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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2004

OR

For the transition period from              to             

Commission File Number 0-17920

MetaSolv, Inc.

(Exact name of registrant as specified in its charter)

5556 Tennyson Parkway

Plano, Texas 75024

(Address of principal executive offices)

Registrant’s telephone number, including area code: (972) 403-8300

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

Indicate by check mark whether Registrant is an accelerated filer (as defined in Rule 126-2 of the Act).    Yes  x    No  ¨

As of June 30, 2004, there were 40,555,289 shares of the registrant’s common stock outstanding.

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METASOLV, INC.

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

METASOLV, INC.

Condensed Consolidated Balance Sheets

(In thousands, except share and per share data)

See accompanying notes to condensed consolidated financial statements.

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METASOLV, INC.

Condensed Consolidated Statements of Operations

(In thousands, except per share data)

See accompanying notes to condensed consolidated financial statements.

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METASOLV, INC.

Condensed Consolidated Statements of Cash Flows

(In thousands)

See accompanying notes to condensed consolidated financial statements.

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METASOLV, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1) Basis of Presentation

These unaudited condensed consolidated financial statements reflect all adjustments (consisting only of those of a normal recurring nature), which are, in the opinion of management, necessary to fairly present the financial position, results of operations and cash flows for the interim periods. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted, although the Company believes that the disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto for the year ended December 31, 2003, contained in the Company’s Annual Report to Stockholders and Form 10-K filed with the Securities and Exchange Commission. Operating results for the six months ended June 30, 2004, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2004.

Statement of Financial Accounting Standards (“SFAS”) No. 130, Reporting Comprehensive Income, establishes requirements for the reporting and display of comprehensive income and its components. Unrealized gains and losses on available-for-sale securities and foreign currency translation adjustments are the only items of other comprehensive income for the Company. Total comprehensive losses are as follows for the three-month and six-month periods ended June 30, 2004 and 2003 (in thousands):

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The Company recognizes compensation cost associated with stock-based awards under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. The difference between the quoted market price as of the date of the grant and the contract purchase price of shares is charged to operations over the vesting period. No compensation cost is recognized for fixed stock options with exercise prices equal to the market price of the stock on the dates of grant (unless there has been a subsequent modification) or for shares acquired by employees under the Company’s stock purchase plans. Pro forma net loss and loss per share disclosures, as if the Company recorded compensation expense based on the fair value for stock-based awards, have been presented in accordance with the provisions of SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, and are as follows for the three-month and six-month periods ended June 30, 2004 and 2003 (in thousands, except per share amounts):

2) Revenue Recognition

The Company recognizes revenue using the “residual method” when there is vendor-specific objective evidence of the fair values of all undelivered elements in a multiple-element arrangement that is not accounted for using long-term contract accounting. Under the residual method, the arrangement fee is recognized as follows: (1) the total fair value of the undelivered elements, as indicated by vendor-specific objective evidence, is deferred and subsequently recognized in accordance with the relevant sections of Statement of Position (“SOP”) 97-2, Software Revenue Recognition, and (2) the difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements.

3) Earnings Per Share

Securities that were not included in the computation of earnings per share because their effect was antidilutive, consist of restricted common stock and options to purchase shares of common stock as follows (in thousands):

4) Acquisitions

In February 2003, the Company acquired London-based Orchestream Holdings plc, a recognized leader in Internet Protocol (IP) service activation software solutions for wire line and mobile carriers. The Orchestream acquisition added an IP service activation product to the Company’s portfolio and technology partnerships in Europe. The Company paid £0.06 per share of Orchestream common stock, valuing the transaction at approximately £7.9 million ($13.0 million). This acquisition became effective on February 1, 2003, and, as of March 31, 2003, the Company had acquired 92% of Orchestream common stock. Effective April 25, 2003, the Company completed the acquisition of the remaining shares and Orchestream became a wholly owned subsidiary.

The Company accounted for the acquisition using the purchase method of accounting, as required by SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. The results of Orchestream have been included with those of the Company effective February 1, 2003.

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The purchase price was allocated to tangible assets and liabilities based on their respective estimated fair values as of the closing date of the transaction. The excess of the purchase price over the fair value of the net tangible assets acquired was allocated to identifiable intangible assets, including customer relationships, contract rights, the core technology related to the products, and in-process research and development costs, partially offset by minority interests with the remainder being allocated to goodwill which will not be deductible for tax purposes. In addition, deferred taxes were recognized for the difference between the book and tax basis of certain intangible assets.

A summary of the allocation of the purchase price follows (in thousands):

The $1.8 million allocated to in-process research and development was charged to expense with $1.6 million recognized in the first quarter of 2003 and the remaining $0.2 million in the second quarter of 2003. Under SFAS No. 142, goodwill recorded as a result of the acquisition was not amortized and was subsequently written off (see note 7). The developed technology is being amortized over its useful life of three years; the customer relationships are being amortized over their useful life of five years; and the contract rights were amortized over one year.

The following summary, which was prepared on a pro forma basis, reflects the results of operations for the six-month period ended June 30, 2003, as if the acquisition had occurred at the beginning of the period (in thousands except for share data):

5) Segment Information

The Company operates in a single operating segment: communication software and related services. Revenue information regarding operations for different products and services is as follows (in thousands):

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6) Restructuring and Other Costs

During the six months ended June 30, 2004, the Company recorded restructuring charges of $4.9 million. The $2.7 million charge in the second quarter consisted of approximately $1.1 million for vacating additional space in our London office, approximately $0.7 million for revised sublease assumptions on previously vacated space, and approximately $0.9 million for a stock compensation charge for options previously granted to a terminating executive. During the first quarter of 2004, the Company reduced its workforce to align costs with expected market conditions, and to continue to integrate and rationalize the operations of previous acquisitions with those of the Company. These actions resulted in charges of $2.1 million and the elimination of 64 positions. The remaining severance payments from the first quarter 2004 actions are expected to be completed by September 30, 2004.

During the six months ended June 30, 2003, the Company restructured its operations to align costs with expected market conditions, and to integrate and rationalize the acquired Orchestream operations with those of the Company. This program resulted in the elimination of 55 positions during the quarter ended March 31, 2003, and 60 positions during the quarter ended June 30, 2003, and charges of $1.3 million and $1.7 million, respectively. All expenditures related to the 2003 employee severance have been completed.

Expenditures related to the exit costs will be completed by the end of 2010.

The following table summarizes the status of the restructuring actions (in thousands):

7) Goodwill and Other Intangible Assets

The Company is required to periodically assess the value of goodwill under the provisions of SFAS No. 142. The Company is one reporting unit, as defined by the standard. As outlined in the authoritative literature, the assessment of whether goodwill has been impaired is based on the Company’s estimate of the fair value of the reporting unit using a model that considers both a discounted future cash flow analysis and market capitalization data.

At March 31, 2003, the market capitalization of the Company had been at a level well below its book value for an extended period. The prolonged decline in the market capitalization indicated that the capitalization of goodwill as a result of the acquisition of Orchestream Holdings plc was not warranted. Accordingly, the Company recorded a charge of $2.2 million to eliminate the goodwill that would have been recorded at the time of the acquisition.

The following is a summary of intangible assets at June 30, 2004 and December 31, 2003 (in thousands):

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Amortization expense related to intangible assets was approximately $850,000 and $1,683,000 for the three months ended June 30, 2004 and 2003, respectively, and approximately $1,914,000 and $3,296,000 for the six months ended June 30, 2004 and 2003, respectively.

Amortization expense related to intangible assets subject to amortization at June 30, 2004, is projected as follows for the next five years (in thousands):

8) Indemnifications

The Company licenses its software and sells services to its customers under contracts that the Company refers to as Master Software License and Service Agreements (“MSLA”). Each MSLA contains the relevant terms of the contractual arrangement with the customer, and normally includes certain provisions for indemnifying the customer against losses, expenses, and liabilities from damages that may be awarded against the customer in the event the Company’s software is found to infringe upon a patent, copyright, trademark, or other proprietary right of a third party. The MSLA usually seeks to mitigate the potential impact of such indemnification obligations in various ways, including but not limited to certain geographic and time limitations, and a right to replace an infringing product.

To date, the Company has not had to reimburse any of its customers for any losses related to these indemnification provisions and no material claims are outstanding as of June 30, 2004. For several reasons, including the lack of prior indemnification claims and the lack of a monetary liability limit for certain infringement cases under the MSLA, the Company cannot determine the maximum amount of future payments, if any, related to such indemnification provisions.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

We are a leading global provider of operations support systems (OSS) software solutions that help communications service providers manage their networks and services. Our network resource management and service activation products automate service providers’ business processes across network planning and engineering, operations and customer care. Our customers successfully use MetaSolv products to introduce new services more easily, reduce service delivery times, reduce operating expenses, and optimize return on capital expenditures. All of our revenues come from the sale of software licenses, related professional services, and support of our software.

Our business was founded in 1992, and soon afterward we began to build order-processing software to help service providers connect local telephone service networks with long distance service networks. By 1999, the year of our introduction as a publicly held company, we had become a leading provider of order processing, management and fulfillment software for service providers offering voice and data communications services over both traditional communications networks and internet-based networks. During that period our customer base was largely composed of competitive local exchange companies. The turndown of the communications market in 2000 through 2001 saw the departure of many of these customers from the marketplace, as funding for competitive local exchange carriers declined severely. In 2002 and 2003, we extended our product portfolio to include service activation products, through successive acquisitions of Nortel Network’s Service Commerce Division (2002) and Orchestream Holdings, plc (2003). These acquisitions also provided us with a significant worldwide expansion of our customer base, operations capabilities and staff of skilled, experienced employees. Today we have offices in 10 locations around the world, serving over 180 customers in over 40 countries, and are internationally recognized as a global leader in OSS software for next-generation communications service providers.

The environment for marketing OSS software solutions to communications service providers remains challenging, after the precipitous downturn in the communications industry that began in late 2000 and accelerated during 2001. MetaSolv’s acquisitions of new products, customers, personnel, and sales territories have been key factors that resulted in significant increases in our operating costs as a percentage of revenue when revenues from certain products were declining during 2002 and 2003. The difficult market environment along with these acquisitions necessitated that we rationalize our product offerings and reduce staffing levels in order to realize expected cost synergies and to bring our cost structure to a sustainable level.

We expect the trends that will drive increasing demand for our products and services will include an increasing worldwide use of converged, multi-service IP-based infrastructure for both mobile and fixed environments, and an overall growing demand for voice and data services. We have continued to invest in research and development of our products, particularly in the areas of network resource management and service activation capabilities, in order to meet the requirements of our customers and be well positioned for future growth.

We believe our product portfolio, our customer base, our people, and our continued investment and focus on network resource management and activation position us well to provide end to end service fulfillment capabilities to both leading and emerging communications service providers around the world.

CRITICAL ACCOUNTING POLICIES

We prepare financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America. This requires management to make judgments, assumptions and estimates that affect significantly the amounts reported in the financial statements and accompanying notes. For example, estimates are used in the accounting for the allowance for doubtful accounts, contingencies, restructuring costs, realizability of deferred tax assets and other special charges. Actual results may differ from these estimates.

Our software licensing and professional services agreements with customers typically have terms and conditions that are described in signed orders and a master agreement with each customer. Our sales for a given period typically involve large financial commitments from a relatively small number of customers. Accordingly, delays in the completion of sales during a quarter may negatively impact revenues in that quarter. Consistent with industry practice, we sometimes agree to bill our license fees in more than one installment over extended periods. When installments extend beyond six months, amounts not due immediately are deferred and recorded as revenue when payments are due, assuming all revenue recognition criteria have been met.

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We recognize license revenues when our customer has signed a license agreement, we have delivered the software product, product acceptance is not subject to express conditions, the fees are fixed or determinable and we consider collection to be probable. We allocate the agreed fees for multiple products and services licensed or sold in a single transaction among the products and services using the “residual method” as required by SOP 98-9 (Software Revenue Recognition, With Respect to Certain Transactions), deferring the fair value of the undelivered elements and recognizing the residual amount of the fees as revenue upon delivery of the software license. On occasion we may enter into a license agreement with a customer requiring development of additional software functions or services necessary for the software’s performance of specified functions. For those agreements, we recognize revenue for the entire arrangement on a percentage-of-completion basis as the development services are provided. We generally recognize service revenues as the services are performed. We recognize revenues from maintenance agreements ratably over the maintenance period, usually one year.

Our software products are priced to be competitive in our target market segments, which include large facility-based incumbent service providers and wireless and IP service providers. We charge a base price for core products, coupled with additional license fees for add-on modules. In addition, we typically scale our license pricing based on the extent of our customer’s usage as measured by the number of users of our product, the number of our customer’s subscribers, or the size of the network that our product helps to manage. We sell additional license capacity for our products when our customers’ usage of our product exceeds earlier license limits. Annual maintenance and support contracts are generally priced as a percentage of the license fee for the product being maintained. For a new customer, our initial sale of licenses and associated services, including maintenance and support, generally ranges from several hundred thousand to several million dollars.

Service revenues consist principally of software implementations, upgrades and configurations, and customer training, as well as software maintenance agreements that include both customer support and the right to product updates. We use our own employees and subcontract with system integrator partners to provide consulting services to our customers. The majority of our service contracts are priced on an hourly basis. We also offer fixed-price consulting packages, primarily for repeatable solutions.

Since we implement some of our services on a fixed fee basis, if we incur more costs than we expect in implementations, our profitability will suffer. Our process for tracking progress to completion on such arrangements is through individual detailed project plans and regular review of labor hours incurred compared to estimated hours to complete the project. When estimates of costs to complete the project indicate that a loss will be incurred, these losses are recognized immediately.

Any estimation process, including that which is used in preparing contract accounting models, involves inherent risk. To the extent that our estimates of revenues and expenses on these contracts change periodically in the normal course of business, due to modifications of our contractual arrangements or changes in cost, such changes would be reflected in the results of operations as a change in accounting estimates in the period the revisions are determined.

We normally ship our software and perform services shortly after we receive orders. As a result, our quarterly financial results are largely dependent on orders received during that period.

We recognize revenue only in cases where we believe collection is probable. In situations where collection is doubtful or when we have indications that a customer is facing financial difficulty, we recognize revenue as cash payments are received. In addition, for customers not on the cash basis of accounting, we maintain an allowance for doubtful accounts based upon the expected collectibility of accounts receivable. We regularly review the adequacy of our allowance for doubtful accounts through identification of specific receivables where it is expected that payment will not be received, in addition to establishing a general reserve policy that is applied to all amounts that are not specifically identified. If there is a deterioration of a major customer’s credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due us could be adversely affected. The allowance for doubtful accounts reflects our best estimate of the ultimate recovery of accounts receivable as of the reporting date. Changes may occur in the future that may cause us to reassess the collectibility of amounts and at which time we may need to reduce or provide additional allowances in excess of that currently provided.

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We assess the realizability of our deferred tax assets by projecting whether it is more likely than not that some portion or all of the deferred tax assets will not be realized in the foreseeable future. Accordingly, we carry a valuation allowance against our deferred tax assets, which are related primarily to net deductible temporary differences, tax credit carryforwards and net operating loss carryforwards. We evaluate a variety of factors in determining the amount of the deferred income tax assets to be recognized pursuant to SFAS No. 109, “Accounting for Income Taxes”, including our earnings history, the number of years our operating loss and tax credits can be carried forward, the existence of taxable temporary differences, near-term earnings expectations, and the highly competitive nature of the telecommunication industry and its potential impact on our business. As a result of these analyses, we have stopped recognizing deferred tax benefits as of April 1, 2003.

We evaluate our long-lived assets, including acquired intangibles, for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. The recoverability of any assets to be held and used is measured by a comparison of the carrying amount of any asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell.

PRO FORMA FINANCIAL RESULTS

We report quarterly unaudited financial statements prepared in accordance with accounting principles generally accepted in the United States of America. We also report pro forma financial information in earnings releases and investor conference calls. This pro forma financial information excludes certain non-cash and special charges, consisting primarily of the amortization and impairment of goodwill and other intangible assets, purchased in process research and development write-offs, stock compensation expenses, and restructuring costs. In accordance with applicable regulations, when we disclose pro forma financial information, such disclosure is accompanied by (i) the most comparable financial measure calculated and presented in accordance with accounting principles generally accepted in the United States of America and (ii) a reconciliation of the differences between the pro forma financial information and the most comparable financial measure. We believe the disclosure of the pro forma financial information helps investors evaluate the results of our ongoing operations. However, we urge investors to carefully review the financial information that conforms to accounting principles generally accepted in the United States of America that accompanies the pro forma financial information and that is included as part of our quarterly reports on Form 10-Q and our annual reports on Form 10-K.

ACQUISITIONS

Orchestream. In the first quarter of 2003, we acquired Orchestream Holdings plc, a UK headquartered company whose core product is Service Activator. With this acquisition, we expanded our OSS product suite with market-leading software that automates fulfillment and simplifies management and configuration of complex internet protocol virtual private networks (IP VPNs). This acquisition strengthened our globalization, mobile and IP efforts by adding key customers and expanding our European presence. The Orchestream Service Activator product complements our OSS assets previously acquired from Nortel Networks, and allowed us to further penetrate mobile and fixed-line carriers with a comprehensive capability for managing complex IP VPNs. We acquired Orchestream for approximately £7.9 million ($13.0 million). Our financial results include revenues and costs of Orchestream since February 1, 2003.

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Results of Operations

The following table sets forth, for the periods indicated, the percentage of total revenues represented by certain line items in our statements of operations.

Revenues

Total revenues in the second quarter of 2004 were $19.9 million, a 9% decrease from $21.8 million in the second quarter of 2003. For the first six months of 2004, total revenues decreased 8% to $39.5 million from $43.0 million in the first six months of 2003. The decrease in revenues in both the quarter and six-month periods primarily resulted from fewer large software license transactions and related implementation projects.

License Fees. License revenues in the second quarter of 2004 were $5.9 million, a 14% decrease from $6.9 million in the second quarter of 2003. For the first six months of 2004, license revenues decreased 18% to $11.8 million from $14.4 million in the first six months of 2003. During the first half of 2003, MetaSolv recorded revenue from several multi-million dollar service activation projects, whereas the license transactions in 2004 have not been of a similar magnitude. License revenue from network resource management solutions in the first six months of 2004 have increased compared to the amounts for the same period in 2003 due to the release of our new MetaSolv Solution M6 product.

Services. Services revenues are comprised of both technical consulting and education services, and post-contract customer support. Services revenues of $14.0 million in the second quarter of 2004 represent a 7% decrease from $15.0 million in the second quarter of 2003. For the first six months of 2004, services revenues decreased 3% to $27.6 million from $28.5 million in the first six months of 2003.

Consulting and education service revenues decreased 14% to $4.3 million in the second quarter of 2004 from $5.0 million in the second quarter of 2003. For the first six months of 2004, consulting and education revenues decreased 10% to $8.1 million from $9.0 million in the first six months of 2003. This decrease in consulting and education revenues in the three and six month periods resulted from smaller consulting projects and more competitive pricing of services.

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Post-contract customer support, or maintenance revenues, decreased 3% to $9.7 million in the second quarter of 2004, from $10.0 million in the second quarter of 2003. This decline in maintenance revenues is primarily due to 2003 revenues including an arrangement to provide support to a customer for a third party software product on a resale basis. In 2004 this maintenance was contracted directly between the third party provider and the customer. Maintenance revenues were $19.5 million in each of the six-month periods ended June 30, 2004 and 2003. Excluding the resale of third party maintenance in 2003, maintenance revenues in the six-month period ended June 30, 2004, represented a 3% increase over the first six months of 2003. This increase primarily resulted from high customer retention and the addition of new maintenance revenues from recently completed license sales.

Concentration of Revenues. As of June 30, 2004, our active customer list includes more than 180 communication service providers worldwide, including approximately two-thirds of the world’s 30 largest service providers. During the second quarter of 2004, our top ten customers represented 48% of our total revenue with the largest customer representing 15% of total revenue. In any given quarter, we generally derive a significant portion of our revenues from a small number of relatively large sales. A loss or significant decrease in the sale of products and services to any customer from whom we received a high percentage of our total revenues during a recent quarter is likely to have a material adverse affect on our results of operations and financial condition. Additionally, our inability to consummate one or more substantial sales in any future period could harm our operating results for that period.

International Revenues. During the second quarter of 2004, we recognized $11.8 million in revenues from customers outside the United States compared to $12.5 million in the second quarter of 2003, representing 59% and 57% of revenue in each period, respectively. International revenues for the first half of 2004 and 2003 were $24.4 million and $23.5 million, representing 62% and 55% of total revenues, respectively.

Cost of Revenues

License Cost. License cost of revenues consists primarily of royalties for third party software sold in conjunction with our products. License cost of revenues was $0.2 million in the second quarter of 2004, and $0.3 million in the second quarter of 2003, representing 3% and 5% of license revenues in each period, respectively. For the first six months of 2004, license costs were $0.4 million, compared to $0.9 million in the first six months of 2003, representing 3% and 6% of license revenue in each period, respectively. The decrease in license cost of revenues as a percentage of license revenues in both periods was primarily due to the mix of products sold. Royalties on individual license products range from zero to approximately 50% of revenue.

We plan to continue the use of third party software where it provides an advantage for our customers. While this plan lowers our overall product development cost, it may increase our cost of license revenues, both in absolute terms and as a percentage of revenues.

Service Cost. Service cost of revenues consists of expenses to provide consulting, training and maintenance services. These costs include compensation and related expenses for employees and fees for third party consultants who provide services for our customers under subcontractor arrangements.

Service cost of revenues was $6.7 million in the second quarter of 2004, down from $8.4 million in the second quarter of 2003, representing 48% and 56% of service revenues in each period, respectively. For the first six months of 2004, service costs decreased 17% to $13.8 million from $16.7 million in the first six months of 2003, representing 50% and 59% of service revenues in each period, respectively. This decrease in service cost of revenues in both the quarter and six-month comparisons was primarily due to lower professional consulting staff. Service margins improved in the second quarter and year-to-date periods of 2004 over the same periods in 2003 due to improvements in the utilization of the remaining consulting staff.

Amortization of Intangible Assets. The value assigned to intangible assets, primarily technology rights, is amortized over the estimated useful life of the assets using the greater of straight-line or the ratio that current gross revenues related to those assets bears to the total current and anticipated future gross revenues related to those assets. The original estimated useful lives of these assets range from nine months to sixty months.

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In the second quarter of 2004, cost of revenues included $0.9 million in amortization of intangible assets, a decrease of 49% from $1.7 million in the second quarter of 2003. For the first six months of 2004, amortization of intangible assets totaled $1.9 million, compared to $3.3 million in the first six months of 2003. The decrease in amortization expense between 2004 and 2003 is due to completion of the amortization of certain intangibles from the acquisition of OSS assets from Nortel Networks in 2002.

Operating Expenses

Research and Development Expenses. Research and development expenses consist primarily of costs related to our staff of software developers, contracted development costs and the associated infrastructure costs required to support product development. During the second quarter of 2004, research and development expenses decreased 32% to $5.8 million from $8.5 million in the second quarter of 2003, representing 29% and 39% of total revenues in each period, respectively. For the first six months of 2004, research and development expenses decreased 21% to $12.8 million from $16.3 million in the first six months of 2003, representing 32% and 38% of revenues in each period, respectively. The decrease in research and development expense for both the quarterly and year to dates periods was primarily due to a 20% reduction in staffing, related to the consolidation of our European research and development function into our Canadian operations.

During second quarter of 2004, our research and development investments were focused on our core competencies of network resource management, network mediation, and service activation, in support of mobility, internet protocol (IP) and voice over IP (VOIP) domains. Additionally, we are investing to ease integration for our customers, enabling rapid flow-through of service requests not only within our portfolio but between MetaSolv products with other business systems to further automate our customers’ business processes and lower their overall cost of doing business. During the past year we have focused our development investments in core product areas, while lowering development costs in general by shifting many routine tasks to offshore development resources.

The modular structure of our products allows communication service providers to implement product functionality in phases, depending on their needs, to realize near-term value and to maximize opportunities for longer-term benefits from an integrated OSS system.

Our product development methodology generally establishes technological feasibility near the end of the development process, when we have a working model. Costs incurred after the development of a working model and prior to product release are insignificant. Accordingly, we have not capitalized any software development costs.

Sales and Marketing Expenses. Sales and marketing expenses consist primarily of salaries, commissions, travel, trade shows, and other related expenses required to sell our software.

In the second quarter of 2004, sales and marketing expenses decreased 20% to $5.8 million from $7.2 million in the second quarter of 2003, representing 29% and 33% of revenue in each period, respectively. For the first six months of 2004, sales and marketing expenses decreased 14% to $11.5 million from $13.3 million in the first six months of 2003, representing 29% and 31% of revenues in each period, respectively. The decrease in sales and marketing expense in 2004 compared to 2003 for both the quarter and the year-to-date periods was primarily due to 24% lower staffing and related expenses. The staffing reductions were due to integration of the acquired businesses and the alignment of resources with expected market conditions. We will invest in sales and marketing resources, where necessary, in order to expand our direct and indirect sales and marketing channels, and to achieve additional revenues.

General and Administrative Expenses. General and administrative expenses consist of costs for finance and accounting, legal, human resources, information systems, facilities, bad debt expense, and corporate management not directly allocated to other departments.

General and administrative expenses in the second quarter of 2004 decreased 25% to $2.7 million, compared to $3.6 million in the second quarter of 2003, representing 13% and 16% of revenues in each period, respectively. For the first six months of 2004, general and administrative expenses decreased 32% to $5.4 million from $8.0 million in the first six months of 2003, representing 14% and 19% of revenues in each period, respectively. The decrease in general and administrative expenses for both the quarter and the year-to-date periods, was primarily due to 23% lower staffing in administrative functions, cost reductions in facilities and telecommunications expense, and lower provisions for bad debts.

In-Process Research and Development Write-Off. In connection with our acquisition of Orchestream, we recorded acquired in-process research and development (IPR&D) charges of $1.6 million and $0.2 million in the quarters ended

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March 31 and June 30, 2003, respectively. These in-process projects consisted primarily of upgrades to existing products. The value of the IPR&D was calculated using a discounted cash flow analysis of the anticipated income stream of the related product sales. The projected net cash flows were computed using discount rates from 27% to 30% for the various IPR&D projects.

There were no IPR&D charges during the first half of 2004.

Restructuring and other Costs. During the second quarter of 2004, we recorded a restructuring charge of $2.7 million, comprised of $1.8 million related to consolidation of facilities and $0.9 million in stock compensation expense related to a former executive. During the first quarter of 2004, we reduced our workforce to align costs with expected market conditions. These actions consisted of $2.1 million for a reduction of 64 positions. The estimated annualized cost savings from these reductions is approximately $7 million. The severance payments are expected to be completed by September 30, 2004.

During the six months ended June 30, 2003, the Company restructured its operations to align costs with expected market conditions, and to integrate and rationalize the acquired Orchestream operations with those of the Company. This program resulted in the elimination of 55 positions during the quarter ended March 31, 2003, and 60 positions during the quarter ended June 30, 2003, and charges of $1.3 million and $1.7 million, respectively.

Goodwill Impairment. We are required to periodically assess the value of goodwill under the provisions of Statement of Financial Accounting Standards No. 142. We are one reporting unit, as defined by the Standard. As outlined in the authoritative literature, the assessment of whether goodwill has been impaired is based on our estimate of the fair value of the reporting unit using a model that considers both a discounted future cash flow analysis and market capitalization data.

At the end of the second quarter of 2003, our market capitalization remained at a level well below our book value, and therefore the prolonged decline in our market capitalization indicated capitalization of goodwill as a result of the Orchestream Holdings plc acquisition was not warranted. Accordingly, we eliminated the goodwill and recorded a charge of $2.2 million in the first quarter of 2003.

Interest and Other Income, Net

In the second quarter of 2004, interest and other income, net, consisting primarily of interest income, was $0.3 million, the same as second quarter 2003, with lower interest income offset by favorable exchange gains in the second quarter of 2004. For the first six months of 2004, interest and other income, net, decreased 31% to $0.4 million from $0.6 million in the first six months of 2003. The decrease in interest and other income was primarily due to the decline in cash and marketable securities balances upon which we receive interest income and a decline in the yields on our investments.

Income Tax Expense (Benefit)

We recorded income tax expense of $0.2 million in the second quarter of 2004 and $0.1 million in 2003. The tax expense in second quarter of 2004 was international withholding taxes. For the first six months of 2004, we recorded income tax expense of $0.4 million for international withholding taxes, compared to a benefit of $2.4 million in the first six months of 2003.

Under Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (“FAS 109”), deferred tax assets and liabilities are determined based on the difference between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. FAS 109 provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the available evidence, which includes our recent operating performance and projections for near term future performance, we are continuing to fully reserve our deferred tax assets, which we started reserving in the second quarter of 2003. We believe that, when taxable income is generated, the reversal of this valuation reserve will result in a tax provision that will be lower than the expected tax rate based on the statutory US federal tax rate.

Liquidity and Capital Resources

At June 30, 2004, our primary sources of liquidity were cash and cash equivalents and marketable securities totaling $33.4 million and representing 48% of total assets. We invest our cash in excess of current operating requirements in short

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and intermediate term investment grade securities that are available for sale as needed. Total cash and marketable securities decreased $8.5 million during the six month period ended June 30, 2004, from a balance of $41.9 million at December 31, 2003.

Cash used in operating activities during the six months ended June 30, 2004, was $8.8 million, comprised of our $11.2 million net loss adjusted for non-cash items such as amortization of intangibles, depreciation expense and non-cash changes in working capital.

Net cash used in investing activities was $3.6 million for the first six months of 2004, comprised primarily of a net purchase of $2.5 million of marketable securities and $1.2 million of expenditures for operating equipment and facilities improvement.

Cash generated by financing activities was $1.5 million for the six months of 2004, comprised of proceeds from the exercise of employee stock options and the issuance of common shares through our employee stock purchase plan.

We have no unusual capital commitments at June 30, 2004, and our principal commitments consist of obligations under operating leases.

We believe that our projected cash flows to be generated by operations, together with current cash and marketable securities balances, will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the next twelve months. From time to time we evaluate potential acquisitions and other strategic relationships with complementary businesses, products and technologies. Should cash balances be insufficient to meet our long-term business objectives, or to complete an acquisition, we may seek to sell additional equity or debt securities. The decision to sell additional equity or debt securities could be made at any time and could result in additional dilution to our stockholders.

New Accounting Pronouncements

There were no new accounting pronouncements in the second quarter of 2004 that would have a material impact on our financial results.

Factors That May Affect Future Results

We operate in a dynamic and rapidly changing environment that involves numerous risks and uncertainties. The following section describes some, but not all, of these risks and uncertainties that we believe may adversely affect our business, financial conditions or results of operations. There are additional risks and uncertainties that we do not presently know, or that we currently view as immaterial, that may also impair our business operations. This report is qualified in its entirety by these risks. You should carefully consider the risks described below before making an investment decision. If any of the following risks actually occur, they could materially harm our business, financial condition, or results of operations. In that case, the trading price of our common stock could decline.

OUR QUARTERLY OPERATING RESULTS CAN VARY SIGNIFICANTLY AND MAY CAUSE OUR STOCK PRICE TO FLUCTUATE.

Our quarterly operating results can vary significantly and are difficult to predict. As a result, we believe that period-to-period comparisons of our results of operations are not a good indication of our future performance. It is likely that in certain quarters our operating results will be below the expectations of public market analysts or investors. In such an event, the market price of our common stock may decline significantly. A number of factors are likely to cause our quarterly results to vary, including:

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We forecast the volume and timing of orders for our operational planning, but these forecasts are based on many factors and subjective judgments, and we cannot assure their accuracy. We have hired and trained a large number of personnel in core areas, including product development and professional services, based on our forecast of future revenues. As a result, significant portions of our operating expenses are fixed in the short term. Therefore, failure to generate revenues according to our expectations in a particular quarter could have an immediate material negative effect on results for that quarter.

Our quarterly revenues are dependent, in part, upon orders booked and delivered during that quarter. We expect that our sales will continue to involve large financial commitments from a relatively small number of customers. As a result, the cancellation, deferral, or failure to complete the sale of even a small number of licenses for our products and related services may cause our revenues to fall below expectations. Accordingly, delays in the completion of sales near the end of a quarter could cause quarterly revenues to fall substantially short of anticipated levels. Significant sales may also occur earlier than expected, which could cause operating results for later quarters to compare unfavorably with operating results from earlier quarters.

Some contracts for software licenses may not qualify for revenue recognition upon product delivery. Revenue may be deferred when there are significant elements required under the contract that have not been completed, there are express conditions relating to product acceptance, there are deferred payment terms, or when collection is not considered probable. A higher concentration of orders from large telecom service providers, and larger more complex agreements, may increase the frequency and amount of these deferrals. With these uncertainties we may not be able to predict accurately when revenue from these contracts will be recognized.

THE COMMUNICATIONS MARKET IS CHANGING RAPIDLY, AND FAILURE TO ANTICIPATE AND REACT TO THE RAPID CHANGE COULD RESULT IN LOSS OF CUSTOMERS OR UNPRODUCTIVE EXPENDITURES.

Over the last decade, the market for communications products and services has been characterized by rapid technological developments, evolving industry standards, dramatic changes in the regulatory environment, emerging

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companies, bankruptcy filings by many new entrants, and frequent new product and service introductions. Our future success depends largely on our ability to enhance our existing products and services and to introduce new products and services that are capable of adapting to changing technologies, industry standards, regulatory changes, and customer preferences. If we are unable to successfully respond to these changes or do not respond in a timely or cost-effective way, our sales could decline and our costs for developing competitive products could increase.

New technologies, services or standards could require significant changes in our business model, development of new products or provision of additional services. New products and services may be expensive to develop and may result in our encountering new competitors in the marketplace. Furthermore, if the overall market for our software grows more slowly than we anticipate, or if our products and services fail in any respect to achieve market acceptance, our revenues would be lower than we anticipate and operating results and financial condition could be materially adversely affected.

THE COMMUNICATIONS INDUSTRY IS EXPERIENCING CONSOLIDATION, WHICH MAY REDUCE THE NUMBER OF POTENTIAL CUSTOMERS FOR OUR SOFTWARE.

The communications industry has experienced significant consolidation. In the future, there may be fewer potential customers requiring operations support systems and related services, increasing the level of competition in the industry. In addition, larger communications companies generally have stronger purchasing power, which could create pressure on the prices we charge and the margins we realize. These companies are also striving to streamline their operations by combining different communications systems and the related operations support systems into one system, reducing the number of vendors needed. Although we have sought to address this situation by continuing to market our products and services to new customers and by working with existing customers to provide products and services that they need to remain competitive, we cannot be certain that we will not lose additional customers as a result of industry consolidation.

CONSOLIDATIONS IN THE COMMUNICATIONS INDUSTRY OR SLOWDOWN IN COMMUNICATIONS SPENDING COULD HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATION.

We have derived substantially all of our revenues from sales of products and related services to the communications industry. Slowdowns in spending often cause delays in sales and installations and could cause cancellations of current or planned projects, any of which could harm our financial results in a particular period.

OUR CUSTOMERS’ FINANCIAL WEAKNESS OR THEIR INABILITY TO OBTAIN FINANCING MAY LEAD TO LOWER SALES AND DECREASED PROFITABILITY.

Many of our customers are small to medium sized competitive communications service providers with limited operating histories. Some of these customers are not profitable and dependent on private sources of capital to fund their operations, and many competitive communications service providers are currently unable to obtain sufficient funds to continue expansion of their businesses. At the same time, many communications companies are encountering significant difficulties in achieving their business plans and financial projections. During the last three years, several of our customers ceased their business operations, and a significant number initiated bankruptcy proceedings. The downturn in the communications industry and the inability of many communications companies to raise capital have resulted in a decrease in the number of potential customers that are capable of purchasing our software, a delay by some of our existing customers in purchasing additional products, decreases in our customers’ operating budgets relating to our software maintenance services, delays in payments by existing customers, or failure to pay for our products. If our customers are unable to obtain adequate financing, sales of our software could suffer. If we fail to increase revenue related to our software, our operating results and financial condition would be adversely affected. In addition, adverse market conditions and limitations on the ability of our current customers to obtain adequate financing could adversely affect our ability to collect outstanding accounts receivable resulting in increased bad debt losses and a decrease in our overall profitability. Decreases in our customers’ operating budgets relating to software maintenance services could adversely affect our maintenance revenues and profitability. Any of our current customers who cease to be viable business operations would no longer be a source of maintenance revenue, or revenue from sales of additional software or services products, and this could adversely affect our financial results.

WE RELY ON A LIMITED NUMBER OF CUSTOMERS FOR A SIGNIFICANT PORTION OF OUR REVENUES.

A significant portion of revenues each quarter is derived from a relatively small number of large sales. As consolidation in the communications industry continues, our reliance on a limited number of customers for a significant portion of our revenues may increase. The amount of revenue we derive from a specific customer is likely to vary from