UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2005

March 31, 2006

OR

For the transition period from                    to                    

Commission File Number 000-20981

DOCUMENT SCIENCES CORPORATION

(Exact name of registrant as specified in its charter)

5958 Priestly Drive

Carlsbad, California 92008

(Address of Principal Executive Offices including Zip Code)

(760) 602-1400

(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.    Yesþ    No¨

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

Large accelerated filer  ¨  No                Accelerated filer  ¨                Non-accelerated filer  þ

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

As of November 11, 2005,May 15, 2006, there were 4,202,3724,248,211 shares of common stock of the registrant outstanding.

DOCUMENT SCIENCES CORPORATION

PART I. FINANCIAL INFORMATION

DOCUMENT SCIENCES CORPORATION

CONSOLIDATED BALANCE SHEETS

On December 22, 2005, of our Board of Directors approved the acceleration of the underlyingvesting of all unvested stock onoptions awarded under our stock incentive plans for those employees and directors with more than one year of service with the dateCompany, effective December 22, 2005. The decision to accelerate the vesting of grant, nothese outstanding stock options was made primarily to reduce the non-cash compensation expense is recognized.

As required underthat we would have otherwise recorded in future periods as a result of adopting SFAS No. 123,123(R). We estimate that the pro forma effectsacceleration eliminated approximately $1.5 million of stock-basedcumulative pre-tax compensation on net income (loss) and net earnings (loss) per common sharecharges that would have been estimated atrecognized during 2006, 2007 and 2008 as the datestock options would have continued to vest. Additionally, as a result of grant usingchanges in accounting required by SFAS No. 123(R) and a desire to design our long-term incentive plans in a manner that creates a stronger link to operating and market performance, our Board of Directors approved a substantial change in the form of awards that we grant. Beginning in late 2005, stock option grants issued under our existing stock incentive plans were reduced and replaced with grants of restricted stock.

We use the Black-Scholes option pricing model based on the following weighted-average expected life of the option of seven years and the following weighted average assumptions:

In determining fair value, we used the following criteria:

Expected Term.The expected term of options granted represents the period of time that the option is expected to be outstanding. We estimate the expected term of the option grants based on historical exercise patterns that are believed to be representative of future behavior as well as other various factors. When and if applicable we use separate groups of employees that have similar historical exercise behavior for valuation purposes.

Expected Volatility.We estimate our volatility using our historical share price performance over the expected life of the options, which management believes is materially indicative of expectations about expected future volatility.

Risk-Free Interest Rate.We use risk-free interest rates in the Black-Scholes option valuation model that are based on U.S. Treasury zero-coupon issues with a remaining term equal to the expected life of the options.

Dividend Rate.We do not issue dividends on our common stock and do not anticipate paying any cash dividends in the foreseeable future. Therefore, we use an expected dividend yield of zero in the Black-Scholes option valuation model.

Forfeitures. SFAS No. 123R requires companies to estimate forfeitures at the time of grant and revise those estimates in subsequent reporting periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. For purposes of calculating pro forma information under SFAS No. 123 for periods prior to the date of adoption of SFAS No. 123R, we accounted for forfeitures as they occurred.

For purposes of adjusted pro forma disclosures, the estimated fair value of the options is amortized to expense over the option’s vesting period. The effect of applying SFAS No. 123 for purposes of providing pro forma disclosures is not likely to be representative of the effects on our operating results for future years because changes in the subjective input assumptions can materially affect future value estimates. Our pro forma information is as follows for the three months ended March 31, 2005:

Nonvested Shares

A summary of the status of our nonvested stock options issued under the plan for the three months ended March 31, 2006 was as follows:

As of March 31, 2006, there was approximately $154,000 of total compensation cost related to nonvested share-based compensation arrangements for stock options granted under the plans. That cost is expected to be recognized over a weighted average period of 2.32 years. During the three months ended March 31, 2006, we recognized approximately $28,000 in compensation expense related to nonvested shares.

A summary of the status of our nonvested restricted stock issued under the plan for the three months ended March 31, 2006 was as follows:

As of March 31, 2006, there was approximately $630,000 of total compensation cost related to nonvested share-based compensation arrangements for restricted stock granted under the plans. That cost is expected to be recognized over a weighted average period of 2.67 years. During the three months ended March 31, 2006, we recognized approximately $59,000 in compensation expense related to nonvested restricted stock.

Critical Accounting Policies

Our discussion and analysis of the financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition, software development costs, allowance for doubtful accounts and valuation allowance for net deferred tax assets. We base our estimates on historical and anticipated results and trends and on assumptions that we believe are reasonable under the circumstances, including assumptions as to future events. These estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results may differ from our estimates. We believe that the following critical accounting policies and assumptions may involve a higher degree of judgment and complexity than others.

Revenue Recognition.We derive our revenues principally from the licensing of software, annual renewal license andpost contract support fees (ALF)(PCS) and professional services. We recognize revenue in accordance with SOPStatement of Position (SOP) 97-2,Software Revenue Recognitionand SAB No. 104,Revenue Recognition in Financial Statements. Initial license fees (ILF)Although some software is licensed on a perpetual basis, the majority of our licenses are currently time-based licenses that are required to be renewed annually. Revenues are recognized when a contract exists, the fee is fixed and determinable, software delivery has occurred and collection of the receivable is deemed probable. Amounts billed or payments received in advance of revenue recognition are recorded as deferred revenue.

If an arrangement includes multiple elements, we allocate the contract amount to the various elements based on vendor-specific objective evidence (VSOE) of fair value, regardless of any separate prices stated within the contractcontracts for each element. We base our VSOE on the price charged when the same element is sold separately.

We use the residual method to recognize revenue for all of our license models when bundled with ALF (post-contract support). Under the residual method, the fair value of the undelivered element (ALF) is deferred and the remaining value of the contract is recognized as revenue (ILF) when the license has been delivered, the fee is fixed and collectibility is probable. ALF is recognized ratably over the contract period. Included in our ALF are unspecified maintenance releases.

Our contracts do not provide for specific upgrades. In addition, our standard contracts do not provide for rights of return or conditions of acceptance; however, in the rare case that acceptance criteria are provided, revenue is deferred and not recognized until all conditions are satisfied and written customer acceptance is obtained. Where acceptance criteria exist, we believe our approach to revenue recognition would not result in materially different amounts being reported under different conditions or using different assumptions.

If an undelivered element of the arrangement exists, under the license arrangement, revenue is deferred based

on VSOE of the fair value of the undelivered element. If VSOE of fair value does not exist for all undelivered elements, all revenue is deferred until sufficient evidence exists or all elements have been delivered. We use the residual method to recognize revenue on transactions with payment terms less thanwhen an arrangement includes one or more elements to be delivered at a future date and VSOE of the fair value of all undelivered elements exists.

We recognize fees for annual licensing arrangements ratably over the contract term of twelve months frombecause we are unable to establish VSOE for the contract date, if we have a historylicense and support elements under this type of successfully collecting frombundled arrangement.

For perpetual license arrangements, VSOE of fair value for ongoing maintenance and support obligations (PCS) is determined based upon the historical, stand-alone renewal rates or pricing. We recognize revenue relating to the perpetual software license arrangements at inception of the arrangement using the residual method as discussed above.

Our contracts do not provide for specific upgrades. In addition, our standard contracts do not provide for rights of return or conditions of acceptance; however, in cases where acceptance criteria are provided, revenue is deferred and not recognized until all conditions are satisfied and written customer without providing concessions. Amounts billed or payments received in advance of revenue recognition are recorded as deferred revenue.acceptance is obtained.

Professional services revenue includes consulting services and training related to our software products. Revenues generated from consulting services and training are recognized as the related services are performed and collectibility is deemed probable. However,probable, based on VSOE of fair value of the services. VSOE of fair value for professional services is determined based upon the price charged when these services are sold separately. For professional services that are bundled with annual software licenses and are not deemed to be essential to the functionality of the delivered software product, we recognize the entire arrangement fee ratably over the longer of the period over which the professional services are expected to be rendered, or the PCS period, beginning with delivery of the software and commencement of the professional services. In the vast majority of cases, the arrangement fee is recognized ratably over the twelve month PCS period. In certain limited situations where we determine that professional services period is the longer period, upon the end of the PCS term, we recognize license and PCS revenues at that stage (on the residual basis), recognizing the remaining deferred revenue for the unfinished services over the remaining period of such services.

If consulting services are deemed to be essential to the functionality of the delivered software product, revenue from the entire arrangement is recognized on a percentage of completion method or not until the contract is completed in accordance with SOP 81-1,Accounting for Performance of Construction-Type and Certain Production-Type Contracts, and Accounting Research Bulletin (ARB) No. 45,Long-Term Construction-Type Contracts. We measure progress under the percentage of completion method, depending on how the contract language is written, either by using the percentage of total project hours completed or by the completion of phases in the consulting project. Because (i) the phases of our consulting projects are generally not of great duration (2-6 weeks on average) and (ii) we have a variety of projects progressing at the same time,, we believe that there are very limited circumstances where materially different amounts would be reported under different conditions or using different assumptions.

We work in conjunction with our established value added resellers (VARs),VARs, with whom we have formal contracts defining the rights and obligations of the parties, to license software to end-users. We license software to our VARs, less a discount, from a fixed price list. We require a binding purchase order as evidence of an unconditional order by an end user from our VARs, with no rights of return or acceptance. License revenue from our VARs is recognized when software is licensed to an end user.

Software Development Costs. In accordance with SFAS No. 86,Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, costs incurred in the research and development of new software products and significant enhancements to existing software products are expensed as incurred until technological feasibility of the product has been established. After technological feasibility has been established, direct production costs, including programming and testing, are capitalized until general release of the product.

Capitalized costs of software to be sold, licensed or otherwise marketed are amortized using the greater of the amount computed using the ratio of current period product revenues to estimated total product revenues or the straight-line method over the remaining estimated economic lives of the products. It is possible that estimated total product revenues, the estimated economic life of the product, or both, will be reduced in the future. As a result, the carrying amount of capitalized software costs may be reduced in the future, which could cause our operating results in future periods to be adversely affected.

Impairment of Goodwill.The value of our goodwill could be impacted by future adverse changes such as declines in our operating results or failure to meet the performance projections included in our forecasts of future operating results. We evaluate these assets on an annual basis or more frequently if indicators of impairment exist. In the process of our annual impairment review, we primarily use the income approach methodology of valuation that includes thea discounted cash flow method as well as other generally accepted valuation methodologies to determine the fair value of our assets. Significant management judgment is required in the forecasts of future operating results that are used in the discounted cash flow

method of valuation. The estimates we have used are consistent with the plans and estimates that we use to manage our business. It is possible, however, that the plans and estimates used may be incorrect. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur impairment charges.

Allowance for Doubtful Accounts.Accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required, which would result in an additional general and administrative expense in the period such determination is made. At the end of each reporting period, we perform a detailed review of outstanding balances by customer and invoice. We utilize statistical and account specific analysis to determine the adequacy of our reserve, as well as comparing balances to historical losses. If our assumptions or analysis are incorrect, our operating results for future periods may be adversely affected.

Deferred Income Taxes.Taxes. Deferred income taxes reflect the net effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. At December 31, 2004,2005, we had net deferred tax assets of $2.9$4.3 million. Due to the uncertainty of realizing a portion of these net deferred tax assets, we have maintained a valuation allowance of $2.6$4.0 million for net deferred tax assets. Such uncertainty primarily relates to the potential for future taxable income as well as loss carryforwards and tax credits expiring in 2018 and 2012, respectively. In addition, pursuant to Sections 382 and 383 of the Internal Revenue Code, annual use of our net operating loss carryforwards may be limited in the event of a cumulative change in ownership of more than 50% within a three-year period. No valuation allowance has been recorded to offset the remaining $275,000 of net deferred tax assets as we have determined that it is more likely than not that these assets will be realized within the next twelve months.realized. We will continue to assess the likelihood of realization of such assets; however, if future events occur which do not make the realization of such assets more likely than not, we will record a valuation allowance against all or a portion of the remaining net deferred tax assets. An exampleExamples of a future eventevents that might occur which couldwould make the realization of such assets not likely is

a lack of taxable income resulting from poor operating results. At September 30, 2005,results during 2006. As a result of our assessment at March 31, 2006, our net deferred tax asset remained at $275,000.

Accounting Change.On January 1, 2006, we adopted Statement of Financial Accounting Standards (SFAS) 123(R) (revised 2004),Share-Based Payment, which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options and employee stock purchases based on estimated fair values. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) 107 relating to SFAS 123(R). We have applied the provisions of SAB 107 in its adoption of SFAS 123(R).

SFAS 123(R) requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in our consolidated income statement. SFAS 123(R) supersedes our previous accounting under the provisions of SFAS 123,Accounting for Stock-Based Compensation. Through December 31, 2005, as permitted by SFAS 123, we accounted for equity-based compensation in accordance with Accounting Principles Board Opinion (APB) No. 25,Accounting for Stock Issued to Employees, and related interpretations. Accordingly, no accounting recognition was given to stock options granted at fair market value until they were exercised. Upon exercise, net proceeds, including tax benefits realized, were credited to equity.

We adopted SFAS 123(R) 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. 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 123(R).

On December 22, 2005, of our Board of Directors approved the acceleration of the vesting of all unvested stock options awarded under our stock incentive plans for those employees and directors with more than one year of service with the Company, effective December 22, 2005. The decision to accelerate the vesting of these outstanding stock options was made primarily to reduce the non-cash compensation expense that we would have otherwise recorded in future periods as a result of adopting SFAS No. 123(R). We estimate that the acceleration eliminated approximately $1.5 million of cumulative pre-tax compensation charges that would have been recognized during 2006, 2007 and 2008 as the stock options would have continued to vest. Additionally, as a result of changes in accounting required by SFAS No. 123(R) and a desire to design our long-term incentive plans in a manner that creates a stronger link to operating and market performance, our Board of Directors approved a substantial change in the form of awards that we grant. Beginning in late 2005, stock option grants issued under our existing stock incentive plans were reduced and replaced with grants of restricted stock.

We recognized approximately $28,000 of compensation expense associated with stock options resulting from the adoption of SFAS No. 123(R) during the three months ended March 31, 2006. In addition, we recognized approximately $59,000 of compensation expense associated with restricted stock during the same period. As a result of Board of Directors decisions as previously discussed, the adoption of SFAS No. 123(R) on January 1, 2006 did not significantly affect our accounting for equity-based compensation or our net income for the three months ended March 31, 2006. We do not currently expect this change in accounting to significantly impact our future results of operations; however, we do expect equity-based compensation expense to increase over the next several years because of the incremental expense that will be recognized each year as our Board of Directors grants additional awards. As of March 31, 2006, there was approximately $154,000 of total compensation cost related to nonvested share-based compensation arrangements for stock options granted under the plans. That cost is expected to be recognized over a weighted average period of 2.32 years. In addition, as of March 31, 2006, there

was approximately $630,000 of total compensation cost related to nonvested share-based compensation arrangements for restricted stock granted under the plans. That cost is expected to be recognized over a weighted average period of 2.67 years.

Results of Operations for the Three and Nine Months Ended September 30,March 31, 2006 and 2005 and 2004

The following table shows the percentage of revenues, cost of revenues, operating expenses and other items to total revenues in our consolidated statements of operations for the periods indicated:

Gross profit		60			69			60			71
Operating expenses:
Research and development		20			16			19			17
Selling and marketing		26			37			28			37
General and administrative		10			13			12			14
Total operating expenses		56			66			59			68
Income from operations		4			3			1			3
Interest and other income, net		1			—			1			—
Income before income taxes		5			3			2			3
Provision for income taxes		—			—			—			—
Net income		5	%		3	%		2	%		3	%

Revenues

Our revenues are divided into threetwo categories based upon the sources from which they are derived: initial license fees,(i) term-based licenses and perpetual licenses and related annual renewal license and support fees, and (ii) services and other revenues. The following discussion is separated into these categories. We sell our products principally through our direct sales force domestically and through distributors and VARs internationally.

The following table summarizes revenues (in thousands) and the percentage change over the same period of the prior year:

Initial license fees. Initial licenseLicense fees consist primarily of upfront license fees for the first year of use of our products.

The components of initial license fees (in thousands) of our product families consist of the following:

The increases in initial license fees for the threeproducts and nine months ended September 30, 2005 were due to higher sales from our Canadian and Australian operations and improvement in xPression product sales.

Annualannual renewal license and support fees. Annual renewal license and support fees consist of license fees for the initial and continued support and use of our licensed products. The increases for the three and nine months ended September 30, 2005 were due primarily to increases in our base of licensed software.

Services and other.PCS fees. Services and other revenues consist of fees for consulting, software outsourcing, application development and training services performed by us as well as miscellaneous other operational revenues. A majority of the growth for the threeWe sell our products principally through our direct sales force domestically and nine months ended September 30, 2005 was from the delivery of implementation services to customers who have licensed our xPression software. Additionally, results for the nine months ended September 30, 2005 benefited from consulting services delivered by our Objectiva subsidiary.

Cost of Revenues

through distributors and VARs internationally. The following table summarizes cost of revenues (in thousands) and the percentage change over the same period ofprevious year for the prior year:periods indicated:

Cost of Revenues

Cost of initial license fees. Cost of initial license fees includes amortization of previously capitalized software development costs, costs of third party software, employmentemployee related costs for distribution personnel and technical support staff and product packaging. The decrease for the three months ended September 30, 2005 was due to a decrease in royalty fees. The increase for the nine months ended September 30, 2005 was due to an increase in amortization of software development costs due to the release of xPression 2.0 in the fourth quarter of 2004.

Amortization of software development costs were $360,400 and $1.3 million for the three and nine months ended September 30, 2005, respectively, and $353,800 and $730,100 for the three and nine months ended September 30, 2004, respectively. For the nine months ended September 30, 2005, cost of initial license fees grew at a faster rate than initial license fees due to higher amortization of software development costs, causing gross margins to decrease.

Cost of annual renewal license and support fees. Cost of annual renewal license fees consist principally of the employee related costs for our technical support staff. The increases for the three and nine months ended September 30, 2005 were primarily due to increases in personnel costs of $67,500 and $74,600, respectively, to support our growing customer base.

Cost of services and other. CostCosts of services and other consist principally of the employee related costs of our consulting and training staff. The increases for the three and nine months ended September 30, 2005 were due to an increase in personnel costs to support our increasing project workload.

Operating Expenses

The following table summarizes operating expensescost of revenues (in thousands) and the percentage change over the sameprevious quarter for the period of the prior year:indicated:

Operating Expenses

Research and developmentdevelopment.. Research and development expenses consist primarily of the employee related costs of personnel associated with developing new products, enhancing existing products, testing software products and developing product documentation. We anticipate that we will continue to direct significant resources to the development of new products and enhancement of our existing products.

The following table adds back capitalized software development costs (in thousands) and shows the percentage change over the same period of the prior year:

Capitalized software development costs mainly include payroll related costs of our engineering resources, allocated facilities costs and consulting fees related to the development of xPression. We expect the amount of capitalized software development costs to continue to be less in 2005 because we expect the time between the establishment of technological feasibility and general releases of our products to be substantially the same. We incurred no capitalized software development costs for the three and nine months ended September 30, 2005, but capitalized $449,000 and $1.7 million, respectively, related to xPression 2.0 development in the three and nine months ended September 30, 2004.

The increase in gross research and development costs for the three months ended September 30, 2005 was primarily due to an increase in personnel costs of $336,800 offset by a decrease in outside consultant costs of $80,800. The decrease in gross research and development costs for the nine months ended September 30, 2005 was primarily due to a decrease in outside consultant costs of $1.0 million offset by an increase in personnel costs of $816,000, largely driven by the impact of our Objectiva acquisition.

Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions, marketing programs and related costs for pre- and post-sales activity. The decrease for the three months ended September 30, 2005 was primarily due to decreases in personnel costs of $113,700 and outside

consultant costs of $129,100, offset by an increase in sales commissions of $90,100. Costs were largely unchanged for the nine months ended September 30, 2005.

General and administrative. General and administrative expenses consist of employee related costs for finance, administration, information technology and human resources, allowance for doubtful accounts and general corporate management expenses, including legal and accounting fees.

The increasefollowing table summarizes operating expenses (in thousands) and the percentage change over the previous year for the three months ended September 30, 2005 was primarily due to increases in personnel costs of $201,000, outside consultant costs of $59,300 and bad debt expense of $107,500, offset by a French VAT refund of $391,000 which we had previously taken as an expense in the fourth quarter of 2003. The increase for the nine months ended September 30, 2005 was primarily due to increases in personnel costs of $311,400 and outside consultant costs of $94,100, offset by a French VAT refund of $391,000.periods indicated:

Other items

Interest and other income, net. Interest and other income, net is composed primarily of interest income from cash and cash equivalents and proceeds from short-term investments,investment disposals, offset by interest expense related to capital leases and gains/losses onproceeds from disposals of fixed assets.

Provision for income taxes. Provision for income taxes reflects the net effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.

Three months ended March 31, 2006 compared to the three months ended March 31, 2005

The 25% increase in license fee revenue in the first quarter of 2006 over the comparable 2005 period was primarily due to higher initial sales of our xPression Enterprise Suite and increased PCS revenues from our increasing base of licensed software users, somewhat offset by reduced sales in our older Autograph suite.

First quarter 2006 services and other revenues increased 22% over first quarter 2005 amounts. The majority of the increase was from the delivery of implementation and other services to customers who have licensed our xPression software. Consulting services provided by our Objectiva subsidiary also contributed to the quarterly increase.

The 5% increase in license fees cost of revenue in the first quarter of 2006 was primarily due to increases in personnel costs of approximately $200,000 over the comparable 2005 quarter, as additional staff was required to support our expanding customer base and product set, and an increase of approximately $50,000 in software royalties, offset by a decrease of approximately $220,000 in software amortization related to older products now fully amortized.

Services and other cost of revenues in the first quarter of 2006 increased by 65% over the first quarter of 2005 due to an increase in personnel related costs and management required to sustain existing projects and to staff anticipated new projects. Staffing increased from 37 employees at the end of the first quarter of 2005 to 64 at the end of 2006’s first quarter. Salary and salary related costs accounted for approximately 92% of the total cost increase. Increased facility costs related to our new headquarters facility, outside consultant costs, travel and communication costs also contributed to the percentage growth in services costs in excess of the percentage growth in services revenues.

The 5% decrease in first quarter 2006 research and development costs from the comparable quarter in 2005 was primarily due to a decrease in staffing costs related to reduced staffing for our Autograph products.

The 17% increase in first quarter 2006 selling and marketing expenses over the 2005 quarter was primarily due to increases in salary and salary related costs, which accounted for 43% of the 17% increase, and sales representative commissions, which accounted for 37% of the 17% increase.

The 7% increase in first quarter 2006 general and administrative expenses over the 2005 quarter was primarily composed of salary and salary related expense increases, offset by consulting and travel and entertainment decreases.

Interest and other income, net was $47,300 and $13,600 forin the three months ended September 30,first quarter of 2006 increased by approximately $30,000 over the comparable 2005 and 2004, respectively, and $168,900 and $55,000 for the nine months ended September 30, 2005 and 2004, respectively. The increases for the three and nine months ended September 30, 2005 were largely the result of a one-time sale of stock acquired in conjunction with the acquisition of Objectiva, as well as morequarter due to higher interest income due to higherimproved interest rates on invested cash balances and interest rates.balances.

Provision for income taxes. ProvisionThe first quarter provisions for income taxes is comprised ofin 2006 and 2005 relate to foreign taxes. Provision for income taxes was $6,375 and $0 for the three months ended September 30, 2005 and 2004, respectively, and $19,500 and $19,100 for the nine months ended September 30, 2005 and 2004, respectively. We will continue to assess the likelihood of realization of our federal and state net deferred tax assets. If future events occur that do not make the realization of such assets more likely than not, a valuation allowance will be established against all or a portion of the net deferred tax assets.

Trends and Factors That May Affect Future Operating Results

Our total revenues and operating results can vary, sometimes substantially, from quarter to quarter and are expected to vary significantly in the future. Our revenues and operating results are difficult to forecast. Future results will depend upon many factors, including the demand for our products, the level of product and price competition, the length of our sales cycle, the size and timing of individual license transactions, the delay or deferral of customer implementations, the budget cycles of our customers, our success in expanding our direct sales force and indirect distribution channels, the acceptance and timing of new product introductions and product enhancements by us and our competitors, the mix of products and services sold, levels of international sales, capitalization or amortization of software development costs, our ability to successfully implement our operational, growth and other strategies, activities of and acquisitions by competitors, the timing of new hires, changes in foreign currency exchange rates, our ability to develop and market new products, and controlcontrolling costs and general domestic and international economic conditions. In addition, a high percentage of our total revenues are generated bysales generally reflect a relatively low numberhigh amount of orders,revenue per order, and, therefore, the loss or delay of individual orders could have a significant impact on our revenues and quarterly operating results. In addition, a significant amount of our revenues occur predominantly in the third month of each fiscal quarter and tend to be concentrated in the latter half of that third month.

Our software products generally are shipped as orders are received. As a result, initialquarterly license fees in any quarterrelated to these products are substantially dependent on orders booked and shipped in that quarter. The timing of receipt of initialthese license fees is difficult to predict because of the length of our sales cycle. ForAutograph products, our sales cycle is typically three to nine months from initial contact. ForxPression products, our sales cycle is typically six months to over one year from initial contact. Because our operating expenses are based on anticipated revenue trends and because a high percentage of our expenses are relatively fixed, a delay in the recognition of revenue from a limited number of initial license transactions could cause significant variations in operating results from quarter to quarter and could result in losses. To the extent such expenses precede, or are not subsequently followed by, increased revenues, our operating results could be materially adversely affected.

Due to the foregoing factors, revenues and operating results for any quarter are subject to significant variation, and we believe that period-to-period comparisons are not necessarily meaningful and should not be relied upon as indications of future performance.

Liquidity and Capital Resources

Our sources of cash come mainly from operations and sales and maturities of short-term investments. Our main uses of cash are for payroll.payroll and employee related costs. Our main project underwayin 2006 is a maintenance program, xPression 2.1.1, which we intend to release in the fourth quarter of 2005.additionalxPresso design products targeted at new potential growth applications such as email distribution. We currently do not have noany debt from borrowed money. Our short-term investments are invested in U.S. government agency obligations and high quality commercial paper.

We believe that our existing cash balances and anticipated cash flows from operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures at least through the next twelve months. In this regard, a portion of our cash could be used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies.

We have no material current understandings, commitments or agreements with respect to any acquisition in whole of other businesses, products or technologies.

At September 30, 2005,March 31, 2006, we had $6.2$6.9 million in cash, cash equivalents and short-term investments. This is a decrease of $510,300$969,000 from December 31, 2004 and reflects seasonality in our cash balance, largely around2005. Cash decreased during the collection of annual license fees. The corresponding balance on September 30, 2004 was $4.8 million.

The declinequarter mainly due to the loss for the first nine months of 2005 is due in part to a net increase of $2.1 million in operating assetsquarter and liabilities, most notably an increase in accounts receivable of $2.3 million. Accounts receivable typically grow significantly in the third quarter on billings associated with annual license renewals coming due at the end of the year. Also contributing to the decline isdecrease in accrued compensation related to the purchasespayment of fixed assets of $525,600. Partially offsetting these items are the year-to-date net income of $445,600 as well as non-cash depreciation and amortization expense of $1.5 million, much of which relates to amortization of previously capitalized software development costs.year-end merit bonuses.

We have no significant capital spending or purchase commitments other than normal purchase commitments and commitments under facilities and equipment leases. We currently anticipate leaseLease commitments for ourthe next five fiscal years to be $1.1 million, $1.1 million, $1.1 million, $598,500are $751,933, $769,338, $675,822, $527,346 and $509,700,$517,251, respectively.

Forward-looking Statements

We make forward-looking statements in this quarterly report on Form 10-Q that are subject to risks and uncertainties. These forward-looking statements include information about possible or assumed future

results of our financial condition, operations, plans, objectives and performance. When we use the words “believe,” “expect,” “anticipate,” “estimate” or similar expressions, we are making forward-looking statements. Many possible events or factors could affect our future financial results and performance. This could cause our results or performance to differ materially from those expressed in our forward-looking statements. You should consider these risks when you review this document, along with the following possible events or factors:

Our actual results could differ materially from those discussed herein due to a number of factors, including those set forth in this discussion, under “Certain Factors Affecting Document Sciences Corporation” and other risks detailed from time to time in our SEC reports. In addition, the discussion of our results of operations should be read in conjunction with the sections entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 20042005 Annual Report on Form 10-K for the fiscal year ended December 31, 20042005 and in reports we file with the Securities and Exchange Commission. You are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis only as of the date of that statement. We undertake no obligation to publicly release the results of any revision of the forward-looking statements.

Certain Factors Affecting Document Sciences Corporation

The following is a discussion of certain factors that currently impact or may impact our business, operating results and/or financial condition. Anyone making an investment decision with respect to our common stock or other securities is cautioned to carefully consider these factors. If any of the following risks actually occur, our business, results of future operations and financial condition could be materially adversely affected. In such case, the trading price of our common stock could decline and you may lose part or all of your investment.

Our quarterly results fluctuate significantly and we may not be able to grow our business.

Our total revenues and operating results are difficult to forecast and can vary, sometimes substantially, from quarter to quarter, and we expect them to vary significantly in the future. Additionally, our revenues andOur future quarterly operating results are difficult to forecast, and our future results will depend uponaffected by many factors, including the following:

Our initial license fee revenues mainly depend on when orders are received from the customers and shipped.shipped to them. However, because of our sales model, our customers’ implementation schedule and the complexity of the implementation process, revenue from some software shipments may not be recognized in the same quarter as the shipment occurs. Our operating expenses are primarily based on anticipated revenue levels. Since a high percentage of those expenses are relatively fixed, a delay in the recognition of revenue from license transactions could cause significant variations in operating results from quarter to quarter, and we may sustain losses as a result. To the extent such expenses precede, and/or are not subsequently followed by, increased revenues, our operating results could be materially adversely affected.

As a result of these factors, results from operations for any quarter are subject to significant variation, and we believe that period-to-period comparisons of our results of operations aremay not necessarily be meaningful. Accordingly, you should not rely upon them as an indication of our future performance. Furthermore, our operating results in future quarters may fall below the expectations of market analysts and investors. If this occurs, the price of our common stock could be materially adversely affected.

Our growth depends on market acceptance of our existing products, enhancements to existing products, and our introduction of new products.

Our future business, operating results and financial condition depend upon market acceptance of our existing products, as well as our ability to respond to emerging industry standards and practices and to develop new products that address the future needs of our target markets. OurAutographfamily of products has been applied mainly to document automation applications producing paper-based documents. We have started to extend our core technology to the Internet, intranets and commercial

on-line services. However, we cannot assure you that we will be successful in developing, introducing and marketing new products or product enhancements, including new products or the extension of existing products for the Internet, intranets and commercial on-line services, on a timely and cost effective basis, if at all. In addition, we cannot assure you that our newer products, such as xPressoandxPression, or enhancements to existing products will adequately meet the requirements of the marketplace or achieve market acceptance. Moreover, delays in our commercial shipments of new products or enhancements may result in client dissatisfaction and a delay or loss of product revenues. In addition, in order to provide our customers with integrated product solutions, our future success will also depend in part upon our ability to maintain and enhance relationships with our technology partners.

If for technological or other reasons we are unable to develop and introduce new products or enhancements of existing products in a timely manner in response to changing market conditions or client requirements, this may impact our ability to grow our services revenues andthen our business, operating results and financial condition could be materially adversely affected. In addition, we cannot assure you that our existing products, new products or new versions of our existing products will achieve market acceptance. In order to provide our customers with integrated product solutions, our future success will also depend in part upon our ability to maintain and enhance relationships with our technology partners.

Longer than expected sales cycles and implementation periods have and may continue to affect our revenues and operating results.

The licensing of our software products is often an enterprise-wide decision by prospective customers and generally involves a sales cycle of three months to more than one year in order to educate ourthese prospective customers regarding the use and benefits of our products.products, often requiring us to expend considerable financial and personnel resources without any assurance that revenue will be realized. In addition, the implementation of our products by customers involves a significant commitment of their resources over an extended period of time and is commonly associated with substantial customer business process reengineering efforts. Sales of our enterprise-widexPression product line often involve many participants in the corporate decision-making process. Additionally, we have experienced and may, from time to time, continue to experience defects in our software which cause implementation problems and affect our salesrevenues and our sales cycle. For these and other reasons, our sales cycles and customer implementation periods are subject to a number of significant delays over which we may have little or no control. Any delay in the sale or customer implementation of a limited number of license transactions could have a material adverse effect on our business and results of operations and cause our operating results to vary significantly from quarter to quarter.

We currently derive a significant portion of our revenues fromthrough Xerox.

We currently have a variety of contractual and informal relationships with Xerox and affiliates of Xerox, including a cooperative marketing agreement, a transfer and license agreement and various distribution agreements. We rely on these relationships and agreements for a significant portion of our total revenues. Revenues derived from relationships with Xerox and affiliates of Xerox accounted for approximately $3.0 million$929,000 and $2.6$1.3 million for the ninethree months ended September 30,March 31, 2006 and 2005, and 2004, respectively, representing 13%12% and 15%21% of our total revenues, respectively.

In November 2003, we paid $2.7 million to Xerox to repurchase the remaining 740,024 shares of Document Sciences’ common stock owned by Xerox. Since Xerox no longer has an equity interest in us, there may be less incentive in continuing to do business with us at the same level. Though we intend to continue our existing relationships with Xerox, our strategy has been, and continues to be, to lessen our dependence on Xerox. However, there can be no assurance that we will be able to do so and, because of our current level of dependence on Xerox, there can be no assurance that our plans to become more independent will not adversely affect our business, results of operations and financial condition. Our

failure to maintain these relationships or to establish new relationships in the future could have a material adverse effect on our business, operating results and financial condition.

There can be no assurance that existing and potential customers will continue to do business with us because of these relationships or our historical ties with Xerox and its affiliates. Xerox has strategic alliances and other business relationships with other companies who supply software and services used in high volume electronic publishing applications and who now are, or in the future may become, our competitors. There can be no assurance that Xerox or one of its affiliated companies will not engage in a business that directly competes with us. In addition, Xerox has ongoing internal development activities

that could in the future lead to products that compete with us. Xerox could in the future expand these relationships or enter into additional ones, and as a result our business could be materially adversely affected.

Our growth depends on our ability to compete successfully against current and future competitors.

The market for our dynamic content publishing products is intensely competitive. We face competition from a broad range of competitors, many of whom have greater financial, technical and marketing resources than we do. Our principal competition currently comes from systems developed in-house by the internal MISIS departments of large organizations and direct competition from numerous software vendors, including Docucorp International, Inc., InSystems Technologies, Inc., Group 1 Software, Inc., Exstream Software, Inc. and Metavante Corporation. We believe that the principal competitive factors affecting our market include product performance and functionality, ease of use, scalability, operating across multiple computer and operating system platforms, product and company reputation, client service and support and price. Although we believe we currently compete favorably with respect to such factors, we can not assure you that we will be able to maintain our competitive position against current and future competitors, especially those with greater financial, technical and marketing resources than us, or that we will be successful in the face of increasing competition from new products or new solutions introduced by existing competitors or by new companies entering the market.

Our operating results are substantially dependent on sales of a small number of products in highly concentrated industries.

As of September 30, 2005, we hadWe derived 72%, 26% and 2%a substantial percentage of our initial license revenuesrevenue from our xPression, CompuSet and DLStwo product lines respectively.in 2005. As a result, factors that may adversely impact the pricing of or demand for these products, such as competition from other products, negative publicity or obsolescence of the hardware or software environments in which our products run, could have a material adverse effect on our business, operating results and financial condition. Our financial performance will depend significantly on the successful development, introduction and customer acceptance of new and enhanced versions of ourxPression software andxPresso software, as well as continued customer acceptance of CompuSet, Compose,DLS and related products.

Initial licenses toRevenues from end users in the insurance finance, government and manufacturing industriesindustry accounted for 43% of total revenues in the United States accounted for 54%, 14%, 11% and 10%, respectively,first quarter of initial license revenues in fiscal year 2005 to date.2006. Our future success will depend on our ability to continue to successfully market our products in thesethe insurance industry, as well as the finance and otherprint services industries, and introduce their use in new industries. Our failure to do so could have a material adverse effect on our business, operating results and financial condition.

Inaccurate sales forecasts and/or revenue projections could cause improper planning and budgeting of our resources.

Our revenues, and particularly our new software license revenues, are difficult to forecast, and as a result our quarterly operating results can fluctuate substantially. We use a “pipeline” system, a common industry practice, to forecast sales and trends in our business. Our sales personnel monitor the status of all proposals and estimate when a customer will make a purchase decision and the dollar amount of the sale. These estimates are aggregated periodically to generate a sales pipeline. Our pipeline estimates can prove to be unreliable both in a particular quarter and over a longer period of time, in part because the “conversion rate” of the pipeline into contracts can be very difficult to estimate. A variation in the conversion rate, or in the pipeline itself, could cause us to plan or budget incorrectly and adversely affect our business or results of operations. While this sales estimation process provides us with some guidance in business planning, it is based on estimates only and is therefore subject to numerous risks and uncertainties. Because a substantial portion of our new software license revenue contracts are completed in the latter part of a quarter, and our cost structure is largely fixed in the short term, revenue shortfalls tend to have a disproportionately negative impact on our profitability. A delay in even a small number of large new software license transactions could cause our quarterly new software licenses revenues to fall significantly short of our predictions.

Our growth is dependent upon successfully focusing our distribution channels.

To grow our business, we must streamlineimprove the performance of our worldwide sales and distribution channels by focusing on key target industry market segments where our current and planned products can enjoy a significant competitive advantage and high market demand. We also must leverage our existing relationships with Xerox and other partners by launching targeted joint marketing and value added reseller programs and by introducing new product offerings that are optimized for selected target markets and marketing channels. Additionally, we must form additional partnerships with system integrators and consultants in order to broaden our capacity to deliver complete dynamic content publishing solutions that incorporate significant services content, while also maintaining our core domain expertise. We cannot assure you that we will be able to successfully streamline and focus our worldwide channels, leverage our existing

relationships or form new alliances. If we fail to do so, it could have a material adverse effect on our business, operating results and financial condition.

Our products may suffer from defects or errors.

Software products, as complex as those we offer, may contain undetected defects or errors when first introduced or as new versions are released. As a result, depending on the severity of the defect or error, we could in the future loseforego or delay recognition of revenues as a result of softwarethese errors or defects. In addition, our products are typically intended for use in applications that may be critical to a customer’s business. As a result, we expect that our customers and potential customers have a greater aversion and sensitivity to product defects than the general market for software products. We have experienced defects in connection with the introduction of ourxPression product line in 2004, and believe that we have worked to addressaddressed this problem, but we cannot assure you that, despite our testing, as well as testing by current and potential customers, additional errors will not be found in our existing products or new products or releases. Defects discovered after the commencement of commercial shipments, can result in any of the following:

Maintaining our professional services expertise is necessary for our future growth.

We are continuing our focus on the consulting services component of our professional services to assist customers in the planning and implementation of enterprise-wide, mission-critical dynamic content publishing applications. This strategy is dependent on hiring and retaining and hiring professionalsqualified professional staff to

perform these consulting services. Should we be unable to maintain the necessary services workforce, ourOur business, operating results and financial condition could be materially adversely affected.

affected if we are unsuccessful in developing and retaining our professional services workforce.

We may be exposed to risks associated with international operations.

Our revenues from export sales accounted for 23%16% and 19% of our total revenues for the three months ended September 30,March 31, 2006 and 2005, and 2004, respectively, and 22% and 21% for the nine months ended September 30, 2005 and 2004, respectively.

We license our products in Europe through VARs and to a much lesser extent, direct sales.VARs. Revenues generated by these activities were $685,900$742,000 and $706,000$766,000 for the three months ended September 30,March 31, 2006 and 2005, and 2004, respectively, and $2.3 million for each of the nine month periods ended September 30, 2005 and 2004.

Our wholly owned subsidiary, Objectiva, develops, markets and supports our products in Asia. As of September 30, 2005, they had 210 employees.

respectively.

In Australia, Canada and Latin America, our products are distributed and/or supported by Xerox affiliates and also by direct sale in Canada. In Asia,China, our products are distributed and/or supported by our subsidiary, Objectiva. Revenues generated inby these regionsXerox affiliates and Objectiva were $1.1 million$469,000 and $444,000$396,000 for the three

months ended September 30,March 31, 2006 and 2005, and 2004, respectively, and $2.6 million and $1.3 million for the nine months ended September 30, 2005 and 2004, respectively.

In order to successfully expand export sales, we must establish additional foreign operations,increase our international presence in select countries, hire additional personnel and develop relationships with additional international resellers. If we are unable to do so in a timely manner, our growth in international export sales could be limited, and our business, operating results and financial condition could be materially adversely affected. In addition, we cannot assure you that we will be able to maintain or increase international market demand for our products.

Additional risks inherent in ourOur international business activities include:

Our Objectiva software engineering team of 206 employees is located in a 12,000 square foot facility in Beijing, China. We are subject to a variety of risks associated with conducting operations in China, including those related to general economic conditions, regulatory changes, political unrest and potential reduced protection for our intellectual property rights. In addition to facing the difficulty of managing a large offshore organization, we must comply with a variety of laws and regulations, including trade restrictions, local labor ordinances, changes in tariff rates and import and export licensing requirements. Our success depends, in part, on our ability to anticipate these risks and manage these difficulties.

A portion of our business is conducted in currencies other than the U.S. Dollar, primarily the Euro and the Chinese Yuan. Although exchange rate fluctuations have not had a significant impact on us, fluctuations in the value of the currencies in which we conduct our business relative to the U.S. Dollar could cause currency transaction gains and losses in future periods. We do not currently engage in currency hedging transactions, and we cannot assure you that fluctuations in currency exchange rates in the future will not have a material adverse impact on our international revenues and our business, operating results and financial condition.

Our business is dependent on the market for dynamic content publishing software.

The market for dynamic content publishing software is intensely competitive, highly fragmented and subject to rapid change. We cannot assure you that the market for dynamic content publishing software will continue to grow or that, if it does grow, organizations will adopt our products. WeAlthough we have spent, and intend to continue to spend, significant resources developing open-architecture software products and educating potential customers about the benefits of our products. However,products, we cannot assure you that such expenditures will enable our products to achieve further market acceptance, andacceptance. Additionally, if the dynamic content publishing software market develops more slowly than we currently anticipate, our business, operating results and financial condition could be materially adversely affected.

In addition,Furthermore, the commercial market for dynamic content publishing of electronic documents designed for use with the Internet, intranets and commercial on-line services has only recently begun to develop, and the success of our products designed for this market will depend in part on their compatibility with such services. It is difficult to predict whether the demand for related products and services would increase or decrease in the future.these elements. Since the increased commercial use of the Internet, intranets and commercial

on-line services is difficult to predict and could require substantial modification and customization of certain of our products and services, as well as the introduction of new products and services, we cannot assure you that we will be able to effectively or successfully compete in the future in this market.

Our ability to manage future change could affect our business.

Our ability to compete effectively and to manage future change will require us to continue to improve our financial and management controls, reporting systems and procedures on a timely basis and to expand, train and manage our work force. We cannot assure you that we will be able to do so successfully. Our failure to do so could have a material adverse effect on our business, operating results and financial condition.

Our executive officers and certain key personnel are critical to our business, and these officers and key personnel may not remain with us in the future.

Our future performance depends in significant part upon the continued service of our key technical, sales and senior management personnel. The loss of the services of one or more of our executive officers could have a material adverse effect on our business, operating results and financial condition. Our future success also depends on our continuing ability to attract and retain highly qualified product development, sales and management personnel. Competition for such personnel is intense, and there can be no assurance that we will be able to retain our key employees or that we will be able to attract or retain other highly qualified product development, sales and managerial personnel in the future.

Our business is dependent upon successfully protecting our proprietary rights.

We rely on a combination of copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our proprietary rights. Despite these protective measures, it may be possible for unauthorized third parties to copy portions of our products or use information we consider proprietary. Policing unauthorized use of our products is difficult and, while we are unable to determine the extent to which piracy of our software products exists, we expect software piracy to be a persistent problem. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. We cannot assure you that our means of protecting our proprietary rights will be adequate or that our competitors will not independently develop similar technology.

We are not aware of any infringement of our products upon the proprietary rights of third parties. However, we cannot assure you that third parties will not claim infringement by us with respect to current or future products. We expect that software product developers will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows, companies hire employees from competitors, and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could have a material adverse effect upon our business, operating results and financial condition.

Our failure to adequately limit our exposure to product liability claims may adversely affect us.

Our license agreements with our customers typically contain provisions designed to limit our exposure to potential product liability claims. However, it is possible that the limitation of liability provisions contained in our license agreements may not be effective under the laws of certain jurisdictions.

Although we have not experienced any product liability claims to date, sale and support of our products may entail the risk of such claims in the future. A successful product liability claim brought against us or a claim arising as a result of our professional services could have a material adverse effect upon our business, operating results and financial condition.

Integration of potential business or technology acquisitions may be difficult.

If we acquire complementary businesses, products or technologies instead of developing them ourselves, we may be unable to successfully integrate an acquired business, product or technology in a cost-effective and non-disruptive manner. Integrating any business, product or technology we acquire could be expensive and time-consuming, disrupt our ongoing business and distract company management. In addition, in order to finance any acquisition, we might need to raise additional funds through public or private equity or debt financings. In that event, we could be forced to obtain financing on less than favorable terms which, in the case of equity financing, may result in dilution to our stockholders. If we are unable to integrate any acquired entities, products or technologies effectively, our business, operating results and financial condition could be materially adversely affected. In addition, under certain circumstances, amortization of assets or charges resulting from the costs of acquisitions could have a negative impact on our reported operating results and financial condition.

Enacted and proposed changes in securities laws and regulations are likely to increase our costs.

The Sarbanes-Oxley Act of 2002 and the rules subsequently implemented by the SEC and the NASD have imposed various new requirements on public companies, including requiring changes in corporate governance practices. Our management and other personnel will need to continue to devote a substantial amount of time to comply with these requirements. Moreover, these rules and regulations have increased our annual legal and financial compliance costs, have made some activities more time-consuming and costly, and could expose us to additional liability. In addition, these rules and regulations may make retention and recruitment of qualified persons to serve on our board of directors or executive management team more difficult.

If any of these factorsevents occur, it could have a material adverse effect upon our business, operating results and financial condition.

Foreign Currency Exchange Risk

Our earnings and cash flows are subject to fluctuations due to changes in foreign currency exchange rates. To a certain extent, foreign currency exchange rate movements also affect our competitive position, as exchange rate changes may affect business practices and/or pricing strategies on non-U.S. based competitors. Our primary foreign currency risk exposure isexposures are related to U.S. Dollar to Euro and U.S. Dollar to Chinese Yuan conversions. Our subsidiary in China conducts business primarily in the Chinese Yuan. Considering the anticipated cash flows from firm sales commitments and anticipated sales for the next quarter, a hypothetical 10% weakening of the U.S. Dollar relative to the Euro would not materially adversely affect expected thirdsecond quarter 20052006 earnings or cash flows. This analysis is dependent on

actual export sales during the next quarter occurring within 90% of budgeted forecasts. The effect of the hypothetical change in exchange rates ignores the affecteffect this movement may have on other variables including competitive risk. If it were possible to quantify this competitive impact, the results could well be different than the sensitivity effects described above. Each month, we review our position for expected currency exchange rate movements.

Interest Rate Risk

We are exposed to changes in interest rates primarily from our short-term available-for-sale investments. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments at September 30, 2005.March 31, 2006. Declines in interest rates over time will, however, reduce our interest income.