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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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QUARTERLY REPORT PURSUANT TO SECTION
13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



For the quarterly period ended September 30, 2004



Commission File Number: 0-24983



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NetSolve, Incorporated

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



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Delaware                                                       |  | 75-2094811-2                     
|(State or Other Jurisdiction of Incorporation or Organization) |  | (IRS Employer Identification No.)



9500 Amberglen
Boulevard

Austin, Texas 78729

(Address of principal executive offices, including zip code)



(512) 340-3000

(Registrants telephone number, including area code)



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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 ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule
126-2).    Yes ̈No  x



Number of shares outstanding of the issuers common stock, $.01 par
value, as of November 8, 2004: 11,739,952



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NETSOLVE, INCORPORATED



INDEX



|         |  |                                                                                                                                               |  |     
|-------- |  | --------------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|         |  |                                                                                                                                               |  | Page
|PART I.  |  | FINANCIAL INFORMATION                                                                                                                         |  |     
|         |  |                                                                                                                                              
|Item 1.  |  | Financial Statements                                                                                                                          |  |     
|         |  |                                                                                                                                              
|         |  | Condensed Consolidated Balance Sheets as of March 31, 2004 and September 30, 2004 (unaudited)                                                 |  | 3   
|         |  |                                                                                                                                              
|         |  | Condensed Consolidated Statements of Operations for the three and six month periods ended September 30, 2003 (unaudited) and 2004 (unaudited) |  | 4   
|         |  |                                                                                                                                              
|         |  | Condensed Consolidated Statements of Cash Flows for the six month periods ended September 30, 2003 (unaudited) and 2004 (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                                                                                    |  | 25  
|         |  |                                                                                                                                              
|Item 4.  |  | Controls and Procedures                                                                                                                       |  | 25  
|         |  |                                                                                                                                              
|PART II. |  | OTHER INFORMATION                                                                                                                             |  |     
|         |  |                                                                                                                                              
|Item 1.  |  | Legal Proceedings                                                                                                                             |  | 25  
|         |  |                                                                                                                                              
|Item 5.  |  | Other Information                                                                                                                             |  | 26  
|         |  |                                                                                                                                              
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                                                                              |  | 26  



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PART I. FINANCIAL INFORMATION



Item 1. Financial Statements



NETSOLVE, INCORPORATED



CONDENSED
CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)



|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | --------- | ------- | - | ----------- | - | ------- | -
|                                                                                                                                                                                                                                           |  | 3/31/2004 |         |   | 9/30/2004   |  
|                                                                                                                                                                                                                                           |  |           |         |   | (unaudited) |  
|ASSETS                                                                                                                                                                                                                                     |  |           |         |   |             |   |         |  
|Current assets:                                                                                                                                                                                                                            |  |           |         |   |             |   |         |  
|Cash and cash equivalents                                                                                                                                                                                                                  |  | $         | 19,885  |   |             | $ | 19,289  |  
|Short-term investments                                                                                                                                                                                                                     |  |           | 20,085  |   |             |   | 20,964  |  
|Restricted cash                                                                                                                                                                                                                            |  |           | 358     |   |             |   | 359     |  
|Accounts receivable, net of allowance for doubtful accounts of $303 at March 31, 2004 and $454 at September 30, 2004                                                                                                                       |  |           | 4,696   |   |             |   | 4,494   |  
|Prepaid expenses and other assets                                                                                                                                                                                                          |  |           | 3,001   |   |             |   | 1,368   |  
|Deferred tax assets                                                                                                                                                                                                                        |  |           | 672     |   |             |   | 672     |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  
|Total current assets                                                                                                                                                                                                                       |  |           | 48,697  |   |             |   | 47,146  |  
|                                                                                                                                                                                                                                           |  |          
|Property and equipment:                                                                                                                                                                                                                    |  |           |         |   |             |   |         |  
|Computer equipment and software                                                                                                                                                                                                            |  |           | 12,553  |   |             |   | 13,024  |  
|Furniture, fixtures and leasehold improvements                                                                                                                                                                                             |  |           | 5,115   |   |             |   | 5,127   |  
|Other equipment                                                                                                                                                                                                                            |  |           | 523     |   |             |   | 423     |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  
|                                                                                                                                                                                                                                           |  |           | 18,191  |   |             |   | 18,574  |  
|Less accumulated depreciation and amortization                                                                                                                                                                                             |  |           | (11,979 | ) |             |   | (13,455 | )
|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  
|Net property and equipment                                                                                                                                                                                                                 |  |           | 6,212   |   |             |   | 5,119   |  
|                                                                                                                                                                                                                                           |  |          
|Deferred tax assets, net of current portion                                                                                                                                                                                                |  |           | 3,053   |   |             |   | 3,307   |  
|Other assets                                                                                                                                                                                                                               |  |           |        |   |             |   | 19      |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  
|Total assets                                                                                                                                                                                                                               |  | $         | 57,962  |   |             | $ | 55,591  |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                                                                                       |  |           |         |   |             |   |         |  
|                                                                                                                                                                                                                                           |  |          
|Current liabilities:                                                                                                                                                                                                                       |  |           |         |   |             |   |         |  
|Accounts payable                                                                                                                                                                                                                           |  | $         | 961     |   |             | $ | 529     |  
|Accrued liabilities                                                                                                                                                                                                                        |  |           | 1,722   |   |             |   | 1,115   |  
|Accrued transaction expenses                                                                                                                                                                                                               |  |           |        |   |             |   | 1,009   |  
|Accrued employee liabilities                                                                                                                                                                                                               |  |           | 814     |   |             |   | 526     |  
|Deferred revenue                                                                                                                                                                                                                           |  |           | 387     |   |             |   | 65      |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  
|Total current liabilities                                                                                                                                                                                                                  |  |           | 3,884   |   |             |   | 3,244   |  
|                                                                                                                                                                                                                                           |  |          
|Stockholders equity:                                                                                                                                                                                                                      |  |           |         |   |             |   |         |  
|Common stock, $.01 par value; 25,000,000 shares authorized at March 31, 2004 and September 30, 2004; 16,085,635 issued and 11,628,149
outstanding at March 31, 2004 and 16,195,186 issued and 11,737,700 outstanding at September 30, 2004 |  |           | 160     |   |             |   | 161     |  
|Additional paid-in capital                                                                                                                                                                                                                 |  |           | 84,831  |   |             |   | 85,586  |  
|Treasury stock                                                                                                                                                                                                                             |  |           | (30,888 | ) |             |   | (30,888 | )
|Retained earnings (accumulated deficit)                                                                                                                                                                                                    |  |           | (25     | ) |             |   | (2,512  | )
|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  
|Total stockholders equity                                                                                                                                                                                                                 |  |           | 54,078  |   |             |   | 52,347  |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  
|Total liabilities and stockholders equity                                                                                                                                                                                                 |  | $         | 57,962  |   |             | $ | 55,591  |  
|                                                                                                                                                                                                                                           |  |           |         |   |             |   |         |  



See accompanying notes.



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NETSOLVE, INCORPORATED



CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)



|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|------------------------------------------------------------- |  | ------------------ | ------ | - | ---------------- | - | ------ | --------- |  | - | --------- | - |  | - | ------ | -
|                                                              |  | Three Months Ended |        |   | Six Months Ended |  
|                                                              |  | 9/30/2003          |        |   | 9/30/2004        |   |        | 9/30/2003 |  |   | 9/30/2004 |  
|                                                              |  | (unaudited)        |        |   | (unaudited)      |  
|Revenues:                                                     |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|IT infrastructure management services                         |  | $                  | 9,756  |   |                  | $ | 8,840  |           |  | $ | 19,809    |   |  | $ | 17,651 |  
|Maintenance and equipment                                     |  |                    | 2,121  |   |                  |   | 1,162  |           |  |   | 4,600     |   |  |   | 2,461  |  
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Total revenues                                                |  |                    | 11,877 |   |                  |   | 10,002 |           |  |   | 24,409    |   |  |   | 20,112 |  
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Costs of revenues:                                            |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|IT infrastructure management services                         |  |                    | 5,605  |   |                  |   | 5,271  |           |  |   | 11,803    |   |  |   | 10,799 |  
|Maintenance and equipment                                     |  |                    | 1,515  |   |                  |   | 851    |           |  |   | 3,319     |   |  |   | 1,703  |  
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Total costs of revenues                                       |  |                    | 7,120  |   |                  |   | 6,122  |           |  |   | 15,122    |   |  |   | 12,502 |  
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Gross profits:                                                |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|IT infrastructure management services                         |  |                    | 4,151  |   |                  |   | 3,569  |           |  |   | 8,006     |   |  |   | 6,852  |  
|Maintenance and equipment                                     |  |                    | 606    |   |                  |   | 311    |           |  |   | 1,281     |   |  |   | 758    |  
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Total gross profits                                           |  |                    | 4,757  |   |                  |   | 3,880  |           |  |   | 9,287     |   |  |   | 7,610  |  
|                                                              |  |                    |        |  
|Operating expenses:                                           |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Development                                                   |  |                    | 1,284  |   |                  |   | 1,111  |           |  |   | 2,764     |   |  |   | 2,199  |  
|Selling and marketing                                         |  |                    | 2,347  |   |                  |   | 2,007  |           |  |   | 4,438     |   |  |   | 4,184  |  
|General and administrative                                    |  |                    | 1,346  |   |                  |   | 1,132  |           |  |   | 2,584     |   |  |   | 2,271  |  
|Transaction expenses                                          |  |                    |       |   |                  |   | 1,846  |           |  |   | 276       |   |  |   | 1,846  |  
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Total operating expenses                                      |  |                    | 4,977  |   |                  |   | 6,096  |           |  |   | 10,062    |   |  |   | 10,500 |  
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Operating loss                                                |  |                    | (220   | ) |                  |   | (2,216 | )         |  |   | (775      | ) |  |   | (2,890 | )
|                                                              |  |                    |        |  
|Other income (expense):                                       |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Interest income                                               |  |                    | 65     |   |                  |   | 128    |           |  |   | 230       |   |  |   | 203    |  
|Other, net                                                    |  |                    |       |   |                  |   | (1     | )         |  |   |          |   |  |   | (4     | )
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Total other income                                            |  |                    | 65     |   |                  |   | 127    |           |  |   | 230       |   |  |   | 199    |  
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Loss before income taxes                                      |  |                    | (155   | ) |                  |   | (2,089 | )         |  |   | (545      | ) |  |   | (2,691 | )
|Income tax benefit                                            |  |                    | (56    | ) |                  |   |       |           |  |   | (208      | ) |  |   | (204   | )
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Net loss                                                      |  | $                  | (99    | ) |                  | $ | (2,089 | )         |  | $ | (337      | ) |  | $ | (2,487 | )
|                                                              |  |                    |        |   |                  |   |        |           |  |   |           |   |  |   |        |  
|Basic net loss per share                                      |  | $                  | (0.01  | ) |                  | $ | (0.18  | )         |  | $ | (0.03     | ) |  | $ | (0.21  | )
|Weighted average shares used in basic per share calculation   |  |                    | 11,211 |   |                  |   | 11,682 |           |  |   | 11,350    |   |  |   | 11,663 |  
|                                                              |  |                    |        |  
|Diluted net loss per share                                    |  | $                  | (0.01  | ) |                  | $ | (0.18  | )         |  | $ | (0.03     | ) |  | $ | (0.21  | )
|Weighted average shares used in diluted per share calculation |  |                    | 11,211 |   |                  |   | 11,682 |           |  |   | 11,350    |   |  |   | 11,663 |  



See accompanying notes.



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NETSOLVE, INCORPORATED



CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                |  |                  |         |   |           |   |         |  
|------------------------------------------------------------------------------- |  | ---------------- | ------- | - | --------- | - | ------- | -
|                                                                                |  | Six Months Ended |        
|                                                                                |  | 9/30/2003        |         |   | 9/30/2004 |  
|                                                                                |  | (unaudited)      |        
|Cash flows from operating activities:                                           |  |                  |         |   |           |   |         |  
|Net loss                                                                        |  | $                | (337    | ) |           | $ | (2,487  | )
|                                                                                |  |                 
|Adjustments to reconcile net loss to net cash provided by operating activities: |  |                  |         |   |           |   |         |  
|Depreciation and amortization                                                   |  |                  | 1,734   |   |           |   | 1,533   |  
|Loss on disposition of property and equipment                                   |  |                  | 3       |   |           |   | 1       |  
|Transaction expenses                                                            |  |                  |        |   |           |   | 1,009   |  
|Change in assets and liabilities:                                               |  |                  |         |   |           |   |         |  
|Accounts receivable, net                                                        |  |                  | 1,627   |   |           |   | 202     |  
|Prepaid expenses and other assets                                               |  |                  | (715    | ) |           |   | 1,614   |  
|Deferred tax assets                                                             |  |                  | (4      | ) |           |   | (254    | )
|Accounts payable                                                                |  |                  | (723    | ) |           |   | (432    | )
|Accrued liabilities                                                             |  |                  | (18     | ) |           |   | (895    | )
|Unearned revenue                                                                |  |                  | (58     | ) |           |   | (322    | )
|                                                                                |  |                  |         |   |           |   |         |  
|Net cash provided by (used in) operating activities                             |  |                  | 1,509   |   |           |   | (31     | )
|                                                                                |  |                  |         |   |           |   |         |  
|Cash flows from investing activities:                                           |  |                  |         |   |           |   |         |  
|Purchases of short-term investments                                             |  |                  | (20,727 | ) |           |   | (39,205 | )
|Sale of short-term investments                                                  |  |                  | 15,414  |   |           |   | 38,326  |  
|Transfer of funds to restricted cash                                            |  |                  | (1      | ) |           |   | (1      | )
|Purchases of property and equipment                                             |  |                  | (2,697  | ) |           |   | (441    | )
|                                                                                |  |                  |         |   |           |   |         |  
|Net cash used in investing activities                                           |  |                  | (8,011  | ) |           |   | (1,321  | )
|                                                                                |  |                  |         |   |           |   |         |  
|Cash flows from financing activities:                                           |  |                  |         |   |           |   |         |  
|Repurchase of common stock                                                      |  |                  | (1,176  | ) |           |   |        |  
|Proceeds from exercise of common stock options and warrants                     |  |                  | 758     |   |           |   | 756     |  
|                                                                                |  |                  |         |   |           |   |         |  
|Net cash provided by (used in) financing activities                             |  |                  | (418    | ) |           |   | 756     |  
|                                                                                |  |                  |         |   |           |   |         |  
|Net change in cash and cash equivalents                                         |  |                  | (6,920  | ) |           |   | (596    | )
|Cash and cash equivalents, beginning of period                                  |  |                  | 28,073  |   |           |   | 19,885  |  
|                                                                                |  |                  |         |   |           |   |         |  
|Cash and cash equivalents, end of period                                        |  | $                | 21,153  |   |           | $ | 19,289  |  
|                                                                                |  |                  |         |   |           |   |         |  
|Supplemental disclosure of cash flow information:                               |  |                  |         |   |           |   |         |  
|Cash paid for interest                                                          |  | $                |        |   |           | $ |        |  
|                                                                                |  |                  |         |   |           |   |         |  
|Income taxes paid                                                               |  | $                | 7       |   |           | $ | 3       |  
|                                                                                |  |                  |         |   |           |   |         |  



See accompanying notes.



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NETSOLVE, INCORPORATED



NOTES TO
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2004



Information with respect to the three and six months ended September 30, 2003 and 2004 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 ongoing IT infrastructure management services and, to a lesser extent, network configuration and design and installation and
implementation coordination services. 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 to an entity in Japan. 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, 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, 2004, which can be found in the Companys annual report on Form 10-K, as filed on June 9, 2004 (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. Pending Acquisition of the Company by Cisco Systems, Inc.



On September 9, 2004, the Company entered into a definitive agreement to be acquired by Cisco Systems, Inc. (Cisco), a leading manufacturer
and vendor of networking and communications products and a provider of services associated with that equipment and its use. The merger agreement contemplates that the proposed acquisition will be effected by the merger of a wholly owned subsidiary
of Cisco with and into the Company, whereby, upon the completion of such merger, the Company will become a wholly owned subsidiary of Cisco. Under the terms of the merger agreement, each holder of shares of the outstanding common stock of the
Company will be entitled to receive $11.00 in cash, less applicable withholding taxes, for each share of the Companys common stock held by such holder as determined at the effective time of the merger. Costs associated with this transaction
include banker, attorney and accountant fees. Completion of the proposed merger, which is expected to close in the fourth quarter of calendar 2004, is subject to the approval of the stockholders of the Company and other customary closing conditions.
To this end, the Company commenced the mailing of a Notice of Special Meeting of Stockholders together with a proxy statement and form of proxy on October 22, 2004 for the purpose of obtaining stockholder approval of the merger. The special meeting
of the Companys stockholders is scheduled to be held on Thursday, November 18, 2004 at 4:00 p.m., Central Standard Time, at the principal offices of the Company in Austin, Texas. There can be no assurance that the merger will be consummated.
In the event that the merger is terminated under certain circumstances, the Company will be required to pay Cisco a termination fee of $4.125 million. Risks associated with the delay in the completion of, or the inability to complete, the proposed
merger appear in Item 2 of this quarterly report on Form 10-Q under the caption Risk Factors.



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NETSOLVE, INCORPORATED



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

September 30, 2004



4. Earnings Per Share



The Companys earnings per share data are presented in accordance with SFAS 128,Earnings Per Share. Basic net loss per share is computed by
dividing the net loss available to common stockholders for the period by the weighted average number of common shares outstanding during the period, excluding shares subject to repurchase or forfeiture. Pursuant to Statement of Financial Accounting
Standards No. 128, the effect of the assumed exercise of stock options and contingently issued shares has not been included as it is antidilutive.



5. Contingencies



In December 2001, the Company and certain of its officers and directors, as well as the underwriters of its 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 its officers and directors and its
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.



On September 14, 2004, two lawsuits were filed in the District Court of
Travis County, Texas against the Company and its directors by purported shareholders of the Company on behalf of a putative class of shareholders. The plaintiffs claim self dealing and breaches of fiduciary duty on the part of the directors in
connection with the announced agreement between the Company and Cisco Systems, Inc. for the acquisition of the Company for a purchase price of $11.00 per share in cash (Acquisition). The plaintiffs seek injunctive relief, including
enjoining the Company and the directors from consummating the Acquisition, and attorneys fees. The Company believes that the plaintiffs claims are without merit. The Company and the directors intend to vigorously defend these lawsuits.
As with any litigation, the Company is unable at this early stage to predict the outcome of the lawsuits or the impact of their pendency on the Company and the consummation of the Acquisition.



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NETSOLVE, INCORPORATED



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

September 30, 2004



6. 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 loss.



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
weighted-average assumptions were used to estimate the fair value of options:



|                        |  |                               |   |  |         |  
|----------------------- |  | ----------------------------- | - |  | ------- | -
|                        |  | Six months endedSeptember 30, |  
|                        |  | 2003                          |   |  | 2004    |  
|Expected life           |  | 4 years                       |   |  | 4 years |  
|Expected volatility     |  | 49.7                          | % |  | 51.0    | %
|Risk-free interest rate |  | 2.5                           | % |  | 3.4     | %
|Dividend expense yield  |  | None                          |   |  | None    |  



The following table
illustrates the effect on net loss and loss 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, |  
|                                                                                                                                  |  | 2003                            |       |   | 2004                          |   |        | 2003 |  |   | 2004   |  
|Reported net income (loss)                                                                                                        |  | $                               | (99   | ) |                               | $ | (2,089 | )    |  | $ | (337   | ) |  | $ | (2,487 | )
|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       |  |                                 | (621  | ) |                               |   | (655   | )    |  |   | (1,331 | ) |  |   | (1,123 | )
|                                                                                                                                  |  |                                 |       |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Pro forma net income (loss) from continuing operations (in thousands)                                                             |  |                                 | (720  | ) |                               |   | (2,744 | )    |  |   | (1,668 | ) |  |   | (3,610 | )
|                                                                                                                                  |  |                                 |       |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Basic net loss per share:                                                                                                         |  |                                 |       |   |                               |   |        |      |  |   |        |   |  |   |        |  
|Reported net loss per share                                                                                                       |  |                                 | (0.01 | ) |                               |   | (0.18  | )    |  |   | (0.03  | ) |  |   | (0.21  | )
|Pro forma basic net loss per share                                                                                                |  |                                 | (0.06 | ) |                               |   | (0.23  | )    |  |   | (0.15  | ) |  |   | (0.31  | )



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NETSOLVE, INCORPORATED



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

September 30, 2004



7. Effective Tax Rate



For the three months ended September 30, 2003 and 2004, the effective rate was 36.1% and 0%, respectively. For the six months ended September 30,
2003 and 2004, the effective rate was 38.1% and 7.6%, respectively. This effective rate variance is due to the consideration of estimated year-end earnings in estimating the quarterly effective rate, the recording of a valuation allowance on certain
deferred tax assets, and the effect of significant potential nondeductible items related to transaction costs.



8. Recent Pronouncements



In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 (FIN 46), CONSOLIDATION OF VARIABLE INTEREST ENTITIES,
AN INTERPRETATION OF ARB NO. 51, which addresses consolidation by business enterprises of variable interest entities (VIEs) either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without
additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 (Revised
Interpretations) resulting in multiple effective dates based on the nature as well as the creation date of the VIE. VIEs created after January 31, 2003, but prior to January 1, 2004, may be accounted for either based on the original interpretation
or the Revised Interpretations. However, the Revised Interpretations must be applied no later than the first quarter of fiscal year 2004. VIEs created after January 1, 2004 must be accounted for under the Revised Interpretations. The adoption of FIN
46 did not have a material impact on our results of operations or financial position.



In October 2004, the FASB concluded that Statement 123R, SHARE-BASED PAYMENT, which would require all companies to measure compensation cost for all share-based payments (including employee stock options) at fair
value, would be effective for public companies (except small business issuer as defined in SEC Regulation S-B) for interim or annual periods beginning after June 15, 2005. Upon final ruling the Company will evaluate the effect that the adoption of
Statement 123R will have on its financial position and results of operations.



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 and orders from customers for our services, company growth, sales, margin and expenses, cash flow needs and the drivers behind those trends and projections and orders from customers
for our services. Although we believe that in making any such statement our expectations are based on reasonable assumptions, any such statement involves known and unknown risks and uncertainties and is qualified in its entirety by reference to the
risks discussed below under Risk Factors and to the following factors, among others, that could cause our actual results to differ materially from those projected in such forward-looking statements: general and economic business
conditions; conditions affecting



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the industries served by the Company; the effect of national and international political and economic conditions; 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 develop new
service offerings and the market acceptance of such offerings; our ability to maintain and develop new arrangements with resellers and network equipment manufacturers; 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, exploration of potential business opportunities, 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 IT infrastructure-specific activities in order to increase IT infrastructure 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 Japan. 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 Japan. We expect a new agreement that will replace the existing licensing agreement will be finalized in the third quarter of fiscal
year 2005. 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 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, 2004, approximately 89% of IT infrastructure management services revenues were from recurring services.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Nonrecurring IT infrastructure management services consist primarily of project implementation services and equipment installation services. Nonrecurring IT infrastructure
management services primarily relate to services performed to assist customers in implementing new networks. Nonrecurring IT infrastructure management services 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.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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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 fiscal year 2004 and in the six months ended September 30, 2004. 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 customer
premise equipment (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, 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 not be significant, and could decline, as we seek to manage our mix of revenues.



We have derived a significant portion of our revenues from one reseller,
AT&T, which is discussed below. In addition, in the six months ended September 30, 2004, we derived 12% of our total revenue from IBM. No other customers or resellers accounted for more than 10% of our revenues in any of the last three fiscal
years or in the six months ended September 30, 2004.



At the
beginning of fiscal year 2004, we 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 Relay Plus offering; and one for the management of the WAN
for one large end user  The Home Depot. AT&T has sold our services to their customers in conjunction with AT&Ts overall network solution offering using AT&Ts trade and brand names. As with our other reseller
arrangements, we receive our revenues for the resale of our services to AT&T customers directly from AT&T. AT&T accounted for 52% of our total revenues in fiscal year 2003, 39% of our total revenues in fiscal year 2004, and 24% of our
total revenues in the six months ended September 30, 2004.



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



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of its intention to terminate the Home Depot agreement in July of 2003. Primarily as a result of these terminations,
total revenues from AT&T decreased to $17.9 million in fiscal year 2004 from $26.1 million in fiscal year 2003, and decreased to $4.9 million in the six months ended September 30, 2004 from $10.7 million in the six months ended September 30,
2003.



The agreement for Frame Relay Plus Service provides for
NetSolve to deliver the services for the original end-user service term of each order (subject to certain exceptions specifically set forth in the agreement), up to a maximum service term of 36 months, and further provides AT&T the option to
continue the services on a month-to-month basis following the expiration of the service term for individual end users. The Frame Relay Plus Service agreement with AT&T was renewed in July 2003 and terminated on June 30, 2004 with respect to
placing new orders for service. Services under this agreement accounted for 23% of our total revenues in fiscal year 2003, 22% of our total revenues in fiscal year 2004, and 24% of our total revenues in the six months ended September 30, 2004. As of
September 30, 2004, we are providing this service to 597 of AT&Ts end user customers and expect total revenues of $2.1 million in the quarter ending December 31, 2004. Should AT&T elect not to renew this agreement during the quarter
ending December 31, 2004, a portion of this revenue could be at risk. We anticipate that this agreement will be renewed effective in January 2005 at a discount to the pricing under the current agreement.



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



We anticipate that we will grow our revenues by developing new services internally; expanding the number of reseller channels; increasing the
effectiveness of our existing reseller channels; and expanding our sales and marketing function as new order rates become more predictable. We may also elect to enhance our future growth prospects by engaging in merger and acquisition (M&A)
activities on an opportunistic basis should the current proposed merger with Cisco Systems not be completed.



Results of Operations



Three months
ended September 30, 2003 compared to three months ended September 30, 2004



Revenues



Total
revenues.Total revenues decreased 16%, from $11.9 million in the three months ended September 30, 2003 to $10.0 million in the three months ended September 30, 2004.



IT infrastructure management services.Revenues from IT infrastructure management services decreased 9%, from $9.8
million in the three months ended September 30, 2003 to $8.8 million in the three months ended September 30, 2004, representing 82% of total revenues in the three months ended September 30, 2003 and 88% in the three months ended September 30, 2004.
The dollar decrease was due primarily to the termination of the AT&T Managed Router Service and Home Depot Agreements discussed above and to a lesser extent a decrease in revenue from software licensing fees.



Maintenance and equipment.Maintenance and equipment revenues
decreased 45%, from $2.1 million in the three months ended September 30, 2003 to $1.2 million in the three months ended September 30, 2004. Revenues from maintenance and equipment decreased primarily due to the termination of the AT&T Managed
Router Service and Home Depot Agreements discussed above.



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



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providers of CPE installation services. Cost of IT infrastructure management services is expensed as incurred. Cost of IT
infrastructure management services decreased 6%, from $5.6 million in the three months ended September 30, 2003 to $5.3 million in the three months ended September 30, 2004, representing 57% of IT infrastructure management services revenues in the
three months ended September 30, 2003 and 60% in the three months ended September 30, 2004. The dollar decrease was due primarily to a decrease in the number of employees and a decrease in amortized software development costs related to a software
licensing agreement.



Cost of maintenance and equipment.Cost of maintenance and equipment includes the purchase of maintenance contracts and CPE from manufacturers and distributors for resale to end users. These costs are expensed in the period the related revenues are recognized. Cost of maintenance
and equipment decreased 44% from $1.5 million in the three months ended September 30, 2003 to $851,000 in the three months ended September 30, 2004, representing 71% of maintenance and equipment revenues in the three months ended September 30, 2003
and 73% of maintenance and equipment revenues in the three months ended September 30, 2004. The decrease in dollars was primarily due to the decrease in maintenance revenue as a result of the termination of the AT&T Managed Router Service and
Home Depot Agreements discussed above.



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 decreased 13% from $1.3 million in the three months ended September 30, 2003 to $1.1 million in the three months ended September 30, 2004, representing 11% of total revenues in the three months ended September 30, 2003
and 2004. The decrease in dollars was primarily due to a decrease in contract programming services.



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 decreased 14%, from $2.3 million in the three months ended September 30, 2003 to $2.0 million in the three months ended September 30, 2004, representing 20% of total revenues in the three
months ended September 30, 2003 and 2004. The decrease in spending was due primarily to a decrease in spending on marketing programs and lower outside commissions for acquired customers. This decrease was partially offset by increased spending
related to the addition of sales personnel.



General and
administrative.General and administrative expenses consist primarily of expenses related to our human resources, finance and executive departments. Included in human resources spending is a majority of costs of recruiting and relocating new
employees. General and administrative expenses decreased 16%, from $1.3 million in the three months ended September 30, 2003 to $1.1 million in the three months ended September 30, 2004, representing 11% of total revenues in the three months ended
September 30, 2003 and 2004. The dollar decrease was due primarily to severance payments to terminated employees which occurred in the previous year.



Transaction Expenses.In the three months ended September 30, 2004, approximately $1.8 million in charges were recorded representing expenses
associated with the proposed merger with Cisco and other M&A-related activities.



Other income, net



Other income, net consists primarily of interest income earned on our cash balances. Other income, net increased from $65,000 in the three months ended September 30, 2003 to $127,000 in the three months ended September 30, 2004. The
increase was due primarily to higher average interest rates on cash balances for the three months ended September 30, 2004 compared to the same period in the prior year.



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Income taxes



During the quarter ended September 30, 2004, we recorded a valuation allowance of approximately $450,000 due to
managements determination that it is more likely than not that certain deferred tax assets (primarily net operating losses) would not be realized. The recording of the valuation allowance resulted in no net tax provision or benefit being
recorded in the second quarter.



Six months ended September 30, 2003
compared to six months ended September 30, 2004



Revenues



Total revenues.Total
revenues decreased 18%, from $24.4 million in the six months ended September 30, 2003 to $20.1 million in the six months ended September 30, 2004.



IT infrastructure management services.Revenues from IT infrastructure management services decreased 11%, from $19.8 million in the six months
ended September 30, 2003 to $17.7 million in the six months ended September 30, 2004, representing 81% of total revenues in the six months ended September 30, 2003 and 88% in the six months ended September 30, 2004. The dollar decrease was due
primarily to the termination of the AT&T Managed Router Service and Home Depot Agreements discussed above and to a lesser extent 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 an increase in the number of managed devices under contract through direct sales and non-AT&T channels.



Maintenance and equipment.Revenues from maintenance and equipment decreased 47%, from $4.6 million in the six months
ended September 30, 2003 to $2.5 million in the six months ended September 30, 2004. Revenues from maintenance and equipment decreased primarily due to the termination of the AT&T Managed Router Service and Home Depot Agreements discussed above.



Costs of revenues



Cost of IT infrastructure management services.Cost of IT
infrastructure management services decreased 9%, from $11.8 million in the six months ended September 30, 2003 to $10.8 million in the six months ended September 30, 2004, representing 60% of IT infrastructure management services revenues in the six
months ended September 30, 2003 and 61% in the six months ended September 30, 2004. The dollar decrease was due primarily to a decrease in the number of employees and to a lesser extent lower employee education expenses.



Cost of maintenance and equipment.Cost of maintenance and equipment
decreased 49%, from $3.3 million in the six months ended September 30, 2003 to $1.7 million in the six months ended September 30, 2004, representing 72% of maintenance and equipment revenues in the six months ended September 30, 2003 and 69% of
maintenance and equipment revenues in the six months ended September 30, 2004. The decrease in dollars and as a percentage of revenue was primarily due to the decrease in lower margin maintenance revenue as a result of the termination of the
AT&T Managed Router Service and Home Depot Agreements discussed above.



Operating expenses



Development.Development expenses decreased 20% from $2.8 million in the six months ended September 30, 2003 to $2.2 million in the six months ended September 30, 2004, representing 11% of total revenues in the six months ended
September 30, 2003 and 2004. The decrease in dollars was primarily due to a decrease in contract programming services and to a lesser extent a decrease in severance payments to terminated employees which occurred in the previous year.



Selling and marketing.Selling and marketing expenses decreased 6%,
from $4.4 million in the six months ended September 30, 2003 to $4.2 million in the six months ended September 30, 2004, representing 18% of total



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revenues in the six months ended September 30, 2003 and 21% in the six months ended September 30, 2004. The decrease in
spending was due primarily to a decrease in spending on marketing programs and outside commissions for acquired customers. This decrease was partially offset by increased spending related to the addition of sales personnel.



General and administrative.General and administrative expenses
decreased 21%, from $2.9 million in the six months ended September 30, 2003 to $2.3 million in the six months ended September 30, 2004, representing 12% of total revenues in the six months ended September 30, 2003 and 11% in the six months ended
September 30, 2004. The dollar decrease was due primarily to approximately $276,000 related to exploration of potential M&A activities which occurred in the previous year, a decrease in severance payments in the current year and to a lesser
extent lower costs resulting from a decrease in the number of general and administrative personnel.



Transaction Expenses.In the six months ended September 30, 2004, approximately $1.8 million in charges were recorded representing expenses
associated with the proposed merger with Cisco and other M&A-related activities.



Other income, net



Other income, net decreased from $230,000 in the six months ended September 30, 2003 to $199,000 in the six months ended September 30, 2004. The decrease was primarily due to lower average interest rates earned on invested cash during the
six months ended September 30, 2004 compared to the six months ended September 30, 2003 and to a lesser extent lower average cash balances.



Quarterly results of operations



Results of operations have varied from quarter to quarter. Accordingly, we believe that period-to-period comparisons of results of operations are not
necessarily meaningful and should not be relied upon as indications of future performance. Our operating results may fluctuate as a result of many factors, including our ability to renew or retain existing end user and reseller relationships, our
ability to successfully enter into new reseller or end user relationships, our ability to develop and market new service offerings, the cost of introducing such offerings and the profitability thereof, and the level and nature of competition.
Further, we may be unable to adjust spending rapidly enough to compensate for any significant fluctuations in the number of new managed devices implemented in a given period. Any significant shortfall in the number of new managed devices could
therefore seriously damage our business. Finally, there can be no assurance that we will 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 period ended
September 30, 2003 was $1.5 million. Net cash used in operating activities during the six month period ended September 30, 2004 was $31,000.



We used $2.7 million during the six months ended September 30, 2003 and $441,000 in the six months ended September 30, 2004 to purchase capital assets
used in the delivery of our network management services. We currently have no material commitments for capital expenditures. We used $20.7 million during the six months ended September 30, 2003 and $39.2 million in the six months ended September 30,
2004 to purchase short-term investments. Cash provided by the maturity of short-term investments was $15.4 million during the six month period ending September 30, 2003 and $38.3 million during the six month period ending September 30, 2004.



We have approval from our Board of Directors to purchase up to
an aggregate of six million shares of our common stock, including those previously repurchased. Since the inception of the stock repurchase program, we have repurchased 4.5 million shares of our common stock at an aggregate price of approximately
$30.9 million. The extent and timing of any additional repurchases will depend on market conditions and other business



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considerations. Repurchases have been suspended during the pendency of our merger with Cisco. Repurchased shares may be
held in treasury for general corporate purposes, including use in connection with our stock option plans, or may be retired. There were no repurchases of our common stock in the six months ended September 30, 2004.



As of September 30, 2004, we had $40.3 million in cash and short-term
investments, $4.5 million in net accounts receivable and $43.9 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 and
capital expenditures 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, 2004, we
have no debt or off-balance sheet debt. As of September 30, 2004, we have noncancelable operating lease obligations of approximately $2.9 million. At September 30, 2004, 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.



As of September 30, 2004, we had net operating loss carryforwards of approximately $8.2 million available to offset future net income for U.S. federal
income tax purposes. These net operating loss carryforwards will expire beginning in 2005 if not utilized. We have alternative minimum tax credit carryforwards of $302,000 which do not expire. We also have foreign tax credits of $338,000 that expire
beginning in 2006 if not utilized. Our utilization of these net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the change in ownership provisions of the Internal Revenue Code. The
annual limitation may result in the expiration of the net operating losses before utilization.



A valuation allowance has been provided to offset a portion of the deferred tax assets related to foreign tax credits and net operating losses. During the quarter ended September 30, 2004, we recorded a valuation
allowance of approximately $450,000 due to managements determination that it is more likely than not that certain deferred tax assets (primarily net operating losses) would not be realized. The recording of the valuation allowance resulted in
no net tax provision or benefit being recorded in the second quarter. At this time, the Company believes that it is more likely than not that the balance of the deferred tax assets will be utilized. Future operating results could alter these
conclusions, potentially resulting in the recording of an additional provision for income taxes.



Critical Accounting Policies



General



The discussion and analysis of our
financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial
statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on
various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.
Estimates and assumptions are reviewed periodically. Actual results may differ from these estimates under different assumptions or conditions.



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Revenue Recognition



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



Receivables



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



Availability Reserve



Our remote 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, we generally are obligated to refund its WAN management fees for that month. We provide a reserve based on the estimated costs of these refunds. Historically,
guarantee payments have not been significant.



Risk Factors



Our business may be seriously impaired if the pending acquisition of us by Cisco is
delayed or is not completed.



On September 9, 2004, we
announced that we had entered into a merger agreement to be acquired by Cisco. Our expectation is that the merger will close in the fourth quarter of calendar 2004. The merger agreement provides for numerous conditions to closing, many of which are
beyond our control. Any failure to conclude the pending merger could have negative effects on our business in a number of areas including, but not limited to, the following:



| |  | our business reputation within the investment community may be damaged, and we may be perceived as a less attractive acquisition candidate by other companies;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | considerable management time and attention have been devoted to the pending merger which will negatively impact our short term operating results until our managements focus is
re-oriented to promoting our business operations as an independent company;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | as we have provided Cisco with access to our confidential information, personnel and business plans and strategies through the course of its due diligence investigation of us, not
all of which may be protected under the terms of our non-disclosure agreement with Cisco, Cisco has the knowledge and the means to become a formidable competitor to us either through the potential acquisition of one or more of our current
competitors or the internal development of information technology (IT) infrastructure management services that effectively compete with our services; moreover, any services offered by Cisco as an alternative to our services potentially could be
offered at prices lower than those charged for our services and could be packaged with other Cisco products and services making them easier for Cisco to sell in competition to us;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | with the prospect of Cisco entering the IT infrastructure management services market, competitors of Cisco may increase their efforts to develop services that compete with our
services in order to compete more effectively with Cisco, resulting in an escalation of competitive forces within our market that could adversely affect our operating results and growth prospects;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Cisco could cease working with us in joint selling opportunities, and/or cease recommending our services to their customers, which would adversely affect our ability to expand our
customer base and could result in the loss of our current customers;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our employee morale could be negatively affected and we could suffer the loss of key employees or members of our management team; moreover, as we do not have an employee
non-solicitation agreement with Cisco, Cisco is not contractually precluded from hiring our employees;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our contract to manage portions of Ciscos internal network, which accounted for 8% of our total management revenues in our second fiscal quarter ended September 30, 2004,
could potentially be canceled by Cisco;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | as our business strategy in recent years has emphasized the sale of our services through resellers and because most of our reseller partners are also resellers of Cisco products and
services, should Cisco announce that it will cease to continue its business relationship with us, it is possible that many of our current resellers may decrease the level of their endorsement of our services in their resale activities and elect not
to renew their agreements with us upon their expiration, and that new reseller prospects may not enter into reseller agreements with us, which in turn would hamper our ability to maintain our current end user base or add new end users;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | current and prospective customers could delay their buying decisions while they assess the impact on us of remaining an independent company, and also seek shorter service terms or
delay the renewal of their existing contracts in order to evaluate alternative solutions in the market, including those that may be offered by Cisco;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Cisco could be less willing to work with our development organization making the development of new software tools that we use to provide our services more difficult;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our financial condition will have been weakened as a result of the costs incurred in connection with the proposed merger with Cisco and our other merger activities in fiscal year
2005; and
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our stock price could fall, perhaps precipitously, which could subject us to lawsuits from our stockholders in which they may seek the recovery of substantial damages.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------



We may be unable to implement our business strategy and
achieve profitability.



We may not operate profitably. Our
ability to regain profitability depends, among other things, on our ability to implement our business strategy, which includes broadening and increasing the effectiveness of our base of



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reseller channels and broadening our service offerings, and on increasing sales of our services while maintaining
sufficient gross profit margins. We must, among other things:



| |  | maintain satisfactory relationships with, and increase the effectiveness of existing resellers and network equipment manufacturers;
| | - | -----------------------------------------------------------------------------------------------------------------------------------



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



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



| |  | 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 and sell 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;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | reduce the costs of our non-WAN services to levels comparable with our current WAN offerings as revenues from these offerings increase; 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 renewing the AT&T Frame Relay Plus agreement or if AT&T discontinues, or materially reduces, that business with us.



Our Frame Relay Plus agreement with AT&T is not an exclusive arrangement. We cannot assure that AT&T will renew that agreement or that any renewal
will be on favorable terms. Even if this agreement is renewed, the anticipated price reductions could significantly reduce the gross margins from this business in both dollar and percentage of revenue terms. Further, even with a renewal of this
agreement, AT&T may not continue to sell our services to existing or additional AT&T customers, or continue to utilize our services following the expiration of the service terms under this agreement. A reduction in this 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, IBM and other resellers, and our revenues therefore depend significantly on the willingness and ability of our resellers to sell
our services to their customers;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | 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 maintenance services from other sources; therefore, we anticipate that our revenues from equipment maintenance
resales could decline;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



| |  | the implementation schedules of our customers may vary in duration, resulting in higher or lower levels of new recurring IT infrastructure management services revenues and
fluctuating levels of the related nonrecurring revenues;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | 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, develop and maintain these alternative sales channels in order to increase our revenues and become consistently
profitable. We must maintain a positive relationship with Cisco to maintain and add relationships with their resellers, many of which are current or potential resellers of our services. 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 and IBM,
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 and IBM, generally do not require that the resellers sell any minimum level of our services and
generally do not restrict the resellers development or sale of competitive services. We cannot be sure that these resellers will dedicate resources or give priority to selling our services. In addition, resellers may seek to make us reduce the
prices for our services in order to lower the total price of their equipment, software or service offerings. 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.



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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 ability of manufacturers of networking equipment to reduce operating complexity, 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.



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 81% of our recurring network management services revenues in fiscal year 2004 and 71% in the six months ended September 30, 2004. Likewise, a substantial portion of our nonrecurring network management services and equipment
maintenance 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 reduce costs and introduce enhanced versions of these services that make these services more efficient and economical as the
market matures.



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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, servers, 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.



During
fiscal years 2003 and 2004, we made several changes and additions to our management team, including a new chief executive officer, and new leaders over our service delivery, marketing, sales, development, program management and human resources
areas. 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. The effective execution of our business strategy will depend in large part on how well our management team and other personnel
perform in their positions, and our business will be harmed if our new management team is unable to implement our strategy.



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



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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 largely with our customers internal solutions
and see increasing competition from other IT infrastructure management 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 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;
| | - | -------------------------



| |  | the ability to bundle their offers with non-competing services to provide an overall price advantage; 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:



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| |  | 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 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



We carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this report. Based upon that evaluation, our principal executive officer and principal financial officer concluded that disclosure controls and procedures were effective, in all material
respects, to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported in a timely manner. There has been no change in our internal control over financial reporting during the period
covered by this report, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



PART II. OTHER INFORMATION



Item 1. LEGAL PROCEEDINGS



In
December 2001, the Company and certain of its officers and directors, as well as the underwriters of its 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.



On September 14, 2004, two lawsuits were filed in the District Court of Travis County, Texas against the Company and its directors by purported
shareholders of the Company on behalf of a putative class of shareholders. The plaintiffs claim self dealing and breaches of fiduciary duty on the part of the directors in connection with the announced agreement between the Company and Cisco
Systems, Inc. for the acquisition of the Company for a purchase price of $11.00 per share in cash (Acquisition). The plaintiffs seek injunctive relief, including enjoining the Company and the directors from consummating the Acquisition,
and attorneys fees. The Company believes



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that the plaintiffs claims are without merit. The Company and the directors intend to vigorously defend these
lawsuits. As with any litigation, the Company is unable at this early stage to predict the outcome of the lawsuits or the impact of their pendency on the Company and the consummation of the Acquisition



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 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 July 23, 2004, the Company filed a Form 8-K reporting under Item 12 Results of Operation and Financial Condition the Companys press
release, dated July 22, 2004, regarding its 2005 first quarter results of operations and financial condition.



On September 14, 2004, the Company filed a Form 8-K reporting under Item 1.01 Entry into a Material Definite Agreement an Agreement and Plan
of Merger with Cisco Systems, Inc. and reporting under Item 3.03 Material Modification to Rights of Security Holders an amendment to its existing Rights Agreement dated as of February 5, 2003.



On September 21, 2004, the Company filed a Form 8-K reporting under Item
8.01 Other Events two lawsuits filed in the District Court of Travis County, Texas against the Company and its directors by purported shareholders of the Company on behalf of a putative class of shareholders.



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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 12, 2004 |  | NETSOLVE, INCORPORATED
|                        |  |                       
|                        |  | By:                    |  | /s/ David D. Hood                              
|                        |  |                        |  | David D. Hood                                  
|                        |  |                        |  | President and Chief Executive Officer          
|                        |  |                       
|                        |  | By:                    |  | /s/ Kenneth C. Kieley                          
|                        |  |                        |  | Kenneth C. Kieley                              
|                        |  |                        |  | Vice President-Finance, Chief Financial Officer
|                        |  |                        |  | and Secretary                                  
|                        |  |                       
|                        |  | By:                    |  | /s/ H. Perry Barth                             
|                        |  |                        |  | H. Perry Barth                                 
|                        |  |                        |  | Controller and Chief Accounting Officer        



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