FORWARD-LOOKING STATEMENTS

This Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. For example, words such as "may," "will," "should," "estimates," "predicts," "potential," "continue," "strategy," "believes," "anticipates," "plans," "expects," "intends," and similar expressions are intended to identify forward-looking statements. You should not place undue reliance on these forward-looking statements. Actual results and trends may differ materially from historical results or those projected in any such forward-looking statements depending on a variety of factors. These factors include, but are not limited to, customer acceptance and demand for our VoIP products and services, the reliability of our services, the prices for our services, customer renewal rates, customer acquisition costs, actions by our competitors, including price reductions for their telephone services, potential federal and state regulatory actions, compliance costs, potential warranty claims and product defects, our needs for and the availability of

BUSINESS OVERVIEW

We develop and market telecommunication technology for Internet protocol, or IP, telephony and video applications. We offer the Packet8 broadband voice over Internet protocol, or VoIP, and video communications service, Packet8 Virtual Office service, Packet8 Trunking service, Packet8 Hosted Key System service, Packet8 MobileTalk and videophone equipment and services (collectively, Packet8). We shipped our first VoIP product in 1998, launched our Packet8 service in November 2002, launched the Packet8 Virtual Office business service offering in March 2004, and launched the Packet8 Virtual Trunking service offering in June 2008. Substantially all of our revenues are generated from the sale, license and provisioning of VoIP products, services and technologies.

Our fiscal year ends on March 31 of each calendar year. Each reference to a fiscal year in this report refers to the fiscal year ending March 31 of the calendar year indicated (for example, fiscal 2009 refers to the fiscal year ending March 31, 2009).

CRITICAL ACCOUNTING POLICIES & ESTIMATES

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of assets and liabilities. On an on-going basis, we evaluate our critical accounting policies and estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended March 31, 2008.

RECENT ACCOUNTING PRONOUNCEMENTS

In September 2006, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards (SFAS) No. 157, "Fair Value Measurements" ("SFAS No. 157"). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP) and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements, but does not require any new fair value measurements. The adoption of SFAS No. 157 did not have a material effect on our condensed consolidated results of operations and financial condition

In February 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities" ("SFAS No. 159") which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The adoption of SFAS No. 159 did not have a material effect on our condensed consolidated results of operations and financial condition

In December 2007, the FASB issued SFAS No. 141(Revised 2007), "Business Combinations" ("SFAS No. 141(R)"). SFAS No. 141(R) significantly changes the accounting for business combinations in a number of areas including the treatment of contingent consideration, acquired contingencies, transaction costs, in-process research and development and restructuring costs. In addition, under SFAS No. 141(R), changes in an acquired entity's deferred tax assets and uncertain tax positions after the measurement period will impact income tax expense. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. We will adopt this pronouncement in the first quarter of fiscal 2010 and do not expect the adoption of SFAS No. 141(R) will have a

In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interest in Consolidated Financial Statements an Amendment of ARB no. 51" ("SFAS No. 160"), which establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary, changes in a parent's ownership interest in a subsidiary and the deconsolidation of a subsidiary. SFAS No. 160 is effective for fiscal years beginning on or after December 15, 2008. Earlier adoption is prohibited. We will adopt this pronouncement in the first quarter of fiscal 2010 and do not expect the adoption of SFAS No. 160 will have a material impact on our consolidated results of operations and financial condition.

In May 2008, the FASB issued SFAS No. 162, "The Hierarchy of Generally Accepted Accounting Principles" ("SFAS No. 162"). SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (the GAAP hierarchy). SFAS No. 162 will become effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board amendments to AU Section 411, "The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles." We do not expect the adoption of SFAS No. 162 to have a material impact on our consolidated results of operations and financial condition.

KEY BUSINESS METRICS

We periodically review certain key business metrics, within the context of our articulated performance goals, in order to evaluate the effectiveness of our operational strategies, allocate resources and maximize the financial performance of our business. The key business metrics include the following:

Churn: Average monthly subscriber line churn for a particular period is calculated by dividing the number of lines that terminated during that period by the simple average number of lines during the period and dividing the result by the number of months in the period. The simple average number of lines during the period is the number of lines on the first day of the period, plus the number of lines on the last day of the period, divided by two. Terminations, as used in the calculation of churn statistics, do not include customers terminated during the period if termination occurred within the first 30 days after purchasing our service. Management reviews this metric to evaluate whether we are retaining our existing customers in accordance with our business plans. Churn approximated 3.5% for the first fiscal quarter of 2009 and 4.6% for the same period of fiscal 2008. Churn decreased due to a greater percentage of business customers than residential customers in the first fiscal quarter of 2009 compared with the same period in fiscal 2008. Business customers typically have a lower churn rate than residential customers. If we are unable to compete effectively against our existing competitors as well as against potential new entrants into the VoIP telephone service business, in both retaining our existing customers and attracting new customers, or if an increasing percentage of our customers decide to drop our VoIP services for other reasons such as cost, lack of use, or our inability to meet their requirements for phone service, our churn will likely increase and our business will be adversely affected.

Subscriber acquisition cost: Subscriber acquisition cost is defined as the combined costs of advertising, marketing, promotions, commissions and equipment subsidies. Management reviews this metric to evaluate how effective our marketing programs are in acquiring new customers on an economical basis in the context of estimated subscriber lifetime value. Subscriber acquisition costs increased to $162 per service for the first fiscal quarter of 2009 from $138 per service for the comparable period in fiscal 2008 due to our marketing focus on small businesses rather than residential customers. Historically, the subscriber cost of acquisition for a business customer is greater than the cost to acquire a residential subscriber.

RESULTS OF OPERATIONS

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

                                         June 30,
                                 -------------------------     Dollar   Percent
Service revenues                   2008            2007        Change   Change
                                 ---------       ---------     ------   -------
                                    (dollar amounts in thousands)
Three months ended             $   15,019     $    13,411    $ 1,608      12.0%
Percentage of total revenues         92.2%           91.0%

                                        June 30,
                                 -----------------------      Dollar   Percent
Product revenues                   2008           2007        Change   Change
                                 --------       --------      ------   -------
                                    (dollar amounts in thousands)
Three months ended             $   1,262     $    1,331     $   (69)     -5.2%
Percentage of total revenues         7.8%           9.0%

Product revenues consist of revenues from sales of VoIP terminal adapters, telephones and videophones, primarily attributable to our Packet8 service. Product revenue for the first quarter of fiscal 2009 was lower primarily because of a decrease in new residential customers and in the first quarter of fiscal 2009.

No customer represented greater than 10% of our total revenues for the three months ended June 30, 2008 and 2007. Revenues from customers outside the United States were not material for the three months ended June 30, 2008 or 2007.

                                          June 30,
                                   -----------------------      Dollar   Percent
Cost of service revenues             2008           2007        Change   Change
                                   --------       --------      ------   -------
                                      (dollar amounts in thousands)
Three months ended               $   3,814     $    3,986     $  (172)     -4.3%
Percentage of service revenues        25.4%          29.7%

The cost of service revenues primarily consists of costs associated with network operations and related personnel, telephony origination and termination services provided by third party carriers and technology license and royalty expenses. Cost of service revenues for the three months ended June 30, 2008 decreased $0.2 million over the comparable period in the prior fiscal year primarily due to a reduction in pricing by third party network service vendors and our system for using multiple third party network provider vendors. This system allows us to route call traffic to the third party network provider vendor with the most favorable pricing which resulted in a $0.3 million reduction in expenses during the first quarter of fiscal 2009. The $0.3 million decrease in cost of service revenues during the first quarter of fiscal 2009 was partially offset by an increase of $0.1 million in personnel expenses related to the establishment of a network operation center.

Cost of service revenues as a percentage of service revenues decreased from 29.7% of service revenues for the three months ended June 30, 2007 to 25.4% of service revenues for the three months ended June 30, 2008. The cost of service revenues decreased from the three months ended June 30, 2007 to the three months ended June 30, 2008 due to a reduction in pricing by third party network service vendors and an increase in the percentage of total revenue from business customers. The cost of service revenues for business customers is less than the cost of service revenues for residential customers.

                                          June 30,
                                   -----------------------      Dollar   Percent
Cost of product revenues             2008           2007        Change   Change
                                   --------       --------      ------   -------
                                      (dollar amounts in thousands)
Three months ended               $   1,432     $    1,383     $    49       3.5%
Percentage of product revenues       113.5%         103.9%

The cost of product revenues consists of costs associated with systems, components, system and semiconductor manufacturing, assembly and testing performed by third-party vendors, estimated warranty obligations and direct and indirect costs associated with product purchasing, scheduling, quality assurance, shipping and handling. The cost of product revenues remained consistent as product revenue did not increase.

We generally do not separately charge Packet8 customers for the terminal adapters used to provide our service when they subscribe on our website. We have offered incentives to customers who purchase terminal adapters in our retail channels to offset the cost of the equipment purchased from a retailer, and generally these incentives are recorded as reductions of revenue. In accordance with FASB Emerging Issues Task Force Issue No. 00-21, a portion of Packet8 services revenues is allocated to product revenues, but these revenues are less than the cost of the terminal adapters at the time of purchase.

Cost of product revenues as a percentage of product revenues increased from 103.9% of product revenues for the three months ended June 30, 2007 to 113.5% of product revenues for the three months ended June 30, 2008. The cost of product revenues as a percentage of product revenues increased due to increased discounting of product sales by our sales force in the three months ended June 30, 2008.

                                        June 30,
                                 -----------------------      Dollar   Percent
Research and development           2008           2007        Change   Change
                                 --------       --------      ------   -------
                                    (dollar amounts in thousands)
Three months ended             $   1,192     $    1,057     $   135      12.8%
Percentage of total revenues         7.3%           7.2%

Research and development expenses consist primarily of personnel, system prototype, software and equipment costs necessary for us to conduct our engineering and development efforts. The increase in research and development expenses for the first quarter of fiscal 2009, compared with the same period in the prior fiscal year, was primarily attributable to an increase in personnel expenses.

                                               June 30,
                                        -----------------------      Dollar   Percent
Selling, general and administrative       2008           2007        Change   Change
                                        --------       --------      ------   -------
                                           (dollar amounts in thousands)
Three months ended                    $   8,751     $    8,919     $  (168)     -1.9%
Percentage of total revenues               53.7%          60.5%

Selling, general and administrative expenses consist primarily of personnel and related overhead costs for sales, marketing, customer support, finance, human resources and general management. Such costs also include sales commissions, trade show, advertising and other marketing and promotional expenses. Selling, general and administrative expenses for the first quarter of fiscal 2009 decreased over the same quarter in the prior fiscal year primarily because of a $0.9 reduction in sales and use tax expense as we began collecting such taxes directly from customers in fiscal 2008, a $0.3 million decrease in sales agent and retailer commission and a $0.2 million decrease in accounting and tax related expenses. The decrease in expenses was offset by a $0.7 million net increase in personnel and temporary personnel costs and a $0.5 million increase in advertising, public relations and other marketing and promotional expenses.

                                       June 30,
                                 ---------------------         Dollar     Percent
Other income, net                 2008          2007           Change     Change
                                 -------       -------       ----------   -------
                                     (dollar amounts in thousands)
Three months ended             $     85     $     132     $        (47)    -35.6%
Percentage of total revenues        0.5%          0.9%

In the first fiscal quarter of 2009, other income, net primarily consisted of interest and investment income earned on our cash, cash equivalents and investment balances. The decrease in other income for the first quarter of fiscal 2009 over the same period in fiscal 2008 was primarily due to lower average interest rates.

                                          June 30,
Income (loss) on change in fair     ---------------------         Dollar     Percent
   value of warrant liability        2008          2007           Change     Change
                                    -------       -------       ----------   -------
                                        (dollar amounts in thousands)
Three months ended                $     69     $     979     $       (910)    -93.0%
Percentage of total revenues           0.4%          6.6%

In connection with the sale of shares of our common stock in fiscal 2005 and 2006, we issued warrants in three different equity financings. The warrants included a provision that we must deliver freely tradable shares upon exercise of the warrant. Because there are circumstances that may not be within our control that could prevent delivery of registered shares, EITF 00-19 requires the warrants be recorded as a liability at fair value with subsequent changes in fair value recorded as a gain or loss. The fair value of the warrant is determined using a Black-Scholes option pricing model, and is affected by changes in inputs to that model including our stock price, expected stock price volatility and contractual term. To the extent that the fair value of the warrant liability increases or decreases, we record a loss or income in our statement of operations. The decrease in the income from change in fair value of warrants in the first fiscal quarter of 2009 compared to the same period in fiscal 2008 was due to the reclassification of amended warrants for 3,659,624 shares of common stock from a liability to equity in the second quarter of fiscal 2008 and a reduction in the fair value of the remaining warrants due to a reduction in the expected stock price, volatility, interest rates and contractual life of the warrants which are the primary assumptions applied to the Black-Scholes model which we have used to calculate the fair value of the warrants.

                                       June 30,
                                 ---------------------         Dollar     Percent
Provision for income tax          2008          2007           Change     Change
                                 -------       -------       ----------   -------
                                     (dollar amounts in thousands)
Three months ended             $     58     $       -     $         58     100.0%
Percentage of total revenues        0.4%          0.0%

The income tax provision for the first quarter of fiscal 2009 was due to a 10% foreign withholding tax on royalty revenue related to one of our technology licensee customers. No income tax provision was recorded during the three month period ended June 30, 2007, due to year to date net losses incurred. We believe that, based on the history of our operating losses and other factors, the weight of available evidence indicates that it is more likely than not that we will not be able to realize the entire benefit of our net operating losses. Accordingly, a valuation reserve has been recorded against our net deferred tax assets.

As of June 30, 2008, we had approximately $14.8 million in cash and cash equivalents and short-term investments.

Net cash provided by operating activities for the three months ended June 30, 2008 was $0.4 million, compared with $0.2 million provided by operating activities for the three months ended June 30, 2007. The net cash provided by operating activities for the three months ended June 30, 2008 resulted primarily from net income of $1.2 million, an $0.8 million increase in accounts payable, a $0.7 million adjustment for depreciation and stock compensation and a $0.2 million reduction in accounts receivable related to the payment by a nationwide retailer reduced by an $0.8 million reduction of accrued taxes, a $0.7 million reduction of deferred revenue, a reduction of $0.7 million due to payment of accrued sales tax, and a $0.2 million increase in inventory due to the procurement of the new business IP phones launched in July 2008. The net cash provided by operating activities for the three months ended June 30, 2007 was primarily due to net income of $0.5 million reduced by the change in fair value of warrant liability of $1.0 million off set by an increase in accounts payable of $0.2 million and a $0.6 million adjustment for depreciation and stock compensation.

Contractual Obligations

In April 2005, June 2006 and March 2007, we entered into a series of noncancelable capital lease agreements for office equipment bearing interest at various rates. Assets under capital lease at June 30, 2008 totaled $182,000 with accumulated amortization of $74,000.

We lease our primary facility in Santa Clara, California under a noncancelable operating lease that expires in fiscal 2010. We also have a leased facility in France. The facility leases include rent escalation clauses that require us to pay taxes, insurance and normal maintenance costs. Rent expense is reflected in our consolidated financial statements on a straight-line basis over the term of the leases.

In January 2008, we entered into a contract with one of our third party customer support vendors containing a minimum monthly commitment of approximately $436,000 effective January 1, 2008 through March 31, 2009. At June 30, 2008, the total remaining obligation under the contract was $3.9 million.

At June 30, 2008, we had open purchase orders of approximately $2.4 million, primarily related to inventory purchases from our contract manufacturers. These purchase commitments are reflected in our consolidated financial statements once goods or services have been received or at such time when we are obligated to . . .