Ixia (XXIA) 10-Q 2006 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 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 000-31523

IXIA

(Exact name of Registrant as specified in its charter)

California	95-4635982
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

26601 West Agoura Road, Calabasas, CA 91302
(Address of principal executive offices, including zip code)

(818) 871-1800
(Registrant’s telephone number, including area code)

     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 o No þ

     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.

     Large accelerated filer þ Accelerated filer o Non-accelerated filer o 

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

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common Stock	67,350,595
(Class of Common Stock)	(Outstanding at February 1, 2007)

IXIA

TABLE OF CONTENTS

			Page Number
PART I. FINANCIAL INFORMATION
	Item 1.	Financial Statements (unaudited)
		Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005		3
		Condensed Consolidated Statements of Income for the three and nine months ended September 30, 2006 and 2005		4
		Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005		5
		Notes to Condensed Consolidated Financial Statements		6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		20
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk		29
	Item 4.	Controls and Procedures		29
PART II. OTHER INFORMATION
	Item 1A.	Risk Factors		31
	Item 5.	Other Information		31
	Item 6.	Exhibits		31
SIGNATURES				32
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

2

IXIA
Condensed Consolidated Balance Sheets
(in thousands)
(unaudited)

	September 30,		December 31,
	2006		2005
			(Restated)
Assets
Current assets:
Cash and cash equivalents	$	70,189	$	51,837
Short-term investments in marketable securities		137,184		124,456
Accounts receivable, net of allowance for doubtful accounts of $1,076 and $854 as of September 30, 2006 and December 31, 2005, respectively		37,978		31,565
Inventories		10,564		9,846
Deferred income taxes		10,352		8,588
Prepaid expenses and other current assets		3,347		3,519
Total current assets		269,614		229,811
Investments in marketable securities		4,352		25,392
Property and equipment, net		22,431		19,750
Deferred income taxes		6,807		13,018
Goodwill		16,728		13,468
Intangible assets, net		21,894		20,462
Other assets		479		315
Total assets	$	342,305	$	322,216
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	2,773	$	2,872
Accrued expenses		15,242		12,399
Deferred revenues		18,009		19,233
Income taxes payable		3,995		4,131
Total current liabilities		40,019		38,635
Deferred revenues and other liabilities		10,801		20,101
Total liabilities		50,820		58,736
Shareholders’ equity:
Common stock, without par value; 200,000 shares authorized, 67,186 and 66,580 shares issued and outstanding as of September 30, 2006 and December 31, 2005, respectively		131,194		126,792
Additional paid-in capital		82,721		68,098
Retained earnings		77,570		68,590
Total shareholders’ equity		291,485		263,480
Total liabilities and shareholders’ equity	$	342,305	$	322,216

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

3

IXIA
Condensed Consolidated Statements of Income
(in thousands, except per share data)
(unaudited)

	Three months ended				Nine months ended
	September 30,				September 30,
	2006		2005		2006		2005
			(Restated)				(Restated)
Revenues:
Products	$	49,696	$	34,491	$	114,339	$	100,301
Services		5,532		5,401		18,426		15,015
Total revenues		55,228		39,892		132,765		115,316
Costs and operating expenses:(1)
Cost of revenues — products		7,694		6,635		21,783		18,683
Cost of revenues — amortization of purchased technology		1,256		991		3,449		2,876
Cost of revenues — services		629		561		1,723		1,640
Research and development		11,097		7,994		32,720		23,514
Sales and marketing		15,317		9,753		45,163		28,245
General and administrative		5,824		4,421		16,627		11,940
Amortization of intangible assets		464		316		1,287		944
Total costs and operating expenses		42,281		30,671		122,752		87,842
Income from operations		12,947		9,221		10,013		27,474
Interest and other, net		2,431		1,361		6,741		3,486
Income before income taxes		15,378		10,582		16,754		30,960
Income tax expense		7,278		2,602		7,774		6,119
Net income	$	8,100	$	7,980	$	8,980	$	24,841
Earnings per share:
Basic	$	0.12	$	0.12	$	0.13	$	0.38
Diluted	$	0.12	$	0.11	$	0.13	$	0.36
Weighted average number of common and common equivalent shares outstanding:
Basic		67,129		66,015		66,907		64,753
Diluted		68,636		69,923		68,804		69,281

⁽¹⁾ Stock-based compensation included in:

Cost of revenues — products	$	144	$	—	$	452	$	—
Cost of revenues — services		55		—		172		—
Research and development		1,695		—		5,130		—
Sales and marketing		2,126		—		6,154		—
General and administrative		869		—		2,346		—

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

4

IXIA
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)

	Nine months ended
	September 30,
	2006			2005
				(Restated)
Cash flows from operating activities:
Net income	$	8,980		$	24,841
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		7,238			3,976
Amortization of intangible assets		4,737			3,820
Allowance for doubtful accounts		222			(6	)
Stock-based compensation		14,254			—
Deferred income taxes		4,447			(9,683	)
Tax benefit from stock option transactions		369			15,102
Excess tax benefits from stock-based compensation		(253	)		—
Changes in operating assets and liabilities, net of effect of acquisitions:
Accounts receivable		(6,634	)		(11,468	)
Inventories		(718	)		(1,188	)
Prepaid expenses and other current assets		172			1,616
Other assets		(164	)		322
Accounts payable		(99	)		1,107
Accrued expenses		1,537			2,836
Deferred revenues		(11,253	)		7,559
Income taxes payable		(136	)		529
Net cash provided by operating activities		22,699			39,363
Cash flows from investing activities:
Purchases of property and equipment		(9,919	)		(9,214	)
Purchases of available-for-sale securities		(100,400	)		(119,611	)
Proceeds from available-for-sale securities		90,725			92,976
Purchases of held-to-maturity securities		(7,978	)		(18,679	)
Proceeds from held-to-maturity securities		25,965			27,203
Purchases of technology and other intangible assets		(121	)		(126	)
Payments in connection with acquisitions		(7,274	)		(8,536	)
Net cash used in investing activities		(9,002	)		(35,987	)
Cash flows from financing activities:
Proceeds from exercise of stock options		4,402			23,667
Excess tax benefits from stock-based compensation		253			—
Net cash provided by financing activities		4,655			23,667
Net increase in cash and cash equivalents		18,352			27,043
Cash and cash equivalents at beginning of period		51,837			16,383
Cash and cash equivalents at end of period	$	70,189		$	43,426

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

5

IXIA
Notes to Condensed Consolidated Financial Statements
(unaudited)

1. Business

     We were incorporated on May 27, 1997 as a California corporation. We are a leading provider of performance test systems for Internet Protocol (IP) based infrastructure and services that allow our customers to test and measure the performance, functionality, and conformance of IP equipment and networks, and the applications that run over them. Our solutions generate, capture, characterize, and analyze high volumes of realistic network and application traffic, exposing problems, assessing performance, ensuring functionality and interoperability, and verifying conformance to industry specifications. We offer a hardware platform with interchangeable interfaces, utilizing a single set of applications and Application Programming Interfaces (APIs) that allows our customers to create an integrated, easy-to-use test bed. The networks our systems analyze include Ethernet networks operating at speeds of up to 10 gigabits per second, which carry data traffic over optical fiber or electrical cable. Other networks include Packet over SONET networks operating at speeds of up to 10 gigabits per second, which transmit information over high-speed optical links and Asynchronous Transfer Mode (ATM) networks, operating at speeds of up to 622 megabits per second. We also offer a telephony test suite that is used to test and verify traditional Time-Division Multiplexing (TDM) voice based networks, Voice over IP technology, devices, and systems, as well as the interoperability, troubleshooting, service optimization and call traffic monitoring of Video Telephony. Customers also use our performance applications to test and verify web servers, internet networks, security, and business applications.

2. Basis of Presentation

     The accompanying condensed consolidated financial statements as of September 30, 2006 and for the three and nine months ended September 30, 2006 and 2005, are unaudited and reflect all adjustments (consisting only of normal recurring adjustments except for restatement adjustments discussed in Note 3) which are, in the opinion of management, necessary for a fair statement of our financial position, operating results and cash flows for the interim periods presented. The results of operations for the current interim periods presented are not necessarily indicative of results to be expected for the full year ending December 31, 2006 or any other future period.

     These condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in our amended Annual Report on Form 10-K/A for the year ended December 31, 2005.

     Certain reclassifications have been made to prior period financial statements to conform to the current presentation.

     We determined in connection with the preparation of our financial statements for the year ended December 31, 2005 that certain marketable securities were incorrectly classified as short-term investments in marketable securities rather than cash and cash equivalents in the September 30, 2005 balance sheet. Accordingly, as of September 30, 2005, we have revised the presentation of certain marketable securities with remaining maturities of three months or less to properly reflect such investments as cash equivalents rather than short-term investments in marketable securities. This resulted in an adjustment of approximately $10.0 million on the September 30, 2005 balance sheet from short-term investments in marketable securities to cash and cash equivalents. As a result, such short-term investments in marketable securities were adjusted from investing activities in the statement of cash flows for the nine month period ended September 30, 2005 to reflect such securities as cash and cash equivalents rather than gross purchases and proceeds of marketable securities, the net impact of which reduced net cash used in investing activities by $10.0 million. These revisions had no impact on our results of operations or changes in equity for the nine months ended September 30, 2005.

     We have revised the presentation of our consolidated statement of income (i) to separately disclose product and service revenues, and the associated costs, in accordance with Regulation S-X as the service revenues comprise

6

more than the 10 percent threshold prescribed by the SEC due to the restatement of implied PCS as further described in Note 3, and (ii) to remove the gross profit computation and line item to conform to prior and future filings.

3. Restatement of Previously Issued Financial Statements

     Subsequent to the issuance of our 2005 consolidated financial statements, we determined that we had not properly applied Statement of Position 97-2 “Software Revenue Recognition” (“SOP 97-2”) with respect to the accounting for implied post contract customer support (“PCS”) obligations, and as a result we determined that we had incorrectly allocated revenue between product revenue and PCS revenue. As such, the timing of when we recognized revenue in the consolidated financial statements was incorrect. Specifically, in November 2006 and as a result of the findings during an accounting review related to revenue recognition with respect to our software upgrade and support practices and the potential impact of those practices on our previously reported financial results, management recommended to the Audit Committee, and the Audit Committee concurred with the recommendation, that we restate our consolidated financial statements for certain prior periods to correct our recognition of revenue related to the provision of unspecified software upgrades and support for products for which the contractual PCS period had expired, which upgrades and support had created implied PCS obligations for those products that extended beyond the contractual PCS periods. The implied PCS obligations should have resulted in an additional deferral of revenue when the products were initially shipped. SOP 97-2 required that we re-allocate certain previously reported product revenues, which revenues had generally been recognized at the time of product shipment, to implied PCS revenues, which revenues are required to be recognized over the multi-year period during which the implied PCS obligations are in effect (such multi-year period would typically begin 12 months after the date of product shipment). Our previous practice at the time of sale of a software product was to allocate revenue to PCS only for the initial contractual 12 months of PCS.

     In connection with the restatement discussed above, we also corrected certain errors that we had previously identified and determined not to be material with respect to our consolidated financial statements for the affected periods and that related to (i) our classification of certain customer support costs as sales and marketing expenses rather than as cost of revenues in our consolidated statements of income, and (ii) our presentation of certain deferred tax assets and deferred tax liabilities on a gross basis rather than on a net basis in our consolidated balance sheets. These additional adjustments had no impact on our previously reported revenues, income from operations, net income or the related earnings per share amounts.

     We corrected the above-described errors through a restatement (the “Restatement”) of our previously issued financial statements for (i) the year ended December 31, 2003, (ii) the year ended December 31, 2004 and each of the quarters and year-to-date periods therein, (iii) the year ended December 31, 2005 and each of the quarters and year-to-date periods therein, and (iv) the quarter ended March 31, 2006 and the quarter ended June 30, 2006 and the year-to-date period therein, as well as the Company’s selected financial data for the years 2001 through 2005 which had been set forth in Part II, Item 6 of the Company’s original filing of its Annual Report on Form 10-K for the year ended December 31, 2005. To effect this restatement we previously filed with the Commission on or about the date hereof (i) an amendment on Form 10-K/A to our Annual Report on Form 10-K for the year ended December 31, 2005, (ii) an amendment on Form 10-Q/A to our Quarterly Report on Form 10-Q for the quarter ended March 31, 2006 and (iii) an amendment on Form 10-Q/A to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2006. This Form 10-Q includes restated financial information for the accompanying consolidated financial statements as of and for the three and nine months ended September 30, 2005.

     We also revised in our restated financial statements the presentation of our consolidated statement of income (i) to separately disclose product and service revenues, and the associated costs, in accordance with Regulation S-X as the service revenues comprise more than the 10 percent threshold prescribed by the SEC due to the restatement of implied PCS, and (ii) to remove the gross profit computation and line item to conform to future and certain prior presentations of our consolidated statement of income in our filings with the Commission.

7

     Revenue Recognition for Implied PCS

     In connection with the Restatement, we determined that because of our past business practice of providing some of our customers with unspecified software upgrades for products for which the initial or extended contractual PCS periods had expired, we created implied PCS obligations for these software products that extended beyond the contractual PCS period. We further determined that the implied PCS obligations should have resulted in an additional deferral and re-allocation of a portion of the product revenues previously recognized at the time of product sale to deferred PCS revenues that should be recognized ratably into revenues over the implied PCS period, which is typically based on the expected economic life of our software products of four years. To the extent we determine that implied PCS is no longer being provided after the expiration of the customer’s contractual PCS period, the remaining deferred revenue balance related to the implied PCS obligation will be reversed and recognized as revenue in the period of cessation of the implied PCS obligation. The implied PCS obligation for our software products ceases upon (i) the license management of our software upgrades and (ii) our determination not to provide PCS after the expiration of the contractual PCS period. Our license management system locks a software license to a specific computer or Ixia hardware chassis on which our software resides. The system then manages and controls the provision of software upgrades to ensure that the upgrades are only provided to customers that are entitled to receive such upgrades during an initial or extended PCS period. For software products that are not controlled under a license management system and for certain customers where we expect to continue to provide implied PCS outside of the contractual PCS period, we will continue to allocate and defer revenue for these implied PCS obligations and to recognize this revenue ratably over the implied PCS periods as described above. For the three months ended September 30, 2006 and 2005, approximately $15.5 million and $0, respectively, of deferred revenue relating to implied PCS was reversed and recognized as revenue as a result of the license management of certain products and our determination not to provide PCS after the expiration of the contractual PCS period. For the nine months ended September 30, 2006 and 2005, the reversal of implied PCS deferred revenue approximated $18.8 million and $1.0 million, respectively. Reversals of implied PCS deferred revenue are expected to be significant during the fourth quarter of 2006 as a result of the license management of certain additional products and our determination not to provide PCS after the expiration of the contractual PCS period.

     Classification of Certain Customer Support Costs and Classification of Deferred Tax Assets and Liabilities

     Prior to the determination to effect the Restatement, certain previously identified errors had been determined to be immaterial both individually and in the aggregate to our consolidated financial statements. We also corrected these errors in our consolidated financial statements in connection with the Restatement. These adjustments consisted of:

     (i) Adjustments to reclassify certain direct customer support costs, such as those associated with our technical support group, that had been classified as a component of sales and marketing expenses rather than cost of revenues in the consolidated statements of income. These adjustments had no impact on our previously reported revenues, income from operations, net income or the related earnings per share amounts.

     (ii) Adjustments to combine and net, as prescribed by SFAS No. 109, certain deferred tax assets and deferred tax liabilities that were previously reported separately in our consolidated balance sheets on a gross basis.

     Summary of Restatement Adjustments

     The following schedules reconcile the amounts as originally reported in our consolidated balance sheets as of December 31, 2005 and the consolidated statements of income and cash flows for the three and nine months ended September 30, 2005 to the corresponding restated amounts in each of these consolidated financial statements (in thousands, except per share data):

8

	As of December 31, 2005
	As Previously		Restatement
	Reported		Adjustments			Restated
Consolidated Balance Sheet:
Assets
Current assets:
Cash and cash equivalents	$	51,837	$	—		$	51,837
Short-term investments in marketable securities		124,456		—			124,456
Accounts receivable, net		31,565		—			31,565
Inventories		9,846		—			9,846
Deferred income taxes		4,401		4,187	(1)(2)		8,588
Prepaid expenses and other current assets		3,519		—			3,519
Total current assets		225,624		4,187			229,811
Investments in marketable securities		25,392		—			25,392
Property and equipment, net		19,750		—			19,750
Deferred income taxes		10,004		3,014	(1)(2)		13,018
Goodwill		13,468		—			13,468
Intangible assets, net		20,462		—			20,462
Other assets		315		—			315
Total assets	$	315,015	$	7,201		$	322,216
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	2,872	$	—		$	2,872
Accrued expenses		12,399		—			12,399
Deferred revenues		8,338		10,895	(3)		19,233
Income taxes payable		4,131		—			4,131
Total current liabilities		27,740		10,895			38,635
Deferred revenues		528		19,573	(3)		20,101
Deferred income taxes		4,651		(4,651	)(2)		—
Total liabilities		32,919		25,817			58,736
Total shareholders’ equity		282,096		(18,616	)(4)		263,480
Total liabilities and shareholders’ equity	$	315,015	$	7,201		$	322,216

(1)	To reflect the income tax effects of the revenue adjustment for implied PCS detailed in Item (3).
(2)	To reflect the combination of certain deferred tax assets and deferred tax liabilities that were previously reported separately on a gross basis.
(3)	To reflect the revenue adjustment for implied PCS as described in the section entitled “Revenue Recognition for Implied PCS” above.
(4)	To reflect the cumulative effects on shareholders’ equity of the adjustments detailed in Items (1) and (3).

9

	For the Three Months Ended September 30, 2005
	As Previously		Restatement
	Reported		Adjustments			Restated
Consolidated Statement of Income:
Revenues:
Products	$	42,134	$	(7,643	)(A)	$	34,491
Services		—		5,401	(A)		5,401
Total revenues		42,134		(2,242	)		39,892
Costs and operating expenses:
Cost of revenues — products		6,685		(50	)(B)		6,635
Cost of revenues — amortization of purchased technology		991		—			991
Cost of revenues — services		—		561	(B)		561
Research and development		7,994		—			7,994
Sales and marketing		10,264		(511	)(B)		9,753
General and administrative		4,421		—			4,421
Amortization of intangible assets		316		—			316
Total costs and operating expenses		30,671		—			30,671
Income from operations		11,463		(2,242	)		9,221
Interest and other income, net		1,361		—			1,361
Income before income taxes		12,824		(2,242	)		10,582
Income tax expense		3,754		(1,152	)(C)		2,602
Net income	$	9,070	$	(1,090	)	$	7,980
Earnings per share:
Basic	$	0.14	$	(0.02	)(D)	$	0.12
Diluted	$	0.13	$	(0.02	)(D)	$	0.11
Weighted average number of common and common equivalent shares outstanding:
Basic		66,015		—			66,015
Diluted		69,923		—			69,923

(A)	To reflect the revenue adjustment for implied PCS as described in the section entitled “Revenue Recognition for Implied PCS” above. Adjustment also includes $3.2 million of services revenues that were previously reported within the $42.1 million revenue amount by reducing product revenues by $3.2 million and increasing services revenues by $3.2 million.
(B)	To reflect the reclassification of certain direct customer support costs to cost of revenues from sales and marketing expenses and to separately disclose the costs associated with products and services revenues.
(C)	To reflect the income tax effects of the revenue adjustment for implied PCS detailed in Item (A).
(D)	To reflect earnings per share effects from adjustments detailed in Items (A) and (C).

10

	For the Nine Months Ended September 30, 2005
	As Previously		Restatement
	Reported		Adjustments			Restated
Consolidated Statement of Income:
Revenues:
Products	$	121,874	$	(21,573	)(A)	$	100,301
Services		—		15,015	(A)		15,015
Total revenues		121,874		(6,558	)		115,316
Costs and operating expenses:
Cost of revenues — products		18,879		(196	) (B)		18,683
Cost of revenues — amortization of purchased technology		2,876		—			2,876
Cost of revenues — services		—		1,640	(B)		1,640
Research and development		23,514		—			23,514
Sales and marketing		29,689		(1,444	)(B)		28,245
General and administrative		11,940		—			11,940
Amortization of intangible assets		944		—			944
Total costs and operating expenses		87,842		—			87,842
Income from operations		34,032		(6,558	)		27,474
Interest and other income, net		3,486		—			3,486
Income before income taxes		37,518		(6,558	)		30,960
Income tax expense		9,353		(3,234	)(C)		6,119
Net income	$	28,165	$	(3,324	)	$	24,841
Earnings per share:
Basic	$	0.43	$	(0.05	)(D)	$	0.38
Diluted	$	0.41	$	(0.05	)(D)	$	0.36
Weighted average number of common and common equivalent shares outstanding:
Basic		64,753		—			64,753
Diluted		69,281		—			69,281

(A)	To reflect the revenue adjustment for implied PCS as described in the section entitled “Revenue Recognition for Implied PCS” above. Adjustment also includes $9.1 million of services revenues that were previously reported within the $121.9 million revenue amount by reducing product revenues by $9.1 million and increasing services revenues by $9.1 million.
(B)	To reflect the reclassification of certain direct customer support costs to cost of revenues from sales and marketing expenses and to separately disclose the costs associated with products and services revenues.
(C)	To reflect the income tax effects of the revenue adjustment for implied PCS detailed in Item (A).
(D)	To reflect earnings per share effects from adjustments detailed in Items (A) and (C).

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     The restatement adjustments described above did not impact our total cash flows from operating activities, investing activities or financing activities within our consolidated statements of cash flows. The effects of the restatement adjustments described above on the categories within the consolidated statement of cash flows for the nine months ended September 30, 2005 are as follows (in thousands):

	As Previously			Restatement
Increase (Decrease):	Reported			Adjustments			Restated
Nine Months Ended September 30, 2005
Cash flows from operating activities:
Net income	$	28,165		$	(3,324	)	$	24,841
Changes in deferred income taxes		(6,449	)		(3,234	)		(9,683	)
Changes in deferred revenues		1,001			6,558			7,559
Net cash provided by operating activities		39,363			—			39,363

4. Inventories

     Inventories consist of the following (in thousands):

	September 30,		December 31,
	2006		2005
Raw materials	$	2,145	$	3,574
Work in process		7,174		3,426
Finished goods		1,245		2,846
	$	10,564	$	9,846

5. Stock-Based Compensation

     On January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including stock options and employee stock purchase rights based on the estimated fair values for accounting purposes on the grant date. Prior to the adoption of SFAS 123R, we accounted for our share-based awards in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and the related interpretations of FASB Interpretation (“FIN”) No. 44, “Accounting for Certain Transactions involving Stock Compensation.” Accordingly, compensation expense related to employee stock options was recorded only if, on the date of the grant, the fair market value of the underlying stock exceeded the exercise price. We accounted for share-based awards issued to non-employees in accordance with the provisions of SFAS 123, “Accounting for Stock-Based Compensation,” and Emerging Issues Task Force (“EITF”) 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees.”

     We adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our fiscal year 2006. Our consolidated financial statements as of September 30, 2006 and for the three and nine months ended September 30, 2006 reflect the impact of SFAS 123R. In accordance with the modified prospective transition method, our consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R. Under SFAS 123R, actual tax benefits recognized in excess of tax benefits previously recognized, if any, are reported as a financing cash inflow. Prior to adoption of SFAS 123R, such excess tax benefits were reported as an increase to operating cash flows. Stock-based compensation expense recognized under SFAS 123R for the three and nine months ended September 30, 2006 was $4.9 million and $14.3 million, respectively. There was no stock-based compensation expense recognized in the consolidated financial statements during the three and nine months ended September 30, 2005. See Note 9 for additional information.

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     SFAS 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. We will continue to use the Black-Scholes model to estimate the fair value for accounting purposes of share-based awards. The determination of the fair value of share-based awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected volatility, expected life and risk-free interest rate. The expected life and expected volatility are based on historical and other data trended into the future. The risk-free interest rate assumption is based on observed interest rates appropriate for the terms of our stock options and stock purchase rights. We will evaluate the assumptions used to value share-based awards on a periodic basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. Stock-based compensation expense recognized in our consolidated statement of income for the three and nine months ended September 30, 2006 included (a) compensation expense for share-based awards granted prior to, but not yet vested, as of January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123, and (b) compensation expense for the share-based awards granted subsequent to January 1, 2006 based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. Consistent with our past practice under SFAS 123, we attribute the value of stock-based compensation to expense based on the graded, or accelerated multiple-option, approach. Stock-based compensation expense is recorded over the requisite service periods for awards ultimately expected to vest based on estimated future forfeitures. The amount of stock-based compensation expense to be recognized in periods after the grant dates will be adjusted for the impact of actual forfeitures, or vesting, compared to the estimated forfeitures used to expense the fair value of the awards. In our pro forma information required under SFAS 123 for periods prior to fiscal 2006, we accounted for actual forfeitures in the periods in which they occurred.

     The balance of gross unearned stock-based compensation to be expensed in the periods 2006 through 2010 related to unvested share-based awards as of September 30, 2006 was approximately $23.7 million. To the extent that we grant additional share-based awards to employees, future expense may increase by the additional unearned compensation resulting from those grants. We anticipate that we will continue to grant additional share-based awards in the future as part of our long-term incentive compensation programs. The impact of these future grants cannot be estimated at this time because it will depend on a number of factors, including the amount of share-based awards granted and the then current fair values for accounting purposes.

6. Earnings Per Share

     Basic earnings per share is based on the weighted average number of common shares outstanding during the period. Diluted earnings per share is based on the weighted average number of common shares and dilutive potential common shares outstanding during the period.

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     The following table sets forth the computation of basic and diluted earnings per share for the three and nine months ended September 30, 2006 and 2005 (in thousands, except per share data):

	Three months ended				Nine months ended
	September 30,				September 30,
	2006		2005		2006		2005
			(Restated)				(Restated)
Numerator:
Net income	$	8,100	$	7,980	$	8,980	$	24,841
Denominator:
Basic presentation:
Weighted average common shares		67,129		66,015		66,907		64,753
Denominator for basic calculation		67,129		66,015		66,907		64,753
Diluted presentation:
Shares used above		67,129		66,015		66,907		64,753
Weighted average effect of dilutive stock options and warrants		1,507		3,908		1,897		4,528
Denominator for diluted calculation		68,636		69,923		68,804		69,281
Basic earnings per share	$	0.12	$	0.12	$	0.13	$	0.38
Diluted earnings per share	$	0.12	$	0.11	$	0.13	$	0.36

     The diluted per share computations for the three months ended September 30, 2006 and 2005 and for the nine months ended September 30, 2006 and 2005 exclude weighted average outstanding stock options and awards to purchase 7.3 million, 0.8 million, 6.3 million and 0.6 million shares, respectively, which were antidilutive.

7. Concentrations

     Significant Customer

     For the three and nine months ended September 30, 2006 and 2005, only one customer comprised more than 10% of total revenues as follows (in thousands, except percentages):

	Three months ended						Nine months ended
	September 30,						September 30,
	2006			2005			2006			2005
				(Restated)						(Restated)
Amount of total revenues	$	12,965		$	14,271		$	36,187		$	43,957
As a percentage of total revenues		24	%		36	%		27	%		38	%

     As of September 30, 2006 and December 31, 2005, we had receivable balances from the customer approximating 30% and 27%, respectively, of total accounts receivable.

     International Data

     For the three and nine months ended September 30, 2006 and 2005, total revenues from international product shipments consisted of the following (in thousands, except percentages):

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	Three months ended						Nine months ended
	September 30,						September 30,
	2006			2005			2006			2005
				(Restated)						(Restated)
Amount of total revenues	$	15,047		$	10,069		$	40,616		$	30,988
As a percentage of total revenues		27	%		25	%		31	%		27	%

     Long-lived assets are primarily located in the United States. As of September 30, 2006, approximately $7.0 million, or 10.6%, of our total long-lived assets were located at international locations. As of December 31, 2005, approximately $4.9 million, or 5.5%, of our total long-lived assets were located at international locations.

8. Acquisitions

     In January 2006, we completed the acquisition of the mobile video and multimedia test business (“Test Business”) of privately-held Dilithium Networks. This acquisition marks our entry into the third generation wireless, or 3G, cellular market and opens new growth opportunities by allowing us to offer a broader portfolio of products to our existing customers, as well as gain access to new customers. The results of the acquired Test Business have been included in the consolidated financial statements since the acquisition date.

     The Test Business purchase price of $5.2 million included $4.9 million in cash and approximately $300,000 in legal and other acquisition costs. The following table summarizes the preliminary allocation of the purchase price based on the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition (in thousands):

Intangible assets	$	2,430
Goodwill		3,260
Total assets acquired		5,690
Current liabilities assumed		(477	)
Net assets acquired	$	5,213

     Of the $2.4 million of acquired intangible assets, $1.0 million was assigned to acquired technology, $1.2 million was assigned to customer contracts and relationships, and approximately $200,000 was assigned to other intangible assets, including a covenant not to compete. These intangible assets were generally valued using the “income” valuation approach and will be amortized using a straight-line method over their expected useful lives ranging from two to seven years. The $3.3 million of goodwill is expected to be deductible for income tax purposes.

     In June 2006, we completed the acquisition of certain technology from Bell Canada (“Test Tools”). Included with the acquired Test Tools are certain intellectual property rights and pending patents, and we also entered into a services agreement with Bell Canada for the use of certain Bell Canada employees to assist us with market development activities related to the Test Tools. The purchase price for the Test Tools asset acquisition was $3.6 million, of which $2.1 million in cash was paid in the second quarter of 2006. We accounted for the Test Tools acquisition under the purchase method of accounting and allocated the purchase price to the net tangible and intangible assets acquired based on their estimated fair values.

9. Share-Based Compensation

     Stock Option Plans

     Our Amended and Restated 1997 Equity and Incentive Plan, as amended (the “1997 Plan”), provides for the issuance of share-based awards to our qualified employees and consultants. The share-based awards may include incentive stock options, nonqualified stock options, restricted stock units (“RSU”) or restricted stock awards. Options become exercisable over a vesting period as determined by the Board of Directors and expire over terms not exceeding 10 years from the date of grant. The exercise price for options granted under the 1997 Plan

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may not be granted at less than 100% of the fair market value of our common stock on the date of grant (110% if granted to an employee who owns more than 10% of the voting shares of the outstanding stock). Options generally vest over a four-year period. In the event the holder ceases to be employed by us, all unvested options are forfeited and all vested options may be exercised within a period of up to 30 days after the optionee’s termination for cause, up to three months after termination other than for cause or as a result of death or disability, or up to six months after termination as a result of disability or death. As of September 30, 2006, we have reserved 28.5 million shares of our common stock for issuance under the 1997 Plan, 4.3 million shares of which were available for future grant as of such date.

     Our Amended and Restated Non-Employee Director Stock Option Plan (the “Director Plan”) provides for the issuance of share-based awards to our non-employee directors. We have reserved a total of 400,000 shares of common stock for issuance under the plan. The option grants under the plan are automatic and non-discretionary, and the exercise price of the options is 100% of the fair market value of our common stock on the grant date. The plan provides for an initial grant to a non-employee director of an option to purchase at least 25,000 and up to 35,000 shares of common stock upon the director’s appointment to the board, which options vest and become exercisable in eight equal quarterly installments. The plan also provides for each non-employee director to be granted an option to purchase 10,000 shares of common stock upon the director’s re-election to the board at an annual meeting of shareholders. These subsequent grants vest and become exercisable in four equal quarterly installments commencing on the last day of the calendar quarter in which the option is granted. The plan will terminate in September 2010, unless terminated sooner by the Board of Directors. As of September 30, 2006, the Director Plan had approximately 177,000 shares available for future grant.

     The following table summarizes stock option activity for the nine months ended September 30, 2006:

						Weighted Average
				Weighted Average		Remaining		Aggregate
	Number			Exercise Price		Contractual		Intrinsic
	of Options			Per Share		Life (in years)		Value
Outstanding as of December 31, 2005		10,465		$	10.62
Granted		1,082			11.21
Exercised		(412	)		6.40
Forfeited/canceled		(841	)		13.37
Outstanding as of September 30, 2006		10,294		$	10.62		4.88	$	13,066
Exercisable as of September 30, 2006		6,214		$	9.11		4.02	$	12,341

     The weighted average grant-date fair value of options granted during the nine months ended September 30, 2006 and 2005 was $5.74 and $8.28 per share, respectively. The total intrinsic value of options exercised during the nine months ended September 30, 2006 and 2005 was $2.1 million and $44.2 million, respectively. As of September 30, 2006, the remaining unrecognized compensation expense related to stock options is expected to be recognized over a weighted average period of 1.38 years.

     The following table summarizes RSU activity for the nine months ended September 30, 2006:

				Weighted Average
				Grant Date Fair
	Number			Value
	of Awards			Per Share
Outstanding as of December 31, 2005		—		$	—
Awarded		338			9.64
Released		(1	)		10.72
Forfeited/canceled		—			—
Outstanding as of September 30, 2006		337		$	9.64

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     The weighted average remaining contractual life and expense recognition period of the outstanding RSUs as September 30, 2006 was 2.0 years.

Employee Stock Purchase Plan

     The employee stock purchase plan (the “Plan”) was adopted and approved in September 2000. The Plan became effective upon the closing of our initial public offering in October 2000. We have reserved a total of 2.5 million shares of common stock for issuance under the Plan, together with the potential for an annual increase in the number of shares reserved under the Plan on May 1 of each year. As of September 30, 2006, 636,000 shares were available for future issuance. For the nine months ended September 30, 2006 and 2005, 194,000 and 143,000 shares, respectively, were issued under the Plan.

     The Plan permits eligible employees to purchase common stock, subject to limitations as set forth in the Plan, through payroll deductions which may not exceed the lesser of 15% of an employee’s compensation or $21,250 per annum.

     The Plan is designed to provide our employees with an opportunity to purchase, on a periodic basis and at a discount, shares of our common stock through payroll deductions. The Plan was adopted and approved by the Board of Directors and the shareholders of the Company in 2000 and was amended in May 2003 and in April 2006. The Plan is implemented in a series of consecutive, overlapping 24-month offering periods, with each offering period consisting of four six-month purchase periods. Offering periods begin on the first trading day on or after May 1 and November 1 of each year. During each 24-month offering period under the Plan, participants accumulate payroll deductions which on the last trading day of each six-month purchase period within the offering period are applied toward the purchase of shares of our common stock at a purchase price equal to 85% of the lower of (i) the fair market value of a share of our common stock as of the first trading day of the 24-month offering period and (ii) the fair market value of a share of common stock on the last trading day of the six-month purchase period.

     Prior to the April 2006 amendment to the Plan, Plan participants could increase or decrease the rate of their payroll deductions (subject to the limitations set forth in the Plan) during the course of a 24-month offering period for future six-month purchase periods within the offering period. The April 2006 amendment amends the Plan to provide that, for all offering periods beginning on or after May 1, 2006, Plan participants may decrease, but not increase, the rate of their payroll deductions for future six-month purchase periods within a 24-month offering period. In addition, prior to the April 2006 amendment, if the fair market value of our common stock on the last trading day of a six-month purchase period within a 24-month offering period was lower than the fair market value of our common stock on the first trading day of the 24-month offering period, then all participants in the 24-month offering period would automatically be withdrawn from the offering period and automatically re-enrolled in the next 24-month offering period on the first day thereof. The April 2006 amendment amends the Plan to eliminate this automatic re-enrollment feature of the Plan for all offering periods beginning on or after May 1, 2006. The April 2006 amendment will allow us to better estimate, on the grant dates under the Plan, the amount of stock-based compensation expense to be recognized in our consolidated statements of income related to awards granted under the Plan.

Stock-Based Compensation Expense

     We calculated the estimated fair value for accounting purposes of each share-based award on the respective dates of grant using the Black-Scholes option pricing model using the following weighted average assumptions:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
Expected lives (in years)		4.0			3.7			4.1			3.8
Risk-free interest rates		4.9	%		4.2	%		4.8	%		4.0	%
Dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Expected volatility		59.3	%		58.3	%		61.3	%		60.6	%

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     The following table reflects net income and earnings per share for the three and nine months ended September 30, 2006 compared with the pro forma information for the three and nine months ended September 30, 2005 as follows (in thousands, except per share data):

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
				(Restated)						(Restated)
Net income — as reported for prior period(1)		N/A		$	7,980			N/A		$	24,841
Stock-based compensation expense related to share-based awards, net of tax(2)	$	(3,817	)		(2,548	)	$	(11,139	)		(5,259	)
Net income — including the effects of stock-based compensation(3)	$	8,100		$	5,432		$	8,980		$	19,582
Earnings per share:
Basic — as reported for prior period(1)		N/A		$	0.12			N/A		$	0.38
Basic — including the effects of stock-based compensation(3)	$	0.12		$	0.08		$	0.13		$	0.30
Diluted — as reported for prior period(1)		N/A		$	0.11			N/A		$	0.36
Diluted — including the effects of stock-based compensation(3)	$	0.12		$	0.08		$	0.13		$	0.28

(1)	Net income and earnings per share for the three and nine months ended September 30, 2005 did not include stock-based compensation expense for share-based awards under SFAS 123 because we did not adopt the recognition provisions of SFAS 123.
(2)	Stock-based compensation expense prior to fiscal 2006 is calculated based on the pro forma application of SFAS 123. Stock-based compensation expense, excluding tax effects, under SFAS 123R and SFAS 123 for the three months ended September 30, 2006 and 2005 was $4.9 million and $3.3 million, respectively. Stock-based compensation expense, excluding tax effects, under SFAS 123R and SFAS 123 for the nine months ended September 30, 2006 and 2005 was $14.3 million and $10.9 million, respectively.
(3)	Net income and earnings per share prior to fiscal 2006 represent pro forma information based on SFAS 123.

10. Recent Accounting Pronouncements

     In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies Statement 109, “Accounting for Income Taxes,” to indicate the criteria that an individual tax position would have to meet for some or all of the benefit of that position to be recognized in an entity’s financial statements. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are continuing to evaluate the requirements under FIN 48, but currently do not believe that the adoption of FIN 48 will have a significant impact on our consolidated financial statements, statement of cash flows or earnings per share.

     In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157 “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (“GAAP”), and expands disclosures about fair value measurements. This Statement is applied under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently evaluating the impact on our financial statements of adopting SFAS 157.

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     In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”). SAB 108 provides guidance on the consideration of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The SEC staff believes registrants must quantify the impact of correcting all misstatements, including both carryover and reversing effects of prior year misstatements, on a company’s current year consolidated financial statements. The SEC staff prescribes two approaches to assessing the materiality of misstatements; the “rollover” approach, which quantifies misstatements based on the amount of error originating in the current year income statement and the “iron curtain approach,” which quantifies misstatements based on the effects of correcting the cumulative effect existing in the balance sheet at the end of the current year. If under either approach, misstatements are deemed material, a company is required to adjust its financial statements, including correcting prior year financial statements, even though such correction was and continues to be immaterial to the prior year financial statements. Correcting prior year financial statements for immaterial errors would not require a company to amend previously filed reports, rather such corrections may be made the next time the company files its prior year statements. We are continuing to evaluate the provisions of SAB 108, but currently do not believe that the application of SAB 108 will have a significant impact on our consolidated financial statements.

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

     As discussed further in Note 3 of the “Notes to Condensed Consolidated Financial Statements” contained in Part I, Item 1 of this Form 10-Q, we have restated our unaudited condensed consolidated financial statements for the quarter ended September 30, 2005. Specifically, we have restated these financial statements as the result of certain errors that existed in our previously issued financial statements for that period, which errors principally related to our application of Statement of Position 97-2 “Software Revenue Recognition” (“SOP 97-2”) with respect to the accounting for implied post contract customer support (“PCS”) obligations. In connection with the restatement, we also corrected certain errors that we had previously identified and determined not to be material with respect to our condensed consolidated financial statements for the affected periods and that related to (i) our classification of certain customer support costs as sales and marketing expenses rather than as cost of revenues in our consolidated statements of income, and (ii) our presentation of certain deferred tax assets and deferred tax liabilities on a gross basis rather than on a net basis in our consolidated balance sheets. These additional adjustments had no impact on our previously reported revenues, income from operations, net income or the related earnings per share amounts. All referenced amounts in this Form 10-Q for the quarter ended September 30, 2005 reflect the balances and amounts on a restated basis. In connection with the restatement of our previously issued financial statements we also revised the presentation of our consolidated statement of income (i) to separately disclose product and service revenues, and the associated costs, in accordance with Regulation S-X as the service revenues comprise more than the 10 percent threshold prescribed by the SEC due to the restatement of implied PCS, and (ii) to remove the gross profit computation and line item to conform to future and certain prior presentations of our consolidated statement of income in our filings with the Commission.

     The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of many factors. The results of operations for the three and nine months ended September 30, 2006, are not necessarily indicative of the results that may be expected for the full year ending December 31, 2006, or for any other future period. The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and the notes thereto included in Item 1 of this Quarterly Report and in conjunction with Amendment No. 2 on Form 10-K/A to our Annual Report on Form 10-K for the year ended December 31, 2005 (the “Amended 2005 Form 10-K”), including the “Risk Factors” section and the consolidated financial statements and notes included therein.

OVERVIEW

     We are a leading provider of performance test systems for Internet Protocol (IP) based infrastructure and services that allow our customers to test and measure the performance, functionality, and conformance of IP equipment and networks, and the applications that run over them. Our solutions generate, capture, characterize, and analyze high volumes of realistic network and application traffic, exposing problems, assessing performance, ensuring functionality and interoperability, and verifying conformance to industry specifications. We offer a hardware platform with interchangeable interfaces, utilizing a single set of applications and Application Programming Interfaces (APIs) that allows our customers to create an integrated, easy-to-use test bed. The networks our systems analyze include Ethernet networks operating at speeds of up to 10 gigabits per second, which carry data traffic over optical fiber or electrical cable. Other networks include Packet over SONET networks operating at speeds of up to 10 gigabits per second, which transmit information over high-speed optical links and Asynchronous Transfer Mode (ATM) networks, operating at speeds of up to 622 megabits per second. We also offer a telephony test suite that is used to test and verify traditional Time-Division Multiplexing (TDM) voice based networks, Voice over IP technology, devices, and systems, as well as the interoperability, troubleshooting, service optimization and call traffic monitoring of Video Telephony. Customers also use our performance applications to test and verify web servers, internet networks, security, and business applications.

     Revenues.Our revenues are principally derived from the sale and support of our test systems. Product revenues primarily consist of sales of our hardware and software products. Our service revenues primarily consist of the provision of post contract customer support and maintenance (“PCS”) related to the initial free 12-month and separately purchased extended PCS contracts and to our implied PCS obligations. Service revenues also include separately purchased extended hardware warranty support (generally offered for 12 month periods). PCS on our software products includes unspecified software upgrades and customer technical support services. Our hardware

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products primarily consist of chassis and interface cards, and during the past three years, our Ethernet interface cards have represented the majority of our product shipments. In general, our Ethernet interface cards are used to test equipment and advanced IP services at the edge of the internet and in enterprise applications, where demand has been consistently increasing. Over the same time period, product shipments for our SONET interface cards have not been significant. Looking forward, we expect demand for our Ethernet interface cards to remain strong and we expect demand for our SONET interface cards to decline or to remain consistent with our historical experience. Our growth over the past three years has also been driven by increasing shipments of our software products. The increase in software shipments is the result of our strategy to use specialized software applications to drive demand for our proprietary hardware platform. Looking forward, we expect demand for our software products to remain strong.

     Sales to our largest customer accounted for approximately $13.0 million or 23.5% and $36.2 million or 27.3% of our total revenues for the three and nine months ended September 30, 2006, respectively, and $14.3 million or 35.8% and $44.0 million or 38.1% of our total revenues for the three and nine months ended September 30, 2005. In addition, to date, we have sold our products primarily to network equipment manufacturers. While we expect that we will continue to have customer concentration for the foreseeable future, we continue to sell our products to a wide variety of customers and, to the extent we develop a broader and more diverse customer base, our reliance on any one customer or customer type may diminish.

     In some instances our software products may be installed and operated independently from our hardware products. At other times, our software products are installed on and work with our hardware products to enhance the functionality of the overall test system. In addition, our chassis is generally shipped with our core operating system software installed, which is an integral part of the chassis’ functionality. As our software is generally more than incidental to the sale of our test systems, we recognize revenue by applying the provisions of the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition” as amended by SOP 98-9, “Software Revenue Recognition with Respect to Certain Arrangements” (collectively, “SOP 97-2”).

     Our test systems are generally fully functional at the time of shipment and do not require us to perform any significant production, modification, customization or installation after shipment. As such, revenue from hardware and software product sales is recognized upon shipment provided that (i) an arrangement exists, which is typically in the form of a customer purchase order; (ii) delivery has occurred, including the transfer of title and risk of loss to the customer; (iii) the sales price is fixed or determinable; and (iv) collectibility is deemed probable.

     When a sale involves multiple elements, or multiple products, and we have vendor-specific objective evidence (“VSOE”) of fair value for each element in the arrangement, we recognize revenue based on the relative fair value of all elements within the arrangement. We determine VSOE based on sales prices charged to customers when the same element is sold separately or based upon renewal pricing for PCS. Many of our products, such as our software and chassis products, are not sold separately as these products include 12 months of free PCS, and accordingly we are unable to establish VSOE for these products.

     In cases where VSOE only exists for the undelivered elements such as PCS, we apply the residual method to recognize revenue. Under the residual method, the total arrangement fee is allocated first to the undelivered elements, typically the initial or extended PCS, based on their VSOE, and the residual portion of the fee is allocated to the delivered elements, typically our hardware and software products, and recognized as revenue assuming all other revenue recognition criteria as described above have been met.

     If VSOE cannot be determined for all undelivered elements of an arrangement, we defer revenue until the earlier of (i) the delivery of all elements or (ii) the establishment of VSOE for all undelivered elements, provided that if the only undelivered element is PCS or a service, the total fee of the arrangement is recognized as revenue over the PCS or service term.

     Services revenues from our initial and separately purchased extended contractual PCS arrangements (generally offered for 12 month periods) are recognized ratably over the contractual coverage period. In addition, for implied PCS obligations we defer revenues from product sales and allocate these amounts to PCS revenues to account for the circumstances in which we provide PCS after the expiration of the customer’s contractual PCS period. Deferred revenues for these implied PCS obligations are recognized ratably over the implied PCS period, which is typically based on the expected economic life of our software products of four years. To the extent we

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determine that implied PCS is no longer being provided after the expiration of the customer’s contractual PCS period, the remaining deferred revenue balance related to the implied PCS obligation is reversed and recognized as revenue in the period of cessation of the implied PCS obligation.

     The implied PCS obligation for our software products results from our past business practice of providing some of our customers with unspecified software upgrades for products that were not license managed and for which the initial or extended contractual PCS periods had expired. The implied PCS obligation for our software products ceases, however, upon (i) the license management of our software upgrades and (ii) our determination not to provide PCS after the expiration of the contractual PCS period. Our license management system locks a software license to a specific computer or Ixia hardware chassis on which our software resides. The system then manages and controls the provision of software upgrades to ensure that the upgrades are only provided to customers that are entitled to receive such upgrades during an initial or extended PCS period. In connection with the restatement described in our Amended 2005 Form 10-K, in our Amendments on Form 10-Q/A to our Quarterly Reports on Form 10-Q for the quarters ended March 31, 2006 and June 30, 2006 and in certain of our other filings with the Securities and Exchange Commission (the “Commission”), in December 2006 we completed the implementation of a license management system for all of our significant software products. For software products that are not controlled under a license management system and for certain customers where we expect to continue to provide implied PCS outside of the contractual PCS period, we will continue to allocate and defer revenue for these implied PCS obligations and to recognize this revenue as described above. For the three months ended September 30, 2006 and 2005, services revenues related to our implied PCS obligations were approximately $1.6 million and $2.2 million, respectively. For the nine months ended September 30, 2006 and 2005, services revenues related to our implied PCS obligations approximated $6.7 million and $5.9 million, respectively. For the three months ended September 30, 2006 and 2005, approximately $15.5 million and $0, respectively, of deferred revenue relating to implied PCS was reversed and recognized as revenue as a result of the license management of certain products and our determination not to provide PCS after the expiration of the contractual PCS period. For the nine months ended September 30, 2006 and 2005, the reversal of implied PCS deferred revenue approximated $18.8 million and $1.0 million, respectively. Reversals of implied PCS deferred revenue are expected to be significant during the fourth quarter of 2006 as a result of the license management of certain additional products and our determination not to provide PCS after the expiration of the contractual PCS period.

     Revenues from our separately purchased extended hardware warranty arrangements are recognized ratably over the contractual coverage period.

     We use distributors to complement our direct sales and marketing efforts in certain international markets. Due to the broad range of features and options available with our hardware and software products, distributors generally do not stock our products and typically place orders with us after receiving an order from an end customer. These distributors receive business terms of sale generally similar to those received by our other customers.

     Stock-Based Compensation.Effective January 1, 2006, we adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” or SFAS 123R. SFAS 123R requires all share-based payments, including grants of stock options and employee stock purchase rights, to be recognized in the financial statements based on the estimated fair values for accounting purposes on the grant date. Under this standard, the estimated fair value for accounting purposes of each stock option and employee stock purchase right is estimated on the date of grant using an option pricing model that meets certain requirements. We use the Black-Scholes option pricing model to estimate the fair value for accounting purposes of our share-based payments which meets the requirements of SFAS 123R. The determination of the fair value for accounting purposes of share-based payment awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected volatility, expected life and risk-free interest rate. The expected life and expected volatility are based on historical and other data trended into the future. The risk-free interest rate assumption is based on observed interest rates appropriate for the terms of our stock options and stock purchase rights. Stock-based compensation expense recognized in our consolidated financial statements in fiscal 2006 and thereafter will be based on awards that are ultimately expected to vest. The amount of stock-based compensation expense in fiscal 2006 and thereafter will be reduced for estimated forfeitures based on historical experience as well as future expectations. Forfeitures are required to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We will evaluate the assumptions used to value share-based awards on a periodic basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If

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there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense.

     We adopted SFAS 123R using the modified prospective method which requires the application of the accounting standard as of January 1, 2006. Our condensed consolidated financial statements as of and for the three and nine months ended September 30, 2006 reflect the impact of SFAS 123R. In accordance with the modified prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R. Prior to the adoption of SFAS 123R, we accounted for our stock-based compensation using the intrinsic value method which resulted in no compensation expense being recognized for the three and nine months ended September 30, 2005. The balance of gross unearned stock-based compensation to be expensed in the periods 2006 through 2010 related to unvested share-based awards as of September 30, 2006 was approximately $23.7 million. To the extent that we grant additional share-based awards to employees, future expense may increase by the additional unearned compensation resulting from those grants. We anticipate that we will continue to grant additional share-based awards in the future as part of our long-term incentive compensation programs. The impact of future grants cannot be estimated at this time because it will depend on a number of factors, including the amount of share-based awards granted and the then current fair values for accounting purposes.

     Cost of Revenues. Our cost of revenues related to the sale of our hardware and software products includes materials, payments to third party contract manufacturers, royalties, and salaries and other expenses related to our manufacturing and operations personnel. We outsource the majority of our manufacturing operations, and we conduct final assembly, supply chain management, quality assurance, documentation control and shipping at our facility in Calabasas, California. Accordingly, a significant portion of our cost of revenues related to our products consists of payments to our contract manufacturers. Cost of revenues related to the provision of services includes salaries and other expenses associated with customer and technical support services and the warranty cost of hardware to be replaced during the warranty coverage period. Cost of revenues also includes the amortization of purchased intangible assets in connection with our acquisitions of certain product lines and technologies.

  ��  Our cost of revenues as a percentage of total revenues is primarily affected by the following factors:

• changes in our pricing policies and those of our competitors;

• the pricing we are able to obtain from our component suppliers and contract manufacturers;

• the mix of our products sold, such as the mix of software versus hardware product sales, including the effects of any related deferral, reversal and recognition of revenues for implied PCS obligations;

• new product introductions by us and by our competitors;

• demand for our products;

• expenses related to acquired technologies, such as royalties and amortization of intangible assets;

• production volume; and

• the mix of sales channels through which our products are sold.

     In the near term, we anticipate that our cost of revenues as a percentage of total revenues will increase, excluding the effects of the reversal of certain implied PCS obligations, due to the January 1, 2006 adoption of SFAS 123R and potentially due to lower sales prices on larger transactions as a result of increased competition.

     Operating Expenses. Our operating expenses are generally recognized when incurred and consist of research and development, sales and marketing, general and administrative, and amortization of intangible assets. In the near term, we expect total operating expenses to increase modestly in dollar terms as we seek to attain our strategic product development objectives and to meet changing customer requirements and technological advances, and due to an increase in stock-based compensation expense as a result of the adoption of SFAS 123R.

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     Research and development expenses consist primarily of salaries and other personnel costs related to the design, development, testing and enhancements of our products. We expense our research and development costs as they are incurred. We also capitalize and depreciate over a five-year period costs of our products used for research and development purposes.

     Sales and marketing expenses consist primarily of compensation and related costs for personnel engaged in direct sales, sales support and marketing functions, as well as promotional and advertising expenditures. We also capitalize and depreciate over a two-year period costs of our products used for sales and marketing activities, including product demonstrations for potential customers.

     General and administrative expenses consist primarily of salaries and related expenses for executive, finance, human resources, information technology and administrative personnel, as well as recruiting and professional fees, insurance costs and other general corporate expenses.

     Amortization of intangible assets consists of the amortization of the purchase price of the various intangible assets over their useful lives. Periodically we review goodwill and other intangible assets for impairment. An impairment charge would be recorded to the extent that the carrying value exceeds the fair value in the period that the impairment circumstances occurred.

     Interest and Other, Net.Interest and other, net represents interest on cash and a variety of securities, including commercial paper, money market funds, and government, federal agency and corporate debt securities, and certain foreign currency gains and losses.

     Income Tax Expense.Income tax expense is determined based on the amount of earnings and enacted federal, state and foreign tax rates, adjusted for allowable credits and the effects of equity compensation plans. As a result of the adoption of SFAS 123R, our fiscal 2006 effective tax rate may be significantly higher than our fiscal 2005 effective tax rate.

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RESULTS OF OPERATIONS

     The following table sets forth certain statement of operations data as a percentage of total revenues for the periods indicated:

	Three months ended						Nine months ended
	September 30,						September 30,
	2006			2005			2006			2005
				(Restated)						(Restated)
Revenues:
Products		90.0	%		86.5	%		86.1	%		87.0	%
Services		10.0			13.5			13.9			13.0
Total revenues		100.0			100.0			100.0			100.0
Costs and operating expenses:(1)
Cost of revenues — products		13.9			16.6			16.4			16.2
Cost of revenues — amortization of purchased technology		2.3			2.5			2.6			2.5
Cost of revenues — services		1.1			1.4			1.3			1.4
Research and development		20.2			20.0			24.6			20.4
Sales and marketing		27.8			24.5			34.0			24.5
General and administrative		10.5			11.1			12.5			10.4
Amortization of intangible assets		0.8			0.8			1.0			0.8
Total costs and operating expenses		76.6			76.9			92.4			76.2
Income from operations		23.4			23.1			7.6			23.8
Interest and other, net		4.4			3.4			5.1			3.0
Income before income taxes		27.8			26.5			12.7			26.8
Income tax expense		13.2			6.5			5.9			5.3
Net income		14.6	%		20.0	%		6.8	%		21.5	%

⁽¹⁾ Stock-based compensation included in:

Cost of revenues — products	0.3	%	—	0.3	%	—
Cost of revenues — services	0.1		—	0.1		—
Research and development	3.1		—	3.9		—
Sales and marketing	3.8		—	4.6		—
General and administrative	1.6		—	1.8		—

Comparison of Three and Nine Months Ended September 30, 2006 and 2005

     Revenues.In the third quarter of 2006, total revenues increased 38.4% to $55.2 million from the $39.9 million recorded in the third quarter of 2005. This overall increase primarily relates to the $15.2 million increase in product revenues in the third quarter of 2006 over the same period in 2005 due to the $15.5 million of implied PCS deferred revenue that was reversed and recognized as revenue during the three months ended September 30, 2006, as compared to reversals of $0 during the three months ended September 30, 2005, as a result of the license management of certain products and our determination not to provide PCS after the expiration of the contractual PCS period. In the third quarter of 2006, services revenues increased 2.4% to $5.5 million from the $5.4 million recorded in the third quarter of 2005. Revenues from Cisco, our largest account, were $13.0 million, representing 23.5% of our total revenues for the third quarter of 2006, and were $14.3 million or 35.8% of our total revenues for the third quarter of 2005. In the first nine months of 2006, total revenues increased 15.1% to $132.8 million from the $115.3 million recorded in the same period of 2005. This overall growth primarily relates to the reversal of $18.8 million of implied PCS deferred revenue during the nine months ended September 30, 2006, as compared to reversals of $1.0 million during the same period of 2005, as a result of the license management of certain products and our determination not to provide PCS after the expiration of the contractual PCS period. In the first nine months of 2006, services revenues increased 22.7% to $18.4 million from the $15.0 million recorded in the same

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period of 2005 primarily due to the ratable recognition of revenues related to our contractual and implied PCS obligations which directly relates to the sequential increases in shipments of our software products during the preceding periods. Revenues from Cisco were $36.2 million, representing 27.3% of our total revenues for the first nine months of 2006, and were $44.0 million or 38.1% of our total revenues for the first nine months of 2005.

     Cost of Revenues. As a percentage of total revenues, our total cost of revenues decreased to 17.3% in the third quarter of 2006 from 20.5% in the third quarter of 2005. For the nine months ended September 30, 2006 and 2005, total cost of revenues as a percentage of total revenues was 20.3% and 20.1%, respectively. Excluding the reversals of implied PCS deferred revenue of $15.5 million and $0 from total revenues in the third quarters of 2006 and 2005, respectively, total cost of revenues as a percentage of total revenues was 24.1% and 20.5%, respectively. Excluding the reversals of implied PCS deferred revenue of $18.8 million and $1.0 million from total revenues in the first nine months of 2006 and 2005, respectively, total cost of revenues as a percentage of total revenues was 23.7% and 20.3%, respectively. These increases in the total cost of revenues percentages for the third quarter and for the first nine months of 2006 were due in part to the competitive pricing pressures on certain larger deals during the 2006 periods and the impact of stock-based compensation expense of $199,000 and $624,000, respectively, recognized during the 2006 periods as a result of the adoption of SFAS 123R effective January 1, 2006. In the third quarter and first nine months of 2006, our total cost of revenues increased 17.0% to $9.6 million and 16.2% to $27.0 million, respectively, from the $8.2 million and $23.2 million recorded during the same periods in 2005. Our cost of product revenues for the three and nine months ended September 30, 2006, excluding stock-based compensation expense of $144,000 and $452,000 for the respective periods, increased 13.8% to $7.6 million and 14.2% to $21.3 million, respectively, from the $6.6 million and $18.7 million in the same periods of 2005. These increases were primarily due to the increase in inventory costs. For the three and nine months ended September 30, 2006, amortization of purchased technology increased to $1.3 million and $3.4 million, respectively, from the $1.0 million and $2.9 million in the same periods of 2005. These increases related to the higher amortization of intangible asset charges associated with the July 2005 purchase of Communication Machinery Corporation, the January 2006 purchase of certain product lines from Dilithium Networks and the June 2006 acquisition of certain technology from Bell Canada. For the three and nine months ended September 30, 2006, our cost of services revenues increased to $629,000 and $1.7 million, respectively, from the $561,000 and $1.6 million recorded in the same periods of 2005 due primarily to the adoption of SFAS 123R effective January 1, 2006.

     Research and Development Expenses.In the third quarter of 2006, research and development expenses increased 38.8% to $11.1 million from the $8.0 million recorded in the third quarter of 2005. This increase was primarily due to the adoption of SFAS 123R effective January 1, 2006 which resulted in stock-based compensation expense of $1.7 million recorded during the third quarter of 2006. The increase in research and development expenses in the third quarter of 2006 compared to the third quarter of 2005 was also due to higher compensation and related employee costs of approximately $560,000, an increase in facilities costs of approximately $337,000 and higher depreciation expense of over $330,000. In the first nine months of 2006, research and development expenses increased 39.2% to $32.7 million from the $23.5 million recorded in the first nine months of 2005. The adoption of SFAS 123R resulted in stock-based compensation expense of $5.1 million recorded during the first nine months of 2006. The increase in research and development expenses in the first nine months of 2006 compared to the first nine months of 2005 was also due to higher compensation and related employee costs of approximately $2.0 million, an increase in facilities costs of approximately $960,000 and higher depreciation expense of approximately $930,000. The increases in compensation, facilities costs and depreciation for both the third quarter and first nine months of 2006 as compared to the same periods during 2005 were due in part to the expansion of our international development operations in India and Romania.

     Sales and Marketing Expenses.In the third quarter of 2006, sales and marketing expenses increased 57.0% to $15.3 million from the $9.8 million recorded in the third quarter of 2005. This increase was due in part to the adoption of SFAS 123R effective January 1, 2006 which resulted in stock-based compensation expense of $2.1 million recorded during the third quarter of 2006. The increase in sales and marketing expenses in the third quarter of 2006 compared to the third quarter of 2005 was also due to a higher number of direct sales and marketing personnel and their associated benefit costs and travel expenses, which resulted in an increase of $2.6 million. Additionally, depreciation expense increased by approximately $260,000 and facility expenses increased by approximately $370,000 in the third quarter of 2006 as compared to the third quarter of 2005. These increases were due in part to the increased use of our products by sales and marketing personnel and our new facility in the United Kingdom. In the first nine months of 2006, sales and marketing expenses increased 59.9% to $45.2 million from the $28.2 million recorded in the first nine months of 2005. This increase was due in part to the adoption of SFAS 123R effective January 1, 2006 which resulted in stock-based compensation expense of $6.2 million recorded

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during the first nine months of 2006. The increase in sales and marketing expenses in the first nine months of 2006 compared to the first nine months of 2005 was also due to a higher number of direct sales and marketing personnel and their associated benefit costs and travel expenses, which resulted in an increase of $7.3 million. Additionally, depreciation expense increased by approximately $950,000 and facility expenses increased by approximately $910,000 in the first nine months of 2006 as compared to the first nine months of 2005. These increases were due in part to the increased use of our products by sales and marketing personnel and our new facility in the United Kingdom.

     General and Administrative Expenses.In the third quarter of 2006, general and administrative expenses increased 31.7% to $5.8 million from the $4.4 million recorded in the third quarter of 2005. This increase was due primarily to the adoption of SFAS 123R effective January 1, 2006 which resulted in stock-based compensation expense of $869,000 recorded during the third quarter of 2006. The increase in general and administrative expenses in the third quarter of 2006 compared to the third quarter of 2005 also included increases in facilities costs, including certain internal system support costs, of $232,000 and legal and accounting fees of approximately $179,000. The overall increase in general and administrative expenses in the third quarter of 2006 compared to the third quarter of 2005 was partially offset by a decrease in recruiting fees of approximately $205,000. In the first nine months of 2006, general and administrative expenses increased 39.3% to $16.6 million from the $11.9 million recorded in the first nine months of 2005. This increase was due in part to the adoption of SFAS 123R effective January 1, 2006 which resulted in stock-based compensation expense of $2.3 million recorded during the first nine months of 2006. The increase in general and administrative expenses in the first nine months of 2006 compared to the first nine months of 2005 was also due to the expansion of our administrative infrastructure in 2006. Administrative expansion efforts resulted in an increase in facility expenses, including certain internal system support costs, of $715,000, an increase in salary and benefit costs of just over $530,000 and an increase in depreciation expense of approximately $450,000 in the first nine months of 2006 as compared to the first nine months of 2005.

     Amortization of Intangible Assets.In the third quarter of 2006, amortization of intangible assets increased to $464,000 from the $316,000 recorded in the third quarter of 2005. In the first nine months of 2006, amortization of intangible assets increased to $1.3 million from the $944,000 recorded in the first nine months of 2005. These increases for the third quarter and first nine months of 2006 as compared to the same periods in 2005 were primarily the result of increases in intangible assets resulting from the July 2005 purchase of Communication Machinery Corporation, the January 2006 purchase of certain product lines from Dilithium Networks and the June 2006 acquisition of certain technology from Bell Canada.

     Interest and Other, Net.Interest and other, net increased to $2.4 million in the third quarter of 2006 from the $1.4 million recorded in the third quarter of 2005. Interest and other, net increased to $6.7 million in the first nine months of 2006 from the $3.5 million recorded in the first nine months of 2005. These increases were largely attributable to higher interest rates and larger cash and investment balances in the aggregate during the third quarter and first nine months of 2006 as compared to the third quarter and first nine months of 2005.

     Income Tax Expense.Income tax expense increased to $7.3 million, or an effective rate of 47.3%, for the third quarter of 2006 from $2.6 million, or an effective rate of 24.6%, for the third quarter of 2005. Income tax expense increased to $7.8 million, or an effective rate of 46.4%, for the first nine months of 2006 from $6.1 million, or an effective rate of 19.8%, for the first nine months of 2005. The effective tax rates in the third quarter and first nine months of 2006 differ from the effective tax rates in the third quarter and first nine months of 2005 primarily due to the impact of stock-based compensation as recognized pursuant to SFAS 123R, as certain stock-based compensation charges, such as those associated with incentive stock options, may not be tax deductible. The effective tax rate for the third quarter and first nine months of 2006 were also adversely impacted by lower research and development tax credits, due in part to the expiration of the applicable federal law. In addition, the higher effective rate for the first nine months of 2006 as compared to the effective rate for the first nine months of 2005 was due to a decreased amount of tax benefits related to the disqualifying disposition of incentive stock options to the extent that stock-based compensation expense had previously been reflected in our consolidated financial statements.

LIQUIDITY AND CAPITAL RESOURCES

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     Net cash provided by operating activities was $22.7 million in the first nine months of 2006 and $39.4 million in the first nine months of 2005. Net cash generated from operations in the first nine months of 2006 and 2005 was provided by net income of $9.0 million and $24.8 million, respectively, adjusted for non-cash items and changes in working capital. In the first nine months of 2006 and 2005, non-cash items included $12.0 million and $7.8 million, respectively, for depreciation and amortization of fixed and intangible assets. The first nine months of 2006 also included non-cash stock-based compensation charges of $14.3 million related to the adoption of SFAS 123R effective January 1, 2006. The first nine months of 2005 included a $15.1 million tax benefit related to certain stock option transactions, which was partially offset by the $9.7 million increase in net deferred tax assets. In the first nine months of 2006 and 2005, changes in working capital included a reduction of $6.6 million and $11.5 million, respectively, for increases in accounts receivable due in part to the timing of shipments to customers. In the first nine months of 2005, deferred revenues increased by $7.6 million related to additional deferrals of revenue for implied and contractual PCS obligations, whereas in the first nine months of 2006, deferred revenues decreased by $11.3 million primarily due to reversals of implied PCS deferred revenue as a result of the license management of certain products and our determination not to provide PCS after the expiration of the contractual PCS period.

     Cash used in investing activities was $9.0 million in the first nine months of 2006 and $36.0 million in the first nine months of 2005. In the first nine months of 2006, cash used in investing activities principally consisted of $9.9 million for the purchase of property and equipment and $7.3 million related to the January 2006 acquisition of the mobile video and multimedia test business of Dilithium Networks and the June 2006 acquisition of certain technology from Bell Canada. These cash outflows from investing activities were partially offset with cash inflows of $8.3 million related to the net proceeds from marketable securities. For the nine months ended September 30, 2005, cash used in investing activities consisted of $18.1 million related to the net purchases of marketable securities, $9.2 million for the purchase of property and equipment, $4.2 million related to the July 2005 acquisition of Communication Machinery Corporation, $2.5 million related to the January 2005 purchase of the remaining assets of the NetIQ Chariot business, and $1.8 million payment related to the January 2005 payment of the remainder of the G3 Nova contingent earnout.

     Financing activities provided $4.7 million in the first nine months of 2006 and $23.7 million in the first nine months of 2005. In the first nine months of 2006, financing activities consisted of $4.4 million from the proceeds related to the exercise of stock options and stock purchases through the employee stock purchase plan, and $253,000 from the excess tax benefits from stock-based compensation pursuant to the guidance of SFAS 123R, which was adopted January 1, 2006. Financing activities consisted exclusively of proceeds from the exercise of stock options and stock purchases through the employee stock purchase plan during the first nine months of 2005.

     As of September 30, 2006, we had no material commitments for capital expenditures. We believe that our existing balances of cash and cash equivalents, investments and cash flows expected to be generated from our operations will be sufficient to satisfy our operating requirements for at least the next twelve months. Nonetheless, we may seek additional sources of capital as necessary or appropriate to fund acquisitions or to otherwise finance our growth or operations; however, there can be no assurance that such funds, if needed, will be available on favorable terms, if at all. Our access to the capital markets to raise funds, through the sale of equity or debt securities, is subject to various factors, including the timely filing of our periodic reports with the Commission, and our failure to timely file this Form 10-Q with the Commission currently limits our ability to access the capital markets using short-form registration.

SAFE HARBOR UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

     Statements that are not historical facts in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and other sections of this Quarterly Report on Form 10-Q may be deemed to be forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and are subject to the safe harbor created by that Section. Words such as “may,” “will,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “project,” “predict,” “potential” and variations of these words and similar expressions are intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks

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and uncertainties. These risks, uncertainties and other factors may cause our actual results, performances or achievements to be materially different from those expressed or implied by our forward-looking statements and include, among other things: consistency of orders from significant customers, our success in developing and producing new products and market acceptance of our products. Many of these risks and uncertainties are outside of our control and are difficult for us to forecast or mitigate. Factors that may cause our actual results to differ materially from our forward-looking statements include the risks and other factors set forth in the “Risk Factors” and other sections of the Company’s Amended 2005 Form 10-K and in our other filings with the Commission.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

     The primary objective of our investment activities is to maintain the safety of principal and preserve liquidity while maximizing yields without significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. To minimize this risk, we maintain our portfolio of cash equivalents and investments in a variety of securities, including commercial paper, government and federal agency debt securities, corporate debt securities, auction rate securities and money market funds. We do not use any derivatives or similar instruments to manage our interest rate risk. We intend and have the ability to hold these securities to maturity and, therefore, we would not expect our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates. Currently, the carrying amount of these securities approximates fair market value. However, the fair market value of these securities is subject to interest rate risk and would decline in value if market interest rates increased. If market interest rates were to increase immediately and uniformly by ten percent from the levels as of September 30, 2006, the decline in the fair market value of the portfolio would not be material to our financial position, results of operations or cash flows.

Exchange Rate Sensitivity

     The majority of our revenue and expenses are denominated in U.S. dollars. However, since we have sales and service operations outside of the United States, we do have some transactions that are denominated in foreign currencies, primarily the Japanese Yen, Romanian Lei, Indian Rupee and British Pound. We utilize foreign currency forward contracts to hedge certain accounts receivable amounts that are denominated primarily in Japanese Yen. These contracts are used to reduce our risk associated with exchange rate movements, as gains and losses on these contracts are intended to offset exchange losses and gains on underlying exposures. Changes in the fair value of these forward contracts are recorded immediately in earnings. We do not enter into foreign exchange forward contracts for speculative or trading purposes and we do not expect net gains or losses on these derivative instruments to have a material impact on our results of operations or cash flows.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

     As required by Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “Exchange Act”), we carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer (“CEO”) and our Chief Financial Officer (“CFO”), of the effectiveness, as of the end of the quarter covered by this report, of the design and operation of our “disclosure controls and procedures” as defined in Rule 13a-15(e) promulgated by the Commission under the Exchange Act. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its

29

principal executive and principal financial officers, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosures.

     Based upon this evaluation as of September 30, 2006, our CEO and CFO have concluded that, in light of the material weakness discussed below and our inability to timely file this Form 10-Q with the Commission, our disclosure controls and procedures were not effective as of September 30, 2006 to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and to ensure that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

     Notwithstanding the ineffectiveness of our disclosure controls and procedures as of September 30, 2006 and the material weakness in our internal control over financial reporting that existed as of that date as described below, management believes that (i) this Form 10-Q does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading with respect to the periods covered by this Report and (ii) the condensed consolidated financial statements, and other financial information, included in this Report fairly present in all material respects in accordance with generally accepted accounting principles (“GAAP”) our financial condition, results of operations and cash flows as of, and for, the dates and periods presented.

Restatement and Impact on Internal Control over Financial Reporting

     In connection with the restatement of certain financial statements as discussed in our Amended 2005 Form 10-K and in Note 3 of the “Notes to Condensed Consolidated Financial Statements” contained in Part I, Item 1 of this Form 10-Q, management concluded, as disclosed in Part II, Item 9A of our Amended 2005 Form 10-K, that the Company did not maintain effective internal control over financial reporting as of December 31, 2005, based on criteria established inInternal Control — Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), and that the restatement was the result of a material weakness in our internal control over financial reporting that existed as of December 31, 2005. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

     In our Amended 2005 Form 10-K, management concluded that as of December 31, 2005, we did not maintain effective controls over the completeness and accuracy of revenue reporting for implied PCS obligations. Specifically, management concluded that we did not maintain effective controls to ensure that (i) we did not provide software upgrades and support to customers after the expiration of the contractual PCS periods and (ii) the circumstances under which our sales and support personnel provided software upgrades and support beyond the contractual periods were adequately identified, communicated to, and reviewed by our finance personnel to ensure the proper recognition of revenue for implied PCS obligations in accordance with generally accepted accounting principles. Management further concluded that this control deficiency resulted in the restatement of our 2005, 2004 and 2003 annual consolidated financial statements, all of our interim condensed consolidated financial statements for 2005 and 2004 as well as the first two interim periods of 2006. Additionally, this control deficiency could result in a misstatement of revenue and deferred revenue that would result in a material misstatement of our annual and interim consolidated financial statements that would not be prevented or detected. Accordingly, as disclosed in Part II, Item 9A of our Amended 2005 Form 10-K, we determined that this control deficiency constituted a material weakness in our internal control over financial reporting as of December 31, 2005. We believe that this material weakness continued to exist as of September 30, 2006.

Changes in Internal Control over Financial Reporting

     There were no changes in our internal control over financial reporting during our quarter ended September 30, 2006, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. As such, the material weakness in our internal control over financial reporting that existed as of December 31, 2005, as described above and as disclosed in Part II, Item 9A of our Amended 2005 Form 10-K, continued to exist as of September 30, 2006.

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Inherent Limitations on Effectiveness of Controls

     Our management, including our CEO and our CFO, does not expect that our disclosure controls and procedures or our internal control over financial reporting are or will be capable of preventing or detecting all errors and all fraud. Any control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

PART II. OTHER INFORMATION

ITEM 1A. Risk Factors

     Information regarding risk factors appears in Part I, “Item 1A. Risk Factors,” in Amendment No. 2 on Form 10-K/A to our Annual Report on Form 10-K for the year ended December 31, 2005 (the “Amended 2005 Form 10-K”) and in certain of our other filings with the Securities and Exchange Commission. There have been no material changes in our risk factors previously disclosed in the Amended 2005 Form 10-K.

ITEM 5. Other Information

     Our policy governing transactions in our securities by our directors, officers and employees permits such persons to adopt stock trading plans pursuant to Rule 10b5-1 promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended. Our directors, officers and employees may from time to time establish such stock trading plans. We do not undertake any obligation to disclose, or to update or revise any disclosure regarding, any such plans and specifically do not undertake to disclose the adoption, amendment, termination or expiration of any such plans.

ITEM 6. Exhibits

10.1	Supplemental Provisions, effective April 14, 2006, to Employee Stock Purchase Plan(1)
31.1	Certification of Chief Executive Officer of Ixia pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer of Ixia pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certifications of Chief Executive Officer and Chief Financial Officer of Ixia pursuant to Rule 13a-14(b) under the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1) Incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K (File No. 000-31523) filed with the Commission on April 20, 2006

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SIGNATURES

     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.

	IXIA
Date: February 23, 2007	By:	/s/ Errol Ginsberg
		Errol Ginsberg
		President and Chief Executive Officer
Date: February 23, 2007	By:	/s/ Thomas B. Miller
		Thomas B. Miller
		Chief Financial Officer

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EXHIBIT INDEX

Exhibit No.		Description
	31.1	Certification of Chief Executive Officer of Ixia pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	31.2	Certification of Chief Financial Officer of Ixia pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
	32.1	Certifications of Chief Executive Officer and Chief Financial Officer of Ixia pursuant to Rule 13a-14(b) under the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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