Keynote Systems 10Q 2006 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended March 31, 2006

¨	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 incorporation or organization)		(I.R.S. Employer Identification No.)

777 Mariners Island Blvd., San Mateo, CA		94404
(Address of principal executive offices)		(Zip Code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): YES ¨ NO x

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


Class		Shares outstanding as of May 9, 2006

Common Stock, $.001 par value		19,102,260

KEYNOTE SYSTEMS, INC.

TABLE OF CONTENTS


		Page
	PART I—FINANCIAL INFORMATION

Item 1.	Financial Statements	3

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	34

Item 4.	Controls and Procedures	35
	PART II—OTHER INFORMATION

Item 1.	Legal Proceedings	35

Item 1A.	Risk Factors	35

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	43

Item 3.	Defaults Upon Senior Securities	43

Item 4.	Submission of Matters for a Vote of Security Holders	43

Item 5.	Other Information	43

Item 6.	Exhibits	44

Signatures		45

PART I—FINANCIAL INFORMATION

Item 1.

Financial Statements.

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

Index to Unaudited Condensed Consolidated Financial Statements


		Page
Condensed Consolidated Balance Sheets as of March 31, 2006 and September 30, 2005		4

Condensed Consolidated Statements of Operations for the three and six months ended March 31, 2006 and 2005		5

Condensed Consolidated Statements of Cash Flows for the six months ended March 31, 2006 and 2005		6

Notes to Condensed Consolidated Financial Statements		7

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)


	March 31, 2006			September 30, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	70,042		$	46,934
Short-term investments		67,247			86,869

Total cash, cash equivalents, and short-term investments		137,289			133,803
Accounts receivable, less allowance for doubtful accounts and billing adjustment of $392 and
$534 as of March 31, 2006 and September 30, 2005, respectively		6,283			6,387
Prepaid and other current assets		2,567			2,623
Deferred tax assets		367			405

Total current assets		146,506			143,218
Property and equipment, net		34,237			34,669
Goodwill		23,565			21,186
Identifiable intangible assets, net		3,426			3,760
Deferred tax assets		6,142			6,995

Total assets	$	213,876		$	209,828

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	1,566		$	538
Accrued expenses		7,696			9,088
Current portion of capital lease obligation		32			40
Deferred revenue		7,133			6,217

Total current liabilities		16,427			15,883
Long term portion of capital lease obligation		15			27

Total liabilities		16,442			15,910

Commitments and contingencies - see Note 10
Stockholders’ equity:
Common stock		19			20
Treasury stock		(1,582	)		(11,037	)
Additional paid-in capital		328,810			335,350
Accumulated deficit		(129,611	)		(130,044	)
Accumulated other comprehensive loss		(202	)		(371	)

Total stockholders’ equity		197,434			193,918

Total liabilities and stockholders’ equity	$	213,876		$	209,828

See accompanying notes to the condensed consolidated financial statements

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)


	Three months ended March 31,					Six months ended March 31,
	2006			2005		2006			2005
Revenue:
Subscription services	$	9,947		$	9,652	$	19,767		$	19,675
Professional services		2,792			3,513		6,688			7,078

Total revenue		12,739			13,165		26,455			26,753

Costs and Expenses:
Costs of subscription services		1,552			1,309		3,011			2,660
Costs of professional services		2,210			2,440		4,655			4,868
Research and development		2,091			2,074		4,080			4,036
Sales and marketing		4,020			2,987		7,389			6,535
Operations		1,847			1,440		3,494			3,005
General and administrative		1,702			1,841		3,911			3,634
Excess occupancy costs		(40	)		114		(50	)		248
Amortization of identifiable intangible assets		418			677		815			1,341

Total expenses*		13,800			12,882		27,305			26,327

Income (loss) from operations		(1,061	)		283		(850	)		426
Interest income and other, net		1,280			783		2,388			1,486

Income before provision for income taxes		219			1,066		1,538			1,912
Provision for income taxes		373			69		1,105			124

Net income (loss)	$	(154	)	$	997	$	433		$	1,788

Net income (loss) per share:
Basic	$	(0.01	)	$	0.05	$	0.02		$	0.09
Diluted	$	(0.01	)	$	0.05	$	0.02		$	0.08
Shares used in computing basic and diluted net income (loss) per share:
Basic		18,902			20,096		18,812			19,979
Diluted		18,902			21,214		19,762			21,276
_______ * Stock based compensation by category:

Costs of professional services	$	161		$	—	$	282		$	—
Research and development		215			—		401			—
Sales and marketing		255			—		501			—
Operations		183			—		333			—
General and administrative		94			—		187			—

	$	908		$	—	$	1,704		$	—

See accompanying notes to the condensed consolidated financial statements

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Six Months Ended March 31,
	2006			2005
Cash flows from operating activities:
Net income	$	433		$	1,788
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization of property, equipment and software		1,824			1,594
Stock-based compensation		1,704			—
Charges to bad debt and billing adjustment reserves		116			223
Amortization of debt investment premium		265			1,793
Amortization of identifiable intangible assets		815			1,341
Deferred tax assets		891			—
Changes in operating assets and liabilities, net of acquired assets and liabilities:
Accounts receivable, net		(4	)		(1,710	)
Prepaids and other current assets		81			233
Accounts payable and accrued expenses		(468	)		(299	)
Deferred revenue		789			(352	)

Net cash provided by operating activities		6,446			4,611

Cash flows from investing activities:
Purchases of property, equipment and software		(1,392	)		(1,436	)
Purchase of businesses and assets, net		(2,662	)		(681	)
Effect of exchange rate fluctuations on cash and cash equivalents		20			22
Sale of short-term investments		68,851			70,520
Purchases of short-term investments		(49,345	)		(59,327	)

Net cash provided by investing activities		15,472			9,098

Cash flows from financing activities:
Payment of capital leases		(20	)		(20	)
Proceeds from issuance of common stock and exercise of stock options		2,796			3,620
Repurchase of outstanding common stock		(1,586	)		(2,321	)
Final payment associated with prior year tender offers		—			(400	)

Net cash provided by financing activities		1,190			879

Net increase in cash and cash equivalents		23,108			14,588
Cash and cash equivalents at beginning of the period		46,934			9,932

Cash and cash equivalents at end of the period	$	70,042		$	24,520

Cash paid during the period for income taxes, net	$	92		$	87

Retirement of treasury stock	$	11,037		$	—

See accompanying notes to the condensed consolidated financial statements

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(1) Basis of Presentation

The accompanying interim unaudited condensed consolidated balance sheets, and condensed consolidated statements of operations and cash flows reflect all normal recurring adjustments that are, in the opinion of management, necessary for a fair presentation of the financial position of Keynote Systems, Inc. and subsidiaries (the “Company”) as of March 31, 2006, and the results of operations and cash flows for the interim periods ended March 31, 2006 and 2005.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”), and therefore, do not include all information and footnotes necessary for a complete presentation of the Company’s results of operations, financial position and cash flows. This report should be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended September 30, 2005 included in the Company’s Report on Form 10-K as filed with the SEC.

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

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

The Company reclassified a portion of WebEffective services from subscription services revenue to professional services revenue for the three and six months ended March 31, 2005 on the Consolidated Statements of Operations to conform to the current year presentation.

Excess occupancy costs are fixed costs associated with the portion of the Company’s headquarters’ building not occupied by the Company, such as property taxes, insurance and depreciation. These particular costs, which are reduced by any rental income from the sublease of space in its headquarters building, represent the fixed costs of operating the Company’s headquarters’ building acquired in September 2002 and are based on the actual square footage, which was determined to be approximately 60% of the total rentable square footage of the headquarters’ building during the three months ended March 31, 2006 and 2005. These particular costs are reduced by the rental income from the leasing of space not occupied by the Company in our headquarters building. Rental income was approximately $231,000 and $142,000 for the three months ended March 31, 2006 and 2005, respectively. Rental income was approximately $490,000 and $282,000 for the six months ended March 31, 2006 and 2005, respectively. As of March 31, 2006, the Company had leased space with ten tenants of which eight had noncancellable operating leases, which expire on various dates through March 2014. As of March 31, 2006, future minimum rents receivable under the leases, are as follows (in thousands):


Twelve Months Ended March 31:
2007	$	1,050
2008		1,058
2009		917
2010		497
2011		142
Thereafter		308

Total future minimum rents receivable	$	3,972

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

(a) Change in Accounting Principle

Effective October 1, 2005, the Company adopted the Financial Accounting Standards Board's (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 123R “Share-Based Payment” (“SFAS 123R”) using the modified prospective method, in which compensation cost was recognized beginning with the effective date for (a) all share-based payments granted or modified after the effective date and (b) for all awards granted to employees prior to the effective date of SFAS 123R that remain unvested on the effective date.

With the adoption of SFAS 123R, the Company elected to amortize stock-based compensation for awards granted on or after the adoption of SFAS 123R on a straight-line basis. The fair value of the stock awards is measured based on the fair market value of the underlying common stock as of the date of grant. For awards granted prior to October 1, 2005, the Company elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations in accounting for stock-based awards to employees. The Company applied the disclosure provisions of SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by SFAS No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure” as if the fair-value-based method had been applied in measuring compensation expense.

(b) Summary of Plans

As of March 31, 2006, the Company was authorized to issue up to approximately 9.9 million shares of common stock under its 1999 Equity Incentive Plan (“Incentive Plan”) to employees, directors, and consultants, including both nonqualified and incentive stock options. Options expire ten years after the date of grant. Vesting periods are determined by the Board of Directors and generally provide for shares to vest over a period of four years with 25% of the shares vesting one year from the date of grant and the remainder vesting monthly over the next three years. As of March 31, 2006, options to purchase approximately 6.5 million shares were outstanding under the Incentive Plan, and approximately 2.4 million shares were available for future issuance under the Incentive Plan.

As of March 31, 2006, the Company had reserved a total of approximately 1.4 million shares of common stock for issuance under its 1999 Employee Stock Purchase Plan (“Purchase Plan”). Under the Purchase Plan, eligible employees may defer an amount not to exceed 10% of the employee’s compensation, as defined in the Purchase Plan, to purchase common stock of the Company. The purchase price per share is 85% of the lesser of the fair market value of the common stock on the first day of the applicable purchase period or the last day of each purchase period. The Purchase Plan is intended to qualify as an “employee stock purchase plan” under Section 423 of the Internal Revenue Code. As of March 31, 2006, approximately 674,000 shares had been issued under the Purchase Plan, and approximately 749,000 shares had been reserved for future issuance.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model that uses the weighted-average assumptions noted in the following table. The exercise price of the options granted is equal to the fair market value of the Company’s common stock on the date of grant. Expected volatilities are based on the historical volatility of the Company's common stock. The expected term of options granted is derived from a risk-adjusted single-exercise factor lattice model. The estimated forfeiture rate of 25% is derived from historical pre-vest termination rates and is used in determining compensation expense. The risk-free rate for the expected term of the option is based on the average yield to maturity of treasury bills and bonds as reported by the Federal Reserve bank of St. Louis in effect at the time of grant.

Weighted-average assumptions for options granted and stock purchases under the equity incentive plans for the three and six months ended March 31, 2006 and 2005, respectively, are as follows:


	Three Months Ended March 31,				Six Months Ended March 31,
	2006		2005*		2006		2005*
Volatility-stock options	31.9	%	33.6	%	31.9	%	33.6	%
Volatility-stock purchases	30	%	33.0	%	28	%	33.0	%
Risk-free interest rates-stock options	4.6	%	3.5	%	4.5	%	3.2	%
Risk-free interest rates-stock purchases	3.7	%	1.7	%	3.7	%	1.7	%
Expected life (in years)-stock options	3.56		2.5		3.33		2.5
Expected life (in years)-stock purchases	1.25		1.25		1.25		1.25
Dividend yield	—		—		—		—

*	The assumptions used in the three and six months ended March 31, 2005 were used to calculate pro forma net income (loss) and net income (loss) per share as disclosed in Note 1(d) “Pro-Forma Disclosure for Three and Six Months ended March 31, 2005” per SFAS No. 123.

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

A summary of option activity as of December 31, 2005 and March 31, 2006, and changes during the quarters then ended, is presented below (in thousands except per share and term amounts):


	Shares		Weighted Average Exercise Price		Weighted Average Remaining contractual Term (years)	Aggregate Intrinsic Value
Outstanding at October 1, 2005	6,236		$	13.42
Granted	105			13.13
Exercised	(222	)		7.98
Forfeited, canceled or expired	(124	)		11.94

Outstanding at December 31, 2005	5,995		$	13.65	7.3	$	14,320
Granted	858			11.75
Exercised	(69	)		9.15
Forfeited, canceled or expired	(245	)		12.14

Outstanding at March 31, 2006	6,539		$	13.50	7.3	$	8,662
Exercisable at March 31, 2006	3,445		$	14.84	5.6	$	8,292

The weighted average grant-date fair value of options granted during the quarters ended December 31, 2005 and March 31, 2006 was $3.63 per share and $3.57 per share, respectively. The aggregate intrinsic value of options exercised during the quarters ended December 31, 2005 and March 31, 2006 was approximately $1.1 million and $156,000, respectively. The total grant-date fair value of options vested during the quarters ended December 31, 2005 and March 31, 2006 was $653,000 and $623,000, respectively. Upon the exercise of options, the Company issues new common stock from its authorized shares.

A summary of the status of the Company's unvested stock options as of March 31, 2006, and changes during the quarter ended March 31, 2006, is presented below (in thousands except per share amounts):


	Shares		Weighted Average Grant-Date Fair Value
Stock option awards:
Nonvested balance at October 1, 2005	2,886		$	2.99
Stock options granted	105			3.63
Vested	(221	)		2.95
Forfeited	(116	)		3.00

Nonvested balance at December 31, 2005	2,654		$	3.01
Stock options granted	858			3.57
Vested	(188	)		3.15
Forfeited	(230	)		3.02

Nonvested balance at March 31, 2006	3,094		$	3.15

As of March 31, 2006, there was $9.3 million of total unrecognized compensation cost (net of estimated forfeitures) related to nonvested share-based compensation (nonvested stock options) arrangements as determined using the Black-Scholes option valuation model. That cost is expected to be recognized over the next 5 fiscal years (or a weighted average period of 3.2 years).

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

(d) Pro-Forma Disclosure for Three and Six Months ended March 31, 2005

If the fair value based method prescribed by SFAS 123 had been applied in measuring employee stock compensation expense for the three and six months ended March 31, 2005 the pro-forma effect on net income and net income per share would have been as follows (in thousands, except per share amounts):


	Three Months Ended March 31, 2005			Six Months Ended March 31, 2005
Net income, as reported:	$	997		$	1,788
Less: Stock-based compensation expense determined using the fair value method for all awards, zero tax effect*		(751	)		(2,057	)

Pro forma net income (loss)	$	246		$	(269	)

Basic net income (loss) per share:
Basic - as reported	$	0.05		$	0.09
Basic - pro forma	$	0.01		$	(0.01	)
Diluted - as reported	$	0.05		$	0.08
Diluted - pro forma	$	0.01		$	(0.01	)

*	No tax effects were included in the determination of pro forma net income (loss) because the deferred tax asset resulting from stock-based employee compensation would be offset by an additional valuation allowance for deferred tax assets.

(2) Revenue Recognition

Revenue consists of subscription services revenue and professional services revenue. Subscription services revenue consists of fees from subscriptions to the Company's service level management, mobile, and customer experience management services. Professional services revenue consists of fees generated by the Company's professional services. Revenue related to the use of our WebEffective and WebExcellence services is accounted for as either subscription services revenue or professional services revenue depending upon the contracted use.

The Company recognizes revenue in accordance with Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition”, and Emerging Issues Task Force (“EITF”) Issue 00-21 “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”).

Subscription and professional services revenue is recognized when all of the following criteria have been met: persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is deemed reasonably assured. The Company evaluates each of these criteria as follows:

•

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.

•

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.

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

Deferred revenue is comprised of all unearned revenue that has been collected in advance, primarily unearned subscription services revenue, and is recorded as deferred revenue on the balance sheet until the revenue is earned. Any uncollected deferred revenue reduces the balance of accounts receivable. The Company does not generally grant refunds. All discounts granted reduce revenue. Revenue is not recognized for free trial periods.

Subscription Services Revenue: For customers that pay in advance, subscription services revenue is deferred upon invoicing and is recognized ratably over the service period, generally ranging from one to twelve months, commencing on the day service is first provided. For customers billed in arrears, subscription services revenue is invoiced monthly upon completion of the services. If a customer purchases a subscription to the Company's WebEffective and WebExcellence services, revenue is recognized ratably over the subscription period, commencing on the day service is first provided, and recorded as subscription services revenue.

Professional Services Revenue: Professional services revenue consists of fees generated by the Company's professional services, and is recognized as the services are performed, typically over a period of one to three months. For professional service projects that span one month or less, the Company recognizes revenue once the project is complete. For professional service projects that contain milestones, the Company recognizes revenue once the services or milestones have been delivered. For those professional service projects that do not have milestones, the Company recognizes revenue as services are proportionally performed, based on labor hours incurred as a percentage of total estimated hours. Payment occurs either up front or over time.

On limited occasions, the Company enters into arrangements with multiple elements, which include both subscription and professional service revenue. For these arrangements, the Company recognizes revenue in accordance with EITF 00-21 and allocates and defers revenue for the undelivered items based on vendor specific objective evidence, or VSOE, of fair value of the undelivered elements, and recognizes the difference between the total arrangement fee and the amount deferred for the undelivered items as revenue. VSOE of each element is based on the price for which the undelivered element is sold separately. The Company determines fair value of the undelivered elements based on historical evidence of its stand-alone sales of these elements to third parties. When VSOE does not exist for undelivered items, then the entire arrangement fee is recognized ratably over the applicable performance period.

(3)

Comprehensive Income

Comprehensive income includes net income (loss), unrealized gains and losses on short-term investments in debt securities and foreign currency translation. The unrealized gains and losses on short-term investments in debt securities and foreign currency translation are excluded from earnings and reported as a component of stockholders' equity. The Company has subsidiaries located in France, United Kingdom and Canada. The functional currency of the Company's foreign operations is the applicable local currency. Accordingly, all assets and liabilities related to these operations are translated at the current exchange rates at the end of each period. The resulting cumulative translation adjustments are recorded directly to the accumulated other comprehensive loss account in stockholders' equity. Revenue and expenses are translated at average exchange rates in effect during the period. Gains and losses from foreign currency transactions are reflected in interest and other expenses in the condensed consolidated statements of operations as incurred. The components of comprehensive income (loss) are as follows (in thousands):


	Three Months Ended March 31,						Six Months Ended March 31,
	2006			2005			2006		2005
Net income (loss)	$	(154	)	$	997		$	433	$	1,788
Net unrealized gain (loss) on available-for-sale investments		47			(129	)		149		(374	)
Foreign currency translation (loss) gain		42			(16	)		20		22

Comprehensive income (loss)	$	(65	)	$	852		$	602	$	1,436

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

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

(4)

Financial Instruments and Concentration of Risk

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

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

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

As of March 31, 2006, one customer accounted for 15% of the Company’s total accounts receivable. At March 31, 2005, no single customer accounted for more than 10% of the Company’s total accounts receivable. For the three and six months ended March 31, 2006, one customer accounted for more than 10% of the Company’s total revenue during each period. For the three and six months ended March 31, 2005, no single customer accounted for more than 10% of the Company’s total revenue during each period. For the three months ended March 31, 2006 and 2005, the ten largest customers accounted for approximately 33% and 37% of total revenue, respectively. For the six months ended March 31, 2006 and 2005, the ten largest customers accounted for approximately 33% and 35% of total revenue, respectively.

(5)

Cash, Cash Equivalents, and Short-Term Investments

The Company considers all highly liquid investments held at major banks, commercial paper, money market mutual funds and other money market securities with original maturities of three months or less to be cash equivalents. The Company classifies all of its short-term investments as available-for-sale. These investments mature in two years or less, and consist of investment-grade corporate and government debt securities with Moody’s ratings of A2 or better. Investments classified as available-for-sale are recorded at fair market value with the related unrealized gains and losses included in accumulated other comprehensive loss, a component of stockholders’ equity. Realized gains and losses are recorded based on specific identification. There were no realized gains or losses during the three or six months ended March 31, 2006.

The following table summarizes the Company's cash and cash equivalents as of March 31, 2006 (in thousands):


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Market Value
Cash	$	38,233	$	—	$	—	$	38,233
Commercial paper		18,158		4		—		18,162
Money market mutual funds		1,636		—		—		1,636
Other money market securities		12,011		—		—		12,011

Total	$	70,038	$	4	$	—	$	70,042

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

The following table summarizes the Company’s short-term investments in investment-grade debt securities as of March 31, 2006 (in thousands):


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Market Value
State government agency securities	$	16,899	$	—	$	—		$	16,899
FNMA and FHLMC securities		8,074		—		(34	)		8,040
Other U.S. government agency securities		8,068		—		(36	)		8,032
Corporate bonds and commercial paper		34,526		—		(250	)		34,276

Total	$	67,567	$	—	$	(320	)	$	67,247

The following table summarizes the maturities of fixed maturity short-term investments available for sale as of March 31, 2006 (in thousands). Expected maturities of debt securities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties.


	Amortized Cost		Estimated Market Value
Year ending March 31,
2007	$	47,464	$	47,313
2008		20,103		19,934

Total	$	67,567	$	67,247

(6)

Goodwill and Identifiable Intangible Assets

The following table represents the changes in goodwill during the six months ended March 31, 2006 (in thousands):


Balance at September 30, 2005	$	21,186
Additional goodwill for acquisition of the GomezPro business of Watchfire Corporation (Note 8)		2,379

Balance at March 31, 2006	$	23,565

Identifiable intangible assets amounted to approximately $3.4 million (net of accumulated amortization of approximately $15.0 million) at March 31, 2006, and approximately $3.8 million (net of accumulated amortization of approximately $14.2 million) at September 30, 2005. The components of identifiable intangible assets excluding goodwill are as follows (in thousands):


	Technology Based			Customer Based			Trademark			Total
As of March 31, 2006:
Gross carrying value	$	11,965		$	6,203		$	250		$	18,418
Accumulated amortization		(9,766	)		(4,976	)		(250	)		(14,992	)

Net carrying value at March 31, 2006	$	2,199		$	1,227		$	—		$	3,426

As of September 30, 2005:
Gross carrying value	$	11,623		$	6,064		$	250		$	17,937
Accumulated amortization		(9,263	)		(4,664	)		(250	)		(14,177	)

Net carrying value at September 30, 2005	$	2,360		$	1,400		$	—		$	3,760

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

Amortization expense for the three months ended March 31, 2006 and 2005 was $418,000 and $677,000, respectively. Amortization expense for the six months ended March 31, 2006 and 2005 was $815,000 and $1,341,000, respectively. Assuming no additional acquisitions or impairment charges, the amortization expense for existing identifiable intangible assets as of March 31, 2006 is estimated to be approximately $801,000 for the remainder of fiscal 2006, $1.3 million for fiscal 2007, $1.2 million for fiscal 2008, $104,000 in fiscal 2009, and $16,000 in fiscal 2010.

(7)

Net Income (Loss) Per Share

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

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


	Three Months Ended March 31,					Six Months Ended March 31,
	2006			2005		2006		2005
Numerator:
Net income (loss)	$	(154	)	$	997	$	433	$	1,788
Denominator:
Denominator for basic net income (loss) per share—weighted average shares		18,902			20,096		18,812		19,979
Incremental common shares attributable to shares issuable under stock option plans less reduction in shares for average unrecognized compensation costs		—			1,118		950		1,297

Denominator for diluted net income (loss) per share—weighted average shares		18,902			21,214		19,762		21,276

Basic net income (loss) per share	$	(0.01	)	$	0.05	$	0.02	$	0.09
Diluted net income (loss) per share	$	(0.01	)	$	0.05	$	0.02	$	0.08

Potential shares of common stock that have been excluded from the computation of diluted net income (loss) per share because the effect would have been antidilutive were 3.1 million and 1.7 million shares subject to outstanding stock options for the three months ended March 31, 2006 and 2005, respectively. Potential shares of common stock that have been excluded from the computation of diluted net income (loss) per share because the effect would have been antidilutive were 1.6 million and 1.5 million shares subject to outstanding stock options for the six months ended March 31, 2006 and 2005, respectively. The weighted-average exercise price of excluded outstanding stock options was $18.51 and $24.93 for the three months ended March 31, 2006 and 2005, respectively. The weighted-average exercise price of excluded outstanding stock options was $24.40 and $25.90 for the six months ended March 31, 2006 and 2005, respectively.

(8)

Acquisitions

On November 30, 2005, the Company acquired the GomezPro business of Watchfire Corporation, a consultative e-business financial performance provider, for a purchase price of approximately $2.5 million plus direct transaction costs of $128,000. Pursuant to the Asset Purchase Agreement, the initial cash purchase price of $2.5 million was reduced by approximately $51,000 which represented the preliminary difference between the total assets and liabilities of the business (“net assets”) as of the acquisition date. In addition, approximately $250,000 of the purchase price was held back and will be released in December 2006 pursuant to an escrow agreement. The results of operations for this business are included in the Company’s Condensed Consolidated Statements of Operations from the date of acquisition. The Company believes this acquisition will enhance and broaden its customer experience management solutions for assessing, benchmarking and improving the online customer experience.

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

The preliminary purchase price allocation was based on the estimated fair value of the assets and liabilities of the business at the acquisition date, including technology-based and customer-based intangible assets acquired. The following table summarizes the preliminary estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands):


Accounts receivable	$	8
Prepaid and other assets		25
Customer-based intangible assets (weighted-average amortization period of 3.3 years)		150
Technology-based intangible assets (weighted-average amortization period of 3.2 years)		330
Goodwill		2,379
Liabilities assumed		(174	)
Deferred revenue		(127	)

Total purchase price, including direct acquisition costs	$	2,591

Pro forma consolidated results of operations have not been presented for this acquisition as the effect of this acquisition was not considered material to the three or six months ended March 31, 2006.

In connection with the acquisition of Vividence Corporation (“Vividence”) in September 2004, an escrow fund was established to secure the indemnification obligations relating to the acquisition of Vividence. In October 2005, $310,000 was disbursed from escrow to the various respective parties in the amounts specified in the Vividence Merger Agreement.

In February 2005, the Company acquired Hudson Williams Europe (“HWE”), a privately held online business performance consulting firm based in the Netherlands, for $260,000 in cash and paid an additional contingent consideration cash payment of approximately $85,000 in fiscal 2006 as a result of the achievement of certain revenue and profitability targets. This additional payment had been recorded as an addition to goodwill as of March 31, 2006. In connection with the HWE acquisition, an escrow fund was established to secure the indemnification obligations relating to the acquisition of HWE. In February 2006, $49,000 was disbursed from escrow to the various respective parties in the amounts specified in the HWE Merger Agreement.

(9)

Income Taxes

The Company’s effective tax rate for the three months ended March 31, 2006 and 2005 was 170.3% and 6.5%, respectively. The Company’s effective tax rate for the six months ended March 31, 2006 and 2005 was 71.8% and 6.5%, respectively.

The increase in the effective tax rate was primarily due to two factors: 1) deferred income tax expense was included in the tax rate for the three months ended March 31, 2006 but was not included in the tax rate for the three months ended March 31, 2005 since the Company had a full valuation allowance as of March 31, 2005; and 2) the combined effect of the stock-based compensation charges under SFAS 123R associated with the incentive stock options and 1999 Employee Stock Purchase Plan (“ESPP”) shares which was only partially recognized for tax provision purposes, and other miscellaneous items. These items are described more fully as follows: Significant management judgment is involved in determining the extent to which a valuation allowance is necessary. In the three months ended March 31, 2005, it was management’s judgment that a full valuation allowance was required against the deferred tax assets due to the limited history of profitable quarters and uncertainties in projecting future taxable income at that time as a result of recent acquisitions; however, as of the year ended September 30, 2005, the projected sources of taxable income were considered to be sufficient to eliminate a portion of the valuation allowance. In future quarters, the projected taxable income will be evaluated for this purpose, and it is possible that the valuation allowance would be increased or reduced further, which would increase or reduce the effective tax rate and deferred tax expense, the goodwill balance, and the paid-in-capital. SFAS 123R has the effect of increasing the effective tax rate due to the charge to earnings from incentive stock options and ESPP shares, which have no associated tax benefit to the company. In a future period it is possible that a tax benefit would be realized on these options, at which time the tax rate may be reduced as a result.

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

Historically, the Company has calculated the provision for income taxes in interim periods using an estimate of the annual effective tax rate. In the second quarter of 2006, the Company concluded that as a result of the uncertainty of the effect of stock-based compensation charges under SFAS 123R associated with incentive stock options and the ESPP shares in relation to the projected pre-tax book income, and the fact that the Company’s income tax rate is highly dependent upon this relationship, a small variation in projected pre-tax book income could have a significant impact on our effective tax rate. Accordingly, consistent with footnote 7 of Financial Accounting Standard Board (“FASB”) Interpretation No. 18, “Accounting for Income Taxes in Interim Periods”, the Company has used the actual book income through the six months ended March 31, 2006, to calculate the effective tax rate for the six months ended March 31, 2006. This tax expense, less the amount recorded in the three months ended December 31, 2005, was recorded for the three months ended March 31, 2006.

The American Jobs Creation Act of 2004 (the “Act”) was enacted in October 2004, and it creates a temporary incentive for U.S. corporations to repatriate foreign subsidiary earnings by providing an elective 85% dividends received deduction for certain dividends from controlled foreign corporations, with the balance of 15% taxed at regular rates with no offset for loss carryovers. The deduction is subject to several limitations and requirements, including adoption of a specific domestic reinvestment plan for the repatriated funds. The Company does not have sufficient accumulated foreign profits to justify the administrative costs and professional fees to repatriate the funds under this provision. Further, there is an approximate 5% tax cost of repatriation the Company would incur upon repatriation. Therefore, based on the Company’s current understanding of the Act and subsequent guidance published by the U.S. Treasury, the Company does not intend to repatriate dividends subject to the elective 85% dividends received deduction.

10)

Commitments and Contingencies

(A) Leases

The Company leases certain of its facilities and equipment under noncancellable capital and operating leases, which expire on various dates through August 2015. As of March 31, 2006, future minimum payments under the leases are as follows (in thousands):


	Operating Leases		Capital Leases
Twelve months ended March 31:
2007	$	505	$	33
2008		383		11
2009		344		4
2010		349		—
2011		358		—
Thereafter		1,272		—

Total minimum lease payments	$	3,211		48

Less amounts representing interest				(1	)

Present value of minimum lease payments				47
Less current portion of obligation under capital lease				(32	)

Long-term portion of capital lease obligation			$	15

Rent expense for the three months ended March 31, 2006 and 2005 was approximately $160,000 and $110,000, respectively. Rent expense for the six months ended March 31, 2006 and 2005 was approximately $315,000 and $241,000, respectively.

(B) Commitments

The Company has contingent commitments, which range in length from one to twelve months, to 120 bandwidth and collocation providers amounting to $702,000 in the aggregate for 106 locations, which commitments become due if the Company terminates any of these agreements prior to their expiration.

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

(C) Legal Proceedings

Beginning on August 16, 2001, several class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company, certain of its officers, and the underwriters of its initial public offering. These lawsuits were essentially identical, and were brought on behalf of those who purchased the Company's securities between September 24, 1999 and August 19, 2001. These complaints alleged generally that the underwriters in certain initial public offerings, including the Company's, allocated shares in those initial public offerings in unfair or unlawful ways, such as requiring the purchaser to agree to buy in the aftermarket at a higher price or to buy shares in other companies with higher than normal commissions. The complaint also alleged that the Company had a duty to disclose the activities of the underwriters in the registration statement relating to its initial public offering. The plaintiffs' counsel and the issuer defendants' counsel have reached a preliminary settlement agreement whereby the issuers and individual defendants will be dismissed from the case, without any payments by the Company. The settlement was preliminarily approved and awaits final approval by the Court. No amount is accrued as March 31, 2006 and September 30, 2005, as the Company anticipates that it will be dismissed from the case as a result of the settlement.

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

(D) Indemnification

The Company does not generally indemnify its customers against legal claims that its services infringe on third-party intellectual property rights. Other agreements entered into by the Company may include indemnification provisions that could subject the Company to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party.

However, the Company has never been a party to an infringement claim and its management is not aware of any liability related to any infringement claims subject to indemnification. As such, no amount is accrued for infringement claims as of March 31, 2006 and September 30, 2005 in the condensed consolidated balance sheets.

(11)

Stock Repurchase Program

The Company’s Board of Directors approved a program to repurchase shares of its common stock in January 2001. Pursuant to the stock repurchase program, approximately 12.4 million shares had been repurchased as of March 31, 2006 for an aggregate price of approximately $114.4 million.

On February 3, 2006, the Company entered into an agreement with UBS Securities LLC (“UBS”) to establish a trading plan (the “Trading Plan”) intended to qualify under Rule 10b5-1 of the Securities Exchange Act of 1934 (the “Exchange Act”). The Trading Plan instructs UBS to repurchase for the Company, in accordance with Rule 10b-18 of the Exchange Act, up to 1 million shares of the Company’s common stock.

No repurchases occurred during the three months ended March 31, 2006 or 2005. The Company repurchased 121,716 shares during the six months ended March 31, 2006 for approximately $1.6 million. No repurchases occurred during the six months ended March 31, 2005.

As of March 31, 2006, the Company was authorized to repurchase up to an additional $15.6 million of its common stock pursuant to this stock repurchase program.

During the six months ended March 31, 2006, the Company retired 852,200 shares of treasury stock.

(12)

Geographic and Segment Information

The Company has determined that it operates in a single reportable operating segment: the development and sale of services to measure, test, assure and improve the quality of service of Web sites. While the Company operates under one operating segment, management reviews revenue under three categories – service level management, mobile and customer experience management services in addition to subscription services and professional services revenue. Management continues to allocate resources based on the one operating segment.

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

The Company markets its products primarily from its operations in the United States. International sales are primarily to customers in Europe. International sales were approximately 7% and 9% of total revenue for the three months ended March 31, 2006 and 2005 respectively. International sales were approximately 9% and 7% of total revenue for the six months ended March 31, 2006 and 2005 respectively. The Company's foreign-owned assets are not significant.

The following table identifies which services are categorized as service level management and customer experience management services and where they are recorded in the Company’s consolidated statements of operations (listed in alphabetical order):


	Subscription Services	Professional Services
Service Level Management:
Application Perspective Private Edition	X
Diagnostic Services	X
Enterprise Solutions	X	X
LoadPro		X
NetMechanic	X
Network Perspective	X
Professional Services		X
Red Alert	X
Streaming Perspective	X
Test Perspective	X
Transaction Perspective	X
WebIntegrity	X
Web Site Perspective	X
VoIP Perspective	X

Mobile:
Wireless Perspective & Wireless Perspective Network Edition	X
Mobile Application Perspective	X

Customer Experience Management:
WebEffective	X	X
WebExcellence	X	X

The following table summarizes service level management, mobile, and customer experience management solutions revenue (in thousands):


	2006		2005
	(in thousands)
For the three months ended March 31:
Service level management	$	9,781	$	9,865
Mobile		488		338
Customer experience management		2,470		2,962

Total Revenue	$	12,739	$	13,165

For the six months ended March 31:
Service level management	$	19,690	$	19,312
Mobile		1,027		1,141
Customer experience management		5,738		6,300

Total Revenue	$	26,455	$	26,753

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

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

(13)

Subsequent Events

On April 3, 2006, the Company entered into a definitive share purchase and transfer agreement (the “Purchase Agreement”) to acquire SIGOS Systemintegration GmbH (“SIGOS”). Under the Purchase Agreement, the Company will acquire all the outstanding shares of SIGOS for approximately $30 million (25 million euros) in cash. Of the cash issued at closing, approximately $6 million (5 million euros) is being withheld by the Company for specified holdbacks. In addition, the Company will pay earn-out proceeds up to an additional $9.6 million (8 million euros) in cash if certain revenue and profitability milestones are achieved in calendar 2006.

On April 5, 2006, the Company provided temporary financing to an unaffiliated third party and received a secured convertible promissory note for $300,000 that matures on September 30, 2006 at a rate of up to 6% interest. The note may be converted into stock of the unaffiliated third party at the earlier of the maturity date or upon the third party receiving additional financing.

Item 2.

Management Discussion and Analysis of Financial Condition and Results of Operations

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

Except for historical information, this Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements involve risks and uncertainties, including, among other things, statements regarding our anticipated costs and expenses and revenue mix. These forward-looking statements include, among others, statements including the words “expects,” “anticipates,” “intends,” “believes” and similar language. Our actual results may differ significantly from those projected in the forward-looking statements. Factors that might cause or contribute to these differences include, but are not limited to, those discussed in this section, the section entitled “Risk Factors” in Item 1A of Part II of this report, and in our annual report on Form 10-K for the fiscal year ended September 30, 2005 and elsewhere in that report. You should carefully review the risks described in other documents we file from time to time with the Securities and Exchange Commission, including the quarterly reports on Form 10-Q and current reports on Form 8-K that we may file during the current year. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this quarterly report on Form 10-Q. Except as required by law, we undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.

On May 8, 2006, we announced that we recorded approximately $96,000 of additional stock-based compensation expense for our second quarter from that previously reported on May 2, 2006. This additional amount related to additional stock-based compensation expense related to our Employee Stock Purchase Plan required under Statement of Financial Accounting Standard No. 123R “Accounting for Share-Based Payments” (“SFAS 123R”). As a result, our loss for the second quarter ended March 31, 2006 was $154,000 or ($0.01) per share, compared to a net loss of approximately $58,000, or $0.00 per share, previously announced by us.

Overview

We offer technology-based services that enable corporate enterprises to improve their online business performance and communications technologies. We categorize our services in three broad areas: service level management ("SLM"), mobile, and customer experience management ("CEM"). The SLM category comprises our traditional Perspective Measurement Services, VoIP Perspective, Load Testing and Enterprise Solutions. The Mobile category comprises our Wireless Perspective and Mobile Application Perspective Services. The CEM category consists of the WebEffective and WebExcellence services whether sold on a technology license basis or as part of a competitive intelligence study or custom engagement. All of these categories of services help our customers reduce costs, improve customer satisfaction and increase profitability.

We offer our SLM and mobile services primarily on a subscription basis and our CEM services primarily on an engagement basis although, in some cases, we offer SLM professional services on an incident and per engagement basis. We also offer the use of our CEM technology for a fixed period on a self-service subscription basis. Subscription fees range from monthly to annual commitments, and vary based on the type of service selected, the number of URLs, transactions or devices monitored, the number of measurement locations and or appliances, the frequency of the measurements and any additional features ordered. Engagements typically involve fixed price contracts based on the complexity of the project, the size of a CEM panel, and the type of testing to be conducted.

Our net income decreased by $1.2 million, from net income of $997,000 for the quarter ended March 31, 2005 to net loss of $154,000 for the quarter ended March 31, 2006. Total revenue decreased by $426,000 or 3%, from approximately $13.2 million for the quarter ended March 31, 2005 to approximately $12.7 million for the quarter ended March 31, 2006. The decrease in revenue was mainly related to decreased contribution from our CEM WebEffective engagements. Total expenses increased by $918,000, from approximately $12.9 million for the quarter ended March 31, 2005 to approximately $13.8 million for the quarter ended March 31, 2006. The increase in total expenses was mainly attributable to a $908,000 increase in stock-based compensation expense due to the adoption of SFAS 123R on October 1, 2005, increased costs of subscription services related to increased depreciation, equipment charges and connection fees, and international sales growth resulting in increased personnel and associated compensation and travel related expenses. The increase in total expenses for the three months ended March 31, 2006 compared to the three months ended March 31, 2005, was offset by the following, as listed in descending order of impact: 1) lower amortization expense due to certain intangible assets being fully amortized in the second half of fiscal 2005 and first half of fiscal 2006, 2) the resolution of a preferential claim settlement for $184,000, 3) lower excess occupancy costs due to the leasing of additional space in our headquarters’ building during fiscal 2005, 4) a $109,000 reduction in the allowance for doubtful accounts, and 5) a $72,000 net reduction in expenses due to refunds and the reversal of accruals related to the resolutions of our property tax returns for the fiscal years 2002 through 2004. The $72,000 net reduction in expenses related to our property taxes and the $184,000 reduction in expense related to our preferential claim settlement are not expected to recur.

Our net income decreased by $1.4 million, from net income of $1.8 million for the six months ended March 31, 2005 to net income of $433,000 for the six months ended March 31, 2006. Total revenue decreased by $298,000 or 1%, from approximately $26.8 million for the six months ended March 31, 2005 to approximately $26.5 million for the six months ended March 31, 2006. The decrease in revenue was mainly related to decreased contribution from our CEM WebEffective engagements, partially offset by increases in contribution from our Transaction Perspective and Application Perspective subscription services. Total expenses increased by $978,000, from approximately $26.3 million for the six months ended March 31, 2005 to approximately $27.3 million for the six ended March 31, 2006. The increase in total expenses for the six months ended March 31, 2006 compared to the six months ended March 31, 2005, was mainly attributable to a $1.7 million increase in stock-based compensation expense due to the adoption of SFAS 123R on October 1, 2005, increased costs of subscription services related to increased depreciation, equipment charges and connection fees, international sales growth resulting in increased personnel and associated compensation and travel related expenses, and an increase in audit and accountancy fees primarily attributable to increased costs for corporate governance and compliance requirements and audit work related to fiscal 2005 where such services were performed in the six months ended March 31, 2006. The increase in total expenses was offset by the following, as listed in descending order of impact: 1) lower amortization expense due to certain intangible assets being fully amortized in the second half of fiscal 2005 and first half of fiscal 2006, 2) a $439,000 net reduction in expenses due to refunds and the reversal of accruals related to the resolutions of our property tax returns for the fiscal years 2002 through 2004, 3) the resolution of a preferential claim settlement for $184,000, 4) lower excess occupancy costs due to the leasing of additional space in our headquarters’ building during fiscal 2005, and 5) a $109,000 reduction in the allowance for doubtful accounts. The $439,000 net reduction in expenses related to our property taxes and the $184,000 reduction in expense related to our preferential claim settlement are not expected to recur.

We anticipate that total expenses for the third quarter of fiscal 2006 will increase compared to the second quarter of fiscal 2006 as a result of our acquisition of SIGOS Systemintegraton GmbH (“SIGOS”) on April 3, 2006.

At the end of March 31, 2006, we measured for revenue 9,269 Internet URLs and 6,904 internet-connected devices through our Red Alert services. At the end of March 31, 2005, we measured for revenue 8,302 Internet URLs and 7,719 internet-connected devices.

For the three and six months ended March 31, 2006, our 10 largest customers accounted for approximately 33% of total revenue. We cannot be certain that customers that have accounted for significant revenue in past periods, individually or in aggregate, will renew our services and continue to generate revenue in any future period. In addition, our customers that have monthly renewal arrangements may terminate their services at any time with little or no penalty. If we lose a major customer or a group of significant customers, our revenue could significantly decline.

We believe that the challenges for our business include 1) increasing SLM, mobile and CEM revenue by generating organic revenue growth from our existing services and by continuing to internally develop enhanced services, 2) integrating and realizing anticipated benefits from our prior acquisitions and any acquisitions that may occur in the future and 3) continuing to control our expenses for the remainder of fiscal 2006.

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements and accompanying notes included elsewhere in this quarterly report on Form 10-Q are prepared in accordance with accounting principles generally accepted in the United States of America. Note 2, “Summary of Significant Accounting Policies,” to the consolidated financial statements in our Annual Report on Form 10-K for the fiscal year ended September 30, 2005 describes the significant accounting policies and methods used in the preparation of our consolidated financial statements. These accounting principles require us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

•

Revenue recognition

•

Allowance for doubtful accounts and billing allowance

•

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

Revenue consists of subscription services revenue and professional services revenue. Subscription services revenue consists of fees from subscriptions to our service level management, mobile and customer experience management services. Professional services revenue consists of fees generated by our professional services. Revenue related to the use of our WebEffective and WebExcellence services is accounted for as either subscription services revenue or professional services revenue depending upon the use.

We recognize revenue in accordance with Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition”, and Emerging Issues Task Force (“EITF”) Issue 00-21 “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”).

•

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.

•

Deferred revenue is comprised of all unearned revenue that has been collected in advance, primarily unearned subscription services revenue, and is recorded as deferred revenue on our balance sheet until the revenue is earned. Any uncollected deferred revenue reduces the balance of accounts receivable. We do not generally grant refunds. All discounts granted reduce revenue. Revenue is not recognized for free trial periods.

Subscription Services Revenue: For customers that pay in advance, subscription services revenue is deferred upon invoicing and is recognized ratably over the service period, generally ranging from one to twelve months, commencing on the day service is first provided. For customers billed in arrears, subscription services revenue is invoiced monthly upon completion of the services. If a customer purchases a subscription to our WebEffective and WebExcellence services, revenue is recognized ratably over the subscription period, commencing on the day service is first provided, and recorded as subscription services revenue.

Professional Services Revenue: Professional services revenue consists of fees generated by the Company's professional services, and is recognized as the services are performed, typically over a period of one to three months. For professional service projects that span one month or less, we recognize revenue once the project is complete. For professional service projects that contain milestones, we recognize revenue once the services or milestones have been delivered. For those professional service projects that do not have milestones, we recognize revenue as services are proportionally performed, based on labor hours incurred as a percentage of total estimated hours. Payment occurs either up front or over time.

On limited occasions, we enter into arrangements with multiple elements, which include both subscription and professional service revenue. For these arrangements, we recognize revenue in accordance with EITF 00-21 and allocate and defer revenue for the undelivered items based on vendor specific objective evidence, or VSOE, of fair value of the undelivered elements, and recognize the difference between the total arrangement fee and the amount deferred for the undelivered items as revenue. VSOE of each element is based on the price for which the undelivered element is sold separately. We determine fair value of the undelivered elements based on historical evidence of our stand-alone sales of these elements to third parties. When VSOE does not exist for undelivered items, then the entire arrangement fee is recognized ratably over the performance period.

Revenue results are difficult to predict and any shortfall in revenue or unforeseen delay in recognizing revenue could cause operating results to vary from quarter to quarter.

Allowance for Doubtful Accounts and Billing Allowance

Accounts receivable are recorded net of an allowance for doubtful accounts receivable and billing allowance of approximately $392,000, or 6% of total accounts receivable, and approximately $534,000, or 8% of total accounts receivable, as of March 31, 2006 and September 30, 2005, respectively. The decrease in our allowance for doubtful accounts and billing allowance is due to improved collection experience rates and a reduction in actual billing adjustments.

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

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

Allocation of Purchase Price for Business Combinations

We are required to allocate the purchase price of acquired companies to the tangible and intangible assets acquired and liabilities assumed, as well as any in-process research and development ("IPR&D"), based on their estimated fair values. Our methodology for allocating the purchase price relating to acquisitions is usually determined based on valuations performed by an independent third party. Such valuations require making significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing certain intangible assets include, but are not limited to, future expected cash flows from customer contracts, customer lists and acquired developed technologies, expected costs to develop IPR&D into commercially viable products and estimating cash flows from projects when completed and discount rates. Estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Other estimates such as accruals associated with the accounting for acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed.

Impairment Assessments of Goodwill, Identifiable Purchased Intangibles and Long-Lived Assets

Goodwill is measured as the excess of the cost of acquisition over the sum of the amounts assigned to identifiable assets acquired less liabilities assumed.

We evaluate our goodwill, identifiable intangible assets, and other long-lived assets for impairment on an annual basis, and whenever events or changes in circumstances indicate that the carrying value of an asset may not be fully recoverable for our single reporting unit. Factors we consider important which could trigger an impairment review include the following:

•

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

•

significant negative industry or economic trends;

•

significant decline in our stock price for a sustained period; and

•

our market capitalization relative to net book value.

Management continually applies its judgment when performing these evaluations to determine the timing of the testing, the undiscounted net cash flows used to assess recoverability of the intangible assets and the fair value of the asset group. If future events or circumstances indicate that an impairment assessment is required and an asset group is determined to be impaired, our financial results could be materially and adversely impacted in future periods.

If our estimates or the related assumptions change in the future, we may be required to record an impairment charge on goodwill to reduce its carrying amount to its estimated fair value. If future events or circumstances indicate that an impairment assessment is required on intangible or long-lived assets and an asset group is determined to be impaired, our financial results could be materially and adversely impacted in future periods.

Stock-Based Compensation

We issue stock options to our employees and outside directors and provide our employees the right to purchase common stock under employee stock purchase plans. Since October 1, 2005, we account for stock-based compensation in accordance with SFAS No. 123R. Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the service (vesting) period. In determining this disclosure, the value of an option is estimated using the Black-Scholes option valuation model. This model requires the input of highly subjective assumptions and a change in our assumptions could materially affect the fair value estimate, and thus, the total calculated costs associated with the grant of stock options or issue of stock under employee stock purchase plans. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted.

Accounting for Income Taxes and Deferred Income Tax Assets

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

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our net deferred tax assets. Tax exposures can involve complex issues and may require an extended period to resolve. Changes in the geographic mix or estimated level of annual income before taxes can affect the overall effective tax rate. We perform an analysis of our effective tax rate and we assess the need for a valuation allowance against our deferred tax assets quarterly.

Historically, we have calculated the provision for income taxes in interim periods using an estimate of the annual effective tax rate. In the second quarter of 2006, we concluded that as a result of the uncertainty of the effect of stock-based compensation charges under SFAS 123R associated with incentive stock options and the 1999 Employee Stock Purchase Plan shares in relation to our projected pre-tax book income, and the fact that our income tax rate is highly dependent upon this relationship, a small variation in projected pre-tax book income could have a significant impact on our effective tax rate. Accordingly, consistent with footnote 7 of Financial Accounting Standard Board (“FASB”) Interpretation No. 18, “Accounting for Income Taxes in Interim Periods,” we have used the actual book income through the six months ended March 31, 2006, to calculate the effective tax rate for the six months ended March 31, 2006. This tax expense, less the amount recorded in the three months ended December 31, 2005, was recorded for the three months ended March 31, 2006.

The uncertainties which could affect the realization of our deferred tax assets include various factors as described in the risk factors section including the amount of deductions for tax purposes related to our stock options, potential successful challenges to the deferred tax assets by taxing authorities, and a mismatch of the period during which the type of taxable income and the deferred tax assets are realized. As of September 30, 2005, we had a material weakness in our internal controls over financial reporting that existed as of September 30, 2005 with respect to our accounting for income taxes. The Company has taken steps to ensure that this material weakness was remediated by implementing enhanced control processes over accounting for income taxes including hiring a third-party professional services firm with expertise in accounting for income taxes to assist in the preparation and review of our income tax provision and deferred tax assets and liabilities.

We establish liabilities or reserves when we believe that certain tax positions are likely to be challenged and we may not succeed, despite our belief that our tax returns are fully supportable. We evaluate these reserves each quarter and adjust the reserves and the related interest in light of changing facts and circumstances regarding the probability of realizing tax benefits, such as the progress of a tax audit or the expiration of a statute of limitations. We believe that our tax positions comply with applicable tax laws and that we have adequately provided for known material tax contingencies; however, due to the inherent complexity and uncertainty relating to tax matters, including the likelihood and potential outcome of any tax audits, management is not able to estimate the range of reasonably possible losses in excess of amounts recorded.

Results of Operations

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


	Three Months Ended March 31,				Six Months Ended March 31,
	2006		2005		2006		2005
Revenue:
Subscription services	78.1	%	73.3	%	74.7	%	73.5	%
Professional services	21.9		26.7		25.3		26.5

Total revenue	100.0		100.0		100.0		100.0
Expenses:
Costs of subscription services	12.2		9.9		11.4		10.0
Costs of professional services	17.3		18.5		17.6		18.2
Research and development	16.4		15.8		15.4		15.1
Sales and marketing	31.5		22.7		27.9		24.4
Operations	14.5		10.9		13.2		11.2
General and administrative	13.4		14.0		14.8		13.6
Excess occupancy costs	(0.3	)	0.9		(0.2	)	0.9
Amortization of identifiable intangible assets	3.3		5.1		3.1		5.0

Total expenses	108.3		97.8		103.2		98.4
Income (loss) from operations	(8.3	)	2.2		(3.2	)	1.6
Interest income, net	10.0		5.9		9.0		5.6

Net income before provision for income taxes	1.7		8.1		5.8		7.2
Provision for income taxes	(2.9	)	(0.5	)	(4.2	)	(0.5	)

Net income (loss)	(1.2	)%	7.6	%	1.6	%	6.7	%

Comparison of Three and Six Months Ended March 31, 2006 and 2005

Revenue


	2006		2005		% Change
	(In thousands)
For the three months ended March 31:
Subscription services	$	9,947	$	9,652	3	%
Professional services		2,792		3,513	-21	%

Total revenue	$	12,739	$	13,165	-3	%

For the six months ended March 31:
Subscription services	$	19,767	$	19,675	0	%
Professional services		6,688		7,078	-6	%

Total revenue	$	26,455	$	26,753	-1	%

Subscription Services. Revenue from subscription services increased $295,000 for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005. Revenue from subscription services increased $92,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005. The increase in subscription services revenue for the three months ended March 31, 2006, as listed in descending order of impact, was mainly attributable to an increase in our Application

Perspective, our Wireless Perspective, our CEM WebExcellence, our Transaction Perspective, our Streamcheck, and our diagnostic services, offset by a decrease in our Web Site Perspective and our NetMechanic services.

The increase in subscription services revenue for the six months ended March 31, 2006, as listed in descending order of impact, was mainly attributable to an increase in our Application Perspective, our Transaction Perspective, our CEM WebExcellence, offset by a decrease in our Web Site Perspective, and our NetMechanic services.

Professional Services. Revenue from professional services decreased $721,000 for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005. Revenue from professional services decreased $390,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005. The decrease in professional services revenue for the three months ended March 31, 2006, as listed in descending order of impact, was primarily due to decreased contribution from our CEM WebEffective engagements and, to a lesser extent, a decreased contribution in our Load Testing and our Enterprise Solutions services, offset partially by an increased contribution from our CEM WebExcellence services.

The decrease in professional services revenue for the six months ended March 31, 2006 was primarily due to decreased contribution from our CEM WebEffective engagements, offset partially by increased contributions from our CEM WebExcellence, our Competitive Intelligence, and our Load Testing and Enterprise Solutions services. Because our consulting and support services are provided on a per engagement basis, revenue depends on the number of engagements and the size of such engagements. As a result, consulting and support services revenue are less predictable than subscription services revenue and may vary from period to period.

In addition to analyzing revenue for subscription services and professional services, management also internally analyzes revenue categorized as SLM, mobile, and CEM. The following table identifies which services are categorized as SLM, mobile and CEM revenue and where they are recorded in our condensed consolidated statements of operations listed in alphabetical order:


	Subscription Services	Professional Services
Service Level Management:
Application Perspective Private Edition	X
Diagnostic Services	X
Enterprise Solutions	X	X
LoadPro		X
NetMechanic	X
Network Perspective	X
Professional Services		X
Red Alert	X
Streaming Perspective	X
Test Perspective	X
Transaction Perspective	X
WebIntegrity	X
Web Site Perspective	X
VoIP Perspective	X

Mobile:
Wireless Perspective & Wireless Perspective Network Edition	X
Mobile Application Perspective	X

Customer Experience Management:
WebEffective	X	X
WebExcellence	X	X

The following table summarizes SLM, Mobile, and CEM revenue:


	2006		2005		% change
	(In thousands)
For the Three Months Ended March 31:
SLM Subscriptions	$	8,876	$	8,783	1	%
SLM Engagements		905		1,082	(16	)%

Total SLM revenue		9,781		9,865	(1	)%

Mobile Subscriptions		488		338	44	%
Mobile Engagements		—		—	—	%

Total Mobile Revenue		488		338	44	%

CEM Subscriptions		583		531	10	%
CEM Engagements		1,887		2,431	(22	)%

Total CEM revenue		2,470		2,962	(17	)%

Total revenue	$	12,739	$	13,165	(3	)%

For the Six Months Ended March 31:
SLM Subscriptions	$	17,658	$	17,408	1	%
SLM Engagements		2,032		1,904	7	%

Total SLM revenue		19,690		19,312	2	%

Mobile Subscriptions		1,027		1,141	(10	)%
Mobile Engagements		—		—	—	%

Total Mobile Revenue		1,027		1,141	(10	)%

CEM Subscriptions		1,082		1,126	(4	)%
CEM Engagements		4,656		5,174	(10	)%

Total CEM revenue		5,738		6,300	(9	)%

Total revenue	$	26,455	$	26,753	(1	)%

SLM revenue decreased by $84,000 for the three months ended March 31, 2006 compared to three months ended March 31, 2005. SLM revenue represented 77% and 75% of total revenue for the three months ended March 31, 2006 and 2005, respectively. The decrease in SLM revenue for the three months ended March 31, 2006 was mainly attributable to decreased contribution from our Load Testing and our Enterprise Solutions engagements and a decrease in our Web Site Perspective subscriptions, offset partially by increased contribution from our Application Perspective, our Transaction Perspective, our Streamcheck, our Red Alert and our diagnostic services. SLM revenue increased by $378,000 for the six months ended March 31, 2006 compared to six months ended March 31, 2006. The increase in SLM revenue for the six months ended March 31, 2006 was mainly attributable to increased contribution from our Transaction Perspective and our Application Perspective subscription services and our Load Testing engagement services, offset partially by a decrease in our Web Site Perspective subscription services.

Mobile revenue increased by $150,000 for the three months ended March 31, 2006 compared to the three months ended March 31, 2005. Mobile revenue represented 4% and 3% of total revenue for the three months ended March 31, 2006 and 2005, respectively. Mobile revenue decreased by $114,000 for the six months ended March 31, 2006 compared to the six months ended March 31, 2005. Mobile revenue represented 4% of total revenue for both the six months ended March 31, 2006 and 2005. Both the increase for the three months ended March 31, 2006 and the decrease for the six months ended March 31, 2006 were attributable to fluctuating demand for our Wireless Perspective services.

CEM revenue decreased by $492,000 for the three months ended March 31, 2006 compared to the three months ended March 31, 2005. CEM revenue represented 19% and 22% of total revenue for the three months ended March 31, 2006 and 2005, respectively. CEM revenue decreased by $562,000 for the six months ended March 31, 2006 compared to the six months ended March 31, 2005. CEM revenue represented 22% and 24% of total revenue for the six months ended March 31, 2006 and 2005, respectively. The decrease in CEM revenue for both the three and six months ended March 31, 2006 was mainly attributable to a decrease in

WebEffective engagements and decreased subscription renewals to our WebEffective technology, offset partially by an increased contribution from our WebExcellence technology and engagements.

For both the three and six months ended March 31, 2006, Microsoft Corporation accounted for more than 10% of total revenue. For both the three and six months ended March 31, 2005, no single customer accounted for more than 10% of total revenue. As of March 31, 2006, Microsoft Corporation accounted for 15% of the Company’s total accounts receivable. International sales were approximately 7% and 9% of our total revenue for the three months ended March 31, 2006 and 2005, respectively. International sales were approximately 9% and 7% of our total revenue for the six months ended March 31, 2006 and 2005, respectively.

Expenses:

Costs of Subscription and Professional Services


	2006		2005		% Change
	(In thousands)
For the three months ended March 31:
Costs of subscription services	$	1,552	$	1,309	19	%
Costs of professional services	$	2,210	$	2,440	(9	)%
For the six months ended March 31:
Costs of subscription services	$	3,011	$	2,660	13	%
Costs of professional services	$	4,655	$	4,868	(4	)%

Costs of Subscription Services. Costs of subscription services consist of connection fees to major telecommunication and internet access providers for bandwidth usage of our measurement computers, which are located around the world, depreciation, maintenance and other equipment charges for our measurement and data collection infrastructure. Costs of subscription services increased $243,000 for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005 and represented 16% and 14% of subscription services revenue for the three months ended March 31, 2006 and 2005, respectively. Costs of subscription services increased $351,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005 and represented 15% and 14% of subscription services revenue for the six months ended March 31, 2006 and 2005, respectively. The increases in cost for both the three and six months ended March 31, 2006 were primarily due to increased depreciation, equipment charges, and connection fees related to additional measurement computers as well as replacing existing measurement computers, and increased depreciation related to software development for a product that launched during the quarter ended March 31, 2006.

Costs of Professional Services. Costs of professional services consist of compensation expenses and related costs for professional services personnel, external consulting costs to deliver our professional services, panel and reward costs associated with our WebEffective and WebExcellence Intelligence Platform services, all load-testing bandwidth costs and related network infrastructure costs. Costs of professional services decreased $230,000 for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005, and represented 79% and 69% of professional services revenue for the three months ended March 31, 2006 and 2005, respectively. Costs of professional services decreased $213,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005, and represented 70% and 69% of professional services revenue for both the six months ended March 31, 2006 and 2005. The decreases in costs of professional services for both the three and six months ended March 31, 2006 were directly related to the decrease in the CEM WebEffective engagements resulting in a decrease in compensation expenses, panel and reward costs. An additional reduction in expense was due to a reduction in SLM professional services personnel as compared to March 31, 2005. These decreases were partially offset by an increase in stock-based compensation expense due to the adoption of SFAS 123R on October 1, 2005 and additional personnel costs associated with our acquisition of the GomezPro division of Watchfire in December 2005.

Research and Development


	2006		2005		% Change
	(In thousands)
For the three months ended March 31:
Research and development	$	2,091	$	2,074	1	%
For the six months ended March 31:
Research and development	$	4,080	$	4,036	1	%

Research and development expenses consist primarily of compensation and related costs for research and development personnel. Research and development expenses increased by $17,000 for the three months ended March 31, 2006 compared to the three months ended March 31, 2005. Research and development expenses increased by $44,000 for the six months ended March 31, 2006 compared to the six months ended March 31, 2005. Although research and development expenses increased due to the stock-based compensation expense due to the adoption of SFAS 123R on October 1, 2005, this increase in expense was partially offset by a reduction in expense attributable to lower personnel, consulting and temporary labor costs of $217,000 and $288,000 for the three and six months ended March 31, 2006, respectively, and an allocation for the applicable portion of the resolution of our property tax returns for the years 2002 through 2004 of $5,000 and $69,000 for the three and six months ended March 31, 2006, respectively. To date, all research and development expenses have been expensed as incurred. We believe that research and development expenses in absolute dollars for the third quarter of fiscal 2006 will increase due to our acquisition of SIGOS on April 3, 2006.

Sales and Marketing


	2006		2005		% Change
	(In thousands)
For the three months ended March 31:
Sales and marketing	$	4,020	$	2,987	35	%
For the six months ended March 31:
Sales and marketing	$	7,389	$	6,535	13	%

Sales and marketing expenses consist primarily of salaries, stock-based compensation, commissions and bonuses earned by sales and marketing personnel, lead-referral fees, marketing programs and travel expenses. Our sales and marketing expenses increased by approximately $1.0 million for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005. Our sales and marketing expenses increased $854,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005. These increases were mainly attributable to an increase in international growth and the addition of sales personnel and related travel costs associated with this growth. In addition, expenses increased related to stock-based compensation expense due to the adoption of SFAS 123R on October 1, 2005, an increase in tradeshow costs, and marketing expense related to modifications to our web site. We believe that sales and marketing expenses will increase in absolute dollars for the third quarter of fiscal 2006 compared to the second quarter of fiscal 2006 due to our acquisition of SIGOS on April 3, 2006.

Operations


	2006		2005		% Change
	(In thousands)
For the three months ended March 31:
Operations	$	1,847	$	1,440	28	%
For the six months ended March 31:
Operations	$	3,494	$	3,005	16	%

Operations expenses consist primarily of compensation and related costs for management and technical support personnel who manage and maintain our field measurement and collection infrastructure and headquarters data center, and provide basic and extended customer support. Our operations personnel also work closely with other departments to assure the reliability of our services and to support our sales and marketing activities. Our operations expenses increased $407,000 for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005. Our operations expenses increased $489,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005. The increases in operations expenses for both the three and six month periods were primarily attributable to an increase in stock-based compensation due to the adoption of SFAS 123R on October 1, 2005, and the reclassification of certain operations personnel from general and administrative expense to operations expense during the second half of fiscal 2005. We do not anticipate that operations expenses for the third quarter of fiscal 2006 will fluctuate significantly in absolute dollars compared to the second quarter of fiscal 2006.

General and Administrative


	2006		2005		% Change
	(In thousands)
For the three months ended March 31:
General and administrative	$	1,702	$	1,841	(8	)%
For the six months ended March 31:
General and administrative	$	3,911	$	3,634	8	%

General and administrative expenses consist primarily of salaries and related expenses including stock-based compensation, accounting, legal and administrative expenses, insurance, professional service fees and other general corporate expenses. General and administrative expenses decreased $139,000 for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005. The decrease was attributable to the reclassification of certain operations personnel from general and administrative expense to operations expense during the second half of fiscal 2005, the settlement of a preferential claim in the quarter ended March 31, 2006 for approximately $184,000, a reduction in the allowance for doubtful accounts due to improved collection experience rates and a reduction in actual billing adjustments, legal fees, recruiting and consulting expenses, offset partially by an increase in audit fees and expense attributable to an increase in stock-based compensation due to the adoption of SFAS 123R on October 1, 2005.

General and administrative expenses increased $277,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005. The increase in our general and administrative expenses was primarily attributable to increased costs for corporate governance and compliance requirements and audit work, and an increase in stock-based compensation due to the adoption of SFAS 123R on October 1, 2005. These increases were partially offset by the reclassification of certain operations personnel from general and administrative expense to operations expense during the second half of fiscal 2005, the claim settlement described above, a reduction in the allowance for doubtful accounts due to improved collection experience rates and a reduction in actual billing adjustments, and legal fees. We believe that general and administrative expenses for the third quarter of fiscal 2006 will increase in absolute dollars compared to the second quarter of fiscal 2006 due to our acquisition of SIGOS on April 3, 2006.

Excess Occupancy Costs


	2006			2005		% Change
	(In thousands)
For the three months ended March 31:
Excess occupancy costs	$	(40	)	$	114	(135	)%
For the six months ended March 31:
Excess occupancy costs	$	(50	)	$	248	(120	)%

Excess occupancy costs are fixed expenses associated with the unoccupied portion of our headquarters’ building, such as property taxes, insurance, and depreciation. These particular expenses are reduced by the rental income from the leasing of our space in our headquarters building. The costs are based on the actual unoccupied square footage, which was 60% of the total rentable square footage of the headquarters’ building for both the three and six months ended March 31, 2006 and 2005. Excess occupancy costs decreased $154,000 for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005. Excess occupancy costs decreased $298,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005. The decreases in expenses were primarily due to a $89,000 and $208,000 increase in tenant income for the three and six months ended March 31, 2006, respectively, due to the leasing of additional space and a $72,000 and $111,000 net decrease in expense for the three and six months ended March 31, 2006, respectively, due to the resolution of our property tax returns for the years 2002 through 2004. The decreases in expenses were partially offset by an increase in lease commission costs of approximately $7,000 and $21,000, for the three and six months ended March 31, 2006, respectively. We expect the unoccupied portion of our headquarters building for the third quarter of fiscal 2006 will remain comparable to the second quarter of fiscal 2006.

Amortization of Identifiable Intangible Assets


	2006		2005		% Change
	(In thousands)
For the three months ended March 31:
Amortization of identifiable intangible assets	$	418	$	677	(38	)%
For the six months ended March 31:
Amortization of identifiable intangible assets	$	815	$	1,341	(39	)%

Amortization of identifiable intangible assets decreased by $259,000 for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005. Amortization of identifiable intangible assets decreased by $526,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005. The decreases for both comparable periods were primarily due to certain intangibles becoming fully amortized in the second half of fiscal 2005 and the first half of fiscal 2006.

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

At March 31, 2006, we had a remaining balance of approximately $3.4 million of identifiable intangible assets that are being amortized over a two to four-year expected life. We expect the amortization of identifiable intangible assets to be approximately $400,000 for the third quarter of fiscal 2006, assuming no additional acquisitions or impairment charges. We expect the remaining carrying value of the identifiable intangible assets as of March 31, 2006, as listed in the table below, will be fully amortized by November 2010 (in thousands):


	Technology Based		Customer Based		Total
Net carrying value at March 31, 2006	$	2,199	$	1,227	$	3,426

*Interest Income and Interest and Other Expenses*

	2006		2005		% Change
	(In thousands)
For the three months ended March 31:
Interest income, interest and other expenses, net	$	1,280	$	783		63	%
For the six months ended March 31:
Interest income, interest and other expenses, net	$	2,388	$	1,486		61	%

Interest income and interest and other expenses, net increased $497,000 for the three months ended March 31, 2006 as compared to the three months ended March 31, 2005. Interest income and interest and other expenses, net increased $902,000 for the six months ended March 31, 2006 as compared to the six months ended March 31, 2005. The increases in interest income and interest and other expenses, net, for both comparable periods were primarily attributable to increased investment yields resulting from higher market interest rates earned on invested cash, cash equivalents, and short-term investments. We expect that interest income, and interest and other expenses, net, for the third quarter of fiscal 2006 will be approximately $1.0 million, absent any additional transactions, and assuming no material changes in interest rates.

Provision for Income Taxes


	2006		2005		% Change
	(In thousands)
For the three months ended March 31:
Provision for income taxes	$	373	$	69	441	%
For the six months ended March 31:
Provision for income taxes	$	1,105	$	124	791	%

Our effective tax rate for the quarter ended March 31, 2006 and 2005 was approximately 170.3% and 6.5%, respectively. Our effective tax rate for the six months ended March 31, 2006 and 2005 was approximately 71.8% and 6.5%, respectively.

In the three months ended March 31, 2005, we determined that a full valuation allowance was required against the deferred tax assets due to the limited history of profitable quarters and uncertainties in projecting future taxable income at that time as a result of recent acquisitions; however, as of the year ended September 30, 2005, the projected sources of taxable income were considered to be sufficient to eliminate a portion of the valuation allowance. In future quarters, the projected taxable income will be evaluated for this purpose, and it is possible that the valuation allowance would be increased or reduced further. Any such changes in the valuation allowance could have a material effect on the effective tax rate and deferred tax expense, the goodwill balance, and the paid-in-capital. SFAS 123R has the effect of increasing the effective tax rate due to the charge to earnings from incentive stock options and ESPP shares, which have no associated tax benefit to the company. In a future period it is possible that we may realize a tax benefit on these options, at which time the tax rate may be reduced as a result.

Due to the amount of SFAS 123R expenses associated with incentive stock options and ESPP shares in relation to the projected pre-tax book income, the estimated annual effective rate varies significantly for a relatively small change in projected pre-tax book income. Therefore, we have used the actual book income through the six months ended March 31, 2006, to calculate the effective tax rate for the six months ended March 31, 2006. This tax expense, less the amount recorded in the three months ended December 31, 2005, was recorded for the three months ended March 31, 2006.

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

Deferred tax liabilities have not been recognized for undistributed earnings of foreign subsidiaries because it is management's intention to reinvest such undistributed earnings outside the United States.

Federal and California tax laws impose substantial restrictions on the utilization of net operating loss and credit carryforwards in the event of an "ownership change" for tax purposes, as defined in Section 382 of the Internal Revenue Code. We have preliminarily determined that ownership changes have occurred, and the effects of the limitations have been included in the loss and credit carryforwards. If an ownership change has occurred at different dates or in addition to the dates preliminarily identified, the utilization of net operating loss and credit carryforwards could be significantly reduced.

Stock-based Compensation Expense

On October 1, 2005, we adopted SFAS 123R, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock-options and employee stock purchases based on estimated fair values. The following table summarizes stock-based compensation related to employee stock options and employee stock purchases under SFAS 123R which was allocated as follows:


	Three Months Ended March 31, 2006		Six Months Ended March 31, 2006
	(in thousands)
Costs of professional services	$	161	$	282
Research and development		215		401
Sales and marketing		255		501
Operations		183		333
General and administrative		94		187

Stock-based compensation expense included in operating expenses related to stock options and employee stock purchase	$	908	$	1,704

Liquidity and Capital Resources


	As of March 31, 2006		As of September 30, 2005
	(In thousands)
Cash, cash equivalents and short-term investments	$	137,289	$	133,803
Accounts receivable, net	$	6,283	$	6,387
Working capital	$	130,079	$	127,335
Days sales in accounts receivable (DSO) (a)		44		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 six months ended March 31:
Cash provided by operating activities	$	6,446	$	4,611
Cash provided by investing activities	$	15,472	$	9,098
Cash provided by financing activities	$	1,190	$	879

Cash, cash equivalents and short-term investments

As of March 31, 2006, we had approximately $70.0 million in cash and cash equivalents and approximately $67.3 million in short-term investments, for a total of approximately $137.3 million. Cash and cash equivalents consist of highly liquid investments held at major banks, commercial paper, money market mutual funds and other money market securities with original maturities of three months or less. Short-term investments consist of investment-grade corporate and government debt securities and issuances with Moody’s ratings of A2 or better. The increase in cash, cash equivalents and short-term investments for the six months ended March 31, 2006 was primarily due to approximately $6.4 million from cash flow from operating activities and approximately $1.2 million from cash flow from financing activities. The largest uses of cash from investing activities during the six months ended March 31, 2006 were payments related to our acquisitions of approximately $2.7 million, and the purchases of property and equipment of approximately $1.4 million.

Cash provided by operating activities

We expect that cash provided by operating activities may fluctuate in future periods as a result of a number of factors, including fluctuations in our operating results, accounts receivable collections, and the timing and amount of tax and other payments. For the six months ended March 31, 2006, net cash provided by operating activities was approximately $6.4 million which was mainly due to net income, excluding all non-cash amortization and depreciation charges and deferred tax assets, a decrease of accounts payable and accrued expenses of $468,000, and an increase in non-acquisition related deferred revenue of $789,000. The decrease in accounts payable and accrued expenses was mainly attributable to payments made resulting in a reduction in audit and accountancy accruals. The increase in non-acquisition related deferred revenue was mainly attributable to the acquisition of the Gomez-Pro business of Watchfire acquired on November 30, 2005, and increased prepayments received from a wireless customer and international customers.

Cash provided by investing activities

The changes in cash flows from investing activities primarily relate to the timing of purchases and maturities of investments and acquisitions. We also use cash to invest in capital and other assets to support our growth and infrastructure. For the six months ended March 31, 2006, net cash provided by our investing activities was approximately $15.5 million. We received $19.5 million for the net sales of short-term investments. We utilized approximately $2.7 million, mainly for the acquisition of the GomezPro business on November 30, 2005. We also utilized $1.4 million to purchase property and equipment, primarily for our production infrastructure, information systems, and tenant improvements associated with space that we have leased in our headquarters building.

Cash provided by financing activities

The changes in cash flows from financing activities primarily relate to payments made for stock repurchases and proceeds received from the issuance of common stock associated with our employee stock option plan and employee stock purchase plan. Our Board of Directors has approved a plan to repurchase shares of our common stock. The Board has expanded the repurchase program several times by either increasing the authorized number of shares to be repurchased or by authorizing a fixed dollar amount expansion, most recently in October 2005. From the inception of the stock repurchase program in January 2001 to March 31, 2006, a total of approximately 12.4 million shares have been repurchased in the open market for approximately $114.4 million. At March 31, 2006, approximately $15.6 million was available to repurchase shares of our common stock pursuant to the stock repurchase program. For the six months ended March 31, 2006, net cash provided by our financing activities was $1.2 million. We utilized approximately $1.6 million to repurchase shares of our common stock and received approximately $2.8 million from the issuance of common stock and exercise of stock options.

Commitments

As of March 31, 2006, our principal commitments consisted of approximately $3.3 million in real property operating leases and equipment capital and operating leases, with various lease terms, the longest of which expires in August 2015. Additionally, we had contingent commitments ranging in length from one to twelve months to 120 bandwidth and collocation providers amounting to $702,000 in the aggregate for 106 locations, which commitments become due if we terminate any of these agreements prior to their expiration. At present, we do not intend to terminate any of these agreements prior to their expiration. We expect to continue to invest in capital and other assets to support our growth. We expect to make additional capital expenditures of approximately $1.1 million related to our operations and headquarters building and approximately $30.1 million related to our acquisition of SIGOS announced on April 3, 2006 during the third quarter of fiscal 2006, absent any other acquisitions or extraordinary transactions.

The following table summarizes our minimum contractual obligations and commercial commitments as of March 31, 2006 (in thousands):


	Total		Less than 1 year		2 –3 years		4–5 years		More than 5 years
Contractual Obligations: Leases	$	3,259	$	538	$	742	$	707	$	1,272
Commercial Commitments: Bandwidth and Collocation		702		702		—		—		—

Total	$	3,961	$	1,240	$	742	$	707	$	1,272

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

Off Balance Sheet Arrangements

We did not enter into any transactions with unconsolidated entities whereby we have financial guarantees, subordinated retained interests, derivative instruments or other contingent arrangements that expose us to material continuing risks, contingent liabilities, or any other obligation under a variable interest in a unconsolidated entity that provides financing, liquidity, market risk or credit risk support to us.

Item 3.

Quantitative and Qualitative Disclosures About Market Risks.

Interest Rate Sensitivity. Our interest income and expense is sensitive to changes in the general level of U.S. interest rates, particularly because most of our cash, cash equivalents and short-term investments are invested in short-term debt instruments. If

market interest rates were to change immediately and uniformly by ten percent (10%) from levels as of March 31, 2006, the interest earned on those cash, cash equivalents, and short-term investments could increase or decrease by approximately $490,000 on an annualized basis.

Foreign Currency Fluctuations and Derivative Transactions. We have not had any significant transactions in foreign currencies, nor do we have any significant balances that are due or payable in foreign currencies as of March 31, 2006. We do not enter into derivative transactions for trading or speculative purposes.

Item 4.

Controls and Procedures

(a)

Changes in Internal Controls

There were no changes in our internal control over financial reporting during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

(b)

Evaluation of Disclosure Controls and Procedures

Regulations under the Securities Exchange Act of 1934 require public companies to maintain "disclosure controls and procedures," which are defined to mean a company's controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Commission's rules and forms. Our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective in reaching a level of reasonable assurance in achieving our desired control objectives.

PART II—OTHER INFORMATION

Item 1.

Legal Proceedings

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

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.

We had a net loss for the quarter ended March 31, 2006 and we may not be able to sustain operating profitability in the future. As of March 31, 2006, we had an accumulated deficit of approximately $129.6 million. As of March 31, 2006, we had approximately $3.4 million of net identifiable intangible assets and approximately $23.6 million of goodwill. If we complete additional acquisitions in the future, we may have additional goodwill and/or identifiable intangibles and, accordingly, may incur expenses in connection with a write-down of goodwill and identifiable intangible assets due to changes in market conditions as we did in the quarter ended June 30, 2001 when we recorded an impairment charge for goodwill and identifiable intangible assets of $30.5 million in connection with our acquisitions of Velogic and Digital Content. We believe that our operating expenses could increase as they have in certain past periods. We also experienced increased expenses due to the adoption of SFAS 123R. As a result, we will need to increase our revenue to sustain profitability. We may not sustain a sequential quarterly increase in revenue and may never be able to regain our historic revenue growth rates.

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

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

Further, we depend on sales to new customers and sales of additional services to our existing customers. Renewals by existing customers or purchases of our services by new customers may be limited as companies limit or reduce their technology spending in

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

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

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

•

The rate of new and renewed subscriptions to our services during the quarter;

•

The amount 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;

•

Our ability to increase revenues from our CEM services;

•

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.

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

We may face difficulties assimilating our acquisitions and may incur costs associated with any future acquisitions.

We have completed several acquisitions, and as a part of our business strategy we may seek to acquire or invest in additional businesses, products or technologies that we feel could complement or expand our business, augment our market coverage, enhance our technical capabilities or that may otherwise offer growth opportunities. Future acquisitions could create risks for us, including:

•

difficulties in assimilating acquired personnel, operations and technologies;

•

difficulties in managing a larger organization 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 service and our customers;

•

difficulties in managing geographically-dispersed businesses;

•

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

•

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

•

failure to realize any of the anticipated benefits of the acquisition; and

•

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

Our operating results could be harmed if sales of SLM subscriptions decline.

Sales of our service level management subscription services, primarily our Web Site Perspective-Business Edition and Transaction Perspective services, have generated a majority of our total revenue in the past. Therefore, the success of our business currently depends, and for the immediate future will continue to substantially depend, on sales and renewals of our service level management services. Our service level management subscriptions revenue has not increased significantly from historic levels. If these revenue trends continue with respect to our service level management subscriptions services, our operating results could suffer if we are not able to increase revenue from other services.

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

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

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

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

These problems could also result in tort or warranty claims. Although we attempt to reduce the risk of losses resulting from any claims through warranty disclaimers and liability-limitation clauses in our customer agreements, these contractual provisions may not be enforceable in every instance. Furthermore, although we maintain errors and omissions insurance, this insurance coverage may not adequately cover us for claims. If a court refused to enforce the liability-limiting provisions of our contracts for any reason, or if liabilities arose that were not contractually limited or adequately covered by insurance, we could be required to pay damages.

If we do not continually improve our services in response to technological changes, including changes to the Internet, we may encounter difficulties retaining existing customers and attracting new customers.

The ongoing evolution of the Internet has led to the development of new technologies such as Internet telephony, wireless devices, wireless fidelity, and WI-FI networks. These developing technologies require us to continually improve the functionality, features and reliability of our services, particularly in response to offerings of our competitors. If we do not succeed in developing and marketing new services that respond to competitive and technological developments and changing customer needs, we may encounter difficulties retaining existing customers and attracting new customers. We must also introduce any new services as quickly as possible. The success of new services depends on several factors, including proper definition of the scope of the new services and timely completion, introduction and market acceptance of our new services. If new Internet, networking or telecommunication technologies or standards are widely adopted or if other technological changes occur, we may need to expend significant resources to adapt our services to these developments or we could lose market share or some of our services could become obsolete.

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

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

We could also face competition from other companies, which currently do not offer services similar to our services, but offer software or services related to Web analytics services, such as Webtrends, Omniture, Webside Story and Coremetrics, and free services that measure Web site availability. In addition, companies that sell systems management software, such as BMC Software, CompuWare, CA-Unicenter, HP-Openview, Quest Software, NetIQ, Symantec’s Precise Software, and IBM’s Tivoli Unit, with some of whom we have strategic relationships, could choose to offer services similar to ours. We also face competition for our wireless services from companies such as Argogroup, Casabyte, Agilent, Datamat and Mobile Complete.

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

There are many experienced firms that offer computer network and Internet-related consulting services. These consulting services providers include consulting companies, such as Accenture, as well as consulting divisions of large technology companies such as IBM. Because we do not have an established reputation for delivering professional services, because this area is very competitive, and because we have limited experience in delivering professional services, we may not succeed in selling these services.

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

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

Our ten largest customers accounted for approximately 33% and 35% of our total revenue for the six months ended March 31, 2006 and 2005, respectively. We cannot be certain that customers that have accounted for significant revenue in past periods, individually or as a group, will renew, will not cancel or will not reduce their services and, therefore, continue to generate revenue in any future period. In addition, our customers that do not have written contracts or that have monthly renewal arrangements may terminate their services at any time with little or no penalty. If we lose a major customer, our revenue could decline.

If we do not complement our direct sales force with relationships with other companies to help market our services, we may not be able to grow our business.

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

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

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

We may be unable to retain our key employees, namely our management team and experienced engineers, or to attract, assimilate or retain other highly qualified employees. In fiscal 2005, we experienced three changes in executive management. In addition, our Chief Financial Officer departed the Company in January 2006. Although we, and a number of other technology companies, have implemented workforce reductions, there remains substantial competition for highly skilled employees. Our key employees are not bound by agreements that could prevent them from terminating their employment at any time. If we fail to attract and retain key employees, our business could be harmed.

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

Professional services revenue represented approximately 25% and 26% of total revenue for the six months ended March 31, 2006 and 2005, respectively. Professional services revenue has decreased in absolute dollars recently, and this trend could continue. We will need to successfully market these services in order to increase consulting revenue. Each professional services engagement typically spans a one- to three-month period, and therefore, it is more difficult for us to predict the amount of professional services revenue recognized in any particular quarter. Our business could be harmed if we cannot increase our professional services revenues.

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

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

•

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

•

inconsistent quality of service, including well-publicized outages of popular Web sites;

•

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.

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

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

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

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

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

Our measurement computers that we use to provide many of our services are located at facilities that are not owned by our customers or us. Instead, these computers are installed at locations near various Internet access points worldwide. Although we operate these computers remotely from our San Mateo, California operations center, we do not own or operate the facilities, and we have little control over how these computers are maintained on a day-to-day basis. We do not have long-term contractual relationships with the companies that operate the facilities where our measurement computers are located. We may have to find new locations for these computers if we are unable to develop relationships with these companies or if these companies cease their operations as some have done due to bankruptcies or are acquired. In addition, if our measurement computers cease to function properly, we may not be able to repair or service these computers on a timely basis, as we may not have immediate access to our measurement computers. Our ability to collect data in a timely manner could be impaired if we are unable to maintain and repair our computers should performance problems arise.

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

In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. We could become subject to intellectual property infringement claims as the number of our competitors grows and our services overlap

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

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

We believe we must expand the sales of our services outside the United States. Although we completed our first international acquisition in February 2005, to date, we have little experience with operating outside the United States, and we may not succeed in these efforts. International sales were approximately 9% and 7% of our total revenue for the six months ended March 31, 2006 and 2005, respectively. We intend to expand the sales of our services by selling directly to certain customers and through resellers to other customers. Therefore, we expect to continue to commit our resources to expand our international sales and marketing activities. Conducting international operations subjects us to risks we do not face in the United States. These include:

•

currency exchange rate fluctuations;

•

seasonal fluctuations in purchasing patterns;

•

unexpected changes in regulatory requirements;

•

maintaining and servicing computer hardware in distant locations;

•

longer accounts receivable payment cycles and difficulties in collecting accounts receivable;

•

difficulties in managing and staffing international operations;

•

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

•

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

•

reduced protection for intellectual property rights in some countries.

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

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

The Sarbanes-Oxley Act, which was signed into law in July 2002, mandated, among other things, that companies adopt new corporate governance measures and imposes comprehensive reporting and disclosure requirements, thorough reviews and attestations of our internal controls and imposes increased civil and criminal penalties for companies, their chief executive officers and chief financial officers and directors for securities law violations. In addition, The Nasdaq Stock Market, on which our common stock is listed, has also adopted additional comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations have increased the scope, complexity and cost of our corporate governance, reporting and disclosure practices. As a result, we have experienced and expect to continue to experience increased costs of compliance which could harm our results of operations and divert management’s attention from business operations.

We also expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. Further, our board members, Chief Executive Officer and Chief Financial Officer could face an increased risk of personal liability in connection

with the performance of their duties as a result of these developments. As a result, we may have difficultly attracting and retaining qualified board members and executive officers, which would adversely affect our results of operations.

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

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

•

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

•

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

•

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

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

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

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

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

One or more material weaknesses in our internal controls over financial reporting could occur or be identified in the future. For example, as set forth in Item 9A of our Form 10-K for the fiscal year ended September 30, 2005, we had a material weakness in our internal controls over financial reporting that existed as of September 30, 2005 with respect to our accounting for income taxes. In addition, because of inherent limitations, our internal controls over financial reporting may not prevent or detect misstatements, and any projections of any evaluation of the effectiveness of internal controls to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with our policies or procedures may deteriorate. If we fail to maintain the adequacy of our internal controls, including any failure to implement or difficulty in implementing required new or improved controls, our business and results of operations could be harmed, we could fail to be able to provide reasonable assurance as to our financial results or meet our reporting obligation and there could be a material adverse effect on the price of our securities.

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.

Although we believe that the estimates and assumptions supporting our assessments of tax reserves are reasonable, the final determination of tax audits could be materially different than that which is reflected in historical income tax benefits or provisions and recorded assets and liabilities. Due to the complexity involved, we are not able to estimate the range of reasonably possible losses in excess of amounts recorded, which could adversely affect our future operating results.

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

(a) Recent Sales of Unregistered Securities; Use of Proceeds from Registered Securities

Not applicable.

(b) Purchases of Equity Securities by the Issuer and Affiliated Purchases

Not applicable.

Item 3.

Defaults Upon Senior Securities

Not applicable.

Item 4.

Submission of Matters to a Vote of Security Holders

(a)

We held our Annual Meeting of Stockholders on March 23, 2006. Proxies for the meeting were solicited pursuant to Regulation 14A of the Securities and Exchange Act.

(b)

The matters described below were voted on at the Annual Meeting of Stockholders and the number of votes cast with respect to each matter and with respect to the election of directors were as indicated:

(1)

Holders of our common stock voted to elect six directors, each to service until his or her successor has been elected and qualified or until his or her earlier resignation or removal as follows:


	For	Against	Withheld	Non-Vote
Umang Gupta	16,802,824	—	562,030	—
David Cowan	12,620,751	—	4,744,103	—
Deborah Rieman	16,866,526	—	498,328	—
Mohan Gyani	17,038,324	—	326,550	—
Geoffrey Penney	17,040,601	—	324,253	—
Raymond L. Ocampo Jr.	17,015,794	—	349,060	—
Jennifer J. Bolt	17,103,499	—	261,355	—

(2)

Holders of our common stock voted to approve the amendments of the 1999 Equity Incentive Plan to (i) increase the size of the automatic initial grant of stock options awarded to new directors, and (ii) establish a limit on the amount of shares covered by the discretionary grants of stock options awarded to non-employee directors.


For	Against	Abstain	Non-Vote
8,701,827	3,169,511	1,130,838	—

(3)

Holders of our common stock voted to ratify the appointment of KPMG LLP as our auditors for the fiscal year ending September 30, 2006.


For	Against	Abstain	Non-Vote
16,404,994	951,930	7,929	—

Item 5.

Other Information

Not applicable.

Item 6.

Exhibits

EXHIBIT INDEX

Exhibit

Incorporated by Reference

Form

File No.

Filing Date

Exhibit No.

Filed Herewith

10.1

1999 Equity Incentive Plan, as amended, dated March 23, 2006*

10.2

Agreement with UBS Securities LLC dated February 3, 2006

31.1

Certification of Periodic Report by Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002

31.2

Certification of Periodic Report by Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002

32.1

Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 **

32.2

Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 **

*	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.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Mateo, State of California, on this 10th day of May 2006.


KEYNOTE SYSTEMS, INC.

By:		/s/ UMANG GUPTA
		Umang Gupta
		Chairman of the Board and Chief Executive Officer
		(Principal Executive Officer)



By:		/s/ ANDREW HAMER
		Andrew Hamer
		Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)

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Keynote Systems (KEYN) Inactive 10-Q2006 Q2 Quarterly report

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