The following discussion of our financial condition and results of operations should be read together with the financial statements and related notes that are included elsewhere in this Quarterly Report. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth in this Quarterly Report under "Risk Factors," in our Annual Report on Form 10-K for the year ended December 31, 2011 under "Risk Factors" and in other parts of this Quarterly Report.

Overview

We were incorporated and commenced operations in 1997. From 1997 through 2002, we generated a substantial portion of our revenues from the sale of our EnCase® Forensic products and related services. We have experienced increases in our revenue as a result of the release of EnCase® Enterprise in 2002, the release of EnCase® eDiscovery in 2005 and the release of EnCase® Information Assurance in 2006 (which was replaced by EnCase® Cybersecurity in 2009), which expanded our customer base into corporate enterprises and federal government agencies. In May 2010, we added a family of data acquisition forensic hardware products including forensic duplicators, multiple write blockers and other hardware through our acquisition of Tableau. In February 2012, we added cloud-based document review and production software-as-a-service for corporations and law firms through our acquisition of CaseCentral.

We develop and provide leading software and hardware solutions for digital investigations, including EnCase® Enterprise, a network-enabled product primarily for large corporations and government agencies, and EnCase® Forensic, a desktop-based product primarily for law enforcement agencies. We anticipate that sales of subscriptions for our cloud-based review and production software, our EnCase® Enterprise products and related services, in particular our EnCase® eDiscovery and EnCase® Cybersecurity solutions, and the sales of our forensic hardware products, will comprise a substantial portion of our future revenues.

Factors Affecting Our Results of Operations

There are a number of trends that may affect our business and our industry. Some of these trends or other factors include:

† Legislative and regulatory developments. Our digital investigation solutions allow law enforcement agencies, government organizations and corporations to conduct investigations within the legal and regulatory framework. Historically, the implementation of new laws and regulations surrounding digital investigations has helped create demand for our products. Future changes in applicable laws or regulations could enhance or detract from the desirability of our products.

† Information technology budgets. Deployment of our solutions may require substantial capital expenditures by our customers. Budgets for information technology-related capital expenditures at corporations and all levels of government organizations are typically cyclical in nature, with generally higher budgets in times of improving economic conditions and lower budgets in times of economic slowdowns.

† Law enforcement agency budgets. We sell our EnCase® Forensic products and training services primarily to law enforcement agencies. Because of the limited nature of law enforcement budgets, funds are typically initially allocated toward solving issues perceived to be the most pressing. Sales of our products could be impacted by changes in the budgets of law enforcement agencies or in the relative priority assigned to digital law enforcement investigations.

† Prevalence and impact of hacking incidents and spread of malicious software. The increasing sophistication of hacking attacks on government and private networks and the global spread of malicious software, such as viruses, worms and rootkits, have increased the focus of corporations and large government organizations on digital investigations and other aspects of network security, which has, in turn, increased demand for our products. Future changes in the number and severity of such attacks or the spread of malicious software could have an effect on the demand for our products.

† Seasonality in revenues. We experience seasonality in our revenues, with the third and fourth quarters typically having the highest revenues for the year. We believe that this seasonality results primarily from our customers' budgeting cycles. The federal government's budget year ends in the third calendar quarter of the year and a majority of corporate budget years end in the fourth calendar quarter of the year. In addition, our customers also tend to make software purchases near the end of a particular quarter, which tends to make our revenues for a particular quarter unpredictable for a significant portion of that quarter. We expect that this seasonality in our revenues and unpredictability of our revenues within particular quarterly periods will continue for the foreseeable future.

† Amount of commercial litigation. Because commercial litigation often involves eDiscovery, an increase in commercial litigation could increase demand for our products and services, while a decrease in commercial litigation could decrease demand.

Critical Accounting Policies and Estimates

In preparing our financial statements, we make estimates, assumptions and judgments that can have a significant impact on our net revenue, operating income or loss and net income or loss, as well as on the value of certain assets and liabilities on our balance sheet. We believe that the estimates, assumptions and judgments involved in the accounting policies described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2011 have the greatest potential impact on our financial statements, so we consider them to be our critical accounting policies and estimates. There have no significant changes in those critical accounting policies and estimates during the three months ended March 31, 2012 other than the addition to revenue recognition mentioned below.

With the acquisition of CaseCentral in February 2012, we now also generate revenue from cloud-based document review and production software-as-a-service where customers have the right to access our document review management software via the web; however, they may not take possession of the software at any time during the term of the agreement. In general, we recognize revenue for subscriptions on a straight-line basis over the contractual contract period commencing on the date the subscription is made available to the customer. Usage-based fees, which are determined monthly, are recognized when incurred.

When subscription services and usage-based fee arrangements involve multiple elements that qualify as separate units of accounting, we allocate arrangement consideration in multiple deliverable revenue arrangements at the inception of an arrangement to all deliverables based on the relative selling price method in accordance with the selling price hierarchy, which includes: 1) vendor-specific objective evidence of fair value ("VSOE"), if available, 2) third-party evidence ("TPE") if VSOE is not available; or 3) best estimate of selling price ("BESP") if neither VSOE nor TPE is available.

† VSOE. We determine VSOE based on its historical pricing and discounting practices for the specific product or service when sold separately. In determining VSOE, we require that a substantial majority of the selling prices for these services fall within a reasonably narrow pricing range.

† TPE. When VSOE cannot be established for deliverables in a multiple element arrangement, we apply judgment with respect to whether we can establish a selling price based on TPE. TPE is determined based on competitor prices for similar deliverables when sold separately. Generally, our go-to-market strategy differs from our peers and our offerings contain a significant level of differentiation such that comparable pricing of services with similar functionality has not been able to be obtained. Furthermore, we have been unable to reliably determine selling prices of similar competitive services on a stand-alone basis. As a result, we have not been able to establish selling prices based on TPE.

† BESP. When VSOE or TPE is unable to be established, we use BESP in our allocation of arrangement consideration. The objective of BESP is to determine the price at which we would transact a sale if the service was sold on a stand-alone basis. We determine BESP for deliverables by considering multiple factors including but not limited to prices we charge for similar offerings, market conditions, competitive landscape and pricing practices.

We have not established VSOE or TPE for our subscription services or usage-based fee arrangements and therefore we use BESP to allocate the selling price to subscription services and usage-based fee deliverables.

Results of Operations



The following table sets forth our results of operations for the three months
ended March 31, 2012 and 2011, respectively, expressed as a percentage of total
revenues:



                                            Three Months Ended
                                                 March 31,
                                             2012         2011
Revenues:
Product revenue                                40.4 %       40.5 %
Subscription revenue                            4.7            -
Services and maintenance revenue               54.9         59.5
Total revenues                                100.0        100.0

Cost of revenues:
Cost of product revenue                         6.5          5.4
Cost of subscription revenue                    2.3            -
Cost of services and maintenance revenue       20.9         26.7
Total cost of revenues                         29.7         32.1

Gross profit                                   70.3         67.9

Operating expenses:
Selling and marketing                          33.2         34.5
Research and development                       20.3         20.2
General and administrative                     23.9         20.4
Depreciation and amortization                   6.2          5.3
Total operating expenses                       83.6         80.4

Operating loss                                (13.3 )      (12.5 )

Other income and expense:
Interest income                                 0.0          0.0
Interest expense                                0.0          0.0
Other income, net                               0.0          0.0
Loss before income taxes                      (13.3 )      (12.5 )
Income tax provision                            0.5          0.4
Net loss                                      (13.8 )%     (12.9 )%

The following table sets forth share-based compensation expense recorded in each of the respective periods (in thousands):

                                               Three Months Ended
                                                   March 31,
                                                2012         2011
Non-Cash Share-Based Compensation Data(1):
Cost of product revenue                      $       23    $     22
Cost of subscription revenue                         22           -
Cost of services and maintenance revenue            216         253
Selling and marketing                               377         437
Research and development                            290         421
General and administrative                          369         421
Total non-cash share-based compensation      $    1,297    $  1,554

Comparison of Results of Operations for the Three Months Ended March 31, 2012 and 2011

Sources of Revenues

Our software product sales transactions typically include the following elements: (i) a software license fee paid for the use of our products under a perpetual license term, or for a specific term; (ii) an arrangement for first-year support and maintenance, which includes unspecified software updates, upgrades and post-contract support; (iii) and professional services for installation, implementation, consulting and training. With our acquisition of CaseCentral in February 2012, we began to generate revenue from cloud-based document review and production software sold as subscription services. We derive the majority of our revenues from sales of our software products. We sell our software products and services primarily through our direct sales force and in some cases we utilize resellers. We sell our hardware products primarily through resellers.

                                                Three Months Ended
                                                    March 31,
(Dollars in thousands)                      2012     Change %     2011
Product revenues                          $ 10,509     10%      $  9,554

Subscription revenue                         1,225     100%            -

Services and maintenance revenues:
Services                                     5,648    (20)%        7,101
Maintenance                                  8,637     25%         6,922
Total services and maintenance revenues     14,285      2%        14,023

Total revenues                            $ 26,019     10%      $ 23,577

Product Revenues

We generate product revenues principally from two product categories: Enterprise and Forensic products. Our Enterprise products include perpetual licenses and Pay-Per-Use fees related to our EnCase® Enterprise, eDiscovery, Legal Hold, EnCase® Cybersecurity and OEM add-on products. Our Forensic products include revenues related to EnCase® Forensic, EnCase® Portable and forensic hardware sales. Our Forensic products also include our Premium License Support Program ("PLSP") product, which was sold on a subscription basis for a term of one or three years; sales of PLSP ended in June 2011 when we introduced EnCase® Forensic v7. During the first two quarters of each fiscal year, we typically experience our lowest levels of product sales due to the seasonal budgetary cycles of our customers. The third quarter is typically the strongest quarter for sales to our federal government customers. Typically, sales to our corporate customers are highest in the fourth quarter.

Product revenues for the first quarter of 2012 were $10.5 million, an increase of $1.0 million, or 10%, from $9.6 million for the first quarter of 2011. The increase in product revenues was primarily due to increased demand for version 7 of our Encase® software products.

Subscription Revenues

With our acquisition of CaseCentral in February 2012, we began to generate revenue from cloud-based document review and production software sold as subscription services. Subscription service customers have the right to access our cloud-based document review and production software; however, they may not take possession of the software at any time during the term of the agreement. In general, we recognize revenue for subscriptions on a straight-line basis over the contract period commencing on the date the subscription is made available to the customer. Usage-based fees, that are determined monthly, are recognized when incurred.

Subscription revenues for the first quarter of 2012 were $1.2 million, compared to none in the first quarter 2011. We started to earn revenue from cloud-based document review and production software products which we acquired as a result of our acquisition of CaseCentral in February 2012.

Services and Maintenance Revenues

Services and maintenance revenues for the first quarter of 2012 were $14.3 million, an increase of $0.3 million, or 2%, from $14.0 million for the first quarter of 2011.

Services revenues for the first quarter of 2012 were $5.6 million, a decrease of $1.5 million, or 20%, from $7.1 million for the first quarter of 2011. The decrease in services revenues was primarily due to the completion of a significant consulting engagement performed during the first quarter of 2011 partially offset by an increase in professional services revenues due to our acquisition of CaseCentral in February 2012 and an increase of $0.6 million in training revenue in the first quarter of 2012. Training revenue increased primarily a result of higher demand for training classes related to the new product releases that occurred in 2011 and early 2012.

Maintenance and other revenues for the first quarter of 2012 were $8.6 million, an increase of $1.7 million, or 25%, from $6.9 million for the first quarter of 2011. The increase was primarily a result of sustained increases in our installed product base and high annual renewal rates by customers desiring continuing maintenance support on our products.

Cost of Revenues



                                                       Three Months Ended
                                                           March 31,
(Dollars in thousands)                             2012     Change %    2011
Cost of product revenues                          $ 1,683     31%      $ 1,285

Cost of subscription revenues                         586     100%           -

Cost of services and maintenance revenues:
Services                                            4,915    (14)%       5,741
Maintenance                                           535     (4)%         557
Total cost of services and maintenance revenues     5,450    (13)%       6,298

Total cost of revenues                            $ 7,719      2%      $ 7,583
Share-based compensation included above:
Cost of product revenues                          $    23              $    22
Cost of subscription revenues                     $    22              $     -
Cost of services and maintenance revenues         $   216              $   253

Gross Margin Percentages
Products                                             84.0 %               86.6 %
Subscriptions                                        52.2 %                  - %
Services and maintenance                             61.8 %               55.1 %
Total                                                70.3 %               67.8 %

Cost of Product Revenues

Cost of product revenues consists principally of the cost of producing our software products, the cost of manufacturing our hardware products and product distribution costs, including the cost of compact discs, packaging, shipping, customs duties, and, to a lesser extent, compensation and related overhead expenses. While these costs are primarily variable with respect to sales volumes, they remain low in relation to the revenues generated and result in higher gross margins than our services and training businesses. Our gross margins can be affected by product mix, as our enterprise products are generally higher margin products than our forensic products, which include software and hardware.

Cost of product revenues for the first quarter of 2012 were $1.7 million, an increase of $0.4 million, or 31%, from $1.3 million for the first quarter of 2011. This increase was primarily a result of an increase in forensic product revenues due to increased sales of the latest versions of our EnCase® software product and higher sales of our forensic hardware products. Product revenue gross margin decreased slightly to 84.0% in the first quarter of 2012, compared with 86.6% in the first quarter of 2011. The decrease in gross margin percentage was primarily due to an increase in sales of forensic hardware products, which have lower margins.

Cost of Subscription Revenues

The cost of subscription revenues consist principally of employee compensation costs, including share-based compensation and related overhead, software maintenance paid to third party vendors, and SaaS hosting infrastructure costs. Cost of subscription revenues for the first quarter of 2012 were $0.6 million, compared to none in the first quarter of 2011, as the cloud-based document review and production software products did not become a part of our product mix until the consummation of our acquisition of CaseCentral in February 2012.

Cost of Services and Maintenance Revenues

The costs of services and maintenance revenues are largely comprised of employee compensation costs, including share-based compensation and related overhead, travel and facilities costs. The cost of maintenance revenues is primarily outsourced, but also includes employee compensation costs for customer technical support and related overhead costs.

Total cost of services and maintenance revenues for the first quarter of 2012 were $5.5 million, a decrease of $0.8 million, or 13%, from $6.3 million in the first quarter of 2011. The decrease was primarily due to lower compensation associated with the lower revenues and lower utilization rates in our professional services organization year-over-year, partially offset by an increase in costs due to the acquisition of CaseCentral in February 2012. Services and maintenance gross margin for the first quarter of 2012 increased to 61.8%, compared to 55.1% in the first quarter of 2011. The increase in gross margin was primarily a result of the higher mix of higher-margin maintenance revenues versus lower-margin services revenues during the quarter.

Operating Expenses



                                              Three Months Ended March 31,
(Dollars in thousands)                        2012        Change %      2011
Selling and marketing expenses             $    8,637        6%        $ 8,129
Research and development expenses          $    5,290        11%       $ 4,772
General and administrative expenses        $    6,220        29%       $ 4,807
Depreciation and amortization expenses     $    1,626        31%       $ 1,241

Share-based compensation included above:
Selling and marketing expenses             $      377                  $   437
Research and development expenses          $      290                  $   421
General and administrative expenses        $      369                  $   421

As a percentage of revenue:
Selling and marketing expenses                   33.2 %                   34.5 %
Research and development expenses                20.3 %                   20.2 %
General and administrative expenses              23.9 %                   20.4 %
Depreciation and amortization expenses            6.2 %                    5.3 %

Selling and Marketing Expenses

Selling and marketing expenses consist primarily of personnel costs and costs related to our sales force and marketing staff. Selling and marketing expenses also include expenses relating to advertising, brand building, marketing promotions and trade show events (net of amounts received from sponsors and participants), product management, and travel and allocated overhead. We increased the number of selling and marketing personnel we employ to 125 at March 31, 2012, from 120 during the same period in the prior year.

Selling and marketing expenses for the first quarter of 2012 were $8.6 million, an increase of $0.5 million, or 6%, from $8.1 million for the first quarter of 2011. The higher expenses were driven primarily by an increase in headcount and related expenses as a result of the acquisition of CaseCentral in February 2012.

Research and Development Expenses

Research and development expenses consist primarily of compensation, including share-based compensation and related overhead expenses. In order to develop new product offerings, continue developing existing products and improve quality assurance, and incorporate personnel to support our new cloud-based subscription offerings, we increased the number of research and development personnel that we employ to 118 at March 31, 2012, from 97 during the same period in the prior year.

Research and development expenses for the first quarter of 2012 were $5.3 million, an increase of $0.5 million, or 11%, from $4.8 million for the first quarter of 2011. The higher expenses were driven primarily by an increase in headcount and related expenses as a result of the acquisition of CaseCentral in February 2012.

General and Administrative Expenses

General and administrative expenses consist of personnel and related costs for accounting, legal, information systems, human resources and other administrative functions. In addition, general and administrative expenses include professional service fees, bad debt expense, and other corporate expenses and related overhead. We increased the number of general and administrative personnel we employ to 70 at March 31, 2012, from 60 during the same period in the prior year.

General and administrative expenses for the first quarter of 2012 were $6.2 million, an increase of $1.4 million, or 29%, from $4.8 million for the first quarter of 2011. The increase in general and administrative expenses was primarily attributable to acquisition related costs of $2.0 million related to the CaseCentral acquisition, legal fees of $0.4 million related to the patent infringement complaints filed in 2011, and increased headcount and related expenses primarily due to the acquisition of CaseCentral, offset by a charge of $1.3 million related to certain state sales tax obligations including related interest penalties that occurred in the first quarter of 2011.

Depreciation and Amortization Expenses

Depreciation and amortization expenses consist of depreciation and amortization of our leasehold improvements, furniture, computer hardware and software, and intangible assets. Depreciation and amortization expenses for the first quarter of 2012 were $1.6 million, an increase of $0.4 million, or 31%, from $1.2 million for the first quarter of 2011, primarily as a result of the amortization of intangibles assets and depreciation expense related to our acquisition of CaseCentral.

Other Income and Expense

Interest income (expense) and other income (expense), net consist of interest earned on cash balances and other miscellaneous income and expense items. For the first quarter 2012, total other income and expense was approximately $7,000, an increase of $1,000, or 17%, from $6,000 for the same period in the prior year. The increase relates to a $5,000 increase in interest income, a $5,000 increase in other income, net, offset by a $9,000 decrease in interest expense.

Income Tax Provision

The Company recorded an income tax provision for the first quarter of 2012 of . . .