005, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 26 PART II ITEM 1. LEGAL PROCEEDINGS. From time to time, the Company is subject to claims in legal proceedings arising in the normal course of its business. The Company does not believe that it is currently party to any pending legal actions that could reasonably be expected to have a material adverse effect on its business, financial condition and results of operations. ITEM 6. EXHIBITS. (a) Exhibit Index. ------------- 31.1 Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certifications of Chief Executive Officer and Chief Financial Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 27 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ULTICOM, INC. Dated: December 12, 2005 /s/ Shawn K. Osborne -------------------------------------- Shawn K. Osborne President and Chief Executive Officer Dated: December 12, 2005 /s/ Mark A. Kissman -------------------------------------- Mark A. Kissman Vice President of Finance and Chief Financial Officer 28