UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

	ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2003

OR

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

For the transition period from ________________ to ________________.

Commission File No.: 000-20698

BROOKTROUT, INC.

(Exact Name of Registrant as Specified in Its Charter)

MASSACHUSETTS		04-2814792
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

250 FIRST AVENUE, NEEDHAM, MASSACHUSETTS 02494
(Address of Principal Executive Offices) (Zip Code)

Registrant’s Telephone Number, Including Area Code: (781) 449-4100

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

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

As of October 31, 2003, 12,451,328 shares of common stock, $.01 par value per share, were outstanding.

BROOKTROUT, INC.
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2003

TABLE OF CONTENTS

		Page
PART I FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements	1
	Unaudited Condensed Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002	1
	Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2003 and September 30, 2002	2
	Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2003 and September 30, 2002	3
	Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2003 and September 30, 2002	4
	Notes to Unaudited Condensed Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
	Overview	11
	Application of Critical Accounting Policies	11
	Discontinued Operations	13
	Results of Operations	14
	Liquidity and Capital Resources	18
	Recent Accounting Pronouncements	19
	Factors That May Affect Future Results	20
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	26
Item 4.	Controls and Procedures	27


PART II OTHER INFORMATION
Item 6.	Exhibits and Reports on Form 8-K	28
	Signatures	29
	Exhibit Index	30

“BROOKTROUT,” the “NEW NETWORK,” and the “PARTNER ACCESS NETWORK PROGRAM” are trademarks or registered trademarks of Brooktrout, Inc.

PART I FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

BROOKTROUT, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)

	September 30, 2003			December 31, 2002
Assets
Current assets:
Cash and cash equivalents	$	14,845		$	23,685
Marketable debt securities, available for sale	35,027			18,103
Accounts receivable (less allowance for doubtful accounts and sales returns of $1,203 at September 30, 2003 and $1,679 at December 31, 2002)	9,284			8,853
Inventory	4,492			6,797
Income tax receivable	201			6,236
Deferred tax assets	4,436			3,856
Prepaid expenses	913			1,137

Total current assets	69,198			68,667

Equipment and furniture, net	2,463			3,404
Deferred tax assets	9,341			9,341
Intangible assets, net	6,263			7,412
Other assets	1,002			1,511

Total assets	$	88,267		$	90,335

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	4,034		$	5,715
Accrued expenses	6,127			5,104
Accrued compensation and commissions	2,027			2,141
Accrued warranty costs	1,095			1,060
Customer deposits	866			883
Net liabilities related to discontinued operations	59			125

Total current liabilities	14,208			15,028

Deferred rent	159			209

Total liabilities	14,367			15,237

Commitments and contingencies (Note 8)

Stockholders’ equity:
Preferred stock, $1.00 par value; authorized 100,000 shares; issued and outstanding, none	—			—
Common stock, $0.01 par value; authorized 40,000,000 shares; issued 12,593,212 at September 30, 2003 and 12,532,810 at December 31, 2002	126			125
Additional paid-in capital	64,399			64,170
Accumulated other comprehensive loss	(26		)	(64		)
Notes receivable — officers	(11,741		)	(11,760		)
Retained earnings	24,939			26,387
Treasury stock, 260,386 shares at September 30, 2003 and 255,384 shares at December 31, 2002, at cost	(3,797		)	(3,760		)

Total stockholders’ equity	73,900			75,098

Total liabilities and stockholders’ equity	$	88,267		$	90,335

See notes to unaudited condensed consolidated financial statements.

BROOKTROUT, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

	Three Months Ended September 30,					Nine Months Ended September 30,
	2003		2002			2003			2002
Revenue	$	19,446	$	18,510		$	52,370		$	55,730

Costs and expenses:
Cost of product sold	6,680		8,223			19,280			25,753
Research and development	4,455		4,576			13,868			15,703
Selling, general and administrative	7,503		6,937			22,337			21,952

Total costs and expenses	18,638		19,736			55,485			63,408

Operating income (loss)	808		(1,226		)	(3,115		)	(7,678		)

Other income (expense), net:
Gain on sale of investment	499		—			499			—
Interest income, net and other	172		175			617			765
Total other income (expense), net	671		175			1,116			765

Income (loss) before income taxes	1,479		(1,051		)	(1,999		)	(6,913		)

Income tax provision (benefit)	562		(422		)	(551		)	(2,884		)

Income (loss) from continuing operations	917		(629		)	(1,448		)	(4,029		)

Gain on disposal of discontinued operations, net of income tax	—		147			—			227

Net income (loss)	$	917	$	(482	)	$	(1,448	)	$	(3,802	)

Income (loss) from continuing operations per common share:
Basic	$	0.07	$	(0.05	)	$	(0.12	)	$	(0.33	)
Diluted	0.07		(0.05		)	(0.12		)	(0.33		)
Net income (loss) per common share:
Basic	$	0.07	$	(0.04	)	$	(0.12	)	$	(0.31	)
Diluted	0.07		(0.04		)	(0.12		)	(0.31		)
Weighted average shares outstanding:
Basic	12,325		12,244			12,298			12,220
Diluted	12,870		12,244			12,298			12,220

See notes to unaudited condensed consolidated financial statements.

BROOKTROUT, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF
COMPREHENSIVE INCOME (LOSS)
(in thousands)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002
Net income (loss)	$	917		$	(482	)	$	(1,448	)	$	(3,802	)
Unrealized (losses) gains on marketable debt securities, net of applicable taxes	(11		)	8			38			4
Comprehensive income (loss)	$	906		$	(474	)	$	(1,410	)	$	(3,798	)

See notes to unaudited condensed consolidated financial statements.

BROOKTROUT, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS
OF CASH FLOWS
(in thousands)

	Nine Months Ended September 30,
	2003			2002
Cash flows from operating activities:
Net loss	$	(1,448	)	$	(3,802	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Loss on disposal of discontinued operations	—			469
Deferred income taxes	—			(696		)
Depreciation and amortization	2,510			3,191
Amortization of acquired and licensed software	516			876
Inventory obsolescence expense	599			3,646
Gain on sale of investment	(499		)	—
Increase (decrease) in cash from changes in:
Accounts receivable	(442		)	679
Inventory	1,706			1,281
Prepaid expenses and other assets	5,704			1,602
Current liabilities	(907		)	(2,832		)

Cash flows from operating activities	7,739			4,414

Cash flows from investing activities:
Expenditures for equipment and furniture	(419		)	(481		)
Proceeds from the sale of an investment	499			—
Sales and maturities of marketable debt securities	7,956			16,555
Purchases of marketable debt securities	(24,826		)	(9,778		)

Cash flows from investing activities	(16,790		)	6,296

Cash flows from financing activities:
Proceeds from the sale of common stock	211			180

Cash flows from financing activities	211			180

(Decrease) increase in cash and cash equivalents	(8,840		)	10,890
Cash and cash equivalents, beginning of period	23,685			22,425

Cash and cash equivalents, end of period	$	14,845		$	33,315

See notes to unaudited condensed consolidated financial statements.

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Description of Business and Summary of Significant Accounting Policies and Practices

(a) Description of Business

Brooktrout, Inc. (the “Company” or “Brooktrout”) develops, manufactures and sells hardware and software products that enable the development of communications systems and services. The Company sells its products to system vendors, service providers, enterprise customers, original equipment manufacturers, and value-added resellers, both domestically and internationally, through a direct sales force and a two-tiered distribution system. Prior to February 8, 2001, the Company was organized and reported the results of its operations in the following three business segments: Brooktrout Technology, Inc. (“Brooktrout Technology”), Brooktrout Software, Inc. (“Brooktrout Software”), and Interspeed, Inc. (“Interspeed”). These segments were differentiated based upon the products provided to the marketplace, the customers served, and the distribution channels utilized. Two of these segments have been discontinued and are classified as discontinued operations for the periods presented in these condensed consolidated financial statements. For further discussion of discontinued operations, please see the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. Following the discontinuance of the Brooktrout Software and Interspeed segments, the Company’s operations consist of one reportable segment, Brooktrout Technology. Disclosures included herein pertain to the Company’s continuing operations unless noted otherwise.

(b) Use of Estimates

Accounting policies, methods and estimates are an integral part of the condensed consolidated financial statements and are based upon management’s current judgments. These policies, methods, and estimates affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. The judgments made by management are based on knowledge and experience with regard to past and current events and assumptions about future events that are believed to be reasonable under the circumstances. The Company’s management evaluates these estimates and assumptions and adjusts them if expectations concerning events, including future events, affecting them differ markedly from management’s current judgments.

(c) Basis of Presentation and Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002.

The accompanying unaudited condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the interim periods presented. The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. The operating results for the interim periods presented are not necessarily indicative of the results that could be expected for the full year.

(d) Revenue Recognition

Revenue from product sales is recognized upon shipment to the customer (which constitutes delivery), provided that persuasive evidence of an arrangement exists, the fee is fixed or determinable, and collection is reasonably assured. To the extent that one or more of these conditions are not met, which has occurred from time to time, revenue is deferred until such time as all four criteria are met. Revenue from sales to certain distributors is recognized on a “sell-through” basis, that is, when the distributors report to the Company that resale of the product

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

to the ultimate customer of the distributor in question has occurred. If the Company receives a payment from a customer prior to meeting all of the revenue recognition criteria, the payment is recorded as a customer deposit or deferred revenue. The Company records a provision for estimated sales returns and allowances on product sales in the same period as the related revenue is recorded. These estimates are based on historical sales returns, analysis of credit memo data and other known factors.

(e) Warranties

The Company provides warranties on its products for periods of up to five years. Provisions are made at the time revenue is recognized for the cost of fulfilling these commitments. Actual costs of fulfilling these warranty obligations have been within amounts estimated and provided. At September 30, 2003 and December 31, 2002, the Company’s accrued warranty obligation was $1.1 million.

(f) Concentration of Credit Risk

The Company sells its products to various customers in the high technology industry. The Company generally requires no collateral. To reduce credit risk, the Company performs credit evaluations of its customers. The Company maintains allowances for doubtful accounts for estimated losses resulting from its customers’ inability to make required payments. At September 30, 2003 and December 31, 2002, 23% of the Company’s accounts receivable were from one customer. For these same periods, 10% and 13% of the Company’s accounts receivable, respectively, were from a second customer, while 11% and 7% of the Company’s accounts receivable, respectively, were from a third customer.

The Company has one customer that generates more than 10% of total revenue. This customer accounted for approximately 20% and 13% of revenue for the three months ended September 30, 2003 and 2002, respectively. For the nine months ended September 30, 2003 and 2002, this customer accounted for approximately 17% and 14% of revenue, respectively.

(g) Stock-Based Compensation

The Company uses the intrinsic value method to measure compensation expense associated with the grants of stock options or awards to employees. The Company accounts for stock options and awards to non-employees using the fair value method.

Under the intrinsic value method, compensation associated with stock awards to employees is determined as the excess, if any, of the current fair value of the underlying common stock on the date compensation is measured over the price an employee must pay to exercise the award. The measurement date for employee awards is generally the date of grant. Under the fair value method, compensation associated with stock awards to non-employees is determined based on the estimated fair value of the award itself, measured using either current market data or an established option pricing model. The measurement date for non-employee awards is generally the date that performance of certain services is complete.

Had the Company used the fair value method to measure compensation related to stock awards to employees, reported income (loss) from continuing operations and loss per share would have been as follows:

(in thousands, except per share data)	Three Months Ended September 30,						Nine Months Ended September 30,
	2003			2002			2003			2002

Income (loss) from continuing operations, as reported	$	917		$	(629	)	$	(1,448	)	$	(4,029	)
Stock-based compensation recorded	—			—			—			—
Pro forma stock-based compensation, net of tax	(1,232		)	(938		)	(3,431		)	(2,852		)

Loss from continuing operations, pro forma	$	(315	)	$	(1,567	)	$	(4,879	)	$	(6,881	)

Basic loss per common share	$	(.03	)	$	(.13	)	$	(.40	)	$	(.56	)
Diluted loss per common share	$	(.03	)	$	(.13	)	$	(.40	)	$	(.56	)

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

For purposes of determining the disclosures provided above, the fair value of options on their grant date is measured using the Black-Scholes option-pricing model. Key assumptions used to apply this pricing model were as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2002		2003		2002
Risk-free interest rate	3.0	%	4.3	%	3.0	%	4.3	%
Expected life of option grants (years)	5.4		4.3		5.4		4.3
Expected volatility of underlying stock	86	%	65	%	86	%	65	%

The estimated weighted average fair value of option grants made during the three months ended September 30, 2003 and 2002 was $5.10 and $2.90, respectively, per option. The estimated weighted average fair value of option grants made during the nine months ended September 30, 2003 and 2002 was $4.89 and $2.66, respectively, per option.

From time to time, the Company receives shares of its common stock as payment for the exercise price of stock options. In the nine months ended September 30, 2003, $0.04 million worth of common stock was received from an employee in payment for the exercise price of this employee’s stock option. These shares of common stock were added to our treasury share balance. The employee had held the shares tendered for at least six months prior to the transaction, and accordingly, no compensation charge was required.

(h) Earnings Per Share

Basic earnings per common share is computed using the weighted average number of common shares outstanding during each period. Diluted earnings per common share is calculated by dividing the net income (loss) by the sum of the weighted average number of common shares outstanding and all additional common shares that would have been outstanding if potentially dilutive securities had been issued, using the treasury method, if such shares have a dilutive effect. For the three months ended September 30, 2003, the weighted average shares used for computing diluted earnings per share included 545,000 shares which represent the additional potentially dilutive common shares that would have been outstanding if exercised as of that date using the treasury method.

Stock options to purchase 1,559,303 shares and 3,920,627 shares were excluded from the computation of diluted earnings per share in the three and nine months ended September 30, 2003, respectively, because of their anti-dilutive effect. Stock options to purchase 3,531,200 shares were excluded from the computation of diluted earnings per share in both the three and nine months ended September 30, 2002, because of their anti-dilutive effect.

(i) Reclassifications

Certain amounts in the 2002 unaudited condensed consolidated financial statements have been reclassified to conform to the 2003 presentation.

2. Marketable Debt Securities

The Company has classified all of its marketable debt securities as available-for-sale. Because these securities are available for immediate sale, they have been classified as current assets in the accompanying condensed consolidated balance sheets. There were no material realized or unrealized gains recognized during the three and nine months ended September 30, 2003 and 2002. As of both September 30, 2003 and December 31, 2002, the remaining maturities of debt securities ranged from one month to approximately two years.

Marketable debt securities consisted of the following:

	Amortized Cost		Market Value
	(in thousands)
September 30, 2003:
U.S. government notes and bonds	$	17,847	$	17,881
Corporate debt securities and foreign investments	17,106		17,146

Total	$	34,953	$	35,027

December 31, 2002:
U.S. government notes and bonds	$	7,520	$	7,532
Corporate debt securities and foreign investments	10,644		10,571

Total	$	18,164	$	18,103

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

3. Inventory

The components of inventory, net of reserves, are as follows:

	September 30, 2003		December 31, 2002
	(in thousands)
Raw materials	$	828	$	1,076
Work in process	422		740
Finished goods	3,242		4,981

Total	$	4,492	$	6,797

The following is a rollforward of reserves provided for inventory obsolescence:

	Nine months ended September 30,
	2003			2002
	(in thousands)
Balance, beginning of the period	$	3,909		$	6,591
Provisions	599			3,646
Write offs	(421		)	(609		)

Balance, end of period	$	4,087		$	9,628

4. Intangible Assets

Intangible assets consisted of the following:

	September 30, 2003			December 31, 2002
	(in thousands)
Acquired technology	$	12,038		$	12,038
Customer base	1,264			1,264
In-place workforce	972			972
Trademarks	301			301

Total intangible assets	14,575			14,575
Less: accumulated amortization	(8,312		)	(7,163		)

Intangible assets, net	$	6,263		$	7,412

Intangible asset amortization expense was $0.4 million for both the three months ended September 30, 2003 and 2002. Intangible asset amortization expense was $1.2 million for both the nine months ended September 30, 2003 and 2002. The Company has adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” Included in intangible assets are amounts allocated to in-place workforce, which SFAS No. 142 requires be reclassified to goodwill; such assets were fully amortized prior to January 1, 2002, and as a result, no adjustments or reclassifications were recorded. All intangibles carried on the balance sheet are being amortized.

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

5. Valuation and Qualifying Accounts

Allowances for doubtful accounts and sales returns:

The Company’s allowance for doubtful accounts and sales returns was $1.2 million and $1.8 million as of September 30, 2003 and 2002, respectively. The following is a rollforward of allowances provided for doubtful accounts and sales returns:

	Nine months ended September 30,
	2003			2002
	(in thousands)
Balance, beginning of the period	$	1,679		$	2,074
Provisions	(261		)	(81		)
Write offs, payments issued, and other	(215		)	(223		)

Balance, end of period	$	1,203		$	1,770

Accrued warranty costs:

The Company’s accrued warranty costs liability was $1.1 million and $0.5 million as of September 30, 2003 and 2002, respectively. The following is a rollforward of accrued warranty costs:

	Nine months ended September 30,
	2003			2002
	(in thousands)
Balance, beginning of the period	$	1,060		$	789
Provisions for claims	134			(113		)
Claims incurred	(99		)	(207		)

Balance, end of period	$	1,095		$	469

6. Gain on Sale of Investment

On July 21, 2003, the Company completed the sale of approximately 135,000 shares of Network Engines, Inc. (“NEI”) common stock at prices ranging from $3.70 to $3.75 per share (net of commissions). The Company had acquired these shares in early July 2003 through the exercise of a warrant with NEI at a price of $0.0733 per share. The one-time gain on the sale of this investment was $0.5 million and the net proceeds are being invested in accordance with the Company’s cash management guidelines.

7. Product Sales Information

Brooktrout’s products are sold for applications in the New Network and for applications in Today’s Network. Today’s Network involves core technologies and platforms that are primarily used in business premise products such as fax, LAN fax, and voice mail. The New Network applications expand the capabilities of communications networks to allow data, voice and fax information to be distributed using packet-based data networks, such as the Internet, for portions of the transmission and also allow information to be distributed using the traditional circuit-switched telephone network. For the three months ended September 30, 2003, sales of products for use in the New Network accounted for approximately 35% of total revenue as compared to approximately 38% of total revenue for the three months ended September 30, 2002. For both the nine months ended September 30, 2003 and 2002, sales of products for use in the New Network accounted for approximately 36% of total revenue. Other than the revenue data described above, the Company does not maintain separate financial information related to its New Network and Today’s Network products.

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)

8. Commitments and Contingencies

From time to time, the Company is a party to legal and other actions, which may include allegations of patent infringement made against us and/or our customers, that arise in the normal course of business. The Company, taking into account advice of counsel, does not currently believe the eventual outcome of any such pending or potential matters, including matters in which we have an obligation on behalf of our customers, will have a material effect on the Company’s consolidated financial condition or results of operations.

9. Subsequent Events

On October 16, 2003, the Company announced that its Board of Directors had authorized the repurchase of up to 1,000,000 shares of the Company’s common stock from time to time on the open market or in privately negotiated transactions. Under the program, shares may be repurchased prior to October 15, 2004 and in such amounts as market conditions warrant, and subject to regulatory and other considerations. The Company plans to use the repurchased shares for general corporate purposes including the Company’s stock option plans, employee stock purchase plan and other stock benefit plans. As of October 31, 2003, the Company has not repurchased any shares under the plan.

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

The following discussion should be read in conjunction with the condensed consolidated financial statements and related notes appearing elsewhere in this quarterly report and in our Annual Report on Form 10-K for the year ended December 31, 2002. The discussion contains forward-looking statements that involve known and unknown risks and uncertainties, including those set forth below under “Factors That May Affect Future Results.”

Overview

We develop hardware and software platforms that original equipment manufacturers, or OEMs, developers and corporate information technology managers build into their communications systems. Customers incorporate our products into applications, systems and services that allow voice, fax and data to be distributed over both Internet protocol, or IP, packet-based networks, which we refer to as the New Network, and the traditional circuit-based telephone network. We supply products for media processing, network interface, call control and signal processing, including protocols that allow Internet and traditional telephony systems to communicate.

We measure our operating success using both financial and market metrics. The financial metrics include revenue, gross margin, operating expenses, and income from continuing operations, as well as working capital and cash provided by operating activities. Other key metrics include the total number of enterprise and service provider customers, customers whose purchases exceed $100,000, and the portion of our revenue that is generated by the sales of products for applications in the New Network. Our long-term business model stresses our commitment to establishing and maintaining close customer relationships and to continuing to develop innovative products.

The most significant trend that has impacted our business has been the unfavorable economic conditions affecting the communications sector. This had resulted in a decrease in our revenue in the first two quarters of 2003 and for the fiscal years 2002 and 2001, compared to prior periods. Sales of products, particularly for applications in the New Network, to OEMs for use by large service providers had declined most significantly. In response to the revenue decreases, we implemented expense control programs to reduce operating expenses, while at the same time, we have continued to invest in developing products that we believe our customers will need when the economy improves. While the third quarter of 2003 revenue exceeded third quarter of 2002 revenue, and while we expect revenue in the fourth quarter of 2003 to exceed the revenue in the fourth quarter of 2002, we believe it is too early to determine whether this will be sustainable.

Despite these uncertain economic conditions, we have been able to increase our cash and marketable debt securities balances to $49.9 million at September 30, 2003 from $26.0 million at December 31, 2000. This was accomplished primarily through income tax refunds, operating expense reductions, inventory reductions, and the sale of a business segment. If current economic conditions continue for an extended period of time or worsen, we may experience adverse effects on our business, operating results, and cash and marketable debt securities balances.

Application of Critical Accounting Policies

Management’s discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America applicable to interim financial information. We make estimates and assumptions in the preparation of the condensed consolidated financial statements that affect the reported amounts of assets and liabilities, revenue and expenses, and the related disclosures of contingent assets and liabilities. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We base our estimates and judgments on historical experience and on various other assumptions that we believe are reasonable under the circumstances. However, actual results may differ from these estimates under different assumptions or conditions.

The following critical accounting policies require the use of significant judgment and estimates in the preparation of the condensed consolidated financial statements. This listing is not a comprehensive list of all of our

significant accounting policies. For further information regarding the application of these and other accounting policies, see Note 1 to the condensed consolidated financial statements in Part I, Item 1 of this report.

Revenue Recognition

Revenue from product sales is recognized upon shipment to the customer (which constitutes delivery), provided that persuasive evidence of an arrangement exists, the fee is fixed or determinable, and collection is reasonably assured. In determining when to recognize revenue we often are required to exercise judgment. To the extent that one or more of these criteria are not met, which has occurred from time to time, revenue is deferred until such time as all four conditions are satisfied. We record a provision for estimated sales returns and allowances on product sales in the same period as the related revenue is recorded. These estimates are based on historical sales returns, analysis of credit memo data and other known factors. Actual results could differ from these estimates and could therefore impact our results of operations and cash flows.

Allowances for Doubtful Accounts

Accounts receivable are reduced by an allowance for amounts that may become uncollectible in the future. The estimated allowance for doubtful accounts is based primarily on a specific analysis of accounts in the receivable portfolio and a general reserve based on the aging of receivables. While management believes the allowance to be adequate, if the financial condition of our customers were to deteriorate, resulting in impairment of their ability to make payments, additional allowances may be required and could materially impact our financial position and results of operations.

Inventory Allowances

We evaluate our inventories for estimated excess quantities and obsolescence. This evaluation includes analyses of sales levels by product and projections of anticipated future demand. In addition, we assess the impact of changing technology on our inventory-on-hand. We provide reserves for inventories that are considered excess or obsolete. If future demand or market conditions are less favorable than our projections, additional inventory reserves may be required and would be reflected in cost of sales in the period in which the revision is made. If future demand or market conditions are more favorable and products for which reserves have been provided become more marketable and are sold, our gross margin could improve. These actions could impact both our results of operations and our cash flows.

Intangible Assets

We review our intangible assets for impairment periodically and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. The evaluation of the recoverability of our intangible assets includes assumptions regarding estimated future undiscounted cash flows associated with these assets and other factors. If these estimates or assumptions change in the future, we may be required to record impairment charges for these assets. Such an impairment charge would impact the results of operations, but would not directly impact our cash flows. All of our remaining net intangible assets are being amortized, with original useful lives of approximately five to ten years.

Deferred Tax Assets

We assess the carrying value of our deferred tax assets to determine if it is more likely than not that we will be able to generate sufficient future taxable income in certain tax jurisdictions in order to realize these assets. When necessary, we have reduced the deferred tax asset to its estimated realizable value by recording a valuation allowance. This assessment requires us to make estimates and assumptions about our future profitability. In determining the carrying value of the deferred tax assets as of September 30, 2003, we are assuming profitability in the future and that it is more likely than not that we will be able to realize these assets. This assumption is based in part upon our history of profitability and our profitability in the three months ended September 30, 2003. If current economic conditions deteriorate or future results of operations are less than expected, future assessments may result in a determination that all or a portion of the remaining deferred tax assets are not realizable. As a result, we may

need to establish additional valuation allowances for all or a portion of the deferred tax assets, which may have a material adverse effect on our results of operations.

Accrued Warranty Costs

We accrue for warranty costs based on historical trends in product return rates and the expected material and labor costs to provide warranty services. If we were to experience an increase in warranty claims compared with our historical experience, or if costs of servicing warranty claims were greater than the expectation on which the accrual had been based, our gross margins could be adversely affected.

Discontinued Operations

Prior to February 8, 2001, we were organized and reported the results of our operations in three operating segments, Brooktrout Technology, Brooktrout Software, and Interspeed. On February 8, 2001, our board of directors adopted formal plans to discontinue our Brooktrout Software and Interspeed segments. We have accounted for these businesses as discontinued operations. These businesses were substantially disposed of prior to December 31, 2001, and adjustments recorded in 2002 primarily reflect additional proceeds and changes in estimates to the amounts recorded related to gains or losses on disposal. There are no operating activities related to discontinued operations included in our condensed consolidated financial statements in either 2002 or 2003.

Results of Operations

The following discussion focuses on our results from continuing operations for the three and nine months ended September 30, 2003 and 2002. The table below sets forth certain condensed consolidated statements of operations data as a percentage of total revenue for the periods presented.

	Three Months Ended September 30,				Nine Months Ended September 30,
	2003		2002		2003		2002
Domestic revenue	81	%	74	%	78	%	78	%
International revenue	19		26		22		22
Total revenue	100		100		100		100
Cost of product sold	34		44		37		46
Gross margin	66		56		63		54
Operating expenses:
Research and development	23		25		26		28
Selling, general and administrative	39		38		43		40
Total operating expenses	62		63		69		68
Operating income (loss)	4		(7	)	(6	)	(14	)
Other income (expense), net	4		1		2		2
Income (loss) before income taxes	8		(6	)	(4	)	(12	)
Income tax provision (benefit)	3		(3	)	(1	)	(5	)
Income (loss) from continuing operations	5	%	(3	)%	(3	)%	(7	)%

Revenue

Three Months Ended September 30, 2003 and 2002

The following table presents our domestic and international revenue:

	Three Months Ended September 30,
	2003				2002
	(dollars in thousands)
Domestic revenue	$	15,768	81	%	$	13,783	74	%
International revenue, principally export	3,678		19		4,727		26

Total revenue	$	19,446	100	%	$	18,510	100	%

Revenue for the three months ended September 30, 2003 increased by $0.9 million compared to the three months ended September 30, 2002. Sales to domestic OEMs and enterprise customers increased by 15%. We believe that this increased demand is the result of strengthening economic conditions in the communications marketplace during the third quarter of 2003. International revenue for the three months ended September 30, 2003 was similar to the revenue generated in previous quarters of 2003. In comparison to the three months ended September 30, 2002, international revenue decreased by $0.1 million due to favorable foreign exchange rates and decreased by approximately $1.1 million due to a reduction in sales volume. The larger than usual revenue total during the third quarter of 2002 was due to several customers purchasing product for significant one-time projects.

Our products are sold for applications in the New Network and for applications in Today’s Network. Today’s Network involves core technologies and platforms that are primarily used in business premise products such as fax, LAN fax, and voice mail. The New Network applications expand the capabilities of communications networks to allow data, voice and fax information to be distributed using packet-based data networks, such as the Internet, for portions of the transmission and also allow information to be distributed using the traditional circuit-switched telephone network. Revenue from sales of products for applications in the New Network for the three months ended

September 30, 2003 decreased by $0.1 million compared to the three months ended September 30, 2002. This revenue decrease was attributable to weakness in both the service provider and enterprise segments. New Network revenue was approximately 35% of total revenue for the three months ended September 30, 2003, as compared to 38% of total revenue in the three months ended September 30, 2002.

Nine Months Ended September 30, 2003 and 2002

The following table presents our domestic and international revenue:

	Nine Months Ended September 30,
	2003				2002
	(dollars in thousands)
Domestic revenue	$	40,911	78	%	$	43,450	78	%
International revenue, principally export	11,459		22		12,280		22

Total revenue	$	52,370	100	%	$	55,730	100	%

Revenue for the nine months ended September 30, 2003 decreased by $3.4 million compared to the nine months ended September 30, 2002. Year to date sales to domestic OEMs and enterprise customers decreased primarily due to the economic conditions in the communications marketplace, as well as world events that affected product demand in the first three months of 2003. For the nine months ended September 30, 2003, international revenue declined by $1.3 million as sales to Pacific Rim and European customers were less than the corresponding period of 2002. This revenue decline was partially offset by favorable foreign currency exchange rates that increased revenue in 2003 by approximately $0.5 million.

As discussed above, our products are sold for applications in the New Network and for applications in Today’s Network. Revenue from sales of products for applications in the New Network for the nine months ended September 30, 2003 decreased by $1.1 million compared to the nine months ended September 30, 2002. This revenue decrease was attributable to weakness in service provider segment offset by relative strength in the enterprise segment. New Network revenue was at approximately 36% of total revenue for both the nine months ended September 30, 2003 and September 30, 2002.

Cost of Product Sold and Gross Margin

Three Months Ended September 30, 2003 and 2002

The following table presents cost of product sold and gross margin information:

	Three Months Ended September 30,
	2003			2002
	(dollars in thousands)
Cost of product sold	$	6,680		$	8,223
Gross profit	$	12,766		$	10,287
Gross margin	66		%	56		%

The decrease in cost of product sold in the three months ended September 30, 2003 compared to the corresponding period in 2002 was primarily the result of direct material cost reductions achieved from using new manufacturing subcontractors and due to reduced inventory obsolescence expense. Obsolescence expense decreased by $1.7 million, primarily due to reduced levels of excess inventory of service provider product in the three months ended September 30, 2003. These factors, along with a shift in product mix to higher margin products, contributed to a significant improvement in gross margin percentages in the third quarter of 2003 compared to the third quarter of 2002.

Nine Months Ended September 30, 2003 and 2002

The following table presents cost of product sold and gross margin information:

	Nine Months Ended September 30,
	2003			2002
	(dollars in thousands)
Cost of product sold	$	19,280		$	25,753
Gross profit	$	33,090		$	29,977
Gross margin	63		%	54		%

The decrease in cost of product sold in the nine months ended September 30, 2003 compared to the corresponding period in 2002 was primarily the result of direct material cost reductions achieved from using new manufacturing subcontractors, combined with decreased product sales. In addition, inventory obsolescence expense decreased by $3.0 million, primarily due to reduced levels of excess inventory of service provider product in the nine months ended September 30, 2003. These factors, along with a shift in product mix to higher margin products, contributed to a significant improvement in gross margin percentages in the nine months ended September 30, 2003 compared to the nine months ended September 30, 2002.

Operating Expenses

Three Months Ended September 30, 2003 and 2002

The following table presents our operating expenses:

	Three Months Ended September 30,
	2003		2002
	(in thousands)
Research and development	$	4,455	$	4,576
Selling, general and administrative	7,503		6,937

Total operating expenses	$	11,958	$	11,513

Research and development expense

Research and development expense represented 23% of total revenue in the three months ended September 30, 2003, compared with 25% of total revenue in the corresponding period in 2002. The $0.1 million decrease in 2003 was primarily the result of reduced consulting and contract labor expenses, decreased depreciation expense, and decreased spending on new product prototypes, offset by a slight increase in equipment and maintenance costs. Our continuing development efforts are focused on hardware and software for media processing products (voice, fax and data), network interface products, call control products and signal processing products.

Selling, general and administrative expense

Selling, general and administrative expense represented 39% of total revenue for the three months ended September 30, 2003 compared with 38% of total revenue in the corresponding period of 2002. The $0.6 million increase was primarily due to increases in expenses associated with the Partner Access Network Program, a marketing program providing financial assistance for the porting of approved applications, access to lab facilities worldwide, sales leads, technical training and support, and co-op funded marketing support.

Nine Months Ended September 30, 2003 and 2002

The following table presents our operating expenses:

	Nine Months Ended September 30,
	2003		2002
	(in thousands)
Research and development	$	13,868	$	15,703
Selling, general and administrative	22,337		21,952

Total operating expenses	$	36,205	$	37,655

Research and development expense

Research and development expense represented 26% of total revenue in the nine months ended September 30, 2003, compared with 28% of total revenue in the corresponding period in 2002. The $1.8 million decrease in 2003 was primarily the result of reduced consulting and contract labor expenses, decreased spending on new product prototypes and decreased depreciation expense. Our continuing development efforts are focused on hardware and software for media processing products (voice, fax and data), network interface products, call control products and signal processing products.

Selling, general and administrative expense

Selling, general and administrative expense represented 43% of total revenue for the three months ended September 30, 2003 compared with 40% of total revenue in the corresponding period of 2002. The $0.4 million increase in selling, general and administrative expense from the nine months ended September 30, 2002 to the corresponding period of 2003 was primarily due to increases in professional fees and marketing expenses associated with the Partner Access Network Program, and increases in employee health insurance premiums. These expense increases were partially offset by decreased depreciation expense and reduced spending for variable incentive compensation.

Other income (expense), net

Three and Nine Months Ended September 30, 2003 and 2002

The increase in other income (expense), net, to $0.7 million in the three months ended September 30, 2003 from $0.2 million in the corresponding three month period in 2002, and to $1.1 million in the nine months ended September 30, 2003 from $0.8 million in the corresponding nine month period in 2002 was the result of a $0.5 million one-time gain on sale of investment in July 2003 resulting from the sale of securities acquired from the exercise of stock purchase warrants, offset by a decline in short-term interest rates.

Income tax provision (benefit)

Three and Nine Months Ended September 30, 2003 and 2002

The following table presents our income tax provision (benefit) and effective tax rate for the three months ended September 30, 2003 and 2002:

	Three Months Ended September 30,
	2003			2002
	(dollars in thousands)
Income tax provision (benefit)	$	562		$	(422	)
Effective tax rate	38		%	(40		)%

The following table presents our income tax benefit and effective tax rate for the nine months ended September 30, 2003 and 2002:

	Nine Months Ended September 30,
	2003			2002
	(dollars in thousands)
Income tax benefit	$	(551	)	$	(2,884	)
Effective tax rate	(28		)%	(42		)%

The Company has recorded an income tax provision in the three months ended September 30, 2003, versus an income tax benefit in the nine months ended September 30, 2003, as a result of earning a pre-tax profit. The reduction in the effective tax rate for the nine months ended September 30, 2003 relative to the corresponding period

in 2002, was primarily due a decrease in the loss before income taxes and also due to a limitation of, and corresponding reduction in, the research and development tax credit that we can utilize in 2003.

Liquidity and Capital Resources

Cash flows for the nine months ended September 30, 2003 and 2002

Net cash provided by operating activities was $7.7 million in the nine months ended September 30, 2003. This primarily resulted from tax refunds of $6.0 million and reductions in inventory, offset by a decrease in current liabilities. Cash provided by operating activities was $4.4 million in the nine months ended September 30, 2002. This primarily resulted from income tax refunds of $4.4 million and reductions in inventory, offset by a decrease in current liabilities.

Net cash used in investing activities was $16.8 million in the nine months ended September 30, 2003. This primarily resulted from net purchases of marketable debt securities of $16.9 million. Net cash provided by investing activities was $6.3 million in the nine months ended September 30, 2002. This primarily resulted from net sales of marketable debt securities of $6.8 million.

Net cash provided by financing activities was $0.2 million in both the nine months ended September 30, 2003 and 2002, primarily attributable to proceeds from the sale of common stock under the our employee stock purchase plan. From time to time, the Company receives shares of its common stock as payment for the exercise price of stock options. In the nine months ended September 30, 2003, $0.04 million worth of common stock was received from an employee in payment for the exercise price of this employee's stock option. These shares of common stock were added to our treasury share balance. The employee had held the shares tendered for at least six months prior to the transaction, and accordingly, no compensation charge was required.

Contractual Obligations and Capital Expenditures

The following table presents our future contractual obligations and commercial commitments as of September 30, 2003:

	Total		Remainder of 2003		2004		2005		2006		2007		Thereafter
	(in thousands)
Operating leases	$	7,273	$	740	$	3,006	$	2,062	$	786	$	211	$	468

We have operating lease commitments for our primary office and manufacturing facilities that expire between 2004 and 2006. In addition, we lease office space for sales and support functions that expire beyond 2006. Certain lease agreements require us to pay all of the building’s taxes, insurance and maintenance costs.

We purchased $0.4 million and $0.5 million of capital equipment in the nine months ended September 30, 2003 and September 30, 2002, respectively. We currently have no material commitments for additional capital expenditures. We have certain inventory purchase commitments that are part of our ordinary course of business in which the product delivery dates range from one month to three months into the future. We do not expect these short term commitments to have a material adverse impact on our financial results.

We had no long-term debt as of September 30, 2003 or November 7, 2003.

Cash and Cash Liquidity Position

The following table presents our cash and liquidity position as of September 30, 2003 and December 31, 2002:

	September 30, 2003		December 31, 2002
	(dollars in thousands)
Cash and cash equivalents	$	14,845	$	23,685
Marketable debt securities	35,027		18,103
Total	$	49,872	$	41,788

Working capital	$	54,990	$	53,639
Quick ratio	4.16		3.37
Maximum available line of credit	$	5,000	$	5,000

Cash, cash equivalents and marketable debt securities increased to $49.9 million as of September 30, 2003 from $41.8 million as of December 31, 2002, primarily due to a $6.0 million tax refund and a net cash inflow from other operating activities of $2.2 million in the first nine months of 2003. Working capital increased by $1.4 million from December 31, 2002 to September 30, 2003. This increase was the result of a reduction in accounts payable balances along with a $0.5 million increase in total current assets. Our quick ratio improved from 3.37 at December 31, 2002 to 4.16 at September 30, 2003, due primarily to a 19% increase in cash, cash equivalents, and marketable debt securities while current liabilities decreased modestly.

We have a $5.0 million working capital line of credit available from a commercial bank. Any borrowings would bear interest at the lender’s prime rate. The line of credit is secured by a pledge of substantially all of our assets. Availability of funds under this line of credit is subject to compliance with certain financial covenants relating to its quick ratio, minimum tangible net worth, and other standard reporting requirements. As of September 30, 2003, letters of credit issued against the existing line totaled $1.0 million, representing the collateral required for certain lease obligations. Other than the issuance of letters of credit and using the credit line to secure immaterial foreign currency forward contracts, there have been no borrowings under the line during the past three years. The line of credit expires on July 29, 2005.

In October 2003, the we announced that our Board of Directors had authorized the repurchase of up to 1,000,000 shares of the our common stock from time to time on the open market or in privately negotiated transactions. This program will be funded by our existing and future cash and marketable debt securities balances. As of October 31, 2003, we have not repurchased any shares under the plan.

We believe that our cash and cash equivalents and marketable debt securities are likely to meet our needs for the foreseeable future. Though we do not expect to make any major capital expenditures in 2003, we are always looking for opportunities to expand the business, which could include acquisitions or organic expansion into new markets. If we find that our cash and cash equivalents, marketable debt securities and funds available from our bank line of credit are not sufficient, we may choose to utilize or to seek other sources of financing. If we were to seek future equity financings, the terms may be dilutive to our stockholders and may contain restrictive covenants, which could limit our ability to pursue certain courses of action. It is possible that, should the need arise, we will not be able to obtain additional financing, or that the financing made available to us will not be on acceptable terms.

The pricing of our products and the costs of our goods can be significantly affected by current market conditions. Market conditions can be impacted by inflation; however, we believe that inflation has not had a significant effect on our operations to date.

Recent Accounting Pronouncements

We have adopted Statement of Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This pronouncement is effective for exit or disposal activities that are initiated after December 31, 2002, and requires these costs to be recognized when the liability is incurred and not at project initiation. The adoption of SFAS No. 146 has not had an impact on our operations or financial position since there have been no exit or disposal activities in the periods presented.

In January 2003, the Emerging Issues Task Force (“EITF”) issued EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables”. EITF 00-21 addresses the issues of how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting and how arrangement consideration should be measured and allocated to the separate units of accounting in the arrangement. EITF 00-21 does not change otherwise applicable revenue recognition criteria. EITF 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF 00-21 has not had a material impact on the Company’s operations or financial position.

Factors That May Affect Future Results

The risks and uncertainties described below are those that we currently believe may materially affect us. The trading price of our common stock could decline due to any of these factors. You should also refer to the other information in this report, including the condensed consolidated financial statements and related notes, and information included in our Annual Report on Form 10-K for the year ended December 31, 2002. Additional risks and uncertainties that we are unaware of, or that we currently deem immaterial, also may become important factors that affect us.

Risks Related to Our Business

Downturns in the economy generally, and in sectors of the telecommunications industry in particular, make it difficult to anticipate or expand sales.

As a result of the uncertain economic conditions affecting most technology sectors and the telecommunications sector in particular, many of our customers are seeking aggressively to increase efficiency in their supply chains and reduce their inventory levels. Additionally, the slowdown in the telecommunications industry and the resulting decrease in spending by companies in our target markets have reduced the rate of growth of data traffic and the use of the Internet, which are driving the convergence of data and telephony that we expect will give rise to demand for New Network applications. The economic downturn has adversely affected our business and operating results, including a reduction in revenue of $3.4 million for the nine months ended September 30, 2003, or 6%, compared to the nine months ended September 30, 2002, and $9.8 million, or 16%, compared to the nine months ended September 30, 2001. If current economic conditions continue for an extended period of time or worsen, we may experience additional adverse effects on our revenue, net income and cash flow. For example, if the rate at which our customers order product decreases, it becomes more likely that our current inventories would be exposed to technological obsolescence, which would require us to reduce the value of those inventories on our balance sheet.

If we fail to compete successfully in the highly competitive telecommunications market, our revenue and profitability will suffer.

The market for telecommunications equipment is highly competitive. If we are unable to differentiate our products from existing and future offerings of our competitors, and thereby effectively compete in the market for telecommunications equipment, our operating results could be materially adversely affected. Many of our current and potential competitors have significantly greater selling and marketing, technical, manufacturing, financial, and other resources. We expect our current competitors to continue to improve the design and performance of their existing products and to introduce new products and enhancements with improved price and performance characteristics. Our product sales may be threatened by new technologies, products or market trends, and we may have to reduce the prices of our products to stay competitive. In addition, new competitors may emerge in the markets we serve. An acquisition of, or by, one of our competitors may result in a substantially strengthened competitor with greater financial, engineering, manufacturing, marketing, and customer service and support resources than we have. If our current or future competitors enter into strategic relationships with leading manufacturers covering products similar to those sold or being developed by us, our ability to sell products to those manufacturers may be adversely affected.

Capitalizing on our technology will require a continued high level of investment in research and development, marketing, and customer service and support. We may be unable, or otherwise fail, to allocate sufficient resources to achieve the technological advances necessary to compete successfully with existing competitors or new entrants.

Internal development efforts by our customers may adversely affect demand for our products.

Many of our customers, including the large OEMs on which we focus a significant portion of our sales and marketing efforts, have the technical and financial ability to design and produce components replicating or improving on the functionality of most of our products. These customers often consider in-house development of technologies and products as an alternative to doing business with us. We cannot assure you that our existing or potential customers will do business with us, rather than attempting to develop similar technology and products internally or obtaining technology or products through acquisitions. We cannot be certain that we will be able to find

customers to replace the revenue lost as a result of customers developing technologies or products in-house. Any such occurrence could have a material adverse effect on our business, financial condition or operating results.

If we fail to develop and sell new or enhanced products for the telecommunications hardware and software market, we will not be able to compete effectively.

The telecommunications hardware and software market is characterized by:

• rapid technological advances;

• evolving industry standards;

• changes in customer requirements and product life cycles;

• frequent new product introductions;

• declining prices;

• intense competition; and

• evolving offerings by telecommunications service providers.

Our future success depends in large part on our ability to offer products that address the sophisticated and varied needs of our current and prospective customers and to respond to technological advances and evolving industry standards on a timely and cost-effective basis.

The timely development of new or enhanced products is a complex and uncertain process. We intend to continue to invest significantly in product and technology development. We may experience design, manufacturing, marketing and other difficulties that could delay or prevent our development, introduction or commercialization of any new and enhanced products. We may also not be able to incorporate new technologies on a cost-effective or timely basis, which may result in unexpected expenses. We may not anticipate technological or market trends accurately or manage long development cycles successfully. We may be required to collaborate with third parties to develop products and may not be able to do so on a timely and cost-effective basis, if at all.

The introduction of new or enhanced products also requires that we manage the transition from older products so as to minimize the disruption to customers and ensure that adequate supplies of new products can be delivered to meet anticipated customer demand. If we are unable to develop new products or enhancements on a timely and cost-effective basis, or if the new products or enhancements that we introduce fail to achieve market acceptance, our ability to grow our business would be harmed and competitors could achieve greater market share.

Our revenue could decline significantly if we lose a major customer or if a major customer cancels, reduces or delays an order.

One customer accounted for 17% of our revenue in the nine months ended September 30, 2003 and for 14% of our revenue in the nine months ended September 30, 2002. The loss of this or any other major customer or the cancellation, reduction or delay of significant orders from such customers, even if only temporary, could significantly reduce our revenue and cash flow and could harm our reputation in the industry.

Our dependence on sole and single source suppliers and independent manufacturers could result in increased costs or delays in the manufacture and delivery of our products.

Although we generally use standard parts and components for our products, some key components are purchased from sole or single source vendors for which alternative sources are not currently available or are difficult to obtain. Our inability to obtain sufficient quantities of these components may result in future delays or reductions

in product shipments that could cause us to lose sales, incur additional costs and suffer harm to our reputation. We currently purchase proprietary components from a number of suppliers for which there are no direct substitutes.

These components could be replaced with alternatives from other suppliers, but that might require redesign of our products. If such a redesign were required, we would incur considerable delay and expenses. We currently enter into purchase orders with our suppliers for materials based on forecasts of need, but have no guaranteed supply arrangements with these suppliers.

In addition, we currently use a number of independent manufacturers to manufacture printed circuit boards, chassis and subassemblies in accordance with our design and specification. Our reliance on independent manufacturers involves a number of risks, including the potential for inadequate capacity of, unavailability of, or interruptions in access to, process technologies, and reduced control over delivery schedules, manufacturing yields and costs. If our manufacturers are unable or unwilling to continue manufacturing our components in required quantities or to our quality expectations, we will have to transfer manufacturing to acceptable alternative manufacturers that we have identified, which could result in significant delays in shipment of products to customers. Moreover, the manufacture of these components is extremely complex, and our reliance on the suppliers of these components exposes us to potential production difficulties and quality variations, which could negatively affect the cost and timely delivery of our products. We currently enter into purchase orders with independent manufacturers of materials based on forecasts of need, but have no guaranteed capacity arrangements with these manufacturers. Any significant interruption in the supply, or degradation in the quality, of any component could cause us to lose sales, incur additional costs and suffer harm to our reputation.

Defects in our products or problems arising from the use of our products may seriously harm our business and reputation.

Products as complex as ours may contain known and undetected errors, bugs, or other performance problems. Defects are frequently found during the period immediately following introduction and initial implementation of new products or enhancements to existing products. Although it is our objective to resolve all bugs that we believe would be considered serious by our customers before implementation, our products may not be bug-free. We also provide warranties against defects in materials and workmanship on our hardware products for five years. Errors, bugs or performance problems, however, could result in lost revenue or customer relationships and could be detrimental to our business and reputation generally. In addition, our customers generally use our products together with their own products and products from other vendors. As a result, when problems occur, it may be difficult to identify the source of the problem. These problems may cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems.

Changes to regulations affecting the telecommunications or Internet industries could reduce demand for our products or increase our costs.

Laws and regulations governing telecommunications, electronic commerce and the Internet are emerging, but remain largely unsettled, even in the areas where there has been some legislative action. Regulation may focus on, among other things, assessing access or settlement charges, or imposing tariffs or regulations based on the characteristics and quality of products, either of which could restrict our business or increase our cost of doing business. Any changes to existing laws or the adoption of new regulations by federal or state regulatory authorities or any legal challenges to existing laws or regulations relating to the telecommunications industry could materially adversely affect the market for our products. Moreover, our value-added resellers or other customers may require, or we may otherwise deem it necessary or advisable, for us to alter our products to address actual or anticipated changes in the regulatory environment. Our inability to alter our products or address any regulatory changes could have a material adverse effect on our business, financial condition or operating results.

Limitations on our ability to adequately protect our proprietary rights may prevent us from retaining our competitive advantage and negatively affect our future operating results.

Our success and ability to compete are dependent, in part, upon our proprietary technology. Taken as a whole, we believe our intellectual property rights are significant and any failure to adequately protect the unauthorized use

of our proprietary rights could result in our competitors offering similar products, potentially resulting in loss of a competitive advantage and decreased revenue. We rely upon a combination of patents, trademark law, trade secret protections, copyright law and confidentiality agreements with consultants and third parties to protect our proprietary rights. Notwithstanding our efforts, third parties may infringe or misappropriate our proprietary rights. In addition, we generally require each of our employees to execute a proprietary information agreement designed to protect our trade secrets, our inventions created in the course of employment with us and other proprietary information of our company. Moreover, effective patent, trademark, copyright or trade secret protections may not be available in every country in which we operate or intend to operate to the same extent as the laws of the United States. Also, it may be possible for unauthorized third parties to copy or reverse engineer aspects of our products, develop similar technology independently or otherwise obtain and use information that we regard as proprietary. Furthermore, detecting unauthorized use of our proprietary rights is difficult. Litigation may be necessary to enforce our proprietary rights. Such litigation could result in the expenditure of significant financial and managerial resources and could have a material adverse effect on our future operating results.

Intellectual property claims against us can be costly and negatively affect our business.

In the telecommunications business, there is frequent litigation based on allegations of patent infringement. As the number of entrants in our market increases and the functionality of our products is enhanced and overlaps with the products of other companies, we may become subject to claims of infringement or misappropriation of the intellectual property rights of others. As a result, from time to time, third parties may claim exclusive patent or other intellectual property rights to technologies that we use. Although we believe that we do not face material liability related to infringement of the intellectual property of others, any claims asserting that our products infringe or may infringe proprietary rights of third parties, if determined adversely to us, could have a material adverse effect on our business, financial condition or operating results. Any claims, with or without merit, could be time-consuming, result in costly litigation, divert the efforts of our engineering and management personnel, cause delays in product shipments or require us to enter into royalty or licensing agreements, any of which could have a material adverse effect upon our operating results. If any legal action claiming patent infringement is commenced against us, we cannot assure you that we would prevail in such litigation given the complex technical issues and inherent uncertainties in patent litigation. In the event a claim against us was successful, and we could not obtain a license on acceptable terms or license a substitute technology or redesign to avoid infringement, we may be unable to market our affected products. This could have a material adverse effect on our business, financial condition and operating results.

Certain of our products depend upon the continued availability of licensed technology from third parties.

We currently license and will continue to license certain technology integral to certain of our products from third parties. For example, we have obtained licenses from third parties for software for certain of our voice and fax products. While we believe that much of this technology is available from multiple sources, any difficulties in acquiring third-party technology licenses, or integrating the related third-party technology into our products, could result in delays in product development or upgrades until equivalent technology can be identified, licensed and integrated.

We may require new licenses in the future as our business grows and technology evolves. We cannot assure you that these licenses will continue to be available to us on commercially reasonable terms, if at all, which could have a material adverse effect on our business, financial condition and operating results.

If we are unable to attract or retain key personnel, we may be unable to operate our business successfully.

Our success depends in large part upon the continued contributions of our key management, sales, marketing, and engineering personnel, many of whom perform important functions and would be difficult to replace. If we lose one or more members of our senior management team our business and operating results would be harmed. We do not have employment contracts with our key personnel. There has been significant competition in our industry for qualified personnel, and, at times, we have experienced difficulty in recruiting qualified personnel. We may not be able to attract and retain the necessary personnel to accomplish our business objectives, and we may experience constraints that will adversely affect our ability to satisfy customer demand in a timely fashion or to support our

customers and operations. Our inability to hire qualified personnel on a timely basis, or to retain our key personnel, could materially adversely affect our business, financial condition and operating results.

Our products typically have long sales cycles, causing us to expend significant resources before recognizing revenue.

The length of our sales cycle typically ranges from six to eighteen months and varies substantially from customer to customer. Prospective customers generally must commit significant resources to test and evaluate our products and integrate them into larger systems. This evaluation period is often prolonged due to delays associated with approval processes that typically accompany the design and testing of new communications equipment by our customers.

In addition, the rapidly emerging and evolving nature of the markets in which we and our customers compete may cause prospective customers to delay their purchase decisions as they evaluate new technologies and develop and implement new systems. During the period in which our customers are evaluating whether to place an order with us, we often incur substantial sales and marketing expenses, without any assurance of future orders or their timing. Even after a customer places an order, the timing of the development, introduction and implementation of the customer’s product or service using our product is controlled by, and can vary significantly with the needs of, the customer. In some circumstances, the customer will not require the product for several months. This continuing uncertainty can complicate our planning processes and reduce the predictability of our earnings and cash flows.

Our business and operating results could be adversely affected by downturns in economic conditions in countries outside the United States and other risks associated with international operations.

Sales of our products to customers outside the United States accounted for 22% of our revenue in the nine months ended September 30, 2003. We anticipate that international sales will continue to account for a significant portion of our revenue. Because of our dependence upon international sales, we are subject to a number of risks, including volatility in currency exchange rates, political and economic instability in other countries, the imposition of trade and tariff regulations by foreign governments, difficulties in accounts receivable collections, extended payment terms beyond those customarily offered in the United States, potentially adverse tax consequences, and the difficulties in managing and/or expanding operations across disparate geographic areas. In addition, most countries require technical approvals from their telecommunications regulatory agencies for products that operate in conjunction with the local telephone system. Obtaining these approvals is generally a prerequisite for sales in a given jurisdiction. Obtaining requisite approvals takes from two months to a year or more depending on the product and the jurisdiction. These or other factors may limit our ability to sell our products in other countries, which could have a material adverse effect on our business, financial condition and operating results.

We may seek to expand through acquisitions of complementary businesses, and we may not be able to successfully integrate acquired companies.

We may seek to acquire complementary companies in the future. In addition to the difficulties we may face in identifying and consummating acquisitions, we will also be required to integrate and consolidate any acquired businesses or assets with our existing operations. Managing an acquired business entails numerous operational and financial risks, including difficulties in integrating disparate administrative, accounting and finance, and information systems, difficulties in assimilating acquired operations and new personnel, diversion of management’s attention from other business concerns, and potential loss of key employees or customers of any acquired operations. Accordingly, we may be unable to successfully identify, consummate and integrate future acquisitions or operate acquired businesses profitably. If we are unable to integrate successfully an acquired company, our future growth may suffer, and our results of operations could be harmed.

Risks Related to Our Financial Results

Our operating results could fluctuate significantly and cause our stock price to be volatile, which may cause the value of your investment to decline.

Our operating results could fluctuate in the future due to a variety of factors, many of which are outside of our control. If our operating results do not meet the expectations of securities analysts, the trading price of our common stock could significantly decline. This may cause the value of your investment in our company to decline. In addition, the value of your investment could be affected by investor perception of our industry or our prospects generally, independent of our operating performance. Some of the factors that could affect our operating results or the market price of our common stock include:

• our ability to cope with difficult conditions in the economy in general, and the telecommunications market in particular;

• our ability to formulate and implement effective strategies to respond to changing market requirements and conditions;

• cancellation or rescheduling of orders for our products;

• our ability to collect accounts receivable from customers that have been adversely affected by the difficult economic conditions;

• our ability to develop, manufacture, market and support our products and product enhancements;

• the timing and number of orders for our products, which have historically been weighted more heavily toward the last month of each quarter and the second and fourth quarters of each year;

• we typically experience lower revenue in the third quarter, due to customer summer vacation schedules, particularly in Europe, and to a lesser extent, the first quarter of each year;

• our ability to hire, train and retain key management, sales, marketing and engineering personnel;

• announcements or technological innovations by our competitors or in competing technologies;

• our ability to obtain sufficient supplies of sole or limited source components for our products;

• a decrease in the average selling prices of our products;

• changes in costs of components that we include in our products;

• the mix of products that we sell;

• any interruptions in the flow of our products through our resellers or our two-tiered distribution system; and

• a decrease in the demand for our common stock.

Due to these and other factors, revenue, expenses and operating results could vary significantly in the future, and period-to-period comparisons should not be relied upon as indications of future performance.

The market price of our common stock may be volatile, which could lead to losses for individual investors.

Stock markets in general, and the market for technology stocks, including our common stock, in particular, have experienced extreme price and volume fluctuations that often have been unrelated, or disproportionate, to the operating performance of those companies. The market for our common stock has been and is likely to continue to be volatile. Many factors could cause the trading price of our common stock to fluctuate substantially, including the following:

• future announcements concerning our business, technology, acquisitions, strategic partnerships, management, customers or competitors;

• introduction of new products or changes in product pricing policies by us, our competitors or our customers;

• changes in earnings estimates by securities analysts or announcements of results of operations that are not aligned with the expectations of analysts and investors;

• changes in market valuations of similar companies;

• reduced spending for telecommunications hardware and software;

• the economic and competitive conditions in the telecommunications sectors in which our customers operate; and

• general economic conditions and stock market trends.

In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. Many technology companies have been subject to this type of litigation. This type of litigation, if instituted against us, could result in substantial costs and a diversion of our management’s attention and resources.

Our corporate documents may prevent a change in control or management that stockholders consider desirable.

Our charter and by-laws contain provisions that might enable our management to resist a takeover of our company. In addition, our board of directors has adopted a shareholder rights plan. These provisions and our shareholder rights plan could have the effect of delaying, deferring, or preventing a change in control of Brooktrout or a change in our management that stockholders consider favorable or beneficial. They could discourage proxy contests and make it more difficult for you and other stockholders to elect directors and take other corporate actions. They also could limit the price that investors may be willing to pay in the future for shares of our common stock.

We may need additional financing in the future, and any additional financing may result in restrictions on our operations or substantial dilution to our stockholders.

We may need to raise additional funds in the future, for example, to develop new technologies, support our expansion, respond to competitive pressures, acquire complementary businesses or respond to unanticipated situations. We may try to raise additional funds through public or private financings, strategic relationships or other arrangements. Our ability to obtain debt or equity funding will depend on a number of factors, including market conditions, our operating performance and investor interest. Additional funding may not be available to us on acceptable terms or at all. If adequate funds are not available, we may be required to revise our business plan to reduce expenditures, including curtailing our growth strategies, foregoing acquisitions or reducing our product development efforts. If we succeed in raising additional funds through the issuance of equity or convertible securities, the issuance could result in substantial dilution to existing stockholders. If we raise additional funds through the issuance of debt securities or preferred stock, these new securities would have rights, preferences and privileges senior to those of the holders of our common stock. The terms of these securities, as well as any borrowings under our bank line of credit agreement, could impose restrictions on our operations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risk from changes in interest rates and currency exchange rates has not changed materially from our exposure at December 31, 2002. Please refer to our Annual Report on Form 10-K for the year ended December 31, 2002 for more information.

Item 4. Controls and Procedures

Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2003. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of September 30, 2003, our disclosure controls and procedures were (1) designed to ensure that material information relating to our company, including our consolidated subsidiaries, is made known to our chief executive officer and chief financial officer by others within those entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

27 PART II OTHER INFORMATION

Item 6.		Exhibits and Reports on Form 8-K

(a)		Exhibits

3.1		Restated Articles of Organization of Brooktrout, Inc. are hereby incorporated by reference from Exhibit 3.1 to Annual Report on Form 10-K for the fiscal year ended December 31, 1999 filed with the SEC on March 30, 2000 (File No. 000-20698).

3.2		Articles of Amendment to the Restated Articles of Organization of Brooktrout, Inc. are hereby incorporated by reference from Exhibit 3.2 to Annual Report on Form 10-K for the fiscal year ended December 31, 1999 filed with the SEC on March 30, 2000 (File No. 000-20698).

3.3		Articles of Amendment to the Restated Articles of Organization of Brooktrout, Inc. are hereby incorporated by reference from Exhibit 3.3 to Amendment No. 2 to the quarterly report on Form 10-Q/A for the fiscal quarter ended June 30, 2000 filed with the SEC on November 17, 2000 (File No. 000-20698).

3.4		Amended and Restated By-laws of Brooktrout, Inc. are hereby incorporated by reference from Exhibit 3.4 to Annual Report on Form 10-K for the fiscal year ended December 31, 2001 filed with the SEC on March 25, 2002 (File No. 000-20698).

31.1		Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

(b)		Reports on Form 8-K

On July 16, 2003, we filed a current report on Form 8-K, dated July 16, 2003, furnishing under Item 12 our press release announcing financial results for the quarter ended June 30, 2003.

On October 16, 2003, we filed a current report on Form 8-K, dated October 16, 2003, filing under Item 5 our press release announcing the authorization of a stock repurchase program and furnishing under Item 12 our press release announcing financial results for the quarter ended September 30, 2003.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	BROOKTROUT, INC.

Date: November 7, 2003	By:	/s/ ERIC R. GILER
		Eric R. Giler President (Principal Executive Officer)

Date: November 7, 2003	By:	/s/ ROBERT C. LEAHY
		Robert C. Leahy Vice President of Finance and Operations (Principal Financial and Accounting Officer)

EXHIBIT INDEX

3.1		Restated Articles of Organization of Brooktrout, Inc. are hereby incorporated by reference from Exhibit 3.1 to Annual Report on Form 10-K for the fiscal year ended December 31, 1999 filed with the SEC on March 30, 2000 (File No. 000-20698).

3.2		Articles of Amendment to the Restated Articles of Organization of Brooktrout, Inc. are hereby incorporated by reference from Exhibit 3.2 to Annual Report on Form 10-K for the fiscal year ended December 31, 1999 filed with the SEC on March 30, 2000 (File No. 000-20698).

3.3		Articles of Amendment to the Restated Articles of Organization of Brooktrout, Inc. are hereby incorporated by reference from Exhibit 3.3 to Amendment No. 2 to the quarterly report on Form 10-Q/A for the fiscal quarter ended June 30, 2000 filed with the SEC on November 17, 2000 (File No. 000-20698).

3.4		Amended and Restated By-laws of Brooktrout, Inc. are hereby incorporated by reference from Exhibit 3.4 to Annual Report on Form 10-K for the fiscal year ended December 31, 2001 filed with the SEC on March 25, 2002 (File No. 000-20698).

31.1		Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14 or 15d-14, as adopted pursuant to Section 302 of Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(b) or 15d-14(b) and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.