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UNITED STATES  

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2002

Commission File Number: 0-24983

NetSolve, Incorporated

(Exact name of the registrant as specified in its charter)

9500 Amberglen Boulevard

Austin, Texas 78729

(Address of principal executive offices, including zip code)

(512) 340-3000

(Registrant’s telephone number, including area code)

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  ¨

Number of shares outstanding of the issuer’s common stock, $.01 par value, as of February 10, 2003: 11,585,455            

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NETSOLVE, INCORPORATED

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

NETSOLVE, INCORPORATED

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

Certain reclassifications have been made to prior year balances to conform to the current year presentations.

See accompanying notes.

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NETSOLVE, INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

See accompanying notes.

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NETSOLVE, INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

See accompanying notes

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NETSOLVE, INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2002

Information with respect to the three and nine months ended December 31, 2001 and 2002 is unaudited.

1. Organization and Description of the Company

NetSolve, Incorporated, a Delaware corporation (the “Company”), engages in the business of providing remote network management services. These services include network configuration and design, installation and implementation coordination, fault diagnosis and resolution, and ongoing network management. The Company also resells data network equipment and equipment maintenance services manufactured or provided by selected leading suppliers of these products. The Company also licenses its software overseas. The Company’s services are designed to allow its customers to selectively outsource network specific tasks in order to migrate to new technology, increase network reliability, and reduce overall network costs.

2. Basis of Presentation

The quarterly financial information presented herein should be read in conjunction with the Company’s annual financial statements for the year ended March 31, 2002, which can be found in the Company’s annual report on Form 10-K, as filed on June 10, 2002 (File No. 000-24983). The accompanying unaudited interim financial statements reflect all adjustments (which include only normal, recurring adjustments) that are, in the opinion of management, necessary to state fairly the results for the periods presented. The results for such periods are not necessarily indicative of the results to be expected for the full fiscal year.

3. Earnings Per Share

The Company’s earnings per share data are presented in accordance with SFAS 128, Earnings Per Share. Basic income per share is computed using the weighted average number of common shares outstanding. Diluted income per share is computed using the weighted average number of common shares outstanding adjusted for the incremental shares attributed to outstanding securities with the ability to purchase or convert into common stock. The treasury stock method, using the average price of the Company’s common stock for the period, is applied to determine dilution from options and warrants.

A reconciliation of the denominators used in computing per share net income is as follows (in thousands):

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NETSOLVE, INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

December 31, 2002

4. Contingencies

A consolidated putative class action complaint was filed on February 21, 2001 against the Company and certain of its officers in the United States District Court for the Western District of Texas, Austin Division. In re NetSolve Incorporated Securities Litigation, Civil Action No. A00-CA-591 SS. Plaintiffs sought to represent a class comprised of purchasers of the Company’s common stock between April 18, 2000 and August 18, 2000 (“Class Period”). They alleged that the defendants engaged in a fraudulent scheme by issuing false and materially misleading statements regarding the Company’s business during the Class Period.

On December 17, 2001, the Company and individual defendants settled this action. The plaintiff class received $2,750,000 in connection with the settlement, all of which was funded by the Company’s insurance carrier. On May 28, 2002, the Court preliminarily certified the class and approved the settlement. A Settlement Fairness Hearing was subsequently held before the Honorable Sam Sparks, at which time Judge Sparks approved the settlement. The case is thus concluded.

On December 6, 2001, a second putative securities class action complaint was filed against the Company, certain of its officers and the Company’s underwriters of its initial public offering in the United States District Court for the Southern District of New York. Woodward v. NetSolve, Inc., 01 CV 11239. Plaintiff seeks to represent a class comprised of purchasers of the Company’s common stock between September 29, 1999 and December 6, 2000. The plaintiffs allege that the defendants failed to properly disclose certain commissions, discounts and purported tie-in arrangements related to the Company’s initial public offering. The plaintiffs allege claims under Sections 11 and 15 of the Securities Act of 1933, as amended (“Securities Act), against the Company, and the plaintiffs allege claims under Sections 11 and 12 of the Securities Act, and Section 10(b) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), against the Company’s underwriters. This case has been coordinated for pretrial purposes with over 300 other cases alleging similar claims against other underwriters and companies. In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). Preliminary settlement proposals have been offered by representatives of both the underwriter defendants and the plaintiffs. Such proposals are being analyzed by the various issuer defendants. It is not feasible to predict or determine the final outcome of this proceeding, and if the outcome were to be unfavorable, the Company’s business, financial condition, cash flow and results of operations could be materially adversely affected.

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-looking Statements

This report and other presentations made by us contain “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. We sometimes identify forward-looking statements with such words as “expects,” “anticipates,” “intends,” “believes” or similar words concerning future events. They include, among others, statements relating to trends and projections in revenue, company growth, sales, margin and expenses, and the drivers behind those trends; our ability to obtain any needed additional working capital; trends in sales of network management services and sales of customer premise equipment; our ability to retain current customer arrangements and develop new arrangements; our ability to replace the business lost by the termination and transition of the AT&T Managed Router Service Agreement; our ability to develop new service offerings and the market acceptance of such offerings; the level of any stock repurchase we may undertake; payments requested by customers regarding our WAN guarantee; the amount of any added costs from anticipated new sales, marketing and development resources we gain, our reliance on resellers, and the continued development of competition; the outcome of pending litigation; revenues derived from AT&T and other customers; our ability to attract and retain a qualified workforce; our ability to protect our intellectual property rights; and the impact of changes in accounting rules.

Any forward-looking statement speaks only as of the date on which such statement was made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement was made or to reflect the occurrence of unanticipated events. New factors emerge from time to time and it is not possible for us to predict all of such factors, nor can we assess the impact of each such factor or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement.

Overview

We provide network management services that allow enterprises and carriers to outsource some or all network-specific activities in order to increase network reliability and uptime, reduce overall network costs, and simplify timely migration to new technologies. We were incorporated in September 1985 in the State of Delaware and began operating during the second half of 1987. Until December 1996, substantially all of our services revenues were derived from the sale of data transport services. To provide these transport services, we leased network transmission facilities from major carriers, and we also resold AT&T’s transport services. We began developing our first remote network management service offering for WANs in early 1993 and began offering that service, together with AT&T’s transport services, in the quarter ended March 31, 1994. We began selling network management services separately from our data transport services in the quarter ended March 31, 1995. We introduced our first security service in the quarter ended September 30, 1996. We discontinued our data transport business in the quarter ended December 31, 1996. We began offering network management services for LANs in the quarter ended June 30, 1997. We began offering virtual private network (VPN) management services during the quarter ended September 30, 2000. On June 21, 2001, we announced that IBM Global Services would offer selected ProWatch managed network services. The acceptance of our first software licensing agreement occurred in the quarter ended September 30, 2001. This agreement allows another organization to utilize our technology to provide remote network management services to its customers. Additionally, on October 1, 2001, we announced that we will offer remote network management for Cisco Systems, Inc. Architecture for Voice, Video and Integrated Data (AVVID) Internet Protocol IP Telephony (IPT).

Revenues

Our revenues consist of network management services revenues as well as maintenance revenue and equipment resales. Our network management services include both recurring and nonrecurring revenues:

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Our network management services revenues are derived from contracts with telecommunications carriers, value-added resellers of networking equipment and services, and enterprises to which we sell directly through our sales force. Our services include both initial implementation and project management services for a one-time fee per location as well as ongoing management services for a fixed monthly fee per managed device. Network management services revenues also include software licensing, usage royalties, maintenance fees and professional fees. Our contracts with end users are generally for terms of 24 to 36 months, although customers may cancel services prior to the end of the service terms. Cancellations due to reasons other than closings of managed locations, which to date have not been material, are generally subject to cancellation fees ranging from 20% to 80% of the recurring charges payable for the remainder of the service term. Cancellation fees as a percentage of network management services revenues were less than 1% in each of fiscal years 2001 and 2002 and in the nine months ended December 31, 2002. We recognize revenues from cancellation fees on a cash basis unless collection is assured. Our contracts with resellers typically extend from 12 to 36 months and, in most cases, require that we continue providing services throughout the term of the reseller’s contract with the end user. In these cases, we continue to recognize revenues upon performance of the services, even if performance occurs after the term of the contract with the reseller.

Our network management services for WANs typically include a guarantee providing end-to-end network availability for at least 99.5% of the time in any given month. In the event the guaranteed availability is not achieved, we generally are obligated to refund a portion, and in some cases all, of our WAN management fees for that month. This guarantee covers some components of the end user’s WAN, such as the transport services provided by the end user’s carrier, that are not directly under our control. As a result, we may, in some instances, refund amounts to customers for circumstances beyond our control. We establish a reserve against guarantees we offer for these WAN services. Historically, guarantee payments have not been material in relation to network management services revenues. However, in the future, refunds made under our guarantees or otherwise could have a material adverse impact on the results of our operations.

We derive maintenance and equipment revenues from the sale of CPE maintenance contracts and from the resale of customer premise equipment, or CPE, to certain of our network management services resellers or customers. CPE is networking equipment which usually resides at the customer’s location and includes routers, customer service units or CSUs, and LAN switches. We utilize CPE produced by Cisco and, to a lesser extent, by Bay/Nortel, Visual Networks and others. We recognize equipment revenues in the period the CPE is shipped to the customer. However, if the transaction is financed through our lease financing subsidiary, we recognize the revenues upon sale of the underlying lease contract on a nonrecourse basis. We recognize revenues from CPE maintenance contracts on a monthly basis as the services are provided. We generally only resell CPE to our network management services customers. Although we believe some of our customers will continue to purchase CPE from us, our

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strategy is to focus on our network management services which generate higher margins. We therefore anticipate that revenues from CPE sales will continue to decline as we seek to manage our mix of revenues.

We currently have two primary reseller agreements with AT&T, one for Managed Router Service and one for Managed DSU Service. AT&T accounted for 69% of our total revenues in fiscal year 2001, 61% of our total revenues in fiscal year 2002, and 53% of our total revenues in the nine months ended December 31, 2002. No other customer accounted for more than 10% of our revenues in fiscal years 2001, 2002 or the nine months ended December 31, 2002. In January of 2003, we were notified by AT&T of its intention to exercise its right to terminate and transition all existing Managed Router Service orders beginning July 1, 2003, which will start an eight-month transition period under this agreement. Managed Router Service revenue under this agreement accounted for approximately 27% of recurring network management services revenues in fiscal year 2002, and 17% in the nine months ended December 31, 2002 and 34% of total revenues in fiscal year 2002 and 23% in the nine months ended December 31, 2002.

Historically, we have generated substantially all of our revenues from sales to customers in the United States, although we manage devices in several locations around the world for these U.S. based customers.

Results of Operations

Three months ended December 31, 2001 compared to three months ended December 31, 2002

Revenues

Total revenues. Total revenues increased 5%, from $12.4 million in the three months ended December 31, 2001 to $13.0 million in the three months ended December 31, 2002.

Network management services. Revenues from network management services increased 5%, from $9.9 million in the three months ended December 31, 2001 to $10.4 million in the three months ended December 31, 2002, representing 80% of total revenues in the three months ended December 31, 2001 and 2002. The dollar increase was due primarily to increased recurring revenues resulting from a growth in the number of managed devices under contract and to a lesser extent increased revenue from software licensing fees, partially offset by contractual discounts provided to AT&T relating to the Managed Router Services Agreement and a decrease in equipment installation services due to a decrease in the level of new installations from carrier agreements utilizing those services. The discounts to AT&T will no longer be a factor following the termination of the Managed Router Service Agreement. In the near term, revenue growth in Network Management Services is expected to be adversely impacted by the July 1, 2003 termination of the AT&T Managed Router Service Agreement discussed above.

Maintenance and equipment. Revenues from maintenance and equipment increased 7%, from $2.4 million in the three months ended December 31, 2001 to $2.6 million in the three months ended December 31, 2002. This increase was primarily due to increased equipment sales to an isolated number of customers during the quarter. This increase was partially offset by a decrease in maintenance revenue due to contractual discounts provided to AT&T relating to the Managed Router Services Agreement. The discounts to AT&T will no longer be a factor following the termination of the Managed Router Service Agreement.

Costs of revenues

Cost of network management services. Cost of network management services includes salary and other costs of personnel, depreciation of equipment utilized to manage customer networks, the network management infrastructure utilized to provide remote network management services, and the costs of third-party providers of CPE installation services. Cost of network management services is expensed as incurred. Cost of network management services increased 5%, from $5.8 million in the three months ended December 31, 2001 to $6.1 million in the three months ended December 31, 2002, representing 58% of network management services revenues in the

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three months ended December 31, 2001 and 2002. The dollar increase was due primarily to increased network circuit costs and increased depreciation expense resulting primarily from the addition of equipment placed in service for disaster recovery purposes. The July 1, 2003 termination of the AT&T Managed Router Service Agreement discussed above may have a beneficial impact on gross margins for these services.

Cost of maintenance and equipment. Cost of maintenance and equipment includes the purchase of maintenance contracts and CPE from manufacturers and distributors for resale to end users. These costs are expensed in the period the related revenues are recognized. Cost of maintenance and equipment increased 16%, from $1.6 million in the three months ended December 31, 2001 to $1.9 million in the three months ended December 31, 2002, representing 66% of maintenance and equipment revenues in the three months ended December 31, 2001 and 71% in the three months ended December 31, 2002. The increase in dollars was due to an increase in maintenance and equipment revenues. The increase in percentage is a result of contractual sales discounts provided to AT&T during the three months ended December 31, 2002 relating to the Managed Router Services Agreement which did not have a corresponding decrease in costs and to a lesser extent increased equipment sales as a percentage of maintenance and equipment revenue which generally has lower gross margins than CPE maintenance revenue. The discounts to AT&T will no longer be a factor following the termination of the Managed Router Service Agreement.

Operating expenses

Development. Development expenses consist primarily of salaries and related costs of development personnel including contract programming services. Development employees are responsible for developing internal software systems, selecting and integrating purchased software applications, developing software tools for our network management services, developing our Web-enabled software applications that give customers access to network management information, and defining and developing operating processes for new services. Development expenses increased 4% from $1.0 million in the three months ended December 31, 2001 to $1.1 million in the three months ended December 31, 2002, representing 8% of total revenues in the three months ended December 31, 2001 and 2002. The increase in dollars was primarily due to costs of approximately $93,000 related to executive severance packages. This increase was partially offset by a decrease in the use of software development consulting.

Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions, travel and costs associated with creating awareness of our services. Selling and marketing expenses increased 11%, from $1.7 million in the three months ended December 31, 2001 to $1.9 million in the three months ended December 31, 2002, representing 14% of total revenues in the three months ended December 31, 2001 and 2002. The increase in dollars was due primarily to costs of approximately $154,000 related to recruiting for new executives and executive severance packages.

General and administrative. General and administrative expenses consist primarily of expenses related to our human resources, finance and executive departments and the cost of an idle facility for the five quarters ending June 30, 2002. Included in human resources spending is a majority of the costs of recruiting and relocating new employees. General and administrative expenses increased 12%, from $1.3 million in the three months ended December 31, 2001 to $1.5 million in the three months ended December 31, 2002, representing 10% of total revenues in the three months ended December 31, 2001 and 11% in the three months ended December 31, 2002. The dollar and percentage increase was due primarily to costs of approximately $481,000 related to strategic consulting and executive severance packages and to a lesser extent increased insurance expenses. This was offset by approximately $438,000 of lower spending in the three months ended December 31, 2002 related to rent and operating costs of an idle facility. We moved into this new facility at the end of June 2002 in order to consolidate substantially all of our operations into one facility.

Other income, net

Other income, net consists primarily of interest income earned on our cash balances. Other income, net decreased from $267,000 in the three months ended December 31, 2001 to $191,000 in the three months ended

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December 31, 2002, representing 2% of total revenues in the three months ended December 31, 2001 and 1% in the three months ended December 31, 2002. The decrease was due to lower average interest rates on cash balances for the three months ended December 31, 2002 compared to the same period in the prior year.

Nine months ended December 31, 2001 compared to nine months ended December 31, 2002

Revenues

Total revenues. Total revenues increased 5%, from $35.9 million in the nine months ended December 31, 2001 to $37.7 million in the nine months ended December 31, 2002.

Network management services. Revenues from network management services increased 8%, from $28.2 million in the nine months ended December 31, 2001 to $30.6 million in the nine months ended December 31, 2002, representing 79% of total revenues in the nine months ended December 31, 2001 and 81% in the nine months ended December 31, 2002. The dollar and percentage increase was due primarily to increased recurring revenues resulting from a growth in the number of managed devices under contract and to a lesser extent increased revenue from software licensing fees, partially offset by contractual discounts provided to AT&T relating to the Managed Router Services Agreement. The discounts to AT&T will no longer be a factor following the termination of the Managed Router Service Agreement.

Maintenance and equipment. Revenues from maintenance and equipment decreased 7%, from $7.7 million in the nine months ended December 31, 2001 to $7.1 million in the nine months ended December 31, 2002. This decrease was primarily due to contractual discounts provided to AT&T relating to the Managed Router Services Agreement. The discounts to AT&T will no longer be a factor following the termination of the Managed Router Service Agreement.

Costs of revenues

Cost of network management services. Cost of network management services increased 9%, from $16.6 million in the nine months ended December 31, 2001 to $18.1 million in the nine months ended December 31, 2002, representing 59% of network management services revenues in the nine months ended December 31, 2001 and 2002. The dollar increase was due primarily to the addition of personnel and to a lesser extent increased depreciation expense resulting primarily from the addition of equipment placed in service for disaster recovery purposes.

Cost of maintenance and equipment. Cost of maintenance and equipment decreased 7%, from $5.2 million in the nine months ended December 31, 2001 to $4.9 million in the nine months ended December 31, 2002, representing 68% of maintenance and equipment revenues in the nine months ended December 31, 2001 and 2002. The decrease in dollars was due to a decrease in maintenance and equipment revenues, partially offset by contractual sales discounts provided to AT&T relating to the Managed Router Services Agreement which did not have a corresponding decrease in costs.

Operating expenses

Development. Development expenses increased 3% from $2.7 million in the nine months ended December 31, 2001 to $2.8 million in the nine months ended December 31, 2002, representing 8% of total revenues in the nine months ended December 31, 2001 and 7% in the nine months ended December 31, 2002. The increase in dollars and as a percentage of revenue was primarily due to costs related to executive severance packages and increased personnel partially offset by a decrease in the use of outside consultants and maintenance costs.

Selling and marketing. Selling and marketing expenses increased 16%, from $4.7 million in the nine months ended December 31, 2001 to $5.4 million in the nine months ended December 31, 2002, representing 13% of total

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revenues in the nine months ended December 31, 2001 and 14% in the nine months ended December 31, 2002. The increase in dollars and as a percentage of revenue was due primarily to increased costs related to the addition of sales and marketing personnel, recruiting for new executives, executive severance packages, outside commissions for acquired customers and additional spending related to identifying software licensing opportunities overseas. These increases were partially offset by decreases in agency fees, expenses related to vendor relations and commissions to our direct sales force.

General and administrative. General and administrative expenses decreased 2%, from $3.7 million in the nine months ended December 31, 2001 to $3.6 million in the nine months ended December 31, 2002, representing 10% of total revenues in the nine months ended December 31, 2001 and 9% of total revenues in the nine months ended December 31, 2002. The dollar and percentage decrease was due primarily to approximately $629,000 of lower spending in the nine months ending December 31, 2002 related to rent and operating costs of an idle facility. This was partially offset by increased costs related to strategic consulting, executive severance packages and to a lesser extent additional personnel.

Other income, net

Other income, net decreased from $1.2 million in the nine months ended December 31, 2001 to $623,000 in the nine months ended December 31, 2002, representing 3% of total revenues in the nine months ended December 31, 2001 and 2% in the nine months ended December 31, 2002. The decrease was due to lower average interest rates on cash balances for the nine months ended December 31, 2002 compared to the same period in the prior year.

Quarterly results of operations

Results of operations have varied from quarter to quarter. Accordingly, we believe that period-to-period comparisons of results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Our operating results may fluctuate as a result of many factors, including our ability to renew or retain existing end user and reseller relationships, our ability to successfully enter into new reseller or end user relationships, our ability to develop and market new service offerings, the cost of introducing such offerings and the profitability thereof, and the level and nature of competition. Further, we may be unable to adjust spending rapidly enough to compensate for any significant fluctuations in the number of new managed devices implemented in a given period. Any significant shortfall in the number of new managed devices could therefore seriously damage our business. Finally, there can be no assurance that we will continue to be profitable in the future or, if we are profitable, that our levels of profitability will not vary significantly between quarters.

Liquidity and capital resources

Net cash provided by operating activities during the nine month periods ended December 31, 2001 and December 31, 2002 was $7.4 million and $3.0 million, respectively. The decrease in cash generated in the nine months ended December 31, 2002 as compared to the prior year period was primarily due to payments related to the idle facility and slower collections of accounts receivable from AT&T. We believe that these amounts are fully collectible and we anticipate accounts receivable balances to decrease by March 31, 2003.

We used $4.8 million during the nine months ended December 31, 2001 and $1.9 million in the nine months ended December 31, 2002 to purchase capital assets which includes leasehold improvements related to the addition of our new facility and to purchase capital assets used in the delivery of our network management services. We currently have no material commitments for capital expenditures. We paid $252,000 during the nine months ended December 31, 2001 toward our lease obligations for capital equipment. The capital leases matured in the prior fiscal year and therefore we made no capital lease payments in the nine months ended December 31, 2002. We currently have no future commitments for capital leases.

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We used $3.2 million during the nine months ended December 31, 2002 to repurchase 449,000 shares of our common stock. We have approval from our Board of Directors to purchase up to five million shares, including those previously repurchased. Since the inception of the stock repurchase program through December 31, 2002, we have repurchased 3.4 million shares of our common stock at an aggregate price of approximately $24.2 million. The extent and timing of any additional repurchases will depend on market conditions and other business considerations. Repurchased shares may be held in treasury for general corporate purposes, including for use in connection with our stock option plans, or may be retired.

As of December 31, 2002, we had $45.2 million in cash and short-term investments, $7.3 million in net accounts receivable and $49.0 million in working capital. We believe that our current cash balances, together with cash generated from operations, will be sufficient to fund our anticipated working capital needs, capital expenditures, stock buy back program and any potential future acquisitions for at least 12 months. Our current cash balances are kept in short-term, investment-grade, interest-bearing securities pending their use. In the event our plans or assumptions change or prove to be inaccurate, or if we consummate any unplanned acquisitions of businesses or assets, we may be required to seek additional sources of capital. Sources of additional capital may include public and/or private equity offerings and debt financings, sales of nonstrategic assets and other financing arrangements.

As of December 31, 2002, we had net operating loss carryforwards of approximately $600,000 available to offset future net income for U.S. federal income tax purposes. These net operating loss carryforwards will expire beginning in 2009 if not utilized. We have alternative minimum tax credit carryforwards of $350,000 which do not expire. We also have foreign tax credits of $218,000 that expire beginning in 2006 if not utilized. Our utilization of these net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the “change in ownership” provisions of the Internal Revenue Code. The annual limitation may result in the expiration of the net operating losses before utilization.

As of December 31, 2002, we have no debt or off-balance sheet debt. As of December 31, 2002, we have noncancelable operating lease obligations of approximately $6.2 million. At December 31, 2002, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we were engaged in such relationships.

Related Party Transactions

The consolidated balance sheets as of December 31, 2001 and 2002 include in accounts receivable a $100,000 loan to an officer of the Company, which was made August 4, 2000. The loan is represented by a full recourse note, is payable upon default, bears interest at 4.65% per annum and is secured by a security interest in all stock options granted to the officer by the Company at any time prior to the satisfaction of the loan and all shares of the Company’s common stock issued upon the exercise of any such options.

Critical Accounting Policies

General

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and

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assumptions are reviewed periodically. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition

Network management services revenues are recognized in the period services are provided by the Company, whether sold directly or through resellers, based upon rates established by contract. These amounts are adjusted to the extent of any reserves affecting the realization of these revenues as described below. The typical contract terms are from 24 to 36 months and provide for one-time services, consisting primarily of project implementation services at a fixed fee per customer site or device, as well as recurring services which are provided at a fixed monthly fee per customer site or device over the life of the contract. Revenues for project implementation services are recognized upon completion of the assignment or service, and recurring revenues are recognized on a monthly basis as the services are performed. Revenue from software licensing arrangements is deferred and amortized on a straight-line basis over the licensing agreement’s term. Revenue from software royalty fees are based on the number of devices in place and are recognized monthly. Equipment revenues are recognized in the period the equipment is shipped to the customer. Equipment revenues from assets leased by the Company’s lease financing subsidiary are recognized upon the sale of the equipment and the related lease to a third-party lessor on a nonrecourse basis following installation of the equipment. Other revenues, which consist primarily of equipment maintenance services, are recognized in the period services are provided.

Receivables

We continuously monitor collections and payments from our customers and maintain allowances for doubtful accounts based upon our historical experience and any specific customer collection issues that we have identified. While losses due to bad debt have historically been within our expectations, there can be no assurance that we will continue to experience the same level of bad debt losses that we have in the past. In addition, a significant amount of our revenues and accounts receivable are concentrated in AT&T. A significant change in the liquidity or financial position of AT&T could have a material adverse impact on the collectability of our accounts receivable and our future operating results, including a reduction in future revenues and additional allowances for doubtful accounts.

Availability Reserve

Our remote network management services for WANs typically include a guarantee providing end-to-end network availability for at least 99.5% of the time in any given month. In the event the guaranteed availability is not achieved, we generally are obligated to refund a portion, and in some cases all, of our WAN management fees for that month. We provide a reserve based on the estimated costs of these refunds. Historically, guarantee payments have not been significant.

Risk Factors

We may be unable to operate profitably in the future.

We may not operate profitably. Our ability to operate profitably in the future depends on increasing sales of our services while maintaining sufficient gross profit margins. We must, among other things:

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•    develop software to make our principal existing service, ProWatch for WANs, as well as other services as they achieve larger volumes, more efficient and economical; and

Our revenues will decline significantly and our business will be adversely affected if AT&T discontinues, or materially reduces, sales of our services, and we are not successful in replacing such sales.

Sales to AT&T, which resells our services to its customers, accounted for 61% of our total revenues in fiscal year 2002 and 53% of our total revenues in the nine months ended December 31, 2002. In January of 2003, we were notified by AT&T of its intention to exercise its right to terminate and transition all existing Managed Router Service orders beginning July 1, 2003, which will start an eight-month transition period under this agreement. Managed Router Service revenue under this agreement accounted for approximately 27% of recurring network management services revenues in fiscal year 2002, and 17% in the nine months ended December 31, 2002 and 34% of total revenues in fiscal year 2002 and 23% in the nine months ended December 31, 2002. Although we anticipate being able to replace this business over time, the termination of this agreement will result in diminished prospects for growth in revenues in the short-term. Furthermore, we cannot be sure that we will be successful in our sales and marketing efforts to replace this business, or that AT&T will continue its remaining business with us.

Our remaining Frame Relay Plus agreement with AT&T is not an exclusive arrangement. We cannot assure that AT&T will continue to sell our services to existing or additional AT&T customers or continue to utilize our Frame Relay Plus services following the expiration of the service terms set forth in our agreement with AT&T, and a further reduction in our AT&T business from any cause would result in diminished revenues for an extended period of time as we attempted to replace that business.

Our quarterly results may fluctuate and cause the price of our common stock to fall.

Our revenues and results of operations are difficult to predict and may fluctuate significantly from quarter to quarter. If either our revenues or results of operations fall below the expectations of investors or public market analysts, the price of our common stock could fall dramatically.

Our revenues are difficult to forecast and may fluctuate for a number of reasons:

•    the market for network management services is relatively new, and we have no reliable means to assess overall customer demand;

•    we derive a majority of our revenues from AT&T and other resellers, and our revenues therefore depend significantly on the willingness and ability of AT&T and those other resellers to sell our services to their customers;

•    we may not be able to renew or retain existing end user and reseller relationships;

•    we may not be able to attract additional resellers to market our services as expected;

•    we expect to continue encouraging end users to purchase equipment and equipment maintenance services from other sources; therefore, we anticipate that our revenues from equipment hardware and maintenance resales will continue to decline as we seek to manage our mix of revenues;

•    we may not add new end users as rapidly as we expect;

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•    we may lose existing end users as the result of competition, problems with our services or, in the case of end users who are customers of our resellers, problems with the reseller’s services or an unwillingness by our resellers to renew their agreements with us; and

•    we may not be able to develop new or improved services as rapidly as they are needed.

Most of our expenses, particularly employee compensation and rent, are relatively fixed. As a result, variations in the timing of revenues could significantly affect our results of operations from quarter to quarter and could result in quarterly losses.

Our future operating results may vary by season, which will make it difficult to predict our future performance.

As a result of seasonal factors, we believe that quarter-to-quarter comparisons of our results of operations are not necessarily meaningful. These factors may adversely affect our operating results or cause our operating results to fluctuate, resulting in a decrease in our stock price. Quarterly results of operations should not be relied upon to predict our future performance.

Our bookings may be slower during the months of July and August due to the vacation schedules of our resellers’ sales and marketing employees. This situation may lead to lower levels of revenues earned during the following fiscal quarter, which ends December 31.

Our revenues during our third and fourth fiscal quarters may be more volatile and difficult to predict due to the budgeting and purchasing cycles of our end users. End users often purchase our services at the same time they purchase new network equipment such as routers. As a result, the timing of their large capital expenditures could affect the timing of their purchases of our services. Some end users may not be able to purchase network equipment and our services near the end of a calendar year due to depleted budgets. Other end users may accelerate purchases in order to use an unspent portion of their budget.

The market for our services is evolving rapidly, and our business will be seriously damaged if the market does not develop as we expect.

Our long-term viability depends significantly upon the acceptance and use of remote network management services. The market for remote network management services is rapidly evolving. This market environment makes it more difficult to determine the size and growth of the market and to predict how this market will develop. Changes in technology, the availability of qualified information technology professionals and other factors that make internal network management more cost-effective than remote network management would adversely affect the market for our services. Our business may be seriously damaged if this market fails to grow, grows more slowly than we expect or develops in some way that is different from our expectations.

We must establish relationships with additional resellers in order to increase our revenues and become consistently profitable.

We expect to continue to rely on resellers such as data networking value-added resellers and integrators and, to a lesser extent, telecommunications carriers to market our services. We must establish and develop these alternative sales channels in order to increase our revenues and become consistently profitable. We have a limited history developing these sales channels, and we have established productive relationships with only a few resellers. While we have gained additional experience in managing sales through resellers, we have not yet achieved consistent results from such sales. Except for AT&T, these resellers have not generated significant sales of our services to date and may not succeed in marketing our services in the future.

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Our agreements with resellers, including AT&T, generally do not require that the resellers sell any minimum level of our services and generally do not restrict the resellers’ development or sale of competitive services. We cannot be sure that these resellers will dedicate resources or give priority to selling our services. In addition, resellers may seek to make us reduce the prices for our services in order to lower the total price of their equipment, software or service offerings.

Reseller relationships may adversely affect our business by weakening our relationships with end users, decreasing the strength of our brand name and limiting our ability to sell services directly to resellers’ customers.

Our strategy of selling our services primarily through resellers may result in our having weaker relationships with the end users of our services. This may inhibit our ability to gather customer feedback that helps us improve our services, develop new services and monitor customer satisfaction. We may also lose brand identification and brand loyalty, since our services may be identified by private label names or may be marketed differently by our resellers. A failure by any of our resellers to provide their customers with satisfactory products, services or customer support could injure our reputation and seriously damage our business. Our agreements with these resellers may limit our ability to sell our services directly to the resellers’ customers in the future.

Any material decrease in sales of our WAN management services will significantly reduce our total revenues and adversely affect our business.

Competitive pressures, general declines in the levels of new wide area network, or WAN, installations or other factors that adversely affect sales of our WAN management services or that cause significant decreases in the prices of our WAN management services could significantly limit or reduce our revenues. Sales of our ProWatch for WANs and similar WAN management services accounted for 84% of our recurring network management services revenues in the nine months ended December 31, 2002. Likewise, a substantial portion of our nonrecurring network management services and equipment resale revenues depend on the successful sale of these WAN management services. We expect that these WAN management services will continue to generate a significant portion of our revenues for the foreseeable future. Our financial performance therefore depends directly on continued market acceptance of our WAN management services and our ability to introduce enhanced versions of these services that make these services more efficient and economical.

Our failure to develop and sell additional services could impair our financial results and adversely affect our business.

Our future financial performance will depend in part on our ability to develop, introduce and sell new and enhanced network management services other than WAN management services, including services that:

•    address the increasingly sophisticated needs of current and prospective end users; and

•    respond on a timely and cost-effective basis to technological advances and emerging industry standards and protocols.

Although we have developed new services, such as network management services for local area networks, or LANs, network security services and IP Telephony, we have not derived significant revenues from these services to date. We cannot be sure that we will be successful selling these services or developing additional services on time or on budget. The development of new services is a complex and uncertain process. The newness of the market for remote network management services makes it difficult to determine whether a market will develop for any particular network management service. If we succeed in increasing the percentage of our revenues that is derived from resellers, we may have weaker relationships with the end users of our services, making it even more difficult for us to identify services acceptable to our target market. We cannot assure that future technological or industry

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developments will be compatible with our business strategy or that we will be successful in responding to these changes in a timely or cost-effective manner. Our failure to develop and sell services other than WAN management services could seriously damage our business.

Our business may be harmed if we lose the services of any member of our management team without appropriate succession and transition arrangements.

Our ability to continue to build our business and meet our goals going forward depends to a significant degree on the skills, experience and efforts of each member of our management team. We do not have employment contracts requiring any of our personnel, including the members of our management team, to continue their employment for any period of time, and we do not maintain key man life insurance on any of our personnel, including our executive officers. The loss of the expertise of any member of our management team without appropriate succession and transition arrangements could seriously damage our business.

In order to support our business, we must continue to hire information technology professionals, who are in short supply.

We derive all of our revenues from network management services and related resales of equipment. These services can be extremely complex, and in general only highly qualified, highly trained information technology, or IT, professionals have the skills necessary to develop and provide these services. In order to continue to support our current and future business, we need to attract, motivate and retain a significant number of qualified IT professionals. Qualified IT professionals are in short supply, and we face significant competition for these professionals, from not only our competitors but also our end users, marketing partners and other companies throughout the network services industry. Other employers may offer IT professionals significantly greater compensation and benefits or more attractive career paths or geographic locations than we are able to offer. Any failure on our part to hire, train and retain a sufficient number of qualified IT professionals would seriously damage our business.

We could incur significant costs if we are unable to retain our information technology professionals.

Because of the limited availability of IT professionals, we seek to hire persons who have obtained college bachelor’s degrees and then train those persons to provide our services. As a result, we invest a significant amount of time and money in training these new employees before they begin to support our business. We do not enter into employment agreements requiring these employees to continue in our employment for any period of time. Departures of trained employees could limit our ability to generate revenues and would require us to incur additional costs in training new employees.

We currently compete most directly with our customers’ internal solutions, and we expect increasing competition from other network services companies.

To compete successfully, we must respond promptly and effectively to the challenges of technological change, evolving standards and our competitors’ innovations by continuing to enhance our services, as well as our sales programs and channels. Any pricing pressures, reduced margins or loss of market share resulting from increased competition, or our failure to compete effectively, could seriously damage our business.

We face competition from different sources. Currently, a major source of competition is the internal network administration organizations of our end users and resellers. These organizations may have developed tools and methodologies to manage their network processes and may be reluctant to adopt applications offered by third parties like us.

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If the market for outsourced network management services grows as we expect, we believe this market will become highly competitive. Competition is likely to increase significantly as new network management services companies enter the market and current competitors expand their service and product lines. Many of these potential competitors are likely to enjoy substantial competitive advantages, including:

•    larger technical staffs;

•    more established sales channels;

•    more software development experience;

•    greater name recognition; and

•    substantially greater financial, marketing, technical and other resources.

If our operations are interrupted, we may lose customers and revenues.

We must be able to operate our network management infrastructure 24 hours a day, 365 days a year without interruption. If our operations are interrupted, we may lose customers and revenues. All of our network management services are provided remotely from our network management center, which is located at a single site in Austin, Texas. We currently have a geographically separate disaster recovery location with redundant systems. However, in order to operate without undue risk of interruption, we must guard against:

•    power outages, fires, tornadoes and other natural disasters at our network management center and disaster recovery location;

•    telecommunications failures;

•    equipment failures or “crashes;”

•    security breaches; and

•    other potential interruptions.

Any interruptions could:

•    require us to make payments on the contractual performance guarantees we offer our customers;

•    cause end users to seek damages for losses incurred;

•    require us to spend more money replacing existing equipment or adding redundant facilities;

•    damage our reputation for reliable service;

•    cause existing end users and resellers to cancel our contracts; and

•    make it more difficult for us to attract new end users and resellers.

Our revenues would decline and our business would be adversely affected if the networking equipment and carrier services we support become obsolete or are otherwise not used by a large part of our target market.

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As part of our strategy, we have elected to support only selected providers of networking equipment and carrier services. For example, we support routers manufactured by 3Com, Bay/Nortel and Cisco, but not by other equipment providers. Our services cannot be used by companies with networking equipment and carrier services that we do not support. Our business would be seriously damaged if, in the future, the networking equipment manufacturers and carrier services that we support were not the predominant providers to our target market or if their equipment or services became unavailable or significantly more expensive. Technological advances that make obsolete any of the networking equipment and carrier services that we support, or that offer significant economic or functional advantages over the equipment and services, also could limit or reduce our revenues or could force us to incur significant costs attempting to support other networking equipment and carrier services.

We may be unable to protect our intellectual property, and we could incur substantial costs enforcing our intellectual property against infringers or defending claims of infringement made by others.

Our business and financial performance depends to a significant degree upon our software and other proprietary technology. The software industry has experienced widespread unauthorized reproduction of software products. We have only two patents. The steps we have taken may not be adequate to deter competitors from misappropriating our proprietary information, and we may not be able to detect unauthorized use and take appropriate steps to enforce our intellectual property rights.

We could be the subject of claims alleging infringement of third-party intellectual property rights. In addition, we may be required to indemnify our distribution partners and end users for similar claims made against them. Any infringement claim could require us to spend significant time and money in litigation, pay damages, develop non-infringing intellectual property or acquire licenses to intellectual property that is the subject of the infringement claims. As a result, any infringement claim could seriously damage our business.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company invests its cash in money market funds or instruments which meet high credit quality standards specified by the Company’s investment policy. The Company does not use financial instruments for trading or other speculative purposes.

Item 4. CONTROLS AND PROCEDURES

The Company’s Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) of the Securities Exchange Act of 1934, as amended) as of a date within 90 days of the filing of this quarterly report (the “Evaluation Date”), have concluded that, as of the Evaluation Date, the Company’s disclosure controls and procedures were effective to ensure the timely collection, evaluation and disclosure of information relating to the Company that would potentially be subject to disclosure under the Securities Exchange Act of 1934, as amended, and the rules and regulations promulgated thereunder. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the Evaluation Date.

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PART II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

A consolidated putative class action complaint was filed on February 21, 2001 against the Company and certain of its officers in the United States District Court for the Western District of Texas, Austin Division. In re NetSolve Incorporated Securities Litigation, Civil Action No. A00-CA-591 SS. Plaintiffs sought to represent a class comprised of purchasers of the Company’s common stock between April 18, 2000 and August 18, 2000 (“Class Period”). They alleged that the defendants engaged in a fraudulent scheme by issuing false and materially misleading statements regarding the Company’s business during the Class Period.

On December 17, 2001, the Company and individual defendants settled this action. The plaintiff class received $2,750,000 in connection with the settlement, all of which was funded by the Company’s insurance carrier. On May 28, 2002, the Court preliminarily certified the class and approved the settlement. A Settlement Fairness Hearing was subsequently held before the Honorable Sam Sparks, at which time Judge Sparks approved the settlement. The case is thus concluded.

On December 6, 2001, a second putative securities class action complaint was filed against the Company, certain of its officers and the Company’s underwriters of its initial public offering in the United States District Court for the Southern District of New York. Woodward v. NetSolve, Inc., 01 CV 11239. Plaintiff seeks to represent a class comprised of purchasers of the Company’s common stock between September 29, 1999 and December 6, 2000. The plaintiffs allege that the defendants failed to properly disclose certain commissions, discounts and purported tie-in arrangements related to the Company’s initial public offering. The plaintiffs allege claims under Sections 11 and 15 of the Securities Act against the Company, and the plaintiffs allege claims under Section 11 and 12 of Securities Act, and Section 10 (b) of the Exchange Act, against the Company’s underwriters. This case has been coordinated for pretrial purposes with over 300 other cases alleging similar claims against other underwriters and companies. In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS). Preliminary settlement proposals have been offered by representatives of both the underwriter defendants and the plaintiffs. Such proposals are being analyzed by the various issuer defendants. It is not feasible to predict or determine the final outcome of this proceeding, and if the outcome were to be unfavorable, the Company’s business, financial condition, cash flow and results of operations could be materially adversely affected.

Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

The Company’s registration statement on Form S-1 (File No. 333-65691) was declared effective on September 28, 1999. Gross proceeds from the offering were used to pay offering costs through December 31, 1999. Net proceeds from the offering in the amount of $24,239,000 have been used through December 31, 2002 to repurchase 3,379,125 shares of the Company’s common stock under its stock repurchase program. The remainder of the proceeds of this offering is temporarily invested in short-term, investment-grade, interest bearing securities pending their use for other purposes.

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Item 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) EXHIBITS

(b) Report on Form 8-K

Reports on Form 8-K were filed on November 14, 2002 containing reference to certifications with registrant’s Quarterly Report on Form 10-Q as required pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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CERTIFICATION OF CHIEF EXECUTIVE OFFICER

I, David D. Hood, certify that:

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CERTIFICATION OF CHIEF EXECUTIVE OFFICER

I, Kenneth C. Kieley, certify that:

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