Natural MicroSystems Corporation

LIQUIDITY AND CAPITAL RESOURCES

Cash provided by (used by) operations for the years ended December 31, 1999, 1998 and 1997 was $7.6 million, ($4.1 million) and $3.2 million, respectively. Cash was provided by operations in 1999 from decreases in our accounts receivable, inventory and prepaid assets and increases in accrued expenses, partially offset by the net loss. Cash was used in operations in 1998 from the net loss, and increases in inventory, prepaid expenses and a restructuring accrual partially offset by a decrease in accounts receivable. Cash was provided by operations in 1997 from net income and increased accounts payable partially offset by increased accounts receivable and inventory in support of higher revenues.

Cash (used in) provided by investing activities in 1999, 1998 and 1997 was ($7.7 million), $7.2 million and ($7.8 million), respectively. Cash of $17.3 million, $6.5 million and $33.0 million was used to purchase marketable securities, with cash of $16.4 million, $27.6 million and $32.7 million provided from maturities of marketable securities for 1999, 1998 and 1997, respectively. Capital expenditures were $6.2 million, $8.6 million and $7.2 million for 1999, 1998 and 1997, respectively. Increased capital expenditures in 1998 were primarily due to increases in personnel-related and capital improvement costs. Capital expenditures for 1997 were associated with our new headquarters facility. We expect capital expenditures in 2000 will approximate $7.0 million, principally for testing equipment, development equipment and computer hardware and software.

Cash provided by financing activities in 1999, 1998 and 1997 was $4.2 million, $3.2 million and $4.1 million, respectively. The financing in 1999 was provided primarily by the exercise of stock options and the issuance of debt used to fund QWES operations. This was partially offset by our purchase for $1.1 million of 100,000 shares of common stock through our repurchase plan, which our board of directors authorized in July 1999 and subsequently rescinded. The financing in 1998 was provided primarily from the exercise of stock options and the issuance of debt used to fund QWES operations. The financing in 1997 was provided primarily from the exercise of stock options.

We established a new $7.5 million bank line of credit for working capital purposes effective in May 1999. Borrowings under our line of credit bear interest at the bank’s floating rate of prime plus one percent. We are subject to covenants requiring maintenance of certain profitability, equity and liquidity ratios. As of December 31, 1999, we were in compliance with all of those covenants, and there were no amounts outstanding. This credit agreement is subject to renewal on May 13, 2000.

We believe that our current cash and marketable securities will be sufficient to meet our cash requirement to fund operations and expected expenditures for the foreseeable future.

QUARTERLY RESULTS

The following tables set forth unaudited selected financial information for the periods indicated, as well as certain information expressed as a percentage of total revenues for the same periods. This information has been derived from unaudited consolidated financial statements, which we believe include all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of such information. This information has not been audited or reviewed by our independent accountants in accordance with standards established for such reviews. The results of operations for any quarter are not necessarily indicative of the results to be expected for any future period.

Revenues have grown relatively steadily over the four quarters for the period ended December 31, 1999, after we significantly increased expenses in 1998 as we began our repositioning. Revenue growth from the first quarter of 1999 to the second quarter was 6%, from the second quarter to the third quarter was 15% and from the third quarter to the fourth quarter was 23%. We believe that our repositioning efforts have been successful to date. We expect that revenues will continue to increase into the period ending December 31, 2000.

Operating income (loss) during the eight quarters has varied, decreasing as a percentage of revenues from quarter to quarter for 1999, after increasing steadily over four quarters of 1998. Cost of revenues remained flat in 1999 after increasing steadily over the four quarters in 1998. In 1998 and 1999, increases in the services and manufacturing departments led to higher cost of revenues percentages. During this eight-quarter period, selling, general and administrative expenses have varied due to costs associated with increased sales activity and increased expenditures for marketing and international operations. Research and development remained relatively constant as a percentage of revenues.

Our quarterly operating results may fluctuate as a result of a number of other factors, including timing of customer orders, adjustments of delivery schedules to accommodate customer or regulatory requirements, availability of components from suppliers, timing and level of international sales, mix of products sold and timing and level of expenditures for sales, marketing and new product development.

We operate on a relatively small backlog. Quarterly sales and operating results therefore generally depend on the volume and timing of orders received during or just before the start of the quarter. Our expense levels are based in part on our forecasts of future revenues and, if such revenues were to fall below expectations, our operating results could be adverse-ly affected. Accordingly, we cannot be sure that we will be profitable in any particular quarter.