Deltathree (DDDC) 10-Q 2006 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended June 30, 2006

OR

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

For the transition period from ___________ to _____________

Commission file number 000-28063

DELTATHREE, INC.

A Delaware Corporation I.R.S. Employer No. 13-4006766

75 Broad Street, New York, New York 10004

Telephone Number: (212) 500-4850

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

Yes x  No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).   

Yes  o    No x

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

Yes o  No x

As of August 7, 2006, 29,789,564shares of Class A Common Stock, par value $0.001 per share, were outstanding.

Table of Contents

Item Description	Page
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements	1
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	6
Item 3. Quantitative and Qualitative Disclosures About Market Risk	14
Item 4. Controls and Procedures	14
PART II - OTHER INFORMATION
Item 1. Legal Proceedings	14
Item 6. Exhibits	15
Signatures	15
Exhibit Index	16

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements.

DELTATHREE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(unaudited)

($ in thousands)

	June 30			December 31
	2006			2005
ASSETS
Current assets:
Cash and cash equivalents	$	3,233		$	3,847
Restricted cash and short-term investments		13,596			10,648
Accounts receivable, net		1,191			703
Prepaid expenses and other current assets		537			612
Inventory		236			242
Total current assets		18,793			16,052
Restricted cash and long -term investments		1,216			1,216
Property and equipment, net		3,828			4,131
Deposits		107			105
Total assets		23,944			21,504
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		3,983			4,279	*
Deferred revenues		1,884			344
Other current liabilities		1,465			1,165	*
Total current liabilities		7,332			5,788
Long-term liabilities:
Severance pay obligations		202			155
Total liabilities		7,534			5,943
Commitments and Contingencies
Stockholders’ equity:
Class A common stock, - par value $0.001		30			30
Additional paid-in capital		167,745			167,690
Accumulated deficit		(151,365	)		(151,949	)
		16,410			15,771
Treasury stock at cost: 257,600 shares of class A common stock as of December 31, 2005		—			(210	)
Total stockholders’ equity		16,410			15,561
Total liabilities and stockholders’ equity	$	23,944		$	21,504

See notes to unaudited condensed consolidated financial statements.

* Reclassified

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DELTATHREE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

($ in thousands, except share and per share data)

	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2006		2005			2006		2005
Revenues	$	9,966	$	6,927		$	20,715	$	13,531
Costs and operating expenses:
Cost of revenues		6,166		4,284			13,360		8,494
Research and development expenses		1,044		777			2,124		1,591
Selling and marketing expenses		1,271		1,001			2,473		1,865
General and administrative expenses		732		735			1,664		1,345
Depreciation and amortization		379		534			750		1,144
Total costs and operating expenses		9,592		7,331			20,371		14,439
Income (loss) from operations		374		(404	)		344		(908	)
Interest income, net		148		10			277		104
Net income (loss) before income taxes		522		(394	)		621		(804	)
Income taxes		26		15			37		32
Net income (loss)	$	496	$	(409	)	$	584	$	(836	)
Net income (loss) per share - basic and diluted	$	0.02	$	(0.01	)	$	0.02	$	(0.03	)
Basic weighted average number of shares outstanding		29,745,897		29,707,860			29,744,860		29,619,908
Diluted weighted average number of shares outstanding		30,604,982		29,707,860			30,640,319		29,619,908

See notes to unaudited condensed consolidated financial statements

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DELTATHREE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

($ in thousands)

	Six Months Ended June 30,
	2006			2005
Cash flows from operating activities:
Net income (loss)	$	584		$	(836	)
Adjustments to reconcile net loss to net cash used in operating activities
Depreciation and amortization		750			1,137
Increase in liability for severance pay, net		47			57
Stock based compensation		244			—
Changes in assets and liabilities:
Increase in accounts receivable		(488	)		(606	)
Decrease (increase) in prepaid expenses and other current assets		75			(292	)
Decrease (increase) in inventory		6			(12	)
Decrease in accounts payable		(323	)		(220	)*
Increase in deferred revenues		1,540			658
Increase (decrease) in other current liabilities		300			(584	)*
Net cash provided by (used in) operating activities		2,735			(698	)
Cash flows from investing activities:
Purchase of property and equipment		(420	)		(846	)
Decrease (increase) in deposits		(2	)		3
Long-term investments, net		—			(270	)
Unrealized gain on available for sale securities					95
Short-term investments, net		(2,948	)		2,351
Net cash (used in) provided by investing activities		(3,370	)		1,333
Cash flows from Financing activities:
Proceeds from exercise of employee options		21			378
Net cash provided by financing activities		21			378
(Decrease) increase in cash and cash equivalents		(614	)		1,013
Cash and cash equivalents at beginning of year		3,847			3,905
Cash and cash equivalents at end of period	$	3,233		$	4,918

Supplemental schedule of cash flow information:

Taxes	$	24	$	24
Supplemental schedule of non cash investing and financing activities:
Acquisition of fixed assets on credit	$	27	$	190
Cancellation of shares	$	210	$	—

See notes to unaudited condensed consolidated financial statements

*Reclassified

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DELTATHREE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Basis of Presentation

Financial Statement Preparation

The unaudited condensed consolidated financial statements of deltathree, Inc. and its subsidiaries (collectively referred to in this report as the “Company”, “we”, “us”, or “our”), of which these notes are a part, have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the instructions of Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements. In the opinion of our management, all adjustments (consisting only of normal recurring accruals) considered necessary for a fair presentation of the financial information as of and for the periods presented have been included.

The results for the interim periods presented are not necessarily indicative of the results that may be expected for any future period. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes for the year ended December 31, 2005 included in our Annual Report on Form 10-K.

Use of estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions, primarily for allowances for doubtful accounts receivable and the useful lives of fixed assets and intangible assets, that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Earnings Per Common Share

Basic earnings per common share is computed by dividing net income by the weighted-average number of common shares outstanding during the reporting period. Diluted earnings per common share is computed by dividing net income by the combination of dilutive common share equivalents, comprised of shares issuable under the Company’s stock option and stock incentive compensation plans, and the weighted-average number of common shares outstanding during the reporting period. Dilutive common share equivalents include the dilutive effect of in-the-money shares, which is calculated based on the average share price for each period using the treasury stock method. Under the treasury stock method, the exercise price of a share, the amount of compensation cost, if any, for future service that the Company has not yet recognized, and the amount of estimated tax benefits that would be recorded in additional paid-in capital, if any, when the share is exercised are assumed to be used to repurchase shares in the current period. The incremental dilutive common share equivalents, calculated using the treasury stock method, for the six months ended June 30, 2006 were 895,459, and for the three months ended June 30, 2006 were 859,084. There is no effect on the calculation of diluted

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earnings per common share for the quarter ended June 30, 2005, because the Company had a net loss. If the Company had a profit and needed to calculate the dilutive common share equivalents at June 30, 2005, the Company would have had 2,706,019 share equivalents.

2. Stock-Based Compensation

In December 2004, the Financial Accounting Standards Board (FASB) revised Statement of Financial Accounting Standards No. 123 (FAS 123R), “Share-Based Payment,” which establishes accounting for share-based awards exchanged for employee services and requires companies to expense the estimated fair value of these awards over the requisite employee service period. On April 14, 2005, the U.S. Securities and Exchange Commission, or SEC, adopted a new rule amending the effective dates for FAS 123R. In accordance with the new rule, the Company adopted the accounting provisions of FAS 123R beginning in the first quarter of fiscal 2006.

Under FAS 123R, share-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as expense over the employee’s requisite service period. The Company has no awards with market or performance conditions. The Company adopted the provisions of FAS 123R on January 1, 2006, the first day of the Company’s fiscal year 2006, using a modified prospective application. Under the modified prospective method, prior periods are not revised for comparative purposes. The valuation provisions of FAS 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. Estimated compensation expense for awards outstanding at the effective date will be recognized over the remaining service period using the compensation cost calculated for pro forma disclosure purposes under FASB Statement No. 123, “Accounting for Stock-Based Compensation” (FAS 123).

The fair value of the employees’ stock options granted during the six months ended June 30, 2006 was $2.77 per share using the Black-Scholes model, with the following assumptions:

Volatility	128	%
Risk-free interest rate	4	%
Dividend yield	0	%
Expected life of options	5.5-	6yrs

The risk-free interest rate assumption is based upon observed interest rates appropriate for the terms of the Company’s employee stock options. The Company is required to assume a dividend yield as an input to the Black-Scholes. The dividend yield assumption is based on the Company’s history and expectation of future dividends payout and may be subject to substantial change in the future. The Company does not expect to pay any dividends for the expected term of the options. The expected life of employee stock options represents the period the stock options are expected to remain outstanding. The Black-Scholes model assumes that the exercise behavior of the employees is a function of the option’s remaining contractual life and the extent to which the option is in-the-money (i.e., the average stock price during the period is above the strike price of the stock option).

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For the period ended on June 30, 2005, had the Company elected to recognize compensation expense for the issuance of options to employees of the Company based on the fair value method of accounting prescribed by FAS No. 123, net loss and loss per share would have been reduced to the pro forma amounts as follows (in thousands, except per share amounts):

	Three Months Ended June 30, 2005			Six Months Ended June 30, 2005
Net Loss:
Reported net loss	$	(409	)	$	(836	)
Add stock-based employee compensation expense, included in reported net income, net of tax		—			—
Deduct stock-based employee compensation expense determined under fair value method, net of tax		(110	)		(219	)
Pro forma net loss	$	(519	)	$	(1,055	)
Net loss per share:
Basic and diluted, as reported	$	(0.01	)	$	(0.03	)
Basic and diluted, pro forma	$	(0.02	)	$	(0.04	)

For the purpose of presenting pro forma information required under FAS 123, the fair value option grant has been estimated on the date of grant using the Black-Scholes option-pricing model for grants made after the Company became a public entity.

There were no option grants in the three month and six month period ended June 30, 2005.

3. Recently issued accounting standards

On July 13, 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires recognition in the financial statements of the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective for the 2007 fiscal year with the cumulative effect of the change in accounting principle recorded as an adjustment to opening balance of retained earnings. The Company is currently evaluating the impact of adopting FIN 48 on the consolidated financial statements.

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations, or MD&A should be read in conjunction with the Management's Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and the Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005.

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Forward-Looking Statements

This MD&A contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are based on current expectations, estimates, forecasts and projections about us, our future performance, the industries in which we operate, our beliefs and our management’s assumptions. In addition, other written or oral statements that constitute forward-looking statements may be made by us or on our behalf. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to assess. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in such forward-looking statements. These risks and uncertainties include, but are not limited to, the following:

· uncertainty of our future profitability;

· our ability to expand our revenues from multiple sources and customer bases;

· our ability to obtain additional capital to finance operations and grow our business;

· decreasing rates of all related telecommunications services, which could prevent our future profitability;

· our limited operating history;

· the public’s acceptance of Voice over Internet Protocol, or VoIP, telephony, and the level and rate of customer acceptance of our new products and services;

· the competitive environment of Internet telephony and our ability to compete effectively;

· fluctuations in our quarterly financial results;

· our ability to handle a large number of simultaneous calls;

· our ability to maintain and operate our computer and communications systems, without interruptions or security breaches;

· our ability to operate in international markets;

· our ability to retain key personnel to support our products and ongoing operations;

· our ability to provide quality and reliable service, which is in part dependent upon the proper functioning of equipment owned and operated by third parties;

· the uncertainty of future governmental regulation;

· the need for ongoing product and service development in an environment of rapid technological change; and

· other risks referenced from time to time in our filings with the SEC.

For a more complete list and description of such risks and uncertainties, as well as other risks, refer to our Form 10-K for the year ended December 31, 2005. Except as required under the federal securities laws and the rules and regulations of the SEC, we do not have any intention or obligation to update publicly any forward-looking statements or risk factors after the distribution of this MD&A, whether as a result of new information, future events, changes in assumptions or otherwise.

Overview

Founded in 1996, we are a leading provider of integrated VoIP telephony services, products, hosted solutions, and infrastructure. We offer customers high quality Internet telephony solutions that are viable and

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cost-effective alternatives to traditional telephone services. Supporting hundreds of thousands of active users around the world, we serve customers through our two primary distribution channels: the Service Provider and Reseller channel and the iConnectHere direct-to-consumer channel. We offer a broad suite of private label VoIP products and services as well as a back-office platform for service providers, resellers, and corporate customers. Based on our customizable VoIP solutions, these customers can offer private label telecommunications to their own customer bases, under either their own brand name, a white-label brand, and/or the iConnectHere or deltathree brand name. At the same time, iConnectHere, our direct-to-consumer offering, provides award-winning VoIP products directly to consumers and small businesses online using the same primary platform.

During the second quarter of fiscal 2006, we focused on regaining our gross margin and increasing our profitability while refocusing our sales efforts in areas that satisfy our long-term strategic goals. To that end, we realigned our promotional activities and marketing expenses with our long-term gross margin and revenue objectives. Our second quarter 2006 financial results were highlighted by the following: 

· We achieved record levels of net income and operating profit.

o Net income increased to a record $496,000 or $0.02 per diluted share.

o Achieved the first operating profit in our history of $374,000.

· Our progress in driving profitability was further supported by a significant rise in total gross margin across our combined service provider, reseller and consumer businesses. We raised our gross margin back to 38%, a 5% increase sequentially and on par with the same period last year. The 5% sequential increase in gross margin was primarily due to a reduction in marketing and promotional activities offered during the second quarter.

· Quarterly cash flow from operations increased to a record $2.7 million. This was driven by additional cash received related to an advanced payment from a leading global consumer hardware manufacturer to support a planned direct to consumer VoIP service offering.

· Revenues increased 44% year-over-year to $10.0 million, down 7% sequentially. Sequential revenue growth was below our range of expectations for the quarter primarily due to our decision to scale back certain aggressive promotional pricing and marketing activities predominantly aimed at the service provider and reseller market which had a larger than expected impact on our revenues. To a lesser extent, our revenue growth during the quarter was also impacted by new regulations imposed on VoIP service providers in select foreign countries. As we continue to operate on a global basis, we are focusing our business development efforts on countries with more favorable regulatory environments, as well as broadening our sales and partnering efforts with locally licensed VoIP service providers. We cannot, however, assure you that we will be, or of the extent to which we will be, successful in these endeavors.

· Cash, restricted cash, and short and long term investments increased to $18.0 million, representing an increase of $1.8 million sequentially. As stated above, the increase is primarily attributable to the cash received during the quarter by the leading global consumer hardware manufacture. In addition, the cash received had a direct impact on our net deferred revenues as well, increasing net deferred revenues by $1.3 million sequentially to $1.9 million.

Going forward, we expect to continue to devote a significant amount of our resources to develop and expand our Service Provider and Reseller base and we expect our revenue from this key channel to represent a growing percentage of our total revenue over the next several years. We are actively marketing our products and services to a large number of broadband operators, including telecom, cable companies, Internet service

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providers, and consumer oriented retailers around the world. In connection with the non-binding memorandum of understanding that we signed with a leading global consumer hardware manufacturer to develop and support a direct to consumer VoiP service offering, we received an additional $1.8 million in an advanced payment from the manufacturer during the second quarter of fiscal 2006. We previously received an amount of $200,000 from this manufacturer during the first quarter of fiscal 2006. We anticipate formalizing our relationship with this manufacturer with a definitive agreement, but we can not assure you that we will succeed in signing such a definitive agreement.   

The above items are forward-looking statements about our expectations for future performance. Actual results could differ materially.

Results of Operations - Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005

Revenues

Revenues increased approximately $7.2 million or 53.3% to approximately $20.7 million for the six months ended June 30, 2006 from approximately $13.5 million for the six months ended June 30, 2005. Revenues from enhanced IP communications services (primarily PC-to-Phone and Broadband Phone) through iConnectHere decreased slightly by $0.5 million or 14.28% to approximately $3.0 million for the six months ended June 30, 2006 from approximately $3.5 million for the six months ended June 30, 2005 due primarily to a slightly reduced volume of PC-to-Phone and Broadband Phone calls. Revenues from enhanced IP communications services through our reseller and service provider sales efforts (including sales of our Hosted Communications Solution) increased approximately $7.7 million or 77% to approximately $17.7 million for the six months ended June 30, 2006 from approximately $10 million for the six months ended June 30, 2005, due primarily to a greater number of PC-to-Phone and Broadband Phone calls being placed by an increasing user base. One of our master reseller/service provider customers accounted for approximately 11% of our sales in aggregate during the six months ended June 2005.

Costs and Operating Expenses

Cost of revenues. Cost of revenues increased by approximately $4.9million or 57.6% to approximately $13.4 million for the six months ended June 30, 2006 from approximately $8.5 million for the six months ended June 30, 2005, due primarily to an increase in the amount of traffic being terminated on our network which directly contributed to our increase in revenues. The increased cost was also caused by an increase in fixed costs associated with our E911 service and local number portability service, and we expect these costs to have less of an impact on our cost of revenues going forward as our sales in the United States continue to increase as expected. The impact of FAS 123R was minimal to our cost of revenue, amounting to only $12,000.

Research and development expenses. Research and development expenses increased by approximately $0.5 million or 31.25% to approximately $2.1 million for the six months ended June 30, 2006 from approximately $1.6 million for the six months ended June 30, 2005, due to higher personnel costs associated with the development of new services and enhancements to our existing services and to $79,000 of costs related to the impact of FAS 123R.

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Selling and marketing expenses. Selling and marketing expenses increased by approximately $0.6 million or 31.6% to approximately $2.5 million for the six months ended June 30, 2006 from approximately $1.9 million for the six months ended June 30, 2005 due to slightly higher personnel and external marketing related costs associated with the sales and marketing of our products and services, including $32,000 of costs related to the impact of FAS 123R.

General and administrative expenses. General and administrative expenses increased by approximately $0.4 million or 30.7% to approximately $1.7 million for the six months ended June 30, 2006 from approximately $1.3 million for the six months ended June 30, 2005 due to somewhat higher personnel costs associated with the increased general and administrative activities associated with higher transaction volumes, including $121,000 of costs related to the impact of FAS 123R.

Depreciation and amortization. Depreciation and amortization decreased by approximately $ 0.4 million or 36.36% to approximately $0.7 million for the six months ended June 30, 2006 from approximately $1.1 million for the six months ended June 30, 2005 primarily due to a lower level of certain assets purchased in prior years being included in the computation of depreciation expense in 2006 compared to 2005 as they have already been fully depreciated in prior periods.

Income from Operations

Income from operations increased by approximately $1.2 million or to approximately $0.3 million for the six months ended June 30, 2006 from loss from operations of approximately $0.9 million for the six months ended June 30, 2005, due primarily to the increase in revenues and relative decrease in indirect operating expenses, including depreciation and amortization expenses.

Interest Income, Net

Interest income, net increased by approximately $173,000 or 166.35% to approximately $277,000 for the six months ended June 30, 2006 from approximately $104,000 for the six months ended June 30, 2005.

Income Taxes, Net

We paid net income taxes of approximately $37,000 for the six months ended June 30, 2006 compared to approximately $32,000 for the six months ended June 30, 2005. These payments were related to income taxes accrued by us and miscellaneous minimum taxes that we incur annually. The income taxes that we have accrued are not significant, but are based on alternative minimum taxes that are not covered by our net operating losses, or NOL’s. We have not recorded any tax benefits due to our accrued NOL’s , as we believe that, based on our history of net operating losses and other factors, that the evidence of our recent profits do not yet support the realization of the benefit of our NOL’s. Accordingly, a full valuation allowance has been recorded against our net deferred tax assets. We believe that we have enough usable NOL’s in the foreseeable future to offset any significant net income that we expect to generate at this time. We understand that if we continue to achieve quarterly net income then we will have to re-evaluate our valuation of our NOL’s and deferred tax assets.

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Net Income

Net income increased by approximately $1.4 million to approximately $0.6 million for the six months ended June 30, 2006 from a loss of approximately $0.8 million for the six months ended June 30, 2005 due to the foregoing factors.

Results of Operations - Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005

Revenues

Revenues increased approximately $3.0 million or 42.86 % to approximately $10 million for the three months ended June 30, 2006 from approximately $7.0 million for the three months ended June 30, 2005. Revenues from VoIP telephony services through our reseller and service provider sales efforts (including sales of our Outsourced Platform Solution) increased approximately $3.3 million or 63.5 % to approximately $8.5 million for the three months ended June 30, 2006 from approximately $5.2 million for the three months ended June 30, 2005, due primarily to our increased market penetration in the worldwide reseller and service provider market. Management believes that the reseller and service provider market will be one of our primary revenue drivers throughout the balance of the fiscal year and will contribute significantly to our projected growth rate previously stated for the first quarter of 2006. Revenues from VoIP telephony services (primarily PC-to-Phone and Broadband Phone) through iConnectHere decreased slightly by $0.3 million or 16.67 % to approximately $1.5 million for the three months ended June 30, 2006, from approximately $1.8 million for the three months ended June 30, 2005.

Costs and Operating Expenses

Cost of revenues. Cost of revenues increased by approximately $1.9 million or 44.2 % to approximately $6.2 million for the three months ended June 30, 2006 from approximately $4.3 million for the three months ended June 30, 2005, due primarily to the increase in the amount of traffic being terminated on our network which directly contributed to our increase in revenues. The increased cost was also caused by an increase in fixed costs associated with our E911 service and local number portability service, and we expect these costs to have less of an impact on our cost of revenues going forward as our sales in the United States continue to increase as expected. The impact of FAS 123R was minimal to our cost of revenue, amounting to only $2,372.

Research and development expenses. Research and development expenses increased by approximately $0.2 million or 25% to approximately $1 million for the three months ended June 30, 2006 from approximately $0.8 million for the three months ended June 30, 2005, due to higher personnel costs associated with the development of new services and enhancements to our existing services and to $13,798 of costs related to the impact of FAS 123R.

Selling and marketing expenses. Selling and marketing expenses increased by approximately $0.3 million or 30% to approximately $1.3 million for the three months ended June 30, 2006 from approximately $1 million for the three months ended June 30, 2005 due to higher personnel costs to $11,111 of costs related to FAS 123R and higher external marketing expenses.

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General and administrative expenses. General and administrative expenses stayed at the same level. We have added additional general and administrative personnel to assist us with handling the transaction volume created by our increase in sales and we have also increased salaries through our normal annual reviews. Our core increase in salaries amounted to approximately 9.9% with the balance of the increase, $73,363 related directly to costs associated with FAS 123R.

Depreciation and amortization. Depreciation and amortization decreased by approximately $0.2 million or 33.3% to approximately $0.4 million for the three months ended June 30, 2006 from approximately $0.6 million for the three months ended June 30, 2005 primarily due to a lower level of depreciation expense that we have been able to take on certain assets in 2006 compared to 2005 as they have already been fully depreciated.

Income from Operations

Income from operations increased by approximately $0.8 million to approximately $0.4 million for the three months ended June 30, 2006 from approximately a loss of $0.4 million for the three months ended June 30, 2005. This is due primarily to the significant increase in our revenue base of approximately $3.0 million which helped contribute to an increased gross profit of $1.2 million, when comparing the second quarter of fiscal 2006 to fiscal 2005. The increase in gross profit was offset by an increase in our other operating costs of approximately $0.4 million.

Interest Income, Net

Interest income, net increased by approximately $138,000 or 1280 % to approximately $148,000 for the three months ended June 30, 2006 from approximately $10,000 for the three months ended June 30, 2005. The increase was primarily driven by higher interest rates received on our cash, restricted cash, and short and long term investments.

Income Taxes, Net

We incurred net income taxes of approximately $26,000 for the three months ended June 30, 2006 compared to approximately $15,000 for the three months ended June 30, 2005. These payments were related to income taxes accrued by us and miscellaneous minimum taxes that we incur annually. The income taxes that we have accrued are not significant, but are based on alternative minimum taxes that are not covered by our NOL’s. We have not recorded any tax benefits due to our accrued NOL’s , as we believe that, based on our history of net operating losses and other factors, that the evidence of our recent profits do not yet support the realization of the benefit of our NOL’s. Accordingly, a full valuation allowance has been recorded against our net deferred tax assets. We believe that we have enough usable NOL’s in the foreseeable future to offset any significant net income that we expect to generate at this time. We understand that if we continue to achieve quarterly net income then we will have to re-evaluate our valuation of our NOL’s and deferred tax assets.

Net Income (Loss)

Net Income increased by approximately $0.9 million to approximately $0.5 million for the three months ended June 30, 2006 from a loss of approximately $ 0.4 million for the three months ended June 30, 2005 due to

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the foregoing factors. Additionally, our profit for the second quarter of 2006 in comparison to our loss in the second quarter of 2005 has been reduced in the amount of $0.1 million, due to our adoption of FAS 123R on January 1, 2006.

Liquidity and Capital Resources

Since our inception in 1996, we have incurred significant operating and net losses, due in large part to the start-up and development of our operations. As of June 30, 2006, we had an accumulated deficit of approximately $151 million. We have generated net income for the past three consecutive quarters and management anticipates that this trend will continue, but we cannot assure you that it will continue.

As of June 30, 2006, we had cash and cash equivalents of approximately $3.2 million, restricted cash and short-term investments of approximately $13.6 million, long-term investments of $1.2 million or a total of $18 million in cash, restricted cash, short and long term investments and increase of $1.8 million, as compared to March 31, 2006. The change in our cash includes the amount of $1.8 million advanced payment which we received from the leading global consumer hardware manufacturer in accordance with our memorandum of understanding. Our change in cash is relatively flat without including the amount we received from this manufacturer.  Without the effects of the amount we received from this manufacturer, we generated approximately $0.9 million from operations which was offset by our capital expenditure spending.  The decrease in cash and cash equivalents of $0.6 million reflected in the cash flow statement was the effect of our investing more of our money in short term investments.

We generated positive cash flow from operating activities of approximately $ 2.7 million during the six months ended June 30, 2006 compared with negative cash flow from operating activities of approximately $0.7 million during the six months ended June 30, 2005. The increase in our cash generated from operating activities was primarily driven by our increase in net income of $1.4 million and increased of $0.9 million in deferred revenue. Changes in current assets and liabilities during the six months ended June 30, 2006 were $2.1 million, compared with $0.1 million during the six months ended June 30, 2005.

Our capital expenditures were approximately $0.4 million in the six months ended June 30, 2006 compared to approximately $1.0 million expended in the six months ended June 30, 2005 as we made moderate investments to optimize our overall utilization of our existing domestic and international network infrastructure. The Company plans to increase its spending in capital expenditures over the next three quarters to meet our strategic sales goals.

If we experience a negative material impact to our cash flow or our capital expenditures, or if in the long-term we are not able to successfully implement our business strategy, we may be required to raise additional funds for our ongoing operations. Additional financing may not be available when needed or, if available, such financing may not be on terms favorable to us. If additional funds are raised through the issuance of equity securities, our existing stockholders may experience significant dilution. In addition, we cannot assure you that any third party will be willing or able to provide additional capital to us on favorable terms or at all.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

The SEC's rule related to market risk disclosure requires that we describe and quantify our potential losses from market risk sensitive instruments attributable to reasonably possible market changes. Market risk sensitive instruments include all financial or commodity instruments and other financial instruments (such as investments and debt) that are sensitive to future changes in interest rates, currency exchange rates, commodity prices or other market factors. We believe that our exposure to market risk is immaterial. We currently do not invest in, or otherwise hold, for trading or other purposes, any financial instruments subject to market risk. There has been no change in the Company’s market risk profile during this quarter.

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures.

Our principal executive officer and principal financial officer, with the participation of our management, evaluated the effectiveness of our disclosure controls and procedures. Based on that evaluation, the principal executive officer and principal financial officer has concluded that as of the end of the period covered by this report, our disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and timely reported as provided in the SEC rules and forms.

(b) Changes in Internal Controls.

There have been no changes in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q 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

We, as well as certain of our former officers and directors, were named as defendants in a number of purported securities class actions in United States District Court for the Southern District of New York, arising out of our initial public offering in November 1999.  On August 31, 2005, the United States District Court granted preliminary approval of an omnibus settlement of the litigation between the plaintiffs and issuer defendants.  Final approval is pending.  Under the terms of the settlement, we are not conceding any liability and we presently do not expect to make any payments under the pending settlement, other than legal fees we may incur (which fees are being submitted to the insurance carrier for reimbursement).

We are not a party to any other material litigation and are not aware of any other pending or threatened litigation that could have a material adverse effect on us or our business taken as a whole.

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Item 6. Exhibits

See Exhibit Index on page 16 for a description of the documents that are filed as Exhibits to this report on Form 10-Q or incorporated by reference herein.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this quarterly report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.

	DELTATHREE, INC.
Date: August 11, 2006	By:	/s/ Shimmy Zimels
		Name:   Shimmy Zimels Title:     Chief Executive Officer

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EXHIBIT INDEX

Exhibit
Number	Description
31.1	Certification of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certifications of CEO and CFO Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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