##### Table of Contents




---




SECURITIES
AND EXCHANGE COMMISSION


Washington, D.C. 20549





---




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, 2002





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





---




KEYNOTE SYSTEMS, INC.


(Exact name of registrant as specified in its charter)





Delaware

94-3226488(State or other jurisdiction of

(I.R.S. Employerincorporation or organization)

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





---




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





Class Common
Stock, $.001 par value

Shares outstanding at April 30, 2002 28,419,036





---



---

##### Table of Contents




KEYNOTE SYSTEMS, INC.





TABLE OF CONTENTS


PagePART IFINANCIAL INFORMATIONItem 1.

Financial Statements

3Item 2.

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

13Item 3.

Qualitative and Quantitative Disclosures about Market Risk

32PART IIOTHER INFORMATIONItem 1.

Legal Proceedings

32Item 2.

Changes in Securities and Use of Proceeds

32Item 3.

Defaults Upon Senior Securities

32Item 4.

Submission of Matters for a Vote of Security Holders

32Item 5.

Other Information

32Item 6.

Exhibits and Reports on Form 8-K

32Signatures

33




2




---

##### Table of Contents




PART IFINANCIAL INFORMATION





Item 1.
    Financial Statements.





KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





Index to Unaudited Condensed Consolidated Financial Statements





PageCondensed Consolidated Balance Sheets as of March 31, 2002 and September 30, 2001

4Condensed Consolidated Statements of Operations for the three months and six months ended March 31, 2002 and 2001


5Condensed Consolidated Statements of Cash Flows for the six months ended March 31, 2002 and 2001

6Notes to Condensed Consolidated Financial Statements

7




3




---

##### Table of Contents




KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





CONDENSED CONSOLIDATED BALANCE SHEETS


(In thousands)


(Unaudited)





March 31, 2002


September 30, 2001ASSETSCurrent assets:Cash and cash equivalents

$
38,778


$
53,130Short-term investments


207,840



198,566Total cash, cash equivalents, and short-term investments


246,618



251,696Accounts receivable, less allowance for doubtful accounts of $1,080 and $1,041 as of March 31, 2002 and September 30,
2001


5,494



7,862Prepaid and other current assets


3,945



4,649Total current assets


256,057



264,207Restricted cash


85,000



85,000Property and equipment, net


15,787



17,208Goodwill, net


3,196



3,025Other intangible assets, net


1,888



1,472Other assets


187



1,752Total assets

$
362,115


$
372,664LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Notes payable and capital lease obligation


183



830Accounts payable


1,402



2,385Accrued expenses


7,905



10,626Accrued excess facility costs


9,288



10,303Deferred revenue


5,625



5,401Total current liabilities


24,403



29,545Total liabilities


24,403



29,545Stockholders equity:Common stock


28



28Treasury stock


(74
)


(1,086
)Additional paid-in capital


413,986



413,966Deferred compensation


(282
)


(452
)Accumulated deficit


(77,797
)


(71,804
)Accumulated other comprehensive income


1,851



2,467Total stockholders equity


337,712



343,119Total liabilities and stockholders equity

$
362,115


$
372,664





See accompanying notes to the condensed consolidated financial statements




4




---

##### Table of Contents




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 31,2002


2001


2002


2001Revenue:Subscription services

$
8,557


$
11,583


$
17,353


$
24,108Consulting and support services


652



444



1,445



937Total revenues


9,209



12,027



18,798



25,045Operating Expenses:Cost of subscription services


2,857



3,120



6,249



6,254Cost of consulting and support services


937



700



1,889



1,484Research and development


2,101



1,885



4,280



3,825Sales and marketing


4,802



5,722



9,725



11,586Operations


2,046



1,998



4,127



3,707General and administrative


1,992



1,722



4,062



3,489Acquisition related charges and amortization of goodwill, other intangible assets, and stock-based compensation


307



5,755



606



13,230Total operating expenses


15,042



20,902



30,938



43,575Loss from operations


(5,833
)


(8,875
)


(12,140
)


(18,530
)Interest income, net


2,844



5,282



6,148



10,709Loss before income taxes


(2,989
)


(3,593
)


(5,992
)


(7,821
)Provision for income taxes






100







300Net loss

$
(2,989
)

$
(3,693
)

$
(5,992
)

$
(8,121
)Net Loss per share:Basic and diluted

$
(0.11
)

$
(0.13
)

$
(0.21
)

$
(0.29
)Shares used in computing basic and diluted net loss per share:Basic and diluted


27,965



27,673



27,892



27,630





See accompanying notes to the condensed consolidated financial statements




5




---

##### Table of Contents




KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(In thousands)


(Unaudited)


Six months ended March 31,2002


2001Cash flows from operating activities:Net loss

$
(5,992
)

$
(8,121
)Adjustments to reconcile net loss to net cash from operating activities:Depreciation and amortization


4,045



2,783Amortization of goodwill and other intangible assets


436



7,971Amortization of deferred compensation


170



5,006Changes in operating assets and liabilities:Accounts receivable


2,368



(1,165
)Prepaids and other assets


2,269



(1,622
)Accounts payable and accrued expenses


(4,719
)


1,412Deferred revenue


224



(795
)Net cash (used for) provided by operating activities


(1,199
)


5,469Cash flows from investing activities:Purchases of property and equipment


(2,624
)


(8,923
)Purchase of assets of onDevice and Envive


(1,023
)


Purchase of short-term investments


(36,097
)


(51,499
)Sale of short-term investments


26,206



29,430Net cash used for investing activities


(13,538
)


(30,992
)Cash flows from financing activities:Repayment of notes payable


(647
)


(661
)Issuance of common stock, net of issuance costs


1,278



1,351Purchase of treasury stock


(246
)


(1,326
)Net cash provided by (used for) financing activities


385



(636
)Net decrease in cash and cash equivalents


(14,352
)


(26,159
)Cash and cash equivalents at beginning of the period (1)


53,130



260,201Cash and cash equivalents at end of the period (1)

$
38,778


$
234,042Cash, cash equivalents, and short-term investments at end of the period (1)

$
246,618


$
256,109


---

|(1) |  | Excludes $85.0 million of restricted cash.
|--- |  | ------------------------------------------




See accompanying notes to the condensed consolidated financial statements




6




---

##### Table of Contents




KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





(1)    Basis of
Presentation





The accompanying 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, 2002, and the
results of operations and cash flows for the interim periods ended March 31, 2002 and 2001.





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, 2001 included
in the Companys Report on Form 10-K as filed with the SEC.





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





Certain reclassifications have been made to previously issued financial statements to conform to current presentation.





(2)    Revenue Recognition





Subscription services revenues consist of fees from
subscriptions to the Companys Internet measurement, monitoring, testing and diagnostic services. The Companys subscription services revenues are generally deferred upon invoicing and are recognized ratably over the service period,
generally ranging from one to twelve months. Deferred revenue is comprised mainly of deferred subscription services revenue. A portion of subscription services revenues is invoiced monthly upon completion of measurement services. Any unearned
revenue is recorded as deferred revenue on the balance sheet. The Company does not generally grant refunds during the initial subscription term. All discounts granted are netted against revenue. Revenue is not recognized for free trial periods.
Revenues from consulting and support services are recognized as the services are performed, typically over a period of one to three months. For consulting projects that span multiple months, the Company recognizes revenue on a percentage of
completion basis.





(3)    Other Comprehensive Loss





Other comprehensive loss includes unrealized gains on short-term investments in debt securities, which are excluded from earnings and reported as a component of stockholders
equity. Comprehensive loss for the interim periods ended March 31, 2002 and 2001 are presented below:





Three Months Ended


Six Months EndedMarch 31, 2002


March 31, 2001


March 31, 2002


March 31, 2001Net loss

$
(2,989
)

$
(3,693
)

$
(5,992
)

$
(8,121
)Unrealized gain on investments, net of taxes


299







616



Comprehensive loss

$
(2,690
)

$
(3,693
)

$
(5,376
)

$
(8,121
)




7




---

##### Table of Contents




(4)    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,
restricted cash, accounts payable, capital lease obligation, and notes payable approximates their fair market value. Cash and cash equivalents, restricted cash, accounts receivable, and accounts payable approximate fair market value due to their
short-term nature. Notes payable and capital lease obligations approximate fair market value as interest rates on these notes and capital lease obligations approximate market rates. Financial instruments that subject the Company to concentrations of
credit risk consist primarily of cash and cash equivalents, restricted cash, and trade 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 policy for its allowance for doubtful accounts is based on historical trends, experience and current market and industry conditions. Management regularly reviews the adequacy of the Companys allowance for doubtful
accounts after considering the accounts receivable aging, the age of each invoice, each customers expected ability to pay and the Companys collection history with each customer. Management reviews any invoices greater than 60 days old to
determine if an allowance is appropriate based on the risk category. 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 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 a requirement for additional allowances in the future. Based on the historical amount of accounts receivable written off in prior periods, the Company currently believes that it has adequately reserved for doubtful accounts as of the date
of each balance sheet presented herein. At March 31, 2002 and 2001, no one customer accounted for more than 10% of the Companys total accounts receivable. For the three and six months ended March 31, 2002 and 2001, no single customer accounted
for more than 10% of the Companys total revenues.





(5)    Investments





For the purposes of the consolidated financial
statements, the Company considers all highly liquid investment with original maturities of three months or less when acquired to be cash equivalents. All 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 loss. The following table summarizes the Companys short-term
investments in investment-grade debt securities as of March 31, 2002 (in thousands):





Amortized Cost

Gross Unrealized Gains

Gross Unrealized Losses

Estimated Fair Market ValueObligations of U.S. government agencies

$
14,991

$
76

$


$
15,067Corporate debt securities


190,998


2,145


370


192,773Total

$
205,989

$
2,221

$
370

$
207,840





Income taxes on net unrealized gains are expected to be immaterial.





The following table summarizes the maturities of fixed maturity investments available for sale at March 31, 2002 (in thousands). Expected maturities
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.




8




---

##### Table of Contents




Amortized Cost

Estimated Fair Market ValueDue in 1 year

$
94,616

$
95,700Due in 2 years


111,373


112,140Total

$
205,989

$
207,840





(6)    Goodwill and Other Intangible Assets





Effective October 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible
Assets. As a result, the Company no longer amortizes goodwill. Instead, the Company evaluates its goodwill for recoverability on an annual basis, thereby eliminating quarterly and annual goodwill amortization of approximately $334,000 and $1.3
million, respectively, based on the projected amortization for fiscal 2002. The Company will also evaluate goodwill whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable from estimated
future cash flows.





With its adoption of SFAS 142, the Company reassessed the useful lives and residual values of all acquired
intangible assets to identify any necessary amortization period adjustments and to determine if any amount of intangible assets should be reclassed to goodwill. Based on that assessment, no adjustments were made to the amortization periods or
residual values of other intangible assets.





SFAS 142 provided a six-month transitional period from the effective date of
adoption, for the Company to perform an assessment as to whether there is an indication that goodwill is impaired. To accomplish this, the Company was required to identify its reporting units and determine the carrying value of each reporting unit
by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of adoption. As of October 1, 2001, the Company determined that it has one reporting unit.





The Company was required to determine the fair value of its one reporting unit and compare it to the reporting units carrying amount.
To the extent that the reporting units carrying amount exceeds its fair value, an indication exists that the reporting units goodwill may be impaired and the Company must perform the second step of the transitional impairment test. In
the second step, the Company must compare the implied fair value of the reporting units goodwill, determined by allocating the reporting units fair value to all of its assets (recognized and unrecognized) and liabilities in a manner
similar to a purchase price allocation in accordance with SFAS 141, to its carrying amount, both of which would be measured as of the date of adoption. This second step must be performed as soon as possible, but no later than the end of the fiscal
year. Any impairment measured as of the date of adoption will be recognized as the cumulative effect of a change in accounting principle. The Company has performed the first step of the transitional impairment test required under SFAS 142, and has
obtained an indicator of impairment in the Companys single reporting unit. The second step of the transitional impairment test will be performed in the third quarter of fiscal 2002 in order to determine whether a loss should be recognized.





At March 31, 2002, the Company had remaining goodwill of $3.2 million (net of accumulated amortization of $14.9 million and
impairment charges of $26.0 million).





The following table outlines the pro forma adjustments to reported net loss and net loss
per share for the three and six months ended March 31, 2001, to exclude the amortization of goodwill (in thousands, except for loss per share).





Three Months Ended March 31, 2001


Six Months Ended March 31, 2001Net Loss:Reported net loss

$
(3,693
)

$
(8,121
)Add back goodwill amortization


3,497



7,014Adjusted net loss

$
(196
)

$
(1,107
)Basic and diluted loss per share:Reported basic and diluted loss per share

$
(0.13
)

$
(0.29
)Add back goodwill amortization


.13



.25Adjusted basic and diluted loss per share

$
0.00


$
(0.04
)




9




---

##### Table of Contents




Additionally, the Company has approximately $1.9 million of unamortized
other intangible assets, which are all subject to amortization. During the first quarter of fiscal 2002, the Company acquired approximately $860,000 of technology-based intangible assets, which are being amortized over a three-year period. No
significant residual value is estimated for these intangible assets. During the three and six months ended March 31, 2002, the amortization expense for intangible assets was approximately $222,000 and $436,000, respectively. The components of
intangible assets are as follows (in thousands):








Technology Based


Customer Based


Trademark


TotalAs of March 31, 2002Gross Carrying Value

$
5,587


$
3,605


$
250


$
9,442Accumulated Amortization


(3,934
)


(3,388
)


(232
)


(7,554
)Net Carrying Value at March 31, 2002

$
1,653



217


$
18


$
1,888As of September 30, 2001Gross Carrying Value

$
4,735


$
3,605


$
250


$
8,590Accumulated Amortization


(3,575
)


(3,318
)


(225
)


(7,118
)Net Carrying Value at September 30, 2001

$
1,160


$
287


$
25


$
1,472





The amortization expense for existing intangible assets is estimated to be
$446,000 for the remainder of fiscal 2002, $852,000 for fiscal 2003, $579,000 for fiscal 2004, and $11,000 for fiscal 2005.





(7)    Net Loss Per Share





Basic net loss per share is computed using the weighted-average
number of outstanding shares of common stock excluding shares of restricted stock subject to repurchase summarized below. Diluted net loss per share is computed using the weighted-average number of shares of common stock outstanding and, when
dilutive, potential common shares from options and warrants to purchase common stock using the treasury stock method and from convertible securities using the as-if-converted basis.





The following potential common shares have been excluded from the computation of diluted net loss per share because the effect would have been antidilutive (in thousands):








2002

2001For the three and six months ended March 31:Shares subject to outstanding stock options

5,677

4,166Shares of restricted stock subject to repurchase

39

177Total shares excluded

5,716

4,343




10




---

##### Table of Contents

The weighted-average exercise price per share of common stock subject to stock options was $13.74 as of March 31, 2002 and $30.53 as of
March 31, 2001. The weighted-average repurchase price of restricted stock was $0.90 as of March 31, 2002, and $0.68 as of March 31, 2001.





(8)    Acquisitions





On October 10, 2001, the Company acquired the business of onDevice
Corporation (onDevice), a provider of wireless application testing services. The Company believes this acquisition will enhance the Companys ability to offer additional performance improvement services to wireless customers, and was accounted
for under the purchase method of accounting. The transaction was completed for $860,000 in cash, plus up to an additional $1.25 million in cash to be paid if certain revenue target goals are met in the 12 months ending September 30, 2002.





The $860,000 cash purchase consideration was based on estimated fair values of the assets of onDevice at the acquisition date,
and allocated to the technology-based intangible assets acquired. There was no goodwill arising from the acquisition. Intangible assets are being amortized on a straight-line basis over three years, and amortization of intangible assets related to
onDevice was $70,000 and $133,000 for the three and six months ended March 31, 2002, respectively. The consolidated statements of operations include activity relating to onDevices business activities subsequent to the acquisition. If the
results of the two companies were combined on a pro forma basis for the three and six months ended March 31, 2001, the difference between pro forma results, and the actual results reported herein, would be immaterial.





For the three months ended March 31, 2002, we recorded $222,000 in amortization related to intangible assets and $85,000 in amortization of stock-based
compensation. For the six months ended March 31, 2002, we recorded $436,000 in amortization related to intangible assets and $170,000 in amortization of stock-based compensation.





Acquisition-related charges, and amortization of goodwill and other intangibles and stock based compensation of approximately $5.8 million recorded in the condensed consolidated
statement of operations for the three months ended March 31, 2001, includes acquisition related charges of approximately $1.6 million, amortization of goodwill and other intangibles of approximately $4.1 million and amortization of stock-based
compensation of approximately $85,000. Acquisition-related charges, and amortization of goodwill and other intangibles and stock based compensation of approximately $13.2 million recorded in the condensed consolidated statement of operations for the
six months ended March 31, 2001, includes acquisition related charges of approximately $4.8 million, amortization of goodwill and other intangibles of approximately $8.3 million and amortization of stock-based compensation of approximately $170,000.





(9)    Commitments and Contingencies





(A)  Leases





The Company leases its facilities
and certain equipment under non-cancelable operating leases, which expire on various dates through December 2005. Additionally, the Company has leased equipment under a capital lease. At March 31, 2002, future minimum payments under the leases, net
of sublease income, are as follows (in thousands):





Year ended March 31:

Operating

Capital2003

$
1,822

$
332004


2,156


2005


3,983


2006


86,238


Thereafter





Total minimum lease payments

$
94,199

$
33Less amount representing interest





(1
)Present value of minimum capital lease paymentsall current





32




11




---

##### Table of Contents




The above amounts do not include lease expenses related to excess facilities that were accrued
as of September 30, 2001.





In July 2000, the Company entered into a five-year lease agreement for a 188,000 square foot office
building in San Mateo, California which the Company began occupying in March 2001. The agreement has a mutual one-year renewal option. The development and acquisition of the property has been financed by a third party through a financial
institution. Monthly lease payments under this operating lease are based on LIBOR using 30-day to 180-day LIBOR contracts.





The
lease agreement specifies that the occurrence of certain events will constitute a default under the lease, including the Companys failure to comply with the terms of the lease, a change in control, the Companys failure to make payments
on indebtedness of $3.0 million or more, a judgment against the Company in excess of $3.0 million and other customary events of default. A default under the lease, including the occurrence of one of these events, could require the Company to
purchase the leased property for a specified amount, which approximates the lessors original cost (the Termination Value), as well as any unpaid rent. As of March 31, 2002, the Termination Value was approximately $85.0 million and
was fully secured by the $85.0 million restricted cash held by the financial institution.





At the end of the lease term, the
Company has an option to either purchase the leased property for the Termination Value, or to assist the lessor with the sale of the property. The Company has the ability to exercise this option during the term of the lease. The Company has provided
the lessor with a residual value guarantee for up to $79.0 million to cover any deficiency should the property ultimately be sold for less than the Termination Value.





In the event that it is probable that the expected fair value of the property at the end of the lease term will be less than the Termination Value, and the expected loss resulting from
the residual value guarantee can be reasonably estimated, the expected loss will be accrued on a straight-line basis over the remaining lease term. At present, management does not currently know whether it is probable that the fair market value of
the property at the end of the lease term will be less than the Termination Value.





Management has evaluated the expected fair
value of the property at the end of the lease term by reviewing current real estate market conditions and indicators of expectations for the market in the future. Real estate market conditions subsequent to the origination of the lease have
generally worsened due to the amount of available space for lease and the corresponding lease rates. The range of current market values for the property is estimated to be between $40 million to $50 million. However, due to the historical and
expected significant volatility of the real estate market in the San Francisco Bay Area, management is currently unable to estimate the fair value of the property at the end of the lease term.





To fully collateralize this obligation, $85.0 million has been deposited in an interest-bearing escrow account and is included in the balance sheet as restricted cash as of March
31, 2002 and 2001, and is reflected as a future minimum payment in 2006 in the above table. In accordance with the lease agreement, the cash restriction expires on June 2005. In addition, the property covered by the lease, as well as all of the
Companys personal property and its headquarters building, is subject to a deed of trust in favor of the lessor in order to secure the Companys obligations under the lease.




12




---

##### Table of Contents




(B)  Legal Proceedings





Beginning on August 16, 2001, a number of class action lawsuits have been filed in the United States District Court for the Southern District of New York against the Company,
certain of its officers and the underwriters of the Companys initial public offering. These so-called laddering lawsuits are essentially identical, and were brought on behalf of those who purchased the Companys publicly
traded securities between September 24, 1999 and August 19, 2001. These complaints allege that the underwriters of the Companys initial public offering allocated shares in exchange for agreements by investors to buy additional shares in the
aftermarket at a higher price or to buy shares in other companies with higher than normal commissions. The complaint also alleges that the prospectus for the Companys initial public offering was false and misleading in violation of federal
securities laws because it did not disclose these alleged arrangements. The complaints have been consolidated into a single action with cases brought against over three hundred other issuers and their underwriters that make similar allegations
regarding the initial public offerings of those issuers. The proceedings against the issuers, including the Company, have been stayed pending an outcome in the proceedings against the underwriters. The Company believes the claims are without merit
and intends to defend the actions vigorously. However, these claims, even if not meritorious, could be expensive and divert managements attention from operating the Company.





The Company is 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 the Companys consolidated financial position, results of operations, or cash flows.





(10)    Geographical, Segment, and Significant Customer Reporting





The Company has determined that it operates in a single operating segment: the development and sale of services to measure, assure and improve the quality of service of web sites.





The Company markets its products primarily from its operations in the United States. International sales are primarily to
customers in Europe. These sales and foreign-owned assets are not significant. For the three months and six months ended March 31, 2002 and 2001, respectively, no single customer accounted for more than 10% of total revenues. At March 31, 2002 and
2001, respectively, no single customer accounted for more than 10% of total net accounts receivables.





(11)    Subsequent Event





On May 1, 2002, the Company acquired NetMechanic, Inc., a provider of remote Web site quality assurance and testing
services for small to medium size businesses. The transaction was completed for approximately $1.5 million in cash, plus an additional cash payment if certain revenue and profitability targets are met in the twelve months ending September 30, 2003.





ITEM 2.    Management
 Discussion and Analysis of Financial Condition and Results of Operations





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





Except for historical information, this report 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 revenue, costs and expenses. 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, 2001, 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 carefully review the risks described in other documents we file from time to time with the Securities and Exchange Commission including,




13




---

##### Table of Contents

the quarterly reports on Form 10-Q and current reports on Form 8-K that we have filed and will file. 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 provide Internet performance services that enable companies to benchmark, test, manage and improve their e-business web sites. We believe that companies who use our services can increase revenues, improve customer support and retention
while, at the same time, reduce customer support costs, and gain a competitive advantage.





Revenues consist of subscription
services revenue and consulting and support services revenues. Subscription services revenue consists of fees from subscriptions to our Internet measurement, monitoring, testing and diagnostic services. Our subscription services revenues are
generally deferred upon invoicing and are recognized ratably over the service period, generally ranging from one to twelve months. Deferred revenue is comprised primarily of deferred subscription services revenue. A portion of subscription services
revenues is invoiced monthly upon completion of measurement services. Any unearned revenue is recorded as deferred revenue on our balance sheet. We do not generally grant refunds during the initial subscription term. All discounts granted are netted
against revenue. Revenue is not recognized for free trial periods. As of March 31, 2002, we had recorded $5.6 million of deferred revenue. Revenues from our consulting and support services are recognized as the services are performed; a typical
project duration is approximately one to three months. For longer consulting projects, we recognize revenue on a percentage-of-completion basis.





We derive and expect to continue to derive our revenues from the sale of our web performance benchmarking, application performance management and testing services. These services include our Perspective services,
together with our Red Alert monitoring and alarm services, which are subscription-based services that our customers purchase for an initial three to twelve month term and then may renew on an annual, semi-annual, or month-to-month basis.
Subscription fees vary based on the number of URLs measured, the number of devices monitored, the number of measurement locations, the frequency of the measurements, the additional features ordered, and the type of services. We offer our consulting
and support services on a per engagement basis. Consulting and support services revenues have amounted to 7% and 8% of total revenues for the three months and six months ended March 31, 2002, respectively. We believe that consulting and support
services revenues may increase in the future somewhat as a percentage of total revenue, as we introduce additional services and as our services are more widely used.





For the quarter ended March 31, 2002, our 10 largest customers accounted for approximately 27% of total revenues. We cannot be certain that customers that have accounted for significant
revenues in past periods, individually or in aggregate, will renew our services and continue to generate revenue in any future period. In addition, our customer agreements can generally be terminated at any time with little or no penalty. If we lose
a major customer or a group of significant customers, our revenues could significantly decline.




14




---

##### Table of Contents




Results of Operations





Revenues





2002

2001

% Change(In thousands)For the three months ended March:Subscription services

$
8,557

$
11,583

(26
%)Consulting and support services


652


444

47
%$
9,209

$
12,027

(23
%)For the six months ended March:Subscription services

$
17,353

$
24,108

(28
%)Consulting and support services


1,445


937

54
%$
18,798

$
25,045

(25
%)





Subscription Services.    Revenues from subscription services
decreased approximately $3.0 million or 26% for the three months ended March 31, 2002 as compared to the same period in 2001. Revenues from subscription services decreased $6.8 million or 28% for the six months ended March 31, 2002 as compared to
the same period in 2001. Subscription services represented approximately 93% and 96% of total revenues for the three months ended March 31, 2002 and 2001, respectively, and approximately 92% and 96% of total revenues for the six months ended March
31, 2002 and 2001, respectively. The decreases resulted primarily from lower sales to the Internet service provider, e-commerce and Internet business market segment, which declined to 15% of total revenue, compared to 27% in the comparable quarter a
year ago and 16% last quarter.





Consulting and Support Services.    Revenues from consulting and support
services increased $208,000 or 47% for the three months ended March 31, 2002 as compared to the same period in 2001. Revenues from consulting and support services increased $508,000 or 54% for the six months ended March 31, 2002 as compared to the
same period in 2001. Consulting and support services represented approximately 7% and 4% of total revenues for the three months ended March 31, 2002 and 2001, respectively, and approximately 8% and 4% of total revenues for the six months ended March
31, 2002 and 2001.





For the three and six months ended March 31, 2002 and 2001, no single customer accounted for more than 10%
of total revenues.





Expenses:





Costs of Subscription and Consulting and Support Services





2002

2001

% Change(In thousands)For the three months ended March 31:Costs of subscription services

$
2,857

$
3,120

(8
)%Costs of consulting and support services

$
937

$
700

34
%For the six months ended March 31:Costs of subscription services

$
6,249

$
6,254

0
%Costs of consulting and support services

$
1,889

$
1,484

27
%





Costs of Subscription Services.    Costs of subscription
services consist of connection fees to Internet service 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 subscription services decreased $263,000 or 8% for the three months ended March 31, 2002 as compared to the same period in 2001 and declined sequentially by $535,000 or 16% compared to the first quarter of fiscal 2002. The
decrease was primarily due to our bandwidth cost reduction program. Costs of subscription services decreased $5,000 for the six months ended March 31, 2002 as compared to the same period in 2001. Costs of subscription services were 33% and 27% of
subscription service revenue for the three months ended March 31, 2002 and 2001, respectively, and approximately 36% and 26% of subscription service revenue for the six months ended March 31, 2002 and 2001. We believe that costs of subscription
services in absolute dollars for the third quarter of fiscal 2002 will remain comparable to the second quarter of fiscal 2002.





Costs of Consulting and Support Services.  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. Costs of consulting and support services exceeded consulting and support services revenue for the three and six months ended March 31, 2002 and 2001. Costs of consulting and
support services increased $237,000 or 34% for the three months ended March 31, 2002 compared to the same period in 2001 and were sequentially flat compared to the first quarter of fiscal 2002. Costs of consulting and support services increased
$405,000 or 27% for the six months ended March 31, 2002 compared




15




---

##### Table of Contents




to the same period in 2001. The costs primarily increased because, in accordance with our recently introduced program of
charging for Advance Technical Service, the costs of our Advanced Technical Services support personnel are included in the costs of consulting and support services. There were no associated costs with the Advanced Technical Services support
personnel in fiscal 2001. We expect that the costs of consulting and support services as a percentage of consulting and support services revenue will continue to be greater than the costs of subscription services as a percentage of subscription
services revenue. We expect that costs of consulting and support services in absolute dollars for the third quarter of fiscal 2002 will decrease slightly compared to the second quarter of fiscal 2002.





Research and Development





2002

2001

% Change(In thousands)For the three months ended March 31:Research and development

$
2,101

$
1,885

11
%For the six months ended March 31:Research and development

$
4,280

$
3,825

12
%





Research and development expenses consist primarily of compensation and related
costs for research and development personnel. Research and development expenses increased $216,000 or 11% for the three months ended March 31, 2002 as compared to the same period in 2001 and were sequentially flat compared to the first quarter of
fiscal 2002. Research and development expenses increased $455,000 or 12% for the six months ended March 31, 2002 as compared to the same period in 2001. The increase was primarily attributable to the increase in personnel to support our new
offerings in our Testing and Wireless Perspective services as well as costs incurred in the enhancement and expansion of our current services. To date, all research and development expenses have been expensed as incurred. We believe that a
significant investment in research and development is essential for us to continue to enhance and expand our services. We anticipate that research and development expenses in absolute dollars for the third quarter of fiscal 2002 will remain
comparable to the second quarter of fiscal 2002.





Sales and Marketing





2002

2001

% Change(In thousands)For the three months ended March 31:Sales and marketing

$
4,802

$
5,722

(16
%)For the six months ended March 31:Sales and marketing

$
9,725

$
11,586

(16
%)





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 $920,000 or 16% for the three months ended March 31, 2002 as compared to the same period in 2001
and sequentially declined compared to the first quarter of fiscal 2002 by $121,000 or 2%. Our sales and marketing expenses decreased approximately $1.9 million or 16% for the six months ended March 31, 2002 as compared to the same period in 2001.
The decrease was primarily a result of the restructuring of our sales organization designed to focus greater resources on our large corporate customers and reduced spending on marketing programs. We expect to continue to make investments in our
sales and marketing efforts for us to maintain our market position and to further increase acceptance of our services. We anticipate that sales and marketing expenses in absolute dollars for the third quarter of fiscal 2002 will remain comparable to
the second quarter of fiscal 2002.




16




---

##### Table of Contents




Operations





2002

2001

% Change(In thousands)For the three months ended March 31:Operations

$
2,046

$
1,998

2
%For the six months ended March 31:Operations

$
4,127

$
3,707

11
%





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 twenty-four by seven basic customer support. 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 increased $48,000 or 2% for the three months ended March 31, 2002 as compared to the same period in 2001 and
were sequentially flat compared to the first quarter of fiscal 2002. Our operations expenses increased $420,000 or 11% for the six months ended March 31, 2002 as compared to the same period in 2001. The increase in operations expenses was primarily
related to the hiring of personnel to manage and support our customer base and data center. We believe that continued investment is necessary to support our ability to successfully support our current customer base and to further support our
increased number of service offerings. We anticipate that operations expenses in absolute dollars for the third quarter of fiscal 2002 will remain comparable to the second quarter of fiscal 2002.





General and Administrative





2002

2001

% Change(In thousands)For the three months ended March 31:General and administrative

$
1,992

$
1,722

16
%For the six months ended March 31:General and administrative

$
4,062

$
3,489

16
%





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 increased $270,000 or 16% for the three months ended March 31, 2002 as compared
to the same period in 2001 and sequentially declined compared to the first quarter of fiscal 2002 by $78,000 or 4%. General and administrative expenses increased $573,000 or 16% for the six months ended March 31, 2002 as compared to the same period
in 2001. The increase in our general and administrative expenses was mainly attributable to the hiring of additional personnel to support our business as well as higher insurance and occupancy costs. We anticipate that general and administrative
expenses in absolute dollars for the third quarter of fiscal 2002 will remain comparable to the second quarter of fiscal 2002.




17




---

##### Table of Contents




Acquisition-Related Charges and Amortization of Goodwill, Other Intangible Assets and
Stock-Based Compensation





2002

2001

% Change(In thousands)For the three months ended March 31:Amortization of goodwill

$
0

$
3,497

Amortization of intangible assets


222


555

(60
)%Amortization of acquisition-related deferred compensation


0


1,618

Amortization of stock-based compensation


85


85

Acquisition-related charges, amortization of goodwill and other intangible assets and amortization of stock-based
compensation

$
307

$
5,755

(95
)%For the six months ended March 31:Amortization of goodwill

$
0

$
7,014

Amortization of intangible assets


436


1,210

(64
)%Amortization of acquisition-related deferred compensation


0


4,836

Amortization of stock-based compensation


170


170

Acquisition-related charges, amortization of goodwill and other intangible assets and amortization of stock-based
compensation

$
606

$
13,230

(95
)%





Beginning October 1, 2001, we adopted SFAS 142, and as a result, we no longer
amortize goodwill. Goodwill amortization for the three and six months ended March 31, 2001 was $3.5 million and $7.0 million, respectively. As of March 31, 2002, unamortized goodwill was approximately $3.2 million. Although goodwill is no longer
subject to amortization, it is now subject to impairment testing to be performed at a minimum on an annual basis, as discussed in Note 6, Goodwill and Other Intangible Assets, of the Notes to Condensed Consolidated Financial Statements.





In connection with the purchase of Velogic Inc. (Velogic) in June 2000, Digital Content, L.L.C. (Digital Content) in August
2000, the management service provider business of Envive Corporation (Envive) in July 2001, and the business of onDevice Corporation (onDevice) in October 2001, we recorded approximately $53.6 million in goodwill and other intangible assets. For the
three months ended March 31, 2002 and 2001, we recorded expenses of $222,000 and $555,000 relating to amortization of intangible assets, respectively. For the six months ended March 31, 2002 and 2001, we recorded expenses of $436,000 and $1.2
million relating to amortization of intangible assets, respectively. At March 31, 2002, we had a remaining balance of approximately $1.9 million in other intangible assets that are being amortized over a three-year period from the date of
acquisition. For the three and six months ended March 31, 2001, we expensed acquisition-related deferred compensation costs of $1.6 million and $4.8 million, respectively.





We review our goodwill and other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable.
Our policy is to assess the recoverability of goodwill using estimated undiscounted cash flows. Those cash flows include an estimated terminal value based on a hypothetical sale of the acquired entity at the end of the related goodwill amortization
period.




18




---

##### Table of Contents




The remaining carrying value of goodwill and intangible assets at March 31, 2002 is summarized
as follows (in thousands):





Goodwill

Intangible Assets

TotalDigital Content

$
570

$
228

$
798Velogic


379


45


424Envive


2,247


897


3,144onDevice





718


718





A portion of the consideration for the Digital Content acquisition, in the amount
of $6.4 million, was attributed to deferred compensation, and was fully amortized by March 31, 2001.





Some options granted prior
to June 30, 1999, have been 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. As a result, we have recorded amortization
of deferred compensation expense in the amount of $85,000 for the three months ended March 31, 2002 and 2001, and we had an aggregate of $282,000 included in unamortized deferred compensation as of March 31, 2002. Deferred compensation is amortized
on a straight-line basis over the vesting period of the options.





We expect the amortization of intangible assets and
stock-based compensation to be approximately $300,000 for the third quarter of fiscal 2002, assuming no additional acquisitions or impairment charges.





Interest Income, Net





2002

2001

% Change(In thousands)For the three months ended March 31:Interest income, net

$
2,844

$
5,282

(46
)%For the six months ended March 31:Interest income, net

$
6,148

$
10,709

(43
)%





Net interest income decreased approximately $2.4 million or 46% for the three
months ended March 31, 2002 as compared to the same period in 2001. Net interest income decreased approximately $4.6 million or 43% for the six months ended March 31, 2002 as compared to the same period in 2001. Substantially all of the balance
represents interest income from our investments and restricted cash. The decrease in interest income, net, was primarily due to the decline in interest rates during the three and six months ended March 31, 2002 compared to the same period of fiscal
2001. We expect that net interest income will decline further during fiscal 2002 due to the general decline in interest rates available for the reinvestment of funds from securities maturing during the remainder of fiscal 2002.





Provision for Income Taxes





No
provision for federal and state income taxes was recorded for the three months ended March 31, 2002, due to the operating loss, net operating loss carryforwards, and tax credits.





A provision for federal and state income taxes of $100,000 and $300,000 was recorded for the three and six months ended March 31, 2001, principally for alternative minimum tax.





Liquidity and Capital Resources





Since our inception, we have funded our operations primarily through sales of our equity securities. Prior to our initial public offering, in September 1999, we had raised approximately $25.8 million, net of offering costs, from the sale of
common stock and preferred stock. In September and October 1999, we raised $56.7 million, net of issuance costs, in connection with our initial public offering. In a subsequent public offering in




19




---

##### Table of Contents




February 2000, we raised $286.3 million, net of issuance costs. In addition, we have financed our operations through
subordinated and other debt, equipment loans and a capital lease. The principal balance outstanding at March 31, 2002 for the notes payable and capital lease obligation was $183,000. At March 31, 2002, we had approximately $38.8 million in cash and
cash equivalents, approximately $207.8 million in short-term investments, and $85.0 million in restricted cash in connection with the lease for our headquarters building, for a total of approximately $331.6 million. Our short-term investments
consist of investment-grade debt securities.





Net cash used for operating activities was approximately $1.2 million for the six
months ended March 31, 2002. For the six months ended March 31, 2002, net cash used for operating activities was primarily the result of the loss from operations before deductions for depreciation and amortization, a decrease in accounts payable and
accrued expenses mainly due to payments associated with our headquarters building, periodic insurance renewals and other vendors that support our operations. The use of cash was partially offset by a decrease in accounts receivable as a result of
successful collection efforts, and a decrease in prepaids and other assets mainly due to the receipt of accrued interest generated from interest earned on our restricted cash balance. Net cash provided by operating activities was $5.5 million for
the six months ended March 31, 2001 and resulted from income from operations before deduction for depreciation and amortization, somewhat offset by an increase in accounts receivable and prepaids and other assets. Accounts receivable increased due
to poor collections results and prepaids and other assets increased due to an increase in interest receivable.





Cash used for
our investing activities totaled approximately $13.5 million for the six months ended March 31, 2002. During the six months ended March 31, 2002, we used $36.1 million for short-term investments, $2.6 million for property and equipment, and $1.0
million for our acquisitions of onDevice and Envive. We received $26.2 million from the sale of short-term investments. Cash used for our investing activities totaled $31.0 million for the six months ended March 31, 2001. During the six months ended
March 31, 2001, we used $51.5 million for short-term investments and $8.9 million for capital expenditures. We received $29.4 million from the sale of short-term investments. We expect capital expenditures to be approximately $500,000 to $1.0
million for the third quarter of fiscal 2002, absent any acquisitions or other extraordinary transactions.





Financing activities
generated $385,000 for the six months ended March 31, 2002. We received $1.3 million from the issuance of common stock under our employee stock option and stock purchase plans, offset by $647,000 used for the repayment of notes payable, and $246,000
used for the repurchase of 34,500 shares of our common stock under our repurchase program. We used $636,000 for financing activities for the six months ended March 31, 2001. We received $1.4 million from the issuance of common stock under our
employee stock option and stock purchase plans, offset by $661,000 used for the repayment of notes payable, and $1.3 million used for the repurchase of 103,300 shares of our common stock under our repurchase program.





As of March 31, 2002, our principal commitments consisted of $94.4 million in loans and operating and capital leases, including future minimum payments
under the lease for our headquarters building. In connection with the lease for our headquarters building, we have $85.0 million of restricted cash that is deposited with a financial institution in an interest-bearing escrow account, and serves to
fully collateralize the lease obligation. The building lease costs have amounted to approximately $4.0 million annually, but may fluctuate based on fluctuations in the interest rates, which are based on LIBOR.





The lease agreement specifies that the occurrence of certain events will constitute a default under the lease, including our failure to comply with the
terms of the lease, a change in control, our failure to make payments on indebtedness of $3.0 million or more, a judgment against us in excess of $3.0 million and other customary events of default. A default under the lease, including the occurrence
of one of these events, could require us to purchase the leased property for a specified amount, which approximates the lessors original cost (the Termination Value), as well as any unpaid rent. As of March 31, 2002, the
Termination Value was approximately $85.0 million.





We have an option during or at the end of the lease term, to either purchase
the leased property for the Termination Value, or at the end of the lease term to assist the lessor with the sale of the property. We have the ability to exercise this option during the term of the lease. We have provided the lessor with a residual
value guarantee for up to $79 million to cover any deficiency should the property ultimately be sold for less than the Termination Value.




20




---

##### Table of Contents




In the event that it is probable that the expected fair value of the property at the end of the
lease term will be less than the Termination Value, and the expected loss resulting from the residual value guarantee can be reasonably estimated, the expected loss will be accrued on a straight-line basis over the remaining lease term.





Management has evaluated the expected fair value of the property at the end of the lease term by reviewing current real estate
market conditions and indicators of expectations for the market in the future. Real estate market conditions subsequent to the origination of the lease have generally worsened due to the amount of available space for lease and the corresponding
lease rates. The range of current market values for the property is currently estimated to be between $40 million to $50 million. However, due to the historical and expected significant volatility of the real estate market in the San Francisco Bay
Area, management is currently unable to estimate the fair value of the property at the end of the lease term in 2005.





We had no
material commitments for capital expenditures as of March 31, 2002. Because we expect to continue to support our measurement computer capacity, we expect to make additional capital expenditures during fiscal 2002, although at a significantly lower
level than in fiscal 2001. We anticipate that we will also make additional capital expenditures related to upgrades of our headquarters but at lower levels than in the past. A significant part of the upgrades yet to be completed to the facility are
related to providing complete backup electrical generation capability in the event of electrical power loss or interruption.





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, 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.





Critical Accounting Policies and Judgments





In preparing our financial statements in accordance with generally accepted accounting principles, our management is
required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.





Our critical accounting policies and judgments are of both a routine and nonroutine nature. The recurring policies relate to
revenue recognition, the allowance for doubtful accounts receivable, and the valuation of our corporate headquarters building, which is subject to an operating lease. The nonroutine policies are those for the excess facility charge, and impairment
assessments for goodwill and other intangible assets. Our revenue recognition policy is discussed above in the section Overview. Each of the other areas is discussed below.





Allowance for Doubtful Accounts Receivable





Accounts
receivable is recorded net of an allowance for doubtful accounts receivable of $1.1 million and $1.0 million as of March 31, 2002 and September 30, 2001, respectively. We regularly review the adequacy of our accounts receivable allowance after
considering the accounts receivable aging, the age of each invoice, each customers expected ability to pay




21




---

##### Table of Contents

22





and our collection history with each customer. We review all invoices greater than 60 days old to
determine if 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 to the outstanding accounts receivable balance, based on historical
collection trends. Based on the amount of accounts receivable written off in prior periods, management believes that it has adequately reserved for doubtful accounts as of the date of each balance sheet presented herein. The allowance for doubtful
accounts represents managements best estimate, but changes in circumstances relating to accounts receivable may result in a requirement for additional allowances or reductions in the allowances due to recoveries in the future.





Valuation of Corporate Headquarters Building





In July 2000, we entered into a five-year lease agreement for our corporate headquarters building in San Mateo, California. We have provided the lessor a residual value guarantee for up to $79 million to cover any
deficiency should the property ultimately be sold for less than the termination value of the property. This obligation is fully collateralized with restricted cash of $85.0 million. On a quarterly basis, management evaluates the expected fair value
of our building at the end of the lease term by consulting with external real estate experts, reviewing current real estate market conditions and future market indicators. Managements evaluation considers recent real estate sale and lease
transactions for comparable properties and published market forecasts that may indicate expected future valuation trends. The range of current market values for the property is estimated to be between $40 million to $50 million, which is less than
the residual value guarantee of $79 million. Due to the historical and expected significant volatility of the real estate market in the San Francisco Bay Area, management is currently unable to estimate the fair value of the property at the end of
the lease term. If, however, the value of the building at the end of the lease could reasonably be estimated and was expected to be below the residual value guarantee provided by us, an accrual, which could be significant, would have to be recorded
in the financial statements, reflecting the estimated loss under the lease.





Excess Facility Charges





We recorded an accrual for excess facility charges of approximately $10.3 million at September 30, 2001, of which approximately $9.3 million
remains accrued at March 31, 2002, for certain costs related to the unoccupied portion of our headquarters building in San Mateo, California. The accrual includes certain lease costs such as lease expense, insurance, and property taxes. Other
operating costs associated with the unoccupied space will be reported as incurred as operating expenses in future periods. The accrual was determined by estimating the lease costs for unleased space over the life of the lease. Managements
assumptions and estimates included in determining the excess facility charge were based on expected LIBOR rates for establishing lease rates, expected insurance and property tax costs, and expected sublease rates. We currently do not have any
significant sublease income and do not expect any significant sublease income in the foreseeable future. The remaining accrual for the unoccupied space is reviewed quarterly including updates to managements assumptions and estimates based on
current real estate market conditions. If actual market conditions are less favorable than those projected by management and adversely impact the assumptions made by management, additional lease cost accruals may be required.





Impairment Assessments of Goodwill and Other Intangibles





We evaluate our long-lived assets, including goodwill and other intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of these
assets may not be recoverable. Recoverability of an asset to be held and used is measured by a comparison of the carrying amount of the asset to future net cash flows expected to be generated by t7he asset. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs
to sell.





Effective October 1, 2001, we adopted Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill
and Other Intangible Assets. With our adoption of SFAS 142, we reassessed the useful lives and residual values of all acquired intangible assets to identify any necessary amortization period adjustments and to determine if any amount of
intangible assets should be reclassed to goodwill. Based on that assessment, no adjustments were made to the amortization periods or residual values of other intangible assets.





SFAS 142 provided a six-month transitional period from the effective date of adoption for us to perform an assessment as to whether there is an indication that goodwill is impaired. To
accomplish this, we must identify its reporting units and determine the carrying value of each reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to those reporting units as of the date of
adoption. As of October 1, 2001, we determined that we have one reporting unit.





We were required to
determine the fair value of our one reporting unit and compare it to the reporting units carrying amount. To the extent that the reporting units carrying amount exceeds its fair value, an indication exists that the reporting units
goodwill may be impaired and we must perform the second step of the transitional impairment test. In the second step, we must compare the implied fair value of the reporting units goodwill, determined by allocating the reporting units
fair value to all of its assets (recognized and unrecognized) and liabilities in a manner similar to a purchase price allocation in accordance with SFAS 141, to its carrying amount, both of which could be measured as of the date of adoption. This
second step must be performed as soon as possible, but no later than the end of the fiscal year. Any impairment measured as of the date of adoption will be recognized as the cumulative effect of a change in accounting principle.





We have performed the first step of the transitional impairment test required under SFAS 142, and have obtained an indicator of impairment in
our single reporting unit. The second step of the transitional impairment test will be performed in the third quarter of fiscal 2002 in order to determine whether a loss should be recognized.





At March 31, 2002, we had remaining goodwill of $3.2 million (net of accumulated amortization of $14.9 million and impairment charges of $26.0 million).




22




---

##### Table of Contents




Recent Accounting Pronouncements





In October 2001, the Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of
Long-Lived Assets. SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While SFAS 144 supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be
Disposed of (SFAS 121), it retains many of the fundamental provisions of that statement. SFAS 144 is effective for fiscal years beginning after December 15, 2001. We are currently evaluating the impact of SFAS 144 on our financial position and
results of operations, but the Statement is not expected to have any material impact on reported results.





Factors That May Impact Future Operating Results





We have an unproven business model that makes it difficult to
evaluate our current business and future prospects.





We have introduced many new products and services and latest versions
of existing products since the beginning of fiscal 2000. We have only a limited operating history upon which to base an evaluation of our current business and future prospects. Our recent product offerings include:





| |  |  | We introduced our SLA Perspective service in February 2001, and Keynote Enterprise Perspective service in July 2001.
| | - |  | --------------------------------------------------------------------------------------------------------------------




| |  |  | In July 2001, we acquired the assets of the management service provider business of Envive Corporation and introduced our Test Perspective service.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------




| |  |  | In October 2001, we acquired the assets of onDevice and introduced our Wireless Perspective service.
| | - |  | ----------------------------------------------------------------------------------------------------




| |  |  | In November 2001, we introduced our Advanced Technical Services and Custom Perspective service.
| | - |  | -----------------------------------------------------------------------------------------------




| |  |  | In December 2001, we introduced latest version of our Transaction Perspective.
| | - |  | ------------------------------------------------------------------------------




| |  |  | We introduced our latest versions of our Website Perspective in March 2002.
| | - |  | ---------------------------------------------------------------------------




| |  |  | In May 2002, we acquired NetMechanic, Inc., which we expect will enhance the monitoring services that we already provide through our Red Alert division.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------




The revenue and income potential of our current business and services and the related markets are unproven. In addition,
because of our limited operating history and because the market for web performance benchmarking and web application performance testing and management services is relatively new and rapidly evolving, we have limited insight into trends that may
emerge and affect our business. Before investing, you should evaluate the risks, expenses and problems frequently encountered by companies such as ours that are in the early stages of development and that are entering new and rapidly changing
markets such as web performance benchmarking and web performance management services.





We have incurred losses, we expect to incur future losses and
we may never achieve profitability.





We have experienced operating losses in each quarterly and annual period since
inception, and we expect to incur operating losses in the future. We incurred net losses of $3.0 million and $6.0 million for the three and six months ended March 31, 2002, and as of March 31, 2002, we had an accumulated deficit of $77.8 million. In
addition, we are required under generally accepted accounting principles to review our goodwill and other intangible assets for impairment when events or circumstances indicate that the carrying value may not be recoverable. As of March 31, 2002, we
had $5.1 million of goodwill and




23




---

##### Table of Contents




other intangible assets. We may incur additional expenses in connection with a write-down of goodwill or other
intangible assets due to changes in market conditions as we did in the quarter ended June 30, 2001, when we recorded an impairment charge of $30.5 million in connection with our acquisitions of Velogic and Digital Content. We believe that our
operating expenses could increase as they have in certain past periods. As a result, we will need to increase our revenues to initially achieve and then to maintain profitability. We may continue our recent trend of reporting sequential quarterly
decreases 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 revenues, we must achieve
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, because of the relatively small size of initial orders, 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 new customers may be limited as companies limit or reduce their technology spending in
response to uncertain economic conditions. During fiscal 2001 and the first half of fiscal 2002, we experienced a reduction in revenue form Internet service providers and e-commerce and internet businesses. We also experienced an increase in
cancellations and non-renewals. If we continue to 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 business would
continue to be adversely affected. If we continue to experience cancellations and/or reductions in service, our revenues could continue to decline unless we are able to obtain additional customers or sources of revenues, sufficient to replace lost
revenues. Continued reductions and/or cancellations could 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 public-market analysts and investors, the price of our common stock may decline.





Results of operations could vary significantly from quarter to quarter. If revenues fall 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 Internet performance measurement services;
| | - |  | -------------------------------------------------------------------------------------------




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




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




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




| |  |  | the amount and timing of professional services revenues;
| | - |  | --------------------------------------------------------




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




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



24




---

##### Table of Contents




| |  |  | restructuring costs if the market continues its downward trend or market conditions do not improve; and
| | - |  | -------------------------------------------------------------------------------------------------------




| |  |  | excess facility charges and other charges related to our headquarters building if the real estate market continues its downward trend or market conditions do not improve.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------




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.





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





Because our business is based on providing web performance benchmarking, testing and
application performance management services, the Internet must be widely adopted as a means of electronic commerce, or e-business, and communications. Because e-business and communications over the Internet are new and evolving, with many companies
entering and exiting this market, it is difficult to predict the size of this market and its sustainable growth rate. 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 operating results depend on sales of our benchmarking services.





Sales of our benchmarking services,
primarily our Website Perspective  Business Edition services, have generated a substantial majority of our total revenue. Therefore, the success of our business currently depends, and for the immediate future will continue to substantially
depend, on the sale of our benchmarking services. Therefore, we believe that initial sales and renewals of our benchmarking services will account for a substantial portion of our revenues for the immediate future. A decline in the price of, or
fluctuation in the demand for, benchmarking services, or our inability to maintain or increase sales, would cause our revenues to decline.





If one of
our competitors Internet performance measurement service is adopted as the industry standard for measuring the speed and reliability of web sites, we may lose existing customers or encounter difficulties in attracting new customers.





To date, no Internet performance measurement service has been adopted as an accepted industry standard for measuring the
speed and reliability of web sites. As a result, if one of our current or potential competitors develops an Internet performance measurement service that is adopted as the industry standard, our customers may turn to the services provided by these
competitors. In addition, it would be more difficult for us to attract




25




---

##### Table of Contents




the additional customers for our Internet performance measurement services that are necessary for our business to grow.
If this were to occur, our business would be harmed.





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 measuring and evaluating the performance of their web sites is no longer important to their business. The Internet is a complex, heterogeneous
network of communications networks with multiple operators and vendors supplying and managing the underlying infrastructure as well as connections to this infrastructure. 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.





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





Services as complex as those we offer may not perform as customers expect. We have, from time to time, given credits to
customers as a result of past problems with our service, though we do not believe that any customers failed to renew their subscription to our services due to these problems. 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 revenues, loss of market share, failure to achieve market acceptance, diversion of development resources, injury to our reputation, increased insurance costs or increased
service costs.





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 benchmarking, testing and application performance management services, particularly in response to
competitive offerings. 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 Internet services as quickly as possible. The success of new services depends on several factors, including properly defining 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.





Our services and brand name might not attain the brand awareness necessary for our business to succeed.





We believe that maintaining and strengthening the Keynote brand in a cost-effective manner is an important aspect of our business and an important element in attracting new




26




---

##### Table of Contents




customers. In the past, our efforts to build our brand have involved significant expense. We may not be successful in
building our brand in a cost-effective manner. If our brand-building strategy is unsuccessful, we may fail to attract enough new customers or retain our existing customers to the extent necessary to realize a sufficient return on our brand-building
efforts.





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





The market for web performance benchmarking, testing, and application performance management services is relatively new and 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. For example, Mercury Interactive offers services that
compete with our Transaction and Test Perspective services, and Gomez Advisors offers services similar to our Website Perspective-Business Edition and Transaction Perspective services. In addition, with respect to our LoadPro service, we compete
with companies that offer load-testing software, such as Segue Software, or that offer both load-testing software and services, such as Mercury Interactive. With respect to our Red Alert monitoring service, we face competition from software
companies such as Freshwater Software, a division of Mercury Interactive. 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, MIDS Matrix IQ Service, and INS INSoft Division, a unit of Lucent Technologies, and free services that measure web site availability, including the WebSite Garage unit of Netscape, and Internet Weather
Report, a unit of MIDS Matrix IQ Service. In addition, companies that sell network management software, such as BMC Software, CompuWare, CA-Unicenter, HP-Openview 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 to continue to measure
the impact of new Internet technologies such as Internet telephony. 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 revenues, and the loss of a major customer could harm our operating results.





Ten customers accounted for approximately 27% of our total revenues for the three months ended March 31, 2002. No one customer accounted for more than 10% of total revenue for the
quarters ended March 31, 2000 and 2001. This concentration may continue in the future. We cannot be certain that customers that have accounted for significant revenues 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 customer agreements can generally be terminated at any time with little or no penalty. If we lose a major customer, our revenues could
decline.




27




---

##### Table of Contents




To grow our business, we need to establish and maintain relationships with other companies to help market our
Internet performance measurement, testing and benchmarking services.





To increase sales of our Internet performance
measurement, testing, and benchmarking services worldwide, we must complement our direct sales force with relationships with companies to market and sell our services to their customers. If we are unable to maintain our existing contractual
marketing and distribution relationships, or fail to enter into additional relationships, we will have to devote substantially more resources to the direct sale and marketing of our services. We would also lose anticipated revenues from customer
referrals and other co-marketing benefits. Our success depends in part on the ultimate success of these relationships and the ability of these companies to 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 revenues.





In addition, growth in the sales of our
services depends on our ability to obtain domestic and international resellers, distributors and integrators who will market and sell our services on our behalf. We have increased, and in the future plan to further increase, our indirect
distribution channels through distribution arrangements. We may not be successful in establishing relationships with these companies, and any of these relationships, if established, may not increase our revenue.





To grow our business, we must retain qualified personnel in a competitive marketplace.





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 with experience in the Internet industry, a complex industry that requires a unique knowledge base. Key
employees are not bound by agreements that could prevent them from terminating their employment at any time.





Our ability to
deliver our services also depends on our ability to attract and retain operations personnel. There is a shortage of qualified sales and operations personnel and competition for personnel in our industry is intense. If we are unable to hire, train,
motivate or retain qualified employees, including sales and operations personnel, our business could be harmed.





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





We formed our application performance management services
organization in January 1999 and expanded our service offerings during fiscal 2001 and the first half of fiscal 2002 to include certain products as well as professional services. We have limited experience in delivering consulting services and we
may not be able to successfully introduce additional consulting services. Consulting services represented approximately 7% and 8% of total revenues for the three and six months ended March 31, 2002. In addition, our cost of consulting services has
exceeded our consulting revenue for all periods. We expect that the costs of consulting and support services as a percentage of consulting and support services revenue will continue to be greater than the costs of subscription services as a
percentage of subscription services revenue. We also expect that costs of consulting and support services in absolute dollars could increase slightly in subsequent quarters for the foreseeable future. We will also need to successfully market these
services to potential customers. There are many experienced firms which offer computer network and Internet-related consulting services. These consulting services providers include consulting companies, such as Accenture and Ernst & Young, 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.




28




---

##### Table of Contents




The growth of our business depends on the continued performance of and future improvements to the Internet.





The growth in Internet traffic has caused frequent periods of decreased performance, requiring Internet service providers
and web sites on the Internet to upgrade their infrastructures. Our ability to increase the speed of access to the services we provide to our customers and to increase the scope of these services is limited by and depends upon the speed and
reliability of the Internet. Consequently, the emergence and growth of the market for our services and, consequently our revenues, depends on the performance of and future improvements to the Internet.





Because we have expanded our operations, our success will depend on our ability to manage our growth, improve our existing systems and implement new systems, procedures and
controls.





We intend to continue to expand our operations by deploying additional measurement computers, both domestically
and internationally, hiring new personnel and implementing and integrating new accounting and control systems to manage this expansion. In addition, we acquired Velogic Inc. and Digital Content L.L.C. in fiscal 2000, we acquired certain assets of
Envive Corp. in fiscal 2001, and, in the first half of 2002, we acquired certain assets of onDevice Corp. and completed the acquisition of NetMechanic, Inc. We may encounter difficulties in managing this growth and integrating the operations of
these and additional services and personnel we may acquire. Our ability to compete effectively and to manage any future expansion of our operations will require continual improvement of our financial and management controls, reporting systems and
procedures on a timely basis. We may not succeed in these efforts and a disruption could impair our ability to retain existing customers or attract new customers.





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
resulting from a shortage of electricity in California. If we experience outages at our operations center, we would not be able to receive data from our measurement computers and we would not be able to deliver our services to our customers. We plan
to develop a redundant system for computer-network and other services at an alternate site, and to provide our own source of long-term uninterruptible power. However, we do not currently have and may never develop a redundant system, and we now
currently have only short-term power back-up capability. Various factors could cause us to not be able to ever develop 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, floods, earthquakes and general business interruptions, the amount of coverage may not be adequate in any
particular case. If our operations center is damaged, causing a disruption in our services, this 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, the last of which occurred in November 2001. The outages that we have experienced have lasted no more than a few hours. 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. Although we do
not believe we have lost any customers due to these prior outages, 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 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.




29




---

##### Table of Contents




In addition to intentional security breaches, the inadvertent transmission of computer viruses could expose us to
litigation or to a material risk of loss.





We rely on a continuous power supply to conduct our business, and shortages of electricity in California
could disrupt our operations and increase our expenses.





We collect and store performance data at our data center located in
California, which experienced a shortage of electricity in 2001. Although we currently have battery powered back-up capacity and short-term diesel powered electrical generating capability, if power outages extend for periods extending beyond the
levels of our battery powered and diesel powered back-up, we would be temporarily unable to continue operations at our facilities. We would not be able to receive data from our measurement computers and we would not be able to deliver our services
to our customers. Our current insurance does not provide coverage for any damages our customers or we may suffer as a result of any interruption in our power supply or that of our hosting provider. Any interruption of our electrical power could
damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which could substantially harm our business and results of operations.





Our measurement computers are located at sites, which 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, 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 were not functioning 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. 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 infringing their intellectual property rights, we would 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, if at all.





As we expand our international activities, 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 and hire additional international personnel. Therefore, we expect to commit resources to expand our
international sales and marketing activities, which were approximately 7% of our total revenues for the three and six months ended March 31, 2002. In addition, we intend to deploy additional measurement computers worldwide, which would require us to
maintain and service computers over larger distances. Conducting international operations would subject us to risks we do not face in the United States. These include:





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



30




---

##### Table of Contents




| |  |  | 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 to consummate the acquisition and/or operate the acquired business.
| | - |  | ---------------------------------------------------------------------------------------------------------------------




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





For the year ended September 30, 2001, we incurred an excess facility charge of $11.0 million for
certain costs related to the unoccupied portion of our building in San Mateo, of which approximately $9.3 million remains accrued as of March 31, 2002. We currently expect that we will need to sublease approximately 60% of the space to a third
party. 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 costs in connection with leasing




31




---

##### Table of Contents




space in the building. The excess facility accrual may be subject to market condition changes.





The lease for this building expires in 2005. We have the option to purchase the property for $85.0 million during or at the end of the lease term, or at
the end of the lease term to assist the lessor with the sale of the property. If we purchase the property, we must pay $85.0 million to the lessor, regardless of the fair value of the building at the time of purchase, which may be lower. Real estate
market conditions have generally worsened since we entered into the lease for this building. We estimate the current market value for the property to be between $40.0 million and $50.0 million. If we choose not to purchase the property, we will be
obligated to assist in the sale of the property to a third person. We have provided the lessor with a residual guarantee of up to $79.0 million to cover any deficiency if the property is sold for less than that amount. As a result of the guarantees
in this lease, our operating results could be substantially harmed. To secure our obligations under this lease, we have reserved $85.0 million of restricted cash on our balance sheet. We could also incur a charge if a third party purchases the
property for less than the guaranteed price.





Item 3.    Qualitative and Quantitativ
e 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 equivalents, short-term investments, and restricted cash are invested in short-term debt instruments. If market
interest rates were to change immediately and uniformly by ten percent from levels at March 31, 2002, the interest earned on those cash and cash equivalents, short-term investments and restricted cash could increase or decrease by approximately $1.2
million 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 are due or payable in foreign currencies at March 31, 2002. We do not enter into derivative transactions for trading or speculative
purposes.





PART IIOTHER INFORMATION





Item 1.    Le
gal Proceedings





A number of securities class action lawsuits have been filed against us, certain of
our officers and the underwriters of our initial public offering, in connection with the offering. The complaints have been consolidated into a single action with cases brought against over three hundred other issuers and their underwriters that
make similar allegations regarding the initial public offerings of those issuers. The proceedings against the issuers, including us, have been stayed pending an outcome in the proceedings against the underwriters. We believe the claims are without
merit and intend to defend the actions vigorously.





Item 2.    Changes in Securitie
s and Use of Proceeds





Not applicable.





Item 3.    Defaults Upon Senior Se
curities





Not applicable.





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





Not applicable.





Item 5.    Other I
nformation





Not applicable.





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





(a)  Index to Exhibits





Not applicable.





(b)  Reports on Form 8-K





We did not file any reports on Form 8-K during the three months ended March 31,
2002.




32




---

##### Table of Contents




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 15th day of May 2002.





KEYNOTE SYSTEMS, INC.By:

/s/    UMANG GUPTAUmang Gupta Chairman of the Board and Chief Executive
Officer (Principal Executive Officer)





By:

/s/    JOHN J. FLAVIOJohn J. Flavio Senior Vice President and Chief Financial
Officer (Principal Financial Officer)





By:

/s/    PETER J. MALONEYPeter J. Maloney Vice President and Controller
(Principal Accounting Officer)




33