The following discussion should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto.

Bitstream Inc. was incorporated in the State of Delaware in 1981. Bitstream Inc. (together with its subsidiaries, "Bitstream" or the "Company") is a software development company focused on bringing unique software products to a wide variety of markets. Today, our core software products include award-winning fonts and font rendering technologies, mobile browsing and messaging technologies and variable data publishing and Web-to-print technologies.

We maintain our executive offices at 245 First Street, 17th Floor, Cambridge, Massachusetts 02142-1270. Our telephone number is (617) 497-6222 and we maintain websites at www.bitstream.com, www.myfonts.com, and www.pageflex.com. Investors may obtain copies of our filings with the Securities and Exchange Commission (the "SEC") free of charge from our website at www.bitstream.com or from the SEC's website at www.sec.gov.

We incorporate herein by reference the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operation - Critical Accounting Policies" contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 and filed with the SEC on March 28, 2008. No changes have been made to those policies since December 31, 2007.

Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These forward-looking statements generally are identified by the words "believes," "project," "expects," "anticipates," "estimates," "intends," "strategy," "plan," "may," "will," "would," "will be," "will continue," "will likely result," and similar expressions. Investors are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, including, without limitation, market acceptance of our products, competition and the timely introduction of new products. Additional information concerning certain risks and uncertainties that would cause actual results to differ materially from those projected or suggested in the forward-looking statements is contained in our filings with the SEC, including those risks and uncertainties discussed under the section entitled "Forward Looking Statements" contained in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 filed with the SEC on March 28, 2008. The forward-looking statements contained herein represent our judgment as of the date of this report, and we caution readers not to place undue reliance on such statements. We undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.

 RESULTS OF OPERATIONS (in thousands, except percentages and per share amounts)

Revenue and Gross Profit:



                                            Three Months Ended September 30,
                                       % of                   % of              Change
                             2008     Revenue       2007     Revenue     Dollars      Percent
   Revenue
   Software licenses       $  4,222      77.0 %   $  4,699      80.9 %   $   (477 )     (10.2 )%
   Services                   1,261      23.0        1,108      19.1          153        13.8

   Total revenue              5,483     100.0        5,807     100.0         (324 )      (5.6 )

   Cost of Revenue
   Software licenses          1,696      40.2        1,779      37.9          (83 )      (4.7 )
   Services                     598      47.4          434      39.2          164        37.8

   Total cost of revenue      2,294      41.8        2,213      38.1           81         3.7

   Gross Profit            $  3,189      58.2 %   $  3,594      61.9 %   $   (405 )     (11.3 )%


                                            Nine Months Ended September 30,
                                       % of                   % of              Change
                             2008     Revenue       2007     Revenue     Dollars      Percent
   Revenue
   Software licenses       $ 14,563      79.3 %   $ 14,189      81.9 %   $    374         2.6 %
   Services                   3,807      20.7        3,146      18.1          661        21.0

   Total revenue             18,370     100.0       17,335     100.0        1,035         6.0

   Cost of Revenue
   Software licenses          5,555      38.1        5,190      36.6          365         7.0
   Services                   1,782      46.8        1,410      44.8          372        26.4

   Total cost of revenue      7,337      39.9        6,600      38.1          737        11.2

   Gross Profit            $ 11,033      60.1 %   $ 10,735      61.9 %   $    298         2.8 %

License revenue from direct sales, which includes e-commerce sales, decreased $93, or 2.9%, to $3,135 for the three months ended September 30, 2008 as compared to $3,228 for the three months ended September 30, 2007, and increased $82, or 0.8%, to $9,816 for the nine months ended September 30, 2008 as compared to $9,734 for the nine months ended September 30, 2007. License revenue from resellers decreased $21, or 5.9%, to $336 for the three months ended September 30, 2008 as compared to $357 for the three months ended September 30, 2007, and decreased $33, or 2.9%, to $1,123 for the nine months ended September 30, 2008 as compared to $1,156 for the nine months ended September 30, 2007. License revenue from OEMs and ISVs decreased $363, or 32.6%, to $751 for the three months ended September 30, 2008 as compared to $1,114 for the three months ended September 30, 2007, and increased $325, or 9.9%, to $3,624 for the nine months ended September 30, 2008 as compared to $3,299 for the nine months ended September 30, 2007.

License revenue varies between quarters due to the timing of license agreements. Revenue for the three months ended September 30, 2008 decreased across all of our product lines and sales channels (direct, reseller, OEM and ISV) due to delays in purchasing decisions by customers and due to decreases in royalties from shipments by OEMs and ISVs during the quarter. We believe these decreases can be attributed primarily to the poor general economic conditions in effect during this period. The increase in license revenue for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 was due to the increase in license revenue during the six months ended June 30, 2008. If general economic conditions do not improve, revenue for the quarter ending December 31, 2008 may continue to lag the level of license revenue for the same period in 2007.

The increase in revenue from services was due to increases across all of our product lines. These increases were primarily driven by increases in our customer base and customer demand for consulting and design services, resulting in an increase in services revenue from customers acquired both directly and through resellers of $153, or 13.8%, to $1,261 for the three months ended September 30, 2008 as compared to $1,108 for the three months ended September 30, 2007, and an increase of $661 or 21% to $3,807 for the nine months ended September 30, 2008 as compared to $3,146 for the nine months ended September 30, 2007. We believe that our overall services revenue during 2008 will continue to exceed the level attained during 2007.

We recognize license revenue from direct sales and from licensing our products and third party products including e-commerce sales made via our websites, from licensing agreements with OEMs and ISVs, and from the resale of our products through various resellers. We recognize reseller revenue if collection is probable, upon notification from the reseller that it has sold the product or, if for a physical product, upon delivery of the software. E-commerce sales include revenue from the licensing of Bitstream fonts and font technology, licensing of the ThunderHawk browser, licensing of fonts and font technology developed by third parties and from fees received from referring customers to other sites for which we have referral agreements. Referral income for the three months ended September 30, 2008 and 2007 was $17 and $7, respectively. Referral income for the nine months ended September 30, 2008 and 2007 was $40 and $23, respectively. There are minimal costs associated with referral revenue, and such costs primarily represent the time to load copies of the fonts provided by each participating foundry to the MyFonts.com database. We expense those costs as incurred.

The decrease in cost of license revenue for the three-month period ended September 30, 2008 as compared to the three-month period ended September 30, 2007 was primarily due to a $99 decrease in direct costs, including royalty costs, associated with decreased sales of third party products for the three months ended September 30, 2008. The increase in cost of license revenue for the nine-month period ended September 30, 2008 as compared to the nine-month period ended September 30, 2007 was primarily due to a $323 increase in direct costs, including royalty costs, associated with increased sales of third party products for the nine-month period ended September 30, 2008. We expect the cost of license revenue as a percentage of license revenue for the fiscal year ending December 31, 2008 to approximate the percentage for the first nine months of 2008, although the results may vary based upon the mix of products sold during the remainder of the year.

The increase in cost of services revenue for the three and nine month periods ended September 30, 2008 as compared to the same periods ended September 30, 2007 was due to an increase in the cost of customer consulting resources and support personnel of $165 and $437 partially offset by a decrease in the utilization of customer support and consulting personnel on internal research and development projects of $22 and $120 for the three and nine-month periods ended September 30, 2008, respectively. Total cost of services increased slightly as a percentage of services revenue for the three and nine months ended September 30, 2008 as compared to the same period in 2007. We expect our cost of services as a percentage of service revenue to approximate that of the first nine months of 2008.

Cost of revenue includes royalties and fees paid to third parties for the development of, or license of rights to, technology and/or unique typeface designs, costs incurred in the fulfillment of custom orders, costs incurred in providing customer support, maintenance, and training, and costs associated with the duplication, packaging and shipping of product.

Operating Expenses:



                                              Three Months Ended September 30,
                                          % of                  % of             Change
                                2008     Revenue      2007     Revenue     Dollars    Percent
  Marketing and selling        $   979      17.9 %   $   974      16.8 %   $      5       0.5 %
  Research and development       1,334      24.3       1,223      21.1          111       9.1
  General and administrative       713      13.0         666      11.5           47       7.1

  Total operating expenses     $ 3,026      55.2 %   $ 2,863      49.3 %   $    163       5.7 %


                                              Nine Months Ended September 30,
                                          % of                  % of             Change
                                2008     Revenue      2007     Revenue     Dollars    Percent
  Marketing and selling        $ 3,358      18.3 %   $ 2,937      16.9 %   $    421      14.3 %
  Research and development       4,048      22.0       3,514      20.3          534      15.2
  General and administrative     2,072      11.3       1,870      10.8          202      10.8

  Total operating expenses     $ 9,478      51.6 %   $ 8,321      48.0 %   $  1,157      13.9 %

Marketing and selling ("M&S") expense consists primarily of salaries and benefits, commissions, travel expense and facilities costs related to sales and marketing personnel, as well as marketing program-related costs including trade shows and advertising. The increase in M&S expense for the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 was primarily the result of a $83 increase in salaries & benefits, a $21 increase in professional services, and a $13 increase in facilities cost; partially offset by a $65 decrease in advertising and marketing activities including tradeshow participation in travel expense, and a $51 decrease in travel & entertainment. The increase in M&S expense for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 was primarily the result of a $219 increase in salaries & benefits, a $159 increase in professional services, and a $106 increase in advertising and marketing activities including tradeshow participation; partially offset by a decrease in travel expense of $79. We expect our M&S expenses to continue at a similar level during the remainder of 2008.

Research and development ("R&D") expense consists primarily of salary and benefits costs, contracted third-party development costs, and facility costs related to software developers and management. The increase in R&D expense for the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 was primarily the result of increases in salaries and benefits and the use of third party contractors of $57, an increase in the utilization of customer support and consulting personnel on internal R&D projects of $22, and an increase in facilities costs of $24. The increase in R&D expense for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 was primarily the result of increases in salaries and benefits and the use of third party contractors of $323, an increase in the utilization of customer support and consulting personnel on internal R&D projects of $120, and an increase in facilities costs of $45. We expect our development efforts to continue at a similar level during the remainder of 2008.

General and administrative ("G&A") expense consists primarily of salaries, benefits, and other related costs including travel and facility expenses for finance, human resource, legal and executive personnel, legal and accounting professional services, provision for bad debts and director and officer insurance. The increase in G&A for the three months ended September 30, 2008 as compared to the three months ended September 30, 2007 is primarily due to an increase in professional fees of $63, partially offset by decrease in bad debt expense of $19. The increase in G&A for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007 is

primarily due to an increase in salaries, wages and benefits of $65, an increase in professional fees of $155, including expenses related to the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley") of $46, and legal expenses of $43, partially offset by decrease in bad debt expense of $35. We expect G&A expense to continue at a similar level during the remainder of 2008.

Other Income, Net:

Other income includes interest income earned on cash and money market instruments. Net interest income has decreased as compared to the same periods in the prior year due to a lower rate of interest earned on our cash and money market instruments.

Provision for Income Taxes:

Our tax provision for the three and nine month periods ended September 30, 2008 consisted of $6 and $42 of foreign withholding taxes and $0 and $14 of state income taxes, respectively. The tax provision for the three and nine months ended September 30, 2007 consisted of $11 and $21 of foreign withholding taxes respectively. The Company did not have a provision for U.S. Federal tax during these periods due to Net Operating Loss and Tax Credit carry forwards. Foreign taxes vary with OEM license royalties from customers in countries who are party to tax conventions with the United States, including Korea and Poland.

The Company's income tax provisions for the three and nine months ended September 30, 2008 and 2007 are primarily attributable to federal and state income taxes in the U.S. and taxes related to foreign jurisdictions. Federal and state tax provisions for those periods included amounts in relation to the Company's income generated in the U.S., reduced by previously unused net operating loss (NOL) carry forwards and tax credits that were recorded on the balance sheet with a full valuation allowance.

As of September 30, 2008, a full valuation allowance was recorded against the Company's net deferred tax assets in the U.S. As of December 31, 2007, the Company had gross U.S. federal NOL carry forwards of $14,612, state NOL carry forwards of $2,366, U.S. federal research and development credit ("R&D Credit") carry forwards of $864, state R&D credit carry forwards of $291 and foreign tax credits of $179.

We continued to provide a full valuation allowance for our net deferred tax assets at September 30, 2008, as we believe it is more likely than not that the future tax benefits from accumulated net operating losses and deferred taxes will not be realized. We continue to assess the need for the valuation allowance at each balance sheet date based on all available evidence. However, it is possible that the "more likely than not" criterion could be met in future periods, which could result in the reversal of a significant portion or all of the valuation allowance, which, at that time, would be recorded as a tax benefit in the consolidated statement of operations.

LIQUIDITY AND CAPITAL RESOURCES (in thousands, except share and per share amounts)

The Company has funded its operations primarily through the public sale of equity securities, cash flows from operations, cash received from the sale of our MediaBank and InterSep OPI product lines to Inso Providence Corporation in August of 1998, and cash received from the sale of our investment in DiamondSoft to Extensis in July of 2003. As of September 30, 2008, we had net working capital of $13,207 versus $14,514 at December 31, 2007, a decrease of $1,307 or 9%. Working capital decreased due to our two stock buyback plans pursuant to which we acquired 697,700 shares of our common stock during the nine months ended June 30, 2008 for a total cost of approximately $4,118.

Our operating activities generated cash during the nine months ended September 30, 2008 and 2007 of $2,500 and $3,400, respectively, primarily due to our net income before adjustment for non-cash expenses of $1,659 and $2,817,

respectively. Our operating activities for the nine months ended September 30, 2008 generated $900 less cash than for the nine months ended September 30, 2007 primarily due to the decrease in net income. We used cash of $164 and $392 for the nine months ended September 30, 2008 and 2007, respectively, for the purpose of acquiring additional property and equipment and intangible assets. For the nine months ended September 30, 2008, we used cash of $4,118 to repurchase shares of our common stock during the quarter, partially offset by $562 in proceeds from the exercise of stock options. Our financing activities for the nine months ended September 30, 2007 provided cash of $1,679 from the exercise of stock options.

We believe our current cash and cash equivalent balances will be sufficient to meet our operating and capital requirements for at least the next 12 months. There can be no assurance, however, that we will not require additional financing in the future. If we were required to obtain additional financing in the future, there can be no assurance that sources of capital would be available on terms favorable to us, if at all.

As of September 30, 2008, we had no material commitments for capital expenditures. In July 2008, Bitstream India Pvt. Ltd., our wholly-owned subsidiary, entered into a 33 month lease agreement in Nodia India. This lease agreement commenced May 1, 2008 and obligates us to make monthly payments including service taxes. The total commitment during the 33 month lease period is approximately $148 U.S. dollars.

In August 2003, we entered into a six-year lease agreement and moved our corporate offices. Our current lease expires August 31, 2009 and we are currently reviewing our options for renewing the current lease or obtaining other suitable office space. We understand that sufficient office space is currently available in our geographic area and that, given general economic conditions, we will be able to secure the amount of space we need to conduct our operations at reasonable market rates.

From time to time, we evaluate potential acquisitions of products, businesses and technologies that may complement or expand our business. Any such transactions consummated may use a portion of our working capital or require the issuance of equity or debt securities.

We have certain royalty commitments associated with the shipment and licensing of certain products. Royalty expense is primarily based on a dollar amount per unit shipped or a percentage of the underlying revenue. Royalty expense is recorded as cost of license revenue on our Consolidated Statement of Operations.

Off-Balance Sheet Arrangements

We enter into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally business partners or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is minimal, but we can provide no assurance that payments will not be required under these agreements in the future.

Stock Repurchase Plans

On December 10, 2007 our Board of Directors authorized and announced a program to repurchase up to $2,500 of our common stock. On February 12, 2008, we reached the authorized limit set by the December 10, 2007 stock repurchase plan purchasing a total of 428,100 shares at an average price of $5.84 per share or approximately $2,500.

On March 18, 2008 our Board of Directors authorized a second stock repurchase program, which was announced on March 19, 2008, to repurchase up to $2,500 of our common stock. On June 16, 2008, we reached the authorized limit set by the March 18, 2008 stock repurchase plan purchasing a total of 415,300 shares at an average price of $6.02 per share or approximately $2,500.

During the nine months ended September 30, 2008, as part of these two repurchase programs, we repurchased 697,700 shares, at an average price of $5.903 per share or approximately $4,118 under a structured share repurchase agreement with a large financial institution.

In June 2008, the FASB issued FSP EITF 03-6-1, "Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities." FSP EITF 03-6-1 clarifies that share-based payment awards that entitle their holders to receive nonforfeitable dividends before vesting should be considered participating securities. As participating securities, these instruments should be included in the calculation of basic earnings per share. FSP EITF 03-6-1 is effective in 2009. We are currently evaluating the impact of adoption.

In April 2008, the FASB issued FASB Staff Position ("FSP") No. 142-3, "Determination of the Useful Life of Intangible Assets". FSP No. 142-3 amends the factors an entity should consider in developing or extending assumptions used in determining the useful life of recognized intangible assets under FASB No. 142. This new guidance applies prospectively to intangible assets that are acquired individually or with a group of other assets in business combinations and asset acquisitions. FSP No. 142-3 is effective for financial statements issued for fiscal year and interim periods beginning after December 15, 2008. Early adoption is prohibited. We are currently evaluating the impact, if any, that FSP No. 142-3 will have on our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141R, "Business Combinations." SFAS No. 141R does the following: requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose certain information to enable users to understand the nature and financial effect of the business combination. The statement requires that cash outflows such as transaction costs and post-acquisition restructuring be charged to expense instead of capitalized as a cost of the acquisition. Contingent purchase price will be recorded at its initial fair value and then re-measured as time passes through adjustments to net income. SFAS No. 141R is effective in 2009. We do not believe the impact of this accounting standard to be material.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of FASB Statement No. 115 ("SFAS No. 159"). SFAS No. 159 expands the use of fair value accounting but does not affect existing standards which require assets or liabilities to be carried at fair value. The objective of SFAS No. 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting . . .