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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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(Mark One)

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



For the quarterly period ended December 31, 2004



OR



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



For the transition period from
 to



Commission File Number: 000-27241



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KEYNOTE SYSTEMS, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 94-3226488                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|777 Mariners Island Blvd., San Mateo, CA                       |  | 94404                               
|(Address of principal executive offices)                       |  | (Zip Code)                          



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



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



Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).    YES  x    NO ̈



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



|                              |  |                                          
|----------------------------- |  | -----------------------------------------
|Class                         |  | Shares outstanding as of January 31, 2005
|Common Stock, $.001 par value |  | 20,048,823                               



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##### Table of Contents

KEYNOTE SYSTEMS, INC.



TABLE OF CONTENTS



|           |  |                                                                                       |  |     
|---------- |  | ------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                       |  | Page
|           |  | PART IFINANCIAL INFORMATION                                                          |  |     
|           |  |                                                                                      
|Item 1.    |  | Financial Statements                                                                  |  | 3   
|           |  |                                                                                      
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 17  
|           |  |                                                                                      
|Item 3.    |  | Qualitative and Quantitative Disclosures about Market Risk                            |  | 30  
|           |  |                                                                                      
|Item 4.    |  | Controls and Procedures                                                               |  | 30  
|           |  |                                                                                      
|           |  | PART IIOTHER INFORMATION                                                             |  |     
|           |  |                                                                                      
|Item 1.    |  | Legal Proceedings                                                                     |  | 30  
|           |  |                                                                                      
|Item 2.    |  | Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities     |  | 31  
|           |  |                                                                                      
|Item 3.    |  | Defaults Upon Senior Securities                                                       |  | 31  
|           |  |                                                                                      
|Item 4.    |  | Submission of Matters for a Vote of Security Holders                                  |  | 31  
|           |  |                                                                                      
|Item 5.    |  | Other Information                                                                     |  | 31  
|           |  |                                                                                      
|Item 6.    |  | Exhibits                                                                              |  | 32  
|           | 
|Signatures |  | 33                                                                                   



2



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##### Table of Contents

PART IFINANCIAL INFORMATION



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



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



Index to Unaudited Condensed Consolidated Financial Statements



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



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)



|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------- | - | ----------------- | - | -------- | -
|                                                                                                                                        |  | December 31,2004 |          |   | September 30,2004 |  
|ASSETS                                                                                                                                  |  |                  |          |   |                   |   |          |  
|Current assets:                                                                                                                         |  |                  |          |   |                   |   |          |  
|Cash and cash equivalents                                                                                                               |  | $                | 26,129   |   |                   | $ | 19,338   |  
|Short-term investments                                                                                                                  |  |                  | 123,554  |   |                   |   | 128,779  |  
|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|Total cash, cash equivalents, and short-term investments                                                                                |  |                  | 149,683  |   |                   |   | 148,117  |  
|Accounts receivable, less allowance for doubtful accounts of $589 and $758 as of December 31, 2004 and September 30, 2004,
respectively |  |                  | 5,912    |   |                   |   | 6,138    |  
|Prepaid and other current assets                                                                                                        |  |                  | 2,210    |   |                   |   | 2,329    |  
|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|Total current assets                                                                                                                    |  |                  | 157,805  |   |                   |   | 156,584  |  
|Property and equipment, net                                                                                                             |  |                  | 34,492   |   |                   |   | 34,573   |  
|Goodwill                                                                                                                                |  |                  | 24,665   |   |                   |   | 24,442   |  
|Identifiable intangible assets, net                                                                                                     |  |                  | 5,467    |   |                   |   | 6,131    |  
|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|Total assets                                                                                                                            |  | $                | 222,429  |   |                   | $ | 221,730  |  
|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                    |  |                  |          |   |                   |   |          |  
|Current liabilities:                                                                                                                    |  |                  |          |   |                   |   |          |  
|Accounts payable                                                                                                                        |  | $                | 1,495    |   |                   | $ | 1,692    |  
|Accrued expenses                                                                                                                        |  |                  | 9,722    |   |                   |   | 10,188   |  
|Current portion of capital lease obligation                                                                                             |  |                  | 78       |   |                   |   | 80       |  
|Deferred revenue                                                                                                                        |  |                  | 7,228    |   |                   |   | 7,741    |  
|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|Total current liabilities                                                                                                               |  |                  | 18,523   |   |                   |   | 19,701   |  
|Long term portion of capital lease obligation                                                                                           |  |                  | 29       |   |                   |   | 35       |  
|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|Total liabilities                                                                                                                       |  |                  | 18,552   |   |                   |   | 19,736   |  
|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|Commitments and contingencies - see Note 11                                                                                             |  |                  |          |   |                   |   |          |  
|Stockholders equity:                                                                                                                   |  |                  |          |   |                   |   |          |  
|Common stock                                                                                                                            |  |                  | 19       |   |                   |   | 19       |  
|Treasury stock                                                                                                                          |  |                  | (29      | ) |                   |   | (29      | )
|Additional paid-in capital                                                                                                              |  |                  | 341,033  |   |                   |   | 339,734  |  
|Accumulated deficit                                                                                                                     |  |                  | (136,618 | ) |                   |   | (137,409 | )
|Accumulated other comprehensive loss                                                                                                    |  |                  | (528     | ) |                   |   | (321     | )
|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|Total stockholders equity                                                                                                              |  |                  | 203,877  |   |                   |   | 201,994  |  
|                                                                                                                                        |  |                  |          |   |                   |   |          |  
|Total liabilities and stockholders equity                                                                                              |  | $                | 222,429  |   |                   | $ | 221,730  |  
|                                                                                                                                        |  |                  |          |   |                   |   |          |  



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 endedDecember 31, |       
|                                                                 |  | 2004                           |        |   | 2003 |  
|Revenue:                                                         |  |                                |        |   |      |   |        |  
|Subscription services                                            |  | $                              | 10,283 |   |      | $ | 8,671  |  
|Consulting and support services                                  |  |                                | 3,305  |   |      |   | 1,052  |  
|                                                                 |  |                                |        |   |      |   |        |  
|Total revenue                                                    |  |                                | 13,588 |   |      |   | 9,723  |  
|                                                                 |  |                                |        |   |      |   |        |  
|Expenses:                                                        |  |                                |        |   |      |   |        |  
|Costs of subscription services                                   |  |                                | 1,351  |   |      |   | 1,506  |  
|Costs of consulting and support services                         |  |                                | 2,609  |   |      |   | 803    |  
|Research and development                                         |  |                                | 1,962  |   |      |   | 1,624  |  
|Sales and marketing                                              |  |                                | 3,548  |   |      |   | 2,709  |  
|Operations                                                       |  |                                | 1,384  |   |      |   | 1,255  |  
|General and administrative                                       |  |                                | 1,793  |   |      |   | 1,164  |  
|Excess occupancy costs                                           |  |                                | 134    |   |      |   | 266    |  
|Amortization of identifiable intangible assets                   |  |                                | 664    |   |      |   | 362    |  
|                                                                 |  |                                |        |   |      |   |        |  
|Total expenses                                                   |  |                                | 13,445 |   |      |   | 9,689  |  
|                                                                 |  |                                |        |   |      |   |        |  
|Income from operations                                           |  |                                | 143    |   |      |   | 34     |  
|Interest income and other, net                                   |  |                                | 703    |   |      |   | 663    |  
|                                                                 |  |                                |        |   |      |   |        |  
|Income before provision for income taxes                         |  |                                | 846    |   |      |   | 697    |  
|Provision for income taxes                                       |  |                                | (55    | ) |      |   | (30    | )
|                                                                 |  |                                |        |   |      |   |        |  
|Net income                                                       |  | $                              | 791    |   |      | $ | 667    |  
|                                                                 |  |                                |        |   |      |   |        |  
|Net income per share:                                            |  |                                |        |   |      |   |        |  
|Basic                                                            |  | $                              | 0.04   |   |      | $ | 0.04   |  
|Diluted                                                          |  | $                              | 0.04   |   |      | $ | 0.03   |  
|Shares used in computing basic and diluted net income per share: |  |                                |        |   |      |   |        |  
|Basic                                                            |  |                                | 19,866 |   |      |   | 19,031 |  
|Diluted                                                          |  |                                | 21,357 |   |      |   | 20,435 |  



See accompanying notes
to the condensed consolidated financial statements



5



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                                     |  |                                |         |   |      |   |         |  
|------------------------------------------------------------------------------------ |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                                                     |  | Three months endedDecember 31, |        
|                                                                                     |  | 2004                           |         |   | 2003 |  
|Cash flows from operating activities:                                                |  |                                |         |   |      |   |         |  
|Net income                                                                           |  | $                              | 791     |   |      | $ | 667     |  
|Adjustments to reconcile net income to net cash provided by operating activities:    |  |                                |         |   |      |   |         |  
|Depreciation and amortization of property, equipment and software                    |  |                                | 793     |   |      |   | 1,088   |  
|Amortization of debt investment premium                                              |  |                                | 794     |   |      |   | 1,017   |  
|Amortization of identifiable intangible assets                                       |  |                                | 664     |   |      |   | 362     |  
|Changes in operating assets and liabilities, net of acquired assets and liabilities: |  |                                |         |   |      |   |         |  
|Accounts receivable, net                                                             |  |                                | 226     |   |      |   | (331    | )
|Prepaids and other current assets                                                    |  |                                | (120    | ) |      |   | 116     |  
|Accounts payable and accrued expenses                                                |  |                                | 122     |   |      |   | (40     | )
|Deferred revenue                                                                     |  |                                | (497    | ) |      |   | 1,439   |  
|                                                                                     |  |                                |         |   |      |   |         |  
|Net cash provided by operating activities                                            |  |                                | 2,773   |   |      |   | 4,318   |  
|                                                                                     |  |                                |         |   |      |   |         |  
|Cash flows from investing activities:                                                |  |                                |         |   |      |   |         |  
|Purchases of property, equipment and software                                        |  |                                | (712    | ) |      |   | (405    | )
|Purchase of businesses and assets, net                                               |  |                                | (385    | ) |      |   | (582    | )
|Sale of short-term investments                                                       |  |                                | 27,329  |   |      |   | 29,271  |  
|Purchases of short-term investments                                                  |  |                                | (23,105 | ) |      |   | (32,964 | )
|                                                                                     |  |                                |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                                  |  |                                | 3,127   |   |      |   | (4,680  | )
|                                                                                     |  |                                |         |   |      |   |         |  
|Cash flows from financing activities:                                                |  |                                |         |   |      |   |         |  
|Payment of capital leases                                                            |  |                                | (8      | ) |      |   |        |  
|Proceeds from issuance of common stock and exercise of stock options                 |  |                                | 1,299   |   |      |   | 3,358   |  
|Final payment associated with prior year issuer tender offers                        |  |                                | (400    | ) |      |   |        |  
|                                                                                     |  |                                |         |   |      |   |         |  
|Net cash provided by financing activities                                            |  |                                | 891     |   |      |   | 3,358   |  
|                                                                                     |  |                                |         |   |      |   |         |  
|Net increase in cash and cash equivalents                                            |  |                                | 6,791   |   |      |   | 2,996   |  
|Cash and cash equivalents at beginning of the period                                 |  |                                | 19,338  |   |      |   | 23,242  |  
|                                                                                     |  |                                |         |   |      |   |         |  
|Cash and cash equivalents at end of the period                                       |  | $                              | 26,129  |   |      | $ | 26,238  |  
|                                                                                     |  |                                |         |   |      |   |         |  



See accompanying notes
to the condensed consolidated financial statements



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)



(1) Basis of Presentation



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



The accompanying unaudited condensed consolidated financial statements have been prepared in
accordance with the rules and regulations of the Securities and Exchange Commission (SEC), and therefore, do not include all information and footnotes necessary for a complete presentation of the Companys results of operations,
financial position and cash flows. This report should be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended September 30, 2004 included in the Companys Report on Form 10-K as filed with
the SEC.



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



The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, 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.
Significant estimates made in preparing the consolidated financial statements relate to the allowance for doubtful accounts and billing allowance and income taxes. Actual results could differ from those estimates, and such differences may be
material to the financial statements.



Excess occupancy costs are fixed costs
associated with the portion of the Companys headquarters building which is not occupied by the Company, such as property taxes, insurance and depreciation. These particular costs, which are reduced by any rental income from the sublease
of space in its headquarters building, represent the fixed costs of operating the Companys headquarters building acquired in September 2002 and are based on the actual unoccupied square footage, which was determined to be 60% and 70% of
the total rentable square footage of the headquarters building during the three months ended December 31, 2004 and 2003, respectively.



(2) Stock-Based Compensation Plans



In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (Revised 2004)
(SFAS No. 123R), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b)
liabilities that are based on the fair value of the enterprises equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions
using the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead that companies recognize the cost of employee services
received in exchange for awards of equity instruments based on the grant-date fair value of those awards (the fair-value-based method). The Company is currently reviewing SFAS No. 123R to determine which fair-value based model and
transitional provision it will follow upon adoption. The options for transition methods as prescribed in SFAS No. 123R include either the modified prospective or the modified retrospective methods. SFAS No. 123R will be effective beginning in the
Companys fourth quarter of fiscal 2005. Although the Company will continue to evaluate the application of SFAS No. 123R, management expects the adoption of SFAS No. 123R will lead to substantial additional compensation expense and, therefore,
could have a material impact on its results of operations.



The Company
currently measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25. The Company applies the disclosure provisions of SFAS No. 123, Accounting for
Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based CompensationTransition and Disclosure as if the fair-value-based method had been applied in measuring compensation expense. Under APB Opinion
No. 25, no compensation expense is recognized on the grant date, when the exercise price of the Companys employee stock options equals or exceeds the market price of the underlying common stock.



As required under SFAS No. 123, the pro forma effects of stock-based compensation on net
income and income per share for employee stock options granted have been estimated at the date of grant, using a Black Scholes option pricing model. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to pro
forma net income over the options vesting period.



The Black Scholes
option valuation model was developed for use in estimating the fair value of freely traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly sensitive assumptions
including the expected life of options and the Companys expected stock price volatility. Because the Companys employee stock options and employee stock purchase plan shares have characteristics significantly different from those of
freely traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in managements opinion, the existing models do not provide a reliable measure of the fair value of the Companys
employee stock options.



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)(Continued)



The Companys pro forma information for the three months ended December 31, 2004 and 2003 is as follows (in
thousands, except per share amounts):



|                                                                                                              |  |                                |        |   |      |   |        |  
|------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ---- | - | ------ | -
|                                                                                                              |  | Three Months EndedDecember 31, |       
|                                                                                                              |  | 2004                           |        |   | 2003 |  
|Net income, as reported                                                                                       |  | $                              | 791    |   |      | $ | 667    |  
|Less: Total stock-based employee compensation expense determined under fair value based method for all awards |  |                                | (1,241 | ) |      |   | (2,029 | )
|                                                                                                              |  |                                |        |   |      |   |        |  
|Pro forma net loss                                                                                            |  | $                              | (450   | ) |      | $ | (1,362 | )
|                                                                                                              |  |                                |        |   |      |   |        |  
|Net income (loss) per share:                                                                                  |  |                                |        |   |      |   |        |  
|Basicas reported                                                                                             |  | $                              | 0.04   |   |      | $ | 0.04   |  
|Basicpro forma                                                                                               |  | $                              | (0.02  | ) |      | $ | (0.07  | )
|Dilutedas reported                                                                                           |  | $                              | 0.04   |   |      | $ | 0.03   |  
|Dilutedpro forma                                                                                             |  | $                              | (0.02  | ) |      | $ | (0.07  | )
|Number of shares used in computing as reported and pro forma net income (loss) per share:                     |  |                                |        |   |      |   |        |  
|Basicas reported                                                                                             |  |                                | 19,866 |   |      |   | 19,031 |  
|Basicpro forma                                                                                               |  |                                | 19,866 |   |      |   | 19,031 |  
|Dilutedas reported                                                                                           |  |                                | 21,357 |   |      |   | 20,435 |  
|Dilutedpro forma                                                                                             |  |                                | 19,866 |   |      |   | 19,031 |  



No tax effects were included in the
determination of pro forma net income because the deferred tax asset resulting from stock-based employee compensation would be offset by an additional valuation allowance for deferred tax assets. The effects on pro forma disclosures of applying SFAS
No. 123 may not be representative of the effects on pro forma disclosures in future periods. The amounts reflected as stock-based compensation included in pro forma net loss for the three months ended December 31, 2003 have been revised from the
historically reported amounts. The revision was required to correct an immaterial error in these amounts associated with the Companys April 2001 Stock Repurchase Program under SFAS No. 123.



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



|                         |  |                                |   |  |      |  
|------------------------ |  | ------------------------------ | - |  | ---- | -
|                         |  | Three Months EndedDecember 31, |  
|                         |  | 2004                           |   |  | 2003 |  
|Volatility               |  | 33.6                           | % |  | 38.6 | %
|Risk-free interest rates |  | 2.9                            | % |  | 2.1  | %
|Expected life (in years) |  | 2.5                            |   |  | 2.5  |  
|Dividend yield           |  |                               |   |  |     |  



(3) Revenue Recognition



Revenue consists of subscription services revenue and consulting and
support services revenue. Subscription services revenue consists of fees from subscriptions to the Companys e-business performance measurement services and performance management solutions. Subscription services revenue also consists of the
subscription to use its technology for its WebEffective Intelligence Platform. Subscription services revenue is deferred upon invoicing and is recognized ratably over the service period, commencing on the day service is first provided, generally
ranging from one to twelve months. For some customers, subscription services revenue is invoiced monthly upon completion of the services. Subscription revenue related to the use of the WebEffective Intelligence Platform to conduct evaluations is
recognized upon completion of each evaluation. Deferred revenue is comprised of all unearned revenue that has been collected in advance, primarily unearned subscription services revenue, and is recorded as deferred revenue on the balance sheet until
the revenue is earned. Any uncollected deferred revenue reduces the balance of accounts receivable. The Company does not generally grant refunds. All discounts granted reduce revenue. Revenue is not recognized for free trial periods. Consulting and
support services revenue consists of fees generated by the Companys consulting and support services, and is recognized as the services are performed, typically over a period of one to three months. For most consulting projects that span more
than one month, the Company recognizes revenue as milestones or deliverables are completed.





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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)(Continued)



(4) Comprehensive Income



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



|                                                      |  |                                |      |   |      |   |      |  
|----------------------------------------------------- |  | ------------------------------ | ---- | - | ---- | - | ---- | -
|                                                      |  | Three Months EndedDecember 31, |     
|                                                      |  | 2004                           |      |   | 2003 |  
|Net income                                            |  | $                              | 791  |   |      | $ | 667  |  
|Net unrealized loss on available-for-sale investments |  |                                | (245 | ) |      |   | (180 | )
|Foreign currency translation gain                     |  |                                | 38   |   |      |   | 13   |  
|                                                      |  |                                |      |   |      |   |      |  
|Comprehensive income                                  |  | $                              | 584  |   |      | $ | 500  |  
|                                                      |  |                                |      |   |      |   |      |  



The tax effect on the foreign currency
translation gain is immaterial.



(5) Financial Instruments and Concentration
of Risk



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



Credit risk is concentrated in North America, but exists in Europe as well. The Company generally requires no collateral from customers; however, throughout the
collection process, it conducts an ongoing evaluation of customers ability to pay. The Companys accounting for its allowance for doubtful accounts is determined based on historical trends, experience and current market and industry
conditions. Management regularly reviews the adequacy of the Companys allowance for doubtful accounts by considering the aging of accounts receivable, the age of each invoice, each customers expected ability to pay and the Companys
collection history with each customer. Management reviews invoices greater than 60 days past due to determine whether an allowance is appropriate based on the receivable balance. In addition, the Company maintains a reserve for all other invoices,
which is calculated by applying a percentage to the outstanding accounts receivable balance, based on historical collection trends as well as specifically identified accounts that are deemed uncollectible. In addition to the allowance for doubtful
accounts, the Company maintains a billing allowance which represents the reserve for potential billing adjustments that are recorded as a reduction of revenue. The Companys accounting for billing allowance represents a percentage of revenue
based on historical trends and experience.



The allowance for doubtful accounts
and billing allowance represent managements best current estimate, but changes in circumstances relating to accounts receivable and billing adjustments, including unforeseen declines in market conditions and collection rates and the number of
billing adjustments, may result in additional allowances or recoveries in the future. The Company believes that it has adequately reserved for doubtful accounts and potential billing adjustments as of the date of each balance sheet presented herein.



As of December 31, 2004 and 2003, no single customer accounted for more than
10% of the Companys total accounts receivable. For the three months ended December 31, 2004 and 2003, no single customer accounted for more than 10% of the Companys total revenue during each period. For the three months ended December
31, 2004 and 2003, the ten largest customers accounted for approximately 34% and 32% of total revenue, respectively.



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)(Continued)



(6) Investments



The Company classifies all of its short-term investments as available-for-sale. These investments mature in two years or less, and consist of investment-grade corporate
and government debt securities with Moodys ratings of A2 or better. Investments classified as available-for-sale are recorded at fair market value with the related unrealized gains and losses included in accumulated other comprehensive income
(loss), a component of stockholders equity. Realized gains and losses are recorded based on specific identification. There were no realized gains or losses during the quarter ended December 31, 2004. The Company considers all highly liquid
investments with original maturities of three months or less when acquired to be cash equivalents. The following table summarizes the Companys short-term investments in investment-grade debt securities as of December 31, 2004 (in thousands):



|                                                               |  |               |         |                 |   |                  |  |   |                            |   |  |   |        
|-------------------------------------------------------------- |  | ------------- | ------- | --------------- | - | ---------------- |  | - | -------------------------- | - |  | - | -------
|                                                               |  | AmortizedCost |         | UnrealizedGains |   | UnrealizedLosses |  |   | Estimated FairMarket Value
|Obligations of U.S. federal and state governments and agencies |  | $             | 55,696  |                 | $ | 0                |  | $ | (251                       | ) |  | $ | 55,445 
|Corporate bonds and commercial paper                           |  |               | 68,586  |                 |   | 0                |  |   | (477                       | ) |  |   | 68,109 
|                                                               |  |               |         |                 |   |                  |  |   |                            |   |  |   |        
|Total                                                          |  | $             | 124,282 |                 | $ | 0                |  | $ | (728                       | ) |  | $ | 123,554
|                                                               |  |               |         |                 |   |                  |  |   |                            |   |  |   |        



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



|                         |  |                |         |                             |   |        
|------------------------ |  | -------------- | ------- | --------------------------- | - | -------
|Year ending December 31, |  | Amortized Cost |         | Estimated Fair Market Value
|2005                     |  | $              | 86,384  |                             | $ | 86,046 
|2006                     |  |                | 37,898  |                             |   | 37,508 
|                         |  |                |         |                             |   |        
|Total                    |  | $              | 124,282 |                             |   | 123,554
|                         |  |                |         |                             |   |        



(7) Goodwill and Identifiable
Intangible Assets



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



|                                                                                 |  |   |        |  
|-------------------------------------------------------------------------------- |  | - | ------ | -
|Balance at September 30, 2004                                                    |  | $ | 24,442 |  
|Adjustment to goodwill for the acquisition of NetRaker Corporation (see Note 9)  |  |   | (16    | )
|Adjustment to goodwill for the acquisition of Vividence Corporation (see Note 9) |  |   | 239    |  
|                                                                                 |  |   |        |  
|Balance at December 31, 2004                                                     |  | $ | 24,665 |  
|                                                                                 |  |   |        |  



As of December 31, 2004, the net
carrying value of identifiable intangible assets was approximately $5.5 million (net of accumulated amortization of approximately $12.4 million). The components of identifiable intangible assets are as follows (in thousands):



|                                         |  |                 |        |   |               |   |        |           |  |   |       |   |  |   |         |  
|---------------------------------------- |  | --------------- | ------ | - | ------------- | - | ------ | --------- |  | - | ----- | - |  | - | ------- | -
|                                         |  | TechnologyBased |        |   | CustomerBased |   |        | Trademark |  |   | Total |  
|As of December 31, 2004:                 |  |                 |        |   |               |   |        |           |  |   |       |   |  |   |         |  
|Gross carrying value                     |  | $               | 11,623 |   |               | $ | 6,000  |           |  | $ | 250   |   |  | $ | 17,873  |  
|Accumulated amortization                 |  |                 | (8,158 | ) |               |   | (3,998 | )         |  |   | (250  | ) |  |   | (12,406 | )
|                                         |  |                 |        |   |               |   |        |           |  |   |       |   |  |   |         |  
|Net carrying value at December 31, 2004  |  | $               | 3,465  |   |               | $ | 2,002  |           |  | $ | 0     |   |  | $ | 5,467   |  
|                                         |  |                 |        |   |               |   |        |           |  |   |       |   |  |   |         |  
|As of September 30, 2004:                |  |                 |        |   |               |   |        |           |  |   |       |   |  |   |         |  
|Gross carrying value                     |  | $               | 11,623 |   |               | $ | 6,000  |           |  | $ | 250   |   |  | $ | 17,873  |  
|Accumulated amortization                 |  |                 | (7,603 | ) |               |   | (3,889 | )         |  |   | (250  | ) |  |   | (11,742 | )
|                                         |  |                 |        |   |               |   |        |           |  |   |       |   |  |   |         |  
|Net carrying value at September 30, 2004 |  | $               | 4,020  |   |               | $ | 2,111  |           |  | $ | 0     |   |  | $ | 6,131   |  
|                                         |  |                 |        |   |               |   |        |           |  |   |       |   |  |   |         |  



10



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)(Continued)



Assuming no additional acquisitions and no impairment, the amortization expense for existing intangible assets as of
December 31, 2004 is estimated to be approximately $1.8 million for the remainder of fiscal 2005, approximately $1.5 million for fiscal 2006, approximately $1.2 million for fiscal 2007, and approximately $1.0 million for fiscal 2008.



(8) Net Income Per Share



Basic net income 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 income per share is computed using the weighted-average number of shares of common stock outstanding and, when dilutive, potential
shares from options to purchase common stock using the treasury stock method.



The following table sets forth the computation of basic and diluted income per share (in thousands, except per share amounts):



|                                                                                   |  |                                |        |      |   |       
|---------------------------------------------------------------------------------- |  | ------------------------------ | ------ | ---- | - | ------
|                                                                                   |  | Three months endedDecember 31,
|                                                                                   |  | 2004                           |        | 2003
|Numerator:                                                                         |  |                                |        |      |   |       
|Net income                                                                         |  | $                              | 791    |      | $ | 667   
|Denominator:                                                                       |  |                                |        |      |   |       
|Denominator for basic net income per shareweighted average shares                 |  |                                | 19,866 |      |   | 19,031
|Incremental common shares attributable to shares issuable under stock option plans |  |                                | 1,491  |      |   | 1,404 
|                                                                                   |  |                                |        |      |   |       
|Denominator for diluted net income per shareweighted average shares               |  |                                | 21,357 |      |   | 20,435
|                                                                                   |  |                                |        |      |   |       
|Net income per sharebasic                                                         |  | $                              | 0.04   |      | $ | 0.04  
|                                                                                   |  |                                |        |      |   |       
|Net income per sharediluted                                                       |  | $                              | 0.04   |      | $ | 0.03  
|                                                                                   |  |                                |        |      |   |       



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)(Continued)



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



|                                       |  |                                |  |     
|-------------------------------------- |  | ------------------------------ |  | ----
|                                       |  | Three months endedDecember 31,
|                                       |  | 2004                           |  | 2003
|Shares outstanding under stock options |  | 985                            |  | 589 



The weighted-average exercise price of
excluded outstanding stock options was $34.05 and $47.50 for the three months ended December 31, 2004 and 2003, respectively. The weighted average purchase price of restricted stock was $2.06 for the three months ended December 31, 2004 and
2003.



(9) Acquisitions



In September 2004, the Company acquired Vividence Corporation (Vividence), a
provider of web-based customer experience management for an initial cash payment of $20.0 million plus direct transaction costs of $572,000. The initial purchase price of $20.0 million, payable in cash, was reduced by approximately $400,000 which
represented the preliminary difference between Vividences total assets and liabilities (net assets) as of the acquisition date after certain adjustments as defined in the Agreement and Plan of Reorganization dated September 10,
2004 (Agreement and Plan). The Company and the Shareholders Representative of Vividence are currently working on finalizing the amount representing the net assets as of the acquisition date. Both parties intend to resolve the
matter pursuant of the terms of the Agreement and Plan and no later than March 31, 2005. Any difference in net assets as of the acquisition date will change the purchase price, however, pursuant to the Agreement and Plan, the initial purchase price
cannot exceed $20.0 million. Any changes to purchase price will be recorded as a reduction or addition to goodwill. An additional contingent consideration payment of up to $6 million in cash could be made if certain revenue and profitability targets
are achieved by the acquired business through September 30, 2005. The Company believes that this acquisition will enhance and broaden its customer experience management solutions for enterprise customers as well as allow it to target e-business
marketing executives within Fortune 500 companies such as usability and market research managers. The Company and the Shareholders Representative of Vividence are working with a third party tax consultant in resolving several pre-acquisition
sales and use tax matters. Any payment, if the tax matter is resolved by September 2005, would be the subject of a claim against the escrow by the Company. Based on its preliminary analysis, the Company believes that the matter will be resolved by
September 2005 for a range between $350,000 to $750,000, although there can be no assurance as to the final outcome.



The preliminary purchase price allocation was based on the estimated fair value of the assets and liabilities acquired at the acquisition date, including technology-based
and customer-based intangible assets acquired. During the three months ended December 31, 2004, an adjustment of $239,000 was made to finalize the fair value of prepaid and other assets. This reduction in prepaid and other assets correspondingly
increased goodwill. The following table summarizes the revised estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands):



|                                                         |  |   |        |  
|-------------------------------------------------------- |  | - | ------ | -
|Cash                                                     |  | $ | 678    |  
|Accounts receivable                                      |  |   | 431    |  
|Prepaid and other assets                                 |  |   | 304    |  
|Property and equipment                                   |  |   | 86     |  
|Customer-based intangible assets                         |  |   | 1,680  |  
|Technology-based intangible assets                       |  |   | 2,780  |  
|In-process research and development                      |  |   | 241    |  
|Goodwill                                                 |  |   | 18,642 |  
|Liabilities assumed:                                     |  |   |        |  
|Line of credit                                           |  |   | (723   | )
|Deferred revenue                                         |  |   | (1,889 | )
|Accrued employee compensation                            |  |   | (937   | )
|Other liabilities assumed                                |  |   | (1,121 | )
|                                                         |  |   |        |  
|Total purchase price, including direct acquisition costs |  | $ | 20,172 |  
|                                                         |  |   |        |  



The in-process research and
development expense of $241,000 related to the estimated fair value of an acquired in-process research and development project in connection with the acquisition of Vividence. This project related to Vividences technology for its web-based
customer research, which had not yet reached technological feasibility and had no alternative future use. The estimated fair value of this project was determined based on the avoided cost approach as of the acquisition date where the fair value of
the acquired technology was equal to the costs which an acquirer would avoid spending in developing a similar functional technology. This amount was immediately expensed as of the acquisition date during the three months ended September 30, 2004.



12



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)(Continued)



The following summary, prepared on an unaudited pro-forma basis, reflects consolidated results of operations for the
three months ended December 31, 2003, assuming Vividence had been acquired on October 1, 2003, (in thousands, except per share data):



|                                                         |  |                                     |       
|-------------------------------------------------------- |  | ----------------------------------- | ------
|                                                         |  | Three months endedDecember 31, 2003
|Revenue                                                  |  | $                                   | 11,247
|                                                         | 
|Net income                                               |  | $                                   | 97    
|                                                         | 
|Net income per share  basic                             |  | $                                   | 0.01  
|                                                         | 
|Net income per share  diluted                           |  | $                                   | 0.00  
|                                                         | 
|Shares used in pro forma per share computation - basic   |  |                                     | 19,031
|                                                         | 
|Shares used in pro forma per share computation - diluted |  |                                     | 20,435



In April 2004, the Company acquired
NetRaker Corporation (NetRaker), a provider of online customer experience management solutions that help e-business managers measure, evaluate and improve the design and navigability of their websites. The total price of approximately
$3.7 million included a $2.6 million initial cash payment made in April 2004, a second payment of approximately $530,000 based on the final calculation of the NetRaker net assets as of the closing date, and approximately $553,000 of direct
acquisition costs. An additional contingent consideration cash payment of up to $7.9 million could be made if certain revenue and profitability targets are achieved by the acquired business during the twelve months ending March 31, 2005. Any
additional payments would be recorded to purchase price. The Company believes this acquisition will enhance and broaden its customer experience management solutions for enterprise customers as well as allow it to target e-business marketing
executives within Fortune 500 companies, such as usability and market research managers.



The preliminary purchase price allocation was based on the estimated fair value of the assets and liabilities of the business at the acquisition date, including technology-based and customer-based intangible assets
acquired. An adjustment of $16,000 was made in the three months ended December 31, 2004 between goodwill and deferred revenue to reflect an adjustment in a contract that was entered into prior to the Companys acquisition of NetRaker. The
following table summarizes the revised estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands):



|                                                         |  |   |       |  
|-------------------------------------------------------- |  | - | ----- | -
|Cash                                                     |  | $ | 12    |  
|Accounts receivable                                      |  |   | 150   |  
|Prepaid and other assets                                 |  |   | 104   |  
|Property and equipment                                   |  |   | 20    |  
|Customer-based intangible assets                         |  |   | 165   |  
|Technology-based intangible assets                       |  |   | 512   |  
|Goodwill                                                 |  |   | 4,106 |  
|Liabilities assumed                                      |  |   | (870  | )
|Deferred revenue                                         |  |   | (516  | )
|                                                         |  |   |       |  
|Total purchase price, including direct acquisition costs |  | $ | 3,683 |  
|                                                         |  |   |       |  



Pro forma consolidated results of
operations have not been presented for Netraker as the effect of this acquisition was not considered material to the three months ended December 31, 2003.



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)(Continued)



(10) Income Taxes



The Companys effective tax rate for the three months ended December 31, 2004 and 2003 was 6.5% and 4.3%, respectively.



On October 22, 2004, the American Jobs Creation Act (the AJCA) was signed into
law. The AJCA includes a deduction of 85% of certain foreign earnings that are repatriated, as defined in the AJCA. The Company may elect to apply this provision to qualifying earnings repatriations in the future. The Company is currently evaluating
the effects of the repatriation provision; however, the Company does not expect to be able to complete this evaluation until after Congress or the Treasury Department provide additional clarifying language on key elements of the provision. The
Company expects to complete its evaluation of the effects of the repatriation provision within a reasonable period of time following the publication of the additional clarifying language. When the Company completes its evaluation, any changes in the
current position on the repatriation of undistributed earnings could result in the recognition of deferred tax liabilities at that time.



(11) Commitments and Contingencies



(A) Leases



The Company leases certain of its facilities and equipment under noncancellable capital and operating leases, which expire on various dates through April 2008. As of
December 31, 2004, future minimum payments under the leases are as follows (in thousands):



|                                                                    |  |                  |     |                |   |     |  
|------------------------------------------------------------------- |  | ---------------- | --- | -------------- | - | --- | -
|                                                                    |  | Operating Leases |     | Capital Leases |  
|Twelve months ended December 31:                                    |  |                  |     |                |   |     |  
|2005                                                                |  | $                | 247 |                | $ | 82  |  
|2006                                                                |  |                  | 128 |                |   | 29  |  
|2007                                                                |  |                  | 92  |                |   |    |  
|2008                                                                |  |                  | 17  |                |   |    |  
|Thereafter                                                          |  |                  |    |                |   |    |  
|                                                                    |  |                  |     |                |   |     |  
|Total minimum lease payments                                        |  | $                | 484 |                | $ | 111 |  
|                                                                    |  |                  |     |                |   |     |  
|less amounts representing interest                                  |  |                  |     |                |   | (4  | )
|                                                                    |  |                  |     |                |   |     |  
|Present value of minimum lease payments                             |  |                  |     |                | $ | 107 |  
|                                                                    |  |                 
|Less current portion of obligation under capital lease              |  |                  |     |                |   | (78 | )
|                                                                    |  |                  |     |                |   |     |  
|Obligation under capital and operating leases, less current portion |  |                  |     |                |   | 29  |  
|                                                                    |  |                  |     |                |   |     |  



Rent expense for the three months
ended December 31, 2004 and 2003 were approximately $130,000 and $95,000, respectively.



(B) Commitments



The Company has
contingent commitments to 126 bandwidth and collocation providers amounting to $881,000 for 100 locations that represent one to fifteen months commitments. The commitments become due if the Company terminates any of these agreements prior to their
expiration. At present, the Company does not intend to terminate any of these agreements prior to their expiration.



(C) Legal Proceedings



Beginning on August 16, 2001, several class action lawsuits were 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 its initial public offering. These lawsuits were essentially identical, and were brought on behalf of those who purchased the Companys securities between September 24, 1999 and August 19, 2001.
These complaints alleged generally that the underwriters in certain initial public offerings, including the Companys, allocated shares in those initial public offerings in unfair or unlawful ways, such as requiring the purchaser to agree to
buy in the aftermarket at a higher price or to buy shares in other companies with higher than normal commissions. The complaint also alleged that the Company had a duty to disclose the activities of the underwriters in the registration statement
relating to its initial public offering. The plaintiffs counsel and the issuer defendants counsel have reached a preliminary settlement agreement whereby the issuers and individual defendants were dismissed from the case, without any
payments by the Company. The settlement awaits approval by the Court. No amount is accrued as of December 31, 2004 and September 30, 2004, as the Company anticipates that it will be dismissed from the case as a result of the settlement.



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.



(12) Stock
Repurchase Program



The Companys Board of Directors approved a
program to repurchase shares of its common stock in January 2001. Pursuant to the stock repurchase program, a total of 10.4 million shares had been repurchased as of December 31, 2004, for approximately $90.1 million. No repurchases occurred during
the three months ended December 31, 2004 and 2003.



On January 27, 2005, the
Company entered into an agreement with UBS Securities LLC (UBS) to establish a trading plan (the Trading Plan) intended to qualify under Rule 10b5-1 of the Securities Exchange Act of 1934 (the Exchange Act). The
Trading Plan instructs UBS to repurchase for the Company, in accordance with Rule 10b-18 of the Exchange Act, up to 2 million shares of the Companys common stock, representing approximately 10% of the Companys outstanding common stock,
over a period of twelve months commencing as early as March 1, 2005.



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



During the three months ended December 31, 2004, in accordance with its agreement between the Company and Goldman Sachs, the Company paid the final payment of $400,000
for costs associated with its previous issuer tender offers in fiscal 2003.



14



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)(Continued)



(13) Geographic and Segment Information



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



The following table identifies which services fall under measurement services and management solutions and where they are recorded in the condensed consolidated
statements of operations listed in alphabetical order:



|                                   |  |                      |  |                              
|---------------------------------- |  | -------------------- |  | -----------------------------
|                                   |  | SubscriptionServices |  | ConsultingandSupport Services
|Measurement Services:              |  |                      |  |                              
|Application Perspective Outside    |  | X                    |  |                              
|NetMechanic                        |  | X                    |  |                              
|Red Alert                          |  | X                    |  |                              
|Streaming Perspective              |  | X                    |  |                              
|Transaction Perspective            |  | X                    |  |                              
|Website Perspective                |  | X                    |  |                              
|                                   |  |                     
|Management Solutions:              |  |                      |  |                              
|Application Perspective Private    |  | X                    |  |                              
|Diagnostic Services                |  |                      |  | X                            
|Enterprise Solutions               |  | X                    |  | X                            
|LoadPro                            |  |                      |  | X                            
|Network Perspective                |  | X                    |  |                              
|Professional Services              |  |                      |  | X                            
|Test Perspective                   |  | X                    |  |                              
|WebEffective Intelligence Platform |  | X                    |  | X                            
|WebIntegrity                       |  | X                    |  |                              
|Wireless Perspective               |  | X                    |  |                              



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



|                                        |  |      |        |      |   |      
|--------------------------------------- |  | ---- | ------ | ---- | - | -----
|                                        |  | 2004 |        | 2003
|For the three months ended December 31: |  |      |        |      |   |      
|Measurement services revenue            |  | $    | 7,087  |      | $ | 7,053
|Management solutions revenue            |  |      | 6,501  |      |   | 2,670
|                                        |  |      |        |      |   |      
|Total Revenue                           |  | $    | 13,588 |      | $ | 9,723
|                                        |  |      |        |      |   |      



International revenue was
approximately 6% of total revenue for each of the three months ended December 31, 2004 and 2003, respectively.



15



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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)(Continued)



(14) Recently Issued Accounting Pronouncements



In March 2004, the Emerging Issues Task Force reached consensus on Issue No. 03-01 (EITF 03-01), The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-01 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments
that are deemed to be temporarily impaired. In September 2004, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) EITF 03-1-1 which delays the effective date until additional guidance is issued
for the application of the recognition and measurement provisions of EITF 03-01 to investments in securities that are impaired; however, the disclosure requirements are effective for fiscal years ending after December 15, 2003 for investments
accounted for under SFAS No. 115. Although the Company will continue to monitor the application of EITF 03-01, it does not currently believe adoption will have a material impact on its financial position or results of operations.



In December 2004, the FASB issued FSP 109-2, Accounting and Disclosure Guidance for the
Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004. FSP 109-2 provides additional time to companies beyond the financial reporting period of enactment to evaluate the effects of the AJCA on their plans for
repatriation of foreign earnings for purposes of applying SFAS No. 109, Accounting for Income Taxes. The Company is currently evaluating the repatriation provisions of AJCA, which if implemented, would affect its tax provision and
deferred tax assets and liabilities. However, given the preliminary stage of its evaluation, it is not possible at this time to determine the amount, if any, that may be repatriated or the related potential income tax effects of such repatriation.



In December 2004, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 153, Exchanges of Nonmonetary Assets, which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not
have commercial substance. SFAS No. 153 will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The Company does not believe the adoption of SFAS No. 153 will have a material impact on its
financial position or results of operations.



In December 2004, the FASB issued
SFAS No. 123 (Revised 2004) (SFAS No. 123R), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of
the enterprise or (b) liabilities that are based on the fair value of the enterprises equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based
compensation transactions using the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead that companies recognize the
cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards (the fair-value-based method). The Company is currently reviewing SFAS No. 123R to determine which
fair-valuebased model and transitional provision it will follow upon adoption. The options for transition methods as prescribed in SFAS No. 123R include either the modified prospective or the modified retrospective methods. SFAS No. 123R will
be effective beginning in the Companys fourth quarter of fiscal 2005. Although the Company will continue to evaluate the application of SFAS No. 123R, it expects the adoption will lead to substantial additional compensation expense and
therefore could have a material impact on its results of operations. The accounting impact, had the Company chosen to apply the fair-value recognition provisions of SFAS No. 123, instead of the recognition provisions under APB Opinion No. 25, is
described in Note 2 of the Notes to Condensed Consolidated Financial Statements.



(15) Subsequent Event



On February 1, 2005, the Company
acquired Hudson Williams Europe (HWE), a privately held e-business performance consulting firm based in the Netherlands, for a purchase price of approximately $260,000. An initial cash payment of approximately $210,000 was made to HWE as
of the closing date. Pursuant to the Asset Purchase Agreement, approximately $50,000 of the purchase price is being held back and will be released on January 31, 2006. An additional contingent consideration cash payment of up to approximately
$130,000 could be made if profitability targets are achieved by HWE through June 30, 2005. The Company believes that this acquisition will provide its European customers the same range of management solutions that it has been offering in North
America.



16



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##### Table of Contents

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



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



Except for historical information, this Form 10-Q contains
forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements involve risks and uncertainties, including, among other things,
statements regarding our anticipated costs and expenses and revenue mix. These forward-looking statements include, among others, statements including the words expect, anticipate, intend, believe and
similar language. Our actual results may differ significantly from those projected in the forward-looking statements. Factors that might cause or contribute to these differences include, but are not limited to, those discussed in this section and in
our annual report on Form 10-K for the fiscal year ended September 30, 2004, in the section Managements Discussion and Analysis of Financial Condition and Results of OperationsFactors That May Impact Future Operating Results
and elsewhere in that report. You should also carefully review the risks described in other documents we file from time to time with the Securities and Exchange Commission, including the quarterly reports on Form 10-Q and current reports on Form 8-K
that we may file during the current year. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this quarterly report on Form 10-Q. We undertake no obligation to publicly release any
revisions to the forward-looking statements or reflect events or circumstances after the date of this document.



Overview



We offer e-business performance measurement services (measurement services) and performance management solutions (management solutions) that enable corporate enterprises to measure, monitor,
test and tune, diagnose and optimize their e-business systems both inside and outside the firewall. Keynotes services provide enterprise customers with solutions enabling them to increase return on investment, save money and efficiently link
information technology resources to e-business goals. Our solutions are comprised of three broad areas: customer experience management (CEM), service level management (SLM) and web monitoring and measurement which include a broad portfolio of
cost-effective measurement, monitoring, performance management, load testing, content quality testing and usability testing services. Our customer experience management and service level management services represent our management solutions. Our
web monitoring and measurement services represents our measurement services. Keynotes goal is to empower customers to deliver an optimal experience to end-users and to gain competitive advantage, while helping them reduce unnecessary capital
expenditures and leverage enterprise management software they already own.



Revenue consists of subscription services revenue and consulting and support services revenue. Subscription services revenue consists of fees from subscriptions to our Internet measurement, monitoring, testing, customer experience,
diagnostic and WebEffective Intelligence Platform services. Subscription services revenue is deferred upon invoicing and is recognized ratably over the service period, commencing on the day service is first provided, generally ranging from one to
twelve months. For some customers, subscription services revenue is invoiced monthly upon completion of the services. Subscription revenue related to the use of our WebEffective Intelligence Platform to conduct evaluations is recognized upon
completion of each evaluation. Deferred revenue is comprised of all unearned revenue that has been collected, primarily unearned subscription services revenue, and is recorded as deferred revenue on our balance sheet until the revenue is earned. Any
uncollected deferred revenue is offset against accounts receivable on our balance sheet. As of December 31, 2004, we had recorded approximately $7.2 million of deferred revenue. We do not generally grant refunds. All discounts granted reduce
revenue. Revenue is not recognized during free trial periods. For most consulting engagements that span more than one month, revenue is recognized as milestones or deliverables are completed. A majority of our subscription services revenue comes
from our e-business performance measurement services, which include our Perspective services. Subscription services revenue also includes our Red Alert and NetMechanic monitoring and alarm services, Test Perspective, WebEffective Intelligence
Platform, performance management subscription services, our private agent and application performance management services. Our customers purchase these services for an initial term of three to twelve months and then may renew on an annual,
semi-annual, or month-to-month basis. Subscription services fees can vary based on the number of URLs measured, the number of devices monitored, the number of measurement locations, the number of users, the number of hours, the frequency of the
measurements, the number of private agents, the additional features ordered, and the type of services purchased.



We offer our consulting and support services on a per engagement basis. Consulting and support services revenue amounted to approximately 24% and 11% of total revenue for
the three months ended December 31, 2004 and 2003, respectively. We believe that consulting and support services revenue may increase somewhat in the future as a percentage of total revenue, as our existing consulting and support services become
more widely used, as a result of acquisitions of NetRaker, Hudson Williams, Vividence and Hudson Williams Europe and as we introduce additional services that require consulting expertise. However, we cannot assure you that this revenue will increase
in absolute dollars in future periods.



We had total revenue of approximately
$13.6 million and $9.7 million for the three months ended December 31, 2004 and 2003, respectively. We achieved net income of $791,000 and $667,000 for the three months ended December 31, 2004 and 2003, respectively. We had total expenses of
approximately $13.4 million and $9.7 million for the three months ended December 31, 2004 and 2003, respectively. The increase in total expenses was mainly attributable to increased personnel costs related to the acquisitions of NetRaker, Hudson
Williams, and Vividence in the second half of fiscal 2004 and higher spending on accounting and audit fees mainly attributable to the increasing cost of compliance requirements. The increase in total expenses was offset by a $300,000 reduction in
personnel expenses related to a reduction in the required incurred but not reported claims reserve associated with our previous medical program that was partially self-funded by us. This partially self-funded medical program was terminated in March
2004, and we currently have a fully insured medical program. Our revision of the estimated incurred but not reported claims reserve was based on claims information provided by the previous insurance provider.



As of December 31, 2004 and 2003, no single customer accounted for more than 10% of our total
accounts receivable. For the three months ended December 31, 2004 and 2003, no single customer accounted for more than 10% of total revenue during each period. For the three months ended December 31, 2004 and 2003, our ten largest customers
accounted for approximately 34% and 32% of total revenue, respectively. We cannot be certain that customers that have accounted for significant revenue in past periods, individually or in aggregate, will renew our services and continue to generate
revenue in any future period. In addition, our customers that have monthly renewal arrangements may terminate their services at any time with little or no penalty. If we lose a major customer or a group of significant customers, our revenue could
decline significantly.



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



Costs of consulting and support services consist of
compensation expenses and related costs for consulting and support services personnel, external consulting costs to deliver our consulting and support services revenue, panel and reward costs associated with our WebEffective Intelligence Platform
services, all load-testing bandwidth costs and related network infrastructure costs.



We believe that the challenges for our business include 1) increasing management solutions revenue while continuing to stabilize measurement services revenue, 2) integrating and realizing the anticipated benefits of our recent acquisitions
and 3) controlling our expenses for the second quarter of fiscal 2005 at 2% to 4% lower than the first quarter of fiscal 2005, excluding expenses associated with our most recent acquisition of the business of Hudson Williams Europe.



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



17



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##### Table of Contents

The following table identifies which services are categorized as measurement services and management solutions and where
they are recorded in our condensed consolidated statements of operations listed in alphabetical order):



|                                   |  |                       |  |                               
|---------------------------------- |  | --------------------- |  | ------------------------------
|                                   |  | Subscription Services |  | Consulting andSupport Services
|Measurement Services:              |  |                       |  |                               
|Application Perspective Outside    |  | X                     |  |                               
|NetMechanic                        |  | X                     |  |                               
|Red Alert                          |  | X                     |  |                               
|Streaming Perspective              |  | X                     |  |                               
|Transaction Perspective            |  | X                     |  |                               
|Website Perspective                |  | X                     |  |                               
|                                   |  |                      
|Management Solutions:              |  |                       |  |                               
|Application Perspective Private    |  | X                     |  |                               
|Diagnostic Services                |  |                       |  | X                             
|Enterprise Solutions               |  | X                     |  | X                             
|LoadPro                            |  |                       |  | X                             
|Network Perspective                |  | X                     |  |                               
|Professional Services              |  |                       |  | X                             
|Test Perspective                   |  | X                     |  |                               
|WebEffective Intelligence Platform |  | X                     |  | X                             
|WebIntegrity                       |  | X                     |  |                               
|Wireless Perspective               |  | X                     |  |                               



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



|                                        |  |      |        |      |   |          |  |     |  
|--------------------------------------- |  | ---- | ------ | ---- | - | -------- |  | --- | -
|                                        |  | 2004 |        | 2003 |   | % change | 
|For the three months ended December 31: |  |      |        |      |   |          |  |     |  
|Measurement services revenue            |  | $    | 7,087  |      | $ | 7,053    |  | 0   | %
|Management solutions revenue            |  |      | 6,501  |      |   | 2,670    |  | 143 | %
|                                        |  |      |        |      |   |          |  |     |  
|Total Revenue                           |  | $    | 13,588 |      | $ | 9,723    |  | 40  | %
|                                        |  |      |        |      |   |          |  |     |  



Measurement services revenue increased
by $34,000 for the three months ended December 31, 2004 as compared to the corresponding period in fiscal 2003. Measurement services revenue represented 52% and 73% of total revenue for the three months ended December 31, 2004 and 2003,
respectively. The slight increase in measurement services revenue was mainly attributable to revenue from our Application Perspective service which was newly introduced in the second quarter of fiscal 2004 and increased subscriptions for our
Transaction Perspective service. The decrease in the percentage of total revenue was mainly attributable to higher revenue in the three months ended December 31, 2004 as compared to the three months ended December 31, 2003 for management solutions
revenue.



Management solutions revenue increased by approximately $3.8 million
for the three months ended December 31, 2004 as compared to the corresponding period in fiscal 2003. Management solutions revenue represented 48% and 27% of total revenue for the three months ended December 31, 2004 and 2003, respectively. The
increase in management solutions revenue as listed in descending order of impact, was mainly attributable to our acquisitions of NetRaker in April 2004 and Vividence in September 2004, as well as increases in revenue from our Wireless Perspective
and our Enterprise Solutions.



Critical Accounting Policies and Estimates



In preparing our consolidated financial statements in accordance with
accounting principles generally accepted in the United States, our management is required to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and related notes. We believe that the estimates,
judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of
assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenue and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions
and actual results, our financial statements will be affected. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.



Our critical accounting policies and estimates are of both a routine and non-routine nature.
The recurring policies relate to revenue recognition, the allowance for doubtful accounts and billing allowance, goodwill impairments, and accounting for income taxes. The non-routine policy relates to the valuation of our long-lived assets
including purchased intangibles.



Revenue Recognition



Substantially all of our revenue is derived from three sources: (1)
subscriptions to our monitoring and measurement services, otherwise known as subscription revenue, (2) subscription for the use of our technology for our WebEffective Intelligence Platform which is also recorded as subscription revenue, and (3)
providing services including consulting services, training, premium support and other miscellaneous items.



18



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##### Table of Contents

We recognize revenue in accordance with Staff Accounting Bulletin (SAB) 104, Emerging Issue Task Force
(EITF) Issue 00-21, and Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9, where applicable. We recognize revenue when all of the following criteria are met: (1)
persuasive evidence of an arrangement exists, (2) service has occurred or milestone or deliverable has been completed, (3) the fee is fixed or determinable, and (4) collectibility is probable.



One of the critical judgments we make is the assessment that collectibility is
probable. Our recognition of revenue is based on our assessment of the probability of collecting the related accounts receivable balance on a customer-by-customer basis considering past payment history and credit history. The timing or amount
of revenue recognition may have been different if different assessments of the probability of collection had been made at the time the transactions were recorded in revenue. In cases where collectibility is not deemed probable, revenue is recognized
at the time collection becomes probable, which is generally upon receipt of cash.



We recognize our subscription services revenue, which is generally deferred upon invoicing, ratably over the service period, generally ranging from one to twelve months. For some customers, subscription services revenue is invoiced monthly
upon completion of the services. Subscription revenue related to the use of the WebEffective Intelligence Platform to conduct evaluations is recognized upon completion of each evaluation. We do not generally grant refunds. All discounts granted
reduce revenue. Revenue is not recognized for free trial periods.



We recognize
our consulting and support services revenue ratably as the services are performed, typically over a period of one to three months. For most consulting engagements that span more than one month, we generally recognize revenue as milestones or
deliverables are completed.



Deferred revenue is comprised of all unearned
revenue that has been collected in advance, primarily unearned subscription services revenue and is recorded as deferred revenue on our balance sheet until the revenue is earned. Any uncollected deferred revenue reduces the balance of accounts
receivable.



Allowance for Doubtful Accounts and Billing
Allowance



Accounts receivable are recorded net of an allowance for
doubtful accounts receivable and billing allowance of approximately $589,000, or 9% of total accounts receivable, and approximately $1.1 million, or 18% of total accounts receivable, as of December 31, 2004 and 2003, respectively. The decrease in
our allowance for doubtful accounts and billing allowance is primarily due to improved collection efforts.



Our accounting policy for our allowance for doubtful accounts is determined based on historical trends, experience and current market and industry conditions. We regularly review the adequacy of our accounts
receivable allowance after considering the age of each invoice of the accounts receivable aging, each customers expected ability to pay and our collection history with each customer. We review invoices greater than 60 days past due to
determine whether an allowance is appropriate based on the receivable balance. In addition, we maintain a reserve for all other invoices, which is calculated by applying a percentage, based on historical collection trends, to the outstanding
accounts receivable balance as well as specifically identified accounts that are deemed uncollectible.



Billing allowance represents the reserve for potential billing adjustments that are recorded as a reduction of revenue and represents a percentage of revenue based on historical trends and experience. The allowance
for doubtful accounts and billing allowance represent managements best estimate, but changes in circumstances relating to accounts receivable and billing adjustments, including unforeseen declines in market conditions and collection rates and
the number of billing adjustments, may result in additional allowances in the future or reductions in allowances due to future recoveries or trends.



Impairment Assessments of Goodwill and Identifiable Purchased Intangibles



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



We perform goodwill impairment tests on an annual basis, and between annual tests in certain circumstances for our single reporting unit.
Factors we consider important which could trigger an impairment review include the following:



| |  |  | significant changes in the manner of our use of the acquired assets or the strategy of our overall business;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | significant negative industry or economic trends;
| | - |  | -------------------------------------------------



| |  |  | significant decline in our stock price for a sustained period;
| | - |  | --------------------------------------------------------------



| |  |  | our market capitalization relative to net book value
| | - |  | ----------------------------------------------------



We performed an annual impairment review during the fourth quarter in both fiscal 2003 and 2004. We did not record an impairment charge based on our reviews. If our
estimates or the related assumptions change in the future, we may be required to record an impairment charge on goodwill to reduce its carrying amount to its estimated fair value. The goodwill recorded on the Unaudited Condensed Consolidated Balance
Sheets as of December 31, 2004 was approximately $24.7 million as compared to $501,000 as of December 31, 2003.



Valuation of Long Lived Assets



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



Accounting for Income Taxes



We are required to estimate our income taxes in each of the jurisdictions in which we
operate. This process involves estimating our actual current tax liabilities, including the impact, if any, of additional taxes resulting from tax examinations together with assessing temporary differences resulting from differing treatment of
items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to
the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement
of operations.



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##### Table of Contents

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and
liabilities, and any valuation allowance recorded against our net deferred tax assets. At present, our deferred tax assets have been offset by a full valuation allowance because of our history of losses through fiscal 2003, limited number of
profitable quarters and the impact of acquisitions on our quarterly results. If we subsequently determine that some or all deferred tax assets that were previously offset by a valuation allowance are realizable, the result would be a positive
adjustment to earnings in the period such determination is made.



We establish
liabilities or reserves when we believe that certain tax positions are likely to be challenged and we may not succeed, despite our belief that our tax returns are fully supportable. We adjust these reserves, as well as related interest, in light of
changing circumstances such as the progress of tax exams.



Results of
Operations



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



|                                                                            |  |                                |   |  |       |  
|--------------------------------------------------------------------------- |  | ------------------------------ | - |  | ----- | -
|                                                                            |  | Three months endedDecember 31, |  
|                                                                            |  | 2004                           |   |  | 2003  |  
|Revenue:                                                                    |  |                                |   |  |       |  
|Subscription services                                                       |  | 75.7                           | % |  | 89.2  | %
|Consulting and support services                                             |  | 24.3                           |   |  | 10.8  |  
|                                                                            |  |                                |   |  |       |  
|Total revenue                                                               |  | 100.0                          |   |  | 100.0 |  
|Expenses:                                                                   |  |                                |   |  |       |  
|Costs of subscription services                                              |  | 9.9                            |   |  | 15.5  |  
|Costs of consulting and support services                                    |  | 19.2                           |   |  | 8.3   |  
|Research and development                                                    |  | 14.4                           |   |  | 16.7  |  
|Sales and marketing                                                         |  | 26.1                           |   |  | 27.9  |  
|Operations                                                                  |  | 10.2                           |   |  | 12.9  |  
|General and administrative                                                  |  | 13.2                           |   |  | 12.0  |  
|Excess occupancy costs                                                      |  | 1.0                            |   |  | 2.7   |  
|Amortization of identifiable intangible assets and stock-based compensation |  | 4.9                            |   |  | 3.7   |  
|                                                                            |  |                                |   |  |       |  
|Total expenses                                                              |  | 98.9                           |   |  | 99.7  |  
|Income from operations                                                      |  | 1.1                            |   |  | 0.3   |  
|Interest income, net                                                        |  | 5.2                            |   |  | 6.8   |  
|                                                                            |  |                                |   |  |       |  
|Net income before provision for income taxes                                |  | 6.3                            |   |  | 7.1   |  
|Provision for income taxes                                                  |  | (0.4                           | ) |  | (0.3  | )
|                                                                            |  |                                |   |  |       |  
|Net income                                                                  |  | 5.9                            | % |  | 6.8   | %
|                                                                            |  |                                |   |  |       |  



Our results improved by $124,000, from
a net income of $667,000 for the three months ended December 31, 2003 to a net income of $791,000 for the three months ended December 31, 2004. Total revenue increased by approximately $3.9 million or 40%, from approximately $9.7 million for the
three months ended December 31, 2003 to approximately $13.6 million for the three months ended December 31, 2004. Total expenses increased by approximately $3.8 million or 39%, from approximately $9.7 million for the three months ended December 31,
2003 to approximately $13.4 million for the three months ended December 31, 2004. The increase in total expenses was mainly attributable to increased personnel costs related to the acquisitions of NetRaker, Hudson Williams, and Vividence in the
second half of fiscal 2004 and higher spending on accounting and audit fees mainly attributable to the increasing cost of compliance requirements. The increase in total expenses was offset by a $300,000 reduction in personnel expenses related to our
estimate of the required reserve needed for incurred but not reported claims associated with our previous medical program that was partially self-funded by us. This partially self-funded medical program was terminated in March 2004, and we currently
have a fully insured medical program.



We anticipate that total expenses for
the second quarter of fiscal 2005 will decrease slightly compared to the first quarter of fiscal 2005 excluding costs associated with the acquisition of the business of Hudson Williams Europe in February 2005.



Revenue



|                                        |  |                |        |      |   |          |  |     |  
|--------------------------------------- |  | -------------- | ------ | ---- | - | -------- |  | --- | -
|                                        |  | 2004           |        | 2003 |   | % Change | 
|                                        |  | (in thousands) |       
|For the three months ended December 31: |  |                |        |      |   |          |  |     |  
|Subscription services                   |  | $              | 10,283 |      | $ | 8,671    |  | 19  | %
|Consulting and support services         |  |                | 3,305  |      |   | 1,052    |  | 214 | %
|                                        |  |                |        |      |   |          |  |     |  
|Total revenue                           |  | $              | 13,588 |      | $ | 9,723    |  | 40  | %
|                                        |  |                |        |      |   |          |  |     |  



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##### Table of Contents

Subscription Services. Revenue from subscription services increased approximately $1.6 million for the three months ended
December 31, 2004 as compared to the same period in fiscal 2004. The increase in subscription services revenue was mainly attributable to increases in our subscription based management solutions services. These increases, as listed in descending
order of impact, were mainly from our WebEffective Intelligence Platform Services due to our recent acquisitions of NetRaker in April 2004 and Vividence in September 2004, our Wireless Perspective, our Transaction Perspective, our Enterprise
Solutions, and our Application Perspective services, offset by a decrease in our Website Perspective services. At the end of December 31, 2004, we measured for revenue 8,661 page measurements or URLs, and 7,451 internet-connected devices. At the end
of December 31, 2003, we measured for revenue 7,231 URLs and 7,897 internet-connected devices.



Consulting and Support Services. Revenue from consulting and support services increased approximately $2.3 million for the three months ended December 31, 2004 as compared to the same period in fiscal 2004. The
increase in consulting and support services revenue was primarily due to increased contribution from our WebEffective Intelligence Platform services due to our recent acquisitions of NetRaker and Vividence. Because our consulting and support
services are provided on a per engagement basis, revenue depends on the number of engagements and the size of such engagements. As a result, consulting and support services revenue are less predictable than subscription services revenue and may vary
from period to period.



Expenses:



Costs of Subscription and Consulting and Support Services



|                                         |  |                |       |      |   |          |  |     |   
|---------------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | --- | --
|                                         |  | 2004           |       | 2003 |   | % Change | 
|                                         |  | (In thousands) |       |      |  
|For the three months ended December 31:  |  |                |       |      |   |          |  |     |   
|Costs of subscription services           |  | $              | 1,351 |      | $ | 1,506    |  | (10 | )%
|Costs of consulting and support services |  | $              | 2,609 |      | $ | 803      |  | 225 | % 



Costs of Subscription Services. Costs
of subscription services decreased $155,000 for the three months ended December 31, 2004 as compared to the same period in fiscal 2004 and represented 13% and 17% of subscription services revenue for the three months ended December 31, 2004 and
2003, respectively. The decrease was due to reduced costs for bandwidth and a decrease in depreciation expenses, partially offset by costs associated with our NetRaker and Vividence acquisitions.



Costs of Consulting and Support Services. Costs of consulting and support services increased
approximately $1.8 million for the three months ended December 31, 2004 as compared to the corresponding period in fiscal 2004, and represented 79% and 76% of consulting and support services revenue for the three months ended December 31, 2004 and
2003, respectively. The increase in costs of consulting and support services for the three months ended December 31, 2004 as compared to the corresponding period in fiscal 2004 was primarily due to additional personnel and consulting costs
associated with our acquisitions of NetRaker in April 2004, Hudson Williams in July 2004, and Vividence in September 2004.



Research and Development



|                                        |  |                |       |      |   |          |  |    |  
|--------------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | -- | -
|                                        |  | 2004           |       | 2003 |   | % Change | 
|                                        |  | (In thousands) |       |      |  
|For the three months ended December 31: |  |                |       |      |   |          |  |    |  
|Research and development                |  | $              | 1,962 |      | $ | 1,624    |  | 21 | %



Research and development expenses
consist primarily of compensation and related costs for research and development personnel. Research and development expenses increased $338,000 for the three months ended December 31, 2004 as compared to the corresponding period in fiscal 2004. The
increase in research and development expenses was mainly attributable to additional personnel costs as a result of our acquisitions of NetRaker, Hudson Williams, and Vividence in the second half of fiscal 2004. To date, all research and development
expenses have been expensed as incurred. We believe that research and development expenses in absolute dollars for the second quarter of fiscal 2005 will remain comparable to those of the first quarter of fiscal 2005.



Sales and Marketing



|                                        |  |                |       |      |   |          |  |    |  
|--------------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | -- | -
|                                        |  | 2004           |       | 2003 |   | % Change | 
|                                        |  | (In thousands) |       |      |  
|For the three months ended December 31: |  |                |       |      |   |          |  |    |  
|Sales and marketing                     |  | $              | 3,548 |      | $ | 2,709    |  | 31 | %



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 increased $839,000 for the three months ended December 31, 2004 as
compared to the corresponding period in fiscal 2004. The increase for the three months ended December 31, 2004 as compared to the corresponding period in fiscal 2004 was mainly attributable to additional personnel costs as a result of our
acquisitions of NetRaker, Hudson Williams, and Vividence in the second half of fiscal 2004. We believe that sales and marketing expenses in absolute dollars for the second quarter of fiscal 2005 will decrease slightly compared to the first quarter
of fiscal 2005 due to the fact that the expense for the 2004 Global Internet Performance Conference event that was held in the first quarter of fiscal 2005 will not be incurred in the second quarter of fiscal 2005.



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##### Table of Contents

Operations



|                                        |  |                |       |      |   |          |  |    |  
|--------------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | -- | -
|                                        |  | 2004           |       | 2003 |   | % Change | 
|                                        |  | (In thousands) |       |      |  
|For the three months ended December 31: |  |                |       |      |   |          |  |    |  
|Operations                              |  | $              | 1,384 |      | $ | 1,255    |  | 10 | %



Operations expenses consist primarily
of compensation and related costs for management and technical support personnel who manage and maintain our field measurement and collection infrastructure and headquarters data center, and provide basic customer support during the business day.
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 $129,000 for the three months ended December 31, 2004 as
compared to the corresponding period in fiscal 2004. The increase in operations expenses was primarily attributable to additional personnel costs as a result of our acquisitions of NetRaker, Hudson Williams, and Vividence in the second half of
fiscal 2004. We believe that operations expenses in absolute dollars for the second quarter of fiscal 2005 will remain comparable to the first quarter of fiscal 2005.



General and Administrative



|                                        |  |                |       |      |   |          |  |    |  
|--------------------------------------- |  | -------------- | ----- | ---- | - | -------- |  | -- | -
|                                        |  | 2004           |       | 2003 |   | % Change | 
|                                        |  | (In thousands) |       |      |  
|For the three months ended December 31: |  |                |       |      |   |          |  |    |  
|General and administrative              |  | $              | 1,793 |      | $ | 1,164    |  | 54 | %



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 $629,000 for the three months
ended December 31, 2004 as compared to the same period in fiscal 2004. The increase in our general and administrative expenses was primarily attributable to increased costs for corporate governance, compliance requirements, audit work and temporary
personnel costs associated with our Vividence acquisition in September 2004. We believe that general and administrative expenses for the second quarter of fiscal 2005 will decrease slightly as compared to the first quarter of fiscal 2005 due to
lower temporary personnel costs.



Excess Occupancy Costs



|                                        |  |                |     |      |   |          |  |     |   
|--------------------------------------- |  | -------------- | --- | ---- | - | -------- |  | --- | --
|                                        |  | 2004           |     | 2003 |   | % Change | 
|                                        |  | (In thousands) |     |      |  
|For the three months ended December 31: |  |                |     |      |   |          |  |     |   
|Excess occupancy costs                  |  | $              | 134 |      | $ | 266      |  | (50 | )%



Excess occupancy costs are fixed
expenses associated with the portion of our headquarters building not occupied by us, such as property taxes, insurance, and depreciation. These particular expenses are reduced by the rental income from the sublease of space in our
headquarters building. Rental income from the sublease of space has increased as well. The costs are based on the actual unoccupied square footage, which were 60% and 70% of the total rentable square footage of the headquarters building
for the three months ended December 31, 2004 and 2003, respectively.



Amortization of Identifiable Intangible Assets



|                                               |  |                |     |      |   |          |  |    |  
|---------------------------------------------- |  | -------------- | --- | ---- | - | -------- |  | -- | -
|                                               |  | 2004           |     | 2003 |   | % Change | 
|                                               |  | (In thousands) |     |      |  
|For the three months ended December 31:        |  |                |     |      |   |          |  |    |  
|Amortization of identifiable intangible assets |  | $              | 664 |      | $ | 362      |  | 83 | %



As of December 31, 2004 and 2003, we
had identifiable intangible assets with a gross carrying value of approximately $17.9 million and $12.1 million, respectively. Amortization of identifiable intangible assets increased by $302,000 mainly due to our recent acquisitions of NetRaker,
Hudson Williams, and Vividence in the second half of fiscal 2004. As of December 31, 2004 and 2003, the net carrying value of identifiable intangible assets was approximately $5.5 million and $1.9 million, respectively.



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



We expect the amortization of intangible assets to be approximately $700,000 for the second quarter of fiscal 2005, assuming no additional acquisitions, changes in preliminary purchase price allocations or impairment
charges. We expect the remaining carrying value of the identifiable intangible assets as of December 31, 2004, as listed in the table below, will be fully amortized by September 2008 (in thousands).



|                                        |  |                 |       |               |   |       |  |   |      
|--------------------------------------- |  | --------------- | ----- | ------------- | - | ----- |  | - | -----
|                                        |  | TechnologyBased |       | CustomerBased |   | Total
|Net carrying value at December 31, 2004 |  | $               | 3,465 |               | $ | 2,002 |  | $ | 5,467
|                                        |  |                 |       |               |   |       |  |   |      



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##### Table of Contents

Interest Income and Other, Net



|                                        |  |                |     |      |   |          |  |   |  
|--------------------------------------- |  | -------------- | --- | ---- | - | -------- |  | - | -
|                                        |  | 2004           |     | 2003 |   | % Change | 
|                                        |  | (In thousands) |     |      |  
|For the three months ended December 31: |  |                |     |      |   |          |  |   |  
|Interest income and other, net          |  | $              | 703 |      | $ | 663      |  | 6 | %



Interest income and other, net,
increased $40,000 for the three months ended December 31, 2004 as compared to the corresponding period in fiscal 2004. The increase in interest income and other, net, was primarily attributable to increasing investment yields resulting from higher
market interest rates earned on our invested cash. Substantially all of the interest income represents interest earned from our cash, cash equivalents, and short-term investments. The weighted average interest rate earned on our invested funds
increased to 2.02% in the first quarter of fiscal 2005 compared to the 1.8% earned during the same period in fiscal 2004.



Provision for Income Taxes



|                                        |  |                |    |      |   |          |  |    |  
|--------------------------------------- |  | -------------- | -- | ---- | - | -------- |  | -- | -
|                                        |  | 2004           |    | 2003 |   | % Change | 
|                                        |  | (In thousands) |    |      |  
|For the three months ended December 31: |  |                |    |      |   |          |  |    |  
|Provision for income taxes              |  | $              | 55 |      | $ | 30       |  | 83 | %



Provision for income taxes increased
by $25,000 for the three months ended December 31, 2004, as compared to the comparable period in fiscal 2004. The increase was attributable to alternative minimum tax and state tax associated with the net income generated during the three months
ended December 31, 2004. Our effective tax rate for the three months ended December 31, 2004 and 2003 was 6.5% and 4.3%, respectively.



On October 22, 2004, the American Jobs Creation Act (the AJCA) was signed into law. The AJCA includes a deduction of 85% of certain foreign earnings that are
repatriated, as defined in the AJCA. We may elect to apply this provision to qualifying earnings repatriations in the future. The deduction is subject to a number of limitations and requirements, including adoption of a specific domestic
reinvestment plan for the repatriated funds. We are currently evaluating the effects of the repatriation provision; however, we do not expect to be able to complete this evaluation until after Congress or the Treasury Department provides further
clarifying language on key elements of the provision.



Liquidity and Capital
Resources



Cash, cash equivalents and short-term
investments



|                                                  |  |                         |         |                          |   |        
|------------------------------------------------- |  | ----------------------- | ------- | ------------------------ | - | -------
|                                                  |  | As of December 31, 2004 |         | As of September 30, 2004
|                                                  |  | (In thousands)         
|Cash, cash equivalents and short-term investments |  | $                       | 149,683 |                          | $ | 148,117
|Accounts receivable, net                          |  | $                       | 5,912   |                          | $ | 6,138  
|Working capital                                   |  | $                       | 139,282 |                          | $ | 136,883
|Days sales in accounts receivable (DSO) (a)       |  |                         | 40      |                          |   | 45     

---

|(a) | DSO is calculated as: ((ending net accounts receivable) / net sales for the three months period) multiplied by number of days in the period
|--- | -------------------------------------------------------------------------------------------------------------------------------------------



|                                                |  |                |       |      |   |        |  
|----------------------------------------------- |  | -------------- | ----- | ---- | - | ------ | -
|                                                |  | 2004           |       | 2003 |  
|                                                |  | (In thousands) |      
|For the three months ended December 31:         |  |                |       |      |   |        |  
|Cash provided by operating activities           |  | $              | 2,773 |      | $ | 4,318  |  
|Cash provided by (used in) investing activities |  | $              | 3,127 |      | $ | (4,680 | )
|Cash provided by financing activities           |  | $              | 891   |      | $ | 3,358  |  



Cash, cash
equivalents and short-term investments



As of December 31,
2004, we had approximately $26.1 million in cash and cash equivalents and approximately $123.6 million in short-term investments, for a total of approximately $149.7 million. Cash and cash equivalents consist of highly liquid investments held at
major banks, commercial paper, United States government agency discount notes, money market mutual funds and other money market securities with original maturities of three months or less. Short-term investments consist of investment-grade corporate
and government debt securities and issuances with Moodys ratings of A2 or better. The increase in cash, cash equivalents and short-term investments for the three months ended December 31, 2004 was primarily due to approximately $2.8 million
from cash flow from operating activities, $3.1 million from investing activities primarily related to sales of short term investments and approximately $900,000 from cash flow from financing activities. The largest uses of cash from investing
activities during the three months ended December 31, 2004 were the purchases of property and equipment of $712,000 and $385,000 for additional direct costs associated with our acquisitions of NetRaker, Hudson Williams, and Vividence in the second
half of fiscal 2004.



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Cash provided by operating activities



For the three months ended December 31, 2004, net cash provided by operating activities was
approximately $2.8 million which was mainly due to net income, excluding all non-cash amortization and depreciation charges, a decrease in accounts receivable of $226,000, and increase of accounts payable and accrued expenses of $122,000, partially
offset by a decrease in deferred revenue of $497,000 and an increase of prepaids and other assets of $120,000. The decrease in accounts receivable was mainly attributable to lower DSO for the period. The increase in accounts payable and accrued
expenses was mainly attributable to an increased spending in legal and audit services related to regulatory compliance and acquisitions. The decrease in deferred revenue was mainly attributable to less consulting engagements that span quarters. The
increase in prepaids and other assets was mainly attributable to higher prepaid insurance costs.



Cash used in investing activities



For the three months ended December 31, 2004, net cash provided in our investing activities was approximately $3.1 million. We realized a net amount of approximately $4.2
million on the net sale of short-term investments. We utilized approximately $712,000 to purchase property and equipment, primarily for our production infrastructure, information systems, and tenant improvements associated with space that we have
rented in our headquarters building. We utilized $385,000, mainly for payments of direct costs associated with our acquisitions of NetRaker, Hudson Williams, and Vividence in the second half of fiscal 2004.



Cash provided by financing activities



For the three months ended December 31, 2004, net cash provided by our financing activities
was $891,000. We received approximately $1.3 million from the issuance of common stock, associated with our employee stock option plan. Our board of directors has approved a program to repurchase shares of our common stock, and pursuant to the stock
repurchase program, a total of 10.4 million shares were repurchased between January 2001 and December 2004 for an aggregate price of approximately $90.1 million. As of December 31, 2004, approximately $39.9 million was available to repurchase shares
of our common stock pursuant to this stock repurchase program. On January 25, 2005, we announced that we would be entering into a trading plan with a broker intended to qualify under Rule 10b5-1 of the Securities Exchange Act of 1934, for the broker
to repurchase up to 2 million shares of our common stock in accordance with Rule 10b-18 of the Securities Exchange Act of 1934 over a twelve month period. We utilized $400,000 to pay the final costs associated with our previous issuer tender offers
in fiscal 2003.



Commitments



As of December 31, 2004, our principal commitments consisted of $595,000 in real property
operating leases and equipment capital and operating leases, with various lease terms, the longest of which expires in June 2007. Additionally, we had contingent commitments to 126 bandwidth and collocation providers amounting to $881,000 for 100
locations ranging from one to fifteen months commitments, which commitments become due if we terminate any of these agreements prior to their expiration. At present, we do not intend to terminate any of these agreements prior to their expiration. We
expect to continue to invest in capital and other assets to support our growth. We expect to make additional capital expenditures of approximately $1.0 million related to our operations and headquarters building for the second quarter of fiscal
2005, absent any other acquisitions or extraordinary transactions.



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



|                                                 |  |       |       |                  |   |            |  |            |     |                   |   |    |  |   |  
|------------------------------------------------ |  | ----- | ----- | ---------------- | - | ---------- |  | ---------- | --- | ----------------- | - | -- |  | - | -
|                                                 |  | Total |       | Less than 1 year |   | 1 3 years |  | 3 5 years |     | More than 5 years
|Contractual Obligations Leases                   |  | $     | 595   |                  | $ | 329        |  | $          | 249 |                   | $ | 17 |  | $ | 
|Commercial Commitments Bandwidth and Collocation |  |       | 881   |                  |   | 864        |  |            | 17  |                   |   |   |  |   | 
|                                                 |  |       |       |                  |   |            |  |            |     |                   |   |    |  |   |  
|Total                                            |  | $     | 1,476 |                  | $ | 1,193      |  | $          | 266 |                   | $ | 17 |  | $ | 
|                                                 |  |       |       |                  |   |            |  |            |     |                   |   |    |  |   |  



As of December 31, 2004, we did not
have any purchase commitments other than obligations incurred in the normal course of business. These amounts are accrued when services or goods are received.



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



Off Balance Sheet Arrangements



We do not have any off balance sheet arrangements.



Recently Issued Accounting Pronouncement



In March 2004, the Emerging Issues Task Force reached consensus on Issue No. 03-01
(EITF 03-01), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-01 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well
as new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) EITF 03-1-1 which delays the
effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-01 to investments in securities that are impaired; however, the disclosure requirements are effective for fiscal years
ending after December 15, 2003 for investments accounted for under SFAS No. 115. Although we will continue to monitor the application of EITF 03-01, we do not currently believe adoption will have a material impact on our financial position or
results of operations.



In December 2004, the FASB issued FSP 109-2,
Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004. FSP 109-2 provides additional time to companies beyond the financial reporting period of enactment to
evaluate the effects of the AJCA on



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their plans for repatriation of foreign earnings for purposes of applying SFAS No. 109, Accounting for Income
Taxes. We are currently evaluating the repatriation provisions of AJCA, which if implemented, would affect our tax provision and deferred tax assets and liabilities. However, given the preliminary stage of our valuation, it is not possible at
this time to determine the amount, if any, that may be repatriated or the related potential income tax effects of such repatriation.



In December 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 153, Exchanges of Nonmonetary Assets, which eliminates
the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS No. 153 will be effective for nonmonetary asset exchanges
occurring in fiscal periods beginning after June 15, 2005. We do not believe the adoption of SFAS No. 153 will have a material impact on our financial position or results of operations.



In December 2004, the FASB issued SFAS No. 123 (Revised 2004) (SFAS No. 123R), Share-Based Payment, that addresses
the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprises equity
instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions using the intrinsic value method under Accounting Principles Board
(APB) Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead that companies recognize the cost of employee services received in exchange for awards of equity instruments based on the
grant-date fair value of those awards (the fair-value-based method). We are currently reviewing SFAS No. 123R to determine which fair-valuebased model and transitional provision it will follow upon adoption. The options for
transition methods as prescribed in SFAS No. 123R include either the modified prospective or the modified retrospective methods. SFAS No. 123R will be effective beginning our fourth quarter of fiscal 2005. Although we will continue to evaluate the
application of SFAS No. 123R, we expect the adoption will lead to substantial additional compensation expense and therefore will have a material impact on our results of operations. The accounting impact, had we chosen to apply the fair-value
recognition provisions of SFAS No. 123, instead of the recognition provisions under APB Opinion No. 25, is described in Note 2 of the Notes to Condensed Consolidated Financial Statements.



Factors That May Impact Future Results



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



Although we have been profitable since the fourth quarter of fiscal 2003, we have
experienced operating losses in each quarterly period since inception through the third quarter of fiscal 2003. We may not be able to sustain operating profitability in the future. We generated net income of approximately $791,000 for the three
months ended December 31, 2004, and as of December 31, 2004, we had an accumulated deficit of $136.6 million. In addition, we are required under generally accepted accounting principles to review our goodwill and identifiable intangible assets for
impairment when events or circumstances indicate that the carrying value may not be recoverable. As of December 31, 2004, we had approximately $5.5 million of net identifiable intangible assets and approximately $24.7 million of goodwill. If we
complete additional acquisitions in the future, we may have additional goodwill and/or identifiable intangibles and, accordingly, may incur expenses in connection with a write-down of goodwill and identifiable intangible assets due to changes in
market conditions as we did in the quarter ended June 30, 2001 when we recorded an impairment charge for goodwill and identifiable intangible assets of $30.5 million in connection with our acquisitions of Velogic and Digital Content. We believe that
our operating expenses could increase as they have in certain past periods. As a result, we will need to increase our revenue to sustain profitability. We may not sustain a sequential quarterly increase in revenue and may never be able to regain our
historic revenue growth rates.



Changes in accounting rules could affect our
future operating results.



Financial statements are prepared in accordance
with U.S. generally accepted accounting principles. These principles are subject to interpretation by various governing bodies, including the FASB and the Securities and Exchange Commission (SEC), who interpret and create appropriate
accounting regulations. A change from current accounting regulations could have a significant effect on our results of operations. In December 2004, the FASB issued new guidance that addresses the accounting for share-based payments, SFAS No. 123R,
which will be effective for us in our fourth quarter of fiscal 2005. Although we will continue to evaluate the application of SFAS 123R, we expect the adoption to have a material adverse affect on our results of operations. Note 2 of the Condensed
Consolidated Financial Statements shows the impact that such a change in accounting treatment would have had on our net income and net income per share if it had been in effect during the reporting periods shown and if the compensation expense were
calculated as described in Note 2.



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



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



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



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



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



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



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



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



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



| |  |  | our ability to successfully introduce new products and services to offset any reductions in revenue from services that are not as widely used;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



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



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



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;
| | - |  | -----------------------------------------------------------------------------



| |  |  | difficulties in managing a larger organization;
| | - |  | -----------------------------------------------



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



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



| |  |  | entry in new businesses in which we have little direct experience, as was the case with our acquisition of Vividence Corporation;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



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



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



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



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



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



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



Our operating results could be harmed if sales of our
e-business performance measurement services decline.



Sales of our
e-business performance measurement services, primarily our Web Site Perspective-Business Edition and Transaction Perspective services, have generated a majority of our total revenue in the past. Therefore, the success of our business currently
depends, and for the immediate future will continue to substantially depend, on sales and renewals of our performance measure services and performance management solutions. While total revenue has been increasing for the past six quarters, our
measurement services revenue has experienced declines from historic levels. If these revenue continues to decline, our operating results could suffer if we are not able to increase revenues from other services.



26



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



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



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



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



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



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



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



We could also face competition from other companies, which currently do not offer services similar to our services, but offer software or services related to e-business performance management solutions, such as
Webtrends, Omniture, Webside Story and Coremetrics, and free services that measure web site availability. In addition, companies that sell systems management software, such as BMC Software, CompuWare, CA-Unicenter, HP-Openview, Quest Software,
NetIQ, Veritas Precise Software, and IBMs Tivoli Unit, with some of whom we have strategic relationships, could choose to offer services similar to ours.



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



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



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



Our ten largest customers accounted for approximately 34% and 32% of our total revenue for the three months ended December 31, 2004 and
2003, respectively. We cannot be certain that customers that have accounted for significant revenue in past periods, individually or as a group, will renew, will not cancel or will not reduce their services and, therefore, continue to generate
revenue in any future period. In addition, our customers that do not have written contracts may terminate their services at any time with little or no penalty. If we lose a major customer, our revenue could decline.



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



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



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



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



We may be unable to retain our key employees, namely our management team and experienced engineers, or to attract, assimilate or retain other highly qualified



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employees. Although we, and a number of other technology companies, have implemented workforce reductions, there remains
substantial competition for highly skilled employees. In addition, Vividence had approximately 50 employees, and some of these employees have decided not to continue to work with us. Because the Vividence business is an area in which we have little
experience, it will be important for us to retain the key personnel from this company and we cannot ensure that we will be successful in doing so. Our key employees are not bound by agreements that could prevent them from terminating their
employment at any time. If we fail to attract and retain key employees, our business could be harmed.



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



Consulting and support services revenue represented approximately 24% and 11% of total revenue for the three months ended December 31, 2004 and 2003, respectively. We
have recently added to our consulting services with our acquisitions of NetRaker Corporation in April 2004, Hudson-Williams Corporation in July 2004, and Vividence Corporation in September 2004. In the past, the cost of consulting and support
services has, at times, exceeded our consulting revenue. We will also need to successfully market these services to potential customers in order to increase consulting revenue. Each consulting engagement typically spans a one- to three-month period,
and therefore, it is more difficult for us to predict the amount of consulting and support services revenue recognized in any particular quarter. There are many experienced firms that offer computer network and Internet-related consulting services.
These consulting services providers include consulting companies, such as Accenture, as well as consulting divisions of large technology companies such as IBM. Because we do not have an established reputation for delivering consulting services,
because this area is very competitive, and because we have limited experience in delivering consulting services, we may not succeed in selling these services.



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



Because our business is based on providing e-business performance management solutions, the
Internet must continue to be used as a means of electronic business, or e-business, and communications. In addition, we believe that the use of the Internet for conducting business transactions could be hindered for a number of reasons, including,
but not limited to:



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



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



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



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



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



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



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



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



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



All data collected from our measurement computers are
stored in and distributed from our operations center, which we maintain at a single location. Therefore, our operations depend upon our ability to maintain and protect our computer systems, most of which are located at our corporate headquarters in
San Mateo, California, which is an area susceptible to earthquakes and possible power outages. Although we have a generator to provide our own source of long-term uninterruptible power, if we experience power outages at our operations center, we
might not be able to promptly receive data from our measurement computers and we might not be able to deliver our services to our customers on a timely basis. Although we believe our main operations are redundant between our San Mateo and Plano,
Texas datacenters, an outage at either center could lead to service interruptions. Therefore, our operations systems are vulnerable to damage from break-ins, computer viruses, unauthorized access, vandalism, fire, floods, earthquakes, power loss,
telecommunications failures and similar events.



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



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



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



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



Our measurement computers that we use
to provide many of our services 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,



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



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



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



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



We believe we must expand the sales of our services outside the United States. Although we
completed our first international acquisition in February 2005, to date, we have little experience with direct sales outside the United States, and we may not succeed in these efforts. International sales were approximately 6% of our total revenue
for each of the three months ended December 31, 2004 and 2003, respectively. We intend to expand the sales of our services by selling directly to certain customers and through resellers to other customers. Therefore, we expect to continue to commit
our resources to expand our international sales and marketing activities. Conducting international operations subjects us to risks we do not face in the United States. These include:



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



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



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



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



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



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



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



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



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



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



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



We currently do not occupy approximately 60% of our headquarters building in San Mateo,
California. We may be unable to lease all or a part of the available space, and if it is leased, we may not receive sufficiently high rental rates to cover our building operating costs. In addition, we have previously incurred a charge for the
write-down of the building, and, if the real estate market continues to deteriorate, we may incur charges for future write-downs. Any such charge could harm our results of operations.



Compliance with new rules and regulations concerning corporate governance may increase our costs and could harm our business.



The Sarbanes-Oxley Act, which was signed into law in July 2002, mandates,
among other things, that companies adopt new corporate governance measures and imposes comprehensive reporting and disclosure requirements, sets stricter independence and financial expertise standards for audit committee members and imposes
increased civil and criminal penalties for companies, their chief executive officers and chief financial officers and directors for securities law violations. In addition, The Nasdaq Stock Market, on which our common stock is listed, has also
adopted additional comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations have increased the scope, complexity and cost of our corporate governance, reporting and disclosure practices, which could
harm our results of operations and divert managements attention from business operations. We also expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be
required to accept reduced coverage or incur substantially higher costs to obtain coverage. Further, our board members, Chief Executive Officer and Chief Financial Officer could face an increased risk of personal liability in connection with the
performance of their duties. As a result, we may have difficultly attracting and retaining qualified board members and executive officers, which would adversely affect our business.



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



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



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



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



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



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



Industry consolidation may lead to increased competition and may harm our operating
results.



There has been a trend toward industry consolidation in our
markets for several years. We expect this trend to continue as companies attempt to strengthen or hold their market positions in an evolving industry and as companies are acquired or are unable to continue operations. We believe that industry
consolidation may result in stronger competitors that are better able to compete for customers. This could lead to more variability in operating results and could have a material adverse effect on our business, operating results, and financial
condition. Furthermore, rapid consolidation could also lead to fewer customers, with the effect that loss of a major customer could harm our revenue.



If we fail to maintain the adequacy of our internal controls, our ability to provide accurate financial statements could be impaired and any failure to maintain our
internal controls and provide accurate financial statements could cause our stock price to decrease substantially.



We are in the process of reviewing our internal controls and procedures to satisfy the requirements of the Sarbanes-Oxley Act of 2002, when and as such requirements
become applicable to us. We are continuing to evaluate, and where appropriate, enhance, our written policies and procedures and internal controls. If we fail to maintain the adequacy of our internal controls as such standards are modified,
supplemented or amended form time to time, we may not be able to provide accurate financial statements and comply with the Sarbanes-Oxley Act of 2002. Any failure to maintain the adequacy of our internal controls and provide accurate financial
statements would cause the trading price of our common stock to decrease substantially.



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



Interest Rate Sensitivity.    Our interest income and expense is sensitive to changes in the general level of
U.S. interest rates, particularly because most of our cash, cash equivalents and short-term investments are invested in short-term debt instruments. If market interest rates were to change immediately and uniformly by ten percent (10%) from levels
as of December 31, 2004, the interest earned on those cash, cash equivalents, and short-term investments could increase or decrease by approximately $274,000 on an annualized basis.



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



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



(a) Evaluation of Disclosure Controls and Procedures



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



(b) Changes in Internal Controls



There have been no significant changes in our internal control over financial reporting during the first quarter of fiscal 2005 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial reporting.



PART IIOTHER INFORMATION



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



Beginning on August 16, 2001, several class action lawsuits were filed in the United States District Court for the Southern District of New York against us, certain of our officers, and the underwriters of our initial
public offering. These lawsuits were essentially identical, and were brought on behalf of those who purchased our securities between September 24, 1999 and August 19, 2001. These complaints alleged generally that the underwriters in certain initial
public offerings, including ours, allocated shares in those initial public offerings in unfair or unlawful ways, such as requiring the purchaser to agree to buy in the aftermarket at a higher price or to buy shares in other companies with higher
than normal commissions. The complaint also alleged that we had a duty to disclose the activities of the underwriters in the registration statement relating to our initial public offering. The plaintiffs counsel and the issuer defendants
counsel have reached a preliminary settlement agreement whereby the issuers and individual defendants were dismissed from the case, without any payment by us. The settlement awaits approval by the Court.



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



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



Not applicable.



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



Not applicable.



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



Not applicable.



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



Not applicable.



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|Item 6. | Exhibits
|------- | --------



The following documents are filed as Exhibits to this Report:



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

---

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



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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 9th day of February 2005.



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



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EXHIBIT INDEX



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

---

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



34