##### Table of Contents




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SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





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FORM 10-Q





(Mark One)


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





For the quarterly period ended June 30, 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





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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





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Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.   YES   x    NO  ̈





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





Class

Shares outstanding at July 31,
2002Common Stock, $.001 par value

28,490,289





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##### 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

14Item 3.    Qualitative and Quantitative Disclosures about Market Risk

32PART IIOTHER INFORMATIONItem 1.    Legal Proceedings

33Item 2.    Changes in Securities and Use of Proceeds

33Item 3.    Defaults Upon Senior Securities

33Item 4.    Submission of Matters for a Vote of Security Holders

33Item 5.    Other Information

33Item 6.    Exhibits and Reports on Form 8-K

33Signatures

34




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##### Table of Contents




PART IFINANCIAL INFORMATION





Item 1.    Financial Statements.





KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





Index to Unaudited Condensed Consolidated Financial Statements





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

4Condensed Consolidated Statements of Operations for the three months and nine months ended June 30, 2002 and 2001

5Condensed Consolidated Statements of Cash Flows for the nine months ended June 30, 2002 and 2001

6Notes to Condensed Consolidated Financial Statements

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##### Table of Contents




KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





CONDENSED CONSOLIDATED BALANCE SHEETS


(In thousands)


(Unaudited)





June 30, 2002


September 30, 2001ASSETSCurrent assets:Cash and cash equivalents

$
51,130


$
53,130Short-term investments


192,809



198,566Total cash, cash equivalents, and short-terminvestments


243,939



251,696Accounts receivable, less allowance for doubtfulaccounts of $1,465 and $1,041 as of June 30, 2002and September
30, 2001, respectively


5,348



7,862Prepaid and other current assets


3,103



4,649Total current assets


252,390



264,207Restricted cash


85,000



85,000Property and equipment, net


14,248



17,208Goodwill, net






3,025Other intangible assets, net


3,215



1,472Other assets


385



1,752Total assets

$
355,238


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


37



830Accounts payable


757



2,385Accrued expenses


8,740



10,626Accrued excess facility costs


8,854



10,303Deferred revenue


5,658



5,401Total current liabilities


24,046



29,545Total liabilities


24,046



29,545Stockholders equity:Common stock


28



28Treasury stock


(1,600
)


(1,086
)Additional paid-in capital


413,971



413,966Deferred compensation


(197
)


(452
)Accumulated deficit


(83,457
)


(71,804
)Accumulated other comprehensive income


2,447



2,467Total stockholders equity


331,192



343,119Total liabilities and stockholders equity

$
355,238


$
372,664





See accompanying notes to the condensed consolidated financial statements




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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(In thousands, except per share amounts)


(Unaudited)





Three Months Ended


Nine Months EndedJune 30,


June 30,2002


2001


2002


2001Revenue:Subscription services

$
8,516


$
10,376


$
25,869


$
34,484Consulting and support services


958



693



2,403



1,630Total revenue


9,474



11,069



28,272



36,114Operating Expenses:Costs of subscription services


2,721



3,375



8,970



9,629Costs of consulting and support services


742



739



2,631



2,223Research and development


2,140



1,575



6,420



5,400Sales and marketing


4,709



4,992



14,434



16,578Operations


1,909



1,832



6,036



5,539General and administrative


2,071



1,776



6,133



5,265Restructuring costs






271







271Acquisition-related charges, impairmentand amortization of goodwill andintangible assets, and
stock-basedcompensation


597



34,676



1,203



47,906Total operating expenses


14,889



49,236



45,827



92,811Loss from operations


(5,415
)


(38,167
)


(17,555
)


(56,697
)Interest income, net


2,916



3,869



9,064



14,578Loss before provision for income taxesand the cumulative effect of a changein accounting principle


(2,499
)


(34,298
)


(8,491
)


(42,119
)Provision for income taxes






150







450Net loss before cumulative effect of achange in accounting principle


(2,499
)


(34,448
)


(8,491
)


(42,569
)Cumulative effect of a change inaccounting principle










(3,160
)


Net loss

$
(2,499
)

$
(34,448
)

$
(11,651
)

$
(42,569
)Net loss per share:Net loss per share before the cumulativeeffect of a change in accounting principle


(0.09
)


(1.24
)


(0.30
)


(1.54
)Cumulative effect per share of a change inAccounting principle










(0.12
)


Basic and diluted net loss per share

$
(0.09
)

$
(1.24
)

$
(0.42
)

$
(1.54
)Shares used in computing basic anddiluted net loss per share:


27,999



27,784



27,928



27,663





See accompanying notes to the condensed consolidated financial statements




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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(In thousands)


(Unaudited)





Nine months ended June 30,2002


2001Cash flows from operating activities:Net loss

$
(11,651
)

$
(42,569
)Adjustments to reconcile net loss to net cashfrom operating activities:Depreciation and amortization


6,031



4,167Amortization of goodwill and otherintangible assets


748



12,075Impairment of goodwill and intangible assets






30,493Amortization of deferred compensation


255



5,091In-process research and development charge


200



Cumulative effect of a change in accountingprinciple


3,160



Changes in operating assets and liabilities,net of assets acquired and liabilities assumedin
acquisitions:Accounts receivable


2,596



225Prepaids and other assets


2,913



(1,152
)Accounts payable and accrued expenses


(5,360
)


560Deferred revenue


(61
)


(1,135
)Net cash (used in) provided byoperating activities


(1,169
)


7,755Cash flows from investing activities:Purchases of property and equipment


(3,074
)


(10,701
)Purchases of assets and business


(2,212
)


Purchases of short-term investments


(51,097
)


(248,123
)Sales and maturities of short-term investments


56,854



51,430Net cash provided by (used in)investing activities


471



(207,394
)Cash flows from financing activities:Repayment of notes payable


(793
)


(986
)Issuance of common stock, net of issuance costs


1,447



1,547Repurchase of outstanding common stock


(1,956
)


(1,326
)Net cash used in financing activities


(1,302
)


(765
)Net decrease in cash and cash equivalents


(2,000
)


(200,404
)Cash and cash equivalents at beginning of the period (1)


53,130



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

$
51,130


$
59,797Cash, cash equivalents, and short-terminvestments at end of the period (1)

$
243,939


$
255,465


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




See accompanying notes to the condensed consolidated financial statements




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS










(1)    Basis of Presentation





The accompanying 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 June 30, 2002, and the
results of operations and cash flows for the interim periods ended June 30, 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 the current presentation.





(2)    Revenue Recognition





Subscription services revenue consists of fees from subscriptions to the Companys Internet measurement, monitoring, testing and diagnostic services. The Companys subscription services revenue is generally deferred upon
invoicing and is recognized ratably over the service period, generally ranging from one to twelve months. For some customers, subscription services revenue is invoiced monthly upon completion of measurement services. Deferred revenue is comprised
mainly of deferred subscription services revenue. All 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. Revenue from consulting and support services, which includes revenue from the Companys load testing service, are recognized as the services are performed, typically over a period of
one to three months. For consulting projects that span more than one month, the Company recognizes revenue on a percentage of completion basis.





(3)    Cumulative Effect of a Change in Accounting Principle





Effective October 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142 requires that goodwill and other intangible assets with indefinite useful
lives no longer be amortized, but instead be tested for impairment at least annually.





With the 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 reclassified to
goodwill. Based on that assessment, no adjustments were made to the amortization period or residual values of the other intangible assets other than goodwill.





SFAS 142 provides 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 identified its reporting units and determined 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. The Company determined that it had one reporting unit.





The Company determined the fair value of
its one reporting unit as of October 1, 2001, and compared it to the reporting units carrying amount. To the extent that the reporting units carrying amount exceeded its fair value, an indication exists that the reporting units
goodwill




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)




may be impaired and the Company must perform the second step of the transitional impairment test. During the second quarter of fiscal 2002, the Company performed the first step of the
transitional impairment test, and obtained an indicator of impairment in the Companys single reporting unit. During the third quarter of fiscal 2002, the Company performed the second step of the transitional impairment test to measure the
amount of the impairment. In the second step, the Company compared 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. The Company determined the implied fair value of its single reporting
unit using its market capitalization value, adjusted for a control premium and compared it to the Companys carrying value. The Company determined its market capitalization value based on the number of shares outstanding and the stock price as
of October 1, 2001, adjusted for a control premium. This evaluation indicated that goodwill associated with acquisitions completed prior to fiscal 2002 was impaired as of October 1, 2001. Accordingly, the Company recorded a $3.2 million non-cash
impairment charge as a cumulative effect of a change in accounting principle for the write-off of the remaining goodwill as of October 1, 2001. The charge is reflected in the results for the nine months ended June 30, 2002. Currently, there is no
remaining goodwill on the Companys balance sheet.





(4) Other Comprehensive Loss





Accumulated other comprehensive gain includes unrealized gains or losses on short-term investments in debt securities, which are excluded
from earnings and reported as a component of stockholders equity. The comprehensive loss for the interim periods ended June 30, 2002 and 2001 are presented below:





Three Months Ended


Nine Months EndedJune 30, 2002


June 30, 2001


June 30, 2002


June 30, 2001Net loss

$
(2,499
)

$
(34,448
)

$
(11,651
)

$
(42,569
)Unrealized gain (loss) on investments


596



(1,025
)


(20
)


(1,025
)Comprehensive loss

$
(1,903
)

$
(35,473
)

$
(11,671
)

$
(43,594
)





(5)    Financial Instruments and Concentration of Risk





The carrying value of the Companys financial instruments, including cash and cash equivalents,
short-term investments, accounts receivable, 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. For the quarter ended June 30, 2002, the Company increased its allowance for doubtful accounts. 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 June 30, 2002, one customer accounted for more than 10%
of the Companys total accounts receivable. At




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)







June 30, 2001 no single customer accounted for more than 10% of the Companys total
accounts receivable. For the three months ended June 30, 2002, one customer accounted for 10% of the Companys total revenue, of which 53% has been paid subsequent to June 30, 2002. For the nine months ended June 30, 2002, and the three and
nine months ended June 30, 2001, no single customer accounted for more than 10% of the Companys total revenue.





(6)    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 of the Companys cash equivalents and short-term investments are classified as
available-for-sale. These securities are carried at fair market value, with unrealized gains and losses excluded from earnings and reported as a component of other comprehensive loss. The following table summarizes the Companys short-term
investments in investment-grade debt securities as of June 30, 2002 (in thousands):





Amortized Cost

GrossUnrealized Gains

GrossUnrealized Losses

EstimatedFair Market ValueObligations of U.S. government agencies

$
11,000

$


$


$
11,000Corporate bonds and commercial paper


179,362


2,695


248


181,809Total

$
190,362

$
2,695

$
248

$
192,809





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 June 30, 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.





Amortized Cost

Estimated FairMarket ValueDue in 1 year

$
155,178

$
157,052Due in 2 years


35,184


35,757Total

$
190,362

$
192,809





(7)    Goodwill and Other Intangible Assets





As described in Note 3, Cumulative Effect of a Change in Accounting Principle, the Company adopted SFAS 142 as of
October 1, 2001. The following table outlines the pro forma adjustments for reported net loss and net loss per share for the three and nine months ended June 30, 2001, to exclude the amortization of goodwill (in thousands, except for loss per
share).





Three Months EndedJune 30, 2001


Nine Months EndedJune 30, 2001Net Loss:Reported net loss

$
(34,448
)

$
(42,569
)Add back goodwill amortization


3,064



10,078Adjusted net loss

$
(31,384
)

$
(32,491
)Basic and diluted loss per share:Reported basic and diluted loss per share

$
(1.24
)

$
(1.54
)Add back goodwill amortization


.11



.37Adjusted basic and diluted loss per share

$
(1.13
)

$
(1.17
)




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)







Additionally, the Company has approximately $3.2 million of other
intangible assets, which are all subject to amortization but have yet to be amortized. During the first quarter of fiscal 2002, as part of the Companys acquisition of OnDevice, Corp. (onDevice), it acquired approximately $860,000 of
technology-based intangible assets. During the third quarter of fiscal 2002, as part of the Companys acquisition of NetMechanic, Inc (NetMechanic), it acquired $55,000 of customer-related intangible assets and approximately $1.5 million of
technology-based intangible assets. All intangible assets are being amortized over a three-year period. No significant residual value is estimated for these intangible assets. During the three and nine months ended June 30, 2002, the amortization
expense for intangible assets was approximately $312,000 and $748,000, respectively. During the three and nine months ended June 30, 2001, the amortization expense for intangible assets was approximately $1.0 million and $2.2 million, respectively.
The components of intangible assets excluding goodwill are as follows (in thousands):





Technology Based


Customer Based


Trademark


TotalAs of June 30, 2002:Gross carrying value

$
7,171


$
3,660


$
250


$
11,081Accumulated amortization


(4,205
)


(3,426
)


(235
)


(7,866
)Net carrying value atJune 30, 2002

$
2,966


$
234


$
15


$
3,215As of September 30, 2001:Gross carrying value

$
4,735


$
3,605


$
250


$
8,590Accumulated amortization


(3,575
)


(3,318
)


(225
)


(7,118
)Net carrying value atSeptember 30, 2001

$
1,160


$
287


$
25


$
1,472





The amortization expense for existing intangible assets is
estimated to be $403,000 for the fourth quarter of fiscal 2002, approximately $1.4 million for fiscal 2003, approximately $1.1 million for fiscal 2004, and $312,000 for fiscal 2005.





(8)    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.







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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)







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 nine months ended June 30:Shares subject to outstanding stock options

5,875

2,666Shares of restricted stock subject to repurchase

18

130Total shares excluded

5,893

2,796





The weighted-average exercise price per share of common stock
subject to stock options was $13.45 as of June 30, 2002 and $22.39 as of June 30, 2001. The weighted-average repurchase price of restricted stock was $1.07 as of June 30, 2002, and $0.72 as of June 30, 2001.





(9)    Acquisitions





On May 1, 2002, the Company acquired NetMechanic, a provider of remote web site quality assurance and testing services. The Company believes this acquisition enhances its ability to provide a complete suite of cost-effective
content testing and availability monitoring services for the small to medium size business market. The acquisition was accounted for under the purchase method of accounting, and was completed for approximately $1.2 million in cash plus an additional
cash payment if certain revenue and profitability targets are achieved during the twelve months ended September 30, 2003.





The $1.2 million cash purchase consideration was allocated to assets and liabilities acquired based on estimated fair values at the acquisition date. The following table summarizes the estimated fair value of the assets acquired and
liabilities assumed at the date of acquisition (in thousands):





Cash

$
18Accounts receivable


81Technology-based intangible assets


1,548Customer-based intangible assets


55In-process research and development


200Current liabilities


(396
)Deferred revenue


(317
)Total purchase consideration

$
1,189





Approximately $200,000 of the purchase price has been allocated to
the estimated fair value of an acquired in-process research and development project that had not yet reached technological feasibility and had no alternative future use. The value assigned to in-process research and development relates to
NetMechanics technology for web page testing. The estimated fair value of this project was determined based on actual costs incurred as of the acquisition date. This amount was immediately expensed upon the acquisition date and this charge was
included in acquisition-related charges, impairment and amortization of goodwill and other intangible assets, and stock-based compensation expenses.





Of the $1.6 million of acquired intangible assets, approximately $1.5 million was allocated to technology-based intangible assets and $55,000 was allocated to customer-based intangible assets. The
estimated fair value of the technology-based intangible assets was determined using a discounted cash flow model. The discount rates used took into consideration the stage of completion and the risks surrounding the technologies that were valued.





Intangible assets are being amortized on a straight-line basis over three years. Amortization of intangible
assets related to the NetMechanic acquisition was $89,000 for the three and nine months ended June 30, 2002. The consolidated statement of operations includes activity relating to NetMechanics business activity subsequent to the acquisition.
If the results of the two companies were combined on a pro forma basis for the three and nine months ended June 30, 2001, the difference between pro forma results and the actual results reported herein, would be immaterial.





On October 10, 2001, the Company acquired the business of onDevice Corp. (onDevice), a provider of wireless application testing services.
The Company believed this acquisition would 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 $71,000 and $204,000 for
the three and nine months ended June 30, 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 nine months ended June 30, 2001, the difference between pro forma results, and the actual results


reported herein, would be immaterial.





For the three months ended June 30, 2002, the Company recorded $312,000 in amortization related to intangible
assets, $200,000 in in-process research and development charge associated with its acquisition of NetMechanic, and $85,000 in amortization of stock-based compensation. For the nine months ended June 30, 2002, the Company recorded $748,000 in
amortization related to intangible assets, $200,000 in in-process research and development charge associated with its acquisition of NetMechanic, and $255,000 in amortization of stock-based compensation.




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)







Additionally, the Company recorded an approximately $3.2 million charge as a cumulative
effect of a change in accounting principal for the write-off of the remaining goodwill as of October 1, 2001 associated with its Digital Content and Red Alert acquisitions.





Acquisition-related charges, impairment and amortization of goodwill and other intangibles and stock based compensation of approximately $34.7 million recorded in the
condensed consolidated statement of operations for the three months ended June 30, 2001, includes amortization of goodwill and other intangibles of approximately $4.1 million, impairment of goodwill and intangible assets of approximately $30.5
million, and amortization of stock-based compensation of approximately $85,000. Acquisition-related charges, impairment and amortization of goodwill and other intangibles and stock based compensation of approximately $47.9 million recorded in
the condensed consolidated statement of operations for the nine months ended June 30, 2001, includes acquisition related deferred compensation charges of approximately $4.8 million, amortization of goodwill and other intangibles of approximately
$12.3 million, impairment of goodwill and intangible assets of approximately $30.5 million, and amortization of stock-based compensation of $255,000.





(10) 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 leased equipment under a capital lease, which expired in the third quarter of fiscal 2002. At June 30, 2002, future minimum payments under the leases, net of sublease income, are as follows (in thousands):





Twelve months ended June 30:

Operating Leases2003

$
1,9072004


2,2412005


88,6612006


58Thereafter


Total minimum lease payments

$
92,867





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 of the Company, 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 June 30,
2002, the Termination Value was approximately $85.0 million and was fully secured by $85.0 million of restricted cash held by the lessor financial institution.





The Company has an option that is exercisable during the term of the lease to either purchase the leased property for the Termination Value, or, to assist the lessor with the sale of the property at
the end of the lease term. 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 cannot currently




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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)




determine 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 in 2005. The Company will be engaging real estate experts to assist in evaluating the fair value of the property and
alternatives associated with the ownership structure of the building in the fourth quarter of fiscal 2002, which may result in the termination of the lease, the acquisition of the property, and the recording of a non-cash charge for the difference
between the fair value of the property and the termination value. Upon termination of the lease, the entire amount of the restricted cash will be utilized to satisfy all obligations under the lease agreement.





To fully collateralize this obligation, $85.0 million has been deposited in an interest-bearing escrow account with the lessor financial
institution and is included in the balance sheet as restricted cash as of June 30, 2002 and 2001, and is reflected as a future minimum payment in 2005 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, is subject to a deed of trust in favor of the lessor in order to secure the Companys obligations under the lease.





(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. 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. Plaintiffs counsel and the individual named defendants counsel are in negotiations whereby the individual named defendants may be dismissed from the case, without any payments by
the Company. A formal dismissal has not yet occurred. The case against the underwriters and the Company continues. 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.





(11)
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 international sales and the Companys foreign-owned assets are not
significant. At June 30, 2002, one customer accounted for 10% of the Companys total accounts receivable. At June 30, 2001, no single customer accounted for more than 10% of the Companys total accounts receivable. For the three months
ended June 30, 2002, one customer accounted for 10% of the Companys total revenue. For the nine months ended June 30, 2002, and the three and nine months ended June 30, 2001, no single customer accounted for more than 10% of the Companys
total revenue.




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##### Table of Contents




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





The following information should be read in conjunction with the 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, margins, 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 the section Managements Discussion and Analysis of Financial Condition and Results of
Operations-Factors That May Impact Future Operating Results and elsewhere in our annual report on Form 10-K for the fiscal year ended September 30, 2001. You should also carefully review the risks described in other documents we file from time
to time with the Securities and Exchange Commission including the 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 revenue, improve customer support and
retention while reducing customer support costs, and gain a competitive advantage.





Revenue consists of
subscription services revenue and consulting and support services revenue. Subscription services revenue consists of fees from subscriptions to our Internet measurement, monitoring, testing and diagnostic services. Our subscription services revenue
is generally deferred upon invoicing and are recognized ratably over the service period, generally ranging from one to twelve months. For some customers, subscription services revenues is invoiced monthly upon completion of measurement services.
Deferred revenue is comprised primarily of deferred subscription services revenue. All unearned revenue is recorded as deferred revenue on our balance sheet, and as of June 30, 2002, we had recorded $5.7 million of deferred revenue. 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. Revenue from our consulting and support services, which includes revenue from our load
testing service, is recognized as the services are performed, typically over a period of one to three months. For consulting projects that span more than one month, we recognize revenue on a percentage-of-completion basis.





We derive and expect to continue to derive our revenue from the sale of our web performance benchmarking, application performance
management and testing services. These services include our subscription-based services such as our Perspective series of offerings, our Red Alert and NetMechanic monitoring and alarm services, and our private agent application performance
management services. Our customers purchase these services 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 number of private agents, the additional features ordered, and the type of services purchased. We offer our consulting and support services on a per
engagement basis. Consulting and support services revenue amounted to 10% and 8% of total revenue for the three months and nine months ended June 30, 2002, respectively. We believe that consulting and support services revenue may increase in the
future somewhat as a percentage of total revenue, as we introduce additional services that require consulting expertise and as our Advanced Technical Support services are more widely used.





For the quarter ended June 30, 2002, our 10 largest customers accounted for approximately 32% of total revenue. 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 for future services 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.




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##### Table of Contents




Results of Operations





Revenue


2002

2001

% Change(In thousands)For the three months ended June 30:Subscription services

$
8,516

$
10,376

(18%)Consulting and support services


958


693

38%$
9,474

$
11,069

(14%)For the nine months ended June 30:Subscription services

$
25,869

$
34,484

(25%)Consulting and support services


2,403


1,630

47%$
28,272

$
36,114

(22%)





Subscription Services.    Revenue from
subscription services decreased approximately $1.9 million or 18% for the three months ended June 30, 2002 as compared to the same period in 2001. Revenue from subscription services decreased $8.6 million or 25% for the nine months ended June 30,
2002 as compared to the same period in 2001. Subscription services represented approximately 90% and 94% of total revenue for the three months ended June 30, 2002 and 2001, respectively, and approximately 92% and 95% of total revenue for the nine
months ended June 30, 2002 and 2001, respectively. The decreases during the quarter and for the nine months resulted primarily from lower sales to two customer segments; Internet service providers and Internet e-commerce websites, which declined
from 26% of total revenue for the comparable quarter a year ago to 15% for the third quarter. In the previous quarter, 15% of our revenue also came from these same two segments. Revenue from the Internet service providers and Internet e-commerce
websites segments decreased by 37% for the three months ended June 30, 2002 as compared to the comparable quarter a year ago. Sales to all other customer segments declined by 6% as compared to the comparable quarter a year ago. The decrease during
the quarter and for the nine months in revenue was partially offset by an increase of prices for some of our Perspective services during the third quarter of fiscal 2002.





Consulting and Support Services.    Revenue from consulting and support services increased $265,000 or 38% for the three months ended June 30, 2002 as
compared to the same period in 2001. Revenue from consulting and support services increased $773,000 or 47% for the nine months ended June 30, 2002 as compared to the same period in 2001. Consulting and support services represented approximately 10%
and 6% of total revenue for the three months ended June 30, 2002 and 2001, respectively, and approximately 8% and 5% of total revenue for the nine months ended June 30, 2002 and 2001, respectively. The increase during the quarter and for the nine
months resulted primarily from new Advanced Technical Support product offerings in fiscal 2002 as well as some large testing transactions during these periods.





At June 30, 2002, one customer accounted for 10% of the Companys total accounts receivable. At June 30, 2001, no single customer accounted for more than 10% of the Companys total accounts
receivable. For the three months ended June 30, 2002, one customer accounted for 10% of the Companys total revenue. For the nine months ended June 30, 2002, and the three and nine months ended June 30, 2001, no single customer accounted for
more than 10% of the Companys total revenue.





Expenses:





Costs of Subscription and Consulting and Support Services


2002

2001

% Change(In thousands)For the three months ended June 30:Costs of subscription services

$
2,721

$
3,375

(19)%Costs of consulting and support services

$
742

$
739

0%For the nine months ended June 30:Costs of subscription services

$
8,970

$
9,629

(7)%Costs of consulting and support services

$
2,631

$
2,223

18%




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##### Table of Contents




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 $654,000 or 19% for the three months ended June 30, 2002 as compared to the same period in 2001 and decreased sequentially by $136,000 or 5% compared to the second quarter of fiscal 2002.
Costs of subscription services decreased $659,000 or 7% for the nine months ended June 30, 2002 as compared to the same period in 2001. The decrease during the quarter and for the nine months was primarily due to reduced costs for bandwidth and
reduction in our excess bandwidth capacity related to our bandwidth cost reduction program. Costs of subscription services were 32% and 33% of subscription service revenue for the three months ended June 30, 2002 and 2001, respectively, and
approximately 35% and 28% of subscription service revenue for the nine months ended June 30, 2002 and 2001. We believe that costs of subscription services in absolute dollars for the fourth quarter of fiscal 2002 will remain comparable to the third
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 was 77% and 107%
of consulting and support service revenue for the three months ended June 30, 2002 and 2001, respectively. Costs of consulting and support services decreased $3,000 for the three months ended June 30, 2002 compared to the same period in 2001 and
decreased $195,000 or 21% compared to the second quarter of fiscal 2002. The decreases were primarily from organizational changes implemented to improve productivity and reduce the costs of delivering testing and support services. Costs of
consulting and support services increased $408,000 or 18% for the nine months ended June 30, 2002 compared to the same period in 2001. For the nine month period, the costs primarily increased because, our recently introduced program of charging for
Advance Technical Support has resulted in the costs of our Advanced Technical Support personnel being 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 fourth quarter of fiscal 2002 will increase slightly from the third quarter of fiscal 2002.





Research and Development





2002

2001

% Change(In thousands)For the three months ended June 30:Research and development

$
2,140

$
1,575

36%For the nine months ended June 30:Research and development

$
6,420

$
5,400

19%





Research and development expenses consist primarily of compensation
and related costs for research and development personnel. Research and development expenses increased $565,000 or 36% for the three months ended June 30, 2002 as compared to the same period in 2001 and increased $39,000 or 2% compared to the second
quarter of fiscal 2002. Research and development expenses increased $1.0 million or 19% for the nine months ended June 30, 2002 as compared to the same period in 2001. The increases during the third quarter of fiscal 2002 and for the nine months
were primarily attributable to the increase in personnel to support our new offerings in our Testing, Wireless Perspective, and NetMechanic 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 we may need to continue to invest in research and development to enhance and expand our services. We anticipate that research and development expenses in absolute
dollars for the fourth quarter of fiscal 2002 will increase slightly from the third quarter of fiscal 2002 due to the costs for additional research and development personnel in connection with our acquisition of NetMechanic.




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Sales and Marketing





2002

2001

% Change(In thousands)For the three months ended June 30:Sales and marketing

$
4,709

$
4,992

(6%)For the nine months ended June 30:Sales and marketing

$
14,434

$
16,578

(13%)





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 $283,000 or 6% for the three months ended June 30, 2002 as compared to the same
period in 2001 and sequentially declined compared to the second quarter of fiscal 2002 by $93,000 or 2%. Our sales and marketing expenses decreased approximately $2.1 million or 13% for the nine months ended June 30, 2002 as compared to the same
period in 2001. The decreases during the third quarter of fiscal 2002 and for the nine months were primarily a result of the restructuring of our sales organization to focus greater resources on our large corporate customers and reduced spending on
marketing programs. We believe that we may need to continue to invest in our sales and marketing efforts to maintain our market position to expand our direct sales force in the United Kingdom, and to further increase acceptance of our services. We
anticipate that sales and marketing expenses in absolute dollars for the fourth quarter of fiscal 2002 will increase slightly compared to the third quarter of fiscal 2002 due to the sales and marketing costs associated with promoting the NetMechanic
services.





Operations





2002

2001

% Change(In thousands)For the three months ended June 30:Operations

$
1,909

$
1,832

4%For the nine months ended June 30:Operations

$
6,036

$
5,539

9%





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 $77,000 or 4% for the three months ended June 30, 2002 as compared to the same period
in 2001 and sequentially decreased compared to the second quarter of fiscal 2002 by $137,000 or 7%. The decrease from the second quarter was primarily due to organization changes including a reduction in the number of operations personnel. Our
operations expenses increased $497,000 or 9% for the nine months ended June 30, 2002 as compared to the same period in 2001. The increase during the quarter and for the nine months in operations expenses was primarily related to the hiring of
personnel to manage and support our customers and data center. We believe that we may need to continue to invest in our operations 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 fourth quarter of fiscal 2002 will remain comparable to the third quarter of fiscal 2002.





General and Administrative





2002

2001

% Change(In thousands)For the three months ended June 30:General and administrative

$
2,071

$
1,776

17%For the nine months ended June 30:General and administrative

$
6,133

$
5,265

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 $295,000 or 17% for the three
months ended June 30, 2002 as compared to the same period in 2001 and sequentially increased compared to the second quarter of fiscal 2002 by $79,000 or 4%. General and administrative expenses increased $868,000 or 16% for the nine months ended June
30, 2002 as compared to the same period in 2001. The increase during the third quarter of fiscal 2002 and for the nine months in our general and administrative expenses was mainly attributable to the hiring of additional personnel to support our
business as well as higher insurance, personal property taxes, and occupancy costs. We anticipate that general and administrative expenses in absolute dollars for the fourth quarter of fiscal 2002 will decrease slightly comparable to the third
quarter of fiscal 2002.




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##### Table of Contents




Restructuring Costs





2002

2001

% Change(In thousands)For the three months ended June 30:Restructuring costs

$


$
271

For the nine months ended June 30:Restructuring costs

$


$
271







In April 2001, we incurred restructuring costs of $271,000 relating
to a reduction of our workforce by approximately 36 employees, or 13% reduction from March 31, 2001. The restructuring costs consisted of severance payments, which were paid in full by June 30, 2001.





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





2002

2001

% Change(In thousands)For the three months ended June 30:Amortization of goodwill

$


$
3,064

Amortization of intangible assets


312


1,034

(70
)%Impairment of goodwill and intangible assets





30,493

Amortization of stock-based compensation


85


85

In-Process research and development costs


200




100
%Acquisition-related charges, impairment and amortization of goodwill and other intangible assets, and stock-based compensation

$
597

$
34,676

(98
)%For the nine months ended June 30:Amortization of acquisition-related deferred compensation

$


$
4,836

Amortization of goodwill





10,078

Amortization of intangible assets


748


2,244

(67
)%Impairment of goodwill and intangible assets





30,493

Amortization of stock-based compensation


255


255

In-Process research and development


200




100
%Acquisition-related charges, impairment  and amortization of goodwill and other intangible assets, and
stock-based compensation

$
1,203

$
47,906

(97
)%





As discussed in Note 3, Cumulative Effect of a Change in
Accounting Principle, and Note 7, Goodwill and Other Intangible Assets, of the Notes to Condensed Consolidated Financial Statements, we no longer amortize goodwill and have no remaining goodwill on our balance sheet.





In connection with the purchases 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, the business of onDevice Corporation (onDevice) in October 2001, and our recent acquisition of NetMechanic Inc. (NetMechanic) in May 2002, we have recorded




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an aggregate of approximately $55.2 million in goodwill and other intangible assets. For the three
months ended June 30, 2002 and 2001, we recorded expenses of $312,000 and approximately $1.0 million relating to amortization of intangible assets, respectively. For the nine months ended June 30, 2002 and 2001, we recorded expenses of $748,000 and
approximately $2.2 million relating to amortization of intangible assets, respectively. In addition, for the three and nine months ended June 30, 2001, we recorded an impairment charge of approximately $30.5 million for the write-down of goodwill
and intangible assets associated with our Digital Content and Red Alert acquisitions. We also recorded an approximately $3.2 million charge as a cumulative effect of a change in accounting principle for the write-off of the remaining goodwill as of
October 1, 2001, associated with our Digital Content and Red Alert acquisitions. At June 30, 2002, we had a remaining balance of intangible assets of approximately $3.2 million that are being amortized over a three-year period from the date of
acquisition. For the three and nine months ended June 30, 2001, we expensed acquisition-related deferred compensation costs of $0 and $4.8 million, respectively.





The $200,000 charge for the three and nine months ended June 30, 2002, related to the estimated fair value of an acquired in-process research and development project that had not yet reached
technological feasibility and had no alternative future use. The value assigned to in-process research and development relates to NetMechanics technology for web page testing. The estimated fair value of this project was determined based on
actual costs incurred as of the acquisition date. This amount was immediately expensed upon the acquisition date.





A portion of the consideration for the Digital Content acquisition, in the aggregate amount of $6.4 million, was attributed to deferred compensation, and was fully amortized by June 30, 2001. Approximately $4.8 million related to the
deferred compensation was amortized during the nine months ended June 30, 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 and $255,000 for the three and nine months ended June 30, 2002 and 2001, respectively, and we had an aggregate of $197,000 included in unamortized deferred compensation as of June 30, 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 $500,000 for the fourth quarter of fiscal 2002, assuming no additional acquisitions or impairment charges. We expect the remaining carrying value of the intangible
assets at June 30, 2002, as listed in the table below, will be fully amortized by April 2005.





Intangible AssetDigital Content

$   185Velogic

35Envive

835onDevice

646NetMechanic

1,514Total

$3,215





Interest Income, Net


2002

2001

% Change(In thousands)For the three months ended June 30:Interest income, net

$
2,916

$
3,869

(25)%For the nine months ended June 30:Interest income, net

$
9,064

$
14,578

(38)%





Net interest income decreased approximately $953,000 or 25% for the
three months ended June 30, 2002 as compared to the same period in 2001. Net interest income decreased approximately $5.5 million or 38% for the nine months ended June 30, 2002 as compared to the same period for 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 earned on our cash, short-term investments, and restricted cash during the three
and nine months ended June 30, 2002 compared to the same period for fiscal 2001. We expect that net interest income will continue to decline further during fiscal 2002 due to the general decline in interest




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rates and the corresponding lower rates on government and corporate debt securities available for
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 June 30, 2002, due to
the operating loss, net operating loss carryforwards, and tax credits.





A provision for federal and state income
taxes of $150,000 and $450,000 was recorded for the three and nine months ended June 30, 2001, principally for alternative minimum tax.





Cumulative Effect of a Change in Accounting Principle





As
discussed in Note 3, Cumulative Effect of a Change in Accounting Principle, as a result of the implementation of SFAS 142, we recorded a charge of approximately $3.2 million as a cumulative effect of a change in accounting principle
for the write-off of the remaining goodwill. The charge is reflected in the results for the nine months ended June 30, 2002. Goodwill amortization for the three and nine months ended June 30, 2001 was approximately $3.1 million and $10.1 million,
respectively.





Liquidity and Capital Resources





At June 30, 2002, we had approximately $51.1 million in cash and cash equivalents, approximately $192.8 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 $328.9 million. Our short-term investments consist of investment-grade debt securities.





Net cash used in operating activities was approximately $1.2 million for the nine months ended June 30, 2002, primarily from the loss from operations before non-cash
charges and 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 $7.8 million for the nine months ended June 30, 2001 and resulted from income from operations before non-cash charges and a decrease in accounts receivable. The increase in cash was partially offset by an increase in
prepaids and other assets and a reduction in deferred revenue. Accounts receivable decreased slightly as a result of successful collection efforts. Prepaids and other assets increased due to an increase in interest receivable.





Investing activities generated $471,000 for the nine months ended June 30, 2002. During the nine months ended June 30, 2002, we
generated a net amount of $5.8 million from the net sale of our short-term investments and used $3.1 million for property and equipment and $2.2 million for our acquisitions of onDevice, Envive and NetMechanic. Cash used in our investing activities
totaled $207 million for the nine months ended June 30, 2001. During the nine months ended June 30, 2001, we invested a net amount of $196.7 million in short-term investments and $10.7 million for capital expenditures. We expect capital expenditures
to be approximately $1.3 million for the fourth quarter of fiscal 2002, absent any acquisitions or other extraordinary transactions.





Cash used in our financing activities totaled approximately $1.3 million for the nine months ended June 30, 2002. We used $793,000 for the repayment of notes payable and approximately $2.0 million for the repurchase of
214,900 shares of our common stock under our repurchase program, partially offset by approximately $1.4 million generated from the issuance of common stock under our employee stock option and stock purchase plans. We used $765,000 for financing
activities for the nine months ended June 30, 2001. We received approximately $1.5 million from the issuance of common stock under our employee stock option and stock purchase plans, partially offset by $986,000 used for the repayment of notes
payable, and approximately $1.3 million used for the repurchase of 103,300 shares of our common stock under our repurchase program.





As of June 30, 2002, our principal commitments consisted of $94.2 million in loans and operating 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 the lessor financial institution in an interest-bearing escrow account, and serves to fully collateralize the lease obligation. The building lease costs have




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amounted to approximately $4.0 million annually, but may fluctuate based on interest rate fluctuations,
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 our 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 June 30, 2002, the Termination Value was approximately $85.0 million.





We have an option that is exercisable during the term of the lease to either purchase the leased property for the Termination Value, or to assist the lessor with the sale of the property at the end of the lease term. 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.





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, we cannot
currently determine 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.





We have 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 and $50 million. However, due to the historical and expected significant volatility of the real estate market in the San Francisco Bay Area, we are currently unable to estimate the fair value of the property at
the end of the lease term in 2005. We will be engaging real estate experts to assist us in evaluating the fair value of the property and alternatives associated with the ownership structure of the building in the fourth quarter of fiscal 2002, which
may result in the termination of the lease, the acquisition of the property, and the recording of a non-cash charge for the difference between the fair value of the property and the Termination Value. Upon termination of the lease, the entire amount
of the restricted cash will be utilized to satisfy all obligations under the lease agreement.





We had no material
commitments for capital expenditures as of June 30, 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 comprehensive 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 requirements 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 revenue 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.




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Our critical accounting policies and judgments are of both a routine and
non-routine nature. The recurring policies relate to revenue recognition, the allowance for doubtful accounts receivable, and the valuation of our corporate headquarters building, which is subject to an operating lease. The non-routine 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 approximately $1.5 million and $1.0 million as of June 30, 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 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 that we have provided to the lessor. 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. We
will be engaging real estate experts to assist us in evaluating the fair value of the property and alternatives associated with the ownership structure of the building in the fourth quarter of fiscal 2002, which may result in the termination of the
lease, the acquisition of the property, and the recording of a non-cash charge for the difference between the fair value of the property at the end of the fourth quarter of fiscal 2002 and the Termination Value. Upon termination of the lease, the
entire amount of the restricted cash will be utilized to satisfy all obligations under the lease agreement.





Excess Facility Charges





We recorded an accrual for excess facility charges of
approximately $10.3 million at September 30, 2001, of which approximately $8.9 million remains accrued at June 30, 2002, for certain costs related to the unoccupied portion of our headquarters building in San Mateo, California. The accrual includes
certain direct 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. If a valuation charge were to be recorded as described in the previous




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paragraph, the remaining balance of the accrual for excess facility charges would be reversed during the
same period the valuation charge were recorded.





Impairment Assessments of Goodwill and Other Intangibles





Effective October 1, 2001, we adopted SFAS 142. 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 reclassified to goodwill. Based on that assessment, no adjustments
were made to the amortization periods or residual values of other intangible assets.





SFAS 142 provides 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 had to identify our 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 as of October 1, 2001, 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. During the second quarter of fiscal 2002, we performed the first step of the transitional impairment test required under SFAS 142, and obtained an indicator of impairment in our single reporting unit. During the third
quarter of fiscal 2002, we performed 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. We determined the
implied fair value of our single reporting unit using our market capitalization value, adjusted for a control premium and compared it to our carrying value. We determined our market capitalization value based on the number of shares outstanding and
the stock price as of October 1, 2001, adjusted for a control premium. This evaluation indicated that goodwill associated with acquisitions completed prior to fiscal 2002 was impaired as of October 1, 2001. Accordingly, we recorded a
$3.2 million non-cash impairment charge as a cumulative effect of a change in accounting principle for the write-off of the remaining goodwill as of October 1, 2001. The charge is reflected in the results for the nine months ended June 30,
2002. Currently, there is no remaining goodwill on our balance sheet.





Recent Accounting Pronouncements





In July 2002, the Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards (SFAS) No. 146,
Accounting for Costs Associated with Exit of Disposal Activities. SFAS No. 146 addresses financial accounting and reporting associated with exit or disposal activities. Under SFAS No. 146, costs associated with an exit or disposal
activity shall be recognized and measured at their fair value in the period in which the liability is incurred rather than at the date of a commitment to an exit or disposal plan. We are required to adopt SFAS No. 146 for all exit and disposal
activities initiated after December 31, 2002. We are evaluating the provisions of SFAS No. 146, but do not expect the adoption of SFAS No. 146 to have a material impact on our financial position or results of operations.





In April 2002, FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and
Technical Corrections. Among other provisions, SFAS No. 145 rescinds SFAS No. 4, Reporting Gains and Losses from Extinguishment of Debt. Accordingly, gains or losses from extinguishment of debt shall not be reported as
extraordinary items unless the extinguishment qualifies as an extraordinary item under the criteria of Accounting Principles Board Opinion No. 30 (APB No. 30). Gains or losses from extinguishment of debt that do not meet the criteria of APB No. 30
should be reclassified to income from continuing operations in all prior periods presented. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. We will adopt the provisions of SFAS No. 145 in our fiscal year beginning October 1,
2002. We do not expect the adoption of SFAS No. 145 to have a material impact on our financial position or results of operations.





In October 2001, FASB issued 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




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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





Because we have introduced new products and services, 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 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 March 2002, we introduced our latest versions of Keynote Website Perspective.
| | - |  | --------------------------------------------------------------------------------




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




| |  |  | In July 2002, we introduced the latest version of our Transaction Perspective.
| | - |  | ------------------------------------------------------------------------------




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, we may incur charges in the
future, 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 $2.5 million and $11.7 million for the three and nine months ended June 30, 2002, and as of June 30, 2002, we had an accumulated deficit
of $83.5 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 June 30, 2002, we had approximately $3.2 million of other intangible assets. We may incur additional expenses in connection with a write-down of 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 not maintain a sequential quarterly increase in revenue and may never be able to regain our historic revenue growth rates.




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





Further, 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 from Internet service providers and Internet e-commerce websites. Although the percentage of total revenue from
Internet service providers and Internet e-commerce websites in the third quarter of fiscal 2002 remained constant from the previous quarter, we may continue to experience a reduction in revenue from this particular customer segment. We have
experienced an increase in cancellations and non-renewals in the past and while the number of cancellations in the third quarter of fiscal 2002 remained constant compared to the previous quarter, we may continue to experience an increased amount of
cancellations and/or non-renewals. We increased our prices for some of our Perspective services during the third quarter of fiscal 2002 and may do so again in the future for our other Perspective services. As a result, we may experience
cancellations and/or reduction in service. 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 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;
| | - |  | --------------------------------------------------------------------------------------------




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




| |  |  | 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.
| | - |  | --------------------------------------------------------------------------------------




| |  |  | 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.




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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. We have recently increased the price of some of our Perspective services and may do so again in the future for our other Perspective services, which could reduce demand for our benchmarking services. This may result in decreased
sales, which 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 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.




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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 our 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 solely 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 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 currently 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,




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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 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 revenue, and the loss of a major customer could harm our operating results.





Ten customers accounted for approximately 32% of our total revenue for the three months ended June 30, 2002, and one customer accounted for 10% of our total revenue for the three months ended June 30,
2002. 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 for future services can generally be terminated at any time with little or no penalty. If we lose a major customer, our revenues could decline.





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. For example, in fiscal 2002, we terminated relationships with two of
our international resellers. As a result, we must invest time and resources to evaluate replacements for these resellers and to expand our direct sales effort in the United Kingdom. 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




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substantial competition for highly skilled employees. 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
consulting and other support services, our results of operations could be harmed.





We formed our application
performance management services organization in January 1999 and have expanded our service offerings since the beginning of fiscal 2001 to include additional 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 and other support services represented approximately 10% and 8% of total revenues for the three and nine months ended June 30, 2002. In
addition, our cost of consulting and support services has exceeded our consulting revenue for all periods except for the three months ended June 30, 2002. 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.





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 nine months of fiscal 2002, we acquired certain assets of onDevice Corp. and acquired 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




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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 recently
had a breach of our security through what appears to be unauthorized access to certain data belonging to one of our customers, we have not yet experienced any breaches of our network security or sabotage that has prevented us from serving our
customers. We might be required to expend significant capital and resources to protect against, or to alleviate, problems caused by hackers. We may not have a timely remedy against a hacker who is able to breach our network security.





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





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.




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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. We
intend to expand the sales of our services by selling directly to our customers in the United Kingdom. Therefore, we expect to commit resources to expand our international sales and marketing activities. Revenues from international customers were
approximately 5% and 7% of our total revenues for the three and nine months ended June 30, 2002, respectively. 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;
| | - |  | ------------------------------------




| |  |  | 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;
| | - |  | ---------------------------------------------------------------------------------------------------



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| |  |  | 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 $8.9 million remains accrued as of June 30, 2002. We currently expect that we will need to sublease
approximately 60% of the space to third parties. 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 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 to assist the lessor with the sale of the property at the end of the lease term. 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. We will be engaging real estate experts to assist us in evaluating the fair
value of the property and alternatives associated with the building in the fourth quarter of fiscal 2002, which may result in the termination of the lease, the acquisition of the property, and the recording of a non-cash charge for the value between
the expected fair value of the property at the end of the lease term and the termination value. Upon termination of the lease, the entire amount of the restricted cash will be utilized to satisfy all obligations under the lease agreement.





Item 3.    Qualitative and Quantitative Disclosures about Market Risks.





Interest Rate Sensitivity.    Our interest income and expense is sensitive to changes in the general level of U.S. interest rates, particularly because most of our cash 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 June 30, 2002, the interest earned on those cash and cash equivalents, short-term
investments and restricted cash could increase or decrease by approximately $1.4 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 June 30, 2002. We do not enter into derivative transactions for trading or speculative purposes.







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PART IIOTHER INFORMATION





Item 1.    Legal 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 plaintiffs counsel and the individual named defendants counsel are in negotiations whereby the
individual named defendants may be dismissed from the case, without any payments by us. A formal dismissal has not yet occurred. The case against the underwriters and the company continues. We believe the claims are without merit and intend to
defend the actions vigorously.





Item 2.    Changes in Securities and Use of Proceeds





Not applicable.





Item 3.    Defaults Upon Senior Securities





Not applicable.





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





Not applicable.





Item 5.    Other Information





Appointment of Director





On July 31, 2002, Mr. Geoffrey Penney, executive vice president and chief information officer for The Charles Schwab Corp., was appointed
to our Board of Directors.





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 June 30, 2002.







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SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Mateo, State of California, on this 14th day of August 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 of Finance and Chief Financial Officer (Principal
Financial Officer)





By:

/s/    PETER J. MALONEYPeter J. Maloney Vice
President of Finance (Principal Accounting Officer)




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