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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



(Mark
One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



| | For the quarterly period ended March 31, 2004
| | ---------------------------------------------



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



| | For the transition period from  to
| | ----------------------------------



Commission File Number: 000-27241



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KEYNOTE SYSTEMS, INC.

(Exact name of registrant as specified in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 94-3226488                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



|                                         |  |           
|---------------------------------------- |  | ----------
|777 Mariners Island Blvd., San Mateo, CA |  | 94404     
|(Address of principal executive offices) |  | (Zip Code)



Registrants
telephone number, including area code: (650) 403-2400



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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 Rule 12b-2 of the Exchange Act).    YES  x    NO ̈



Indicate the number of shares
outstanding of each of the issuers classes of common stock, as of the latest practicable date:



|                              |  |                                     
|----------------------------- |  | ------------------------------------
|Class                         |  | Shares outstanding at April 30, 2004
|Common Stock, $.001 par value |  | 19,473,996                          



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##### Table of Contents

KEYNOTE SYSTEMS, INC.



TABLE OF CONTENTS



|           |  |                                                                                       |  |     
|---------- |  | ------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                       |  | Page
|           |  |                                                                                      
|           |  | PART IFINANCIAL INFORMATION                                                          |  |     
|           |  |                                                                                      
|Item 1.    |  | Financial Statements                                                                  |  | 3   
|           |  |                                                                                      
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 13  
|           |  |                                                                                      
|Item 3.    |  | Qualitative and Quantitative Disclosures about Market Risk                            |  | 26  
|           |  |                                                                                      
|Item 4.    |  | Controls and Procedures                                                               |  | 26  
|           |  |                                                                                      
|           |  | PART IIOTHER INFORMATION                                                             |  |     
|           |  |                                                                                      
|Item 1.    |  | Legal Proceedings                                                                     |  | 26  
|           |  |                                                                                      
|Item 2.    |  | Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities     |  | 27  
|           |  |                                                                                      
|Item 3.    |  | Defaults Upon Senior Securities                                                       |  | 27  
|           |  |                                                                                      
|Item 4.    |  | Submission of Matters for a Vote of Security Holders                                  |  | 27  
|           |  |                                                                                      
|Item 5.    |  | Other Information                                                                     |  | 27  
|           |  |                                                                                      
|Item 6.    |  | Exhibits and Reports on Form 8-K                                                      |  | 27  
|           | 
|Signatures |  | 28                                                                                   



2



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##### Table of Contents

PART IFINANCIAL INFORMATION



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



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



Index to Unaudited Condensed Consolidated Financial Statements



|                                                                                                           |  |     
|---------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                           |  | Page
|                                                                                                           | 
|Condensed Consolidated Balance Sheets as of March 31, 2004 and September 30, 2003                          |  | 4   
|                                                                                                           | 
|Condensed Consolidated Statements of Operations for the three and six months ended March 31, 2004 and 2003 |  | 5   
|                                                                                                           | 
|Condensed Consolidated Statements of Cash Flows for the six months ended March 31, 2004 and 2003           |  | 6   
|                                                                                                           | 
|Notes to Condensed Consolidated Financial Statements                                                       |  | 7   



3



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##### Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)



|                                                                                                                                       |  |               |          |   |                   |   |          |  
|-------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                       |  | March 31,2004 |          |   | September 30,2003 |  
|ASSETS                                                                                                                                 |  |               |          |   |                   |   |          |  
|Current assets:                                                                                                                        |  |               |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                              |  | $             | 25,806   |   |                   | $ | 23,242   |  
|Short-term investments                                                                                                                 |  |               | 144,269  |   |                   |   | 136,972  |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total cash, cash equivalents, and short-term investments                                                                               |  |               | 170,075  |   |                   |   | 160,214  |  
|                                                                                                                                       |  |              
|Accounts receivable, less allowance for doubtful accounts of $879 and $1,048 as of March 31, 2004 and September 30, 2003,
respectively |  |               | 4,723    |   |                   |   | 4,349    |  
|Prepaid and other current assets                                                                                                       |  |               | 1,298    |   |                   |   | 1,506    |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total current assets                                                                                                                   |  |               | 176,096  |   |                   |   | 166,069  |  
|                                                                                                                                       |  |              
|Property and equipment, net                                                                                                            |  |               | 32,952   |   |                   |   | 33,928   |  
|Goodwill                                                                                                                               |  |               | 479      |   |                   |   | 195      |  
|Identifiable intangible assets, net                                                                                                    |  |               | 1,569    |   |                   |   | 2,176    |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total assets                                                                                                                           |  | $             | 211,096  |   |                   | $ | 202,368  |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                   |  |               |          |   |                   |   |          |  
|Current liabilities:                                                                                                                   |  |               |          |   |                   |   |          |  
|Accounts payable                                                                                                                       |  |               | 659      |   |                   |   | 654      |  
|Accrued expenses                                                                                                                       |  |               | 7,419    |   |                   |   | 7,077    |  
|Deferred revenue                                                                                                                       |  |               | 5,778    |   |                   |   | 4,357    |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total current liabilities                                                                                                              |  |               | 13,856   |   |                   |   | 12,088   |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total liabilities                                                                                                                      |  |               | 13,856   |   |                   |   | 12,088   |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  
|                                                                                                                                       |  |              
|Stockholders equity:                                                                                                                  |  |               |          |   |                   |   |          |  
|Common stock                                                                                                                           |  |               | 19       |   |                   |   | 19       |  
|Treasury stock                                                                                                                         |  |               | (29      | ) |                   |   | (29      | )
|Additional paid-in capital                                                                                                             |  |               | 336,967  |   |                   |   | 331,912  |  
|Accumulated deficit                                                                                                                    |  |               | (140,220 | ) |                   |   | (142,056 | )
|Accumulated other comprehensive income                                                                                                 |  |               | 503      |   |                   |   | 434      |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total stockholders equity                                                                                                             |  |               | 197,240  |   |                   |   | 190,280  |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                             |  | $             | 211,096  |   |                   | $ | 202,368  |  
|                                                                                                                                       |  |               |          |   |                   |   |          |  



See accompanying notes
to the condensed consolidated financial statements



4



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)



|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|--------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                            |  | Three months ended March 31, |        |   | Six months ended March 31, |  
|                                                                            |  | 2004                         |        |   | 2003                       |   |        | 2004 |  |   | 2003   |  
|Revenue:                                                                    |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Subscription services                                                       |  | $                            | 8,803  |   |                            | $ | 8,567  |      |  | $ | 17,474 |   |  | $ | 17,408 |  
|Consulting and support services                                             |  |                              | 1,016  |   |                            |   | 991    |      |  |   | 2,068  |   |  |   | 1,908  |  
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total revenue                                                               |  |                              | 9,819  |   |                            |   | 9,558  |      |  |   | 19,542 |   |  |   | 19,316 |  
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Expenses:                                                                   |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Costs of subscription services                                              |  |                              | 1,298  |   |                            |   | 2,262  |      |  |   | 2,804  |   |  |   | 4,745  |  
|Costs of consulting and support services                                    |  |                              | 891    |   |                            |   | 971    |      |  |   | 1,694  |   |  |   | 1,870  |  
|Research and development                                                    |  |                              | 1,634  |   |                            |   | 2,053  |      |  |   | 3,258  |   |  |   | 4,235  |  
|Sales and marketing                                                         |  |                              | 2,278  |   |                            |   | 4,033  |      |  |   | 4,987  |   |  |   | 8,478  |  
|Operations                                                                  |  |                              | 1,234  |   |                            |   | 1,688  |      |  |   | 2,489  |   |  |   | 3,406  |  
|General and administrative                                                  |  |                              | 1,221  |   |                            |   | 1,612  |      |  |   | 2,385  |   |  |   | 3,116  |  
|Excess occupancy costs                                                      |  |                              | 254    |   |                            |   | 293    |      |  |   | 520    |   |  |   | 578    |  
|Amortization of identifiable intangible assets and stock-based compensation |  |                              | 372    |   |                            |   | 424    |      |  |   | 734    |   |  |   | 827    |  
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total expenses                                                              |  |                              | 9,182  |   |                            |   | 13,336 |      |  |   | 18,871 |   |  |   | 27,255 |  
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Income (Loss) from operations                                               |  |                              | 637    |   |                            |   | (3,778 | )    |  |   | 671    |   |  |   | (7,939 | )
|Interest income, net                                                        |  |                              | 662    |   |                            |   | 1,661  |      |  |   | 1,325  |   |  |   | 3,825  |  
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Income (Loss) before provision for income taxes                             |  |                              | 1,299  |   |                            |   | (2,117 | )    |  |   | 1,996  |   |  |   | (4,114 | )
|                                                                            |  |                              |        |  
|Provision for income taxes                                                  |  |                              | (130   | ) |                            |   |       |      |  |   | (160   | ) |  |   |       |  
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss)                                                           |  | $                            | 1,169  |   |                            | $ | (2,117 | )    |  | $ | 1,836  |   |  | $ | (4,114 | )
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss) per share:                                                |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Basic                                                                       |  | $                            | 0.06   |   |                            | $ | (0.09  | )    |  | $ | 0.10   |   |  | $ | (0.17  | )
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                                                     |  | $                            | 0.06   |   |                            | $ | (0.09  | )    |  | $ | 0.09   |   |  | $ | (0.17  | )
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Shares used in computing basic and diluted net income (loss) per share:     |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Basic                                                                       |  |                              | 19,341 |   |                            |   | 22,838 |      |  |   | 19,187 |   |  |   | 24,407 |  
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                                                     |  |                              | 20,833 |   |                            |   | 22,838 |      |  |   | 20,637 |   |  |   | 24,407 |  
|                                                                            |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  



See accompanying notes
to the condensed consolidated financial statements



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                                         |  |                            |         |   |      |   |         |  
|---------------------------------------------------------------------------------------- |  | -------------------------- | ------- | - | ---- | - | ------- | -
|                                                                                         |  | Six months ended March 31, |        
|                                                                                         |  | 2004                       |         |   | 2003 |  
|Cash flows from operating activities:                                                    |  |                            |         |   |      |   |         |  
|Net income (loss)                                                                        |  | $                          | 1,836   |   |      | $ | (4,114  | )
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                            |         |   |      |   |         |  
|Depreciation and amortization of property and equipment                                  |  |                            | 2,013   |   |      |   | 3,352   |  
|Amortization of identifiable intangible assets                                           |  |                            | 734     |   |      |   | 800     |  
|Amortization of debt investment premium                                                  |  |                            | 2,137   |   |      |   | 2,095   |  
|Amortization of deferred stock-based compensation                                        |  |                            |        |   |      |   | 27      |  
|Changes in operating assets and liabilities, net of acquired assets and liabilities:     |  |                            |         |   |      |   |         |  
|Accounts receivable, net                                                                 |  |                            | (319    | ) |      |   | 671     |  
|Prepaids and other current assets                                                        |  |                            | 208     |   |      |   | (74     | )
|Accounts payable and accrued expenses                                                    |  |                            | 347     |   |      |   | (454    | )
|Deferred revenue                                                                         |  |                            | 1,414   |   |      |   | 46      |  
|                                                                                         |  |                            |         |   |      |   |         |  
|Net cash provided by operating activities                                                |  |                            | 8,370   |   |      |   | 2,349   |  
|                                                                                         |  |                            |         |   |      |   |         |  
|Cash flows from investing activities:                                                    |  |                            |         |   |      |   |         |  
|Purchases of property and equipment                                                      |  |                            | (936    | ) |      |   | (1,540  | )
|Proceeds from (purchase of) businesses and assets, net                                   |  |                            | (560    | ) |      |   | 75      |  
|Sale of short-term investments                                                           |  |                            | 60,841  |   |      |   | 103,633 |  
|Purchases of short-term investments                                                      |  |                            | (70,206 | ) |      |   | (59,548 | )
|                                                                                         |  |                            |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                                      |  |                            | (10,861 | ) |      |   | 42,620  |  
|                                                                                         |  |                            |         |   |      |   |         |  
|Cash flows from financing activities:                                                    |  |                            |         |   |      |   |         |  
|Proceeds from issuance of common stock and exercise of stock options                     |  |                            | 5,055   |   |      |   | 1,273   |  
|Repurchase of outstanding common stock                                                   |  |                            |        |   |      |   | (38,538 | )
|                                                                                         |  |                            |         |   |      |   |         |  
|Net cash provided by (used in) financing activities                                      |  |                            | 5,055   |   |      |   | (37,265 | )
|                                                                                         |  |                            |         |   |      |   |         |  
|Net increase in cash and cash equivalents                                                |  |                            | 2,564   |   |      |   | 7,704   |  
|Cash and cash equivalents at beginning of the period                                     |  |                            | 23,242  |   |      |   | 20,874  |  
|                                                                                         |  |                            |         |   |      |   |         |  
|Cash and cash equivalents at end of the period                                           |  | $                          | 25,806  |   |      | $ | 28,578  |  
|                                                                                         |  |                            |         |   |      |   |         |  



See accompanying notes
to the condensed consolidated financial statements



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##### Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



(1) Basis of Presentation



The accompanying interim unaudited
condensed consolidated balance sheets, and condensed consolidated statements of operations and cash flows reflect all normal recurring adjustments that are, in the opinion of management, necessary for a fair presentation of the financial position of
Keynote Systems, Inc. and subsidiaries (the Company) at March 31, 2004, and the results of operations and cash flows for the interim periods ended March 31, 2004 and 2003.



The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of
the Securities and Exchange Commission (SEC), and therefore, do not include all information and footnotes necessary for a complete presentation of the Companys results of operations, financial position and cash flows. This report should be
read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended September 30, 2003 included in the Companys Report on Form 10-K as filed with the SEC.



The results of operations and cash flows for any interim period are not necessarily
indicative of the Companys results of operations and cash flows for any other future interim period or for a full fiscal year.



Excess occupancy costs are fixed costs associated with the unoccupied portion of the Companys headquarters building, such as property taxes, insurance and
depreciation. These particular costs represent the fixed costs of operating the Companys headquarters building acquired in September 2002 and are based on the actual unoccupied square footage, which was determined to be 70% and 60% during the
three and six months ended March 31, 2004 and 2003, respectively.



(2)
Stock-Based Compensation Plans



The Company accounts for stock option
grants under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation (SFAS No. 123), which permits the use of the intrinsic-value method in accordance with Accounting Principles
Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No compensation expense is recognized on the grant date, when the option exercise price equals or exceeds the market price of the
underlying common stock.



The following table illustrates the effect on net
income (loss) and basic and diluted net income (loss) per share if the Company had accounted for its stock option and stock purchase plans under the fair value method of accounting under SFAS No. 123 as amended by SFAS No. 148, Accounting for
Stock-Based CompensationTransition and Disclosure (in thousands):



|                                                                                                              |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                                              |  | Three Months Ended March 31, |        |   | Six Months Ended March 31, |  
|                                                                                                              |  | 2004                         |        |   | 2003                       |   |        | 2004 |  |   | 2003   |  
|Net income (loss), as reported                                                                                |  | $                            | 1,169  |   |                            | $ | (2,117 | )    |  | $ | 1,836  |   |  | $ | (4,114 | )
|Add: Stock-based employee compensation included in net loss                                                   |  |                              |       |   |                            |   | 3      |      |  |   |       |   |  |   | 27     |  
|Less: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                              | (1,608 | ) |                            |   | (2,605 | )    |  |   | (3,637 | ) |  |   | (5,487 | )
|                                                                                                              |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Pro forma net loss                                                                                            |  | $                            | (439   | ) |                            | $ | (4,719 | )    |  | $ | (1,801 | ) |  | $ | (9,574 | )
|                                                                                                              |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss) per share:                                                                                  |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Basicas reported                                                                                             |  | $                            | 0.06   |   |                            | $ | (0.09  | )    |  | $ | 0.10   |   |  | $ | (0.17  | )
|Basicpro forma                                                                                               |  | $                            | (0.02  | ) |                            | $ | (0.21  | )    |  | $ | (0.09  | ) |  | $ | (0.39  | )
|Dilutedas reported                                                                                           |  | $                            | 0.06   |   |                            | $ | (0.09  | )    |  | $ | 0.09   |   |  | $ | (0.17  | )
|Dilutedpro forma                                                                                             |  | $                            | (0.02  | ) |                            | $ | (0.21  | )    |  | $ | (0.09  | ) |  | $ | (0.39  | )
|Number of shares used in the computing as reported and pro forma:                                             |  |                              |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Basicas reported                                                                                             |  |                              | 19,341 |   |                            |   | 22,838 |      |  |   | 19,187 |   |  |   | 24,407 |  
|Basicpro forma                                                                                               |  |                              | 19,341 |   |                            |   | 22,838 |      |  |   | 19,187 |   |  |   | 24,407 |  
|Dilutedas reported                                                                                           |  |                              | 20,833 |   |                            |   | 22,838 |      |  |   | 20,637 |   |  |   | 24,407 |  
|Dilutedpro forma                                                                                             |  |                              | 19,341 |   |                            |   | 22,838 |      |  |   | 19,187 |   |  |   | 24,407 |  



The net tax effect on the stock-based
employee compensation determined under the fair value based method for all awards is zero.



The pro forma compensation expenses for the three and six months ended March 31, 2003 have been revised from the historically reported numbers.



The fair value of each option was estimated on the date of grant using the Black-Scholes option pricing model. Weighted-average assumptions
for options granted are as follows:



|                         |  |                             |   |  |                           |   |  |      |   |  |      |  
|------------------------ |  | --------------------------- | - |  | ------------------------- | - |  | ---- | - |  | ---- | -
|                         |  | Three Months EndedMarch 31, |   |  | Six Months EndedMarch 31, |  
|                         |  | 2004                        |   |  | 2003                      |   |  | 2004 |   |  | 2003 |  
|Volatility               |  | 34.7                        | % |  | 50.8                      | % |  | 37.4 | % |  | 50.8 | %
|Risk-free interest rates |  | 2.0                         | % |  | 1.9                       | % |  | 2.1  | % |  | 2.0  | %
|Expected life (in years) |  | 2.5                         |   |  | 2.5                       |   |  | 2.5  |   |  | 2.5  |  
|Dividend yield           |  |                            |   |  |                          |   |  |     |   |  |     |  



7



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##### Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(3) Revenue Recognition



Revenue consists of subscription services revenue and consulting and support services
revenue. Subscription services revenue consists of fees from subscriptions to the Companys web performance measurement and management services. Subscription services revenue is deferred upon invoicing and is recognized ratably over the service
period, generally ranging from one to twelve months. For some customers, subscription services revenue is invoiced monthly upon completion of the services. Deferred revenue is comprised of all unearned revenue, primarily unearned subscription
services revenue, and is recorded as deferred revenue on the balance sheet until the revenue is earned. The Company does not generally grant refunds. All discounts granted reduce revenue. Revenue is not recognized for free trial periods. Consulting
and support services revenue consists of fees generated by the Companys consulting and support services and the Companys load-testing services, and is recognized as the services are performed, typically over a period of one to three
months. For consulting projects that span more than one month, the Company recognizes revenue as milestones or deliverables are completed.



(4) Comprehensive Income (Loss)



Comprehensive income (loss) includes net income (loss), unrealized gains and losses on short-term investments in debt securities and foreign currency translation. The
unrealized gains and losses on short-term investments in debt securities and foreign currency translation are excluded from earnings and reported as a component of stockholders equity. The functional currency of the Companys foreign
operations is the applicable local currency or United States dollar. Gains and losses from foreign currency transactions are reflected in the condensed consolidated statements of operations as incurred. The components of comprehensive income (loss)
are as follows (in thousands):



|                                                             |  |                              |       |      |                            |        |      |  |      |       |  |   |        |  
|------------------------------------------------------------ |  | ---------------------------- | ----- | ---- | -------------------------- | ------ | ---- |  | ---- | ----- |  | - | ------ | -
|                                                             |  | Three Months Ended March 31, |       |      | Six Months Ended March 31, |       
|                                                             |  | 2004                         |       | 2003 |                            |        | 2004 |  | 2003 |      
|Net income (loss)                                            |  | $                            | 1,169 |      | $                          | (2,117 | )    |  | $    | 1,836 |  | $ | (4,114 | )
|Net unrealized gain (loss) on available-for-sale investments |  |                              | 214   |      |                            | (569   | )    |  |      | 34    |  |   | (1,209 | )
|Foreign currency translation gain (loss)                     |  |                              | 22    |      |                            | (63    | )    |  |      | 35    |  |   | (59    | )
|                                                             |  |                              |       |      |                            |        |      |  |      |       |  |   |        |  
|Comprehensive income (loss)                                  |  | $                            | 1,405 |      | $                          | (2,749 | )    |  | $    | 1,905 |  | $ | (5,382 | )
|                                                             |  |                              |       |      |                            |        |      |  |      |       |  |   |        |  



The net tax effect on the foreign
currency gain/(loss) is immaterial.



(5) Financial Instruments and
Concentration of Risk



The carrying value of the Companys financial
instruments, including cash and cash equivalents, short-term investments, accounts receivable, and accounts payable and accrued expenses, approximates fair market value due to their short-term nature. Financial instruments that subject the Company
to concentrations of credit risk consist primarily of cash and cash equivalents, short-term investments and accounts receivable.



Credit risk is concentrated in North America, but exists in Europe as well. The Company generally requires no collateral from customers; however, throughout the
collection process, it conducts an ongoing evaluation of customers ability to pay. The Companys accounting for its allowance for doubtful accounts is determined based on historical trends, experience and current market and industry
conditions. Management regularly reviews the adequacy of the Companys allowance for doubtful accounts by considering the aging of accounts receivable, the age of each invoice, each customers expected ability to pay and the Companys
collection history with each customer. Management reviews invoices greater than 60 days past due to determine whether an allowance is appropriate based on the receivable balance. In addition, the Company maintains a reserve for all other invoices,
which is calculated by applying a percentage to the outstanding accounts receivable balance, based on historical collection trends. The allowance for doubtful accounts represents managements best current estimate, but changes in circumstances
relating to accounts receivable, including unforeseen declines in market conditions and collection rates, may result in additional allowances in the future. The Company believes that it has adequately reserved for doubtful accounts as of the date of
each balance sheet presented herein. At March 31, 2004 and 2003, no single customer accounted for more than 10% of the Companys total accounts receivable. For the three and six months ended March 31, 2004 and 2003, no single customer accounted
for more than 10% of the Companys total revenue during each period. For the three months ended March 31, 2004 and 2003, the top ten customers accounted for approximately 34% and 30% of total revenue, respectively. For the six months ended
March 31, 2004 and 2003, the top ten customers accounted for approximately 32% and 28% of total revenue, respectively.



8



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##### Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(6) Investments



The Company considers all highly liquid investments with original maturities of three months
or less when acquired to be cash equivalents. The Companys short-term investments consist of investment-grade corporate and government debt securities with Moodys ratings of A2 or better and which mature in two years or less. All of the
Companys cash equivalents and short-term investments are classified as available-for-sale. These securities are carried at fair market value, with unrealized gains and losses excluded from earnings and reported as a component of other
comprehensive income (loss). The following table summarizes the Companys short-term investments in investment-grade debt securities as of March 31, 2004 (in thousands):



|                                                              |  |                |         |                        |   |                         |  |   |                             |   |  |   |        
|------------------------------------------------------------- |  | -------------- | ------- | ---------------------- | - | ----------------------- |  | - | --------------------------- | - |  | - | -------
|                                                              |  | Amortized Cost |         | Gross Unrealized Gains |   | Gross Unrealized Losses |  |   | Estimated Fair Market Value
|Obligations of U.S. federal and state government and agencies |  | $              | 62,832  |                        | $ | 136                     |  | $ | (12                         | ) |  | $ | 62,956 
|Corporate bonds and commercial paper                          |  |                | 81,106  |                        |   | 235                     |  |   | (28                         | ) |  |   | 81,313 
|                                                              |  |                |         |                        |   |                         |  |   |                             |   |  |   |        
|Total                                                         |  | $              | 143,938 |                        | $ | 371                     |  | $ | (40                         | ) |  | $ | 144,269
|                                                              |  |                |         |                        |   |                         |  |   |                             |   |  |   |        



The following table
summarizes the contractual maturities of fixed maturity investments available for sale at March 31, 2004 (in thousands). Expected maturities of debt securities will differ from contractual maturities of the debt securities because borrowers may have
the right to call or repay obligations with or without call or prepayment penalties.



|                      |  |                |         |                             |   |        
|--------------------- |  | -------------- | ------- | --------------------------- | - | -------
|                      |  | Amortized Cost |         | Estimated Fair Market Value
|Year ending March 31, |  |                |         |                             |   |        
|2005                  |  | $              | 83,447  |                             | $ | 83,659 
|2006                  |  |                | 60,491  |                             |   | 60,610 
|                      |  |                |         |                             |   |        
|Total                 |  | $              | 143,938 |                             | $ | 144,269
|                      |  |                |         |                             |   |        



(7) Goodwill and Identifiable
Intangible Assets



The following table represents the changes in goodwill
during the six months ended March 31, 2004 (in thousands):



|                                                                                                        |  |   |    
|------------------------------------------------------------------------------------------------------- |  | - | ---
|Balance at September 30, 2003                                                                           |  | $ | 195
|Additional goodwill for acquisition of the business of the MatrixNet division of Xaffire, Inc. (Note 9) |  |   | 284
|                                                                                                        |  |   |    
|Balance at March 31, 2004                                                                               |  | $ | 479
|                                                                                                        |  |   |    



9



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##### Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



As of March 31, 2004, the net carrying value of identifiable intangible
assets was approximately $1.6 million. During the first quarter of fiscal 2004, the Company acquired approximately $84,000 of technology-based and $43,000 of customer-based intangible assets related to the acquisition of the business of the
MatrixNet division of Xaffire, Inc. (MatrixNet) (see Note 9). As a result, the gross carrying value of the identifiable intangible assets for the six months ended March 31, 2004 increased by $127,000. These assets are being amortized
over a three-year period, with minimal expected residual values. For the three and six months ended March 31, 2004, the amortization expense for intangible assets was $372,000 and $734,000, respectively. The components of identifiable intangible
assets are as follows (in thousands):



|                                         |  |                 |        |   |               |   |        |       |  |   |         |  
|---------------------------------------- |  | --------------- | ------ | - | ------------- | - | ------ | ----- |  | - | ------- | -
|                                         |  | TechnologyBased |        |   | CustomerBased |   |        | Total | 
|As of March 31, 2004:                    |  |                 |        |   |               |   |        |       |  |   |         |  
|Gross carrying value                     |  | $               | 8,090  |   |               | $ | 3,768  |       |  | $ | 11,858  |  
|Accumulated amortization                 |  |                 | (6,643 | ) |               |   | (3,646 | )     |  |   | (10,289 | )
|                                         |  |                 |        |   |               |   |        |       |  |   |         |  
|Net carrying value at March 31, 2004     |  | $               | 1,447  |   |               | $ | 122    |       |  | $ | 1,569   |  
|                                         |  |                 |        |   |               |   |        |       |  |   |         |  
|As of September 30, 2003:                |  |                 |        |   |               |   |        |       |  |   |         |  
|Gross carrying value                     |  | $               | 8,006  |   |               | $ | 3,725  |       |  | $ | 11,731  |  
|Accumulated amortization                 |  |                 | (5,951 | ) |               |   | (3,604 | )     |  |   | (9,555  | )
|                                         |  |                 |        |   |               |   |        |       |  |   |         |  
|Net carrying value at September 30, 2003 |  | $               | 2,055  |   |               | $ | 121    |       |  | $ | 2,176   |  
|                                         |  |                 |        |   |               |   |        |       |  |   |         |  



The amortization expense for existing
intangible assets as of March 31, 2004 is estimated to be approximately $688,000 for the remainder of fiscal 2004, approximately $742,000 for fiscal 2005, approximately $135,000 for fiscal 2006, and approximately $4,000 for fiscal 2007.



(8) Net Income (Loss) Per Share



Basic earnings per share is computed using the weighted-average number of common shares
outstanding, and diluted earnings per share is computed using the weighted-average number of common shares outstanding, and all dilutive potential common shares outstanding, using the treasury stock method. For the three and six months ended March
31, 2004, dilutive potential common shares outstanding reflects shares issuable under the Companys stock option plan. For the three and six months ended March 31, 2003, 483,000 and 282,000 net dilutive potential common shares with a weighted
average price of $8.52 and $7.99, respectively, computed using the treasury stock method were considered anti-dilutive and excluded from the denominator for diluted net loss per share as a result of the Companys net loss.



The following table summarizes the Companys net income (loss) per share computations
for the three and six months ended March 31, 2004, and 2003 (in thousands, except per share amounts):



|                                                                                   |  |                              |        |      |                            |        |      |  |      |        |  |   |        |  
|---------------------------------------------------------------------------------- |  | ---------------------------- | ------ | ---- | -------------------------- | ------ | ---- |  | ---- | ------ |  | - | ------ | -
|                                                                                   |  | Three months ended March 31, |        |      | Six months ended March 31, |       
|                                                                                   |  | 2004                         |        | 2003 |                            |        | 2004 |  | 2003 |       
|Numerator:                                                                         |  |                              |        |      |                            |        |      |  |      |        |  |   |        |  
|Net income (loss)                                                                  |  | $                            | 1,169  |      | $                          | (2,117 | )    |  | $    | 1,836  |  | $ | (4,114 | )
|Denominator:                                                                       |  |                              |        |      |                            |        |      |  |      |        |  |   |        |  
|Denominator for basic net income (loss) per shareweighted average shares          |  |                              | 19,341 |      |                            | 22,838 |      |  |      | 19,187 |  |   | 24,407 |  
|Incremental common shares attributable to shares issuable under stock option plans |  |                              | 1,492  |      |                            |       |      |  |      | 1,450  |  |   |       |  
|                                                                                   |  |                              |        |      |                            |        |      |  |      |        |  |   |        |  
|Denominator for diluted net income (loss) per shareweighted average shares        |  |                              | 20,833 |      |                            | 22,838 |      |  |      | 20,637 |  |   | 24,407 |  
|                                                                                   |  |                              |        |      |                            |        |      |  |      |        |  |   |        |  
|Net income (loss) per sharebasic                                                  |  | $                            | 0.06   |      | $                          | (0.09  | )    |  | $    | 0.10   |  | $ | (0.17  | )
|                                                                                   |  |                              |        |      |                            |        |      |  |      |        |  |   |        |  
|Net income (loss) per sharediluted                                                |  | $                            | 0.06   |      | $                          | (0.09  | )    |  | $    | 0.09   |  | $ | (0.17  | )
|                                                                                   |  |                              |        |      |                            |        |      |  |      |        |  |   |        |  



10



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##### Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(9) Acquisition



In December 2003, the Company acquired the business of the MatrixNet division of Xaffire,
Inc. for $582,000 in cash. The MatrixNet service measures performance from network agent locations to a customers web infrastructure or devices. The preliminary purchase price allocation was based on the estimated fair value of the assets and
liabilities of the business at the acquisition date, including the technology-based and customer-based intangible assets acquired. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of
acquisition (in thousands):



|                                   |  |   |     |  
|---------------------------------- |  | - | --- | -
|Accounts receivable, net           |  | $ | 55  |  
|Property and equipment             |  |   | 101 |  
|Customer-based intangible assets   |  |   | 43  |  
|Technology-based intangible assets |  |   | 84  |  
|Goodwill                           |  |   | 306 |  
|Deferred revenue                   |  |   | (7  | )
|                                   |  |   |     |  
|Total purchase price               |  | $ | 582 |  
|                                   |  |   |     |  



During the three months ended March
31, 2004, the Company updated its preliminary purchase price allocation for the fair value of the property and equipment that were acquired as a result of the acquisition of the business of MatrixNet. Therefore, goodwill decreased by $22,000, from
$306,000 initially recorded to $284,000.



(10) Commitments and Contingencies



(A) Leases



The Company leases certain of its facilities under non-cancelable operating leases, which
expire on various dates through December 2005. At March 31, 2004, future minimum payments under the leases are as follows (in thousands):



|                              |  |                  |    
|----------------------------- |  | ---------------- | ---
|Twelve months ended March 31: |  | Operating Leases
|2005                          |  | $                | 103
|2006                          |  |                  | 77 
|                              |  |                  |    
|Total minimum lease payments  |  | $                | 180
|                              |  |                  |    



(B) Commitments



The Company has contingent commitments to 61 bandwidth and collocation
providers amounting to $896,000 for 113 locations, which commitments become due if the Company terminates any of these agreements prior to their expiration. At present, the Company does not intend to terminate any of these agreements prior to their
expiration.



(C) Legal Proceedings



Beginning on August 16, 2001, a number of class action lawsuits were filed in the United
States District Court for the Southern District of New York against us, certain of our officers, and the underwriters of our initial public offering. These lawsuits were essentially identical, and were brought on behalf of those who purchased our
securities between September 24, 1999 and August 19, 2001. These complaints alleged generally that the underwriters in certain initial public offerings, including ours, allocated shares in those initial public offerings in unfair or unlawful ways,
such as requiring the purchaser to agree to buy in the aftermarket at a higher price or to buy shares in other companies with higher than normal commissions. The complaint also alleged that we had a duty to disclose the activities of the
underwriters in the registration statement relating to our initial public offering. The plaintiffs counsel and the issuer defendants counsel have reached a preliminary settlement agreement, which awaits approval by the Court.



We are subject to legal proceedings, claims, and litigation arising in the ordinary course
of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of
operations, or cash flows.



(11) Stock Repurchase Program



The Companys Board of Directors approved a program to repurchase shares of its common
stock in January 2001. Pursuant to the stock repurchase program, a total of 10.4 million shares had been repurchased as of March 31, 2004, for approximately $90.1 million. For the three and six months ended March 31, 2004, the Company did not
repurchase any of its common stock. For the three months ended March 31, 2003, the Company repurchased approximately 363,000 for $4.1 million, primarily in connection with purchases in the open market. For the six months ended March 31, 2003, the
Company repurchased 4.7 million shares for $38.5 million, primarily in connection with its issuer tender offer in November 2002.



At March 31, 2004, the Company had authorization to repurchase up to approximately $39.9 million of its common stock pursuant to this stock repurchase program.



11



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##### Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(12) Geographic and Segment Information



The Company has determined that it operates in a single reportable operating segment: the
development and sale of services to measure, test, assure and improve the quality of service of web sites. While the Company operates under one operating segment, management reviews revenue under two categories  measurement services revenue
and management solutions revenue. Management continues to allocate resources based on the one operating segment.



The following table describes which services fall under measurement service and management solutions and how they are recorded under the GAAP income statement under
subscription services and consulting and other support services:



|                        |  |                      |  |                              
|----------------------- |  | -------------------- |  | -----------------------------
|                        |  | SubscriptionServices |  | Consulting andSupportServices
|Measurement Services:   |  |                      |  |                              
|Application Perspective |  | X                    |  |                              
|NetMechanic             |  | X                    |  |                              
|Red Alert               |  | X                    |  |                              
|Streaming Perspective   |  | X                    |  |                              
|Transaction Perspective |  | X                    |  |                              
|Website Perspective     |  | X                    |  |                              
|Management Solutions:   |  |                      |  |                              
|Diagnostic Services     |  |                      |  | X                            
|Enterprise Solutions    |  | X                    |  | X                            
|LoadPro                 |  |                      |  | X                            
|Network Perspective     |  | X                    |  |                              
|Professional Services   |  |                      |  | X                            
|Test Perspective        |  | X                    |  |                              
|WebEffective            |  | X                    |  | X                            
|WebIntegrity            |  | X                    |  |                              
|Wireless Perspective    |  | X                    |  |                              



The following table summarizes
measurement services and management solutions revenue (in thousands):



|                                     |  |      |        |      |   |       
|------------------------------------ |  | ---- | ------ | ---- | - | ------
|                                     |  | 2004 |        | 2003
|For the three months ended March 31: |  |      |        |      |   |       
|Measurement services revenue         |  | $    | 6,867  |      | $ | 7,237 
|Management solutions revenue         |  |      | 2,952  |      |   | 2,321 
|                                     |  |      |        |      |   |       
|Total Revenue                        |  | $    | 9,819  |      | $ | 9,558 
|                                     |  |      |        |      |   |       
|                                     |  |     
|                                     |  | 2004 |        | 2003
|For the six months ended March 31:   |  |      |        |      |   |       
|Measurement services revenue         |  | $    | 13,920 |      | $ | 14,832
|Management solutions revenue         |  |      | 5,622  |      |   | 4,484 
|                                     |  |      |        |      |   |       
|Total Revenue                        |  | $    | 19,542 |      | $ | 19,316
|                                     |  |      |        |      |   |       



International sales were approximately
6% and 7% of total revenue for the three months ended March 31, 2004 and 2003, respectively.



(13) Subsequent Event



On April 2,
2004, the Company acquired NetRaker Corporation, a provider of online customer experience management solutions that helps e-business managers measure, evaluate and improve the design and navigability of their websites for an initial cash payment of
approximately $2.6 million plus a second cash payment to be made by July 1, 2004 based on the final calculation of the NetRaker net assets as of the close, estimated to be up to approximately $800,000. An additional cash payment could be made if
certain revenue and profitability targets are achieved by the acquired business during the twelve months ending March 31, 2005. The Company believes this acquisition will enhance and broaden its customer experience management solutions for
enterprise customers as well as allow it to target e-business marketing executives within Fortune 500 companies, such as usability and market research managers.



12



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##### Table of Contents

|Item  2. | Management Discussion and Analysis of Financial Condition and Results of Operations
|-------- | -----------------------------------------------------------------------------------



The following information should be read in conjunction with the interim unaudited condensed consolidated financial statements and related notes.



Except for historical information, this Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements involve risks and uncertainties, including, among other things, statements regarding our anticipated
costs and expenses and revenue mix. These forward-looking statements include, among others, statements including the words expect, anticipate, intend, believe and similar language. Our actual results
may differ significantly from those projected in the forward-looking statements. Factors that might cause or contribute to these differences include, but are not limited to, those discussed in this section and in our annual report on Form 10-K for
the fiscal year ended September 30, 2003, in the section Managements Discussion and Analysis of Financial Condition and Results of OperationsFactors That May Impact Future Operating Results and elsewhere in that report. You
should also carefully review the risks described in other documents we file from time to time with the Securities and Exchange Commission, including the annual report on Form 10-K, the quarterly reports on Form 10-Q and current reports on Form 8-K.
You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this quarterly report on Form 10-Q. We undertake no obligation to publicly release any revisions to the forward-looking statements or
reflect events or circumstances after the date of this document.



Overview



We offer Web performance measurement and management services that enable
corporate enterprises to monitor, benchmark, test and tune, diagnose and optimize their e-business systems both inside and outside the firewall. Keynotes services provide enterprise customers with Total Performance Management solutions
enabling them to increase return on investment, save money and efficiently link information technology resources to e-business goals. Total Performance Management includes a broad portfolio of cost-effective measurement, monitoring, performance
management, load testing, content quality testing and usability testing services. Keynotes goal is to empower customers to deliver an optimal experience to end-users and to gain competitive advantage, while helping them reduce unnecessary
capital expenditures and leverage enterprise management software they already own.



Revenue consists of subscription services revenue and consulting and support services revenue. Subscription services revenue consists of fees from subscriptions to our Internet measurement, monitoring, testing and diagnostic services.
Subscription services revenue is deferred upon invoicing and is recognized ratably over the service period, generally ranging from one to twelve months. For some customers, subscription services revenue is invoiced monthly upon completion of the
services. Deferred revenue is comprised of all unearned revenue, primarily unearned subscription services revenue and is recorded as deferred revenue on our balance sheet until the revenue is earned. As of March 31, 2004, we had recorded
approximately $5.8 million of deferred revenue. We do not generally grant refunds. All discounts granted reduce revenue. Revenue is not recognized during free trial periods. Consulting and support services revenue, which consists of fees generated
by our consulting and support services and our load testing services, is recognized as the services are performed, typically over a period of one to three months. For longer consulting projects that span more than one month, we recognize revenue as
milestones or deliverables are completed.



A majority of our subscription
services revenue comes from our web performance benchmarking services, which include our Perspective services. Subscription services revenue also includes our Red Alert and NetMechanic monitoring and alarm services, Test Perspective subscription
services, WebEffective subscription services, performance management subscription services and our private agent application performance management services. Our customers purchase these services for an initial term of three to twelve months and
then may renew on an annual, semi-annual, or month-to-month basis.



Subscription services fees can vary based on the number of URLs measured, the number of devices monitored, the number of measurement locations, the number of users, the number of hours, the frequency of the measurements, the number of
private agents, the additional features ordered, and the type of services purchased.



We offer our consulting and support services on a per engagement basis. Consulting and support services revenue amounted to approximately 10% of total revenue for each of the three months ended March 31, 2004 and 2003, respectively.
Consulting and support services revenue amounted to approximately 11% and 10% of total revenue for the six months ended March 31, 2004 and 2003, respectively. We believe that consulting and support services revenue may increase somewhat in the
future as a percentage of total revenue, as our existing consulting and support services become more widely used and we introduce additional services that require consulting expertise. However, we cannot assure you that this revenue will increase in
absolute dollars in future periods.



In addition to analyzing revenue for
subscription services and consulting and support services, management also internally analyzes revenue categorized as measurement services and management solutions.



The following table describes which services fall under measurement service and management solutions and how they are recorded under the
GAAP income statement under subscription services and consulting and other support services:



|                        |  |                      |  |                              
|----------------------- |  | -------------------- |  | -----------------------------
|                        |  | SubscriptionServices |  | Consulting andSupportServices
|Measurement Services:   |  |                      |  |                              
|Application Perspective |  | X                    |  |                              
|NetMechanic             |  | X                    |  |                              
|Red Alert               |  | X                    |  |                              
|Streaming Perspective   |  | X                    |  |                              
|Transaction Perspective |  | X                    |  |                              
|Website Perspective     |  | X                    |  |                              
|Management Solutions:   |  |                      |  |                              
|Diagnostic Services     |  |                      |  | X                            
|Enterprise Solutions    |  | X                    |  | X                            
|LoadPro                 |  |                      |  | X                            
|Network Perspective     |  | X                    |  |                              
|Professional Services   |  |                      |  | X                            
|Test Perspective        |  | X                    |  |                              
|WebEffective            |  | X                    |  | X                            
|WebIntegrity            |  | X                    |  |                              
|Wireless Perspective    |  | X                    |  |                              





13



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##### Table of Contents

The following table summarizes measurement services and management solutions revenue (in thousands):



|                                     |  |      |        |      |   |          |  |    |   
|------------------------------------ |  | ---- | ------ | ---- | - | -------- |  | -- | --
|                                     |  | 2004 |        | 2003 |   | % change | 
|For the three months ended March 31: |  |      |        |      |   |          |  |    |   
|Measurement services revenue         |  | $    | 6,867  |      | $ | 7,237    |  | (5 | )%
|Management solutions revenue         |  |      | 2,952  |      |   | 2,321    |  | 27 | % 
|                                     |  |      |        |      |   |          |  |    |   
|Total Revenue                        |  | $    | 9,819  |      | $ | 9,558    |  | 3  | % 
|                                     |  |      |       
|                                     |  | 2004 |        | 2003 |   | % change | 
|For the six months ended March 31:   |  |      |        |      |   |          |  |    |   
|Measurement services revenue         |  | $    | 13,920 |      | $ | 14,832   |  | (6 | )%
|Management solutions revenue         |  |      | 5,622  |      |   | 4,484    |  | 25 | % 
|                                     |  |      |        |      |   |          |  |    |   
|Total Revenue                        |  | $    | 19,542 |      | $ | 19,316   |  | 1  | % 



Measurement services revenue decreased
by $370,000 for the three months ended March 31, 2004 as compared to the corresponding period in fiscal 2003. Measurement services revenue represented 70% and 76% of total revenue for the three months ended March 31, 2004 and 2003, respectively.
Measurement services revenue decreased by $912,000 for the six months ended March 31, 2004 as compared to the corresponding period in fiscal 2003. Measurement services revenue represented 71% and 77% of total revenue for the six months ended
March 31, 2004 and 2003, respectively. The decrease in measurement services revenue was mainly attributable to reduced subscriptions for our benchmarking and monitoring services, resulting in fewer measurements and fewer monitoring devices being
measured.



Management solutions revenue increased by $631,000 for the three
months ended March 31, 2004 as compared to the corresponding period in fiscal 2003. Management solutions revenue represented 30% and 24% of total revenue for the three months ended March 31, 2004 and 2003, respectively. Management solutions revenue
increased by approximately $1.1 million for the six months ended March 31, 2004 as compared to the corresponding period in fiscal 2003. Management solutions revenue represented 29% and 23% of total revenue for the six months ended March 31,
2004 and 2003, respectively. The increase in management solutions revenue was mainly attributable to increased contribution from our Wireless Perspective, Enterprise Solutions, WebEffective, WebIntegrity, and Test Perspective solutions, as well as
Network Perspective, which was newly introduced in December 2003 as a result of our acquisition of the business of MatrixNet division of Xaffire, Inc. (MatrixNet).



We believe that the challenges for our business include increasing management solutions revenue while stabilizing measurement services
revenue and slightly increasing quarterly expenses for fiscal 2004 at levels consistent with those for the first and second quarters of fiscal 2004, assuming no acquisitions.



At March 31, 2004 and 2003, no single customer accounted for more than 10% of the Companys total accounts receivable. For the three
and six months ended March 31, 2004 and 2003, no single customer accounted for more than 10% of the Companys total revenue.



For the three months ended March 31, 2004, our 10 largest customers accounted for approximately 34% of total revenue. We cannot be certain that customers that have
accounted for significant revenue in past periods, individually or in aggregate, will renew our services and continue to generate revenue in any future period. In addition, our customers that have monthly renewal arrangements may terminate their
services at any time with little or no penalty. If we lose a major customer or a group of significant customers, our revenue could decline significantly.



Costs of subscription services consist of connection fees to major telecommunication and internet access providers for bandwidth usage of our measurement computers, which
are located around the world, depreciation, maintenance and other equipment charges for our measurement and data collection infrastructure.



Costs of consulting and support services consist of compensation expenses and related costs for consulting and support services personnel, all load-testing bandwidth
costs and related network infrastructure costs.



Results of Operations



The following table sets forth, as a percentage of total revenue, certain
condensed consolidated statements of operations data for the periods indicated. All information is derived from our condensed consolidated financial statements included in this Form 10-Q. The operating results are not necessarily indicative of the
results for any future period.



|                                                                            |  |                              |   |  |                            |    |  |       |   |  |       |   
|--------------------------------------------------------------------------- |  | ---------------------------- | - |  | -------------------------- | -- |  | ----- | - |  | ----- | --
|                                                                            |  | Three months ended March 31, |   |  | Six months ended March 31, |   
|                                                                            |  | 2004                         |   |  | 2003                       |    |  | 2004  |   |  | 2003  |   
|Revenue:                                                                    |  |                              |   |  |                            |    |  |       |   |  |       |   
|Subscription services                                                       |  | 89.7                         | % |  | 89.6                       | %  |  | 89.4  | % |  | 90.1  | % 
|Consulting and support services                                             |  | 10.3                         |   |  | 10.4                       |    |  | 10.6  |   |  | 9.9   |   
|                                                                            |  |                              |   |  |                            |    |  |       |   |  |       |   
|Total revenue                                                               |  | 100.0                        |   |  | 100.0                      |    |  | 100.0 |   |  | 100.0 |   
|Expenses:                                                                   |  |                              |   |  |                            |    |  |       |   |  |       |   
|Costs of subscription services                                              |  | 13.2                         |   |  | 23.7                       |    |  | 14.3  |   |  | 24.6  |   
|Costs of consulting and support services                                    |  | 9.1                          |   |  | 10.2                       |    |  | 8.7   |   |  | 9.7   |   
|Research and development                                                    |  | 16.6                         |   |  | 21.5                       |    |  | 16.7  |   |  | 21.9  |   
|Sales and marketing                                                         |  | 23.2                         |   |  | 42.2                       |    |  | 25.5  |   |  | 43.9  |   
|Operations                                                                  |  | 12.6                         |   |  | 17.7                       |    |  | 12.7  |   |  | 17.6  |   
|General and administrative                                                  |  | 12.4                         |   |  | 16.9                       |    |  | 12.2  |   |  | 16.1  |   
|Excess occupancy costs                                                      |  | 2.6                          |   |  | 3.1                        |    |  | 2.7   |   |  | 3.0   |   
|Amortization of identifiable intangible assets and stock-based compensation |  | 3.8                          |   |  | 4.4                        |    |  | 3.8   |   |  | 4.3   |   
|                                                                            |  |                              |   |  |                            |    |  |       |   |  |       |   
|Total expenses                                                              |  | 93.5                         |   |  | 139.7                      |    |  | 96.6  |   |  | 141.1 |   
|                                                                            |  |                              |   |  |                            |    |  |       |   |  |       |   
|Income (loss) from operations                                               |  | 6.5                          |   |  | (39.7                      | )  |  | 3.4   |   |  | (41.1 | ) 
|Interest income, net                                                        |  | 6.7                          |   |  | 17.4                       |    |  | 6.8   |   |  | 19.8  |   
|                                                                            |  |                              |   |  |                            |    |  |       |   |  |       |   
|Net income (loss) before provision for income taxes                         |  | 13.2                         |   |  | (22.3                      | )  |  | 10.2  |   |  | (21.3 | ) 
|Provision for income taxes                                                  |  | (1.3                         | ) |  |                           |    |  | (0.8  | ) |  |      |   
|                                                                            |  |                              |   |  |                            |    |  |       |   |  |       |   
|Net income (loss)                                                           |  | 11.9                         | % |  | (22.3                      | )% |  | 9.4   | % |  | (21.3 | )%



14



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Our results improved by approximately $3.3 million, from a net loss of approximately $2.1 million for the three months
ended March 31, 2003 to a net income of approximately $1.2 million for the three months ended March 31, 2004. Total revenue increased by $261,000 or 3%, from $9.6 million for the three months ended March 31, 2003 to approximately $9.8 million
for the three months ended March 31, 2004. Total expenses decreased by approximately $4.2 million or 31%, from approximately $13.3 million for the three months ended March 31, 2003 to approximately $9.2 million for the three months ended March 31,
2004.



Our results improved by approximately $6.0 million, from a net loss of
approximately $4.1 million for the six months ended March 31, 2003 to a net income of approximately $1.8 million for the six months ended March 31, 2004. Total revenue increased by $226,000 or 1%, from $19. 3 million for the six months ended
March 31, 2003 to approximately $19.5 million for the six months ended March 31, 2004. Total expenses decreased by approximately $8.4 million or 31%, from approximately $27.3 million for the six months ended March 31, 2003 to approximately $18.9
million for the six months ended March 31, 2004.



We anticipate that total
expenses for the third quarter of fiscal 2004 will increase as compared to the second quarter of fiscal 2004 primarily due to our recent acquisition of NetRaker Corporation in April 2004 and additional investment in our sales and marketing efforts.



Revenue



|                                     |  |      |        |      |   |          |  |   |  
|------------------------------------ |  | ---- | ------ | ---- | - | -------- |  | - | -
|                                     |  | 2004 |        | 2003 |   | % Change | 
|For the three months ended March 31: |  |      |        |      |   |          |  |   |  
|Subscription services                |  | $    | 8,803  |      | $ | 8,567    |  | 3 | %
|Consulting and support services      |  |      | 1,016  |      |   | 991      |  | 3 | %
|                                     |  |      |        |      |   |          |  |   |  
|                                     |  | $    | 9,819  |      | $ | 9,558    |  | 3 | %
|                                     |  |      |       
|                                     |  | 2004 |        | 2003 |   | % Change | 
|For the six months ended March 31:   |  |      |        |      |   |          |  |   |  
|Subscription services                |  | $    | 17,474 |      | $ | 17,408   |  | 0 | %
|Consulting and support services      |  |      | 2,068  |      |   | 1,908    |  | 8 | %
|                                     |  |      |        |      |   |          |  |   |  
|                                     |  | $    | 19,542 |      | $ | 19,316   |  | 1 | %



Subscription Services. Revenue from
subscription services increased by $236,000 for the three months ended March 31, 2004 as compared to the same period in fiscal 2003. Revenue from subscription services increased slightly by $66,000 for the six months ended March 31, 2004 as compared
to the same period in fiscal 2003. The increase in subscription services revenue was mainly attributable to increases in our Transaction Perspective, Wireless Perspective, Test Perspective, Enterprise Solutions, and the contribution from our newly
acquired Network Perspective services, offset by a decrease in our benchmarking and monitoring services, resulting in fewer measurements and fewer monitoring devices being measured. At the end of March 31, 2004, we measured for revenue 7,217 page
measurements or URLs, and 7,629 internet-connected devices. At the end of March 31, 2003, we measured for revenue 7,239 URLs and 7,998 internet-connected devices.



Consulting and Support Services. Revenue from consulting and support services increased slightly by $25,000 for the three months ended March
31, 2004 as compared to the same period in fiscal 2003. Revenue from consulting and support services increased by $160,000 for the six months ended March 31, 2004 as compared to the same period in fiscal 2003. The increase in consulting and support
services revenue was primarily due to increased contribution from our Enterprise Solutions and LoadPro services. Because our consulting and support services are provided on a per engagement basis, revenue depends on the number of engagements and the
size of such engagements. As a result, consulting and support services revenue are less predictable than subscription services revenue and may vary from period to period.



15



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##### Table of Contents

Expenses:



Costs of Subscription and Consulting and Support Services



|                                         |  |                |       |      |   |          |  |     |   
|---------------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                         |  | 2004           |       | 2003 |   | % Change | 
|                                         |  | (In thousands) |       |      |  
|For the three months ended March 31:     |  |                |       |      |   |          |  |     |   
|Costs of subscription services           |  | $              | 1,298 |      | $ | 2,262    |  | (43 | )%
|Costs of consulting and support services |  | $              | 891   |      | $ | 971      |  | (8  | )%



|                                         |  |                |       |      |   |          |  |     |   
|---------------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                         |  | 2004           |       | 2003 |   | % Change | 
|                                         |  | (In thousands) |       |      |  
|For the six months ended March 31:       |  |                |       |      |   |          |  |     |   
|Costs of subscription services           |  | $              | 2,804 |      | $ | 4,745    |  | (41 | )%
|Costs of consulting and support services |  | $              | 1,694 |      | $ | 1,870    |  | (9  | )%



Costs of Subscription Services. Costs
of subscription services decreased $964,000 for the three months ended March 31, 2004 as compared to the same period in fiscal 2003 and represented 15% and 26% of subscription services revenue for the three months ending March 31, 2004 and 2003,
respectively. Costs of subscription services decreased approximately $1.9 million for the six months ended March 31, 2004 as compared to the same period in fiscal 2003 and represented 16% and 27% of subscription services revenue for the six months
ending March 31, 2004 and 2003, respectively. The decreases were primarily due to reduced costs for bandwidth and a decrease in depreciation expenses as capital equipment became fully depreciated, and, to a lesser extent, hardware and software
maintenance expenses.



Costs of Consulting and Support Services. Costs of
consulting and support services decreased $80,000 for the three months ended March 31, 2004 as compared to the corresponding period in fiscal 2003, and represented 88% and 98% of consulting and support services revenue for the three months ended
March 31, 2004 and 2003, respectively. Costs of consulting and support services decreased $176,000 for the six months ended March 31, 2004 as compared to the corresponding period in fiscal 2003, and represented 82% and 98% of consulting and support
services revenue for the six months ended March 31, 2004 and 2003, respectively. The decrease in costs of consulting and support services was primarily attributable to reduced costs for bandwidth expenses and lower personnel costs.



We expect that total costs of subscription and consulting and support services in absolute
dollars for the third quarter of fiscal 2004 will increase compared to the second quarter of fiscal 2004 due to our acquisition of NetRaker Corporation in April 2004.



Research and Development



|                                     |  |                |       |      |   |          |  |     |   
|------------------------------------ |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                     |  | 2004           |       | 2003 |   | % Change | 
|                                     |  | (In thousands) |       |      |  
|For the three months ended March 31: |  |                |       |      |   |          |  |     |   
|Research and development             |  | $              | 1,634 |      | $ | 2,054    |  | (20 | )%



|                                   |  |                |       |      |   |          |  |     |   
|---------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                   |  | 2004           |       | 2003 |   | % Change | 
|                                   |  | (In thousands) |       |      |  
|For the six months ended March 31: |  |                |       |      |   |          |  |     |   
|Research and development           |  | $              | 3,258 |      | $ | 4,235    |  | (23 | )%



Research and development expenses
consist primarily of compensation and related costs for research and development personnel. Research and development expenses decreased $420,000 for the three months ended March 31, 2004 as compared to the corresponding period in fiscal 2003.
Research and development expenses decreased $977,000 for the six months ended March 31, 2004 as compared to the corresponding period in fiscal 2003. The decrease was primarily attributable to lower costs resulting from a reduced number of research
and development personnel and reduced salaries, offset, in part, by additional personnel costs related to acquisitions. To date, all research and development expenses have been expensed as incurred. We believe that research and development expenses
in absolute dollars for the third quarter of fiscal 2004 will increase compared to the second quarter of fiscal 2004 due to our acquisition of NetRaker Corporation in April 2004.



Sales and Marketing



|                                     |  |                |       |      |   |          |  |     |   
|------------------------------------ |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                     |  | 2004           |       | 2003 |   | % Change | 
|                                     |  | (In thousands) |       |      |  
|For the three months ended March 31: |  |                |       |      |   |          |  |     |   
|Sales and marketing                  |  | $              | 2,278 |      | $ | 4,033    |  | (44 | )%



|                                   |  |                |       |      |   |          |  |     |   
|---------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                   |  | 2004           |       | 2003 |   | % Change | 
|                                   |  | (In thousands) |       |      |  
|For the six months ended March 31: |  |                |       |      |   |          |  |     |   
|Sales and marketing                |  | $              | 4,987 |      | $ | 8,478    |  | (41 | )%



Sales and marketing expenses consist
primarily of salaries, commissions and bonuses earned by sales and marketing personnel, lead-referral fees, marketing programs and travel expenses. Our sales and marketing expenses decreased approximately $1.8 million for the three months ended
March 31, 2004 as compared to the corresponding period in fiscal 2003. Our sales and marketing expenses decreased approximately $3.5 million for the six months ended March 31, 2004 as compared to the corresponding period in fiscal 2003. The decrease
primarily resulted from a reduced number of sales and marketing personnel as well as reduced salaries for our marketing personnel, and, to a lesser extent, from reduced spending on certain marketing programs. We believe that sales and marketing
expenses in absolute dollars for



16



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##### Table of Contents

the third quarter of fiscal 2004 will increase compared to the second quarter of fiscal 2004 due to our acquisition of
NetRaker Corporation in April 2004 and the expenses associated with our Customer Advisory Board Meeting in April 2004, our Total Performance Management Symposium to be held in New York in June 2004 and additional marketing programs.



Operations



|                                     |  |                |       |      |   |          |  |     |   
|------------------------------------ |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                     |  | 2004           |       | 2003 |   | % Change | 
|                                     |  | (In thousands) |       |      |  
|For the three months ended March 31: |  |                |       |      |   |          |  |     |   
|Operations                           |  | $              | 1,234 |      | $ | 1,688    |  | (27 | )%



|                                   |  |                |       |      |   |          |  |     |   
|---------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                   |  | 2004           |       | 2003 |   | % Change | 
|                                   |  | (In thousands) |       |      |  
|For the six months ended March 31: |  |                |       |      |   |          |  |     |   
|Operations                         |  | $              | 2,489 |      | $ | 3,406    |  | (27 | )%



Operations expenses consist primarily
of compensation and related costs for management and technical support personnel who manage and maintain our field measurement and collection infrastructure and headquarters data center, and provide basic customer support 24 hours per day, 7 days a
week. Our operations personnel also work closely with other departments to assure the reliability of our services and to support our sales and marketing activities. Our operations expenses decreased $454,000 for the three months ended March 31, 2004
as compared to the corresponding period in fiscal 2003. Our operations expenses decreased $917,000 for the six months ended March 31, 2004 as compared to the corresponding period in fiscal 2003. The decrease in operations expenses was primarily the
result of lower personnel costs from a reduced number of operations personnel, and, to a lesser extent, to reduced salaries for operations personnel. Additionally, the decrease was attributable to the costs associated with our temporary generator
that has now been replaced with our permanent generator, which was completed in mid 2003. We anticipate that operations expenses in absolute dollars for the third quarter of fiscal 2004 will increase compared to the second quarter of fiscal 2004 due
to our acquisition of NetRaker Corporation in April 2004 and additional customer support personnel.



General and Administrative



|                                     |  |                |       |      |   |          |  |     |   
|------------------------------------ |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                     |  | 2004           |       | 2003 |   | % Change | 
|                                     |  | (In thousands) |       |      |  
|For the three months ended March 31: |  |                |       |      |   |          |  |     |   
|General and administrative           |  | $              | 1,221 |      | $ | 1,612    |  | (24 | )%



|                                   |  |                |       |      |   |          |  |     |   
|---------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                   |  | 2004           |       | 2003 |   | % Change | 
|                                   |  | (In thousands) |       |      |  
|For the six months ended March 31: |  |                |       |      |   |          |  |     |   
|General and administrative         |  | $              | 2,385 |      | $ | 3,116    |  | (23 | )%



General and administrative expenses
consist primarily of salaries and related expenses, accounting, legal and administrative expenses, insurance, professional service fees and other general corporate expenses. General and administrative expenses decreased $391,000 for the three months
ended March 31, 2004 as compared to the same period in fiscal 2003. General and administrative expenses decreased $731,000 for the six months ended March 31, 2004 as compared to the same period in fiscal 2003. The decrease in our general and
administrative expenses was primarily attributable to a reduced number of general and administrative personnel and reduced salaries for general and administrative personnel. We anticipate that general and administrative expenses in absolute dollars
for the third quarter of fiscal 2004 will remain comparable to the second quarter of fiscal 2004.



Excess Occupancy Costs



|                                     |  |                |     |      |   |          |  |     |   
|------------------------------------ |  | -------------- | --- | ---- | - | -------- |  | --- | --
|                                     |  | 2004           |     | 2003 |   | % Change | 
|                                     |  | (In thousands) |     |      |  
|For the three months ended March 31: |  |                |     |      |   |          |  |     |   
|Excess occupancy costs               |  | $              | 254 |      | $ | 293      |  | (13 | )%



|                                   |  |                |     |      |   |          |  |     |   
|---------------------------------- |  | -------------- | --- | ---- | - | -------- |  | --- | --
|                                   |  | 2004           |     | 2003 |   | % Change | 
|                                   |  | (In thousands) |     |      |  
|For the six months ended March 31: |  |                |     |      |   |          |  |     |   
|Excess occupancy costs             |  | $              | 520 |      | $ | 578      |  | (10 | )%



Excess occupancy costs are fixed
expenses associated with the unoccupied portion of our headquarters building, acquired in September 2002, such as property taxes,



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##### Table of Contents

insurance, and depreciation. The costs are based on the actual unoccupied square footage, which were 70% and 60% of the
total rentable square footage of the headquarters building for the three months ended March 31, 2004 and 2003, respectively. We anticipate that excess occupancy costs in absolute dollars for the third quarter of fiscal 2004 will decrease
slightly compared to the second quarter of fiscal 2004.



Amortization of Identifiable Intangible Assets and Stock-Based Compensation



|                                                                            |  |                |     |      |   |          |  |     |   
|--------------------------------------------------------------------------- |  | -------------- | --- | ---- | - | -------- |  | --- | --
|                                                                            |  | 2004           |     | 2003 |   | % Change | 
|                                                                            |  | (In thousands) |     |      |  
|For the three months ended March 31:                                        |  |                |     |      |   |          |  |     |   
|Amortization of identifiable intangible assets                              |  | $              | 372 |      | $ | 421      |  | (12 | )%
|Amortization of stock-based compensation                                    |  |                |    |      |   | 3        |  |    |   
|                                                                            |  |                |     |      |   |          |  |     |   
|Amortization of identifiable intangible assets and stock-based compensation |  | $              | 372 |      | $ | 424      |  | (12 | )%
|                                                                            |  |                |     |      |   |          |  |     |   



|                                                                            |  |                |     |      |   |          |  |     |   
|--------------------------------------------------------------------------- |  | -------------- | --- | ---- | - | -------- |  | --- | --
|                                                                            |  | 2004           |     | 2003 |   | % Change | 
|                                                                            |  | (In thousands) |     |      |  
|For the six months ended March 31:                                          |  |                |     |      |   |          |  |     |   
|Amortization of identifiable intangible assets                              |  | $              | 734 |      | $ | 800      |  | (8  | )%
|Amortization of stock-based compensation                                    |  |                |    |      |   | 27       |  |    |   
|                                                                            |  |                |     |      |   |          |  |     |   
|Amortization of identifiable intangible assets and stock-based compensation |  | $              | 734 |      | $ | 827      |  | (11 | )%
|                                                                            |  |                |     |      |   |          |  |     |   



As of March 31, 2004 and 2003, we had
identifiable intangible assets with a gross carrying value of approximately $12.1 million and $11.7 million, respectively. For the three months ended March 31, 2004 and 2003, we recorded expenses of $372,000 and $421,000, respectively, for
amortization related to these identifiable intangible assets. For the six months ended March 31, 2004 and 2003, we recorded expenses of $734,000 and $800,000, respectively, for amortization related to these identifiable intangible assets. As of
March 31, 2004 and 2003, the net carrying value of identifiable intangible assets was approximately $1.6 million and $2.7 million, respectively.



Certain options granted prior to June 30, 1999, were considered to be compensatory, as the estimated fair value for accounting purposes was greater than the stock price
as determined by the board of directors on the date of grant. We did not record any amortization of deferred compensation expense for the three months ended March 31, 2004, since deferred compensation was fully amortized as September 30, 2003. We
recorded amortization of deferred compensation expenses of $3,000 for the three months ended March 31, 2003 and $27,000 for the six months ended March 31, 2003.



We review our identifiable intangible assets for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of these assets
may not be recoverable.



We expect the amortization of intangible assets to be
approximately $450,000 for the third quarter of fiscal 2004, including the amortization related to our recent NetRaker acquisition and assuming no additional acquisitions or impairment charges. We expect the remaining carrying value of the
identifiable intangible assets as of March 31, 2004, as listed in the table below, will be fully amortized by July 2006 (in thousands).



|                                     |  |                 |       |               |   |           |  |       |   |  |   |      
|------------------------------------ |  | --------------- | ----- | ------------- | - | --------- |  | ----- | - |  | - | -----
|                                     |  | TechnologyBased |       | CustomerBased |   | Trademark |  | Total
|Net carrying value at March 31, 2004 |  | $               | 1,447 |               | $ | 122       |  | $     |  |  | $ | 1,569
|                                     |  |                 |       |               |   |           |  |       |   |  |   |      



Interest Income
and Other, Net



|                                     |  |                |     |      |   |          |  |     |   
|------------------------------------ |  | -------------- | --- | ---- | - | -------- |  | --- | --
|                                     |  | 2004           |     | 2003 |   | % Change | 
|                                     |  | (In thousands) |     |      |  
|For the three months ended March 31: |  |                |     |      |   |          |  |     |   
|Interest income and other, net       |  | $              | 662 |      | $ | 1,661    |  | (60 | )%



|                                   |  |                |       |      |   |          |  |     |   
|---------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                   |  | 2004           |       | 2003 |   | % Change | 
|                                   |  | (In thousands) |       |      |  
|For the six months ended March 31: |  |                |       |      |   |          |  |     |   
|Interest income and other, net     |  | $              | 1,325 |      | $ | 3,825    |  | (65 | )%



Interest income and other, net,
decreased $999,000 for the three months ended March 31, 2004 as compared to the corresponding period in fiscal 2003. Interest income and other, net, decreased approximately $2.5 million for the six months ended March 31, 2004 as compared to the
corresponding period in fiscal 2003. The decrease in interest income and other, net, was primarily attributable to a lower level of invested cash due to the use of approximately $79.2 million of cash to repurchase our common stock primarily in our
two issuer tender offers in November 2002 and May 2003, and lower average interest rates. Substantially all of the interest income



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##### Table of Contents

represents interest earned from our cash, cash equivalents, and short-term investments. We expect that interest income
and other, net, for the third quarter of fiscal 2004 will be approximately $650,000, absent any additional transactions, and assuming no material changes in interest rates



Provision for Income Taxes



|                                     |  |                |     |      |   |          |  |  
|------------------------------------ |  | -------------- | --- | ---- | - | -------- |  | -
|                                     |  | 2004           |     | 2003 |   | % Change
|                                     |  | (In thousands) |     |     
|For the three months ended March 31: |  |                |     |      |   |          |  |  
|Provision for income taxes           |  | $              | 130 |      | $ |         |  | 



|                                   |  |                |     |      |   |          |  |  
|---------------------------------- |  | -------------- | --- | ---- | - | -------- |  | -
|                                   |  | 2004           |     | 2003 |   | % Change
|                                   |  | (In thousands) |     |     
|For the six months ended March 31: |  |                |     |      |   |          |  |  
|Provision for income taxes         |  | $              | 160 |      | $ |         |  | 



Provision for income taxes was
$130,000 for the three months ended March 31, 2004, attributable to alternative minimum tax associated with the net income generated during the three months ended March 31, 2004. Provision for income taxes was $160,000 for the six months ended March
31, 2004, attributable to alternative minimum tax associated with the net income generated during the six months ended March 31, 2004. No provision for federal and state income taxes was recorded for the three and six months ended March 31, 2003,
due to our operating losses, operating loss carryforwards, and tax credits.



Liquidity and Capital Resources



|                                                  |  |                    |         |   |                        |   |         |          |  |      |   
|------------------------------------------------- |  | ------------------ | ------- | - | ---------------------- | - | ------- | -------- |  | ---- | --
|                                                  |  | As ofMarch 31,2004 |         |   | As ofSeptember 30,2003 |   |         | % Change | 
|                                                  |  | (In thousands)     |         |   |                        |  
|Cash, cash equivalents and short-term investments |  | $                  | 170,075 |   |                        | $ | 160,214 |          |  | 6    | % 
|                                                  |  |                    |        
|                                                  |  | 2004               |         |   | 2003                   |   |         | % Change | 
|                                                  |  | (In thousands)     |         |   |                        |  
|For the six months ended March 31:                |  |                    |         |   |                        |   |         |          |  |      |   
|Cash provided by operating activities             |  | $                  | 8,370   |   |                        | $ | 2,349   |          |  | 256  | % 
|Cash provided by (used in) investing activities   |  | $                  | (10,861 | ) |                        | $ | 42,620  |          |  | (125 | )%
|Cash provided by (used in) financing activities   |  | $                  | 5,055   |   |                        | $ | (37,265 | )        |  | 114  | % 



Cash, cash
equivalents and short-term investments



At March 31, 2004, we had
approximately $25.8 million in cash and cash equivalents and approximately $144.3 million in short-term investments, for a total of approximately $170.1 million. Cash and cash equivalents consist of highly liquid investments held at major banks,
commercial paper, United States government agency discount notes, money market mutual funds and other money market securities with original maturities of three months or less. Short-term investments consist of investment-grade corporate and
government debt securities with Moodys ratings of A2 or better. The increase in cash, cash equivalents and short-term investments for the six months ended March 31, 2004 was primarily due to $8.4 million from cash flow from operating
activities, including the collection of a receivable from a large customer that represented $600,000 of prepaid deferred revenue, and $5.1 million from cash flow from financing activities. The largest use of cash from investing activities was the
net purchases of short-term investments for $9.4 million.



The timeliness in
the collection of accounts receivable impacts the amount of cash, cash equivalents and short-term investments. Days sales outstanding, which is calculated by dividing period end accounts receivable by average daily sales for the quarter, was 43 days
and 41 days for the quarters ended March 31, 2004 and September 30, 2003, respectively. Days sales outstanding was higher due to an increase in accounts receivable from an increase in revenue for the three months ended March 31, 2004 as compared to
the three months ended September 30, 2003.



Cash provided by
operating activities



For the six months ended March 31, 2004, net cash
provided by operating activities was approximately $8.4 million which was mainly due to net income, excluding all non-cash amortization and depreciation charges and an increase in deferred revenue of $1.4 million, partially offset by an increase in
accounts receivable of $319,000. The increase in deferred revenue was mainly attributable to an increase in the value of prepaid invoices. Net accounts receivable increased primarily due to the increase in revenue for the first six months of fiscal
2004 as compared to the corresponding period in 2003.



Cash
used in investing activities



For the six months ended March 31, 2004, net
cash used in our investing activities was approximately $10.9 million. We utilized a net amount of approximately $9.4 million for the net purchase of short-term investments. We utilized $936,000 to purchase property and equipment, primarily for our
production infrastructure, information systems, and tenant improvements associated with space that we have rented in our headquarters building and $560,000 for the acquisition of the business of the MatrixNet division of Xaffire, Inc.



Cash provided by financing activities



For the six months ended March 31, 2004, net cash provided by our financing activities was
approximately $5.1 million, which was received from the issuance of



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common stock, associated with our employee stock option plan and employee stock purchase plan. Our board of directors has
approved a program to repurchase shares of our common stock, and pursuant to the stock repurchase program, a total of 10.4 million shares were repurchased between January 2001 and June 2003 for an aggregate price of approximately $90.1 million. At
March 31, 2004, approximately $39.9 million was available to repurchase shares of our common stock pursuant to this stock repurchase program.



Commitments



As of March 31, 2004, our principal commitments consisted of $180,000 in real property operating leases, with various lease terms, the longest of which expires in
December 2005. Additionally, we had contingent commitments to 61 bandwidth and collocation providers amounting to $896,000 for 113 locations, which commitments become due if we terminate any of these agreements prior to their expiration. At present,
we do not intend to terminate any of these agreements prior to their expiration. We expect to continue to invest in capital and other assets to support our growth. We expect to make additional capital expenditures of approximately $1.1 million
related to our operations and headquarters building for the third quarter of fiscal 2004, absent any other acquisitions or extraordinary transactions.



The following table summarizes our minimum contractual obligations and commercial commitments as of March 31, 2004 (in thousands), and the effect we expect them to have
on our liquidity and cash flow in future periods:



|                                                 |  |                       |       |                  |   |            |  |            |    |                   |   |   |  |   |  
|------------------------------------------------ |  | --------------------- | ----- | ---------------- | - | ---------- |  | ---------- | -- | ----------------- | - | - |  | - | -
|                                                 |  | Payment due by period
|                                                 |  | Total                 |       | Less than 1 year |   | 1 3 years |  | 3 5 years |    | More than 5 years
|Contractual Obligations Leases                   |  | $                     | 180   |                  | $ | 103        |  | $          | 77 |                   | $ |  |  | $ | 
|Commercial Commitments Bandwidth and Collocation |  |                       | 896   |                  |   | 884        |  |            | 12 |                   |   |  |  |   | 
|                                                 |  |                       |       |                  |   |            |  |            |    |                   |   |   |  |   |  
|Total                                            |  | $                     | 1,076 |                  | $ | 987        |  | $          | 89 |                   | $ |  |  | $ | 
|                                                 |  |                       |       |                  |   |            |  |            |    |                   |   |   |  |   |  



We believe that our existing cash and
cash equivalents will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Factors that could affect our cash position include potential acquisitions, additional stock
repurchases, decreases in customers or renewals, or changes in the value of our short-term investments. If, after some period of time, cash generated from operations is insufficient to satisfy our liquidity requirements, we may seek to sell
additional equity or debt securities or to obtain a credit facility. If additional funds are raised through the issuance of debt securities, these securities could have rights, preferences and privileges senior to holders of common stock, and the
term of this debt could impose restrictions on our operations. The sale of additional equity or convertible debt securities could result in dilution to our stockholders, and we may not be able to obtain additional financing on acceptable terms, if
at all. If we are unable to obtain this additional financing, our business may be harmed.



Off Balance Sheet Arrangements



We do
not have any off balance sheet arrangements.



Critical Accounting Policies
and Judgments



Our consolidated financial statements are prepared in
accordance with accounting principles generally accepted in the United States. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely
are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the
financial statements, as well as the reported amounts of revenue and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements
will be affected. The significant accounting policies that we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:



| |  | Revenue Recognition
| | - | -------------------



| |  | Allowance for Doubtful Accounts Receivable
| | - | ------------------------------------------



| |  | Impairment Assessments of Goodwill and Identifiable Intangibles
| | - | ---------------------------------------------------------------



| |  | Valuation of Long-Lived Assets
| | - | ------------------------------



Our critical accounting policies and judgments are of both a routine and non-routine nature. The recurring policies relate to revenue recognition, the allowance for
doubtful accounts receivable, and goodwill impairments. The non-routine policy relates to the valuation of our long-lived assets.



Revenue Recognition



Revenue consists of subscription services revenue and consulting and support services revenue. Subscription services revenue consists of fees from subscriptions to our
web performance measurement and management services. Subscription services revenue is generally deferred upon invoicing and is recognized ratably over the service period, generally ranging from one to twelve months. For some customers, subscription
services revenue is invoiced monthly upon completion of the services. All unearned revenue is recorded as deferred revenue on the balance sheet. We do not generally grant refunds. All discounts granted reduce revenue. Revenue is not recognized for
free trial periods. Consulting and support services revenue, which consists of fees generated by our consulting and supports services and our load testing services, is recognized as the services are performed, typically over a period of one to three
months. For consulting projects that span more than one month, we recognize revenue as milestones or deliverables are completed.



Allowance for Doubtful Accounts Receivable



Our accounting policy for our allowance for doubtful accounts is determined based on historical trends, experience and current market and industry conditions. We
regularly review the adequacy of our accounts receivable allowance after considering the age of each invoice of the accounts receivable aging, each customers



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expected ability to pay and our collection history with each customer. We review invoices greater than 60 days past due
to determine whether an allowance is appropriate based on the receivable balance. In addition, we maintain a reserve for all other invoices, which is calculated by applying a percentage, based on historical collection trends, to the outstanding
accounts receivable balance. The allowance for doubtful accounts represents managements best estimate, but changes in circumstances, in the future, relating to accounts receivable may result in a requirement for additional allowances in the
future or reductions in allowances due to future recoveries or trends. Accounts receivable is recorded net of an allowance for doubtful accounts receivable of 879,000, or 16% of total account receivable, and approximately $1.0 million, or 19% of
total accounts receivable, as of March 31, 2004 and September 30, 2003, respectively.



Impairment Assessments of Goodwill and Identifiable Intangibles



Our methodology for allocating the purchase price relating to acquisitions is determined based on valuations performed by an independent third party. Goodwill is measured as the excess of the cost of the acquisition
over the sum of the amounts assigned to identifiable assets acquired less liabilities assumed.



We perform goodwill impairment tests on an annual basis in the fourth quarter and between annual tests in certain circumstances for our single reporting unit. The goodwill recorded on our consolidated balance sheet as
of March 31, 2004 was $479,000, as compared to $195,000 as of September 30, 2003.



Valuation of Long Lived Assets



We
evaluate the recoverability of fixed assets and identifiable intangible assets other than goodwill whenever events or changes in circumstances indicate the carrying amount of any such asset group may not be fully recoverable. Changes in
circumstances include economic conditions or operating performance. Our evaluation is based upon assumptions about the estimated future undiscounted net cash flows from such asset groups. Management continually applies its best judgment when
performing these evaluations to determine the timing of the testing, the undiscounted net cash flows used to assess recoverability and the fair value of the asset group. If future events or circumstances indicate that an impairment assessment is
required and an asset group is determined to be impaired, our financial results could be materially and adversely impacted in future periods.



New Accounting Pronouncement



In November 2003, the Emerging Issues Task Force reached consensus on paragraph 18 of Issue No. 03-01 (EITF 03 01), The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments. EITF 03-01 requires that certain quantitative and qualitative disclosures should be required for debt and marketable equity securities classified as available-for-sale or held-to-maturity
under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities and SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations that are impaired at the balance sheet date but
for which an other-than-temporary impairment has not been recognized. We are currently evaluating the impact of EITF 03-01 on our financial position and results of operations, but it is not expected to have any material impact on our reported
results.



Factors That May Impact Future Operating Results



We have introduced new products and services, and we have an unproven business model,
which makes it difficult to evaluate our current business and future prospects.



We have recently introduced many new products, including:



| |  | In January 2004, we introduced Network Perspective, which we acquired in connection with our acquisition of the business of the MatrixNet division of Xaffire, Inc in December 2003,
and QuickTime support for our Streaming Perspective service.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In February 2004, we introduced Application Perspective Outside Edition, an outside the firewall transaction monitoring service that complements our recently delivered Application
Perspective Private Edition for inside the firewall monitoring and diagnostics, and E-government Web Transaction Index, which measures the speed and reliability of leading federal government web sites.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In April 2004, we introduced WebEffective Intelligence Platform, an integration of our existing WebEffective services with NetRakers services as a result of our acquisition of
NetRaker Corporation in April 2004, and our Travel and Hospitality Web Transaction Performance Index which measures the transaction performance of over 25 leading airline, hotel and online travel agency web sites.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The long-term revenue and income potential of our current business and services and the
related markets are unproven. In addition, because some of our products and services are new and because the market for web performance management services is evolving, we have limited insight into trends that may emerge and affect our business.



We have incurred and may in the future continue to incur losses, and we may
not sustain profitability.



We have experienced operating losses in each
annual period since inception and in each quarterly period since inception through the third quarter of fiscal 2003. We may not be able to sustain operating profitability in the future. We incurred net losses of $2.1 million for the three months
ended March 31, 2003, and as of March 31, 2004, we had an accumulated deficit of $140.2 million. In addition, we are required under generally accepted accounting principles to review our goodwill and identifiable intangible assets for impairment
when events or circumstances indicate that the carrying value may not be recoverable. As of March 31, 2004, we had approximately $1.6 million of net identifiable intangible assets and $478,000 of goodwill. If we complete additional acquisitions in
the future, we may have additional goodwill and/or identifiable intangibles and, accordingly, may incur expenses in connection with a write-down of goodwill and identifiable intangible assets due to changes in market conditions as we did in the
quarter ended June 30, 2001 when we recorded an impairment charge for goodwill and identifiable intangible assets of $30.5 million in connection with our acquisitions of Velogic and Digital Content. In addition, in fiscal 2002, we recorded a charge
of approximately $3.2 million as a cumulative effect of a change in accounting principle for the write-off of all the remaining goodwill associated with our acquisitions made prior to September 30, 2002. We believe that our operating expenses could
increase as they have in certain past periods. As a result, we will need to increase our revenue to sustain profitability. We may not sustain a sequential quarterly increase in revenue and may never be able to regain our historic revenue growth
rates.



The success of our business depends on customers renewing their
subscriptions for our services and purchasing additional services.



To
maintain and grow our revenue, we must achieve and maintain high customer renewal rates for our services. Our customers have no obligation to renew our services and therefore, they could cease using our services at any time. In addition, our
customers may renew for fewer services. Further, our customers may reduce their use of our services during the term of their subscription. We cannot project the level of renewal rates. Our customer renewal rates may decline as a result of a number
of factors, including consolidations in the Internet industry or if a significant number of our customers cease operations.



Further, we depend on sales to new customers and sales of additional services to our existing customers. Renewals by existing customers or purchases of our services by



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new customers may be limited as companies limit or reduce their technology spending in response to uncertain economic
conditions. We have experienced, and may in the future experience, cancellations, non-renewals and/or reduction in service. If we experience reduced renewal rates or if customers renew for a lesser amount of our services, or if customers, at any
time, reduce the amount of services they purchase from us, our revenue could continue to decline unless we are able to obtain additional customers or sources of revenue, sufficient to replace lost revenue. Continued reductions and/or cancellations
could also result in our inability to collect amounts due.



Our quarterly
financial results are subject to significant fluctuations, and if our future results are below the expectations of investors, the price of our common stock may decline.



Results of operations could vary significantly from quarter to quarter. If revenue falls below our expectations, we may not be able to
reduce our spending rapidly in response to the shortfall. Other factors that could affect our quarterly operating results include those described below and elsewhere in this report:



| |  | the rate of new and renewed subscriptions to our services;
| | - | ----------------------------------------------------------



| |  | the amount and timing of any reductions by our customers in their usage of our services;
| | - | ----------------------------------------------------------------------------------------



| |  | our ability to increase the number of web sites we measure and the scope of services we offer for our existing customers in a particular quarter;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to attract new customers in a quarter, particularly larger customers;
| | - | ---------------------------------------------------------------------------------



| |  | our ability to successfully introduce new products and services to offset any reductions in revenue;
| | - | ----------------------------------------------------------------------------------------------------



| |  | the timing and amount of consulting and support services revenue, which is difficult to predict because this is dependent on the number of consulting and support services
engagements in any given period, the size of these engagements, and our ability to continue our existing engagements and secure new engagements from customers;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the timing and amount of operating costs and capital expenditures relating to expansion or contraction of our domestic and international operations infrastructure;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the timing and amount, if any, of impairment charges related to potential write-down of acquired assets in acquisitions; and
| | - | ----------------------------------------------------------------------------------------------------------------------------



| |  | the timing and amount, if any, of restructuring costs if we are required to further restructure our operations.
| | - | ---------------------------------------------------------------------------------------------------------------



Due to these and other factors, we believe that period-to-period comparisons of our results
of operations are not meaningful and should not be relied upon as indicators of our future performance. It is possible that in some future periods, our results of operations may be below the expectations of public-market analysts and investors. If
this occurs, the price of our common stock may decline.



If we are required
by law or elect to account for stock options under our stock option plans as a compensation expense, our results of operations would be materially affected.



We expect that we will be required to record compensation expense in connection with option grants in accordance with SFAS 123 that have an
exercise price at or below fair market value. It is possible that future laws or regulations will require us to treat all stock options as a compensation expense or we may voluntarily elect to do so. If there is any such change in accounting
regulations or if we elect to account for options in this way, this could result in our reporting increased operating expenses, which would decrease any reported net income or increase any reported net loss. Note 2 of our consolidated financial
statements shows the impact that such a change in accounting treatment would have had on our net loss and net income loss per share if it had been in effect during the reporting periods shown and if the compensation expense were calculated as
described in Note 2.



Our operating results could be harmed if sales of our
web performance measurement services decline.



Sales of our web
performance measurement services, primarily our Web Site Perspective-Business Edition services, and, to a lesser degree, our Transaction Perspective services, have generated a majority of our total revenue. Therefore, the success of our business
currently depends, and for the immediate future will continue to substantially depend, on sales and renewals of our benchmarking services. We have, from time to time, increased the prices of our web performance measurement services, which could
reduce demand for these services. This could result in decreased sales, which would cause our revenue to decline.



Improvements to the infrastructure of the Internet could reduce or eliminate demand for our Internet performance measurement services.



The demand for our Internet performance measurement services could be reduced or eliminated
if future improvements to the infrastructure of the Internet lead companies to conclude that the measurement and evaluation of the performance of their web sites is no longer important to their business. Because the inherent complexity of the
Internet currently causes significant quality of service problems for e-business companies, the vendors and operators that supply and manage the underlying infrastructure are continuously seeking to improve the speed, availability, reliability and
consistency of the Internet. If these vendors and operators succeed in significantly improving the performance of the Internet, which would result in corresponding improvements in the performance of companies web sites, demand for our services
would likely decline which would harm our operating results.



The inability
of our services to perform properly could result in loss of or delay in revenue, injury to our reputation or other harm to our business.



We offer complex services, which may not perform at the level our customers expect. We have, in the past, occasionally given credits to customers as a result of past
problems with our service. Despite our testing, our existing or future services may not perform as expected due to unforeseen problems, which could result in loss of or delay in revenue, loss of market share, failure to achieve market acceptance,
diversion of development resources, injury to our reputation, increased insurance costs or increased service costs. In addition, we have acquired, rather than developed internally, some of our services in connection with our acquisitions of
companies and businesses. These services may not perform at the level we or our customers expect.



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These problems could also result in tort or warranty claims. Although we attempt to reduce the risk of losses resulting
from any claims through warranty disclaimers and liability-limitation clauses in our customer agreements, these contractual provisions may not be enforceable in every instance. Furthermore, although we maintain errors and omissions insurance, this
insurance coverage may not adequately cover us for claims. If a court refused to enforce the liability-limiting provisions of our contracts for any reason, or if liabilities arose that were not contractually limited or adequately covered by
insurance, we could be required to pay damages.



If we do not continually
improve our services in response to technological changes, including changes to the Internet, we may encounter difficulties retaining existing customers and attracting new customers.



The ongoing evolution of the Internet requires us to continually improve the functionality, features and reliability of our web performance
management services, particularly in response to offerings of our competitors. If we do not succeed in developing and marketing new services that respond to competitive and technological developments and changing customer needs, we may encounter
difficulties retaining existing customers and attracting new customers. We must also introduce any new services as quickly as possible. The success of new services depends on several factors, including proper definition of the scope of the new
services and timely completion, introduction and market acceptance of our new services. If new Internet, networking or telecommunication technologies or standards are widely adopted or if other technological changes occur, we may need to expend
significant resources to adapt our services to these developments.



We face
competition that could make it difficult for us to acquire and retain customers.



The market for web performance measurement and management services is rapidly evolving. Our competitors vary in size and in the scope and breadth of the products and services that they offer. We face competition from companies that offer
software and services with features similar to our services such as Mercury Interactive, Gomez Advisors, Segue Software, WatchFire and a variety of small companies that offer a combination of testing, market research capabilities and data. While we
believe these services are not as comprehensive as ours, customers could still choose to use these services or these companies could enhance their services to offer all of the features we offer. As we expand the scope of our products and services,
we expect to encounter many additional market-specific competitors.



We could
also face competition from other companies, which currently do not offer services similar to our services, but offer software or services related to web performance benchmarking, testing, and application performance management, such as WebCriteria,,
a division of Coremetrics, Inc. and INS INSoft Division, an unit of Lucent Technologies, and free services that measure web site availability. In addition, companies that sell systems management software, such as BMC Software, CompuWare,
CA-Unicenter, HP-Openview, Quest Software, NetIQ, Veritas Precise Software, and IBMs Tivoli Unit, with some of whom we have strategic relationships, could choose to offer services similar to ours.



In the future, we intend to expand our service offerings and continue to measure and manage
the performance of emerging technologies such as Internet telephony, wireless devices, and wireless fidelity, or WI-FI, networks and, as a result, could face competition from other companies. Some of our existing and future competitors have or may
have longer operating histories, larger customer bases, greater brand recognition in similar businesses, and significantly greater financial, marketing, technical and other resources. In addition, some of our competitors may be able to devote
greater resources to marketing and promotional campaigns, to adopt more aggressive pricing policies, and to devote substantially more resources to technology and systems development.



Increased competition may result in price reductions, increased costs of providing our services and loss of market share, any of which could
seriously harm our business. We may not be able to compete successfully against our current and future competitors.



A limited number of customers account for a significant portion of our revenue, and the loss of a major customer could harm our operating results.



Ten customers accounted for approximately 34% and 30% of our total revenue for the three
months ended March 31, 2004 and 2003, respectively. We cannot be certain that customers that have accounted for significant revenue in past periods, individually or as a group, will renew, will not cancel or will not reduce their services and,
therefore, continue to generate revenue in any future period. In addition, our customers that do not have written contracts may terminate their services at any time with little or no penalty. If we lose a major customer, our revenue could decline.



If we do not complement our direct sales force with relationships with
other companies to help market our web performance management services, we may not be able to grow our business.



To increase sales of our web performance management services worldwide, we must complement our direct sales force with relationships with companies to help market and
sell our services to their customers. If we are unable to maintain our existing marketing and distribution relationships, or fail to enter into additional relationships, we may have to devote substantially more resources to the direct sale and
marketing of our services. We would also lose anticipated revenue from customer referrals and other co-marketing benefits. In the past, we terminated relationships with three of our international resellers, and we may be required to terminate other
reseller relationships in the future. As a result, we are investing time and resources in evaluating replacements for these resellers and are committing resources to modify our direct sales effort in the United Kingdom and Germany.



Our success depends in part on the ability of these companies to help market and sell our
services. Our existing relationships do not, and any future relationships may not, afford us any exclusive marketing or distribution rights. Therefore, they could reduce their commitment to us at any time in the future. Many of these companies have
multiple relationships and they may not regard us as significant for their business. In addition, these companies generally may terminate their relationships with us, pursue other relationships with our competitors or develop or acquire products or
services that compete with our services. Even if we succeed in entering into these relationships, they may not result in additional customers or revenue.



We must retain qualified personnel in a competitive marketplace, or we may not be able to grow our business.



We may be unable to retain our key employees, namely our management team and experienced
engineers, or to attract, assimilate or retain other highly qualified employees. Although we, and a number of other technology companies, have implemented workforce reductions, there remains substantial competition for highly skilled employees. Our
key employees are not bound by agreements that could prevent them from terminating their employment at any time. If we fail to attract and retain key employees, our business could be harmed.



If the market does not accept our professional services, our results of operations could
be harmed.



Consulting and support services revenue represented
approximately 10% of total revenue for the three months ended March 31, 2004. The cost of consulting and support services has, at times, exceeded our consulting revenue. We expect that the costs of consulting and support services as a percentage of
consulting and support services revenue will be greater than the costs of subscription services as a percentage of subscription services revenue. We will also need to successfully market these services to potential customers in order to increase
revenue. Each consulting engagement typically spans a one- to three-month period, and therefore, it is more difficult for us to predict the amount of consulting and support services revenue recognized in any particular quarter. There are many
experienced firms that offer computer network and Internet-related consulting services. These consulting services providers include consulting companies, such as Accenture, as well as consulting divisions of large technology companies such as IBM.
Because we do not have an established reputation for delivering consulting services, because this area is very competitive, and due to our limited experience in delivering consulting services, we may not succeed in selling these services.



The success of our business depends on the continued use of the Internet by
business and consumers for e-business and communications.



Because our
business is based on providing web performance management services, the Internet must continue to be used as a means of electronic business, or e-



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business, and communications. In addition, we believe that the use of the Internet for conducting business transactions
could be hindered for a number of reasons, including, but not limited to:



| |  | security concerns including the potential for fraud or theft of stored data and information communicated over the Internet;
| | - | ---------------------------------------------------------------------------------------------------------------------------



| |  | inconsistent quality of service, including well-publicized outages of popular web sites;
| | - | ----------------------------------------------------------------------------------------



| |  | lack of availability of cost-effective, high-speed services;
| | - | ------------------------------------------------------------



| |  | limited numbers of local access points for corporate users;
| | - | -----------------------------------------------------------



| |  | delay in the development of enabling technologies or adoption of new standards;
| | - | -------------------------------------------------------------------------------



| |  | inability to integrate business applications with the Internet;
| | - | ---------------------------------------------------------------



| |  | the need to operate with multiple and frequently incompatible products; and
| | - | ---------------------------------------------------------------------------



| |  | a lack of tools to simplify access to and use of the Internet.
| | - | --------------------------------------------------------------



Our network infrastructure could be disrupted by a number of different occurrences, which could impair our ability to serve and retain existing customers or attract
new customers.



All data collected from our measurement computers are
stored in and distributed from our operations center, which we maintain at a single location. Therefore, our operations depend upon our ability to maintain and protect our computer systems, most of which are located at our corporate headquarters in
San Mateo, California, which is an area susceptible to earthquakes and possible power outages. Although we completed a generator project to provide our own source of long-term uninterruptible power, if we experience power outages at our operations
center, we might not be able to promptly receive data from our measurement computers and we might not be able to deliver our services to our customers on a timely basis. We are currently developing a redundant system for computer-network and other
services at an alternate site. Various factors could cause us to not be able to ever complete such systems. Therefore, our operations systems are vulnerable to damage from break-ins, computer viruses, unauthorized access, vandalism, fire, floods,
earthquakes, power loss, telecommunications failures and similar events.



Although we maintain insurance against fires, earthquakes and general business interruptions, the amount of coverage may not be adequate in any particular case. If our operations center is damaged, this could disrupt our services, which
could impair our ability to retain existing customers or attract new customers.



If our computer infrastructure is not functioning properly, we may not be able to deliver our services in a timely or accurate manner. We have occasionally experienced outages of our service in the past, which have typically lasted no more
than a few hours, with the last one of significance occurring in October 2002. These outages have been caused by a variety of factors including electrical distribution equipment malfunctions, operator error, the failure of a back-up computer to
operate when the primary computer ceased functioning and power outages due to our previous facilitys being inadequately equipped to house our operations center. Any outage for any period of time or loss of customer data could cause us to lose
customers.



Individuals who attempt to breach our network security, such as
hackers, could, if successful, misappropriate proprietary information or cause interruptions in our services. Although in the past, we had a breach of our security through what appears to be unauthorized access to certain data belonging to one of
our customers, we have not yet experienced any breaches of our network security or sabotage that has prevented us from serving our customers. We might be required to expend significant capital and resources to protect against, or to alleviate,
problems caused by hackers. We may not have a timely remedy against a hacker who is able to breach our network security. In addition to intentional security breaches, the inadvertent transmission of computer viruses could expose us to litigation or
to a material risk of loss.



Our measurement computers are located at sites
that we do not own or operate, and it could be difficult for us to maintain or repair them if they do not function properly.



Our measurement computers are located at facilities that are not owned by our customers or us. Instead, these computers are installed at locations near various Internet
access points worldwide. Although we operate these computers remotely from our San Mateo, California operations center, we do not own or operate the facilities, and we have little control over how these computers are maintained on a day-to-day
basis. We do not have long-term contractual relationships with the companies that operate the facilities where our measurement computers are located. We may have to find new locations for these computers if we are unable to develop relationships
with these companies or if these companies cease their operations as some have done due to bankruptcies or are acquired. In addition, if our measurement computers cease to function properly, we may not be able to repair or service these computers on
a timely basis, as we may not have immediate access to our measurement computers. Our ability to collect data in a timely manner could be impaired if we are unable to maintain and repair our computers should performance problems arise.



Others might bring infringement claims against us or our suppliers that could harm our
business.



In recent years, there has been significant litigation in the
United States involving patents and other intellectual property rights. We could become subject to intellectual property infringement claims as the number of our competitors grows and our services overlap with competitive offerings. In addition, we
are also subject to other legal proceedings, claims, and litigation arising in the ordinary course of our business. Any of these claims, even if not meritorious, could be expensive and divert managements attention from operating our company.
If we become liable to others for infringement of their intellectual property rights, we could be required to pay a substantial damage award and to develop noninfringing technology, obtain a license or cease selling the services that contain the
infringing intellectual property. We may be unable to develop non-infringing technology or to obtain a license on commercially reasonable terms, or at all.



Our business will be susceptible to additional risks associated with international operations.



We believe we must expand the sales of our services outside the United States. To date, we have little experience with direct sales outside
the United States, and we may not succeed in these efforts. International sales were approximately 6% and 7% of our total revenue for the three months ended March 31, 2004 and 2003, respectively. We intend to expand the sales of our services by
selling directly to certain customers and through resellers to other customers. Therefore, we expect to



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continue to commit our resources to expand our international sales and marketing activities. Conducting international
operations subjects us to risks we do not face in the United States. These include:



| |  | currency exchange rate fluctuations;
| | - | ------------------------------------



| |  | seasonal fluctuations in purchasing patterns;
| | - | ---------------------------------------------



| |  | unexpected changes in regulatory requirements;
| | - | ----------------------------------------------



| |  | maintaining and servicing computer hardware in distant locations;
| | - | -----------------------------------------------------------------



| |  | longer accounts receivable payment cycles and difficulties in collecting accounts receivable;
| | - | ---------------------------------------------------------------------------------------------



| |  | difficulties in managing and staffing international operations;
| | - | ---------------------------------------------------------------



| |  | potentially adverse tax consequences, including restrictions on the repatriation of earnings;
| | - | ---------------------------------------------------------------------------------------------



| |  | the burdens of complying with a wide variety of foreign laws; and
| | - | -----------------------------------------------------------------



| |  | reduced protection for intellectual property rights in some countries.
| | - | ----------------------------------------------------------------------



The Internet may not be used as widely in other countries and the adoption of e-business may evolve slowly or may not evolve at all. As a result, we may not be successful
in selling our services to customers in markets outside the United States.



We may face difficulties assimilating our acquisitions and may incur costs associated with any future acquisitions.



We have completed several acquisitions, and as a part of our business strategy we may seek to acquire or invest in additional businesses, products or technologies that we
feel could complement or expand our business, augment our market coverage, enhance our technical capabilities or that may otherwise offer growth opportunities. Future acquisitions could create risks for us, including:



| |  | difficulties in assimilating acquired personnel, operations and technologies;
| | - | -----------------------------------------------------------------------------



| |  | unanticipated costs associated with the acquisition;
| | - | ----------------------------------------------------



| |  | diversion of managements attention from other business concerns;
| | - | -----------------------------------------------------------------



| |  | adverse effects on existing business relationships with resellers of our service and our customers;
| | - | ---------------------------------------------------------------------------------------------------



| |  | difficulties in managing geographically-dispersed businesses;
| | - | -------------------------------------------------------------



| |  | the need to integrate or enhance the systems of an acquired business;
| | - | ---------------------------------------------------------------------



| |  | impairment charges related to potential write-down of acquired assets in acquisitions;
| | - | --------------------------------------------------------------------------------------



| |  | failure to realize any of the anticipated benefits of the acquisition; and
| | - | --------------------------------------------------------------------------



| |  | use of substantial portions of our available cash or dilution in equity if stock is used to consummate the acquisition and/or operate the acquired business.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------



Our future operating results could be harmed if we are unable
to lease a major portion of the space in our corporate headquarters building or if the fair value of this property decreases further.



We estimate that we will need to lease the unoccupied portion, or approximately 70%, of our headquarters building in San Mateo, California. We may be unable to lease all
or a part of the available space, and if it is leased, we may not receive sufficiently high rental rates to cover our building operating costs. In addition, we have previously incurred a charge for the write-down of the building, and, if the real
estate market continues to deteriorate, we may incur charges for future write-downs. Any such charge could harm our results of operations.



Compliance with new rules and regulations concerning corporate governance may be costly and could harm our business.



The Sarbanes-Oxley Act, which was signed into law in July 2002, mandates, among other
things, that companies adopt new corporate governance measures and



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imposes comprehensive reporting and disclosure requirements, sets stricter independence and financial expertise standards
for audit committee members and imposes increased civil and criminal penalties for companies, their chief executive officers and chief financial officers and directors for securities law violations. In addition, The Nasdaq Stock Market, on which our
common stock is listed, has also adopted additional comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations have increased the scope, complexity and cost of our corporate governance, reporting and
disclosure practices, which could harm our results of operations and divert managements attention from business operations. We also expect these developments to make it more difficult and more expensive for us to obtain director and officer
liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. Further, our board members, Chief Executive Officer and Chief Financial Officer could face an increased risk of personal
liability in connection with the performance of their duties. As a result, we may have difficultly attracting and retaining qualified board members and executive officers, which would adversely affect our business.



We have anti-takeover protections that may delay or prevent a change in control that could
benefit our stockholders.



Our amended and restated certificate of
incorporation and bylaws contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. These provisions include:



| |  | our stockholders may take action only at a meeting and not by written consent;
| | - | ------------------------------------------------------------------------------



| |  | our board must be given advance notice regarding stockholder-sponsored proposals for consideration at annual meetings and for stockholder nominations for the election of directors;
and
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | special meetings of our stockholders may be called only by our Board of Directors, the Chairman of the Board, our Chief Executive Officer or our President, not by our stockholders.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We have also adopted a stockholder rights plan that may
discourage, delay or prevent a change of control and make any future unsolicited acquisition attempt more difficult. The rights will become exercisable only upon the occurrence of certain events specified in the rights plan, including the
acquisition of 20% of our outstanding common stock by a person or group. In addition, it is the policy of our board of directors that a committee consisting solely of independent directors will review the rights plan at least once every three years
to consider whether maintaining the rights plan continues to be in the best interests of Keynote and our stockholders. The board may amend the terms of the rights without the approval of the holders of the rights.



|Item 3. | Qualitative And Quantitative Disclosures About Market Risks.
|------- | ------------------------------------------------------------



Interest Rate Sensitivity. Our interest income and expense is sensitive to changes in the general level of U.S. interest rates, particularly because most of our
cash, cash equivalents and short-term investments are invested in short-term debt instruments. If market interest rates were to change immediately and uniformly by ten percent (10%) from levels at March 31, 2004, the interest earned on those cash,
cash equivalents, and short-term investments could increase or decrease by approximately $270,000 on an annualized basis.



Foreign Currency Fluctuations and Derivative Transactions. We have not had any significant transactions in foreign currencies, nor do we have any significant
balances that were due or payable in foreign currencies at March 31, 2004. We do not enter into derivative transactions for trading or speculative purposes.



|Item 4. | Controls and Procedures
|------- | -----------------------



(a) Evaluation of Disclosure Controls and Procedures



Regulations under the Securities Exchange Act of 1934 require public companies to maintain disclosure controls and procedures, which are defined to mean a
companys controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the Commissions rules and forms. Our chief executive officer and our chief financial officer, based on their evaluation of the effectiveness of our disclosure controls and procedures as of the end of the
period covered by this report, concluded that our disclosure controls and procedures were effective for this purpose.



(b) Changes in Internal Controls



There have been no significant changes in our internal control over financial reporting during the last fiscal quarter that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.



PART IIOTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------



Beginning on August 16, 2001, a number of class action lawsuits were filed in the United States District Court for the Southern District of New York against us, certain of our officers, and the underwriters of our
initial public offering. These lawsuits were essentially identical, and were brought on behalf of those who purchased our securities between September 24, 1999 and August 19, 2001. These complaints alleged generally that the underwriters in certain
initial public offerings, including ours, allocated shares in those initial public offerings in unfair or unlawful ways, such as requiring the purchaser to agree to buy in the aftermarket at a higher price or to buy shares in other companies with
higher than normal commissions. The complaint also alleged that we had a duty to disclose the activities of the underwriters in the registration statement relating to our initial public offering. The plaintiffs counsel and the issuer
defendants counsel have reached a preliminary settlement agreement, which awaits approval by the Court.



We are subject to legal proceedings, claims, and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate
costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations, or cash flows.



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|Item 2. | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
|------- | --------------------------------------------------------------------------------



Not applicable.



|Item 3. | Defaults Upon Senior Securities
|------- | -------------------------------



Not applicable.



|Item 4. | Submission of Matters to a Vote of Security Holders
|------- | ---------------------------------------------------



(a) We held our Annual Meeting of Stockholders on March 25, 2004. Proxies for the meeting were solicited pursuant to Regulation 14A.



(c) The matters described below were voted on at the Annual Meeting of Stockholders and the
number of votes cast with respect to each matter and with respect to the election of directors were as indicated.



(1) Holders of our common stock voted to elect six directors, each to serve until his or her successor has been elected and qualified or until his or her earlier
resignation or removal as follows:



|                      |  |            |  |         |  |          |  |         
|--------------------- |  | ---------- |  | ------- |  | -------- |  | --------
|                      |  | For        |  | Against |  | Withheld |  | Non-Vote
|David Cowan           |  | 17,039,425 |  | 475,719 |  |         |  |        
|Umang Gupta           |  | 16,890,024 |  | 625,120 |  |         |  |        
|Mohan Gyani           |  | 17,358,999 |  | 156,145 |  |         |  |        
|Raymond L. Ocampo Jr. |  | 17,378,387 |  | 136,757 |  |         |  |        
|Geoffrey Penney       |  | 17,136,187 |  | 378,957 |  |         |  |        
|Deborah Rieman        |  | 17,058,831 |  | 456,331 |  |         |  |        



(2) Holders of our common stock voted
to ratify the appointment of KPMG LLP as our independent auditors for the fiscal year ending September 30, 2004.



|           |  |         |  |          |  |         
|---------- |  | ------- |  | -------- |  | --------
|For        |  | Against |  | Withheld |  | Non-Vote
|16,904,367 |  | 587,208 |  | 23,569   |  |        



|Item 5. | Other Information
|------- | -----------------



Not applicable.



|Item 6. | Exhibits and Reports on Form 8-K
|------- | --------------------------------



(A) Exhibits



The following documents are filed as Exhibits to this Report:



|     |  |                                                                                                                                                   
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|     | 
|31.1 |  | Certification of Periodic Report by Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002                                   
|     | 
|31.2 |  | Certification of Periodic Report by Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002                                   
|     | 
|32.1 |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 *
|     | 
|32.2 |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 *



|* | As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this Quarterly Report on Form 10-Q and are not deemed filed with the Securities and Exchange Commission
and are not incorporated by reference in any filing of Keynote Systems, Inc. Under the Securities Act of 1933 or the Securities Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in such
filings.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



(b) Reports on Form 8-K



Not applicable.



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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, in the City of San Mateo, State of California, on this 17th day of May 2004.



|                      |  |                                                                                        
|--------------------- |  | ---------------------------------------------------------------------------------------
|KEYNOTE SYSTEMS, INC.
|                      | 
|By:                   |  | /s/    UMANG GUPTA                                                                     
|                      |  |                                                                                        
|                      |  | Umang Gupta                                                                            
|                      |  | Chairman of the Board and Chief Executive Officer (Principal Executive Officer)        
|                      | 
|By:                   |  | /s/    PETER J. MALONEY                                                                
|                      |  |                                                                                        
|                      |  | Peter J. Maloney                                                                       
|                      |  | Vice President and Chief Financial Officer (Principal
Financial and Accounting Officer)



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EXHIBIT INDEX



|            |  |                                                                                                                                                   
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT NO. |  |                                                                                                                                                   
|            | 
|31.1        |  | Certification of Periodic Report by Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002                                   
|            | 
|31.2        |  | Certification of Periodic Report by Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002                                   
|            | 
|32.1        |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 *
|            | 
|32.2        |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 *



|* | As contemplated by SEC Release No. 33-8212, these exhibits are furnished with this Quarterly Report on Form 10-Q and are not deemed filed with the Securities and Exchange Commission
and are not incorporated by reference in any filing of Keynote Systems, Inc. Under the Securities Act of 1933 or the Securities Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in such
filings.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



29