UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

FOR THE QUARTER ENDED JUNE 30, 2006

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

SMITH MICRO SOFTWARE, INC.

DELAWARE		33-0029027
(STATE OR OTHER JURISDICTION OF		(I.R.S. EMPLOYER INCORPORATION OR
ORGANIZATION)		IDENTIFICATION NUMBER)
51 COLUMBIA, SUITE 200, ALISO VIEJO, CA		92656
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)		(ZIP CODE)

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (949) 362-5800

     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 þ NO o

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

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

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

YES o NO þ

     As of July 28, 2006 there were 24,038,164 shares of Common Stock outstanding.

 

 

SMITH MICRO SOFTWARE, INC.

FORM 10-Q

TABLE OF CONTENTS

PART I.FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005			3
Condensed Consolidated Statements of Operations For The Three and Six Months Ended June 30, 2006 and June 30, 2005			4
Condensed Consolidated Statement of Stockholders’ Equity For The Six Months Ended June 30, 2006			5
Condensed Consolidated Statements of Cash Flows For The Six Months Ended June 30, 2006 and June 30, 2005			6
Notes to Condensed Consolidated Financial Statements			8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			20
Item 3. Quantitative and Qualitative Disclosures About Market Risk			28
Item 4. Controls and Procedures			28
Part II. OTHER INFORMATION
Item 1. Legal Proceedings			29
Item 1A. Risk Factors			29
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			36
Item 3. Defaults Upon Senior Securities			36
Item 4. Submission of Matters To A Vote Of Security Holders			36
Item 5. Other Information			37
Item 6. Exhibits			37
Signatures			37
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

     PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SMITH MICRO SOFTWARE, INC.

(In Thousands, Except Per Share Data)

		June 30,				December 31,
		2006				2005 (A)
		(unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	31,319			$	21,215
Accounts receivable, net of allowances for doubtful accounts and other adjustments of $376 (2006) and $439 (2005)			4,200				6,786
Inventories, net			1,035				530
Prepaid expenses and other current assets			299				556
Total current assets			36,853				29,087
Equipment and improvements, net			384				241
Goodwill			15,039				9,288
Intangible assets, net			4,524				4,093
Other assets			—				7
Total assets		$	56,800			$	42,716
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable		$	2,197			$	2,383
Accrued liabilities			3,186				1,376
Total current liabilities			5,383				3,759
COMMITMENTS AND CONTINGENCIES			—				—
STOCKHOLDERS’ EQUITY:
Preferred stock, par value $0.001 per share; 5,000,000 shares authorized; none issued or outstanding			—				—
Common stock, par value $0.001 per share; 50,000,000 shares authorized; 24,038,000 and 22,147,000 shares issued and outstanding at June 30, 2006 and December 31, 2005, respectively			24				22
Additional paid-in capital			60,444				50,880
Accumulated deficit			(9,051	)			(11,945	)
Net stockholders’ equity			51,417				38,957
Total liabilities and stockholders’ equity		$	56,800			$	42,716

SMITH MICRO SOFTWARE, INC.

(In Thousands, Except Per Share Data)

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
		(Unaudited)				(Unaudited)				(Unaudited)				(Unaudited)
NET REVENUES
Products		$	12,362			$	3,179			$	22,072			$	5,038
Services			193				151				368				322
Total Net Revenues			12,555				3,330				22,440				5,360
COST OF REVENUES
Products			5,226				476				8,455				746
Services			79				69				150				144
Total Cost of Revenues			5,305				545				8,605				890
GROSS PROFIT			7,250				2,785				13,835				4,470
OPERATING EXPENSES:
Selling and marketing			2,293				369				4,166				809
Research and development			2,077				697				3,754				1,394
General and administrative			2,029				1,161				3,438				1,937
Total operating expenses			6,399				2,227				11,358				4,140
OPERATING INCOME			851				558				2,477				330
INTEREST INCOME			265				214				489				314
INCOME BEFORE INCOME TAXES			1,116				772				2,966				644
INCOME TAX EXPENSE			33				8				72				8
NET INCOME		$	1,083			$	764			$	2,894			$	636
NET INCOME PER SHARE, basic		$	0.05			$	0.04			$	0.13			$	0.03
WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING, basic			23,635				21,584				22,973				20,629
NET INCOME PER SHARE, diluted		$	0.04			$	0.03			$	0.12			$	0.03
WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING, diluted			25,598				22,713				24,740				21,901

SEE ACCOMPANYING NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

SMITH MICRO SOFTWARE, INC.

(In Thousands)

										Additional
		Common stock								paid-in				Accumulated
		Shares				Amount				capital				deficit				Total
BALANCE, December 31, 2005			22,147			$	22			$	50,880			$	(11,945	)		$	38,957
Exercise of common stock options			1,056				1				2,629				—				2,630
Acquisition of PhoTags, Inc.			385				1				4,730				—				4,731
Non cash compensation recognized on stock options			—				—				1,485				—				1,485
Non cash compensation recognized on Restricted Stock			450				—				720				—				720
Net income			—				—				—				2,894				2,894
BALANCE, June 30, 2006			24,038			$	24			$	60,444			$	(9,051	)		$	51,417

SEE ACCOMPANYING NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

SMITH MICRO SOFTWARE, INC.

(In Thousands)

		Six Months
		Ended June 30,
		2006				2005
		(Unaudited)				(Unaudited)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	2,894			$	636
Adjustments to reconcile net income to net cash provided by operating activities, net of the effect of the acquisition of PhoTags, Inc.:
Depreciation and amortization			926				64
Provision for doubtful accounts and other adjustments to accounts receivable			221				15
Provision for slow moving inventory			35				—
Non cash compensation related to stock options & restricted stock			2,204				—
Change in operating accounts, net of effect from acquisition:
Accounts receivable			2,368				(651	)
Inventories			(540	)			21
Prepaid expenses and other assets			183				(68	)
Accounts payable and accrued liabilities			1,574				339
Net cash provided by operating activities			9,865				356
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of PhoTags, Inc., net of cash received			(2,165	)			—
Capital expenditures			(228	)			(21	)
Net cash used in investing activities			(2,393	)			(21	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Cash received from issuance of common stock, net of offering costs			—				20,786
Cash received from exercise of stock options			2,632				191
Net cash provided by financing activities			2,632				20,977
NET INCREASE IN CASH AND CASH EQUIVALENTS			10,104				21,312
CASH AND CASH EQUIVALENTS, beginning of period			21,215				8,634
CASH AND CASH EQUIVALENTS, end of period		$	31,319			$	29,946

SEE ACCOMPANYING NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

SMITH MICRO SOFTWARE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)

		For the Six Months Ended
		June 30,
		2006				2005
		(Unaudited)				(Unaudited)
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash Paid for income taxes		$	66			$	2

SEE ACCOMPANYING NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

SMITH MICRO SOFTWARE, INC.

1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

     Description of Business — Smith Micro Software, Inc. and subsidiaries (the “Company”) is a diversified developer and marketer of communications and utilities software products and services. The Company’s strategic focus is to market and sell value-added wireless products targeted to the original equipment manufacturers (“OEM”) market, particularly wireless service providers and mobile phone manufacturers. The Company offers software products for Windows, Mac OSX, Unix and Linux operating systems. The Company also offers wireless communication software products and services to the enterprise market that include enhanced wireless security features.

     On April 5, 2006, the Company acquired PhoTags, Inc. (“PhoTags”), a Delaware Corporation with offices in Jerusalem, Israel (see Note 3). PhoTags is a leading developer and marketer of revolutionary photo and music management technology. The company’s pioneering product suite known as Active Images turns any JPEG file into a self-contained multimedia messaging system, allowing users to send text messages, music, sound files, documents and more — all in a single JPEG file. Among PhoTags’ product suite was Music Express, now known as QuickLink Music, an innovative music management solution which assists users enhance the media-rich capabilities of listening to music on their PCs. QuickLink Music allows users to simplify managing their music files, buy music from an online store, manage music files on a PC. PhoTags Inc.’s patented Active Images technology is designed to easily add any type of metadata or media file to a JPEG Image. Watermarks, forms, text messages, music, links to Internet sites, voice recordings, portable digital wallet information, and even videos can all be stored in a JPEG image, and accessed on any device that has the Active Image thin client application installed. This technology plays directly into Smith Micro’s strategy of broadening its wireless product offerings and provides for the first time that carriers and handset manufacturers can provide enhanced music and photo management technology that can reside directly in the handset and on a consumers PC. In addition to broadening Smith Micro’s family of mobility products, the PhoTags acquisition will help expand Smith Micro’s ability to serve OEM customers in Europe and Asia through an international sales and support office now based in Jerusalem, Israel that is now renamed Smith Micro Software, Israel.

     On July 1, 2005, the Company acquired Allume Systems (“Allume”), which was a wholly owned subsidiary of International Microcomputer Software, Inc. (see Note 4). Allume develops and publishes award-winning software solutions that empower users in the area of information access, removal, recovery, security, productivity and online distribution. Allume’s flagship product is StuffIt^® Deluxe. StuffIt Wireless, a new and advanced technology that is patent pending by Allume Systems, will compress an already compressed JPEG file by up to 30% more without loosing any of the picture quality. This technology is particularly important to mobile phone manufactures who now can store up to 30% more images and carriers who are interested in the reduction of utilized bandwidth. In addition, StuffIt Wireless has been enhanced to also compress and decompress handset resources, potentially reducing the cost to build handsets by reducing memory requirements. Other award winning products include icSpyware & Anti-Phising Suite™ which targets spyware and phishing intrusions, Internet Cleanup™ which removes spyware and detects and prevents intruders from access to private information and Spring Cleaning^® which cleans and optimizes computer operating systems.

     Basis of Presentation — The accompanying unaudited interim consolidated financial statements reflect adjustments (consisting of normal recurring adjustments) necessary to present fairly the consolidated financial position of the Company at June 30, 2006, the consolidated results of its operations for the three and six months ended June 30, 2006 and 2005 and its consolidated cash flows for the six month periods ended June 30, 2006 and 2005. Certain information and footnote disclosures normally included in the consolidated financial statements have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”), although the Company believes that the disclosures in the unaudited consolidated financial statements are adequate to ensure the information presented is not misleading. These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005. The results of operations of interim periods are not necessarily indicative of future operating results. All intercompany amounts have been eliminated in consolidation.

     Cash and Cash Equivalents — Cash and cash equivalents generally consist of cash, government securities and money market funds. These securities are all held in one financial institution and are uninsured except for minimum FDIC coverage. As of June 30, 2006 and December 31, 2005, balances totaling approximately $31.4 and $21.4 million, respectively, were uninsured. All have original maturity dates of three months or less.

     Accounts Receivable — The Company sells its products worldwide. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. The Company maintains reserves for estimated credit losses, and those losses have been within management’s estimates. Allowances for product returns are included in other adjustments to accounts receivable on the accompanying consolidated balance sheets. Product returns are estimated based on historical experience and have also been within management’s estimates.

     Inventories — Inventories consist principally of cables, CDs, boxes and manuals and are stated at the lower of cost (determined by the first-in, first-out method) or market. The Company regularly reviews its inventory quantities on hand and records a provision for excess and obsolete inventory based primarily on management’s forecast of product demand and production requirements. At June 30, 2006 our inventory balance consisted of approximately $601,000 in assembled products and $434,000 of components.

     Equipment and Improvements — Equipment and improvements are stated at cost. Depreciation is computed using the straight-line method based on the estimated useful lives of the assets, generally ranging from three to seven years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful life of the asset or the lease term.

     Long Lived Assets — The Company accounts for the impairment and disposition of long-lived assets in accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. This statement addresses financial accounting and reporting for the impairment of long-lived assets and for the disposal of long-lived assets. In accordance with SFAS No. 144, long-lived assets to be held are reviewed for events or changes in circumstances, which indicate that their carrying value may not be recoverable. The Company periodically reviews the carrying value of long-lived assets to determine whether or not an impairment to such value has occurred. The Company has determined that there was no impairment at June 30, 2006.

     Goodwill — The Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, effective January 1, 2002. As a result of the adoption, the Company is no longer required to amortize goodwill. Prior to the adoption of SFAS 142, goodwill was amortized over 7 years. In accordance with SFAS No. 142, the Company reviews the recoverability of the carrying value of goodwill at least annually or whenever events or circumstances indicate a potential impairment. The Company’s annual impairment testing date is December 31. Recoverability of goodwill is determined by comparing the fair value of the Company’s reporting units to the carrying value of the underlying net assets in the reporting units. If the fair value of a reporting unit is determined to be less than the carrying value of its net assets, goodwill is deemed impaired and an impairment loss is recognized to the extent that the carrying value of goodwill exceeds the difference between the fair value of the reporting unit and the fair value of its other assets and liabilities. The Company determined that it did not have any impairment of goodwill at December 31, 2005.

     The carrying amount of the Company’s goodwill was approximately $15,039,000 and $9,288,000 as of June 30, 2006 and December 31, 2005, respectively. The Company’s reporting units are equivalent to its operating segments. At June 30, 2006 the amount of goodwill allocated to the products segment is $14,704,000 and the amount of goodwill allocated to the services segment is $335,000. At December 31, 2005 the amount of goodwill allocated to the products segment is $8,953,000 and the amount of goodwill allocated to the services segment is $335,000.

     Other Intangible Assets — The following table sets forth the acquired intangible assets by major asset class:

		Useful				June 30, 2006												December 31, 2005
		Life								Accumulated				Net Book								Accumulated				Net Book
		(Years)				Gross				Amortization				Value				Gross				Amortization				Value
(in thousands)
Amortizing:
Purchased and Licensed Technology			3			$	2,260				(2,260	)			—			$	2,260				(2,260	)			—
Capitalized Software			4-5				3,849				(1,119	)			2,730				2,649				(534	)			2,115
Distribution Rights			5				482				(152	)			330				482				(76	)			406
Customer Lists			5				923				(184	)			739				923				(92	)			831
Trademarks			10				809				(136	)			673				809				(68	)			741
Customer Agreements			1.5				65				(13	)			52				—				—				—
Totals						$	8,388			$	(3,864	)		$	4,524			$	7,123			$	(3,030	)		$	4,093

     Aggregate amortization expense on intangible assets was approximately $449,000 and $834,000 for the three and six months ended June 30, 2006, respectively. Expected future amortization expense is as follows: $736,000 for the remainder of 2006, $1,696,000 for the year 2007, $1,121,000 for the year 2008, $522,000 for the year 2009 and $449,000 thereafter. Amortization expense related to intangibles acquired in the Allume acquisition is calculated on a discounted cash flow basis over five years for Capitalized Software, Distribution Rights and Customer Lists and ten years for Trademarks. Amortization is calculated on a straight line basis over five years for Customer Lists. Amortization expense related to intangibles acquired in the PhoTags acquisition is calculated on a discounted cash flow basis over four years for Capitalized Software and 18 months for Customer Agreements.

     Revenue Recognition — Software revenue is recognized in accordance with the Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended, when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed and determinable, and collectibility is probable. The Company recognizes revenues from sales of its software to Retail and OEM customers or end users as completed products are shipped and title passes, or from royalties generated as authorized customers duplicate the Company’s software, if the other requirements of SOP 97-2 are met. If the requirements of SOP 97-2 are not met at the date of shipment, revenue is not recognized until these elements are known or resolved. Returns from Retail and OEM customers are limited to defective goods or goods shipped in error. Historically, OEM customer returns have not been significant. The Company reviews available retail channel information and makes a determination of a return provision for sales made to distributors and retailers based on current channel inventory levels and historical return patterns. Certain sales to distributors or retailers are made on a consignment basis. Revenue for consignment sales are not recognized until sell through to the final customer is established.

     Product sales directly to end-users are recognized upon delivery. End users have a thirty day right of return, but such returns are reasonably estimable and have historically been immaterial. The Company also provides technical support to its customers. Such costs have historically been insignificant.

     Service revenues include sales of consulting services, web site hosting and fulfillment. Service revenues are recognized as services are provided or as milestones are delivered and accepted by our customers.

     Sales Incentives — Pursuant to the consensus of EITF 01-09, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Product), effective January 1, 2002, the cost of sales incentives the Company offers without charge to customers that can be used in, or that are exercisable by a customer as a result of, a single exchange transaction is accounted

for as a reduction of revenue. We track incentives by program and use historical redemption rates to estimate the cost of customer incentives. These costs have historically been less than 10% of our revenues.

     Software Development Costs — Development costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. The Company considers technological feasibility to be established when all planning, designing, coding and testing has been completed according to design specifications. After technological feasibility is established, any additional costs are capitalized. Through June 30, 2006, software has been substantially completed concurrently with the establishment of technological feasibility; and, accordingly, no costs have been capitalized to date.

     Income Taxes — The Company accounts for income taxes under SFAS No. 109, Accounting for Income Taxes. This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been recognized in the Company’s consolidated financial statements or tax returns. The measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and the tax bases of the Company’s assets and liabilities result in a deferred tax asset, SFAS No. 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized. The Company currently has a full valuation allowance on its deferred tax assets. Based on the Company’s assessment of all available evidence, the Company concluded that it is not more likely than not that its deferred tax assets will be realized. This conclusion is based primarily on our history of net operating losses as compared to only a recent trend of profitable operations, the potential for future stock option deductions to significantly reduce taxable income, annual net operating loss limitations under Section 382 of the Code and the need to generate significant amounts of taxable income in future periods on a consistent and prolonged basis in order to utilize the deferred tax assets. The Company will continue to monitor all available evidence and reassess the potential realization of our deferred tax assets. If the Company continues to meet our financial projections and improve our results of operations, or if circumstances otherwise change, it is reasonably possible that we may release all or a portion of our valuation allowance in the future. Any such release would result in recording a tax benefit that would increase net income in the period the valuation is released.

     Net Income per Share — Pursuant to SFAS No. 128, Earnings per Share, the Company is required to provide dual presentation of “basic” and “diluted” earnings per share (EPS). Basic EPS amounts are based upon the weighted average number of common shares outstanding. Diluted EPS amounts are based upon the weighted average number of common and potential common shares outstanding. Potential common shares for diluted EPS include stock options, using the treasury stock method, of 1,963,000 and 1,129,000 for the three months ended June 30, 2006 and June 30, 2005, respectively. Potential common shares for diluted EPS include stock options, using the treasury stock method, of 1,767,000 and 1,272,000 for the six months ended June 30, 2006 and June 30, 2005, respectively.

     Fulfillment Services — The Company currently holds consigned inventory for a customer, which is used to fulfill internet orders. As the Company does not hold title to the inventory, it is not recorded in the accompanying unaudited condensed consolidated balance sheet. In addition, the Company receives cash for internet fulfillment orders which is paid out to the fulfillment customer on a monthly basis. Such cash and the related payable are recorded on a net basis as the amounts are held for the benefit of this fulfillment customer. Revenue is recognized for fulfillment services as services are performed.

     Segment Information — The Company currently operates in two business segments: products and services. In addition, revenues are broken down into three units, Wireless and OEM Sales, and Consumer Sales and Enterprise Sales. The Company’s Enterprise Sales unit includes Enterprise software products as well as consulting, fulfillment and hosting revenue.

     The Company does not separately allocate operating expenses to these segments, nor does it allocate specific assets to these segments. Therefore, segment information reported includes only revenues and cost of revenues.

     The following table shows the net revenues and cost of revenues generated by each segment:

		Three Months Ended June 30,																Six Months Ended June 30,
		2006								2005								2006								2005
		(in thousands)																(in thousands)
		Products				Services				Products				Services				Products				Services				Products				Services
Wireless & OEM Revenues		$	10,115			$	—			$	2,963			$	—			$	17,237			$	—			$	4,623			$	—
Consumer Revenues			2,169				—				185				—				4,638				—				366				—
Enterprise Revenues			78				193				31				151				197				368				49				322
Total Revenues			12,362				193				3,179				151				22,072				368				5,038				322
Cost of Revenues			5,226				79				476				69				8,455				150				746				144
Gross Profit		$	7,136			$	114			$	2,703			$	82			$	13,617			$	218			$	4,292			$	178

          Sales to individual customers and their affiliates which amounted to more than 10% of the Company’s net revenues for the three months ended June 30, 2006 and 2005, respectively, included one OEM customer at 74.4% in 2006 and one OEM customer at 81.7% in 2005. Sales to individual customers and their affiliates which amounted to more than 10% of the Company’s net revenues for the six months ended June 30, 2006 and 2005, respectively, included one OEM customer at 72.5% in 2006 and one OEM customer at 71.6% in 2005.

          Use of Estimates — The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could materially differ from those estimates.

          Comprehensive Income — Comprehensive income, as defined, includes all changes in equity (net assets) during a period from non-owner sources. For each of the periods ended June 30, 2006 and 2005, there was no difference between net income, as reported, and comprehensive income.

2. EQUITY TRANSACTIONS

          On February 18, 2005, the Company entered into a Securities Purchase Agreement with certain institutional investors related to the private placement of 3,500,000 shares of our common stock, par value $0.001 per share. The transaction closed on February 18, 2005 and the Company realized gross proceeds of $22.4 million from the financing before deducting commissions and other expenses. Offering costs related to the transaction totaled $1,613,000, comprised of $1,344,000 in commissions and $269,000 cash payments for legal and investment services, resulting in net proceeds of $20,786,000. The Company agreed to register for resale the shares of Common Stock issued in the private placement. Such registration statement became effective on June 17, 2005. The agreement provides for penalties of one percent (1%) of the purchase price per month should effectiveness of the registration not be maintained.

3. ACQUISITION OF PHOTAGS INC.

          On April 3, 2006, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) by and among the Company, Tag Acquisition Corporation, a Delaware corporation and a wholly owned subsidiary of the Company (“Merger Sub”), Tag Acquisition Corporation II, a Delaware corporation and wholly owned subsidiary of the Company (“Merger Sub II”), PhoTags, Inc., a Delaware corporation (“PhoTags”), Harry Fox, as Stockholders’ Agent, and certain stockholders of PhoTags, that provides for, among other things, the merger of Merger Sub with and into PhoTags and, immediately upon the completion thereof, the merger of PhoTags with and into Merger Sub II pursuant to which PhoTags became a wholly owned subsidiary of the Company (the “Merger”). The transaction closed on April 5, 2006.

          In connection with the Merger, the Company acquired the underlying technology of PhoTags, Inc. which includes patented JPEG enhancements. As a result, the Company assumed $2,000,000 in liabilities of PhoTags, which were paid at closing, and issued 384,897 shares of the Company’s common stock with an aggregate fair market value of $4,730,384 (based on a closing share price on the closing date, April 5, 2006, of $12.29) as consideration for the purchase of all of the outstanding shares of PhoTags. In addition, the Company agreed to pay an earn-out payment of up to an additional $3,500,000 in either cash or the Company’s common stock, at the Company’s sole election, if the PhoTags business line achieves certain milestones over a 15-month period beginning April 1, 2006. As of June 30, 2006, approximately $300,000 in Wireless & OEM revenues have been attributed to the acquisition. The Company estimates that $241,000 in direct costs (legal and professional services) were incurred to close the transaction.

          As part of the transaction, CDI, a company organized under the laws of the State of Israel and a related party of PhoTags (“CDI”), agreed to grant the Company an option to acquire CDI for a period of ten (10) years following the effective time of the Merger at a purchase price of $3,000.

          The Merger is intended to constitute a reorganization under Section 368 of the Internal Revenue Code of 1986, as amended, and is subject to the requisite approval of PhoTags’ stockholders and receipt of certain third-party consents to assignments of PhoTags’ customer contracts.

          As part of the transaction, the Company filed a registration statement with the Securities and Exchange Commission as soon as reasonably practicable but no later than ninety (90) days after date of the Merger Agreement covering the resale of the shares of the Company’s common stock issued to the stockholders of PhoTags.

          A copy of the Merger Agreement has been filed under Form 8-K with the Securities and Exchange Commission and with this Report on Form 10-Q.

          The results of operations of the business acquired have been included in the Company’s consolidated financial statements from the date of acquisition. Amortization related to the acquisition was calculated based on an independent valuation for certain identifiable intangibles acquired.

          The total purchase price is summarized as follows (in thousands):

Cash consideration		$	2,000
Common stock			4,730
Acquisition related costs			241
Total purchase price		$	6,971

          The Company’s preliminary allocation of the purchase price is summarized as follows (in thousands):

Assets:
Cash		$	2
Accounts Receivable, net			3
Intangible Assets			1,265
Goodwill			5,751
Total Assets			7,021
Liabilities:
Accrued Liabilities			50
Total Liabilities			50
Total purchase price		$	6,971

          As the cost of the acquisition did not exceed 20% of the Company’s net assets at the date of the transaction, proforma information is not required.

4. ACQUISITION OF ALLUME INC.

          On July 1, 2005, the Company acquired 100% of the issued and outstanding capital stock of Allume, Inc. from International Microcomputer Software, Inc. (IMSI) for $10.6 million in cash and 397,547 restricted shares of its common stock. Allume, Inc. is a leading developer of compression software solutions for JPEG, MPEG and MP3 platforms. A portion of the purchase price, including $1,250,000 cash and shares of common stock having a market value of $750,000, was deposited in an indemnity escrow to secure certain representations and warranties included in the Stock Purchase Agreement. The aggregate purchase price was approximately $12.8 million, which includes $10.6 million cash paid, the 397,547 shares issued which have been valued using the average closing market price of the Company’s common stock over the two-day period before and after the sale was announced and $316,000 of direct acquisition costs. The direct acquisition costs incurred to date include $116,000 for legal and professional services, as well as a transaction fee of $200,000.

          The results of operations of the business acquired have been included in the Company’s consolidated financial statements from the date of acquisition. Depreciation and amortization related to the acquisition were calculated based on the estimated fair market values and estimated lives for property and equipment and an independent valuation for certain identifiable intangibles acquired.

          The total purchase price is summarized as follows (in thousands):

Cash consideration		$	10,626
Common stock			1,858
Acquisition related costs			316
Total purchase price		$	12,800

          The purchase price is contingent upon a final calculation of Allume’s net assets. If the final net asset calculation is less than the minimum amount specified in the purchase agreement, the purchase price will be adjusted downward accordingly. Any such adjustment will be recorded as an adjustment to the cost of Allume Systems, Inc. and reflected in the final purchase price allocation.

          The Company’s preliminary allocation of the purchase price is summarized as follows (in thousands):

Assets:
Cash		$	46
Accounts Receivable, net			822
Inventories, net			237
Property & Equipment			67
Other Assets			244
Intangible Assets			4,863
Goodwill			7,573
Total Assets			13,852
Liabilities:
Accounts Payable			659
Accrued Liabilities			393
Total Liabilities			1,052
Total purchase price		$	12,800

          Unaudited pro forma consolidated results of operations for the three and six months ended June 30, 2005 as if the acquisition had occurred January 1, 2005 are as follows (in thousands, except per share data):

		Three Months Ended								Six Months Ended
		June 30, 2005								June 30, 2005
		Historical				Proforma				Historical				Proforma
Net Revenues		$	3,330			$	5,178			$	5,360			$	9,749
Net Income (Loss)		$	764			$	(75	)		$	636			$	2
Net Income (Loss) per share, basic		$	0.04			$	—			$	0.03			$	—
Net Income (Loss) per share, diluted		$	0.03			$	—			$	0.03			$	—
Weighted average shares outstanding, basic			21,584				21,982				20,629				21,027
Weighted average shares outstanding, diluted			22,713				21,982				21,901				22,299

          Pro forma adjustments have been applied to reflect the addition of amortization related to the intangible assets and the fixed assets acquired and reduction in interest income as if the acquisition had occurred at the beginning of such period presented. The pro forma adjustment for amortization related to intangible assets acquired was $385,000 and $770,000 for the three and six month pro forma periods ended June 30, 2005.

5. STOCK BASED COMPENSATION.

          In July 2005, the Shareholders approved the 2005 Stock Option/Stock Issuance Plan (“2005 Plan”), which replaced by the 1995 Stock Incentive Plan (“1995 Plan”). All outstanding options under the 1995 Plan will remain outstanding, but no further grants will be made under that Plan. The 2005 Plan provides for the issuance of non-qualified or incentive stock options to employees, non-employee members of the board and consultants. The exercise price per share is not to be less than the fair market value per share of the Company’s common stock on the date of grant. The Board of Directors has the discretion to determine the vesting schedule. Options may be either immediately exercisable or in installments, but generally vest over a four-year period from the date of grant. In the event the holder ceases to be employed by the Company, all unvested options terminate and all vested installment options may be exercised within an installment period following termination. In general, options expire ten years from the date of grant.

          Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment (SFAS 123(R)), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including stock options based on their fair values. SFAS 123(R) supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), which the Company previously followed in accounting for stock-based awards. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB 107) to provide guidance on SFAS 123(R). The Company has applied SAB 107 in its adoption of SFAS 123(R).

          The Company adopted SFAS 123(R) using the modified prospective transition method as of and for the three and six months ended June 30, 2006. In accordance with the modified prospective transition method, the Company’s financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recognized is based on the value of the portion of share-based payment awards that is ultimately expected to vest. Share-based compensation expense recognized in the Company’s Condensed Consolidated Statement of Operations during the three and six months ended June 30, 2006 includes compensation expense for share-based payment awards granted prior to, but not yet vested as of, December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123.

          In conjunction with the adoption of SFAS 123(R), the Company elected to attribute the value of share-based compensation to expense using the straight-line method, which was previously used for its pro forma information required under SFAS 123. Share-based compensation expense related to stock options and restricted stock grants was $1.7 million and $2.4 million for the three and six months ended June 30, 2006, and was recorded in the financial statements as follows (in thousands):

		Three Months				Six Months
Cost of Goods Sold		$	9			$	15
Selling and Marketing			673				904
Research and Development			401				652
General and Administrative			618				842
Total Stock Compensation Expense		$	1,701			$	2,413

          In the six months ended June 30, 2006 a total of 50,000 shares of Restricted Stock, with a total value of $440,000, were granted to the Board of Directors. This cost will be amortized over 12 months. In addition, 400,000 shares of Restricted Stock, with a total value $3.6 million, were granted to key officers and employees of the Company. This cost will be amortized over 24 months.

          During the three and six months ended June 30, 2005, there was no share-based compensation expense related to stock options recognized under the intrinsic value method in accordance with APB 25. In addition, there was no compensation expense for restricted stock grants as the Company had not issued any restricted stock. Had compensation cost for the Company’s stock options been recognized based upon the estimated fair value on the grant date under the fair value methodology prescribed by SFAS No. 123, as amended by SFAS No. 148, the Company’s net income and income per share would have been as follows (in thousands):

		Three Months Ended				Six Months
		June 30, 2005				June 30, 2005
Net income, as reported		$	764			$	636
Less: total stock based compensation			(162	)			(294	)
Net income, as adjusted		$	602			$	342
Income per common share
Basic, as reported		$	0.04			$	0.03
Basic, pro forma		$	0.03			$	0.02
Fully Diluted, as reported		$	0.03			$	0.03
Fully Diluted, pro forma		$	0.03			$	0.02

          In the three months ended June 30, 2006 and 2005, respectively, the Company’s calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 48 months following the grant date; stock volatility, 81.7% and 109%; risk-free interest rates of 4.95% and 3.79%; and no dividends during the expected term. As stock-based compensation expense recognized in the consolidated statement of operations pursuant to SFAS No. 123(R) is based on awards ultimately expected to vest, expense for grants beginning upon adoption of SFAS No. 123(R) on January 1, 2006 will be reduced for estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Forfeitures are estimated based on historical experience.

A summary of the Company’s stock option activity is as follows:

						Weighted Ave.				Aggregate
		# of Shares				Exercise Price				Intrinsic Value
Outstanding as of December 31, 2005			3,856,000			$	3.57
Granted			241,000			$	11.45
Exercised			(1,057,000	)		$	2.49
Cancelled			(117,000	)		$	5.00
Outstanding as of June 30, 2006			2,923,000			$	4.56			$	33,508,000
Exercisable as of June 30, 2006			474,000			$	2.81			$	6,259,000

Additional information regarding options outstanding as of June 30, 2006 is as follows :

										Options outstanding								Options exercisable
										Weighted average				Weighted								Weighted
		Range of								remaining				average								average
		exercise				Number				contractual				exercise				Number				exercise
		prices				outstanding				life (years)				price				exercisable				price
		$	0.24 — $0.50				168,000			6.6				$	0.25				95,000			$	0.25
		$	0.51 — $1.00				13,000			8.0				$	0.88				13,000			$	0.90
		$	1.01 — $2.00				612,000			7.9				$	1.89				159,000			$	1.88
		$	2.01 — $4.00				45,000			7.9				$	3.56				42,000			$	7.07
		$	4.01 — $5.00				1,782,000			9.1				$	4.95				144,000			$	2.06
		$	5.01 — $14.00				303,000			9.7				$	10.38				21,000			$	7.36
							2,923,000			8.7				$	4.56				474,000			$	2.81

          During the six months ended June 30, 2006 approximately 1,057,000 options have been exercised with an intrinsic value of $14.3 million, resulting in cash proceeds to the Company of $2.6 million. The weighted-average grant-date fair value of options granted during the six months ended June 30, 2006 was $7.22. At June 30, 2006 there was $5.7 million of total unrecognized compensation costs related to non-vested stock options granted under the Plan, which will be recognized over a period not to exceed four years. At June 30, 2006, 2,172,000 shares were available for future grants under the Stock Issuance / Stock Option Plan.

6. NEW ACCOUNTING PRONOUNCEMENTS

          In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, which amends SFAS No. 133, Accounting for Derivatives Instruments and Hedging Activities and SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. SFAS No. 155 amends SFAS No. 133 to narrow the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principle cash flows. SFAS No. 155 also amends SFAS No. 140 to allow qualifying special-purpose entities to hold a passive derivative financial instrument pertaining to beneficial interests that itself is a derivative instrument. The Company is currently evaluating the impact this new Standard but believes that it will not have a material impact on the Company’s financial position, results of operations, or cash flows.

          In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets (SFAS No. 156), which provides an approach to simplify efforts to obtain hedge-like (offset) accounting. This Statement amends FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities. The Statement (1) requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in certain situations; (2) requires that a separately recognized servicing asset or servicing liability be initially measured at fair value, if practicable; (3) permits an entity to choose either the amortization method or the fair value method for subsequent measurement for each class of separately recognized servicing assets or servicing liabilities; (4) permits at initial adoption a one-time reclassification of available-for-sale securities to trading securities by an entity with recognized servicing rights, provided the securities reclassified offset the entity’s exposure to changes in the fair value of the servicing assets or liabilities; and (5) requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the balance sheet and additional disclosures for all separately recognized servicing assets and servicing liabilities. SFAS No. 156 is effective for all separately recognized servicing assets and liabilities as of the beginning of an entity’s fiscal year that begins after September 15, 2006, with earlier adoption permitted in certain circumstances. The Statement also describes the manner in which it should be initially applied. The Company does not believe that SFAS No. 156 will have a material impact on its financial position, results of operations or cash flows.

          In July 2006, the FASB released FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting and reporting for uncertainties in income tax law. This interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. This statement is effective for fiscal years beginning after December 15, 2006. The Company is currently in the process of evaluating the expected effect of FIN 48 on its results of operations and financial position.

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

          This report contains forward-looking statements regarding Smith Micro which include, but are not limited to, statements concerning projected revenues, expenses, gross profit and income, the competitive factors affecting our business, market acceptance of products, customer concentration, the success and timing of new product introductions, the protection of our intellectual property, and the need for additional capital. These forward-looking statements are based on our current expectations, estimates and projections about our industry, management’s beliefs, and certain assumptions made by us. Words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “potential,” “believes,” “seeks,” “estimates,” “should,” “may,” “will” and variations of these words or similar expressions are intended to identify forward-looking statements. Forward-looking statements also include the assumptions underlying or relating to any of the foregoing statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors. Such factors include, but are not limited to the following:

	•		our ability to predict consumer needs, introduce new products, gain broad market acceptance for such products and ramp up manufacturing in a timely manner;
	•		the intensity of the competition and our ability to successfully compete;
	•		the pace at which the market for new products develop;
	•		the response of competitors, many of whom are bigger and better financed than us;
	•		our ability to successfully execute our business plan and control costs and expenses;
	•		our ability to protect our intellectual property and our ability to not infringe on the rights of others;
	•		our ability to integrate Allume and PhoTags into our business model;
	•		our depressed market capitalization; and
	•		those additional factors which are listed under the section “Risk Factors” beginning on page 23.

All forward looking statements included in this document are based on information available to us on the date hereof. We do not undertake any obligation to revise or update publicly any forward-looking statements for any reason.

OVERVIEW

          Our business model is based primarily upon developing and marketing innovative software solutions for the wireless industry. Our leading-edge mobility and music management products simplify communications access over Wireless Wide Area Networks (WWANs) and Wireless Local Area Networks (WLANs); our mobile media manager manages content from PC to mobile device and back; and our compression technologies are well on the way to being established as industry standards.

          Today, Smith Micro Software develops productivity and entertainment software solutions for an expanding universe of customers. Our leading QuickLink^® Mobile brands have long been products of choice for wireless carriers and device manufacturers around the world.

          These wireless carriers and device manufacturers (OEMs) generally incorporate our products into their brands selling direct to individual consumers and in multiples to their enterprise customers. Our products are utilized in many major wireless network installations throughout the world to facilitate data communications via PC Cards, embedded network devices and mobile phones.

          We began adding value to QuickLink Mobile with new features and security protocol enhancements for secure enterprise level connectivity compliance, thus allowing enterprise users to move between cellular networks and WLAN coverage securely. We

20

anticipate that this market will grow over the next several years as enterprise customers provide wireless connectivity for their workforce.

          In addition, late in 2005 Smith Micro began shipping its first music management software to help manage the transfer of music files to a mobile device. Our launch of QuickLink Music is expected to have a positive impact as we gain market-share within the wireless carrier space. As with all our mobility solutions our product strategies revolve around driving wireless data usage on our customer’s wireless networks.

          Our business is primarily dependent upon the demand for wireless communications and connectivity software. During the last three years, demand for these types of products has fluctuated dramatically, and there has been a significant increase in price competition within our industry.

          We continue to invest in research and the development of wireless software products, and we believe we have one of the industry’s leading wireless product lines in terms of performance and innovative features. Our unique “out-of-the-box” design focusing on ease-of-use further differentiates our products and help to reduce support costs for our customers.

          During 2006, we have maintained a sharp focus on our operating cost structure while ensuring that we maintain our operating flexibility to support future growth in the industry. We measure success by monitoring our net sales and gross margin dollars and operating cash flow. We believe that there continues to be excellent growth opportunities within the wireless software marketplace and we continue to focus on positioning Smith Micro to benefit from these opportunities.

RESULTS OF OPERATIONS

          The following table sets forth, for the periods indicated, certain statement of operations data expressed as a percentage of total revenue.

		Three Months Ended								Six Months Ended
		June 30,								June 30,
		2006				2005				2006				2005
Net Revenues:
Products			98.5	%			95.5	%			98.4	%			94.0	%
Services			1.5	%			4.5	%			1.6	%			6.0	%
Total net revenues			100.0	%			100.0	%			100.0	%			100.0	%
Cost of revenues:
Products			41.6	%			14.3	%			37.7	%			13.9	%
Services			0.6	%			2.1	%			0.7	%			2.7	%
Total cost of revenues			42.2	%			16.4	%			38.4	%			16.6	%
Gross profit			57.8	%			83.6	%			61.6	%			83.4	%
Operating expenses:
Selling and marketing			18.3	%			11.1	%			18.6	%			15.1	%
Research and development			16.5	%			20.9	%			16.7	%			26.0	%
General and administrative			16.2	%			34.9	%			15.3	%			36.1	%
Total operating expenses			51.0	%			66.9	%			50.6	%			77.2	%
Operating income			6.8	%			16.7	%			11.0	%			6.2	%
Interest income			2.1	%			6.4	%			2.2	%			5.9	%
Income before income taxes			8.9	%			23.1	%			13.2	%			12.1	%
Income tax expense			0.3	%			0.2	%			0.3	%			0.2	%
Net income			8.6	%			22.9	%			12.9	%			11.9	%

Three and Six Months Ended June 30, 2006 and 2005

Revenues

          Total net revenues were $12.6 million and $3.3 million for the three months ended June 30, 2006 and 2005, respectively, representing an increase of $9.2 million, or 277.0% from 2005 to 2006. Sales to individual customers and their affiliates which amounted to more than 10% of the Company’s net revenues for the three months ended June 30, 2006 and 2005, consisted of Verizon at 74.4% and 81.7% respectively. If our sales to this customer are reduced, it could have a material adverse effect on our results of operations. The current quarter results include approximately $2.1 million of net revenue attributable to the Allume acquisition.

          Total net revenues were $22.4 million and $5.4 million for the six months ended June 30, 2006 and 2005, respectively, representing an increase of $17 million, or 318.7% from 2005 to 2006. Sales to individual customers and their affiliates which amounted to more than 10% of the Company’s net revenues for the six months ended June 30, 2006 and 2005, consisted of Verizon at 72.5% and 71.6% respectively. The 2006 period includes approximately $4.5 million of net revenues attributable to the Allume acquisition, which was completed in the third quarter of 2005.

          We currently operate in two business segments: products and services. In addition, revenues are broken down into three business units, Wireless and OEM, Consumer and Enterprise. Our Enterprise unit sales include software products as well as consulting, fulfillment and hosting.

          The following table shows the net revenues and cost of revenues generated by each segment (in thousands):

		Three Months Ended June 30,																Six Months Ended June 30,
		2006								2005								2006								2005
		Products				Services				Products				Services				Products				Services				Products				Services
Wireless & OEM		$	10,115			$	—			$	2,963			$	—			$	17,237			$	—			$	4,623			$	—
Consumer			2,169				—				185				—				4,638				—				366.00				—
Enterprise			78				193				31				151				197				368				49				322
Total Net Revenues			12,362				193				3,179				151				22,072				368				5,038				322
Cost of Revenues			5,226				79				476				69				8,455				150				746				144
Gross Profit		$	7,136			$	114			$	2,703			$	82			$	13,617			$	218			$	4,292			$	178

          Products. Net product revenues were $12.4 million and $3.2 million in the three months ended June 30, 2006 and 2005, respectively, representing an increase of $9.2 million, or 288.9%, from 2005 to 2006. Wireless and OEM sales increased $7.2 million, or 241.4%, as a result of the continued success of the EVDO rollout by our carrier customers and the success of our Music Essentials Kit product, which was launched in the fourth quarter of 2005. Consumer sales primarily represent the sales of Allume products to distributors, retail customers and individuals. Allume was acquired on July 1, 2005 (see Note 4 of Notes to Unaudited Condensed Consolidated Financial Statements). Enterprise sales increased $47,000 or 151.6% as a result of the addition of Allume’s site license and enterprise sales of its Stuffit product line. Product revenues accounted for 98.5% of total revenues in the three months ended June 30, 2006 compared with 95.5% of total revenues in the comparable period of 2005.

          Net product revenues were $22.1 million and $5.0 million in the six months ended June 30, 2006 and 2005, respectively, representing an increase of $17.1 million, or 338.1%, from 2005 to 2006. Wireless and OEM sales increased $12.6 million, or 272.9%, as a result of the continued success of the EVDO rollout by our carrier customers and the success of our Music Essentials Kit product, which was launched in the fourth quarter of 2005. Consumer sales primarily represent the sales of Allume products to distributors, retail customers and individuals. Allume was acquired on July 1, 2005 (see Note 4 of Notes to Unaudited Condensed Consolidated Financial Statements). Enterprise sales increased $148,000 or 302.0% as a result of the addition of Allume’s site license and enterprise sales of its Stuffit product line. Product revenues accounted for 98.4% of total revenues in the six months ended June 30, 2006 compared with 94.0% of total revenues in the comparable period of 2005.

          Services. Service revenues were $193,000 and $151,000 in the three months ended June 30, 2006 and 2005, respectively, with an increase of $42,000 or 27.8%, from 2005 to 2006. Service revenues accounted for 1.5% of total revenues in the three months ended June 30, 2006 compared with 4.5% of total revenues in the comparable period of 2005.

          Service revenues were $368,000 and $322,000 in the six months ended June 30, 2006 and 2005, respectively, with an increase of $46,000 or 14.3%, from 2005 to 2006. Service revenues accounted for 1.6% of total revenues in the six months ended June 30, 2006 compared with 6.0% of total revenues in the comparable period of 2005.

Cost of Revenues and Gross Margin

          Cost of Product Revenues. Cost of product revenues were $5.2 million and $476,000 in the three months ended June 30, 2006 and 2005, respectively, representing an increase of $4.8 million, or 997.9%, from 2005 to 2006. Cost of product revenues as a percentage of product revenues was 42.3% and 15.0% for 2006 and 2005, respectively. Product gross margin as a percentage of product revenues was 57.7% as compared to 85.0% for the year earlier period. Cost of product revenues for the 2006 quarter includes $318,000 of amortization of intangibles associated with the acquisitions of Allume and PhoTags and $9,000 of stock based compensation expense which is not included in 2005 expenses. Factoring out such amortization of intangibles and compensation expense, product gross margin for the three months ending June 30, 2006 was 60.4%. The 24.6% pro-forma decrease from the year earlier period is attributed to product mix, in particular the significant success of the lower margin Music Essentials Kits in 2006.

          Cost of product revenues were $8.5 million and $746,000 in the six months ended June 30, 2006 and 2005, respectively, representing an increase of $7.7 million, or 1033.4%, from 2005 to 2006. Cost of product revenues as a percentage of product revenues was 38.3% and 14.8% for 2006 and 2005, respectively. Product gross margin as a percentage of product revenue was 61.7% as compared to 85.2% for the year earlier period. Cost of product revenues for the 2006 period includes $585,000 of amortization of intangibles associated with the acquisitions of Allume and PhoTags and $15,000 of stock based compensation expense which is not included in 2005 expenses. Factoring out such amortization of intangibles and compensation expense, product gross margin for the six month period ending June 30, 2006 was 64.4%. The 20.8% pro-forma decrease from the year earlier period is attributed to product mix and as noted above, significant sales of the lower margin Music Essentials Kits in 2006.

          Cost of Service Revenues. Cost of service revenues were $79,000 and $69,000 in the three months ended June 30, 2006 and 2005, respectively, representing an increase of $10,000 or 14.5%, from 2005 to 2006. Cost of service revenues as a percentage of service revenues was 40.9% and 45.7% for 2006 and 2005, respectively. Cost of service revenues includes the cost of our consulting personnel and the cost of hiring outside contractors to support our staff of consultants and vary by contract.

          Cost of service revenues were $150,000 and $144,000 in the six months ended June 30, 2006 and 2005, respectively, representing an increase of $6,000 or 4.2%, from 2005 to 2006. Cost of service revenue as a percentage of service revenues was 40.7% and 44.7% for 2006 and 2005, respectively. Cost of service revenues includes the cost of our consulting personnel and the cost of hiring outside contractors to support our staff of consultants and vary by contract.

Operating Expenses

          The following table presents a breakdown of our operating expenses by functional category and as a percentage of total net revenues (in thousands):

		Three Months Ended June 30,																Six Months Ended June 30,
		2006								2005								2006								2005
Operating expenses:
Selling and marketing		$	2,293				18.3	%		$	369				11.1	%		$	4,166				18.6	%		$	809				15.1	%
Research and development			2,077				16.5	%			697				20.9	%			3,754				16.7	%			1,394				26.0	%
General and administrative			2,029				16.2	%			1,161				34.9	%			3,438				15.3	%			1,937				36.1	%
Total operating expenses		$	6,399				51.0	%		$	2,227				66.9	%		$	11,358				50.6	%		$	4,140				77.2	%

          Selling and Marketing. Selling and marketing expenses were $2.3 million and $369,000 in the three months ended June 30, 2006 and 2005, respectively, representing an increase of $1.9 million, or 521.4%, from 2005 to 2006. Our selling and marketing expenses consist primarily of personnel costs, advertising costs, sales commissions and trade show expenses. These expenses vary significantly from quarter to quarter based on the timing of trade shows and product introductions. Selling and marketing expenses for the current period include $131,000 of amortization of intangibles associated with acquisitions and $673,000 of stock based compensation expense which is not included in 2005 expenses. Factoring out such amortization of intangibles and compensation expense, selling and marketing expenses increased $1.1 million, or 303.5% from the prior year quarter. While most of the increases in selling and marketing expenses were due to the Allume acquisition, we also had a slight increase in headcount and increases in costs related to trade shows and to product collateral concept and design. As a percentage of revenues, selling and marketing expenses increased to 18.3% for the three months ended June 30, 2006 from 11.2% in the six months ended June 30, 2005, as a result of the increase in absolute dollars spent.

          Selling and marketing expenses were $4.2 million and $809,000 in the six months ended June 30, 2006 and 2005, respectively, representing an increase of $3.4 million, or 415.0%, from 2005 to 2006. Selling and marketing expenses for the current period include $249,000 of amortization of intangibles associated with acquisitions and $904,000 of stock based compensation expense which is not included in 2005 expenses. Factoring out such amortization of intangibles and compensation expense, selling and marketing expenses increased $2.2 million, or 272.4% from the prior year quarter. While most of the increases in selling and marketing expenses were due to the Allume acquisition, we also had a slight increase in headcount and increases in costs related to trade shows and to product collateral concept and design. As a percentage of revenues, selling and marketing expenses increased to 18.6% for the six months ended June 30, 2006 from 15.1% in the six months ended June 30, 2005 as a result of the increase in absolute dollars spent.

          Research and Development. Research and development expenses were $2.1 million and $697,000 in the three months ended June 30, 2006 and 2005, respectively, representing an increase of $1.4 million, or 198.0%, from 2005 to 2006. Our research and development expenses consist primarily of personnel and equipment costs required to conduct our software development efforts. We remain focused on the development and expansion of our technology, particularly our wireless and compression software technologies. Research and development expenses for the current period include $401,000 of stock based compensation expense which is not included in 2005 expenses. Factoring out such compensation expense, research and development expenses increased $979,000 million, or 140.6% from the prior year quarter. The increase in our research and development expenses was primarily due to the addition of the Allume operations, increases to headcount and a refocus of our consulting services to internal product development. Despite the increase in absolute dollars, as a percentage of revenues, research and development expenses decreased to 16.5% for the three months ended June 30, 2006 from 20.9% in the three months ended June 30, 2005, as a result of the increase in sales.

          Research and development expenses were $3.8 million and $1.4 million in the six months ended June 30, 2006 and 2005, respectively, representing an increase of $2.4 million, or 169.3%, from 2005 to 2006. Research and development expenses for the current period include $652,000 of stock based compensation expense which is not included in 2005 expenses. Factoring out such compensation expense, research and development expenses increased $1.7 million, or 122.5% from the prior year quarter. The increase in our research and development expenses was primarily due to the addition of the Allume operations, increases to headcount and a refocus of our consulting services to internal product development. Despite the increase in absolute dollars, as a percentage of revenues, research and development expenses decreased to 16.7% for the six months ended June 30, 2006 from 26.0% in the six months ended June 30, 2005, as a result of the increase in sales.

          General and Administrative. General and administrative expenses were $2.0 million and $1.2 million in the three months ended June 30, 2006 and 2005, respectively, representing an increase of $868,000, or 74.8%, from 2005 to 2006. General and administrative expenses for the current period include $618,000 of stock based compensation expense which is not included in 2005 expenses. Factoring out such compensation expense, general and administrative increased $250,000, or 21.5% from the prior year quarter. The increase in our general and administrative expenses is due to the Allume acquisition and increases in headcount, legal and consulting expenses, partially offset by a reduction in benefit costs. Despite the increase in absolute dollars, as a percentage of revenues, general and administrative expenses decreased to 16.2% for the three months ended June 30, 2006 from 34.9% in the three months ended June 30, 2005, as a result of the increase in sales.

          General and administrative expenses were $3.4 million and $1.9 million in the six months ended June 30, 2006 and 2005, respectively, representing an increase of $1.5 million, or 77.5%, from 2005 to 2006. General and administrative expenses for the current period include $842,000 of stock based compensation expense which is not included in 2005 expenses. Factoring out such compensation expense, general and administrative increased $659,000, or 34.0% from the prior year quarter. The increase in our general and administrative expenses is due to the Allume acquisition and increases in headcount, legal and consulting expenses, partially offset by a reduction in benefit costs. Despite the increase in absolute dollars, as a percentage of revenues, general and administrative expenses decreased to 15.3% for the six months ended June 30, 2006 from 36.1% in the six months ended June 30, 2005, as a result of the increase in sales.

          Interest Income. Interest income was $265,000 and $214,000 in the three months ended June 30, 2006 and 2005, respectively, representing an increase of $51,000 or 23.8% from 2005 to 2006. Interest income was $489,000 and $314,000 in the six months ended June 30, 2006 and 2005, respectively, representing an increase of $175,000 or 55.7% from 2005 to 2006. Interest income is directly related to our average cash balance during the period and varies among periods. On February 18, 2005, we closed a private placement equity transaction, netting approximately $20.8 million in cash. We have not changed our investment strategy during the periods being reported on, with our excess cash consistently being invested in short term marketable debt securities classified as cash equivalents.

          Provision for Income Taxes. The provision for income taxes was $33,000 and $8,000 in the three months ended June 30, 2006 and 2005, respectively, representing an increase of $25,000, or 312.5% from 2005 to 2006. The provision for income taxes was $72,000 and $8,000 in the six months ended June 30, 2006 and 2005, respectively, representing an increase of $64,000, or 800.0% from 2005 to 2006. In all periods, the provision for income taxes relates to an accrual for alternative minimum taxes which are expected to be owed on income as well as certain state minimum tax payments. The Company has a full valuation allowance on its net deferred tax assets.

Liquidity and Capital Resources

          Since our inception, we have financed operations primarily through cash generated from operations and from proceeds of $18.1 million generated by our initial public offering in 1995. On February 18, 2005, the Company entered into a Common Stock Purchase Agreement for the private placement of 3,500,000 shares of the Company’s common stock, $0.001 par value, at a price of $6.40 per share, resulting in aggregate gross cash proceeds to the Company of $22,400,000 and approximate net cash proceeds to the Company of $20,786,000 after expenses. The transaction closed simultaneously with the execution of the Purchase Agreement on February 18, 2005. C.E. Unterberg, Towbin LLC, the placement agent for the transaction, received a cash fee equal to 6% of the aggregate gross proceeds of the Private Placement.

          Net cash provided by operating activities was $9.9 million and $356,000 in the six months ended June 30, 2006 and 2005, respectively. The primary source of operating cash in 2006 was the net income, the non-cash stock based compensation expense and the collection of accounts receivable, partially offset by the increase in inventory. The primary source of cash in 2005 was the net income and increase in accounts payable and accrued liabilities, offset by the increase in accounts receivable.

          During the six months ended June 30, 2006, we used $2.4 million in investing activities, consisting of primarily of the PhoTags acquisition ($2 million) and the purchase of office equipment. In 2005, our capital expenditures consisted of purchases of office equipment in the amount of $21,000.

          We received $2.6 million in cash from the exercise of employee stock options during the six months ended June 30, 2006 compared to $191,000 during the comparable period of 2005.

          At June 30, 2006, we had $31.3 million in cash and cash equivalents and $31.5 million of working capital. Our accounts receivable balance, net of allowance for doubtful accounts and other adjustments, was $4.2 million at June 30, 2006. We have no

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