Ditech Networks 10Q 2006 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended January 31, 2006

OR

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

For the transition period from to

Commission file number 000-26209

Ditech Communications Corporation

(Exact name of registrant as specified in its charter)

Delaware		94-2935531
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

825 East Middlefield Road
Mountain View, California 94043
(650) 623-1300
(Address, including zip code, and telephone number, including area code, of registrant’s executive offices)

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

YES ý NO o

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 Exchange Act. (Check one):

Large accelerated filer o

Accelerated filer ý

Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). YES o NO ý

As of February 28, 2006, 32,340,623 shares of the Registrant’s common stock were outstanding.

PART I. FINANCIAL INFORMATION

Item 1 —Financial Statements

Ditech Communications Corporation

Condensed Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)

	Three months ended January 31,						Nine months ended January 31,
	2006			2005			2006			2005
Revenue	$	13,995		$	21,310		$	34,865		$	71,103
Cost of goods sold	4,280			4,788			10,608			16,491

Gross profit	9,715			16,522			24,257			54,612

Operating expenses:
Sales and marketing	4,234			4,164			12,692			11,722
Research and development	4,479			4,499			13,211			12,016
General and administrative	1,720			2,017			5,291			5,300
Amortization of purchased intangible assets	246			—			575			—
In-process research and development	—			—			700			—

Total operating expenses	10,679			10,680			32,469			29,038

Income (loss) from operations	(964		)	5,842			(8,212		)	25,574
Other income, net	1,175			747			3,154			1,685

Income (loss) from continuing operations before benefit from income taxes	211			6,589			(5,058		)	27,259
Provision (benefit) for income taxes	278			(524		)	(1,668		)	(36,047		)

Income (loss) from continuing operations	(67		)	7,113			(3,390		)	63,306

Discontinued operations:
Income on disposition	—			23			—			94
Income tax benefit	—			—			—			(110		)
Income from discontinued operations	—			23			—			204

Net income (loss)	$	(67	)	$	7,136		$	(3,390	)	$	63,510

Basic income (loss) per share:
From continuing operations	$	(0.00	)	$	0.21		$	(0.11	)	$	1.87
From discontinued operations	—			—			—			0.01
Basic net income (loss) per share	$	(0.00	)	$	0.21		$	(0.11	)	$	1.88

Diluted income (loss) per share:
From continuing operations	$	(0.00	)	$	0.20		$	(0.11	)	$	1.77
From discontinued operations	—			—			—			0.01
Diluted net income (loss) per share	$	(0.00	)	$	0.20		$	(0.11	)	$	1.78

Weighted shares used in per share calculation:
Basic	32,300			34,084			32,198			33,867
Diluted	32,300			35,498			32,198			35,780

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

Ditech Communications Corporation

Condensed Consolidated Balance Sheets

(in thousands)

(unaudited)

	January 31, 2006			April 30, 2005

Assets
Cash and cash equivalents	$	25,331		$	36,781
Short-term investments	97,208			98,853
Accounts receivable, net	3,122			9,318
Inventories	8,216			5,732
Deferred income taxes	4,836			4,836
Other current assets	2,234			1,561

Total current assets	140,947			157,081

Property and equipment, net	4,787			4,937
Goodwill	9,913			—
Purchased intangibles, net	3,626			—
Deferred income taxes	47,746			46,771
Other assets	378			931

Total assets	$	207,397		$	209,720

Liabilities and Stockholders’ Equity
Accounts payable	$	1,879		$	2,166
Accrued expenses	6,998			8,505
Deferred revenue	324			202
Income taxes payable	1,500			1,582
Total current liabilities	10,701			12,455

Long term accrued expenses	550			—

Common stock	291,780			287,068
Accumulated deficit	(93,147		)	(89,757		)
Deferred stock-based compensation	(2,483		)	—
Other comprehensive loss	(4		)	(46		)

Total stockholders’ equity	196,146			197,265

Total liabilities and stockholders’ equity	$	207,397		$	209,720

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

Ditech Communications Corporation

Condensed Consolidated Statements of Cash Flows

(in thousands)

(unaudited)

	Nine months ended January 31,
	2006			2005

Cash flows from operating activities:
Net income (loss)	$	(3,390	)	$	63,510
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization	2,652			2,012
Loss from discontinued operations	—			344
Provision for doubtful accounts	(65		)	—
Loss on disposal of fixed assets	—			159
Tax benefit from exercise of stock options	100			15,419
Deferred income taxes	(1,696		)	(51,235		)
Amortization of deferred stock-based compensation	634			—
Amortization of purchased intangibles	575			—
Amortization of Jasomi contingent consideration	395			—
In-process research and development	700			—
Other	79			418
Changes in assets and liabilities:
Accounts receivable	6,727			(10,617		)
Inventories	(2,484		)	(640		)
Other current assets	(840		)	(268		)
Income taxes	(82		)	(205		)
Accounts payable	(783		)	1,076
Accrued expenses and other	(2,035		)	(944		)
Deferred revenue	10			(1,783		)

Net cash provided by operating activities	497			17,246

Cash flows from investing activities:
Purchases of property and equipment	(1,884		)	(2,094		)
Purchases of available for sale investments	(46,500		)	(39,921		)
Sales and maturities of available for sale investments	48,108			39,798
Proceeds from sale of discontinued operations	—			542
Acquisition of Jasomi Networks, Inc., net of cash received	(12,636		)	—
Decrease in other assets	(47		)	—

Net cash used in investing activities	(12,959		)	(1,675		)

Cash flows from financing activities:
Repurchase of common stock	—			(21,553		)
Proceeds from employee stock plan issuances	1,012			10,042

Net cash provided by (used in) financing activities	1,012			(11,511		)

Net (decrease) increase in cash and cash equivalents	(11,450		)	4,060
Cash and cash equivalents, beginning of period	36,781			45,610

Cash and cash equivalents, end of period	$	25,331		$	49,670

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

DITECH COMMUNICATIONS CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. DESCRIPTION OF BUSINESS

Ditech Communications Corporation (the “Company” or “Ditech”) designs, develops and markets telecommunications equipment for use in wireline, wireless, satellite and IP telecommunications networks. The Company’s products enhance and monitor voice quality and provide security in the delivery of voice services. The Company has established a direct sales force that sells its products in the U.S. and internationally. In addition, the Company is expanding its use of value added resellers and distributors in an effort to broaden its sales channels, and this expanded use of value added resellers and distributors has occurred primarily in the Company’s international markets.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The accompanying condensed consolidated financial statements as of January 31, 2006, and for the three and nine month periods ended January 31, 2006 and 2005, together with the related notes, are unaudited but include all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary for the fair statement, in all material respects, of the financial position and the operating results and cash flows for the interim date and periods presented. Results for the interim periods ended January 31, 2006 are not necessarily indicative of results for the entire fiscal year or future periods. These condensed consolidated financial statements should be read in conjunction with the financial statements and related notes thereto for the year ended April 30, 2005, included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 14, 2005, file number 000-26209.

In May 2003, the Company announced that it was exiting the optical communications portion of its business. In July 2003, the Company executed a sale of a substantial portion of the assets used in the optical business. As a result, the optical business has been presented as a discontinued operation in the condensed consolidated statements of operations for all periods presented. See Note 5 for a further discussion of the discontinued operations.

Reclassifications

Certain items in the condensed consolidated financial statements for the nine months ended January 31, 2005 have been reclassified to conform to classifications used in the current fiscal year.

Computation of Income (Loss) per Share

Basic income (loss) per share is calculated based on the weighted average number of shares of common stock outstanding during the period less shares subject to repurchase, which are considered contingently issuable shares. Diluted income per share is calculated based on the weighted average number of shares of common stock and common stock equivalents outstanding, including the dilutive effect of stock options, using the treasury stock method, and common stock subject to repurchase. Diluted loss per share is calculated excluding the effects of all common stock equivalents, which totaled 789,000 and 644,000 for the three and nine month periods ended January 31, 2006, as their effect would be anti-dilutive. Also potentially dilutive are $7.0 million of convertible debentures issued as part of the Jasomi Networks, Inc. (“Jasomi”) acquisition that either mature or convert into Ditech common stock at the election of the holder. The debentures potentially convert to a maximum of approximately 767,000 shares of common stock (see Note 3).

A reconciliation of the numerator and denominator used in the calculation of the basic and diluted net income (loss) per share follows (in thousands, except per share amounts):

	Three months ended January 31,						Nine months ended January 31,
	2006			2005			2006			2005
Net income (loss) per share, basic and diluted:
Income (loss) from continuing operations	$	(67	)	$	7,113		$	(3,390	)	$	63,306
Income from discontinued operations	—			23			—			204
Net income (loss)	$	(67	)	$	7,136		$	(3,390	)	$	63,510

Basic:
Weighted average shares of common stock outstanding	32,302			34,086			32,200			33,869
Less stock subject to repurchase	(2		)	(2		)	(2		)	(2		)
Shares used in calculation of basic per share amounts	32,300			34,084			32,198			33,867

Income (loss) from continuing operations	$	(0.00	)	$	0.21		$	(0.11	)	$	1.87
Income from discontinued operations	—			—			—			0.01
Net income (loss) per share	$	(0.00	)	$	0.21		$	(0.11	)	$	1.88

Diluted:
Shares used in calculation of basic per share amounts	32,300			34,084			32,198			33,867
Shares subject to repurchase	—			2			—			2
Dilutive effect of stock plans	—			1,412			—			1,910
Shares used in calculation of diluted per share amounts	32,300			35,498			32,198			35,780

Income (loss) from continuing operations	$	(0.00	)	$	0.20		$	(0.11	)	$	1,77
Income from discontinued operations	—			—			—			0.01
Net income (loss) per share	$	(0.00	)	$	0.20		$	(0.11	)	$	1.78

Comprehensive Income (Loss)

For the three and nine-month periods ended January 31, 2006, total comprehensive loss was ($63,000) and ($3.3) million, respectively. For the three and nine-month periods ended January 31, 2005, total comprehensive income was $7.1 million and $63.4 million, respectively. Total comprehensive income (loss) includes the impact of unrealized gains and losses on available-for-sale securities, net of tax.

Accounting for Stock-Based Compensation

Statement of Financial Accounting Standards No. 123, “Accounting for Stock-based Compensation,” (“SFAS 123”), encourages, but does not require, companies to record compensation cost for stock-based compensation plans at fair value. The Company accounts for grants of equity instruments to employees using the intrinsic value method described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and complies with the disclosure provisions of SFAS 123. Accordingly, compensation cost for stock options is measured as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock and is recognized over the vesting period of the related shares. The Company recorded deferred stock compensation and associated amortization in conjunction with its acquisition of Jasomi in the first quarter of fiscal 2006 (see Note 3).

If compensation cost for the Company’s stock option plan had been determined based on the fair value at the grant dates for awards under those plans consistent with SFAS 123, the Company’s net income (loss) for the three and nine-month periods ended January 31, 2006 and 2005 would have been adjusted to the pro forma amounts indicated in the following table (in thousands, except per share amounts):

	Three months ended January 31,						Nine months ended January 31,
	2006			2005			2006			2005
Net income (loss) as reported	$	(67	)	$	7,136		$	(3,390	)	$	63,510

Add: Stock-based compensation expense included in reported net income (loss), net of applicable tax effects	163			—			393			—

Deduct: Stock-based compensation determined under the fair value method for all stock awards, net of applicable taxes	(1,527		)	(1,927		)	(4,663		)	(6,188		)

Pro forma net income (loss)	$	(1,431	)	$	5,209		$	(7,660	)	$	57,322

Basic net income (loss) per share:

As reported	$	(0.00	)	$	0.21		$	(0.11	)	$	1.88

Pro forma	$	(0.04	)	$	0.15		$	(0.24	)	$	1.69

Diluted net income (loss) per share:

As reported	$	(0.00	)	$	0.20		$	(0.11	)	$	1.78

Pro forma	$	(0.04	)	$	0.15		$	(0.24	)	$	1.60

Recent Accounting Pronouncements

In November 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 151, Inventory Costs, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company does not believe the adoption of SFAS No. 151 will have a material impact on its financial statements.

In December 2004, the FASB issued Statement No. 123(Revised 2004) “Share-Based Payment” (SFAS 123R) which requires companies to measure and recognize compensation expense for all stock-based payments at fair value. SFAS 123R is effective for the first annual reporting period beginning after June 15, 2005 and, thus, will be effective for the Company beginning in fiscal 2007. In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107 regarding the SEC’s interpretation of SFAS No. 123R and the valuation of share-based payments for public companies. The Company is currently evaluating the impact of SFAS 123R and SAB 107 on its financial position and results of operations. See “Accounting for Stock-Based Compensation” for information related to the pro forma effects on the Company’s reported net income (loss) and net income (loss) per share of applying the fair value recognition provisions of the previous Statement of Financial Accounting Standards (SFAS) 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and FASB No. 3, Reporting Accounting Changes in Interim Financial Statements. The Statement applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. SFAS 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. It is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections of errors made occurring in fiscal years beginning after June 1, 2005. The Company does not expect the effect of SFAS 154 will have material impact on its financial statements.

In November 2005, the Financial Accounting Standards Board (FASB) issued final staff position (FSP) 115-1 and FSP 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which nullify certain requirements of Emerging Issues Task Force (EITF) Issue No. 03-1 and supersede EITF Topic No. D-44. The FSPs provide guidance for identifying impaired investments and new disclosure requirements for investments that are deemed to be temporarily impaired. The Company does not believe the impact of adoption of the measurement provisions of the FSPs will have a material impact on its financial statements.

3. ACQUISITIONS

On June 30, 2005, the Company acquired privately-held Jasomi. Jasomi develops and sells session border controllers, which enable VoIP calls to traverse the network address translation (NAT) and firewall devices in customers’ networks, ensuring that reliable VoIP service can be provided to them. The combination of Ditech’s Packet Voice Processor and Jasomi’s session border control technology may enable Ditech to provide a comprehensive solution to VoIP carriers’ border services needs.

The preliminary merger consideration paid totaled $14.8 million and included a cash payment of $10.4 million that was paid at closing, an additional $2.0 million in cash that was placed in escrow, with the remainder consisting of the assumption of vested stock options, acquisition costs and net liabilities assumed. The escrowed cash shall be available to satisfy any claims for indemnification that Ditech may make for certain breaches of representations, warranties and covenants set forth in the acquisition agreements and any remaining and available amount in such escrow shall be distributed to the former Jasomi stockholders two years from the acquisition date. In addition, further merger consideration not yet recorded included $7.0 million in non-transferable convertible notes, divided into two tranches with principal amounts of $3.0 million and $4.0 million, respectively. The $3.0 million notes either mature or convert into Ditech common stock on the date one year or, at the election of the holder, two years from the closing date. The $4.0 million notes either mature or convert into Ditech common stock at the election of the holder two years from the closing date. The notes bear an interest rate of 5%, payable on maturity or conversion, and are convertible at $9.84 per share. The payment of the full $7.0 million principal amount of the convertible notes is contingent on the retention of a specified number of designated employees. In accordance with Statement of Financial Accounting Standards No. 141 (SFAS 141), the Company has not recorded the $7.0 million as merger consideration as the Company believes the retention of the designated employees is not assured beyond a reasonable doubt. At the time these contingencies are satisfied, the Company will record the amounts due to the former non-employee Jasomi stockholders, if any, as goodwill. The portion of the notes that have been issued to employee-stockholders, totaling $947,000, is being amortized as compensation expense over the remaining life of each note. During the third quarter and first nine months of fiscal 2006, the Company recorded $234,000 and $395,000, respectively, of compensation expense related to the notes.

Ditech also (i) assumed Jasomi unvested stock options outstanding on the date of the closing, which converted into options to buy 112,343 shares of the Company’s common stock, and (ii) issued to Jasomi employees restricted stock and restricted stock units for an aggregate of 393,212 shares of the Company’s common stock. The intrinsic value of the unvested options assumed and restricted shares granted to Jasomi employees have been recorded as deferred stock-based compensation and are being amortized as compensation expense over the remaining respective vesting periods. The restricted stock has a three year vesting schedule while the unvested options assumed typically have a ten year term and a four year vesting period.

The 78,768 vested stock options assumed, at an intrinsic value of $483,000, have been recorded as part of the purchase consideration.

The Company allocated the purchase price to in-process research and development (“in-process R&D”), goodwill and intangibles through established valuation techniques in the high-technology communications equipment industry. In-process R&D was expensed at the time of the acquisition because technological feasibility was not established and no future alternative use existed.

In valuing in-process R&D, cash flow projections were based on estimates from Ditech and Jasomi management and from various public, financial and industry sources. The Company expected net revenue to grow through calendar 2008 and decline thereafter based on the rate of technology changes in the industry, product life cycles and various projects’ stages of development. The Company estimated cost of goods sold and operating expenses, including research and development expenses and selling, general and administrative expenses, as a percentage of revenue based on historical averages and forward-looking projections. The Company also included in the projections estimated costs to bring projects to technological feasibility and costs associated with activities undertaken to correct errors or keep products updated (also referred to as “maintenance” research and development). The Company based tax expense on statutory Federal and California tax rates.

The Company based the percentage of completion of in-process projects on an averaging of (i) expenses incurred to-date compared to the total estimated development costs for each project, (ii) time incurred to-date and remaining time to complete each project and (iii) milestone-based percent complete estimates. The average percentage complete for the in-process projects was 56% as of the date of the acquisition.

The 30% cost of capital used to discount estimated cash flows reflects the estimated time to complete the projects and the level of risk involved.

The preliminary consideration paid for Jasomi was comprised of (in thousands):

Cash	$	12,449
Vested options assumed	483
Acquisition costs	706
Net liabilities assumed	1,175
Total consideration	$	14,813

The preliminary purchase price of Jasomi was allocated as follows (in thousands):

In-process research and development	$	700
Other intangible assets consisting of:
Core technology	2,900
Customer relationships	1,100
Trade name and trademarks	200
Goodwill	9,913
Total purchase price	$	14,813

Goodwill originating from the Jasomi acquisition will not be amortized. Purchased intangible assets are being amortized on a straight-line basis over a period of four to five years. For the three and nine-months ended January 31, 2006, the Company recorded $246,000 and $575,000, respectively, of amortization of Jasomi acquisition-related intangibles.

For the three and nine-months ended January 31, 2006, the Company recorded $263,000 and $634,000, respectively, of compensation expense related to assumed unvested stock options and a restricted stock plan. The $2.5 million remaining balance of deferred stock-based compensation is reflected as a component of Stockholders’ Equity.

Since July 1, 2005, the results of operations of Jasomi have been included in the Company’s condensed consolidated statements of operations. Pro forma results of operations have not been presented, as the effect of this acquisition was not material.

4. BALANCE SHEET ACCOUNTS

Inventories comprised (in thousands):

	January 31, 2006		April 30, 2005

Raw materials	$	1,420	$	667
Work in progress	—		72
Finished goods	6,796		4,993

Total	$	8,216	$	5,732

Accrued expenses comprised (in thousands):

	January 31, 2006		April 30, 2005

Accrued employee related	$	2,835	$	3,831
Accrued warranty	1,796		2,010
Accrued restructuring costs	228		228
Accrued professional services	680		561
Other accrued expenses	1,459		1,875

Total	$	6,998	$	8,505

Warranties. The Company provides for estimated future warranty costs upon shipment of its products. The specific terms and conditions of those warranties may vary depending upon the product sold, the customer and the country in which it does business. However, the Company’s warranties generally start from the shipment date and continue for a period of one to five years. As part of the sale of the Company’s optical business to JDS Uniphase (“JDSU”), see Note 5, the Company has retained its warranty obligations for optical products sold prior to July 16, 2003. Pursuant to the terms of the agreement with JDSU, JDSU will perform warranty repairs on the Company’s behalf and then bill the Company for the cost of those services at rates stipulated in the agreement.

Because the Company’s products are manufactured to a standardized specification and products are internally tested to these specifications prior to shipment, the Company historically has experienced minimal warranty costs. Factors that affect the Company’s warranty liability include the number of installed units, historical experience and management’s judgment regarding anticipated rates of warranty claims and cost per claim. The Company assesses the adequacy of its recorded warranty liabilities every quarter and makes adjustments to the liability, if necessary.

Changes in the warranty liability, which is included as a component of “Accrued expenses” on the Condensed Consolidated Balance Sheet, were as follows (in thousands):

	Three months ended January 31,						Nine months ended January 31,
	2006			2005			2006			2005

Balance as of the beginning of the fiscal period	$	1,796		$	2,087		$	2,010		$	1,980
Provision for warranties issued during fiscal period	72			102			295			493
Warranty costs incurred during fiscal period	(72		)	(102		)	(295		)	(341		)
Other adjustments to the liability (including changes in estimates for pre-existing warranties) during fiscal period	—			—			(214		)	(45		)

Balance as of January 31	$	1,796		$	2,087		$	1,796		$	2,087

Guarantees and Indemnifications. As is customary in the Company’s industry and as required by law in the U.S. and certain other jurisdictions, certain of the Company’s contracts provide remedies to its customers, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of the Company’s products. From time to time, the Company indemnifies customers against combinations of losses, expenses, or liabilities arising from various trigger events related to the sale and the use of the Company’s products and services. In addition, from time to time the Company also provides protection to customers against claims related to undiscovered liabilities, additional product liability or environmental obligations. In the Company’s experience, claims made under such indemnifications are rare. In connection with the sale of the Company’s echo cancellation software technology to Texas Instruments (TI) in April 2002 and the sale of the Company’s optical business to JDSU in July 2003, the Company indemnified TI and JDSU for various matters. The indemnifications to TI expired without any claims made against them and the Company believes the estimated fair value of the indemnifications made to JDSU will not have a material affect on future operations.

As permitted or required under Delaware law and to the maximum extent allowable under that law, the Company has certain obligations to indemnify its current and former officers and directors for certain events or occurrences while the officer or director is, or was serving at the Company’s request in such capacity. These indemnification obligations are valid as long as the director or officer acted in good faith and in a manner that a person reasonably believed to be in or not opposed to the best interests of the Company, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his or her conduct was unlawful. The maximum potential amount of future payments the Company could be required to make under these indemnification obligations is unlimited; however, the Company has a director and officer insurance policy that reduces the Company’s exposure and enables the Company to recover a portion of any future amounts paid. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification obligations is minimal.

5. DISCONTINUED OPERATIONS

On July 16, 2003, the Company completed the primary step in the planned exit of its optical communications business through the sale of a large portion of the assets of its optical communications business to JDSU, pursuant to an Asset Purchase Agreement (the “Purchase Agreement”). The assets sold consisted primarily of inventory, certain specified optical-related equipment and intellectual property rights, which were sold for an aggregate purchase price of up to approximately $6.5 million in cash, of which (i) approximately $1.4 million was paid to the Company at closing, (ii) $225,000 to be paid to the Company one year from the closing (subject to reduction in the event any successful indemnification claims are made against the Company), and (iii) up to an additional $4.9 million to be paid to the Company, which is comprised of up to $900,000 based on the level of inventory consumed by JDSU, and up to $4.0 million based on revenues generated by the optical business acquired by JDSU through June 30, 2005, if any. Additionally, JDSU had the right to require the Company to reimburse JDSU for any purchased but unused inventory at June 30, 2004, up to $2.0 million, which right expired as of July 31, 2004. JDSU also has indemnification rights in connection with the performance of certain warranty obligations relating to optical products that were sold by the Company on or prior to July 16, 2003. The Company and JDSU are currently evaluating the remaining obligations of each party. However, the Company does not expect that the outcome of these discussions will have a material affect on its financial statements.

The following table shows the components of the gain from the disposal of the Company’s discontinued operations for the three and nine month periods ended January 31, 2006 and 2005 (in thousands):

	Three months ended January 31,					Nine months ended January 31,
	2006		2005			2006		2005
Proceeds from sale	$	—	$	—		$	—	$	(55	)
Less: Net book value of assets sold	—		—			—		—
Transaction costs	—		—			—		(68		)
Gain (loss) on sale	—		—			—		13
Costs to exit remainder of optical business	—		(23		)	—		(81		)
Income (loss) on disposition	—		23			—		94
Tax provision (benefit)	—		—			—		(110		)
Total gain (loss) on disposal	$	—	$	23		$	—	$	204

As of January 31, 2006, the Company has resolved all loss contingencies related to closing the optical business with the exception of certain matters related to the closure of one of the Company’s international optical operations, for which the Company has accrued $228,000. The Company expects to resolve this matter within the current fiscal year.

6. BORROWING AGREEMENT

In September 2005, the Company renewed its $2.0 million operating line of credit with its bank. The renewed line of credit, which expires on July 31, 2006, carries the same basic terms as the original line of credit and financial covenants related to minimum effective tangible net worth and cash and cash equivalent and short-term investment balances. As of January 31, 2006, the Company had no borrowings outstanding under the line of credit.

7. INCOME TAXES

The Company recorded tax expense (benefit) of $278,000 and ($1,668,000), respectively, for the three and nine-month periods ended January 31, 2006 resulting in effective tax rates of 132% and 33%, respectively. The effective tax rates for the third quarter and nine-month period were affected by non-deductible Jasomi acquisition-related charges, including the Company’s inability to deduct for tax purposes $700,000 for in-process R&D related to the acquisition of Jasomi. The Company recorded tax benefits of $524,000 and $36.0 million for the three and nine-month periods ended January 31, 2005, reflecting the reversal of a valuation allowance.

Tax benefits related to employee stock option and stock purchase plan transactions totaled $8,000 and $100,000, respectively, for the three and nine-month periods ended January 31, 2006 and $511,000 and $15.4 million, respectively, for the three and nine-month periods ended January 31, 2005, and increased additional paid-in capital.

The acquisition of Jasomi resulted in a reduction in deferred tax assets of $720,000, due to acquired non-deductible intangible assets partially offset by Jasomi’s net operating loss carryforward.

The Company’s research and development tax credits, which are a component of its deferred tax assets, generated in fiscal years 1999, 2000 and 2001 are under examination by the State of California Franchise Tax Board. The Company believes that adequate amounts had previously been reserved for any adjustments which may ultimately result from these examinations.

8. COMMITMENTS AND CONTINGENCIES

Lease Amendment

On September 22, 2005, the Company amended its facility lease which reduces the cost per square foot and extends the lease term through July 31, 2011, with an option to extend the term for an additional three years. As part of the agreement, the landlord provided $442,000 for tenant improvements.

At January 31, 2006, future minimum payments under the Company’s operating leases are as follows (in thousands):

Fiscal Year	January 31, 2006
2006 (remaining 3 months)	$	255
2007	956
2008	958
2009	1,012
2010	1,058
Thereafter	1,371
Total	$	5,610

Legal Proceedings

Beginning on June 14, 2005, several purported class action lawsuits were filed in the United States District Court for the Northern District of California, purportedly on behalf of a class of investors who purchased Ditech’s stock between August 25, 2004 and May 26, 2005. The complaints allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against the Company and its Chief Executive Officer and Chief Financial Officer. All of the lawsuits were consolidated into a single action entitled In re Ditech Communications Corp. Securities Litigation, No. C 05-02406-JSW. This matter is at an early stage; no lead plaintiff has been selected, no consolidated complaint has been filed, no discovery has taken place and no trial date has been set. The Company intends to take all appropriate action in connection with the defense of the litigation. The Company cannot predict the outcome of the class action at this time.

On June 20, 2005, the first of two shareholder’s derivative complaints was filed in the California Superior Court for the County of Santa Clara. Both complaints are purportedly brought derivatively by shareholders on behalf of the Company against several executives of the Company and all members of its board of directors, and name the Company as a nominal defendant. The plaintiffs allege that the defendants breached their fiduciary duties to the Company in connection with alleged misrepresentations concerning VQA orders and the potential effect on the Company of the merger between Sprint and Nextel, that certain of the defendants improperly sold the Company stock while in possession of material nonpublic information, and that the defendants are liable to the Company for damages as a result thereof. Both lawsuits were consolidated into a single action entitled In re Ditech Communications Corp. Derivative Litigation, No. 105-CV-043429. The defendants filed a demurrer to the consolidated complaint, and the consolidated action was subsequently voluntarily dismissed without prejudice.

9. REPORTABLE SEGMENTS AND GEOGRAPHIC INFORMATION

As a result of the Company exiting the optical communications business in the first quarter of fiscal 2004, that segment has been reported as a discontinued operation in the condensed consolidated statements of operations for all periods presented. As such, the Company currently operates in a single segment, voice processing products.

The Company’s revenue from external customers by geographic region, based on ship to destination, was as follows (in thousands):

	Three months ended January 31,				Nine months ended January 31,
	2006		2005		2006		2005

USA	$	13,548	$	18,922	$	31,455	$	65,944
Canada	63		1,164		1,907		1,720
Europe	108		320		1,162		1,116
Asia	26		867		70		2,107
Latin America	250		37		271		216

Total	$	13,995	$	21,310	$	34,865	$	71,103

Sales for the three months ended January 31, 2006 included sales to one customer that represented greater than 10% of total revenue (81.9%). Sales for the nine-month period ended January 31, 2006 included sales to one customer that represented greater than 10% of total revenue (80.0%). Sales for the three and nine-month periods ended January 31, 2005 each included sales to two customers (44.9% and 40.0%) and (43.1% and 43.7%), respectively, that represented greater than 10% of total revenue. As of January 31, 2006, the Company had two customers that represented greater than 10% of accounts receivable (45.4% and 36.2%). At April 30, 2005, two customers represented greater than 10% of accounts receivable (51.6% and 20.4%).

As of January 31, 2006 and April 30, 2005, the Company maintained its property and equipment in the following countries (in thousands):

	January 31, 2006		April 30, 2005

USA	$	4,623	$	4,896
Rest of World	164		41

Total	$	4,787	$	4,937

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 our Consolidated Financial Statements and Notes thereto for the year ended April 30, 2005, included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 14, 2005. The discussion in this Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, such as statements of our expected future financial operating results, plans, objectives, expectations and intentions. Our actual results could differ materially from those discussed here. See “Future Growth and Operating Results Subject to Risk” at the end of this Item 2 for factors that could cause future results to differ materially.

Overview

We design, develop and market telecommunications equipment for use in canceling echo and enhancing voice quality in voice calls over wireline, wireless and internet protocol (IP) telecommunications networks. Our products enhance and monitor voice quality and provide security in the delivery of voice services. Since entering the voice processing market, we have continued to refine our echo cancellation products to meet the needs of the ever-changing telecommunications marketplace. Our more recent product introductions have leveraged off the processing capacity of our newer hardware platforms to offer not only echo cancellation but also enhanced Voice Quality Assurance (VQA) features including noise reduction, acoustic echo cancellation, voice level control and noise compensation through enhanced voice intelligibility. We have directed the majority of our R&D spending since the beginning of fiscal 2005 towards the development of our Packet Voice Processor, a new product targeting Voice-over-Internet-Protocol (VoIP) based network deployments. The Packet Voice Processor introduces cost effective voice format transcoding capabilities and combines our VQA software and newly developed Packet Quality Assurance (PQA) technology to improve call quality and clarity by eliminating acoustic echo and voice level imbalances and reducing packet loss, delay and jitter. Also targeting VoIP-based network deployments was our acquisition of Jasomi Networks, Inc. (Jasomi). Jasomi’s current session border controller product enables VoIP calls to traverse the network address translation (NAT) and firewall devices in customers’ networks, ensuring that reliable VoIP service can be provided to them. We plan to combine the Packet Voice Processor and session border controller technologies to provide a comprehensive solution to carriers’ border services needs.

Since becoming a public company in June 1999, our financial success has been primarily predicated on the success of the U.S. wire-line and more recently wireless carriers. Merger and acquisition activity among North American telecommunication service providers has affected our revenue this year as one of our two largest fiscal 2005 U.S. customers is involved in post-merger integration and orders from that customer in fiscal 2006 have been minimal. Our revenue will continue to be heavily influenced by the buying trends of Verizon Wireless, our largest customer in fiscal 2006. In an attempt to diversify our customer base, beginning in fiscal 2004 and throughout fiscal 2005, we added sales and marketing resources to increase our presence in the international marketplace and to focus on new large account opportunities in the United States. In the United States, we believe that our continued focus on voice quality in a competitive wireless services landscape and the expansion of wireless networks will be key factors in driving our revenue growth. Internationally, Orascom Telecom Holding (Orascom) became our largest VQA shipment to-date, as well as a step toward our goal of customer diversification. The VQA technology allows Orascom to provide voice quality over its network and to provide efficient spectrum utilization, thereby increasing its customers’ satisfaction and reducing the cost of building and deploying its network. The shipment is included in deferred revenue at January 31, 2006. We continue to focus on international mobile carriers who might best apply our VQA solution. We also expect that long-term opportunities for growth will occur in VoIP based network deployments as there appears to be a growing trend of service providers transitioning away from traditional circuit-switched network infrastructure to VoIP. Our Packet Voice Processor, which is in its beta phase, and our Session Border Controller (SBC), which is already commercialized, target these VoIP-based networks. Through the third quarter of fiscal 2006, we have recognized modest revenue from PeerPoint, our SBC product. Through the third quarter of fiscal 2006, we have not generated any revenue from the sale of our Packet Voice Processor, but we expect to generate nominal sales from it in the fourth quarter.

Exit of Optical Business. In May 2003, we announced a change to our strategic direction. We decided to focus all of our assets in continuing to grow our voice processing business, including our echo cancellation and new VQA features, and as a result we decided to sell our optical communications business. In July 2003, we completed the primary step in our planned exit of our optical communications business through the sale of a large portion of the assets of the optical communications business to JDS Uniphase Corporation (“JDSU”). The assets sold consisted primarily of inventory, certain specified optical-related equipment and intellectual property rights, which were sold for an aggregate purchase price of up to approximately $6.5 million in cash, of which (a) approximately $1.4 million was paid to us at closing, (b) $225,000 to be paid to us one year from the closing (subject to reduction in the event any successful indemnification claims are made against us), and (c) up to an additional $4.9 million to be paid to us, which is comprised of up to $900,000 based on the level of inventory consumed by JDSU, and up to $4.0 million based on revenues generated by the optical business acquired by JDSU through June 30, 2005, if any. Additionally, JDSU had the right to require us to reimburse JDSU for any purchased but unused inventory at June 30, 2004, up to $2.0 million, which right expired as of July 31, 2004. JDSU also has indemnification rights in connection with the performance of certain warranty obligations relating to optical products that were sold by us on or prior to July 16, 2003. We and JDSU are currently evaluating the remaining obligations of each party, but have not reached agreement on what the remaining obligations are. In fiscal 2005, income from discontinued operations was due to adjustments needed to reflect actual costs incurred and our assessment of remaining obligations. No additional revenue was recognized from the sale to JDSU. See Note 5 of Notes to the Condensed Consolidated Financial Statements.

We have sold or abandoned all of the assets not purchased by JDSU. As a result of exiting the optical business, our Consolidated Statements of Operations reflect the optical business as a discontinued operation for all periods presented. See Note 5 of Notes to the Condensed Consolidated Financial Statements.

Acquisition History. Our most recent acquisition, which occurred in June 2005, was our acquisition of Jasomi for approximately $14.8 million in cash, escrow payments, vested options assumed, acquisition costs, and net liabilities assumed plus $7.0 million in non-transferable convertible notes. The payment of the full $7.0 million principal amount of the convertible notes is contingent on the retention of a specified number of designated employees and is not reflected in the purchase price. We additionally issued shares of Ditech restricted stock to new employees hired as part of the merger. Jasomi developed and sold session border controllers, which enable VoIP calls to traverse the network address translation (NAT) and firewall devices in customers’ networks, ensuring that reliable VoIP service can be provided to them. The combination of Ditech’s Packet Voice Processor and Jasomi’s session border control technology may enable Ditech to provide a comprehensive solution to carriers’ border services needs. See Note 3 of Notes to the Condensed Consolidated Financial Statements.

Our Customer Base. Historically the majority of our sales have been to customers in the United States. These customers accounted for approximately 90% of our revenue in the first nine months of fiscal 2006, and 91% and 89% of our revenue in fiscal 2005 and 2004, respectively. However, sales to some of our customers in the U.S. may result in our products purchased by these customers eventually being deployed internationally. To date, the vast majority of our international sales have been export sales and denominated in U.S. dollars. We expect that as we expand shipments of our newer voice processing products, which are targeted at GSM networks, international revenue will begin to become a larger percentage of our overall revenue.

Our revenue historically has come from a small number of customers. Sales for the nine-month period ended January 31, 2006 included sales to one customer that represented 80% of total revenue. Sales to our five largest customers accounted for approximately 90% of revenue in the first nine months of fiscal 2006, and 91% and 86% of our revenue in fiscal 2005 and 2004, respectively. Consequently, the loss of any one of these customers, without an offsetting increase in revenue from existing or new customers, would have a substantial negative effect on our business. This was evidenced in the first nine months of fiscal 2006 as revenue was approximately half of our revenue in the first nine months of fiscal 2005 primarily due to a lack of orders from one of our prior largest customers. This caused the nine month period ended January 31, 2006 to result in a net loss.

Critical Accounting Policies and Estimates. The preparation of our financial statements requires us to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosures. We evaluate these estimates on an ongoing basis, including those related to our revenues, allowance for bad debts, provisions for inventories, warranties and recovery of deferred income taxes. Estimates are based on our historical experience and other assumptions that we consider reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual future results may differ from these estimates in the event that facts and circumstances vary from our expectations. To the extent there are material differences between our ongoing estimates and the ultimate actual results, our future results of operations will be affected as adjustments to our estimates are required. We believe that the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition—In applying our revenue recognition and allowance for doubtful accounts policies that are outlined in our Form 10-K filed on July 14, 2005, the level of judgment is generally relatively limited, as the vast majority of our revenue has been generated by a handful of relatively long-standing customer relationships. These customers are some of the largest wire-line and wireless carriers in the United States and our relationships with them are documented in contracts, which clearly highlight potential revenue recognition issues, such as passage of title and risk of loss. As of January 31, 2006, we had deferred $8.2 million of revenue. To the extent that we have received cash for some or all of a given deferred revenue transaction, it is reported on the Condensed Consolidated Balance Sheet as a deferred revenue liability. However, to the extent that cash has not been collected against the deferred revenue transaction, the deferred revenue is reflected as a reduction in the corresponding account receivable balance. Of the $8.2 million of revenue deferred as of January 31, 2006, approximately $7.9 million was deferred due to contractually required installation or acceptance, and was primarily associated with our new international customer. The majority of the remaining deferred balance is associated with maintenance contracts and receivables whose collectibility is not reasonably assured. In dealing with smaller customers, we closely evaluate the credit risk of these customers. In those cases where credit risk is deemed to be high, we either mitigate the risk by having the customer post a letter of credit, which we can draw against on a specified date to effectively provide reasonable assurance of collection, or we defer the revenue until customer payment is received.

Investments—Investment securities that have maturities of more than three months at the date of purchase but remaining maturities of less than one year and auction rate securities, which we are able to liquidate on 28 or 35 day auction cycles, are considered short-term investments. Other investment securities with remaining maturities of one year or more are considered long-term investments. Short-term and long-term investments consist primarily of U.S. Government securities and corporate bonds, as well as, commercial paper, asset backed securities and certificates of deposit. We have classified our short-term and long-term investments as available-for-sale securities in the accompanying consolidated financial statements. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in a separate component of stockholders’ equity. Realized gains and losses and declines in value judged to be other-than-temporary, if any, on available-for-sale securities are included in interest income based on specific identification. Interest on securities classified as available-for-sale is also included in interest income.

Inventory Valuation Allowances—In conjunction with our ongoing analysis of inventory valuation allowances, we are constantly monitoring projected demand on a product by product basis. Based on these projections we evaluate the levels of allowances required both for inventory on hand, as well as inventory on order from our contract manufacturers. Although we believe we have been reasonably successful in identifying allowance requirements in a timely manner, sudden changes in future buying patterns from our customers, either due to a shift in product interest and/or a complete pull back from their expected order levels has resulted in some larger than anticipated write-downs being recognized, such as the OC-3 write-down recorded in fiscal 2002. In the case of the OC-3 write-down, the complete pull back from the forecasted demand by the primary customer for this product resulted in a $3.5 million write-down of the OC-3 inventory. However, beginning in 2003, the addition of a few new major customers helped to utilize a large portion of the inventory that had been written down resulting in approximately $2.2 million and $455,000 of previously written down inventory being sold in fiscal 2004 and 2003, respectively. For the nine months ended January 31, 2006 and 2005, we sold $323,000 and $713,000, respectively, of previously written-down inventory.

Goodwill—Our methodology for allocating a portion of the purchase price to goodwill in connection with the purchase of Jasomi was determined through established valuation techniques in the high-technology communications equipment industry. Goodwill was measured as the excess of the cost of acquisition over the sum of the amounts assigned to tangible and identifiable intangible assets acquired less liabilities assumed. We will test goodwill for impairment on an annual basis in the fourth quarter of our fiscal year or more frequently if indicators of potential impairment arise. The goodwill recorded in the Condensed Consolidated Balance Sheet as of January 31, 2006 was $9.9 million.

Cost of Warranty— At the time that we recognize revenue, we accrue for the estimated costs of the warranty we offer on our products. We currently offer warranties on our products ranging from one to five years. The warranty generally provides that we will repair or replace any defective product and provide software bug fixes within the term of the warranty. Our accrual for the estimated warranty is based on our historical experience and expectations of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, we may revise our estimated warranty accrual to reflect these additional exposures, which would result in a decrease in gross profits. As of January 31, 2006, we had recorded $1.8 million of accruals related to estimated future warranty costs. See Note 4 of the Notes to the Condensed Consolidated Financial Statements.

Accounting for Income Taxes — We estimate our actual current tax exposure together with our temporary differences resulting from differing treatment of items such as valuation allowances for bad debts and inventory, for tax and accounting purposes. These temporary differences, in conjunction with net operating loss and tax credit carryforwards, result in deferred tax assets and liabilities. At least once per quarter, we assess the likelihood that our net deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is no longer more likely than not, we establish a valuation allowance. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets.

Beginning in fiscal 2002, we determined that a valuation allowance against our then existing deferred tax asset position was necessary. We based this decision on the fact that in the fourth quarter of 2002, we generated sufficient operating losses on a tax basis to fully recover all taxes paid in prior years. In addition, our expectations of limited profitability, if any, due to the softness in the telecommunication industry during fiscal 2003, combined with the significant tax losses generated by the sale of our echo cancellation software technology led us to conclude that the recovery of our deferred tax assets was no longer more likely than not. In the second quarter of fiscal 2005, based on the level of historical taxable income and projections for future taxable income over the periods that our deferred tax assets are deductible, we determined that it was more likely than not that our deferred tax assets would be realized. We therefore released the valuation allowance of $51.6 million in fiscal 2005.

Recent Accounting Pronouncements In November 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 151, Inventory Costs, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not believe the adoption of SFAS No. 151 will have a material impact on our financial statements.

In December 2004, the FASB issued Statement No. 123(Revised 2004) “Share-Based Payment” (SFAS 123R) which requires companies to measure and recognize compensation expense for all stock-based payments at fair value. SFAS 123R is effective for the first annual reporting period beginning after June 15, 2005 and, thus, will be effective for us beginning fiscal 2007. In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107 regarding the SEC’s interpretation of SFAS No. 123R and the valuation of share-based payments for public companies. We are currently evaluating the impact of SFAS 123R and SAB 107 on our financial position and results of operations. See “Accounting for Stock-Based Compensation” for information related to the pro forma effects on our reported net income (loss) and net income (loss) per share of applying the fair value recognition provisions of the previous Statement of Financial Accounting Standards (SFAS) 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and FASB No. 3, Reporting Accounting Changes in Interim Financial Statements. The Statement applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. SFAS 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. It is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Earlier application is permitted for accounting changes and corrections of errors made occurring in fiscal years beginning after June 1, 2005. We do not expect the effect of SFAS 154 will have material impact on our financial statements.

In November 2005, the Financial Accounting Standards Board (FASB) issued final staff position (FSP) 115-1 and FSP 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” which nullify certain requirements of Emerging Issues Task Force (EITF) Issue No. 03-1 and supersede EITF Topic No. D-44. The FSPs provide guidance for identifying impaired investments and new disclosure requirements for investments that are deemed to be temporarily impaired. We do not believe the impact of adoption of the measurement provisions of the FSPs will have a material impact on our financial statements.

RESULTS OF OPERATIONS

The following table sets forth, for the periods indicated, the components of the results of operations, as reflected in our statements of operations, as a percentage of sales.

	Three months ended January 31,				Nine months ended January 31,
	2006		2005		2006		2005
Revenue	100.0	%	100.0	%	100.0	%	100.0	%
Cost of goods sold	30.6		22.5		30.4		23.2
Gross profit	69.4		77.5		69.6		76.8
Operating expenses:
Sales and marketing	30.2		19.5		36.4		16.5
Research and development	32.0		21.1		37.9		16.9
General and administrative	12.3		9.5		15.2		7.4
Amortization of purchased intangibles	1.8		—		1.6		—
In-process R&D	—		—		2.0		—
Total operating expenses	76.3		50.1		93.1		40.8
Income (loss) from operations	(6.9	)	27.4		(23.5	)	36.0
Other income, net	8.4		3.5		9.0		2.3
Income (loss) from continuing operations before provision for (benefit from) income taxes	1.5		30.9		(14.5	)	38.3
Provision for (benefit from) income taxes	2.0		(2.5	)	(4.8	)	(50.7	)
Income from continuing operations	(0.5	)	33.4		(9.7	)	89.0
Income (loss) from discontinued operations, net of tax	—		0.1		—		0.3
Net income (loss)	(0.5	)%	33.5	%	(9.7	)%	89.3	%

THREE AND NINE MONTHS ENDED JANUARY 31, 2006 AND 2005.

Revenue.

									Increase (Decrease) From Prior Year,
	Three months ended January 31,				Nine months ended January 31,				3 Month			9 Month
$s in thousands	2006		2005		2006		2005		Period			Period
Revenue	$	13,995	$	21,310	$	34,865	$	71,103	$	(7,315	)	$	(36,238	)

The decrease in revenue during the third quarter and first nine months of fiscal 2006 was due to a lack of orders from one of our two largest customers and to a level of shipments to our other large customer more consistent with historical shipments to that customer. Sales to one customer accounted for approximately 82% of our revenue in the third quarter of fiscal 2006 while sales to two large customers accounted for 85% of our revenue in the third quarter of fiscal 2005. For the first nine months of fiscal 2006, sales to one customer accounted for 80% of our revenues as compared to sales to two customers accounting for 87% of revenue for the first nine months of fiscal 2005. The primary source of product revenue has come from our Broadband Voice Processor Flex (“BVP-Flex”) Echo Cancellation System, which was introduced in the third quarter of fiscal 2004 and has become the primary system purchased by our U.S. customers over the last eight quarters.

Geographically, our third quarter of fiscal 2006 revenue remained primarily U.S. at 97% of total worldwide revenue compared to U.S. sales of 89% realized in the third quarter last year. U.S. revenue for the first nine months of fiscal 2006 accounted for 90% of worldwide revenue compared to 93% in the first nine months of fiscal 2005.

We continue to believe the VQA presents material revenue opportunities, and we will therefore continue to invest in our international infrastructure and in customer trials. Although we expect that sales of our BVP-Flex to U.S. customers will continue to represent the majority of our revenue in the foreseeable future, we expect to recognize $3 - $4 million of VQA revenue in the fourth quarter. We expect revenue in the fourth quarter of fiscal 2006 to increase by approximately 30% compared to the third quarter.

Cost of Goods Sold.

									Increase (Decrease) From Prior Year,
	Three months ended January 31,				Nine months ended January 31,				3 Month			9 Month
$s in thousands	2006		2005		2006		2005		Period			Period
Cost of Goods Sold	$	4,280	$	4,788	$	10,608	$	16,491	$	(508	)	$	(5,883	)

Cost of goods sold consists of direct material costs, personnel costs for test, configuration and quality assurance, costs of licensed technology incorporated into our products, post-sales installation costs, provisions for inventory and warranty expenses and other indirect costs. The decrease in cost of goods sold was primarily driven by the decrease in business volume during the third quarter and first nine months of fiscal 2006 as compared to the third quarter and first nine months of fiscal 2005. However, cost of goods sold did not decrease in direct proportion to the decrease in sales due to the fact that our manufacturing overhead and installation service costs are relatively fixed, thus holding the overall decrease in cost of goods sold below the rate of revenue reduction. We would expect that cost of goods sold will continue to follow the general trend in revenue.

Gross Profit.

													Increase (Decrease) From Prior Year,
	Three months ended January 31,						Nine months ended January 31,						3 Month			9 Month
$s in thousands	2006			2005			2006			2005			Period			Period
Gross Profit	$	9,715		$	16,522		$	24,257		$	54,612		$	(6,807	)	$	(30,355	)
Gross Margin %	69.4		%	77.5		%	69.6		%	76.8		%	(8.1		)%pts	(7.2		)%pts

The primary reason for the decrease in gross margin in the third quarter and first nine months of fiscal 2006 was the relatively fixed manufacturing overhead and installation service costs, which represented a higher percentage of revenue as revenue decreased during the third quarter and first nine months of fiscal 2006. In addition, for the third quarter and first nine months of fiscal 2006, gross margins were unfavorably impacted by customer and product mix, which included the impact of the higher standard cost of the Flex 400 sales relative to the standard cost of BVP-Flex. The Flex 400 combines echo cancellation technology with our VQA suite of voice enhancement software to provide quality enhancement. We expect that gross margins will be in the high 60%s in the coming quarter based on forecasted product and customer mix. Over the next several quarters, if we are successful in international deployment, we expect to experience pricing pressures as we expand the distribution of our products through value-added resellers and distributors.

Sales and Marketing.

													Increase (Decrease) From Prior Year,
	Three months ended January 31,						Nine months ended January 31,						3 Month			9 Month
$s in thousands	2006			2005			2006			2005			Period			Period
Sales & Marketing Expense	$	4,234		$	4,164		$	12,692		$	11,722		$	70		$	970
% of Revenue	30.3		%	19.5		%	36.4		%	16.5		%	10.7		%pts	19.9		%pts

Sales and marketing expenses consist primarily of personnel costs, including commissions and costs associated with customer service, travel, trade shows and outside consulting services. In the third quarter and first nine months of fiscal 2006, salary and related expense increased $681,000 and $1.3 million, respectively, due primarily to incremental hiring of international sales and pre-sales support staff as well as for the additional employees acquired from Jasomi. Those costs included stock-based compensation, convertible debenture amortization and other compensation expense associated with the Jasomi acquisition discussed in more detail in “Acquisition-Related Compensation Expense” below. During the first nine months of fiscal 2006, we incurred incremental costs of approximately $380,000 for participation in trade shows primarily showcasing our Packet Voice Processor applications although there were not significant incremental expenditures in the third quarter of fiscal 2006 compared to the third quarter of fiscal 2005. Travel and related costs declined $211,000 in the third quarter compared to the same quarter last year due to the timing of some events and changes in personnel but increased $358,000 in the nine month period compared to the same period last year due to support required for international product evaluations of our VQA applications. Those increases were partially offset by an increase in absorption of service expenses to cost of sales of $131,000 and $363,000, respectively, in the third quarter and first nine months of fiscal 2006 due to installation support requirements at our largest customer. Amortization of demonstration and field units previously being used in customer demonstrations and trials declined by $104,000 and $455,000, respectively, in the third quarter and first nine months of fiscal 2006. During the first quarter of fiscal 2006, we aggressively pursued the return of this equipment, which was previously being amortized, when customer demonstrations and trials were completed. Finally, we reduced our competitor equipment purchases in the third quarter and first nine months of fiscal 2006 by $163,000 and $256,000, respectively. From time-to-time, depending on releases of new products, we may purchase competitor equipment to evaluate performance and features versus our own products. We expect sales and marketing expenses will increase in the fourth quarter of fiscal 2006 due to the timing of trade shows and expected international sales agent fees.

Research and Development.

													Increase (Decrease) From Prior Year,
	Three months ended January 31,						Nine months ended January 31,						3 Month			9 Month
$s in thousands	2006			2005			2006			2005			Period			Period
Research & Development Expense	$	4,479		$	4,499		$	13,211		$	12,016		$	(20	)	$	1,195
% of Revenue	32.0		%	21.1		%	37.9		%	16.9		%	10.9		%pts	21.0		%pts

Research and development expenses consist primarily of personnel costs, contract consultants, and materials and supplies used in the development of voice processing products. Salary and related costs increased $456,000 and $1.7 million, respectively, in the third quarter and first nine months of fiscal 2006 compared to the same periods in fiscal 2005. Those increases in spending were primarily associated with our research and development efforts for our new packet-based voice products and include the incremental salaries and stock-based and other compensation associated with the Jasomi acquisition discussed in more detail in “Acquisition-Related Compensation Expense” below. Depreciation, facilities, information technology related costs and maintenance on software and equipment used by the engineering departments accounted for an aggregate increase of $69,000 and $795,000, respectively, for the third quarter and first nine months of fiscal 2006 due, in large part, to the increased demands from the larger engineering workforce needed to support our existing voice products, as well as our move into packet-based voice products which required purchases of lab equipment. Travel related expense increased $56,000 and $186,000, respectively, for the third quarter and nine month period due to increased support of field trials and travel between our Canada location and our California headquarters. For the third quarter and nine month period, those increases were partially offset by decreases of $498,000 and $1.0 million, respectively, in outside service expense. That expense declined based on our stage in Packet Voice Processor development and our hiring of additional regular employees to complete the work. Additionally, for the nine month period, our purchases of prototype equipment supporting voice processing product development declined by $403,000 as the earlier stages of the development of our chassis, interface and processing cards required more prototypes. There was no meaningful change in our purchases of prototype equipment supporting voice processing product development between the third quarter of fiscal 2006 and the third quarter of fiscal 2005. We expect flat to slightly higher research and development spending as we continue to spend incrementally on the development of our Packet Voice Processor and session border controller products.

General and Administrative.

													Increase (Decrease) From Prior Year,
	Three months ended January 31,						Nine months ended January 31,						3 Month			9 Month
$s in thousands	2006			2005			2006			2005			Period			Period
General & Administrative Expense	$	1,720		$	2,017		$	5,291		$	5,300		$	(297	)	$	(9	)
% of Revenue	12.3		%	9.5		%	15.2		%	7.5		%	2.8		%pts	7.7		%pts

General and administrative expenses consist primarily of personnel costs for corporate officers, finance and human resources personnel, as well as insurance, legal, accounting and consulting costs. Compared to fiscal 2005, consulting costs related to Sarbanes-Oxley compliance costs declined $396,000 and $441,000, respectively, in the third quarter and first nine months of fiscal 2006. Those reductions were offset by the cost of legal work related to the class action lawsuits, which resulted in an increase of $170,000 and $425,000, respectively, in the third quarter and first nine months of fiscal 2006. We expect general and administrative expenses to be approximately the same as the third quarter of fiscal 2006.

Acquisition-Related Compensation Expense.

For the third quarter and nine months ended January 31, 2006, we recorded $263,000 and $634,000, respectively, of compensation expense related to the vesting of assumed stock options and the restricted stock grants made in connection with the Jasomi acquisition. Deferred stock-based compensation represents the intrinsic value of the unvested portion of options assumed and restricted shares granted to Jasomi employees and is amortized to research and development expense and sales and marketing expense over the corresponding vesting periods. See Note 3 of Notes to the Condensed Consolidated Financial Statements.

Stock-based compensation charges included in operating expenses were as follows:

	Three months ended January 31,		Nine months ended January 31,
$’s in thousands	2006		2006

Sales and marketing	$	77	$	179
Research and development	186		455

Total	$	263	$	634

For the third quarter and nine months ended January 31, 2006, we additionally recorded $234,000 and $395,000, respectively, of compensation expense related to the portion of convertible debentures issued to employee-stockholders. The compensation expense is being amortized to research and development expense and sales and marketing expense over the lives of the convertible debentures. See Note 3 of Notes to the Condensed Consolidated Financial Statements.

Convertible debenture amortization included in operating expenses was as follows:

	Three months ended January 31,		Nine months ended January 31,
$’s in thousands	2006		2006

Sales and marketing	$	221	$	368
Research and development	13		27

Total	$	234	$	395

Amortization of purchased intangible assets.

	Three months ended January 31,			Nine months ended January 31,
$’s in thousands	2006			2006

Amortization of purchased intangible assets	$	246		$	575
% of revenue	1.8		%	1.6		%

In the third quarter and first nine months of fiscal 2006, we recorded amortization of purchased intangible assets related to the Jasomi acquisition. Purchased intangible assets are being amortized to operating expense over their estimated useful life which ranges from four to five years.

In-process research and development.

	Three months ended January 31,			Nine months ended January 31,
$’s in thousands	2006			2006

In-process research and development	$	—		$	700
% of revenue	0.0		%	2.0		%

In the first quarter of fiscal 2006, we incurred a charge for in-process research and development (“in process R&D”) acquired as part of our acquisition of Jasomi. The amount of the purchase price for Jasomi allocated to in-process R&D was determined through established valuation techniques in the high-technology communications equipment industry. In-process R&D is expensed upon acquisition because technological feasibility has not been established and no future alternative uses exist.

In valuing in-process R&D, cash flows were based on estimates from our and Jasomi’s management and from various public, financial and industry sources. We projected net revenue to grow through calendar 2008 and decline thereafter based on the rate of technology changes in the industry, product life cycles and various projects’ stages of development. We estimated cost of goods sold and operating expenses, including research and development expenses and selling, general and administrative expenses, as a percentage of revenue based on historical averages and forward-looking projections. We also included in the projections estimated costs to bring projects to technological feasibility and costs associated with activities undertaken to correct errors or keep products updated (also referred to as “maintenance” research and development). We based the tax expense on statutory Federal and California tax rates.

We based the percentage of completion of in-process projects on an averaging of (i) expenses incurred to-date compared to the total estimated development costs for each project, (ii) time incurred to-date and remaining time to complete each project and (iii) milestone-based percent complete estimates. The average percentage complete for the in-process projects was 56%.

The 30% cost of capital used to discount estimated cash flows reflects the estimated time to complete the projects and the level of risk involved.

Other Income, Net.

													Increase (Decrease) From Prior Year,
	Three months ended January 31,						Nine months ended January 31,						3 Month			9 Month
$s in thousands	2006			2005			2006			2005			Period			Period
Other income, net	$	1,175		$	747		$	3,154		$	1,685		$	428		$	1,469
% of Revenue	8.4		%	3.5		%	9.0		%	2.4		%	4.9		%pts	6.7		%pts

Other income, net consists of interest income on our invested cash and cash equivalent and short-term investment balances and nominal foreign currency activities. The third quarter and first nine months of fiscal 2006 increase in other income, net was primarily attributable to higher interest income, due to a significant improvement in the return on our invested cash.

Income Taxes.

													Increase (Decrease) From Prior Year,
	Three months ended January 31,						Nine months ended January 31,						3 Month			9 Month
$s in thousands	2006			2005			2006			2005			Period			Period
Provision for (benefit from) income taxes	$	278		$	(524	)	$	(1,668	)	$	(36,047	)	$	802		$	34,379
% of Revenue	2.0		%	(2.5		)%	(4.8		)%	(50.7		)%	4.4		%pts	45.9		%pts

Income taxes consist of federal, state and foreign income taxes. The tax provision (benefit) for the third quarter and nine months ended January 31, 2006 resulted in effective tax rates of 132% and 33%, respectively. The effective tax rates for those periods were affected by non-deductible Jasomi acquisition-related charges, including our inability to deduct for tax purposes $700,000 for in-process R&D related to the acquisition of Jasomi. Our tax benefits for the three and nine-month periods ended January 31, 2005 reflected the reversal of a valuation allowance.

Our tax benefits related to employee stock option and stock purchase plan transactions totaled $8,000 and $100,000, respectively, for the three and nine-month periods ended January 31, 2006 and $511,000 and $15.4 million, respectively, for the three and nine-month periods ended January 31, 2005.

The acquisition of Jasomi resulted in a reduction in deferred tax assets of $720,000, due to acquired non-deductible intangible assets partially offset by Jasomi’s net operating loss carryforward.

Income from Discontinued Operations.

	Three months ended January 31,			Nine months ended January 31,
$’s in thousands	2005			2005

Income from discontinued operations	$	23		$	204
% of revenue	0.1		%	0.3		%

Income from discontinued operations for the nine months ended January 31, 2005 is net of an $110,000 income tax benefit related to the reversal of our valuation reserve on deferred tax assets. There was no discontinued operations activity in the first nine months of fiscal 2006. See Note 5 of Notes to the Condensed Consolidated Financial Statements.

LIQUIDITY AND CAPITAL RESOURCES

As of January 31, 2006, we had cash and cash equivalents of $25.3 million as compared to $36.8 million at April 30, 2005. Additionally we had short-term investments of $97.2 million as of January 31, 2006 as compared to $98.9 million at April 30, 2005. We currently have a $2 million line of credit facility with our bank.

Since March 1997, we have satisfied the majority of our liquidity requirements through cash flow generated from operations, funds received from stock issued under our various stock plans and the proceeds from our initial and follow-on public offerings in fiscal 2000.

	Nine Months Ended January 31,			Increase (Decrease) from Prior Year
$s in thousands	2006		2005	Increase (Decrease) from Prior Year
Cash flow from operating activities	$	497	17,246	$	(16,749	)

The reduction in our cash flow from operations reflects the overall decrease in our operating results due in large part to decreased product shipments to our two largest customers from fiscal 2005. This cash flow reduction was partially offset by a favorable trend in accounts receivable. Our average days sales outstanding at January 31, 2006 improved to approximately 20 days from 37 days at April 30, 2005. We expect our cash flows from operations for the remainder of the fiscal year to be positive based on our projected revenue growth. Over the longer-term, our entry into new customer markets internationally, where payment terms are somewhat longer, and our introduction of the packet voice processor, which may require us to increase inventory levels, may adversely impact cash flows from operations.

	Nine Months Ended January 31,					Increase (Decrease) from Prior Year
$s in thousands	2006			2005		Increase (Decrease) from Prior Year
Cash flow from investing activities	$	(12,959	)	(1,675	)	$	(11,284	)

The increase in our cash outflows from investing activities during fiscal 2006 was due in large part to our acquisition of Jasomi on June 30, 2005 which used approximately $12.6 million of cash. This increase in outflows was partially offset by higher cash inflows in fiscal 2006 from the net sales of short-term investments. We also used $1.9 million of cash for purchases of property and equipment primarily to support new product introductions. We plan to continue to invest in capital assets related to new product introductions at levels similar to the first nine months of the year.

	Nine Months Ended January 31,				Increase (Decrease) from Prior Year
$s in thousands	2006		2005		Increase (Decrease) from Prior Year
Cash flow from financing activities	$	1,012	(11,511	)	$	12,523

Through the first nine months of fiscal 2005, we repurchased $21.6 million of our common stock. We completed the stock repurchase program by the end of fiscal 2005. Partially offsetting the cash outflow from common stock repurchases, proceeds from stock option and stock purchase plan activities were $10.0 million in the first nine months of fiscal 2005. In the first nine months of fiscal 2006, stock options and stock purchase plan proceeds were $1.0 million. The limited level of option activity in fiscal 2006 was largely due to a large portion of the options being out-of-the-money or only marginally in-the-money due to the year-over-year decline in our stock price. Although we expect to continue to have positive cash flows from financing activities due to employee stock plan activity, the level of cash flow will vary depending on market conditions.

We have no material commitments other than obligations under operating leases, particularly our facility leases. We currently occupy approximately 61,000 square feet of space in the two buildings that form our Mountain View headquarters. On September 22, 2005, we amended our facility lease which reduces our cost per square foot and extends the lease term through July 31, 2011, with an option to extend the term for an additional three years.

	Payments due by period
Contractual Obligations	Total		Less than 1 year		1 to 3 years		3 to 5 years		Over 5 years

Operating leases	$	5,610	$	947	$	1,977	$	2,134	$	552
Purchase commitments	3,949		3,949		—		—		—

Total	$	9,559	$	4,896	$	1,977	$	2,134	$	552

In addition, as part of the optical sale agreement with JDSU, JDSU had the right to require us to indemnify JDSU for any purchased but unused inventory at June 30, 2004, up to $2.0 million, and certain costs incurred by JDSU in connection with the performance of certain warranty obligations relating to optical products that we sold prior to July 16, 2003. We and JDSU are currently evaluating the remaining obligations of each party, but have not reached agreement.

Jasomi merger consideration included $7.0 million in non-transferable convertible notes, divided into two tranches with principal amounts of $3.0 million and $4.0 million, respectively. The $3.0 million notes either mature or convert into Ditech common stock on the date one year or, at the election of the holder, two years from the closing date. The $4.0 million notes either mature or convert into Ditech common stock at the election of the holder two years from the closing date. The notes bear an interest rate of 5%, payable on maturity or conversion, and are convertible at $9.84 per share. The payment of the full $7.0 million principal amount of the convertible notes is contingent on the retention of a specified number of designated employees.

We believe that we will be able to satisfy our cash requirements for at least the next two fiscal years from our existing cash and short-term investments. The ability to fund our operations beyond the next two fiscal years will be dependent on the overall demand of telecommunications providers for new capital equipment. Should we continue to operate at a loss for several quarters or incur larger quarterly losses, we could be forced to reduce our spending levels to protect our cash reserves or need to find additional sources of cash during fiscal 2008.

Future Growth and Operating Results Subject to Risk

Our business and the value of our stock are subject to a number of risks, which are set out below. If any of these risks actually occur, our business, financial condition or operating results could be materially adversely affected, which would likely have a corresponding impact on the value of our common stock. These risk factors should be carefully reviewed.

WE DEPEND ON A LIMITED NUMBER OF CUSTOMERS, THE LOSS OF ANY ONE OF WHICH COULD CAUSE OUR REVENUE TO DECREASE.

Our revenue historically has come from a small number of customers. Our five largest customers accounted for approximately 90% of our revenue in the first nine months of fiscal 2006 and 91% and 86% of our revenue in fiscal 2005 and 2004, respectively. Our largest customer accounted for approximately 80% of our revenue in the first nine months of fiscal 2006. A customer may stop buying our products or significantly reduce its orders for our products for a number of reasons, including the acquisition of a customer by another company, a delay in a scheduled product introduction or completion of a network expansion or upgrade. If this happens, our revenue could be greatly reduced, which would materially and adversely affect our business.

Since the beginning of calendar year 2004, North American telecommunication service providers have been involved in a series of merger and acquisition activities and some affected telecommunication service providers are still assessing the network technology and deployment plans. In any merger, product purchases for network deployment may be reviewed, postponed or canceled based on revised plans for technology or network expansion for the merged entity, which we believe has happened at Nextel, leading to the majority of our decline in revenue in the first nine months of fiscal 2006. If this situation occurs at other customers, it may result in the delay of product purchases or the loss of those customers.

WE ARE RELIANT SOLELY ON OUR VOICE QUALITY BUSINESS TO GENERATE REVENUE GROWTH AND PROFITABILITY, WHICH COULD LIMIT OUR RATE OF FUTURE REVENUE GROWTH.

We expect that, at least through fiscal 2006, our sole business will be the design, development and marketing of voice processing products. However, the relatively small size of the overall echo cancellation portion of the voice market, which is where we have derived the majority of our revenue to date, could limit the rate of growth of our business. In addition, certain telecommunication service providers may utilize different technologies, such as VoIP, which would further limit demand for products we sold in fiscal 2005 and in the first nine months of fiscal 2006, which are deployed in wireline networks. Although we have begun to distribute for trial our Packet Voice Processor for use in the VoIP market, we expect to generate only nominal revenue in the fourth quarter of fiscal 2006.

OUR OPERATING RESULTS HAVE FLUCTUATED SIGNIFICANTLY IN THE PAST, AND WE ANTICIPATE THAT THEY MAY CONTINUE TO DO SO IN THE FUTURE, WHICH COULD ADVERSELY AFFECT OUR STOCK PRICE.

Our quarterly operating results have fluctuated significantly in the past and may fluctuate in the future as a result of several factors, some of which are outside of our control. If revenue significantly declines in a quarter, as we experienced in the second half of fiscal 2001, again in the second quarter of fiscal 2002 and again in the first nine months of fiscal 2006, our operating results will be adversely affected because many of our expenses are relatively fixed. In particular, sales and marketing, research and development and general and administrative expenses do not change significantly with variations in revenue in a quarter. Adverse changes in our operating results could adversely affect our stock price. For example, when we announced in May 2005 that we expected our revenue for the first quarter of fiscal 2006 would be less than half of our revenue in the last quarter of fiscal 2005, our stock price dropped from a closing price of $12.59 just prior to our announcement to a closing price of $7.79 per share on the day following our announcement.

OUR REVENUE MAY VARY FROM PERIOD TO PERIOD.

Factors that could cause our revenue to fluctuate from period to period include:

• changes in capital spending in the telecommunications industry and larger macroeconomic trends;

• the timing or cancellation of orders from, or shipments to, existing and new customers;

• the loss of, or a significant decline in orders from, a customer;

• delays outside of our control in obtaining necessary components from our suppliers;

• delays outside of our control in the installation of products for our customers;

• the timing of new product and service introductions by us, our customers, our partners or our competitors;

• delays in timing of revenue recognition, due to new contractual terms with customers;

• competitive pricing pressures;

• variations in the mix of products offered by us; and

• variations in our sales or distribution channels.

Sales of our products typically come from our major customers ordering large quantities when they deploy a switching center. Consequently, we may get one or more large orders in one quarter from a customer and then no orders in the next quarter. As a result, our revenue may vary significantly from quarter to quarter.

Our customers may delay or rescind orders for our existing products in anticipation of the release of our or our competitors’ new products, due to merger and acquisition activity or if they are unable to put credit facilities in place. Further, if our or our competitors’ new products substantially replace the functionality of our existing products, our existing products may become obsolete, which could result in inventory write-downs, and/or we could be forced to sell them at reduced prices or even at a loss.

In addition, the sales cycle for our products is typically lengthy. Before ordering our products, our customers perform significant technical evaluations, which typically last up to 90 days or more for our base echo cancellation systems and up to 180 days or more for our newer VQA product offering. Once an order is placed, delivery times can vary depending on the product ordered and the timing of installations or product acceptance may be delayed by our customers. As a result, revenue forecasted for a specific customer for a particular quarter may not occur in that quarter. Because of the potential large size of our customers’ orders, this would adversely affect our revenue for the quarter.

OUR EXPENSES MAY VARY FROM PERIOD TO PERIOD.

Many of our expenses do not vary with our revenue. Factors that could cause our expenses to fluctuate from period to period include:

• the extent of marketing and sales efforts necessary to promote and sell our products;

• the timing and extent of our research and development efforts;

• the availability and cost of key components for our products; and

• the timing of personnel hiring.

If we incur such additional expenses in a quarter in which we do not experience increased revenue, our operating results would be adversely affected.

IF WE DO NOT SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS, OUR PRODUCTS MAY BECOME OBSOLETE WHICH COULD CAUSE OUR SALES TO DECLINE.

We operate in an industry that experiences rapid technological change, and if we do not successfully develop and introduce new products and our existing products become obsolete due to product introductions by competitors, our revenues will decline. Even if we are successful in developing new products, we may not be able to successfully produce or market our new products in commercial quantities, or increase our overall sales levels. These risks are of particular concern when a new generation product is introduced. Although we believe we will meet our product introduction timetables, there is no guarantee that delays will not occur. We realized our first modest levels of revenue from our new voice quality features, which are being offered on our BVP-Flex and Quad Voice Processor (QVP) voice processing hardware platforms, in the fourth quarter of fiscal 2004 and are currently experiencing numerous customer evaluations of these features around the world. These evaluations have taken longer than we first anticipated. We expect more significant levels of revenue from these new features in the fourth quarter of fiscal 2006. However, should the customer evaluation process become further protracted or the product not meet the customers’ expectations, the timing of our realization of any revenues from these new products could be delayed or not materialize at all.

The Packet Voice Processor provides voice processing functionality to enable the deployment of end-to-end VoIP services. This is the first packet-based product developed by us. In the first quarter of fiscal 2006, we began to beta trial our Packet Voice Processor. In this initial trial, we learned of enhanced requirements from our customer, and the trial has not concluded. We may have similar experiences in subsequent trials. The product may not be accepted in the market due to feature or capabilities mis-matches with customer requirements, pricing of the product, or limitations of our sales and marketing organizations to properly interact with customers to communicate the benefits of the product.

We have in the past experienced, and in the future may experience, unforeseen delays in the development of our new products. For example, an unexpected drop in demand for our OC-3 product led to the write down of $3.5 million of excess inventory in the third quarter of fiscal 2002. Although we were eventually able to sell this product after having written it down, there can be no assurances that we will be able to sell additional written-down units in the future.

We must devote a substantial amount of resources in order to develop and achieve commercial acceptance of our new products, most recently our Packet Voice Processor and our voice quality features offered on our BVP-Flex and QVP hardware platforms. Our new and/or existing products may not be able to address evolving demands in the telecommunications market in a timely or effective way. Even if they do, customers in these markets may purchase or otherwise implement competing products.

WE OPERATE IN AN INDUSTRY EXPERIENCING RAPID TECHNOLOGICAL CHANGE, WHICH MAY MAKE OUR PRODUCTS OBSOLETE.

Our future success will depend on our ability to develop, introduce and market enhancements to our existing products and to introduce new products in a timely manner to meet our customers’ requirements. The markets we target are characterized by:

• rapid technological developments;

• frequent enhancements to existing products and new product introductions;

• changes in end user requirements; and

• evolving industry standards.

WE MAY NOT BE ABLE TO RESPOND QUICKLY AND EFFECTIVELY TO THESE RAPID CHANGES. The emerging nature of these products and their rapid evolution will require us to continually improve the performance, features and reliability of our products, particularly in response to competitive product offerings. We may not be able to respond quickly and effectively to these developments. The introduction or market acceptance of products incorporating superior technologies or the emergence of alternative technologies and new industry standards could render our existing products, as well as our products currently under development, obsolete and unmarketable. In addition, we may have only a limited amount of time to penetrate certain markets, and we may not be successful in achieving widespread acceptance of our products before competitors offer products and services similar or superior to our products. We may fail to anticipate or respond on a cost-effective and timely basis to technological developments, changes in industry standards or end user requirements. We may also experience significant delays in product development or introduction. In addition, we may fail to release new products or to upgrade or enhance existing products on a timely basis.

WE MAY NEED TO MODIFY OUR PRODUCTS AS A RESULT OF CHANGES IN INDUSTRY STANDARDS. The emergence of new industry standards, whether through adoption by official standards committees or widespread use by service providers, could require us to redesign our products. If such standards become widespread, and our products are not in compliance, our current and potential customers may not purchase our products. The rapid development of new standards increases the risk that our competitors could develop and introduce new products or enhancements directed at new industry standards before us.

ACQUISITIONS AND INVESTMENTS MAY ADVERSELY AFFECT OUR BUSINESS.

From time to time, we review acquisition and investment prospects that would complement our existing product offerings, augment our market coverage, secure supplies of critical materials or enhance our technological capabilities. For example, in June 2005 we acquired Jasomi. Acquisitions or investments could result in a number of financial consequences, including:

• potentially dilutive issuances of equity securities;

• large one-time write-offs;

• reduced cash balances and related interest income;

• higher fixed expenses which require a higher level of revenues to maintain gross margins;

• the incurrence of debt and contingent liabilities; and

• amortization expenses related to other acquisition related intangible assets and impairment of goodwill.

Furthermore, acquisitions involve numerous operational risks, including:

• difficulties in the integration of operations, personnel, technologies, products and the information systems of the acquired companies;

• diversion of management’s attention from other business concerns;

• diversion of resources from our existing businesses, products or technologies;

• risks of entering geographic and business markets in which we have no or limited prior experience; and

• potential loss of key employees of acquired organizations.

WE ANTICIPATE THAT AVERAGE SELLING PRICES FOR OUR PRODUCTS WILL DECLINE IN THE FUTURE, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO BE PROFITABLE.

We expect that the price we can charge our customers for our products will decline as new technologies become available, as we expand the distribution of products through value-added resellers and distributors internationally and as competitors lower prices either as a result of reduced manufacturing costs or a strategy of cutting margins to achieve or maintain market share. If this occurs, our operating results will be adversely affected. We expect price reductions to be more pronounced due to our planned expansion internationally. While we intend to reduce our manufacturing costs in an attempt to maintain our margins and to introduce enhanced products with higher selling prices, we may not execute these programs on schedule. In addition, our competitors may drive down prices faster or lower than our planned cost reduction programs. Even if we can reduce our manufacturing costs, many of our operating costs will not decline immediately if revenue decreases due to price competition.

In order to respond to increasing competition and our anticipation that average-selling prices will decrease, we are attempting to reduce manufacturing costs of our new and existing products. If we do not reduce manufacturing costs and average selling prices decrease, our operating results will be adversely affected. Manufacturing is currently outsourced to primarily one contract manufacturer. We believe that our current contract manufacturing relationship provides us with competitive manufacturing costs for our products. However, if we or this contract manufacturer terminates our relationship, or if we otherwise establish new relationships, we may encounter problems in the transition of manufacturing to another contract manufacturer, which could temporarily increase our manufacturing costs and cause production delays.

IF WE LOSE THE SERVICES OF ANY OF OUR KEY MANAGEMENT OR KEY TECHNICAL PERSONNEL, OR ARE UNABLE TO RETAIN OR ATTRACT ADDITIONAL TECHNICAL PERSONNEL, OUR ABILITY TO CONDUCT AND EXPAND OUR BUSINESS COULD BE IMPAIRED.

We depend heavily on key management and technical personnel for the conduct and development of our business and the development of our products. However, there is no guarantee that if we lost the services of one or more of these people for any reason, that it would not adversely affect our ability to conduct and expand our business and to develop new products. We believe that our future success will depend in large part upon our continued ability to attract, retain and motivate highly skilled employees. However, we may not be able to do so.

WE FACE INTENSE COMPETITION, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO MAINTAIN OR INCREASE SALES OF OUR PRODUCTS.

The markets for our products are intensely competitive, continually evolving and subject to rapid technological change. We may not be able to compete successfully against current or future competitors. Certain of our customers also have the ability to internally produce the equipment that they currently purchase from us. In such cases, we also compete with their internal product development capabilities. We expect that competition will increase in the future. We may not have the financial resources, technical expertise or marketing, manufacturing, distribution and support capabilities to compete successfully.

We face competition from two major direct manufacturers of stand-alone voice processing products, Tellabs and Natural Microsystems. The other competition in these markets comes from voice switch manufacturers. These switch manufacturers do not sell voice processing products or compete in the stand-alone voice processing product market, but they integrate voice processing functionality within their switches, either as hardware modules or as software running on chips. A more widespread adoption of internal voice processing solutions would present an increased competitive threat to us, if the net result was the elimination of demand for our voice processing system products.

Many of our competitors and potential competitors have long-standing relationships with our existing and potential customers, and have substantially greater name recognition and technical, financial and marketing resources than we do. Such competitors may undertake more extensive marketing campaigns, adopt more aggressive pricing policies and devote substantially more resources to developing new products than we will.

WE NOW LICENSE OUR ECHO CANCELLATION SOFTWARE FROM TEXAS INSTRUMENTS, AND IF WE DO NOT RECEIVE THE LEVEL OF SUPPORT WE EXPECT FROM TEXAS INSTRUMENTS, IT COULD ADVERSELY AFFECT OUR ECHO CANCELLATION SYSTEMS BUSINESS.

In April 2002, we sold our echo cancellation software technology and future revenue streams from our licenses of acquired technology to Texas Instruments, in return for cash and a long-term license of the echo cancellation software. Although the licensing agreement has strong guarantees of support for the software used in our products, if Texas Instruments were to breach that agreement in some fashion, and not deliver complete and timely support to us, our success in the echo cancellation systems business could be adversely affected.

IF TEXAS INSTRUMENTS LICENSES ITS ECHO CANCELLATION SOFTWARE TO OTHER ECHO CANCELLATION SYSTEMS COMPANIES, THIS COULD INCREASE THE COMPETITIVE PRESSURES ON OUR ECHO CANCELLATION SYSTEMS BUSINESS.

Under the terms of the sale agreement of our echo cancellation software to Texas Instruments, Texas Instruments is precluded from licensing the software to two specified competitors for a period of four years from the date of the sale. If Texas Instruments were to license its echo cancellation software to other echo cancellation systems companies other than the two specified competitors, or beginning in April 2006 to either or both of the two specified competitors, it could increase the level of competition and adversely affect our success in our echo cancellation systems business.

IF INCUMBENT AND EMERGING COMPETITIVE SERVICE PROVIDERS AND THE TELECOMMUNICATIONS INDUSTRY AS A WHOLE EXPERIENCE A DOWNTURN OR REDUCTION IN GROWTH RATE, THE DEMAND FOR OUR PRODUCTS WILL DECREASE, WHICH WILL ADVERSELY AFFECT OUR BUSINESS.

Our success will continue to depend in large part on development, expansion and/or upgrade of voice and communications networks. We are subject to risks of growth constraints due to our current and planned dependence on U.S. and international telecommunications service providers. In fiscal 2001, for example, we experienced, as did other companies in our sector, a slowdown in infrastructure spending by our customers. These potential customers may be constrained for a number of reasons, including their limited capital resources, economic conditions, changes in regulation and mergers or consolidations which we have seen in North America since calendar year 2004.

WE MAY EXPERIENCE UNFORESEEN PROBLEMS AS WE DIVERSIFY OUR INTERNATIONAL CUSTOMER BASE, WHICH WOULD IMPAIR OUR ABILITY TO GROW OUR BUSINESS.

Historically, we have sold mostly to customers in North America. We are continuing to execute on our plans to expand our international presence through the establishment of new relationships with established international value-added resellers and distributors. However, we may still be required to hire additional personnel for the overseas market, may invest in markets that ultimately generate little or no revenue, and may incur other unforeseen expenditures related to our international expansion. Despite these efforts, to date our expansion overseas has met with limited success and there is no guarantee of future success. As we expand our sales focus farther into international markets, we will face new and complex issues that we may not have faced before, such as expanded risk to currency fluctuations, longer payment cycles, manufacturing overseas, political or economic instability, potential adverse tax consequences and broadened import/export controls, which will put additional strain on our management personnel. In the past, the vast majority of our international sales have been denominated in U.S. dollars; however, in the future, we may be forced to denominate a greater amount of international sales in foreign currencies.

The number of installations we will be responsible for may increase as a result of our continued international expansion and recognition of revenue may be dependent on acceptances. In addition, we may not be able to establish more relationships with international value-added resellers and distributors. If we do not, our ability to increase sales could be materially impaired.

SOME OF THE KEY COMPONENTS USED IN OUR PRODUCTS ARE CURRENTLY AVAILABLE ONLY FROM SOLE SOURCES, THE LOSS OF WHICH COULD DELAY PRODUCT SHIPMENTS.

We rely on certain suppliers as the sole source of certain key components that we use in our products. For example, we rely on Texas Instruments as the sole source supplier for the digital signal processors used in our echo cancellation and voice enhancement products. We have no guaranteed supply arrangements with our suppliers. Any extended interruption in the supply of these components would affect our ability to meet scheduled deliveries of our products to customers. If we are unable to obtain a sufficient supply of these components, we could experience difficulties in obtaining alternative sources or in altering product designs to use alternative components.

Resulting delays or reductions in product shipments could damage customer relationships, and we could lose customers and orders. Additionally, because these suppliers are the sole source of these components, we are at risk that adverse increases in the price of these components could have negative impacts on the cost of our products or require us to find alternative, less expensive components, which would have to be designed into our products in an effort to avoid erosion in our product margin.

SOME SUPPLIERS OF KEY COMPONENTS MAY REDUCE THEIR INVENTORY LEVELS WHICH COULD RESULT IN LONGER LEAD TIMES FOR FUTURE COMPONENT PURCHASES AND ANY DELAYS IN FILLING OUR DEMAND MAY REDUCE OR DELAY OUR EXPECTED PRODUCT SHIPMENTS AND REVENUES.

Although we believe there are currently ample supplies of components for our products, it is possible that in the near-term component manufacturers may reduce their inventory levels and require firm orders before they manufacture components. This reduction in stocking levels could lead to extended lead times in the future. If we are unable to procure our planned quantities of materials from all prospective suppliers, and if we cannot use alternative components, we could experience revenue delays or reductions and potential harm to customer relationships. An example of this risk occurred in the third quarter of fiscal 2001 as two suppliers supplying us with components used in our OC-3 product did not meet our total demand. As a result, the schedule shipment of our OC-3 product was delayed, which contributed to our revenue shortfall in that quarter.

OUR ABILITY TO COMPETE SUCCESSFULLY WILL DEPEND, IN PART, ON OUR ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, WHICH WE MAY NOT BE ABLE TO PROTECT.

We may rely on a combination of patents, trade secrets, copyright and trademark laws, nondisclosure agreements and other contractual provisions and technical measures to protect our intellectual property rights. Nevertheless, such measures may not be adequate to safeguard the technology underlying our products. In addition, employees, consultants and others who participate in the development of our products may breach their agreements with us regarding our intellectual property, and we may not have adequate remedies for any such breach. In addition, we may not be able to effectively protect our intellectual property rights in certain countries. We may, for a variety of reasons, decide not to file for patent, copyright or trademark protection outside of the United States. We also realize that our trade secrets may become known through other means not currently foreseen by us. Notwithstanding our efforts to protect our intellectual property, our competitors may be able to develop products that are equal or superior to our products without infringing on any of our intellectual property rights.

WE CURRENTLY ARE, AND IN THE FUTURE MAY BE, SUBJECT TO SECURITIES CLASS ACTION LAWSUITS DUE TO DECREASES IN OUR STOCK PRICE.

We are at risk of being subject to securities class action lawsuits if our stock price declines substantially. Securities class action litigation has often been brought against a company following a decline in the market price of its securities. For example, in May 2005, we announced that we expected our first quarter fiscal 2006 revenue to be approximately one half of our last quarter fiscal 2005 revenue, and our stock price declined dramatically. On June 14, 2005, a lawsuit entitled Richard E. Jaffe v. Ditech Communications Corp., Timothy K. Montgomery and William J. Tamblyn, Case No. C 05 02406 was filed in the United States District Court for the Northern District of California, purportedly on behalf of a class of investors who purchased Ditech’s stock between August 25, 2004 and May 26, 2005. The complaint alleges claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Ditech and our Chief Executive Officer and Chief Financial Officer. Several similar lawsuits have been filed, and expect that additional similar suits may subsequently be filed in the same court, and that all of the cases will be consolidated into a single action. In addition, a shareholder’s derivative suit was filed against our directors and the same two executive officers, and has named Ditech nominally as a defendant, making similar allegations. This shareholder’s derivative suit was subsequently voluntarily dismissed without prejudice, which means that the shareholder is able to refile the shareholder’s derivative suit at any time. We cannot predict the outcome of the lawsuits. If our stock price declines substantially in the future, we may be the target of similar litigation. The current, and any future, securities litigation could result in substantial costs and divert management’s attention and resources, and could seriously harm our business.

OUR PRODUCTS EMPLOY TECHNOLOGY THAT MAY INFRINGE ON THE PROPRIETARY RIGHTS OF THIRD PARTIES, WHICH MAY EXPOSE US TO LITIGATION.

Although we do not believe that our products infringe the proprietary rights of any third parties, third parties may still assert infringement or invalidity claims (or claims for indemnification resulting from infringement claims) against us. Such assertions could materially adversely affect our business, financial condition and results of operations. In addition, irrespective of the validity or the successful assertion of such claims, we could incur significant costs in defending against such claims.

THERE IS RISK THAT WE WILL NOT BE ABLE TO FULLY UTILIZE THE DEFERRED TAX ASSETS RECORDED ON OUR BALANCE SHEET.

In accordance with Statement of Financial Accounting Standard (SFAS) No. 109, “Accounting for Income Taxes,” we are required to establish a valuation allowance against our deferred tax assets if it is more likely than not that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. At January 31, 2006, we had $52.6 million in net deferred tax assets, which we believe are realizable based on the requirements of SFAS 109. However, because we incurred pre-tax losses in the first and second quarters of fiscal 2006, have shown volatile operating results in the past and because there is no guarantee that the amount and timing of our net profits will be sufficient to fully utilize our deferred tax assets, there is a risk that we will have to record valuation allowances in the future. Moreover, there is a risk that unfavorable audits by government agencies or change of ownership limitations (Section 382) may reduce the value of our deferred tax assets. If any of these events were to occur, our financial results for one or more periods would be adversely affected.

BEGINNING MAY 1, 2006, WE WILL BE REQUIRED TO RECORD COMPENSATION EXPENSE FOR STOCK OPTIONS. AS A RESULT, OUR FINANCIAL RESULTS WILL BE ADVERSELY AFFECTED.

In December 2004, FASB issued an accounting standard that will require the fair value of all equity-based awards granted to employees be recognized in the statement of operations as compensation expense, beginning on May 1, 2006 for our company. The various methods for determining the fair value of stock options are based on, among other things, the volatility of the underlying stock. Our stock price has historically been volatile. Therefore, the adoption of this accounting standard will negatively affect our financial results and may adversely affect our stock price. Such adoption could also limit our ability to continue to use stock options as an incentive and retention tool, which could, in turn, hurt our ability to recruit employees and retain existing employees.

Item 3—Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risk due to changes in the general level of United States interest rates relates primarily to our cash equivalents and short-term investment portfolios. Our cash, cash equivalents and short-term investments are primarily maintained at four major financial institutions in the United States. As of January 31, 2006, we did not hold any derivative instruments. The primary objective of our investment activities is the preservation of principal while maximizing investment income and minimizing risk, and we attempt to achieve this by diversifying our portfolio in a variety of highly rated investment securities that have limited terms to maturity. We do not hold any instruments for trading purposes.

Investment securities that have maturities of more than three months at the date of purchase but current maturities of less than one year are considered short-term investments. Our short-term investments consist primarily of U.S. Government securities and corporate bonds, as well as, commercial paper, asset backed securities and certificates of deposit. Short-term investments are maintained at one major financial institution, are classified as available-for-sale, and are recorded on the accompanying Condensed Consolidated Balance Sheets at fair value.

The following table presents the hypothetical changes in fair values of our investments as of January 31, 2006, based on discounted cash flow calculation over the remaining term of each investment that are sensitive to changes in interest rates (dollars in thousands):

	Valuation of Securities Given an Interest Rate Decrease of X Basis Points						Fair Value as of January 31, 2006		Valuation of Securities Given an Interest Rate Increase of X Basis Points
	(150 BPS)		(100 BPS)		(50 BPS)				50 BPS		100 BPS		150 BPS
Total investments	$	97,208	$	97,208	$	97,208	$	97,208	$	97,208	$	97,208	$	97,208

There is no change in the hypothetical values of our investments at January 31, 2006 because nearly all of our short-term investments are in auction rate securities, the principal of which is not sensitive to interest rate changes.

This compares to the hypothetical changes in fair values of our investments as of April 30, 2005, based on a discounted cash flow calculation over the remaining term of each investment, that are sensitive to changes in interest rates (dollars in thousands):

	Valuation of Securities Given an Interest Rate Decrease of X Basis Points						Fair Value as of April 30, 2005		Valuation of Securities Given an Interest Rate Increase of X Basis Points
	(150 BPS)		(100 BPS)		(50 BPS)				50 BPS		100 BPS		150 BPS
Total investments	$	98,949	$	98,917	$	98,885	$	98,853	$	98,820	$	98,785	$	98,753

These instruments are not leveraged. The modeling technique used measures the change in fair values arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points (BPS), 100 BPS, and 150 BPS over the remaining life of the investments, which shifts are representative of the historical movements in the Federal Funds Rate.

The following table presents our cash equivalents and short-term investments subject to interest rate risk and their related weighted average interest rates as of January 31, 2006 and April 30, 2005 (in thousands). Carrying value approximates fair value.

	January 31, 2006				April 30, 2005
	Carrying Value		Average Interest Rate		Carrying Value		Average Interest Rate
Cash and cash equivalents	$	25,331	3.58	%	$	36,781	1.62	%
Short-term investments	97,208		4.37	%	98,853		2.97	%

Total	$	122,539	4.20	%	$	135,634	2.61	%

To date, the vast majority of our sales have been denominated in U.S. dollars. As only a small amount of foreign invoices are paid in currencies other than the U.S. dollar, our foreign exchange risk is considered immaterial to our consolidated financial position, results of operations or cash flows.

Item 4—Controls and Procedures

We carried out an evaluation, under the supervision and with the participation of Timothy Montgomery, our principal executive officer, and William Tamblyn, our principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) as of January 31, 2006. Based on this evaluation, Messrs. Montgomery and Tamblyn concluded that our disclosure controls and procedures were effective to provide a reasonable assurance that the information required to be disclosed by us in our reports that we file with the Securities and Exchange Commission is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission’s rules and forms. It should be noted that a control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. For example, controls can be circumvented by a person’s individual acts, by collusion of two or more people or by management override of the control. Because a cost-effective control system can only provide reasonable assurance that the objectives of the control system are met, misstatements due to error or fraud may occur and not be detected.

In addition, we reviewed our internal control over financial reporting, and there were no changes in our internal control over financial reporting during the quarter ended January 31, 2006, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II. OTHER INFORMATION

Item 1.—LEGAL PROCEEDINGS

Beginning on June 14, 2005, several purported class action lawsuits were filed in the United States District Court for the Northern District of California, purportedly on behalf of a class of investors who purchased Ditech’s stock between August 25, 2004 and May 26, 2005. The complaints allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Ditech and its Chief Executive Officer and Chief Financial Officer. All of the lawsuits were consolidated into a single action entitled In re Ditech Communications Corp. Securities Litigation, No. C 05-02406-JSW. This matter is at an early stage; no lead plaintiff has been selected, no consolidated complaint has been filed, no discovery has taken place and no trial date has been set. Ditech intends to take all appropriate action in connection with the defense of the litigation.

On June 20, 2005, the first of two shareholder’s derivative complaints was filed in the California Superior Court for the County of Santa Clara. Both complaints are purportedly brought derivatively by shareholders on behalf of Ditech against several executives of Ditech and all members of its board of directors, and name Ditech as a nominal defendant. The plaintiffs allege that the defendants breached their fiduciary duties to Ditech in connection with alleged misrepresentations concerning VQA orders and the potential effect on Ditech of the merger between Sprint and Nextel, that certain of the defendants improperly sold Ditech stock while in possession of material nonpublic information, and that the defendants are liable to Ditech for damages as a result thereof. Both lawsuits were consolidated into a single action entitled In re Ditech Communications Corp. Derivative Litigation, No. 105-CV-043429. The defendants filed a demurrer to the consolidated complaint, and the consolidated action was subsequently voluntarily dismissed without prejudice on February 14, 2006.

Item 2.—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

Item 3.—DEFAULTS ON SENIOR SECURITIES

None.

Item 4.—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

Item 5.—OTHER INFORMATION

None.

Item 6.—EXHIBITS

Exhibit		Description of document
2.1(1)		Asset Purchase Agreement, dated as of April 16, 2002, by and between Ditech and Texas Instruments
2.2(2)		Asset Purchase Agreement, dated as of July 16, 2003, by and between Ditech Communications Corporation and JDS Uniphase Corporation
2.3(3)		Agreement and Plan of Merger, dated as of June 6, 2005, among Ditech, Spitfire Acquisition Corp., Jasomi Networks, Inc., Jasomi Networks (Canada), Inc., Daniel Freedman, Cullen
3.1(4)		Restated Certificate of Incorporation of Ditech Communications Corporation
3.2(5)		Bylaws of Ditech Communications Corporation, as amended and restated on March 28, 2002
3.3(6)		Certificate of Designation of Series A Junior Participating Preferred Stock
4.1		Reference is made to Exhibits 3.1, 3.2 and 3.3
4.2(7)		Specimen Stock Certificate
4.3(6)		Rights Agreement, dated as of March 26, 2001 among Ditech Communications Corporation and Wells Fargo Bank Minnesota, N.A.
4.4(6)		Form of Rights Certificate
10.1(8)		Offer Letter, executed February 4, 2006, between Ditech and Gary Testa.
10.2(8)		2005 New Hire Stock Option Plan, as amended.
10.3(9)		Form of Stock Option Agreement under the 2005 New Hire Stock Option Plan.
31.1		Certification by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32**		Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1) Incorporated by reference from the exhibit with corresponding number from Ditech’s Report on Form 8-K (File No. 000-26209), filed April 30, 2002.

(2) Incorporated by reference from the exhibit with corresponding number from Ditech’s Current Report on Form 8-K (File No. 000-26209) filed July 30, 2003.

(3) Incorporated by reference from the exhibit with corresponding number from Ditech’s Annual Report on Form 10-K for the fiscal year ended April 30, 2005 (File No. 000-26209), filed July 14, 2005.

(4) Incorporated by reference from the exhibit with corresponding number from Ditech’s Quarterly Report on Form 10-Q for the quarter ended October 31, 2000 (File No. 000-26209), filed December 13, 2000.

(5) Incorporated by reference from the exhibit with corresponding number from Ditech’s Annual Report on Form 10-K for the fiscal year ended April 30, 2002 (File No. 000-26209), filed July 29, 2002.

(6) Incorporated by reference from the exhibit with corresponding title from Ditech’s Current Report on Form 8-K (File No. 000-26209), filed March 30, 2001.

(7) Incorporated by reference from the exhibits with corresponding descriptions from Ditech’s Registration Statement (No. 333-75063), declared effective on June 9, 1999.

(8) Incorporated by reference from the exhibit with corresponding description from Ditech’s Current Report on Form 8-K (File No. 000-26209), filed February 9, 2006.

(9) Incorporated by reference from the exhibit with corresponding description from Ditech’s Current Report on Form 8-K (File No. 000-26209), filed November 15, 2005.

** The certification attached as Exhibit 32 accompanies the Quarterly Report on Form 10-Q pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by Ditech for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.

SIGNATURE

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

Date: March 9, 2006	Ditech Communications Corporation
	By:	/s/ WILLIAM J. TAMBLYN
		William J. Tamblyn
		Executive Vice President and Chief Financial Officer (Principal Financial and Chief Accounting Officer)

EXHIBIT LIST

Exhibit		Description of document
2.1(1)		Asset Purchase Agreement, dated as of April 16, 2002, by and between Ditech and Texas Instruments
2.2(2)		Asset Purchase Agreement, dated as of July 16, 2003, by and between Ditech Communications Corporation and JDS Uniphase Corporation
2.3(3)		Agreement and Plan of Merger, dated as of June 6, 2005, among Ditech, Spitfire Acquisition Corp., Jasomi Networks, Inc., Jasomi Networks (Canada), Inc., Daniel Freedman, Cullen
3.1(4)		Restated Certificate of Incorporation of Ditech Communications Corporation
3.2(5)		Bylaws of Ditech Communications Corporation, as amended and restated on March 28, 2002
3.3(6)		Certificate of Designation of Series A Junior Participating Preferred Stock
4.1		Reference is made to Exhibits 3.1, 3.2 and 3.3
4.2(7)		Specimen Stock Certificate
4.3(6)		Rights Agreement, dated as of March 26, 2001 among Ditech Communications Corporation and Wells Fargo Bank Minnesota, N.A.
4.4(6)		Form of Rights Certificate
10.1(8)		Offer Letter, executed February 4, 2006, between Ditech and Gary Testa.
10.2(8)		2005 New Hire Stock Option Plan, as amended.
10.3(9)		Form of Stock Option Agreement under the 2005 New Hire Stock Option Plan.
31.1		Certification by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32**		Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002