Catapult Communications 10Q 2006 Q2 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


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

For the quarterly period ended March 31, 2006


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 number 0-24701

CATAPULT COMMUNICATIONS CORPORATION

(Exact name of Registrant as specified in its charter)


Nevada		77-0086010
(State or other jurisdiction of		(I.R.S. Employer
Incorporation or organization)		Identification Number)

160 South Whisman Road
Mountain View, California 94041

(650) 960-1025

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

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Securities Exchange Act of 1934. (Check one):


Large accelerated filero		Accelerated filerþ		Non-accelerated filero

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ

As of April 28, 2006, there were 14,798,228 shares of the Registrant’s Common Stock, $0.001 par value, outstanding.

CATAPULT COMMUNICATIONS CORPORATION

FORM 10-Q

INDEX


	Page
Part I—Financial Information

Item 1. Financial Statements

Unaudited Condensed Consolidated Balance Sheets at March 31, 2006 and September 30, 2005		1

Unaudited Condensed Consolidated Statements of Operations for the three and six months ended March 31, 2006 and 2005		2

Unaudited Condensed Consolidated Statements of Cash Flows for the six months ended March 31, 2006 and 2005		3

Notes to Unaudited Condensed Consolidated Financial Statements		4

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		12

Item 3. Quantitative and Qualitative Disclosures About Market Risk		21

Item 4. Controls and Procedures		21

Part II—Other Information

Item 1. Legal Proceedings		22

Item 1A. Risk Factors		22

Item 4. Submission of Matters to a Vote of Security Holders		30

Item 6. Exhibits		30

Signatures		31
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32

Part I. Financial Information

Item 1. Financial Statements

CATAPULT COMMUNICATIONS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS


	March 31,		September 30,
	2006		2005
	(In thousands)
ASSETS
Current Assets:
Cash and cash equivalents	$	31,631	$	24,852
Short-term investments		39,857		43,955
Accounts receivable, net		12,395		14,724
Inventories		4,495		3,104
Deferred income taxes		952		603
Prepaid expenses		1,805		1,401

Total current assets		91,135		88,639
Property and equipment, net		1,921		1,693
Goodwill		49,394		49,394
Other intangibles, net		3,540		4,051
Other assets		3,958		3,983

Total assets	$	149,948	$	147,760


LIABILITIES AND STOCKHOLDERS’ EQUITY

Current Liabilities:
Accounts payable	$	967	$	1,547
Accrued liabilities		4,082		5,508
Deferred revenue		10,997		7,697

Total current liabilities		16,046		14,752
Deferred revenue, long-term portion		371		485

Total liabilities		16,417		15,237

Stockholders’ Equity:
Common stock		15		15
Additional paid-in capital		50,652		48,944
Deferred stock-based compensation		—		(3	)
Accumulated other comprehensive income		530		587
Retained earnings		82,334		82,980

Total stockholders’ equity		133,531		132,523

Total liabilities and stockholders’ equity	$	149,948	$	147,760

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

CATAPULT COMMUNICATIONS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


	Three months ended						Six months ended
	March 31,						March 31,
	2006			2005			2006			2005
	(In thousands, except per share amounts)
Revenues:
Products	$	6,914		$	15,095		$	15,448		$	27,468
Services		3,749			3,955			7,317			7,453

Total revenues		10,663			19,050			22,765			34,921

Cost of revenues:
Products		1,245			1,429			2,433			2,671
Services		956			852			2,018			1,673
Amortization of purchased technology		172			172			343			343

Total cost of revenues		2,373			2,453			4,794			4,687

Gross profit		8,290			16,597			17,971			30,234

Operating expenses:
Research and development		3,433			3,211			6,515			6,182
Sales and marketing		4,154			4,802			8,782			9,505
General and administrative		2,321			2,026			4,748			3,932

Total operating expenses		9,908			10,039			20,045			19,619

Operating income (loss)		(1,618	)		6,558			(2,074	)		10,615
Interest income		620			289			1,240			513
Other income (expense), net		40			(144	)		53			(137	)

Income (loss) before income taxes		(958	)		6,703			(781	)		10,991
Provision for (benefit from) income taxes		(169	)		1,273			(135	)		1,748

Net income (loss)	($	789	)	$	5,430		($	646	)	$	9,243


Net income (loss) per share — basic	($	0.05	)	$	0.37		($	0.04	)	$	0.63

Net income (loss) per share — diluted	($	0.05	)	$	0.36		($	0.04	)	$	0.61


Shares used in per share calculation:
Basic		14,784			14,676			14,763			14,637
Diluted		14,784			15,103			14,763			15,129

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

CATAPULT COMMUNICATIONS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


	Six months ended
	March 31,
	2006			2005
	(In thousands)
Cash flows from operating activities:
Net income (loss) as reported	$	(646	)	$	9,243
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of property and equipment		477			892
Amortization of deferred stock-based compensation		3			18
Amortization of purchased technology		343			343
Amortization of other acquisition related intangibles		168			168
Stock based compensation expenses		1,054			—
Provision for doubtful accounts		—			40
Deferred income taxes		(351	)		62
Total tax benefits related to stock based compensation		80			—
Excess tax benefits from stock options exercised		(35	)		—
Change in assets and liabilities:
Accounts receivable		2,341			(2,575	)
Inventories		(1,405	)		(156	)
Prepaid expenses		(419	)		146
Other assets		24			23
Accounts payable		(572	)		(405	)
Accrued liabilities		(1,403	)		338
Deferred revenue		3,185			2,340


Net cash provided by operating activities		2,844			10,477


Cash flows from investing activities:
Sale and maturities of short-term investments		42,608			20,341
Purchase of short-term investments		(38,471	)		(26,758	)
Purchase of property and equipment		(719	)		(467	)


Net cash provided by (used in) investing activities		3,418			(6,884	)


Cash flows from financing activities:
Proceeds from exercise of stock options		576			1,890
Excess tax benefit from stock-based compensation		35			—


Net cash provided by financing activities		611			1,890


Effect of exchange rate changes on cash and cash equivalents		(94	)		152

Net increase in cash and cash equivalents		6,779			5,635
Cash and cash equivalents, beginning of period		24,852			20,108


Cash and cash equivalents, end of period	$	31,631		$	25,743


Unrealized gain (loss) on investments	$	40		$	(37	)

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

CATAPULT COMMUNICATIONS CORPORATION

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1—THE COMPANY AND BASIS OF PRESENTATION

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

The accompanying unaudited interim condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended September 30, 2005 and filed with the SEC on December 14, 2005. The unaudited condensed consolidated financial statements as of March 31, 2006, and for the three and six months ended March 31, 2006 and 2005, reflect, in the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to state fairly the financial information set forth herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for any subsequent interim period or for an entire year. The September 30, 2005 balance sheet was derived from audited financial statements at that date, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

NOTE 2—RECENT ACCOUNTING PRONOUNCEMENTS

In November 2005, the FASB issued FSP FAS123(R)-3,Transition Election to Accounting for the Tax Effects of Share-Based Payment Awards.This FSP requires an entity to follow either the transition guidance for the additional-paid-in-capital pool as prescribed in SFAS 123(R),Share-Based Payment, (“SFAS 123(R)”) or the alternative transition method as described in the FSP. An entity that adopts SFAS 123(R) using the modified prospective application may make a one-time election to adopt the transition method described in this FSP. An entity may take up to one year from the later of its initial adoption of SFAS 123(R) or the effective date of this FSP to evaluate its available transition alternatives and make its one-time election. This FSP became effective in November 2005. We continue to evaluate the impact that the adoption of this FSP could have on our financial statements.

In February 2006, the FASB issued FSP FAS123(R)-4,Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event.This FSP addresses the classification of options or similar instruments issued as employee compensation that allow for cash settlement upon the occurrence of a contingent event. The guidance in this FSP amends paragraph 32 and A229 of SFAS 123(R),Share-Based Payment.This FSP became effective in February 2006. We expect the adoption of SFAS 123(R)-4 will not have a material effect on our financial position or results of operations.

NOTE 3 — STOCK-BASED COMPENSATION

Effective October 1, 2005, the Company adopted FASB Statement Number 123(R),Share-Based Payment,(“SFAS 123(R)”). SFAS 123(R) establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period. The Company previously applied Accounting Principles Board (APB) Opinion No. 25,Accounting for Stock Issued to Employees, and related Interpretations and provided the required pro forma disclosures of SFAS No. 123,Accounting for Stock-Based Compensation(“SFAS 123”). The Company elected to adopt the modified prospective application method as provided by SFAS 123(R), and, accordingly, the Company recorded compensation costs as the requisite service

rendered for the unvested portion of previously issued awards that remain outstanding at the initial date of adoption and any awards issued, modified, repurchased, or cancelled after the effective date of SFAS 123(R). The Company recognizes compensation expense for stock option awards on a ratable basis over the requisite service period of the award.

Periods prior to the adoption of SFAS 123(R)

The following table illustrates the effect on net income and net income per share as if the Company had applied the fair value recognition provisions of SFAS 123(R) to options granted under the Company’s stock-based compensation plans prior to its adoption. For purposes of this disclosure, the value of the options was estimated using a Black-Scholes option pricing formula and amortized on a ratable basis over the respective vesting periods of the awards. Disclosures for the three and six months ended March 31, 2006 are not presented because stock-based payments were accounted for under SFAS 123(R).


	Three months ended			Six months ended
	March 31,			March 31,
	2005			2005
	(In thousands, except per share amounts)
Net income, as reported for basic and diluted earnings per share	$	5,430		$	9,243
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		7			15
Deduct: Total stock-based employee compensation expense determined under fair-value based method for all awards, net of related tax effects		(612	)		(1,290	)

Pro forma net income	$	4,825		$	7,968

Net income per share:
Basic net income per share as reported	$	0.37		$	0.63

Basic net income per share pro forma	$	0.33		$	0.54

Diluted net income per share as reported	$	0.36		$	0.61

Diluted net income per share pro forma	$	0.32		$	0.53

Adoption of SFAS 123(R)

The following table summarizes the effect of recording stock-based compensation expense recognized under SFAS 123(R) for the three and six months ended March 31, 2006. Results for the prior comparable periods have not been restated because we have elected the modified prospective transition method as permitted by SFAS 123(R).


	Three months ended			Six months ended
	March 31,			March 31,
	2006			2006
	(In thousands)
Stock-Based Compensation Expense:
Cost of sales — products	$	19		$	41
Cost of sales — services		34			72
Research and development		118			250
Selling and marketing expense		118			276
General and administrative expense		191			415


Total stock-based compensation expense		480			1,054

Tax effect on stock-based compensation expenses		(155	)		(347	)


Net effect on net income	$	325		$	707

Valuation Assumptions

In connection with the adoption of SFAS 123(R), the Company estimated the fair value of stock options using a Black Scholes option-pricing model. The fair value of each option is estimated on the date of grant using the Black Scholes option pricing model and ratable attribution approach with the following weighted average assumptions:


	Employee Stock Option Plans												Employee Stock Purchase Plan
	Three months ended						Six months ended						Three months ended				Six months ended
	March 31,						March 31,						March 31,				March 31,
	2006			2005			2006			2005			2006*	2005			2006*	2005
Expected life of option		5.42	years		2.68	years		5.42	years		2.67	years	—		0.5	years	—		0.5	years
Expected volatility		66.0	%		80.9	%		66.0	%		81.8	%	—		47.0	%	—		47.0	%
Dividend yield		0.0	%		0.0	%		0.0	%		0.0	%	—		0.0	%	—		0.0	%
Risk-free interest rate		4.47	%		3.56	%		4.50	%		3.39	%	—		2.48	%	—		2.48	%


*		The company terminated its ESPP plan effective November 1, 2005.

Expected life of option: The Company’s calculation of expected life of options represents the period that the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior as influenced by changes to the terms of its stock-based awards.

Expected Volatility: The fair value of stock-based payments made through the three and six months ended March 31, 2006, was determined using the Company’s historical stock price.

Expected Dividend: The Company has not declared or paid any dividends and does not currently expect to do so in the future.

Risk-Free Interest Rate: The risk-free interest rate used in the Black-Scholes valuation method is based on the implied yield currently available in U.S. Treasury zero-coupon issues with an equivalent term.

Stock Option Plans

At September 30, 1997, 1,800,000 shares of common stock had been reserved for issuance to employees under the 1989 Incentive Stock Option Plan (the “1989 Plan”). In June 1998, the Board of Directors adopted the 1998 Stock Plan (the “1998 Plan”), which provided for the issuance of options to purchase an additional 1,800,000 shares. At the January 2003 Annual Meeting, stockholders approved an increase of 1,000,000 shares to the 1998 Plan. At the January 2006 Annual Meeting, stockholders approved a further 1,000,000 share increase. The Board of Directors has the authority to determine optionees, the number of shares, the term of each option and the exercise price. Options under the 1989 and 1998 Plans generally become exercisable at a rate of 1/8th of the total options granted six months after the option grant date and then at a rate of 1/48th per month thereafter. Options will expire, if not exercised, upon the earlier of 10 years from the date of grant or 30 days after termination as an employee of the Company. The 1989 Plan was terminated as to future grants in 1998 effective with the adoption of the 1998 Plan.

Information with respect to stock option activity from September 30, 2005 through March 31, 2006 is set forth below:


	Number of			Weighted		Weighted Average		Aggregate
	Options			Average		Remaining		Intrinsic
	Outstanding			Exercise Price		Contractual Term		Value
						(Years)		(In thousands)
Balance at September 30, 2005		1,956,029		$	15.56
Options granted		73,501		$	15.47
Options exercised		(57,476	)	$	6.57
Options canceled, forfeited or expired		(22,059	)	$	17.42

Balance, March 31, 2006		1,949,995		$	15.80		6.7	$	2,461

Vested or expected to vest, March 31, 2006		1,901,105		$	15.84		6.7	$	2,449

Ending exercisable, March 31, 2006		1,519,324		$	16.53		6.2	$	1,838

The weighted average grant date fair value of options granted during the three and six month period ended March 31, 2006 was $7.19 and $9.36, respectively. As of March 31, 2006, approximately $2.2 million of unrecognized compensation costs related to stock options is expected to be recognized over a weighted-average period of approximately 1.26 years. During the six month period ended March 31, 2006 and March 31, 2005, the aggregate intrinsic value of options exercised under the Company’s stock option plan was approximately $525,700 and $1,916,700, respectively.

On September 16, 2005, the Company accelerated vesting of certain unvested and “out-of-the-money” stock options with exercise prices equal to or greater than $19.00 per share previously awarded to its employees, including its executive officers and its non-employee directors, under the Company’s equity compensation plans. The acceleration of the vesting of these options was undertaken to eliminate the future compensation expense that the Company would otherwise recognize in its income statement with respect to these options upon the effectiveness of SFAS 123(R). The acceleration of vesting became effective for stock options outstanding as of September 16, 2005. Options to purchase 343,618 shares of common stock or 17.6% of the Company’s outstanding options (of which options to purchase 1,121,980 shares or 57.3% of the Company’s outstanding options were held by the Company’s executive officers) were subject to the acceleration. The weighted average exercise price of the options subject to the acceleration was $20.78. The options subject to acceleration vest on average in approximately two years from the effective date of the acceleration.

Employee Stock Purchase Plan

In June 1998, we adopted the 1998 Employee Stock Purchase Plan (the “Purchase Plan”). A total of 750,000 shares of common stock have been reserved for issuance under the Purchase Plan. The Purchase Plan permits eligible employees to purchase common stock through payroll deductions of up to 7% of an employee’s total compensation. The price of the common stock will generally be 85% of the lower of the fair market value at the beginning of the offering period or the end of the relevant purchase period. The maximum number of shares a participant may purchase during a single offering period is 300 shares. A total of 30,078 shares were issued under the Purchase Plan in the year ended September 30, 2005. As of September 30, 2005, 606,032 shares remained available for issuance. On October 31, 2005, 16,044 shares were issued under the Purchase Plan and the Purchase Plan was discontinued.

NOTE 4 — BASIC AND DILUTED NET INCOME PER SHARE

We have presented net income (loss) per share for all periods in accordance with SFAS 128,Earnings per Share. SFAS 128 requires the presentation of basic and diluted earnings per share. Basic net income (loss) per share is computed using the weighted average number of common shares outstanding during the period. Diluted net income per share includes the effect of dilutive potential common shares using the treasury stock method, but in

periods where net losses are recorded, common stock equivalents such as common stock options would decrease the net loss per share and therefore are not added to the weighted average shares outstanding. Net losses were recorded for the three and six months ended March 31, 2006. The following is a reconciliation of the denominator used in calculating basic and diluted earnings (loss) per share:


	Three months ended					Six months ended
	March 31,					March 31,
	2006			2005		2006			2005
	(In thousands, except per share amounts)
Net income (loss), as reported for basic and diluted earnings per share	$	(789	)	$	5,430	$	(646	)	$	9,243


Weighted average shares outstanding		14,784			14,676		14,763			14,637
Dilutive options		0			427		0			492

Weighted average shares assuming dilution		14,784			15,103		14,763			15,129


Net income (loss) per share:
Basic	$	(0.05	)	$	0.37	$	(0.04	)	$	0.63

Diluted	$	(0.05	)	$	0.36	$	(0.04	)	$	0.61

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

Three months ended

Six months ended

March 31,

2006

2005

2006

2005

(In thousands)

Common stock options

1,943

300

1,926

228

NOTE 5 — INVENTORIES

The components of inventories are as follows:


	March 31,		September 30,
	2006		2005
	(In thousands)
Inventories:
Raw materials	$	3,736	$	2,600
Work-in-process		324		231
Finished goods		435		273

	$	4,495	$	3,104

NOTE 6 — GOODWILL AND INTANGIBLE ASSETS

We performed our most recent annual goodwill impairment test as of September 30, 2005 and determined that there was no indicator of impairment. As such, there was no write-down of the goodwill balance. Between October 1, 2005 and March 31, 2006, there have been no changes to the Company’s goodwill balance of $49.4 million.

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


	As of March 31, 2006							As of September 30, 2005
	Gross					Net		Gross					Net
	Carrying		Accumulated			Carrying		Carrying		Accumulated			Carrying
	Amount		Amortization			Amount		Amount		Amortization			Amount
	(In thousands)
Purchased technology	$	4,800	$	(2,457	)	$	2,343	$	4,800	$	(2,115	)	$	2,685
Trade names		1,000		(512	)		488		1,000		(440	)		560
Customer relationships		1,000		(512	)		488		1,000		(440	)		560
Non-compete agreement		400		(179	)		221		400		(154	)		246
System backlog		400		(400	)		—		400		(400	)		—

Total	$	7,600	$	(4,060	)	$	3,540	$	7,600	$	(3,549	)	$	4,051

The estimated future amortization expense of purchased intangible assets as of March 31, 2006 was as follows:


	Estimated
	Amortization
Fiscal Year	Expense
	(In thousands)
2006 (remaining 6 months)	$	511
2007		1,022
2008		1,021
Thereafter		986

Total	$	3,540

NOTE 7 — WARRANTY ACCRUAL

The following table represents the activity in warranty accrual for the six months ended March 31, 2006 and 2005:


	2006			2005
	(In thousands)
Balances at beginning of year	$	74		$	69
Utilized		(27	)		(41	)
Charged (reduction) to cost and expenses		14			48

Balances at end of quarter	$	61		$	76

NOTE 8 — INCOME TAXES

Our provision for (benefit from) income taxes consists of federal, state and foreign taxes. We recorded a tax benefit of $169,000 and tax provision of $1.3 million in the three months ended March 31, 2006 and March 31, 2005, respectively and a tax benefit of $135,000 and tax provision of $1.7 million in the six months ended March 31, 2006 and March 31, 2005, respectively. The tax provision in the six months ended March 31, 2005 reflected a $0.1 million benefit from additional research and development tax benefits claimed with respect to a prior year and a $0.2 million benefit from the retroactive impact of the reinstitution of the research and development tax credit program in that period.

NOTE 9 — COMPREHENSIVE INCOME

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


	Three months ended						Six months ended
	March 31,						March 31,
	2006			2005			2006			2005
				(In thousands)
Net income, as reported	$	(789	)	$	5,430		$	(646	)	$	9,243
Currency translation adjustment		15			(59	)		(97	)		124
Unrealized gains (losses) on investments		7			(21	)		40			(37	)

Comprehensive income	$	(767	)	$	5,350		$	(703	)	$	9,330

NOTE 10 — REPURCHASE OF COMMON STOCK

In December 1999, our Board of Directors authorized a stock repurchase program of up to 2,000,000 shares of our common stock. Depending on market conditions and other factors, repurchases can be made from time to time in the open market and in negotiated transactions, including block transactions, and this program may be discontinued at any time. In the year ended September 30, 2003, we repurchased 257,400 shares at a cost of approximately $1.8 million. The shares repurchased were restored to the status of authorized, but unissued. In addition, in fiscal 2003, $300,000 in treasury stock previously repurchased were restored to the status of authorized but unissued. In the years ended September 30, 2002, 2004 and 2005 and the six months ended March 31, 2006, we repurchased no shares. As of March 31, 2006, we are authorized to repurchase 1,742,600 shares of our common stock under the stock repurchase program.

NOTE 11 — GEOGRAPHICAL INFORMATION

In June 1997, the FASB issued SFAS 131,Disclosures About Segments of an Enterprise and Related Information. The statement requires us to report certain financial information about operating segments. It also requires that we report certain information about our services, the geographic areas in which we operate and our major customers. The method specified in SFAS 131 for determining what information to report is referred to as the “management approach.” The management approach is based on the way that management organizes the segments within the enterprise for making operating decisions and assessing performance.

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

Revenue and assets by geographic region are as follows:


	North		UK, Europe,				Rest of		Consolidated
	America		Other		Japan		World		Total
	(In thousands)
Six months ended March 31, 2006
Revenues from unaffiliated customers	$	7,194	$	7,066	$	5,654	$	2,851	$	22,765

Six months ended March 31, 2005
Revenues from unaffiliated customers	$	10,473	$	9,524	$	11,604	$	3,320	$	34,921

As of March 31, 2006
Goodwill	$	22,896	$	26,498		—		—	$	49,394
Long-lived assets		952		687	$	242	$	40		1,921

As of September 30, 2005
Goodwill	$	22,896	$	26,498		—		—	$	49,394
Long-lived assets		950		479	$	264		—		1,693

Revenues above reflect the location of the end customer and exclude all inter-company sales.

Revenues in the United States represented 29%, and 26% of our total revenues in the six months ended March

31, 2006 and 2005, respectively. Revenues from Germany accounted for less than 10% and 10% of our consolidated net revenues from unaffiliated customers for the six months ended March 31, 2006 and 2005, respectively. Operations in Ireland accounted for 31% and 32% of the consolidated identifiable assets at March 31, 2006 and 2005, respectively.

NOTE 12 — CUSTOMER INFORMATION

We currently sell our products to a small number of customers. Customers representing 10% or more of our accounts receivable balances as of March 31, 2006 or September 30, 2005, or 10% or more of our revenues for the three or six months ended March 31, 2006 or 2005, were as follows:


	Percentage of Accounts Receivable as of						Percentage of Revenues
							Three months ended						Six months ended
	March 31,			September 30,			March 31,						March 31,
	2006			2005			2006			2005			2006			2005
Customer A		13	%		<10	%		11	%		<10	%		11	%		<10	%

Customer B		14	%		<10	%		13	%		<10	%		<10	%		<10	%

Customer C		<10	%		14	%		<10	%		15	%		<10	%		16	%

Customer D		<10	%		13	%		10	%		11	%		<10	%		<10	%

Customer E		17	%		20	%		12	%		12	%		<10	%		<10	%

Customer F		<10	%		<10	%		<10	%		<10	%		13	%		<10	%

Customer G		<10	%		<10	%		<10	%		18	%		<10	%		12	%

NOTE 13 — CONTINGENCIES

A lawsuit was instituted in October 2002 against us and one of our subsidiaries, Catapult Communications International Limited, an Irish corporation, in the Antwerp Commercial Court, Antwerp, Belgium, by Tucana Telecom NV, a Belgian company. Tucana had been a distributor of products for Tekelec, the company from which we acquired the Network Diagnostic Business (NDB) from in August 2002. The writ alleges that the defendants improperly terminated an exclusive distribution agreement with Tucana following the acquisition of NDB and seeks damages of 12,461,000 Euros ($15,127,654 as of March 31, 2006) plus interest and legal costs. A trial date on the matter had originally been scheduled for January 16, 2004 but Tucana did not appear. On March 14, 2005, Tucana filed a further brief with the Belgian court. The case was heard April 28, 2006 and a decision is expected by June 30, 2006. We strongly believe that we properly terminated any contract we had with Tucana and that Tucana is not entitled to any damages in this matter. We have defended the action vigorously and will continue to do so, if required. We may be able to seek indemnification from Tekelec for any damages assessed against us in this matter under the terms of the Asset Purchase Agreement we entered into with Tekelec, although there is no assurance that such indemnification would be available.

On December 9, 2005, we filed suit in federal court in Chicago, Illinois against NetHawk Corporation (“NetHawk”), formerly known as ipNetfusion, Inc. NetHawk is a wholly-owned U.S. subsidiary of NetHawk, Oyj., a Finnish company. In the lawsuit, we assert that NetHawk used improper means to acquire our confidential and trade secret information and that NetHawk used such information in the course of its business. We believe that we have been damaged, possibly materially, by NetHawk’s actions. The lawsuit is in its early stages. Therefore, we are unable to express an opinion regarding the likely outcome of this litigation or the range of any potential damages that could be recovered.

From time to time, we may be involved in other lawsuits, claims, investigations and proceedings, consisting of intellectual property, commercial, employment and other matters, which arise in the ordinary course of business. In accordance with SFAS 5,Accounting for Contingencies, we record a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Litigation is inherently unpredictable. However,

we believe that we have valid defenses with respect to the legal matters pending against us, as well as adequate provisions for any probable and estimable losses. If an unfavorable ruling were to occur in any specific period, there exists the possibility of a material adverse impact on the results of operations of that period.

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

The following discussion and analysis should be read in conjunction with “Selected Financial Data” and our Consolidated Financial Statements and Notes thereto included in our Annual Report on Form 10-K for the year ended September 30, 2005, as filed with the Securities and Exchange Commission on December 14, 2005.

Forward-looking Statements

This Quarterly Report onForm 10-Q contains statements that are not historical facts but are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and relate to such matters as anticipated financial performance and involve known and unknown risks, uncertainties and other factors that may cause our business or our industry’s actual results, levels of activity, performance or achievements to be materially different from those expressed or implied by any forward-looking statements. Such statements include, in particular, statements about our plans, strategies, prospects, changes and trends in our business and the markets in which we operate as described in this Quarterly Report onForm 10-Q. In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “could,” “would,” “should,” “expect,” “plan,” “anticipate,” “intend,” “believe,” “estimate,” “forecast,” “predict,” “propose,” “potential” or “continue” or the negative of those terms or other comparable terminology. These statements are only predictions.

These forward-looking statements include but are not limited to those identified in this report with an asterisk (*) symbol. Actual results may differ materially from those discussed in such forward-looking statements, and you should carefully review the cautionary statements set forth in this Quarterly Report onForm 10-Q, including those set forth under the caption “Risk Factors” in Item 1A of Part II of this report and those set forth in our Annual Report on Form 10-K for the year ended September 30, 2005, as filed on December 14, 2005. We caution the reader, however, that these factors may not be exhaustive.

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

Overview

Our Business and Products

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

We offer a single line of software-based telecommunications test products operating on a common hardware platform range. This product line includes the DCT system, originally introduced in 1985 and since extensively enhanced, and the MGTS system, acquired in 2002 in connection with the acquisition of Tekelec’s Network Diagnostic Business (“NDB”).

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

	•		IP Multimedia Subsystem (IMS);

	•		Third and Fourth Generation Cellular (3G and 4G), including UMTS and cdma2000;

	•		General Packet Radio Service (GPRS);

	•		Global Systems for Mobile Communications (GSM);

	•		Code Division Multiple Access (CDMA);

	•		IP Telephony (Voice over IP or VoIP);

	•		Asynchronous Transfer Mode (ATM); and

	•		Signaling System #7 (SS7).

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

Our test system products consist of advanced proprietary software together with our proprietary hardware interface and co-processor cards. When acquiring a system, customers typically license one or more software modules and purchase hardware and ongoing software support. Customers may upgrade their systems by purchasing additional software protocol test modules and additional hardware interfaces to meet future testing needs. Prices for our products vary widely depending upon the overall system configuration, including the number and type of software protocol modules and the number of hardware interfaces required by the customer. A system sale typically ranges in price from approximately $50,000 to over $250,000.

Conditions and Trends in Our Industry

Over the course of our last fiscal year ended September 30, 2005, we saw further evidence of a recovery in the global telecommunications industry from the severe downturn that affected us in fiscal 2002 and 2003. This improvement in market conditions resulted in increased purchasing of our products and services by our customers in North America, Europe and, most notably, all other markets except Japan (referred to by us as “Rest of World”), where we saw our strongest growth rate. The growth in Rest of World revenues reflected two factors: additional business in China generated by the office we established there late in fiscal 2004, and increased research and development activity in Asia by some of our multinational telecommunications manufacturer customers. In Japan, although market conditions remained healthy, our revenue decreased 6% year-over-year as we failed to secure a Japanese fiscal year end budget surplus order from a major customer.

In our current fiscal year to date, we continued to see healthy demand in the global market for software-based telecommunications test systems, but we experienced lower revenues for the reasons discussed in the first two bullet points in the following section.

Summary of Our Financial Performance in the Second Quarter of Fiscal 2006

Although our market and order input remained healthy in the three months ended March 31, 2006, our financial performance deteriorated in comparison with our performance in the same period in the previous year. We received orders totaling $15.9 million, but revenues decreased by 44% to $10.7 million from $19.1 million in the second quarter of fiscal 2005 and our operating income (loss) decreased to an operating loss of $1.6 million in the second quarter of fiscal 2006 from operating income of $6.6 million in the prior year period.

Four major factors contributed to this deterioration in financial performance in the second quarter:

	•		In Japan, revenues decreased by 51% or $4.3 million from the second quarter of fiscal 2005, primarily due to competition from test products developed by two of our Japanese OEM customers, both for their own internal use and for sale to our major Japanese telecom operator customers. We expect this competitive factor to continue to impact our Japanese revenues for at least the remainder of our current fiscal year. Revenues in Japan were also impacted by an 11% decrease in the value of the yen, in which all our revenues in Japan are denominated.

	•		In regions outside Japan, our revenues continued to be affected adversely by engineering delays. In the second quarter we received a further $2.7 million in orders requiring additional engineering work on which no revenue could be recognized, bringing the cumulative total of orders in this category to

$5.2 million at quarter end. We expect to begin recognizing revenue on these orders in the fourth quarter of our current fiscal year. In addition, other customer orders that we would have expected to receive in the absence of engineering delays were delayed or issued to other vendors.

	•		Our overall gross profit margin decreased by nine percentage points due to increases in hardware component costs, services demonstration equipment costs and manufacturing overhead as percentages of the related revenues.

	•		In the second quarter of fiscal 2006, we recorded $0.5 million in pre-tax, non-cash, stock-based compensation expense under the newly applicable accounting standard, SFAS 123(R),Share-Based Payment.Because we elected to adopt this standard under the modified prospective transition method, we did not restate prior periods to include stock-based compensation expense. Refer to “Stock-Based Compensation” in the “Critical Accounting Policies and Estimates” section below.

During the second quarter of 2006, our cash, cash equivalents and short-term investments decreased by $0.1 million. Operating activities provided $0.2 million in cash and capital expenditures used $0.5 million.

Critical Accounting Policies and Estimates

There have been no material changes to our critical accounting policies and estimates as disclosed in our Annual Report on Form 10-K for the year ended September 30, 2005 except for our adoption of the following additional critical accounting policy.

Stock-Based Compensation

We account for stock-based compensation in accordance with SFAS 123(R),Share-Based Payment. Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense ratably over the requisite service period of the award. Determining the fair value of share-based awards at the grant date requires judgment, including estimating stock price volatility, forfeiture rates, and expected option life. If actual experience differs significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted.

Results of Operations

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


	Three months ended						Six months ended
	March 31,						March 31,
	2006			2005			2006			2005
Revenues:
Products		64.8	%		79.2	%		67.9	%		78.7	%
Services		35.2			20.8			32.1			21.3

Total revenues		100.0			100.0			100.0			100.0

Cost of revenues:
Products		11.7			7.5			10.7			7.6
Services		9.0			4.5			8.9			4.8
Amortization of purchased technology		1.6			0.9			1.5			1.0

Total cost of revenues		22.3			12.9			21.1			13.4

Gross profit		77.7			87.1			78.9			86.6

Operating expenses:
Research and development		32.2			16.9			28.6			17.7
Sales and marketing		38.9			25.2			38.6			27.2
General and administrative		21.8			10.6			20.8			11.3

Total operating expenses		92.9			52.7			88.0			56.2

Operating income (loss)		(15.2	)		34.4			(9.1	)		30.4
Interest income		5.8			1.5			5.5			1.5
Other income (expense), net		0.4			(0.7	)		0.2			(0.4	)

Income (loss) before income taxes		(9.0	)		35.2			(3.4	)		31.5
Provision for (benefit from) income taxes		(1.6	)		6.7			(0.6	)		5.0

Net income (loss)		(7.4	%)		28.5	%		(2.8	%)		26.5	%


Gross margin on products		82.0	%		90.5	%		84.3	%		90.3	%

Gross margin on services		74.5	%		78.5	%		72.4	%		77.6	%

Gross profit margin on products and services excludes amortization of purchased technology.

Comparison of the Three-Month Periods Ended March 31, 2006 and 2005

Revenues

Our revenues for the three months ended March 31, 2006 decreased by 44% to $10.7 million from $19.1 million in the three months ended March 31, 2005. Over the same period, product revenues decreased by approximately 54% to $6.9 million from $15.1 million. The decrease in product revenues was attributable to decreased sales of our DCT and MGTS test systems for the reasons discussed above under the heading “Summary of Our Financial Performance in the Second Quarter of Fiscal 2006.” Services revenues decreased approximately 5% to $3.7 million from $4.0 million due to a decrease in the number and value of DCT and MGTS system maintenance contracts.

Our revenues by geographic region varied as follows in the three months ended March 31, 2006 in comparison with the three months ended March 31, 2005:

	•		North American revenues decreased by 27% to $2.9 million from $3.9 million;

	•		European revenues decreased by 31% to $3.2 million from $4.6 million;

	•		Japanese revenues decreased by 51% to $4.1 million from $8.4 million; and

	•		Rest of World revenues decreased by 77% to $0.5 million from $2.1 million.

An 11% decrease in the value of the Japanese yen, in which all our revenues in Japan are denominated, had the effect of decreasing our revenues by $0.5 million. In Europe, because almost all customer orders are denominated in dollars, the 8% decrease in the value of the Euro and the 7% decrease in the value of the pound had no material quantifiable impact on our revenues. Nevertheless, because our European customers earn their

revenues in Euros and pounds, the relative decrease in the value of those currencies against the dollar made our dollar-denominated product prices less favorable to our European customers when expressed in their local currencies, and this may have resulted in decreased purchases by these customers.

Information on revenues from major customers is provided in Note 12 to the Unaudited Condensed Consolidated Financial Statements included with this Quarterly Report on Form 10-Q.

Cost of Revenues

Cost of product revenues consists of the costs of board assembly by independent contractors, purchased components, payroll, benefits and, in fiscal 2006, stock-based compensation for personnel in product testing, purchasing, shipping and inventory management, as well as supplies, media and freight. Cost of product revenues decreased by 13% to $1.2 million for the three months ended March 31, 2006 from $1.4 million in the same period the previous year. Gross margin on product revenues decreased to 82% from 91% due primarily to increased hardware component and manufacturing overhead costs as a percentage of product revenue. We expect our gross margin on product revenues in future quarterly periods to fluctuate based on product mix and revenue levels.*

Cost of services revenues consists primarily of the costs of payroll, benefits and, in fiscal 2006, stock-based compensation for customer support, installation and training personnel, as well as the costs of materials and equipment. Cost of services revenues increased by approximately 12% to $1.0 million in the three months ended March 31, 2006 from $0.9 million in the three months ended March 31, 2005, due primarily to increased demonstration and development equipment expenses and to an increase of 4%, or one employee, in the number of employees engaged in customer support. Gross margin on services revenues decreased to 74% from 78% as services revenues increased less than the cost of those revenues. We expect our gross margin on services revenues in future quarterly periods to fluctuate based on changes in both revenue and cost levels.*

Amortization of purchased technology remained unchanged at $0.2 million in the three months ended March 31, 2006 compared with the same period the previous year.

Gross margins did not vary significantly by geographic region.

Research and Development

	•		an increase of 6%, or five employees, in the number of employees engaged in research and development, and

	•		the inclusion of $0.1 million in non-cash stock option expenses.

These factors were partially offset by a decrease of $0.2 million in depreciation expense and a decrease of $0.1 million in variable compensation due to below-target performance. As a percentage of total revenues, research and development expenses increased to 32% from 17% over the same period. We expect research and development expenses in each of the remaining quarters of the current fiscal year to increase, primarily as a result of an anticipated increase in the number of engineering employees.*

Sales and Marketing

Sales and marketing expenses consist primarily of the costs of payroll, benefits, commissions, bonuses and, in fiscal 2006, stock-based compensation, occupancy costs, travel and promotional expenses, such as product brochure and trade show costs. Sales and marketing expenses decreased by approximately 13% to $4.2 million for the three months ended March 31, 2006 from $4.8 million for the three months ended March 31, 2005. Two major factors contributed to this decrease:

	•		a decrease of $0.5 million in variable compensation due to below-target order levels;

	•		an exchange rate driven decrease of $0.2 million due to average decreases of 11% in the Japanese yen, 7% in the British pound and 8% in the Euro against the dollar.

These factors were partially offset by the inclusion in the more recent quarter of $0.1 million in non-cash stock-based compensation expenses.

As a percentage of total revenues, sales and marketing expenses increased to 39% from 25% over the same period. We expect quarterly sales and marketing expenses to increase in each of the remaining quarters of the current fiscal year due to increased variable compensation.*

General and Administrative

General and administrative expenses include costs associated with our general corporate and risk management, public reporting, employee recruitment and retention, regulatory compliance, investor relations and finance, accounting and internal control functions, as well as amortization of certain acquired intangible assets, and, in fiscal 2006, stock-based compensation. General and administrative expenses increased approximately 15% to $2.3 million for the three months ended March 31, 2006 from $2.0 million for the three months ended March 31, 2005, reflecting primarily an increase of $0.1 million in legal and accounting expenses largely due to increased regulatory compliance costs, an increase of 5%, or one employee, in the number of general and administrative personnel and the inclusion in the more recent quarter of $0.2 million in non-cash stock-based compensation expenses. These increases were partially offset by a decrease of $0.1 million in variable compensation due to below-target performance. As a percentage of total revenues, general and administrative expenses increased to 22% from 11% over the same period. We expect quarterly general and administrative expenses to remain relatively constant over the remainder of the current fiscal year.*

Interest income

Interest income increased to $0.6 million in the three months ended March 31, 2006 from $0.3 million in the three months ended March 31, 2005 due to increases both in short-term interest rates and in the value of funds invested.

Provision for (benefit from) income taxes

Our provision for (benefit from) income taxes consists of federal, state and foreign income taxes. We recorded a tax benefit of $0.2 million, or 18% of our pre-tax loss, in the three months ended March 31, 2006, compared with a tax provision of $1.3 million, or 19% of pre-tax income, in the three months ended March 31, 2005. Our future tax rate may vary depending in part on the relative pre-tax contribution from our domestic and foreign operations.

Comparison of the Six-Month Periods Ended March 31, 2006 and 2005

Revenues

Our revenues for the six months ended March 31, 2006 decreased by 35% to $22.8 million from $34.9 million in the six months ended March 31, 2005. Over the same period, product revenues decreased by approximately 44% to $15.4 million from $27.5 million. The decrease in product revenues was attributable to decreased sales of our DCT and MGTS test systems due to in-house competition in Japan and engineering delays. Services revenues decreased approximately 2% to $7.3 million from $7.5 million due to a decrease in the number and value of DCT and MGTS system maintenance contracts.

Our revenues by geographic region varied as follows in the six months ended March 31, 2006 in comparison with the six months ended March 31, 2005:

	•		North American revenues decreased by 31% to $7.2 million from $10.5 million;

	•		European revenues decreased by 26% to $7.1 million from $9.5 million;

	•		Japanese revenues decreased by 51% to $5.7 million from $11.6 million; and

	•		Rest of World revenues decreased by 14% to $2.9 million from $3.3 million.

A 10% decrease in the value of the Japanese yen, in which all our revenues in Japan are denominated, had the effect of decreasing our revenues by $0.6 million. In Europe, because almost all customer orders are denominated in dollars, the 8% decrease in the value of the Euro and the 7% decrease in the value of the pound had no material quantifiable impact on our revenues. Nevertheless, because our European customers earn their revenues in Euros and pounds, the relative decrease in the value of those currencies against the dollar made our dollar-denominated product prices less favorable to our European customers when expressed in their local currencies, and this may have resulted in decreased purchases by these customers.

Information on revenues from major customers is provided in Note 12 to the Unaudited Condensed Consolidated Financial Statements included with this Quarterly Report on Form 10-Q.

Cost of Revenues

Cost of product revenues consists of the costs of board assembly by independent contractors, purchased components, payroll, benefits and, in fiscal 2006, stock-based compensation for personnel in product testing, purchasing, shipping and inventory management, as well as supplies, media and freight. Cost of product revenues decreased by 9% to $2.4 million for the six months ended March 31, 2006 from $2.7 million in the six months ended March 31, 2005. Gross margin on product revenues decreased to 84% from 90% due to increased hardware component and manufacturing overhead costs as a percentage of revenue.

Cost of services revenues consists primarily of the costs of payroll, benefits and, in fiscal 2006, stock-based compensation for customer support, installation and training personnel as well as the costs of materials and equipment. Cost of services revenues increased by approximately 21% to $2.0 million in the six months ended March 31, 2006 from $1.7 million in the six months ended March 31, 2005, due primarily to increased demonstration and development equipment expenses, the inclusion of $0.1 million in non-cash stock option expenses in the more recent period and an increase of 6%, or two employees, in the number of employees engaged in customer support. Gross margin on services revenues decreased to 72% from 78% as services revenues increased less than the cost of those revenues.

Amortization of purchased technology remained unchanged at $0.3 million in the six months ended March 31, 2006 compared with the same period the previous year.

Gross margins did not vary significantly by geographic region.

Research and Development

Research and development expenses consist primarily of the costs of payroll, benefits and, in fiscal 2006, stock-based compensation for engineers, materials, equipment and consulting services. To date, because we have released our products as soon as technological feasibility was established, all software development costs have been charged to research and development expenses as incurred. Research and development expenses increased by approximately 5% to $6.5 million for the six months ended March 31, 2006 from $6.2 million for the six months ended March 31, 2005 due to the inclusion of $0.2 million in non-cash stock option expenses in the more recent period and to an increase of 10%, or eight employees, in the number of employees engaged in research and development. These factors were partially offset by a decrease of $0.3 million in depreciation expense and a decrease of $0.3 million in variable compensation due to below-target performance. As a percentage of total revenues, research and development expenses increased to 29% from 18% over the same period.

Sales and Marketing

Sales and marketing expenses consist primarily of the costs of payroll, benefits, commissions, bonuses and, in fiscal 2006, stock-based compensation, occupancy costs, travel and promotional expenses, such as product brochure and trade show costs. Sales and marketing expenses decreased by approximately 8% to $8.8 million for the six months ended March 31, 2006 from $9.5 million for the six months ended March 31, 2005. Two major factors contributed to this decrease:

	•		a decrease of $1.1 million in variable compensation due to below-target order levels;

	•		an exchange rate driven decrease of $0.3 million due to average decreases of 10% in the Japanese yen, 7% in the British pound and 8% in the Euro against the dollar.

These factors were partially offset by an increase of $0.3 million in distributor commission and by the inclusion in the more recent period of $0.3 million in non-cash stock-based compensation expenses.

As a percentage of total revenues, sales and marketing expenses increased to 39% from 27% over the same period.

General and Administrative

General and administrative expenses include costs associated with our general corporate and risk management, public reporting, employee recruitment and retention, regulatory compliance, investor relations and finance, accounting and internal control functions, as well as amortization of certain acquired intangible assets, and, in fiscal 2006, stock-based compensation. General and administrative expenses increased approximately 21% to $4.7 million for the six months ended March 31, 2006 from $3.9 million for the six months ended March 31, 2005, reflecting primarily an increase of $0.4 million in legal and accounting expenses largely due to increased regulatory compliance costs, an increase of 7%, or two employees, in the number of administrative personnel and the inclusion in the more recent period of $0.4 million in non-cash stock-based compensation expenses. These increases were partially offset by a decrease of $0.3 million in variable compensation due to below-target performance. As a percentage of total revenues, general and administrative expenses increased to 21% from 11% over the same period.

Interest income

Interest income increased to $1.2 million in the six months ended March 31, 2006 from $0.5 million in the six months ended March 31, 2005 due to increases both in short-term interest rates and in the value of funds invested, and to interest on a tax refund received.

Provision for (benefit from) income taxes

Our provision for (benefit from) income taxes consists of federal, state and foreign income taxes. We recorded a tax benefit of $0.1 million, or 17% of pre-tax loss, in the six months ended March 31, 2006, compared with a tax provision of $1.7 million, or 16% of pre-tax income, in the six months ended March 31, 2005. The provision for the six months ended March 31, 2005 reflected a $0.3 million benefit from additional research and development tax benefits claimed with respect to prior periods. In the absence of these benefits, we would have recorded a tax provision at a rate of 19% of pre-tax income. Our future tax rate may vary depending in part on the relative pre-tax contribution from our domestic and foreign operations.

Liquidity and Capital Resources

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

Our purchase of NDB in 2002 was additionally financed through the issuance of two convertible notes in the aggregate principal amount of $17.3 million. The convertible notes were issued by our Irish subsidiary and were guaranteed by us. These notes were converted by Tekelec into 1,081,250 shares of our common stock in September 2004.

Cash provided by operating activities decreased to $2.8 million in the six months ended March 31, 2006 from $10.5 million in the six months ended March 31, 2005. Over the same period, the net income (loss) component of cash flows from operating activities decreased to a loss of $0.6 million from income of $9.2 million, and the contribution from adjustments for non-cash charges increased to $1.7 million from $1.5 million. These non-cash charges include charges for additional depreciation and amortization related to our acquisition of NDB and, in fiscal 2006, stock-based compensation expense. The additional acquisition-related non-cash depreciation charges

ended in fiscal 2005 and the majority of the acquisition-related non-cash amortization charges will end in fiscal 2009. Changes in non-cash working capital components increased cash flow from operations by $1.8 million in the six months ended March 31, 2006 and decreased cash flow from operations by $0.3 million in the six months ended March 31, 2005.

Our primary source of operating cash flow is the collection of accounts receivable from our customers. We measure the effectiveness of our collection efforts by an analysis of average accounts receivable days outstanding (“days outstanding”). We calculate our days outstanding by dividing our accounts receivable balance net of allowances at the end of a period by the revenues for that period and multiplying the result by the number of days in the period. Our days outstanding deteriorated to 105 days for the quarter ended March 31, 2006 from 60 days for the quarter ended March 31, 2005 due primarily to a decrease in intra-quarter invoicing linearity that resulted from purchasing by our customers later in the quarter. Collections of accounts receivable and related days outstanding will fluctuate in future periods due to the timing and amount of our future revenues, payment terms extended to our customers and the effectiveness of our collection efforts.*

Investing activities have consisted of two components: purchases of property and equipment, and purchases and sales of short-term investments. Purchases of property and equipment increased to $0.7 million in the six months ended March 31, 2006 from $0.5 million in the six months ended March 31, 2005. We expect that capital expenditures for our full fiscal 2006 year will total approximately $1.2 million.* We invest cash that is surplus to our operating requirements in professionally managed investment portfolios. These portfolios consist of both cash equivalents and short-term investments, and the mix between these elements may vary from period to period due to changes in the investment approaches of the portfolio managers. Purchases and sales of short-term investments provided net cash of $4.1 million in the six months ended March 31, 2006 and used $6.4 million in the six months ended March 31, 2005.

Financing activities provided cash of $0.6 million and $1.9 million in the six months ended March 31, 2006 and 2005, respectively, from the exercise of stock options and the sale of shares under our employee stock purchase plan.

As of March 31, 2006, we had working capital of $75.1 million, cash and cash equivalents of $31.6 million and short-term investments of $39.9 million. As of March 31, 2006, we had the following payment obligations in the listed categories of contractual obligations:


	Payments Due by Period
			Less Than		1-3		3-5		More than
Contractual Obligations	Total		1 Year		Years		Years		5 Years

	(In millions)
Operating leases	$	3.2	$	1.1	$	1.6	$	0.5		—
Unconditional purchase obligations	$	0.5	$	0.5		—		—		—

Total contractual cash obligations	$	3.7	$	1.6	$	1.6	$	0.5		—

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

Recent Accounting Pronouncements

See Note 2 of the Notes to our Unaudited Condensed Consolidated Financial Statements included with this Quarterly Report on Form 10-Q for information on recent accounting pronouncements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Exchange Risk and Derivative Financial Instruments

Our foreign subsidiaries operate and sell our products in various global markets. As a result, we are exposed to changes in exchange rates on foreign currency denominated transactions with foreign subsidiaries. We use foreign currency forward exchange contracts, and we infrequently use options, to mitigate the risk of future movements in foreign exchange rates that affect certain foreign currency denominated inter-company receivables or expected revenues. The forward contracts and options are not designated as accounting hedges. We attempt to match the forward contracts with the underlying receivables in terms of currency, amount and maturity, and to match the options with expected foreign currency revenue in terms of currency, amount and recognition period. We do not use derivative financial instruments for speculative or trading purposes. Because the impact of movements in currency exchange rates on forward contracts and options generally offsets the related impact on the exposures economically hedged, these derivative financial instruments do not subject us to speculative risk that would otherwise result from changes in currency exchange rates. Gains and losses on forward exchange contracts generally offset the foreign exchange transaction gains or losses from revaluation of foreign currency denominated receivables. Gains on options generally offset the reduction in income resulting from revenues recognized at an exchange rate less favorable than the option rate. To date, we have not fully mitigated all risk associated with our revenues and resulting accounts receivable denominated in foreign currencies, and there can be no assurance that our future mitigation activities, if any, will be successful. At March 31, 2006, we had outstanding forward exchange contracts maturing in fiscal 2006 to sell approximately $3.4 million in yen. There were no options outstanding at that date.

We also incur operating expenses in foreign currencies including the Japanese yen, the British pound, the Euro, the Australian dollar, the Canadian dollar, the Swedish krona and the Chinese renminbi. In Japan, our yen operating expenses are lower than our yen revenues and act as a partial natural hedge on our exchange rate exposure to yen-denominated accounts receivable. Our operating expenses in other foreign currencies exceed our revenues in those currencies and thus represent an exchange rate exposure. We do not attempt to mitigate this operating expense exchange rate exposure through the use of derivatives.

We have evaluated the potential near-term losses in future earnings, fair values and cash flows from reasonably possible near-term currency fluctuations, and we believe that any such losses would not be material.*

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our short-term investment portfolio. As of March 31, 2006, short-term investments consisted of available-for-sale securities of $39.9 million. These fixed income marketable securities included corporate and municipal bonds and government securities, all of which are of high investment grade. They are subject to interest rate risk and will decline in value if the market interest rates increase. If the market interest rates were to increase immediately and uniformly by 10% from levels as of March 31, 2006, the decline in the fair value of the portfolio would not be material to our financial position.

Item 4. Controls and Procedures

Evaluation of disclosure controls and procedures

Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this quarterly report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosures, and that such information is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal control over financial reporting

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

Part II. Other Information

Item 1. Legal Proceedings

A lawsuit was instituted in October 2002 against us and one of our subsidiaries, Catapult Communications International Limited, an Irish corporation, in the Antwerp Commercial Court, Antwerp, Belgium, by Tucana Telecom NV, a Belgian company. Tucana had been a distributor of products for Tekelec, the company from which NDB was acquired in August 2002. The writ alleges that the defendants improperly terminated an exclusive distribution agreement with Tucana following the acquisition of NDB and seeks damages of 12,461,000 Euros ($15,127,654 as of March 31, 2006) plus interest and legal costs. A trial date on the matter had originally been scheduled for January 16, 2004 but Tucana did not appear. On March 14, 2005, Tucana filed a further brief with the Belgian court. The case was heard April 28, 2006 and a decision is expected by June 30, 2006. We strongly believe that we properly terminated any contract we had with Tucana and that Tucana is not entitled to any damages in this matter. We have defended the action vigorously and will continue to do so, if required. We may be able to seek indemnification from Tekelec for any damages assessed against us in this matter under the terms of the Asset Purchase Agreement we entered into with Tekelec, although there is no assurance that such indemnification would be available.

Item 1A. Risk Factors

We have listed below various risks and uncertainties relating to our business. In addition to the risk factors identified in our most recent report on Form 10-K, this list includes a new risk factor relating to environmental compliance. This list is not inclusive of all the risks and uncertainties we face, but any of these factors could cause our actual results to differ materially from the results contemplated by the forward-looking statements contained in this report or that we may issue from time to time in the future.

Risks Related to Our Business

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

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

	•		the variable size and timing of individual purchases by our customers;

	•		absence of long-term customer purchase contracts;

	•		seasonal factors that may affect capital spending by customers, such as the varying fiscal year ends of customers and the reduction in business during the summer months, particularly in Europe;

	•		the relatively long sales cycles for our products;

	•		competitive conditions in our markets;

	•		exchange rate fluctuations;

	•		the timing of the introduction and market acceptance of new products or product enhancements by us and by our customers, competitors and suppliers;

	•		costs associated with developing and introducing new products;

	•		product life cycles;

	•		changes in the level of operating expenses relative to revenues;

	•		product defects and other quality problems;

	•		customer order deferrals in anticipation of new products;

	•		supply interruptions;

	•		changes in global or regional economic conditions or in the telecommunications industry;

	•		delays in purchasing decisions or customer orders due to customer consolidation;

	•		the ability to hire sales and technical personnel;

	•		changes in the mix of products sold;

	•		variability in stock-based compensation expense and the associated impact on our effective tax rate; and

	•		changes in the regulatory environment.

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

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

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

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

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

In addition, because of the rapid technological change characteristic of the telecommunications industry, we may be required to support legacy systems used by our customers. As a result, this may place additional demands on our personnel and other resources and may require us to maintain an inventory of otherwise obsolete components.

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

Our success will depend in part on whether a large number of telecommunications equipment manufacturers and network operators purchase our products and services. Because the telecommunications market is rapidly evolving, it is difficult to predict the future success of products and services in this market. The customers in this market use products from a number of competing suppliers for various testing purposes, and there has not been broad adoption of the products of one company. Our current or future products or services may not achieve widespread acceptance among telecommunications equipment manufacturers, network operators or other potential

customers. In addition, our competitors may develop solutions that could render our products obsolete or uncompetitive. In the event the telecommunications industry does not broadly adopt our products or services or does so less rapidly than we expect, or in the event our products are rendered obsolete or uncompetitive by more advanced solutions, our business, financial condition and operating results could be seriously harmed.

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

Our future success will depend in part on our ability to anticipate and respond to changing industry standards and customer requirements by enhancing our existing products and services. We may need to develop and introduce, on a timely and cost-effective basis, new products, features and services that address the needs of our customer base. We may not be successful in identifying, developing and marketing new products, product enhancements and related services that respond to technological change or evolving industry standards or that adequately meet new market demands. For example, in the six months ended March 31, 2006, our revenues were negatively impacted by engineering delays resulting from the length of time and level of resources that had been required to complete our common hardware platform.

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

Our customer base is highly concentrated, and a relatively small number of companies have accounted for substantially all of our revenues to date. In the three months ended March 31, 2006, our top five customers represented approximately 53% of total revenues. In our fiscal year ended September 30, 2005, our top five customers represented approximately 52% of total revenues. We expect that we will continue to depend upon a relatively limited number of customers for substantially all of our revenues in future periods, although no customer is presently obligated either to purchase a specific amount of products or to provide us with binding forecasts of purchases for any period. If we were to lose a significant customer or if a significant customer were to reduce, delay or cancel its orders, our operating results could be seriously harmed.

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

Our success will depend on continued growth in the market for telecommunications test systems and services and the continued commercial acceptance of our products as a solution to address the testing requirements of telecommunications equipment manufacturers and network operators. While most of our present and potential customers have the technical capability and financial resources to produce their own test systems and perform test services internally, to date, many have chosen to outsource a substantial proportion of their test system and service requirements. In the six months ended March 31, 2006, our revenues in Japan were negatively impacted by competition from test products developed by two of our Japanese OEM customers, both for their own internal use and for sale to our major Japanese telecom operator customers. We expect this competitive factor to continue to impact our Japanese revenues for at least the remainder of our current fiscal year. Our customers may not continue, and potential new customers may not choose, to outsource any of their test systems and service requirements. If the market for telecommunications test systems and services, or the demand for outsourcing, declines or fails to grow, or if our products and services are not widely adopted as a telecommunications test solution, our business, financial condition and operating results could be seriously harmed.

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

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

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

In the six months ended March 31, 2006 and the fiscal year ended September 30, 2005, we derived 71% and 75% of our revenues, respectively, from customers outside of the United States, and we maintain operations in ten other countries. International sales and operations are subject to inherent risks, including:

	•		longer customer payment cycles;

	•		greater difficulty in accounts receivable collection;

	•		difficulties in staffing and managing foreign operations;

	•		changes in regulatory requirements or in economic or trade policy;

	•		costs related to localizing products for foreign countries;

	•		potentially weaker protection for intellectual property in certain foreign countries;

	•		the burden of complying with a wide variety of foreign laws and practices, tariffs and other trade barriers; and

	•		potentially adverse tax consequences, including restrictions on repatriation of earnings.

A significant portion of our sales, including all our sales in Japan, is denominated in local currencies. Fluctuations in foreign currency exchange rates may contribute to fluctuations in our operating results. For example, changes in foreign currency exchange rates could adversely affect the revenues, net income, earnings per share and cash flow of our operations in affected markets. A decrease in the value of the Japanese yen against the dollar contributed to some degree to the revenue decrease we experienced in Japan in the first half of fiscal 2006. Similarly, such fluctuations may cause us to raise prices, which could affect demand for our products and services. In addition, if exchange or price controls or other restrictions are imposed in countries in which we do business, our business, financial condition and operating results could be seriously harmed. Although we currently use derivatives in an effort to mitigate the risk of exchange rate fluctuations with respect to receivables resulting from some intercompany sales, we may not continue to do so and our efforts may not be successful.

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

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

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

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

Our future success depends upon the increased utilization of our test solutions by network operators and telecommunications equipment manufacturers. Industry-wide network equipment and infrastructure development

driving the demand for our products and services may be delayed or prevented by a variety of factors, including cost, regulatory obstacles or the lack of or reduction in consumer demand for advanced telecommunications products and services. Telecommunications equipment manufacturers and network operators may not develop new technology or enhance current technology. Further, any such new technology or enhancements may not lead to greater demand for our products or services.

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

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

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

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

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

	•		difficulties associated with assimilating the personnel and operations of acquired companies;

	•		potential disruption of our ongoing business;

	•		distraction of management and other resources;

	•		integration of personnel and technology of an acquired company;

	•		difficulties in evaluating the technology of a potential target;

	•		inability to motivate and retain new personnel;

	•		maintenance of uniform standards, controls, procedures and policies; and

	•		impairment of relationships with employees and clients as a result of the integration of new management personnel.

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

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

We purchase many key components, including certain microprocessors, workstations, bus interface and other chips, connectors and other hardware, from the sole supplier of a particular component. For other components, even though multiple vendors may exist, we may purchase components from only a single source. We do not have any long-term supply agreements with these vendors to ensure uninterrupted supply of these components. If our supply of a key component is reduced or interrupted, we might require a significant amount of time to qualify alternative suppliers and receive an adequate flow of replacement components. We may also need to reconfigure

our products to adapt to new components, which could entail substantial time and expense. In addition, the process of manufacturing certain of these components is extremely complex, and our reliance on the suppliers of these components exposes us to potential production difficulties and quality variations. These could negatively affect cost and timely delivery of our products. We have in the past experienced supply problems as a result of the financial or operational difficulties of our suppliers, shortages and discontinuations resulting from component obsolescence. Although to date we have not experienced material delays in product deliveries to our customers resulting from supply problems, such problems may recur or, if such problems do recur, we may not find satisfactory solutions. If we are unable to obtain adequate amounts of fully functional components or are otherwise required to seek alternative sources of supply, our relationship with our customers and our results of operations could be harmed.

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

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

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

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

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

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

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

Our success and ability to compete effectively are dependent in part upon our proprietary technology. We rely on a combination of trademark, copyright and trade secret laws, as well as nondisclosure agreements and other contractual restrictions, to establish and protect our proprietary rights. To date, we have generally not sought patent protection for our proprietary technology. Patent protection may become more significant in our industry in the future. Likewise, the measures we undertake may not be adequate to protect our proprietary technology. To date, we have federally registered certain of our trademarks and copyrights. Our practice is to affix copyright notices on software, hardware and product literature in order to assert copyright protection for these works. The lack of federal registration of all of our trademarks and copyrights may have an adverse effect on our intellectual property rights in the future. Additionally, we may be subject to further risks as we enter into transactions in countries where intellectual property laws are unavailable, do not provide adequate protection or are difficult to enforce. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to duplicate aspects of our products or to obtain and use information that we regard as proprietary. In December 2005 we brought suit against a competitor for alleged misappropriation of confidential and trade secret information, as described under

“Item 1. Financial Statements” in Note 13 – Contingencies in part I of this report. Our steps to protect our proprietary technology may not be adequate to prevent misappropriation of such technology, and may not preclude competitors from independently developing products with functionality or features similar to our products. If we fail to protect our proprietary technology, our business, financial condition and results of operations could be harmed significantly.

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

The telecommunications industry is characterized by a relatively high level of litigation based on allegations of infringement of proprietary rights. While to date we have not been subject to claims of infringement or misappropriation of intellectual property by third parties, third parties may assert infringement claims against us. In addition, an assertion of infringement may result in litigation in which we may not prevail. Furthermore, any such claims, with or without merit, could result in substantial cost to us and diversion of our management. In addition, infringement claims may require us to develop new technology or require us to enter into royalty or licensing arrangements. These royalty or licensing agreements, if required, may not be available on terms acceptable to us. Because we do not rely on patents to protect our technology, we will not be able to offer a license for patented technology in connection with any settlement of patent infringement lawsuits. If a claim of infringement or misappropriation against us were successful and we fail or are unable to develop non-infringing technology or license any infringed, misappropriated or similar technology at a reasonable cost, our business, financial condition and results of operations would be adversely affected. In addition, we indemnify our customers against claimed infringement of patents, trademarks, copyrights and other proprietary rights of third parties. Any requirement for us to indemnify a customer may significantly harm our business, financial condition and operating results.

Environmental laws and regulations subject us to a number of risks and could result in significant liabilities and costs.

Some of our operations are subject to state, federal, and international laws governing protection of the environment, human health and safety, and regulating the use of certain chemical substances. We endeavor to comply with these environmental laws, yet compliance with such laws could increase our operations and product costs; increase the complexities of product design, procurement, and manufacture; limit our sales activities; and impact our future financial results. Any violation of these laws can subject us to significant liability, including fines, penalties, and prohibiting sales of our products into one or more states or countries, and result in a material adverse effect on our financial condition.

Currently, a significant portion of our revenues comes from international sales. Recent environmental legislation within the European Union (EU) may increase our cost of doing business internationally and impact our revenues from EU countries as we comply with and implement these new requirements. The EU has published Directives on electronic and electrical waste management (the “WEEE Directive”). The WEEE Directive makes producers of certain electrical and electronic equipment financially responsible for collection, reuse, recycling, treatment, and disposal of equipment placed on the EU market after August 13, 2005 (the “effective date”). The WEEE Directive also makes commercial end users of electronic equipment financially responsible for the collection and management of equipment placed on the market before the effective date. The WEEE Directive also requires labeling products placed on the EU market after the effective date. As a result of these obligations, our product distribution, logistics and waste management costs may increase and may adversely impact our financial condition.

Risks Related to Our Stock

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

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

	•		quarterly variations in our operating results;

	•		changes in our revenue growth rates as a whole or for specific geographic areas or products;

	•		changes in earning estimates by market analysts;

	•		the announcements of new products or product enhancements by us or our competitors;

	•		speculation in the press or analyst community; and

	•		general market conditions or market conditions specific to particular industries.

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

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

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our Annual Report on Form 10-K for our fiscal year ending September 30, 2005, we were required to include in our Annual Report on Form 10-K an assessment of the effectiveness of our internal control over financial reporting together with a report from our independent registered public accounting firm on our assessment and the effectiveness of our internal control over financial reporting. While we were successful in complying with these requirements with respect to fiscal 2005, if in the future we fail to achieve and maintain the adequacy of our internal control, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal control over financial reporting. Moreover, effective internal control is necessary for us to produce reliable financial reports and is important in helping prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly.

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

Sales of substantial numbers of shares of common stock by our major stockholders in the public market could harm the market price for our common stock. As of March 31, 2006, Richard A. Karp, our Chief Executive Office and Chairman of our Board, beneficially owned 2,981,602 shares, and Nancy H. Karp, one of our directors, beneficially owned 1,362,645 shares of our common stock. These shares are eligible for resale into the public market within the restrictions imposed by Rule 144 under the Securities Act of 1933. Sales of a significant amount of these shares could adversely affect the market price for our common stock. Effective August 1, 2005, Nancy H. Karp has entered into a Rule 10b5-1 trading plan to sell shares she owns from time to time and other officers and directors may also do so in the future.

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

As of March 31, 2006, Dr. Karp beneficially owned 2,981,602 shares or approximately 20% of our common stock outstanding. Such a concentration of ownership and voting power may have the effect of delaying or preventing a change in the control of our company.

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

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

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

We held our Annual Meeting of Stockholders on January 24, 2006 at the Company’s principal executive offices in Mountain View, California. Out of 14,744,007 shares of Common Stock entitled to vote at such meeting, there were present in person or by proxy 13,942,663 shares. At the Annual Meeting, our stockholders approved the following matters:

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

Peter S. Cross, 10,496,798 votes cast for and 3,445,865 votes withheld;

R. Stephen Heinrichs, 13,455,373 votes cast for and 487,290 votes withheld;

Richard A. Karp, 10,175,100 votes cast for and 3,767,563 votes withheld;

Nancy H. Karp, 9,251,881 votes cast for and 4,690,782 votes withheld;

Henry P. Massey, Jr., 8,984,751 votes cast for and 4,957,912 votes withheld;

John M. Scandalios, 10,495,298 votes cast for and 3,447,365 votes withheld;

Charles L. Waggoner, 10,495,298 votes cast for and 3,447,365 votes withheld.

(b) The amendment of the company’s 1998 Stock Option Plan (the “Plan”) to (i) increase the shares reserved for issuance thereunder by 1,000,000 shares of Common Stock, (ii) extend the term of the Plan to November 1, 2015, and (iii) in addition to stock options and stock purchase rights, permit the award of stock appreciation rights, restricted stock units, performance units, performance shares and other stock awards as determined by the Plan administrator.

7,561,299 votes were cast for and 5,760,534 votes were cast against with 2,664 votes abstaining.

In our proxy statement, we had also asked our shareholders to ratify the appointment of PricewaterhouseCoopers LLP as our independent registered public accounting firm for the fiscal year ending September 30, 2006. As disclosed in its Current Report on Form 8-K filed on January 4, 2006, subsequent to the mailing of our proxy statement and before our Annual Meeting, we dismissed PricewaterhouseCoopers and appointed Deloitte & Touche LLP as our independent registered public accounting firm. As a result, the ratification was withdrawn from consideration at the meeting.

Item 6. Exhibits


31.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURE

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


	CATAPULT COMMUNICATIONS CORPORATION

Date: May 9, 2006		By: /s/	Christopher A. Stephenson

			Christopher A. Stephenson
			Vice President and Chief Financial Officer
			(Principal Financial Officer)

Exhibit Index


Exhibit
Number		Description of Exhibit

31.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	H.S. freshman Good

Catapult Communications (CATT) Inactive 10-Q2006 Q2 Quarterly report

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