KEYNOTE SYSTEMS INC - 10-Q Quarterly Report

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES x NO ¨

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

The accompanying interim unaudited condensed consolidated financial statements reflect all normal recurring adjustments that are, in the opinion of management, necessary for a fair presentation of the financial position of Keynote Systems, Inc. and subsidiaries (the Company) at December 31, 2002, and the results of operations and cash flows for the interim periods ended December 31, 2002 and 2001.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”), and therefore, do not include all information and footnotes necessary for a complete presentation of the Company’s results of operations, financial position and cash flows. This report should be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended September 30, 2002 included in the Company’s Report on Form 10-K as filed with the SEC.

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

Certain reclassifications have been made to previously issued financial statements to conform to current presentation.

Subscription services revenue consists of fees from subscriptions to the Company’s Internet measurement, monitoring, testing and diagnostic services. The Company’s subscription services revenue is deferred upon invoicing and is recognized ratably over the service period, generally ranging from one to twelve months. For some customers, subscription services revenue is invoiced monthly upon completion of the services. Deferred revenue is comprised of all unearned revenue, primarily unearned subscription revenue, and is recorded as deferred revenue on the balance sheet until the revenue is earned. The Company does not generally grant refunds during the initial subscription term. All discounts granted during the initial term are netted against revenue. Revenue is not recognized for free trial periods. Revenue from consulting and support services, which includes revenue from its load-testing services, is recognized as the services are performed, typically over a one to three month period. For consulting projects that span more than one month, the Company recognizes revenue on a percentage-of-completion basis.

Effective October 1, 2001, the Company early adopted Statement of Financial Accounting Standard (SFAS) No. 142, “Goodwill and Other Intangible Assets.” On adoption of SFAS No. 142, the Company determined its market capitalization value based on the number of shares outstanding and the stock price as of October 1, 2001, after adjusting for a 10% premium that is assumed to represent additional value that an acquirer would be required to pay for a controlling interest in the Company. This evaluation indicated that goodwill associated with acquisitions completed prior to fiscal 2002 was impaired as of October 1, 2001. Accordingly, the Company recorded a $3.2 million non-cash impairment charge as a cumulative effect of a change in accounting principle for the write-off of the remaining amount of goodwill as of October 1, 2001. Currently, there is no remaining goodwill on the Company’s balance sheet.

Other comprehensive income (loss) includes unrealized gains and losses on short-term investments in debt securities and foreign currency translation. These items are excluded from earnings and reported as a component of stockholders’ equity. The functional currency of the Company’s foreign operations is the applicable local currency. The translation of foreign currencies into U.S. dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using average exchange

rates for each reporting period. Gains and losses from foreign currency transactions are reflected in the consolidated statements of operations as incurred.

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

Credit risk is concentrated in North America, but also exists in Europe. The Company generally requires no collateral from customers, however, throughout the collection process, it conducts an ongoing evaluation of customers’ ability to pay. The Company’s allowance for doubtful accounts is determined based on historical trends, experience and current market and industry conditions. Management regularly reviews the adequacy of the Company’s allowance for doubtful accounts after considering the aging of accounts receivable, the age of each invoice, each customer’s expected ability to pay and the Company’s collection history with each customer. Management reviews invoices greater than 60 days old to determine whether an allowance is appropriate based on the receivable balance. In addition, the Company maintains a reserve for all other invoices, which is calculated by applying a percentage to the outstanding accounts receivable balance, based on historical collection trends. The allowance for doubtful accounts represents management’s best current estimate, but changes in circumstances relating to accounts receivable, including unforeseen declines in market conditions and collection rates, may result in additional allowances in the future. The Company believes that it has adequately reserved for doubtful accounts as of the date of each balance sheet presented herein. At December 31, 2002, one customer accounted for more than 10% of the Company’s total accounts receivable, which receivable was collected in early January 2003. For the three months ended December 31, 2002 and 2001, no single customer accounted for more than 10% of the Company’s total revenue.

For the purposes of the consolidated financial statements, the Company considers all highly liquid investments with original maturities of three months or less when acquired to be cash equivalents. All of the Company’s cash equivalents and short-term investments are classified as available-for-sale. These securities are carried at fair market value, with unrealized gains and losses excluded from earnings and reported as a component of other comprehensive income (loss). The following table summarizes the Company’s short-term investments in investment-grade debt securities as of December 31, 2002 (in thousands):

The following table summarizes the maturities of fixed maturity investments available for sale at December 31, 2002 (in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties.

As of December 31, 2002, the net carrying value of identifiable intangible assets was approximately $3.2 million. During the first quarter of fiscal 2003, the Company acquired approximately $813,000 of technology-based and $31,000 of customer-based intangible assets related to the acquisition of the business of Enviz, Inc. (see Note 9). In addition, the purchase price allocation for the acquisition of the business of Envive Corporation was adjusted to reflect an amount of approximately $144,000 which was received during the first quarter of fiscal 2003 as a result of the finalization of the acquisition. This amount was allocated between technology–based and customer-based intangible assets. As a result, the net change in identifiable intangible assets for the quarter ended December 31, 2002 was $700,000. These assets are being amortized over a three year period, with minimal residual values. During the three month period ended December 31, 2002, the amortization expense for intangible assets was approximately $380,000. The components of identifiable intangible assets are as follows (in thousands):

The amortization expense for existing intangible assets is estimated to be approximately $1.2 million for the remainder of fiscal 2003, approximately $1.4 million for fiscal 2004, and approximately $580,000 for fiscal 2005.

Basic net loss per share is computed using the weighted-average number of outstanding shares of common stock excluding shares of restricted stock subject to repurchase summarized below. Diluted net loss per share is computed using the weighted-average number of shares of common stock outstanding and, when dilutive, potential common shares from options and warrants to purchase common stock using the treasury stock method and from convertible securities using the “as-if-converted” basis.

The following potential common shares have been excluded from the computation of diluted net loss per share because the effect would have been antidilutive (in thousands):

The weighted-average exercise price per share of common stock subject to stock options was $12.41 as of December 2002 and $15.62 as of December 31, 2001. The weighted-average repurchase price of restricted stock was $1.52 as of December 31, 2002, and $0.81 as of December 31, 2001.

In October 2002, the Company acquired the business of Enviz, Inc. (Enviz), a developer of user experience testing technology for $76,000 in cash and 111,000 shares of the Company’s common stock. The Company believes this acquisition will enhance its ability to provide testing services for diagnosing and improving web effectiveness by testing the total quality of the user experience.

The purchase consideration of approximately $841,000 was allocated to the assets and liabilities acquired based on their estimated fair values at the acquisition date. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands):

Identifiable intangible assets are being amortized on a straight-line basis over a three year period. Amortization of identifiable intangible assets related to the acquisition of the business of Enviz was $70,000 for the three months ended December 31, 2002. The consolidated statement of operations for the three months ended December 31, 2002 includes the results of operations relating to Enviz’s business activity subsequent to the acquisition. If the results of the two companies were combined on a pro forma basis for the three months ended December 31, 2002 and 2001, the difference between pro forma results and the actual results reported herein, would be immaterial.

During the three months ended December 31, 2002, the Company recorded $844,000 related to identifiable intangible assets associated with the acquisition of the business of Enviz. Additionally, as of October 1, 2001, the Company recorded a charge of approximately $3.2 million as a cumulative

effect of a change in accounting principle for the write-off of the remaining goodwill associated with its acquisitions made prior to fiscal 2002.

During the three months ended December 31, 2002, the purchase price allocation for the acquisition of the business of Envive Corporation was adjusted to reflect an amount of approximately $144,000 which was received as a result of the finalization of the acquisition. This amount was allocated between technology–based and customer-based intangible assets. Goodwill related to the acquisition was determined to be fully impaired and was written-off during the year ended September 30, 2002.

The Company leases certain of its facilities under non-cancelable operating leases which expire on various dates through December 2005. At December 31, 2002, future minimum payments under the leases are as follows (in thousands):

Beginning on August 16, 2001, a number of class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company, certain of its officers, and the underwriters of the Company’s initial public offering. These lawsuits are essentially identical, and were brought on behalf of those who purchased the Company’s securities between September 24, 1999 and August 19, 2001. These complaints allege generally that the underwriters in certain initial public offerings, including the Company’s, allocated shares in those initial public offerings in unfair or unlawful ways, such as requiring the purchaser to agree to buy in the aftermarket at a higher price or to buy shares in other companies with higher than normal commissions. The complaint also alleges that the Company had a duty to disclose the activities of the underwriters in the registration statement relating to its initial public offering. The complaints have been consolidated into a single action with cases brought against over three hundred other issuers and their underwriters that make similar allegations regarding the initial public offerings of those issuers. The plaintiffs’ counsel and the individual named defendants’ counsel have reached an agreement whereby the individual named defendants have been dismissed from the case, without any payments by the Company. The case against the underwriters and the Company continues, however, plaintiffs’ counsel and the underwriters have each

offered settlement proposals to the issuers. The Company is still evaluating each proposal. The Company believes the claims are without merit and intends to defend the actions vigorously should settlement not be reached. However, these claims, even if not meritorious, could be expensive to defend and divert management’s attention from operating the Company.

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

On October 28, 2002, the Company announced that its Board of Directors adopted a stockholder rights plan. The plan is designed to protect the long-term value of the Company for its stockholders during any future unsolicited acquisition attempt. Key features of the rights plan include:

The Company has determined that it operates in a single reportable operating segment: the development and sale of services to measure, test, assure and improve the quality of service of web sites.

The Company markets its products primarily from its operations in the United States. International sales are primarily to customers in Europe. These sales and the Company’s foreign-owned assets are not significant. At December 31, 2002, one customer accounted for more than 10% of the Company’s total accounts receivable, which receivable was collected in early January 2003. At December 31, 2001, no single customer accounted for more than 10% of the Company’s total revenue.

ITEM 2. Management Discussion and Analysis of Financial Condition and Results of Operations

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

Except for historical information, this Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements involve risks and uncertainties, including, among other things, statements regarding our anticipated costs and expenses and revenue mix. These forward-looking statements include, among others, statements including the words “expect,” “anticipate,” “intend,” “believe” and similar language. Our actual results may differ significantly from those projected in the forward-looking statements. Factors that might cause or contribute to these differences include, but are not limited to, those discussed in this section and in our annual report on Form 10-K for the fiscal year ended September 30, 2002, in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Factors That May Impact Future Operating Results” and elsewhere in that report. You should also carefully review the risks described in other documents we file from time to time with the Securities and Exchange Commission, including the annual report on Form 10-K, the quarterly reports on Form 10-Q and current reports on Form 8-K that we file in fiscal 2003. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this quarterly report on Form 10-Q. We undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.

We provide services that enable corporate enterprises to benchmark, test, and manage their electronic business, or e-business, applications, and systems, both inside and outside the firewall. Our services are designed to provide “total performance management” by allowing enterprise customers to improve the quality of their e-business from the end-user perspective through cost-effective and easy-to-use web performance management and testing solutions. We provide outsourced services and appliances, which do not require complex and costly software implementations, configuration or maintenance by our customers. We believe that enterprises who use our services leverage their existing software and hardware, improve customer satisfaction and reduce capital expenditures.

Revenue consists of subscription services revenue and consulting and support services revenue. Subscription services revenue consists of fees from subscriptions to our Internet measurement, monitoring, testing, and diagnostic services. Our subscription revenue is deferred upon invoicing and is recognized ratably over the service period, generally ranging from one to twelve months. For some customers, subscription service revenue is invoiced monthly upon completion of the services. Deferred revenue is comprised of all unearned revenue, primarily unearned subscription revenue, and is recorded as deferred revenue on our balance sheet until the revenue is earned. As of December 31, 2002, we had recorded $5.7 million of deferred revenue. We do not generally grant refunds during the initial subscription term. All discounts granted during the initial term are netted against revenue. Revenue is not recognized during free trial periods. Revenue from our consulting and support services, which includes revenue from our load testing services, is recognized as the services are performed, typically over a one to three month period. For longer consulting projects that span more than one month, we recognize revenue on a percentage-of-completion basis.

A majority of our subscription revenue comes from our web performance benchmarking services. Subscription revenue also includes our Red Alert and NetMechanic monitoring and alarm services, and our private agent application performance management services. Our customers purchase these services for an initial terms of three to twelve months and then may renew their subscription on an annual, semi-annual, or month-to-month basis.

Subscription fees can vary based on the number of URLs measured, the number of devices monitored, the number of measurement locations, the frequency of the measurements, the number of private agents, the additional features ordered, and the type of services. We offer our consulting and support services on a per engagement basis. Consulting and support services revenue have amounted to approximately 13% and 8% of total revenue for the quarters ended December 31, 2002 and 2001, respectively. We believe that consulting and support services revenue may increase in the future as a percentage of total revenue, as we introduce additional services that require consulting expertise and as our Keynote Diagnostic and WebEffective services become more widely used. However, we cannot assure you that this revenue will increase in absolute dollars in future periods.

For the quarter ended December 31, 2002, our 10 largest customers accounted for approximately 27% of total revenue. We cannot be certain that customers that have accounted for significant revenue in past periods, individually or in aggregate, will renew our services and continue to generate revenue in any future period. In addition, our customer agreements can generally be terminated at any time with little or no penalty. If we lose a major customer or a group of significant customers, our revenue could significantly decline.

Subscription Services. Revenue from subscription services decreased $271,000 or 3% for the three months ended December 31, 2002 as compared to the corresponding period in 2001. Subscription services represented approximately 87% of total revenue for the three months ended December 31,

2002, and approximately 92% of total revenue for the three months ended December 31, 2001. The revenue decrease compared to the first quarter of fiscal 2002 resulted from a reduction in revenue from the Internet service provider, e-commerce and Internet business market segment, which declined to 13% of total revenue compared to 16% for the first quarter of fiscal 2002.

Consulting and Support Services. Revenue from consulting and support services increased $440,000 or 55% for the three months ended December 31, 2002 as compared to the corresponding period in 2001. Consulting and support services represented approximately 13% of total revenue for the three months ended December 31, 2002, and approximately 8% of total revenue for the three months ended December 31, 2001. The revenue increase compared to the first quarter of fiscal 2002 was primarily due to increased contributions from our new service offerings, Keynote Diagnostic Services, which was introduced in the first quarter of fiscal 2002, and Web Effective, which was introduced in the first quarter of fiscal 2003. The increase was due, to a lesser extent, to our completing a larger number of testing and consulting engagements, which were generally higher in value as compared to the first quarter of fiscal 2002.

At December 31, 2002, one customer accounted for more than 10% of our total accounts receivable, which receivable was collected in early January 2003. At December 31, 2001, no single customer accounted for more than 10% of our total accounts receivable. For the three months ended December 31, 2002 and 2001, no single customer accounted for more than 10% of total revenue.

Costs of Subscription Services. Costs of subscription services consist of connection fees to Internet service providers for bandwidth usage of our measurement computers, which are located around the world, and depreciation, maintenance and other equipment charges for our measurement and data collection infrastructure. Costs of subscription services were 29% and 39% of subscription services revenue in the quarters ending December 31, 2002 and 2001, respectively. Costs of subscription services decreased $910,000 or 27% during the quarter ended December 31, 2002 as compared to the corresponding period in 2001. This decrease was primarily due to reduced costs for bandwidth and, to a lesser extent, lower depreciation expenses. We believe that costs of subscription services in absolute dollars for the second quarter of fiscal 2003 will remain comparable to the first quarter of fiscal 2003.

Costs of Consulting and Support Services. Costs of consulting and support services consist of compensation expenses and related costs for consulting and support services personnel, all load-testing bandwidth costs and related network infrastructure costs. Costs of consulting and support services were 75% and 120% of consulting and support services revenue in the quarters ended December 31, 2002 and 2001, respectively. Costs of consulting and support services decreased $27,000 or 3% during the quarter ended December 31, 2002 compared to the corresponding period in 2001. The decrease in costs of consulting and support services is primarily due to lower costs resulting from a reduced number of consulting and support services personnel. The decrease in costs of consulting and support services as a percentage of consulting and support services revenue was also attributable to increased consulting and support services revenue as mentioned above. We expect that the costs of consulting and support services as a percentage of consulting and support services revenue will continue to be greater than the costs of subscription services as a percentage of subscription services revenue. We expect that costs of consulting and support services in absolute dollars for the second quarter of fiscal 2003 will increase slightly from the first quarter of fiscal 2003.

Research and development expenses consist primarily of compensation and related costs for research and development personnel. Research and development expenses decreased approximately $66,000 or 3% for the three months ended December 31, 2002 as compared to the corresponding period in 2001. The decrease was primarily attributable to lower costs resulting from a reduced number of research and development personnel, offset, in part, by additional costs related to acquisitions. To date, all research and development expenses have been expensed as incurred. We believe that research and development expenses in absolute dollars for the second quarter of fiscal 2003 will remain comparable to the first quarter of fiscal 2003.

Sales and marketing expenses consist primarily of salaries, commissions and bonuses earned by sales and marketing personnel, lead-referral fees, marketing programs and travel expenses. Our sales and marketing expenses decreased $559,000 or 11% for the three months ended December 31, 2002 as compared to the corresponding period in 2001. The decrease primarily resulted from the restructuring of our sales organization to focus more resources on our large corporate customers and, to a lesser extent, from reduced spending on certain marketing programs. We believe that sales and marketing expenses in absolute dollars for the second quarter of fiscal 2003 will remain comparable to the first quarter of fiscal 2003.

Operations expenses consist primarily of compensation and related costs for management and technical support personnel who manage and maintain our field measurement and collection infrastructure and headquarters data center and provide twenty-four by seven basic customer support. Our operations personnel also work closely with other departments to assure the reliability of our services and to support our sales and marketing activities. Our operations expenses decreased $229,000 or 11% for the three months ended December 31, 2002 as compared to the corresponding period in 2001. The decrease in operations expenses was primarily the result of an effort to lower cost by increasing operating efficiencies and reducing the number of personnel in the operations group. We believe that operations expenses in absolute dollars for the second quarter of fiscal 2003 will decrease compared to the first quarter of fiscal 2003 due to continued increases in operating efficiencies.

General and administrative expenses consist primarily of salaries and related expenses, accounting, legal and administrative expenses, insurance, professional service fees and other general corporate expenses. General and administrative expenses decreased $290,000 or 16% for the three months ended December 31, 2002 as compared to the corresponding period in 2001. The decrease in our general and administrative expenses was primarily due to lower bad debt provisions due to improved collection efforts. The decrease was due, to a lesser extent, to lower spending on professional services. We believe that general and administrative expenses in absolute dollars for the second quarter of fiscal 2003 will be slightly lower than the first quarter of fiscal 2003 as a result of a reduction of personnel in the general and administrative group implemented in the second quarter of fiscal 2003.

Amortization of Identifiable Intangible Assets and Stock-Based Compensation

As of December 31, 2002 and 2001, we had identifiable intangible assets with a gross carrying value of approximately $11.8 million and $9.5 million, respectively. For the three months ended December 31, 2002 and 2001, we recorded expenses of $379,000 and $214,000, respectively, in amortization of identifiable intangible assets. The $165,000 increase in amortization of identifiable intangible assets for the three months ended December 31, 2002 was mainly due to the acquisition of identifiable intangible assets in connection with the acquisitions of the businesses of NetMechanic in May 2002 and Enviz in October 2002. As of December 31, 2002 and 2001, the net carrying value of identifiable intangible assets was approximately $3.2 million and $2.2 million, respectively.

Certain options granted prior to June 30, 1999, have been considered to be compensatory, as the estimated fair value for accounting purposes was greater than the stock price as determined by the board of directors on the date of grant. As a result, we recorded amortization of deferred compensation expense of $24,000 and $85,000 for the three months ended December 31, 2002 and 2001, respectively. The decrease in the amortization of deferred compensation for the three months ended December 31, 2002 as compared to the corresponding period in fiscal 2002 was a result of our discontinuing to amortize costs associated with former employees that have been terminated. As of December 31, 2002, we had a remaining balance of $7,000 included in deferred compensation remaining to be amortized during fiscal 2003. Deferred compensation is amortized on a straight-line basis over the vesting period of the options, and will be fully amortized by the end of fiscal 2003.

We expect the amortization of intangible assets and stock-based compensation to be approximately $500,000 for the second quarter of fiscal 2003, assuming no additional acquisitions or impairment charges. We expect the remaining carrying value of the identifiable intangible assets as of December 31, 2002, as listed in the table below, will be fully amortized by October 2005 (in thousands).

Net interest income decreased $1.1 million or 34% for the three months ended December 31, 2002 as compared to the corresponding period in 2001. The majority of the net interest income was earned on our investments. The decrease in net interest income for the three months ended December 31, 2002 as compared to the corresponding period in fiscal 2002 was primarily due to the decline in interest rates during the first quarter of fiscal 2003 compared to the first quarter of fiscal 2002 and a lower level of invested cash due to the issuer tender offer that closed in November 2002 and the use of restricted cash to purchase our headquarters building in September 2002. We utilized approximately $34.5 million to repurchase approximately 4.3 million shares, primarily pursuant to the tender offer, and $85.0 million of restricted cash to purchase our headquarters building.

No provision for federal and state income taxes was recorded for the three months ended December 31, 2002 and December 31, 2001, due to our operating losses, net operating loss carryforwards, and tax credits.

As discussed in Note 3 of the Notes to the Condensed Consolidated Financial Statements, “Cumulative Effect of a Change in Accounting Principle”, as a result of the implementation of Statement of Financial Accounting Standard No. 142, we recorded a charge of approximately $3.2 million as a cumulative effect of a change in accounting principle for the write-off of all the remaining goodwill associated with acquisitions prior to fiscal 2002, in the three months ended December 31, 2001.

At December 31, 2002, we had approximately $18.2 million in cash and cash equivalents and approximately $185.2 million in short-term investments, for a total of approximately $203.4 million in cash, cash-equivalents, and short-term investments. Our short-term investments consist of investment-grade corporate and government debt securities.

Net cash provided by operating activities was approximately $602,000 for the quarter ended December 31, 2002. Net cash provided by operating activities was primarily the result of net income before non-cash charges, and an increase in deferred revenue, offset by an increase in accounts receivable and a decrease in accounts payable and accrued expenses.

Accounts payable and accrued expenses declined mainly due to payments associated with periodic insurance renewals. Net cash used in operating activities was approximately $1.9 million for the three months ended December 31, 2001 and resulted from a loss from operations before non-cash charges, a decrease in deferred revenue, and a decrease in accounts payable and accrued expenses. Accounts payable and accrued expenses declined mainly due to payments associated with our headquarters building and periodic insurance renewals and a decrease in deferred revenue. These decreases were partially offset by a decrease in accounts receivable due to successful collection efforts and a decrease in prepaids and other assets due to the receipt of accrued interest generated from our cash and short-term investments.

Cash provided by our investing activities was approximately $30.8 million for the quarter ended December 31, 2002. We generated the net amount of $31.4 million from the net sale of short-term investments, $317,000 from a refund on the purchase of our headquarters building, and $35,000 in net receipts associated with the closing of the acquisition of the business of Enviz, Inc. and the finalization of the acquisition of the business of Envive Corporation. We utilized $997,000 for capital expenditures. Cash used in our investing activities was approximately $3.9 million for the quarter ended December 31, 2001. During the first quarter of fiscal year 2002, we purchased $1.8 million, net, of short-term investments, and we utilized $1.0 million for capital expenditures and $1.0 million for our acquisitions of the businesses of onDevice Corporation and Envive Corporation.

We used $34.1 million for our financing activities for the quarter ended December 31, 2002. During the quarter, we repurchased approximately 4.3 million shares for approximately $34.5 million, primarily in connection with an issuer tender offer. As of December 31, 2002, the total number of shares repurchased since the initial repurchase program was authorized by our Board of Directors in January 2001 was approximately 5.7 million shares at an aggregate cost of approximately $44.9 million. We currently have authorization to repurchase additional shares of our common stock for up to approximately $55.1 million.

As of December 31, 2002, our principal commitments consisted of $320,000 in real property operating leases. We expect that, in the future, we will make additional capital expenditures related to our operations and headquarters building but at lower overall levels than in the past.

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

In preparing our consolidated financial statements in accordance with accounting principles generally accepted in the United States, our management is required to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and related notes. Actual results could differ from those estimates. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Our critical accounting policies and judgments are of both a routine and non-routine nature. The recurring policies relate to revenue recognition and the allowance for doubtful accounts receivable. The non-routine policy relates to the valuation of long-lived assets.

Subscription services revenue consists of fees from subscriptions to our Internet measurement, monitoring, testing and diagnostic services. Our subscription services revenue is generally deferred upon invoicing and is recognized ratably over the service period, generally ranging from one to twelve months. For some customers, subscription services revenue is invoiced

monthly upon completion of the services. We do not generally grant refunds during the initial subscription term. All discounts granted are netted against revenue. Revenue is not recognized for free trial periods. Revenue from our consulting and support services, which includes revenue from LoadPro, our load testing service, is recognized as the services are performed, typically over one to three month period. For consulting projects that span more than one month, we recognize revenue on a percentage-of-completion basis.

Accounts receivable is recorded net of allowance for doubtful accounts, which doubtful accounts totaled approximately $1.2 million as of December 31, 2002 and September 30, 2002, respectively. Our accounting policy for allowance for doubtful accounts is determined based on historical trends, experience and current market and industry conditions. We regularly review the adequacy of our accounts receivable allowance after considering the aging of accounts receivable, the age of each invoice, each customer’s expected ability to pay and our collection history with each customer. We review invoices greater than 60 days past due to determine whether an allowance is appropriate based on the receivable balance. In addition, we maintain a reserve for all other invoices, which is calculated by applying a percentage to the outstanding accounts receivable balance, based on historical collection trends. The allowance for doubtful accounts represents management’s best current estimate, but changes in circumstances relating to accounts receivable may result in a requirement for additional allowances in the future or reductions in allowances due to future recoveries.

We evaluate the recoverability of fixed assets and intangible assets other than goodwill whenever events or changes in circumstances indicate the carrying amount of any such assets may not be fully recoverable. Changes in circumstances include economic conditions or operating performance. Our evaluation is based upon assumptions about the estimated future undiscounted cash flows. Management continually applies its best judgment when performing these evaluations to determine the timing of the testing, the undiscounted cash flows used to assess recoverability and the fair value of the asset. If a future event or circumstance indicates that an impairment assessment is required and an asset is determined to be impaired, our financial results could be materially and adversely impacted in future periods.

In December 2002, the Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards (SFAS) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”. SFAS No. 148 amends SFAS No. 123 to provide alternative methods of transition to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provision of SFAS No. 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. The disclosure provision is required for all companies with stock-based employee compensation, regardless of whether the company utilizes the fair value method of accounting described in SFAS No. 123 or the intrinsic value method described in APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 148 also amends APB Opinion No. 28 , “Interim Financial Reporting,” to require disclosure about those effects in interim financial information. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods ending after December 15, 2002. We will continue to apply the intrinsic value method of APB 25 and will adopt the disclosure requirements of SFAS No. 148 in our financial statements for the quarter ending March 31, 2003.

In July 2002, the FASB issued Statements of SFAS No. 146, “Accounting for Costs Associated with Exit of Disposal Activities”. SFAS No. 146 addresses financial accounting and reporting associated with exit or disposal activities. Under SFAS No. 146, costs associated with an exit or disposal activity shall be recognized and measured at their fair value in the period in which the liability is incurred rather than at the date of a commitment to an exit or disposal plan. We are required to adopt SFAS No. 146 for all exit and disposal activities initiated after December 31, 2002. We have evaluated the provisions of SFAS No. 146, and do not expect the adoption of SFAS No. 146 to have a material impact on our financial position or results of operations.

We have introduced new products and services, and we have an unproven business model, which makes it difficult to evaluate our current business and future prospects.

• In May 2002, we acquired NetMechanic, Inc., which enhanced the monitoring services that we currently provide through our Red Alert division.

• In July 2002, we released an updated version of our Transaction Perspective.

• In October 2002, we introduced WebEffective, a new online user experience testing service based on our acquisition of Enviz, Inc. We also introduced Enterprise HTML Toolbox, a web site testing service providing the large enterprise with a scaleable tool to test the content and integrity of web sites in all stages from development to deployment, and Traffic Perspective, a service that provides e-businesses with a real-time single graphical view into web site traffic.

• In December 2002, we introduced the latest version of our Web Site Perspective service and the Keynote Tivoli Adapter, part of our Enterprise Perspective family of services.

The revenue and income potential of our current business and services and the related markets are unproven over the long term. In addition, because of our new products and services and because the market for web performance management and web performance testing services is evolving, we have limited insight into trends that may emerge and affect our business.

We have incurred losses and may, in the future, continue to incur losses, and we may never achieve profitability.

We have experienced operating losses in each quarterly and annual period since inception. We incurred net losses of $2.0 million for the three months ended December 31, 2002, and as of December 31, 2002, we had an accumulated deficit of $139.3 million. In addition, we are required under accounting principles generally accepted in the United States to review our identifiable intangible assets for impairment when events or circumstances indicate that the carrying value may not be recoverable. As of December 31, 2002, we had approximately $3.2 million of identifiable intangible assets. If we complete acquisitions in the future, we may have additional goodwill and/or identifiable intangibles and, accordingly, may incur expenses in connection with a write-down of goodwill and identifiable intangible assets due to changes in market conditions as we did in fiscal 2002 when we recorded an impairment charge for goodwill of approximately $3.2 million in connection with acquisitions made prior to fiscal 2002. Although we try to control our operating expenses, we will also need to increase our revenue to initially achieve and then to sustain profitability.

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

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

Further, we depend on sales to new customers and sales of additional services to our existing customers. Renewals by existing customers or purchases of our services by new customers may be limited as companies limit or reduce their technology spending in response to uncertain economic conditions. We have experienced an increase in cancellations and non-renewals in the past and may continue to experience an increased amount of cancellations and/or non-renewals. We increased the prices for our Perspective services during the third quarter of fiscal 2002.

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

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

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

• the amount and timing of any reductions by our customers in their usage of our services;

• our ability to increase the number of web sites we measure and the scope of services we offer for our existing customers in a particular quarter;

• our ability to attract new customers in a quarter, particularly larger customers;

• the timing and amount of consulting and support services revenue, which is difficult to predict in any given quarter due to the short-term nature of these engagements;

• the timing and amount of operating costs and capital expenditures relating to expansion or contraction of our domestic and international operations infrastructure;

• the timing and amount, if any, of impairment charges related to potential write-downs of assets acquired in acquisitions; and

• the timing and amount, if any, of restructuring costs if we are required to further restructure our operations;

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

Our operating results could be harmed if sales of our web performance benchmarking services decline.

Sales of our web performance benchmarking services, primarily our Web Site Perspective—Business Edition services, and, to a lesser degree, Transaction Perspective have generated the substantial majority of our total revenue. Therefore, the success of our business currently depends, and for the immediate future will continue to substantially depend, on sales and renewals of our benchmarking services. We have recently increased the prices of all of our Perspective services, which could reduce demand for these services. This could result in decreased sales, which would cause our revenue to decline.

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

The demand for our Internet performance measurement services could be reduced or eliminated if future improvements to the infrastructure of the Internet lead companies to conclude that the measurement and evaluation of the performance of their web sites is no longer important

to their business. Because the inherent complexity of the Internet currently causes significant quality of service problems for e-business companies, the vendors and operators that supply and manage the underlying infrastructure are continuously seeking to improve the speed, availability, reliability and consistency of the Internet. If these vendors and operators succeed in significantly improving the performance of the Internet, which would result in corresponding improvements in the performance of companies’ web sites, demand for our services would likely decline which would harm our operating results.

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

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

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

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

The ongoing evolution of the Internet requires us to continually improve the functionality, features and reliability of our web performance management and web performance testing services, particularly in response to offerings of our competitors. If we do not succeed in developing and marketing new services that respond to competitive and technological developments and changing customer needs, we may encounter difficulties retaining existing customers and attracting new customers. We must also introduce any new services as quickly as possible. The success of new services depends on several factors, including proper definition of the scope of the new services and timely completion, introduction and market acceptance of our new services. If new Internet, networking or telecommunication technologies or standards are widely adopted or if other technological changes occur, we may need to expend significant resources to adapt our services to these.

Our services and brand name might not attain the brand awareness necessary for our business to succeed.

We believe that maintaining and strengthening the Keynote brand in a cost-effective manner is an important aspect of our business and an important element in attracting new customers. We may not be successful in building our brand in a cost-effective manner. If our brand-building strategy is unsuccessful, we may fail to attract enough new customers or retain our existing customers to the extent necessary to realize a sufficient return on our brand-building efforts.

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

The market for web performance benchmarking, testing, and application performance management services is rapidly evolving. Our competitors vary in size and in the scope and breadth of the products and services that they offer. We face competition from companies that offer software and services with features similar to our services such as Mercury Interactive, Gomez Advisors, Segue Software, WatchFire and a variety of small companies that offer a combination of testing, market research capabilities and data. While we believe these services are not as comprehensive as ours, customers could still choose to use these services or these companies could enhance

their services to offer all of the features we offer. As we expand the scope of our products and services, we expect to encounter many additional market-specific competitors.

We could also face competition from other companies, which currently do not offer services similar to our services, but offer software or services related to web performance benchmarking, testing, and application performance management, such as WebCriteria, MIDS Matrix IQ Service, and INS INSoft Division, an unit of Lucent Technologies, and free services that measure web site availability, including Internet Weather Report, a unit of MIDS Matrix IQ Service. In addition, companies that sell systems management software, such as BMC Software, CompuWare, CA-Unicenter, HP-Openview, Quest Software, NetIQ, Precise Software and IBM’s Tivoli Unit, with some of whom we have strategic relationships, could choose to offer services similar to ours.

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

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

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

Ten customers accounted for approximately 27% of our total revenue for the three months ended December 31, 2002. No single customer accounted for 10% or more of our total revenue for the quarter ended December 31, 2002. We cannot be certain that customers that have accounted for significant revenue in past periods, individually or as a group, will renew, will not cancel or will not reduce their services and, therefore, continue to generate revenue in any future period. In addition, our customers that do not have written contracts may terminate their services at any time with little or no penalty. If we lose a major customer, our revenue could decline.

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

To increase sales of our web performance management and web performance testing services worldwide, we must complement our direct sales force with relationships with companies to help market and sell our services to their customers. If we are unable to maintain our existing marketing and distribution relationships, or fail to enter into additional relationships, we may have to devote substantially more resources to the direct sale and marketing of our services. We would also lose anticipated revenue from customer referrals and other co-marketing benefits. In fiscal 2002, we terminated relationships with two of our international resellers. As a result, we are investing time and resources in evaluating replacements for these resellers and are committing resources to modify our direct sales effort in the United Kingdom.

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

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

We may be unable to retain our key employees, namely our management team and experienced engineers, or to attract, assimilate or retain other highly qualified employees. Although we, and a number of other technology companies, have implemented workforce reductions, there remains substantial competition for highly skilled employees. Our key employees are not bound by agreements that could prevent them from terminating their employment at any time. If we fail to attract and retain key employees, our business could be harmed.

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

Consulting and support services revenue represented approximately 13% of total revenue for the quarter ended December 31, 2002. However, our cost of consulting and support services has exceeded our consulting revenue for all periods except for the third and fourth quarters of fiscal 2002 and the first quarter of fiscal 2003. We expect that the costs of consulting and support services as a percentage of consulting and support services revenue will be greater than the costs of subscription services as a percentage of subscription services revenue. We also expect that costs of consulting and support services in absolute dollars could increase slightly in subsequent quarters for the foreseeable future. We will also need to successfully market these services to potential customers in order to increase revenue. Each consulting engagement typically spans a one to three month period, and therefore, it is more difficult for us to predict the amount of consulting and support services revenue recognized in any particular quarter. There are many experienced firms that offer computer network and Internet-related consulting services. These consulting services providers include consulting companies, such as Accenture and Ernst & Young, as well as consulting divisions of large technology companies such as IBM. Because we do not have an established reputation for delivering consulting services, because this area is very competitive, and due to our limited experience in delivering consulting services, we may not succeed in selling these services.

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

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

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

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

• delay in the development of enabling technologies or adoption of new standards;

Our network infrastructure could be disrupted by a number of different occurrences, which could impair our ability to serve and retain existing customers or attract new customers.

All data collected from our measurement computers are stored in and distributed from our operations center, which we maintain at a single location. Therefore, our operations depend upon our ability to maintain and protect our computer systems, most of which are located at our corporate headquarters in San Mateo, California, which is an area susceptible to earthquakes and possible power outages. If we experience power outages at our operations center, we would not be able to receive data from our measurement computers and we would not be able to deliver our services to our customers on a timely basis. We recently completed a generator project to provide our own source of long-term uninterruptible power. However, we do not currently have a redundant system. Development of a redundant system for computer-network and other services at an alternate site is underway. Various factors could cause us to not be able to ever complete such systems. Therefore, our operations systems are vulnerable to damage from break-ins, computer viruses, unauthorized access, vandalism, fire, floods, earthquakes, power loss, telecommunications failures and similar events.

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

If our computer infrastructure is not functioning properly, we may not be able to deliver our services in a timely or accurate manner. We have occasionally experienced outages of our service in the past, the last of which occurred in October 2002. The outages that we have experienced have lasted no more than a few hours. These outages have been caused by a variety of factors including electrical distribution equipment malfunctions, operator error, the failure of a back-up computer to operate when the primary computer ceased functioning and power outages due to our previous facility’s being inadequately equipped to house our operations center. Any outage for any period of time or loss of customer data could cause us to lose customers.

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

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

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

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

In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. We could become subject to intellectual property

infringement claims as the number of our competitors grows and our services overlap with competitive offerings. These claims, even if not meritorious, could be expensive and divert management’s attention from operating our company. If we become liable to others for infringement of their intellectual property rights, we could be required to pay a substantial damage award and to develop noninfringing technology, obtain a license or cease selling the services that contain the infringing intellectual property. We may be unable to develop non-infringing technology or to obtain a license on commercially reasonable terms, or at all.

As we change expand our international sales, our business will be susceptible to additional risks associated with international operations.

We believe we must expand the sales of our services outside the United States. To date, we have little experience with direct sales outside the United States, and we may not succeed in these efforts. International sales were approximately 6% and 7% of our total revenue for the quarters ended December 31, 2002 and 2001, respectively. We intend to expand the sales of our services by selling directly to certain customers and through resellers to other customers. Therefore, we expect to continue to commit our resources to expand our international sales and marketing activities. Conducting international operations would subject us to risks we do not face in the United States. These include:

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

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

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

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

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

• difficulties in assimilating acquired personnel, operations and technologies;

• adverse effects on existing business relationships with resellers of our service and our customers;

Our future operating results could be harmed if we are unable to lease a major portion of the space in our corporate headquarters building or if the fair value of this property decreases further.

We estimate that we will need to lease the unoccupied portion, or approximately 60%, of our headquarters building in San Mateo, California. We may be unable to lease all or a part of the available space, and if it is leased, we may not receive sufficiently high rental rates to cover our building operating costs. In addition, we have previously incurred a charge for the write-down of the building, and, if the real estate market continues to deteriorate, we may incur charges for future write-downs. Any such charge could harm our results of operations.

Compliance with new rules and regulations concerning corporate governance may be costly and could harm our business.

The Sarbanes-Oxley Act, which was signed into law in July 2002, mandates, among other things, that companies adopt new corporate governance measures and imposes comprehensive reporting and disclosure requirements, sets stricter independence and financial expertise standards for audit committee members and imposes increased civil and criminal penalties for companies, their chief executive officers and chief financial officers and directors for securities law violations. In addition, The Nasdaq Stock Market, on which our common stock is listed, is also considering the adoption of additional comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations will increase the scope, complexity and cost of our corporate governance, reporting and disclosure practices, which could harm our results of operations and divert management’s attention from business operations. We also expect these developments to make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage or incur substantially higher costs to obtain coverage. Further, our board members, Chief Executive Officer and Chief Financial Officer could face an increased risk of personal liability in connection with the performance of their duties. As a result, we may have difficultly attracting and retaining qualified board members and executive officers, which would adversely affect our business.

Threats of war may negatively impact all aspects of our operations, revenue, costs and stock price.

Threats of war and continued economic weakness could have a substantial adverse impact on sales. If these continue or worsen, our revenue and results of operations may be adversely impacted. Any escalation in these events or similar future events may disrupt our operations or those of our customers and suppliers. Any of these events could increase volatility in the U.S. and world financial markets, which could harm our stock price. This could have a significant impact on our operating results, revenue and costs and may result in increased volatility in the market price of our common stock.

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

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

We have also adopted a stockholder rights plan that may discourage, delay or prevent a change of control and make any future unsolicited acquisition attempt more difficult. Key features of the rights plan include:

Interest Rate Sensitivity. Our interest income and expense is sensitive to changes in the general level of U.S. interest rates, particularly because most of our cash, cash equivalents and short-term investments are invested in short-term debt instruments. If market interest rates were to change immediately and uniformly by ten percent (10%) from levels at December 31, 2002, the interest earned on those cash, cash equivalents, and short-term investments could increase or decrease by approximately $660,000 on an annualized basis.

Foreign Currency Fluctuations and Derivative Transactions. We have not had any significant transactions in foreign currencies, nor do we have any significant balances that are due or payable in foreign currencies at December 31, 2002. We do not enter into derivative transactions for trading or speculative purposes.

Within the 90 days prior to the date of this report, our Chief Executive Officer and our Chief Financial Officer performed an evaluation, with the participation of our Disclosure Committee and our management, of the effectiveness of the design and operation of our “disclosure controls and procedures”, which are defined under SEC rules as controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within required time periods. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.

There were no significant changes in our internal controls or other factors that could significantly affect these controls subsequent to the date of the evaluation described in paragraph (a) above.

Beginning on August 16, 2001, a number of class action lawsuits were filed in the United States District Court for the Southern District of New York against us, certain of our officers, and the underwriters of our initial public offering. These lawsuits are essentially identical,

and were brought on behalf of those who purchased our securities between September 24, 1999 and August 19, 2001. These complaints allege generally that the underwriters in certain initial public offerings, including ours, allocated shares in those initial public offerings in unfair or unlawful ways, such as requiring the purchaser to agree to buy in the aftermarket at a higher price or to buy shares in other companies with higher than normal commissions. The complaint also alleges that we had a duty to disclose the activities of the underwriters in the registration statement relating to our initial public offering. The complaints have been consolidated into a single action with cases brought against over three hundred other issuers and their underwriters that make similar allegations regarding the initial public offerings of those issuers. The plaintiffs’ counsel and the individual named defendants’ counsel have reached an agreement whereby the individual named defendants have been dismissed from the case, without any payments by us. The case against the underwriters and us continues, however, plaintiffs’ counsel and the underwriters have each offered settlement proposals to the issuers. We are still evaluating each proposal. We believe the claims are without merit and intend to defend the actions vigorously should a settlement not be reached. However, these claims, even if not meritorious, could be expensive to defend and divert management’s attention from operating our company.

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

On October 7, 2002, in connection with our purchase of substantially all of the assets of Enviz, Inc., we issued an aggregate of 111,000 shares of our common stock. The value of such consideration was approximately $696,000. This sale was exempt from registration under the Securities Act pursuant to Section 4(2) thereof on the basis that the transaction did not involve a public offering. As the seller of the assets, Enviz was a sophisticated investor and had access to the kind of information that registration would disclose as well as the ability to understand the risk of its investment.

On October 29, 2002, we filed a current report on Form 8-K relating to the stockholder rights plan adopted by our Board of Directors on October 25, 2002 and to our results of operations for the quarter and fiscal year ended September 30, 2002. The stockholder rights plan with the exhibits thereto and our unaudited consolidated statements of operations for the three months and year ended September 30, 2002 and 2001 and unaudited consolidated balance sheets as of September 30, 2002 and 2001 were filed as exhibits to the report.

On November 21, 2002, we filed a current report on Form 8-K relating to our rejection of an unsolicited offer to be acquired. The press release announcing such rejection was filed as an exhibit to the report.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Mateo, State of California, on this 14th day of February 2003.

KEYNOTE SYSTEMS, INC.

By:		/S/ UMANG GUPTA

		Umang Gupta Chairman of the Board and Chief Executive Officer (Principal Executive Officer)

By:		/S/ JOHN J. FLAVIO

		John J. Flavio Senior Vice President and Chief Financial Officer (Principal Financial Officer)

By:		/S/ PETER J. MALONEY

		Peter J. Maloney Vice President of Finance (Principal Accounting Officer)

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officer and I have indicated in this quarterly report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

/S/ JOHN J. FLAVIO

John J. Flavio

Senior Vice President and Chief Financial Officer

DELAWARE		94-3226488
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

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

Class		Shares outstanding at January 31, 2003
Common Stock, $.001 par value		22,981,222

		Page

PART I—FINANCIAL INFORMATION

Item 1.	Financial Statements	3

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Qualitative and Quantitative Disclosures about Market Risk	28

Item 4.	Controls and Procedures	28

PART II—OTHER INFORMATION

Item 1.	Legal Proceedings	28

Item 2.	Changes in Securities and Use of Proceeds	29

Item 3.	Defaults Upon Senior Securities	29

Item 4.	Submission of Matters for a Vote of Security Holders	29

Item 5.	Other Information	29

Item 6.	Exhibits and Reports on Form 8-K	29

Signatures		30

Certifications		31

		Page
Condensed Consolidated Balance Sheets as of December 31, 2002 and September 30, 2002		4

Condensed Consolidated Statements of Operations for the three months ended December 31, 2002 and 2001		5

Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2002 and 2001		6

Notes to Condensed Consolidated Financial Statements		7

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Table of Contents

	December 31, 2002			September 30, 2002
ASSETS
Current assets:
Cash and cash equivalents	$	18,194		$	20,874
Short-term investments		185,210			218,413

Total cash, cash equivalents, and short-term investments		203,404			239,287
Accounts receivable, less allowance for doubtful accounts of $1,185 and $1,238 as of December 31, 2002 and September 30, 2002		5,445			4,820
Prepaid and other current assets		1,294			1,347

Total current assets		210,143			245,454
Property and equipment, net		36,787			37,468
Identifiable intangible assets, net		3,180			2,859

Total assets	$	250,110		$	285,781


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		977			1,014
Accrued expenses		7,942			8,191
Deferred revenue		5,724			5,121

Total current liabilities		14,643			14,326

Total liabilities		14,643			14,326

Stockholders’ equity:
Common stock		28			28
Treasury stock		(40,853	)		(6,990	)
Additional paid-in capital		414,168			413,684
Deferred compensation		(7	)		(31	)
Accumulated deficit		(139,328	)		(137,331	)
Accumulated other comprehensive income		1,459			2,095

Total stockholders’ equity		235,467			271,455

Total liabilities and stockholders’ equity	$	250,110		$	285,781

	Three months ended December 31,
	2002			2001
Revenue:
Subscription services	$	8,525		$	8,796
Consulting and support services		1,233			793

Total revenue		9,758			9,589

Operating expenses:
Costs of subscription services		2,483			3,392
Costs of consulting and support services		925			952
Research and development		2,247			2,313
Sales and marketing		4,539			5,098
Operations		1,779			2,008
General and administrative		1,543			1,833
Amortization of identifiable intangible assets and stock-based compensation		403			299

Total operating expenses		13,919			15,895

Loss from operations		(4,161	)		(6,306	)
Interest income, net		2,164			3,303

Loss before provision for income taxes and the cumulative effect of a change in accounting principle		(1,997	)		(3,003	)
Provision for income taxes		—			—

Net loss before cumulative effect of a change in accounting principle		(1,997	)		(3,003	)
Cumulative effect of a change in accounting principle		—			(3,160	)

Net loss	$	(1,997	)	$	(6,163	)

Net loss per share:
Basic and diluted net loss per share before the cumulative effect of a change in accounting principle	$	(0.08	)	$	(0.11	)
Basic and diluted cumulative effect per share of a change in accounting principle	$	—		$	(0.11	)
Basic and diluted net loss per share	$	(0.08	)	$	(0.22	)

Shares used in computing basic and diluted net loss per share		25,885			27,820

	Three months ended December 31
	2002			2001
	(in thousands)
Net loss	$	1,997		$	6,163
Net unrealized loss on available-for-sale investments		640			317
Foreign currency translation gain		(4	)		—

Comprehensive loss	$	2,633		$	6,480

	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Estimated Fair Market Value
Obligations of U.S. government agencies	$	27,189	$	128		—	$	27,317
Corporate bonds and commercial paper		156,673		1,273		53		157,893

Total	$	183,862	$	1,401	$	53	$	185,210

	Amortized Cost		Estimated Fair Market Value
Due in 1 year	$	166,158	$	167,422
Due in 2 years		17,704		17,788

Total	$	183,862	$	185,210

	Technology Based			Customer Based			Trademark			Total
As of December 31, 2002:
Gross carrying value	$	7,853		$	3,680		$	250		$	11,783
Accumulated amortization		(4,860	)		(3,501	)		(242	)		(8,603	)

Net carrying value at December 31, 2002	$	2,993		$	179		$	8		$	3,180


As of September 30, 2002:
Gross carrying value	$	7,173		$	3,660		$	250		$	11,083
Accumulated amortization		(4,520	)		(3,465	)		(239	)		(8,224	)

Net carrying value at September 30, 2002	$	2,653		$	195		$	11		$	2,859

Technology-based intangible assets	$	813
Customer-based intangible assets		31
Fixed assets, net		27
Current liabilities		(15	)
Deferred revenue		(15	)

Total purchase consideration	$	841

Twelve months ended December 31:	Operating
2003	$	114
2004		103
2005		103
Thereafter		—

Total minimum lease payments	$	320

	2002		2001		% Change
For the three months ended December 31:	(In thousands)
Subscription services	$	8,525	$	8,796	(3	)%
Consulting and support services	$	1,233	$	793	55	%

	2002		2001		% Charge
For the three months ended December 31:	(In thousands)
Interest income, net	$	2,164	$	3,303	(34	%)