MERCURY INTERACTIVE CORPORATION - 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 a 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 Securities Exchange Act of 1934). YES x NO ¨

The number of shares of Registrant’s Common Stock outstanding as of March 31, 2003 was 85,369,129.

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

The accompanying condensed consolidated financial statements include the accounts of Mercury Interactive and its subsidiaries. We have subsidiaries in the US, Canada, Brazil (Americas), Europe, the Middle East, and Africa (EMEA), Asia Pacific and Australia (APAC), and Japan. All significant intercompany accounts and transactions have been eliminated.

These interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (US GAAP) for interim financial information, and the rules and regulations of the Securities and Exchange Commission for interim financial statements and accounting policies, consistent, in all material respects, with those applied in preparing our audited consolidated financial statements included in our annual report on Form 10-K for the fiscal year ended December 31, 2002. The unaudited financial information furnished herein reflects all adjustments, consisting only of normal recurring adjustments, that in our opinion are necessary to fairly state our consolidated financial position, the results of operations, and cash flows for the periods presented. This Quarterly Report on Form 10-Q should be read in conjunction with our audited financial statements for the year ended December 31, 2002, included in the 2002 Form 10-K. The condensed consolidated statements of operations for the three months ended March 31, 2003 are not necessarily indicative of results to be expected for the entire fiscal year ended December 31, 2003.

We account for stock-based compensation for our employees using the intrinsic value method presented in Accounting Principles Board (APB) Statement No. 25, Accounting for Stock Issued to Employees, and related interpretations, and comply with the disclosure provisions of Statement of Financial Accounting Standards (SFAS) Interpretation No. 123, Accounting for Stock-Based Compensation, and with the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure Amendment of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise price. We account for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (EITF) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. We do not issue stock options to non-employees.

The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123, to stock-based employee compensation (in thousands, except per share amounts):

We amortize stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four years.

Pro forma information regarding net income and earnings per share is required by SFAS No. 123. This information is required to be determined as if we had accounted for our employee stock options and stock purchase plans (ESPPs) under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

The fair value of options and shares issued pursuant to the option plans and the Employee Stock Purchase Plan at the grant date were estimated using the Black-Scholes model with the following weighted average assumptions for the three months ended March 31, 2003 and 2002:

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility rates trended into future years. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our options. Based upon the above assumptions, the weighted average fair valuation per share of options granted under the option plans during the three months ended March 31, 2003 and 2002 was $20.55 and $19.75, respectively. The weighted average fair valuation per share of options granted under the 1998 ESPP plan during the three months ended March 31, 2003 and 2002 was $10.04 and $13.25, respectively.

We expense the costs of producing advertisements at the time production occurs, and expense the cost of communicating advertising in the period during which the advertising space or airtime is used. For the three months ended March 31, 2003 and 2002, advertising expenses totaled $2.3 million and $0.7 million, respectively.

Certain reclassifications have been made to March 31, 2002 balances in order to conform to the March 31, 2003 presentation, namely the break out of maintenance and professional service fee revenue, costs and expenses, interest income and interest expense, and the reclassification of the extraordinary gain on early retirement of debt to other income and provision for income taxes. The statement of cash flows has also been modified to conform to the current year presentation, namely the reclassification between sales reserve and trade accounts receivable, deferred income taxes and income taxes payable, proceeds from issuance of common stock and collection of notes receivable from issuance of stock, as well as the change in presentation of restricted cash from financing activities to investing activities.

Certain changes have been made to diluted net income per share and diluted weighted average common shares to conform to current period presentation.

In November 2002, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others an Interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34 (FIN No. 45). The Interpretation requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken by issuing the guarantee. The Interpretation also requires additional disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under certain guarantees it has issued. The accounting requirements for the initial recognition of guarantees are applicable on a prospective basis for guarantees issued or modified after December 31, 2002. The disclosure requirements are effective for all guarantees outstanding, regardless of when they were issued or modified,

during the first quarter of fiscal 2003. The adoption of FIN 45 did not have a material effect on our consolidated financial statements. The following is a summary of the agreements that we have determined are within the scope of FIN No. 45.

As permitted under Delaware law, we have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the officer’s or director’s term in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. All of these indemnification agreements were grandfathered under the provisions of FIN 45 as they were in effect prior to December 31, 2002. Accordingly, we have no liabilities recorded for these agreements as of March 31, 2003.

We enter into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners, subsidiaries and/or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements as of March 31, 2003.

We may, at our discretion and in the ordinary course of business, subcontract the performance of any of our services. Accordingly, we enter into standard indemnification agreements with our customers, whereby they are indemnified for other acts, such as personal property damage, of our subcontractors. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have general and umbrella insurance policies that enable us to recover a portion of any amounts paid. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements as of March 31, 2003.

When, as part of an acquisition, we acquire all of the stock or all of the assets and liabilities of a company, we assume the liability for certain events or occurrences that took place prior to the date of acquisition. The maximum potential amount of future payments we could be required to make for such obligations is undeterminable at this time. All previous obligations were grandfathered under the provisions of FIN 45 as they were in effect prior to December 31, 2002. Accordingly, we have no liabilities recorded for these types of agreements as of March 31, 2003.

We have arrangements with certain vendors whereby we guaranty the expenses incurred by certain of our employees. The term is from execution of the arrangement until cancellation and payment of any outstanding amounts. We would be required to pay any unsettled employee expenses upon notification from the vendor. The maximum potential amount of future payments we could be required to make under these indemnification agreements is insignificant. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of March 31, 2003.

We warrant that our software products will perform in all material respects in accordance with our standard published specifications in effect at the time of delivery of the licensed products to the customer for the life of the product. Additionally, we warrant that our maintenance services will be performed consistent with generally accepted industry standards through completion of the agreed upon services. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history, however, we have not incurred significant expense under its product or services warranties. As a result, we believe the estimated fair value on these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of March 31, 2003.

In November 2002, the EITF reached a consensus on EITF No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue-generating activities. EITF No. 00-21 will be effective for interim periods beginning after June 15, 2003. We do not expect the adoption of EITF 00-21 will have a material impact on our financial position and results of operations.

In January 2003, the FASB issued Interpretation No. 46 (FIN No. 46), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, which relates to the identification of, and financial reporting for, variable-interest entities (VIEs). FIN No. 46 has far-reaching effects and applies to new entities that are created after January 31, 2003, as well as to existing VIEs

no later than the beginning of the first interim or annual reporting period that starts after July 1, 2003. We are currently evaluating the impact of the adoption on our financial position and results of operations.

Earnings per share is calculated in accordance with the provisions of SFAS No. 128, Earnings per Share. SFAS No. 128 requires the reporting of both basic earnings per share, which is the weighted-average number of common shares outstanding, and diluted earnings per share, which includes the weighted-average number of common shares outstanding and all dilutive potential common shares outstanding, using the treasury stock method. For the three months ended March 31, 2003 and 2002, dilutive potential common shares outstanding reflects shares issuable under our stock option plans.

The following table summarizes our earnings per share computations for the three months ended March 31, 2003 and 2002 (in thousands, except per share amounts):

For the three months ended March 31, 2003, options to purchase 9,009,000 shares common stock with a weighted average price of $54.52 were considered anti-dilutive because the options’ exercise price was greater than the average fair market value of our common stock for the period then ended. For the three months ended March 31, 2002, options to purchase 9,602,000 shares of common stock with a weighted average price of $55.35 were considered anti-dilutive. For the three months ended March 31, 2003 and 2002, common stock reserved for issuance upon conversion of our outstanding convertible subordinated notes for 2,697,000 and 3,125,000 shares, respectively, were not included in diluted earnings per share because the conversion would be anti-dilutive.

The following table summarizes changes in our sales reserve during the three months ended March 31, 2003 and 2002 (in thousands):

We report components of comprehensive income in our annual consolidated statements of shareholders’ equity. Comprehensive income consists of net income and foreign currency translation adjustments. Total comprehensive income for the three months ended March 31, 2003 and 2002 is as follows (in thousands):

The effective tax rate for the three months ended March 31, 2003 and 2002 differs from statutory tax rates principally because of the non-deductibility of charges for amortization of goodwill and other intangible assets and stock-based compensation, and our participation in taxation programs in Israel. This tax structure is dependent upon continued reinvestment in our Israeli operations.

We comply with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The standard requires us to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through the statements of operations. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings, or recognized in other comprehensive income (loss) until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. The accounting for gains or losses from changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship, as well as on the type of hedging relationship.

We have entered into forward contracts to hedge foreign currency denominated receivables due from certain Americas, EMEA, APAC, and Japan subsidiaries and foreign branches against fluctuations in exchange rates. We have not entered into forward contracts for speculative or trading purposes. The criteria used for designating a forward contract as a hedge considers its effectiveness in reducing risk by matching hedging instruments to underlying transactions. Gains and losses on forward contracts are recognized in other income in the same period as gains and losses on the underlying transactions. We had outstanding forward contracts with notional amounts totaling $22.4 million and $17.5 million at March 31, 2003 and December 31, 2002, respectively. The forward contracts in effect at March 31, 2003 mature at various dates through August 2003 and are hedges of certain foreign currency transaction exposures in the Australian Dollar, British Pound, Canadian Dollar, Danish Kroner, Euro, Japanese Yen, Norwegian Kroner, Singapore Dollar, South African Rand, Swedish Kroner, and Swiss Franc. The unrealized net gain on our forward contracts at March 31, 2003 and December 31, 2002 was $0.4 million and $0.2 million, respectively.

We utilize forward exchange contracts of one fiscal-month duration to offset various non-functional currency exposures. Currencies hedged under this program include the Australian Dollar, Canadian Dollar, British Pound, Euro, Israeli Shekel, and Swedish Kroner. Increases or decreases in the value of these non-functional currency assets are offset by gains and losses on the forward exchange contracts to mitigate the risk associated with foreign exchange market fluctuations.

In January 2002 and February 2002, we entered into two interest rate swaps with respect to $300.0 million of our convertible subordinated notes (Notes). In November 2002, we terminated our January and February interest rate swaps with Goldman Sachs Capital Markets, L.P. (GSCM) and replaced them with a single interest rate swap in order to improve the overall effectiveness of our interest rate swap arrangement. The November interest rate swap is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR rate) relating to $300.0 million of our Notes. The objective of the swap is to convert the 4.75% fixed interest rate on the Notes to a variable interest rate based on the 6-month LIBOR rate plus 46.0 basis points. Beginning in January 2003, the variable interest rate on the swap was modified so that it is now based on the 3-month LIBOR rate plus 48.5 basis points. The gain or loss from changes in the fair value of the interest rate swap is expected to be highly effective at offsetting the gain or loss from changes in the fair value attributable to changes in the LIBOR rate throughout the life of the Notes. The interest rate swap creates a market exposure to changes in the LIBOR rate. Under the terms of the swap, we are required to provide initial collateral in the form of cash or cash equivalents to GSCM in the amount of $6.0 million as continuing security for our obligations under the swap (irrespective of movements in the value of the

swap) and from time to time additional collateral can change hands between Mercury Interactive and GSCM as swap rates and equity prices fluctuate. We accounted for the initial collateral and any additional collateral as restricted cash on our balance sheet. If the price of our common stock exceeds the original conversion or redemption price of the Notes, we will be required to pay the fixed rate of 4.75% and receive a variable rate on the $300.0 million principal amount of the Notes. If we call the Notes at a premium (in whole or in part), or if any of the holders of the Notes elected to convert the Notes (in whole or in part), we will be required to pay a variable rate and receive the fixed rate of 4.75% on the principal amount of such called or converted Notes.

Our interest rate swap qualifies under SFAS No. 133 as a fair-value hedge. We record the fair value of our interest rate swap and the change in the fair value of the underlying Notes attributable to changes in the LIBOR rate on our balance sheets, and we record the ineffectiveness arising from the difference between the two fair values in our statements of operations as other income. At March 31, 2003 and December 31, 2002, the fair value of the swap was approximately $18.1 million and $17.4 million, respectively, and the change in the fair value of our Notes attributable to changes in the LIBOR rate during the period resulted in an increase to the carrying value of our Notes of $17.7 million and $17.0 million, respectively. The difference was recorded in other income as the unrealized gain on interest rate swap for the three months ended March 31, 2003, with nothing recorded for the three months ended March 31, 2002. At March 31, 2003 and December 31, 2002, our total restricted cash associated with the swap was $6.0 million.

We are exposed to credit exposure with respect to GSCM as counterparty under the swap. However, we believe that the risk of such credit exposure is limited because GSCM is an affiliate of a major US investment bank and because its obligations under the swap are guaranteed by the Goldman Sachs Group L.P.

For the three months ended March 31, 2003 and 2002, we have recorded interest expense of $1.4 million and $1.5 million, respectively, and interest income of $3.6 million and $2.8 million, respectively, as a result of our interest rate swap and our prior interest rate swaps for the 2002 period. Our net interest expense, including the interest paid on our debt, was $1.4 million and $2.9 million for the three months ended March 31, 2003 and 2002, respectively.

We have four reportable operating segments: the Americas, EMEA, APAC, and Japan. These segments are organized, managed, and analyzed geographically and operate in one industry segment: the development, marketing, and selling of integrated testing and APM solutions. Our chief decision makers evaluate operating segment performance based primarily on net revenues and certain operating expenses.

Financial information for our operating segments is as follows for the three months ended March 31, 2003 and 2002 (in thousands):

International sales represented 38% and 32% of our total revenues in the first quarters of 2003 and 2002, respectively. The subsidiary located in the United Kingdom accounted for 12% and 10% of the consolidated net revenue to unaffiliated customers for the three months ended March 31, 2003 and 2002, respectively. Operations located in Israel accounted for 29% and 27% of the consolidated identifiable assets at March 31, 2003 and December 31, 2002, respectively.

The following table presents revenue for testing (including deployment assurance which is less than 10%) and application performance management (APM) for the three months ended March 31, 2003 and 2002 (in thousands):

We sold $500.0 million of Zero Coupon Senior Convertible Notes due 2008 (the Notes) in a private offering. The Notes were offered to investors at 100% of their principal amount. The sale of the Notes closed on April 29, 2003.

The Notes will not bear interest, have a zero yield to maturity, and will be convertible into our common stock at a conversion price of $51.69 per share, subject to adjustment upon the occurrence of specified events. This represents a 43% conversion premium based on the closing price of $36.15 of our common stock on April 23, 2003. Each $1,000 principal amount at maturity will initially be convertible into 19.3461 shares of our common stock. However, holders of the Notes may convert their Notes only if: (1) the sales price of our common stock reaches a specified threshold, or (2) specified corporation transactions have occurred. Upon conversion, we will have the right to deliver cash in lieu of shares of our common stock. We may not redeem the Notes prior to their maturity.

The Notes were placed in a private transaction pursuant to Rule 144A under the Securities Act of 1933. Neither the Notes nor the common stock have been registered under the Act and may not be offered or sold in the United States absent registration or an applicable exemption from the registration requirements of the Act.

The following discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors.” Our business may have changed since the date hereof, and we undertake no obligation to update these forward-looking statements.

We were incorporated in 1989 and began shipping testing products in 1991. Since 1991, we have introduced a variety of solutions for testing, deployment assurance, and application performance management (APM). Today’s enterprise is critically dependent on IT-delivered systems and applications that automate business processes to meet business requirements. These needs place IT in the relatively new role as a business-critical function and put IT management under enormous pressure to operate like a business. Business Technology Optimization (BTO) is an emerging new business strategy that enables companies to optimize and align business and technology performance to meet key business objectives. Mercury Interactive is the leading provider of BTO products and services, providing an integrated approach to testing, deployment assurance, and APM solutions that enable customers to optimize the quality of their IT-delivered services, align IT execution with business goals, and reduce spending throughout their IT infrastructure.

The following table sets forth, as a percentage of total revenue, certain consolidated statements of operations data for the periods indicated. These operating results are not necessarily indicative of the results for any future period.

Revenue consists of fees for the license and subscription of our software products, maintenance fees, and professional service fees. License revenue is comprised of license fees charged for the use of our products licensed under perpetual or multiple year arrangements (perpetual licenses) in which the fair value of the license fee is separately determinable from maintenance and/or professional services. Subscription revenue represents license fees to use one or more software products, and to receive maintenance support (such as hotline support and updates) for a limited period of time. Since subscriptions include bundled products and services, both product and service revenue is generally recognized ratably over the term. Maintenance revenue is comprised of fees charged for post contract customer support which are determinable based upon vendor specific evidence of fair value. Professional service revenue is comprised of fees charged for product training and consulting services which are determinable based upon vendor specific evidence of fair value.

Due to the different treatment of subscription and perpetual licenses under applicable accounting rules, each type of license has a different impact on our financial statements. When a customer buys a subscription license, the majority of the revenue will be recorded as deferred revenue on our balance sheet. The amount recorded as deferred revenue is equal to the portion of the license fee that has been invoiced or paid but not recognized as revenue. Deferred revenue is reduced as revenue is recognized. Under perpetual licenses (and some multi-year arrangements for which separate vendor specific objective evidence exists for undelivered elements), a high proportion of all license revenue is recognized in the quarter that the product is delivered, with relatively little recorded as deferred revenue. Therefore, an order for a subscription license will result in significantly lower current-period revenue than an equal-sized order under perpetual licenses. Conversely, an order for a subscription license will result in higher revenues recognized in future periods than an equal-sized order for a perpetual license.

Our license revenue in any given quarter is dependent upon the volume of perpetual orders shipped during the quarter and the amount of subscription revenue amortized from deferred revenue and, to a small degree, recognized on subscription orders received during the quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain license mix of perpetual licenses and subscription licenses. The precise mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected subscription licenses) or may exceed them (if we deliver more-than-expected perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets. In 2002, we effected a change in the mix of software license types to a higher percentage of subscription licenses, especially for our APM products. We believe that this shift may continue in the future, as more of our products are offered on a subscription basis. This shift may decrease or reduce the growth of recognized revenue in the near term.

Cost of license and subscription includes direct costs to produce and distribute our products, such as costs of materials, product packaging and shipping, equipment depreciation and production personnel; and costs associated with our managed services business, including personnel related costs, fees to providers of internet bandwidth and related infrastructure (ISP fees) and depreciation expense of managed services equipment. Cost of maintenance includes direct costs of providing product customer support, largely consisting of personnel costs and related expenses; and the cost of providing upgrades to our subscription customers. We have not broken out the costs associated with licenses or subscriptions because these costs can not be separated between license and subscription cost of revenue. Cost of professional services includes the direct costs of providing product training and consulting, largely consisting of personnel costs and related expenses. License and subscription, maintenance, and professional services costs also include allocated facility expenses and information technology infrastructure costs.

The cost associated with subscription licenses, which include the cost of products and services, are expensed as incurred over the subscription term. In addition, we defer the portion of our commission expense related to subscription licenses and amortize the expense over the subscription term. See Critical Accounting Policies for a full description of our estimation process for accrued liabilities.

License fee revenue was $44.8 million for the three months ended March 31, 2003, compared to $44.7 million for the three months ended March 31, 2002, an increase of less than 1%. Our license fee revenue increased less than in prior years primarily due to a shift to more testing subscription licenses during the quarter ended March 31, 2003. We expect our license fee revenue to continue to increase in absolute dollars in 2003.

Subscription fee revenue was $19.3 million for the three months ended March 31, 2003, compared to $11.3 million for the three months ended March 31, 2002, an increase of 71%. This increase of $8.0 million in subscription fee revenue was primarily attributable to an increase of $4.7 million in testing subscription for our ActiveTune offering and $3.3 million in APM subscription for our Topaz products and services revenue due to continuous effort to shift to a subscription business model. We expect sales of our subscription licenses and services to continue to increase in absolute dollars in 2003.

Maintenance fee revenue was $35.6 million for the three months ended March 31, 2003, compared to $27.7 million for the three months ended March 31, 2002, an increase of 29%. This increase of $7.9 million in maintenance fee revenue was primarily attributable to an increase of $7.1 million in testing maintenance fee revenue and $0.8 million in APM maintenance fee revenue due to higher renewals of existing maintenance contracts. We expect that maintenance fee revenue will continue to increase in absolute dollars in 2003.

Professional service fee revenue was $10.7 million for the three months ended March 31, 2003, compared to $6.9 million for the three months ended March 31, 2002, an increase of 55%. This increase of $3.8 million in professional service fee revenue was primarily attributable to an increase in testing professional service fee revenue due to an increased number of professional service engagements completed this quarter. We expect our professional service fee revenue to continue to increase in absolute dollars in 2003.

International sales represented 38% and 32% of our total revenues in the three months ended March 31, 2003 and 2002, respectively. Our international revenue increased 43% in absolute dollars in the three months ended March 31, 2003, compared to 2002, primarily due to a strong sales performance increase in EMEA of $9.2 million and APAC of $2.5 million and foreign currency fluctuations.

Cost of license and subscription was $6.6 million for the three months ended March 31, 2003, or 6% of total revenue, compared to $6.3 million for the three months ended March 31, 2002, or 7% of total revenue. Based upon our revenue growth as described in “Revenues,” we expect cost of license and subscription to remain flat in absolute dollars in 2003.

Cost of maintenance was $2.7 million for the three months ended March 31, 2003, or 2% of total revenue, compared to $2.8 million for the three months ended March 31, 2002, or 3% of total revenue. Based upon our revenue growth as described in “Revenues,” we expect cost of maintenance to continue to increase in absolute dollars in 2003.

Cost of professional services was $6.6 million for the three months ended March 31, 2003, or 6% of total revenue, compared to $4.3 million for the three months ended March 31, 2002, or 5% of total revenue. The absolute dollar increase of $2.3 million was primarily attributable to an increase of $2.0 million in personnel-related costs due to an increased number of

employees. Based upon our revenue growth as described in “Revenues,” we expect cost of professional service to continue to increase in absolute dollars in 2003.

Marketing and selling expense consists of employee salaries and related costs, sales commissions, marketing programs, and allocated facility expenses and information technology infrastructure costs. Marketing and selling expense was $52.7 million for the three months ended March 31, 2003, or 48% of total revenue, compared to $45.4 million for the three months ended March 31, 2002, or 50% of total revenue. The absolute dollar increase of $7.3 million was primarily attributable to an increase of $6.3 million in personnel-related costs due to an increased number of employees and an increase of $2.1 million in marketing programs for our BTO initiative. Based upon our revenue growth as described in “Revenues,” we expect marketing and selling expenses to increase in absolute dollars in 2003.

Research and development expense consists of costs associated with the development of new products, enhancements of existing products, and quality assurance procedures; research and development expense is comprised primarily of employee salaries and related costs, consulting costs, equipment depreciation and allocated facility expenses and information technology infrastructure costs. Research and development expense was $11.6 million for the three months ended March 31, 2003, or 11% of total revenue, compared to $10.6 million for the three months ended March 31, 2002, or 12% of total revenue. The absolute dollar increase of $1.0 million was primarily attributable to an increase of $1.3 million in personnel-related costs due to an increased number of employees offset by a $0.4 million devaluation of the Israeli Shekel to the US dollar. Based upon our revenue growth as described in “Revenues,” we expect research and development expense to continue to increase in absolute dollars in 2003.

General and administrative expense consists of employee salaries and related costs associated with administration and management, as well as allocated facility expenses and information technology infrastructure costs. General and administrative expense was $9.1 million for the three months ended March 31, 2003, or 8% of total revenue, compared to $7.4 million for the three months ended March 31, 2002, or 8% of total revenue. The absolute dollar increase of $1.7 million was primarily attributable to an increase of $1.4 million in personnel-related costs due to an increased number of employees. We expect general and administrative expenses to continue to increase in absolute dollars in 2003.

During the second quarter of 2001, in connection with the acquisition of Freshwater, we recorded unearned stock-based compensation totaling $10.4 million associated with approximately 140,000 unvested stock options that we assumed. The options assumed were valued using the fair market value of our stock on the date of acquisition, which was $74.21. We also recorded stock-based compensation expense of $0.3 million in conjunction with the third quarter restructuring. The options were valued using the fair market value of our stock on the date of accelerated vesting, which was a weighted average of $32.92. Through December 31, 2002, we reduced unearned stock-based compensation by $6.3 million due to the termination of certain employees. During the three months ended March 31, 2003, we further reduced unearned stock-based compensation by $0.4 million. Amortization of unearned stock-based compensation was $0.2 million and $0.4 million for the three months ended March 31, 2003 and 2002, respectively. We expect to amortize on average $0.1 million per quarter through 2004 and insignificant amounts through the second half of 2005, which is over the remaining vesting periods of the related options.

Amortization of goodwill and other intangible assets was $0.5 million for the three months ended March 31, 2003 compared to $0.6 million for the three months ended March 31, 2002, or 1% of total revenue. In May 2001, we acquired all of the outstanding securities of Freshwater for cash consideration of $146.6 million. In connection with this acquisition, we assumed net assets of $2.4 million and recorded a deferred tax liability of $3.0 million. The purchase price included $0.8 million for the fair value of approximately 13,000 assumed Freshwater vested stock options, as well as direct acquisition costs of $0.5 million. The fair value of options assumed was estimated using the Black-Scholes model with the following assumptions: fair value of $74.21; expected life (years) of four; risk-free interest rate of 4.41%; volatility of 92%; and dividend yield of zero percent. The allocation of the purchase price resulted in an excess of purchase price over net tangible assets acquired of $148.1 million. This was allocated, based on a third party valuation, $2.1 million to workforce, $5.5 million to purchased technology and $140.5

million to goodwill. During 2002, the goodwill and, during 2002 and 2003, other intangible assets were amortized on a straight-line basis over 3 years.

Interest income was $7.6 million for the three months ended March 31, 2003, or 7% of total revenue, compared to $8.1 million for the three months ended March 31, 2002, or 9% of total revenue. The absolute dollar decrease of $0.6 million was primarily attributable to a reduction of $1.2 million in interest income due to lower interest rates offset by an increase of $0.7 million in interest income associated with our interest rate swap.

Interest expense was $5.0 million for the three months ended March 31, 2003, or 5% of total revenue, compared to $5.7 million for the three months ended March 31, 2002, or 6% of total revenue. The absolute dollar decrease of $0.7 million was primarily attributable to a decrease of $0.6 million in interest expense associated with the retirement of Notes and a decrease of $0.1 million in interest expense associated with our interest rate swap.

Other expense was $0.2 million for the three months ended March 31, 2003 compared to other income of $3.8 million for the three months ended March 31, 2002, or 4% of total revenue. The absolute dollar decrease of $4.0 million was primarily attributable to a reduction of $4.6 million on gains on early retirement of Notes, an increase of $0.6 million in foreign exchange losses, and an increase of losses of $0.2 million on two of our investments in non-consolidated companies. These decreases in other income were offset by an increase of $1.2 million in interest income associated with notes receivable from issuance of stock to foreign employees under our stock option plans.

During the year ended December 31, 2002, we paid $65.8 million including accrued interest of $1.2 million to retire $77.5 million face value of the Notes, which resulted in a gain on early retirement of debt of $11.6 million. From December 2001 through June 30, 2002, we retired $200.0 million face value of the Notes. No Notes were retired during the last six months of 2002 or during the first three months of 2003. As a result of the retirement, our interest expense resulting from our Notes decreased during 2002.

Historically, our operations resulted in a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investments. The tax holidays and rate reductions, which we will be able to realize under programs currently in effect, expire at various dates through 2013. Future provisions for taxes will depend upon the mix of worldwide income and the tax rates in effect for various tax jurisdictions. The effective tax rates for the three months ended March 31, 2003 and 2002 differ from statutory tax rates principally because of the non-deductibility of charges for stock-based compensation and our participation in taxation programs in Israel. We intend to continue to increase our investment in our Israeli operations consistent with our overall tax strategy. US income taxes and foreign withholding taxes were not provided for on undistributed earnings for certain non-US subsidiaries. We intend to invest these earnings indefinitely in operations outside the US.

In 2002, we sold the economic rights of Freshwater’s intellectual property to our Israeli subsidiary. As a result of this intellectual property sale, we have recorded a current tax payable and a prepaid tax asset in the amount of $25.5 million, which will be amortized to income tax expense over eight years, which approximates the period over which the expected benefit is expected to be realized. At March 31, 2003 and December 31, 2002, we have a prepaid tax asset of $21.5 million and $22.3 million, respectively.

At March 31, 2003, our principal source of liquidity consisted of $730.0 million of cash and investments, compared to $665.2 million at December 31, 2002. The March 31, 2003 balance included $159.3 million of short-term and $180.5 million of long-term investments in high quality financial, government, and corporate securities. The increase in cash and investments from March 31, 2003, compared to December 31, 2002 was primarily due to positive cash generated from operations, cash received from issuance of common stock under our stock option and employee stock purchase plans, and collection of notes receivable

from issuance of stock, offset by cash used for capital expenditures and other investments. During the three months ended March 31, 2003, we generated $53.2 million of cash from operating activities, compared to $27.5 million during the three months ended March 31, 2002. The increase in cash from operations during the three months of 2003 compared to the three months of 2002 was due primarily to an increase in the deferred revenue balance.

During the three months ended March 31, 2003, our investing activities consisted primarily of net purchases of investments of $23.7 million and purchases of property and equipment of $1.7 million. We have two buildings in Sunnyvale that we purchased but have not yet renovated. We expect to spend approximately $5.0 million on renovations of these buildings in Sunnyvale. We have committed to make additional capital contributions to a private equity fund totaling $9.0 million and we expect to pay approximately $6.0 million through March 31, 2004 as capital calls are made.

During the three months ended March 31, 2003, our primary financing activities consisted of cash proceeds of $10.7 million from common stock issued under our employee stock option and stock purchase plans and collection of notes receivable from issuance of common stock of $2.4 million.

Through March 14, 2003, our Chief Executive Officer repaid his notes in full prior to the due date in the aggregate amount of $3.4 million, of which $2.0 million related to notes receivable from issuance of stock and $1.4 million related to officer receivables.

In July 2000, we raised $485.4 million from the issuance of Notes with an aggregate principal amount of $500.0 million. The Notes mature on July 1, 2007 and bear interest at a rate of 4.75% per annum, payable semiannually on January 1 and July 1 of each year. The Notes are subordinated in right of payment to all of our future senior debt. The Notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. We may redeem our Notes, in whole or in part, at any time on or after July 1, 2003. Accrued interest to the redemption date will be paid by us in each redemption.

During the three months ended March 31, 2003, a significant portion of our cash inflows was generated by our operations. Because our operating results may fluctuate significantly, as a result of decreases in customer demand or decreases in the acceptance of our future products and services, our ability to generate positive cash flow from operations may be jeopardized.

Future payments due under debt and lease obligations at March 31, 2003 are as follows (in thousands):

In 2002, we effected a change in the mix of software license types to a higher percentage of subscription licenses, especially for our APM products. During the three months ended March 31, 2003, the amount of testing products licensed on a subscription basis increased. This shift does not impact our collections cycle as cash is generally received within 30-60 days from

the invoice date, depending upon the region. Our quarterly operating results are affected by the mix of license types entered into in connection with the sale of products. As revenue associated with our subscription licenses is generally recognized ratably over the term of the license, the shift in mix will also result in deferred revenue becoming a larger component of our cash provided by operations. We believe that the shift to a subscription revenue model will continue in the future, as more of our products are offered and as more of our customers license products on a subscription basis. This shift may cause us to experience a decrease or a lower rate of growth in recognized revenue, as well as a higher increase in deferred revenue, in the near term.

In the future, we expect cash will continue to be generated from our operations. We do not expect to spend significant amounts of additional cash to acquire property and equipment in the near term and therefore the level of cash used in investing activities to acquire property and equipment should remain constant with that used in 2002. We do, however, currently plan to reinvest our cash generated from operations in new short and long term investments in high quality financial, government and corporate securities or other investments, consistent with past investment practices, and therefore net cash used in investing activities may increase. Cash could be used in the future to invest in acquisitions, or strategic investments, or repurchase additional debt or equity.

Assuming there is no significant change in our business, we believe that our current cash and investment balances and cash flow from operations will be sufficient to fund our cash needs for at least the next twelve months.

The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our financial statements. The US Securities and Exchange Commission has defined the most critical accounting policies as the ones that are most important to the portrayal of our financial condition and results, and require us to make our most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain.

We discuss these policies further, as well as the estimates and judgments involved. We also have other key accounting policies. We believe that these other policies either do not generally require us to make estimates and judgments that are as difficult or as subjective, or it is less likely that they would have a material impact on our reported results of operations for a given period.

We have made significant judgments related to revenue recognition; specifically, in connection with each transaction involving our arrangements, we must evaluate whether our fee is “fixed or determinable” and we must assess whether “collectibility is probable”. These judgments are discussed below.

With respect to each arrangement, we must make a judgment as to whether the arrangement fee is fixed or determinable. If the fee is fixed or determinable, then revenue is recognized upon delivery of software (assuming other revenue recognition criteria are met). If the fee is not fixed or determinable, then the revenue recognized in each quarter (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees had been fixed or determinable.

A determination that an arrangement fee is fixed or determinable also depends upon the payment terms relating to such an arrangement. Our customary payment terms are generally within 30-60 days of the invoice date, depending upon the region. Arrangements with payment terms extending beyond the customary payment terms are considered not to be fixed or determinable. A determination of whether the arrangement fee is fixed or determinable is particularly relevant to revenue recognition on perpetual licenses.

In order to recognize revenue, we must make a judgment of the collectibility of the arrangement fee. Our judgment of the collectibility is applied on a customer-by-customer basis. We generally sell to customers for which there is a history of successful collection. If we determine that collection of a fee is not probable (the customer does not have a successful collection history with us), we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash.

The preparation of financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Use of estimates and assumptions include, but are not limited to, the sales reserve and prepaid commissions.

We must make estimates of potential future product returns and write-offs of bad debt accounts related to current period product revenue. We analyze historical returns, historical bad debts, current economic trends, and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales reserves. As a percentage of current period revenue, changes against sales reserves was insignificant in both the three months ended March 31, 2003 and the year ended December 31, 2002. Significant management judgments and estimates must be made and used in connection with establishing the sales reserve in any accounting period. Material differences may result in the amount and timing of our revenue for any period if we make different judgments or utilize different estimates. At March 31, 2003 and December 31, 2002, the provision for sales reserves was $6.6 million and $7.4 million, respectively.

We are required to make estimates of the future sales commission expense associated with our revenue that will be recognized in future periods. We analyze historical commission rates, composition of the future revenue and expected timing of revenue recognition of such future amounts. We make significant judgments and estimates in connection with establishing the prepaid commission in any accounting period. Material differences may result in the amount and timing of our sales commission expense for any period if we make different judgments or utilize different estimates. At March 31, 2003 and December 31, 2002, prepaid commission was $14.3 million and $13.6 million, respectively.

We are required to assess the impairment of identifiable intangibles, long-lived assets and goodwill on an annual basis, and potentially more frequently if events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

We completed the preliminary assessment during the first quarter of 2002 and performed an annual impairment review during the fourth quarter and did not record an impairment charge.

When we determine that the carrying value of intangibles, long-lived assets or goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure this impairment based on a projected

discounted cash flow. Net intangible assets and long-lived assets was $88.8 million and $91.1 million at March 31, 2003 and December 31, 2002, respectively. Goodwill was $113.3 million at March 31, 2003 and December 31, 2002, respectively.

As part of the process of preparing our consolidated financial statements we are required to estimate our income tax expense in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future. Our taxes could increase if these tax rate incentives are not renewed upon expiration, tax rates applicable to us are increased, authorities challenge our tax strategy, or are impacted by new laws or rulings.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance for the entire portion of the net operating losses related to the income tax benefits arising from the exercise of employees’ stock options that will be credited directly to stockholders’ equity in the future. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance, which could materially impact our financial position and results of operations.

From time to time, we make venture capital investments in early stage private companies and private equity funds for business and strategic purposes. These investments are accounted for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. We are closely monitoring our investments for impairment and will record reductions in carrying values if and when necessary. The evaluation process is based on information that we request from these privately held companies. This information is not subject to the same disclosure regulations as US public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings/revenue outlook, operational performance, management/ownership changes, and competition. If we determine that the carrying value of a company is at an amount below fair value, or if a company has completed a financing based on a valuation significantly lower than our initial investment, it is our policy to record a reserve and the related write-down is recorded as an investment loss on our consolidated statements of operations. Estimating the fair value of non-marketable equity investments in early-stage technology companies is inherently subjective and may contribute to significant volatility in our reported results of operations.

At March 31, 2003, we had invested $15.4 million in early stage private companies and private equity funds. In addition, we have committed to make capital contributions to a private equity fund totaling $9.0 million and we expect to pay approximately $6.0 million through March 31, 2004 as capital calls are made. If the companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies or for cash, we may not be able to sell these investments. In addition, even if we are able to sell these investments we cannot assure that we will be able to sell them at a gain or even recover our investment. The prolonged general decline in the NASDAQ National Market and the market prices of publicly traded technology companies, as well as any additional declines in the future, will adversely affect our ability to realize gains or a return of our capital on many of these investments. For the year ended December 31, 2002, we had recorded a loss in other income, net, of $5.3 million on three of our investments in early stage private companies. For the three months ended March 31, 2003, we recorded a loss of $0.6 million on our investments in non-consolidated companies.

We account for stock-based compensation for our employees using the intrinsic value method presented in APB No. 25, Accounting for Stock Issued to Employees, and related interpretations, and comply with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation, and with the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure Amendment of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise price. Unearned stock-

based employee compensation cost is reflected in net income, as some options granted under those plans had an exercise price less than the fair value of the underlying common stock on the date of grant.

We amortize stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four years. Pro forma information regarding net income and earnings per share is required by SFAS No. 123. This information is required to be determined as if we had accounted for employee stock options and stock purchase plans under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

The fair value of options and shares issued pursuant to the option plans and the Employee Stock Purchase Plan (ESPP) at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility rates trended into future years. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our options.

The effects of applying pro forma disclosures of net income and earnings per share are not likely to be representative of the pro forma effects on net income and earnings per share in the future years for the following reasons: 1) the number of future shares to be issued under these plans is not known and 2) the assumptions used to determine the fair value can vary significantly.

See Note 1 to the condensed consolidated financial statements for a full description of recent accounting pronouncements.

In addition to the other information included in this Quarterly Report on Form 10-Q, the following risk factors should be considered carefully in evaluating our business and us.

Our future success depends on our ability to respond to rapid market and technological changes by introducing new products and services and continually improving the performance, features and reliability of our existing products and services and responding to competitive offerings. Our business will suffer if we do not successfully respond to rapid technological changes. The market for our software products and services is characterized by:

To maintain our competitive position, we must continue to enhance our existing software testing, deployment assurance and APM products and services and to develop new products and services, functionality and technology that address the increasingly sophisticated and varied needs of our prospective customers. The development of new products and services, and enhancement of existing products and services, entail significant technical and business risks and require substantial lead-time and significant investments in product development. If we fail to anticipate new technology developments, customer requirements or industry standards, or if we are unable to develop new products and services that adequately address these new developments, requirements and standards in a timely manner, our products and services may become obsolete, our ability to compete may be impaired and our revenue could decline.

We expect our quarterly revenue and operating results to fluctuate, and it is difficult to predict our future revenue and operating results. Our revenue and operating results have varied in the past and are likely to vary significantly from quarter to quarter in the future. These fluctuations are due to a number of factors, many of which are outside of our control, including:

(if we deliver more-than-expected perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we will not meet our revenue targets. In 2002, we effected a change in the mix of software license types to a higher percentage of subscription licenses and that shift continued in the first quarter of 2003 with a larger percentage of testing subscription license revenues. We believe that this shift will continue in the future, as more of our products are offered and as more of our customers license our products on a subscription basis. This shift may cause us to experience a decrease in recognized revenue, as well as continued growth of deferred revenue, in the near term.

Although subscription licenses represent a potential source of renewable license revenue, there is also the risk that customers will not renew their licenses at the end of a term.

In addition, the timing of our license revenue is difficult to predict because our sales cycles are typically short and can vary substantially from product to product and customer to customer. We base our operating expenses on our expectations regarding future revenue levels. Because of the timing of larger orders and customer buying patterns, we may not learn of shortfalls in revenue or earnings or other failures to meet market expectations until late in a particular quarter. As a result, if total revenue for a particular quarter is below our expectations, we could not proportionately reduce operating expenses for that quarter.

We have experienced seasonality in our revenue and earnings, with the fourth quarter of the year typically having the highest revenue and earnings for the year and higher revenue and earnings than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers and, to a lesser extent, from the structure of our sales commission program. We expect this seasonality to continue in the future.

Our customers’ decisions to purchase our products and services are discretionary and subject to their internal budgets and purchasing processes. We believe that the ongoing slowdown in the economy, the current international political uncertainties, and uncertainties in the capital markets have caused and may continue to cause customers to reassess their immediate technology needs, to lengthen their purchasing decision-making processes, to require more senior level internal approvals of purchases and to defer purchasing decisions, and accordingly, has reduced and could reduce demand in the future for our products and services.

Due to these and other factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. If our operating results are below the expectations of investors or securities analysts, the trading prices of our securities could decline.

We expect to face increasing competition in the future, which could cause reduced sales levels and result in price reductions, reduced gross margins or loss of market share. The market for our testing, deployment assurance, and APM products and services is extremely competitive, dynamic and subject to frequent technological change. There are few substantial barriers of entry in our market. The Internet has further reduced these barriers of entry, allowing other companies to compete with us in the testing, deployment assurance, and APM markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities.

In the market for testing solutions, our principal competitors include Compuware, Empirix, Rational Software (acquired by IBM Software Group), and Segue Software. In the new and rapidly changing market for APM solutions, our principal competitors include established providers of systems and network management software such as BMC Software, Computer Associates, HP OpenView and Tivoli, a division of IBM, and providers of hosted services such as Keynote Systems, and emerging companies. Additionally, we face potential competition in this market from existing providers of testing solutions such as Segue Software and Compuware.

Although we believe that our products and services currently compete favorably with respect to these factors, the market for APM and deployment assurance are new and rapidly evolving. We may not be able to maintain our competitive position, and competitive pressure could seriously harm our business. The software industry is increasingly experiencing consolidation and this could increase the resources available to our competitors and the scope of their product offerings. For example, our testing competitor Rational Software was recently acquired by IBM Software Group. Our competitors and potential competitors may undertake more extensive marketing campaigns, adopt more aggressive pricing policies or make more attractive offers to distribution partners and to employees.

If we fail to maintain our existing distribution channels and develop additional channels in the future, our revenue could decline. We derive a substantial portion of our revenue from sales of our products and services through distribution channels such as systems integrators or value-added resellers. We generally expect that sales of our products through these channels will continue to account for a substantial portion of our revenue for the foreseeable future, despite a decrease in channel sales in the quarter ended March 31, 2003. We may not experience increased revenue from new channels and may see a decrease from our existing channels, which could harm our business.

The loss of one or more of our systems integrators or value-added resellers, or any reduction or delay in their sales of our products and services could result in reductions in our revenue in future periods. We have recently signed an agreement with SAP AG that allows it to resell our line of products for use with SAP systems, directly and through its subsidiaries and distributors. In addition, our ability to increase our revenue in the future depends on our ability to expand our indirect distribution channels.

Our dependence on indirect distribution channels presents a number of risks, including:

We depend on strategic relationships and business alliances for continued growth of our business. Our development, marketing and distribution strategies rely increasingly on our ability to form strategic relationships with software and other technology companies. These business relationships often consist of cooperative marketing programs, joint customer seminars, lead referrals and cooperation in product development. Many of these relationships are not contractual and depend on the continued voluntary cooperation of each party with us. Divergence in strategy or change in focus by, or competitive product offerings by, any of these companies may interfere with our ability to develop, market, sell or support our products, which in turn could harm our business. Further, if these companies enter into strategic alliances with other companies or are acquired, they could reduce their support of our products. Our existing relationships may be jeopardized if we enter into alliances with competitors of our strategic partners. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products.

Our customers and partners may not accept our new BTO strategy. We increasingly focus our efforts on sales of enterprise-wide solutions, which consist of our entire Optane product suite and related professional services, and managed services, rather than on the sale of component products. As a result, each sale requires substantial time and effort from our sales and support staff as well as involvement by our professional services and managed services organizations and our systems integrator partners. Large individual sales, or even small delays in customer orders, can cause significant variation in our revenues and results of operations for a particular period. The timing of large orders is usually difficult to predict and, like many software and services companies, many of our customers typically complete transactions in the last month of a quarter.

If we are unable to manage rapid changes in our business, our business may be harmed. We have, in the past, experienced significant growth in revenue, employees and number of product and service offerings and we believe this growth will be renewed. This growth has placed a significant strain on our management and our financial, operational, marketing and sales systems. We are implementing a variety of new or expanded business and financial systems, procedures and controls, including the improvement of our sales and customer support systems. The implementation of these systems, procedures and controls may not be completed successfully, or may disrupt our operations. Any failure by us to properly manage these transitions could impair our ability to attract and service customers and could cause us to incur higher operating costs and experience delays in the execution of our business plan. We have also in the past experienced reductions in revenue and that has required us to rapidly reduce costs. If we fail to reduce staffing levels when necessary, our costs would be excessive and our business and operating results could be adversely affected.

The success of our business depends on the efforts and abilities of our senior management and other key personnel. We depend on the continued services and performance of our senior management and other key personnel. We do not have long term employment agreements with any of our key personnel. The loss of any of our executive officers or other key employees could hurt our business. The loss of senior personnel can result in significant disruption to our ongoing operations, and new senior personnel must spend a significant amount of time learning our business and our systems in addition to performing their regular duties.

We depend on our international operations for a substantial portion of our revenue. Sales to customers located outside the US have historically accounted for a significant percentage of our revenue and we anticipate that such sales will continue to be a significant percentage of our revenue. As a percentage of our total revenue, sales to customers outside the US were 38% and 32% in the first quarters of 2003 and 2002, respectively. We face risks associated with our international operations, including:

Any of these risks could harm our international operations and cause lower international sales. For example, some EMEA countries already have laws and regulations related to technologies used on the Internet that are more strict than those currently in force in the US. Any or all of these factors could cause our business to be harmed.

Because our research and development operations are primarily located in Israel, we may be affected by volatile political, economic, and military conditions in that country and by restrictions imposed by that country on the transfer of technology. Our operations depend on the availability of highly skilled scientific and technical personnel in Israel. Our business also depends on trading relationships between Israel and other countries. In addition to the risks associated with international sales and operations generally, our operations could be adversely affected if major hostilities involving Israel should occur or if trade between Israel and its current trading partners were interrupted or curtailed.

These risks are compounded due to the restrictions on our ability to manufacture or transfer outside of Israel any technology developed under research and development grants from the government of Israel, without the prior written consent of the government of Israel. If we are unable to obtain the consent of the government of Israel, we may not be able to take advantage of strategic manufacturing and other opportunities outside of Israel.

We are subject to the risk of increased taxes. Historically, our operations resulted in a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investment. Our taxes could increase if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased. Tax authorities could challenge the manner in which profits are allocated among us and our subsidiaries, and we may not prevail in any such challenge. If the profits

recognized by our subsidiaries in jurisdictions where taxes are lower became subject to income taxes in other jurisdictions, our worldwide effective tax rate would increase. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future.

Other factors that could increase our effective tax rate include the effect of changing economic conditions, business opportunities, and changes in tax laws and rulings. We have in the past and may continue in the future to retire amounts outstanding under our Notes. To the extent that these repurchases are completed below the par value of the outstanding Notes, we may generate a taxable gain from these repurchases. These gains may result in an increase in our effective tax rate. Merger and acquisition activities, if any, could result in nondeductible expenses which may increase our effective tax rate. Our worldwide effective tax rate could be increased to the extent we are impacted by new tax laws or rulings.

Our financial results may be negatively impacted by foreign currency fluctuations. Our foreign operations are generally transacted through our international sales subsidiaries. As a result, these sales and related expenses are denominated in currencies other than the US dollar. Because our financial results are reported in US dollars, our results of operations may be harmed by fluctuations in the rates of exchange between the US dollar and other currencies, including:

We attempt to limit foreign exchange exposure through operational strategies and by using forward contracts to offset the effects of exchange rate changes on intercompany trade balances. This requires us to estimate the volume of transactions in various currencies. We may not be successful in making these estimates. If these estimates are overstated or understated during periods of currency volatility, we could experience material currency gains or losses.

Acquisitions may be difficult to integrate, disrupt our business, dilute stockholder value or divert the attention of our management and investments may become impaired and require us to take a charge against earnings. In May 2001, we acquired Freshwater and we have minority investments in early stage private companies and private equity funds of $15.4 million at March 31, 2003 and we may acquire or make investments in other companies and technologies. For the year ended December 31, 2002, we had recorded a loss in other income, net, of $5.3 million on three of our investments in early stage private companies. For the three months ended March 31, 2003, we recorded a loss of $0.6 million on our investments in non-consolidated companies. In addition, we have committed to make additional capital contributions to a private equity fund totaling $9.0 million and we expect to pay approximately $6.0 million through March 31, 2004 as capital calls are made. We are closely monitoring the financial health of the other private companies in which we hold minority equity investments. If we determine in accordance with our standard accounting policies that an impairment has occurred, then additional losses would be recorded. In the event of any future acquisitions or investments, we could:

If we fail to achieve the financial and strategic benefits of past and future acquisitions or investments, our operating results will suffer. Acquisitions and investments involve numerous other risks, including:

The price of our common stock may fluctuate significantly, which may result in losses for investors and possible lawsuits. The market price for our common stock has been and may continue to be volatile. For example, during the 52-week period ended March 31, 2003, the closing prices of our common stock as reported on the NASDAQ National Market ranged from a high of $39.43 to a low of $15.74. We expect our stock price to be subject to fluctuations as a result of a variety of factors, including factors beyond our control. These factors include:

Because of this volatility, we may fail to meet the expectations of our stockholders or of securities analysts at some time in the future, and the trading prices of our securities could decline as a result. In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many high-technology companies. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. Any negative change in the public’s perception of software or Internet software companies could depress our stock price regardless of our operating results.

If we fail to adequately protect our proprietary rights and intellectual property, we may lose a valuable asset, experience reduced revenue and incur costly litigation to protect our rights. We rely on a combination of patents, copyrights, trademarks, service marks and trade secret laws and contractual restrictions to establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our products and services and use information that we regard as proprietary to create products and services that compete with ours. Some license provisions protecting against unauthorized use, copying, transfer and disclosure of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the US. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase.

In many cases, we enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products.

Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversions of our management resources, either of which could seriously harm our business.

Third parties could assert that our products and services infringe their intellectual property rights, which could expose us to litigation that, with or without merit, could be costly to defend. We may from time to time be subject to claims of infringement of other parties’ proprietary rights. We could incur substantial costs in defending ourselves and our customers against these claims. Parties making these claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the US and abroad and could result in an award of substantial damages against us. In the event of a claim of infringement, we may be required to obtain licenses from third parties, develop alternative technology or to alter our products or processes or cease activities that infringe the intellectual property rights of third parties. If we are required to obtain licenses, we cannot be sure that we will be able to do so at a commercially reasonable cost, or at all. Defense of any lawsuit or failure to obtain required licenses could delay shipment of our products and increase our costs. In addition, any such lawsuit could result in our incurring significant costs or the diversion of the attention of our management.

Future product development is dependent upon early access to third-party software. Software developers have, in the past, provided us with early access to pre-generally available (GA) versions of their software in order to have input into the functionality and to ensure that we can adapt our software to exploit new functionality in these systems. Some companies, however, may adopt more restrictive policies in the future or impose unfavorable terms and conditions for such access. These restrictions may result in high research and development costs for us in connection with the enhancement and modification of our existing products and the development of new products or may prevent us from being able to develop products which will work with such new systems which could harm our business.

We have adopted anti-takeover defenses that could delay or prevent an acquisition of our company, including an acquisition that would be beneficial to our stockholders. Our board of directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present plans to issue shares of preferred stock. Furthermore, our Preferred Share Purchase Rights Agreement, as amended, and certain provisions of our Certificate of Incorporation and of Delaware law may have the effect of delaying or preventing changes in our control or management, which could adversely affect the market price of our common stock.

Leverage and debt service obligations may adversely affect our cash flow. In July 2000, we completed an offering of Notes with a principal amount of $500.0 million. From December 2001 through June 30, 2002, we retired $200.0 million face value of the Notes. We continue to have a substantial amount of outstanding indebtedness, primarily the Notes. There is the possibility that we may be unable to generate cash sufficient to pay the principal of, interest on and other amounts due in respect of our indebtedness when due. Our leverage could have significant negative consequences, including:

In November 2002, we entered into an interest rate swap with Goldman Sachs Capital Markets, L.P. See Note 6 to the condensed consolidated financial statements for a full description of our interest rate swap and related accounting policies.

Our exposure to market rate risk includes the risk of changes in interest rates. We place our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer or issue. In addition, we have classified all of our investments as “held to maturity.” At March 31, 2003, $390.2 million, or 53% of our cash, cash equivalents and investment portfolio have a maturity of less than 90 days, and an additional $159.3 million, or 22% carried a maturity of less than one year. All investments mature, by policy, in less than three years. Information about our investment portfolio is presented in the table below, which states notional amounts and related weighted-average interest rates by year of maturity (in thousands):

Our long-term investments include $102.4 million of government agency instruments, which have callable provisions and accordingly may be redeemed by the agencies should interest rates fall below the coupon rate of the investments.

The fair value of our Notes fluctuates based upon changes in the price of our common stock, changes in interest rates and changes in our creditworthiness. The fair market value of the Notes at March 31, 2003 was $283.4 million while the face value was $300.0 million while the book value was $317.7 million. See Note 6 to the condensed consolidated financial statements.

In November 2002, we entered into an interest rate swap with Goldman Sachs Capital Markets, L.P. See Note 6 to the condensed consolidated financial statements for a full description of our derivative financial instruments and related accounting policies.

A portion of our business is conducted in currencies other than the US dollar. Our operating expenses in each of these countries are in the local currencies, which mitigates a significant portion of the exposure related to local currency revenue.

From time to time, we make venture capital investments in early stage private companies and private equity funds for business and strategic purposes. At March 31, 2003, we had invested $15.4 million in private companies. In addition, we have committed to make capital contributions to a private equity fund totaling $9.0 million and we expect to pay approximately $6.0 million through March 31, 2004 as capital calls are made. If the companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies or for cash, we may not be able to sell these investments. In addition, even if we are able to sell these investments we cannot assure that we will be able to sell them at a gain or even recover our investment. The prolonged general decline in the NASDAQ National Market and the market prices of publicly traded technology companies, as well as any additional declines in the future, will adversely affect our ability to realize gains or a return of our capital on many of these investments. For the year ended December 31, 2002, we recorded a loss in other income, net, of $5.3 million on three of our investments in early stage private companies. For the three months ended March 31, 2003, we recorded a loss of $0.6 million on our investments in non-consolidated companies.

On April 29, 2003, Mercury Interactive Corporation completed its sale of Zero Coupon Senior Convertible Notes due 2008 (the “Notes”) in a private offering, which offering resulted in net proceeds to the Company of approximately $488.0 million. In addition, Mercury Interactive Corporation granted the initial purchaser of the Notes an option, exercisable through May 9, 2003, to purchase up to an additional $100.0 million aggregate principal amount of the Notes. The Notes were issued pursuant to an Indenture, dated as of April 29, 2003, by and between Mercury Interactive Corporation and U.S. Bank National Association. The Notes and the shares of common stock issuable upon conversion of the Notes have not been registered under the Securities Act of 1933, as amended (the “Securities Act”), and may not be offered or sold in the United States absent registration or an applicable exemption from the registration requirements of the Securities Act. Mercury Interactive has agreed in a Registration Rights Agreement, dated as of April 23, 2003, by and between Mercury Interactive Corporation and the initial purchaser of the Notes, for the benefit of the holders of the Notes, to file with the Securities and Exchange Commission a registration statement covering resales of the Notes and the shares of common stock issuable upon conversion of the Notes.

4.1		Indenture, dated as of April 29, 2003, by and between Mercury Interactive Corporation and U.S. Bank National Association related to Zero Coupon Senior Convertible Notes due 2008.

4.2		Registration Rights Agreement, dated as of April 23, 2003, by and between Mercury Interactive Corporation and UBS Warburg LLC related to Zero Coupon Senior Convertible Notes due 2008.

4.3		Amendment No. 3 to Preferred Share Rights Agreement dated April 23, 2003, between Mercury Interactive Corporation and ChaseMellon Shareholder Services, LLC, as successor to Wells Fargo Bank National Association, as rights agent.

10.1		Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated November 5, 2002.

99.1		Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

99.2		Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

We furnished the following Current Reports on Form 8-K during the quarter ended March 31, 2003:

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Mercury Interactive Corporation, a corporation organized and existing under the laws of the State of Delaware, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

By:		/S/ DOUGLAS P. SMITH

		Douglas P. Smith, Executive Vice President and Chief Financial Officer Principal Financial Officer

By:		/S/ BRYAN J. LEBLANC

		Bryan J. LeBlanc, Vice President, Finance Principal Acounting Officer

		Page
PART I.	FINANCIAL INFORMATION

Item 1.	Unaudited Financial Statements

	Condensed Consolidated Balance Sheets—March 31, 2003 and December 31, 2002	3

	Condensed Consolidated Statements of Operations—Three months ended March 31, 2003 and 2002	4

	Condensed Consolidated Statements of Cash Flows—Three months ended March 31, 2003 and 2002	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	30

Item 4.	Controls and Procedures	31

PART II.	OTHER INFORMATION

Item 5.	Other Information	32

Item 6.	Exhibits and Reports on Form 8-K	32

	Signatures	33

	Certifications	34

	March 31, 2003			December 31, 2002
ASSETS
Current assets:
Cash and cash equivalents	$	390,229		$	349,123
Short-term investments		159,277			178,123
Trade accounts receivable, net		78,902			93,095
Prepaid expenses and other assets		42,552			46,548

Total current assets		670,960			666,889
Long-term investments		180,500			137,954
Property and equipment, net		86,717			88,516
Investments in non-consolidated companies		15,380			15,952
Debt issuance costs, net		5,654			6,037
Goodwill		113,327			113,327
Intangible assets, net		2,090			2,548
Restricted cash		6,000			6,000
Interest rate swap		18,091			17,378
Other assets		18,971			21,133

Total assets	$	1,117,690		$	1,075,734


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	9,567		$	12,292
Accrued liabilities		61,265			71,414
Income taxes payable		71,263			70,502
Short-term deferred revenue		147,141			135,338

Total current liabilities		289,236			289,546
Convertible subordinated notes		317,651			316,972
Long-term deferred revenue		34,081			24,048

Total liabilities		640,968			630,566

Stockholders’ equity:
Common stock		171			169
Additional paid-in capital		264,491			254,218
Treasury stock		(16,082	)		(16,082	)
Notes receivable from issuance of stock		(8,641	)		(11,055	)
Unearned stock-based compensation		(695	)		(1,296	)
Accumulated other comprehensive loss		(1,605	)		(1,725	)
Retained earnings		239,083			220,939

Total stockholders’ equity		476,722			445,168

Total liabilities and stockholders’ equity	$	1,117,690		$	1,075,734

	Three months ended March 31,
	2003			2002
Revenues:
License fees	$	44,786		$	44,721
Subscription fees		19,274			11,279
Maintenance fees		35,585			27,650
Professional service fees		10,740			6,850

Total revenues		110,385			90,500

Costs and expenses:
Cost of license and subscription		6,550			6,345
Cost of maintenance		2,679			2,836
Cost of professional services		6,620			4,298
Marketing and selling		52,685			45,417
Research and development		11,589			10,624
General and administrative		9,100			7,443
Amortization of unearned stock-based compensation		189			364
Restructuring, integration and other related charges		—			(537	)
Amortization of goodwill and other intangible assets		458			639

Total costs and expenses		89,870			77,429

Income from operations		20,515			13,071
Interest income		7,558			8,060
Interest expense		(5,000	)		(5,713	)
Other income (expense), net		(231	)		3,783

Income before provision for income taxes		22,842			19,201
Provision for income taxes		4,698			4,041

Net income	$	18,144		$	15,160

Net income per share (basic)	$	0.21		$	0.18

Net income per share (diluted)	$	0.20		$	0.17

Weighted average common shares (basic)		85,032			83,223

Weighted average common shares and equivalents (diluted)		89,349			88,296

	Three months ended March 31,
	2003			2002
Cash flows from operating activities:
Net income	$	18,144		$	15,160
Adjustment to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,879			3,815
Sales reserves		(406	)		1,038
Unrealized gain on interest rate swap		(34	)		—
Amortization of goodwill and other intangible assets		458			639
Amortization of unearned stock-based compensation		189			364
Gain on early retirement of debt		—			(4,573	)
Loss on investments in non-consolidated companies		572			411
Deferred income taxes		2,422			—
Changes in assets and liabilities:
Trade accounts receivable		14,988			11,369
Prepaid expenses and other assets		3,793			(1,754	)
Accounts payable		(2,764	)		(1,355	)
Accrued liabilities		(10,289	)		(5,997	)
Income taxes payable		750			3,811
Deferred revenue		21,497			4,587

Net cash provided by operating activities		53,199			27,515

Cash flows from investing activities:
Maturity of investments		298,972			56,149
Purchases of investments		(322,671	)		(71,100	)
Increase in restricted cash		—			(13,659	)
Purchases of investments in non-consolidated companies		—			(750	)
Acquisition of property and equipment		(1,686	)		(1,760	)

Net cash used in investing activities		(25,385	)		(31,120	)

Cash flows from financing activities:
Proceeds from issuance of common stock under stock option and employee stock purchase plans		10,687			9,737
Collection of notes receivable from issuance of stock		2,414			509
Retirement of convertible subordinated notes		—			(24,723	)

Net cash provided by (used in) financing activities		13,101			(14,477	)

Effect of exchange rate changes on cash		191			640

Net increase (decrease) in cash and cash equivalents		41,106			(17,442	)
Cash and cash equivalents at beginning of period		349,123			248,297

Cash and cash equivalents at end of period	$	390,229		$	230,855

	Three months ended March 31,
	2003			2002
Net income, as reported	$	18,144		$	15,160
Add:
Unearned stock-based compensation expense included in reported net income		189			364
Deduct:
Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(28,867	)		(27,230	)

Pro forma net loss	$	(10,534	)	$	(11,706	)

Net income per share (basic), as reported	$	0.21		$	0.18

Net loss per share (basic), pro forma	$	(0.12	)	$	(0.14	)

Net income per share (diluted), as reported	$	0.20		$	0.17

Net loss per share (diluted), pro forma	$	(0.12	)	$	(0.14	)

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	Option plans				ESPP
	2003		2002		2003		2002
Expected life (years)	4.00		4.00		0.50		0.50
Risk-free interest rate	3.03	%	4.37	%	2.90	%	4.30	%
Volatility	89	%	90	%	89	%	90	%
Dividend yield	None		None		None		None

	4.75% Convertible Subordinated Notes due 2007(a)		Non-Cancelable Operating Leases		Total
2003	$	—	$	7,042	$	7,042
2004		—		6,081		6,081
2005		—		4,034		4,034
2006		—		2,297		2,297
2007		300,000		1,687		301,687
Thereafter		—		2,720		2,720

Total	$	300,000	$	23,861	$	323,861

	March 31,
	2003			2004			Thereafter			Total			Fair Value
Cash equivalents:
Fixed rate	$	253,954		$	—		$	—		$	253,954		$	255,855
Weighted average rate		1.28	%		—			—			1.28	%		—
Investments:
Fixed rate	$	249,627		$	100,690		$	79,810		$	430,127		$	433,750
Weighted average rate		2.30	%		3.55	%		2.64	%		2.66	%		—

Total investments	$	503,581		$	100,690		$	79,810		$	684,081		$	689,605

Weighted average rate		1.79	%		3.55	%		2.64	%		2.15	%		—