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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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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, 2003



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 ofIncorporation or Organization) |  | (IRS EmployerIdentification 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)



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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 7, 2003: 11,418,703



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NETSOLVE, INCORPORATED



INDEX



|         |  |                                                                                                                                   |  | Page
|-------- |  | --------------------------------------------------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                                                                  
|PART I.  |  | FINANCIAL INFORMATION                                                                                                             |  |     
|         |  |                                                                                                                                  
|Item 1.  |  | Financial Statements                                                                                                              |  |     
|         |  |                                                                                                                                  
|         |  | Condensed Consolidated Balance Sheets as of March 31, 2003 and September 30, 2003 (unaudited)                                     |  | 3   
|         |  |                                                                                                                                  
|         |  | Condensed Consolidated Statements of Operations for the three and six month periods ended September 30, 2002 and 2003 (unaudited) |  | 4   
|         |  |                                                                                                                                  
|         |  | Condensed Consolidated Statements of Cash Flows for the six month periods ended September 30, 2002 and 2003 (unaudited)           |  | 5   
|         |  |                                                                                                                                  
|         |  | Notes to Condensed Consolidated Financial Statements                                                                              |  | 6   
|         |  |                                                                                                                                  
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                             |  | 9   
|         |  |                                                                                                                                  
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                                                                        |  | 24  
|         |  |                                                                                                                                  
|Item 4.  |  | Controls and Procedures                                                                                                           |  | 24  
|         |  |                                                                                                                                  
|PART II. |  | OTHER INFORMATION                                                                                                                 |  |     
|         |  |                                                                                                                                  
|Item 1.  |  | Legal Proceedings                                                                                                                 |  | 24  
|         |  |                                                                                                                                  
|Item 5.  |  | Other Information                                                                                                                 |  | 25  
|         |  |                                                                                                                                  
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                                                                  |  | 25  



2



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PART I. FINANCIAL INFORMATION

|Item 1. |  | Financial Statements
|------- |  | --------------------



NETSOLVE, INCORPORATED



CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)



|                                                                                                                                                                                                                                           |  | 3/31/2003 |         |   | 9/30/2003   |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | --------- | ------- | - | ----------- | -
|                                                                                                                                                                                                                                           |  |           |         |   | (unaudited) |  
|ASSETS                                                                                                                                                                                                                                     |  |           |         |   |             |  
|Current assets:                                                                                                                                                                                                                            |  |           |         |   |             |  
|Cash and cash equivalents                                                                                                                                                                                                                  |  | $         | 28,073  |   |             | $
|Short-term investments                                                                                                                                                                                                                     |  |           | 15,431  |   |             |  
|Restricted cash                                                                                                                                                                                                                            |  |           | 354     |   |             |  
|Accounts receivable, net of allowance for doubtful accounts of $130 at March 31, 2003 and $182 at September 30,
2003                                                                                                                       |  |           | 6,061   |   |             |  
|Prepaid expenses and other assets                                                                                                                                                                                                          |  |           | 1,883   |   |             |  
|Deferred tax assets                                                                                                                                                                                                                        |  |           | 1,487   |   |             |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |  
|Total current assets                                                                                                                                                                                                                       |  |           | 53,289  |   |             |  
|                                                                                                                                                                                                                                           |  |          
|Property and Equipment:                                                                                                                                                                                                                    |  |           |         |   |             |  
|Computer equipment and software                                                                                                                                                                                                            |  |           | 11,466  |   |             |  
|Furniture, fixtures and leasehold improvements                                                                                                                                                                                             |  |           | 5,073   |   |             |  
|Other equipment                                                                                                                                                                                                                            |  |           | 373     |   |             |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |  
|                                                                                                                                                                                                                                           |  |           | 16,912  |   |             |  
|Less accumulated depreciation and amortization                                                                                                                                                                                             |  |           | (10,690 | ) |             |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |  
|Net property and equipment                                                                                                                                                                                                                 |  |           | 6,222   |   |             |  
|                                                                                                                                                                                                                                           |  |          
|Deferred tax assets, net of current portion                                                                                                                                                                                                |  |           | 1,375   |   |             |  
|Other assets                                                                                                                                                                                                                               |  |           | 104     |   |             |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |  
|Total assets                                                                                                                                                                                                                               |  | $         | 60,990  |   |             | $
|                                                                                                                                                                                                                                           |  |           |         |   |             |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                                                       |  |           |         |   |             |  
|Current liabilities:                                                                                                                                                                                                                       |  |           |         |   |             |  
|Accounts payable                                                                                                                                                                                                                           |  | $         | 1,839   |   |             | $
|Accrued liabilities                                                                                                                                                                                                                        |  |           | 3,098   |   |             |  
|Future rentals for idle facility                                                                                                                                                                                                           |  |           | 1,138   |   |             |  
|Deferred revenue                                                                                                                                                                                                                           |  |           | 1,055   |   |             |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |  
|Total current liabilities                                                                                                                                                                                                                  |  |           | 7,130   |   |             |  
|Deferred revenue, net of current portion                                                                                                                                                                                                   |  |           | 247     |   |             |  
|                                                                                                                                                                                                                                           |  |          
|Stockholders equity:                                                                                                                                                                                                                      |  |           |         |   |             |  
|Common stock, $.01 par value; 25,000,000 shares authorized at March 31, 2003 and September 30, 2003; 15,613,690 issued and
11,455,204 outstanding at March 31, 2003 and 15,746,497 issued and 11,395,011 outstanding at September 30, 2003 |  |           | 156     |   |             |  
|Additional paid-in capital                                                                                                                                                                                                                 |  |           | 81,732  |   |             |  
|Treasury stock                                                                                                                                                                                                                             |  |           | (28,891 | ) |             |  
|Retained earnings                                                                                                                                                                                                                          |  |           | 616     |   |             |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |  
|Total stockholders equity                                                                                                                                                                                                                 |  |           | 53,613  |   |             |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |  
|Total liabilities and stockholders equity                                                                                                                                                                                                 |  | $         | 60,990  |   |             | $
|                                                                                                                                                                                                                                           |  |           |         |   |             |  



See accompanying notes.



3



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NETSOLVE, INCORPORATED



CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)



|                                                              |  | Three Months Ended |        |   | Six Months Ended |  
|------------------------------------------------------------- |  | ------------------ | ------ | - | ---------------- | -
|                                                              |  | 9/30/2002          |        |   | 9/30/2003        |  
|                                                              |  | (unaudited)        |        |   | (unaudited)      |  
|Revenues:                                                     |  |                    |        |   |                  |  
|IT infrastructure management services                         |  | $                  | 9,881  |   |                  | $
|Maintenance and equipment                                     |  |                    | 2,223  |   |                  |  
|                                                              |  |                    |        |   |                  |  
|Total revenues                                                |  |                    | 12,104 |   |                  |  
|                                                              |  |                    |        |   |                  |  
|Costs of revenues:                                            |  |                    |        |   |                  |  
|IT infrastructure management services                         |  |                    | 6,056  |   |                  |  
|Maintenance and equipment                                     |  |                    | 1,496  |   |                  |  
|                                                              |  |                    |        |   |                  |  
|Total costs of revenues                                       |  |                    | 7,552  |   |                  |  
|                                                              |  |                    |        |   |                  |  
|Gross profits:                                                |  |                    |        |   |                  |  
|IT infrastructure management services                         |  |                    | 3,825  |   |                  |  
|Maintenance and equipment                                     |  |                    | 727    |   |                  |  
|                                                              |  |                    |        |   |                  |  
|                                                              |  |                    | 4,552  |   |                  |  
|Operating expenses:                                           |  |                    |        |   |                  |  
|Development                                                   |  |                    | 859    |   |                  |  
|Selling and marketing                                         |  |                    | 1,689  |   |                  |  
|General and administrative                                    |  |                    | 856    |   |                  |  
|                                                              |  |                    |        |   |                  |  
|Total operating expenses                                      |  |                    | 3,404  |   |                  |  
|                                                              |  |                    |        |   |                  |  
|Operating income (loss)                                       |  |                    | 1,148  |   |                  |  
|                                                              |  |                    |        |  
|Other income (expense):                                       |  |                    |        |   |                  |  
|Interest income                                               |  |                    | 218    |   |                  |  
|Interest expense                                              |  |                    | (1     | ) |                  |  
|Other, net                                                    |  |                    | (1     | ) |                  |  
|                                                              |  |                    |        |   |                  |  
|Total other income (expense)                                  |  |                    | 216    |   |                  |  
|                                                              |  |                    |        |   |                  |  
|Income (loss) before income taxes                             |  |                    | 1,364  |   |                  |  
|Income tax expense (benefit)                                  |  |                    | 491    |   |                  |  
|                                                              |  |                    |        |   |                  |  
|Net income (loss)                                             |  | $                  | 873    |   |                  | $
|                                                              |  |                    |        |   |                  |  
|Basic net income (loss) per share                             |  | $                  | 0.07   |   |                  | $
|Weighted average shares used in basic per share calculation   |  |                    | 11,957 |   |                  |  
|                                                              |  |                    |        |  
|Diluted net income (loss) per share                           |  | $                  | 0.07   |   |                  | $
|Weighted average shares used in diluted per share calculation |  |                    | 12,749 |   |                  |  



See accompanying notes.



4



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NETSOLVE, INCORPORATED



CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                  |  | Six Months Ended |       
|--------------------------------------------------------------------------------- |  | ---------------- | ------
|                                                                                  |  | 9/30/2002        |       
|                                                                                  |  | (unaudited)      |       
|Cash flows from operating activities:                                             |  |                  |       
|Net income (loss)                                                                 |  | $                | 1,706 
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                  |       
|Depreciation and amortization                                                     |  |                  | 1,903 
|Amortization of deferred compensation                                             |  |                  | 15    
|Loss on disposition of property and equipment                                     |  |                  | 181   
|Reduction in future rentals for idle facility                                     |  |                  | (692  
|Change in assets and liabilities:                                                 |  |                  |       
|Accounts receivable, net                                                          |  |                  | 2,867 
|Prepaid expenses and other assets                                                 |  |                  | (45   
|Deferred tax assets                                                               |  |                  | 4     
|Accounts payable                                                                  |  |                  | (42   
|Accrued liabilities                                                               |  |                  | 358   
|Unearned revenue                                                                  |  |                  | (155  
|                                                                                  |  |                  |       
|Net cash provided by operating activities                                         |  |                  | 6,100 
|                                                                                  |  |                  |       
|Cash flows from investing activities:                                             |  |                  |       
|Purchases of short-term investments                                               |  |                  | (3,476
|Sale of short-term investments                                                    |  |                  |      
|Transfer of funds to restricted cash                                              |  |                  | (2    
|Purchases of property and equipment                                               |  |                  | (1,727
|Proceeds from the sale of property and equipment                                  |  |                  | 11    
|                                                                                  |  |                  |       
|Net cash used in investing activities                                             |  |                  | (5,194
|                                                                                  |  |                  |       
|Cash flows from financing activities:                                             |  |                  |       
|Repurchase of common stock                                                        |  |                  | (2,035
|Proceeds from exercise of common stock options and warrants                       |  |                  | 39    
|                                                                                  |  |                  |       
|Net cash used in financing activities                                             |  |                  | (1,996
|                                                                                  |  |                  |       
|Net change in cash and cash equivalents                                           |  |                  | (1,090
|Cash and cash equivalents, beginning of period                                    |  |                  | 47,160
|                                                                                  |  |                  |       
|Cash and cash equivalents, end of period                                          |  | $                | 46,070
|                                                                                  |  |                  |       
|Supplemental disclosure of cash flow information:                                 |  |                  |       
|Cash paid for interest                                                            |  | $                | 1     
|                                                                                  |  |                  |       
|Income taxes paid                                                                 |  | $                | 64    
|                                                                                  |  |                  |       



See accompanying notes.



5



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NETSOLVE, INCORPORATED



NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2003



Information with respect to the three and six months ended September 30, 2002 and 2003 is unaudited.



1. Organization and Description of the Company



NetSolve, Incorporated, a Delaware corporation, (the Company)
engages in the business of providing information technology (IT) infrastructure management services. These services include network configuration and design, installation and implementation coordination, fault diagnosis and resolution, and ongoing
IT infrastructure management. The Company also resells CPE maintenance contracts and data network equipment manufactured by selected leading suppliers of these products. The Company also licenses its software in other countries. The Companys
IT infrastructure management services are designed to allow its customers to selectively outsource IT infrastructure management in order to simplify the timely migration to new technologies, and increase network reliability, performance and security
while reducing overall IT infrastructure operating 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, 2003, which can be found in the Companys annual report on Form 10-K, as filed on June 6, 2003 (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 (loss) per share is computed using the weighted average number of common shares outstanding. Diluted income (loss)
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.



6



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NETSOLVE, INCORPORATED



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

September 30, 2003



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





|                                                                                                                                    |  | Three months endedSeptember 30, |        |      | Six months endedSeptember 30, |       
|----------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | ---- | ----------------------------- | ------
|                                                                                                                                    |  | 2002                            |        | 2003 |                               |       
|Numerator:                                                                                                                          |  |                                 |        |      |                               |       
|Net income (loss)                                                                                                                   |  | $                               | 873    |      | $                             | (99   
|                                                                                                                                    |  |                                 |        |      |                               |       
|Denominator:                                                                                                                        |  |                                 |        |      |                               |       
|Denominator for basic net income (loss) per share-weighted average common stock outstanding                                         |  |                                 | 11,957 |      |                               | 11,211
|Dilutive common stock equivalents-common stock outstanding                                                                          |  |                                 | 792    |      |                               |      
|                                                                                                                                    |  |                                 |        |      |                               |       
|Denominator for diluted net income (loss) per share-weighted average common stock outstanding and dilutive common stock
equivalents |  |                                 | 12,749 |      |                               | 11,211
|                                                                                                                                    |  |                                 |        |      |                               |       



4. Contingencies



In December 2001, the Company and certain of our officers and directors, as
well as the underwriters of our initial public offering (IPO) and hundreds of other companies (Issuers), directors and officers and IPO underwriters, were named as defendants in a series of class action shareholder complaints
filed in the United States District Court for the Southern District of New York. Those cases are now consolidated under the caption In re Initial Public Offering Securities Litigation, Case No. 91 MC 92. In the amended complaint, the plaintiffs
allege that the Company, certain of our officers and directors and our IPO underwriters violated section 11 of the Securities Act of 1933 based on allegations that the Companys registration statement and prospectus failed to disclose material
facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The complaint also contains a claim for violation of section 10(b) of the Securities Exchange Act of 1934 based on allegations that this
omission constituted a deceit on investors. The plaintiffs seek unspecified monetary damages and other relief.



In February 2003, the Court issued a decision denying the motion to dismiss the Section 11 claims against the Company and almost all of the other Issuers,
and granting the motion to dismiss the Section 10(b) claim against the Company. The Court dismissed the Section 10(b) claim against the Company without leave to amend. In June 2003, the Issuers and Plaintiffs reached a tentative settlement agreement
that would, among other things, result in the dismissal with prejudice of all claims against the Issuers and their officers and directors in the IPO Lawsuits. A special committee of disinterested directors appointed by the board of directors
received and analyzed the settlement proposal and determined that, subject to final documentation, the settlement proposal should be accepted. Although the Company has approved this settlement proposal in principle, it remains subject to a number of
procedural conditions, including formal approval by the Court. 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.



7



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NETSOLVE, INCORPORATED



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

September 30, 2003



5. Stock-Based Compensation Plans



Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, (Statement 123),
prescribes accounting and reporting standards for all stock-based compensation plans, including employee stock options. As allowed by Statement 123, the Company has elected to continue to account for its employee stock-based compensation using the
intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted
under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The Company has calculated the fair value of options granted in these periods using the Black-Scholes option-pricing model and has
determined the pro forma impact on net income.



The
Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, this option valuation model requires the input of highly
subjective assumptions including the expected stock price volatility. Because the Companys employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input
assumptions can materially affect the fair value estimate, in managements opinion, the Black-Scholes model does not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma
disclosures, the estimated fair value of the options is amortized to expense over the options vesting period.



The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of
Statement 123 to stock-based employee compensation (in thousands, except per share data):



|                                                                                                                                  |  | Three months endedSeptember 30, |      |   | Six months endedSeptember 30, |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ---- | - | ----------------------------- | -
|                                                                                                                                  |  | 2002                            |      |   | 2003                          |  
|Reported net income (loss)                                                                                                        |  | $                               | 873  |   |                               | $
|Total stock based employee compensation expense included in the determination of net loss as reported, net of related tax
effects |  |                                 |     |   |                               |  
|Total stock based employee compensation expense determined under the fair value method for all awards, net of related
taxes       |  |                                 | (769 | ) |                               |  
|                                                                                                                                  |  |                                 |      |   |                               |  
|Pro forma net income (loss) from continuing operations (in thousands)                                                             |  |                                 | 104  |   |                               |  
|                                                                                                                                  |  |                                 |      |   |                               |  
|Basic net income (loss) per share:                                                                                                |  |                                 |      |   |                               |  
|Reported net income (loss) per share                                                                                              |  |                                 | 0.07 |   |                               |  
|Pro forma basic net income (loss) per share                                                                                       |  |                                 | 0.01 |   |                               |  
|                                                                                                                                  |  |                                 |      |  
|Diluted net income (loss) per share                                                                                               |  |                                 |      |   |                               |  
|Reported net income (loss) per share                                                                                              |  |                                 | 0.07 |   |                               |  
|Pro forma diluted net income (loss) per share                                                                                     |  |                                 | 0.01 |   |                               |  





8



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|Item 2. |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS 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 indicating future events. They include, among
others, statements relating to trends and projections in revenue, company growth, sales, margin and expenses, cash flow needs and the drivers behind those trends and projections; the size and growth potential of the IT infrastructure management
industry; trends in sales of our services and products and resulting revenues; our ability to retain current customer arrangements and develop new arrangements; our ability to replace the business lost by the termination and transition of the
AT&T Managed Router Service Agreement and the AT&T Home Depot agreement and the impact of the termination of those agreemnets; our ability to develop new service offerings and the market acceptance of such offerings; our ability to develop
new reseller arrangements; the level of any stock repurchases we may undertake; payments requested by customers regarding our WAN guarantee or any of our other services guarantees; the amount of any added costs from anticipated new sales, marketing
and development efforts, our reliance on resellers, the continued development of new service offerings and 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 a range of IT infrastructure management services that allow enterprises and carriers to outsource some or all
network-specific activities in order to increase network availability, performance and security while reducing overall IT infrastructure operations cost, and simplifying timely migration to new technologies. We have also licensed our software in
another country. 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 IT infrastructure management services to its customers
in another country. Additionally, on October 1, 2001, we announced the offering of remote IT infrastructure management for Cisco Systems, Inc. Architecture for Voice, Video and Integrated Data (AVVID) Internet Protocol IP Telephony (IPT).



Revenues



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



| |  | Revenues from recurring services represent monthly fees charged to resellers or end users for our IT infrastructure management services, and software licensing, royalty and
maintenance fees. Recurring IT infrastructure 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 2003, approximately 88% of IT infrastructure management services revenues were from recurring services.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



9



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| |  | Nonrecurring IT infrastructure management services consist primarily of project implementation services, equipment installation services and one-time project and development
assignments that assist resellers in defining and creating new IT infrastructure management services. Nonrecurring IT infrastructure management services primarily relate to services performed to assist customers in implementing new networks.
Nonrecurring IT infrastructure management revenues are also earned when implementing IT infrastructure management services for existing networks; however, the level of work and related fees are both lower. Nonrecurring IT infrastructure 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 IT infrastructure management services revenues are derived from contracts with telecommunications carriers, system integrators and 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. IT
infrastructure 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 IT infrastructure management services revenues were less than 1% in each of fiscal years 2002 and 2003 and in the six months ended September 30, 2003. 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 IT infrastructure 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 during a particular month, 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 IT
infrastructure 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 resale of CPE maintenance contracts and from the resale of customer
premise equipment, or CPE, to certain of our IT infrastructure 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 IT infrastructure management services customers. Although we believe some of our customers will continue to purchase CPE from us, our strategy is to focus on our IT infrastructure 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.



We first entered into a reseller arrangement with AT&T in 1995. We subsequently entered into other agreements and since 1999 have had three primary
reseller agreements with AT&T: one for managed router service; one for managed DSU service marketed by AT&T as part of its Frame Plus offering; and one for the management of



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the WAN of one large customer  The Home Depot. These agreements accounted for $6.0 million in revenues in quarter ended March 31, 2003.



In February 2003, we were notified by AT&T of its intention to terminate
the managed router service agreement over an eight-month transition period beginning July 1, 2003. In May 2003, we were notified by AT&T of its intention to terminate the Home Depot agreement in July of 2003. As a result of these terminations,
total revenues from AT&T decreased to $4.9 million in the quarter ended September 30, 2003. Additionally, we anticipate total revenues from AT&T to sequentially decline to approximately $3.9 and $3.1 million in the quarters ended December
31, 2003 and March 31, 2004, respectively.



We anticipate that
we will substantially offset these declines in revenues from AT&T with increased IT infrastructure management revenues from other reseller channels and direct sales.



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,
2002 compared to three months ended September 30, 2003



Revenues



Total revenues.Total
revenues decreased 2%, from $12.1 million in the three months ended September 30, 2002 to $11.9 million in the three months ended September 30, 2003.



IT infrastructure management services.Revenues from IT infrastructure management services decreased 1%, from $9.9 million in the three months
ended September 30, 2002 to $9.8 million in the three months ended September 30, 2003, representing 82% of total revenues in the three months ended September 30, 2002 and 2003. The dollar decrease was due primarily to a decrease in implementation
services due to a decrease in the level of new installations from carrier agreements utilizing those services. This decrease was partially offset by increased revenue from software licensing fees and to a lesser extent an increase in the number of
managed devices under contract. Revenue growth in IT infrastructure management services is expected to be adversely impacted in the second half of the current fiscal year due to the termination of the AT&T Managed Router Service agreement
discussed above.



Maintenance and equipment.Maintenance
and equipment revenues decreased 5%, from $2.2 million in the three months ended September 30, 2002 to $2.1 million in the three months ended September 30, 2003. These revenues decreased primarily as a result of lower equipment sales. This decrease
was partially offset by an increase in the number of devices under maintenance contracts.



Costs of revenues



Cost of IT infrastructure management services.Cost of IT infrastructure management services includes salary and other costs of personnel, depreciation of equipment utilized to manage customer networks, the network management
infrastructure utilized to provide IT infrastructure management services, and the costs of third-party providers of CPE installation services. Cost of IT infrastructure management services is expensed as incurred. Cost of IT infrastructure
management services decreased 7%, from $6.1 million in the three months ended September 30, 2002 to $5.6 million in the three months ended September 30, 2003, representing 61% of IT infrastructure management services revenues in the three months
ended September 30, 2002 and 57% in the three months ended September 30, 2003. The dollar and percentage decrease was due primarily to a decrease in the number of employees and a decrease in depreciation expense on equipment used to provide IT
infrastructure management services.





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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 was relatively constant at $1.5 million in the
three months ended September 30, 2002 and 2003, representing 67% of maintenance and equipment revenues in the three months ended September 30, 2002 and 71% of maintenance and equipment revenues in the three months ended September 30, 2003. The
slight increase in dollars was primarily due to the increase in maintenance revenue. This increase was partially offset by a decrease in equipment revenue.



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 IT infrastructure management services, developing our Web-enabled
software applications that give customers access to IT infrastructure management information, and defining and developing operating processes for new services. Development expenses increased 49% from $859,000 in the three months ended September 30,
2002 to $1.3 million in the three months ended September 30, 2003, representing 7% of total revenues in the three months ended September 30, 2002 and 11% in the three months ended September 30, 2003. The increase in dollars and as a percentage of
revenue was due to an increase in the number of software and service development personnel, including contract programming personnel, devoted to the development and enhancement of IT infrastructure management tools and our network management
services. Development costs of approximately $35,000 in the quarter ended September 30, 2003 were capitalized to match against software license fees under a licensing agreement with a one-year term.



Selling and marketing.Selling and marketing expenses consist
primarily of salaries, commissions, travel and costs associated with creating awareness of our services. Sales and marketing expenses increased 39%, from $1.7 million in the three months ended September 30, 2002 to $2.3 million in the three months
ended September 30, 2003, representing 14% of total revenues in the three months ended September 30, 2002 and 20% in the three months ended September 30, 2003. The increase in dollars and as a percentage of revenue was due to our decision to
increase spending in this area in an effort to expand and increase new business. The increase in spending was due primarily to the addition of sales and marketing personnel and to a lesser extent increased spending related to creating market
awareness.



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 during 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 increased 57%, from $856,000 in the three months ended September 30, 2002 to $1.3 million in the three months ended September 30, 2003, representing 7%
of total revenues in the three months ended September 30, 2002 and 11% in the three months ended September 30, 2003. The dollar and percentage increase was due primarily to severance payments to terminated employees and higher payroll costs and to a
lesser extent increased costs related to insurance and legal fees.



Other income, net



Other income, net consists
primarily of interest income earned on our cash balances. Other income, net decreased from $216,000 in the three months ended September 30, 2002 to $65,000 in the three months ended September 30, 2003, representing 2% of total revenues in the three
months ended September 30, 2002 and 1% in the three months ended September 30, 2003. The decrease was due primarily to lower average interest rates on cash balances for the three months ended September 30, 2003 compared to the same period in the
prior year and to a lesser extent lower average cash balances for the three months ended September 30, 2003 compared to the same period in the prior year.



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Six months ended September 30, 2002 compared to six months ended September 30, 2003



Revenues



Total revenues.Total revenues decreased 1%, from $24.7 million in
the six months ended September 30, 2002 to $24.4 million in the six months ended September 30, 2003.



IT infrastructure management services.Revenues from IT infrastructure management services decreased 2%, from $20.2 million in the six months ended
September 30, 2002 to $19.8 million in the six months ended September 30, 2003, representing 82% of total revenues in the six months ended September 30, 2002 and 81% in the six months ended September 30, 2003. The dollar and percentage decrease was
due primarily to a decrease in implementation services due to a decrease in the level of new installations from carrier agreements utilizing those services and contractual discounts provided to AT&T relating to the Managed Router Services
Agreement. This decrease was partially offset by increased revenue from software licensing fees and to a lesser extent an increase in the number of managed devices under contract. Revenue growth in IT infrastructure management services is expected
to be adversely impacted in the second half of the current fiscal year due to the termination of the AT&T Managed Router Service agreement discussed above.



Maintenance and equipment.Revenues from maintenance and equipment increased 2%, from $4.5 million in the six months ended September 30, 2002 to
$4.6 million in the six months ended September 30, 2003. Revenues from maintenance and equipment increased primarily as a result of an increase in the number of devices under maintenance contracts. This increase was partially offset by lower
equipment sales and to a lesser extent due to contractual discounts provided to AT&T relating to the Managed Router Service Agreement.



Costs of revenues



Cost of IT infrastructure management services.Cost of IT infrastructure management services decreased 2%, from $12.0 million in the six months
ended September 30, 2002 to $11.8 million in the six months ended September 30, 2003, representing 60% of IT infrastructure management services revenues in the six months ended September 30, 2002 and 2003. The dollar decrease was due primarily to a
decrease in deprecation expense on equipment used to provide IT infrastructure management services and due to a decrease in the number of employees. This decrease was partially offset by an increase in employee severance payments resulting from a
reduction in force.



Cost of maintenance and equipment.Cost of maintenance and equipment increased 10%, from $3.0 million in the six months ended September 30, 2002 to $3.3 million in the six months ended September 30, 2003, representing 67% of maintenance and equipment revenues in the six months
ended September 30, 2002 and 72% of maintenance and equipment revenues in the six months ended September 30, 2003. The increase in dollars was primarily due to the increase in maintenance revenue. This increase was partially offset by a decrease in
equipment revenue. The increase in percentage is primarily the result of contractual sales discounts provided to AT&T customers under the Managed Router Services Agreement which did not have a corresponding decrease in costs.



Operating expenses



Development.Development expenses increased 58% from $1.8 million in
the six months ended September 30, 2002 to $2.8 million in the six months ended September 30, 2003, representing 7% of total revenues in the six months ended September 30, 2002 and 11% in the six months ended September 30, 2003. The increase in
dollars and as a percentage of revenue was due to an increase in the number of software and service development personnel, including contract programming personnel, devoted to the development and enhancement of IT infrastructure management tools and
our network management services. Development costs of approximately $121,000 in the six months ended September 30, 2003 were capitalized to match against software license fees under a licensing agreement with a one-year term.



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Selling and marketing.Sales and marketing expenses increased 26%, from $3.5 million in the six
months ended September 30, 2002 to $4.4 million in the six months ended September 30, 2003, representing 14% of total revenues in the six months ended September 30, 2002 and 18% in the six months ended September 30, 2003. The increase in dollars and
as a percentage of revenue was due to our decision to increase spending in this area in an effort to expand and increase new business. The increase in spending was due primarily to the addition of sales and marketing personnel and to a lesser extent
increased spending related to creating market awareness. This increase was partially offset by the absence of spending related to identifying software licensing opportunities overseas that occurred in the previous year.



General and administrative.General and administrative expenses
increased 33%, from $2.1 million in the six months ended September 30, 2002 to $2.9 million in the six months ended September 30, 2003, representing 9% of total revenues in the six months ended September 30, 2002 and 12% in the six months ended
September 30, 2003. The dollar and percentage increase was due primarily to approximately $276,000 related to acquisition activities and to a lesser extent increased costs related to employee severance payments, the addition of general and
administrative personnel, and increased insurance and legal fees. This increase was partially offset by $419,000 of spending in the six months ended September 30, 2002 related to rent and operating costs of an idle facility that were not a factor in
the current year.



Other income, net



Other income, net decreased from $432,000 in the six months ended September
30, 2002 to $230,000 in the six months ended September 30, 2003, representing 2% of total revenues in the six months ended September 30, 2002 and 1% in the six months ended September 30, 2003. The decrease was due primarily to lower average interest
rates on cash balances for the six months ended September 30, 2003 compared to the same period in the prior year and to a lesser extent lower average cash balances for the six months ended September 30, 2003 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, and to enter into new relationships, our ability to develop and market new service offerings and the acceptance of such service offerings, 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 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, 2002 and September 30, 2003 was $6.1 million and $1.5 million, respectively primarily due to a decrease in accounts receivable during the six months ended September 30, 2002 and 2003.



We used $1.7 million during the six months ended September 30,
2002 and $2.7 million in the six months ended September 30, 2003 to purchase capital assets which included leasehold improvements related to the addition of our new facility in 2002 and to purchase capital assets used in the delivery of our network
management services in both years. We currently have no material commitments for capital expenditures. We used $3.5 million during the six months ended September 30, 2002 and $20.7 million in the six months ended September 30, 2003 to



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purchase short-term investments. Cash provided by the maturity of short-term investments during the six month period ending September 30, 2003 was $15.4
million.



We used $1.2 million during the six months ended
September 30, 2003 to repurchase 193,000 shares of our common stock compared to $2.0 million used during the six months ended September 30, 2002 to purchase 284,000 shares of our common stock. We have approval from our Board of Directors to purchase
up to an aggregate of five million shares, including those previously repurchased. Since the inception of the stock repurchase program, the Company has repurchased 4.4 million shares of its common stock at an aggregate price of approximately $30.1
million. The extent and timing of any additional repurchases will depend on market conditions and other business considerations. Repurchased shares may be held in treasury for general corporate purposes, including use in connection with the
Companys stock option plans, or may be retired.



As of
September 30, 2003, we had $41.9 million in cash and short-term investments, $4.4 million in net accounts receivable and $44.3 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 initiate 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, 2003, we have no debt or off-balance sheet debt. As of September 30, 2003, we have noncancelable
operating lease obligations of approximately $4.3 million. At September 30, 2003, 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.



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.



Revenue Recognition



IT infrastructure management services revenues are recognized in the period services are provided by NetSolve, 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



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based on a flat fee per device 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 debts 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



The Companys remote IT infrastructure management services for WANs typically include a guarantee of 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, the Company generally is obligated to refund its WAN management fees for that month. The Company provides a reserve based on the estimated costs of
these refunds. Historically, guarantee payments have not been significant.



Recent Pronouncements



In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities and
results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For
variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The adoption of FIN 46 did not have a material impact on our
results of operations or financial position.



In May 2003, the
FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of
both liabilities and equity. The provisions of SFAS 150 are effective for financial instruments entered into or modified after May 31, 2003 and to all other instruments that exist as of the beginning of the first interim financial reporting period
beginning after December 15, 2003. The Company is currently evaluating the effect of Interpretation 46. At this time, the Company does not believe that the adoption of Interpretation 46 will have a material impact on our consolidated financial
statements.



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Risk Factors



We may be unable to implement our business strategy and operate profitably in the future.



We may not operate profitably. Our ability to operate profitably in the future depends, among other things, on our ability
to implement our business strategy, which includes broadening our service and channel partner bases, and on increasing sales of our services while maintaining sufficient gross profit margins. We must, among other things:



| |  | maintain satisfactory relationships with existing resellers and network equipment manufacturers;
| | - | ------------------------------------------------------------------------------------------------



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



| |  | develop and sell other IT infrastructure management services;
| | - | -------------------------------------------------------------



| |  | renew the Frame Relay Plus agreement with AT&T beyond the ordering period that currently expires in June of 2004;
| | - | -----------------------------------------------------------------------------------------------------------------



| |  | replace the revenue under the AT&T Managed Router Service agreement that will continue the transition that began in July 2003 to an internal AT&T operating unit;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | maintain and develop a sales and marketing organization that can cost-effectively promote the sale of our services to existing and new customers at consistently sufficient levels;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | develop new service offerings which effectively meet our customers needs and support and utilize ever-evolving technologic advancements;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------



| |  | 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; 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 we are not successful in replacing business being transitioned away by AT&T, and if AT&T discontinues, or materially reduces, its remaining business with us.



Sales to AT&T, which resells our services to its
customers, accounted for 52% of our total revenues in fiscal year 2003 and 44% in the six months ended September 30, 2003. In February of 2003, we were notified by AT&T of its intention to exercise its right to terminate and transition all
existing Managed Router Service orders beginning July 1, 2003, which began an eight-month transition period under this agreement. Managed Router Service revenue under this agreement accounted for approximately 16% of recurring IT Infrastructure
management services revenues in fiscal year 2003 (12% in the six months ended September 30, 2003) and 22% of total revenues in fiscal year 2003 (17% in the six months ended September 30, 2003). In July of 2003, AT&T transitioned The Home Depot
account to an AT&T internal service center. The revenue under this Home Depot agreement accounted for approximately 7% of recurring IT infrastructure management services revenues in fiscal year 2003 (5% in the six months ended September 30,
2003) and 7% of total revenues in fiscal year 2003 (6% in the six months ended September 30, 2003). Although we anticipate being able to replace this business over time, the termination of these agreements will result in diminished prospects for
growth in revenues in the current fiscal year. Furthermore, we cannot be sure that we will be successful in our sales and marketing efforts to replace this business, or that AT&T will continue its remaining business with us.



Our Frame Relay Plus agreement with AT&T is not an exclusive arrangement.
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



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following the expiration of the service terms set forth in our agreements with AT&T, and a further reduction in our AT&T business from any cause
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 including:



| |  | the market for IT infrastructure management services is still evolving, 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;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | 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.



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 of 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 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



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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. Our resellers could use their own internal resources or third parties to replace our services as end user order terms expire.



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 still evolving, 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 IT infrastructure management services. The market for remote IT infrastructure management services is still 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 IT infrastructure management more
cost-effective than remote IT infrastructure management would adversely affect the market for our services. We may also incur fixed costs associated with new services which could lower our earnings if the sales of these services fail to meet our
expectations. 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.



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 resellers may limit our ability to sell our services directly to the resellers customers in the future. If our resellers do not compete successfully against their competitors, we will typically lose such sales opportunities to
those competitors.



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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 83% of our recurring network management services revenues in the six months ended September 30, 2003. 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 IT infrastructure 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 IT infrastructure 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 rapidly evolving market for remote IT infrastructure
management services makes it difficult to determine whether a market will develop for any particular IT infrastructure 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.



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We made a number of changes in our management team in the last fiscal year, and our business will be harmed if our new
management team is unable to implement our strategy.



During fiscal years 2003 and 2004, we made and will continue to make several changes and additions to our management team, including a new chief executive officer, and new leaders over our marketing, sales, development, program management
and human resources areas. We are currently in the process of selecting a new leader for our operations organization. We believe that the individuals now comprising our management team bring experience to help us create, implement and drive our
business strategy, and add breadth and depth of capability to our organization. While each new member of our management team has demonstrated capabilities in previous positions at other organizations, they are new to NetSolve. We may not be
successful in meeting our goals if our management team, individually or collectively, is not able to meet expectations.



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



We derive all of our revenues from IT infrastructure management services and
related resales of equipment. These services can be extremely complex, and in general only highly qualified, highly trained 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 IT infrastructure 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 highly qualified, highly trained 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 methodologies to manage their network processes and may
be reluctant to adopt applications offered by third parties like us.



If the market for outsourced IT infrastructure management services grows as we expect, we believe this market will become highly competitive. Competition is likely to increase significantly as new IT infrastructure management services
companies enter the market and current competitors expand their service and product lines. Many of these



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potential competitors are likely to enjoy substantial competitive advantages, as do some of our current competitors, 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 IT infrastructure 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.
| | - | ---------------------------------------------------------------------



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 network 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



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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 three 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.



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|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.



|Item 4. |  | CONTROLS AND PROCEDURES
|------- |  | -----------------------



The Company, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness
of the design and the operation of the Companys disclosure controls and procedures as of the end of the period covered by this report. Based upon this evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the
disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in the Companys Exchange Act reports is recorded, processed, summarized and reported in a timely manner. There has
been no change in the Companys internal control over financial reporting during the quarter ended September 30, 2003 that has materially affected, or is reasonably likely to materially affect, the Companys internal control over financial
reporting.



PART II. OTHER INFORMATION



|Item 1. |  | LEGAL PROCEEDINGS
|------- |  | -----------------



In December 2001, the Company and certain of our officers and directors, as well as the underwriters of our initial public offering (IPO) and
hundreds of other companies (Issuers), directors and officers and IPO underwriters, were named as defendants in a series of class action shareholder complaints filed in the United States District Court for the Southern District of New
York. Those cases are now consolidated under the caption In re Initial Public Offering Securities Litigation, Case No. 91 MC 92. In the amended complaint, the plaintiffs allege that the Company, certain of our officers and directors and our IPO
underwriters violated section 11 of the Securities Act of 1933 based on allegations that the Companys registration statement and prospectus failed to disclose material facts regarding the compensation to be received by, and the stock
allocation practices of, the IPO underwriters. The complaint also contains a claim for violation of section 10(b) of the Securities Exchange Act of 1934 based on allegations that this omission constituted a deceit on investors. The plaintiffs seek
unspecified monetary damages and other relief.



In February
2003, the Court issued a decision denying the motion to dismiss the Section 11 claims against the Company and almost all of the other Issuers, and granting the motion to dismiss the Section 10(b) claim against the Company. The Court dismissed the
Section 10(b) claim against the Company without leave to amend. In June 2003, the Issuers and Plaintiffs reached a tentative settlement agreement that would, among other things, result in the dismissal with prejudice of all claims against the
Issuers and their officers and directors in the IPO Lawsuits. A special committee of disinterested directors appointed by the board of directors received and analyzed the settlement proposal and determined that, subject to final documentation, the
settlement proposal should be accepted. Although the Company has approved this settlement proposal in principle, it remains subject to a number of procedural conditions, including formal approval by the Court. 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 5. |  | OTHER INFORMATION
|------- |  | -----------------



Pursuant to Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002, we are responsible for
disclosing the approval of non-audit services by the audit committee of our board of directors (the Audit Committee) to be performed by Ernst & Young LLP, our independent auditors. Non-audit services are defined as services other
than those provided in connection with an audit or a review of our financial statements. Except as set forth below, the services approved by the Audit Committee are each considered by the Audit Committee to be audit-related services that are closely
related to the financial audit process. Each of the services was pre-approved by the Audit Committee.



The Audit Committee has also pre-approved additional engagements of Ernst & Young LLP for the non-audit services of preparation of state and federal tax returns, and various small tax consulting services.



|Item 6. |  | EXHIBITS AND REPORTS ON FORM 8-K
|------- |  | --------------------------------



| | (a) | EXHIBITS
| | --- | --------



|ITEMNUMBER |  | EXHIBIT                                                                                                                                                                             
|---------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|           | 
|31.1       |  | Certification of David D. Hood, the registrants chief executive officer, required pursuant to § 302 of the Sarbanes-Oxley Act of 2002                                              
|           | 
|31.2       |  | Certification of Kenneth C. Kieley, the registrants chief financial officer, required pursuant to § 302 of the Sarbanes-Oxley Act of 2002                                          
|           | 
|32.1       |  | 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.    
|           | 
|32.2       |  | 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
| | --- | -------------------



On October 16, 2003, the Company filed a Form 8-K reporting under Item 12 Results of Operation and Financial Condition the Companys
press release, dated October 15, 2003, regarding its second quarter results of operations and financial condition.



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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, 2003 |  |  |  | NETSOLVE, INCORPORATED
|----------------------- |  |  |  | ----------------------
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