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UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





---




FORM 10-Q





QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES EXCHANGE ACT OF 1934





For the quarterly period ended September 30, 2002





Commission File Number: 0-24983





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NetSolve, Incorporated


(Exact name of the registrant as specified in its charter)





Delaware

75-2094811-2(State or Other Jurisdiction of

(IRS EmployerIncorporation or Organization)

Identification No.)





9500 Amberglen Boulevard


Austin, Texas 78729


(Address of principal executive offices, including zip code)





(512) 340-3000


(Registrants
telephone number, including area code)





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  ̈





Number of shares outstanding of the issuers common stock, $.01 par value, as of November 4, 2002: 11,748,278


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NETSOLVE, INCORPORATED





INDEX





PART I.

FINANCIAL INFORMATION

PageItem 1.

Financial StatementsCondensed Consolidated Balance Sheets as of March 31, 2002 and September 30, 2002 (unaudited)

3Condensed Consolidated Statements of Operations for the three and six month periods ended September 30, 2001 and 2002 (unaudited)

4Condensed Consolidated Statements of Cash Flows for the six month periods ended September 30, 2001 and 2002 (unaudited)

5Notes to Condensed Consolidated Financial Statements

6Item 2.

Managements Discussion and Analysis of Financial Condition and Results of Operations

8Item 3.

Quantitative and Qualitative Disclosures About Market Risk

21PART II.

OTHER INFORMATIONItem 1.

Legal Proceedings

22Item 2.

Changes in Securities and Use of Proceeds

22Item 6.

Exhibits and Reports on Form 8-K

23




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PART I.    FINANCIAL INFORMATION


Item 1.    Financial Statements





NETSOLVE, INCORPORATED





CONDENSED CONSOLIDATED BALANCE SHEETS


(in thousands, except share data)





3/31/2002


9/30/2002(unaudited)ASSETSCurrent assets:Cash and cash equivalents

$
47,160


$
46,070Short-term investments






3,476Restricted cash


349



351Accounts receivable, net of allowance for doubtful accounts of $202 at March 31, 2002 and at September 30,
2002


6,169



3,302Prepaid expenses and other assets


1,586



1,805Deferred tax assets


2,082



2,082Total current assets


57,346



57,086Property and Equipment:Computer equipment and software


10,337



11,807Furniture, fixtures and leasehold improvements


5,316



4,664Other equipment


410



37316,063



16,844Less accumulated depreciation and amortization


(8,094
)


(9,243
)Net property and equipment


7,969



7,601Deferred tax assets, net of current portion


1,962



1,958Other assets


492



318Total assets

$
67,769


$
66,963LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable

$
642


$
600Accrued liabilities


4,189



4,547Future rentals for idle facility


1,602



1,696Deferred revenue


1,055



1,043Total current liabilities


7,488



7,886Deferred revenue, net of current portion


891



748Future rentals for idle facility, net of current portion


1,048



262Stockholders equity:Common stock, $.01 par value; 25,000,000 shares authorized at March 31, 2002 and September 30, 2002; 15,063,591 issued
and 12,133,275 outstanding at March 31, 2002 and 15,077,415 issued and 11,863,199 outstanding at September 30, 2002


150



150Additional paid-in capital


81,110



81,149Treasury stock


(21,059
)


(23,094
)Deferred compensation


(27
)


(12
)Accumulated deficit


(1,832
)


(126
)Total stockholders equity


58,342



58,067Total liabilities and stockholders equity

$
67,769


$
66,963


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|(1) |  | Certain reclassifications have been made to prior year balances to conform to the current year presentations.
|--- |  | -------------------------------------------------------------------------------------------------------------




See accompanying notes.




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NETSOLVE, INCORPORATED





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(in thousands, except share data)





Three Months Ended


Six Months Ended9/30/2001


9/30/2002


9/30/2001


9/30/2002(unaudited)


(unaudited)Revenues:Network management services

$
9,655


$
9,881


$
18,290


$
20,172Maintenance and equipment


2,630



2,223



5,244



4,519Total revenues


12,285



12,104



23,534



24,691Costs of revenues:Network management services


5,537



6,056



10,770



12,022Maintenance and equipment


1,843



1,496



3,623



3,017Total costs of revenues


7,380



7,552



14,393



15,039Gross profits:Network management services


4,118



3,825



7,520



8,150Maintenance and equipment


787



727



1,621



1,5024,905



4,552



9,141



9,652Operating expenses:Development


910



859



1,712



1,751Selling and marketing


1,563



1,689



2,962



3,519General and administrative


1,280



849



2,361



2,133Amortization of deferred compensation


9



7



18



15Total operating expenses


3,762



3,404



7,053



7,418Operating income


1,143



1,148



2,088



2,234Other income (expense):Interest income


412



218



943



418Interest expense


(3
)


(1
)


(6
)


(1
)Other, net


(2
)


(1
)


14



15Total other income (expense)


407



216



951



432Income before income taxes


1,550



1,364



3,039



2,666Income tax expense


541



491



1,061



960Net income

$
1,009


$
873


$
1,978


$
1,706Basic net income per share

$
0.08


$
0.07


$
0.16


$
0.14Weighted average shares used in basic per share calculation


12,107



11,957



12,073



12,005Diluted net income per share

$
0.08


$
0.07


$
0.15


$
0.13Weighted average shares used in diluted per share calculation


13,378



12,749



13,171



12,773





See accompanying notes.




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NETSOLVE, INCORPORATED





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(in thousands, except share data)





Six Months Ended9/30/2001


9/30/2002(unaudited)Cash flows from operating activities:Net income

$
1,978


$
1,706Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization


1,554



1,903Amortization of deferred compensation


18



15Loss on disposition of property and equipment


1



181Change in assets and liabilities:Reduction in future rentals for idle facility






(692
)Accounts receivable, net


(763
)


2,867Prepaid expenses and other assets


428



(45
)Deferred tax assets


871



4Accounts payable


(141
)


(42
)Accrued liabilities


513



358Unearned revenue


1,048



(155
)Net cash provided by operating activities


5,507



6,100Cash flows from investing activities:Purchases of short-term investments






(3,476
)Transfer of funds to restricted cash


(133
)


(2
)Purchases of property and equipment


(3,951
)


(1,727
)Proceeds from the sale of property and equipment






11Net cash used in investing activities


(4,084
)


(5,194
)Cash flows from financing activities:Repurchase of common stock


(880
)


(2,035
)Payments under capital lease obligations


(219
)


Proceeds from exercise of common stock options and warrants


302



39Net cash used in financing activities


(797
)


(1,996
)Net change in cash and cash equivalents


626



(1,090
)Cash and cash equivalents, beginning of period


45,411



47,160Cash and cash equivalents, end of period

$
46,037


$
46,070Supplemental disclosure of cash flow information:Cash paid for interest

$
6


$
1Income taxes paid

$
49


$
64





See accompanying notes.




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NETSOLVE, INCORPORATED





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


September 30, 2002





Information with respect to the three and six months ended September 30, 2001 and 2002 is unaudited.





1.    Organization and Description of the Company





NetSolve,
Incorporated, a Delaware corporation, (the Company) engages in the business of providing remote network management services. These services include network configuration and design, installation and implementation coordination, fault
diagnosis and resolution, and ongoing network management. The Company also resells data network equipment and equipment maintenance services manufactured or provided by selected leading suppliers of these products. The Company also licenses its
software overseas. The Companys services are designed to allow its customers to selectively outsource network specific tasks in order to migrate to new technology, increase network reliability, and reduce overall network costs.





2.    Basis of Presentation





The quarterly financial information presented herein should be read in conjunction with the Companys annual financial statements for the year ended March 31, 2002, which can be found in the
Companys annual report on Form 10-K, as filed on June 10, 2002 (File No. 000-24983). The accompanying unaudited interim financial statements reflect all adjustments (which include only normal, recurring adjustments) that are, in the opinion of
management, necessary to state fairly the results for the periods presented. The results for such periods are not necessarily indicative of the results to be expected for the full fiscal year.





3.    Earnings Per Share





The Companys earnings per share data are presented in accordance with SFAS 128,Earnings Per Share. Basic income per share is computed using the weighted average number of common shares outstanding. Diluted income per
share is computed using the weighted average number of common shares outstanding adjusted for the incremental shares attributed to outstanding securities with the ability to purchase or convert into common stock. The treasury stock method, using the
average price of the Companys common stock for the period, is applied to determine dilution from options and warrants.





A reconciliation of the denominators used in computing per share net income is as follows (in thousands):





Three months ended

Six months endedSeptember 30

September 302001

2002

2001

2002Numerator:Net Income

$
1,009

$
873

$
1,978

$
1,706Denominator:Denominator for basic net income per shareweighted average common stock outstanding


12,107


11,957


12,073


12,005Dilutive common stock equivalentscommon stock outstanding


1,271


792


1,098


768Denominator for diluted net income per share-weighted average common stock outstanding and dilutive common stock
equivalents


13,378


12,749


13,171


12,773




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NETSOLVE, INCORPORATED





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)


September
30, 2002





4.    Contingencies





A consolidated putative class action complaint was filed on February 21, 2001 against the Company and certain of its officers in the United States District Court for the
Western District of Texas, Austin Division. In re NetSolve Incorporated Securities Litigation, Civil Action No. A00-CA-591 SS. Plaintiffs seek to represent a class comprised of purchasers of the Companys common stock between April 18, 2000 and
August 18, 2000 (Class Period). They allege that the defendants engaged in a fraudulent scheme by issuing false and materially misleading statements regarding the Companys business during the Class Period.





The Company moved to dismiss the complaint on March 8, 2001 for failing to state a claim under which relief could be granted and for
failing to comply with the pleading requirements of the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4 et seq. On August 15, 2001, the District Court granted this motion in part and denied it in part. The District Court
dismissed claims against one officer of the Company and dismissed certain of the theories under which Plaintiffs alleged liability against the Company. However, the District Court let stand certain of the stated claims against the Company and
certain of its officers.





On December 17, 2001, the Company and individual defendants reached a settlement of this
action. The plaintiff class will receive $2,750,000 in connection with the settlement, all of which will be funded by the Companys insurance carrier. The District Court approved this settlement by its Order issued on October 30, 2002.





On December 6, 2001, a second putative securities class action complaint was filed against the Company, certain
of its officers and the Companys underwriters of its initial public offering in the United States District Court for the Southern District of New York. Woodward v. NetSolve, Inc., 01 CV 11239. Plaintiff seeks to represent a class comprised of
purchasers of the Companys common stock between September 29, 1999 and December 6, 2000. The plaintiffs allege that the defendants failed to properly disclose certain commissions, discounts and purported tie-in arrangements related to the
Companys initial public offering. The plaintiffs allege claims under Sections 11 and 15 of the Securities Act against the Company, and the plaintiffs allege claims under Sections 11 and 12 of Securities Act, and Section 10(b) of the Exchange
Act, against the Companys underwriters. This case has been coordinated for pretrial purposes with over 300 other cases alleging similar claims against other underwriters and companies. In re Initial Public Offering Securities Litigation, 21 MC
92 (SAS). Preliminary settlement proposals have been offered by representatives of both the underwriter defendants and the plaintiffs. Such proposals are being analyzed by the various issuer defendants. It is not feasible to predict or determine the
final outcome of this proceeding, and if the outcome were to be unfavorable, the Companys business, financial condition, cash flow and results of operations could be materially adversely affected.




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Item 2.

MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS





Forward-looking Statements





This report and other presentations made by us contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934,
as amended. We sometimes identify forward-looking statements with such words as expects, anticipates, intends, believes or similar words concerning future events. They include, among others, statements
relating to trends and projections in revenue, company growth, sales, margin and expenses, and the drivers behind those trends; our ability to obtain any needed additional working capital; trends in sales of network management services, sales of
customer premise equipment, and sales which may be derived from our work related to Cisco Systems, Inc.s AVVID systems; our ability to retain current customer arrangements and develop new arrangements; the level of any stock repurchase we may
undertake; payments requested by customers regarding our WAN guarantee; the amount of any added costs from anticipated new sales, marketing and development resources we gain, our reliance on resellers, and the continued development of competition;
the outcome of pending litigation; revenues derived from AT&T and other customers; our ability to attract and retain a qualified workforce; our ability to protect our intellectual property rights; and the impact of changes in accounting rules.





Any forward-looking statement speaks only as of the date on which such statement was made, and we do not
undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement was made or to reflect the occurrence of unanticipated events. New factors emerge from time to time and it is
not possible for us to predict all of such factors, nor can we assess the impact of each such factor or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking
statement.





Overview





We provide network management services that allow enterprises and carriers to outsource some or all network-specific activities in order to increase network reliability and uptime, reduce overall
network costs, and simplify timely migration to new technologies. We were incorporated in September 1985 in the State of Delaware and began operating during the second half of 1987. Until December 1996, substantially all of our services revenues
were derived from the sale of data transport services. To provide these transport services, we leased network transmission facilities from major carriers, and we also resold AT&Ts transport services. We began developing our first remote
network management service offering for WANs in early 1993 and began offering that service, together with AT&Ts transport services, in the quarter ended March 31, 1994. We began selling network management services separately from our data
transport services in the quarter ended March 31, 1995. We introduced our first security service in the quarter ended September 30, 1996. We discontinued our data transport business in the quarter ended December 31, 1996. We began offering network
management services for LANs in the quarter ended June 30, 1997. We began offering virtual private network (VPN) management services during the quarter ended September 30, 2000. On June 21, 2001, we announced that IBM Global Services would offer
selected ProWatch managed network services. The acceptance of our first software licensing agreement occurred in the quarter ended September 30, 2001. This agreement allows another organization to utilize our technology to provide remote network
management services to its customers. Additionally, on October 1, 2001, we announced that we will offer remote network management for Cisco Systems, Inc. Architecture for Voice, Video and Integrated Data (AVVID) Internet Protocol IP Telephony (IPT).





Revenues





Our revenues consist of network management services revenues as well as maintenance revenue and equipment resales. Our network management services include both recurring and nonrecurring revenues:





| |  |  | Revenues from recurring services represent monthly fees charged to resellers or end users for our network management services, software licensing fees, software
usage royalties and software maintenance fees.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Recurring network management services revenues are typically based on a fixed monthly fee per customer site or device and
are recognized in the period in which the services are rendered. For the six months ended September 30, 2002, approximately 83% of network management services revenues were from recurring services.





| |  |  | Nonrecurring network management services consist primarily of project implementation services, equipment installation services, one-time project and development
assignments that assist resellers in defining and creating new network management services and software professional fees. Nonrecurring network management services primarily relate to services performed to assist customers in implementing new
networks. Nonrecurring network management revenues are also earned when implementing network management services for existing networks; however, the level of work and related fees are both lower. Nonrecurring network management services revenues are
generally recognized upon completion of the assignment or service. For example, we charge fees for project implementation services on a per-location or per-device basis and we recognize revenues associated with these services upon completion of the
network implementation for the location or device.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




Our network management services revenues
are derived from contracts with telecommunications carriers, value-added resellers of networking equipment and services, and enterprises to which we sell directly through our sales force. Our services include both initial implementation and project
management services for a one-time fee per location as well as ongoing management services for a fixed monthly fee per managed device. Network management services revenues also include software licensing, usage royalties, maintenance fees and
professional fees. Our contracts with end users are generally for terms of 24 to 36 months, although customers may cancel services prior to the end of the service terms. Cancellations due to reasons other than closings of managed locations, which to
date have not been material, are generally subject to cancellation fees ranging from 20% to 80% of the recurring charges payable for the remainder of the service term. Cancellation fees as a percentage of network management services revenues were
less than 1% in each of fiscal years 2001 and 2002 and in the six months ended September 30, 2002. We recognize revenues from cancellation fees on a cash basis unless collection is assured. Our contracts with resellers typically extend from 12 to 36
months and, in most cases, require that we continue providing services throughout the term of the resellers contract with the end user. In these cases, we continue to recognize revenues upon performance of the services, even if performance
occurs after the term of the contract with the reseller.





Our network management services for WANs typically
include a guarantee providing end-to-end network availability for at least 99.5% of the time in any given month. In the event the guaranteed availability is not achieved, we generally are obligated to refund a portion, and in some cases all, of our
WAN management fees for that month. This guarantee covers some components of the end users WAN, such as the transport services provided by the end users carrier, that are not directly under our control. As a result, we may, in some
instances, refund amounts to customers for circumstances beyond our control. We establish a reserve against guarantees we offer for these WAN services. Historically, guarantee payments have not been material in relation to network management
services revenues. However, in the future, refunds made under our guarantees or otherwise could have a material adverse impact on the results of our operations.





We derive maintenance and equipment revenues from the sale of CPE maintenance contracts and from the resale of customer premise equipment, or CPE, to certain of our network management services
resellers or customers. CPE is networking equipment which usually resides at the customers location and includes routers, customer service units or CSUs, and LAN switches. We utilize CPE produced by Cisco and, to a lesser extent, by
Bay/Nortel, Visual Networks and others. We recognize equipment revenues in the period the CPE is shipped to the customer. However, if the transaction is financed through our lease financing subsidiary, we recognize the revenues upon sale of the
underlying lease contract on a nonrecourse basis. We recognize revenues from CPE maintenance contracts on a monthly basis as the services are provided. We generally only resell CPE to our network management services customers. Although we believe
some of our customers will continue to purchase CPE from us, our strategy is to focus on our network management services which generate higher margins. We therefore anticipate that revenues from CPE sales will continue to decline as we seek to
manage our mix of revenues.




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We currently have two primary reseller agreements with AT&T, one for Managed
Router Service and one for Managed DSU Service. AT&T accounted for 69% of our total revenues in fiscal year 2001, 61% of our total revenues in fiscal year 2002, and 55% of our total revenues in the six months ended September 30, 2002. We
anticipate that sales to AT&T will continue to comprise a substantial percentage of our revenues in fiscal 2003, but believe the percentage will continue to decline. No other customer accounted for more than 10% of our revenues in fiscal years
2001, 2002 or the six months ended September 30, 2002.





Historically, we have generated substantially all of our
revenues from sales to customers in the United States, although we manage devices in several locations around the world for these U.S.-based customers.





Results of Operations





Three months ended September 30, 2001 compared to three months ended September 30, 2002





Revenues





Total revenues.    Total revenues decreased 1%, from $12.3 million in the three months ended September 30, 2001 to $12.1 million in the three months ended September 30, 2002.





Network management services.    Revenues from network management services increased
2%, from $9.7 million in the three months ended September 30, 2001 to $9.9 million in the three months ended September 30, 2002, representing 79% of total revenues in the three months ended September 30, 2001 and 82% in the three months ended
September 30, 2002. The dollar and percentage increase was due primarily to increased recurring revenues resulting from a growth in the number of managed devices under contract and to a lesser extent increased revenue from software licensing fees,
partially offset by additional contractual discounts with AT&T relating to the Managed Router Services Agreement and a decrease in equipment installation services due to a decrease in the level of new installations from carrier agreements
utilizing those services.





Maintenance and equipment.    Revenues from maintenance and
equipment decreased 15%, from $2.6 million in the three months ended September 30, 2001 to $2.2 million in the three months ended September 30, 2002. This decrease was primarily due to additional contractual discounts with AT&T relating to the
Managed Router Services Agreement and to a lesser extent lower equipment sales due to continued efforts to decrease equipment sales by encouraging end users to purchase equipment from other sources.





Costs of revenues





Cost of network management services.    Cost of network management services includes salary and other costs of personnel, depreciation of equipment utilized to manage customer networks, the network
management infrastructure utilized to provide remote network management services, and the costs of third-party providers of CPE installation services. Cost of network management services is expensed as incurred. Cost of network management services
increased 9%, from $5.5 million in the three months ended September 30, 2001 to $6.1 million in the three months ended September 30, 2002, representing 57% of network management services revenues in the three months ended September 30, 2001 and 61%
in the three months ended September 30, 2002. The dollar and percentage increase was due primarily to the addition of personnel and to a lesser extent depreciation expense which increased due to the addition of equipment put in place for disaster
recovery that was not in place in the prior year quarter. The percentage increase was also due to the additional contractual discounts on revenue with AT&T relating to the Managed Router Services Agreement which did not have an equivalent
decrease in costs.





Cost of maintenance and equipment.    Cost of maintenance and
equipment includes the purchase of maintenance contracts and CPE from manufacturers and distributors for resale to end users. These costs are expensed in the period the related revenues are recognized. Cost of maintenance and equipment decreased
19%, from $1.8 million in the three months ended September 30, 2001 to $1.5 million in the three months ended September 30, 2002, representing 70% of maintenance and equipment revenues in the three months ended September 30, 2001 and 67%




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in the three months ended September 30, 2002. The decrease in dollars was due to a decrease in maintenance and equipment revenues. The decrease
in percentage is a result of increased CPE maintenance revenue as a percentage of maintenance and equipment revenue which generally has higher gross margins than equipment sales, partially offset by additional contractual discounts on revenue with
AT&T relating to the Managed Router Services Agreement which did not have a corresponding decrease in costs.





Operating expenses





Development.    Development expenses consist
primarily of salaries and related costs of development personnel, including contract programming services. Development employees are responsible for developing internal software systems, selecting and integrating purchased software applications,
developing software tools for our network management services, developing our Web-enabled software applications that give customers access to network management information, and defining and developing operating processes for new services.
Development expenses decreased 6% from $910,000 in the three months ended September 30, 2001 to $859,000 in the three months ended September 30, 2002, representing 7% of total revenues in the three months ended September 30, 2001 and 2002. The
decrease in dollars was due to a decrease in the use of software development consulting and contract programming services partially offset by increased costs associated with an increase in the number of software and service development personnel.





Selling and marketing.    Selling and marketing expenses consist primarily of
salaries, commissions, travel and costs associated with creating awareness of our services. Selling and marketing expenses increased 8%, from $1.6 million in the three months ended September 30, 2001 to $1.7 million in the three months ended
September 30, 2002, representing 13% of total revenues in the three months ended September 30, 2001 and 14% in the three months ended September 30, 2002. The increase in dollars and as a percentage of revenue was due primarily to increased costs
related to the addition of sales and marketing personnel.





General and
administrative.    General and administrative expenses consist primarily of expenses related to our human resources, finance and executive departments and the cost of an idle facility for the five quarters ending June 30,
2002. Included in human resources spending is a majority of costs of recruiting and relocating new employees. General and administrative expenses decreased 34%, from $1.3 million in the three months ended September 30, 2001 to $849,000 in the three
months ended September 30, 2002, representing 10% of total revenues in the three months ended September 30, 2001 and 7% in the three months ended September 30, 2002. The dollar and percentage decrease was due primarily to approximately $371,000 of
additional spending in the three months ended September 30, 2001 related to rent and operating costs of an idle facility. We moved into this facility at the end of June 2002 in order to consolidate substantially all of our operations into one
facility.





Other income, net





Other income, net consists primarily of interest income earned on our cash balances. Other income, net decreased from $407,000 in the three months ended September 30, 2001
to $216,000 in the three months ended September 30, 2002, representing 3% of total revenues in the three months ended September 30, 2001 and 2% in the three months ended September 30, 2002. The decrease was due to lower average interest rates on
cash balances for the three months ended September 30, 2002 compared to the same period in the prior year.




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Six months ended September 30, 2001 compared to six months ended September 30, 2002





Revenues





Total revenues.    Total revenues increased 5%, from $23.5 million in the six months ended September 30, 2001 to $24.7 million in the six months ended September 30, 2002.





Network management services.    Revenues from network management services increased 10%, from $18.3 million in
the six months ended September 30, 2001 to $20.2 million in the six months ended September 30, 2002, representing 78% of total revenues in the six months ended September 30, 2001 and 82% in the six months ended September 30, 2002. The dollar and
percentage increase was due primarily to increased recurring revenues resulting from a growth in the number of managed devices under contract and to a lesser extent increased revenue from software licensing fees, partially offset by additional
contractual discounts with AT&T relating to the Managed Router Services Agreement.





Maintenance and
equipment.    Revenues from maintenance and equipment decreased 14%, from $5.2 million in the six months ended September 30, 2001 to $4.5 million in the six months ended September 30, 2002. This decrease was primarily due to
additional contractual discounts with AT&T relating to the Managed Router Services Agreement, fewer maintenance contracts in place during the period and to a lesser extent lower equipment sales due to continued efforts to decrease equipment
sales by encouraging end users to purchase equipment from other sources.





Costs of revenues





Cost of network management services.    Cost of network management services increased 12%, from
$10.8 million in the six months ended September 30, 2001 to $12.0 million in the six months ended September 30, 2002, representing 59% of network management services revenues in the six months ended September 30, 2001 and 60% in the six months ended
September 30, 2002. The dollar increase was due primarily to the addition of personnel and to a lesser extent depreciation expense which increased due to the addition of equipment put in place for disaster recovery that was not in place in the prior
year. The percentage increase was due to the additional contractual discounts on revenue with AT&T relating to the Managed Router Services Agreement which did not have an equivalent decrease in costs.





Cost of maintenance and equipment.    Cost of maintenance and equipment decreased 17%, from $3.6 million in the
six months ended September 30, 2001 to $3.0 million in the six months ended September 30, 2002, representing 69% of maintenance and equipment revenues in the six months ended September 30, 2001 and 67% in the six months ended September 30, 2002. The
decrease in dollars was due to a decrease in maintenance and equipment revenues. The decrease in percentage is a result of increased CPE maintenance revenue as a percentage of maintenance and equipment revenue which generally has higher gross
margins than equipment sales, partially offset by additional contractual discounts on revenue with AT&T relating to the Managed Router Services Agreement which did not have a corresponding decrease in costs.





Operating expenses





Development.    Development expenses increased 2% from $1.7 million in the six months ended September 30, 2001 to $1.8 million in the six months ended September 30, 2002, representing 7% of total
revenues in the six months ended September 30, 2001 and 2002. The increase in dollars was due to an increase in the number of software and service development personnel devoted to the development and enhancement of network management tools and our
network management services partially offset by a decrease in the number of contract programming services.





Selling and marketing.    Selling and marketing expenses increased 19%, from $3.0 million in the six months ended September 30, 2001 to $3.5 million in the six months ended September 30, 2002, representing
13% of total revenues in the six months ended September 30, 2001 and 14% in the six months ended September 30, 2002. The




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increase in dollars and as a percentage of revenue was due primarily to increased costs related to the addition of sales and marketing personnel
and additional spending related to identifying software licensing opportunities overseas.





General and
administrative.    General and administrative expenses decreased 10%, from $2.4 million in the six months ended September 30, 2001 to $2.1 million in the six months ended September 30, 2002, representing 10% of total revenues
in the six months ended September 30, 2001 and 9% of total revenues in the six months ended September 30, 2002. The dollar and percentage decrease was due primarily to approximately $190,000 of spending in the six months ending September 30, 2001
related to rent and operating costs of an idle facility as well as reduced spending for recruiting and relocation in the six months ending September 30, 2002.





Other income, net





Other income, net decreased from
$951,000 in the six months ended September 30, 2001 to $432,000 in the six months ended September 30, 2002, representing 4% of total revenues in the six months ended September 30, 2001 and 2% in the six months ended September 30, 2002. The decrease
was due to lower average interest rates on cash balances for the six months ended September 30, 2002 compared to the same period in the prior year.





Quarterly results of operations





Results of operations have varied from quarter to
quarter. Accordingly, we believe that period-to-period comparisons of results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Our operating results may fluctuate as a result of many
factors, including our ability to renew or retain existing end user and reseller relationships, our ability to successfully enter into new reseller or end user relationships, the cost of introducing new service offerings and the profitability of
such offerings, and the level and nature of competition. Further, we may be unable to adjust spending rapidly enough to compensate for any significant fluctuations in the number of new managed devices implemented in a given period. Any significant
shortfall in the number of new managed devices could therefore seriously damage our business. Finally, there can be no assurance that we will continue to be profitable in the future or, if we are profitable, that our levels of profitability will not
vary significantly between quarters.





Liquidity and capital resources





Net cash provided by operating activities during the six month periods ended September 30, 2001 and September 30, 2002 was $5.5 million and $6.1 million, respectively. The
increase in cash generated in the six months ended September 30, 2002 as compared to the prior year period was primarily due to collections of accounts receivable.





We used $4.0 million during the six months ended September 30, 2001 and $1.7 million in the six months ended September 30, 2002 to purchase capital assets which includes
leasehold improvements related to the addition of our new facility and to purchase capital assets used in the delivery of our network management services. We currently have no material commitments for capital expenditures. We paid $219,000 during
the six months ended September 30, 2001 toward our lease obligations for capital equipment. The capital leases matured in the prior fiscal year and therefore we made no capital lease payments in the six months ended September 30, 2002. We currently
have no future commitments for capital leases.





We used $2.0 million during the six months ended September 30,
2002 to repurchase 284,000 shares of our common stock. We have approval from our Board of Directors to purchase up to four million shares, including those previously repurchased. Since the inception of the stock repurchase program through September
30, 2002, we have repurchased 3.2 million shares of our common stock at an aggregate price of approximately $23.1 million. The extent and timing of any additional repurchases will depend on market conditions and other business considerations.




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Repurchased shares may be held in treasury for general corporate purposes, including for use in connection with our stock option plans, or may
be retired.





As of September 30, 2002, we had $49.9 million in cash and short-term investments, $3.3 million in
net accounts receivable and $49.2 million in working capital. We believe that our current cash balances, together with cash generated from operations, will be sufficient to fund our anticipated working capital needs, capital expenditures, stock buy
back program and any potential future acquisitions for at least 12 months. Our current cash balances are kept in short-term, investment-grade, interest-bearing securities pending their use. In the event our plans or assumptions change or prove to be
inaccurate, or if we consummate any unplanned acquisitions of businesses or assets, we may be required to seek additional sources of capital. Sources of additional capital may include public and/or private equity offerings and debt financings, sales
of nonstrategic assets and other financing arrangements.





As of September 30, 2002, we had net operating loss
carryforwards of approximately $1.5 million available to offset future net income for U.S. federal income tax purposes. These net operating loss carryforwards will expire beginning in 2007 if not utilized. We have alternative minimum tax credit
carryforwards of $350,000 which do not expire. We also have foreign tax credits of $218,000 that expire beginning in 2006 if not utilized. Our utilization of these net operating loss and tax credit carryforwards may be subject to a substantial
annual limitation due to the change in ownership provisions of the Internal Revenue Code. The annual limitation may result in the expiration of the net operating losses before utilization.





As of September 30, 2002, we have no debt or off-balance sheet debt. As of September 30, 2002, we have noncancelable operating lease
obligations of approximately $6.8 million. At September 30, 2002, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which
would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we were
engaged in such relationships.





Related Party Transactions





The consolidated balance sheets as of September 30, 2001 and 2002 include in accounts receivable a $100,000 loan to an officer of the Company. The loan is represented by a
full recourse note, is payable upon default, bears interest at 4.65% per annum and is secured by a security interest in all stock options granted to the officer by the Company at any time prior to the satisfaction of the loan and all shares of the
Companys common stock issued upon the exercise of any such options.





Critical Accounting Policies





General





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 contingent assets and liabilities. We base
our estimates on historical experience and on various other assumptions that are believed 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. Estimates and assumptions are reviewed periodically. Actual results may differ from these estimates under different assumptions or conditions.




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Revenue Recognition





Network management services revenues are recognized in the period services are provided by the Company, whether sold directly or through resellers, based upon rates
established by contract. These amounts are adjusted to the extent of any reserves affecting the realization of these revenues as described below. The typical contract terms are from 24 to 36 months and provide for one-time services, consisting
primarily of project implementation services at a fixed fee per customer site or device, as well as recurring services which are provided at a fixed monthly fee per customer site or device over the life of the contract. Revenues for project
implementation services are recognized upon completion of the assignment or service, and recurring revenues are recognized on a monthly basis as the services are performed. Revenue from software licensing arrangements is deferred and amortized on a
straight-line basis over the licensing agreements term. Revenue from software royalty fees are based on the number of devices in place and are recognized monthly. Equipment revenues are recognized in the period the equipment is shipped to the
customer. Equipment revenues from assets leased by the Companys lease financing subsidiary are recognized upon the sale of the equipment and the related lease to a third-party lessor on a nonrecourse basis following installation of the
equipment. Other revenues, which consist primarily of equipment maintenance services, are recognized in the period services are provided.





Receivables





We continuously monitor collections and payments from our customers
and maintain allowances for doubtful accounts based upon our historical experience and any specific customer collection issues that we have identified. While losses due to bad debt have historically been within our expectations, there can be no
assurance that we will continue to experience the same level of bad debt losses that we have in the past. In addition, a significant amount of our revenues and accounts receivable are concentrated in AT&T. A significant change in the liquidity
or financial position of AT&T could have a material adverse impact on the collectability of our accounts receivable and our future operating results, including a reduction in future revenues and additional allowances for doubtful accounts.





Availability Reserve





Our remote network management services for WANs typically include a guarantee providing end-to-end network availability for at least 99.5% of the time in any given month.
In the event the guaranteed availability is not achieved, we generally are obligated to refund a portion, and in some cases all, of our WAN management fees for that month. We provide a reserve based on the estimated costs of these refunds.
Historically, guarantee payments have not been significant.





Risk Factors





We may be unable to operate profitably in the future.





We may not operate profitably. Although we began operating in 1987, we did not introduce our first network management service until the quarter ended March 31, 1994. Our history of operating profitably in the network management
services business is short, and it is difficult to predict our future revenues and operating results. We have previously incurred substantial net losses. Our ability to operate profitably in the future depends on increasing sales of our services
while maintaining sufficient gross profit margins. We must, among other things:





| |  |  | maintain satisfactory relationships with resellers such as AT&T, our largest customer, and network equipment manufacturers such as Cisco;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------




| |  |  | renew the Frame Relay Plus agreement with AT&T beyond the ordering period that currently expires in June 2003;
| | - |  | --------------------------------------------------------------------------------------------------------------




| |  |  | continue to provide services under the Managed Router Service agreement with AT&T after June 2003;
| | - |  | --------------------------------------------------------------------------------------------------



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| |  |  | establish relationships with additional marketing partners for the resale of our services;
| | - |  | ------------------------------------------------------------------------------------------




| |  |  | develop software to make our principal existing service, ProWatch for WANs, as well as other services as they achieve larger volumes, more efficient and
economical;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | develop and sell other network management services; and
| | - |  | -------------------------------------------------------




| |  |  | maintain reliable, uninterrupted service from our network management center 24 hours per day, seven days per week.
| | - |  | ------------------------------------------------------------------------------------------------------------------




Our revenues will decline significantly and our business will be adversely affected if AT&T discontinues, or materially reduces, sales of our services.





Sales to AT&T, which resells our services to its customers, accounted for 61% of our total revenues in
fiscal year 2002 and 55% of our total revenues in the six months ended September 30, 2002. We anticipate that sales to AT&T will continue to comprise a substantial percentage of our revenues in fiscal year 2003, but we believe the percentage
will continue to decline. To the extent we continue to depend on AT&T for a large portion of our sales, our total revenues will decline materially if AT&T discontinues selling our services, significantly reduces its sales of our services,
fails to renew our two primary agreements that have ordering periods expiring in June 2003, or cancels orders for services provided to existing AT&T customers. We cannot be sure that we will be successful in reducing our dependence on AT&T
in the future, or that AT&T will continue to renew its agreements with us.





Our agreements with AT&T are
not exclusive arrangements. We will need to maintain a good working relationship with AT&T in order to maintain the business we currently provide to AT&Ts customers and to encourage AT&T to sell our services to additional
customers. We cannot assure that AT&T will continue to sell our services to existing or additional AT&T customers or continue to utilize our services following the expiration of the service terms set forth in our agreements with AT&T. A
substantial reduction in our AT&T business from any cause, including those described above, would result in diminished revenues for an extended period of time as we attempted to replace that business.





Our quarterly results may fluctuate and cause the price of our common stock to fall.





Our revenues and results of operations are difficult to predict and may fluctuate significantly from quarter to quarter. If either our revenues or results of operations
fall below the expectations of investors or public market analysts, the price of our common stock could fall dramatically.





Our revenues are difficult to forecast and may fluctuate for a number of reasons:





| |  |  | the market for network management services is relatively new, and we have no reliable means to assess overall customer demand;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------




| |  |  | we derive a majority of our revenues from AT&T and other resellers, and our revenues therefore depend significantly on the willingness and ability of
AT&T and those other resellers to sell our services to their customers;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | we may not be able to renew or retain existing end user and reseller relationships;
| | - |  | -----------------------------------------------------------------------------------




| |  |  | we may not be able to attract additional resellers to market our services as expected;
| | - |  | --------------------------------------------------------------------------------------




| |  |  | we expect to continue encouraging end users to purchase equipment and equipment maintenance services from other sources; therefore, we anticipate that our
revenues from equipment hardware and maintenance resales will continue to decline as we seek to manage our mix of revenues;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | we may not add new end users as rapidly as we expect;
| | - |  | -----------------------------------------------------




| |  |  | we may lose existing end users as the result of competition, problems with our services or, in the case of end users who are customers of our resellers,
problems with the resellers services or an unwillingness by our resellers to renew their agreements with us; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | we may not be able to develop new or improved services as rapidly as they are needed.
| | - |  | -------------------------------------------------------------------------------------




Most of our expenses, particularly employee compensation and rent, are relatively fixed. As a result, variations in the timing of revenues could significantly affect
our results of operations from quarter to quarter and could result in quarterly losses.





Our future operating results may vary by
season, which will make it difficult to predict our future performance.





As a result of seasonal factors, we
believe that quarter-to-quarter comparisons of our results of operations are not necessarily meaningful. These factors may adversely affect our operating results or cause our operating results to fluctuate, resulting in a decrease in our stock
price. Quarterly results of operations should not be relied upon to predict our future performance.





Our bookings
may be slower during the months of July and August due to the vacation schedules of our resellers sales and marketing employees. This situation may lead to lower levels of revenues earned during the following fiscal quarter, which ends
December 31.





Our revenues during our third and fourth fiscal quarters may be more volatile and difficult to
predict due to the budgeting and purchasing cycles of our end users. End users often purchase our services at the same time they purchase new network equipment such as routers. As a result, the timing of their large capital expenditures could affect
the timing of their purchases of our services. Some end users may not be able to purchase network equipment and our services near the end of a calendar year due to depleted budgets. Other end users may accelerate purchases in order to use an unspent
portion of their budget.





The market for our services is new and evolving rapidly, and our business will be seriously damaged if the
market does not develop as we expect.





Our long-term viability depends significantly upon the acceptance and
use of remote network management services. The market for remote network management services is relatively new and rapidly evolving. This market environment makes it more difficult to determine the size and growth of the market and to predict how
this market will develop. Changes in technology, the availability of qualified information technology professionals and other factors that make internal network management more cost-effective than remote network management would adversely affect the
market for our services. Our business may be seriously damaged if this market fails to grow, grows more slowly than we expect or develops in some way that is different from our expectations.





We must establish relationships with additional resellers in order to increase our revenues and become consistently profitable.





We expect to continue to rely on resellers such as data networking value-added resellers and integrators and, to a lesser extent, telecommunications carriers to market
our services. We must establish and develop these alternative sales channels in order to increase our revenues and become consistently profitable. We have a limited history developing these sales channels, and we have established productive
relationships with only a few resellers. While we have gained additional experience in managing sales through resellers, we have not yet achieved consistent




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results from such sales. Except for AT&T, these resellers have not generated significant sales of our services to date and may not succeed
in marketing our services in the future.





Our agreements with resellers, including AT&T, generally do not
require that the resellers sell any minimum level of our services and generally do not restrict the resellers development or sale of competitive services. We cannot be sure that these resellers will dedicate resources or give priority to
selling our services. In addition, resellers may seek to make us reduce the prices for our services in order to lower the total price of their equipment, software or service offerings.





Reseller relationships may adversely affect our business by weakening our relationships with end users, decreasing the strength of our brand name and limiting our ability to sell services directly
to resellers customers.





Our strategy of selling our services primarily through resellers may result in
our having weaker relationships with the end users of our services. This may inhibit our ability to gather customer feedback that helps us improve our services, develop new services and monitor customer satisfaction. We may also lose brand
identification and brand loyalty, since our services may be identified by private label names or may be marketed differently by our resellers. A failure by any of our resellers to provide their customers with satisfactory products, services or
customer support could injure our reputation and seriously damage our business. Our agreements with these resellers may limit our ability to sell our services directly to the resellers customers in the future.





Any material decrease in sales of our WAN management services will significantly reduce our total revenues and adversely affect our business.





Competitive pressures, general declines in the levels of new wide area network, or WAN, installations or
other factors that adversely affect sales of our WAN management services or that cause significant decreases in the prices of our WAN management services could significantly limit or reduce our revenues. Sales of our ProWatch for WANs and similar
WAN management services accounted for 84% of our recurring network management services revenues in the six months ended September 30, 2002. Likewise, a substantial portion of our nonrecurring network management services and equipment resale revenues
depend on the successful sale of these WAN management services. We expect that these WAN management services will continue to generate a significant portion of our revenues for the foreseeable future. Our financial performance therefore depends
directly on continued market acceptance of our WAN management services and our ability to introduce enhanced versions of these services that make these services more efficient and economical.





Our failure to develop and sell additional services could impair our financial results and adversely affect our business.





Our future financial performance will depend in part on our ability to develop, introduce and sell new and enhanced network management services other than WAN management
services, including services that:





| |  |  | address the increasingly sophisticated needs of current and prospective end users; and
| | - |  | --------------------------------------------------------------------------------------




| |  |  | respond on a timely and cost-effective basis to technological advances and emerging industry standards and protocols.
| | - |  | ---------------------------------------------------------------------------------------------------------------------




Although we have developed new services, such as network management services for local area networks, or LANs, network security
services and IP Telephony, we have not derived significant revenues from these services to date. We cannot be sure that we will be successful selling these services or developing additional services on time or on budget. The development of new
services is a complex and uncertain process. The newness of the market for remote network management services makes it difficult to determine whether a market will develop for any particular




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network management service. If we succeed in increasing the percentage of our revenues that is derived from resellers, we may have weaker relationships with the end users of our services, making
it even more difficult for us to identify services acceptable to our target market. We cannot assure that future technological or industry developments will be compatible with our business strategy or that we will be successful in responding to
these changes in a timely or cost-effective manner. Our failure to develop and sell services other than WAN management services could seriously damage our business.





Our business may be harmed if we lose the services of any member of our management team without appropriate succession and transition arrangements.





Our ability to continue to build our business and meet our goals going forward depends to a significant degree on the skills, experience
and efforts of each member of our management team. We do not have employment contracts requiring any of our personnel, including the members of our management team, to continue their employment for any period of time, and we do not maintain key man
life insurance on any of our personnel, including our executive officers. The loss of the expertise of any member of our management team without appropriate succession and transition arrangements could seriously damage our business.





In order to support our business, we must hire additional information technology professionals, who are in short supply.





We derive all of our revenues from network management services and related resales of equipment. These services can be
extremely complex, and in general only highly qualified, highly trained information technology, or IT, professionals have the skills necessary to develop and provide these services. In order to continue to support our current and future business, we
need to attract, motivate and retain a significant number of qualified IT professionals. Qualified IT professionals are in short supply, and we face significant competition for these professionals, from not only our competitors but also our end
users, marketing partners and other companies throughout the network services industry. Other employers may offer IT professionals significantly greater compensation and benefits or more attractive career paths or geographic locations than we are
able to offer. Any failure on our part to hire, train and retain a sufficient number of qualified IT professionals would seriously damage our business.





We could incur significant costs if we are unable to retain our information technology professionals.





Because of the limited availability of IT professionals, we seek to hire persons who have obtained college bachelors degrees and then train those persons to provide our services. As a result, we invest a significant amount of
time and money in training these new employees before they begin to support our business. We do not enter into employment agreements requiring these employees to continue in our employment for any period of time. Departures of trained employees
could limit our ability to generate revenues and would require us to incur additional costs in training new employees.





We currently
compete most directly with our customers internal solutions, and we expect increasing competition from other network services companies.





To compete successfully, we must respond promptly and effectively to the challenges of technological change, evolving standards and our competitors innovations by continuing to enhance our
services, as well as our sales programs and channels. Any pricing pressures, reduced margins or loss of market share resulting from increased competition, or our failure to compete effectively, could seriously damage our business.





We face competition from different sources. Currently, a major source of competition is the internal network administration
organizations of our end users and resellers. These organizations may have developed tools and




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methodologies to manage their network processes and may be reluctant to adopt applications offered by third parties like us.





If the market for outsourced network management services grows as we expect, we believe this market will become highly
competitive. Competition is likely to increase significantly as new network management services companies enter the market and current competitors expand their service and product lines. Many of these potential competitors are likely to enjoy
substantial competitive advantages, including:





| |  |  | larger technical staffs;
| | - |  | ------------------------




| |  |  | more established sales channels;
| | - |  | --------------------------------




| |  |  | more software development experience;
| | - |  | -------------------------------------




| |  |  | greater name recognition; and
| | - |  | -----------------------------




| |  |  | substantially greater financial, marketing, technical and other resources.
| | - |  | --------------------------------------------------------------------------




If our operations are interrupted, we may lose customers and revenues.





We must be able to operate our network management infrastructure 24 hours a day, 365 days a year without interruption. If our operations are interrupted, we may lose customers and revenues. All of our network management services are
provided remotely from our network management center, which is located at a single site in Austin, Texas. We currently have a geographically separate disaster recovery location with redundant systems. However, in order to operate without undue risk
of interruption, we must guard against:





| |  |  | power outages, fires, tornadoes and other natural disasters at our network management center and disaster recovery location;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------




| |  |  | telecommunications failures;
| | - |  | ----------------------------




| |  |  | equipment failures or crashes;
| | - |  | --------------------------------




| |  |  | security breaches; and
| | - |  | ----------------------




| |  |  | other potential interruptions.
| | - |  | ------------------------------




Any interruptions could:





| |  |  | require us to make payments on the contractual performance guarantees we offer our customers;
| | - |  | ---------------------------------------------------------------------------------------------




| |  |  | cause end users to seek damages for losses incurred;
| | - |  | ----------------------------------------------------




| |  |  | require us to spend more money replacing existing equipment or adding redundant facilities;
| | - |  | -------------------------------------------------------------------------------------------




| |  |  | damage our reputation for reliable service;
| | - |  | -------------------------------------------




| |  |  | cause existing end users and resellers to cancel our contracts; and
| | - |  | -------------------------------------------------------------------




| |  |  | make it more difficult for us to attract new end users and resellers.
| | - |  | ---------------------------------------------------------------------



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Our revenues would decline and our business would be adversely affected if the networking equipment
and carrier services we support become obsolete or are otherwise not used by a large part of our target market.





As part of our strategy, we have elected to support only selected providers of networking equipment and carrier services. For example, we support routers manufactured by 3Com, Bay/Nortel and Cisco, but not by other equipment
providers. Our services cannot be used by companies with networking equipment and carrier services that we do not support. Our business would be seriously damaged if, in the future, the networking equipment manufacturers and carrier services that we
support were not the predominant providers to our target market or if their equipment or services became unavailable or significantly more expensive. Technological advances that make obsolete any of the networking equipment and carrier services that
we support, or that offer significant economic or functional advantages over the equipment and services, also could limit or reduce our revenues or could force us to incur significant costs attempting to support other networking equipment and
carrier services.





We may be unable to protect our intellectual property, and we could incur substantial costs enforcing our
intellectual property against infringers or defending claims of infringement made by others.





Our business and
financial performance depends to a significant degree upon our software and other proprietary technology. The software industry has experienced widespread unauthorized reproduction of software products. We have only two patents. The steps we have
taken may not be adequate to deter competitors from misappropriating our proprietary information, and we may not be able to detect unauthorized use and take appropriate steps to enforce our intellectual property rights.





We could be the subject of claims alleging infringement of third-party intellectual property rights. In addition, we may be required to
indemnify our distribution partners and end users for similar claims made against them. Any infringement claim could require us to spend significant time and money in litigation, pay damages, develop non-infringing intellectual property or acquire
licenses to intellectual property that is the subject of the infringement claims. As a result, any infringement claim could seriously damage our business.





Item 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





The Company invests its cash in money market funds or instruments which meet high credit quality standards specified by the Companys investment policy. The Company does not use financial instruments for trading or other
speculative purposes.




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PART II.    OTHER INFORMATION





Item 1.    LEGAL PROCEEDINGS





A consolidated putative class action
complaint was filed on February 21, 2001 against the Company and certain of its officers in the United States District Court for the Western District of Texas, Austin Division. In re NetSolve Incorporated Securities Litigation, Civil Action No.
A00-CA-591 SS. Plaintiffs seek to represent a class comprised of purchasers of the Companys common stock between April 18, 2000 and August 18, 2000 (Class Period). They allege that the defendants engaged in a fraudulent scheme by
issuing false and materially misleading statements regarding the Companys business during the Class Period.





The Company moved to dismiss the complaint on March 8, 2001 for failing to state a claim under which relief could be granted and for failing to comply with the pleading requirements of the Private Securities Litigation Reform Act of
1995, 15 U.S.C. § 78u-4 et seq. On August 15, 2001, the District Court granted this motion in part and denied it in part. The District Court dismissed claims against one officer of the Company and dismissed certain of the theories under which
Plaintiffs alleged liability against the Company. However, the District Court let stand certain of the stated claims against the Company and certain of its officers.





On December 17, 2001, the Company and individual defendants reached a settlement of this action. The plaintiff class will receive $2,750,000 in connection with the
settlement, all of which will be funded by the Companys insurance carrier. The District Court approved this settlement by its Order issued on October 30, 2002.





On December 6, 2001, a second putative securities class action complaint was filed against the Company, certain of its officers and the Companys underwriters of its
initial public offering in the United States District Court for the Southern District of New York. Woodward v. NetSolve, Inc., 01 CV 11239. Plaintiff seeks to represent a class comprised of purchasers of the Companys common stock between
September 29, 1999 and December 6, 2000. The plaintiffs allege that the defendants failed to properly disclose certain commissions, discounts and purported tie-in arrangements related to the Companys initial public offering. The plaintiffs
allege claims under Sections 11 and 15 of the Securities Act against the Company, and the plaintiffs allege claims under Section 11 and 12 of Securities Act, and Section 10 (b) of the Exchange Act, against the Companys underwriters. This case
has been coordinated for pretrial purposes with over 300 other cases alleging similar claims against other underwriters and companies. In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). Preliminary settlement proposals have been
offered by representatives of both the underwriter defendants and the plaintiffs. Such proposals are being analyzed by the various issuer defendants. It is not feasible to predict or determine the final outcome of this proceeding, and if the outcome
were to be unfavorable, the Companys business, financial condition, cash flow and results of operations could be materially adversely affected.





Item 2.    CHANGES IN SECURITIES AND USE OF PROCEEDS





The
Companys registration statement on Form S-1 (File No. 333-65691) was declared effective on September 28, 1999. Gross proceeds from the offering were used to pay offering costs through December 31, 1999. Net proceeds from the offering in the
amount of $23,094,000 have been used through September 30, 2002 to repurchase 3,214,216 shares of the Companys common stock under its stock repurchase program. The remainder of the proceeds of this offering is temporarily invested in
short-term, investment-grade, interest bearing securities pending their use for other purposes.




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Item 6.    EXHIBITS AND REPORTS ON FORM 8-K





(a)  EXHIBITS





ITEM NUMBER

EXHIBIT99.1

Certification of David D. Hood, the registrants chief executive officer, required pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906
of the Sarbanes-Oxley Act of 2002.99.2

Certification of Kenneth C. Kieley, the registrants chief financial officer, required pursuant to 18 U.S.C. § 1350, as adopted pursuant to §
906 of the Sarbanes-Oxley Act of 2002.





(b)  Reports on Form 8-K





Reports on Form 8-K were filed on August 14, 2002 and September 13, 2002 containing reference to certifications filed with
registrants Quarterly Report on Form 10-Q as required pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002 and the press release dated September 6, 2002, announcing the resignation of Craig
Tysdal as President and Chief Executive Officer and the appointment of David D. Hood as his successor.




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SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly
authorized.





Date:    November 14, 2002

NETSOLVE, INCORPORATEDBy:

/s/    DAVID D. HOODDavid D. HoodPresident and Chief Executive OfficerBy:

/s/    KENNETH C. KIELEYKenneth C. KieleyVice President-Finance, Chief Financial Officerand SecretaryBy:

/s/    H. PERRY BARTHH. Perry BarthController and Chief Accounting Officer




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CERTIFICATION OF CHIEF EXECUTIVE OFFICER





I, David D. Hood, certify that:





| | 1. |  | I have reviewed this quarterly report on Form 10-Q of NetSolve, Incorporated;
| | -- |  | -----------------------------------------------------------------------------




| | 2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 4. |  | The registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | a) |  | designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is
made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | b) |  | evaluated the effectiveness of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly
report (the Evaluation Date); and
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | c) |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 5. |  | The registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the equivalent function):
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect the registrants ability to record, process,
summarize and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------




| | 6. |  | The registrants other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------







Date: November 14, 2002

/s/    DAVID D. HOODDavid D. HoodPresident and Chief Executive Officer




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CERTIFICATION OF CHIEF EXECUTIVE OFFICER





I, Kenneth C. Kieley, certify that:





| | 1. |  | I have reviewed this quarterly report on Form 10-Q of NetSolve, Incorporated;
| | -- |  | -----------------------------------------------------------------------------




| | 2. |  | Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 3. |  | Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 4. |  | The registrants other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | a) |  | designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is
made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | b) |  | evaluated the effectiveness of the registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly
report (the Evaluation Date); and
| | -- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | c) |  | presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | 5. |  | The registrants other certifying officers and I have disclosed, based on our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the equivalent function):
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | a) |  | all significant deficiencies in the design or operation of internal controls which could adversely affect the registrants ability to record, process,
summarize and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | b) |  | any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal controls; and
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------




| | 6. |  | The registrants other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------







Date:    November 14, 2002

/s/    KENNETH C. KIELEYKenneth C. KieleyVice President-Finance, Chief Financial Officerand Secretary




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