Annual Reports

  • 10-K (Mar 10, 2017)
  • 10-K (Mar 30, 2016)
  • 10-K (Mar 31, 2015)
  • 10-K (Mar 28, 2014)
  • 20-F (Apr 30, 2013)
  • 20-F (Apr 24, 2012)

 
Quarterly Reports

 
8-K

 
Other

Modsys International Ltd 20-F 2007

Documents found in this filing:

  1. 20-F/A
  2. Ex-12.1
  3. Ex-12.2
  4. Ex-13.1
  5. Ex-13.2
  6. Ex-15
  7. Ex-15
Unassociated Document
 UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
F O R M 20 – F / A2

o
REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
OR
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2006
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
OR
o
SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Date of event requiring this shell company report……………………..

For the transition period from ________ to ________

Commission file number: 005-52583

BLUEPHOENIX SOLUTIONS LTD.
(Exact Name of Registrant as Specified in Its Charter)

Israel
(Jurisdiction of Incorporation or Organization)

8 Maskit Street, Herzlia 46120, Israel
(Address of Principal Executive Offices)

Securities registered or to be registered pursuant to Section 12(b) of the Act:
Ordinary shares, NIS 0.01 par value

Securities registered or to be registered pursuant to Section 12(g) of the Act:
None
(Title of Class)

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
Ordinary shares, NIS 0.01 par value
(Title of Class)
 
Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of December 31, 2006:
 
14,298,358 Ordinary shares, NIS 0.01 per share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o No x
 
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Yes o No x

Note – Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those Sections.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o

Indicated by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o
 
Accelerated filer o
 
Non-accelerated filer x
 
Indicate by check mark which financial statement item the registrant has elected to follow.

Item 17 o Item 18 x

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x
 


TABLE OF CONTENTS
 
 
1
ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT, AND ADVISERS
 
2
ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE
 
2
ITEM 3. KEY INFORMATION
 
2
 
A.
Selected Financial Data
 
2
 
B.
Capitalization and Indebtedness
 
3
 
C.
Reasons for the Offer and Use of Proceeds
 
3
 
D.
Risk Factors
 
4
ITEM 4. INFORMATION ON THE COMPANY
 
17
 
A.
History and Development of the Company
 
17
 
B.
Business Overview
 
18
 
C.
Organizational Structure
 
36
 
D.
Property, Plants and Equipment
 
36
ITEM 4A. UNRESOLVED STAFF COMMENTS
 
37
ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS
 
37
 
A.
Operating Results
 
46
 
B.
Liquidity and Capital Resources
 
51
 
C.
Research and Development, Patents and Licenses
 
56
 
D.
Trend Information
 
56
 
E.
Off-Balance Sheet Arrangements
 
57
 
F.
Tabular Disclosure of Contractual Obligations
 
57
 
G.
Safe Harbor
 
57
ITEM 6. DIRECTORS, SENIOR MANAGEMENT, AND EMPLOYEES
 
57
 
A.
Directors and Senior Management
 
57
 
B.
Compensation
 
60
 
C.
Board Practices
 
60
 
D.
Employees
 
67
 
E.
Share Ownership
 
68
ITEM 7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
 
70
 
A.
Major Shareholders
 
70
 
B.
Related Party Transactions
 
71
 
C.
Interests of Expert and Counsel
 
75
ITEM 8. FINANCIAL INFORMATION
 
75
 
A.
Consolidated Statements and Other Financial Information
 
75
 
B.
Significant Changes
 
76
ITEM 9. THE OFFER AND LISTING
 
76
 
A.
Offer and Listing Details
 
76
 
B.
Plan of Distribution
 
77
 
C.
Markets
 
77
 
D.
Selling Shareholders
 
78
 
E.
Dilution
 
78
 
F.
Expenses of the Issue
 
78
ITEM 10. ADDITIONAL INFORMATION
 
78
 
A.
Share Capital
 
78
 
B.
Memorandum and Articles of Association
 
78
 
C.
Material Contracts
 
81
 
D.
Exchange Controls
 
82
 
E.
Taxation
 
82
 
F.
Dividend and Paying Agents
 
90
 
G.
Statement by Experts
 
90
 
H.
Documents on Display
 
90
 
I.
Subsidiary Information
 
90

ii


ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
91
ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
91
P A R T II
92
ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
92
ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS
92
ITEM 15. CONTROLS AND PROCEDURES
92
ITEM 16A. AUDIT COMMITTEE FINANCIAL EXPERT
92
ITEM 16B. CODE OF ETHICS
93
ITEM 16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES
93
ITEM 16D. EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
94
ITEM 16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS
94
P A R T III
94
ITEM 17. FINANCIAL STATEMENTS
94
94
ITEM 19. EXHIBITS
95

iii

 
This Amendment No. 2 to Form 20-F (the “Amended 20-F”) contains information for the fiscal year ended December 31, 2006, which information was filed with the Securities and Exchange Commission on Form 20-F and Form 20-F/A on March 30, 2007 (the “Original 20-F”) and the consolidated financial statements contained therein (the “Original Financial Statements”); the certifications (Exhibits 12.1, 12.2, 13.1 and 13.2) contained in the Original 20-F speak as of the dates specified. Item 5 of the Original 20-F has been amended to include additional disclosure relating to management’s discussion of the Company’s operating results. The consolidated statements of operations, as well as Notes 1 and 11 of the Original Financial Statements, have been amended to include additional disclosure relating to revenue and cost of revenue line items, significant company policies and employee share option plans.
 
Except as specifically indicated, the Amended 20-F has not been updated to reflect events occurring subsequent to the filing of the Original 20-F. The filing of this Amended 20-F shall not be deemed an admission that the Original 20-F, when filed, included any untrue statement of a material fact or omitted to state a material fact necessary to make a statement not misleading.
 
P A R T I

 
Some of the statements in this annual report, including those in the Risk Factors, Operating and Financial Review and Prospects, and Business Overview sections, are forward-looking statements that involve risks and uncertainties. These forward-looking statements include statements about our plans, objectives, strategies, expectations, intentions, future financial performance, and other statements that are not historical facts. We use words like “anticipates,” “believes,” “expects,” “future,” “intends,” and similar expressions to mean that the statement is forward-looking. You should not unduly rely on these forward-looking statements, which apply only as of the date of this annual report. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the risks described under Risk Factors.

As used in this annual report, references to “we,” “our,” “ours,” and “us” refer to BluePhoenix Solutions Ltd. and its subsidiaries, unless otherwise indicated. References to “BluePhoenix” refer to BluePhoenix Solutions Ltd.

The name BluePhoenix™ and the names BluePhoenix™ IT Discovery, BluePhoenix™ LogicMiner, BluePhoenix™ DBMSMigrator, BluePhoenix™ PlatformMigrator, BluePhoenix™ Rehosting, BluePhoenix™ LanguageMigrator, BluePhoenix™ DataMigrator, BluePhoenix™ SOA-Ready Enablement (Formerly known as WS4Legacy,) BluePhoenix™ FieldEnabler, BluePhoenix™ StandardsEnabler, BluePhoenix™ COBOL/LE-Enabler, BluePhoenix™ EuroEnabler, BluePhoenix™ Refactoring Repository (Nebula- code name), BluePhoenix™ AppBuilder, and BluePhoenix™ Redevelopment appearing in this annual report are trademarks of our company. Other trademarks in this annual report are owned by their respective holders.

1

 
ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT, AND ADVISERS
 
Not applicable.
 
ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE
 
Not applicable.
 
ITEM 3. KEY INFORMATION
 
A. Selected Financial Data
 
The following tables present our consolidated statement of operations and balance sheet data for the periods and as of the dates indicated. We derived the statement of operations data for each of the years ended December 31, 2004, 2005 and 2006 and the balance sheet data as of December 31, 2005 and 2006 from our consolidated financial statements included in Item 18 of this annual report, which have been prepared in accordance with generally accepted accounting principles as applied in the United States, or U.S. GAAP. Our consolidated financial statements have been audited by Ziv Haft registered public accountant (Isr.) BDO member firm. The selected consolidated financial data as of December 31, 2002, 2003 and 2004 and for the years ended December 31, 2002 and 2003 is derived from our audited financial statements not included in this annual report, which have been prepared in accordance with U.S. GAAP. You should read the selected consolidated financial data set forth below together with our consolidated financial statements included elsewhere in this annual report. See “Item 5. Operating and Financial Review and Prospects.”

2

 

   
Year Ended December 31,
 
   
2006
 
2005
 
2004
 
2003
 
2002
 
   
$
 
 
 
 
 
Consolidated Statements of Operations Data: 
 
 (in thousands, except per share data)
 
Revenues
 
$
68,004
 
$
58,947
 
$
57,186
 
$
54,340
 
$
36,668
 
Cost of revenues
   
28,515
   
25,379
   
24,253
   
24,115
   
15,220
 
Gross profit
   
39,489
   
33,568
   
32,933
   
30,225
   
21,448
 
Software development costs
   
9,400
   
8,006
   
8,055
   
8,138
   
7,387
 
Selling, general, and administrative expenses
   
22,149
   
21,611
   
21,388
   
20,140
   
13,245
 
     
7,940
   
3,951
   
3,490
   
1,947
   
816
 
Goodwill impairment, restructuring costs, and non-recurring expenses
   
-
   
-
   
-
   
-
   
472
 
Operating income (loss)
   
7,940
   
3,951
   
3,490
   
1,947
   
344
 
Financial income (expenses), net
   
(3,515
)
 
(1,978
)
 
(882
)
 
165
   
(195
)
Gain on realization of shareholdings
   
-
   
-
   
112
   
376
   
-
 
Other income (expenses), net
   
282
   
104
   
975
   
567
   
(1,581
)
Income (loss) before taxes on income
   
4,707
   
2,077
   
3,695
   
3,055
   
(1,432
)
Income tax expense
   
(282
)
 
149
   
260
   
152
   
160
 
     
4,989
   
1,928
   
3,435
   
2,903
   
(1,592
)
Equity in losses of affiliated companies, net
   
-
   
-
   
(516
)
 
(898
)
 
(1,336
)
Minority interest
   
(317
)
 
(139
)
 
(73
)
 
(154
)
 
(702
)
Net income (loss)
 
$
4,672
 
$
1,789
 
$
2,846
 
$
1,851
 
$
(3,630
)
                                 
Basic earning (loss) per share
 
$
0.34
 
$
0.13
 
$
0.21
 
$
0.14
 
$
(0.35
)
Diluted earnings (loss) per share
 
$
0.33
 
$
0.13
 
$
0.21
 
$
0.14
 
$
(0.35
)
                                 
Weighted average number of shares outstanding
   
13,889
   
13,557
   
13,523
   
13,451
   
10,517
 
Weighted average number of shares outstanding assuming dilution
   
14,371
   
13,973
   
14,679
   
13,644
   
10,517
 
 
   
December 31,
 
   
2006
 
2005
 
2004
 
2003
 
2002
 
   
$
 
     
Consolidated Balance Sheet Data:
           (in thousands)          
Working capital
 
$
17,861
 
$
4,546
 
$
6,357
 
$
246
 
$
1,310
 
Total assets
   
127,466
   
99,691
   
90,882
   
80,820
   
87,481
 
Total liabilities
   
67,517
   
47,925
   
42,251
   
35,422
   
40,760
 
Shareholders’ equity
   
59,949
   
51,766
   
48,631
   
45,398
   
46,721
 
 
B. Capitalization and Indebtedness
 
Not applicable.
 
C. Reasons for the Offer and Use of Proceeds
 
Not applicable.

3

 
D. Risk Factors
 
Our business, operating results, and financial condition could be seriously harmed due to any of the following risks. In addition, the trading price of our ordinary shares and convertible notes could decline due to any of these risks. Additional risks and uncertainties that we are not aware of or that we currently believe are immaterial may also adversely affect our business, financial condition, results of operations and our liquidity.

Risks Related to Our Business

If capital spending on information technology, or IT, slows down, our business could be seriously harmed.

We are affected by global economic changes, in particular trends in capital spending in the IT sector. During 2001 through 2003, the overall business slowdown in the North American and European markets influenced the purchasing patterns of leading software developers who delayed their planned orders and caused developers to reduce the amount of their planned license commitment. These changes in purchasing patterns in the IT industry directly affected our operating results. Although we believe that during the last three years the IT market has begun to recover, we cannot know whether the global market recovery will continue in the future, and how the economic conditions will continue to affect our business. Accordingly, we cannot assure you that we will be able to increase our revenues or keep our revenues at the same level as in 2005 and 2006.

Any future acquisitions of companies or technologies may distract our management and disrupt our business.

As part of our growth strategy, we have invested in and acquired control of various companies to expand our solution portfolio. We intend to continue seeking investment opportunities. We may incur indebtedness or issue equity securities to pay for these acquisitions and investments. The issuance of equity securities could dilute our existing shareholders.

In addition, as part of our expansion strategy, we increased our controlling interest in some of our subsidiaries and fully integrated them within our business. We cannot assure you that we will be able to identify future suitable acquisition or investment candidates or, if we do identify suitable candidates, that we will be able to make the acquisitions or investments on commercially acceptable terms or at all. If we acquire, invest in, or increase our control interest in another company, we could have difficulty assimilating that company’s personnel, operations, technology, or products and service offerings into our own. In addition, the key personnel of the acquired company may decide not to work for us. These difficulties could disrupt our ongoing business, distract our management and employees, increase our expenses, and adversely affect our results of operations. Acquisitions of new companies, like the recent acquisition of CodeStream Software Ltd., also involve the risk of penetrating markets in which we have no or limited experience. For more information about the acquisition of CodeStream, see “Item 4.B. Business Overview–Investments and Acquisitions–CodeStream.”

4

 
We have a limited operating history in our current principal markets, which will make it difficult or impossible for you to predict our future results of operations.

We have experienced major fluctuations in our net results. In 2006, we generated $4.7 million net income from our operations. However, in 2002 and 2001 we h ad a net loss of $3.6 million and $15.0 million, respectively. The net loss in 2002 and 2001 was a reversal from prior years in which we had net income. The fluctuations in our net results are mainly attributable to the changes in the suite of modernization tools we have been offering to our customers, the limited experience we have had in the markets for these tools, the capital spending on information technology, and the difficulties we have encountered in introducing our tools to their respective markets. In addition, global economic conditions affect our net results. Most of the solutions we offer to our customers are based on tools that share a common generic technology and methodology. However, the introduction of new tools to new markets involves increased selling and marketing expenses, which in turn increases our operating expenses and directly affects our results of operations. Because of our limited experience in our principal markets and with our new products, we cannot assure you that our strategy for operating in these markets or selling these products will be successful. You should not rely on our historical results of operations as indications of future performance.

If we are unable to accurately predict and respond to market developments or demands, our business will be adversely affected.
 
The IT modernization business is characterized by rapidly evolving technology and methodologies. This makes it difficult to predict demand and market acceptance for our modernization tools and services. In order to succeed, we need to adapt the tools and services we offer to keep up with technological developments and changes in customer needs. We cannot guarantee that we will succeed in enhancing our tools and services or developing or acquiring new modernization tools and services that adequately address changing technologies and customer requirements. We also cannot assure you that the tools and services we offer will be accepted by customers. If our tools and services are not accepted by customers, our future revenues and profitability will be adversely affected. Changes in technologies, industry standards, the regulatory environment, customer requirements, and new product introductions by existing or future competitors could render our existing solutions obsolete and unmarketable, or require us to enhance our current tools or develop new tools. This may require us to expend significant amounts of money, time, and other resources to meet the demand. This could strain our personnel and financial resources.

We may experience significant fluctuations in our annual and quarterly results, which makes it difficult to make reliable period-to-period comparisons and may contribute to volatility in the market price of our ordinary shares and convertible notes.
 
Our quarterly and annual results of operations have fluctuated significantly in the past and we expect them to continue to fluctuate significantly in the future. These fluctuations are the result of risks related to the introduction of new products as described above and any of the following events:
 
5

 
· adverse economic conditions in various geographic areas where our customers and potential customers operate;
· acquisitions and dispositions of companies;
· timing of completion of specified milestones and delays in implementation;
· timing of product releases;
· timing of contracts;
· increases in selling and marketing expenses, as well as other operating expenses; and
· currency fluctuations and financial expenses related to our financial instruments.

In addition, unexpected events that do not occur on a regular basis and that are difficult to predict may cause fluctuations in our operating results. As a result, we believe that period-to-period comparisons of our historical results of operations are not necessarily meaningful and that you should not rely on them as an indication for future performance. Also, it is possible that our quarterly and annual results of operations may be below the expectations of public market analysts and investors.

A delay in collection of our fees could result in cash flow shortages, which in turn may significantly impact our financial results.

Typical modernization projects, which deploy our solutions, are long-term projects, and therefore, payment for these projects or a substantial portion of our fees may be delayed until the successful completion of specified milestones. In addition, the payment of our fees is dependent upon customer acceptance of the completed work, and our ability to collect the fees. Further, although the timing of receipt of our fees varies, we incur the majority of our expenses on a current basis. As a result, a delay in the collection of our fees could result in cash flow shortages. To date, we have not experienced any significant payment delays that resulted in cash flow shortages. Any significant variation in estimated and actual revenues obtained may significantly impact our financial results in any given period.

Mainsoft’s dependency on Microsoft .NET, an open-source implementation of Microsoft, could have a material adverse effect on our business.

Mainsoft’s Visual MainWin for J2EE has been developed based on the open-source Mono project led by Novell, which is an open-source implementation of the Microsoft .NET framework. Microsoft may claim that software developed based on the open-source Mono project infringes certain Microsoft patents. In addition, Microsoft may cease its business relationship and cooperation with companies using the open source Mono project, which may result in severe damage to Mainsoft’s ability to effectively market the Visual MainWin for J2EE product.

Damage to Mainsoft’s relationship with Microsoft could have a material adverse effect on our business, financial condition, and results of operations.
6

If we fail to address the strain on our resources caused by changes in our company, we will be unable to effectively manage our business.

In the past few years, we have undergone significant changes in our product offerings. These changes include acquiring new technologies, developing and marketing new modernization and porting tools and expanding the sales of our products further into international markets. This has placed and will continue to place substantial demands upon our management, systems, and resources, including our sales, project management, consulting personnel, and software development operations. Our ability to manage any future changes or growth depends on our ability to continue to implement and improve our operational, financial, and management information control and reporting systems on a timely basis, and to expand, train, motivate, and manage our work force. If we cannot respond effectively to changing business conditions, our business, financial condition, and results of operations could be materially adversely affected.

If we are unable to manage the effects of the variations in our offering portfolio, our results will be adversely affected.

We specialize in the development and implementation of sophisticated software modernization and porting tools and products. We leverage our know-how, experience and generic technologies, to develop and introduce new software tools that enable the modernization of legacy systems. The need for our modernization solutions changes over time, and recent regulations or newly introduced technologies may create new needs for modernization solutions. As part of our growth strategy, as a new need evolves, we typically conduct a market analysis to qualify and quantify the market opportunity. If the results justify the investment required for the development of new products or tools, then we begin the development process of the new product. In order to maintain our position in the market, and our ability to address the constantly changing needs of the marketplace, we continually invest in the development of new products. The net annual expense related to research and development was $9.4 million in 2006, $8.0 million in 2005 and $8.1 million in 2004.

In order to properly introduce a new product to the marketplace or to introduce our current products into new markets, we continuously update our marketing materials, educate our sales force and make changes to our operations. If these activities are not completed in a timely manner, our new product introduction may be delayed and our business, financial condition, and results of operations could be materially adversely affected.

If we are unable to attract, train, and retain qualified personnel for our worldwide facilities at competitive prices, we may not be able to achieve our objectives and our business could be harmed.

In order to achieve our objectives, we hire from time to time additional qualified software, administrative, operational, sales, and technical support personnel. The process of attracting, training, and successfully integrating qualified personnel can be lengthy and expensive. We may not be able to compete effectively for the personnel we need. As part of our growth strategy, we developed offshore centers in Cyprus and Romania. We hired professional consultants for these development centers, leveraging the lower employer costs that existed in these countries. Recently, professional work in these countries became more expensive and professional fees may continue to increase in the future. As a result, we may consider establishing alternative off-shore facilities in other countries. The establishment of additional off-shore facilities may result in significant capital expenses which may affect our cash position. We cannot assure you that our off-shore facilities will be profitable. Our future success depends on our ability to absorb and retain senior employees and to attract, motivate, and retain highly qualified professional employees worldwide at competitive prices.
 
7

 
If we fail to estimate accurately the costs of fixed-price contracts, we may incur losses.

We derive a portion of our revenues from engagements on a fixed-price basis. We price these commitments upon estimates of future costs. We bear the risk of faulty estimates and cost overruns in connection with these commitments. Our failure to accurately estimate the resources required for a fixed-price project, to accurately anticipate potential wage increases, or to complete our contractual obligations in a manner consistent with the project plan could materially adversely affect our business, operating results, and financial condition. In addition, we may agree to a price before the design specifications are finalized, which could result in a fixed price that is too low, resulting in lower margins or losses to us.

If our tools or solutions do not function efficiently, we may incur additional expenses.

In the course of providing our modernization solutions, the project team conducts testing to detect the existence of failures, errors and bugs. If our modernization solutions fail to function efficiently or if errors or bugs are detected in our tools, we might incur significant expenditures in an attempt to remedy the problem. The consequences of failures, errors, and bugs could have a material adverse effect on our business, operating results, and financial condition.

If we fail to satisfy our customers’ expectations regarding our solutions, our contracts may be cancelled and we may be the subject of damages claims.

In the event that we fail to satisfy our customers’ expectations from the results of the implementation of our solutions, or if we fail to timely deliver our solutions to our customers, these customers may suffer damages. When and if this occurs, customers may have the ability to cancel our contracts. Any cancellation of a contract could cause us to suffer damages, since we might not be paid for costs that we incurred in performing services prior to the date of cancellation. In addition, from time to time we may be subject to claims as a result of not delivering our products on time or in a satisfactory manner. Such disputes or others may lead to material damages.
 
8

 
We are exposed to significant claims for damage caused to our customers’ information systems.

Some of the products, tools, and services we provide involve key aspects of our customers’ information systems. These systems are frequently critical to our customers’ operations. As a result, our customers have a greater sensitivity to failures in these systems than do customers of other software products generally. We have never been the subject of a material damages claim related to our modernization solutions or modernization services. However, if a customer’s system fails during or following the provision of modernization solutions or services by us, or if we fail to provide customers with proper support for our modernization solutions, we are exposed to the risk of a claim for substantial damages against us, regardless of our responsibility for the failure. We cannot guarantee that the limitations of liability under our product and service contracts, if any, would be sufficient to protect us against legal claims. We cannot assure you that our insurance coverage will be sufficient to cover one or more large claims, or that the insurer will not disclaim coverage as to any future claim. If we lose one or more large claims against us that exceed available insurance coverage, it may have a material adverse effect on our business, operating results, and financial condition. In addition, the filing of legal claims against us in connection with contract liability may cause us negative publicity and damage to our reputation.

If third parties assert claims of infringement against us, we may suffer substantial costs and diversion of management’s attention.

Substantial litigation over intellectual property rights exists in the software industry. Software products may be increasingly subject to third-party infringement claims as the functionality of products in different industry segments overlaps. Although our products and services have never been the subject of an infringement proceeding, we cannot predict whether third parties will assert claims of infringement against us. In addition, our employees and contractors have access to software licensed by us from third parties. A breach of the nondisclosure undertakings by any of our employees or contractors may lead to a claim of infringement against us. Any claim, with or without merit, could be expensive and time-consuming to defend, and would probably divert our management’s attention and resources. In addition, such a claim if submitted may require us to enter into royalty or licensing agreements to obtain the right to use a necessary product or component. Such royalty or licensing agreements, if required, may not be available to us on acceptable terms, if at all.

A successful claim of product infringement against us and our failure or inability to license the infringed or similar technology could have a material adverse effect on our business, financial condition, and results of operations.

We may be unable to adequately protect our proprietary rights, which may limit our ability to compete effectively. 

Our success and ability to compete are substantially dependent upon our internally developed technology. Our intellectual property consists of proprietary or confidential information that is not subject to patent or similar protection. Our employees and contractors have direct access to our technology. In general, we have relied on a combination of technical leadership, trade secret, copyright, and trademark law and nondisclosure agreements to protect our proprietary know-how. Unauthorized third parties may attempt to copy or obtain and use the technology protected by those rights. Any infringement of our intellectual property could have a material adverse effect on our business, financial condition, and results of operations. Policing unauthorized use of our products is difficult and costly, particularly in countries where the laws may not protect our proprietary rights as fully as in the United States.
 
9

 
Pursuant to agreements with certain of our customers, we have placed, and in the future may be required to place, in escrow, the source code of certain of our software. Pursuant to the escrow arrangements, the software may, under specified circumstances, be made available to our customers. From time to time, we also provide our software directly to customers. These factors may increase the likelihood of misappropriation or other misuse of our software.

We are exposed to litigation that could result in considerable financial liabilities.

In July 2003, a former Liraz shareholder filed an application with the Tel-Aviv-Jaffa District Court to approve a claim filed by him against us, as a class action. The claim relates to the acquisition of Liraz shares, which we completed in March 2003. The shareholder alleges that the share price we paid to Liraz’s shareholders in the tender offer and in a subsequent mandatory purchase was lower than the fair price of Liraz shares. The maximum amount of the claim is approximately NIS 30.5 million ($7.3 million) in the aggregate. Under Israeli law, the court’s approval is required for the plaintiff to represent all of the shareholders of Liraz who sold their shares to us pursuant to the tender offer and the mandatory acquisition. The plaintiff has applied for such approval in the lawsuit. If we are not successful in defending this claim, we could be exposed to considerable financial liabilities and, as a result, our financial condition could be materially adversely harmed.

Our largest shareholder, Formula, controls a majority of our ordinary shares and influences the outcome of matters that require shareholder approval.

Formula Systems (1985) Ltd., referred to as Formula, owns, as of March 22, 2007, 52.3% of our outstanding ordinary shares. Therefore, Formula has the power to control the outcome of most matters requiring shareholder approval, including the election of directors and approval of significant corporate transactions. Gad Goldstein, the chairman of our board, and president and chief executive officer of Formula, directly owns 230,628 ordinary shares, representing 1.5% of our outstanding ordinary shares. Gad Goldstein owns 2.5% of the outstanding shares of Formula.

This share ownership may have the effect of delaying or preventing a change in control. Although Israeli law imposes certain procedures (including shareholder approval) for approval of certain related party transactions, including certain of those between us and Formula, we cannot assure you that these procedures will eliminate the possible detrimental effects of conflicts of interest. If certain transactions are not approved in accordance with required procedures under applicable Israeli law, these transactions may be void or voidable.

Our existing credit facilities contain a number of restrictions and obligations that limit our operating and financial flexibility.

Our credit facilities contain a number of restrictive covenants that limit our operating and financial flexibility. These covenants, among other things, restrict our ability to pledge our assets, dispose of assets, make loans or give guarantees, make certain acquisitions and engage in mergers or consolidations. Our credit facilities also contain covenants regarding maintaining certain financial ratios. See “Item 5.B. Liquidity and Capital Resources – How We Have Financed Our Business.”
 
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Our ability to continue to comply with these and other obligations depends in part on the future performance of our business. There can be no assurance that such obligations will not materially adversely affect our ability to finance our future operations or the manner in which we operate our business. In particular, any noncompliance with performance-related covenants and other undertakings of our credit facilities could result in an acceleration of our outstanding debt under our credit facilities and restrict our ability to obtain additional funds, which could have a material adverse effect on our business, financial condition and results of operations.

In some circumstances, a change of control of BluePhoenix will constitute an event of default under our credit facilities and we could be required to repay our debts to the banks. If this occurs, we may not have the financial resources to repay all of our outstanding debt. This also may adversely affect the attractiveness of our company to potential large investors.

Our failure to fulfill our obligations under our credit facility agreements, convertible debentures or other financial arrangements will adversely affect our cash flow, cash position and net results.

We intend to fulfill our debt service obligations from existing cash, investments and our operations. Our failure to fulfill our obligations under our credit facilities, the convertible debentures or our other financial arrangements, will have significant negative consequences, including, without limitation:

 
·
requiring the dedication of a portion of our expected cash flow to service our indebtedness, thereby reducing the amount of our expected cash flow available for other purposes, including funding our research and development programs and other capital expenditures;
·
increasing our vulnerability to general adverse economic conditions;
·
limiting our ability to obtain additional financing;
 
·
placing us at a possible competitive disadvantage relative to less leveraged competitors and competitors that have better access to capital resources; and
 
·
causing a material offset to our results, resulting decreased net profits or increased net losses.

We may not be able to make our debt payments in the future.

Our ability to meet our debt obligations will depend on whether we can successfully implement our strategy, as well as on financial, competitive, and other factors, including some factors that are beyond our control. Most of our debt and credit facilities bear an interest rate based on the LIBOR. If the LIBOR materially increases, our cash flows will be negatively affected. If we are unable to generate sufficient cash flow from operations to meet principal and interest payments on our debt, we may have to refinance all or part of our indebtedness. In case we have to increase our indebtedness, the additional financing expenses will have a negative affect on our results, which cannot be predicted. Our ability to refinance our indebtedness will depend on, among other things:

·
our financial condition at the time;
 
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·
restrictions in agreements governing our debt; and
·
other factors, including market conditions.

We cannot ensure that any such refinancing would be possible on terms that we could accept or that we could obtain additional financing. If refinancing will not be possible or if additional financing will not be available, we may have to sell our assets under circumstances that might not yield the highest prices, or default on our debt obligations, which would permit our noteholders and holders of other outstanding indebtedness to accelerate their maturity dates. If we incur additional debt or liabilities, our ability to pay our debt obligations could be adversely affected.
 
Risks Relating to International Operations
 
Marketing our tools and solutions in international markets may cause increased expenses and greater exposure to risks that we may not be able to successfully address.

We intend to continue to expand our international operations, which will require significant management attention and financial resources. In order to continue to expand worldwide sales, we need to establish additional marketing and sales operations, hire additional personnel, and recruit additional resellers internationally. To the extent that we are unable to do so effectively, our growth is likely to be limited and our business, operating results and financial condition will be materially adversely affected.

Risks inherent in our worldwide business activities generally include:

·
currency exchange devaluations;
·
unexpected changes in regulatory requirements;
·
tariffs and other trade barriers;
·
costs of localizing products for foreign countries;
·
lack of acceptance of localized products.;
·
longer accounts receivable payment cycles;
·
difficulties in operations of management;
·
potentially adverse tax consequences, including restrictions on the repatriation of earnings; and
·
the burdens of complying with a wide variety of local legislation.

We cannot assure you that these factors will not have a material adverse effect on our future international sales and, consequently, on our business, operating results and financial condition.
 
12

 
Inflation, devaluation and fluctuation of various currencies may adversely affect our results of operations, liabilities and assets.

We run our operations in various countries. As a result, we enter into transactions with customers and suppliers in local currencies. The fluctuations in foreign currency exchange rates in countries where we operate can adversely affect the reflection of these activities in our consolidated financial statements. Fluctuations in the value of our non-dollar revenues, costs and expenses measured in dollars could materially affect our results of operations. In addition, our balance sheet reflects non-dollar denominated assets and liabilities, which can be adversely affected by fluctuations in the currency exchange rates.

The reporting currency of our consolidated financial statements is the U.S. dollar. The functional currency of our business is the U.S. dollar. We enter, from time to time, into forward currency exchange contracts or other arrangements in order to hedge this foreign currency exposure. Such arrangements may not always be effective or sufficient to offset the fluctuations in currency exchange rates. For additional information relating to the exchange rates between different relevant currencies, see “Item 5. – Our Reporting Currency.”

Fluctuations in foreign currency values affect the prices of our products, which in turn may affect our business and results of operations.

Most of our worldwide sales are currently denominated in U.S. dollars and euros while our reporting currency is the dollar. A decrease in the value of the dollar relative to foreign currencies, in particular the euro, Danish kroner (DKK) and the NIS would make our products more expensive and increase our operating costs and, therefore, could adversely affect our results and harm our competitive position in the markets in which we compete.

We are subject to multiple taxing jurisdictions. If we fail to estimate accurately the amount of income tax due in any of these jurisdictions, our net income might be affected.

We operate within multiple taxing jurisdictions and are subject to taxation by these jurisdictions at various tax rates. In addition, we may be subject to audits in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. We cannot assure you that the final tax outcome of these issues will not be different than management estimates, which are reflected in our income tax provisions. Such differences could have a material effect on our income tax provision and net income in the period in which such outcome occurs.
 
13

 
Risks Relating to Operations in Israel

Political, economic, and military conditions in Israel could negatively impact our business.

Over the past several decades, a number of armed conflicts have occurred between Israel and its Arab neighbors. Any hostilities involving Israel or the interruption or curtailment of trade between Israel and its present trading partners could affect our operations. Since September 2000, there has been a marked increase in violence, civil unrest and hostility, including armed clashes between the State of Israel and the Palestinian Authority and other groups in the West Bank and Gaza Strip, and acts of terror have been committed inside Israel and against Israeli targets in the West Bank and Gaza. During July and August 2006, major hostilities broke out between Israel and both Palestinian factions in Gaza and Hezbollah in Lebanon, leading to an escalation of the conflict in the area. Major towns and settlements in northern Israel, including Haifa, Naharia, Safed and Karmiel, were under attack from Hezbollah missiles. Such conflicts, as well as the execution of Israel’s plan of unilateral disengagement from the Gaza Strip and some parts of the West Bank and Hamas’ gaining majority of the Palestinian Parliament in the elections held in 2006, may affect Israel’s security, foreign relations and the stability of the region. Increased hostilities, future armed conflicts, political developments in other states in the region, or continued or increased terrorism could make it more difficult for us to conduct our operations in Israel, which could increase our costs and adversely affect our financial results. In addition, many of our male employees in Israel are obligated to perform annual military reserve duty typically until 45 years of age and in some cases up to 54 years of age, and are subject to being called for active duty under emergency circumstances. While we have operated effectively under these requirements since our incorporation, we cannot predict the full impact of such conditions on us in the future, particularly if emergency circumstances occur. If many of our employees are called for active duty, our operations in Israel and our business may be adversely affected.
 
It may be difficult to serve process and enforce judgments against our directors and officers in Israel.
 
We are organized under the laws of the State of Israel. Most of our executive officers and directors are nonresidents of the United States, and a substantial portion of our assets and the assets of these persons are located outside the United States. Therefore, it may be difficult to:
 
 
·
effect service of process within the United States on us or any of our executive officers or directors who are nonresidents of the United States;
 
·
enforce court judgments obtained in the United States including those predicated upon the civil liability provisions of the United States federal securities laws, against us or against any of our executive officers or directors that are nonresidents of the United States, in the United States or Israel; and
 
·
bring an original action in an Israeli court against us or against any of our executive officers or directors to enforce liabilities based upon the United States federal securities laws.
 
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Risks Related to our Traded Securities

The market price of our convertible notes and ordinary shares may be volatile and our investors may not be able to resell the notes or the shares at or above the price they paid, or at all.

During the past few years, the worldwide stock markets have experienced high price and volume fluctuations. The market prices of securities of technology companies have been extremely volatile, and have experienced fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market fluctuations could adversely affect market price of our ordinary shares. The high and low market price of our ordinary shares traded on the Nasdaq Global Market and the Tel Aviv Stock Exchange, or the TASE, during each of the last three years, are summarized in the table below:

   
Nasdaq Global Market
 
TASE
 
   
In $
 
In NIS
 
   
High
 
Low
 
High
 
Low
 
2006
   
6.45
 
 
3.85
 
 
18.30
 
 
28.99
 
2005
   
4.75
 
 
3.81
 
 
21.95
 
 
16.01
 
2004
   
7.49
 
 
3.71
 
 
33.80
 
 
17.00
 

The market price of our ordinary shares may continue to fluctuate substantially due to a variety of factors, including:

 
·
any actual or anticipated fluctuations in our or our competitors’ quarterly revenues and operating results;
·
shortfalls in our operating results from levels forecast by securities analysts;
·
public announcements concerning us or our competitors;
 
·
the introduction or market acceptance of new products or service offerings by us or by our competitors;
·
changes in product pricing policies by us or our competitors;
·
changes in security analysts’ financial estimates;
·
changes in accounting principles;
·
sales of our shares by existing shareholders; and
·
the loss of any of our key personnel.

In addition, economic, political, and market conditions and military conflicts and, in particular, those specifically related to the State of Israel, may affect the market price of our shares.
 
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In February 2006, we completed an underwritten public offering in Israel of series A convertible notes, referred to in this annual report as the convertible notes, in an aggregate principal amount of NIS 54.0 million that were equal at that time to approximately $11.5 million. Following the offering, the convertible notes have been listed for trading on the TASE. The trading price of the convertible notes depends on many factors, including but not limited to, prevailing interest rates, the trading price of our ordinary shares, the market for similar securities and general economic conditions. Therefore, the trading price of the convertible notes could be subject to significant fluctuations. Additionally, it is possible that the market for the convertible notes will be subject to disruptions that may have a negative effect on the holders of the convertible notes, regardless of our prospects or financial performance. During 2006, the market price of our convertible notes traded on the TASE, fluctuated between NIS 1.06 and NIS 1.02.

Our ordinary shares are traded on more than one market and this may result in price variations. 

Our ordinary shares trade on the NASDAQ Global Market and the TASE. Trading in our ordinary shares on these markets take place in different currencies (dollars on the NASDAQ Global Market and NIS on the TASE), and at different times (resulting from different time zones, different trading days and different public holidays in the United States and Israel). The trading prices of our ordinary shares on these two markets may differ due to these and other factors. Any decrease in the trading price of our ordinary shares on one of these markets could cause a decrease in the trading price of our ordinary shares on the other market. 
 
Future sales of our shares to be registered for resale in the public market, as well as conversion of our convertible securities, could dilute the ownership interest of our existing shareholders and could cause the market price for our ordinary shares or convertible notes to fall.
 
As of March 22, 2007, we had 15,374,124 ordinary shares outstanding (excluding 1,647,594 held by two of our wholly owned subsidiaries). In addition, we reserved 2,145,017 ordinary shares for issuance under our option plans. We also have certain commitments described below to issue BluePhoenix ordinary shares and register them for resale, as follows:

 
·
691,105 ordinary shares issuable upon conversion of debentures issued to institutional investors in connection with the $5 million private placement completed in March 2004;

 
·
485,714 ordinary shares issuable upon exercise of warrants issued to institutional investors in connection with the $5 million and $3 million private placements, completed in March 2004 and March 2006, respectively; and

 
·
2,059,064 ordinary shares issuable upon conversion of the convertible notes traded on the TASE sold by us in a public offering in Israel in February 2006.

For information about the debentures and the warrants issued to the institutional investors, see “Item 5.B Liquidity and Capital Resources – Contractual Commitments and Guarantees.”
 
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The conversion of some or all of the convertible debentures held by the institutional investors, the exercise of options and warrants held by investors, and the conversion of the convertible notes traded on the TASE, would dilute the ownership interests of our existing shareholders. Any sales in the public market of our ordinary shares issuable upon such conversion could adversely affect the prevailing market prices of our ordinary shares.

In addition, certain of our shareholders, holding in the aggregate 9,655,663 ordinary shares, have registration rights with respect to the shares they hold, including piggyback rights. For more information about these rights, see “Item 7.B Related Party Transactions – Registration Rights Agreements.”

If a large number of our ordinary shares are sold in a short period, the price of our ordinary shares would likely decrease.

In addition, the price of our ordinary shares could be affected by possible sales of our ordinary shares by investors who view the convertible notes as a more attractive means of equity participation in our company and by hedging or arbitrage trading activity that may develop involving our ordinary shares. The hedging or arbitrage could, in turn, affect the trading price of the convertible notes.

We may be characterized as a passive foreign investment company, or PFIC, for U.S. federal income tax purposes.

If, for any taxable year, our passive income or assets that produce passive income exceed levels provided by law, we may be characterized as a PFIC for U.S. federal income tax purposes. This characterization could result in adverse U.S. tax consequences to U.S. holders of ordinary shares. If we were classified as a PFIC, a U.S. holder of ordinary shares could be subject to increased tax liability upon the sale or other disposition of ordinary shares or upon the receipt of amounts treated as “excess distributions.” United States holders should consult with their own U.S. tax advisors with respect to the tax consequences of investing in our ordinary shares as well as the specific application of the PFIC rules. For a more detailed discussion, see “Taxation—United States Federal Income Tax ConsiderationsTax Consequences if We Are a Passive Foreign Investment Company.”
 
ITEM 4. INFORMATION ON THE COMPANY
 
A. History and Development of the Company
 
We were incorporated in Israel in 1987 under the name A. Crystal Solutions Ltd. In 1996, we changed our name to Crystal Systems Solutions Ltd. In 2003, following the acquisition of Liraz Systems Ltd., we changed our name to BluePhoenix Solutions Ltd. Our registered office is located at 8 Maskit Street, Herzlia, 46120 Israel and our telephone number is 972-9-9526110. Our agent in the United States is Blue Phoenix Solutions USA Inc., 8000 Regency Parkway, Cary, NC 27511 United States and its telephone number is (919) 380-5100.
 
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We run our worldwide operations through several wholly owned subsidiaries, named below:

Name of Subsidiary
 
Country of Incorporation
 
BluePhoenix Solutions USA Inc.
   
United States
 
IntraComp Group Inc.
   
Unites States
 
BluePhoenix Solutions Nordic ApS
   
Denmark
 
BluePhoenix Solutions U.K. Ltd.
   
United Kingdom
 
BluePhoenix Solutions Srl.
   
Italy
 
I-Ter/Informatica & Territorio S.p.A.
   
Italy
 
BluePhoenix Solutions GmbH
   
Germany
 
BluePhoenix Solutions B.V.
   
The Netherlands
 
BluePhoenix Solutions Ltd.
   
Cyprus
 
BluePhoenix Solutions Srl.
   
Romania
 

For information about our significant subsidiaries, see “Item 4.C. Organizational structure.”

Recent Developments

In December 2006, we acquired from CodeStream Software Ltd., or CodeStream, a key competitor in providing IDMS database migrations, certain business assets and activities in the field of modernization of legacy databases. The acquired activities enable us to provide IDMS modernization products and services, enabling organizations to move their IDMS systems to modern relational databases serving modern web based applications on Java, Microsoft .NET or COBOL technology platforms. Pursuant to the purchase agreement, we hired 18 persons previously employed by CodeStream and assumed all the obligations in respect of the purchased activities. In consideration for the acquisition of CodeStream’s assets and activities, we paid to CodeStream 5.2 million (approximately $10.2 million). We believe that this acquisition strengthens our position as a leading provider in the market of database and application migrations.
 
B. Business Overview
 
Our Business
 
We develop and market unique value driven enterprise IT modernization, or EIM, solutions that enable companies to automate the process of modernizing and upgrading their mainframe and distributed IT infrastructure in order to more effectively compete in today’s business environment. The combination of our comprehensive tools and services with our unique methodology provides an efficient and cost-effective process for extending the return on investment of existing enterprise IT assets. Our complete modernization solutions consist of a combination of automated technologies and services that minimize the risk through the whole life cycle of the modernization process. Our solutions are based on technologies that support the four phases of the process, which we call: Understanding, Migration, Remediation, and Redevelopment. The solutions allow companies to fully leverage their current systems and applications, speed up and reduce the cost of the renewal process, and effectively update their systems in order to adapt to new business demands. In addition, by using our technologies our customers gain the added value of extending their systems to be ready for future demands, such as service oriented architecture, or SOA. Our modernization solutions are offered to customers in all business market sectors, particularly financial services, automotive and governmental entities. In addition, we provide consulting services such as application development services and maintenance for core banking systems.
 
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Our solution portfolio includes software products, software tools, and services that address the most pressing IT challenges which organizations and companies face today, including:

·
lack of agility and responsiveness to changing business needs;
·
difficulty in recruiting and retaining mainframe professionals;
·
growing cost of software licenses, maintenance and operations;
·
lack of packaged software and new applications; and
·
difficulties in complying with new regulations.

Our solutions enable companies to:

·
effectively plan and carry out strategic projects that provide real business value;
·
better understand and manage their IT systems and resources;
·
easily integrate packaged applications and build customized applications;
·
significantly decrease maintenance, human resource, and technology costs;
·
quickly migrate to modern databases, platforms, applications, and programming languages with a proven suite of tools and services;
·
substantially transform applications and databases in order to address regulatory and business changes; and
·
directly gain access to cutting edge technology and new business channels.

Our comprehensive enterprise technologies span mainframe, midrange, and client/server computing platforms. We have enhanced our expertise through the successful completion of projects for many large organizations over the past two decades, establishing our credibility and achieving international recognition and presence. Based on our technology and that of our affiliates, we develop and market software products, tools, and related methodologies. We deliver our tools and methodologies together with training and support in order to provide enterprises with comprehensive solutions, primarily for the modernization of existing IT systems.
 
Market Background
 
Companies initiate IT modernization projects for a wide range of reasons, such as:

 
·
maintaining a competitive edge in the market;
 
·
addressing changing business needs;
 
·
complying with new regulations;
 
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·
reducing maintenance, human resources, and technology costs; or
 
·
gaining access to cutting edge technology and new business channels.

Alternatives to modernization, include, among others, renewing legacy systems, buying packaged software, or rebuilding entire applications. Enterprise IT modernization has proven to be the most efficient and viable way for companies to protect their existing investments. We provide a range of solutions designed to efficiently address the challenge of retaining the business knowledge built into the application code while updating the system to reflect new requirements.

The EIM market is divided into the following categories:

Enterprise IT Understanding—These solutions enable companies to make informed strategic decisions regarding the future of their IT systems by automatically capturing multiple levels of operational and development information into a consolidated metadata warehouse. Our tools facilitate global assessments and impact analyses of application assets, thus helping reduce costs, streamline working processes, and increase efficiency.

Enterprise IT Migration—These solutions enable companies to consolidate and eliminate a wide range of legacy hardware and software through automated migration of applications, databases, platforms, programming languages, and data. These tools help to reduce costs and resources, and minimize reliance on proprietary technology, sunset products, and dwindling skill sets. Our SOA-ready solution is provided as a post-migration service, allowing customers to extend their development environment by providing access to mainframe systems through Web services protocols, making legacy systems appear as modern systems.

Enterprise IT Remediation—These solutions enable companies to extend the life of their existing IT systems by quickly adapting to new regulatory changes and business requirements. These automated tools can be easily customized to fit any IT environment and corporate need, including data field adjustment, IT standardization, and system consolidation.

Enterprise IT Redevelopment—These solutions enable companies to mine existing applications by extracting business rules, data flows, and data models, and then re-using the proven code base to create more flexible Java/Web-based applications. Our tools help to reduce maintenance costs and resources and application development time-to-market.

Enterprise IT Understanding

In the current lean budgetary environment, companies that want to extend the return on investment of their existing systems need to modernize their legacy systems. Since modernization projects are intricate and complex, the essential first step is a thorough review of existing IT assets.

Our understanding solutions provide automated, detailed mapping of system-wide IT activity and the interconnections between all software components. This detailed road map serves as the basis for optimizing the re-use of existing IT systems, tailoring the modernization plan for the company’s unique IT environment and corporate requirements, and reducing future ongoing maintenance costs.
 
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Modernization initiatives that need to be based on an in-depth examination of actual system elements include:

 
·
building and rewriting enterprise-scale application components;
 
·
implementing new technologies such as Web-enablement;
 
·
integrating purchased and newly written applications;
 
·
consolidating servers and applications;
 
·
migrating to more modern platforms, databases and languages;
·
transforming current applications to adapt to changing business standards; and
·
protecting against the loss of critical personnel and corporate knowledge base.

Our integrated set of enterprise IT understanding solutions are designed to assist companies in achieving these goals by accurately mapping raw IT operational and development data, down to the program code level, into a consolidated enterprise-wide warehouse. The gathered information enables companies to keep track of system inventories, resources, and interrelationships and to intelligently mine systems and application metadata.

This enterprise-wide view can then be used for a variety of strategic purposes, including:

·
performing impact, cost, and trend analyses as well as ongoing tracking of IT resources, inventories, components, their usage and their interrelationships;
·
running business-logic analyses for business process identification, evaluation, extraction, transition and enhancement;
·
achieving significant cost reductions through the elimination of unused products, unnecessary software upgrades, inefficient storage allocations, and wasteful CPU usage; and
·
providing more efficient application development by reusing systems and leveraging existing business rules.

BluePhoenix™ IT Discovery—This solution provides fast and convenient access to application inventory, dependency, and operational information. This tool performs the complete audit necessary to enable companies to define and analyze all application assets in order to make informed decisions about ongoing modernization activities. IT Discovery provides the ability to analyze on a refreshable basis numerous technology environments, and from them extract and report on the interrelationships among the components that make up these environments. In this manner, it provides an organization the ability to discover information about its current systems, thereby insuring that ongoing decisions are made based on an accurate audit of the current environment.

BluePhoenix™ LogicMiner—This recovery solution mines COBOL and extracts business rules from the legacy code, thus providing IT departments with the ability to begin a modernization process based on techniques that preserve the functionality of legacy code. This tool retains past investments in software assets by producing reusable code objects or descriptive data that can later be used for improving the quality of the legacy code, rewriting the legacy application, or building a full modernization plan. LogicMiner increases a system’s manageability, while eliminating rules that no longer apply to current business procedures.
 
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Enterprise IT Migration

Our comprehensive, integrated set of enterprise IT migration solutions enable companies to standardize and consolidate their IT systems by automatically converting and redeploying applications, databases, platforms, programming languages and data that are implemented on outdated computing platforms.

Buying a packaged application or rebuilding one can often be an expensive and risky proposition. Therefore, companies often look towards migrating their existing applications. This option is much more cost-effective and time-efficient as it leverages their existing investments in custom applications. Additionally, our migration solutions enable companies to operate their IT systems independently, without relying on previous technology support providers. Thus, the migration process provides significant cost savings on development, maintenance, and human resources.

Our migration solutions provide numerous advantages, including:

 
·
significantly decreasing project costs, risk of errors and time;
 
·
preserving corporate business knowledge;
 
·
substantially reducing dependency on scarce skill sets;
 
·
solving problematic maintenance issues;
 
·
enabling end-to-end project control and management;
 
·
directly supplying a full audit trail and documentation of all changes;
 
·
minimizing system freeze time with a unique “refresh” feature; and
 
·
comprehensively working with most mainframe and non-mainframe platforms.

The enterprise IT migration suite includes the following solutions:

BluePhoenix™ DBMSMigrator—An automated migration tool that converts applications from nonrelational databases, such as IDMS (Integrated Database Management System), ADABAS, IMS, and VSAM, to relational databases, such as DB2, Oracle, and SQL Server. The tool performs automated conversions that provide companies with fully functional compliance for source and target applications and minimal application, functional, and logical program flow changes. DBMSMigrator leaves no residuals, emulation software, or translation procedures and allows system support to continue uninterrupted during the migration project. As a result of the conversion process, the migrated application operates more efficiently, is easier to maintain, and contains complete documentation of the customer’s knowledge base and guidelines.

BluePhoenix™ PlatformMigrator—An automated migration tool that converts a range of platforms, including VSE, MVS, and Bull GCOS, to Unix, Linux, Windows, and .Net. PlatformMigrator can be customized to fit the unique IT configuration and business rules of each customer site. The tool converts platforms to a pure, native installation so that programs are not required to run under emulation or through translation techniques. PlatformMigrator solutions assist companies with maintaining service levels, setting and upgrading standards, implementing the new IT environment, training IT users, implementing new facilities like a security system or a batch scheduler, and testing for functional equivalence.

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BluePhoenix™ Rehosting—Organizations implement mainframe rehosting in order to reduce the ongoing costs of existing legacy CICS and batch applications. Rehosting leverages the strength and investment of older COBOL applications while taking advantage of new, cost-efficient hardware and open operating system environments such as Linux, Unix, Windows, J2EE, and .NET.

Using our various automated migration tools, and cooperating with our partners, we offer COBOL migration and mainframe rehosting solutions. We formed the following alliances for providing these solutions:

 
·
a cooperation with Micro Focus for implementing their “Lift and Shift” strategy. Micro Focus is a member of the Migration and Transformation Consortium (MTC) for COBOL solutions;
 
·
an alliance with Clerity for assisting companies to rehost mainframe applications on more cost-efficient, open platforms; and
 
·
a collaboration with Fujitsu for assisting companies to migrate COBOL/CICS applications into Fujitsu NetCOBOL and the Fujitsu NeoKicks and NeoBatch environments for handing CICS and batch/JCL.

BluePhoenix™ LanguageMigrator—An automated migration tool for converting COBOL and 4GLs (fourth generation languages) such as ADSO, Natural, ALLFusion Gen (formerly COOL: Gen), Mantis, and PowerBuilder to COBOL and Java/J2EE. This reliable, time-efficient, and comprehensive solution enables site-wide installation, simultaneous testing, and implementation of batch programs. In addition, LanguageMigrator identifies the compatibility of the code, converts it to the new standards required by customers, and analyzes converted programs to identify potential problems. For more information about future developments of this tool, see “Research and Development.”

BluePhoenix™ DataMigrator—A Windows-based tool for migrating data between various data system environments. Coupled with a step-by-step proven methodology, the tool provides a fully structured but still versatile automated data migration process. DataMigrator enables full control of source and target data definitions resulting in consistent, accurate, highest quality target data with no data loss, and efficient utilization of available resources. In addition, it provides support for partial or incremental migration and for multiple runtime environments.

BluePhoenix™ SOA-Ready Enablement —This post-migration service extends the useful life of valuable legacy applications that run on historic mainframe platforms by allowing them to be easily reused in a modern Web-centric environment. This comprehensive solution provides Web services and Web customers for legacy applications. This unique set of tools enables the exposure of a legacy application to more modern applications written in Java or .NET by providing a Web service interface for the legacy system. Our tools also provide a Web-based display for legacy (3270) applications. These tools are noninvasive and allow the legacy application to remain untouched.


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Enterprise IT Remediation

Our integrated set of enterprise IT remediation solutions enable companies to extend the life of their existing IT systems when facing ongoing regulatory changes and new business requirements. Our remediation solutions address a variety of corporate needs and include:

BluePhoenix™ FieldEnabler—New business decisions or regulatory requirements often require companies to make changes that impact a wide range of system components. These include field adjustments that involve changes in the type, length, and structure of a database or program field, such as expanding a dealer code. FieldEnabler is a rule-based tool that enables a step-by-step, comprehensive process for making these kinds of modifications across an enterprise in a reliable and time-efficient manner.

BluePhoenix™ StandardsEnabler—A highly automated solution for reliably facilitating system consolidation into a single set of naming standards. Since all resources being converted must be changed in parallel, the large task of manually standardizing the naming of system components is not practical. Our tool provides an automated solution addressing this problem.

BluePhoenix™ COBOL/LE-Enabler—A highly automated solution that facilitates the migration of COBOL code from non-LE compliant environments to LE compliant environments.

BluePhoenix™ EuroEnabler—A highly automated solution that enables the transformation of applications to be euro compliant. EuroEnabler fully preserves system and data integrity and helps to maintain existing levels of system application development and maintenance throughout the process.

Enterprise IT Redevelopment

Enterprise IT environments are complex, and can prevent companies from quickly and easily adapting to new business needs and requirements. The more companies can organize and understand their applications, the faster they can adapt to inevitable changes. While organizations are mostly satisfied with the existing business functionality of their applications, they usually want to improve their business processes and leverage technologies such as Web-enabled and service-oriented architectures. Additionally, they are eager to find a way to decrease their maintenance costs, which typically consume 70%–80% of total IT spending.

Our enterprise IT redevelopment suite enables companies to efficiently mine, reuse, and rewrite their existing applications, thus incrementally redeveloping their legacy systems, extending them into new technologies, and saving on development and programmer costs.

BluePhoenix™ AppBuilder—Our primary redevelopment legacy environment has been used for managing, maintaining, and reusing the complicated applications needed by large businesses. It provides the infrastructure for enterprises worldwide, across several industries, with applications running millions of transactions daily on legacy systems. Enterprises using AppBuilder can build, deploy, and maintain large-scale custom-built business applications for years without being dependent on any particular technology until they cease using their legacy infrastructure. AppBuilder acts like a virtual application warehouse, keeping the underlying structure of the system in an organized framework such that developers can easily understand it. This allows companies to reuse critical business components, realizing a long-term return on investment for both new and existing applications.

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BluePhoenix™ Redevelopment —Based on AppBuilder and LogicMiner, Redevelopment transforms legacy COBOL programs into service oriented applications deployed on the latest platforms. The resulting application conforms to industry standards and is written in clean, maintainable source code. This conformance to standard architectures, such as full object-orientation and Web services, is a key differentiator in the Redevelopment approach when compared to more common migrations. Instead of using the common approach where each line of COBOL source code is translated to one or more statements in the target language (known as 1-1 approach), Redevelopment uses a model based approach. Redevelopment develops a platform independent model from platform specific models of legacy COBOL applications identified by BluePhoenix LogicMiner. This platform independent model may then be extended to meet new business requirements. Finally the application is generated to J2EE, .NET, or COBOL.

Visual MainWin® for the Unix and Linux platforms (formerly MainWin)—Visual MainWin® for the Unix and Linux platforms is an application-porting platform that enables independent software vendors to develop applications in Visual C++ and deploy them natively on Unix and Linux without the investment that is usually associated with designing and developing a new source code base for Unix platforms.

In 1994, Mainsoft entered into a licensing agreement with Microsoft, pursuant to which Microsoft granted Mainsoft access to specified Microsoft source code, including new versions, service packs, and upgrade releases for Windows. Microsoft also granted Mainsoft distribution rights to the Windows object code licensed as a component in Visual MainWin for Unix. Visual MainWin for Unix is already a mature product and Mainsoft primarily focuses on supporting and maintaining its existing Visual MainWin for Unix customers. We believe that our growth engine is the Visual MainWin for J2EE product described below.

Visual MainWin® for the J2EE platform—During 2006, Mainsoft continued to invest in the research and development, sales and marketing of its new Visual MainWin® for J2EE product, including the introduction of a Portal Edition. Mainsoft and IBM have been collaborating to market Visual MainWin for J2EE to IBM customers using or considering using WebSphere Portal in a mixed .NET-Java environment.

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Investments and Acquisitions

In order to enhance our solutions and services portfolio, we have been pursuing a strategy of adding new technologies to our suite of automated modernization tools. We implement this strategy via internal development of new software tools and through acquisitions and investments. Accordingly, we devote significant resources to the development and marketing of new software modernization tools, and invest in businesses that develop software tools that are complementary to our existing portfolio. The broad portfolio that we established, among others, through these acquisitions, contributes to our ability to penetrate new markets and to offer a complete set of solutions addressing the broad array of changing demands of our customers. We integrate the acquired businesses into our business and assimilate many of their functions, including, marketing, sales, finance and administration into our existing infrastructure.

Following is a description of our investments and acquisitions, which form a part of our business as described above:

CodeStream Software Ltd. In December 2006, we acquired from a company incorporated in the United Kingdom, CodeStream Software Ltd., certain business activities in the field of modernization of legacy databases, particularly IDMS and other mainframe platforms. Pursuant to the purchase agreement, we hired 18 persons previously employed by CodeStream and assumed all the obligations in respect of the purchased activities. In consideration thereof, we paid CodeStream 5.2 million (approximately $10.2 million). In addition, we undertook to issue to CodeStream a convertible debenture in a principal amount of 2.9 million (approximately $5.7 million), if (i) not later than December 14, 2008, we receive purchase orders from a key customer of CodeStream, in an aggregate amount of not less than 2.2 million (approximately $4.3 million); and (ii) such purchase orders are collectible under the purchase orders not later than December 14, 2009. The debenture shall be issued upon the fulfillment of the aforementioned conditions and shall be due two years after the date of issuance. The debenture shall bear interest at a rate of LIBOR plus 1.5% calculated on a quarterly basis. Interest shall be calculated on the principal amount of the debenture beginning on December 14, 2006.

In addition, we undertook to issue to CodeStream a second convertible debenture in a principal amount of 500,000 (approximately $982,000), if (i) not later than December 14, 2010, we receive additional purchase orders from the same key customer of CodeStream, in an aggregate amount of not less than 800,000 (approximately $1.6 million); and (ii) such purchase orders are collectible not later than 36 months after the first debenture was issued. The debenture shall be due two years after the date of issuance and shall bear interest at a rate of LIBOR plus 1.5% calculated on a quarterly basis. Interest will accrue on the principal amount of the debenture beginning on the date of issuance of the first debenture.
 
The debentures will be convertible into BluePhoenix’s ordinary shares at a conversion rate of $6.00 per ordinary share, subject to adjustment for stock dividends, stock splits, recapitalization and other similar events. At the request of the holders of the debentures, given six months in advance, we will repay the amount of the debentures prior to their respective due dates. At the request of the holders of a majority of the shares underlying each of the debentures, given within 10 business days after issuance of the debenture, we will file a registration statement under the Securities Act 1933, referred to as the Securities Act, for an offering of the shares underlying the debentures. In addition, if we otherwise propose to register our ordinary shares under the Securities Act, the holders of the debentures may request that we register their underlying shares as well, subject to certain limitations. In the event that the repayment date of a debenture occurs earlier than 6 months after the registration statement becomes effective, then, the repayment date of the debenture shall be postponed until a date which is 6 months after the effective date of the registration statement. In the event that holders of 50% or more of the principal amount of a debenture request repayment of the debenture prior to its due date, we shall be released from our undertakings with respect to the registration described above.

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BluePhoenix Solutions Srl. (previously known as AlphaTech (2000) Srl.). In December 2002, we purchased from Intercomp, our affiliate, a 65% controlling interest in AlphaTech (2000) Srl. for aggregate consideration of $100,000. In February 2005, we entered into an agreement with the other shareholder of AlphaTech to purchase for $250,000 its entire holdings in AlphaTech, which as of such date was equal to 35% of AlphaTech’s outstanding share capital. In 2005, AlphaTech changed its name to BluePhoenix Solutions Srl. BluePhoenix Solutions Srl., a company incorporated in Romania, serves as our offshore delivery center in Romania.

CePost. In January 2004, we purchased the entire outstanding share capital of CePost Ltd., an Israeli company that develops and markets software solutions for electronic document mining, management and presentment. Pursuant to the purchase agreement, we paid to the shareholders of CePost $172,500 and issued to them 31,496 BluePhoenix’s ordinary shares. In addition, we undertook to pay to the sellers royalties from CePost’s revenues in an amount of up to $1.5 million. At our option, we may pay the royalties in BluePhoenix’s ordinary shares. In accordance with the purchase agreement, we paid to the sellers in 2005 and 2006 advances in an aggregate amount of $45,000 on account of the royalties.

Intercomp. In 1998, we invested in Intercomp Ltd., which has developed a set of automated analysis and reengineering tools for legacy COBOL applications. During 2002 and 2003, Intercomp focused its efforts on the development of software tools that comprise a part of BluePhoenix LogicMiner. For more information about LogicMiner, see “Research and Development—Enterprise IT Understanding—BluePhoenix LogicMiner.”

In 2004, we exercised an option granted to us to purchase from Eran Tirer all of its holdings in Intercomp, constituting 18.5% of the outstanding share capital of Intercomp. In consideration, we issued to Mr. Tirer warrants to purchase BluePhoenix ordinary shares which expired without being exercised. As part of the transaction with Mr. Tirer, certain shareholders of Intercomp, holding 2.1% of Intercomp’s outstanding share capital, transferred to us their holdings in Intercomp. In addition, the remaining shareholders of Intercomp comprised of several funds acting through their general partner, Infinity, converted certain outstanding loans owed to them by Intercomp into 7,236 shares of Intercomp at a price of $162.70 per share. Following these transactions, our holdings in Intercomp increased from 49% to approximately 62%. Since the end of the first quarter of 2004, we have consolidated the results of operations of Intercomp.

Concurrently with the grant by Mr. Tirer of the option to purchase from him his holdings in Intercomp, Intercomp granted nonexclusive rights to a distributor partially owned by Mr. Tirer, to further develop and distribute Intercomp’s products.

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In April 2004, Infinity granted us a call option to purchase its entire holdings in Intercomp. The option expired without being exercised by us. As a result, Infinity exercised a put option granted to it, to cause us to purchase Infinity’s entire holdings in Intercomp. In consideration for Intercomp’s shares, we issued to Infinity 100,719 BluePhoenix ordinary shares. As previously agreed with Infinity, we filed a registration statement under the Securities Act with respect to the ordinary shares issued to Infinity. Subsequent to the exercise of the option by Infinity, we currently wholly own Intercomp.

In the first quarter of 2006, FIMI, a creditor of Intercomp, has completed exercising a put option to sell to us convertible promissory notes issued by Intercomp, in an aggregate principal amount of $3.5 million. The put option was originally granted to FIMI in January 2001. As consideration thereof, we paid FIMI an aggregate amount of $4.48 million including interest accrued, which equals the book value of the promissory notes, and issued to FIMI warrants to purchase 210,000 BluePhoenix’s ordinary shares at an exercise price of $4.00 per share. No gain or loss was recorded at the repayment date. In the first quarter of 2007 FIMI exercised all its warrants.

I-Ter/Informatica & Territorio S.p.A. In the second quarter of 2005, we entered into an agreement to purchase the entire outstanding share capital of I-Ter. I-Ter is a developer and marketer of software solutions for migration from DL1 to DB2, and from IMS/DC to CICS, porting of applications from mainframe and Unix Sun Solaris. Pursuant to the purchase agreement, we paid to the selling shareholders of I-Ter $1.4 million. Under the terms of the transaction, we agreed to pay the selling shareholders an additional consideration of up to $720,000 calculated based on I-Ter’s cumulative earnings before interest and taxes, referred to as EBIT. As agreed, if the EBIT in any calendar year during the three-year period commencing on January 1, 2005, is equal to or greater than $6,000, we will pay the selling shareholders an additional $240,000 with respect to each such year. In 2006, we paid to the selling shareholders $240,000 since I-Ter met the criteria in 2005. In 2006, the EBIT exceeded the minimal level, and therefore we are required to pay the selling shareholders $240,000. In addition, we agreed to pay to the selling shareholders, at such date that is 15 business days following the date on which the EBIT report for the year ended on December 31, 2007 is final, additional consideration equal to seven times the yearly average EBIT in the three-year period commencing on January 1, 2005, less the amounts already paid to the selling shareholders for the purchased shares. In addition, in the event that the yearly average EBIT in the three-year period commencing on January 1, 2005 is greater than $600,000, we shall pay the selling shareholders an amount equal to nine times of the difference between the yearly average EBIT in the three-year period commencing on January 1, 2005 and $600,000.

MultiConn. In 1999, we acquired 51% of the outstanding share capital of M.S.I. MultiConn Solutions International (1995) Ltd., referred to as M.S.I. MultiConn, and in 2000, we increased our shareholdings in M.S.I. MultiConn to 60%. Effective as of January 2004, the other shareholders of M.S.I. MultiConn transferred their entire holdings in M.S.I. MultiConn to us. Following this transaction, we assumed control over the daily management of M.S.I. MultiConn. We currently wholly own M.S.I. MultiConn and finance its activities.

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In 2000, we established together with the other shareholders of M.S.I. MultiConn, a company named MultiConn Technologies Ltd. and initially owned 19% of its share capital. MultiConn Technologies develops and markets BluePhoenix™ SOA - Ready Enablement. In 2002, we increased our holdings in MultiConn Technologies to 60%. Following a transaction entered into between us and the other shareholders of MultiConn Technologies in 2004, the other shareholders of MultiConn Technologies increased their holdings in MultiConn Technologies to 58.2% in the aggregate, through the issuance of shares by MultiConn Technologies. As a result, we currently hold approximately 40% of the outstanding share capital of MultiConn Technologies. We have an option to increase our holdings in MultiConn Technologies to 60% of its outstanding share capital for an exercise price of $50,000. As of March 22, 2007, we lent to MultiConn Technologies an aggregate amount of $2.5 million. In 2004, we included in our equity in affiliated companies 100% of the losses of MultiConn Technologies. As of December 31, 2004, we consolidate MultiConn Technologies’ balance sheet with ours. For more information about BluePhoenix™ SOA - Ready Enablement, see “Enterprise IT Migration—BluePhoenix™ SOA - Ready Enablement.”

Outlook. Effective as of January 2004, we acquired from an Israeli company, Outlook Systems Ltd., through our new wholly owned subsidiary, Outlook & BluePhoenix Ltd., Outlook Systems’ entire business activities in Israel in the field of software development services. Pursuant to the purchase agreement, we hired 31 employees previously employed by Outlook Systems and assumed all the obligations in respect of the purchased activity. Under the purchase agreement, as amended in 2006, we paid to Outlook Systems an aggregate amount of approximately $1.3 million. In accordance with the amendment to the purchase agreement, a guarantee given by us to secure bank loans of Outlook Systems, was cancelled. In addition, Outlook Systems received 138,591 of BluePhoenix ordinary shares. As part of the amendment, we undertook to pay Outlook Systems a consideration to be calculated based on Outlook & BluePhoenix Ltd.’s annual earnings before interest and taxes, referred to as EBIT, during the three-year period commencing on July 1, 2005, as follows:

 
·
For an amount of up to $300,000 of the annual EBIT in each year within the three-year EBIT period, we will pay Outlook Systems a consideration equal to 10% of the EBIT;
 
·
For an amount of annual EBIT in a fiscal year within the three-year EBIT period in excess of $300,000, we will pay Outlook Systems additional consideration equal to 15% of the excessive amount.

Based on the EBIT during the eighteen months commencing on July 1, 2005, the accrued contingent consideration is $35,000.

Zulu Software Inc. In February 2005, we entered into an agreement to purchase up to 20% of the outstanding share capital of Zulu Software, Inc., or Zulu, on a fully diluted basis. Under the purchase agreement, the purchase price was divided into four installments, each to be paid subject to fulfillment of a certain milestone. We paid the first installment of $350,000 in February 2005 against the issuance to us of 8% of Zulu’s outstanding share capital. We have not made additional payments because the agreed upon milestones have not been met. In January 2006, we purchased from the other shareholders of Zulu additional shares increasing our holdings to 72% of Zulu’s outstanding share capital. The aggregate consideration we paid for this additional purchase was $2.4 million. Zulu is a developer and marketer of software solutions for migration from ADABAS/Natural to Java. For more information about Zulu’s software solutions, see “Enterprise IT Migration—BluePhoenix LanguageMigrator.”

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Cicero Inc. (formerly Level 8 Systems Inc.). As of March 22, 2007, we hold several capital instruments, including warrants and rights to receive warrants, exercisable into shares of Cicero Inc. If we exercise these capital instruments in full, we will hold approximately 545,000 ordinary shares of Cicero. As of March 22, 2007, we provided Bank Ha’Poalim with a guarantee securing Cicero’s bank loans, in an amount of approximately $2 million. The guarantee is extended from time to time and it is currently in effect until November 2007. In consideration for the extension of the guarantee, Cicero issues to us ordinary shares. In the event that the guarantee is exercised, the bank is obligated to grant to us a loan for a three-year period in an amount of up to the amount of the guarantee.

In September 2004, we extended a loan to Cicero of approximately $97,000 under a secured promissory note. The note bears interest at an annual rate of 10%. In consideration, we are entitled to receive warrants to purchase 19,865 ordinary shares of Cicero at an exercise price of $1 per share.

Customers

We provide our modernization solutions directly or through our strategic partners, such as IBM, EDS, NCS, Matrix, and TACT. Additionally, from time to time, other IT services companies license our technologies for use in modernization projects in various markets. Our partners are usually system integrators who assist us in increasing our penetration and exposure in the market. We provide solutions to our partners’ customers in collaboration with the system integrator’s team. In most cases, the partners provide related services to the customers. Our arrangements with our partners vary. We may enter into distribution agreements with our partners under which we grant license rights or to the partners’ customers, provide related services, or a combination of both. Alternatively, we may enter into subcontractor relationships with our strategic partners.

A substantial portion of our agreements are based on fixed price contracts. These projects may bear some risks and uncertainties as we price these contracts based on estimates of future costs, duration of the project and the impact of potential changes in the scope of the work. We also enter into other types of contracts, including annual maintenance contracts, license agreements and arrangements on a time and material basis. To date, shifts in revenues generated from different types of agreements have not materially affected our results of operations.

Our customers include, among others:

Financial Services
 
Insurance
 
Other Industries
         
·
Citibank
 
·
American Family Life Assurance company of Columbus
 
·
Ansys Inc. Canonburg
·
Credit Suisse
 
·
DesJardins General Insurance Group Inc.
 
·
Altera Corporation
·
Fidelity International Resource Management
 
·
Employees retirement system
 
·
Business Objects Corp.

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Financial Services
 
Insurance
 
Other Industries
         
·
Laiki Group
 
·
Europe Assistance
 
·
Commonwealth of Australia represented by the Department of Immigration and Multicultural and Indigenous Affairs
·
Rabobank Netherland BV
 
·
Friends Provident Management Services Ltd.
 
·
Daimler Chrysler AG
·
Rural Servicios Informaticos (Spain)
 
·
Legal and general Resources
 
·
Erhervs-og Selskabsstyrelsen
·
SDC Udvikling (Denmark)
 
·
Scottish Equitable Plc.
 
·
ESRI – Environmental Research Institute, Inc
·
Woolwich PLC
 
·
The New York City
 
·
IBM de Mexico Comercializaion y- servicios S.A
           
·
IBM (Rational Software)
           
·
Lawson Products
           
·
Mentor Graphics Corporation
           
·
Ministry of Defense (Israel)
           
·
Siebel Systems, Inc
           
·
Toyota Motor Sales, USA, Inc.
           
·
TEMENOS Group
 
Each of the customers mentioned above contributed at least $600,000 to our annual revenues for a project performed within the previous two fiscal years.

SDC Udvikling A/S, referred to as SDC Udvikling, an affiliated company of SDC, accounted for 11% and 17% of our revenues in 2006 and 2005, respectively.

Temenos group accounted for 15% of our revenues in 2006.

The following table summarizes the revenues from our tools and services by geographic regions for the periods indicated

   
Year ended December 31,
 
   
2006
 
2005
 
2004
 
   
(in thousands)
 
United States
 
$
15,048
 
$
17,423
 
$
20,438
 
Europe (other than Denmark)
   
28,449
   
18,643
   
15,860
 
Denmark
   
10,304
   
12,334
   
10,122
 
Israel
   
10,156
   
7,991
   
8,353
 
Other
   
4,047
   
2,556
   
2,413
 
                     
Total
 
$
68,004
 
$
58,947
 
$
57,186
 

Research and Development

In order to maintain our position as a market leader in the IT modernization market, we are focusing our development efforts on further enhancements to current solutions, as well as addressing newly emerging aspects of the modernization market. We are planning additional software development activities to extend our modernization solutions by leveraging our technological skills to create added value for our customers and to generate additional business opportunities.

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The next generation of our solutions will be extended to address the entire modernization process from legacy systems to modern platforms. We have started to develop our next generation of products and tools, which will allow the fluent transformation of legacy code to state-of-the-art platforms, such as J2EE and .NET. The new generation of solutions is composed of products and tools in several EIM categories.

Enterprise IT Understanding

BluePhoenix™ IT Discovery— By further refining our existing understanding technology and combining it with the additional technology licensed from Merrill Lynch, IT Discovery will provide the basis for legacy understanding needed by the rest of our modernization solutions.

Enterprise IT Automated Migration

Fourth Generation Language Migration—In the area of automated migration, we continue to build on our 4GL migration solutions. Our assets in the migration area cover COOL:Gen, Mantis, ADSO/IDMS, Natural, CSP, and PowerBuilder transformations. We continue to extend the support target platform of these transformations to include J2EE and .NET platforms.
 
Enterprise IT SOA Ready Solution—A comprehensive solution that provides Web services or clients for a legacy application. Our unique suite of tools enables a legacy application to be exposed to more modern applications written in Java or .NET by providing a web service interface for the legacy system. In addition, our tools are able to provide a web based appearance/ connectivity/ interface legacy applications. Both solutions are not intrusive and allow the legacy application to remain untouched.

BluePhoenix™ LogicMiner—A comprehensive solution for recovery that mines COBOL and extracts business rules from the legacy code, thus providing IT departments with the ability to begin a modernization process based on techniques that preserve the functionality of a legacy code. This tool retains past investments in software assets by producing reusable code objects or descriptive data that can later be used for improving the quality of the legacy code, rewriting the legacy application, or building a full modernization plan. LogicMiner increases a system’s manageability, while eliminating rules that no longer apply to current business procedures.
 
BluePhoenix™ Refactoring Repository—A repository that supports the storage and management of the abstract models and code of applications that make use of multiple development architectures such as legacy information engineering and more modern object oriented and service oriented architectures.

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BluePhoenix™ Redevelopment—Once legacy models and code are refactored, Redevelopment will provide the ability to generate from the abstract platform independent model stored in the Refactoring Repository to platform specific models such as J2EE and .NET. To address this, we are extending robust generation technologies to generate platform specifics for object orientation and SOA. This model driven modernization environment can be used to gradually migrate applications rather than requiring an “all at once” approach. In order to address refactoring, which involves changing from one application model to another, we are adding the necessary tools to assist in the process of taking the information from legacy applications’ architectures via LogicMiner to more modern architectures such as object and SOA.

Mainsoft’s Visual MainWin® for the J2EE platform—Mainsoft’s Visual MainWin® for the J2EE platform is a cross-platform development solution that bridges the .NET/J2EE divide, enabling Visual Basic .NET and C# developers to develop J2EE Web applications and Web services using the Visual Studio .NET development environment. Version 1.7 of Visual MainWin® for the J2EE platform, introduced in December 2005, supports the IBM partnership, including validation on all IBM eServer product line and support for IBM WebSphere Express and WebSphere Application Server 6.0. In 2006, Mainsoft identified the enterprise portal market opportunity and launched a portal edition of the product supporting IBM WebSphere Portal. This product is based on the Mono project, an open source .NET implementation, led by Novell and it is not dependant upon Microsoft source code.
 
Mainsoft continues to market Visual MainWin for Unix. Its current release supports Visual Studio 2005 and additional UNIX and Linux platforms.
 
Costs and Grants

As of December 31, 2006, we employed 150 employees in our software development departments. Our net development expenditures were $9.4 million in 2006, $8.0 million in 2005 and $8.1 million in 2004. Certain of our new product development projects have been awarded research grants, of which some that are repayable as royalties.

Chief Scientist Grants

Visual MainWin® for J2EE Platform—Through December 31, 2006, our subsidiary, Mainsoft, accrued an aggregate of approximately $1.8 million in grants from the Office of the Chief Scientist, or the OCS, for the development of Visual MainWin® for J2EE. Royalties of 3% are payable to the OCS on sales of Visual MainWin® for J2EE, up to 100% of the dollar-linked grant received in respect of the funded product. To date, Mainsoft has paid the royalties to the OCS as required. Mainsoft has submitted to the OCS an application for obtaining research and development grants for 2007, which is pending approval.

PowerText—As of January 1, 2004, we received through our wholly owned subsidiary, an aggregate of approximately $200,000 in grants from the OCS for the development of PowerText. PowerText is a software solution for automated electronic document mining, management and presentment. Royalties of 3% are payable to the OCS on all sales of PowerText up to 100% of the dollar-linked grant received. To date, CePost has paid to the OCS the royalties as required.

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BluePhoenix™ SOA - Ready Enablement—Through December 31, 2004, our subsidiary, MultiConn Technologies, accrued an aggregate of approximately $580,000 in grants from the OCS, for the development of BluePhoenix™ SOA - Ready Enablement. Royalties of 3% are payable to the OCS on sales of BluePhoenix™ SOA - Ready Enablement up to 100% of the dollar-linked grant received in respect of the funded product.

The balance of the contingent liability relating to the royalties payable by our subsidiaries to the OCS, at December 31, 2006, amounted to approximately $2.5 million.

Other Grants

In the first quarter of 2004, the Singapore-Israel Industrial Research and Development Foundation agreed to provide one of our wholly owned subsidiaries together with a company incorporated in Singapore, financing for the development of a Java report generator based on legacy text file input. Accordingly, the foundation agreed to award our subsidiary up to $100,000 payable according to an agreed upon schedule. As of March 22, 2007, we received $45,000 of the grant. The grant is required to be repaid in installments based on sales of the funded product up to the amount of the grant.

Our subsidiary, I-Ter, is entitled to funds to develop Easy4Plan product, from the Ministry of Production in Italy. Easy4Plan is a workflow management tool designed for ISO9000 companies. Approximately 30% of the funds are a grant, and the balance is an 8-year loan to be repaid by I-Ter. The loan bears a minimal annual interest. The development term ended in September 2006. Pending the final approval of the Ministry of Production, we anticipate that during 2007, I-Ter will receive a total aggregate amount of approximately $650,000.
 
Intellectual Property
 
We rely on a combination of trade secret, copyright, and trademark laws and nondisclosure agreements, to protect our proprietary know-how. Our proprietary technology incorporates processes, methods, algorithms, and software that we believe are not easily copied. Despite these precautions, it may be possible for unauthorized third parties to copy aspects of our products or to obtain and use information that we regard as proprietary. However, we believe that with regard to most of our solutions, because of the rapid pace of technological change in the industry, patent and copyright protection are less significant to our competitive position than factors such as the knowledge, ability, and experience of our personnel, new product development, and ongoing product maintenance and support.
 
Competition
 
The modernization market in which we operate is highly competitive. The principal competitive factors affecting the market for our modernization solutions include:

    · product functionality, performance, and reliability;
· technical range of the offered solutions;
· integration between the offered solutions;
 
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· availability of experienced personnel and its expertise;
· prices;
· ability to respond in a timely manner to changing customer needs;
· quality of support and vertical market expertise.

Competition in the enterprise IT modernization field is, to a large extent, based upon the functionality of the available tools and personnel expertise. Vendors in this market address the modernization of legacy systems in different ways, and therefore do not always compete directly with the others. Many small vendors address only a small part of the market, providing IT specific solutions. Only a few vendors offer more comprehensive and integrated tools and solutions that can respond to the most challenging modernization issues that companies are facing. Some large vendors, such as Oracle, HP and Intel have joined forces to lead the market in an organized mainframe modernization initiative, the Application Modernization Initiative (AMI). These three vendors also intend to create a selected consortium of vendors in order to broaden the depth and breadth of their migration offering.

Our principal competitors consist of system integrators, offshore outsourcers, and tool vendors, including leading software developers, who enable the replacement or modernization of legacy systems. Major system integrators in the market include IBM, Accenture, Capgemini, and EDS. IBM has established legacy modernization as a strategic aspect of its long-term application development strategy. Major system integrators have a specific and dominant advantage in the underlying application development infrastructure associated with many legacy environments (predominantly IBM mainframes) and a large service delivery capability. In some cases, we cooperate with some of these system integrators in providing specific solutions or portions of comprehensive projects. Major offshore outsourcers in the market include TCS (Tata Consulting Services), WIPRO, Patni, and Infosys. Both systems integrators and offshore outsourcers have vertical market groups offering consulting and professional services.

We also face competition from niche tools and solutions companies operating in each of the four principal areas of the enterprise IT modernization market:

· Enterprise IT Understanding;
· Enterprise IT Migration;
· Enterprise IT Remediation; and
· Enterprise IT Redevelopment.

For example, Cast Application Intelligence Platform reads application source code to analyze the fine-grained relationships among software artifacts - objects, functions, stored procedures, database tables and columns, scripts and others. MetaWare provides services and products such as re-hosting, database and programming language conversions. Most Software Technologies addresses the ADABAS/Natural arena, and other competitors focus on collecting sufficient information about application portfolios to improve business processes. Other solution developers provide distributed repository solutions and architecture modernization services.
 
35

 
C. Organizational Structure
 
We are part of the Formula group, a global IT solutions and services group headquartered in Israel. The Formula group is principally engaged in providing software consulting services, developing proprietary software products, and providing computer-based business solutions. The Formula group delivers its solutions in over 50 countries worldwide to clients with complex IT services needs, including a number of Fortune 1000 companies. We are a subsidiary of Formula Systems (1985) Ltd., which holds 52.3% of our ordinary shares.
 
Following is a list of our significant subsidiaries, their country of incorporation, and proportion of our ownership interest in them, as of March 22, 2007:

Name of Subsidiary
 
Country of Incorporation
Incorporation
 
Proportion of Ownership
Interest
BluePhoenix Solutions B.V.
 
The Netherlands
 
100%
         
Liraz Systems Ltd.
 
Israel
 
100%
         
Mainsoft Corporation
 
United States
 
58%
 
D. Property, Plants and Equipment
 
We, together with our subsidiaries and affiliates, currently occupy approximately 9,800 square meters of office space. The aggregate annual rent we paid for these facilities in 2006 was $1.9 million. The following table presents certain information about our facilities and the terms of lease of these facilities. 
 
Country and State
 
City
 
Sq.
Meters
 
Expiration
 
Annual
anticipated
rental fees in
2007
(*)
 
               
in thousands $
 
Israel
   
Herzlia
   
2,170
   
December 2008
   
375
 
Israel
   
Holon
   
253
   
February 2007
   
30
 
Israel
   
Lod
   
1,076
   
June 2007
   
146
 
USA, North Carolina
   
Cary
   
860
   
April 2009
   
200
 
USA, California
   
San Jose
   
350
   
November 2007
   
80
 
USA, California
   
Santa Clara
   
160
   
October 2008
   
36
 
USA, Indiana
   
South Bend
   
400
   
February 2008
   
84
 
Denmark
   
Ballerup
   
1,759
   
November 2008
   
365
 
Germany
   
Frankfurt
   
265
   
November 2007
   
48
 
Romania
   
Bucharest
   
900
   
November 2007
   
162
 
 
36

 
Country and State
 
City
 
Sq.
Meters
 
Expiration
 
Annual
anticipated
rental fees in
2007
(*)
 
               
in thousands $
 
United Kingdom
   
Uxbridge
   
40
   
August 2007
   
54
 
United Kingdom
   
Milton Keynes
   
80
   
June 2007
   
112
 
Cyprus
   
Nicosia
   
800
   
June 2009
   
132
 
Italy
   
Milan
   
150
   
October 2010
   
30
 
Italy
   
Riccione
   
330
   
December 2010
   
42
 
Italy
   
Milano
   
110
   
April 2012
   
18
 
Italy
   
Roma
   
124
   
September 2011
   
34
 
Total
         
9,827
         
1,948
 
 
(*) Includes related fess such as management fees, maintenance, parking etc.

If, in the future, we determine that we need additional space to accommodate our growth, we believe that we will be able to obtain this additional space without difficulty and at commercially reasonable prices. We do not own any real property.
 
ITEM 4A. UNRESOLVED STAFF COMMENTS
 
Not applicable.
 
ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS
 
Background

We develop and market unique value driven enterprise IT modernization solutions that enable companies to automate the process of modernizing and upgrading their mainframe and distributed IT infrastructure and to effectively compete in today’s environment. The combination of our comprehensive set of products and tools with our expert services methodology provides an efficient and cost-effective process for extending the return on investment of existing enterprise IT assets. Our solutions, which include technology for Understanding, Migration, Remediation, and Redevelopment, allow companies to fully leverage their current systems and applications, speed up and reduce the cost of the renewal process, and effectively update their systems in order to adapt to new business demands.

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Our quarterly and annual results of operations have fluctuated significantly in the past and we expect them to continue to fluctuate significantly in the future, as a result of numerous factors, including the changes in the suite of modernization tools we have been offering to our customers, the impact of acquisitions and dispositions of companies, and the difficulties we have encountered in introducing our tools to the markets. Therefore, we believe that period-to-period comparisons of our financial results are not necessarily meaningful and you should not rely on them as an indication for future performance.

The following discussion of our critical accounting policies and our financial condition and operating results should be read in conjunction with our consolidated financial statements and related notes, prepared in accordance with U.S. GAAP for the years ended December 31, 2006, 2005 and 2004, and with any other selected financial data included elsewhere in this report.
 
Overview
 
General
 
In recent years, we have been affected by the global economic changes, in particular trends in capital spending in the information technology sector. During 2001 through 2003, the overall business slowdown in the North American and European markets influenced the purchasing patterns of leading software developers who delayed their planned orders and caused developers to reduce the amount of their planned commitment. These changes in purchasing patterns in the IT industry directly affected our operating results. Our revenues decreased from $49.2 million in 2000 to $38.4 million in 2001 and to $36.7 million in 2002. Since 2003, as a result of a recovery of the market, and the impact of strategic acquisitions we completed, this trend changed, and our revenues increased from $57.2 million in 2004 to $58.9 million in 2005 and $68 million in 2006. As part of this change, our average backlog increased from approximately $25 million at the end of 2004 to $50 million at the end of 2005 and $80 million at the end of 2006. This increase improves management’s ability to engage in near-term planning. We typically fill current backlog within one year.

In providing our solutions, we work closely with our customers or system integrators, and can therefore be impacted by holiday seasons of customers and system integrators. As a result, we may sometimes experience a decline in our third quarter revenues due to the summer holiday season in Europe and Israel.

In order to enhance our solutions and services portfolio, we have been pursuing a strategy of adding new technologies to our suite of automated modernization tools. We implement this strategy via internal development of new software tools and through acquisitions and investments. Accordingly, we devote significant resources to the development and marketing of new software modernization tools. In addition, we invest in businesses that develop software tools that are complementary to our existing portfolio and have a skilled and specialized workforce.
 
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Challenges and Opportunities
 
Our principal objective is to enhance our revenues by leveraging the marketing resources and skilled specialized workforce to market the suite of tools and solutions that we offer. In addition, we have identified a market demand for complementary application development services. Our SOA-ready solution is provided as a post-migration service, allowing customers to extend their development environment by providing access to mainframe systems through Web services protocols, making legacy systems appear as modern systems. Therefore, we anticipate an increase in revenues generated from our customers, by offering them SOA-ready solutions and other “post-migration” services.

The principal challenge we face is to accomplish our growth objectives while also enhancing profitability. In order to expand our revenue base, we will continue to invest in our sales and marketing operations and penetrate additional markets such as Far East Asia. In preparation for the expansion of our business we are anticipating the need to expand our off-shore delivery centers. As part of this process we will evaluate the viability of moving or consolidating support and delivery centers to continue to increase efficiencies and margins.

Since our margins are dependent on the degree of automation of our tools, we plan to continue devoting substantial resources to research and development both internally and through acquisitions. There is no assurance that these investments will lead to revenue growth. If they do not lead to growth as anticipated, our profitability will be adversely affected.

Since 2003, we have been enhancing our offshore delivery centers in Romania and Cyprus, where our operational costs are lower. These offshore centers allow us to reduce the prices we charge our customers for our solutions and simultaneously improve our operating profit. Recently, professional work in these countries became more expensive and professional fees may continue to increase in the future. As a result, we may consider establishing offshore facilities in other countries. The establishment of such additional facilities, may result in significant capital expenses which may affect our cash position. As the degree of automation of our tools increases, the need for expert services decreases, and as a result, our direct expenses decrease. In addition, the improved tools enable us to implement our distributed project methodology, and simultaneously use our delivery centers that perform the actual modernization project with our tools. 
 
Consolidation of the Results of Operations of Our Subsidiaries

Following is information regarding the consolidation of the results of operations of certain of our subsidiaries, for the periods indicated. We began to consolidate the results of operations of each of these subsidiaries when we acquired control in them.

Name of Subsidiary
 
Beginning Consolidation
CePost Ltd.
 
First quarter of 2004
Outlook & BluePhoenix Ltd.
 
First quarter of 2004
Intercomp Ltd.
 
Second quarter of 2004
MultiConn Technologies Ltd.
 
First quarter of 2005
I-Ter/Informatica & Territorio S.p.A.
 
Second quarter of 2005
Zulu Software Inc.
 
First quarter of 2006
 
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Critical Accounting Policies

We prepare the consolidated financial statements of BluePhoenix in conformity with U.S. GAAP. Accordingly, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. The significant accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

·       Revenue recognition. Our revenue recognition policy is significant because our revenue is a key component of our results of operations. We follow specific and detailed guidelines in measuring revenue; however, certain judgments affect the application of our revenue policy. Revenue results are difficult to predict and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter and could result in future operating losses. Should changes in conditions cause management to determine that these guidelines are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

We recognize revenues from direct software license agreements in accordance with statement of position (SOP) 97-2 “Software Revenue Recognition” (as amended by SOP 98-4 and SOP 98-9) upon delivery of the software when collection is probable, the license fee is otherwise fixed or determinable, and persuasive evidence of an arrangement exists.

When a project involves significant production, modification or customization of software, and with respect to fixed fee contracts, revenue is generally recognized according to the percentage of completion method in accordance with the provisions of SOP 81-1 “Accounting for performance of Construction-Type Contracts.” Under this method, estimated revenue is generally accrued based on costs incurred to date as a percentage of total updated estimated costs. If we do not accurately estimate the resources required or the scope of work to be performed, or do not manage our projects properly within the planned periods of time or satisfy our obligations under the contracts, then future margins may be significantly and negatively affected or losses on existing contracts may need to be recognized. Any such resulting reductions in margins or contract losses could be material to our results of operations. We recognize contract losses, if any, in the period in which they first become evident.

Under some of our agreements, the customer may have the right to receive unspecified upgrades on a when-and-if available basis. These upgrades are considered post-contract customer support, referred to as PCS, and the fair value allocated to this right, is recognized ratably over the term of the PCS.

40

 
There are no rights of return, price protection or similar contingencies in our contracts. Accordingly, we do not establish a provision due to the lack of warranties claims in the past. Some of our contracts include client acceptance clauses. In determining whether revenue can be recognized, when an acceptance clause exists, we consider our history with similar arrangements, the customer’s involvement in the progress, the existence of other service providers and the payments terms.

·       Capitalized software research and development costs. Development costs of software that is intended for sale that were incurred after the establishment of technological feasibility of the relevant product, are capitalized. Technological feasibility is determined when detailed program design is completed and verified in accordance with the provisions of the FASB Statement of Financial Accounting Standards No. 86 (SFAS 86). Software development costs incurred before technological feasibility is established are charged to the statement of operations as incurred net of participation of the office of the Chief Scientist (OCS). Our policy on capitalized software costs determines the timing of our recognition of certain development costs. In addition, this policy determines whether the cost is classified as development expense or capitalized costs. Management is required to use professional judgment in determining whether development costs meet the criteria for immediate expense or capitalization. Amortization of capitalized software development costs begins when the product is available for general release to customers. Annual amortization is computed by the straight-line method, over the remaining useful life of the product, currently over a period of 5 years, or based on the ratio of current gross revenues to current and anticipated future gross revenues, whichever is higher. Our failure to accurately predict the useful life of capitalized software could cause a one-time amortization, which could adversely affect our operating results.

·       Impairment of goodwill and intangible assets. Our business acquisitions resulted in goodwill and other intangible assets. We periodically evaluate our goodwill, intangible assets, and investments in affiliates for potential impairment indicators. Our judgments regarding the existence of impairment indicators are based on legal factors, market conditions and operational performance of our acquired businesses and investments.

In accordance with FASB Statement of Financial Accounting Standards No. 142 “Goodwill and Other intangible Assets” (SFAS 142), effective January 1, 2002, indefinite life intangible assets and goodwill are not amortized but rather subject to annual impairment testing.
 
Goodwill and intangible assets are tested for impairment by comparing the fair value of the reporting unit with its carrying value. Fair value is generally determined using discounted cash flows, market multiples and market capitalization. Significant estimates used in the fair value methodologies include estimates of future cash flows, future short term and long term growth rates, weighted average cost of capital and estimates of market multiples of the reportable unit. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for our goodwill and intangible assets. These write downs, if any, may have an adverse affect on our operating results. Future events could cause us to conclude that impairment indicators exist and that additional intangible assets associated with our acquired businesses are impaired.
 
41


The process of evaluating the potential impairment of goodwill is subjective and requires significant judgment at many points during the analysis. In estimating the fair value of the reporting unit for the purpose of our annual or periodic analysis, we make estimates and judgments about the future cash flows of that reporting unit. Although our cash flow forecasts are based on assumptions that are consistent with our plans and estimates we are using to manage the underlying businesses, there is significant exercise of judgment involved in determining the cash flows attributable to a reporting unit over its estimated remaining useful life. In addition, we make certain judgments about allocating shared assets to the estimated balance sheets of our reporting units. Changes in judgment on these assumptions and estimates could result in a goodwill impairment charge. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.

·       Income taxes. Our income tax policy records the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in the accompanying consolidated balance sheets, as well as operating loss and tax credit carry forwards. We follow specific and detailed guidelines regarding the recoverability of any tax assets recorded on the balance sheet and provide any necessary allowances as required in our management opinion, in accordance with the provisions of FASB Statement of Financial Accounting Standards No. 109 “Accounting for Income Taxes.” If we fail to accurately predict our estimated tax and if we are required to pay higher taxes than we anticipated, our results of operations could be seriously harmed.

·       Accounts receivable. We maintain a conservative method to assure the collection of our accounts receivable. Under this methodology, we periodically estimate the outstanding amounts and deduct an allowance for receivables with a low collection certainty. When there is a major deterioration of a customer’s credit worthiness, we make allowances for doubtful accounts upon specific review of all outstanding invoices of such customer. A relatively large portion of our revenue is generated from fixed-price-projects. We recognize revenue according to the percentage of completion method, and rely on project managers’ estimations in calculating that percentage. The customers’ payment terms are usually based on milestones. Therefore the delay in actual collection may reach 4-6 months. The average debt duration is approximately 2–3 months. If we fail to estimate accurately the recoverability of amounts due to us, our results of operations could be adversely affected.

·       Derivative Instruments. We have adopted Statement of Financial Accounting Standards SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities” ("FAS 133"). Under the provisions of SFAS 133, all derivatives are recognized on the balance sheet at their fair value. Changes in fair value are recognized periodically in earnings or accumulated other comprehensive income within shareholders’ equity, depending on the intended use of the derivative and whether the derivative has been designated by management as a hedging instrument. Changes in fair value of derivative instruments not designated as hedging instruments are recognized in earnings in the current period.

We use foreign currency options, forward exchange contracts and forward interest contracts to assist in managing financial risks. We do not use derivative financial instruments for speculative purposes. These instruments are recognized at fair value, with all changes in fair value recorded in current period earnings, as these transactions have not been designated as hedging instruments under FAS 133.
 
42


We have an embedded conversion features as part of the $3 million convertible debenture host debt which is being marked to market and accounted in accordance with EITF 00-19"Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled In, a Company's Own Stock". In addition, we have convertible notes which consists an embedded put option which is bifurcated from the host debt and is being recorded at fair value in accordance with FAS 133.

Recently Issued Accounting Pronouncements:

In February 2006, the FASB issued FAS 155, “Accounting for Certain Hybrid Financial Instruments, an Amendment of FASB Statements No. 133 and 140”. This statement permits fair value measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation. This statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We are currently evaluating the impact of this statement, if any, on our consolidated financial statements.

In July 2006, the FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FAS 109.” This financial interpretation clarifies the accounting for uncertainty in income taxes, and prescribes a recognition threshold and measurement attributes for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on various related matters such as the derecognition, interest and penalties and disclosure. As applicable to us, the interpretation prescribed by FIN 48 will be effective commencing January 1, 2007. We are currently evaluating the impact that the adoption of FIN 48 would have on our consolidated financial statements.

In September 2006, the FASB issued FAS 157, “Fair Value Measurements”. This standard establishes a framework for measuring fair value and expands related disclosure requirements; however, it does not require any new fair value measurement. As applicable to us, this statement will be effective as of the year beginning on January 1, 2008. We are currently evaluating the impact that the adoption of FAS 157 would have on our consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin (SAB) 108, which expresses the Staff’s views regarding the process of quantifying financial statement misstatements. The bulletin is effective as of the year beginning January 1, 2006. The implementation of this bulletin had no impact on our consolidated financial statements.

In February 2007, the FASB issued FAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” This standard permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. As applicable to us, this statement will be effective as of the year beginning January 1, 2008. We are currently evaluating the impact that the adoption of FAS 159 would have on our consolidated financial statements.

43

In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans—An Amendment of FASB No. 87, 88, 106 and 132(R)" ("SFAS 158"). SFAS 158 requires that the funded status of defined benefit postretirement plans be recognized on the balance sheet, and changes in the funded status be reflected in comprehensive income, effective fiscal years ending after December 15, 2006. The adoption of this statement did not have an impact on our consolidated financial statements.

In December 2006, the FASB posted FASB Staff Position, or FSP, 00-19-2, “Accounting for Registration Payment Arrangements.” This FSP specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement should be separately recognized and measured in accordance with FAS No. 5, “Accounting for Contingencies.” This FSP further clarifies that a financial instrument subject to a registration payment arrangement should be accounted for in accordance with other applicable GAAP without regard to the contingent obligation to transfer consideration pursuant to the registration payment arrangement. This FSP is effective immediately for registration payment arrangements and financial instruments subject to those arrangements that were entered into or modified subsequent to December 15, 2006. For registration payment arrangements and financial instruments subject to those arrangements that were entered into prior to December 15, 2006, the FSP is effective for fiscal years beginning after December 15, 2006, and interim periods within those fiscal years. We will adopt FSP 00-19-2 beginning January 1, 2007 and we are currently evaluating the potential impact the adoption of this pronouncement will have on our consolidated financial statements.

In November 2006, the FASB ratified EITF Issue No. 06-7," Issuer’s Accounting for a Previously Bifurcated Conversion Option in a Convertible Debt Instrument When the Conversion Option No Longer Meets the Bifurcation Criteria in FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities" (“EITF 06-7”). At the time of issuance, an embedded conversion option in a convertible debt instrument may be required to be bifurcated from the debt instrument and accounted for separately by the issuer as a derivative under FAS 133, based on the application of EITF 00-19. Subsequent to the issuance of the convertible debt, facts may change and cause the embedded conversion option to no longer meet the conditions for separate accounting as a derivative instrument, such as when the bifurcated instrument meets the conditions of Issue 00-19 to be classified in stockholders’ equity. Under EITF 06-7, when an embedded conversion option previously accounted for as a derivative under FAS 133 no longer meets the bifurcation criteria under that standard, an issuer shall disclose a description of the principal changes causing the embedded conversion option to no longer require bifurcation under FAS 133 and the amount of the liability for the conversion option reclassified to stockholders’ equity. In addition, under the EITF, for conversion of option for which the carrying amount has previously been reclassified to shareholders' equity, the issuer should recognize any unamortized discount remaining at the date of conversion immediately as interest expense. EITF 06-7 should be applied to all previously bifurcated conversion options in convertible debt instruments that no longer meet the bifurcation criteria in FAS 133 in interim or annual periods beginning after December 15, 2006, regardless of whether the debt instrument was entered into prior or subsequent to the effective date of EITF 06-7. Earlier application of EITF 06-7 is permitted in periods for which financial statements have not yet been issued. We are currently evaluating the impact of this guidance on our consolidated financial statements.

44


Our Reporting Currency

A substantial portion of our revenues and costs are denominated in United States dollars, or dollars. The dollar is the primary currency of the economic environment in which BluePhoenix operates. Thus the dollar is our functional and reporting currency. Accordingly, monetary accounts maintained in currencies other than the dollar are re-measured into dollars under the principles described in FASB Statement of Financial Accounting Standards No. 52. Assets and liabilities have been translated at period-end exchange rates. For non-dollar transactions reflected in the statements of operations, the exchange rates at transaction dates are used. For consolidated companies whose functional currency is other than the dollar, results of operations have been translated at appropriately weighted average exchange rates. The exchange gains and losses arising from these translations are included in the statement of income (loss).

Following is a summary of the most relevant monetary indicators for the reported periods:

For the year ended
December 31,
 
Inflation rate in Israel
 
Devaluation of NIS
against the US$
 
Devaluation of euro
against the US$
 
 
%
%
 
%
 
2004
   
1.2
   
(1.6)
 
 
(7.4)
 
2005
   
2.4
   
6.8
   
13.3
 
2006
   
(0.1)
 
 
(8.2)
 
 
(11.3)
 
 
45

 
A. Operating Results 

The following table presents the percentage relationships of certain items from our consolidated statement of operations, as a percentage of total revenues for the periods indicated:

Statement of Operations Data
as a Percentage of Revenues:

   
Year ended December 31,
 
   
2006
 
2005
 
2004
 
 
%
 
%
 
%
 
               
Revenues
   
100.0
   
100.0
   
100.0
 
Cost of revenues
   
41.9
   
43.1
   
42.4
 
Gross profit
   
58.1
   
56.9
   
57.6
 
Software development costs
   
13.8
   
13.6
   
14.1
 
Selling, general, and administrative expenses
   
32.6
   
36.7
   
37.4
 
Operating income
   
11.7
   
6.6
   
6.1
 
Financial expenses, net
   
(5.2
)
 
(3.3
)
 
(1.5
)
Gain on realization of shareholdings
   
-
   
-
   
0.1
 
Other income, net
   
0.4
   
0.2
   
1.8
 
Income before taxes on income
   
6.9
   
3.5
   
6.5
 
Income tax expense (income), net
   
(0.4
)
 
0.3
   
0.5
 
     
7.3
   
3.2
   
6.0
 
Minority interest
   
(0.4
)
 
(0.2
)
 
(0.1
)
Equity in losses of affiliated companies, net
   
-
   
-
   
(0.9
)
Net income
   
6.9
   
3.0
   
5.0
 

Years Ended December 31, 2006 and 2005

Revenues. Revenues increased 15% from $58.9 million in 2005 to $68.0 million in 2006. Revenues generated from products grew 16% from $8.7 million in 2005 to $10.2 million in 2006. Revenues from services grew 15% from $50.2 million in 2005 to $57.9 million in 2006. The product mix has not changed in 2006. We attribute the revenue growth of our services and products to the same key factors.

·
The growing realization by major enterprises that are dependent on legacy core systems, of the inevitability of IT modernization to remain effective, competitive and efficient.

·
We have expanded our product offering through acquisitions and internal development efforts. Tools such as Natural/ADABAS to JAVA and IMS migration were introduced during 2006 and were integrated into BluePhoenix’s suite of solutions. We constantly update our suite of Solutions in order to support a larger variety of languages, databases and platform conversions. We believe that, as a result, IT service companies choose to license our technologies for use in modernization projects for their end customers.

·
We have strengthened our sales team and devoted significant management attention to increase market awareness and to establish a strong reputation as a leader in the modernization market. We have also increased our marketing efforts through targeted exhibitions, an expanded public relations program, web and email marketing, online web casts and other lead generation campaigns. These have significantly contributed to increasing the interest in our products and solutions and have helped to drive the growth in revenues.

46

 
We believe that these growth factors will continue to affect our revenues in year 2007.

The price of a modernization project mainly depends on the number of lines of code to be converted, and is determined independently of the source and target platforms. As a result, the prices of our solutions do not fluctuate significantly.

We constantly update our suite of tools in order to support a larger variety of languages, databases and platform conversions. As a result, IT service companies choose to license our technologies for use in modernization projects for their end customers. Revenues generated from products grew from $8.7 million in 2005 to $10.2 million in 2006, representing 15% of the overall revenues in each of these years.

The table below presents the breakdown of our revenues based on the location of our customers for the periods indicated:

   
2006
 
2005
 
2004
 
 
%
 
%
 
 %
 
United States
   
22
 
 
30
 
 
36
 
Europe (other than Denmark)
   
42
 
 
32
 
 
28
 
Denmark
   
15
 
 
21
 
 
18
 
Israel
   
15
 
 
14
 
 
15
 
Other
   
6
 
 
3
 
 
3
 
Total
   
100
 
 
100
 
 
100
 

Relationships that we developed during previous years with several large European customers have matured and started to generate a growing stream of projects. As a result, our revenues in Europe grew from $15.9 million in 2004 to $18.6 million in 2005 and to $28.4 million in 2006.

In order to compensate for the decrease in our revenues generated in North America, we plan to expand our sales and marketing efforts in this market.

Cost of revenues. Cost of revenues consists of salaries, travel costs relating to projects and services rendered, amortization of capitalized software costs and fees paid to independent subcontractors. Cost of revenues increased 12% from $25.4 million in 2005 to $28.5 million in 2006. Cost of revenues as a percentage of revenues decreased 1.2% from 43.1% in 2005 to 41.9% in 2006. The decrease in cost of revenues as a percentage of revenues was mainly due to the expansion of our offshore centers, a process that is expected to continue in 2007. During 2006, we increased the number of professional employees in our offshore centers by 11%. These new employees enabled us to replace on-site facility employees, thus decreasing the number of relatively expensive technical experts. The reduction in costs in our offshore centers relative to the costs in our on-site facilities resulted in an average savings of 30%-50% per employee. In addition, as the degree of automation of our tools increases, the need for expert services decreases, and as a result our direct expenses decrease.

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The total amount of amortization of intangible assets in 2006 was $7.1 million, compared to $5.5 million in 2005. This increase was related to the general release of developed modernization tools and the amortization of intangibles related to 2006 acquisitions.

Software development costs. Software development costs, gross, consist of salaries and consulting fees that we pay to professionals engaged in the development of new software tools and related methodologies. Software development costs, net, consist of software development costs, gross, less development grants and capitalized software costs.

Software development costs, net, increased from $8.0 million in 2005 to $9.4 million in 2006. As a percentage of revenues, software development costs, net remained at 14%.

Software development costs, gross, increased from $16.3 million in 2005 to $17.4 million in 2006. As a percentage of revenues, software development costs, gross decreased to 25.6% in 2006 compared to 27.7% in 2005. This decrease was primarily due to the market release of developed modernization tools and a reduction in costs by using our offshore centers.

In the past few years, our development costs have been attributed to the development of our unique modernization suite of tools. Software development costs are charged to operations as incurred, unless capitalized according to SFAS 86. In 2006, we capitalized software development costs in an aggregate amount of $7.5 million compared to $8.0 million in 2005. During 2005 and 2006, we introduced several new solutions:
 
·
BluePhoenix LogicMiner – Solution for Understanding and Mining COBOL Applications;
·
BluePhoenix Redevelopment SOA – New Redevelopment Solution for Converting COBOL Applications to Java and C#; and
·
Automated Tool for Converting ADABAS/Natural Applications to Java Using Rational databases.

Selling, general and administrative expenses. Selling, general and administrative expenses consist primarily of wages and related expenses, travel expenses, third party and sales people commissions, selling expenses, marketing and advertising expenses, rent, insurance, utilities, professional fees, and depreciation. Selling, general and administrative expenses increased from $21.6 million in 2005 to $22.1 million in 2006. During 2006, our expanded marketing efforts lead to a significant growth in revenue and in number of new signed deals during 2007.

Financial expenses, net. Financial expenses in 2006 were $3.5 million compared to $2.0 million in 2005. The increase in financial expenses is mainly attributable to the issuance of convertible notes in February 2006 and convertible debentures in March 2006. The calculation of the discount amortization and the fair value adjustments of related financial instruments resulted in non-cash financial expenses. The non-cash expenses related to the convertible notes and debentures were $1.2 million in 2006 compared to $556,000 in 2005. In addition, the increase in financial expenses was attributable to the increase of the company’s overall borrowings from banks.

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Other income, net. Other income, net in 2006 was $282,000 compared to $104,000 in 2005. Other income in 2006 consists of dividend received from Steps Ventures, An Israeli venture capital investment group, in which we hold 375,000 shares representing 3.75% of their outstanding share capital.

Income tax expense, net. In 2006, we had income from income tax, net of $282,000 compared to an expense of $149,000 in 2005. The income in 2006 was related to the final settlement of tax assessments with the Israeli Income Tax Authorities, which was partially offset by our local taxes paid worldwide by our international subsidiaries.

Minority interests in profits of subsidiaries. Minority interest in 2006 includes $204,000 representing the minority share in the profits of Mainsoft, $88,000 representing the minority share in the profits of Liacom Systems and $25,000 representing the minority share in the profits of Zulu Software Inc.

Years Ended December 31, 2005 and 2004

Revenues. Revenues increased 3% from $57.2 million in 2004 to $58.9 million in 2005. This increase was mainly in the second half of 2005 and reflects the consolidation of I-Ter results. The price of a modernization project mainly depends on the number of lines of code to be converted, and is determined independently of the source and target platforms. As a result, the prices of our solutions do not fluctuate significantly.

The increase in sales in Europe is partially attributable to our marketing efforts during 2005, which resulted in a 19% increase in revenues in Europe (including Denmark) in 2005 compared to 2004. In addition, the consolidation of I-Ter contributed to our annual revenue growth in Europe. In the United States there was a decrease of 15% in revenues in 2005 compared to 2004. This decrease is mainly attributable to a delay in new orders from the North American market during the first half of 2005.

Cost of revenues. Cost of revenues increased 4.6% from $24.3 million in 2004 to $25.4 million in 2005. Cost of revenues as a percentage of revenues increased 0.7% from 42.4% in 2004 to 43.1% in 2005. The increase in cost of revenues was caused by the increased amount of amortization of intangible assets that reached technical feasibility during 2005. The total amount of amortization of intangible assets in 2005 was $5.5 million, compared to $3.1 million in 2004. This increase was mostly offset by a decline in salaries and project related costs, due to the efficient usage of our offshore delivery centers.

Software development costs. Software development costs, gross, increased 4% from $15.6 million in 2004 to $16.3 million in 2005. As a percentage of revenues, software development costs, gross was not changed materially, 27.7% in 2005 compared to 27.3% in 2004.

In the past few years, our development costs were attributed to the development of our unique modernization suite of tools. Software development costs are charged to operations as incurred, unless capitalized according to SFAS 86. In 2005, we capitalized software development costs in an aggregate amount of $8.0 million compared to $7.1 million in 2004. This increase was primarily due to the implementation of our strategy to expand our tool offerings and increase the degree of automation of our tools. These factors are important in order to maintain our leadership position in the market and perform profitable projects.

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Selling, general and administrative expenses. Selling, general and administrative expenses increased from $21.4 million in 2004 to $21.6 million in 2005. During 2005, our management members devoted significant marketing efforts in order to further expose the Company’s suite of tools to potential customers and partners.

Financial income (expenses), net. Financial expenses in 2005 were $2.0 million compared to $882,000 in 2004. A portion of the increase in financial expenses is due to the issuance of convertible debentures in March 2004, which was partially included in financial expenses in 2004 and fully accounted for in the first quarter of 2005, when a registration statement covering the underlying shares became effective. In addition, the increase in financial expenses is attributable to (i) the increase of the company’s overall borrowings from banks, and (ii) the devaluation of the euro conversion rate compared to the dollar in 2005 by 13.3%, as compared to a 7.4% increase in the euro conversion rate in 2004.

Gain on realization of shareholdings. There was no gain on realization of shareholdings in 2005. Gain on realization of shareholdings in 2004 was $112,000. This gain results from a sale of ordinary shares of Cicero Inc. was $171,000. This gain was partially offset by a loss of $59,000 resulted from transaction-related costs with respect to the sale of our shareholdings in Tesnet – Software Testing Ltd., or Tesnet. The sale of Tesnet’s shares was for cash consideration of $2.8 million.

Other income, net. Other income, net in 2005 was $104,000 compared to $975,000 in 2004. Other income in 2004 consists primarily of a $703,000 dividend received from Steps Ventures.

Income tax expense. In 2005, we had an income tax expense of $149,000 compared to $260,000 in 2004. Due to tax losses carried forward in Israel and in several other locations, our total tax expense is composed of the net aggregate expense of local taxes paid worldwide by our international subsidiaries.

Share in losses of affiliated companies, net. In 2004, share in losses of affiliated companies, net, was $516,000. Share in losses of affiliated companies in 2004 was mainly attributable to $69,000 representing our share in the losses of Intercomp, and $455,000 representing our share in the losses of MultiConn Technologies. In 2005, these two affiliates were consolidated in our result of operations, and therefore no equity in losses of affiliated companies was recorded.

Minority interests in profits of subsidiaries. Minority interest in 2005 includes $137,000 representing the minority share in the profits of Mainsoft, and $2,000 representing the minority share in the profits of Liacom Systems.

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B. Liquidity and Capital Resources 

How We Have Financed Our Business

In 1997, we consummated two public offerings, and received net proceeds of $33.9 million after deducting underwriting discounts and commissions and offering expenses.

On March 30, 2004, we completed a $5 million private placement to institutional investors. Under the terms of this transaction as amended on February 18, 2005, we issued to the institutional investors convertible debentures due in 2007, bearing interest at a rate of six months LIBOR paid quarterly. Pursuant to our agreement with the institutional investors, in March 2006, the institutional investors exercised their right to purchase from us additional convertible debentures and warrants for an aggregate purchase price of $3 million. Those debentures are due in 2009.

As of March 22, 2007, $4.4 million principal amount of the debentures were converted into 929,475 BluePhoenix ordinary shares. For more information regarding the private placement, see “– Contractual Commitments and Guarantees.”

In February 2006, we completed an underwritten public offering in Israel of series A convertible notes in an aggregate principal amount NIS 54.0 million that were equal at that time to approximately $11.5 million . The price of the notes as determined in the offering was 98% of the principal amount of the notes, and the gross proceeds from the offering were $11.2 million. The notes bear an interest at a rate of LIBOR 3 months +1.5% per annum, payable every 3 months beginning on May 1, 2006, with the last payment to be made on February 1, 2011. The principal of the notes is payable in four equal annual installments on February 1 of each of 2008 through 2011. Under certain terms, we may call for an early redemption of the notes, after February 1, 2008. The notes are convertible into ordinary shares of BluePhoenix at a conversion rate of one ordinary share per NIS 26 ($6.15) principal amount of notes, subject to adjustments. Holders may convert their notes into BluePhoenix’s ordinary shares on any trading day, beginning on the date the notes were first listed for trading and until the close of trading on January 16, 2011, except for certain specified days. The convertible notes are not secured.

As of March 22, 2007, NIS 402,000 principal amount of the notes (approximately $96,000) were converted into 15,474 BluePhoenix ordinary shares.

The notes are traded on the TASE. The notes and the shares underlying the notes have not been registered under the Securities Act, and may not be offered or sold in the United States or to U.S. persons, absent registration or an applicable exemption from registration requirements.

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We have entered into credit facilities with Bank Discount Le’Israel Ltd., Bank Ha’Poalim Ltd. Bank Leumi Le’Israel Ltd. and the First International Bank Ltd., of up to an aggregate of $33.5 million. The aggregate amount outstanding under these credit facilities as of December 31, 2006 was $22.2 million, and as of March 22, 2007 was $22.1 million. We used these credit facilities to finance certain acquisitions, to give guarantees, and for interim financing, in accordance with our cash requirements. A portion of the credit lines were used in 2006 to finance the acquisitions of CodeStream and Zulu. See item 4 B" Investment and Acquisitions". These credit facilities provide for loans in various currencies and bear various interest rates. In connection with these credit facilities extended to us by these banks, we are committed to certain covenants related to our operations, such as:

 
·
maintaining a minimum level of shareholders’ equity of no less than 40% of our total assets and no less than $40 million;
 
·
maintaining a level of annual operating income before depreciation and amortization of no less than $5 million; and
 
·
maintaining a ratio of our bank liabilities to current assets, excluding other current assets, of no more than 55%.

To date, we have met all such covenants.

On December 31, 2006, we had cash and cash equivalents (including marketable securities) of $12.7 million and working capital of $17.9 million. On December 31, 2005, we had cash and cash equivalents of $10.8million and working capital of $4.5 million.

Net cash provided by operating activities was $10.0 million in 2006 compared to $5.2 million in 2005. Cash provided by operating activities improved in 2006 as compared to 2005 primarily as a result of an increase in net income. In addition, there was an increase in cash flow due to certain down payments from customers. This increase was partially offset by increased accounts receivables that were a result of extended payment terms to several long-term customers who placed repeat large purchase orders.
 
Typical modernization projects, which deploy our solutions, are long-term projects, and therefore, payment for these projects or a substantial portion of our fees may be delayed until the successful completion of specified milestones and customer acceptance for the completed work. During 2004, we mutually agreed with a customer, to terminate a contract. The contract was accounted for under the percentage of completion method. As a result, we recorded a loss of $400,000 in the first quarter of 2004. The payment of our fees is generally dependent upon customer acceptance of the completed work, and our ability to collect the fees. Further, although the timing of receipt of our fees varies, we incur the majority of our expenses on a current basis. As a result, a delay in the collection of our fees could result in cash flow shortages.
 
Capital Expenditures
 
Our capital expenditures were $676,000 in 2006 and $700,000 in 2005. Our capital expenditures in these years related primarily to purchases of computers and related equipment required to support our software development activities. In 2005, we invested $370,000 in other companies.

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In December 2006, we purchased the activities of CodeStream for a consideration of $10.2 million. For more information about the CodeStream transaction, see “Item 4.B. Business Overview – Investments and Acquisitions –CodeStream.”

In the last three years, we did not repurchase any shares under our buy-back programs. As of December 31, 2006, we had repurchased 1,870,565 of our ordinary shares under our buy-back programs, for an aggregate of approximately $14.7 million. In January 2006, we sold an aggregate of 136,000 of the shares held by one of our subsidiaries to Israeli institutional investors in Israel, for aggregate consideration of approximately $534,000. In February 2006, we sold 86,971 shares held by one of our subsidiaries to Outlook Systems Ltd.; see “Item 4.B. Business Overview – Investments and Acquisitions – Outlook.” Under our buy-back programs, we may purchase our shares from time to time, subject to market conditions and other relevant factors affecting us. Under the Companies Law, the repurchased shares do not confer upon our subsidiaries any voting rights (although they entitle their holders to participation rights upon distribution). The first buy-back program adopted in May 1998 enables us to purchase our shares, through a subsidiary, utilizing up to $5.0 million. Under the second buy-back program adopted in September 1998, and amended in May 1999, we may purchase, through a subsidiary as a trustee, up to an additional 2,000,000 ordinary shares. Under the two plans we may acquire an additional 854,455 shares at the current stock price. The closing price of our ordinary shares as quoted on the NASDAQ Global Market on March 22, 2007 was $6.84. Under the agreement we entered into in connection with the private placement in March 2004, we are restricted to use only up to $200,000 for the repurchase of our shares, as long as 20% or more of the debentures are outstanding.

We believe that cash generated from operations together with existing sources of liquidity and cash flow, will be sufficient to meet our anticipated cash needs for at least the next 18 months.

Contractual Commitments and Guarantees
 
Convertible Debentures Issued in a Private Placement to Institutional Investors

On March 30, 2004, we completed a $5 million private placement of convertible debentures and warrants to four institutional investors. On February 18, 2005, the institutional investors and we amended certain terms of the transaction. Pursuant to the amended agreements, the debentures are due in 2007 and bear interest at a rate equal to the six-month LIBOR, paid quarterly in cash or in a number of BluePhoenix ordinary shares, at our discretion. The debentures are convertible into BluePhoenix’s ordinary shares at a conversion rate of $5.25 per ordinary share, subject to (i) adjustment for stock dividends, stock splits, recapitalization and other similar events; and (ii) anti-dilution adjustments. Following an event of adjustment in January 2006, the conversion rate of the debentures was adjusted to $5.24 per ordinary share. The conversion rate with respect to payments of interest on the debentures will be equal to 90% of the volume weighted average price of our ordinary shares on the NASDAQ Global Market during the 20 trading days preceding the date of payment of interest. In the event the volume weighted average price per ordinary share (as calculated in the preceding sentence) for any 20 consecutive trading days exceeds $6.55, then we may force the holders of the debentures to convert any or all of the principal amount of the debentures held by them as of such date, subject to, among other things, our having an effective resale registration statement at such time for the resale of the ordinary shares underlying the debentures. As of March 22, 2007, subsequent to conversion of some of the debentures, we issued to the investors 262,808 ordinary shares.

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In addition to the debentures, the institutional investors were issued warrants to purchase up to 285,714 BluePhoenix ordinary shares at an exercise price of $6.50 per share, subject to adjustments similar to those pertaining to the conversion price of the debentures. The warrants are exercisable during a 5 years period commencing in September 2004.

Pursuant to our agreement with the institutional investors, in March 2006, three of the investors exercised their right to purchase from us additional debentures and warrants. Accordingly, we issued to the investors debentures at an aggregate purchase price of $3 million on the same terms as the initial debentures, except that the conversion price is $4.50 per share and due in 2009. As of March 22, 2007, subsequent to conversion of the debentures, we issued to the investors 666,667 ordinary shares. In addition, the institutional investors were issued additional warrants on the same terms as the initial warrants, to purchase an aggregate of up to 200,000 of our ordinary shares. The warrants are exercisable during a 5 years period commencing in September 2006.

As agreed with the investors, we registered the shares underlying the debentures and warrants for resale under an effective registration statement.

Series A Convertible Notes Offered to the Public in Israel

In February 2006, we completed an underwritten public offering in Israel of series A convertible notes in an aggregate principal amount of NIS 54.0 million that were equal at that time to approximately $11.5 million. Interest on the notes is LIBOR 3 months +1.5% per annum. The interest is payable every 3 months beginning on May 1, 2006, with the last payment to be made on February 1, 2011. The principal of the notes is payable in four equal annual installments on February 1 of each of 2008 through 2011. The notes are convertible into BluePhoenix’s ordinary shares at a conversion rate of one ordinary share per NIS 26 ($6.15) principal amount of notes. The notes are traded on the TASE. For more information regarding the series A convertible notes, see “Item 5.B. Liquidity and Capital Resources-How Have We Finances Our Business.”

Under funding agreements, three of our subsidiaries have entered into with the Office of the Chief Scientist (OCS), these subsidiaries are obliged to pay royalties to the OCS at a rate of 3% on sales of the funded products, up to 100% of the dollar-linked grant received in respect of these products from the OCS. As of December 31, 2006, the aggregate amount of grants received by our subsidiaries from the OCS was $2.5 million.

In the first quarter of 2004, the Singapore-Israel Industrial Research and Development Foundation agreed to provide one of our wholly owned subsidiaries together with a company incorporated in Singapore, financing for the development of a Java report generator software tool. Accordingly, the foundation agreed to award our subsidiary up to $100,000 payable according to an agreed upon schedule. As of March 22, 2007, we received $45,000 of the grant. The grant is required to be repaid in installments based on sales of the funded software up to the amount of the grant.

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Our subsidiary, I-Ter, is entitled to funds to develop Easy4Plan product, from the Ministry of Production in Italy. Easy4Plan is a workflow management tool designed for ISO9000 companies. Approximately 30% of the funds are a grant, and the balance is an 8-year loan to be repaid by I-Ter. The loan bears a minimal annual interest. The development term ended in September 2006. Pending the final approval of the Ministry of Production, we anticipate that during 2007 I-Ter will receive a total aggregate amount of approximately $650,000.
 
We are obligated to pay to Formula management fees in an annual amount equal to 3% of our revenues, but no more than the NIS equivalent of $180,000. For more information see “Item 7. Major Shareholders and Related Party Transactions – Related Party Transactions – Management Agreement with Formula.”

Under agreements between us and certain of our customers, we undertook to provide such customers bank guarantees for the assurance of performance of our obligations under our agreements with such customers. As of March 22, 2007, there are outstanding bank guarantees on our behalf for our customers in the aggregate amount of $420,000.

We are committed under operating leases for rental of office facilities, vehicles and other equipment for the years 2007 until 2011. Annual rental fees under current leases are approximately $3.1 million, and are expected to remain at this level for each of the next three years. In connection with the office leases, we issued bank guarantees of $107,000 in the aggregate.

We entered into an undertaking to indemnify our office holders in specified limited categories of events and in specified amounts, subject to certain limitations. For more information, see “Item 7.B. Related Party Transactions – Indemnification of Office Holders.”

Effective Corporate Tax Rates

In 1996, 1997 and 1998, certain of our operations were granted “approved enterprise” status under the Law for the Encouragement of Capital Investments – 1969, known as the Investments Law. If we comply with all requirements, we shall be eligible for certain tax benefits with respect to these operations, for the first seven years in which they generate taxable income. Undistributed income derived from our approved enterprise programs will be exempt from corporate tax for a period of two years after we have taxable income, and will be subject to a 25% corporate tax rate for the following five years. We completed the tax exemption period of some of our qualified “approved enterprise” operations and, therefore, these operations are subject to a 25% income tax commencing 1999. If the percentage of our share capital held by foreign shareholders exceeds 25%, future approved enterprises would qualify for reduced tax rates for an additional three years, after the seven years mentioned above. However, we cannot assure you that we will obtain additional “approved enterprise” status for our operations, or that the provisions of the Investments Law will not change, or that the above-mentioned shareholding portion will be reached or maintained for each subsequent year.

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On January 1, 2003, Israel’s tax laws underwent a significant tax reform (Amendment 132 to the Income Tax Ordinance (New Version) – 1961). The legislation broadened the categories of taxable income, and reduced the tax rates imposed on employment income. Among the key provisions of this legislation were (i) changes that may result in the imposition of taxes on dividends received by an Israeli company from its foreign subsidiaries; and (ii) the introduction of the controlled foreign corporation concept according to which an Israeli company may become subject to Israeli taxes on certain income of a non-Israeli subsidiary if the subsidiary’s primary source of income is passive income (such as interest, dividends, royalties, rental income or capital gains). An Israeli company that is subject to Israeli taxes on the income of its non-Israeli subsidiaries will receive a credit for income taxes paid by the subsidiary in its country of residence.

On January 1, 2006, an additional tax reform has been taken place relating primarily to profits from investments. The main goal of the reform was to unify the tax rates applicable to profits from investments, such as interest, capital gains and dividends. In addition, under the new reform, the tax rates applicable to companies were reduced to 31% in 2006, 29% in 2007, 27% in 2008, 26% in 2009 and 25% in 2010.

Our international operations are taxed at the local effective corporate tax rate in the countries of our subsidiaries’ residence. We believe that in the future we will derive an increasing percentage of our income from operations outside of Israel and that, accordingly, our effective tax rate may increase. However, we expect that this increase will be offset by carried forward accumulated losses of consolidated companies. As a result, we anticipate that our net effective tax rate in the foreseeable future shall be lower than 25%.
 
C. Research and Development, Patents and Licenses

For a description of our research and development activities, see “Item 4.B. Business Overview – Research and Development.”

For information concerning our intellectual property rights, see “Item 4.B. Business Overview – Intellectual Property.”
 
D. Trend Information 

We have been affected by global economic changes, in particular the sharp decline in 2001 and 2002, in capital spending in the IT sector and the overall business slowdown in North America and Europe, as well as in Israel. Uncertainties in the North American and European markets have influenced the purchasing patterns of leading software developers who delayed their planned orders and caused developers to reduce the amount of their planned license commitment. These changes in purchasing patterns in the IT industry directly affect our operating results. In 2006, we generated $4.7 million net income from our operations. However, in 2002 and 2001 we had a net loss of $3.6 million and $15.0 million, respectively. The net loss in 2002 and 2001 was a reversal from prior years in which we had net income. We cannot know how the economic conditions will continue to affect our business. As we continue to market new products and penetrate international markets, we expect our selling, general and administrative expenses to continue to be relatively high.

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E. Off-Balance Sheet Arrangements

For information relating to contingent consideration in certain acquisitions, see Item 4.B. Business Overview  Investments and Acquisitions  CodeStream, Outlook, I-Ter, CePost.
 
F. Tabular Disclosure of Contractual Obligations 

The following table summarizes our contractual obligations and commitments as of December 31, 2006:

   
Payment due by period
 
   
Total