BROOKTROUT INC - 10-Q Quarterly Report

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, 2004

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 29, 2004, 12,729,420 shares of common stock, $.01 par value per share, were outstanding.

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, 2004				December 31, 2003
Assets
Current assets:
Cash and cash equivalents	$	30,722			$		28,081
Marketable debt securities	22,277				27,869
Accounts receivable (less allowances for doubtful accounts and sales returns of $558 at September 30, 2004 and $843 at December 31, 2003)	9,351				10,232
Inventory	3,747				4,465
Income tax receivable	124				433
Deferred tax assets	4,028				3,830
Prepaid expenses and other current assets	2,129				2,354

Total current assets	72,378				77,264

Equipment and furniture, less accumulated depreciation	2,248				2,245
Deferred tax assets	14,402				9,413
Intangible assets, less accumulated amortization	5,866				5,909
Other assets, less accumulated amortization	2,072				1,748

Total assets	$	96,966			$	96,579
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$		4,893		$	5,350
Accrued expenses and other	6,095				5,128
Accrued compensation and commissions	2,394				2,405
Accrued warranty costs	1,325				1,138
Customer deposits	728				758

Total current liabilities	15,435				14,779

Deferred rent and other long-term liabilities	130				146

Total liabilities	15,565				14,925

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 80,000,000 shares at September 30, 2004 and 40,000,000 shares at December 31, 2003; issued 13,351,587 at September 30, 2004 and 12,937,019 at December 31, 2003	133				129
Additional paid-in capital	71,320				68,270
Accumulated other comprehensive loss	(141			)	(45			)
Notes receivable — officers	(9,845			)	(9,845			)
Retained earnings	24,622				26,942
Treasury stock, 348,237 shares at September 30, 2004 and 260,386 shares at December 31, 2003, at cost	(4,688			)	(3,797			)

Total stockholders’ equity	81,401				81,654
Total liabilities and stockholders’ equity	$		96,966		$	96,579

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,
	2004			2003			2004				2003
Revenue	$	20,369		$	19,446		$	58,255			$		52,370

Costs and expenses:
Cost of product sold	6,345			6,680			18,619				19,280
Research and development	4,373			4,455			13,705				13,868
In-process research and development	—			—			2,490				—
Selling, general and administrative	9,141			7,503			25,970				22,337

Total costs and expenses	19,859			18,638			60,784				55,485

Operating income (loss)	510			808			(2,529			)	(3,115			)

Other income, net
Gain on sale of investment	—			499			—				499
Interest income, net and other	210			172			509				617
Total other income, net	210			671			509				1,116

Income (loss) before income taxes	720			1,479			(2,020			)	(1,999			)

Income tax provision (benefit)	295			562			300				(551			)

Net income (loss)	$		425	$		917	$	(2,320		)	$	(1,448		)

Net income (loss) per common share:
Basic	$		0.03	$		0.07	$		(0.18	)	$	(0.12		)
Diluted	0.03			0.07			(0.18			)	(0.12			)
Weighted average shares outstanding:
Basic	13,002			12,325			12,960				12,298
Diluted	13,600			12,870			12,960				12,298

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,
	2004			2003			2004			2003
Net income (loss)	$	425		$	917		$	(2,320	)	$	(1,448	)
Unrealized gains (losses) on marketable debt securities, net of applicable taxes	29			(11		)	(83		)	38
Foreign currency translation adjustments	(1		)	—			(13		)	—
Total other comprehensive income (loss)	28			(11		)	(96		)	38
Comprehensive income (loss)	$	453		$	906		$	(2,416	)	$	(1,410	)

See notes to unaudited condensed consolidated financial statements.

BROOKTROUT, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS

OF CASH FLOWS

(in thousands)

	Nine Months Ended September 30,
	2004			2003
Cash flows from operating activities:
Net loss	$	(2,320	)	$	(1,448	)
Adjustments to reconcile net loss to cash flows from operating activities:
In-process research and development	2,490			—
Depreciation and amortization	1,915			2,510
Amortization of purchased and licensed technology	599			516
Inventory obsolescence expense	277			599
Provision for doubtful accounts and sales returns	(73		)	(185		)
Deferred income taxes	212			—
Gain on sale of an investment	—			(499		)
Increase (decrease) in cash from changes in:
Accounts receivable	1,139			488
Inventory	532			1,706
Prepaid expenses and other assets	337			4,959
Current and other liabilities	(279		)	(907		)

Cash flows from operating activities	4,829			7,739

Cash flows from investing activities:
Sales and maturities of marketable debt securities	22,162			7,956
Purchases of marketable debt securities	(16,698		)	(24,826		)
Acquisition of subsidiary, net of cash acquired	(8,255		)	—
Expenditures for equipment and furniture	(823		)	(419		)
Purchased and licensed technology	(737		)	—
Proceeds from the sale of an investment	—			499

Cash flows from investing activities	(4,351		)	(16,790		)

Cash flows from financing activities:
Exercises of stock options	3,017			211
Purchase of treasury stock	(854		)	—

Cash flows from financing activities	2,163			211

Increase (decrease) in cash and cash equivalents	2,641			(8,840		)
Cash and cash equivalents, beginning of period	28,081			23,685

Cash and cash equivalents, end of period	$	30,722		$	14,845

Supplemental schedule of cash flow information:
Tax refunds received	$	321		$	6,040
Tax payments	$	125		$	34
Non-cash activities:
Common stock received for exercise of stock options	$	37		$	36

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 software and hardware 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. The Company’s operations consist of one reportable segment.

(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 their knowledge and experience with regard to past and current events and assumptions about future events that are believed to be reasonable under the circumstances. Management evaluates these estimates and assumptions and adjusts them if expectations concerning events, including future events, affecting them differ markedly from their original expectations.

(c) 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, 2003.

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 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 to the ultimate customer of the distributor 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 that the related revenue is recorded. These estimates are based on historical sales returns, analysis of credit memo data and other known factors.

(e) 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 services is complete.

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Had the Company used the fair value method to measure compensation related to stock awards to employees, reported net loss and net loss per common share would have been as follows:

	Three Months Ended September 30,								Nine Months Ended September 30,
(in thousands, except per share data)	2004				2003				2004				2003

Net income (loss), as reported	$		425		$	917			$	(2,320		)	$	(1,448		)
Stock-based compensation recorded	—				—				—				—
Pro forma stock-based compensation, net of tax	(1,832			)	(1,232			)	(4,314			)	(3,431			)

Net loss, pro forma	$	(1,407		)	$		(315	)	$		(6,634	)	$		(4,879	)

Basic and diluted net loss per common share, pro forma	$	(.11		)	$		(.03	)	$		(.51	)	$		(.40	)

Basic weighted average shares outstanding were used in calculating the pro forma net loss per common share in each of the periods presented since the use of diluted weighted average shares would have had an anti-dilutive effect.

For purposes of determining the disclosures provided above, the fair value of options on their grant date and grants made under the Company’s Employee Stock Purchase Plan (the “Purchase Plan”) are measured using the Black-Scholes option-pricing model. Key assumptions used to apply this pricing model were as follows:

	2004				2003
	Option Plan		Purchase Plan		Option Plan		Purchase Plan
Risk-free interest rate	3.6	%	1.6	%	3.0	%	1.0	%
Expected life (years)	5.6		0.5		5.4		0.5
Expected volatility of underlying stock	86	%	84	%	86	%	49	%

The estimated weighted average fair value of options granted during the three months ended September 30, 2004 and 2003 was $6.67 and $5.10, respectively. The estimated weighted average fair value of options granted during the nine months ended September 30, 2004 and 2003 was $7.26 and $4.89, respectively. The estimated weighted average fair value per share of grants made under the Purchase Plan during the nine months ended September 30, 2004 and 2003 was $2.42 and $0.70, respectively.

(f) 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 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.

	Three Months Ended September 30,		Nine Months Ended September 30,
	2004	2003	2004	2003
Weighted average shares for basic	13,002,000	12,325,000	12,960,000	12,298,000
Dilutive effect of stock options	598,000	545,000	—	—
Weighted average shares for diluted	13,600,000	12,870,000	12,960,000	12,298,000

Stock options to purchase approximately 2,170,000 and 1,675,000 shares were excluded from the computation of diluted earnings per share in the three months ended September 30, 2004 and September 30, 2003, respectively, because of their anti-dilutive effect. Stock options to purchase approximately 4,140,000 and 3,920,000 shares were excluded from the computation of diluted earnings per share in the nine months ended September 30, 2004 and September 30, 2003, respectively, because of their anti-dilutive effect.

(g) Reclassifications

Certain amounts in the 2003 unaudited condensed consolidated financial statements have been reclassified to conform to the 2004 presentation.

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

2. Acquisition

On April 5, 2004, the Company acquired the outstanding capital stock of SnowShore Networks, Inc. (“SnowShore”) pursuant to the terms of an Agreement and Plan of Merger entered into on March 25, 2004. SnowShore, now a wholly owned subsidiary, is a leading-edge provider of software and hardware for voice over IP communications systems. SnowShore was acquired to expand the Company’s voice over IP product offerings specifically for the media server and media firewall markets. The purchase price for the outstanding capital stock of SnowShore was $9.0 million, paid in cash, plus $0.2 million of transaction costs.

The acquisition has been accounted for as a purchase, and accordingly, the results of operations of SnowShore have been included in the Company’s condensed consolidated financial statements from the date of acquisition. The purchase price has been allocated to the assets acquired based on their fair values using an independent appraisal. The purchase price is subject to finalization and could change. The fair value of the assets acquired and liabilities assumed exceeded the purchase price due primarily to deferred tax assets acquired. These assets were not realizable by SnowShore and therefore had zero value to SnowShore. The resulting negative goodwill related to this transaction resulted in a pro rata reduction in the identified long-lived assets purchased. This reduction has been reflected in the asset values contained in the table below. The following is a summary of the purchase price allocation:

	(in thousands)

Cash paid	$	9,000
Acquisition-related costs	220
Total purchase price	$	9,220

Cash and cash equivalents	$	965
Accounts receivable	185
Inventory	91
Prepaid and other assets	36
Equipment and furniture	122
Intangible assets	930
Deferred tax assets, net of valuation allowances of $755	5,346
In-process research and development	2,490
Accounts payable, accrued expenses and other liabilities	(714		)
Accrued compensation and commissions	(231		)
Total	$	9,220

Of the $0.9 million of acquired intangible assets, $0.7 million was assigned to patents (10-year weighted average useful life) and the remaining $0.2 million was assigned to completed technology, trademarks and customer lists (4-year weighted average useful life).

The Company recorded a charge of $2.5 million in the second quarter of 2004 for purchased in-process technology related to development projects that have not reached technological feasibility, have no alternative future use, and for which successful development was uncertain. The value of the purchased in-process research and development was computed by determining the present value of the project’s future economic benefits from future revenues net of anticipated costs and expenses. A discount rate of 25% was used in this calculation and was derived based on the estimated weighted average cost of capital as adjusted to reflect the additional risk inherent in product development. As of September 30, 2004 these projects were approximately 35% complete. The Company estimates that the projects will require an additional spending of $1.0 million to $1.3 million to complete, with an estimated completion date in 2005. Some of the risks and uncertainties inherent in the estimated costs to complete, and the attainment of completion, include the difficulty of predicting the duration of product development and the risk that changes in the product requirements could result in unexpected redesign activity.

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

The following pro forma financial summary is presented as if the acquisition of SnowShore was completed at the beginning of each period presented:

	Three Months Ended September 30,		Nine Months Ended September 30,
(in thousands, except per share data)	2003		2004			2003

Revenue	$	19,885	$	58,700		$	53,465
Net income (loss)	$	275	$	(2,885	)	$	(4,165	)
Net income (loss) per common share:
Basic	$	0.02	$	(0.22	)	$	(0.34	)
Diluted	$	0.02	$	(0.22	)	$	(0.34	)
Weighted average shares outstanding:
Basic	12,325		12,960			12,298
Diluted	12,870		12,960			12,298

The pro forma revenue, net income and basic and diluted income per common share for the three months ended September 30, 2004, are the same as the amounts reported in the unaudited condensed consolidated statements of operations for the period because the acquisition of SnowShore occurred on April 5, 2004.

3. Marketable Debt Securities

Marketable debt securities consisted of the following:

	Amortized Cost					Unrealized Gains			Unrealized Losses				Market Value
	(in thousands)
September 30, 2004:
U.S. government notes and bonds	$			9,587		$	—		$	(30		)	$	9,557
Corporate debt securities and foreign investments	12,780					—			(60			)	12,720
	$				22,367	$	—		$	(90		)	$	22,277

December 31, 2003:
U.S. government notes and bonds	$		13,789			$		22	$		(2	)	$	13,809
Corporate debt securities and foreign investments	14,042					27			(9			)	14,060

	$	27,831				$		49	$		(11	)	$		27,869

Realized gains and losses from the sale of available-for-sale securities are determined on a specific identification basis. Realized gains from the sale of marketable debt securities for the three and nine month periods ended September 30, 2004 were immaterial. As of September 30, 2004 and December 31, 2003, the remaining maturities of debt securities ranged from one month to approximately two years.

4. Inventory

The components of inventory, net of reserves, consisted of the following:

	September 30, 2004		December 31, 2003
	(in thousands)
Raw materials	$	778	$	569
Work in process	639		373
Finished goods	2,330		3,523

Total	$	3,747	$	4,465

BROOKTROUT, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

	Nine months ended September 30,
	2004			2003
	(in thousands)
Balance, beginning of the period	$	4,379		$	3,909
Provisions	277			599
Write offs	(1,425		)	(421		)
Other	29			—

Balance, end of period	$	3,260		$	4,087

Other changes in the reserves provided for inventory obsolescence relate to amounts recorded in connection with the acquisition of SnowShore (see Note 2).

5. Valuation and Qualifying Accounts

Allowances for doubtful accounts and sales returns:

The following is a rollforward of allowances provided for doubtful accounts and sales returns:

	Nine months ended September 30,
	2004			2003
	(in thousands)
Balance, beginning of the period	$	843		$	1,679
Provisions	(73		)	(185		)
Write offs	(182		)	(108		)
Recoveries	47			—
Rebate payments to customers	(150		)	(183		)
Other	73			—

Balance, end of period	$	558		$	1,203

Other changes in allowances provided for doubtful accounts and sales returns relate to amounts recorded in connection with the acquisition of SnowShore (see Note 2).

Accrued warranty costs:

The following is a rollforward of accrued warranty costs:

	Nine months ended September 30,
	2004			2003
	(in thousands)
Balance, beginning of the period	$	1,138		$	1,060
Provisions for claims	320			134
Claims incurred	(145		)	(99		)
Other	12			—

Balance, end of period	$	1,325		$	1,095

Other changes in accrued warranty costs relate to amounts recorded in connection with the acquisition of SnowShore (see Note 2).

6. Stockholders’ Equity

On October 16, 2003, the Company’s Board of Directors 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, which expired on October 15, 2004, the Company repurchased 86,000 shares of common stock on the open market for approximately $0.9 million during the second quarter of 2004. No additional shares were repurchased in the three months ended September 30, 2004. The Company plans to use the repurchased shares for general corporate purposes.

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

The following discussion should be read in conjunction with our condensed consolidated financial statements and the related notes appearing elsewhere in this Quarterly Report and in our Annual Report on Form 10-K for the year ended December 31, 2003. The following 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 software and hardware 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-switched 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 profit, operating expenses, and income from continuing operations, as well as working capital and cash flows from operating activities. Key market metrics include the total number of customers, customers whose purchases exceed $100,000, and the portion of our revenue that is generated by sales of products to enterprise and service provider customers. Our long-term business model stresses our commitment to establishing and maintaining close customer relationships, increasing penetration of the telecommunications markets that we serve and 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 resulted in a decrease in our revenue from 2000 to 2002. Furthermore, we experienced revenue decreases for the first two quarters of 2003 when compared to the corresponding quarters of 2002. Sales of products, particularly for applications in the New Network, to OEMs for use by large service providers declined most significantly over these periods. In response to the revenue decreases, we have implemented expense control programs to reduce operating expenses, while we have continued to invest in developing products that we believe our customers will need when the economy further improves. We believe that the economic conditions in our industry generally have begun, at least temporarily, to improve and that this improvement was reflected in our revenue for the first three quarters of 2004, which exceeded the revenue in the corresponding quarters of 2003. We currently expect the revenue for the fourth quarter of 2004 to be slightly lower than the revenue for the corresponding quarter of 2003.

On April 5, 2004, we completed our acquisition of the outstanding capital stock of SnowShore Networks, Inc., or SnowShore, for approximately $9.2 million in cash. SnowShore, now our wholly owned subsidiary, is a provider of leading-edge voice over IP communications infrastructure products for the media server and media firewall markets.

Despite (i) the general economic conditions; (ii) our $9.2 million acquisition of SnowShore in April 2004; and (iii) our repurchase of $0.9 million in stock in May 2004, our cash and cash equivalents and marketable debt securities balances increased $11.2 million from $41.8 million at December 31, 2002 to $53.0 million at September 30, 2004. This was accomplished primarily through cash flow from operations, bolstered by income tax refunds, operating expense reductions, and inventory reductions. If economic conditions do not continue to improve or if they weaken again, we may experience adverse effects on our business, operating results, and cash and cash equivalents 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.

We consider the following to be the critical accounting policies and areas where significant judgment is applied, which we believe an investor should understand when assessing our financial reporting and performance:

• Revenue recognition;

• Allowances for doubtful accounts and for inventory obsolescence;

• Intangible assets;

• Deferred income taxes; and

• Accrued warranty costs.

This is not intended to be a comprehensive list of all of our significant accounting policies. For more information on our critical accounting policies and on our significant accounting policies in general, see the discussion on those policies in our Annual Report on Form 10-K for the year ended December 31, 2003 and Note 1 to the condensed consolidated financial statements in Part 1, Item 1 of this report.

Results of Operations

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,
	2004		2003		2004		2003
Domestic revenue	82	%	81	%	80	%	78	%
International revenue, principally export	18		19		20		22
Total revenue	100		100		100		100
Cost of product sold	31		34		32		37
Gross profit	69		66		68		63
Operating expenses:
Research and development	21		23		23		26
In-process research and development	—		—		4		—
Selling, general and administrative	45		39		45		43
Total operating expenses	66		62		72		69
Operating income (loss)	3		4		(4	)	(6	)
Other income, net	1		4		1		2
Income (loss) before income taxes	4		8		(3	)	(4	)
Income tax provision (benefit)	2		3		1		(1	)
Net income (loss)	2	%	5	%	(4	)%	(3	)%

Revenue

Three Months Ended September 30, 2004 and 2003

The following table presents our domestic and international revenue:

	Three Months Ended September 30,
	2004				2003
	(dollars in thousands)
Domestic revenue	$	16,714	82	%	$	15,768	81	%
International revenue, principally export	3,655		18		3,678		19

Total revenue	$	20,369	100	%	$	19,446	100	%

Revenue in the three months ended September 30, 2004 was $20.4 million compared to $19.5 million in the corresponding period of 2003, an increase of approximately 5%. This increase was the result of increased sales to domestic value-added resellers and enterprise customers. Many of our customers resumed spending on communications equipment, which had slowed in 2001, 2002, and early 2003. International revenue in the three months ended September 30, 2004 was similar to the corresponding period of 2003 as decreased sales to European customers of $0.3 million was offset by a $0.2 million increase in sales to Pacific Rim customers, due primarily to our establishment of a direct sales operation in Japan. The $0.3 million decrease in sales to European customers is net of a $0.1 million increase in revenue due to favorable foreign currency exchange rates for European sales. During the three months ended September 30, 2004, revenue from enterprise customers accounted for approximately 86% of total revenue, as compared to 83% of total revenue for the three months ended September 30, 2003. The remaining revenue was attributable to sales to service provider customers.

In the three months ended September 30, 2004, a total of 29 of our customers each purchased over $100,000 of products, in aggregate representing 75% of total revenue for the quarter. In the three months ended September 30, 2003, a total of 34 of our customers each purchased over $100,000 of products, in aggregate representing approximately 76% of total revenue for the quarter. Total customers in the third quarter of 2004 increased to a total of 359 from a total of 322 in the third quarter of 2003, primarily due to an increase in the number of customers that purchased $10,000 or less in the quarter. Revenue from one customer accounted for 18% of total revenue in the three months ended September 30, 2004, compared to 20% in the corresponding period of 2003. We expect that revenue from this customer will be greater than 10% of total revenue for 2004.

Nine Months Ended September 30, 2004 and 2003

The following table presents our domestic and international revenue:

	Nine Months Ended September 30,
	2004				2003
	(dollars in thousands)
Domestic revenue	$	46,655	80	%	$	40,911	78	%
International revenue, principally export	11,600		20		11,459		22

Total revenue	$	58,255	100	%	$	52,370	100	%

Revenue in the nine months ended September 30, 2004 was $58.3 million compared to $52.4 million in the corresponding period of 2003, an increase of approximately 11%. This increase was again primarily the result of increased sales to domestic OEMs, value-added resellers and enterprise customers. In comparison to the nine months ended September 30, 2003, international revenue for the corresponding period of 2004 increased by $0.1 million. This was the result of increased sales to Pacific Rim customers of $1.1 million due primarily to our establishment of a direct sales operation in Japan and increased sales to Central and Latin American customers of $0.1 million. These increases were offset by a $1.1 million decrease in sales to our European customers. The $1.1 million decrease in sales to European customers is net of a $0.2 million increase in revenue due to favorable foreign currency exchange rates for European sales. During the nine months ended September 30, 2004, revenue from enterprise customers accounted for approximately 85% of total revenue, as compared to 81% of total revenue for the nine months ended September 30, 2003. The remaining revenue was attributable to sales to service provider customers.

In the nine months ended September 30, 2004, a total of 73 of our customers each purchased over $100,000 of products, in aggregate representing 86% of total revenue for the nine month period. In the nine months ended September 30, 2003, a total of 74 of our customers each purchased over $100,000 of products, in aggregate representing approximately 85% of total revenue for the nine month period. Total customers in the nine months ended September 30, 2004 decreased to a total of 549 from a total of 636 in the nine months period ended September 30, 2003, primarily due to a decline in the number of customers that purchased $10,000 or less in the period. Revenue from one customer accounted for 16% of total revenue in the nine months ended September 30, 2004, compared to 17% in the corresponding period of 2003. We expect that revenue from this customer will be greater than 10% of total revenue for 2004.

Cost of Product Sold and Gross Profit

Three Months Ended September 30, 2004 and 2003

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

	Three Months Ended September 30,
	2004				2003
	(dollars in thousands)
Cost of product sold	$		6,345		$	6,680
Gross profit	$	14,024			$	12,766
Gross profit percentage	69			%	66		%

The decrease in cost of product sold in the three months ended September 30, 2004, compared to the corresponding period in 2003, was the result of changes in product mix as a result of increased sales of our digital fax products and reduced manufacturing and inventory obsolescence expenses. Our manufacturing expenses in the third quarter decreased by $0.1 million due to reduced warehouse operating expenses. Our inventory obsolescence expense in the third quarter of 2004 also decreased by $0.1 million relative to the same period of 2003. Our change in product mix to higher margin products contributed to a significant improvement in the gross profit percentage in the third quarter of 2004, compared to the third quarter of 2003. The gross profit percentage in the fourth quarter of 2004 is expected to be between 67% and 68%.

Nine Months Ended September 30, 2004 and 2003

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

	Nine Months Ended September 30,
	2004			2003
	(dollars in thousands)
Cost of product sold	$	18,619		$	19,280
Gross profit	$	39,636		$		33,090
Gross profit percentage	68		%	63			%

The decrease in cost of product sold in the nine months ended September 30, 2004, compared to the corresponding period in 2003, was the result of changes in product mix as a result of increased sales of our digital fax products and reduced inventory obsolescence and manufacturing expenses. Our inventory obsolescence expense decreased by $0.3 million in the nine months ended September 30, 2004 relative to the same period of 2003 primarily due to reduced reserve requirements for inventory on hand. Our manufacturing expenses decreased by $0.3 million in the nine months ended September 30, 2004 relative to the same period of 2003, primarily due to reduced salaries and employee-related expenses and decreased warehouse supplies purchases. Our change in product mix to higher margin products contributed to a significant improvement in the gross profit percentage in the nine months ended September 30, 2004, compared to the corresponding period of 2003.

Operating Expenses

Three Months Ended September 30, 2004 and 2003

The following table presents our operating expenses:

	Three Months Ended September 30,
	2004		2003
	(in thousands)
Research and development	$	4,373	$	4,455
Selling, general and administrative	9,141		7,503

Total operating expenses	$	13,514	$	11,958

Research and development expense

Research and development expense represented 21% of revenue in the third quarter of 2004, compared with 23% of revenue in the third quarter of 2003. The slight decrease in research and development expense in the third quarter of 2004 relative to the corresponding period of 2003 was primarily the result of reduced expenses for new product prototypes and compliance testing fees. Our continuing development efforts are focused on hardware and software for traditional telephone, or TDM, and IP media processing products (voice, video, fax and data), network interface products, call control products and signal processing products. Research and development expense for the fourth quarter of 2004 is expected to be approximately 20% to 22% of revenue.

Selling, general and administrative expense

Selling, general and administrative expense represented 45% of revenue in the three months ended September 30, 2004, compared with 39% of revenue in the corresponding period of 2003. The $1.6 million increase in selling, general and administrative expense in the third quarter of 2004 relative to the corresponding period of 2003 was primarily the result of a $1.4 million increase in legal and audit expenses. The legal expense increase was related to litigation and other legal matters costs. The audit expense increase was due to fees associated with Sarbanes Oxley compliance and other non-audit services. In addition, expenses increased by $0.3 million related to establishing our Japan operation in December 2003. These increase were offset by a decrease in depreciation and amortization expense of $0.1 million. Selling, general and administrative expense for the fourth quarter of 2004 is expected to be approximately 41% to 44% of revenue.

Nine Months Ended September 30, 2004 and 2003

The following table presents our operating expenses:

	Nine Months Ended September 30,
	2004		2003
	(in thousands)
Research and development	$	13,705	$		13,868
In-process research and development	2,490		—
Selling, general and administrative	25,970		22,337

Total operating expenses	$	42,165	$	36,205

Research and development expense

Research and development expense represented 23% of revenue in the nine months ended September 30, 2004, compared with 26% of revenue in the corresponding period of 2003. The $0.2 million decrease in research and development expense in the nine months ended September 30, 2004 relative to the corresponding period of 2003 was primarily the result of reduced depreciation expense. Our continuing development efforts are focused on hardware and software for traditional telephone, or TDM, and IP media processing products (voice, video, fax and data), network interface products, call control products and signal processing products.

In-process research and development

In the nine months ended September 30, 2004, we recorded a charge of $2.5 million for purchased in-process technology related to development projects that have not reached technological feasibility, have no alternative future use, and for which successful development was uncertain. The value of the purchased in-process research and development was computed by determining the present value of the project’s future economic benefits from future revenues net of anticipated costs and expenses. A discount rate of 25% was used in this calculation and was derived based on the estimated weighted average cost of capital as adjusted to reflect the additional risk inherent in product development. As of September 30, 2004 the project was approximately 35% complete. We estimate that the projects will require an additional spending of $1.0 million to $1.3 million to complete, with an estimated completion date in 2005. Some of the risks and uncertainties inherent in the estimated costs to complete, and the attainment of completion, include the difficulty of predicting the duration of product development and the risks that changes in the product requirements could result in unexpected redesign activity.

Selling, general and administrative expense

Selling, general and administrative expense represented 45% of revenue in the nine months ended September 30, 2004, compared with 43% of revenue in the corresponding period of 2003. The $3.6 million increase in selling, general and administrative expense in the nine months ended September 30, 2004 relative to the corresponding period of 2003 was primarily due to the increases in legal, audit, and other professional fees of $1.8 million, expense increases related to our new Japan sales operation of $1.0 million, and increases in SnowShore employee salary expense and sales commission expense, due to higher revenue, totaling $0.8 million, offset by decreases in depreciation and amortization expenses of $0.5 million. The legal expense increase discussed above was related to litigation and other legal matters costs. The audit expense increase was due to fees associated with Sarbanes Oxley compliance and other non-audit services.

Other Income, Net

Three Months Ended September 30, 2004 and 2003

Other income, net, was $0.2 million for the three months ended September 30, 2004 and $0.7 million for the three months ended September 30, 2003. During the three months ended September 30, 2003, we had a gain on the sale of an investment of $0.5 million from the sale of 0.1 million shares of Network Engines, Inc. common stock acquired from the exercise of stock purchase warrants. During the three months ended September 30, 2004, we had no such gains from the sale of investments.

Nine Months Ended September 30, 2004 and 2003

Other income, net, was $0.5 million for the nine months ended September 30, 2004 and $1.1 million for the nine months ended September 30, 2003. During the three months ended September 30, 2003, we had a gain on the sale of an investment of $0.5 million from the sale of 0.1 million shares of Network Engines, Inc. common stock acquired from the exercise of stock purchase warrants. During the nine months ended September 30, 2004, we had no such gains from the sale of investments.

Income Tax Provision (Benefit)

The following tables presents our income tax provision (benefit) and effective tax rates for the three months and nine months ended September 30, 2004 and 2003:

	Three Months Ended September 30,
	2004			2003
	(dollars in thousands)
Income tax provision	$	295		$	562
Effective tax rate	41		%	38		%

	Nine Months Ended September 30,
	2004			2003
	(dollars in thousands)
Income tax provision (benefit)	$	300		$	(551	)
Effective tax rate (reflecting provision (benefit))	15		%	(28		)%

Three and Nine Months Ended September 30, 2004 and 2003

We recorded an income tax provision of $0.3 million in the three months ended September 30, 2004, compared with an income tax provision of $0.6 million in the three months ended September 30, 2003, resulting in effective tax rates of 41% and 38%, respectively. We recorded an income tax provision of $0.3 million in the nine months ended September 30, 2004, compared with an income tax benefit of $0.5 million in the nine months ended September 30, 2003. The effective tax rate for the nine months ended September 30, 2004 differs from the statutory rate as a result of the non-deductibility of the purchased research and development charge recorded in conjunction with the SnowShore acquisition, the disproportionate relationship between permanent taxable items and our forecasted pre-tax income (loss). Excluding the impact of the SnowShore in-process research and development charge, which is not deductible for tax purposes due to the nature of the acquisition transaction, the effective tax rate for the nine months ended September 30, 2004 is 64% and the anticipated annual effective tax rate is 46%. The current quarter provision included a $0.3 million provision to reflect the change in the anticipated annual effective tax rate since the last quarter.

Liquidity and Capital Resources

Cash flows for the nine months ended September 30, 2004 and 2003

Cash flows from operating activities were $4.8 million in the nine months ended September 30, 2004. This primarily resulted from non-cash expenses exceeding our net loss, along with a decrease in accounts receivable and inventory, offset by a decrease in current liabilities. Cash flows from operating activities were $7.7 million in the nine months ended September 30, 2003. This primarily resulted from income tax refunds of $6.0 million, which were classified as other current assets and reductions in inventory offset by a decrease in current liabilities.

Cash flows from investing activities was $4.4 million in the nine months ended September 30, 2004. This primarily resulted from the net decrease in cash of $8.3 million as a result of the SnowShore acquisition, net sales of marketable debt securities of $5.5 million, expenditures for capital equipment of $0.8 million and the purchase and license of technology for $0.7 million to be used in the development of new products and the modification of existing products. Cash flows from 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 and expenditures for capital equipment of $0.4 million.

Cash flows from financing activities was $2.2 million in the nine months ended September 30, 2004. This was attributable to proceeds from the sale of common stock issued under our employee stock option plans of $3.0 million offset by $0.9 million for the repurchase of 86,000 shares of our common stock. Cash flows from financing activities was $0.2 million in the nine months ended September 30, 2003, all of which was attributable to proceeds from the sale of common stock under our employee stock option plans.

Contractual Obligations and Capital Expenditures

The following table presents our future contractual obligations and commercial commitments as of September 30, 2004:

	Total		Remainder of 2004		2005		2006		2007		2008		Thereafter
	(in thousands)
Operating leases	$	4,916	$	725	$	2,170	$	935	$	360	$	360	$	366

We have operating lease commitments for our primary office and manufacturing facilities that expire between 2005 and 2006. 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. During the third quarter of 2004, we entered into a five year lease for office space in Japan. In addition, we terminated a lease for office space in Massachusetts that was originally scheduled to expire on March 14, 2005.

We have a remaining commitment of approximately $0.4 million related to the acquisition of certain technology. The timing of this payment is subject to the completion of certain additional functionality by the seller, however, we expect to make this payment in the first quarter of 2005. We currently have no material commitments for additional capital expenditures.

We have certain inventory purchase commitments that are part of the ordinary course of business in which the product delivery dates range from one month to five months into the future. We do not expect these short-term commitments to have a material impact on our financial results.

Cash and Cash Liquidity Position

The following table presents our cash and liquidity position as of September 30, 2004 and December 31, 2003:

	September 30, 2004		December 31, 2003
	(dollars in thousands)
Cash and cash equivalents	$	30,722	$		28,081
Marketable debt securities	22,277		27,869
Total	$	52,999	$		55,950

Working capital	$	56,943	$	62,485
Quick ratio	4.0		4.5
Maximum available line of credit	$	5,000	$	5,000

Cash and cash equivalents and marketable debt securities decreased to $53.0 million as of September 30, 2004 from $56.0 million as of December 31, 2003, primarily due to the net decrease in cash of $8.3 million as a result of the SnowShore acquisition and stock repurchase transactions of $0.9 million, offset by the cash flows from operations of $4.8 million and proceeds from the sale of common stock issued under our employee stock option plans of $3.0 million. Working capital decreased by $5.5 million from December 31, 2003 to September 30, 2004 for the same reasons.

Our quick ratio decreased from 4.5 at December 31, 2003 to 4.0 at September 30, 2004, due primarily to the SnowShore acquisition and stock repurchase activity mentioned above and the impact on our cash position. Quick ratio consists of the total of cash and cash equivalents, marketable debt securities, and accounts receivable divided by current liabilities, and is an indicator of a company’s ability to meet short-term financial obligations.

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 our quick ratio, minimum tangible net worth, and other standard reporting requirements. As of September 30, 2004, 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 the use of 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 the nine months ended September 30, 2004, we repurchased 86,000 shares of our common stock for approximately $0.9 million under a stock repurchase program that was authorized by our Board of Directors and that began on October 16, 2003 and expired on October 15, 2004. On October 20, 2004, our Board of Directors authorized a new program for the repurchase of up to 1,000,000 shares of our common stock from time to time on the open market or in privately negotiated transactions subject to regulatory and other considerations. This program is being funded by our existing and future cash and cash equivalents and marketable debt securities balances and will expire on October 19, 2005. As of November 9, 2004, we have repurchased 282,100 shares of common stock under the new program for approximately $2.5 million.

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 the remainder of 2004, we are always looking for opportunities to expand our business, which could include acquisitions or organic expansion into new markets. In April 2004, we used approximately $8.3 million, net of cash acquired, to purchase the outstanding stock of SnowShore. 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.

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.

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 that have affected most technology sectors and the telecommunications sector in particular, over the past few years many of our customers have aggressively sought 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 adversely affected our business and operating results for the first two quarters of 2003, and even more so for the years ended December 31, 2002 and 2001. While we believe the economic condition may be improving somewhat, if current economic conditions do not continue to improve or if they 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 than we have. 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 guarantee 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;

• changes in product life cycles, including the shortening life cycle of products in the market;

• frequent new product introductions or innovations;

• 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 also may 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 19% of our revenue in the year ended December 31, 2003, and we expect this customer will account for more than 10% of our total revenue in 2004. 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 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 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 20% of our revenue in the nine months ended September 30, 2004. We anticipate that international sales will continue to account for a significant portion of our revenue. We are subject to a number of risks as a result of our international sales, including:

• volatility in currency exchange rates;

• political and economic instability in other countries;

• the imposition of trade restrictions, trade barriers, 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

• 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. In addition, obtaining these requisite approvals may require modifications to our products. 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.

In April 2004, we completed our acquisition of SnowShore, a provider of voice over IP communications infrastructure products for the media server and media firewall markets. We may seek to acquire additional strategic 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 an acquired company successfully, our future growth may suffer, and our results of operations could be harmed.

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 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 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 us, or we may otherwise deem it necessary or advisable, 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. 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. Notwithstanding our efforts, third parties may infringe or misappropriate our proprietary rights. 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. In any legal action claiming patent infringement commenced against us, we cannot assure you that we would prevail 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 from third parties certain technology integral to certain of our products. 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.

We are subject to environmental and occupational health and safety regulations that can increase the costs of operations or limit our activities.

We are subject to environmental and occupational health and safety regulations relating to matters such as reductions in the use of harmful substances, comprehensive risk management in manufacturing activities and final products, the use of lead-free soldering, and the recycling of products and packaging materials. On February 13, 2003 the European Parliament and the Counsel of the European Union published directives on waste electrical and electronic equipment and on the restriction of the use of certain hazardous substances in electrical and electronic equipment. These directives will generally require electronics producers after August 2005 to bear the cost of collection, treatment, recovery and safe disposal of past and future products from end-users and to ensure after June 2006 that new electrical and electronic equipment does not contain specified hazardous substances. While the cost of these directives to us cannot be determined before regulations are adopted in individual member states of the European Union, it may be substantial and may divert resources, which could detract from our ability to develop new products. We may not be able to comply in all cases with applicable environmental and other regulations, and if we do not, we may incur remediation costs or we may not be able to offer our products for sale in certain countries, which could adversely affect our results.

Risks Related to Our Common Stock

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;

• quarterly fluctuations in our revenue, which typically is lower in the third quarter due to customer summer vacation schedules, particularly in Europe, and to a lesser extent in 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 decide 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

We invest in marketable debt securities, consisting of U.S. government notes and bonds, certificates of deposit, and corporate debt securities, that expose us to market risk from changes in interest rates. As of September 30, 2004, and December 31, 2003, we estimate that a 1% increase in the effective interest rates would reduce the carrying value of our marketable debt securities by approximately $0.1 million and $0.2 million, respectively. The change in exposure of a 1% change from December 31, 2003 to September 30, 2004 is the result of a lower marketable debt securities balance and shorter average portfolio duration.

Our operations in international markets exposes us to market risk from changes in foreign currency exchange rates. Our exposure to market risk from changes in foreign currency exchange rates as of September 30, 2004 has not changed materially from our exposure at December 31, 2003.

Please refer to our Annual Report on Form 10-K for the year ended December 31, 2003 for more information on market risks related to changes in interest rates and foreign currency exchange rates.

Item 6. 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, 1992 filed with the SEC on March 31, 1993 (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, 1998 filed with the SEC on March 30, 1999 (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 3.2 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).

3.4		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).

3.5		Articles of Amendment to the Restated Articles of Organization of Brooktrout, Inc.

3.6		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).

10.1		Form of Non-Qualified Stock Option Agreement entered into by Brooktrout, Inc. and various executive officers on September 24, 2004 pursuant to the Brooktrout, Inc. Amended and Restated 1992 Stock Incentive Plan.

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 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 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

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, 1992 filed with the SEC on March 31, 1993 (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, 1998 filed with the SEC on March 30, 1999 (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 3.2 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).

3.4		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).

3.5		Articles of Amendment to the Restated Articles of Organization of Brooktrout, Inc.

3.6		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).

10.1		Form of Non-Qualified Stock Option Agreement entered into by Brooktrout, Inc. and various executive officers on September 24, 2004 pursuant to the Brooktrout, Inc. Amended and Restated 1992 Stock Incentive Plan.

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 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 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

	BROOKTROUT, INC.

Date: November 9, 2004	By:	/s/ ERIC R. GILER
		Eric R. Giler President (Principal Executive Officer)

Date: November 9, 2004	By:	/s/ ROBERT C. LEAHY
		Robert C. Leahy Vice President of Finance and Operations (Principal Financial and Accounting Officer)

		Page
PART I FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements	1
	Unaudited Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003	1
	Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2004 and September 30, 2003	2
	Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2004 and September 30, 2003	3
	Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and September 30, 2003	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
	Results of Operations	12
	Liquidity and Capital Resources	16
	Factors That May Affect Future Results	18
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24
Item 4.	Controls and Procedures	25


PART II OTHER INFORMATION
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	26
Item 5.	Other Information	26
Item 6.	Exhibits	27
	Signatures	28
	Exhibit Index	29