##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended December 31, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the transition period from to
 Commission File Number: 000-27241
 KEYNOTE SYSTEMS, INC.
 (Exact name of registrant as specified in its charter)
 Delaware
(State or other jurisdiction of 
incorporation or organization)
    
    94-3226488
(I.R.S. Employer
Identification No.)94404
 777 Mariners Island Blvd., San Mateo, CA
(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (650) 403-2400
 þ o
  o þ o
 o þ
  Class
    

Shares outstanding as of February 7, 2007Common Stock, $.001 par value
    
    19,232,796 including 2,000,000
treasury shares




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##### 



KEYNOTE SYSTEMS, INC.
 TABLE OF CONTENTS
 PagePART IFINANCIAL INFORMATIONItem 1.
    
    Unaudited Financial Statements
    
    
    3Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    21Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risks
    
    
    36Item 4.
    
    Controls and Procedures
    
    
    36PART IIOTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    37Item 1A.
    
    Risk Factors
    
    
    37Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    44Item 3.
    
    Defaults Upon Senior Securities
    
    
    44Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    44Item 5.
    
    Other Information
    
    
    44Item 6.
    
    Exhibits
    
    
    45Signatures
    
    
    
    
    46EXHIBIT 10.22EXHIBIT 10.23EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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##### Table of Contents



PART IFINANCIAL INFORMATION
 
 Item 1. Unaudited Financial Statements.
 KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 Index to Unaudited Condensed Consolidated Financial Statements
 PageCondensed Consolidated Balance Sheets as of December 31, 2006 and September 30, 2006
    
    
    4Condensed Consolidated Statements of Operations for the three months ended December 31, 2006 and 2005
    
    
    5Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2006 and 2005
    
    
    6Notes to Condensed Consolidated Financial Statements
    
    
    7
 3




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (In thousands)
 (Unaudited)
 December 31,
    
    
    September 30,2006
    
    
    2006ASSETSCurrent assets:Cash and cash equivalents
    
    $
    51,177
    
    
    $
    45,662Short-term investments
    
    
    44,405
    
    
    
    45,089Total cash, cash equivalents, and short-term investments
    
    
    95,582
    
    
    
    90,751Accounts receivable, less allowance for doubtful
accounts and billing adjustment of $449 and $473 as of
December 31, 2006 and September 30, 2006, respectively
    
    
    7,735
    
    
    
    7,122Prepaids, deferred costs and other current assets
    
    
    2,738
    
    
    
    2,655Inventories
    
    
    688
    
    
    
    876Deferred tax assets
    
    
    1,437
    
    
    
    1,389Total current assets
    
    
    108,180
    
    
    
    102,793Deferred costs
    
    
    987
    
    
    
    Property and equipment, net
    
    
    34,519
    
    
    
    34,464Goodwill
    
    
    60,202
    
    
    
    48,676Identifiable intangible assets, net
    
    
    9,637
    
    
    
    10,105Deferred tax assets
    
    
    3,114
    
    
    
    3,114Total assets
    
    $
    216,639
    
    
    $
    199,152LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,528
    
    
    $
    1,558Accrued expenses
    
    
    20,945
    
    
    
    10,748Current portion of capital lease obligation
    
    
    24
    
    
    
    31Deferred revenue, net
    
    
    12,874
    
    
    
    9,691Total current liabilities
    
    
    35,371
    
    
    
    22,028Long-term portion of capital lease obligation
    
    
    46
    
    
    
    50Long-term deferred revenue, net
    
    
    1,835
    
    
    
    958Long-term deferred tax liability
    
    
    2,832
    
    
    
    2,727Total liabilities
    
    
    40,084
    
    
    
    25,763Commitments and contingencies  see Note 11Stockholders equity:Common stock
    
    
    19
    
    
    
    19Treasury stock
    
    
    (21,150
    )
    
    
    (21,150
    )Additional paid-in capital
    
    
    332,064
    
    
    
    330,398Accumulated deficit
    
    
    (137,314
    )
    
    
    (137,578
    )Accumulated other comprehensive gain
    
    
    2,936
    
    
    
    1,700Total stockholders equity
    
    
    176,555
    
    
    
    173,389Total liabilities and stockholders equity
    
    $
    216,639
    
    
    $
    199,152
  4




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (In thousands, except per share amounts)
 (Unaudited)
 Three months ended December 31,2006
    
    
    2005Revenue:Subscription services
    
    $
    12,713
    
    
    $
    9,820Professional services
    
    
    3,102
    
    
    
    3,896Total revenue
    
    
    15,815
    
    
    
    13,716Expenses:Costs of subscription services
    
    
    3,141
    
    
    
    1,459Costs of professional services
    
    
    2,123
    
    
    
    2,445Research and development
    
    
    2,872
    
    
    
    1,989Sales and marketing
    
    
    4,629
    
    
    
    3,369Operations
    
    
    1,842
    
    
    
    1,647General and administrative
    
    
    2,379
    
    
    
    2,209Excess occupancy income
    
    
    (27
    )
    
    
    (10
    )Amortization of identifiable intangible assets
    
    
    759
    
    
    
    397Total expenses*
    
    
    17,718
    
    
    
    13,505Income (loss) from operations
    
    
    (1,903
    )
    
    
    211Interest income and other, net
    
    
    1,121
    
    
    
    1,108Income (loss) before benefit (provision) for income taxes
    
    
    (782
    )
    
    
    1,319Benefit (provision) for income taxes
    
    
    1,046
    
    
    
    (732
    )Net income
    
    $
    264
    
    
    $
    587Net income per share:Basic
    
    $
    0.02
    
    
    $
    0.03Diluted
    
    $
    0.01
    
    
    $
    0.03Shares used in computing basic and diluted net income per share:Basic
    
    
    17,116
    
    
    
    18,724Diluted
    
    
    17,686
    
    
    
    19,724* Stock-based compensation by category:Cost of subscription services
    
    $
    36
    
    
    $
    Cost of professional services
    
    
    140
    
    
    
    121Research and development
    
    
    209
    
    
    
    186Sales and marketing
    
    
    281
    
    
    
    246Operations
    
    
    147
    
    
    
    150General and administrative
    
    
    107
    
    
    
    93$
    920
    
    
    $
    796
  5




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (In thousands)
 (Unaudited)
 Three Months EndedDecember
31,2006
    
    
    2005Cash flows from operating activities:Net income
    
    $
    264
    
    
    $
    587Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization of property, equipment and software
    
    
    1,093
    
    
    
    905Stock-based compensation
    
    
    920
    
    
    
    796Charges to bad debt and billing adjustment reserves
    
    
    83
    
    
    
    83Amortization of debt investment premium
    
    
    (245
    )
    
    
    147Amortization of identifiable intangible assets
    
    
    759
    
    
    
    397Changes in operating assets and liabilities, net of acquired assets and liabilities:Accounts receivable, net
    
    
    (648
    )
    
    
    (775
    )Inventories
    
    
    217
    
    
    
    Prepaids, deferred costs and other current assets
    
    
    (34
    )
    
    
    396Deferred costs
    
    
    (987
    )
    
    
    Deferred tax assets
    
    
    
    
    
    
    608Accounts payable and accrued expenses
    
    
    (583
    )
    
    
    695Deferred revenue
    
    
    3,841
    
    
    
    (334
    )Net cash provided by operating activities
    
    
    4,680
    
    
    
    3,505Cash flows from investing activities:Purchases of property, equipment and software
    
    
    (704
    )
    
    
    (337
    )Purchase of businesses and assets, net
    
    
    (307
    )
    
    
    (2,520
    )Sale of short-term investments
    
    
    8,363
    
    
    
    20,131Purchases of short-term investments
    
    
    (7,330
    )
    
    
    (20,345
    )Net cash provided by (used in) investing activities
    
    
    22
    
    
    
    (3,071
    )Cash flows from financing activities:Payment of capital leases
    
    
    (15
    )
    
    
    (9
    )Proceeds from issuance of common stock and exercise of stock options
    
    
    746
    
    
    
    1,771Repurchase of outstanding common stock
    
    
    
    
    
    
    (1,479
    )Net cash provided by financing activities
    
    
    731
    
    
    
    283Effect of exchange rate changes on cash and cash equivalents
    
    
    82
    
    
    
    Net change in cash and cash equivalents
    
    
    5,515
    
    
    
    717Cash and cash equivalents at beginning of the period
    
    
    45,662
    
    
    
    46,934Cash and cash equivalents at end of the period
    
    $
    51,177
    
    
    $
    47,651Supplemental cash flow information:Cash paid during the period for income taxes, net
    
    $
    183
    
    
    $
    20Noncash Operating and Investing Activities:Acquisition of property, equipment and software on account
    
    $
    418
    
    
    $
    212
  6




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 (1) Basis of Presentation
     Stock Based Compensation
  
    7




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##### Table of Contents



Three Months EndedDecember 31,2006
    
    2005Stock Option Under Equity
Incentive Plan:Volatility
    
    
    29.5
    %
    
    
    31.9
    %Risk free interest rate
    
    
    4.6
    %
    
    
    4.4
    %Expected life (in years)
    
    
    3.83
    
    
    
    3.10Dividend yield
    
    
    
    
    
    
    Employee Stock Purchase Plan:Volatility
    
    
    27.0
    %
    
    
    26.0
    %Risk free interest rate
    
    
    5.1
    %
    
    
    2.5
    %Expected life (in years)
    
    
    1.25
    
    
    
    1.25Dividend yield
    
    
    
    
    
    
    
  AverageWeighted
    
    Remaining
    
    AggregateAverage
    
    contractual
    
    IntrinsicShares
    
    Exercise Price
    
    Term (years)
    
    ValueOutstanding at September 30, 2006
    
    
    6,754
    
    
    $
    13.24
    
    
    
    7.1
    
    
    $
    6,146Granted
    
    
    140
    
    
    
    10.65Exercised
    
    
    (86
    )
    
    
    8.70Forfeited, canceled or expired
    
    
    (155
    )
    
    
    12.03Outstanding at December 31, 2006
    
    
    6,653
    
    
    $
    13.27
    
    
    
    7.0
    
    
    $
    6,167Exercisable at December 31, 2006
    
    
    3,932
    
    
    $
    14.54
    
    
    
    5.6
    
    
    $
    6,034
  8




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##### Table of Contents



WeightedAverageGrant-DateShares
    
    
    Fair ValueStock option awards:Nonvested balance at September 30, 2006
    
    
    2,882
    
    
    $
    3.25Stock options granted
    
    
    140
    
    
    
    3.19Vested
    
    
    (206
    )
    
    
    3.28Forfeited
    
    
    (95
    )
    
    
    3.26Nonvested balance at December 31, 2006
    
    
    2,721
    
    
    $
    3.29
  Excess Occupancy Income
  Twelve Months Ended December 31:2007
    
    
    $
    1,1342008
    
    
    
    1,0302009
    
    
    
    6652010
    
    
    
    1862011
    
    
    
    99Thereafter
    
    
    269Total future minimum rents receivable
    
    
    
    
    
    $
    3,383
 (2) Revenue Recognition
  
    
    Evidence of an arrangement.The Company considers a customer signed quote,
contract, or equivalent document to be evidence of an arrangement.
    
    Delivery. For non-SIGOS subscription services, delivery is considered to
occur when the customer has been provided with access to the subscription
services. The Companys subscription services are generally delivered on a
consistent basis over the period of the subscription. For professional services,
delivery is considered to occur when the services or milestones are completed.
For SIGOS services, delivery occurs when services are either delivered or
accepted, if acceptance language exists.
 9




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##### Table of Contents




    
    Fixed or determinable fee.The Company considers the fee to be fixed or
determinable if the fee is not subject to refund or adjustment and payment terms
are standard.
    
    Collection is deemed reasonably assured.Collection is deemed reasonably
assured if it is expected that the client will be able to pay amounts under the
arrangement as payments become due. If it is determined that collection is not
reasonably assured, then revenue is deferred and recognized upon cash collection.
 Subscription Services Revenue:
     Professional Services Revenue:
  10




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##### Table of Contents



Deferred Revenue:
  Deferred Costs:
 (3) Comprehensive Income and Foreign Currency Translation
  Three Months EndedDecember 31,2006
    
    
    2005Net income
    
    $
    264
    
    
    $
    587Net unrealized gain on available-for-sale investments
    
    
    59
    
    
    
    102Foreign currency translation gain (loss)
    
    
    1,177
    
    
    
    (22
    )Comprehensive income
    
    $
    1,500
    
    
    $
    667
  (4) Financial Instruments and Concentration of Risk
   11




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##### Table of Contents



(5) Cash, Cash Equivalents, and Short-Term Investments
   Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    EstimatedCost
    
    
    Gains
    
    
    Losses
    
    
    Market ValueCash
    
    $
    10,829
    
    
    $
    
    
    
    $
    
    
    
    $
    10,829Commercial paper
    
    
    11,945
    
    
    
    2
    
    
    
    
    
    
    
    11,947Money market mutual funds
    
    
    1,766
    
    
    
    
    
    
    
    
    
    
    
    1,766Other money market securities
    
    
    26,635
    
    
    
    
    
    
    
    
    
    
    
    26,635Total
    
    $
    51,175
    
    
    $
    2
    
    
    $
    
    
    
    $
    51,177
  Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    EstimatedCost
    
    
    Gains
    
    
    Losses
    
    
    Market ValueState government agency securities
    
    $
    12,577
    
    
    $
    
    
    
    $
    
    
    
    $
    12,577FNMA and FHLMC securitites
    
    
    2,037
    
    
    
    
    
    
    
    (5
    )
    
    
    2,032Other U.S. government agency
securities
    
    
    8,126
    
    
    
    
    
    
    
    (18
    )
    
    
    8,108Corporate bonds and commercial paper
    
    
    21,766
    
    
    
    
    
    
    
    (78
    )
    
    
    21,688Total
    
    $
    44,506
    
    
    $
    
    
    
    $
    (101
    )
    
    $
    44,405
 12




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##### Table of Contents



EstimatedAmortized
    
    MarketCost
    
    ValueYear ending December 31,2007
    
    $
    36,179
    
    
    $
    36,0992008
    
    
    8,327
    
    
    
    8,306Total
    
    $
    44,506
    
    
    $
    44,405
 (6) Inventories
  (7) Goodwill and Identifiable Intangible Assets
 :
 Balance at September 30, 2006
    
    $
    48,676Additional goodwill for payment of the Signos earnout (see Note 9)
    
    
    10,561Translation adjustments and other
    
    
    965Balance at December 31, 2006
    
    $
    60,202
  Technology
    
    
    Customer
    
    
    
    
    
    
    Non-CompeteBased
    
    
    Based
    
    
    Trademark
    
    
    Covenant
    
    
    Backlog
    
    
    TotalAs of December 31, 2006:Gross carrying value
    
    $
    15,913
    
    
    $
    9,385
    
    
    $
    1,038
    
    
    $
    76
    
    
    $
    254
    
    
    $
    26,666Accumulated amortization
    
    
    (11,027
    )
    
    
    (5,875
    )
    
    
    (370
    )
    
    
    (12
    )
    
    
    (36
    )
    
    
    (17,320
    )Translation adjustments
    
    
    25
    
    
    
    182
    
    
    
    71
    
    
    
    10
    
    
    
    3
    
    
    
    291Net carrying value at
December 31, 2006
    
    $
    4,911
    
    
    $
    3,692
    
    
    $
    739
    
    
    $
    74
    
    
    $
    221
    
    
    $
    9,637As of September 30, 2006:Gross carrying value
    
    $
    15,913
    
    
    $
    9,385
    
    
    $
    1,038
    
    
    $
    76
    
    
    $
    254
    
    
    $
    26,666Accumulated amortization
    
    
    (10,571
    )
    
    
    (5,636
    )
    
    
    (323
    )
    
    
    (7
    )
    
    
    (24
    )
    
    $
    (16,561
    )Net carrying value at
September 30, 2006
    
    $
    5,342
    
    
    $
    3,749
    
    
    $
    715
    
    
    $
    69
    
    
    $
    230
    
    
    $
    10,105
 13




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##### Table of Contents



(8) Net Income Per Share
   Three Months EndedDecember 31,2006
    
    
    2005Numerator:Net income
    
    $
    264
    
    
    $
    587Denominator:Denominator for basic net income per shareweighted average shares
    
    
    17,116
    
    
    
    18,724Incremental common shares attributable to shares issuable under stock option and purchase plans
    
    
    580
    
    
    
    1,186Reduction in shares for average unrecognized compensation costs
    
    
    (10
    )
    
    
    (186
    )Denominator for diluted net income per shareweighted average shares
    
    
    17,686
    
    
    
    19,724
  (9) Acquisitions
 
 Cash paid
    
    $
    30,078Direct transaction costs
    
    
    1,186$
    31,264
  
  14




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##### Table of Contents



(10) Income Taxes
    (11) Commitments and Contingencies
 (A) Leases
  Operating
    
    
    CapitalLeases
    
    
    LeasesTwelve months ended June 30:2007
    
    $
    759
    
    
    $
    232008
    
    
    630
    
    
    
    232009
    
    
    559
    
    
    
    162010
    
    
    517
    
    
    
    142011
    
    
    316
    
    
    
    Thereafter
    
    
    1,046
    
    
    
    Total minimum lease payments
    
    $
    3,827
    
    
    
    76Less amounts representing interest
    
    
    
    
    
    
    (6
    )Present value of minimum lease payments
    
    
    
    
    
    
    70Less current portion of capital lease obligation
    
    
    
    
    
    
    24Long-term portion of capital lease obligation
    
    
    
    
    
    $
    46
  (B) Commitments
 ,
 15




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##### Table of Contents



(C) Legal Proceedings
   (D) Warranties
  (E) Indemnification
  (12) Stock Repurchase Program
     (13) Geographic, Customer and Segment Information
  16




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##### Table of Contents



Three Months EndedDecember 31,2006
    
    
    2005Revenues:United States
    
    $
    12,036
    
    
    $
    12,276Europe*
    
    
    3,024
    
    
    
    1,330Other*
    
    
    755
    
    
    
    110$
    15,815
    
    
    $
    13,716
 December 31,
    
    September 30,2006
    
    2006Long Lived Assets:United States
    
    $
    33,828
    
    
    $
    33,775Germany
    
    
    664
    
    
    
    667Other
    
    
    27
    
    
    
    22$
    34,519
    
    
    $
    34,464
 
 *
    
    No individual country represents more than 10% of total revenue.   17




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##### Table of Contents



Subscription
    
    ProfessionalServices
    
    ServicesInternet Test and Measurement:Application Perspective
    
    
    XDiagnostic Services
    
    
    XEnterprise Adapters
    
    
    XLoadPro
    
    
    
    
    
    
    XNetMechanic
    
    
    XProfessional Services
    
    
    
    
    
    
    XRed Alert
    
    
    XStreaming Perspective
    
    
    XTest Perspective
    
    
    XTransaction Perspective
    
    
    XWebIntegrity
    
    
    XWeb Site Perspective
    
    
    XVoice Perspective
    
    
    XPerformance Scoreboard
    
    
    XMobile Test and Measurement:Mobile Application Perspective
    
    
    XMobile Device Perspective
    
    
    XSIGOS SITE
    
    
    XSIGOS Global Roamer
    
    
    XCustomer Experience Management:WebEffective
    
    
    X
    
    
    
    XWebExcellence
    
    
    X
    
    
    
    X
  2006
    
    
    2005(in thousands)For the three months ended December 31:Internet
    
    $
    10,381
    
    
    $
    9,909Mobile
    
    
    3,203
    
    
    
    539Customer experience management
    
    
    2,231
    
    
    
    3,268Total Revenue
    
    $
    15,815
    
    
    $
    13,716
 (14) Recently Issued Accounting Pronouncements
  18




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##### Table of Contents




    
    Registrants should quantify errors using both the rollover approach (current year
statement of operations effect) and iron curtain approaches (year end balance sheet
effect) and evaluate whether either approach results in quantifying a misstatement that,
when all relevant quantitative and qualitative factors are considered, is material.
    
    If correcting the item in the current year materially affects the current year but the
item was not material in any prior year, the prior year financial statements should be
corrected, even though such revision previously was and continues to be immaterial to the
prior year financial statements. However, in this circumstance, correcting prior year
financial statements for immaterial errors does not require amending previously filed
financial statements. The correction can be made the next time the prior year financial
statements are filed.
    
    For purposes of evaluating materiality under the iron curtain approach, all
uncorrected errors on the balance sheet are presumed to be reversed into the statement of
operations in the current period even though some or all of the uncorrected difference may
relate to periods prior to the latest statement of operations presented and, therefore,
would only impact opening accumulated earnings (deficit). If the amount of the uncorrected
difference(s) is determined to be material to the current period statement of operations,
then such amount would be deemed material and would have to be corrected for in the manner
set forth above.
  
    
    Restatement of prior years is not required if the registrant properly applied its
previous approach, either rollover or iron curtain approach, so long as all relevant
qualitative factors were considered.
    
    The SEC Staff will not object if a registrant records a one-time cumulative effect
adjustment to correct errors existing in prior years that previously had been considered
immaterial, quantitatively and qualitatively, based on the appropriate use of the
registrants previous approach.
    
    If prior years are not restated, the cumulative effect adjustment is recorded in opening
accumulated earnings (deficit) as of the beginning of the fiscal year of adoption (e.g.
October 2006 for the Company).
    
    At transition, registrants electing not to restate prior periods are required to
disclose the nature and amount of each individual error being corrected for in the
cumulative adjustment. The disclosure should also include when and how each error being
corrected arose and the fact that the errors had previously been considered immaterial.
  19




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20




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##### Table of Contents



Item 2. Management Discussion and Analysis of Financial Condition and Results of Operations
 discussion of the financial condition and results of operations of Keynote Systems,
Inc. (referred to herein as we, us, Keynote or the Company) should be read in conjunction
with the Managements Discussion and Analysis of Financial Condition and Results of Operations and
the Consolidated Financial Statements and the Notes thereto included in the Companys Annual Report
on Form 10-K for the year ended September 30, 2006, and subsequent filings with the Securities and
Exchange Commission (the SEC).
  Overview
    21




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##### Table of Contents



Critical Accounting Policies and Estimates
  
    
    Revenue recognition
    
    Allowance for doubtful accounts and billing allowance
    
    Inventories and inventory valuation
    
    Allocation of purchase price for business combinations
    
    Goodwill, identifiable intangible assets, and long-lived assets
    
    Stock-based compensation
    
    Income taxes, deferred income taxes and deferred income tax liabilities
 Revenue Recognition
  
    
    Evidence of an arrangement,
    
    Delivery,
    
    Fixed or determinable fee, and
    
    Collection is deemed reasonably assured.
 22




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##### Table of Contents



Subscription Services Revenue:
     Professional Services Revenue:
  23




---



##### Table of Contents



Deferred Revenue:
 Domestic
    
    
    International
    
    
    TotalNet deferred revenue
    
    $
    6,659
    
    
    $
    8,050
    
    
    $
    14,709Addback: unpaid deferred revenue
    
    
    1,820
    
    
    
    7,090
    
    
    
    8,910Gross deferred revenue at December 31, 2006
    
    $
    8,479
    
    
    $
    15,140
    
    
    $
    23,619Net deferred revenue
    
    $
    5,936
    
    
    $
    4,713
    
    
    $
    10,649Addback: unpaid deferred revenue
    
    
    804
    
    
    
    1,453
    
    
    
    2,257Gross deferred revenue at September 30, 2006
    
    $
    6,740
    
    
    $
    6,166
    
    
    $
    12,906
   Deferred Costs:
 Allowance for Doubtful Accounts and Billing Allowance
    24




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##### Table of Contents



Inventories and Inventory Valuation
    Allocation of Purchase Price for Business Combinations
  Goodwill, Identifiable Intangible Assets and Long-Lived Assets
   
    
    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; and
    
    our market capitalization relative to net book value.
   25




---



##### Table of Contents



Stock-Based Compensation
  Income Taxes, Deferred Income Tax Assets and Deferred Income Tax Liabilities
     26




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##### Table of Contents



Results of Operations
  Three Months EndedDecember 31,2006
    
    
    2005Revenue:Subscription services
    
    
    80.4
    %
    
    
    71.6
    %Professional services
    
    
    19.6
    
    
    
    28.4Total revenue
    
    
    100.0
    
    
    
    100.0Expenses:Costs of subscription services
    
    
    19.9
    
    
    
    10.6Costs of professional services
    
    
    13.4
    
    
    
    17.8Research and development
    
    
    18.1
    
    
    
    14.5Sales and marketing
    
    
    29.3
    
    
    
    24.6Operations
    
    
    11.6
    
    
    
    12.0General and administrative
    
    
    15.0
    
    
    
    16.1Excess occupancy income
    
    
    (0.1
    )
    
    
    0.0Amortization of identifiable intangible assets
    
    
    4.8
    
    
    
    2.9Total expenses
    
    
    112.0
    
    
    
    98.5(Loss) income from operations
    
    
    (12.0
    )
    
    
    1.5Interest
income and other, net
    
    
    7.1
    
    
    
    8.1Net (loss) income before benefit (provision) for income taxes
    
    
    (4.9
    )
    
    
    9.6Benefit (provision) for income taxes
    
    
    6.6
    
    
    
    (5.3
    )Net income
    
    
    1.7
    %
    
    
    4.3
    %
 Comparison of the Quarters Ended December 31, 2006 and 2005
 Revenue
 For the three months ended December 31:
    
    2006
    
    
    2005
    
    
    % Change(In thousands)Subscription services
    
    $
    12,713
    
    
    $
    9,820
    
    
    
    29.5
    %Professional services
    
    
    3,102
    
    
    
    3,896
    
    
    
    (20.4
    )%Total revenue
    
    $
    15,815
    
    
    $
    13,716
    
    
    
    15.3
    %
 Subscription Services
 27




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##### Table of Contents



Professional Services
  Subscription
    
    ProfessionalServices
    
    ServicesInternet Test and Measurement:Application Perspective
    
    
    XDiagnostic Services
    
    
    XEnterprise Adapters
    
    
    XLoadPro
    
    
    
    
    
    
    XNetMechanic
    
    
    XProfessional Services
    
    
    
    
    
    
    XRed Alert
    
    
    XStreaming Perspective
    
    
    XTest Perspective
    
    
    XTransaction Perspective
    
    
    XWebIntegrity
    
    
    XWeb Site Perspective
    
    
    XVoice Perspective
    
    
    XPerformance Scoreboard
    
    
    XMobile Test and Measurement:Mobile Application Perspective
    
    
    XMobile Device Perspective
    
    
    XSIGOS Global Roamer
    
    
    XSIGOS SITE
    
    
    XCustomer Experience Management:WebEffective
    
    
    X
    
    
    
    XWebExcellence
    
    
    X
    
    
    
    X
 28




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##### Table of Contents



%For the Three Months Ended December 31,
    
    2006
    
    
    2005
    
    
    Change(In thousands)Internet Subscriptions
    
    $
    8,884
    
    
    $
    8,782
    
    
    
    1.2
    %Internet Engagements
    
    
    1,497
    
    
    
    1,127
    
    
    
    32.8
    %Total internet revenue
    
    
    10,381
    
    
    
    9,909
    
    
    
    4.8
    %Mobile Subscriptions
    
    
    3,203
    
    
    
    539
    
    
    
    494.2
    %Mobile Engagements
    
    
    
    
    
    
    
    
    
    
    
    %Total mobile revenue
    
    
    3,203
    
    
    
    539
    
    
    
    494.2
    %CEM Subscriptions
    
    
    626
    
    
    
    499
    
    
    
    25.5
    %CEM Engagements
    
    
    1,605
    
    
    
    2,769
    
    
    
    (42.0
    )%Total CEM revenue
    
    
    2,231
    
    
    
    3,268
    
    
    
    (31.7
    )%Total revenue
    
    $
    15,815
    
    
    $
    13,716
    
    
    
    15.3
    %
     Expenses:
 Costs of Subscription and Professional Services
 For the three months ended December 31:
    
    2006
    
    2005
    
    % Change(In thousands)Costs of subscription services
    
    $
    3,141
    
    
    $
    1,459
    
    
    
    115.3
    %Costs of professional services
    
    
    2,123
    
    
    
    2,445
    
    
    
    (13.2
    )%
 29




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##### Table of Contents



Costs of Subscription Service
 Costs of Professional Services.
 Research and Development
 For the three months ended December 31:
    
    2006
    
    2005
    
    % Change(In thousands)Research and development
    
    $
    2,872
    
    
    $
    1,989
    
    
    
    44.4
    %
  Sales and Marketing
 For the three months ended December 31:
    
    2006
    
    2005
    
    % Change(In thousands)Sales and marketing
    
    $
    4,629
    
    
    $
    3,369
    
    
    
    37.4
    %
  30




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##### Table of Contents



Operations
 For the three months ended December 31:

    
    2006
    
    2005
    
    % Change(In thousands)Operations
    
    $
    1,842
    
    
    $
    1,647
    
    
    
    11.8
    %
  General and Administrative
 For the three months ended December 31:
    
    2006
    
    2005
    
    % Change(In thousands)General and administrative
    
    $
    2,379
    
    
    $
    2,209
    
    
    
    7.7
    %
  Excess Occupancy Income
 For the three months ended December 31:
    
    2006
    
    2005
    
    % Change(In thousands)Excess
occupancy income
    
    $
    (27
    )
    
    $
    (10
    )
    
    
    170.0
    %
  Amortization of Identifiable Intangible Assets
 For the three months ended December 31:
    
    2006
    
    2005
    
    % Change(In thousands)Amortization of identifiable intangible assets
    
    $
    759
    
    
    $
    397
    
    
    
    91.2
    %
  31




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##### Table of Contents



Technology
    
    CustomerBased
    
    Based
    
    Trademark
    
    Covenant
    
    Backlog
    
    TotalNet carrying value at December 31, 2006
    
    $
    4,911
    
    
    $
    3,692
    
    
    $
    739
    
    
    $
    74
    
    
    $
    221
    
    
    $
    9,637
 Interest Income and Interest and Other Expenses
 For the three months ended December 31:
    
    2006
    
    2005
    
    % Change(In thousands)Interest income, interest and other expenses, net
    
    $
    1,121
    
    
    $
    1,108
    
    
    
    1.2
    %
  Benefit
(Provision) for Income Taxes
 For the three months ended December 31:
    
    2006
    
    2005
    
    % Change(In thousands)Benefit (provision) for income taxes
    
    $
    1,046
    
    
    $
    (732
    )
    
    
    (243.0
    )%
  Stock-based Compensation Expense
  Three months ended December 31,2006
    
    
    2005(in thousands)Costs of subscription services
    
    $
    36
    
    
    $
    Costs of professional services
    
    
    140
    
    
    
    121Research and development
    
    
    209
    
    
    
    186Sales and marketing
    
    
    281
    
    
    
    246Operations
    
    
    147
    
    
    
    150General and administrative
    
    
    107
    
    
    
    93Stock-based compensation expense included in
operating expenses related to stock options
and employee stock purchase plan
    
    $
    920
    
    
    $
    796
 32




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##### Table of Contents



Liquidity and Capital Resources
 December 31,
    
    September 30,2006
    
    2006(In thousands)Cash, cash equivalents and short-term investments
    
    $
    95,582
    
    
    $
    90,751Accounts receivable, net
    
    $
    7,735
    
    
    $
    7,122Working capital
    
    $
    72,809
    
    
    $
    80,765Days sales in accounts receivable (DSO) (a)
    
    
    45
    
    
    
    43
 
 (a)
    
    DSO is calculated as: ((ending net accounts receivable) / net sales for the
three months period) multiplied by number of days in the periodThe DSOs presented in the table above reflect the three months ended
December 31, 2006 and September 30, 2006. 2006
    
    2005(In thousands)For the three months ended December 31Cash provided by operating activities
    
    $
    4,680
    
    
    $
    3,505Cash provided by (used in) investing activities
    
    $
    22
    
    
    $
    (3,071
    )Cash provided by financing activities
    
    $
    731
    
    
    $
    283
 Cash, cash equivalents and short-term investments
  Cash provided by operating activities
   Cash provided by investing activities
  33




---



##### Table of Contents



Cash provided by financing activities
   Commitments
   Off Balance Sheet Arrangements
  Recently Issued Accounting Pronouncements
  34




---



##### Table of Contents




    
    Registrants should quantify errors using both the rollover approach (current year
statement of operations effect) and iron curtain approaches (year end balance sheet
effect) and evaluate whether either approach results in quantifying a misstatement that,
when all relevant quantitative and qualitative factors are considered, is material.
    
    If correcting the item in the current year materially affects the current year but the
item was not material in any prior year, the prior year financial statements should be
corrected, even though such revision previously was and continues to be immaterial to the
prior year financial statements. However, in this circumstance, correcting prior year
financial statements for immaterial errors does not require amending previously filed
financial statements. The correction can be made the next time the prior year financial
statements are filed.
    
    For purposes of evaluating materiality under the iron curtain approach, all
uncorrected errors on the balance sheet are presumed to be reversed into the statement of
operations in the current period even though some or all of the uncorrected difference may
relate to periods prior to the latest statement of operations presented and, therefore,
would only impact opening accumulated earnings (deficit). If the amount of the uncorrected
difference(s) is determined to be material to the current period statement of operations,
then such amount would be deemed material and would have to be corrected for in the manner
set forth above.
  
    
    Restatement of prior years is not required if the registrant properly applied its
previous approach, either rollover or iron curtain approach, so long as all relevant
qualitative factors were considered.
    
    The SEC Staff will not object if a registrant records a one-time cumulative effect
adjustment to correct errors existing in prior years that previously had been considered
immaterial, quantitatively and qualitatively, based on the appropriate use of the
registrants previous approach.
    
    If prior years are not restated, the cumulative effect adjustment is recorded in opening
accumulated earnings (deficit) as of the beginning of the fiscal year of adoption (e.g.
October 2006 for us).
    
    At transition, registrants electing not to restate prior periods are required to
disclose the nature and amount of each individual error being corrected for in the
cumulative adjustment. The disclosure should also include when and how each error being
corrected arose and the fact that the errors had previously been considered immaterial.
  35




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##### Table of Contents



Item 3. Quantitative and Qualitative Disclosures About Market Risks.
 Interest Rate Sensitivity.
 Foreign Currency Fluctuations and Derivative Transactions.
 
 Item 4. Controls and Procedures
 (a) Changes in Internal Controls
  (b) Evaluation of Disclosure Controls and Procedures
   36




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##### Table of Contents



PART IIOTHER INFORMATION
 
 Item 1. Legal Proceedings
   
 Item 1A.Risk Factors
 We have incurred in the past and may in the future continue to incur losses, and we may not achieve
and thereafter sustain profitability.
  The success of our business depends on customers renewing their subscriptions for our services
and purchasing additional services.
   37




---



##### Table of Contents



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.
  
    
    The rate of new and renewed subscriptions to our services;
    
    The effect of any unforeseen or unplanned operating expenses;
    
    The amount and timing of any reductions by our customers in their usage of our services;
    
    Our ability to increase the number of Web sites we measure and the scope of services we offer for our
existing customers in a particular quarter;
    
    Our ability to attract and retain new customers in a quarter, particularly larger enterprise customers;
    
    The timing and service period of orders received during a quarter;
    
    Our ability to successfully introduce new products and services to offset any reductions in revenue
from services that are not as widely used or that are experiencing decreased demand;
    
    The timing and amount of professional services revenue, which is difficult to predict because this is
dependent on the number of professional 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;
    
    Our success in obtaining additional professional services engagements;
    
    Our ability to increase revenue from each of our three service lines;
    
    The timing and amount of operating costs and capital expenditures relating to changes of our domestic
and international operations infrastructure; and
    
    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.
  Our operating results could be harmed if sales of Internet subscriptions decline.
  Our mobile services may not continue to grow as rapidly, which could harm our business.
  Improvements to the infrastructure of the Internet and mobile networks could reduce or
eliminate demand for our Internet and mobile services.
  38




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##### Table of Contents



If we do not continually improve our services in response to technological changes, including
changes to the Internet and mobile networks, we may encounter difficulties retaining existing
customers and attracting new customers.
  We face competition that could make it difficult for us to acquire and retain customers.
       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.
  39




---



##### Table of Contents



If we do not complement our direct sales force with relationships with other companies
to help market our services, we may not be able to grow our business.
   We must retain qualified personnel in a competitive marketplace, or we may not be able to grow our
business.
  If the market does not accept our professional services, our results of operations could
be harmed.
  The success of our business depends on the continued use of the Internet by business and consumers
for e-business and communications.
  
    
    security concerns including the potential for fraud or theft of stored data and
information communicated over the Internet and mobile networks;
    
    inconsistent quality of service, including well-publicized outages of popular Web sites;
    
    delay in the development or adoption of new standards;
    
    inability to integrate business applications with the Internet; and
    
    the need to operate with multiple and frequently incompatible products.
 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.
  40




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##### Table of Contents



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.
     Our measurement computers and mobile devices 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.
  Others might bring infringement claims against us, our customers or our suppliers that could harm
our business.
  41




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##### Table of Contents



Our business will be susceptible to additional risks associated with international operations.
  
    
    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.
  Compliance with new rules and regulations concerning corporate governance may increase our costs
and could harm our results of operations.
   We have anti-takeover protections that may delay or prevent a change in control that could benefit
our stockholders.
  
    
    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.
 42




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##### Table of Contents



Industry consolidation may lead to increased competition and may harm our operating results.
  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 may face difficulties assimilating our acquisitions and may incur costs associated with any
future acquisitions.
  
    
    difficulties in assimilating acquired personnel, operations and technologies;
    
    difficulties in managing a larger organization with geographically dispersed operations;
    
    unanticipated costs associated with the acquisition or incurring of additional unknown liabilities;
    
    diversion of managements attention from other business concerns;
    
    entry in new businesses in which we have little direct experience;
    
    difficulties in marketing additional services to the acquired companies customer base or to our
customer base;
    
    adverse effects on existing business relationships with resellers of our services, our customers
and other business partners;
    
    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.
 43




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##### Table of Contents



Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 Item 3. Defaults Upon Senior Securities
  
 Item 4. Submission of Matters to a Vote of Security Holders
  
 Item 5. Other Information
  44




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##### Table of Contents



Item 6. Exhibits
 EXHIBIT INDEX
 Exhibit
    
    Incorporated by ReferenceFiledForm
    
    File No.
    
    Filing Date
    
    Exhibit No.
    
    Herewith10.22
Agreement with B. Riley & Co., Inc. dated December 1, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X10.23
Agreement with Craig-Hallum Capital Group LLC dated December 1, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X31.1 Certification of Periodic Report by Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X31.2 Certification of Periodic Report by Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X32.1 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 *
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X32.2 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 *
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X
 
 *
    
    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. 45




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##### Table of Contents



SIGNATURES
  KEYNOTE SYSTEMS, INC.By:
    
    /s/ UMANG GUPTA

Umang GuptaChairman of the Board and Chief Executive Officer(Principal Executive Officer)By:
    
    /s/ ANDREW HAMER

Andrew HamerVice President and Chief Financial Officer(Principal Financial and Accounting Officer)
 46




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##### Table of Contents



EXHIBIT INDEX
 Exhibit
    
    Incorporated by ReferenceFiledForm
    
    File No.
    
    Filing Date
    
    Exhibit No.
    
    Herewith10.22
Agreement with B. Riley & Co., Inc. dated December 1, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X10.23
Agreement with Craig-Hallum Capital Group LLC dated December 1, 2006
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X31.1 Certification of Periodic Report by Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X31.2 Certification of Periodic Report by Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X32.1 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 *
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X32.2 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 *
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    X
 
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    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. 47