FORM 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

For the quarterly period ended March 31, 2005

OR

Commission file number 0-24701

CATAPULT COMMUNICATIONS CORPORATION

160 South Whisman Road
Mountain View, California 94041

(650) 960-1025

(Address, including zip code, and telephone number, including
area code, of principal executive offices)

     Indicate by check mark whether the registrant (1) has filed all reports 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 þ No o

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

     As of April 22, 2005, there were 14,700,274 shares of the Registrant’s Common Stock, $0.001 par value, outstanding.

CATAPULT COMMUNICATIONS CORPORATION
FORM 10-Q

INDEX

2

Part I. Financial Information

Item 1. Financial Statements

CATAPULT COMMUNICATIONS CORPORATION

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

3

CATAPULT COMMUNICATIONS CORPORATION

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

4

CATAPULT COMMUNICATIONS CORPORATION

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

5

CATAPULT COMMUNICATIONS CORPORATION

NOTE 1—THE COMPANY AND BASIS OF PRESENTATION

     Catapult Communications Corporation and its subsidiaries (“we” or the “Company”) design, develop, manufacture, market and support advanced software-based test systems offering integrated suites of testing applications for the global telecommunications industry. Our advanced test systems assist our customers in the design, integration, installation and acceptance testing of a broad range of digital telecommunications equipment and services. The Company was incorporated in California in 1985, was reincorporated in Nevada in 1998 and has operations in the United States, Canada, the United Kingdom, Europe, Japan, China and Australia. Management has determined that we conduct our business within one global industry segment: the design, development, manufacture, marketing and support of advanced software-based telecommunications test systems.

     The accompanying unaudited interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2004, and filed with the SEC on December 10, 2004. The unaudited condensed consolidated financial statements as of March 31, 2005, and for the three and six months ended March 31, 2005 and 2004, reflect, in the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to state fairly the financial information set forth herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for any subsequent interim period or for an entire year. The September 30, 2004 balance sheet was derived from audited financial statements at that date, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

NOTE 2 — RECENT ACCOUNTING PRONOUNCEMENTS

     In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement Number 123 (revised 2004), “SFAS No. 123(R)”, Share-Based Payment. SFAS No. 123(R) requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments, such as stock options granted to employees. On April 14, 2005, the SEC approved a new rule that for public companies delays the effective date of SFAS No. 123(R) to annual, rather than interim, periods that begin after June 15, 2005. We may elect to apply SFAS No. 123(R) using the modified prospective application method, under which we would record compensation expense (as previous awards continue to vest) for the unvested portion of previously granted awards that remain outstanding at the date of adoption, without restating prior periods. Alternatively, we may elect to apply the modified retrospective application method, under which financial statements for prior periods would be adjusted on a basis consistent with the pro forma disclosures required for those periods by SFAS No. 123. We expect the adoption of SFAS No. 123(R) may have a material adverse effect on our reported net income per share. We are currently evaluating the extent of that impact and we have not made an election with respect to application method.

     In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4”. This Statement requires abnormal amounts of idle facility expense, freight, handling costs, and wasted material be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal”. In addition, this Statement requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this Statement are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. However, as we do not include amounts of idle facility expense, freight, handling costs and wasted material in our inventory, the adoption of SFAS No. 151 is not expected to have a material impact on our financial position or results of operations.

6

     In October 2004, the American Jobs Creation Act of 2004 (the “Act”), was signed into law, allowing U.S. companies to repatriate accumulated income from abroad by providing a one-time deduction of 85% for certain dividends from controlled foreign corporations. The deduction is subject to certain limitations, and numerous provisions of the Act contain uncertainties that require interpretation and evaluation. We are currently evaluating whether, and to what extent, to repatriate accumulated income from abroad under the provisions of the Act. Until such evaluation is complete, we have not accrued income taxes on the accumulated undistributed earnings of our Irish subsidiary, as these earnings are currently expected to be reinvested indefinitely.

NOTE 3 — STOCK-BASED COMPENSATION

     We currently account for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” as interpreted by FASB Interpretation No. 44 “Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of Opinion No. 25”. We also comply with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” Under APB Opinion No. 25, compensation cost is recognized over the vesting period based on the difference, if any, on the date of grant between the fair value of our stock and the amount an employee must pay to acquire the stock. The changes that will be required by SFAS No. 123(R) are discussed in Note 2 above.

     Had compensation expense been determined based on the fair value at the grant dates for the awards under these plans using the Black-Scholes option pricing model prescribed by SFAS No. 123, our pro forma net income and pro forma basic and diluted earnings per share would have been as set forth in the table below. Such pro forma disclosures may not be representative of future compensation expense because options vest over several years and additional grants are made each year.

7

     The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model with the assumptions set out in the table below.

NOTE 4—BASIC AND DILUTED NET INCOME PER SHARE

     Basic net income per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share includes the effect of dilutive potential common shares issued during the period from the exercise of options using the treasury stock method.

     Diluted net income per share does not include the effect of the following anti-dilutive potential common shares:

8

NOTE 5—GOODWILL AND INTANGIBLE ASSETS

     We performed our most recent annual impairment test on September 30, 2004, and determined that there was no impairment of goodwill. As such, there was no write-down of the goodwill balance. Between October 1, 2004 and March 31, 2005, there were no changes to the Company’s goodwill balance of $49.4 million or indicators of impairment.

     Intangible assets subject to amortization consist of purchased technology, trade names and customer relationships that are being amortized over a period of seven years, non-compete agreements that are being amortized over a period of eight years, and backlog that was amortized over a period of six months, as follows (in thousands):

     The estimated future amortization expense of purchased intangible assets as of March 31, 2005 was as follows:

NOTE 6—WARRANTY ACCRUAL

     The following table represents the activity in warranty accrual for the six months ended March 31, 2005 and 2004 (in thousands):

9

NOTE 7—COMPREHENSIVE INCOME

     The components of comprehensive income, net of tax, are as follows:

NOTE 8—INVENTORIES

NOTE 9—CONVERTIBLE NOTES PAYABLE

     In connection with the acquisition of the Network Diagnostic Business (“NDB”) from Tekelec in August 2002, our Irish subsidiary issued two convertible notes to Tekelec in the principal amounts of $10.0 million and $7.3 million, respectively. These notes were guaranteed by us, bore interest at 2% per annum and were due and payable on or before August 30, 2004. The two notes were converted by Tekelec in September 2004 into 1,081,250 shares of our common stock.

     The fair value of the notes was $18.1 million, which was recorded on the balance sheet as at the date they were issued. The valuation premium of $0.8 million was amortized to interest income over the term of the notes on an effective interest method.

NOTE 10—ISSUANCE OF COMMON STOCK

     In September 2004, as part of our public offering under our previously filed “shelf” Registration Statement on Form S-3 (File No. 333-112610) which was declared effective by the Securities and Exchange Commission on March 31, 2004, we issued 200,000 shares of our common stock at a public offering price of $18.97 per share. After underwriting discounts and commissions of approximately $190,000 and capitalized external incremental costs of approximately $602,000, the net proceeds to us were approximately $3,002,000. Also sold under the public offering were 300,000 outstanding shares held by certain selling stockholders and 1,081,250 shares that were registered upon conversion of the notes issued to Tekelec described in Note 9 above.

NOTE 11—REPURCHASE OF COMMON STOCK

     In December 1999, our Board of Directors authorized a stock repurchase program of up to 2,000,000 shares of its common stock. Depending on market conditions and other factors, repurchases can be made from time to time in the open market and in negotiated transactions, including block transactions, and this program may be discontinued at any time. In the year ended September 30, 2003,

10

we repurchased 257,400 shares at a cost of approximately $1.8 million. The shares repurchased were restored to the status of authorized but unissued stock. In the same period, treasury stock with a carrying value of $300,000 that had previously been repurchased was restored to the status of authorized but unissued stock. In the years ended September 30, 2002 and 2004 and the six months ended March 31, 2005, we repurchased no shares. As of March 31, 2005, we are authorized to repurchase an additional 1,742,600 shares of our common stock under the stock repurchase program.

NOTE 12—INCOME TAXES

     Our provision for income taxes consists of federal, state and foreign taxes. We recorded a tax provision of $1.3 million and $712,000 in the three months ended March 31, 2005 and March 31, 2004, respectively and $1.7 million and $886,000 in the six months ended March 31, 2005 and March 31, 2004, respectively. The provision in the six months ended March 31, 2005 reflected a $0.1 million benefit from additional research and development tax benefits claimed with respect to a prior year and a $0.2 million benefit from the retroactive impact of the reinstitution of the research and development tax credit program.

NOTE 13—GEOGRAPHIC INFORMATION

     We are organized to operate in and service a single global industry segment: the design, development, manufacture, marketing and support of advanced software-based telecommunications test systems.

     Although we operate in one geographic segment, our chief decision makers evaluate net revenues by customer location based on four geographic regions, as follows:

     Revenues are segmented based on the location of the end customer and exclude all inter-company sales.

     Revenues in the United States represented 26% and 20% of our total revenues in the six months ended March 31 2005 and 2004, respectively, and revenues from Germany accounted for 10% of our consolidated net revenues from unaffiliated customers for the six months ended March 31, 2005. Operations in Ireland accounted for 32% and 39% of our consolidated identifiable assets at March 31, 2005 and 2004, respectively.

11

NOTE 14—CUSTOMER INFORMATION

     We currently sell our products to a small number of customers. Customers representing 10% or more of our accounts receivable balances as of March 31, 2005 or September 2004, or 10% or more of our revenues for the three months or six months ended March 31, 2005 or 2004 were as follows:

NOTE 15—RECLASSIFICATION

     Certain auction rate securities have been reclassified from cash equivalents to short-term investments in prior periods. Auction rate securities are variable rate bonds tied to short-term interest rates with maturities on the face of the securities in excess of 90 days. Auction rate securities have interest rate resets through a modified Dutch auction, at pre-determined short-term intervals, usually every 7, 28 or 35 days. They trade at par and are callable at par on any interest payment date at the option of the issuer. Interest paid during a given period is based upon the interest rate determined during the prior auction.

     Although these securities are issued and rated as long-term bonds, they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset. Based on our ability either to liquidate our holdings or to roll our investment over to the next reset period, we had historically classified some or all of these instruments as cash equivalents if the period between interest rate resets was 90 days or less.

     We account for our marketable securities in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Such investments are classified as “available for sale” and are reported at fair value in the Company’s balance sheets. The short-term nature and structure, the frequency with which the interest rate resets and the ability to sell auction rate securities at par and at our discretion indicates that such securities should more appropriately be classified as short-term investments with the intent of meeting the Company’s short-term working capital requirements.

     Certain variable rate demand and pre-refunded securities have been reclassified from short-term investments to cash equivalents in prior periods. Like auction rate securities, variable rate demand and pre-refunded securities are issued and rated as long term bonds but, unlike auction rate securities, variable rate demand and pre-refunded securities are subject to a redemption requirement on the part of the issuer prior to the originally established maturity dates. For this reason, variable rate demand and pre-refunded securities with required redemption dates within 90 days of the date purchased are more appropriately classified as cash equivalents.

     Based upon our re-evaluation of these securities, we have reclassified as short-term investments any auction rate securities previously classified as cash equivalents in each of the accompanying consolidated balance sheets. We have also reclassified as cash equivalents any variable rate demand and pre-refunded securities previously classified as short-term investments. This resulted in a reclassification from short-term investments to cash and cash equivalents of $1.8 million on the September 30, 2004 balance sheet. In addition, purchases of short-term and long-term investments and sales of short-term investments included in the accompanying consolidated statements of cash flows have been revised to reflect the purchase and sale of

12

auction rate, variable rate demand and pre-refunded securities in the appropriate categories during the periods presented.

NOTE 16 — CONTINGENCIES

     A lawsuit was instituted in October 2002 against us and one of our subsidiaries, Catapult Communications International Limited, an Irish corporation, in the Antwerp Commercial Court, Antwerp, Belgium, by Tucana Telecom NV, a Belgian company. Tucana had been a distributor of products for Tekelec, the company from which NDB was acquired in August 2002. The writ alleges that the defendants improperly terminated an exclusive distribution agreement with Tucana following the acquisition of NDB and seeks damages of 12,461,000 euros ($16,161,917 as at March 31, 2005) plus legal costs. A trial date on the matter had been scheduled for January 16, 2004 but Tucana did not appear. On March 14, 2005, Tucana filed a further brief with the Belgian court. We are currently in process of submitting a response. We strongly believe that we properly terminated any contract we had with Tucana and that Tucana is not entitled to any damages in this matter. We intend to defend ourselves vigorously. We may be able to seek indemnification from Tekelec for any damages assessed against us in this matter under the terms of the Asset Purchase Agreement it entered into with Tekelec, although there is no assurance that such indemnification would be available.

     From time to time, we may be involved in other lawsuits, claims, investigations and proceedings, consisting of intellectual property, commercial, employment and other matters, which arise in the ordinary course of business. In accordance with SFAS No. 5, “Accounting for Contingencies,” we record a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Litigation is inherently unpredictable. However, we believe that we have valid defenses with respect to the legal matters pending against us, as well as adequate provisions for any probable and estimable losses. If an unfavorable ruling were to occur in any specific period, there exists the possibility of a material adverse impact on the results of operations of that period. We believe that, given our current liquidity and cash and investment balances, were we to receive an adverse judgment with respect to litigation that we are currently a party to, such a judgment would not have a material impact on liquidity.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     The following discussion and analysis should be read in conjunction with “Selected Consolidated Financial Data” and our Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K for the year ended September 30, 2004, filed on December 10, 2004.

Forward-looking Statements

     This report on Form 10-Q contains statements that are not historical facts but are forward-looking statements relating to such matters as anticipated financial performance and involve known and unknown risks, uncertainties and other factors that may cause our business or our industry’s actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by any forward-looking statements. Such statements include, in particular, statements about our plans, strategies, prospects, changes and trends in our business and the markets in which we operate as described in this prospectus, the documents incorporated herein by reference and any supplement to this prospectus. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,” “intend,” “believe,” “estimate,” “forecast,” “predict,” “propose,” “potential” or “continue” or the negative of those terms or other comparable terminology. These statements are only predictions.

     These forward-looking statements include but are not limited to those identified in this report with an asterisk (*) symbol. Actual results may differ materially from those discussed in such forward-looking statements, and you should carefully review the cautionary statements set forth in this report on Form 10-Q,

13

including those set forth under the caption “Risk Factors” and those set forth in our Annual Report on Form 10-K for the year ended September 30, 2004, filed on December 10, 2004.

          We may from time to time make additional written and oral forward-looking statements, including statements contained in our filings with the Securities and Exchange Commission and in our reports to stockholders. We do not undertake to update any forward-looking statements that may be made in this Form 10-Q or from time to time by us or on our behalf.

Overview

Our Business and Products

          Catapult Communications Corporation (“we”, “Catapult,” the “Company” or the “Registrant”) designs, develops, manufactures, markets and supports advanced software-based test systems offering integrated suites of testing applications for the global telecommunications industry.

          We offer a single line of software-based telecommunications test products operating on a common hardware platform range. This product line includes the DCT system, originally introduced in 1985 and since extensively enhanced; the MGTS system, acquired in 2002 in connection with the acquisition of NDB; and the Chameleon protocol analyzer, released in the fourth calendar quarter of 2004.

          Our products perform a variety of test and analysis functions, including design and feature verification, conformance testing, interoperability testing, load and stress testing, and monitoring and analysis. We maintain an extensive library of software modules that provide test support for a large number of industry standard protocols and variants thereon. Our emphasis is on testing complex, high-level and emerging protocols, including:

	•	Third and Fourth Generation Cellular (3G and 4G), including UMTS and cdma2000;
	•	General Packet Radio Service (GPRS);
	•	Global Systems for Mobile Communications (GSM);
	•	Code Division Multiple Access (CDMA);
	•	IP Telephony (Voice over IP or VoIP);
	•	Asynchronous Transfer Mode (ATM); and
	•	Signaling System #7 (SS7).

          Our extensive technical know-how and proprietary software development tools enable us to implement test support for new protocols and protocol variants rapidly in response to customer needs. With their extensive libraries of software protocol test modules, large selection of proprietary hardware physical interfaces and versatile range of hardware platforms, our products are easily configured to support a wide variety of digital testing functions, thereby reducing customers’ needs for multiple test systems. In addition, our test systems’ multi-protocol, multi-user capabilities allow multiple complex testing operations to be performed simultaneously, helping our customers to accelerate their product development cycles.

          Our products consist of advanced proprietary software running on third-party Sun Microsystems Solaris™ UNIX™-based workstations or Linux™-based computers together with our proprietary hardware interfaces. When acquiring a system, customers typically license one or more software modules and purchase hardware and ongoing software support. Customers may upgrade their systems by purchasing additional software protocol test modules and additional hardware interfaces to meet future testing needs. Prices for our products vary from approximately $30,000 to over $250,000 depending upon the overall system configuration, including the number and type of software protocol modules and the number of hardware interfaces required by the customer.

14

Conditions and Trends in Our Industry

     Over the course of our last fiscal year ended September 30, 2004, there was increasing evidence that the severe decline that the telecommunications industry had experienced in the previous two years had ended and that at least the beginnings of a recovery were in evidence. This improvement in market conditions resulted in increased purchasing of our products and services by our customers overseas, where third generation wireless deployment has begun. In North America, where third generation wireless deployment had yet to begin except in a few markets, our revenues were unchanged from the previous year.

     In the six months ended March 31, 2005, we saw continuing evidence of improving market conditions in our Europe and Rest of World regions, as well as evidence of improvement in the North American market. In Japan, revenues decreased by 21% in comparison with the same period in the previous year due to the loss in the latter period of fiscal year end budget surplus orders placed by our Japanese customers to a large Japanese OEM supplier to those customers. The resulting weak order input in Japan also resulted in a significant reduction in order backlog as at March 31, 2005 in comparison with a year earlier.

Summary of Our Financial Performance in the Second Quarter of Fiscal 2005

     Our financial performance in the three months ended March 31, 2005 improved over our performance in the same period in the previous year. Our revenues increased by 10% to $19.1 million and our net income increased by 20% to $5.4 million.

     Two major factors contributed to this improved financial performance:

	•	In North America, Europe and Rest of World, our revenues increased by 46%, 69% and 222%, respectively, all due primarily to the improvement in market conditions discussed above.
	•	Our overall gross profit margin improved by two percentage points due principally to a more favorable product mix.

     During the second quarter of fiscal 2005, our cash, cash equivalents and short-term investments increased by $7.7 million, of which $7.6 million was provided by operating activities. Capital expenditures in the second quarter of fiscal 2005 amounted to $0.3 million.

Critical Accounting Policies and Estimates

     There have been no material changes to our critical accounting policies and estimates as disclosed in our Annual Report on Form 10-K for the year ended September 30, 2004.

Results of Operations

     The following table sets forth, for the periods indicated, the percentage relationship of certain items from our condensed consolidated statements of income to total revenues.

15

Comparison of the Three-Month Periods Ended March 31, 2005 and 2004

     Revenues

     Our revenues increased by approximately 10% from $17.2 million for the three months ended March 31, 2004 to $19.1 million for the three months ended March 31, 2005. Over the same period, product revenues increased by approximately 8% from $13.9 million to $15.1 million. The increase in product revenues was attributable to increased sales of our DCT and MGTS test systems due to the improvement in market conditions discussed above. Services revenues increased approximately 19% from $3.3 million to $4.0 million due primarily to an increase in the number and value of DCT and MGTS system maintenance contracts.

     For the reasons discussed above under the heading “Conditions and Trends in Our Industry”, our revenues by geographic region varied as follows in the three months ended March 31, 2005 in comparison with the three months ended March 31, 2004:

	•	North American revenues increased by 46% from $2.7 million to $3.9 million;
	•	European revenues increased by 69% from $2.7 million to $4.6 million;
	•	Japanese revenues decreased by 25% from $11.2 million to $8.4 million; and
	•	Rest of World revenues increased by 222% from $0.7 million to $2.1 million.

16

     A 2% increase in the value of the Japanese yen, in which all our revenues in Japan are denominated, had the effect of increasing our revenues by $0.2 million. In Europe, because almost all customer orders are denominated in dollars, the 5% increase in the value of the Euro and the 3% increase in the value of the pound had no material quantifiable impact on our revenues. Nevertheless, because our European customers earn their revenues in Euros and pounds, the relative decrease in the value of the dollar against those currencies has made our dollar-denominated product prices more favorable to our European customers when expressed in their local currencies, and this may have resulted in increased purchases by these customers.

     Information on revenues from major customers is provided in Note 14 to the Unaudited Condensed Consolidated Financial Statements.

     Cost of Revenues

     Cost of product revenues consists of the costs of board assembly by independent contractors, purchased components, payroll and benefits for personnel in product testing, purchasing, shipping and inventory management, as well as supplies, media and freight. Cost of product revenues decreased approximately 9% from $1.6 million for the three months ended March 31, 2004 to $1.4 million for the three months ended March 31, 2005 and gross profit margin on product revenues increased from 89% to 91% due to a more favorable product mix and to economies of scale in our manufacturing operation. We expect our gross profit margin on product revenues to continue to fluctuate based on product mix and revenue levels.

     Cost of services revenues consists primarily of the costs of payroll and benefits for customer support, installation and training personnel. Cost of services revenues for the three months ended March 31, 2005 remained substantially unchanged at $0.9 million from the three months ended March 31, 2004 as an increase of 9%, or 2 employees, in the number of employees engaged in customer support was offset by a reduction of $0.2 million in variable compensation due to below target performance in the three months ended March 31, 2005 in contrast to above target performance in the three months ended March 31, 2004. Gross profit margin on services revenues increased from 73% to 79% as services revenues increased more than the cost of those revenues. We expect our gross profit margin on services revenues to continue to fluctuate based primarily on revenue levels.

     Amortization of purchased technology related to the NDB acquisition remained unchanged at $0.2 million in the three months ended March 31, 2005 compared with the same period the previous year.

     Gross profit margins did not vary significantly by geographic region.

     Research and Development

     Research and development expenses consist primarily of the costs of payroll and benefits for engineers, materials, equipment and consulting services. To date, because we release our products as soon as technological feasibility is established, all software development costs have been charged to research and development expenses as incurred. Research and development expenses increased by approximately 5% from $3.1 million for the three months ended March 31, 2004 to $3.2 million for the three months ended March 31, 2005 reflecting an increase of 5%, or 4 employees, in the number of employees engaged in research and development. As a percentage of total revenues, research and development expenses decreased from 18% to 17% over the same period. We expect research and development expenses in each of the remaining quarters of the current fiscal year to increase, primarily as a result of an anticipated increase in the number of engineering employees.*

     Sales and Marketing

     Sales and marketing expenses consist primarily of the costs of payroll, benefits, commissions and bonuses, occupancy costs, travel and promotional expenses, such as product brochure and trade show costs. Sales and marketing expenses increased by approximately 3% from $4.7 million for the three months ended March 31, 2004 to $4.8 million for the three months ended March 31, 2005, reflecting an increase of 8%, or 7 employees, in the number of sales and marketing personnel together with an increase of $0.2 million in

17

recruiting costs, partially offset by a decrease of $0.5 million in variable compensation due to below-target performance in the three months ended March 31, 2005 in contrast to above target performance in the three months ended March 31, 2004. As a percentage of total revenues, sales and marketing expenses decreased from 27% to 25% over the same period. We expect quarterly sales and marketing expenses to remain relatively constant over the remainder of the current fiscal year.*

     General and Administrative

     General and administrative expenses include costs associated with our general corporate and risk management, public reporting, employee recruitment and retention, regulatory compliance, investor relations and finance functions, as well as amortization of certain intangible assets acquired with NDB. General and administrative expenses increased approximately 14% from $1.8 million for the three months ended March 31, 2004 to $2.0 million for the three months ended March 31, 2005, reflecting primarily an increase of $0.3 million in legal and accounting expenses, largely due to increased regulatory compliance costs, partially offset by a reduction of $0.1 million in variable compensation. As a percentage of total revenues, general and administrative expenses increased from 10% to 11% over the same period. We expect general and administrative expenses in each of the remaining quarters of the current fiscal year to increase, primarily as a result of continuing costs of meeting the requirements of Section 404 of the Sarbanes-Oxley Act.*

     Provision for income taxes

     Our provision for income taxes consists of federal, state and foreign income taxes. We recorded a tax provision of $1.3 million, or 19% of pre-tax income, in the three months ended March 31, 2005, compared with a provision of $0.7 million, or 14% of pre-tax income, in the three months ended March 31, 2004. The increase in our tax rate was due to an increase in the projected relative share of our annual taxable income from our domestic operations versus our international operations. Our future tax rate will vary depending in part on the relative pre-tax contribution from our domestic and foreign operations.

Comparison of the Six-Month Periods Ended March 31, 2005 and 2004

     Revenues

     Our revenues increased by approximately 23% from $28.3 million for the six months ended March 31, 2004 to $34.9 million for the six months ended March 31, 2005. Over the same period, product revenues increased by approximately 23% from $22.4 million to $27.5 million. The increase in product revenues was attributable to increased sales of our DCT and MGTS test systems due to the improvement in market conditions discussed above. Services revenues increased approximately 25% from $5.9 million to $7.5 million. The increase in services revenues was due primarily to an increase in the number and value of DCT and MGTS system maintenance contracts.

     For the reasons discussed above under the heading “Conditions and Trends in Our Industry”, our revenues by geographic region varied as follows in the six months ended March 31, 2005 in comparison with the six months ended March 31, 2004:

	•	North American revenues increased by 51% from $6.9 million to $10.5 million;
	•	European revenues increased by 60% from $5.9 million to $9.5 million;
	•	Japanese revenues decreased by 21% from $14.7 million to $11.6 million; and
	•	Rest of World revenues increased by 357% from $0.7 million to $3.3 million.

     A 3% increase in the value of the Japanese yen, in which all our revenues in Japan are denominated, had the effect of increasing our revenues by $0.3 million. In Europe, because almost all customer orders are denominated in dollars, the 6% increase in the value of both the Euro and the pound had no material quantifiable impact on our revenues. Nevertheless, because our European customers earn their revenues in Euros and pounds, the relative decrease in the value of the dollar against those currencies has made our dollar-denominated product prices more favorable to our European customers when expressed in their local currencies, and this may have resulted in increased purchases by these customers.

18

     Information on revenues from major customers is provided in Note 14 to the Unaudited Condensed Consolidated Financial Statements.

     Cost of Revenues

     Cost of product revenues consists of the costs of board assembly by independent contractors, purchased components, payroll and benefits for personnel in product testing, purchasing, shipping and inventory management, as well as supplies, media and freight. Cost of product revenues increased approximately 4% from $2.6 million for the six months ended March 31, 2004 to $2.7 million for the six months ended March 31, 2005 and gross profit margin on product revenues increased from 89% to 90% due to a more favorable product mix and to economies of scale in our manufacturing operation.

     Cost of services revenues consists primarily of the costs of payroll and benefits for customer support, installation and training personnel. Cost of services revenues increased by approximately 3% from $1.6 million for the six months ended March 31, 2004 to $1.7 million for the six months ended March 31, 2005 due to an increase of 14%, or 3 employees, in the number of employees engaged in customer support, partially offset by a reduction of $0.1 million in variable compensation due to below target results in the six months ended March 31, 2005 in contrast to above target performance in the six months ended March 31, 2004. Gross profit margin on services revenues increased from 73% to 78% as services revenues increased more than the cost of those revenues.

     Amortization of purchased technology related to the NDB acquisition remained unchanged at $0.3 million in the six months ended March 31, 2005 compared with the same period the previous year.

     Gross profit margins did not vary significantly by geographic region.

     Research and Development

     Research and development expenses consist primarily of the costs of payroll and benefits for engineers, materials, equipment and consulting services. To date, because we release our products as soon as technological feasibility is established, all software development costs have been charged to research and development expenses as incurred. Research and development expenses increased by approximately 8% from $5.7 million for the six months ended March 31, 2004 to $6.2 million for the six months ended March 31, 2005 reflecting an increase of 1%, or 1 employee, in the number of employees engaged in research and development as well as an increase of $0.1 million in new product development and testing costs. As a percentage of total revenues, research and development expenses decreased from 20% to 18% over the same period.

     Sales and Marketing

     Sales and marketing expenses consist primarily of the costs of payroll, benefits, commissions and bonuses, occupancy costs, travel and promotional expenses, such as product brochure and trade show costs. Sales and marketing expenses increased by approximately 10% from $8.6 million for the six months ended March 31, 2004 to $9.5 million for the six months ended March 31, 2005, reflecting an increase of 6%, or 6 employees, in the number of sales and marketing personnel, an increase of $0.2 million in recruiting costs and an exchange rate driven increase of $0.2 million due to average increases of 3% in the Japanese yen and 6% in both the British pound and the Euro against the dollar. These increases were partially offset by a decrease of $0.2 million in variable compensation due to below-target performance in the six months ended March 31, 2005 in contrast to above target performance in the six months ended March 31, 2004. As a percentage of total revenues, sales and marketing expenses decreased from 30% to 27% over the same period.

     General and Administrative

     General and administrative expenses include costs associated with our general corporate and risk management, public reporting, employee recruitment and retention, regulatory compliance, investor relations and finance functions, as well as amortization of certain intangible assets acquired with NDB. General and

19

administrative expenses increased approximately 14% from $3.5 million for the six months ended March 31, 2004 to $3.9 million for the six months ended March 31, 2005, reflecting primarily an increase of $0.4 million in legal and accounting expenses, largely due to increased regulatory compliance costs, partially offset by a reduction of $0.1 million in variable compensation. As a percentage of total revenues, general and administrative expenses decreased from 12% to 11% over the same period.

     Provision for income taxes

     Our provision for income taxes consists of federal, state and foreign income taxes. We recorded a tax provision of $1.7 million, or 16% of pre-tax income, in the six months ended March 31, 2005, compared with a provision of $0.9 million, or 14% of pre-tax income, in the six months ended March 31, 2004. The increase in our tax rate was due to an increase in the projected relative share of our annual taxable income from our domestic operations versus our international operations. Our future tax rate will vary depending in part on the relative pre-tax contribution from our domestic and foreign operations.

Liquidity and Capital Resources

     We have financed our operations primarily through cash generated from operations, from the proceeds of our initial public offering completed in early 1999 and from the proceeds of a second public offering completed in September 2004. The proceeds to us from the 1999 and 2004 offerings, net of underwriter fees and offering costs, were approximately $19.2 million and $3.0 million, respectively.

     Our purchase of NDB was additionally financed through the issuance of two convertible notes in the aggregate principal amount of $17.3 million. The convertible notes were issued by our Irish subsidiary and were guaranteed by us. These notes were converted by Tekelec into 1,081,250 shares of our common stock in September 2004.

     Our operating activities provided cash of $10.5 million and $6.2 million in the six months ended March 31, 2005 and 2004, respectively. In each of these periods, net income was the primary component of cash flows from operating activities, providing $9.2 million and $5.4 million in the six months ended March 31, 2005 and 2004, respectively. Cash generated by net income was increased by adjustments for non-cash depreciation and amortization charges totaling $1.4 million and $1.2 million in the six months ended March 31, 2005 and 2004, respectively. Finally, our cash flows from operations are affected by changes in current assets and liabilities. These changes in non-cash working capital components decreased cash flow from operations by $0.3 million and $0.5 million in the six months ended March 31, 2005 and 2004, respectively.

     Our primary source of operating cash flow is the collection of accounts receivable from our customers. We measure the effectiveness of our collection efforts by an analysis of average accounts receivable days outstanding (“days outstanding”). We calculate our days outstanding by dividing our accounts receivable balance net of allowances at the end of a period by the revenues for that period and multiplying the result by the number of days in the period. Our days outstanding decreased from 68 days at March 31, 2004 to 60 days at March 31, 2005 primarily due to stronger invoicing early in the quarter in the latter period, due in turn to an uncharacteristically high level of backlog as of December 31, 2004. Collections of accounts receivable and related days outstanding will fluctuate in future periods due to the timing and amount of our future revenues, payment terms extended to our customers and the effectiveness of our collection efforts.

     Investing activities have consisted of two components: purchases of property and equipment, and purchases and sales of short-term investments. Purchases of property and equipment increased from $0.3 million in the six months ended March 31, 2004 to $0.5 million in the six months ended March 31, 2005. We expect that purchases of property and equipment for the full fiscal year ending September 30, 2005 will total approximately $1.2 million.* We invest cash that is surplus to our operating requirements in professionally managed investment portfolios. Those portfolios consist of both cash equivalents and short-term investments, and the mix between these elements may vary from period to period due to changes in the investment approaches of the portfolio managers. Purchases and sales of short-term investments used cash of $6.4 million and $5.9 million in the three months ended March 31, 2005 and 2004, respectively.

20

     Financing activities provided cash of $1.9 million and $1.4 million in the six months ended March 31, 2005 and 2004, respectively, from the exercise of stock options and the sale of shares under our employee stock purchase plan.

     As of March 31, 2005, we had working capital of $67.9 million and cash, cash equivalents and short-term investments of $64.7 million. As of March 31, 2005, we had the following contractual obligations, in millions:

     We believe that inflation has not had a material impact on our liquidity or cash requirements.

     We may require additional funds to support our working capital requirements or for other purposes. There can be no assurance that additional financing will be available or that, if available, such financing will be obtainable on terms favorable to us or our stockholders. We believe that cash, cash equivalents and short-term investments together with funds generated from operations will provide us with sufficient funds to finance our requirements for at least the next 12 months.*

Recent Accounting Pronouncements

     See Note 2 of the Notes to our Unaudited Condensed Consolidated Financial Statements for information on recent accounting pronouncements.

Risk Factors

     The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also impair our business operations.

Risks Related to Our Business

Our quarterly operating results may fluctuate significantly, and this may result in volatility in the market price of our common stock.

     We have experienced, and anticipate that we will continue to experience, significant fluctuations in quarterly revenues and operating results. Our revenues and operating results are relatively difficult to forecast for a number of reasons, including:

	•	the variable size and timing of individual purchases by our customers;
	•	seasonal factors that may affect capital spending by customers, such as the varying fiscal year ends of customers and the reduction in business during the summer months, particularly in Europe;
	•	the relatively long sales cycles for our products;
	•	competitive conditions in our markets;
	•	exchange rate fluctuations;
	•	the timing of the introduction and market acceptance of new products or product enhancements by us and by our customers, competitors and suppliers;
	•	costs associated with developing and introducing new products;
	•	product life cycles;
	•	changes in the level of operating expenses relative to revenues;
	•	product defects and other quality problems;
	•	customer order deferrals in anticipation of new products;
	•	supply interruptions;
	•	changes in global or regional economic conditions or in the telecommunications industry;
	•	delays in purchasing decisions or customer orders due to customer consolidation;

21

	•	the ability to hire sales and technical personnel;
	•	changes in the mix of products sold; and
	•	changes in the regulatory environment.

     Our revenues in any period generally have been, and may continue to be, derived from relatively small numbers of sales and service transactions with relatively high average revenues per order. Therefore, the loss of any orders or delays in closing such transactions could have a more significant impact on our quarterly revenues and results of operations than on those of companies with relatively high volumes of sales or low revenues per order. Our products generally are shipped within 15 to 45 days after orders are received. As a result, we generally do not have a significant backlog of orders, and revenues in any quarter are substantially dependent on orders booked, shipped and installed in that quarter.

     Most of our costs, including personnel and facilities costs, are relatively fixed, and our operating expenses are based on anticipated revenue. As a result, a decline in revenue from even a limited number of transactions, failure to achieve expected revenue in any quarter or unanticipated variations in the timing of recognition of specific revenues can cause significant variations in our quarterly operating results and could result in losses. We believe, therefore, that period-to-period comparisons of our operating results should not be relied upon as an indication of future performance.

     Due to the factors described above, as well as other unanticipated factors, it is possible that in some future quarter our results of operations could fail to meet the expectations of public market analysts or investors. If this occurs, the price of our common stock may fall.

Historically, our revenues have been dependent upon a few significant customers, the loss of one or more of which could significantly reduce our revenues.

     Our customer base is highly concentrated, and a relatively small number of companies have accounted for substantially all of our revenues to date. In our fiscal year ended September 30, 2004, the top five customers represented approximately 55% of total revenues. In the three months ended March 31, 2005, the top five customers represented approximately 63% of revenues. We typically see a higher level of customer concentration in a three month period than in a full fiscal year. We expect that we will continue to depend upon a relatively limited number of customers for substantially all of our revenues in future periods, although no customer is presently obligated either to purchase a specific amount of products or to provide us with binding forecasts of purchases for any period. If we were to lose a significant customer or if a significant customer were to reduce, delay or cancel its orders, our operating results could be seriously harmed.

Our business is dependent on our customers outsourcing their telecommunications testing needs, and our business could be harmed if the market for outsourced testing solutions declines or fails to grow.

     Our success will depend on continued growth in the market for telecommunications test systems and services and the continued commercial acceptance of our products as a solution to address the testing requirements of telecommunications equipment manufacturers and network operators. While most of our present and potential customers have the technical capability and financial resources to produce their own test systems and perform test services internally, to date, many have chosen to outsource a substantial proportion of their test system and service requirements. Our customers may not continue, and potential new customers may not choose, to outsource any of their test systems and service requirements. If the market for telecommunications test systems and services, or the demand for outsourcing, declines or fails to grow, or if our products and services are not widely adopted as a telecommunications test solution, our business, financial condition and operating results could be seriously harmed.

If we do not effectively manage our growth, our business and operating results could be adversely affected.

     Our growth has placed, and is expected to continue to place, significant demands on our management, administrative and operational resources. To manage expansion effectively, we need to continue to develop and improve our operational and financial systems, sales and marketing capabilities and expand, train, retain, manage and motivate our employee base. Our systems, procedures or controls may not be adequate to support our operations and our management may not be able to successfully exploit future market opportunities or successfully manage our relationships with customers and other third parties. We may not continue to grow

22

and, if we do, we may not effectively manage such growth. Any failure to manage growth could have an adverse effect on our business, financial condition and results of operations.

We face foreign business, political and economic risks because a significant portion of our sales is to customers outside the United States.

     We derive a significant percentage of our revenues from customers outside of North America, and we maintain operations in seven other countries. International sales and operations are subject to inherent risks, including:

	•	longer customer payment cycles;
	•	greater difficulty in accounts receivable collection;
	•	difficulties in staffing and managing foreign operations;
	•	changes in regulatory requirements or in economic or trade policy;
	•	costs related to localizing products for foreign countries;
	•	potentially weaker protection for intellectual property in certain foreign countries;
	•	the burden of complying with a wide variety of foreign laws and practices, tariffs and other trade barriers; and
	•	potentially adverse tax consequences, including restrictions on repatriation of earnings.

     During the last three fiscal years, a significant portion of our international sales has been to customers in Japan. If economic conditions in Japan deteriorate, our business, financial condition and results of operations could be materially adversely affected. An inability to obtain necessary regulatory approvals in foreign markets on a timely basis could also have an adverse effect on our business, financial condition and results of operations.

     A significant portion of our sales, including all our sales in Japan, is denominated in local currencies. Although we currently engage in hedging transactions with respect to receivables resulting from some inter-company sales, we may not continue to do so and our hedging activities may not be successful. Fluctuations in foreign currency exchange rates may contribute to fluctuations in our operating results. For example, changes in foreign currency exchange rates could adversely affect the revenues, net income, earnings per share and cash flow of our operations in affected markets. Similarly, such fluctuations may cause us to raise prices, which could affect demand for our products and services. In addition, if exchange or price controls or other restrictions are imposed in countries in which we do business, our business, financial condition and operating results could be seriously harmed.

We may not be able to achieve the anticipated benefits of any acquisitions we may make of other companies, products or technologies.

     As part of our business strategy, we acquired Tekelec’s Network Diagnostics Business in 2002, and we may make further acquisitions of, or significant investments in, companies, products or technologies that we believe are complementary. Any such transactions would be accompanied by the risks commonly encountered in making acquisitions of companies, products and technologies. Such risks include, among others:

	•	difficulties associated with assimilating the personnel and operations of acquired companies;
	•	potential disruption of our ongoing business;
	•	distraction of management and other resources;
	•	integration of personnel and technology of an acquired company;
	•	difficulties in evaluating the technology of a potential target;
	•	inability to motivate and retain new personnel;
	•	maintenance of uniform standards, controls, procedures and policies; and
	•	impairment of relationships with employees and clients as a result of the integration of new management personnel.

     We have limited experience in assimilating acquired companies or product lines into our operations. We may not be successful in overcoming these risks or any other problems encountered in connection with any such future acquisitions. Furthermore, any future acquisitions could result in the issuance of dilutive equity securities, the incurrence of debt or contingent liabilities or amortization expenses related to goodwill and other intangible assets, any of which could seriously harm our business, financial condition and operating results or decrease the value of our common stock.

23

We face intense competition in our markets from more established test solutions providers, and if we are unable to compete successfully we may not be able to maintain or grow our business.

     The market for our products is highly competitive. A number of our competitors are better known and have substantially greater financial, technological, production and marketing resources than we do. While we believe that the price/performance characteristics of our products are competitive, competition in the markets for our products could force us to reduce prices. Any material reduction in the price of our products without corresponding decreases in manufacturing costs and increases in unit volume would negatively affect our gross margins. Increased competition for our products that results in lower product sales could also adversely impact our upgrade sales. Our ability to maintain our competitive position will depend upon, among other factors, our success in anticipating industry trends, investing in product research and development, developing new products with improved price/performance characteristics and effectively managing the introduction of new products into targeted markets.

We have experienced delays in completing our new Chameleon product, which could result in lost sales opportunities and lower financial results.

     Due to a six month delay associated with development and testing, Chameleon was not commercially released and made available for beta testing until technological feasibility was established in the fourth calendar quarter of 2004. This delay may have caused us to miss a portion of the market window for Chameleon as we believe that mobile telecommunications operators may have made or may make many of their key 3G maintenance procurement decisions before Chameleon is evaluated.

Our success depends on the continued growth of the telecommunications industry and increased use of our test solutions, and lack of growth in this industry could harm our business.

     Our future success is dependent upon the continued growth of the telecommunications industry. The global telecommunications industry is evolving rapidly, and it is difficult to predict its potential growth rate or future trends in technology development. The deregulation, privatization and economic globalization of the worldwide telecommunications market that have resulted in increased competition and escalating demand for new technologies and services may not continue in a manner favorable to us or our business strategies. In addition, the growth in demand for Internet services and the resulting need for high speed or enhanced telecommunications equipment may not continue at its current rate or at all.

     Our future success depends upon the increased utilization of our test solutions by network operators and telecommunications equipment manufacturers. Industry-wide network equipment and infrastructure development driving the demand for our products and services may be delayed or prevented by a variety of factors, including cost, regulatory obstacles or the lack of or reduction in consumer demand for advanced telecommunications products and services. Telecommunications equipment manufacturers and network operators may not develop new technology or enhance current technology. Further, any such new technology or enhancements may not lead to greater demand for our products or services.

Our business could be harmed if we were to lose the services of one or more members of our senior management team, or if we are unable to attract and retain qualified personnel.

     Our future growth and success depends to a significant extent upon the continuing services of our executive officers and other key employees. We do not have long-term employment agreements or non-competition agreements with any of our employees. Competition for qualified management and other high-level telecommunications industry personnel is intense, and we may not be successful in attracting and retaining qualified personnel. If we lose the services of any key employees, we may not be able to manage our business successfully or achieve our business objectives.

     Our success also depends on our ability to identify, attract and retain qualified technical, sales, finance and management personnel. We have experienced, and may continue to experience, difficulty in hiring and retaining candidates with appropriate qualifications. If we do not succeed in hiring and retaining candidates with appropriate qualifications, our revenues and product development efforts could be harmed.

24

Our ability to deliver products that meet customer demand is dependent on our ability to meet new and changing requirements for telecommunications test systems and services.

     The market for telecommunications test systems and services is subject to rapid technological change, evolving industry standards, rapid changes in customer requirements and frequent product and service introductions and enhancements.

     Our future success will depend in part on our ability to anticipate and respond to these changes by enhancing our existing products and services and by developing and introducing, on a timely and cost-effective basis, new products, features and services that address the needs of our customer base. We may not be successful in identifying, developing and marketing new products, product enhancements and related services that respond to technological change or evolving industry standards or that adequately meet new market demands. In addition, because of the rapid technological change characteristic of the telecommunications industry, we may be required to support legacy systems used by our customers. As a result, this may place additional demands on our personnel and other resources and may require us to maintain an inventory of otherwise obsolete components.

     Our test systems currently operate only on Sun Microsystems’s Solaris™ and the Linux™ operating systems. Our current and prospective customers may require other operating systems, such as Windows 2000™ or Windows XP™, to be used in their telecommunications test systems or may require the integration of other industry standards. We may not be able to successfully adapt our products to such operating systems on a timely or cost-effective basis, if at all. Our failure to respond to rapidly changing technologies and to develop and introduce new products and services in a timely manner could adversely affect our operations and overall profitability.

     Our success will depend in part on whether a large number of telecommunications equipment manufacturers and network operators purchase our products and services. Because the telecommunications market is rapidly evolving, it is difficult to predict the future success of products and services in this market. The customers in this market use products from a number of competing suppliers for various testing purposes, and there has not been broad adoption of the products of one company. Our current or future products or services may not achieve widespread acceptance among telecommunications equipment manufacturers, network operators or other potential customers. In addition, our competitors may develop solutions that could render our products obsolete or uncompetitive. In the event the telecommunications industry does not broadly adopt our products or services or does so less rapidly than we expect, or in the event our products are rendered obsolete or uncompetitive by more advanced solutions, our business, financial condition and operating results could be seriously harmed.

Many of our suppliers are sole source or single source suppliers, and our inability to obtain adequate amounts of components from these suppliers could harm our business.

     We purchase many key components, including certain microprocessors, workstations, bus interface and other chips, connectors and other hardware, from the sole supplier of a particular component. For other components, even though multiple vendors may exist, we may purchase components from only a single source. We do not have any long-term supply agreements with these vendors to ensure uninterrupted supply of these components. If our supply of a key component is reduced or interrupted, we might require a significant amount of time to qualify alternative suppliers and receive an adequate flow of replacement components. We may also need to reconfigure our products to adapt to new components, which could entail substantial time and expense. In addition, the process of manufacturing certain of these components is extremely complex, and our reliance on the suppliers of these components exposes us to potential production difficulties and quality variations. These could negatively affect cost and timely delivery of our products. We have in the past experienced supply problems as a result of the financial or operational difficulties of our suppliers, shortages and discontinuations resulting from component obsolescence. Although to date we have not experienced material delays in product deliveries to our customers resulting from supply problems, such problems may recur or, if such problems do recur, we may not find satisfactory solutions. If we are unable to obtain adequate amounts of fully functional components or are otherwise required to seek alternative sources of supply, our relationship with our customers and our results of operations could be harmed.

25

We depend on a limited number of independent manufacturers, which reduces our ability to control our manufacturing process.

     We rely on a limited number of independent manufacturers, some of which are small, privately held companies, to provide certain assembly services to our specifications. We do not have any long-term supply agreements with any third-party manufacturer. If our assembly services are reduced or interrupted, our business, financial condition and results of operations could be adversely affected until we are able to establish sufficient assembly services supply from alternative sources. Alternative manufacturing sources may not be able to meet our future requirements, and existing or alternative sources may not continue to be available to us at favorable prices.

The high level of complexity and integration of our products increases the risk of latent defects, which could damage customer relationships and increase our costs.

     Our complex products may contain undetected errors or “bugs”, particularly when first introduced or when new versions are released. Errors may be found in future releases of our software. In addition, any such errors may generate adverse publicity, impair the market acceptance of these products, create customer concerns or adversely affect operating results due to product returns, the costs of generating corrective releases or otherwise.

We face exposure to product liability claims, which if successful could harm our business.

     Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. However, it is possible that the limitation of liability provisions contained in our license agreements may not be effective under the laws of certain jurisdictions, particularly since we sell a majority of our products internationally. Although we have not experienced any product liability claims to date, our sale and support of products may entail the risk of such claims. We may be subject to such claims in the future. A successful product liability claim brought against us could have a material adverse effect upon our business, financial condition and results of operations. If we fail to maintain adequate product liability insurance and if we were to lose a large uninsured claim, then such a loss could significantly harm our business, financial condition and operating results.

Our success is dependent on our ability to protect our intellectual property, and our failure to protect our intellectual property could have a significant adverse impact on our business.

     Our success and ability to compete effectively are dependent in part upon our proprietary technology. We rely on a combination of trademark, copyright and trade secret laws, as well as nondisclosure agreements and other contractual restrictions, to establish and protect our proprietary rights. To date, we have generally not sought patent protection for our proprietary technology. Patent protection may become more significant in our industry in the future. Likewise, the measures we undertake may not be adequate to protect our proprietary technology. To date, we have federally registered certain of our trademarks or copyrights. Our practice is to affix copyright notices on software, hardware and product literature in order to assert copyright protection for these works. The lack of federal registration of all of our trademarks and copyrights may have an adverse effect on our intellectual property rights in the future. Additionally, we may be subject to further risks as we enter into transactions in countries where intellectual property laws are unavailable, do not provide adequate protection or are difficult to enforce. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to duplicate aspects of our products or to obtain and use information that we regard as proprietary. Our steps to protect our proprietary technology may not be adequate to prevent misappropriation of such technology, and may not preclude competitors from independently developing products with functionality or features similar to our products. If we fail to protect our proprietary technology, our business, financial condition and results of operations could be harmed significantly.

We could become subject to litigation regarding intellectual property, which could divert management attention, be costly to defend and prevent us from using or selling the challenged technology.

     The telecommunications industry is characterized by a relatively high level of litigation based on allegations of infringement of proprietary rights. While to date we have not been subject to claims of infringement or misappropriation of intellectual property by third parties, third parties may assert infringement claims against us. In addition, an assertion of infringement may result in litigation in which we may not prevail. Furthermore, any such claims, with or without merit, could result in substantial cost to us and diversion of our personnel. In addition, infringement claims may require us to develop new technology or

26

require us to enter into royalty or licensing arrangements. These royalty or licensing agreements, if required, may not be available on terms acceptable to us. Because we do not rely on patents to protect our technology, we will not be able to offer a license for patented technology in connection with any settlement of patent infringement lawsuits. If a claim of infringement or misappropriation against us were successful and we fail or are unable to develop non-infringing technology or license any infringed, misappropriated or similar technology at a reasonable cost, our business, financial condition and results of operations would be adversely affected. In addition, we indemnify our customers against claimed infringement of patents, trademarks, copyrights and other proprietary rights of third parties. Any requirement for us to indemnify a customer may significantly harm our business, financial condition and operating results.

Our success depends on the timely development and introduction of new products.

     Our future success will depend in part on our ability to anticipate and respond to changing industry standards and customer requirements by enhancing our existing products and services. We may need to develop and introduce, on a timely and cost-effective basis, new products, features and services that address the needs of our customer base. We may not be successful in identifying, developing and marketing new products, product enhancements and related services that respond to technological change or evolving industry standards or that adequately meet new market demands.

Risks Related to Our Stock

Our stock has been and will likely continue to be subject to substantial price and volume fluctuations due to a number of factors, many of which will be beyond our control.

     In recent years, the stock market in general and the market for technology stocks in particular, including our common stock, have experienced extreme price fluctuations. The market price of our common stock may be significantly affected by various factors such as:

	•	quarterly variations in our operating results;
	•	changes in our revenue growth rates as a whole or for specific geographic areas or products;
	•	changes in earning estimates by market analysts;
	•	changes in the extent to which a significant percentage of our shares are held by a small number of investors;
	•	the announcements of new products or product enhancements by us or our competitors;
	•	speculation in the press or analyst community; and
	•	general market conditions or market conditions specific to particular industries.

The market price of our common stock may experience significant fluctuations in the future.

The requirement to record an expense for our stock-based compensation plans, and the resultant ongoing accounting charges, will significantly reduce our reported net income and net income per share, and the price of our stock could drop significantly.

     In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement Number 123 (revised 2004), “SFAS 123(R)”, Share-Based Payment, which requires all companies to measure compensation expense for all share-based payments (including employee stock options) at fair value, and will be effective for public companies for annual reporting periods that begin after June 15, 2005. Our future adoption of SFAS 123(R) will require us to record an expense for stock-based compensation plans commencing in the first quarter of our 2006 fiscal year and will result in ongoing accounting charges that will significantly reduce our net income. See Notes 2 and 3 of the Notes to our Unaudited Condensed Consolidated Financial Statements for further information.

If we are unable to determine and demonstrate that we maintain effective controls over internal financial reporting, this may cause investors to lose confidence in our reported financial information and the price of our stock could drop significantly.

     Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our Annual Report on Form 10-K for our fiscal year ending September 30, 2005, we will be required to include in our Annual Report on Form 10-K an assessment of the effectiveness of our internal controls over financial reporting together with a report from our independent registered public accounting firm on our assessment and the effectiveness of our controls over financial reporting. In the course of preparing our assessment, we may identify deficiencies, which we may not be able to remediate in time to meet the deadline for compliance with the requirements of Section 404. In addition, if we fail to achieve and maintain the adequacy of our internal controls, as such

27

standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting. Moreover, effective internal controls are necessary for us to produce reliable financial reports and are important in helping prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly.

Sales of substantial amounts of our common stock by our major stockholders and others could adversely affect the market price of our common stock.

     Sales of substantial numbers of shares of common stock by our major stockholders in the public market could harm the market price for our common stock. As of March 31, 2005, Richard A. Karp, our Chief Executive Officer and Chairman of our Board, beneficially owned 2,958,894 shares, and Nancy H. Karp, one of our directors, beneficially owned 1,356,395 shares of our common stock. These shares are eligible for resale into the public market within the restrictions imposed by Rule 144 under the Securities Act of 1933. Sales of a significant amount of these shares could adversely affect the market price for our common stock.

Our principal stockholder could prevent or delay a change in control.

     As of March 31, 2005, Dr. Karp beneficially owned 2,958,894 shares or approximately 20% of our common stock outstanding. Such a concentration of ownership and voting power may have the effect of delaying or preventing a change in the control of our company.

Provisions in our charter documents and Nevada law could prevent or delay a change in the control of our company and may reduce the market price of our common stock.

     Nevada law, our articles of incorporation and our bylaws contain provisions that could discourage a proxy contest or make more difficult the acquisition of a substantial block of our common stock. In addition, our board of directors is authorized to issue, without stockholder approval, up to 5,000,000 shares of preferred stock with voting, conversion and other rights and preferences that may be superior to those of the common stock and that could adversely affect the voting power or other rights of the holders of common stock. The issuance of preferred stock or rights to purchase preferred stock could be used to discourage an unsolicited acquisition proposal.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Exchange Risk and Derivative Financial Instruments

     Our foreign subsidiaries operate and sell our products in various global markets. As a result, we are exposed to changes in exchange rates on foreign currency denominated transactions with foreign subsidiaries. We use foreign currency forward exchange contracts, and we infrequently use options, to mitigate the risk of future movements in foreign exchange rates that affect certain foreign currency denominated inter-company receivables or expected revenues. The forward contracts and options are not designated as accounting hedges. We attempt to match the forward contracts with the underlying receivables in terms of currency, amount and maturity, and to match the options with expected foreign currency revenue in terms of currency, amount and recognition period. We do not use derivative financial instruments for speculative or trading purposes. Because the impact of movements in currency exchange rates on forward contracts and options generally offsets the related impact on the exposures economically hedged, these derivative financial instruments do not subject us to speculative risk that would otherwise result from changes in currency exchange rates. Gains and losses on forward exchange contracts generally offset the foreign exchange transaction gains or losses from revaluation of foreign currency denominated amounts receivable. Gains on options generally offset the opportunity cost of foreign currency revenue recognized at an exchange rate less favorable than the option rate. To date, we have not fully mitigated all risk associated with our revenues and resulting accounts receivable denominated in foreign currencies, and there can be no assurance that our mitigation activities, if any, will be successful.

     At March 31, 2005, we had no forward exchange contracts or options maturing in fiscal 2005.

28

Interest Rate Risk

     Our exposure to market risk for changes in interest rates relates primarily to our short-term investment portfolio. As of March 31, 2005, short-term investments consisted of available-for-sale securities of $38.9 million. These fixed income marketable securities included corporate and municipal bonds and government securities, all of which are of high investment grade. They are subject to interest rate risk and will decline in value if the market interest rates increase. If the market interest rates were to increase immediately and uniformly by 10% from levels as of March 31, 2005, the decline in the fair value of the portfolio would not be material to our financial position.

Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures.

     Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal control over financial reporting.

     There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II. Other Information

Item 1. Legal Proceedings

              A lawsuit was instituted in October 2002 against us and one of our subsidiaries, Catapult Communications International Limited, an Irish corporation, in the Antwerp Commercial Court, Antwerp, Belgium, by Tucana Telecom NV, a Belgian company. Tucana had been a distributor of products for Tekelec, the company from which NDB was acquired in August 2002. The writ alleges that the defendants improperly terminated an exclusive distribution agreement with Tucana following the acquisition of NDB and seeks damages of 12,461,000 euros ($16,161,917 as at March 31, 2005) plus legal costs. A trial date on the matter had been scheduled for January 16, 2004 but Tucana did not appear. On March 14, 2005, Tucana filed a further brief with the Belgian court. We are currently in process of submitting a response. We strongly believe that we properly terminated any contract we had with Tucana and that Tucana is not entitled to any damages in this matter. We intend to defend ourselves vigorously. We may be able to seek indemnification from Tekelec for any damages assessed against us in this matter under the terms of the Asset Purchase Agreement it entered into with Tekelec, although there is no assurance that such indemnification would be available.

Item 4. Submission of Matters to a Vote of Security Holders

     We held our Annual Meeting of Stockholders on January 25, 2005. Out of 14,616,050 shares of Common Stock entitled to vote at such meeting, there were present in person or by proxy 13,357,049 shares. At the Annual Meeting, our stockholders approved the following matters:

29

(a) The election of Peter S. Cross, Richard A. Karp, Nancy H. Karp, Henry P. Massey, Jr., John M. Scandalios and Charles L. Waggoner, as directors of Catapult Communications Corporation for the ensuing year and until their successors are elected. The vote for the nominated directors was as follows:

(b) The ratification of the appointment of PricewaterhouseCoopers LLP as our independent registered public accounting firm for the fiscal year ending September 30, 2005.

Item 6. Exhibits.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, we have duly caused this report to be signed on our behalf by the undersigned thereunto duly authorized.

30

EXHIBIT INDEX