UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(MARK ONE)

Commission File Number 000-23699

VISUAL NETWORKS, INC.

Registrant’s telephone number, including area code: (301) 296-2300

     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 the filing requirements for the past 90 days. Yes þ No o

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ No o

     The number of outstanding shares of the Registrant’s Common Stock, par value $.01 per share, as of May 4, 2005 was 34,535,341 shares.

VISUAL NETWORKS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED
March 31, 2005

TABLE OF CONTENTS

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PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

VISUAL NETWORKS, INC.

CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)

The accompanying notes are an integral part of these consolidated financial statements.

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VISUAL NETWORKS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share data)

The accompanying notes are an integral part of these consolidated financial statements.

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VISUAL NETWORKS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

The accompanying notes are an integral part of these consolidated financial statements.

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VISUAL NETWORKS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005
(Unaudited)

1. Nature of Operations and Significant Accounting Policies:

     Visual Networks, Inc. (the “Company”) is a leading provider of network and application performance management solutions.

Risk Factors

     The Company is subject to certain risks and uncertainties which could affect its ability to continue as a going concern. These risks and uncertainties include, but are not limited to: the timing and nature of repayment of the outstanding debentures (see Note 3), expenses and an uncertain outcome associated with the Paradyne litigation (see Note 4), customer migration to UpTime Select, availability of hardware components, reliance on two subcontract manufacturers, limited access to the line of credit (see Note 2), substantial dilution if the Company is required to raise capital through the sale of equity, the Company’s history of losses and the size of its accumulated deficit, uncertainty about future profitability, dependence on a limited number of major service provider customers for the majority of its revenue, long sales cycles, rapidly changing technology, competition from several market segments, potential errors in the Company’s products or services, and anti-takeover protections that may delay or prevent a change in control that could benefit stockholders.

     The future success of the Company will depend upon its ability to generate adequate cash for operating and capital needs. The Company is relying on its existing balance of cash and cash equivalents ($10.8 million at March 31, 2005), together with future sales and the collection of related accounts receivable to meet its future operating cash requirements. If cash provided by these sources is inadequate and the line of credit is not available or is not sufficient to fund future operations, the Company will be required to further reduce its expenditures for operations or to seek additional capital through other means that may include additional borrowings, the sale of equity securities or the sale of assets. Under those circumstances, there can be no assurances that additional capital would be available under reasonable or acceptable terms, particularly in light of the Company’s history of losses and accumulated deficit position.

Financial Statement Presentation

     The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates.

     These financial statements are unaudited and have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements, and it is suggested that these financial statements be read in conjunction with the financial statements, and notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004. In the opinion of management, the comparative financial statements for the periods presented herein include all adjustments that are normal and recurring which are necessary for a fair presentation of results for the interim periods. The results of operations for the three months ended March 31, 2005

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are not necessarily indicative of the results that will be achieved for the year ended December 31, 2005.

Principles of Consolidation

     The consolidated financial statements include the accounts of Visual Networks, Inc. and its wholly owned subsidiaries. All intercompany account balances and transactions have been eliminated in consolidation.

Inventory

     Inventory, stated at the lower of cost or market, with costs determined on the first-in, first-out basis, consists of the following (in thousands):

     The Company writes down its inventory to the lower of cost or market value based on assumptions about future demand and market conditions. The following table summarizes the activity in the Company’s reserve for excess and obsolete inventory during the three months ended March 31, 2004 and 2005 (in thousands):

Accounts Payable and Accrued Expenses

     Accounts payable and accrued expenses consist of the following (in thousands):

Revenue Recognition

     The Company’s products and services include hardware, software, professional services and technical support. The Company sells its products directly to service providers, through resellers (indirect channels) and, occasionally, to end-user customers. Professional services and technical support revenues are included in support and services revenue in the accompanying consolidated statements of operations. The Company recognizes revenue from software licensing in accordance with the American Institute of Certified

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Public Accountants Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition.” The Company recognizes revenue from the sale of hardware in accordance with SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,” which summarizes existing accounting literature and requires that four criteria be met prior to the recognition of revenue. The Company’s accounting policies regarding revenue recognition comply with the following criteria: 1) persuasive evidence of an arrangement exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4) collectibility is probable.

     To determine if a fee is fixed or determinable, the Company evaluates rights of return, customer acceptance rights (if applicable), extended payment terms (if any), and multiple-element arrangements of products and services to determine the impact on revenue recognition.

     Certain reseller agreements include stock rotation rights. If an agreement provides for a right of return, the Company recognizes revenue when the right has expired or a specific end-user customer has been identified by the reseller as evidenced with a letter of acceptance or documentation provided by the reseller. If the Company has sufficient historical information to allow it to make an estimate of returns in accordance with the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 48, “Revenue Recognition When Right of Return Exists,” the Company defers revenue based on an estimate for such returns. If an agreement calls for a right of return and sufficient historical return information does not exist, the Company defers revenue for the entire agreement until the right of return expires.

     If an agreement provides for evaluation or customer acceptance, the Company recognizes revenue upon the completion of the evaluation process, acceptance of the product by the customer and completion of all other criteria.

     The Company’s normal payment terms are between 30 and 45 days. Any payment terms beyond those normal terms are considered to be extended payment terms. The Company examines the specific facts and circumstances of all sales arrangements with extended payment terms to make a determination of whether the sales price is fixed or determinable and whether collectibility is probable. Payment terms are not tied to milestone deliverables or customer acceptance. The evaluation of the impact on revenue recognition, if any, includes the Company’s history with the particular customer and the specific facts of each arrangement. Historically, the Company has not provided any concessions or written off any accounts receivable related to extended payment term arrangements.

     Many of the Company’s sales are multiple element arrangements and include hardware, software, and technical support. The Company’s software sales may include professional services for installation, but these services are not a significant source of revenue. The Company does not perform professional services to customize the product. Training is also offered but is not a significant source of revenue. Revenue from multiple element arrangements is recognized using the residual method, as prescribed in SOP No. 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” whereby the fair value of any undelivered elements, such as customer support and services, is deferred and any residual value is allocated to the software and recognized as revenue upon delivery provided all other basic revenue recognition criteria have been met. The fair value of any undelivered elements, typically professional services, technical support and training, have been determined based on the Company’s specific objective evidence of fair value, which is based on the price that the Company charges customers when the element is sold separately. Should the Company introduce new multiple element arrangements into its sales channels, a determination of the objective evidence of the fair value of the undelivered elements will be necessary and an inability to provide objective evidence could impact the Company’s ability to recognize revenue.

     The Company recognizes revenue from services, such as installation and training, when the services are performed. The Company’s technical support contracts require it to provide technical support and unspecified software updates to customers on a when and if available basis. The Company recognizes customer support revenue, including support

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revenue that is bundled with product sales, ratably over the term of the contract period, which typically ranges from one to three years.

     The Company has agreements with certain service providers that provide price protection in the event that more favorable prices and terms are granted to any other similarly situated customer. When required, reserves for estimated price protection credits are established by the Company concurrently with the recognition of revenue. The Company monitors the factors that influence the pricing of its products and service provider inventory levels and makes adjustments to these reserves when management believes that actual price protection credits may differ from established estimates.

Accrued Warranty Costs

     The Company warrants Visual UpTime hardware for a period of up to five years. The Company warrants Visual UpTime Select hardware for one year. The Company estimates its warranty obligation at the end of each period and records changes in the liability to cost of revenue in the respective period. Such estimates are based in part on historical warranty cost experience and expectations of future claims under warranty.

     The following is a summary of the change in the Company’s accrued warranty costs during the three months ended March 31, 2004 and 2005 (in thousands):

Segment Reporting and Significant Customers

     SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information,” establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that these enterprises report selected information about operating segments in interim financial reports. Management has concluded that the Company’s operations occur in one segment only based upon the information used by management in evaluating the performance of the business. SFAS No. 131 also establishes standards for related disclosures about products and services, geographic areas and major customers. The revenue and assets of the Company’s foreign subsidiaries were less than 10% of consolidated revenue and assets. Regarding significant customers, four customers individually represented 39%, 16%, 15% and 10% of revenue for the three months ended March 31, 2004. Three customers individually represented 33%, 16%, and 13% of revenue for the three months ended March 31, 2005. The Company’s major service provider customers include, among others: AT&T, BellSouth, Earthlink, Equant, MCI, SBC, Sprint and Verizon. The revenue generated from sales to service providers was 90% and 80% of the Company’s consolidated revenue for the three months ended March 31, 2004 and 2005, respectively. The agreements with the Company’s significant customers do not obligate these customers to make any minimum purchases from the Company.

Accounting for Stock Options

     During the three months ended March 31, 2004, the Company granted non-qualified stock options to purchase 465,213 shares of common stock to employees under the 1997 Non-Qualified Stock Option Plan at an issuance price that was less than the fair market value of the Company’s common stock and recorded deferred compensation of $330,000. The deferred compensation is being amortized over the vesting period of the stock options, which is 20% as of the grant date and the remaining portion over 24 equal monthly installments after the grant date. As a result, the Company recorded deferred compensation expense of approximately $88,000 and $33,000 during the three months ended

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March 31, 2004 and 2005, respectively.

     The Company accounts for its stock-based compensation under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. APB Opinion No. 25 provides that compensation expense relative to a company’s employee stock options is measured based on the intrinsic value of the stock options at the measurement date.

     If compensation expense had been determined based on the fair value of the options at the grant dates consistent with the method of accounting under SFAS No. 123, “Accounting for Certain Transactions Involving Stock Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” the Company’s net loss per share would have changed to the pro forma amounts for the three months ended March 31, 2004 and 2005 as indicated below (in thousands, except per share amounts):

     The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions used for grants during the three months ended March 31, 2004 and 2005:

     The weighted-average grant-date fair value per share of options granted was $1.53 and $3.28 during the three months ended March 31, 2004 and 2005, respectively.

Basic and Diluted Earnings (Loss) Per Share

     SFAS No. 128, “Earnings Per Share,” requires dual presentation of basic and diluted income (loss) per share. Basic income (loss) per share includes no dilution and is computed by dividing net income (loss) available to common stockholders by the weighted-average number of common shares outstanding for the period.

     Diluted income (loss) per share includes the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.

     Options and warrants to purchase 10,039,837 and 8,834,233 shares of common stock outstanding at March 31, 2004 and 2005, respectively, were not included in the computation of diluted loss per share as their effect would be anti-dilutive. The effect of the convertible debentures issued in March 2002 (see Note 3) that were convertible into 2,986,093 and 2,559,509 shares of common stock at March 31, 2004 and 2005,

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respectively, has not been included in the computation of diluted income per share for the three months ended March 31, 2004 and 2005 as their effect would be anti-dilutive.

Restructuring Charges

     SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” addresses financial accounting and reporting for costs associated with exit or disposal activities and requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and establishes that fair value is the objective for initial measurement of the liability.

     On April 6, 2005, the Company announced a plan to realign its cost structure with an adjusted business model which reflects procurement changes within the Company’s channels and the related effect on the Company’s anticipated future revenue stream. The reorganization included a workforce reduction of approximately 25 employees throughout the Company. In connection with this plan, the Company will record a restructuring charge in the second quarter of 2005 that will consist primarily of employee termination costs, including severance and other benefits.

New Accounting Pronouncements

     In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), which replaces SFAS No. 123 and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS No. 123 no longer will be an alternative to financial statement recognition. In accordance with a recently-issued Securities and Exchange Commission rule, companies will be allowed to implement SFAS No. 123R as of the beginning of the first interim or annual period that begins after June 15, 2005. The company currently expects that it will adopt SFAS No. 123R on January 1, 2006. Under SFAS No. 123R, the company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The permitted transition methods include either retrospective or prospective adoption. Under the retrospective method, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that compensation expense be recorded for all unvested stock options at the beginning of the first quarter of adoption of SFAS No. 123R, while the retrospective methods would record compensation expense for all unvested stock options beginning with the first period presented. The company is currently evaluating the requirements of SFAS No. 123R and expects that adoption of SFAS No. 123R will have a material impact on the company’s consolidated financial position and consolidated results of operations. The company has not yet determined the method of adoption or the effect of adopting SFAS No. 123R, and it has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS No. 123.

2. Line of Credit:

     In July 2004, the Company and Silicon Valley Bank (“SVB”) entered into a $6.0 million line of credit agreement. Borrowings under the line of credit are available once the convertible debentures (see Note 3) have been fully repaid. The Company entered into this line of credit agreement primarily to provide additional capital in the event that the debenture holders exercise their right to require the Company to repay the Debentures in full prior to their due date, and the Company makes all or a substantial portion of the repayment in cash. No amounts were outstanding under this line of credit at December 31, 2004 or March 31, 2005.

     The line of credit agreement with SVB expires on July 22, 2005, at which time any outstanding advances under the agreement are immediately payable. Under the agreement, the Company would be able to borrow amounts not exceeding the lesser of (i) $6.0 million

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or (ii) a borrowing base which is 80% of eligible accounts receivable as defined in the agreement. Interest would be payable monthly at the greater of (i) SVB’s prime rate plus 1.25% per annum or (ii) 5.25% per annum. Collateral under the agreement consists of the Company’s right, title and interest in and to substantially all of its assets other than its intellectual property. Once the convertible debentures are repaid, the agreement subjects the Company to certain financial and other covenants.

3.	Convertible Debentures:

     In March 2002, the Company issued senior secured convertible debentures (the “Debentures”) in the aggregate amount of $10.5 million in a private placement transaction. The Debentures, now due on demand but no later than March 25, 2006, are payable in cash or common stock at the Company’s option provided certain conditions are satisfied, which are currently satisfied. The Debentures bear interest at an annual rate of 5% payable quarterly in cash or common stock, at the Company’s option, provided certain conditions are satisfied, which are currently satisfied. To date, all quarterly interest payments under the Debentures have been made in cash. The conversion price of the Debentures will adjust if the Company issues additional equity or instruments convertible into equity at a price that is less than the then-effective conversion price of the Debentures. The Company has the right to require the holders to convert their Debenture holdings into common stock if the weighted average price of the Company’s common stock exceeds 175% of the conversion price for 20 consecutive trading days. The remaining Debentures totaling $9.0 million are convertible currently into 2,559,509 shares of common stock at March 31, 2005 at a price of $3.5163 per share.

     In connection with the issuance of the Debentures, the Company issued to the holders warrants to purchase 828,861 shares of its common stock at an exercise price of $4.2755 per share. If the Company issues additional equity or instruments convertible into equity at a lower price than the then-effective exercise price, the exercise price would be adjusted downward on a weighted average basis. The warrants expire on March 25, 2007.

     The holders of the Debentures also received the right to purchase shares of to-be-created Series A preferred stock and equity participation rights, which have now expired unexercised. The Debenture holders were also granted registration rights.

     Because the Company did not meet the 2003 earnings target set forth in the Debentures, the Debenture holders may require that the Company repay, in whole or in part, at any time and from time to time, the outstanding principal amount of their Debenture holdings, plus accrued interest. Accordingly, the Debentures, net of unamortized debt discount, are classified as current liabilities in the accompanying consolidated balance sheets. Under the terms of the Debentures: (i) a Debenture holder electing payment for some portion of the Debentures must notify the Company of this election; (ii) the Company, in turn, must notify the Debenture holder of the manner in which it intends to repay that Debenture holder (either all cash or all common stock); and (iii) the notifying Debenture holder then notifies the Company of the amount to be paid in that form at that time. The redemption of each Debenture may be made in cash or common stock, at the Company’s option, provided certain conditions are satisfied, which the Company currently satisfies. During 2004, the Company elected to repay $1.5 million of the outstanding Debentures in cash subsequent to a repayment request from a Debenture holder.

     In addition, under the terms of the Debentures, a number of events could trigger the Debenture holders’ right to force early repayment of 115% of the outstanding principal plus accrued and unpaid interest owed under the Debentures. Events constituting a triggering event include:

•

default by the Company on other indebtedness or obligations under any other debenture, mortgage, credit agreement or other facility, indenture agreement, factoring agreement or other instrument under which there may be issued, or by which there may be secured or evidenced, any indebtedness for borrowed money or money due under any long term leasing or factoring arrangement in an amount

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		exceeding $500,000;
	•	failure by the Company to have its common stock listed on an eligible market;
	•	failure to have an effective registration statement covering the shares of common stock issuable upon conversion of the Debentures or exercise of the warrants;
	•	bankruptcy of the Company;
	•	engagement by the Company in certain change in control, sale of assets or redemption transactions; and
	•	certain other failures by the Company to perform obligations under the Debenture agreement and/or the related agreements.

     The aggregate amounts of the Debentures are reflected in the accompanying balance sheets as a current liability of $9.0 million, net of unamortized debt discount of $0.8 million and $0.7 million, as of December 31, 2004 and March 31, 2005, respectively. The net amount reflects the fair market value on the date of issuance after allocating the proceeds to the various additional components of the debt. $2.1 million in proceeds from the Debentures was allocated to the value of the warrants. Approximately $0.3 million in proceeds from the Debentures was allocated to additional paid-in capital to recognize the value of the rights of the holders to purchase shares of preferred stock, which expired in 2002, as determined by an appraisal. On the date of issuance of the Debentures, the effective conversion price of the Debentures was less than the quoted market price of the Company’s common stock. Accordingly, $0.7 million in proceeds from the Debentures was allocated to additional paid-in capital to recognize this beneficial conversion feature. The discount on the Debentures resulting from the allocation of proceeds to the value of the warrants, preferred stock rights and beneficial conversion feature is being amortized as a charge to interest expense over the four-year period until the Debentures become due in March 2006. Debt issuance costs of $0.9 million were deferred and are being amortized over the term of the Debentures. Because of the early repayment of $1.5 million of the outstanding Debentures in June 2004, a proportionate amount of the unamortized discount and debt issuance costs associated with this $1.5 million repayment was expensed. The related charge of $0.3 million was included in other expense in the statement of operations for the three months ended June 30, 2004.

     Subsequent to March 31, 2005, the Company received a definitive, binding notice from a Debenture holder requesting the repayment in full of an aggregate of $3.0 million of the Company’s $9.0 million outstanding Debentures. The Company plans to pay in cash such amounts and any interest due thereon no later than May 23, 2005, pursuant to the terms of the Debentures.

4. Commitments and Contingencies:

     In January 2004, the Company received notice that a lawsuit had been filed by Paradyne Networks, Inc. (“Paradyne Networks”) of Largo, Florida, in the United States District Court for the Middle District of Florida, Tampa Division (the “Florida Court”) against the Company, seeking damages, and injunctive and declaratory relief, for the Company’s alleged infringement of patents owned by Paradyne Corporation (“Paradyne”), a subsidiary of Paradyne Networks.

     On May 14, 2004, the Florida Court granted the Company’s motion to dismiss the case for lack of subject matter jurisdiction and denied Paradyne Networks’ motion for leave to amend its complaint and its motion for preliminary injunction. Paradyne Networks did not appeal the decision.

     In a related matter, one of the Company’s subsidiaries, Visual Networks Operations, Inc. (“VNO”), filed a lawsuit in United States District Court for the District of Maryland, Southern Division (the “Maryland Court”), against Paradyne. This lawsuit requests declaratory judgment that Visual UpTime and Visual IP InSight do not infringe

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upon certain patents owned by Paradyne and that those patents are invalid and unenforceable and alleges that Paradyne’s assertion of its patents against the Company is baseless and has been for the sole purpose of obtaining an unfair competitive advantage, and that Paradyne has infringed upon certain patents owned by the Company. Paradyne filed counterclaims alleging that VNO infringes upon its patents, mirroring the Florida claims. On October 15, 2004, Paradyne filed amended counterclaims, adding allegations of willful patent infringement and unenforceability of two of the Company’s patents in the lawsuit. The Maryland lawsuit presently is in the fact discovery phase of the litigation. The Maryland Court conducted a hearing concerning patent claim construction on February 7, 2005 and has not yet ruled on that hearing. The fact discovery phase of the Maryland lawsuit was recently completed and a trial date has not yet been scheduled.

     Pursuant to the terms of a confidential settlement agreement entered into on March 11, 2005 between Paradyne and VNO, Paradyne has agreed to dismiss its patent claims against Visual IP Insight. VNO has agreed to dismiss its unfair competition claim against Paradyne with respect to Visual IP Insight and pay royalties to Paradyne through the remaining life of Paradyne’s patents in the amount of 1% of revenue recognized by the Company from the licensing and distribution of Visual IP Insight. On March 15, 2005, the Maryland Court approved a Stipulation of Partial Dismissal submitted by the parties concerning the patent claims against Visual IP InSight and the unfair competition claim against Paradyne.

     Despite the Company’s belief that its products do not infringe upon Paradyne’s patents and that Paradyne’s claims are frivolous and without merit, the defense of these claims is expensive and may divert the Company’s resources from other activities, which could have a material adverse effect on the Company’s business and results of operations. At this point in the litigation, the likelihood of any outcome cannot be determined and the adverse effect, if any, cannot be estimated.

     The Company is periodically a party to disputes arising from normal business activities including various employee-related matters. In the opinion of management, resolution of these various employee-related matters will not have a material adverse effect upon the Company’s financial position or future operating results.

     Litigation costs are expensed as incurred.

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

     This Management’s Discussion and Analysis of Financial Condition and Results of Operations may contain forward-looking statements that involve risks and uncertainties. Under the section “Risk Factors”, we have described what we believe to be some of the major risks related to these forward-looking statements, as well as the general outlook for our business. Investors should review these risk factors and the rest of this Quarterly Report on Form 10-Q in combination with the more detailed description of our business in our 2004 Annual Report on Form 10-K for a more complete understanding of the risks associated with an investment in our common stock.

Overview

     We design and sell products that allow enterprises and network service providers to measure the performance of their networks and identify and monitor software applications that operate on the network. Our solutions correlate traditional network performance information with application data collected from various network locations to provide the network manager with the ability to understand the health and performance of the network and the applications traversing that network - the primary objective is to reduce or avoid expensive network and application downtime. Currently, we offer two product lines to our customers, Visual UpTime and Visual IP InSight. Most of our revenue is derived from the sales and licenses of Visual UpTime products, which sales represented 93% and 96% of our total revenue for the three months ended March 31, 2004 and 2005, respectively.

     We market our products to enterprises, service providers and Value Added Resellers (“VAR’s”). We sell our products through indirect sales channels. An enterprise which desires our technology generally acquires the solution from either a service provider or a VAR. Many of our service provider channel partners have incorporated our products into their value added service offerings to enterprises. Consequently, an enterprise can choose either to utilize our solutions as part of a monthly service offered by the service providers or to purchase our solution. Enterprises that want to host their own systems may procure our solutions through a service provider resale program or through a VAR. Pursuant to agreements with us, our service provider customers purchase our products for internal use, for resale to their customers or to serve as the basis for a value-added service offering. Our major service provider customers include, among others: AT&T, BellSouth, Earthlink, Equant, MCI, SBC, Sprint and Verizon. The revenue generated from sales to service providers was 90% and 80% of the Company’s consolidated revenue for the three months ended March 31, 2004 and 2005, respectively. We intend to increase our efforts in the VAR channel in order to grow this distribution channel. We also intend to expand our international focus, and, during the fourth quarter of 2004, announced the opening of our European headquarters outside of London, England.

     With the appointment of Lawrence Barker as our President and Chief Executive Officer in April 2003, we began to restructure our senior management team and launch new corporate initiatives. The most important initiative involved fundamental changes to our flagship product, Visual UpTime, and which ultimately became known as Visual UpTime Select. Visual UpTime Select built upon the strength of the original Visual UpTime product. Where Visual UpTime was focused solely on performance monitoring of private data networks and was sold only one way – fully loaded as a highly intelligent and capable hardware appliance, Visual UpTime Select represents a modular software approach with expanded capabilities beyond traditional performance monitoring. Visual UpTime Select is a re-architected solution which unbundled our hardware from our software and aggregated our software into its logical modules with the idea of delivering additional capabilities over time through the release of additional software modules. Now customers can purchase only those aspects of our solutions they require while preserving the capability of adding incremental features at a later date. This modular approach has made our solutions more economical for new customers when compared to the original Visual UpTime. Also, this modular approach allows us to sell additional capabilities to our installed base of

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end user customers, a capability not possible under the original Visual UpTime. We announced Visual UpTime Select in October 2003, began shipping in April 2004 and by year end 2004 had essentially completed the transition from Visual UpTime to Visual UpTime Select.

     We expect to release one to two new Visual UpTime Select software modules each year for the next few years. Our first new Visual UpTime Select modules were released during the third quarter 2004 – Select AppFlows and Select AppSummary. These two modules are focused on application discovery, monitoring and reporting. Our next module will significantly enhance our existing voice over internet protocol (“VoIP”) capabilities and is scheduled to be released during the second quarter of 2005.

     We reported net income of $3.4 million in 2002 and incurred net losses in 2003 and in the first two quarters of 2004. However, we returned to profitability in the third and fourth quarters of 2004. We reported net income of $15,000 in 2004, compared with a net loss of $4.3 million in 2003. These improvements can be attributed to both initial success in launching Visual UpTime Select and improvement in the economy. However, during the first three months of 2005, we reported a net loss of $2.7 million. In 2005, Uptime and UpTime Select hardware sales to our service provider channels decreased primarily due to tighter inventory control and reduced capital expenditures resulting from pending consolidation in the telecommunications industry. Sales cycles have increased to accommodate for the increased response time to customer requests from our service provider channels and the extended approval process within the service provider channel. There can be no assurance that we will return to profitability.

     On April 6, 2005, we announced a plan to realign our cost structure with an adjusted business model which reflects the changes within our channels and the anticipated future revenue stream. The reorganization included a workforce reduction of approximately 25 employees throughout the Company. In connection with this plan, we will record a restructuring charge in the second quarter of 2005 that will consist of employee termination costs, including severance and other benefits.

     Based on our current cost structure, our ability to generate net income in the future is, in large part, dependent on our success in achieving quarterly revenue of at least $11.5 million to $12.0 million, achieving quarterly gross margins of 70% to 75% and maintaining or further reducing operating expenses. Due to market conditions, competitive pressures, and other factors beyond our control, there can be no assurances that we will be able to meet these goals. In the event that the anticipated revenue goals are not met, we may not be profitable and we may be required to further reduce our cost structure.

     The market for solutions related to applications delivery infrastructure management is intensely competitive. Increased competition may result in price reductions, reduced profit margins, reduced profitability, and the loss of market share, any of which would have a material adverse effect on our business, financial condition, and results of operations. Current competitors continue to include, among others, Paradyne, Packeteer, Concord Communications and NetScout. If we are successful in the applications management marketplace, we may compete more frequently with significantly larger software companies like IBM, BMC and Computer Associates. Also, consolidations in our traditional service provider channels continue in 2005 and the impact of these consolidations on our business is uncertain.

     We are continuously enhancing Visual UpTime Select with new features and capabilities to expand our value, address new network service requirements, and support new applications. We expect to package many of these enhancements as additional, optional software modules that will be separately licensed. To compete successfully, we must be able to deliver our new product offerings through our channels to enterprise end-users. To assure demand for our products, we intend to continue to strengthen our direct relationships with enterprise end-user customers and cultivate mature alternative channels for bringing our products to market.

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Results of Operations

     The primary statements of operations components are:

     Revenue. Our revenue consists of three types: hardware, software, and support and services. The fees we receive associated with the licensing of our software products are classified as software revenue. The sale of the hardware component of the Visual UpTime and Visual UpTime Select platforms, the analysis service element (“ASE”), is classified as hardware. Visual UpTime sales are primarily hardware. In contrast, Visual UpTime Select sales have unbundled hardware and software components and such sales are classified under hardware and/or software as appropriate. Revenue associated with the licensing of Visual IP Insight is primarily classified as software. Sales of technical support, professional services and training for all products are classified as support and services revenue.

     Cost of revenue and gross profit. Cost of revenue includes both hardware and software cost of revenue. Cost of revenue related to software sales has not been significant. Cost of revenue consists primarily of the direct costs of hardware purchased from contract manufacturing firms, shipping and warehouse costs, warranty repair costs and overhead expenses related to manufacturing operations. Support and services cost of revenue primarily consists of outsourced depot repair and costs associated with the employees who provide technical assistance, training and professional services.

     Operating expenses.

     Research and development expense. Research and development expense consists primarily of research and development staff compensation, outsourced development, testing services and prototype materials.

     Sales and marketing expense. Sales and marketing expense consists primarily of sales and marketing compensation, commissions, travel and entertainment costs and the costs of trade shows and other marketing programs.

     General and administrative expense. General and administrative expense consists primarily of those costs associated with executive management, finance, accounting, legal, information technology and other administrative activities.

Three months ended March 31, 2004 compared to three months ended March 31, 2005

     The following table presents revenue by product line:

     The following table presents the hardware, software, and support and services revenue attributable to customers that individually represented more than 10% of our total revenue for each period presented:

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Revenue, cost of revenue, and gross profit

     The table below sets forth the changes in total revenue, cost of revenue and gross profit:

     The table below sets forth the changes in product revenue, product cost of revenue and product gross profit:

     The table below sets forth the changes in service revenue, service cost of revenue and service gross profit:

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Revenue

     Hardware revenue decreased from period to period due to decreased Uptime and UpTime Select hardware sales to SBC, Sprint and MCI primarily due to changes in procurement practices and inventory investment possibly as a result of pending consolidation in the telecommunications industry. During 2005, sales cycles increased to accommodate increased response time to customer requests from our service provider channels and the extended approval process within the service provider channel. Revenue related to Visual UpTime hardware was $9.5 million and $0.9 million during the first quarter of 2004 and 2005, respectively. No revenue related to Visual UpTime Select hardware was recorded during the first quarter of 2004 as Visual UpTime Select was not available until April 2004. Revenue related to Visual UpTime Select hardware was $3.6 million during the first quarter of 2005.

     The average price of a Visual UpTime Select ASE is lower than the average price of a Visual UpTime ASE. This is due to Visual UpTime Select’s unbundled hardware and software components. When viewed on a comparable basis, the effective average price (hardware plus separately licensed software) of a Visual UpTime Select ASE approximated the effective average price of a Visual UpTime ASE. We are unable to predict how future Visual UpTime Select pricing will compare with historical Visual UpTime pricing on a comparable basis.

     We expect that hardware revenue will decrease as a percentage of revenue in the future as we have largely transitioned to Visual UpTime Select, which has unbundled hardware and software components. This trend may be particularly true throughout 2005, where the full-year effect of Visual UpTime Select sales will be reflected in our operating results.

     Software revenue increased from period to period as we have largely transitioned to Visual UpTime Select, which has unbundled hardware and software components. This trend may be particularly true throughout 2005, where the full-year effect of Visual UpTime Select sales will be reflected in our operating results. Revenue related to Visual UpTime software was $0.2 million during the first quarter of 2004. No revenue related to Visual UpTime software was recorded during the first quarter of 2005. Revenue related to Visual UpTime Select software was $3.0 million during the first quarter of 2005. No revenue related to Visual UpTime Select software was recorded during the first quarter of 2004.

     Insignificant revenue related to Visual IP Insight software was recorded during the first quarter of 2004. Revenue related to Visual IP Insight software was $0.1 million during the first quarter of 2005. Visual IP Insight revenue often fluctuates due to the uncertain timing of orders.

     Support and services revenue decreased from period to period due to decreased Visual IP Insight maintenance revenue of $0.5 million, down from $0.7 million during the first quarter of 2004 to $0.2 million during the first quarter of 2005, due to technical support contracts which were not renewed. Visual UpTime and Visual UpTime Select services were $1.4 million and $1.7 million during the first quarter of 2004 and 2005, respectively.

     We expect that support and services revenue will follow the same trend as product revenue in the future.

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Gross profit

     Gross profit and Gross profit on products as a percentage of revenue decreased from period to period as fixed overhead costs remained constant while revenue levels decreased.

Operating expenses

     The table below sets forth the changes in operating expenses:

     Research and development and Sales and Marketing expenses decreased from period to period primarily due to reduced incentive compensation.

     General and administrative expense increased from period to period primarily due to a $0.4 million increase in legal costs arising from the Paradyne litigation and other legal matters offset by a $0.2 million decrease in incentive compensation costs.

Other items

     The table below sets forth the changes in other items:

     Interest expense decreased from period to period due to reduced interest expense associated with the lower outstanding Debentures balance, which were $10.5 million and $9.0 million at March 31, 2004 and 2005, respectively.

Liquidity and Capital Resources

     We require substantial working capital to fund our business, particularly to finance inventories, accounts receivable, research and development activities, operating expenses and capital expenditures. To date, we have financed our operations and capital expenditures primarily with the proceeds from our initial public offering (completed in February 1998), cash provided by operating activities, bank borrowings, and the proceeds from the issuance of the Debentures. Our future capital requirements will depend on many factors, including the timing and nature of repayment of the $9.0 million in outstanding Debentures, the rate of future revenue growth, if any, and the acceptance of our Visual UpTime Select product suite by our customers. If cash provided by currently available sources is not sufficient, we will be required to further reduce our expenditures for operations and/or to seek additional capital through other means that may include additional borrowings and/or the sale of equity securities or the sale of assets. Our

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access to the SVB line of credit, unavailable until the Debentures are fully repaid, may be limited if we have an insufficient borrowing base or if we cannot meet the financial and other covenants required under the line of credit agreement. Under those circumstances, there can be no assurance that additional capital will be available, or available on terms that are reasonable or acceptable to us, and our business and financial condition may be materially and adversely affected. Based on our cash balance and our revenue and expense expectations, we believe that we will have sufficient cash to operate for at least the next twelve months.

     On April 6, 2005, we announced a plan to realign our cost structure with an adjusted business model which reflects procurement changes within our channels and the related effect on our anticipated future revenue stream. The reorganization included a workforce reduction of approximately 25 employees throughout the Company. In connection with this plan, we will record a restructuring charge in the second quarter of 2005 that will consist of employee termination costs, including severance and other benefits.

     At March 31, 2005, our principal source of liquidity was our existing balance of cash and cash equivalents of $10.8 million.

     Our operating activities consumed $1.5 million in cash and cash equivalents for the three months ended March 31, 2005. The primary use of cash affecting operating activities was the $2.7 million net loss. Accounts payable decreased $1.5 million primarily due to payments made in 2005 for bonus and commissions earned in 2004 as well as other payments for operations. These uses were partially offset by the $3.1 million decrease in accounts receivable which was primarily due to decreased revenue in the quarter.

     Our financing activities provided cash and cash equivalents of $1.1 million for the three months ended March 31, 2005 related to the receipt of cash for the exercise of stock options and issuance of common stock under the employee stock purchase plan.

     Future minimum payments, assuming no additional early Debenture repayments, at March 31, 2005 under the Debentures and non-cancelable operating leases are as follows (in thousands):

     We have a subtenant occupying a portion of our office space under a sublease that expires in December 2005. This sublease runs co-terminus with our lease on that office space. Future minimum lease payments due from the sublessee are $0.2 million as of March 31, 2005.

     The Debentures, now due on demand but no later than March 2006, were issued in March 2002 in the aggregate amount of $10.5 million in a private placement transaction (see Note 3 of Notes to Consolidated Financial Statements). The terms of the Debentures provide for a number of events that could trigger the debenture holders’ right to a repayment of 115% of the outstanding principal plus accrued and unpaid interest. The redemption of each Debenture may be made in cash or common stock, at our option, provided certain conditions are satisfied, which we currently satisfy. If we choose to issue common stock to repay the debt, our stockholders could be subject to significant dilution.

     Subsequent to March 31, 2005, we received a definitive, binding notice from a Debenture holder requesting the repayment in full of an aggregate of $3.0 million of our

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$9.0 million outstanding Debentures. We plan to pay in cash such amounts and any interest due thereon no later than May 23, 2005, pursuant to the terms of the Debentures.

     Should we receive any additional Debenture repayment requests, we intend to carefully evaluate and balance liquidity concerns against dilution considerations and make each determination of whether to repay in cash or common stock on a case-by-case basis. If we choose to repay a Debenture holder with shares of our common stock and the per share issuance price of the stock is less than $3.5163, the conversion price of any outstanding Debentures would be adjusted downward to the issuance price of such stock. In addition, under the terms of the warrants held by the debenture holders, an issuance of shares below the exercise price of the warrants would cause the exercise price to be adjusted on a weighted-average basis.

     The following table outlines the number of shares into which the outstanding Debentures would be convertible if we were to issue additional equity (including for repayment of the Debentures) at the prices specified, as well as the total percent of the outstanding shares of common stock of the Company that such shares would represent upon conversion, calculated using the number of shares outstanding as of May 4, 2005:

     The warrants are subject to weighted average anti-dilution protection which would decrease the exercise price and increase the number of shares issuable under the warrants. These changes would be determined once the total investment amount and price per share of any future equity issuance were known.

     In order to provide us with additional capital resources in the event that the Debentures are repaid in full, we entered into a $6.0 million asset-based line of credit agreement with SVB. Borrowings under the line of credit would be available only after the Debentures are fully repaid (see Note 2 of Notes to Consolidated Financial Statements).

     We are involved in a lawsuit in which we are claiming that (i) our products do not infringe upon patents owned by a competitor, which patents we are arguing are invalid and unenforceable, and (ii) the competitor has infringed upon certain patents owned by us. The competitor has filed counterclaims alleging our infringement of its patents and unenforceability of two of our patents in the lawsuit.

     Despite our belief that our products do not infringe upon the competitor’s patents and that the competitor’s claims are frivolous and without merit, the defense of these claims is expensive and may divert our resources from other activities, which could have a material adverse effect on our business and results of operations. At this point in the litigation, the likelihood of any outcome cannot be determined and the adverse effect, if any, cannot be estimated.

     We have commitments related to inventory purchased by certain suppliers on our behalf. If such inventory is not used within a specified period of time or we discontinue a product for which the suppliers have made purchases or we terminate a relationship with the supplier for which we have set minimum inventory requirements, we are required to purchase the excess inventory from the suppliers. Additionally, if we cancel a purchase order placed with a supplier, we may be subject to certain costs and fees. At March 31, 2005, anticipated demand exceeds the supply of inventory. As such, we do not have a liability recorded at March 31, 2005 for inventory purchase commitments.

     We do not engage in any off-balance sheet financing arrangements. In particular, we

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do not have any so-called limited purpose entities, which include special purpose entities and structured finance entities.

Critical Accounting Policies and Estimates

     The preparation of consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosure of contingent assets and liabilities. Those policies are described in our 2004 Annual Report on Form 10-K. On an ongoing basis, we re-evaluate our estimates, including those related to bad debts, inventory, investment, income taxes, warranty obligations, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Among other things, these estimates form the basis for judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We consider our critical accounting policies to be the following:

     Revenue Recognition

     We recognize revenue from the sale of hardware, the licensing of software and the provision of support and other services. Our revenue recognition policies follow the American Institute of Certified Public Accountants Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition” and SEC Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition,” which summarizes existing accounting literature and requires that four criteria be met prior to the recognition of revenue. Our accounting policies regarding revenue recognition comply with the following required criteria (see Note 1 of Notes to Consolidated Financial Statements): 1) persuasive evidence of an arrangement exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4) collectibility is probable. The third and fourth criteria may require us to make significant judgments or estimates, including the determination of the fair value of the undelivered elements of a sale. Historically, the revenue reserves that we have established relating to estimated returns associated with customer acceptance rights and price protection credits have been adequate. We have not provided any concessions or written off any accounts receivable relating to extended payment term arrangements. If we were to use new multiple element arrangements in our future sales efforts, a determination of the objective evidence of the fair value of the undelivered elements will be necessary and an inability to provide objective evidence could impact our ability to recognize revenue.

     Reserve for Inventory Obsolescence

     Because of the lead times required to obtain manufactured proprietary hardware, we must maintain sufficient quantities of inventory for all of our products to meet expected demand. If actual demand is lower than forecasted, we may not be able to dispose of our inventory at prices exceeding its cost. In addition, hardware model upgrades may result in excess quantities of obsolete models. It is our practice to write down the value of excess and obsolete inventory to the lower of cost or market value based on the number of items that we expect to sell within a one-year period. We review the adequacy of our inventory reserves based on current quantities of hardware in stock, historical sales trends, sales forecasts and certain customer demand and make appropriate inventory valuation adjustments. If future demand is lower than currently estimated, additional valuation adjustments to our inventory may be required. Historically, we have not been required to record significant inventory write-offs of amounts in excess of our reserves.

     Allowance for Doubtful Accounts

     We grant credit terms without collateral to our customers. Other than in 2002, we have not experienced any significant credit related losses. During 2002, we wrote off $0.7 million in accounts receivable from MCI, following MCI’s bankruptcy filing, against the allowance for doubtful accounts. During 2003, we sold those MCI receivables to an unrelated third party and recovered $0.3 million. The accounts receivable balance

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reflects an allowance to state the balance at its estimated net realizable value that is based on assessments of the collectibility of certain problem accounts and a review of historical write-off trends at the end of each reporting period. If future events occur that negatively impact our customers, additional accounts receivable write-downs may be required. As our sales expansion strategies include the identification of alternative North America sales channels and international sales opportunities, we expect that the allowance for doubtful accounts will increase in the future.

     Warranty

     We provide for the estimated cost of product warranties at the time revenue is recognized. We utilize extensive product quality programs and processes including the active monitoring and evaluation of the quality of our component suppliers and contract manufacturers. Our warranty obligation calculation is based on historical product failure rates and material usage and services delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage, or service costs differ from our estimates, revisions to the estimated warranty liability would be required. Our standard warranty term of one year for Visual UpTime Select hardware has been reduced from our historical warranty terms. Our warranty obligation should decrease over time as the warranty terms for older hardware units expire. We account for and disclose our obligations for warranties in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires the accounting for and disclosure of guarantees and clarifies the requirements of FASB No. 5, “Accounting for Contingencies.”

     Deferred Tax Valuation Allowance

     We calculate the deferred tax valuation allowance in accordance with the provisions of Statement of Financial Accounting Standard No. 109, “Accounting for Income Taxes” (“SFAS No. 109”) which requires an assessment of both positive and negative evidence when measuring the need for a valuation allowance. Recent evidence, such as operating results during recent years, is given more weight when assessing whether the level of future profitability needed to recognize the deferred assets will be achieved. Our cumulative loss in the last five years represents sufficient negative evidence to require a full valuation allowance under the provisions of SFAS No. 109. We intend to maintain a full valuation allowance until sufficient positive evidence exists to support the reversal of any portion of the allowance.

Risk Factors

     Investing in our securities involves a high degree of risk. In addition to the other information contained in this Quarterly Report on Form 10-Q, you should consider the following factors before investing in our securities.

     We are highly dependent on sales to telecommunications service providers.

     Our primary sales and marketing strategy has predominantly revolved around sales to telecommunications service providers. We expect that a significant portion of future revenue will be attributable to sales of Visual UpTime Select to service providers. The loss of any one of our service provider customers, which together have historically provided a majority of our revenue, could result in a substantial loss of revenue that could have a material adverse effect on our business and results of operations. Business combinations, such as the prospective MCI-Verizon and AT&T-SBC mergers, would represent significant reductions in the number of our service provider channels. The impact that these combinations may have on our revenue is uncertain. Existing service provider customers are not easily replaced because of the relatively few participants in that market. High barriers to entry due to extraordinary capital requirements and the possibility that existing service providers may merge or fail may further reduce their numbers. Furthermore, the small number of network service providers means that the reduction, delay or cancellation of orders or a delay in shipment of our products to any one service provider customer could have a material adverse effect on our revenue in any

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given quarter. Our anticipated dependence on sizable orders from a limited number of service provider customers will make the relationship between us and each service provider critically important to our business. Further, because our agreements do not contain minimum purchase requirements, there can be no assurance of significant business with our service provider customers on an ongoing basis. With the introduction of Visual UpTime Select, we anticipate that we will see growth in revenue from our value added reseller channel, although there can be no assurance that such growth will occur.

     Our Debenture holders now have the right to demand repayment of any or all of our Debentures at any time and from time to time.

     Because we did not meet the financial targets for 2003 under our Debentures, the Debenture holders may require that we repay any or all of the outstanding principal amount of their Debentures plus accrued interest at any time and from time to time. The choice of whether to repay all common stock or all cash is in our absolute discretion provided we meet certain criteria specified in the Debentures, which we currently meet. If we choose to repay any such demand with common stock, such issuance would have a dilutive effect on our common stockholders. If the issuance price of such shares is below the then-current conversion price of the Debentures, the conversion price of the Debentures is immediately reset to such lower price and the exercise price of the warrants and the number of shares issuable upon exercise would be adjusted upwards on a weighted-average basis.

     If we choose to repay any such demand with cash, and we do not have sufficient cash to both repay amounts and to fund ongoing operations, we may be required to seek additional capital through a sale of assets, sale of additional securities or through additional borrowings, none of which may be available on terms acceptable to us. Our business and financial condition could be materially and adversely affected.

     As of the date of this filing, Debentures totaling $4.5 million of the original Debentures face amount of $10.5 million has been presented for payment prior to the original due date of March 25, 2006. Debentures totaling $1.5 million were presented for payment and paid in the second quarter of 2004 and Debentures totaling $3.0 million were presented for payment and will be paid in the second quarter of 2005. The remaining Debentures, totaling $6.0 million, can be presented at any time.

     Our access to the SVB line of credit may be limited.

     Our access to the SVB line of credit, unavailable until the Debentures are fully repaid, may be limited if we have an insufficient borrowing base or if we cannot meet the financial and other covenants required by the facility. Under those circumstances, there can be no assurance that additional capital will be available, or available on terms that are reasonable or acceptable to us, and our business and financial condition may be materially and adversely affected.

     Substantial dilution to our common stockholders could result if we are required to raise additional capital through the sale of equity below certain price thresholds.

     Debentures outstanding of $9.0 million are convertible into 2,559,509 shares of our common stock at the rate of $3.5163 per share and the associated warrants are exercisable for 828,861 shares of our common stock at a price of $4.2755 per share. The Debentures contain “full ratchet” anti-dilution price protection, meaning that if we issue additional shares of common stock in connection with a financing or under other circumstances at a price lower than $3.5163 per share, the Debentures would become convertible into a greater number of shares of common stock than they are today. Issuances of common stock that do not trigger this anti-dilution protection include: issuances as part of an acquisition or strategic investment, issuances under our stock incentive plan or employee stock purchase plan, or issuances as part of a public offering of more than $30.0 million.

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     The warrants are subject to weighted average anti-dilution protection which would decrease the exercise price and increase the number of shares issuable under the warrants. These changes would be determined once the total investment amount and price per share of any future equity issuance were known.

     The ongoing patent litigation between us and Paradyne, and any other potential intellectual property litigation, could have a significant detrimental effect on our business.

     Despite our belief that our products do not infringe upon Paradyne’s patents and that Paradyne’s claims are frivolous and without merit, the conduct of this litigation is expensive and may divert our resources from other productive activities, which could have a material adverse effect on our business and results of operations. At this point in the litigation, the likelihood of any outcome cannot be determined and the adverse effect of any finding cannot be estimated.

     Additionally, if others claim that our products infringe upon their intellectual property rights, whether the claims are valid or not, we may be forced to incur significant litigation expense, pay damages, delay product shipments, re-engineer our products or acquire licenses to the claimant’s intellectual property. We may be unable to develop non-infringing technology or to obtain licenses on commercially reasonable terms. We expect that these claims may become more common as the number of products in the network management industry increases and the functionality of these products further overlaps. If a claimant is successful in a lawsuit arising from such a claim, it could have a material adverse effect on our business. Adverse publicity related to any intellectual property litigation also could harm (i) the sale of our products and damage our competitive position; (ii) the market for our common stock; and (iii) our ability to obtain additional capital, lines of credit or other borrowings on terms acceptable to us.

     We rely on two firms for contract manufacturing services and one of these firms has sent us a notice of termination.

     We have outsourced the manufacture of our hardware components to two contract manufacturing firms. We derive a substantial portion of our revenue from the sale of our hardware components. A contract manufacturer could decide to tighten or eliminate our credit terms due to concerns about our perceived financial condition or to suspend or cease the shipment of products due to our failure to meet volume expectations.

     On March 25, 2005, Visual Networks Operations, Inc. (“VNO”), a wholly-owned operating subsidiary, received written notice from Celestica Corporation (“Celestica”) that Celestica has exercised its right to terminate the Agreement for Electronic Manufacturing Services dated March 1, 2000, between VNO and Celestica (the “Services Agreement”). The notice states that the effective date of termination of the Services Agreement will be October 17, 2005. Pursuant to the Services Agreement, Celestica has served as our primary manufacturer of electronic products.

     We are exploring alternative electronic product manufacturers and expect to have a new manufacturer in place prior to termination of the Services Agreement. Furthermore, Celestica has indicated that it will manufacture electronic products for us pursuant to the Services Agreement through September 2005. However, there can be no assurance that an agreement with a new manufacturer will be reached on acceptable terms prior to termination of the Services Agreement. We could experience substantial production delays and may be required to pay substantially higher prices in order to complete delivery of customers’ orders, having a material adverse effect on our revenue and gross profit. In addition, we could experience an increase in inventory levels during the transition from Celestica which could negatively affect our liquidity.

     We may not be able to obtain critical hardware components.

     Our contract manufacturers purchase a number of critical components from vendors for which alternative sources are not currently available. Delays or interruptions in the

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supply of these components could result in delays or reductions in product shipments. The purchase of these components from outside suppliers on a sole source basis subjects us to risks, including the continued availability of supplies, price increases and potential quality assurance problems. While alternative suppliers may be available, these suppliers must be identified and qualified. We cannot be certain that any such suppliers will meet our required qualifications or that alternative suppliers can be identified in a timely fashion, if at all. Our contract manufacturers may not be able to obtain sufficient quantities of these components on the same or substantially the same terms. Consolidations involving suppliers could further reduce the number of component alternatives and affect the cost of such supplies. An increase in the cost of such supplies could make our products less competitive. Production delays, lower margins or less competitive product pricing could have a material adverse effect on our business and results of operations.

     We may experience difficulties in migrating customers to Visual UpTime Select.

     Visual UpTime Select is based on a new licensing model and includes significant new technological innovations. We have sales and technical obstacles to overcome related to upgrading Visual UpTime customers to Visual UpTime Select. These obstacles may delay new orders, slow product deployment or result in other unforeseen challenges with otherwise negative impacts.

     We have an accumulated deficit of $475.8 million.

     Our net losses since 2000 have resulted in an accumulated deficit of $475.8 million at March 31, 2005. This accumulated deficit could affect our ability to raise equity financing, arrange bank financing or arrange credit from suppliers on reasonable or acceptable terms.

     We may not be profitable in the future.

     Our ability to generate operating income in the future is dependent on our success in growing revenue and managing operating expenses. Market conditions, competitive pressures, and other factors beyond our control, may adversely affect our ability to adequately sustain revenue in the future. In particular, our ability to sustain revenue may be negatively affected by our dependence on our service provider customers. Pressure on capital expenditures and the decline of the telecommunications industry may delay the roll-out of new services based on our products offered by our service provider customers. Any potential reduction in demand for value added services or products, which our products support, from the service providers’ customers, directly impacts the purchase volume of our products and may impact our ability to sustain revenue. We may be required to further reduce operating expenses if future revenue projections fall short of expectations. Our operating expenses include substantial fixed components which cannot be reduced quickly. If anticipated revenue levels are below expectations, operating results are likely to be materially and adversely affected because we may not be able to reduce operating expenses on a timely basis.

     Our current stock compensation expense negatively impacts our earnings, and when we are required to report the fair value of employee stock options as an expense in conjunction with a new accounting standard, our reported financial performance will be adversely affected, which may cause our stock price to decline.

     Under our current accounting practice for stock options granted to employees, stock compensation expense is recorded to the extent the current market price of the underlying stock exceeds the exercise price on the date of grant. In December 2004, the Financial Accounting Standards Board issued SFAS No. 123R, “Share-Based Payment”. SFAS No. 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. This statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123R requires that the fair value of such equity

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instruments be recognized as an expense in the historical financial statements as services are performed. Prior to SFAS No. 123R, only certain pro forma disclosures of fair value were required. In accordance with a recently-issued Securities and Exchange Commission rule, companies will be allowed to implement SFAS No. 123R as of the beginning of the first interim or annual period that begins after June 15, 2005. We currently expect to adopt SFAS No. 123R on January 1, 2006. The adoption of SFAS No. 123R is expected to have a material effect on our financial statements by depressing net income, possibly causing our stock price to decline.

     Our long sales cycle, which has had a median length of approximately five to six months, requires us to expend significant resources on potential sales opportunities that may never be consummated.

     Our sales cycles are relatively long because large enterprises, our target end-user market, frequently experience delays in making significant capital expenditures on complicated systems. For enterprise customers, our historical sales cycle has a median of approximately five to six months. This extended cycle increases the risk that a potential customer might lower its capital expenditures or change product functionality requirements during the sales process. Because we are required to commit substantial sales and marketing resources during this extended time period without any assurance of consummating an eventual sale, we risk incurring significant expense without generating any associated revenue.

     Failure to adapt to rapid technological change could adversely affect our ability to compete effectively.

     The market for our products is characterized by rapid changes, including continuing advances in technology, frequent new product introductions, changes in customer requirements and preferences and changes in industry standards. If we are unable to develop and introduce new products and product enhancements in a timely fashion that accommodate future changes, we will likely lose customers and business which could have a material adverse effect on our business, financial condition and results of operations. The introduction of new technologies, advances in techniques for network services, the integration of service level management functionality into other network hardware components and improvements to the infrastructure of the Internet could render our products obsolete or unmarketable. There can be no assurance that (i) there will continue to be a need for our products; (ii) our existing products will continue to compete successfully; (iii) our future product offerings will keep pace with the technological changes implemented by our competitors; (iv) our products will satisfy evolving industry standards or preferences of existing or prospective customers; or (v) we will be successful in developing and marketing products for any future technology.

     We face growing competition from several market segments that could make it difficult for us to acquire and retain customers.

     We face competition from several market segments whose functionality our products integrate. We expect competition in each of these market segments to intensify in the future. In addition, consolidation between competitors in various market segments (such as Concord-Computer Associates) could intensify competition. Our primary current competitors include, or in the future may include, the following: Adtran, Brix, Concord, Kentrox, Lucent Technologies, NetScout, Packeteer, and Paradyne. Our competitors vary in size and in the scope and breadth of the products and services that they offer. While we intend to compete by offering superior features, performance, reliability and flexibility at competitive prices and on the strength of our relationships with service providers, many of these competitors have greater financial, technical, marketing and other resources than us, and some have well-established relationships with our current and potential customers. As a result, these competitors may be able to respond to new or emerging technologies and changes in customer requirements more effectively than us, or devote greater resources than us to the development, promotion and sale of products. In addition, we believe that competitors from one or more of our market segments could partner with each other to offer products that supply functionality approaching that

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provided by Visual UpTime Select. Increased competition may result in price reductions, reduced profitability and loss of market share, any of which could have a material adverse effect on our business and results of operations.

     Errors in our products or services could discourage customers, damage our reputation and delay product development and enhancement.

     Products and services as complex as those which we offer may contain undetected errors or failures when first introduced or as new versions are released. There can be no assurance that, despite testing by us and by current and potential customers, errors will not be found in new products and services until commercial shipments have commenced. Such errors can substantially delay the time until we are able to generate revenue from new product releases and could force us to divert additional development resources to correct the errors. If such errors are detected after shipments have been made, then our reputation may be damaged, and we may incur substantial costs covering warranty claims.

     In our research and development spending plan, we plan for a certain level of engineering activity associated with “sustaining issues.” “Sustaining issues” include fixing problems in released products that were not identified in the development and testing cycle. During any period, if more sustaining issues arise than anticipated, we may have to divert resources away from scheduled product development and enhancement activities. A delay in product development and enhancement activities could have a material adverse effect on our future revenue and operating results.

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

     Terms of our certificate of incorporation and bylaws make it more difficult for another individual or company to acquire control of our company, even if a change of control would benefit our stockholders. These terms include:

	•	our board of directors, without stockholder approval, may issue up to 5,000,000 shares of preferred stock on terms that they determine, including terms that delay or prevent the change in control of our company, make removal of management more difficult or depress the price of our stock;
	•	certain provisions of our certificate of incorporation and bylaws and of Delaware law could delay or make more difficult a merger, tender offer or proxy contest;
	•	we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law which prohibits a publicly held Delaware corporation from engaging in a “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner;
	•	our board of directors is “staggered” so that only a portion of its members are elected each year;
	•	only our board of directors, our chairman of the board, our president, or stockholders holding a majority of our stock can call special stockholder meetings; and
	•	special procedures must be followed in order for stockholders to present proposals at stockholder meetings.

     In addition, the outstanding Debentures may become immediately due and payable upon a change of control, which could have the effect of discouraging an acquisition that might otherwise benefit our stockholders.

Item 3. Qualitative and Quantitative Disclosures About Market Risk

     During 2002, we issued long-term debt in the form of the convertible debentures discussed in Note 3 of Notes to Consolidated Financial Statements. The convertible debentures bear interest at a fixed annual rate of 5%. Our investment policy restricts us

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to investing only in investment-grade securities, and we may be exposed to market risk from interest rate changes. A failure of these investment securities to perform at their historical levels could reduce the interest income realized by us.

     While substantially all of our product sales to date have been made to customers in the United States, we plan to sell our products to international customers at prices denominated in United States dollars. However, if we commence selling material volumes of product to such customers at prices not denominated in United States dollars, we intend to adopt a strategy to hedge against fluctuations in foreign currency.

Item 4. Controls and Procedures

     Our management, including our principal executive and principal financial officers, has evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2005. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed in this Quarterly Report on Form 10-Q has been appropriately recorded, processed, summarized and reported. Based on that evaluation, our principal executive and principal financial officers have concluded that our disclosure controls and procedures are effective at the reasonable assurance level.

     Our management, including our principal executive and principal financial officers, has evaluated any changes in our internal control over financial reporting that occurred during the quarterly period ended March 31, 2005, and has concluded that there was no change that occurred during the quarterly period ended March 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

Item 1. Legal Proceedings

     In January 2004, we received notice that a lawsuit had been filed by Paradyne Networks, Inc. (“Paradyne Networks”), of Largo, Florida, in the United States District Court for the Middle District of Florida, Tampa Division (the “Florida Court”) against us, seeking damages, and injunctive and declaratory relief, for our alleged infringement of patents owned by Paradyne Corporation (“Paradyne”), a subsidiary of Paradyne Networks.

     On May 14, 2004, the Florida Court granted our motion to dismiss the case for lack of subject matter jurisdiction and denied Paradyne Networks’ motion for leave to amend its complaint and its motion for preliminary injunction. Paradyne Networks did not appeal the decision.

     In a related matter, one of our subsidiaries, Visual Networks Operations, Inc. (“VNO”), filed a lawsuit in United States District Court for the District of Maryland, Southern Division (the “Maryland Court”), against Paradyne. This lawsuit requests declaratory judgment that Visual UpTime and Visual IP InSight do not infringe upon certain patents owned by Paradyne and that those patents are invalid and unenforceable. The lawsuit further alleges that Paradyne’s assertion of its patents against us is baseless and has been for the sole purpose of obtaining an unfair competitive advantage, and that Paradyne has infringed upon certain patents own by us. Paradyne filed counterclaims alleging that VNO infringes upon its patents, mirroring the Florida claims. On October 15, 2004, Paradyne filed amended counterclaims, adding allegations of willful patent infringement and unenforceability of two of our patents in the lawsuit. The Maryland lawsuit presently is in the fact discovery phase of the litigation. The Maryland Court conducted a hearing concerning patent claim construction on February 7, 2005 and has not yet ruled on that hearing. The fact discovery phase of the Maryland lawsuit was recently completed and a trial date has not yet been scheduled.

     Pursuant to the terms of a confidential settlement agreement entered into on March 11, 2005 between Paradyne and VNO, Paradyne has agreed to dismiss its patent claims against Visual IP Insight. VNO has agreed to dismiss its unfair competition claim against Paradyne with respect to Visual IP Insight and pay royalties to Paradyne through the remaining life of Paradyne’s patents in the amount of 1% of revenue recognized by us from the licensing and distribution of Visual IP Insight. On March 15, 2005, the Maryland Court approved a Stipulation of Partial Dismissal submitted by the parties concerning the patent claims against Visual IP InSight and the unfair competition claim against Paradyne.

     Despite management’s belief that our products do not infringe upon Paradyne’s patents and that Paradyne’s claims are frivolous and without merit, the defense of these claims is expensive and may divert our resources from other activities, which could have a material adverse effect on our business and results of operations. At this point in the litigation, the likelihood of any outcome cannot be determined and the adverse effect, if any, cannot be estimated.

     We are periodically a party to disputes arising from normal business activities including various employee-related matters. In the opinion of our management, resolution of these matters will not have a material adverse effect upon our financial position or future operating results.

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

     On March 11, 2005, Mark B. Skurla was granted options to purchase 100,000 shares of common stock with 25% of the options vesting on March 11, 2006 and the remainder vesting in equal monthly installments over the following 36 months. 100% of the options vest upon a change in control. The options expire on March 11, 2015.

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Item 3. Defaults Upon Senior Securities

     None.

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

     None.

Item 5. Other Information

     None.

Item 6. Exhibits

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SIGNATURES

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

Date: May 6, 2005

Date: May 6, 2005

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