UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

OR

Commission file number: 0-18391

ASPECT COMMUNICATIONS CORPORATION

1320 Ridder Park Drive, San Jose, California 95131-2312
(Address of principal executive offices and zip code)

Registrant’s telephone number: (408) 325-2200

     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 x   No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x   No o

     The number of shares outstanding of the Registrant’s Common Stock, $.01 par value, was 59,857,990 at October 29, 2004.

ASPECT COMMUNICATIONS CORPORATION

TABLE OF CONTENTS

2

ASPECT COMMUNICATIONS CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except par value and share amounts – unaudited)

See Notes to Condensed Consolidated Financial Statements

3

ASPECT COMMUNICATIONS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data – unaudited)

See Notes to Condensed Consolidated Financial Statements

4

ASPECT COMMUNICATIONS CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands-unaudited)

See Notes to Condensed Consolidated Financial Statements

5

ASPECT COMMUNICATIONS

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS-UNAUDITED

Note 1: Basis of Presentation

     The condensed consolidated financial statements include the accounts of Aspect Communications Corporation (Aspect or the Company) and all of its wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

     The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for annual financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004 or any future period. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s 2003 Annual Report on Form 10-K/A.

Note 2: Stock Based Compensation

     At September 30, 2004 the Company had three active stock option plans used as part of employee compensation and one active employee stock purchase plan. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation (in thousands, except per share amounts).

SFAS No. 123

Note 3: Inventories

     Inventories are stated at the lower of cost (first-in, first-out) or market. Inventories consist of (in thousands):

6

Note 4: Other Current Assets

     Other current assets consist of (in thousands):

Note 5: Product Warranties

     The Company generally warrants its products against certain manufacturing and other defects. These product warranties are provided for specific periods of time depending on the nature of the product, geographic location of its sale and other factors. The Company accrues for estimated product warranty claims for certain customers based primarily on historical experience of actual warranty claims as well as current information on repair costs. Accrued warranty costs as of September 30, 2004 were immaterial. Most customers purchase extended warranty contracts, which are accounted for under FASB Technical Bulletin 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts.

     The Company also indemnifies its customers against claims that its products infringe certain copyrights, patents or trademarks, or incorporate misappropriated trade secrets. The Company has not been subject to any material infringement indemnification claims by customers in the past and does not have any material claims pending as of September 30, 2004.

Note 6: Other Accrued Liabilities

     Other accrued liabilities consist of (in thousands):

Note 7: Comprehensive Income

     Comprehensive income for the three months and nine months ended September 30 is calculated as follows (in thousands):

7

Note 8: Earnings Per Share

     Basic earnings per common share (EPS) is generally calculated by dividing net income attributable to common shareholders by the weighted average number of common shares outstanding. However, due to the Company’s issuance of redeemable convertible preferred stock on January 21, 2003, which contains certain participation rights, EITF Topic D-95, Effect of Participating Convertible Securities on the Computation of Basic Earnings, requires those securities to be included in the computation of basic EPS if the effect is dilutive. Furthermore, Topic D-95 requires that the dilutive effect to be included in basic EPS may be calculated using either the if-converted method or the two-class method. The Company has elected to use the two-class method in calculating basic EPS.

     Basic earnings per share for the three months and nine months ended September 30 are calculated using the two-class method as follows (in thousands, except percentages and per share data):

     Basic EPS — Two-Class Method

8

     Diluted EPS

*

Diluted earnings per share cannot be greater than basic earnings per share. Therefore, reported diluted earnings per share and basic earnings per share for the three months and nine months ended September 30 were the same.

     The diluted earnings per share calculation for the three months and nine months ended September 30, 2003 excluded shares issuable from the convertible subordinated debentures, as the inclusion of these shares would have been anti-dilutive. For purposes of this computation, the Company used $47.08, the conversion price of subordinated debentures as of August 2003, to determine the dilution effect of convertible subordinated debentures.

     As of September 30, 2004 and 2003, approximately 2.9 million and 3.0 million common stock options outstanding, respectively, have been excluded from the diluted earnings per share calculations, as the inclusion of these common stock options would have been anti-dilutive.

Note 9: Restructuring Charge

     In fiscal years 2002 and 2001, the Company reduced its workforce by 22% and 28%, respectively, and consolidated selected facilities in its continuing effort to better optimize operations. As of September 30, 2004, the total restructuring accrual was $11 million, of which, $7 million was a short-term liability recorded in other accrued liabilities, and $4 million was a long-term liability. Components of the restructuring accrual were as follows (in thousands):

9

     Severance and outplacement costs are related to the termination of employees in 2001 and 2002. Employee separation costs include severance and other related benefits. Functions impacted by the restructuring included sales infrastructure, support services, manufacturing, marketing, research and development, and corporate functions. In 2003, the Company reduced its estimate of remaining severance and outplacement costs.

     The consolidation of facilities costs component of the restructuring accrual includes rent of unoccupied facilities, net of expected sublease income of $1 million, and write-offs of abandoned internal use software assets. The Company revised its estimate of future facility related obligations and increased the accrual by approximately $4 million in 2003 due to an increase in the estimate of the period of time necessary to sublet abandoned facilities as a result of the then-current real estate market conditions. The Company believes the restructuring accrual balance as of September 30, 2004, adequately covers future obligations associated with the unoccupied facilities, net of sublease income. The remaining accrual balance relates primarily to facilities identified in the 2001 restructurings and will be paid over the next four years.

Note 10: Lines of Credit and Borrowings

     On February 13, 2004, the Company entered into a $100 million revolving credit facility with a number of financial institutions led by Comerica Bank, which is also the administrative agent, and The CIT Group/Business Credit, Inc., which is also the collateral agent. This credit facility amended the Company’s prior $50 million credit facility with Comerica Bank entered into on August 9, 2002. It eliminated the prior facility’s borrowing base requirements and other related restrictions. The revolver has a three-year term and the amounts borrowed are secured by substantially all of the Company’s assets, including the stock of its significant subsidiaries. The Company can select interest options for advances based on the prime rate or eurocurrency rates, which include margins that are subject to quarterly adjustment. The revolver includes a $10 million sub-line for issuance of stand-by letters of credit. Mandatory prepayment and reduction of the facility is required in the amount of 100% of permitted asset sales over $1 million annually and 100% of the proceeds of future debt issuances, subject to certain exclusions. The revolver can be used for working capital, general corporate purposes and the financing of capital expenditures. The credit agreement includes customary representations and warranties and covenants. The financial covenants include minimum liquidity ratio, minimum fixed charge coverage ratio, minimum earnings before interest expense, income taxes, depreciation and amortization, or EBITDA, maximum debt to EBITDA ratio and minimum tangible net worth tests.

     At December 31, 2003, the Company had $41 million outstanding under its borrowing agreements of which $2 million was paid prior to February 13, 2004 in accordance with the original payment terms and the remaining $39 million was refinanced with this new $100 million revolving credit facility on February 13, 2004. On September 1, 2004, the Company repaid the $40 million outstanding under the $100 million revolving credit facility. The Company was in compliance with all related covenants and restrictions as of September 30, 2004.

     In addition to the line of credit the Company has two outstanding bank guarantees with a European bank, which are required for daily operations such as payroll, import/export duties and facilities. As of September 30, 2004, approximately $3 million is recorded as restricted cash in other current assets on the balance sheet related to these bank guarantees.

Note 11: Convertible Preferred Stock

     On January 21, 2003, the Company and Vista Equity Fund II, L.P. (“Vista”) closed a private placement for the sale of $50 million of the Company’s Series B convertible preferred stock with net proceeds of $44 million after expenses. The shares of Series B convertible preferred stock were sold for $1,000 per share and the holders of the 50,000 outstanding shares of Series B convertible preferred stock are entitled to vote (on an as-converted basis) on all matters subject to a stockholder vote. On most issues, the holders of Series B preferred stock and common stock vote together as a single class; however, the holders of Series B convertible preferred stock have veto rights with respect to certain Company actions. The actions which require the affirmative vote of the holders of a majority of the outstanding shares of Series B convertible preferred stock are fully described in the Company’s Certificate of Determination of Rights, Preferences and Privileges of Series B convertible preferred stock. The shares of Series B convertible preferred stock are initially convertible into 22.2 million shares of the Company’s common stock (subject to certain anti-dilution protection adjustments) and are mandatorily redeemable at 125% of the original purchase price of the stock plus accumulated unpaid dividends on January 21, 2013. Each holder of the Series B convertible preferred stock has the right, at any time, to convert all or a portion of its outstanding shares of Series B convertible preferred stock into shares of common stock. As more fully described in the Company’s Certificate of Determination of Rights, Preferences and Privileges of Series B convertible preferred stock, the Company may elect to cause all, or under certain circumstances portions, of the outstanding shares of Series B convertible preferred stock to be converted into common stock. In order for the Company to cause such a conversion to occur, all the shares issued pursuant to such conversion must be sold pursuant to an underwritten public offering of common stock pursuant to an effective registration statement under the Securities Act in which the price per share paid by the public exceeds $8.00 (subject to adjustments to reflect any stock dividends, stock splits and the like) and the Company would need to notify each holder of Series B convertible preferred stock no later than ten business days prior to the conversion date. Prior to such offering, the holder could convert all or a portion of its shares into common stock to avoid selling such shares in such offering.

10

     The shares of Series B convertible preferred stock have a liquidation preference over the shares of common stock such that (i) upon any liquidation, dissolution or winding up of the Company, the holders of Series B convertible preferred stock receive payments equal to 100% of their investment amount, plus unpaid dividends prior to payments to the holders of common stock, or (ii) in the event of a change of control of the Company, the holders of Series B convertible preferred stock receive payments equal to 125% of their investment amount plus accumulated unpaid dividends, prior to payments to the holders of common stock (or, in each case, if greater, the amount they would have received had the Series B convertible preferred stock converted to common stock immediately prior to such liquidation or change of control). Additionally, in the event that the Company declares a dividend or distribution to the holders of common stock, the holders of Series B convertible preferred stock shall be entitled to equivalent participation on an as if converted basis in such dividend or distribution.

     During the time that the Series B Convertible preferred stock is outstanding, the Company is obligated to accrue dividends on each share of the Series B convertible preferred stock, compounded on a daily basis at the rate of 10% per annum. The undeclared preferred stock dividends are forfeited in the event of conversion. Accrued dividends were $1.5 million and $1.3 million for the three months ended September 30, 2004 and 2003 respectively. For the nine months ended September 30, 2004 and 2003, accrued dividends were $4.3 million and $3.6 million, respectively. In addition to the dividend accrual, the Company is recording accounting charges associated with the accretion of the 125% redemption premium and the amortization of the beneficial conversion feature under the net interest method through January 21, 2013. The redemption premium of $17.6 million is calculated based on a redemption value of $62.5 million. Accretion of the redemption premium was $395,000 and $382,000 for the three months ended September 30, 2004 and 2003 respectively. Accretion of the redemption premium was $1,174,000 and $1,053,000 for the nine months ended September 30, 2004 and 2003 respectively. The beneficial conversion feature of $17.6 million is computed based on the difference between the conversion price of the preferred equity and the fair market value of the Company’s common stock on January 21, 2003. Amortization of the beneficial conversion feature was $366,000 and $349,000 for the three months ended September, 2004 and 2003, respectively. Amortization of the beneficial conversion feature was $1,086,000 and $958,000 for the nine months ended September 30, 2004 and 2003, respectively.

     The sale and issuance of the Series B convertible preferred stock to Vista followed the approval of the transaction by the Company’s shareholders at the Special Meeting of Shareholders on January 21, 2003. Pursuant to Vista’s contractual rights, following the sale and issuance of the Series B convertible preferred stock, Vista elected two new members to the Company’s Board of Directors.

Note 12: Convertible Preferred Stock Conversion and Public Offering

     On February 13, 2004, the Company filed a Registration Statement on Form S-3 for the registration of 12,000,000 shares of its common stock, 2,700,000 of which would be offered by the Company and 9,300,000 of which would be offered by selling shareholders. In connection with the offering, Vista agreed to convert all of its Series B convertible preferred stock into 22,222,222 shares of the Company’s common stock immediately prior to the completion of the offering. In consideration for this voluntary conversion, the Company agreed to issue Vista 200,000 additional shares of the Company’s common stock and pay Vista a $3 million transaction fee. On August 23, 2004, the Company announced that it was withdrawing the offering of the 12,000,000 shares of its common stock due to market conditions. As the offering was withdrawn without completion, the conversion agreement with Vista described above expired, without payments being made thereunder and accordingly, the Company expensed approximately $0.8 million in legal, accounting and printing costs incurred for the preparation of the public offering.

11

Note 13: Segment Information

     Under SFAS 131, Disclosures about Segments of an Enterprise and Related Information, the Company’s operations are reported in two operating segments, which are product and services. All financial segment information required by SFAS 131 can be found in the consolidated financial statements. For geographical reporting, revenues are attributed to the geographic location in which customers are invoiced and revenue is recognized. Long-lived assets consist of property and equipment and are attributed to the geographic location in which they are located. No single customer accounted for 10% or more of net revenues or accounts receivable for the three months and nine months ended September 30, 2004 and 2003.

     The following presents net revenues for the three months and nine months ended September 30, by geographic area (in thousands):

     The following presents property and equipment by geographic area (in thousands):

     For management reporting purposes, the Company organizes software license revenues into five groups: call center, contact center integration, workforce management, customer self service and other. The following presents net revenues by product group for the three months and nine months ended September 30, 2004 and 2003 (in thousands):

12

Note 14: Legal Proceedings

     The Company is subject to various legal proceedings and claims that arise in the normal course of business. While the outcome of these proceedings and claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on the Company’s business, operating results or financial condition. However, litigation in general, and intellectual property litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.

     On May 20, 2003, Electronic Data Systems Corporation, or EDS, made a demand for arbitration with the American Arbitration Association in connection with the Master Services Agreement entered into with the Company and EDS in December 2000 where the Company outsourced certain IT needs to EDS. A dispute arose between the Company and EDS over the services and charges to be performed and paid under the Master Services Agreement and the Company terminated the Master Services Agreement for EDS’s breach of the agreement. EDS alleged that the Company breached the Master Services Agreement and implied warranties associated with the Master Services Agreement, and committed fraud and engaged in negligent misrepresentation in inducing EDS to enter into the Master Services Agreement. On June 11, 2003, the Company filed its answer and counterclaims in which it denied every allegation made by EDS, denied that EDS was owed any amount in damages, and counterclaimed that EDS breached the Master Services Agreement, committed fraud in inducing the Company to not terminate for cause the Master Services Agreement earlier, and engaged in fraudulent and unfair business practices. On May 4, 2004, the Company received the interim award of the arbitrator. The arbitrator ruled that EDS breached the Master Services Agreement and ordered EDS to pay damages to the Company in an amount which is not material to the Company. The arbitrator rejected the parties’ claims of fraud, negligent misrepresentation, fraudulent misrepresentation and fraudulent and unfair business practices. The arbitrator also allowed further briefing, if desired by EDS, to consider whether the Company performed services that should have been transferred to EDS, and if so whether EDS should be entitled to any lost profits associated with those services. In the parties’ respective briefs, EDS claimed it was entitled to between $1 million to $2.1 million in lost profits. The Company claimed EDS was entitled to nothing. On July 7, 2004, the arbitrator ruled that EDS is not entitled to any damages and affirmed the interim award of damages payable to the Company, which the Company is seeking to enforce. At a hearing held on September 7, 2004 before the California Superior Court for Santa Clara County, the Company’s petition to enforce the award was heard and approved; EDS waived its right to appeal the award. On October 1, 2004, the Court issued a ruling confirming that the petition could be filed with certain redactions and granting the petition to confirm the award. The Company is preparing the proposed judgment to be entered by the Court. As of September 30, 2004, the Company has not recorded the value of this award as it is an unrealized gain contingency and will recognize a gain when payment is received.

Note 15: Recent Accounting Pronouncements

FIN No. 46R

     In December 2003, the FASB issued Interpretation No. 46 (“FIN 46R”) (revised December 2003), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (“ARB 51”), which addresses how a business enterprise should evaluate whether it has a controlling interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46 (FIN 46), which was issued in January 2003. Before concluding that it is appropriate to apply ARB 51 voting interest consolidation model to an entity, an enterprise must first determine that the entity is not a variable interest entity (VIE). As of the effective date of FIN 46R, an enterprise must evaluate its involvement with all entities or legal structures created before February 1, 2003, to determine whether consolidation requirements of FIN 46R apply to those entities. There is no grandfathering of existing entities. Public companies must apply either FIN 46 or FIN 46R immediately to entities created after January 31, 2003 and no later than the end of the first reporting period that ends after March 15, 2004. The adoption of FIN 46 had no effect on the Company’s consolidated financial position, results of operations or cash flows. We will apply the consolidation requirements of FIN 46 in future periods should interest in a variable interest entity be acquired.

13

     SAB No. 104

     In December 2003, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. SAB 104 revises or rescinds portions of the interpretive guidance included in Topic 13 of the codification of staff accounting bulletins in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The adoption of SAB 104 did not have a material effect on the Company’s results of operations or financial condition.

     EITF 03-01

     In March 2004, the FASB issued No. 03-1 (“EITF 03-01”), “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which provides new 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 03-01; however the disclosure requirements remain effective for annual periods ending after June 15, 2004. We will evaluate the impact of EITF 03-01 once final guidance is issued.

Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

     The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto included in Part I-Item 1 of this Quarterly Report and the audited consolidated financial statements and notes thereto and Management’s Discussion and Analysis in our 2003 Annual Report on Form 10-K/A.

Forward-looking Statements

     The matters discussed in this report including, but not limited to, statements relating to (i) the Company’s belief that its installed base represents a recurring revenue base and expectation that services and support revenues will continue to account for a significant portion of its revenues for the foreseeable future (ii) anticipated spending levels in capital expenditures, research and development, selling, general and administrative expenses; and (iii) the adequacy of the Company’s financial resources to meet currently anticipated cash flow requirements for the next twelve months are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended; Section 21E of the Securities and Exchange Act of 1934, as amended; and the Private Securities Litigation Reform Act of 1995; and are made under the safe-harbor provisions thereof. Forward-looking statements may be identified by phrases such as “we anticipate,” “are expected to,” and “on a forward-looking basis,” and are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in such forward-looking statements. Specific factors that could cause actual earnings per share results to differ include a potentially prolonged period of generally poor economic conditions that could impact our customers’ purchasing decisions; the hiring and retention of key employees; changes in product line revenues; insufficient, excess, or obsolete inventory and variations in valuation; and foreign exchange rate fluctuations. For a discussion of these and other risks related to our business, see the section entitled “Business Environment and Risk Factors” below. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date hereof. Aspect undertakes no obligation to publicly release any revision to these forward-looking statements that may be made to reflect events or circumstances after the date hereof.

Overview

     We are a leading provider of enterprise communication solutions that manage and optimize the contact center by integrating the applications that drive customer communications, customer and contact center information and workforce productivity. Our software and hardware solutions allow businesses to better service their customers by connecting them to appropriate resources, functionalities or applications, regardless of user location or method of communication. We understand the importance of unifying the applications that support customer communications, collect customer information and enhance workforce productivity, and we have focused exclusively on contact center solutions since our inception in 1985. We have a well established customer base, including more than two-thirds of the Fortune 50.

14

     The Current Economic Environment

     The economic climate in which we operate has been difficult over the last three years, and capital spending has decreased dramatically. This climate has had a pronounced effect on our ability to generate new license fees, as IT budgets have been frozen and large capital expenditures like those required to purchase some of our products have been quite limited, with senior executive approval required in many cases. Additionally, competition for these more limited sales opportunities has increased, and we have seen intense price competition both for new licenses and for support services. While we believe our installed base continues to represent a solid recurring revenue opportunity and a significant cash flow generator, and we currently perceive improving global economic conditions and increased capital spending by our customers on information technology, we cannot provide any assurance that the pressures on IT spending will continue to ease or that the general economic climate will continue to improve. Continued competitive pressure and a weak economy could have a continuing pronounced effect on our operating results.

     Significant Financial Events in the Third Quarter of 2004

     In the third quarter of 2004, we generated $13 million in cash flow from operations and eliminated the remaining debt on our balance sheet by repaying $40 million in debt outstanding under our $100 million credit facility.

     Sources of Revenue

     Our product revenues are derived from license fees for software products and, to a lesser extent, sales of hardware products. With respect to our product revenues, a limited number of product lines, including call center hardware and software, workforce management, customer self service and contact center integration products, have accounted for substantially all our product revenues. We also generate a substantial portion of our revenues from fees for services complementing such products, including software license updates, product support (maintenance), and professional services. We typically license our products on a per user basis with the price per user varying based on the selection of products licensed. Our software license updates and support fees are generally based on the level of support selected and the number of users licensed to use our products. Our professional service fees are generally based on a fixed price or time and materials basis. Our education services are generally billed on a per person basis.

     We currently expect that services and support revenues will continue to account for a significant portion of our revenues for the foreseeable future.

     To date, revenues from license fees have been derived from direct sales of software products to end users through our direct sales force and other alliance partners. Our ability to achieve revenue growth and improved operating margins, as well as increased worldwide sales, in the future will depend in part upon our success in expanding and maintaining these indirect sales channels worldwide.

Critical Accounting Policies and Estimates

     The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of financial statements in conformity with accounting standards generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The most significant estimates and assumptions relate to the allowance for revenue reserves, doubtful accounts, valuation allowance and realization of deferred income taxes, excess and obsolete inventory, and impairment of long-lived assets and restructuring reserves. Actual amounts could differ significantly from these estimates. We are not currently aware of any material changes in our business that would cause these estimates to differ significantly. Our critical accounting polices and estimates are discussed in our Annual Report on Form 10-K/A for the fiscal year ended December 31, 2003.

15

Results of Operations

      The following table sets forth statements of operations data for the three months and nine months ended September 30, 2004 and 2003 expressed as a percentage of total revenues:

Revenues
($ in thousands)

16

     Net revenues decreased in the third quarter of 2004 compared to 2003 primarily from reduced revenues from software license updates and product support as a result of license consolidation and to a lesser degree pricing pressures as customers renewed support contracts within the last year. While overall product revenues increased, revenues shifted between software and hardware revenues in the third quarter of 2004 compared to 2003. Net revenues increased for the nine months ended September 30, 2004 compared to 2003 due to improving global economic conditions and increased capital spending by our customers on information technology, partially offset by a decrease in software license updates and product support.

     Net revenues derived from the Americas and from Europe and Asia constituted 65% and 35% of total revenues for the third quarter in both 2004 and 2003, respectively. Net revenues derived from the Americas constituted 64% and 67% of total revenues for the nine months ended September 30, 2004 and 2003, respectively. Net revenues derived from Europe and Asia Pacific constituted 36% and 33% of total revenues for the nine months ended September 30, 2004 and 2003, respectively.

     Software license revenues decreased in the third quarter of 2004 compared to 2003, primarily due to changes in demand between software and hardware products. For the nine months ended September 30, 2004 compared to 2003, software license revenues increased primarily due to an improving economic environment and changes in the product mix between hardware and software.

     Software license updates and product support revenues decreased in the third quarter of 2004 compared to 2003 and in the nine months ended September 30, 2004 compared to 2003, primarily due to a decline in renewals of software updates and support contracts within the last year with certain customers who consolidated several contact centers, as well as pricing discounts on certain support contract renewals.

     Professional services and education revenues consist primarily of installation of product, consulting services, and education fees. For the third quarter of 2004, professional services and consulting services revenues increased due to higher installation revenues of hardware, requiring greater demand on services. For the nine months ended September 30, 2004, professional services revenues increased due to greater demand for consulting services and training.

Gross Margin

     Gross margin on total revenues increased to 59% in the third quarter of 2004 from 57% in the corresponding period of 2003 primarily attributable to our focus on cost efficiencies and lower amortization costs. The three months and nine months ended September 30, 2003 included a charge for impairment of intangible assets and no comparable charge was recorded for the corresponding period in 2004. For the nine months ended September 30, 2004, gross margin on total revenues increased to 60% from 56% for the comparable period in 2003.

     Gross software license margin. Cost of software license revenues includes fees paid to various third parties and amortization of intangible assets. During the third quarter of 2004 as compared to 2003, cost of software license decreased by $2 million due primarily to lower amortization of intangible assets of $0.5 million and impairment of intangible assets of $2.0 million which was recorded for quarter ended September 30, 2003. For the nine months ended September 30, 2004 compared to 2003, cost of software license decreased by $3.9 million due to lower amortization of intangible assets of $1.5 million and impairment of intangible assets of $2.0 million. Additionally, increased sales of 7% for the nine months ended September 30, 2004, as compared to 2003 contributed to the higher gross software license margin.

17

     Gross hardware margin. Cost of hardware revenues includes labor, materials, overhead, and other directly allocated costs involved in the manufacture and delivery of our products. Gross hardware margin for the third quarter of 2004 and for the nine months ended September 30, 2004 increased over the comparable period of 2003, due to increased product revenues of $1.5 million and $3.6 million, respectively, reduced cost of hardware and the sale of excess and obsolete inventory previously written off. For the third quarter of 2004 and for the nine months ended September 30, 2004, cost of hardware was reduced by $0.5 million and $2.9 million over the comparable period of 2003, respectively, due to lower materials cost, freight cost and reduced excess and obsolete inventory write-downs. Included in the gross hardware margin for the nine months ended September 30, 2004 was a net benefit of $1.0 million related to the sale of excess and obsolete inventory previously written off while the comparable period in 2003 included a net charge to excess and obsolete inventory of $1.9 million.

     Gross services margin. Cost of service revenues consists primarily of employee salaries and benefits, facilities and systems costs to support maintenance, consulting and education. Cost of service revenues for the third quarter of 2004 as compared to 2003 remained relatively consistent. Cost of service revenues for the nine months ended September 30, 2004 as compared to 2003 decreased by $1.7 million primarily attributable to decreased IT and facilities expenses.

Operating Expenses

($ in thousands)

     Research and development, or R&D, expenses relate to the development of new products, enhancements of existing products and quality assurance activities. These costs consist primarily of employee salaries and benefits, facilities, IT and consulting expenses. The decrease in R&D expenses in the third quarter of 2004 from 2003 was mainly due to decreased IT and facilities expenses of $0.9 million. The decrease in R&D expenses in the nine months ended September 30, 2004 compared to 2003 was due to decreased IT and facilities expenses of $3.7 million and reduced salaries and benefits of $0.3 million due to lower headcount in the nine months ended September 30, 2004 compared to the same period in 2003. We anticipate that R&D expenses in the remaining quarter of 2004 will be relatively flat to slightly higher compared to the third quarter of 2004.

     Selling, general and administrative, or SG&A, expenses consist primarily of employee salaries and benefits, commissions, professional and consulting fees, facilities and IT costs. The increase in SG&A expenses in the third quarter of 2004 compared to 2003 was primarily due to increased consulting and professional fees of $1.5 million which included $0.8 million for legal, accounting and printing costs incurred for the preparation of our public offering which was subsequently withdrawn, foreign exchange losses of $1.1 million partially offset by decreased salaries and benefits of $1.6 million. The increase in SG&A expenses for the nine months ended September 30, 2004 compared to the comparable period in 2003 was primarily due to increased travel costs of $0.6 million, training costs of $1.4 million, foreign exchange losses of $0.4 million and stock-based compensation of $0.6 million partially offset by decreased salaries and benefits of $0.4 million, decreased consulting and professional fees of $0.9 million and reduced expenses in facilities and IT of $1.9 million. During the nine months ended September 30, 2003, a reversal of accounts receivable reserve of $4.1 million was recorded for the collection of previously reserved for receivables as compared to $1.0 million for the nine months ended September 30, 2004. We anticipate that SG&A expenses in the remaining quarter of 2004 will be relatively flat to slightly higher compared to the third quarter of 2004.

     Restructuring charges consist of costs related to severance, outplacement and consolidation of facilities related to workforce adjustments. In the second quarter of 2003, a restructuring charge of $3.0 million was recorded as a result of the revision of our estimate upward for future facility related obligations.

18

Interest and Other Income (Expense):

($ in thousands)