##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 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
    
    94-3226488(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)777 Mariners Island Blvd., San Mateo, CA
    
    94404(Address of principal executive offices)
    
    (Zip Code)
 Registrants telephone number, including area code: (650) 403-2400
 þ o
  Large accelerated filer    o
    
    Accelerated filer    þ
    
    Non-accelerated filer    o
 o þ
  Class
    
    Shares outstanding as of August 8, 2006
 Common Stock, $.001 par value
    
    19,055,393 including 1,985,728
treasury shares




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##### 



KEYNOTE SYSTEMS, INC.
 TABLE OF CONTENTS
 PagePART IFINANCIAL INFORMATIONItem 1. Financial Statements
    
    
    3Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    22Item 3. Quantitative and Qualitative Disclosures About Market Risks
    
    
    38Item 4. Controls and Procedures
    
    
    39PART IIOTHER INFORMATIONItem 1. Legal Proceedings
    
    
    39Item 1A. Risk Factors
    
    
    39Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    47Item 3. Defaults Upon Senior Securities
    
    
    48Item 4. Submission of Matters to a Vote of Security Holders
    
    
    48Item 5. Other Information
    
    
    48Item 6. Exhibits
    
    
    49Signatures
    
    
    50EXHIBIT 10.1EXHIBIT 10.2EXHIBIT 10.3EXHIBIT 10.4EXHIBIT 10.5EXHIBIT 10.6EXHIBIT 10.7EXHIBIT 10.8EXHIBIT 10.9EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  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
 PageCondensed Consolidated Balance Sheets as of June 30, 2006 and September 30, 2005
    
    
    4Condensed Consolidated Statements of Operations for the three and nine months ended June 30, 2006 and 2005
    
    
    5Condensed Consolidated Statements of Cash Flows for the nine months ended June 30, 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)
 June 30,
    
    
    September 30,2006
    
    
    2005ASSETSCurrent assets:Cash and cash equivalents
    
    $
    46,544
    
    
    $
    46,934Short-term investments
    
    
    50,117
    
    
    
    86,869Total cash, cash equivalents, and short-term investments
    
    
    96,661
    
    
    
    133,803Accounts receivable, less allowance for doubtful
accounts and billing adjustment of $413 and $534 as of
June 30, 2006 and September 30, 2005, respectively
    
    
    6,279
    
    
    
    6,387Prepaid and other current assets
    
    
    2,685
    
    
    
    2,623Inventories
    
    
    1,001
    
    
    
    Deferred tax assets
    
    
    965
    
    
    
    405Total current assets
    
    
    107,591
    
    
    
    143,218Property and equipment, net
    
    
    34,700
    
    
    
    34,669Goodwill
    
    
    48,619
    
    
    
    21,186Identifiable intangible assets, net
    
    
    10,929
    
    
    
    3,760Deferred tax assets
    
    
    6,707
    
    
    
    6,995Total assets
    
    $
    208,546
    
    
    $
    209,828LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,678
    
    
    $
    538Accrued expenses
    
    
    10,307
    
    
    
    9,088Current portion of capital lease obligation
    
    
    38
    
    
    
    40Deferred revenue
    
    
    9,733
    
    
    
    6,217Total current liabilities
    
    
    21,756
    
    
    
    15,883Long-term portion of capital lease obligation
    
    
    56
    
    
    
    27Long-term deferred tax liability
    
    
    2,718
    
    
    
    Total liabilities
    
    
    24,530
    
    
    
    15,910Commitments and contingencies  see Note 11Stockholders equity:Common stock
    
    
    19
    
    
    
    20Treasury stock
    
    
    (14,531
    )
    
    
    (11,037
    )Additional paid-in capital
    
    
    328,505
    
    
    
    335,350Accumulated deficit
    
    
    (131,599
    )
    
    
    (130,044
    )Accumulated other comprehensive income (loss)
    
    
    1,622
    
    
    
    (371
    )Total stockholders equity
    
    
    184,016
    
    
    
    193,918Total liabilities and stockholders equity
    
    $
    208,546
    
    
    $
    209,828
  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
    
    
    Nine months endedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    

2005Revenue:Subscription services
    
    $
    11,448
    
    
    $
    10,043
    
    
    $
    31,215
    
    
    $
    29,718Professional services
    
    
    2,419
    
    
    
    3,422
    
    
    
    9,107
    
    
    
    10,500Total revenue
    
    
    13,867
    
    
    
    13,465
    
    
    
    40,322
    
    
    
    40,218Costs and expenses:Costs of subscription services
    
    
    2,442
    
    
    
    1,308
    
    
    
    5,453
    
    
    
    3,968Costs of professional services
    
    
    2,314
    
    
    
    2,088
    
    
    
    6,969
    
    
    
    6,956Research and development
    
    
    2,673
    
    
    
    1,829
    
    
    
    6,753
    
    
    
    5,865Sales and marketing
    
    
    4,653
    
    
    
    3,154
    
    
    
    12,042
    
    
    
    9,689Operations
    
    
    1,867
    
    
    
    1,543
    
    
    
    5,361
    
    
    
    4,548General and administrative
    
    
    2,443
    
    
    
    2,352
    
    
    
    6,354
    
    
    
    5,986Excess occupancy costs
    
    
    38
    
    
    
    105
    
    
    
    (12
    )
    
    
    353Amortization of identifiable intangible assets
    
    
    798
    
    
    
    591
    
    
    
    1,613
    
    
    
    1,932In-process research and development
    
    
    840
    
    
    
    
    
    
    
    840
    
    
    
    Total expenses*
    
    
    18,068
    
    
    
    12,970
    
    
    
    45,373
    
    
    
    39,297(Loss) income from operations
    
    
    (4,201
    )
    
    
    495
    
    
    
    (5,051
    )
    
    
    921Interest income and other, net
    
    
    1,187
    
    
    
    833
    
    
    
    3,575
    
    
    
    2,319(Loss) income before provision for income taxes
    
    
    (3,014
    )
    
    
    1,328
    
    
    
    (1,476
    )
    
    
    3,240Benefit (provision) for income taxes
    
    
    1,026
    
    
    
    (93
    )
    
    
    (79
    )
    
    
    (217
    )Net (loss) income
    
    $
    (1,988
    )
    
    $
    1,235
    
    
    $
    (1,555
    )
    
    $
    3,023Net (loss) income per share:Basic
    
    $
    (0.11
    )
    
    $
    0.06
    
    
    $
    (0.08
    )
    
    $
    0.15Diluted
    
    $
    (0.11
    )
    
    $
    0.06
    
    
    $
    (0.08
    )
    
    $
    0.14Shares used in computing basic and diluted net
(loss) income per share:Basic
    
    
    18,384
    
    
    
    19,792
    
    
    
    18,670
    
    
    
    19,892Diluted
    
    
    18,384
    
    
    
    20,691
    
    
    
    18,670
    
    
    
    21,059
 
 *Stock-based compensation by category:Costs of subscription services
    
    $
    42
    
    
    $
    
    
    
    $
    42
    
    
    $
    Costs of professional services
    
    
    119
    
    
    
    
    
    
    
    401
    
    
    
    Research and development
    
    
    226
    
    
    
    
    
    
    
    627
    
    
    
    Sales and marketing
    
    
    266
    
    
    
    
    
    
    
    767
    
    
    
    Operations
    
    
    151
    
    
    
    
    
    
    
    484
    
    
    
    General and adminstrative
    
    
    121
    
    
    
    
    
    
    
    308
    
    
    
    
  5




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 Nine months endedJune 30,2006
    
    
    2005Cash flows from operating activities:Net (loss) income
    
    $
    (1,555
    )
    
    $
    3,023Adjustments to reconcile net (loss) income to net cash provided by operating activities:Depreciation and amortization of property, equipment and software
    
    
    2,888
    
    
    
    2,455Stock-based compensation
    
    
    2,629
    
    
    
    Charges to bad debt and billing adjustment reserves
    
    
    (246
    )
    
    
    (336
    )Amortization of debt investment premium
    
    
    335
    
    
    
    2,391Amortization of identifiable intangible assets
    
    
    1,613
    
    
    
    1,932In-process research and development
    
    
    840
    
    
    
    Changes in operating assets and liabilities, net of acquired assets and liabilities assumed:Accounts receivable, net
    
    
    1,681
    
    
    
    (1,398
    )Inventories
    
    
    (85
    )
    
    
    Deferred tax assets
    
    
    (774
    )
    
    
    Prepaids and other current assets
    
    
    450
    
    
    
    269Accounts payable and accrued expenses
    
    
    (243
    )
    
    
    (294
    )Deferred revenue
    
    
    1,851
    
    
    
    (643
    )Net cash provided by operating activities
    
    
    9,384
    
    
    
    7,399Cash flows from investing activities:Purchases of property, equipment and software
    
    
    (2,184
    )
    
    
    (2,455
    )Purchase of businesses and assets, net
    
    
    (31,474
    )
    
    
    (739
    )Sale of short-term investments
    
    
    94,589
    
    
    
    118,577Purchases of short-term investments
    
    
    (57,481
    )
    
    
    (87,070
    )Issuance of
note receivable to an unaffiliated third party
    
    
    (300
    )
    
    
    Net cash provided by investing activities
    
    
    3,150
    
    
    
    28,313Cash flows from financing activities:Payment of capital leases
    
    
    (34
    )
    
    
    (33
    )Proceeds from issuance of common stock and exercise of stock options
    
    
    3,190
    
    
    
    5,425Repurchase of outstanding common stock
    
    
    (16,158
    )
    
    
    (11,690
    )Final payment associated with prior year tender offers
    
    
    
    
    
    
    (400
    )Net cash used in financing activities
    
    
    (13,002
    )
    
    
    (6,698
    )Effect of exchange rate changes on cash and cash equivalents
    
    
    78
    
    
    
    Net (decrease) increase in cash and cash equivalents
    
    
    (390
    )
    
    
    29,014Cash and cash equivalents at beginning of the period
    
    
    46,934
    
    
    
    9,932Cash and cash equivalents at end of the period
    
    $
    46,544
    
    
    $
    38,946Cash paid during the period for income taxes, net
    
    $
    148
    
    
    $
    221Retirement of treasury stock
    
    $
    12,619
    
    
    $
    2,317
  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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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
    Three Months Ended June 30,
    
    Nine Months Ended June 30,2006
    
    2005*
    
    2006
    
    2005*Volatility-stock options
    
    
    30
    %
    
    
    33.6
    %
    
    
    31.2
    %
    
    
    33.6
    %Volatility-stock purchases
    
    
    30
    %
    
    
    33.0
    %
    
    
    29
    %
    
    
    33.0
    %Risk-free interest rates-stock options
    
    
    4.9
    %
    
    
    3.7
    %
    
    
    4.6
    %
    
    
    3.6
    %Risk-free interest rates-stock purchases
    
    
    3.7
    %
    
    
    1.7
    %
    
    
    3.7
    %
    
    
    1.7
    %Expected life (in years)-stock options
    
    
    3.67
    
    
    
    2.5
    
    
    
    3.44
    
    
    
    2.5Expected life (in years)-stock purchases
    
    
    1.25
    
    
    
    1.25
    
    
    
    1.25
    
    
    
    1.25Dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
 
 *
    
    The assumptions used in the three and nine months ended June 30, 2005 were used to calculate
pro forma net income and net income per share as disclosed in Note 1(d) Pro-Forma Disclosure for
Three and Nine Months ended June 30, 2005 per SFAS No. 123.  WeightedAverageWeighted
    
    Remaining
    
    AggregateAverage
    
    Contractual
    
    IntrinsicShares
    
    Exercise Price
    
    Term (Years)
    
    ValueOutstanding at October 1, 2005
    
    
    6,236
    
    
    $
    13.42Granted
    
    
    105
    
    
    
    13.13Exercised
    
    
    (222
    )
    
    
    7.98Forfeited, canceled or expired
    
    
    (124
    )
    
    
    11.94Outstanding at December 31, 2005
    
    
    5,995
    
    
    $
    13.65
    
    
    
    7.3
    
    
    $
    14,320Granted
    
    
    858
    
    
    
    11.75Exercised
    
    
    (69
    )
    
    
    9.15Forfeited, canceled or expired
    
    
    (245
    )
    
    
    12.14Outstanding at March 31, 2006
    
    
    6,539
    
    
    $
    13.50
    
    
    
    7.3
    
    
    $
    8,662Granted
    
    
    783
    
    
    
    10.99Exercised
    
    
    (54
    )
    
    
    7.35Forfeited, canceled or expired
    
    
    (697
    )
    
    
    12.12Outstanding at June 30, 2006
    
    
    6,571
    
    
    $
    13.40
    
    
    
    7.1
    
    
    $
    5,650Exercisable at June 30, 2006
    
    
    3,645
    
    
    $
    14.70
    
    
    
    5.4
    
    
    $
    5,553
  8




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
  WeightedAverageGrant-DateShares
    
    Fair ValueStock option awards:Nonvested balance at October 1, 2005
    
    
    2,886
    
    
    $
    2.99Stock options granted
    
    
    105
    
    
    
    3.63Vested
    
    
    (221
    )
    
    
    2.95Forfeited
    
    
    (116
    )
    
    
    3.00Nonvested balance at December 31, 2005
    
    
    2,654
    
    
    $
    3.01Stock options granted
    
    
    858
    
    
    
    3.57Vested
    
    
    (188
    )
    
    
    3.15Forfeited
    
    
    (230
    )
    
    
    3.02Nonvested balance at March 31, 2006
    
    
    3,094
    
    
    $
    3.15Stock options granted
    
    
    783
    
    
    
    3.21Vested
    
    
    (294
    )
    
    
    3.06Forfeited
    
    
    (657
    )
    
    
    3.04Nonvested balance at June 30, 2006
    
    
    2,926
    
    
    $
    3.20
    Three Months Ended
    
    Nine Months EndedJune 30, 2005
    
    June 30, 2005Net income, as reported:
    
    $
    1,235
    
    
    $
    3,023Less: Stock-based compensation expense determined using the fair value
method for all awards, zero tax effect*
    
    
    (734
    )
    
    
    (2,789
    )Pro forma net income
    
    $
    501
    
    
    $
    234Basic net income per share:Basic  as reported
    
    $
    0.06
    
    
    $
    0.15Basic  pro forma
    
    $
    0.03
    
    
    $
    0.01Diluted  as reported
    
    $
    0.06
    
    
    $
    0.14Diluted  pro forma
    
    $
    0.02
    
    
    $
    0.01
 
 *
    
    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. 9




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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
 Excess Occupancy Costs
  Twelve Months Ended June 30:2007
    
    $
    1,1252008
    
    
    1,1142009
    
    
    9032010
    
    
    3932011
    
    
    97Thereafter
    
    
    312Total future minimum rents receivable
    
    $
    3,944
 (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 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. If milestones are not included in the
project, delivery is based on labor hours incurred as a percentage of total
estimated labor hours.
    
    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.
 10




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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
 
    
    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:
  11




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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
 (3) Comprehensive (Loss) Income
  Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Net (loss) income
    
    $
    (1,988
    )
    
    $
    1,235
    
    
    $
    (1,555
    )
    
    $
    3,023Net unrealized (loss) gain on available-for-sale investments
    
    
    (13
    )
    
    
    298
    
    
    
    136
    
    
    
    (76
    )Foreign currency translation gain (loss)*
    
    
    1,837
    
    
    
    (65
    )
    
    
    1,857
    
    
    
    (43
    )Comprehensive (loss) income
    
    $
    (164
    )
    
    $
    1,468
    
    
    $
    438
    
    
    $
    2,904
 
 *
    
    The tax effect on the foreign currency translation (loss) gain is immaterial. (4) Financial Instruments and Concentration of Risk
     12




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
 (5) Cash, Cash Equivalents, and Short-Term Investments
   Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    EstimatedCost
    
    
    Gains
    
    
    Losses
    
    
    Market ValueCash
    
    $
    7,602
    
    
    $
    
    
    
    $
    
    
    
    $
    7,602Commercial paper
    
    
    14,205
    
    
    
    3
    
    
    
    
    
    
    
    14,208Money market fund
    
    
    1,265
    
    
    
    
    
    
    
    
    
    
    
    1,265Other money market securities
    
    
    23,469
    
    
    
    
    
    
    
    
    
    
    
    23,469Total
    
    $
    46,541
    
    
    $
    3
    
    
    $
    
    
    
    $
    46,544
  Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    EstimatedCost
    
    
    Gains
    
    
    Losses
    
    
    Market ValueState government agency securities
    
    $
    9,413
    
    
    $
    
    
    
    $
    
    
    
    $
    9,413FNMA and FHLMC securitites
    
    
    4,049
    
    
    
    
    
    
    
    (26
    )
    
    
    4,023Other U.S. government agency securities
    
    
    9,125
    
    
    
    
    
    
    
    (68
    )
    
    
    9,057Corporate bonds and commercial paper
    
    
    27,913
    
    
    
    3
    
    
    
    (292
    )
    
    
    27,624Total
    
    $
    50,500
    
    
    $
    3
    
    
    $
    (386
    )
    
    $
    50,117
  EstimatedAmortized
    
    
    MarketCost
    
    
    ValueYear ending June 30,2007
    
    $
    33,486
    
    
    $
    33,2812008
    
    
    17,014
    
    
    
    16,836Total
    
    $
    50,500
    
    
    $
    50,117
 13




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
 (6) Inventories
  June 30,
    
    
    September 30,2006
    
    
    2005Work-in-process
    
    $
    237
    
    
    $
    Finished goods
    
    
    764
    
    
    
    Total
    
    $
    1,001
    
    
    $
    
 (7) Goodwill and Identifiable Intangible Assets
  Balance at September 30, 2005
    
    $
    21,186Additional goodwill for acquisition of the GomezPro business of Watchfire Corporation (Note 9)
    
    
    2,379Additional goodwill for acquisition of SIGOS Systemintegration GmbH business (Note 9)
    
    
    23,583Translation
adjustments
    
    
    1,471Balance at June 30, 2006
    
    $
    48,619
  Technology
    
    
    CustomerBased
    
    
    Based
    
    
    Trademark
    
    
    TotalAs of June 30, 2006:Gross carrying value
    
    $
    15,952
    
    
    $
    9,656
    
    
    $
    1,119
    
    
    $
    26,727Accumulated amortization
    
    
    (10,209
    )
    
    
    (5,299
    )
    
    
    (290
    )
    
    
    (15,798
    )Net carrying value at June 30, 2006
    
    $
    5,743
    
    
    $
    4,357
    
    
    $
    829
    
    
    $
    10,929As of September 30, 2005:Gross carrying value
    
    $
    11,623
    
    
    $
    6,064
    
    
    $
    250
    
    
    $
    17,937Accumulated amortization
    
    
    (9,263
    )
    
    
    (4,664
    )
    
    
    (250
    )
    
    
    (14,177
    )Net carrying value at September 30, 2005
    
    $
    2,360
    
    
    $
    1,400
    
    
    $
    
    
    
    $
    3,760
  14




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
 (8) Net (Loss) Income Per Share
   Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Numerator:Net (loss) income
    
    $
    (1,988
    )
    
    $
    1,235
    
    
    $
    (1,555
    )
    
    $
    3,023Denominator:Denominator for basic net (loss)
income per shareweighted average
shares
    
    
    18,384
    
    
    
    19,792
    
    
    
    18,670
    
    
    
    19,892Incremental common shares
attributable to shares issuable
under stock option plans
    
    
    
    
    
    
    899
    
    
    
    
    
    
    
    1,167Denominator for diluted net income
(loss) per shareweighted average
shares
    
    
    18,384
    
    
    
    20,691
    
    
    
    18,670
    
    
    
    21,059Basic net (loss) income per share
    
    $
    (0.11
    )
    
    $
    0.06
    
    
    $
    (0.08
    )
    
    $
    0.15Diluted net (loss) income per share
    
    $
    (0.11
    )
    
    $
    0.06
    
    
    $
    (0.08
    )
    
    $
    0.14
  (9) Acquisitions
 
 Cash paid
    
    $
    30,078Direct transaction costs
    
    
    1,186$
    31,264
  
  15




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
  Cash and cash equivalents
    
    $
    1,800Short-term investments
    
    
    489Accounts receivable
    
    
    1,244Prepaid expenses
    
    
    178Inventories
    
    
    863Property, plant, equipment and software
    
    
    691Deferred taxes
    
    
    269Intangible Assets:Customer-based intangibles (weighted-average amortization period of 5 years)
    
    
    3,248Technology-based intangibles (weighted-average amortization period of 5 years)
    
    
    3,754Tradenames and trademarks (weighted-average amortization period of 5 years)
    
    
    818In-process research and development
    
    
    840Goodwill
    
    
    23,583Total assets acquired
    
    
    37,777Liabilities assumed
    
    
    (1,709
    )Capital lease obligation
    
    
    (56
    )Deferred revenue
    
    
    (1,444
    )Long-term deferred tax liability
    
    
    (3,304
    )Total purchase price, including direct acquisition costs
    
    $
    31,264
   Nine Months Ended
    
    Nine Months EndedJune 30, 2006
    
    June 30, 2005Revenue
    
    $
    47,835
    
    
    $
    50,889Net income*
    
    $
    109
    
    
    $
    5,757Net income per share-basic
    
    $
    0.01
    
    
    $
    0.29Net income
per share-fully diluted
    
    $
    0.01
    
    
    $
    0.27Shares used in pro forma per share computation-basic
    
    
    18,670
    
    
    
    19,892Shares used in pro forma per share computation-fully diluted
    
    
    19,454
    
    
    
    21,059
 
 *
    
    Included in the unaudited pro-forma net income for the nine months ended June 30, 2006 is a
charge of approximately $840,000 related to acquired in-process research and development costs. 16




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
   Accounts receivable
    
    $
    8Prepaid and other assets
    
    
    25Customer-based intangible assets (weighted-average amortization period of 3.3 years)
    
    
    150Technology-based intangible assets (weighted-average amortization period of 3.2 years)
    
    
    330Goodwill
    
    
    2,379Liabilities assumed
    
    
    (174
    )Deferred revenue
    
    
    (127
    )Total purchase price, including direct acquisition costs
    
    $
    2,591
    (10) Income Taxes
     17




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
   (11) Commitments and Contingencies
 (A) Leases
  Operating
    
    
    CapitalTwelve months ended June 30:
    
    Leases
    
    
    Leases2007
    
    $
    674
    
    
    $
    412008
    
    
    530
    
    
    
    272009
    
    
    495
    
    
    
    162010
    
    
    504
    
    
    
    152011
    
    
    437
    
    
    
    3Thereafter
    
    
    1,182
    
    
    
    Total minimum lease payments
    
    $
    3,822
    
    
    
    102Less amounts representing interest
    
    
    
    
    
    
    (8
    )Present value of minimum lease payments
    
    
    
    
    
    
    94Less current portion of capital lease obligation
    
    
    
    
    
    
    38Long-term portion of capital lease obligation
    
    
    
    
    
    $
    56
  (B) Commitments
  (C) Legal Proceedings
  18




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##### Table of Contents



KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
   (D) Warranties
  (E) Indemnification
  (12) Stock Repurchase Program
      (13) Geographic and Segment Information
  19




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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
  Three Months Ended
    
    
    Nine Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Revenues:United States
    
    $
    11,681
    
    
    $
    12,060
    
    
    $
    35,669
    
    
    $
    36,674Europe*
    
    
    1,829
    
    
    
    1,250
    
    
    
    4,040
    
    
    
    3,090Other*
    
    
    357
    
    
    
    155
    
    
    
    613
    
    
    
    454$
    13,867
    
    
    $
    13,465
    
    
    $
    40,322
    
    
    $
    40,218
 June 30,
    
    September 30,2006
    
    2005Long Lived Assets:United States
    
    $
    33,955
    
    
    $
    34,665Germany
    
    
    727
    
    
    
    Other
    
    
    18
    
    
    
    4$
    34,700
    
    
    $
    34,669
    Subscription
    
    ProfessionalServices
    
    ServicesService Level Management: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:Wireless Perspective
    
    XMobile Application Perspective
    
    XSIGOS SITE
    
    XCustomer Experience Management:WebEffective
    
    X
    
    XWebExcellence
    
    X
    
    X
 20




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KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Continued)
  2006
    
    
    2005(in thousands)For the three months ended June 30:Service level management
    
    $
    9,623
    
    
    $
    10,041Mobile
    
    
    1,949
    
    
    
    442Customer experience management
    
    
    2,295
    
    
    
    2,982Total Revenue
    
    $
    13,867
    
    
    $
    13,465For the nine months ended June 30:Service level management
    
    $
    29,313
    
    
    $
    29,353Mobile
    
    
    2,976
    
    
    
    1,583Customer experience management
    
    
    8,033
    
    
    
    9,282Total Revenue
    
    $
    40,322
    
    
    $
    40,218
 (14) Recently
Issued Accounting Pronouncements
   21




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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, 2005, and subsequent filings with the Securities and
Exchange Commission (the SEC).
  Overview
      22




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##### Table of Contents



Critical Accounting Policies and Estimates
  23




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##### Table of Contents




    
    Revenue recognition
    
    Allowance for doubtful accounts and billing allowance
    
    Valuation of inventory
    
    Allocation of purchase price for business combinations
    
    Impairment assessments of goodwill, identifiable purchased intangibles, and long-lived assets
    
    Stock-based compensation
    
    Accounting for income taxes and deferred income tax assets
 Revenue Recognition
    
    
    Evidence of an arrangement.We consider a customer signed quote, contract, or
equivalent document to be evidence of an arrangement.
    
    Delivery. For subscription services, delivery is considered to occur when the
customer has been provided with access to the subscription services. Our
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. If milestones are not included in the
project, delivery is based on labor hours incurred as a percentage of total
estimated labor hours.
    
    Fixed or determinable fee.We consider 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.
   24




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##### Table of Contents



Subscription Services Revenue:
   Professional Services Revenue:
   Allowance for Doubtful Accounts and Billing Allowance
    25




---



##### Table of Contents



Valuation of Inventory
    Allocation of Purchase Price for Business Combinations
  Impairment Assessments of Goodwill, Identifiable Purchased Intangibles 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.
   26




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##### Table of Contents



Stock-Based Compensation
  Accounting for Income Taxes and Deferred Income Tax Assets
     27




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##### Table of Contents



Results of Operations
  Three Months Ended
    
    Nine Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Revenue:Subscription services
    
    
    82.6
    %
    
    
    74.6
    %
    
    
    77.4
    %
    
    
    73.9
    %Professional services
    
    
    17.4
    
    
    
    25.4
    
    
    
    22.6
    
    
    
    26.1Total revenue
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0
    
    
    
    100.0Expenses:Costs of subscription services
    
    
    17.6
    
    
    
    9.7
    
    
    
    13.5
    
    
    
    9.9Costs of professional services
    
    
    16.7
    
    
    
    15.5
    
    
    
    17.3
    
    
    
    17.3Research and development
    
    
    19.2
    
    
    
    13.6
    
    
    
    16.7
    
    
    
    14.6Sales and marketing
    
    
    33.5
    
    
    
    23.4
    
    
    
    29.9
    
    
    
    24.1Operations
    
    
    13.5
    
    
    
    11.4
    
    
    
    13.3
    
    
    
    11.3General and administrative
    
    
    17.6
    
    
    
    17.5
    
    
    
    15.8
    
    
    
    14.9Excess occupancy costs
    
    
    0.3
    
    
    
    0.8
    
    
    
    0.0
    
    
    
    0.9Amortization of identifiable intangible assets
    
    
    5.8
    
    
    
    4.4
    
    
    
    4.0
    
    
    
    4.8In-process research and development
    
    
    6.1
    
    
    
    0.0
    
    
    
    2.1
    
    
    
    0.0Total expenses
    
    
    130.3
    
    
    
    96.3
    
    
    
    112.6
    
    
    
    97.8(Loss) income from operations
    
    
    (30.3
    )
    
    
    3.7
    
    
    
    (12.6
    )
    
    
    2.2Interest income, net
    
    
    8.6
    
    
    
    6.2
    
    
    
    8.9
    
    
    
    5.8Net (loss) income before provision for income taxes
    
    
    (21.7
    )
    
    
    9.9
    
    
    
    (3.7
    )
    
    
    8.0Benefit (provision) for income taxes
    
    
    7.4
    
    
    
    (0.7
    )
    
    
    (0.2
    )
    
    
    (0.5
    )Net (loss) income
    
    
    (14.3
    )%
    
    
    9.2
    %
    
    
    (3.9
    )%
    
    
    7.5
    %
 Comparison of Three and Nine Months Ended June 30, 2006 and 2005
 Revenue
 2006
    
    
    2005
    
    
    % Change(In thousands)For the three months ended June 30:Subscription services
    
    $
    11,448
    
    
    $
    10,043
    
    
    
    14.0
    %Professional services
    
    
    2,419
    
    
    
    3,422
    
    
    
    (29.3
    )%Total revenue
    
    $
    13,867
    
    
    $
    13,465
    
    
    
    3.0
    %For the nine months ended June 30:Subscription services
    
    $
    31,215
    
    
    $
    29,718
    
    
    
    5.0
    %Professional services
    
    
    9,107
    
    
    
    10,500
    
    
    
    (13.3
    )%Total revenue
    
    $
    40,322
    
    
    $
    40,218
    
    
    
    0.3
    %
 Subscription Services
 28




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##### Table of Contents



Professional Services
   Subscription
    
    ProfessionalServices
    
    ServicesService Level Management: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:Wireless Perspective
    
    XMobile Application Perspective
    
    XSIGOS SITE
    
    XCustomer Experience Management:WebEffective
    
    X
    
    XWebExcellence
    
    X
    
    X
 29




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##### Table of Contents



%2006
    
    
    2005
    
    
    Change(In thousands)For the Three Months Ended June 30:SLM Subscriptions
    
    $
    8,909
    
    
    $
    9,160
    
    
    
    (2.7
    )%SLM Engagements
    
    
    714
    
    
    
    881
    
    
    
    (19.0
    )%Total SLM revenue
    
    
    9,623
    
    
    
    10,041
    
    
    
    (4.2
    )%Mobile Subscriptions
    
    
    1,949
    
    
    
    442
    
    
    
    341.0
    %Mobile Engagements
    
    
    
    
    
    
    
    
    
    
    
    %Total Mobile Revenue
    
    
    1,949
    
    
    
    442
    
    
    
    341.0
    %CEM Subscriptions
    
    
    590
    
    
    
    441
    
    
    
    33.8
    %CEM Engagements
    
    
    1,705
    
    
    
    2,541
    
    
    
    (32.9
    )%Total CEM revenue
    
    
    2,295
    
    
    
    2,982
    
    
    
    (23.0
    )%Total revenue
    
    $
    13,867
    
    
    $
    13,465
    
    
    
    3.0
    %For the Nine Months Ended June 30:SLM Subscriptions
    
    $
    26,567
    
    
    $
    26,568
    
    
    
    (0.0
    )%SLM Engagements
    
    
    2,746
    
    
    
    2,785
    
    
    
    (1.4
    )%Total SLM revenue
    
    
    29,313
    
    
    
    29,353
    
    
    
    (0.1
    )%Mobile Subscriptions
    
    
    2,976
    
    
    
    1,583
    
    
    
    88.0
    %Mobile Engagements
    
    
    
    
    
    
    
    
    
    
    
    %Total Mobile Revenue
    
    
    2,976
    
    
    
    1,583
    
    
    
    88.0
    %CEM Subscriptions
    
    
    1,672
    
    
    
    1,567
    
    
    
    6.7
    %CEM Engagements
    
    
    6,361
    
    
    
    7,715
    
    
    
    (17.6
    )%Total CEM revenue
    
    
    8,033
    
    
    
    9,282
    
    
    
    (13.5
    )%Total revenue
    
    $
    40,322
    
    
    $
    40,218
    
    
    
    0.3
    %
    30




---



##### Table of Contents



Expenses:
 Costs of Subscription and Professional Services
 2006
    
    2005
    
    % Change(In thousands)For the three months ended June 30:Costs of subscription services
    
    $
    2,442
    
    
    $
    1,308
    
    
    
    86.7
    %Costs of professional services
    
    
    2,314
    
    
    
    2,088
    
    
    
    10.8
    %For the nine months ended June 30:Costs of subscription services
    
    
    5,453
    
    
    
    3,968
    
    
    
    37.4
    %Costs of professional services
    
    
    6,969
    
    
    
    6,956
    
    
    
    0.2
    %
 Costs of Subscription Service
 Costs of Professional Services.
 31




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##### Table of Contents



Research and Development
 2006
    
    2005
    
    % Change(In thousands)For the three months ended June 30:Research and development
    
    $
    2,673
    
    
    $
    1,829
    
    
    
    46.1
    %For the nine months ended June 30:Research and development
    
    $
    6,753
    
    
    $
    5,865
    
    
    
    15.1
    %
  Sales and Marketing
 2006
    
    2005
    
    % Change(In thousands)For the three months ended June 30:Sales and marketing
    
    $
    4,653
    
    
    $
    3,154
    
    
    
    47.5
    %For the nine months ended June 30:Sales and marketing
    
    $
    12,042
    
    
    $
    9,689
    
    
    
    24.3
    %
  32




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##### Table of Contents



Operations
 2006
    
    2005
    
    % Change(In thousands)For the three months ended June 30:Operations
    
    $
    1,867
    
    
    $
    1,543
    
    
    
    21.0
    %For the nine months ended June 30:Operations
    
    $
    5,361
    
    
    $
    4,548
    
    
    
    17.9
    %
  General and Administrative
 2006
    
    2005
    
    % Change(In thousands)For the three months ended June 30:General and administrative
    
    $
    2,443
    
    
    $
    2,352
    
    
    
    3.9
    %For the nine months ended June 30:General and administrative
    
    $
    6,354
    
    
    $
    5,986
    
    
    
    6.1
    %
   33




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##### Table of Contents



Excess Occupancy Costs
 2006
    
    2005
    
    % Change(In thousands)For the three months ended June 30:Excess occupancy costs
    
    $
    38
    
    
    $
    105
    
    
    
    (63.8
    )%For the nine months ended June 30:Excess occupancy costs
    
    $
    (12
    )
    
    $
    353
    
    
    
    (103.4
    )%
  Amortization of Identifiable Intangible Assets
 2006
    
    2005
    
    % Change(In thousands)For the three months ended June 30:Amortization of identifiable intangible assets
    
    $
    798
    
    
    $
    591
    
    
    
    35.0
    %In-process research and development
    
    
    840
    
    
    
    
    
    
    
    100.0
    %For the nine months ended June 30:Amortization of identifiable intangible assets
    
    $
    1,613
    
    
    $
    1,932
    
    
    
    (16.5
    )%In-process research and development
    
    
    840
    
    
    
    
    
    
    
    100.0
    %
   34




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##### Table of Contents



Technology
    
    CustomerBased
    
    Based
    
    Trademark
    
    TotalNet carrying value at June 30, 2006
    
    $
    5,743
    
    
    $
    4,357
    
    
    $
    829
    
    
    $
    10,929
 Interest Income and Interest and Other Expenses
 2006
    
    2005
    
    % Change(In thousands)For the three months ended June 30:Interest income, interest and other expenses, net
    
    $
    1,187
    
    
    $
    833
    
    
    
    42.5
    %For the nine months ended June 30:Interest income, interest and other expenses, net
    
    $
    3,575
    
    
    $
    2,319
    
    
    
    54.2
    %
  (Benefit) Provision for Income Taxes
 2006
    
    2005
    
    % Change(In thousands)For the three months ended June 30:Benefit (provision) for income taxes
    
    $
    1,026
    
    
    $
    (93
    )
    
    
    (1,203.2
    )%For the nine months ended June 30:Provision for income taxes
    
    $
    (79
    )
    
    $
    (217
    )
    
    
    (63.6
    )%
     35




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##### Table of Contents



Stock-based Compensation Expense
  Three Months Ended
    
    
    Nine Months EndedJune 30, 2006
    
    
    June 30, 2006(in thousands)Costs of subscription services
    
    $
    42
    
    
    $
    42Costs of professional services
    
    
    119
    
    
    
    401Research and development
    
    
    226
    
    
    
    627Sales and marketing
    
    
    266
    
    
    
    767Operations
    
    
    151
    
    
    
    484General and administrative
    
    
    121
    
    
    
    308Stock-based compensation expense included in
operating expenses related to stock options and employee stock purchase plan
    
    $
    925
    
    
    $
    2,629
 36




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##### Table of Contents



Liquidity and Capital Resources
 As of
    
    As ofJune 30,
    
    September 30,2006
    
    2005(In thousands)Cash, cash equivalents and short-term investments
    
    $
    96,661
    
    
    $
    133,803Accounts receivable, net
    
    $
    6,279
    
    
    $
    6,387Working capital
    
    $
    85,835
    
    
    $
    127,335Days sales in accounts receivable (DSO) (a)
    
    
    41
    
    
    
    44
 
 (a)
    
    DSO is calculated as: ((ending net accounts receivable) / net sales for the three months
period) multiplied by number of days in the period 2006
    
    2005(In thousands)For the nine months ended June 30:Cash provided by operating activities
    
    $
    9,384
    
    
    $
    7,399Cash provided by investing activities
    
    $
    3,150
    
    
    $
    28,313Cash used in financing activities
    
    $
    (13,002
    )
    
    $
    (6,698
    )
 Cash, cash equivalents and short-term investments
  Cash provided by operating activities
   Cash provided by investing activities
  37




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##### Table of Contents



Cash provided by financing activities
  Commitments
 
   Off Balance Sheet Arrangements
  Recently Issued Accounting Pronouncements
   
 Item 3. Quantitative and Qualitative Disclosures About Market Risks .
 Interest Rate Sensitivity.
 38




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##### Table of Contents



Foreign Currency Fluctuations and Derivative Transactions.
 
 Item 4. Controls and Procedures
 (a) Changes in Internal Controls
  (b) Evaluation of Disclosure Controls and Procedures
   
 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 sustain
profitability.
  39




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##### Table of Contents



The success of our business depends on customers renewing their subscriptions for our services and
purchasing additional services.
   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 during the quarter;
    
    The amount of expenses for share-based payments;
    
    The amount and timing of any reductions by our customers in their
usage of our services during the quarter;
    
    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
enterprise customers;
    
    Our ability to integrate the operations of SIGOS effectively;
    
    The timing 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;
    
    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;
 40




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##### Table of Contents




    
    Our ability to increase revenues 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.
  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.
 41




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##### Table of Contents



Our operating results could be harmed if sales of SLM subscriptions decline.
  Our mobile services may not continue to grow as rapidly, which could harm our business.
  Improvements to the infrastructure of the Internet could reduce or eliminate demand for our
Internet subscription services.
  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.
   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.
  42




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##### Table of Contents



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.
  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.
   43




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##### Table of Contents



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;
    
    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.
 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.
    44




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##### Table of Contents



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.
  Others might bring infringement claims against us, our customers or our suppliers that could harm
our business.
  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;
 45




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##### Table of Contents




    
    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.
  Industry consolidation may lead to increased competition and may harm our operating results.
  46




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##### Table of Contents



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.
  Our future operating results could be harmed if tax audits result in material differences between
that which is reflected in historical income tax provisions and recorded assets and liabilities.
  
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
     Cumulative ApproximateCumulative
    
    Dollar Value of Shares ThatTotal
    
    
    
    
    
    Number of Shares
    
    May Yet BeNumber of
    
    Average
    
    Purchased as Part of
    
    Purchased Under theShares
    
    Price Paid
    
    Publicly Announced
    
    Plans or Programs (1)Period
    
    Purchased
    
    per Share
    
    Plans or Programs (1)
    
    (in thousands)April 1, 2006 to April 30, 2006
    
    
    207,000
    
    
    $
    11.00
    
    
    
    207,000
    
    
    $
    76,694May 1, 2006 to May 31, 2006
    
    
    617,000
    
    
    
    10.81
    
    
    
    824,000
    
    
    
    70,029June 1, 2006 to June 30, 2006
    
    
    552,000
    
    
    
    10.19
    
    
    
    1,376,000
    
    
    
    64,4011,376,000
    
    
    $
    10.59
    
    
    
    1,376,000
    
    
    $
    64,401
 
  47




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##### Table of Contents



Item 3. Defaults Upon Senior Securities
  
 Item 4. Submission of Matters to a Vote of Security Holders
  
 Item 5. Other Information
  48




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##### Table of Contents



Item 6. Exhibits
 EXHIBIT INDEX
 Exhibit
    
    Incorporated by ReferenceFiledForm
    
    File No.
    
    Filing Date
    
    Exhibit No.
    
    Herewith10.1
    
    Promotion Letter Agreement dated as of April 4, 2006 between
Keynote Systems, Inc. and Jeffrey Kraatz*
    
    
    
    
    
    
    
    
    
    X10.2
    
    Addendum to Stock Option Agreement dated as of April 1, 2006
between Keynote Systems, Inc. and Jeffrey Kraatz*
    
    
    
    
    
    
    
    
    
    X10.3
    
    Promotion Letter Agreement dated as of April 12, 2006 between
Keynote Systems, Inc. and Eric Stokesberry*
    
    
    
    
    
    
    
    
    
    X10.4
    
    Addendum to Stock Option Agreement dated as of April 4, 2006
between Keynote Systems, Inc. and Eric Stokesberry*
    
    
    
    
    
    
    
    
    
    X10.5
    
    Promotion Letter Agreement dated as of April 12, 2006 between
Keynote Systems, Inc. and Krishna Khadloya*
    
    
    
    
    
    
    
    
    
    X10.6
    
    Addendum to Stock Option Agreement dated as of April 4, 2006
between Keynote Systems, Inc. and Krishna Khadloya*
    
    
    
    
    
    
    
    
    
    X10.7
    
    Separation Agreement with Patrick Quirk dated April 7, 2006*
    
    
    
    
    
    
    
    
    
    X10.8
    
    Share Purchase and Transfer Agreement to acquire SIGOS
Systemintegration GmbH (SIGOS) and the Shareholders of SIGOS dated
April 3, 2006 among Keynote Systems
    
    
    
    
    
    
    
    
    
    X10.9
    
    Agreement with UBS Securities LLC dated June 8, 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
 
 *
    
    Management contract or compensatory plan.**
    
    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.
    
    Confidential treatment has been requested with regards to
certain portions of this document. Such portions were filed
separately with the commission. 49




---



##### Table of Contents



SIGNATURES
  KEYNOTE SYSTEMS, INC.By:
    
    /s/ UMANG GUPTAUmang GuptaChairman of the Board and Chief Executive Officer(Principal Executive Officer)By:
    
    /s/ ANDREW HAMERAndrew HamerVice President and Chief Financial Officer(Principal Financial and Accounting Officer)
 50




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##### Table of Contents



EXHIBIT INDEX
 Exhibit
    
    Incorporated by ReferenceFiledForm
    
    File No.
    
    Filing Date
    
    Exhibit No.
    
    Herewith10.1
    
    Promotion Letter Agreement dated as of April 4, 2006 between
Keynote Systems, Inc. and Jeffrey Kraatz*
    
    
    
    
    
    
    
    
    
    X10.2
    
    Addendum to Stock Option Agreement dated as of April 1, 2006
between Keynote Systems, Inc. and Jeffrey Kraatz*
    
    
    
    
    
    
    
    
    
    X10.3
    
    Promotion Letter Agreement dated as of April 12, 2006 between
Keynote Systems, Inc. and Eric Stokesberry*
    
    
    
    
    
    
    
    
    
    X10.4
    
    Addendum to Stock Option Agreement dated as of April 4, 2006
between Keynote Systems, Inc. and Eric Stokesberry*
    
    
    
    
    
    
    
    
    
    X10.5
    
    Promotion Letter Agreement dated as of April 12, 2006 between
Keynote Systems, Inc. and Krishna Khadloya*
    
    
    
    
    
    
    
    
    
    X10.6
    
    Addendum to Stock Option Agreement dated as of April 4, 2006
between Keynote Systems, Inc. and Krishna Khadloya*
    
    
    
    
    
    
    
    
    
    X10.7
    
    Separation Agreement with Patrick Quirk dated April 7, 2006*
    
    
    
    
    
    
    
    
    
    X10.8
    
    Share Purchase and Transfer Agreement to acquire SIGOS
Systemintegration GmbH (SIGOS) and the Shareholders of SIGOS dated
April 3, 2006 among Keynote Systems
    
    
    
    
    
    
    
    
    
    X10.9
    
    Agreement with UBS Securities LLC dated June 8, 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
 
 *
    
    Management contract or compensatory plan.**
    
    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.
    
    Confidential treatment has been requested with regards to
certain portions of this document. Such portions were filed
separately with the commission. 51