OPSWARE INC - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended April 30, 2005

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

For the transition period from to

Commission file number: 000-32377

OPSWARE INC.

(Exact name of registrant as specified in its charter)

Delaware		94-3340178
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

599 N. Mathilda Avenue, Sunnyvale, CA 94085

(Address, including zip code, of Registrant’s principal executive offices)

Registrant’s telephone number, including area code: (408) 744-7300

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

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

There were 98,400,114 shares of the registrant’s Common Stock, par value $0.001, outstanding on May 31, 2005.

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

OPSWARE INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

	April 30, 2005			January 31, 2005
	(unaudited)			(A)
ASSETS
Current assets:
Cash and cash equivalents	$	102,968		$	118,615
Accounts receivable, net	4,819			3,895
Prepaid expenses and other current assets	3,935			3,506

Total current assets	111,722			126,016
Property and equipment, net	4,352			4,113
Restricted cash	2,480			2,740
Prepaid rent	2,017			2,185
Other assets	354			818
Intangible assets, net	9,831			4,125
Goodwill	27,608			3,594

Total assets	$	158,364		$	143,591

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	552		$	882
Other accrued liabilities	5,675			5,002
Advances from customers	4,642			8,855
Deferred revenue, current portion	14,716			9,840
Accrued restructuring costs, current portion	232			233
Capital lease obligations	17			—

Total current liabilities	25,834			24,812

Capital lease obligations, net of current portion	81			—
Deferred revenue, net of current portion	1,194			651
Accrued restructuring costs, net of current portion	1,411			1,466
Commitments and contingencies
Stockholders’ equity:
Common stock	98			95
Additional paid-in capital	604,569			585,204
Notes receivable from stockholders	—			(1		)
Deferred stock compensation	(1,163		)	(106		)
Accumulated deficit	(473,648		)	(468,519		)
Accumulated other comprehensive loss	(12		)	(11		)

Total stockholders’ equity	129,844			116,662

Total liabilities and stockholders’ equity	$	158,364		$	143,591

(A) The balance sheet at January 31, 2005 has been derived from the audited consolidated financial statements at that date, but does not include all the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.

See accompanying notes.

OPSWARE INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

	Three Months Ended April 30,
	2005			2004

Net revenue:
License revenue	$	8,149		$	5,428
Services revenue	4,466			1,910

Net revenue	12,615			7,338
Cost and expenses:
Cost of license revenue	80			46
Cost of services revenue*	2,939			1,667
Amortization of developed technology	404			138
Research and development*	5,374			2,587
Sales and marketing*	5,017			3,068
General and administrative*	2,633			1,395
In-process research and development charges	1,190			610
Restructuring recoveries, net	(18		)	(150		)
Amortization of other acquisition-related intangibles	321			122
Amortization (reversal) of deferred stock compensation	415			(122		)

Total cost and expenses	18,355			9,361

Loss from operations	(5,740		)	(2,023		)
Gain (loss) on sale of assets and liabilities from Managed Services Business	(33		)	4,280
Interest and other income, net	646			133

Income (loss) before income taxes	(5,127		)	2,390
Provision for income taxes	2			373

Net income (loss)	$	(5,129	)	$	2,017

Basic net income (loss) per share	$	(0.05	)	$	0.02

Diluted net income (loss) per share	$	(0.05	)	$	0.02

Shares used in computing basic net income (loss) per share	97,627			82,051

Shares used in computing diluted net income (loss) per share	97,627			89,542


* Excludes amortization (reversal) of deferred stock compensation of the following (1):

Cost of services revenue	$	3		$	(175	)
Research and development	89			32
Sales and marketing	60			1
General and administrative	263			20

Total amortization (reversal) of deferred stock compensation	$	415		$	(122	)

(1) Given the non-cash nature of the expense, we believe presenting amortization (reversal) of deferred stock compensation, incurred in connection with our initial public offering, in a separate line item more accurately reflects the results of our individual operating expense categories.

See accompanying notes.

OPSWARE INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Three Months Ended April 30,
	2005			2004

Operating activities:
Net income (loss)	$	(5,129	)	$	2,017
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation	775			593
Amortization of intangibles	724			260
Charge (benefit) related to stock-based compensation agreements	(263		)	(248		)
Amortization (reversal) of deferred stock compensation	415			(122		)
Recovery on disposal of property and equipment	—			(6		)
In-process research and development charges	1,190			610
Changes in operating assets and liabilities:
Accounts receivable, net	376			(453		)
Prepaid expenses, other current assets and other assets	(440		)	(278		)
Prepaid rent	168			198
Accounts payable	(330		)	314
Accrued data center facilities costs	—			(4,280		)
Other accrued liabilities	386			(996		)
Advances from customers	(4,213		)	(246		)
Deferred revenue	5,178			3,828
Accrued restructuring costs	(56		)	(92		)

Net cash provided by (used in) operating activities	(1,219		)	1,099

Investing activities:
Purchases of property and equipment	(799		)	(367		)
Restricted cash	260			—
Proceeds from sale of assets	—			6
Direct acquisition costs paid	(15,067		)	(551		)
Cash acquired (overdraft) in acquisition of businesses	(22		)	954

Net cash provided by (used in) investing activities	(15,628		)	42

Financing activities:
Proceeds from issuance of common stock, net of repurchases	1,101			1,385
Principal payments on capital lease obligations	98			(11		)
Proceeds from repayment of notes receivable	1			188

Net cash provided by financing activities	1,200			1,562

Net increase (decrease) in cash and cash equivalents	(15,647		)	2,703
Cash and cash equivalents at beginning of period	118,615			55,205

Cash and cash equivalents at end of period	$	102,968		$	57,908

Supplemental schedule of non-cash investing and financing activities:
Reversal of unamortized portion of deferred stock compensation related to terminated employees	$	—		$	5
Cancellation of stockholder notes receivable for terminated employees related to unvested awards	—			13
Common stock issued in connection with the acquisition of Tangram	—			10,000
Common stock issued in connection with the acquisition of Rendition Networks	16,398			—
Assumption of Rendition Networks vested options and unvested restricted stock	2,162			—

See accompanying notes.

OPSWARE INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Summary of the Company and Significant Accounting Policies

Nature of Operations

Opsware Inc. (“Opsware,” or “the Company,”), was incorporated on September 9, 1999 in the state of Delaware. The Company sells its Opsware Server Automation System (OSAS), Opsware Network Automation System (ONAS) and Opsware Asset Management System (OAMS) product lines to enterprises, government agencies and service providers seeking to reduce costs and increase the quality of data center operations. The Company refers to this business as its Software Business. The Company’s software products automate key network, server and software operations in large data centers, including provisioning, changing, patching, reporting, configuring, scaling, securing, recovering, auditing and reallocating servers, network devices and business applications. The Company’s products work across geographically disparate locations and heterogeneous IT environments consisting of UNIX, Linux and Windows servers and a wide range of software infrastructure and applications, as well as network devices including switches, routers, load balancers and firewalls.

On February 3, 2005, the Company acquired Rendition Networks, Inc. (“Rendition Networks”), a provider of network device automation software located in Redmond, Washington. The purchase enables the Company to create an integrated product solution that allows customers to manage multiple aspects of their IT infrastructure. The results of operations of Rendition Networks since the effective date of the acquisition have been included in the Company’s consolidated financial statements.

On February 20, 2004, the Company acquired Tangram Enterprise Solutions, Inc. (“Tangram”), a software and service provider based in North Carolina, in order to, among other things, extend its product offering and technology capabilities. The results of operations of Tangram since the effective date of the acquisition have been included in the Company’s consolidated financial statements.

Prior to August 15, 2002, the Company primarily provided managed Internet services for corporations and government agencies that operate mission-critical Internet applications. The Company referred to this business as its Managed Services Business. On August 15, 2002, the Company completed the sale of its Managed Services Business to Electronic Data Systems Corporation (“EDS”). The Company used its proprietary Opsware automation technology in the Managed Services Business, and has since integrated this technology into its software products. As a result, the operations and cash flows of the Managed Services Business could not clearly be distinguished from its Software Business, either operationally or for financial reporting purposes. Therefore, the sale of the Managed Services Business was not considered a discontinued operation.

Basis of Presentation

The condensed consolidated financial statements have been prepared by the Company in accordance with U.S. generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”), and include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances have been eliminated. Certain information and footnote disclosures, normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles, have been condensed or omitted pursuant to such principles, rules and regulations. While in the opinion of the Company the unaudited financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods presented, these condensed consolidated financial statements and notes should be read in conjunction with the Company’s audited consolidated financial statements and related notes for the year ended January 31, 2005 included in the Company’s Annual Report on Form 10-K filed with the SEC on April 15, 2005. The condensed consolidated balance sheet at January 31, 2005 has been derived from the audited consolidated financial statements at that date.

The results of operations for the three-month period ended April 30, 2005 are not necessarily indicative of results for any other period.

Use of Estimates

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that materially affect the amounts reported in the consolidated financial statements. Actual results could differ materially from these estimates. The methods, estimates and judgments the Company uses in applying its most critical accounting policies have a significant impact on the results reported in its financial statements.

Significant Accounting Policies

Revenue Recognition

The Company recognizes software revenue in accordance with the American Institute of Certified Public Accountants’ (“AICPA”) Statement of Position No. 97-2 (“SOP 97-2”), “Software Revenue Recognition,” as amended by Statement of Position No. 98-4, “Deferral of the Effective Date of SOP 97-2, ‘Software Revenue Recognition’” (“SOP 98-4”), Statement of Position No. 98-9, “Modification of SOP 97-2 with Respect to Certain Transactions” (“SOP 98-9”), and Statement of Position
No. 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts” (“SOP 81-1”). For each transaction, the Company determines whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility of the fee is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all criteria are met. The Company considers all arrangements with payment terms extending beyond twelve months not to be fixed or determinable in which case revenue is recognized no earlier then when payments become contractually due. If collectibility is not considered probable, revenue is recognized when the fee is collected. No customer has a right of return privilege.

The Company generates revenue from the sale of its software licenses and services including revenue from maintenance and support agreements and professional service agreements. Through the quarter ended April 30, 2005, the Company recognized a majority of its revenue ratably over the remaining post-contract support (“maintenance”) obligation period once deployment of the Company’s software had been completed and all other elements of the arrangement had been delivered because the Company had not established vendor specific objective evidence (VSOE) of fair value of its maintenance for its OSAS product.

Revenue from the sale of OSAS software licenses is comprised of fees for multi-year or perpetual licenses under contracts with customers. For perpetual licenses, until the Company established VSOE of fair value for maintenance, the license, maintenance and professional services revenue was recognized ratably over the remaining maintenance period once all elements except maintenance had been delivered. For term licenses accompanied by maintenance, the entire arrangement fee is recognized ratably over the term of the license period. Subsequent to the establishment of VSOE of fair value for maintenance, the Company will recognize perpetual license revenue based upon the residual method after all elements other than maintenance and non-essential professional services have been delivered with consideration to individual contract terms and conditions and as prescribed by SOP 98-9. The Company will then recognize maintenance revenue ratably over the term of the maintenance contract. In accordance with paragraph 10 of SOP 97-2, VSOE of fair value for maintenance is determined by reference to the price charged to the customer for maintenance when it is sold separately (that is, the stated or renewal rate). Customers that enter into license agreements where maintenance for the initial twelve months is included in the license fee generally have the ability to renew the maintenance contract for an additional one year term at the renewal rate (that is, the price for maintenance when sold separately). Maintenance contracts are generally one year in duration.

In the case of OAMS and ONAS software, for which the Company has established VSOE of fair value for maintenance, the Company recognizes perpetual license revenue based upon the residual method after all elements other than maintenance have been delivered, provided that all of the criteria for revenue recognition discussed above are met. Generally, these criteria are met at the time of delivery. For software arrangements involving multiple elements, revenue is allocated to each element based on the relative fair values of the elements. The fair value of an element is based on VSOE for that element. The Company establishes VSOE based on the price charged when the same element is sold separately. If VSOE of all undelivered elements exists but VSOE does not exist for one or more delivered elements, then revenue is recognized based on the residual method.

Services revenue consists of revenue from maintenance and support agreements and professional services arrangements. In all cases, the Company assesses whether the service element of the arrangement is essential to the functionality of any other elements of the arrangement. Through the quarter ended April 30, 2005, when services

(excluding maintenance and support services) were considered essential to the arrangement, the service revenue fee was recognized ratably over the remaining maintenance period beginning once the services were completed and delivered, as the Company did not have VSOE of fair value for maintenance for OSAS.

For those arrangements where the Company has concluded that the services element is not essential to the other elements of the arrangement, the Company then determines whether: (1) the services are available from other vendors, (2) the services do not involve a significant degree of risk or unique acceptance criteria and (3) it is able to provide the services in order to separately account for the services revenue. When the services qualify for separate accounting, the Company uses VSOE of fair value for the services and maintenance, if available, to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element. Revenue allocable to services is recognized as the services are performed. Through the quarter ended April 30, 2005, the Company did not have VSOE of fair value of services. Consequently, upon delivery of the software and any services, the entire arrangement fee was recognized ratably over the remaining maintenance period. In the case of pre-packaged software for which the Company has established VSOE of fair value for maintenance, the Company recognizes revenue for maintenance using the straight-line method over the period that the maintenance is provided, generally one year. Revenue from training arrangements or seminars and from consulting services is recognized as the services are performed or seminars are held.

VSOE of fair value for professional services is based upon hourly or daily rates. The Company enters into stand-alone contracts for professional services and these contracts provide for payment on a time and materials basis. The hourly or daily rates associated with these contracts are used to determine the VSOE of fair value of professional services in multi-element arrangements.

The Company recognizes revenue associated with software licenses and services sold to distributors, system integrators and value added resellers (collectively, “resellers”) upon satisfaction of all revenue recognition criteria unless it is aware that a reseller does not have a purchase order or other contractual agreement from an end user. In connection with sales to resellers, there is no right of return or price protection.

If the Company has not met the criteria for revenue recognition, the Company defers revenue recognition until such time as all criteria are met. If the Company has not met the criteria for revenue recognition and has received cash from a customer, the amounts received are included in advances from customers. If the Company has met the criteria for revenue recognition, whether or not it has received cash from a customer, the amounts billed are recorded as deferred revenue and recognized into revenue over the period services are provided.

Impairment of Long-Lived Assets and Intangible Assets

The Company continually reviews the carrying value of long-lived assets, including property and equipment and other identified intangible assets, to determine whether there are any indications of impairment. Indicators of impairment might include a decrease in the market price of a long-lived asset, an adverse change in the extent or manner in which a long-lived asset is being used, a change in the business climate that could affect the value of a long-lived asset, or a current-period operating or cash flow loss combined with a history of operating or cash flow losses. When such indicators are present, if the undiscounted cash flows expected to be generated from operations attributable to the long-lived assets are less than the carrying value of such long-lived assets, the Company compares the fair value of the assets (estimated using discounted future net cash flows to be generated from the lowest common level of operations utilizing the assets) to the carrying value of the long-lived assets to determine any impairment charges. The Company reduces the carrying value of the long-lived assets to the extent the carrying value of the long-lived assets is greater than their fair value. The new carrying value is then depreciated over the remaining estimated useful lives of the assets.

As part of the Company’s acquisition of Tangram, approximately $5.4 million of the purchase price was allocated to identified intangible assets, including approximately $2.5 million for customer relationships and approximately $2.9 million for developed technology. As part of the acquisition of Rendition Networks, approximately $6.4 million of the purchase price was allocated to identified intangible assets, including approximately $2.7 million for customer relationships and approximately $3.7 million for developed technology. The Company is amortizing these intangible assets on a straight-line basis over an average estimated life of four years.

Impairment of Goodwill

The Company accounts for goodwill in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Intangible Assets” (“SFAS 142”). In accordance with SFAS 142, goodwill will not be amortized, but instead will be tested for impairment at least annually and more frequently if certain indicators are present. Circumstances that could trigger an impairment test include, but are not limited to, a significant adverse change in the business climate or legal factors, an adverse action or assessment by a regulator, unanticipated competition and loss of key personnel. The assessment of impairment is made by comparing the fair value of the reporting unit to which the goodwill has been assigned by management to its carrying value. To the extent that an impairment is indicated (fair value is less than carrying value), the Company must perform a second test to measure the amount of the impairment. The determination as to whether a write down of goodwill is necessary involves significant judgment based on the short-term and long-term projections of future performance. The assumptions supporting the estimated future cash flows, including the discount rate used and estimated terminal value, reflects the Company’s best estimates. In the event the Company determines that goodwill has been impaired, the Company will incur an accounting charge related to the impairment during the fiscal quarter in which such impairment determination is made. The Company reviews for indicators of potential impairment of goodwill annually. There were no impairment charges recorded during the three-month period ended April 30, 2005.

Restructuring Costs

During fiscal 2002 and 2003, the Company restructured its business under plans approved by the Board of Directors by reducing its headcount, consolidating its facilities and disposing of excess and obsolete property and equipment. As a result of these actions, the Company recorded restructuring and other related charges consisting of cash severance payments to be made to severed employees and lease payments related to property vacated as a result of its consolidation of facilities, net of estimated sublease income. The Company’s estimates include the review of the financial condition of its existing sublessees as well as the state of the regional real estate markets. Each reporting period, the Company reviews these estimates based on the status of execution of its restructuring plan and, to the extent that these assumptions change due to changes in market conditions and its business, the Company revises the estimated fair value of its restructuring liabilities in accordance with SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.”

Contingency Accruals

The Company evaluates contingent liabilities including threatened or pending litigation in accordance with Statement of Financial Accounting Standards No. 5 (“SFAS 5”), “Accounting for Contingencies.” If the potential loss from any claim or legal proceedings is considered probable and the amount can be estimated, the Company accrues a liability for the estimated loss. Because of uncertainties related to these matters, accruals are based upon management’s judgment and the best information available to management at the time. As additional information becomes available, the Company reassesses the potential liability related to its pending claims and litigation and may revise its estimates.

Concentrations of Credit Risk and Significant Customers

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents, restricted cash and accounts receivable. The Company places all of its cash, cash equivalents and restricted cash with high-credit quality issuers. Carrying amounts of financial instruments held by the Company, which include cash equivalents, restricted cash and accounts receivable, approximate fair value due to their short duration. The Company performs ongoing credit evaluations, as warranted, and maintains reserves for potential losses on accounts receivable.

For the three-month period ended April 30, 2005, EDS and British Sky Broadcasting accounted for 41% and 14% of the Company’s net revenue, respectively. For the three-month period ended April 30, 2004, EDS and Northrop Grumman accounted for 65% and 15% of the Company’s net revenue, respectively. As of April 30, 2005, EDS accounted for 41% of the Company’s accounts receivable balance.

Comprehensive Net Income (Loss)

For the three-months ended April 30, 2005, net loss and comprehensive net loss were both $5.1 million. For the three-months ended April 30, 2004, net income and comprehensive net income were both $2.0 million. Other comprehensive income (loss) includes foreign currency translation adjustments that are excluded from net income (loss).

Accounting for Stock-Based Compensation

The Company grants stock options and stock purchase rights for a fixed number of shares to employees and directors with an exercise price equal to the fair value of the shares at the date of grant. As permitted under the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS 148”), the Company accounts for stock option grants and stock purchase rights to employees and directors in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB Opinion No. 25”) and, accordingly, recognizes no compensation expense for stock option grants or stock purchase rights with an exercise price equal to or greater than the fair value of the shares at the date of grant. If compensation expense for the Company’s stock-based compensation plans had been determined in accordance with SFAS 123, the Company’s net income (loss) and net income (loss) per share would have resulted in the pro forma GAAP amounts indicated below:

	Three Months Ended April 30,
	2005			2004
	(in thousands, except per share amounts)
As reported net income (loss)	$	(5,129	)	$	2,017
Stock-based compensation expense (reversal) included in reported net loss	154			(367		)
Total stock-based employee compensation expense determined under the fair value based method for all awards	(3,094		)	(2,209		)

Pro forma GAAP net income (loss)	$	(8,069	)	$	(559	)

Income (loss) per share:
As reported net income (loss) per share—basic and diluted	$	(0.05	)	$	0.02

Pro forma GAAP net income (loss) per share—basic	$	(0.08	)	$	(0.01	)

For purposes of this disclosure, the estimated fair value of the stock purchase rights and stock options is amortized to expense over the stock purchase rights’ and options’ vesting periods. The fair value of stock awards are measured over an expected four year life and the fair value of employee stock purchase plans are measured over an expected two year life. The fair value of stock purchase rights and options granted during all periods was estimated at the date of the option grant using the Black-Scholes option pricing model with the following assumptions:

	Stock Awards				Employee Stock Purchase Plan
	Three Months Ended April 30,				Three Months Ended April 30,
	2005		2004		2005		2004

Risk-free interest yield	3.9	%	3.9	%	3.6	%	2.3	%
Expected life (years)	4.0		4.0		2.0		2.0
Volatility	74	%	84	%	61	%	89	%
Dividend yield	0	%	0	%	0	%	0	%

The weighted average fair value was $3.12 and $2.37, and $4.42 and $1.46 per share, for stock options and stock purchase rights granted in the three-month periods ended April 30, 2005 and April 30, 2004, respectively.

A summary of the total purchase price is as follows (in thousands):

Common stock	$	16,398
Assumption of Rendition Networks vested options and unvested restricted stock	2,162
Cash consideration	15,000
Direct costs of the acquisition	623

Total purchase price	$	34,183

The total purchase price has been allocated as follows (in thousands):

Accounts receivable, net	$	1,300
Other current assets	78
Property and equipment, net	215
Amortizable intangible assets:
Customer Relationships	2,700
Developed Technology	3,730
In-Process Research and Development	1,190
Goodwill	24,015
Deferred stock compensation	1,505
Accounts payable	(22		)
Other accrued liabilities	(287		)
Deferred revenue	(241		)

Total purchase price	$	34,183

Goodwill

Of the total purchase price, approximately $24.0 million was allocated to goodwill. Goodwill represents the excess of the purchase price over the estimated fair value of the underlying net tangible and intangible assets acquired.

Purchased identified intangible assets

Of the total purchase price, approximately $6.4 million was allocated to identified intangible assets, including customer relationships of approximately $2.7 million and developed technology of approximately $3.7 million. The Company is amortizing these intangible assets on a straight-line basis over an average estimated life of four years. Amortization expense for these intangible assets was $387,000 for the three-months ended April 30, 2005. Total intangible assets subject to amortization are as follows (in thousands):

	April 30, 2005

Customer relationships	$	2,700
Developed technology	3,730

Gross intangible assets	6,430
Less accumulated amortization	(387		)

Identified intangible assets, net	$	6,043

The aggregate estimated annual intangible amortization expense through January 31, 2010 is as follows (in thousands):

Fiscal Year	Amortization

2006	$	1,593
2007	1,608
2008	1,608
2009	1,607
2010	14

	$	6,430

In-process research and development

Of the total purchase price, $1.2 million was allocated to in-process research and development (“IPR&D”). Projects that qualify as IPR&D represent those that have not yet reached technological feasibility and for which no future alternative uses exist. The charge of $1.2 million for IPR&D was expensed in the Company’s operating results for the period ending April 30, 2005.

Deferred revenue

Of the total purchase price, $241,000 was allocated to deferred revenue. Deferred revenue represents the fair value, based on the present value of estimated future cash flows, of fulfilling maintenance obligations under customer contracts assumed in the Rendition Networks acquisition.

Pro forma results

The unaudited pro forma financial information below presents the combined results of operations of the Company and Rendition Networks as if the acquisition had occurred as of the beginning of the earliest periods presented. The unaudited pro forma financial information for the three-month period ended April 30, 2005, was derived from the Company’s unaudited condensed consolidated statements of operations for the three-month period ended April 30, 2005, which includes Rendition Networks’ financial data after February 3, 2005. Rendition Networks’ operating results for the period of February 1, 2005 to February 2, 2005 were immaterial, and so have not been included in the calculation below. The unaudited pro forma financial information for the three-month period ended April 30, 2004 was derived from the Company’s unaudited condensed consolidated statements of operations for the three-month period ended April 30, 2004 and Rendition Networks’s unaudited statements of operations for the three-month period ended March 31, 2004. The unaudited pro forma basic and diluted net loss per share computations are based upon the weighted average outstanding common stock of the Company during the periods presented, plus the number of shares of the Company’s common stock issued to complete the acquisition of Rendition Networks as if the acquisition had occurred as of the beginning of the earliest periods presented. The pro forma financial information excludes charges for acquired IPR&D. The unaudited pro forma financial information is not intended to represent or be indicative of the consolidated results of operations or financial condition that the Company would have reported had the acquisition been completed as of the dates presented and should not be taken as representative of the future consolidated results of operations.

Unaudited pro forma financial information is as follows (in thousands, except per share amounts):

	Three Months Ended April 30,
	2005			2004

Net revenue	$	12,615		$		7,668
Net income (loss)	$	(5,932	)	$	85
Basic net income (loss) per share	$	(0.06	)	$		0.00
Diluted net income (loss) per share	$	(0.06	)	$		0.00

Tangram Enterprise Solutions, Inc.

On February 20, 2004, the Company acquired Tangram. The Company acquired Tangram to extend the Company’s product offerings and technology capabilities, expand its customer base and increase research and development opportunities. For purchase accounting purposes, the transaction was valued at approximately $11.5 million, consisting of $10.0 million of Opsware common stock and approximately $1.5 million of direct acquisition costs. The transaction was accounted for using the purchase method. The Company issued approximately 1.1 million shares of common stock with a fair value of $10.0 million in exchange for all of the outstanding stock and the extinguishment of certain indebtedness of Tangram. The common stock issued in the acquisition was valued using the average closing price of the Company’s common stock for the five consecutive trading days ending on the trading day prior to the close of the acquisition, which was $8.92 per share.

The results of operations of Tangram were included in the Company’s consolidated financial statements beginning on the effective date of the acquisition, February 20, 2004.

In accordance with SFAS No. 141 “Business Combinations” (“SFAS 141”), the Company allocated the purchase price of the acquisition to the tangible assets, liabilities and intangible assets acquired, including IPR&D, based on their estimated fair values. The excess purchase price over those fair values was recorded as goodwill. The fair value assigned to intangible assets acquired was based on several factors, including valuations, estimates and assumptions provided by the Company. The purchase price is final as of February 20, 2005, and will not be adjusted.

A summary of the total purchase price is as follows (in thousands):

Common stock	$	10,000
Direct costs of the acquisition	1,540

Total purchase price	$	11,540

The total purchase price has been allocated as follows (in thousands):

Cash and cash equivalents	$	954
Accounts receivable, net	1,687
Property and equipment, net	70
Other assets	708
Amortizable intangible assets:
Customer Relationships	2,535
Developed Technology	2,862
In-Process Research and Development	610
Goodwill	3,594
Accounts payable	(323		)
Other accrued liabilities	(792		)
Deferred revenue	(365		)

Total purchase price	$	11,540

Goodwill

Of the total purchase price, approximately $3.6 million was allocated to goodwill. Goodwill represents the excess of the purchase price over the estimated fair value of the underlying net tangible and intangible assets acquired. Goodwill is not deductible for tax purposes.

Purchased identified intangible assets

Of the total purchase price, approximately $5.4 million was allocated to identified intangible assets, including customer relationships of approximately $2.5 million and developed technology of approximately $2.9 million. The Company is amortizing these intangible assets on a straight-line basis over an average estimated life of four years. Amortization expense for these intangible assets was $337,000 and $260,000 for the three-months ended April 30, 2005 and 2004, respectively. Total intangible assets subject to amortization are as follows (in thousands):

	April 30, 2005			January 31, 2005

Customer relationships	$	2,535		$	2,535
Developed technology	2,862			2,862

Gross intangible assets	5,397			5,397
Less accumulated amortization	(1,609		)	(1,272		)

Identified intangible assets, net	$	3,788		$	4,125

The aggregate estimated annual intangible amortization expense through January 31, 2009 is as follows (in thousands):

Fiscal Year	Amortization

2006	$	1,349
2007	1,349
2008	1,349
2009	78

	$	4,125

In-process research and development

Of the total purchase price, $610,000 was allocated to IPR&D. Projects that qualify as IPR&D represent those that have not yet reached technological feasibility and for which no future alternative uses exist. The charge of $610,000 for IPR&D was expensed in the Company’s operating results for the period ending April 30, 2004.

Deferred revenue

Of the total purchase price, $365,000 was allocated to deferred revenue. Deferred revenue primarily represents the fair value, based on the present value of estimated future cash flows, of fulfilling maintenance obligations under customer contracts assumed in the Tangram acquisition.

Pro forma results

The unaudited pro forma financial information below presents the combined results of operations of the Company and Tangram as if the acquisition had occurred as of the beginning of the periods presented. The unaudited pro forma financial information for the three-month period ended April 30, 2004, was derived from the Company’s unaudited condensed consolidated statements of operations for the three-month period ended April 30, 2004, which includes Tangram financial data after February 20, 2004, and Tangram’s internal statements of operations for the period of February 1, 2004 to February 19, 2004. The unaudited pro forma basic and diluted net loss per share computations are based upon the weighted average outstanding common stock of the Company during the periods presented, plus the number of shares of the Company’s common stock issued to complete the acquisition

of Tangram as if the acquisition had occurred as of the beginning of the periods presented. The pro forma financial information excludes charges for acquired IPR&D. The unaudited pro forma financial information is not intended to represent or be indicative of the consolidated results of operations or financial condition that the Company would have reported had the acquisition been completed as of the dates presented and should not be taken as representative of the future consolidated results of operations.

Unaudited pro forma financial information is as follows (in thousands, except per share amounts):

	Three Months Ended April 30,
	2004

Net revenue	$	7,944
Net loss	$	781
Basic and diluted net loss per share	$	0.01

3. Restructuring Costs

In August 2002, the Company announced a restructuring program in connection with the closing of the sale of its Managed Services Business to EDS. The restructuring program was accounted for under the provisions of Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activity,” (“SFAS 146”). The restructuring program included a provision for the resulting excess facilities located in Sunnyvale, California, and a provision for excess and obsolete property and equipment. The lease payments on excess facilities were based on management’s estimates of its ability to sublease excess facilities based on known prevailing real estate market conditions at that time. As a result, the Company recorded restructuring costs of $13.3 million in the quarter ended October 31, 2002.

In August 2003, the Company entered into an agreement to amend the facility lease of its corporate headquarters, portions of which were idle and included in the August 2002 restructuring program in connection with the closing of the sale of the Company’s Managed Services Business. Pursuant to the agreement, the Company renegotiated its lease payments and paid the lessor of its corporate headquarters approximately $7.4 million. This resulted in a reduction of its restructuring liability related to the closing of the sale of its Managed Services Business of approximately $2.2 million and a recovery of approximately $145,000 resulting from the adjustment to the present value of the remaining payments included in the original restructuring charge. The remainder of the payment was accounted for as prepaid rent and will be amortized to operating expense through May 2010, the end of the lease term.

In May 2004, the Company amended its agreement with its subtenant with respect to the Company’s facility located in Sunnyvale, California. Pursuant to the amendment, the term of the sublease was extended to August 2006, resulting in additional probable future sublease payments. As a result, the Company revised its estimates of the fair value (computed as the revised present value of the future net lease payments on vacated leased facilities) of its restructuring liability, resulting in a reduction to the recorded restructuring liability of approximately $436,000. In addition, the Company recorded a recovery for excess facilities of approximately $313,000 during the fiscal year ended January 31, 2005 due to sublease payments received. The Company also recorded a recovery due to the settlement of a sublease agreement of approximately $190,000. The sublease payments were not included in the calculation of the original 2002 restructuring charge due to the uncertainty of the financial condition of the subtenant. The Company also recorded a recovery of approximately $146,000 for property taxes, due to a change in estimate of future property tax payments as property values have decreased. Property taxes had been included in the original restructuring calculation. In addition, the Company recorded a recovery due to sublease payments received in the three-months ended April 30, 2005 of $18,000.

A summary of the restructuring charges is outlined as follows (in millions):

	Facilities			Disposal of Property and Equipment			Total

Total Charge	$	12.1		$	1.2		$	13.3
Non-cash Charges	—			(1.2		)	(1.2		)
Cash Payments	(3.2		)	—			(3.2		)

Balance at January 31, 2003	8.9			—			8.9
Adjustments	1.1			(0.1		)	1.0
Non-cash Charges	—			0.1			0.1
Cash Payments	(7.4		)	—			(7.4		)

Balance at January 31, 2004	2.6			—			2.6
Amortization	(0.1		)	—			(0.1		)

Balance at April 30, 2004	2.5			—			2.5
Amortization	(0.2		)	—			(0.2		)
Adjustments	(0.4		)	—			(0.4		)

Balance at July 31, 2004	1.9				—		1.9
Amortization	(0.1		)	—			(0.1		)

Balance at October 31, 2004	1.8				—		1.8
Amortization	(0.1		)	—			(0.1		)

Balance at January 31, 2005	1.7				—		1.7
Amortization	(0.1		)	—			(0.1		)

Balance at April 30, 2005	$	1.6			—		$	1.6

Amounts related to the remaining accrual for excess facilities will be paid over the respective lease terms through 2010.

4. Transactions with EDS

On August 15, 2002, the Company received $63.5 million in cash proceeds from the sale of its Managed Services Business to EDS. The sale included the disposal of $31.6 million of assets, including $19.6 million of property and equipment, $10.3 million of accounts receivable, $1.7 million of other current assets and $0.05 million of other assets, and $21.4 million of liabilities, including $2.6 million of accounts payable, $5.7 million of accrued liabilities, $11.2 million of deferred revenue and $1.9 million of capital leases. In addition, the Company incurred transaction costs of $2.3 million and recorded a deferred gain of $333,000 for the maintenance of software for customers transferred to EDS. The Company recognized a gain on the sale of the assets and liabilities of its Managed Services Business in the amount of $50.7 million in the three-month period ended October 31, 2002.

The Company used its proprietary Opsware automation technology in the Managed Services Business, and has since integrated this technology into its software products. As a result, the operations and cash flows of the Managed Services Business could not clearly be distinguished from the Software Business, either operationally or for financial reporting purposes. Therefore, the Managed Services Business was not considered a discontinued operation in accordance with Statement of Financial Accounting Standard No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). The Company has accounted for the sale of assets and liabilities related to the Managed Services Business as a nonoperating gain in the condensed consolidated statement of operations. The Company retained title to all of its proprietary software products.

As part of the purchase price, the Company granted EDS a license to use its software products to service those customers that were transferred to EDS, and agreed to provide certain maintenance services with respect to the license, including desktop support and software updates and enhancements on an if and when available basis. The

Company recorded a deferred gain of $388,000 for the maintenance of software for customers transferred to EDS, all of which was recognized as of the fiscal year ended January 31, 2004.

Original Software License and Maintenance Agreement

At the time that it entered into the asset purchase agreement, the Company also entered into a separate software license and maintenance agreement with EDS (“the EDS License”) pursuant to which the Company granted EDS a license to use the Company’s software products. Under the EDS License, EDS agreed to pay the Company a minimum aggregate license and maintenance fee of $52.0 million over a term of three years beginning in August 2002. EDS’ payment obligation was subject to the Company’s development and delivery of specified software product features and functions, which the Company delivered to EDS and for which the Company received acceptance from EDS in April 2003.

At the time the EDS License was signed, the Company determined it had sufficient objective and reliable evidence of fair value for both the value of the Managed Services Business sold to EDS and the separate EDS license and maintenance agreement based upon the renewal rates stated in the EDS License. The Company further determined that the $52.0 million EDS License entailed a separate earnings process and therefore did not affect the quality of use or the $63.5 million value paid by EDS for the Managed Services Business. Because the EDS License contained extended payment terms and the Company has not established VSOE of fair value for its maintenance, the Company has been recognizing the related license fees when the monthly minimum commitments become due, but only after the Company delivered all specified features and functions in April 2003. Payments received prior to delivery of the specified features and functions are being amortized as revenue by the Company on a straight-line basis over the remaining term of the contract. The Company has allocated 20% of the total license fees under the EDS License to maintenance revenue. The allocation is consistent with the pricing of license and maintenance agreements with other customers. The payments from EDS License were equal to the greater of the monthly minimum commitment or the actual monthly fees, based upon a defined license fee per device per month. Under the EDS License, EDS was required to pay the Company monthly minimum commitment fees of $333,000 for the first six months of the initial term (which commenced on August 16, 2002), $1.3 million for the next twelve months, $1.7 million for the following six months, and $2.0 million per month thereafter until completion of the initial three-year term in August 2005.

Amendments to the EDS License

In August 2004, the Company entered into an amendment to the EDS License. Pursuant to the amendment, (1) the term of the original license and maintenance agreement was extended through March 2008, (2) EDS is required to pay the Company $2.0 million per month from August 15, 2004 through August 14, 2005 and $1,583,333 per month thereafter through March 2008, (3) EDS’ monthly payments are no longer dependent upon the number of devices being managed by the software products, (4) EDS receives rights to license all future products released by the Company, when and if available for commercial release, for no additional fee, (5) the Company agreed to provide certain third-party equipment and software for EDS’ use in connection with the software products, and (6) dedicated Opsware support personnel will continue to be provided to EDS for the duration of the extended term. Following the extended term, the agreement will automatically renew at a fee of $1,583,333 per month for five successive one-year terms unless terminated in advance by EDS. Revenue under the amended arrangement will continue to be recognized based on the lesser of ratably or when monthly payments become due over the extended term of the amended agreement.

In October 2004, the Company entered into another amendment of the EDS License pursuant to which the Company provided EDS with $4.0 million for the purchase of computer equipment required to support the planned deployment of the software products within EDS’ facilities. As a result of this amendment, the Company was released from any further obligation to provide any equipment to EDS. Accordingly, the amounts paid to EDS pursuant to the amendment have been charged to cost of sales as a contract acquisition cost.

5. Stock-Based Compensation

In August 2003, the Company issued an award of restricted stock of 105,000 shares to an executive officer. The issuance resulted in a non-cash compensation charge of approximately $588,000. The expense is being amortized to sales and marketing in the condensed consolidated statement of operations over the three-year vesting period of the stock award. The Company recognized approximately $33,000 and $85,000 of stock compensation expense using

the graded vesting method in the three-month periods ended April 30, 2005 and 2004, respectively, with respect to this award.

In June 2002, at the request of its President and Chief Executive Officer, the Company cancelled an option held by him to purchase 500,000 shares with an exercise price of $18.00 per share. The cancellation of this option resulted in variable accounting expense with respect to the issuance of another option to purchase 500,000 shares with an exercise price of $3.68 held by him. Variable accounting requires recognition of compensation expense, adjusted for increases or decreases in market value, until the options are exercised, forfeited or expire. The Company recognized $(295,000) and $(330,000) of stock compensation expense (recovery) with respect to this option during the three-month periods ended April 30, 2005 and 2004, respectively. The expense (recovery) is being reported in general and administrative expenses in the condensed consolidated statements of operations.

As discussed in Note 1, the Company applies APB 25 and related interpretations in accounting for the Company’s option plans. The Company recorded deferred stock compensation prior to its initial public offering related to grants of stock purchase rights and options with exercise prices below the deemed fair value of its common stock. Additionally, the acquisition of Rendition Networks resulted in the Company recording deferred stock compensation of $1.5 million.

Stock-based compensation expense (recovery) of $415,000 and $(122,000) was recognized using the graded vesting method for the three-month periods ended April 30, 2005 and 2004, respectively. The Company reversed approximately $0 and $200,000 from stock compensation expense related to employees that were terminated during the three-month periods ended April 30, 2005 and 2004, respectively. The reversals were related to previously recognized expense on stock awards for which the terminated employees had not vested in the underlying shares. As a result, the difference between the expense recorded under the graded vesting method and the expense that would have been recorded under the straight-line vesting method was required to be reversed upon termination of these employees. In addition, the Company recorded $415,000 and $78,000 in amortization expense during the three-month periods ended April 30, 2005 and 2004, respectively. The Company’s policy is to use the graded vesting method for recognizing compensation cost for fixed awards with pro rata vesting. The Company amortizes the deferred stock-based compensation on the graded vesting method over the vesting periods of the applicable stock purchase rights and stock options, generally four years. The graded vesting method provides for vesting of portions of the overall awards at interim dates and results in greater vesting and expense in earlier years than the straight-line method. In addition, the Company reversed approximately $0 and $5,000 of unamortized deferred stock compensation related to unvested awards of terminated employees during the three-month periods ended April 30, 2005 and 2004, respectively.

6. Segment Information

Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information,” establishes standards for reporting information about operating segments in the Company’s financial statements. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. The Company’s chief operating decision maker is the Chief Executive Officer of the Company. During the periods ended April 30, 2005 and 2004, the Company had only one operating segment focusing on the Software Business. The Company is organized geographically between the United States, Europe and Asia. While the Chief Executive Officer of the Company evaluates results in a number of different ways, the geographic structure is the primary basis for which allocation of resources and financial performance are assessed. Net revenue by geographic location is as follows (in thousands):

	Three Months Ended April 30,
	2005		2004
	(unaudited)
Revenue generated in North America (1)	$	9,554	$	6,724
Revenue generated in Europe (1)	2,149		139
Revenue generated in Asia	912		475

	$	12,615	$	7,338

(1) For the three-month period ended April 30, 2005, EDS and British Sky Broadcasting accounted for 41% and 14% of the Company’s net revenue. For the three-month period ended April 30, 2004, EDS and Northrop Grumman accounted for 65% and 15% of the Company’s net revenue.

Net long-lived assets and total assets are located primarily in the United States.

7. Settlements

In May 2004, the Company and Qwest entered into a settlement of the arbitration of Qwest’s claim that the Company breached the amended and restated ethernet collocation internet access service agreement, amended and restated reseller agreement and confidentiality agreement that the Company entered into with Qwest in fiscal 2002. Prior to this settlement, the Company accrued a liability related to its Managed Services Business in the amount of $6.8 million in connection with Qwest’s claim. In connection with the settlement, the Company paid $2.0 million to Qwest and transferred ownership of certain items of equipment to Qwest, with an aggregate fair market value of approximately $170,000. In addition, the Company and Qwest reserved from the settlement any claims either party may have under the guaranteed term agreement between the parties, up to an aggregate maximum of $300,000. As a result of the settlement, the Company reversed approximately $4.3 million of previously accrued data center facility costs and recognized a gain on sale of assets and liabilities from the Managed Services Business in the consolidated statements of operations for the quarter ended April 30, 2004.

8. Net Income (Loss) Per Share

The Company follows the provisions of Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (“SFAS 128”). Basic and diluted net income (loss) per share is computed using the weighted average number of common shares outstanding during the period less outstanding nonvested shares. Outstanding nonvested shares are not included in the computation of basic consolidated net income (loss) per share until the time-based vesting restrictions have lapsed and are not included in the computation of diluted net income (loss) per share because their effect would be antidilutive. Diluted net loss per share excludes potential common shares outstanding as their effect is antidilutive, and also excludes nonvested shares as their effect is also antidilutive. The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share amounts):

	Three Months Ended April 30,
	2005			2004

Numerator:
Net income (loss)	$	(5,129	)	$	2,017
Denominator:
Weighted average common shares outstanding	98,122			82,823
Less weighted average shares subject to repurchase	(495		)	(772		)

Shares used in basic net income (loss) per share	97,627			82,051
Diluted impact of employee stock plans	—			7,491

Shares used in diluted net income (loss) per share	97,627			89,542

Basic net income (loss) per share	$	(0.05	)	$	0.02

Diluted net income (loss) per share	$	(0.05	)	$	0.02

For the three-month period ended April 30, 2005, the Company excluded 16.1 million and shares of common stock. The Company has excluded the impact of all shares of common stock subject to repurchase, warrants, and stock options from the calculation of historical diluted consolidated net loss per common share because all such securities are antidilutive.

For the three-month period ended April 30, 2004, the Company excluded 5.4 million shares of common stock. The Company has excluded the impact of all shares of common stock subject to repurchase, warrants, and stock options from the calculation of historical diluted consolidated net income per common share, as the exercise price of the stock options associated with these shares was greater than the Company’s average stock price as of April 30, 2004, and, therefore the effect would have been antidilutive.

9. Legal Proceedings

As of the date of filing of this Quarterly Report, the Company was not involved in any material legal proceedings. In the future, the Company may be subject to legal proceedings. Any litigation, even if not successful against the Company, could result in substantial costs and divert management’s attention and other resources away from the operation of its business.

10. Guarantees and Indemnifications

The Company from time to time in the ordinary course of its business enters into contractual arrangements with third parties under which the Company has agreed to defend, indemnify and hold the third party harmless from and against certain losses. These arrangements may limit the time within which an indemnification claim can be made, the type of the claim and the total amount that the Company can be required to pay in connection with the indemnification obligation. For example, the Company has entered into certain real estate leases that require it to indemnify property owners against certain environmental claims. However, the Company only engages in the development, marketing and distribution of software, and has never been subject to any environmental related claim. The Company is also responsible for certain costs of restoring leased premises to their original condition. In addition, the Company has entered into indemnification agreements with its directors and officers, and the Company’s bylaws contain indemnification obligations in favor of the Company’s directors, officers and agents.

It is not possible to determine or reasonably estimate the maximum potential amount of future payments under any of these indemnification obligations due to the varying terms of such obligations, the lack of any history of prior indemnification claims and the unique facts and circumstances involved in each particular contractual arrangement and in each potential future claim for indemnification. The Company has not had any claims for indemnification under any of these arrangements, nor has it had a history of indemnifying third parties. The Company believes that the likelihood of these indemnifications is remote. As a result, the Company has not recorded a liability under these arrangements.

11. Income Taxes

The Company has incurred losses from operations for the three-month period ended April 30, 2005, and therefore no income tax provision has been recorded other than $2,000 in estimated state income tax. The Company has recorded an income tax provision for foreign withholding taxes paid in connection with the sale of a software license to one of its customers for the three-month period ended April 30, 2004.

12. Recent Accounting Pronouncement

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”), which establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. A key provision of this statement is the requirement of a public entity to measure the cost of employee services received in exchange for an award of equity instruments (including stock options) based on the grant date fair value of the award and recognize such cost over the vesting period. In the absence of further changes, SFAS 123R will be effective for the Company’s fiscal quarter beginning February 1, 2006, and requires the use of either the Modified Prospective or the Modified Retrospective application method. Under the Modified Prospective method, SFAS 123R is applied to new awards and to awards modified, repurchased, or cancelled after the effective date. Compensation cost for the portion of awards for which service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining services are rendered. If the Modified Retrospective method is applied, financial statements for prior periods shall be adjusted to give effect to the fair-value-based method of accounting for awards on a consistent basis with the pro forma disclosures required for those periods under the original SFAS 123. In the absence of further changes, the Company will be adopting the Modified Prospective method of accounting for SFAS 123R. The Company has not yet determined the impact of the adoption of SFAS 123R on its consolidated financial statements.

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

The following discussion should be read together with the condensed consolidated financial statements and the related notes included elsewhere in this Quarterly Report on Form 10-Q. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from those projected in the forward-looking statements. Factors that might cause future results to differ materially from those projected in the forward-looking statements include, but are not limited to, those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in “Risk Factors.” See also “Cautionary Statement Regarding Forward-Looking Statements.” The condensed consolidated financial statements and related information contained in this Quarterly Report on Form 10-Q reflect our results as they existed for the interim periods presented.

Overview

We are a provider of IT automation software for enterprises, government agencies and service providers seeking to reduce the cost and improve the quality of IT operations. In this quarterly report, we refer to this business as our Software Business. Our software products include the Opsware Server Automation System (OSAS), the Opsware Network Automation System (ONAS) and the Opsware Asset Management System (OAMS). Our software products automate IT operations across servers, software, applications and network devices and discover and track assets across the IT environment. OSAS automates key network, server, software and application operations. ONAS automates network device operations for large data centers and remote locations. OAMS enables IT organizations to discover IT hardware and software assets, track these assets on an ongoing basis and reduce costs of excess hardware and software purchases, unnecessary maintenance renewals and underutilization of idle and redundant assets. Our software products automate formerly manual, time-consuming and error-prone tasks, including the provisioning, changing, auditing, patching, reporting, configuring, scaling, securing and recovering of servers, software, business applications and network devices.

We derive a significant portion of our revenue from sales of software licenses. We sell our products principally through our direct sales force and intend to develop additional indirect channels with corporate partners, such as distributors, value-added resellers, hardware providers and systems integrators. We also derive revenue from sales of annual support and maintenance agreements and professional services.

Management Discussion

For the three-month periods ended April 30, 2005 and 2004, 41% and 65% of our revenues came from our license and maintenance agreement with EDS, respectively. Although the percentage of our total revenues coming from customers other than EDS has increased in recent quarters, we expect that our operating results will continue to be largely dependent on our relationship with EDS for the foreseeable future.

On February 3, 2005, we completed our acquisition of Rendition Networks, Inc. (“Rendition Networks”), a provider of network device automation software located in Redmond, Washington. In this acquisition, we acquired our Network Automation System product, which enables us to create an integrated product solution that allows customers to manage multiple aspects of their IT infrastructure. For purchase accounting purposes, the transaction was valued at approximately $34.2 million, which included shares of our common stock valued at $16.4 million, cash of $15.0 million, assumed options and unvested restricted stock with a fair value of $2.2 million and approximately $0.6 million of direct acquisition costs. See Note 2, “Acquisitions” in the notes to the condensed consolidated financial statements for a further description of this transaction.

In May 2005, we announced a major new product, code-named “Darwin,” for our Server Automation System. The Darwin product offers a wide range of new capabilities and feature sets, and is expected to be generally available beginning in June 2005.

Relationship with EDS

Prior to August 2002 (fiscal year ending January 31, 2003), we primarily provided managed Internet services for corporations and government agencies operating mission-critical Internet applications. We referred to this business as our Managed Services Business. We used our proprietary Opsware automation technology in the Managed Services Business, and have since integrated this technology into our software products. In August 2002, we sold our Managed Services Business to EDS for a total purchase price of $63.5 million in cash pursuant to an asset purchase agreement. At that time, we also entered into a separate license and maintenance agreement with EDS pursuant to which we granted EDS a license whereby EDS has certain rights to use our software products. Under the license and maintenance agreement, EDS agreed to pay us a minimum license and maintenance fee of $52.0 million in the aggregate over a term of three years.

In August 2004, we entered into an amendment of our license and maintenance agreement with EDS whereby EDS agreed to extend the term of the agreement through March 2008 and committed to pay minimum additional license and maintenance fees of approximately $50.0 million over the term of the extended license. These payments are in addition to the previous $52.0 million commitment EDS initially made in August 2002. Pursuant to our amendment of this agreement, (1) the term of the original agreement was extended through March 2008, (2) EDS is required to pay $2.0 million per month from August 15, 2004 through August 14, 2005 and $1,583,333 per month thereafter through March 2008, (3) EDS’ monthly payments are no longer dependent upon the number of devices being managed by our software products, (4) EDS receives rights to license all future products released by us, when and if available for commercial release, for no additional fee, (5) we agreed to provide certain third-party equipment and software for EDS’ use in connection with our software products, and (6) dedicated Opsware support personnel will continue to be provided to EDS for the duration of the extended term. Following the extended term, the agreement will automatically renew at a fee of $1,583,333 per month for five successive one-year terms unless terminated in advance by EDS. Revenue under this arrangement will continue to be recognized ratably or, if earlier, when monthly payments become due over the extended term of the amended agreement.

In October 2004, we entered into a second amendment of the license and maintenance agreement with EDS pursuant to which we provided EDS with $4.0 million for their purchase of computer equipment required to support their planned deployment of our software products within EDS’ facilities. As a result of this amendment, we have no further obligation to provide any equipment to EDS.

Results of Operations

Net revenue

Major Customers. For the three-months ended April 30, 2005 and 2004, the following customers accounted for over 10% of our license, services and net revenue:

	Three Months Ended April 30,
	2005		2004

License Revenue
EDS	51	%	69	%
British Sky Broadcasting	14	%	—
Northrop Grumman	—		14	%
Services Revenue
EDS	23	%	52	%
British Sky Broadcasting	14	%	—
Northrop Grumman	—		19	%
Net Revenue
EDS	41	%	65	%
British Sky Broadcasting	14	%	—
Northrop Grumman	—		15	%

We expect that significantly more than 10% of our revenue in the current fiscal year will be attributable to the license and maintenance agreement with EDS.

License revenue. License revenue consists of fees for term or perpetual licenses. License revenue increased to $8.1 million during the three-month period ended April 30, 2005 from $5.4 million during the three-month period ended April 30, 2004. The increase was due to an increase in our customer base, including an approximately 200% increase in revenue derived from customers other than EDS during the three-month period ended April 30, 2005 as compared with the three-month period ended April 30, 2004.

Due to our revenue recognition policy, a substantial portion of the revenue that we recognize in a particular fiscal quarter period is not necessarily indicative of sales activity during that period, but rather generally relates back to sales in prior quarterly periods. Please see the section titled “Critical Accounting Policies” for a description of our revenue recognition policy.

Services revenue. Services revenue consists of fees for annual support and maintenance and professional services. Services revenue increased to $4.5 million during the three-month period ended April 30, 2005 from $1.9 million during the three-month period ended April 30, 2004. The increase was due to increased maintenance revenue that we were able to recognize as our customer base increased.

Costs and Expenses

Cost of license revenue. Cost of license revenue consists of royalties related to third-party technologies included in our software. Cost of license revenue increased in absolute dollars, and remained consistent as a percentage of license revenue, to $80,000, or 1% of license revenue, during the three-month period ended April 30, 2005, from $46,000, or 1% of license revenue, during the three-month period ended April 30, 2004. The increase in absolute dollars in comparison to the prior periods was primarily due to additional royalties due to increased sales of royalty bearing products.

Cost of services revenue. Cost of services revenue consists primarily of salaries and related personnel expenses of employees who provide services to our customers, fees for consulting services, facility costs and travel expenses. Cost of services revenue increased in absolute dollars, and decreased as a percentage of services revenue, to $2.9 million, or 66% of services revenue, during the three-month period ended April 30, 2005, from $1.7 million, or 87% of services revenue, during the three-month period ended April 30, 2004. The increase in absolute dollars in the three-month period was primarily due to increased salaries and related personnel expenses due to an increase in headcount from 34 on April 30, 2004 to 54 on April 30, 2005, which reflects the effect of additional hiring necessary to meet the current needs of our business and increased outsourced contractor fees to fulfill service obligations as a result of the increase in our customer base, while the decrease as a percentage of services revenue was primarily due to a greater increase in revenue relative to costs reported during the three-month period ended April 30, 2005.

Amortization of developed technology. Amortization of developed technology increased in absolute dollars to $0.4 million during the three-month period ended April 30, 2005, from $0.1 million during the three-month period ended April 20, 2004. As a result of the acquisition of Rendition Networks in February 2005, we began amortizing purchased developed technology beginning in the three-month period ended April 30, 2005. The value assigned to developed technology was approximately $3.7 million, which is being amortized on a straight-line basis over a four-year life at a rate of approximately $233,000 per quarter. As a result of the acquisition of Tangram in February 2004, we began amortizing purchased developed technology beginning in the three-month period ended April 30, 2004. The value assigned to developed technology was approximately $2.9 million, which is being amortized on a straight-line basis over a four-year life at a rate of approximately $179,000 per quarter.

Research and development. Research and development expenses consist primarily of salaries and related personnel expenses, fees for consulting services, facility costs and amortization of purchased equipment and software. Research and development expenses increased in absolute dollars and as a percentage of net revenue to $5.4 million, or 43% of net revenue, during the three-month period ended April 30, 2005 from $2.6 million, or 35% of net revenue, during the three-month period ended April 30, 2004. The increase in absolute dollars in the three-month period was primarily due to increased salaries and related personnel expenses due to an increase in headcount from 64 on April 30, 2004 to 113 on April 30, 2005, which reflects the effect of the Rendition Networks acquisition as well as additional hiring necessary to meet the current needs of our business. The increase as a percentage of net revenue was primarily due to a lower increase in revenue relative to the increase in expenses reported during the three-month period ended April 30, 2005.

Sales and marketing. Sales and marketing expenses consist primarily of salaries, commissions and related personnel expenses, travel expenses, advertising expenses, trade shows and other promotional expenses and facility costs. Sales and marketing expenses increased in absolute dollars, and decreased as a percentage of net revenue, to $5.0 million, or 40% of net revenue, during the three-month period ended April 30, 2005 from $3.1 million, or 42% of net revenue, during the three-month period ended April 30, 2004. The increase in absolute dollars was primarily due to increased salaries and related personnel expenses as well as an increase in related recruiting costs due to an increase in headcount from 32 on April 30, 2004 to 64 on April 30, 2005, which reflects the effect of the Rendition Networks acquisition as well as additional hiring necessary to meet the current needs of our business, increased advertising and promotional activities and increased commissions due to increased sales. The decrease as a percentage of net revenue was primarily due to a greater increase in revenue relative to the increase in expenses reported in the three-month period ended April 30, 2005.

We expect that each of our cost of license revenue, cost of service revenue, research and development expenses and sales and marketing expenses will increase in absolute dollars in the next fiscal quarter as we continue to grow our business.

General and administrative. General and administrative expenses consist primarily of salaries and related personnel expenses, fees for outside professional services and non-cash compensation charges (recovery) for the cancellation and modification of stock option awards. General and administrative expenses increased in absolute dollars and as a percentage of net revenue to $2.6 million, or 21% of net revenue, during the three-month period ended April 30, 2005 from $1.4 million, or 19% of net revenue, during the three-month period ended April 30, 2004. The increase in absolute dollars and as a percentage of net revenue was primarily due to increased salaries and related personnel expenses due to an increase in headcount from 29 on April 30, 2004 to 35 on April 30, 2005, which reflects the effect of additional hiring necessary to meet the current needs of our business, and increased costs incurred related to Sarbanes-Oxley compliance. Excluding the effect of costs incurred related to Sarbanes-Oxley compliance and any non-cash compensation charges in connection with the revaluation of variable stock option awards or modification of stock option awards, which cannot be determined until the last day of the quarter, we expect that our general and administrative expenses will increase in absolute dollars in the next fiscal quarter as we continue to grow our business.

In-process research and development charges. In-process research and development was $1.2 million and $610,000 during the three-month periods ended April 30, 2005 and April 30, 2004, respectively. In the three-month period ended April 30, 2005, this charge resulted solely from the write-off of in-process research and development costs in connection with the acquisition of Rendition Networks. In the three-month period ended April 30, 2004, this charge resulted solely from the write-off of in-process research and development costs in connection with the acquisition of Tangram.

Products that qualify for in-process research and development represent those that have not reached technical feasibility and for which no alternative future uses exist. The products were still in development at the time of the acquisitions. The income approach was used to value in-process research and development. The ONAS product, True Control 4.0, has been completed and we began shipping the product as of the three month period ended April 30, 2005. The OAMS product version is still under development as of April 30, 2005 and the exact date of completion has not yet been determined.

Restructuring costs (recoveries), net. In fiscal 2003, we announced a restructuring program in connection with the closing of the sale of our Managed Services Business to EDS and recorded restructuring costs of $13.3 million in the three-month period ended October 31, 2002. The restructuring program included a worldwide workforce reduction, a provision for the resulting excess facilities and a provision for excess and obsolete property and equipment. The lease payments on excess facilities were based on management’s estimates of our ability to sublease excess facilities based on known prevailing real estate market conditions at that time. During the three-month period ended April 30, 2005 and April 30, 2004, we recorded a recovery for sublease payments received of approximately $18,000 and $150,000, respectively. See Note 3, “Restructuring Costs,” in the notes to the condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q for a further discussion of these restructuring charges.

Amortization of other acquisition-related intangibles. As a result of the acquisition of Rendition Networks, we began amortizing customer relationships through operating expenses beginning in the three-month period ended April 30, 2005. The aggregate value assigned to all Rendition Networks customer relationships was $2.7 million, which is being amortized on a straight-line basis over a four-year life at a rate of approximately $169,000 per quarter. As a result of the acquisition of Tangram, we began amortizing customer relationships through operating expenses beginning in the three-month period ended April 30, 2004. The aggregate value assigned to all Tangram customer relationships was $2.5 million, which is being amortized on a straight-line basis over a four-year life at a rate of approximately $158,000 per quarter.

Amortization (reversal) of deferred stock compensation. Amortization (reversal) of deferred stock compensation was approximately $415,000 in the three-month period ended April 30, 2005 compared to ($122,000) in the three-month period ended April 30, 2004. As a result of our acquisition of Rendition Networks, we recorded $1.5 million of deferred stock compensation on our balance sheet. The expense of $415,000 for the three-month period ended April 30, 2005 consisted solely of amortization of this deferred stock compensation. Amortization expense of $78,000 in the three-month period ended April 30, 2004 was more than offset by the reversal of $200,000 of deferred stock compensation as a result of the termination of employees who held unvested shares for which amortization expense had previously been recorded.

In accordance with SFAS 123, when we grant stock options to employees and directors, we do not currently record compensation expense. Rather, we have elected to continue to recognize stock-based compensation expense under APB 25 and provide pro forma disclosures of the impact on our operating results if we had accounted for stock-based compensation under SFAS 123. See Note 1, “Summary of the Company and Significant Accounting Policies,” in the notes to the condensed consolidated financial statements for a description of our policy with respect to our accounting treatment for stock-based compensation pursuant to SFAS 123 and APB Opinion No. 25. However, effective for the Company’s fiscal quarter beginning February 1, 2006, the Company will recognize compensation expense for equity awards to employees in accordance with SFAS No. 123R, “Share-Based Payment.” See Note 12, “Recent Accounting Pronouncement” in the Notes to the condensed consolidated financial statements for a description of the new requirement.

Gain on sale of assets and liabilities from Managed Services Business. In May 2004, we entered into a settlement with Qwest of the arbitration of Qwest’s claim that we breached the amended and restated ethernet collocation internet access service agreement, amended and restated reseller agreement and confidentiality agreement that we entered into with Qwest in fiscal 2002. Prior to this settlement, we accrued a liability related to our Managed Services Business in the amount of $6.8 million in connection with Qwest’s claim. In connection with the settlement, we paid $2.0 million to Qwest and transferred ownership of certain items of equipment to Qwest, with an aggregate fair market value of approximately $170,000. In addition, the parties excluded from the settlement any claims either party may have under the guaranteed term agreement between the parties, up to an aggregate maximum of $300,000. As a result of the settlement, we reversed approximately $4.3 million of previously accrued data center facility costs and recognized the gain as a component of the sale of assets and liabilities from the Managed Services Business in the consolidated statements of operations for the period ended April 30, 2004.

During the three-month period ended April 30, 2005, we recorded $33,000 in sales tax related to the sale of the Managed Service Business.

Interest and other income, net. Interest and other income, net, increased to income of $646,000 in the three-month period ended April 30, 2005 from income of $133,000 in the three-month period ended April 30, 2004, primarily due to an increase in cash due to net proceeds from the sale of 10 million shares of our common stock in December 2004, net of cash paid for Rendition Networks, as well as increased interest rates.

Provision for income taxes. Provision for income taxes decreased to $2,000 in the three-month period ended April 30, 2005 from $373,000 in the three-month period ended April 30, 2004. We incurred losses from operations for the three-month period ended April 30, 2005 and, accordingly, did not make any provision for income taxes other than an immaterial provision for estimated state income tax. We have recorded an income tax provision for foreign withholding taxes paid in connection with the sale of a software license to one of our customers during the three-month period ended April 30, 2004.

Liquidity and Capital Resources

Since inception, we have financed our operations primarily through customer revenue, the sale of our securities, the sale of our Managed Services Business and, to a lesser extent, operating equipment lease financing and capital equipment lease financing. As of April 30, 2005, we had approximately $105.4 million in cash, cash equivalents and restricted cash. On December 15, 2004, we received approximately $61.8 million of net proceeds from the sale of 10 million shares of our common stock.

Net cash provided by (used in) operating activities was $(1.2) million and $1.1 million for the three-month periods ended April 30, 2005 and April 30, 2004, respectively. Net cash used in operating activities for the three-month period ended April 30, 2005 was primarily the result of our net operating loss of $5.1 million (which included a $1.2 million write-off of in-process research and development as part of the acquisition of Rendition Networks), and a $4.2 million decrease in advances from customers, offset by a $0.4 million increase in accounts receivable, $0.8 million depreciation and $0.7 million amortization expense, and a $5.2 million increase in deferred revenue.

Net cash provided by operating activities for the three-month period ended April 30, 2004 was primarily the result of our net income of $2.0 million, (including a $0.6 million write-off of in-process research and development as part of the acquisition of Tangram), $0.6 million depreciation and $0.3 million amortization expense, a $3.8 million increase in deferred revenue, offset by a $4.3 million decrease in accrued data center costs, and a $0.5 million decrease in accounts receivable.

Net cash provided by (used in) investing activities was approximately $(15.6) million and $42,000 for the three-month periods ended April 30, 2005 and April 30, 2004, respectively. Net cash used in investing activities for the three-month period ended April 30, 2005 consisted of $15.0 million in direct acquisition costs paid related to the acquisition of Rendition Networks and purchases of capital equipment, partially offset by a decrease in restricted cash. Net cash provided by investing activities for the three-month period ended April 30, 2004 consisted of net cash acquired from the acquisition of Tangram, partially offset by an increase in direct acquisition costs paid related to the acquisition of Tangram and purchases of capital equipment.

Net cash provided by financing activities was $1.2 million and $1.6 million for the three-month periods ended April 30, 2005 and April 30, 2004, respectively. Net cash provided by financing activities for the three-month period ended April 30, 2005 was primarily attributable to proceeds received from the exercise of stock options. Net cash provided by financing activities for the three-month period ended April 30, 2004 was primarily attributable to proceeds received from the exercise of stock options and payments received from stockholder notes receivable.

As of April 30, 2005, our principal commitments consisted of obligations outstanding under operating leases for facilities. The following summarizes our contractual obligations at April 30, 2005 and the effect such obligations are expected to have on its liquidity and cash flow in future periods (in thousands):

			Less						Greater
			than 1		1-3		4-5		than 5
Contractual Obligations	Total		Year		Years		Years		Years
Operating leases, net of subleases	$	9,079	$	1,928	$	3,522	$	3,481	$	148

We believe that our current cash balances, including cash and cash equivalents, and cash flows from operations will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. Nevertheless, we may seek additional capital through the issuance of public and/or private equity if the market permits, equipment lease facilities, bank financings or arrangements with strategic partners to expand our business. Capital requirements will depend on many factors, including the rate of sales growth, market acceptance of our products, costs of providing our products and services, the timing and extent of research and development projects and increases in our operating expenses. To the extent that existing cash and cash equivalents balances and cash flows from operations are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. We cannot be sure that additional financing will be available if necessary or available on reasonable terms. We may from time to time evaluate potential acquisitions of other businesses, services, products and technologies, which could increase our capital requirements. For example, in February 2005, we completed the acquisition of Rendition Networks, and paid $15 million in cash as part of the acquisition price.

Recent Accounting Pronouncement

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”) which establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. A key provision of this statement is the requirement of a public entity to measure the cost of employee services received in exchange for an award of equity instruments (including stock options) based on the grant date fair value of the award and recognized over the vesting period. SFAS 123R will be effective for our fiscal quarter beginning February 1, 2006, and requires the use of either the Modified Prospective or the Modified Retrospective application method. Under the Modified Prospective method, SFAS 123R is applied to new awards and to awards modified, repurchased or cancelled after the effective date. Compensation cost for the portion of awards for which service has not been rendered (such as unvested options) that are outstanding as of the date of adoption shall be recognized as the remaining services are rendered. If the Modified Retrospective method is applied, financial statements for prior periods shall be adjusted to give effect to the fair-value-based method of accounting for awards on a consistent basis with the pro forma disclosures required for those periods under the original SFAS 123. We will be adopting the Modified Prospective method of accounting for SFAS 123R. We have not yet determined the impact of the adoption of SFAS 123R on our consolidated financial statements.

Critical Accounting Policies

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 condensed consolidated financial statements. Actual results could differ from these estimates. In addition, our estimates may change based upon changed circumstances and as we reassess our underlying assumptions from time to time. The SEC has described 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 believe the following are our critical accounting policies, which affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition. We recognize software revenue in accordance with the American Institute of Certified Public Accountants’ (“AICPA”) Statement of Position No. 97-2 (“SOP 97-2”), “Software Revenue Recognition,” as amended by Statement of Position No. 98-4, “Deferral of the Effective Date of SOP 97-2, ‘Software Revenue Recognition’” (“SOP 98-4”), Statement of Position No. 98-9, “Modification of SOP 97-2 with Respect to Certain Transactions” (“SOP 98-9”), and Statement of Position No. 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts” (“SOP 81-1”). For each transaction, we determine whether evidence

of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility of the fee is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all criteria are met. We consider all arrangements with payment terms extending beyond twelve months not to be fixed or determinable in which case revenue is recognized no earlier then when payments become contractually due. If collectibility is not considered probable, revenue is recognized when the fee is collected. No customer has a right of return privilege.

We generate revenue from the sale of our software licenses and services including revenue from maintenance and support agreements and professional service agreements. Through the quarter ended April 30, 2005, we recognized a majority of our revenue ratably over the remaining post-contract support (“maintenance”) obligation period once deployment of our software had been completed and all other elements of the arrangement had been delivered because we had not established vendor specific objective evidence (“VSOE”) of fair value of our maintenance for our OSAS product.

Revenue from the sale of OSAS software licenses is comprised of fees for multi-year or perpetual licenses under contracts with customers. For perpetual licenses, until we established VSOE of fair value for maintenance, the license, maintenance and professional services revenue was recognized ratably over the remaining maintenance period once all elements except maintenance had been delivered. For term licenses accompanied by maintenance, the entire arrangement fee is recognized ratably over the term of the license period. Subsequent to the establishment of VSOE of fair value for maintenance, we will recognize perpetual license revenue based upon the residual method after all elements other than maintenance and non-essential professional services have been delivered with consideration to individual contract terms and conditions and as prescribed by SOP 98-9. We will then recognize maintenance revenue ratably over the term of the maintenance contract. In accordance with paragraph 10 of SOP 97-2, VSOE of fair value for maintenance is determined by reference to the price charged to the customer for maintenance when it is sold separately (that is, the stated or renewal rate). Customers that enter into license agreements where maintenance for the initial twelve months is included in the license fee generally have the ability to renew the maintenance contract for an additional one year term at the renewal rate (that is, the price for maintenance when sold separately). Maintenance contracts are generally one year in duration.

In the case of OAMS and ONAS software, for which we have established VSOE of fair value for maintenance, we recognize perpetual license revenue based upon the residual method after all elements other than maintenance have been delivered, provided that all of the criteria for revenue recognition discussed above are met. Generally, these criteria are met at the time of delivery. For software arrangements involving multiple elements, revenue is allocated to each element based on the relative fair values of the elements. The fair value of an element is based on VSOE for that element. We establish VSOE based on the price charged when the same element is sold separately. If VSOE of all undelivered elements exists but VSOE does not exist for one or more delivered elements, then revenue is recognized based on the residual method.

Services revenue consists of revenue from maintenance and support agreements and professional services arrangements. In all cases, we assess whether the service element of the arrangement is essential to the functionality of any other elements of the arrangement. Through the quarter ended April 30, 2005, when services (excluding maintenance and support services) were considered essential to the arrangement, the service revenue fee was recognized ratably over the remaining maintenance period beginning once the services were completed and delivered, as we did not have VSOE of fair value for maintenance for OSAS.

For those arrangements where we have concluded that the services element is not essential to the other elements of the arrangement, we then determine whether: (1) the services are available from other vendors, (2) the services do not involve a significant degree of risk or unique acceptance criteria and (3) it is able to provide the services in order to separately account for the services revenue. When the services qualify for separate accounting, we use VSOE of fair value for the services and maintenance, if available, to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element. Revenue allocable to services is recognized as the services are performed. Through the quarter ended April 30, 2005, we did not have VSOE of fair value of services. Consequently, upon delivery of the software and any services, the entire arrangement fee was recognized ratably over the remaining maintenance period. In the case of pre-packaged software for which we have established VSOE of fair value for maintenance, we recognize revenue for maintenance using the straight-line method over the period that the maintenance is provided, generally one year. Revenue from training arrangements or seminars and from consulting services is recognized as the services are performed or seminars are held.

VSOE of fair value for professional services is based upon hourly or daily rates. We enter into stand-alone contracts for professional services and these contracts provide for payment on a time and materials basis. The hourly or daily rates associated with these contracts are used to determine the VSOE of fair value of professional services in multi-element arrangements.

We recognize revenue associated with software licenses and services sold to distributors, system integrators and value added resellers (collectively, “resellers”) upon satisfaction of all revenue recognition criteria unless it is aware that a reseller does not have a purchase order or other contractual agreement from an end user. In connection with sales to resellers, there is no right of return or price protection.

If we have not met the criteria for revenue recognition, we defer revenue recognition until such time as all criteria are met. If we have not met the criteria for revenue recognition and have received cash from a customer, the amounts received are included in advances from customers. If we have met the criteria for revenue recognition, whether or not we have received cash from a customer, the amounts billed are recorded as deferred revenue and recognized into revenue over the period services are provided.

Impairment of Long-Lived Assets and Intangible Assets. We continually review the carrying value of long-lived assets, including property and equipment and other identified intangible assets, to determine whether there are any indications of impairment. Some indicators of impairment include but are not limited to, a decrease in the market price of a long-lived asset, an adverse change in the extent or manner in which a long-lived asset is being used, a change in the business climate that could affect the value of a long-lived asset or a current-period operating or cash flow loss combined with a history of operating or cash flow losses. According to our accounting policy, when such indicators are present, if the undiscounted cash flows expected to be generated from operations from those long-lived assets are less than the carrying value of those long-lived assets, we compare the fair value of the assets (estimated using discounted future net cash flows to be generated from the lowest common level of operations utilizing the assets) to the carrying value of the long-lived assets to determine any impairment charges. We reduce the carrying value of the long-lived assets if the carrying value of the long-lived assets is greater than their fair value. The new carrying value is then depreciated over the remaining estimated useful lives of the assets. The determination as to whether impairment exists involves significant judgment and the assumptions supporting the estimated future cash flows reflects management’s best estimates.

Impairment of Goodwill. We account for goodwill in accordance with Statement of Financial Accounting Standards No. 142, “Goodwill and Intangible Assets” (“SFAS 142”). In accordance with SFAS 142, goodwill will not be amortized, but instead will be tested for impairment at least annually and more frequently if certain indicators are present. Circumstances that could trigger an impairment test include, but are not limited to, a significant adverse change in the business climate or legal factors, an adverse action or assessment by a regulator, unanticipated competition and loss of key personnel. The assessment of impairment is made by comparing the fair value of the reporting unit to which the goodwill has been assigned by management to its carrying value. To the extent that an impairment is indicated (fair value is less than carrying value), we must perform a second test to measure the amount of the impairment. The determination as to whether a write down of goodwill is necessary involves significant judgment based on the short-term and long-term projections of future performance. The assumptions supporting the estimated future cash flows, including the discount rate used and estimated terminal value, reflects management’s best estimates. In the event we determine that goodwill has been impaired, we will incur an accounting charge related to the impairment during the fiscal quarter in which such impairment determination is made. We review for indicators of potential impairment of goodwill annually.

Restructuring Costs. During fiscal 2002 and 2003, we restructured our business under plans approved by the Board of Directors by reducing our headcount, consolidating our facilities and disposing of excess and obsolete property and equipment. As a result of these actions, we recorded restructuring and other related charges consisting of cash severance payments to be made to severed employees and lease payments related to property abandoned as a result of our facilities consolidation, net of estimated sublease income. Our estimates include the review of the financial condition of our existing sublessees as well as the state of the regional real estate markets. Each reporting period we review these estimates based on the status of execution of our restructuring plan and, to the extent that these assumptions change due to changes in market conditions and our business, the ultimate restructuring expenses could vary by material amounts and result in additional expenses or the recovery of amounts previously recorded.

Risk Factors

Set forth below and elsewhere in this Quarterly Report on Form 10-Q and in other documents we file with the Securities and Exchange Commission are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Quarterly Report on Form 10-Q.

We have limited experience operating our Software Business, which makes it difficult to evaluate our future prospects.

As a result of the sale of our Managed Services Business to EDS in fiscal 2003, our business model has shifted from providing managed Internet services to primarily licensing our software products. We have limited experience operating our Software Business. As a result, we have limited ability to forecast future demand for our products and there is limited financial data upon which you may evaluate our business and prospects. In addition, we have acquired existing businesses and a suite of software products from these businesses in order to address additional aspects of the IT automation market. We have limited experience operating these acquired businesses as well. Our potential for future profitability must be considered in light of the risks, uncertainties and difficulties frequently encountered by companies in their early stages of development, particularly companies in new and rapidly evolving markets. In addition, our future prospects may be hindered by our relative lack of experience in operating our own business and any businesses that we may acquire to augment our core business. Some of these risks relate to our potential inability to:

• sign contracts with and deploy our products to a sufficient number of customers;

• provide high levels of support for our products and support the deployment of a higher volume of our products;

• deploy our products in the time frame we anticipate in order to meet our revenue forecasts;

• develop new product offerings and extend the functionality of our existing technologies;

• develop and extend our software products to support a wide range of hardware and software to meet the diverse needs of customers;

• integrate acquired businesses and technologies;

• develop effective direct sales and reseller channels to sell our software product lines;

• develop additional strategic partnerships to facilitate our ability to market and sell our software products;

• develop the capability that permits our software products to be integrated with the variety of existing management systems that customers may already have deployed; and

• establish awareness of our brand.

If we do not successfully address these risks, we may not realize sufficient revenue to reach or sustain profitability.

Our financial results may fluctuate significantly, which could cause our stock price to decline.

Our revenue and operating results could vary significantly from period to period. These fluctuations could cause our stock price to fluctuate significantly or decline. Important factors that could cause our quarterly and annual financial results to fluctuate materially include:

• our ability to obtain new customers and retain existing customers;

• the timing of signing and deploying contracts with new and existing customers;

• that for the foreseeable future, whether we meet our sales targets will depend on closing a small number of relatively large deals each quarter

• the timing and magnitude of operating expenses and capital expenditures;

• the effect of any non-cash compensation charges in connection with the issuance, cancellation or

modification of stock option awards;

• the timing of our satisfaction of revenue recognition criteria;

• costs related to the various third-party technologies we may incorporate into our technology and services;

• changes in our pricing policies or those of our competitors;

• any downturn in our customers’ and potential customers’ businesses;

• the timing of product releases or upgrades by us or by our competitors; and

• changes in the mix of revenue attributable to higher-margin software products versus lower-margin integration and support services.

We are planning to increase our operating expenses and capital expenditures in order to support our growth plans and based on estimates of future revenue. We believe that these expenditures are necessary in order to position our company for growth, but there is no assurance that these investments will result in sales and revenue substantial enough to compensate for these expenses. We may not be able to adjust spending in a timely manner to compensate for any unexpected revenue shortfall, and any significant shortfall in revenue relative to planned expenditures could negatively impact our business and results of operations.

Due to these and other factors, period-to-period comparisons of our operating results may not be meaningful. You should not rely on our results for any one period as an indication of our future performance. In future periods, our operating results may fall below the expectations of public market analysts or investors. If this occurs, the market price of our common stock would likely decline.

Our operating results are and will continue to be highly dependent upon our relationship with EDS and any deterioration of our relationship with EDS could adversely affect the success of our Software Business.

Our operating results are largely dependent on our relationship with EDS and will continue to be so for the foreseeable future. In 2002, we entered into a three-year, $52.0 million license and maintenance agreement with EDS. In August 2004, we entered into an amendment of our license and maintenance agreement with EDS whereby EDS agreed to extend the term of the agreement through March 2008 and committed to pay minimum additional license and maintenance fees of approximately $50.0 million over the term of the extended license. For the three-month period ended April 30, 2005, EDS accounted for 41% of our net revenue. As of April 30, 2005, EDS accounted for 41% of our accounts receivable balance. If our relationship with EDS were to deteriorate, our business and results of operations would be adversely affected. In addition, if EDS’ financial position were to deteriorate, our business and results of operations could be adversely affected.

Although we extended our license and maintenance agreement with EDS through March 2008, we cannot assure you that EDS will renew the license beyond the extended term or that if EDS does renew the license beyond the extended term, it will do so on the terms contemplated in the agreement. Whether or not EDS continues to license our software may depend, in large part, on its level of customer satisfaction. In addition, we cannot assure you that EDS will achieve the benefits they expect from our software products or that they will be able to continue to deploy our software successfully or in the time frames contemplated by the license agreement. Each of these factors may affect EDS’ willingness to renew the license. If EDS does not renew the license, our business and operating results may be adversely affected and this may negatively impact our reputation and our ability to license our software products to other customers. In addition to these risks, the occurrence of any of the adverse events discussed elsewhere in these Risk Factors could negatively impact our relationship with EDS and, consequently, our business.

The IT automation software market is relatively new, and our business will suffer if the market, or the technology standards within that market, do not develop as we expect.

The market for our products and services is relatively new and may not grow as we expect or be sustainable. Potential customers may choose not to purchase automation software from a third-party provider due to concerns about security, reliability, vendor stability and viability, cost or system compatibility. It is possible that our products may never achieve broad market acceptance. We will incur operating expenses based to an extent on anticipated revenue trends that are difficult to predict given the recent emergence of the information technology automation software market. If this market does not develop, or develops more slowly than we expect, we may not achieve

significant market acceptance for our software, our rate of revenue growth may be constrained and our operating results may suffer.

We have also joined together with a number of other technology companies in connection with the establishment of the data center mark-up language (“DCML”) standard within the data center environment. We cannot assure you that the DCML standard will become widely accepted or result in any benefits to our business. If the DCML standard does not gain acceptance as we expect, we may not achieve significant market acceptance, our technology and products may need to be modified and our operating results may suffer.

The rates we charge our customers for our software products may decline over time or we may choose to amend those rates to better achieve our business objectives, which could reduce our revenue and affect our financial results.

As our business model attracts the attention of competitors, we may experience pressure to decrease the fees we charge for our software products, which could adversely affect our revenue and our gross margins. If we are unable to sell our software at acceptable prices, or if we fail to offer additional products with sufficient profit margins, our revenue growth could slow, our margins may not improve and our business and financial results could suffer. In addition, we may choose to amend existing customer contracts or enter into new contracts with existing customers to better achieve our business objectives, and any such amendments or new contracts could affect the manner in which we report our results of operations as well as the historical accounting treatment for any such contracts.

We must satisfy the criteria for revenue recognition in order to recognize the fees generated under our license agreements as revenue.

In order to recognize the fees generated under our license agreements as revenue, we must demonstrate that the license arrangement satisfies the criteria for revenue recognition including that persuasive evidence that an arrangement exists, delivery has occurred, no significant obligations with regard to implementation remain, the fee is fixed or determinable and collectibility is probable. If we are unable to satisfy the criteria for revenue recognition, our operating results may suffer or may fluctuate significantly from period to period. In addition, the timing of our recognition of revenue will depend upon the mix of revenue that is recognized under the residual method, pursuant to the American Institute of Certified Public Accountants (AICPA) SOP 97-2 and SOP 98-9, under the percentage of completion or completed contract method of accounting, pursuant to SOP 81-1, under the ratable method or in connection with multi-year licenses, as well as the timing of our establishment of VSOE of fair value for maintenance. Our revenue recognition requirement, and accordingly the length of time between execution of a sales contract and recognition of revenue, varies among our three primary products. As a result, the mix of sales of particular products will impact our recognition of revenues from these sales in future quarters.

In addition, if we are not able to maintain VSOE of fair value for maintenance for OSAS in the future, we will recognize license, maintenance and professional services revenues ratably over the maintenance period. To date, the vast majority of our revenue from sale of enterprise software has been recognized ratably over the remaining maintenance period after deployment of the software, as we had not established VSOE of fair value for maintenance for OSAS.

Our sales in any quarter depend on a small number of relatively large transactions

Our quarterly sales to customers other than EDS, and consequently the revenues that we recognize in subsequent quarters, are especially subject to fluctuation, because they normally depend on the completion of relatively large license transactions. This dependence on large orders makes our net revenue and operating results more likely to vary from quarter to quarter, and more difficult to predict, because the loss of any particular large order is significant. As a result, our operating results could continue to be adversely impacted if any large orders are delayed or canceled in any future period.

Sales of our products to enterprises, government agencies and service providers involve lengthy sales and deployment cycles, which may cause our financial results to suffer.

We focus our sales efforts on enterprises, government agencies and service providers. Sales of our products to these entities generally involve a long sales cycle. The length of the average sales cycle could make it more difficult

for us to predict revenue and plan expenditures accordingly. The sales cycle associated with the purchase of our products is subject to a number of significant risks over which we have little or no control, such as:

• customers’ budget cycles, budgetary constraints and internal acceptance procedures;

• our lack of customer references due to our limited number of customers and limited experience operating our Software Business;

• concerns about the introduction or announcement of our or our competitors’ new products; and

• potential downturns in the IT market and in economic conditions generally.

In addition, the time it takes to demonstrate and deploy our software with these accounts may be longer than a non-enterprise customer given the complexity of their operations, which may delay our ability to recognize revenue from sales to these accounts and may affect customer satisfaction.

As we develop our software products, we may continue to incur significant operating losses, and we may never be profitable.

We may be required to spend significant funds to continue developing our software products, and to expand research and development and sales and marketing organizations to fit the needs of our Software Business. We have incurred significant operating and net losses and negative cash flow in the past and have not achieved operating profitability. We expect to continue to experience operating losses for the foreseeable future.

To achieve operating profitability, we will need to expand our revenue to exceed our operating expenses. If our revenue grows more slowly than we anticipate or if our operating expenses increase by more than we expect, our cash flow and operating results will suffer. Consequently, it is possible that we will never achieve operating profitability. Even if we do achieve positive cash flow or profitability in any one quarter, we may not sustain or increase positive cash flow or profitability on a quarterly or annual basis in the future.

In addition, any decision to restructure our operations, to exit any activity or to eliminate any excess capacity could result in significant accounting charges. These restructuring charges could also result from future business combinations. Restructuring charges, individually or in aggregate, could create losses in future periods.

Our revenue and operating results will be highly dependent upon our ability to provide high levels of customer satisfaction.

Our products must integrate with many existing computer systems and software programs used by our customers. In addition, integration requires adaptation to each customer environment, both in terms of interoperability and to meet the particular goals and objectives of each customer for our products. This integration can be complex, costly and time consuming, and can cause delays in the deployment of our products for customers. Customers could become dissatisfied with our products if deployments within customer environments prove to be difficult, costly or time consuming, and this could negatively impact our ability to sell our products in the future.

We provide technical support to our customers pursuant to contracts that are generally renewable annually. Our customers’ willingness to renew their maintenance and support agreements, enter into new contracts for additional products and act as a reference account will depend in large part on our ability to provide high levels of customer service. If we fail to provide the level of support demanded by our customers or if the capabilities of our products do not match our customers’ expectations, they may not renew their maintenance and support agreements or enter into new contracts for additional products and may not act as a reference account, each of which could have a material adverse impact on our revenue and operating results.

We may engage in additional acquisitions or investments, which may place a strain on our resources, cause dilution to our stockholders and harm our operating results.

From time to time we may make acquisitions of or investments in other companies in an effort to increase our customer base, broaden our product offerings or expand our technology platform. For example, in February 2004, we completed our acquisition of Tangram Enterprise Solutions, Inc., a software and services provider located in North Carolina. In addition, in February 2005, we completed our acquisition of Rendition Networks, Inc., a network device automation company located in Redmond, Washington. If we fail to evaluate and execute acquisitions or

investments successfully, they may seriously harm our business. We may not realize any benefit from any acquisitions, including the acquisitions of Tangram and Rendition Networks, if we are unable to do the following:

• effectively market and sell the newly acquired products;

• effectively provide services to any newly acquired customers;

• properly evaluate the technology acquired;

• accurately forecast the financial impact of the transaction, including but not limited to, accounting charges related to the impairment of assets acquired and transaction expenses;

• manage the expenses of the acquired business;

• integrate and retain personnel;

• manage geographically dispersed operations;

• address unforeseen liabilities or risks associated with the acquired company;

• combine potentially different corporate cultures; and

• effectively integrate services and products as well as technology, sales, marketing and support operations.

If we fail to do any of these, we may suffer losses, our resources may become strained and/or our management’s attention may be diverted from other important business concerns. We may lose key employees while integrating new organizations. Acquisitions could result in customer dissatisfaction, performance problems with an acquired company and its technology, contingent liabilities or possible impairment charges, any of which could harm our business. In addition, if we conduct acquisitions using convertible debt or equity securities, our existing stockholders will experience dilution in their investment.

The market for our technology and services is competitive and we may not have the resources required to compete effectively.

The market for our technology is relatively new and therefore subject to rapid and significant change and we cannot assure you of the success of our strategy going forward. Our competitors may succeed in developing technologies and products that are more effective than our software, which could render our products obsolete and noncompetitive. Some of our competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, more developed infrastructures, greater brand recognition, international presence and more established relationships in the industry than we have, each of which may allow them to gain greater market share. As a result, some of our competitors may be able to develop and expand their technology offerings more rapidly, adapt to new or emerging technologies and changes in customer requirements more quickly, take advantage of acquisitions and other opportunities more readily, achieve greater economies of scale, devote greater resources to the marketing and sale of their technology and adopt more aggressive pricing policies than we can. Some of our competitors have lower priced offerings and offer solutions that may be easier to sell and demonstrate to prospective customers. In addition, certain large competitors may be able to distribute their software products at minimal cost or free of charge to customers. Furthermore, the open source community may develop competing software products which could erode our market share and force us to lower our prices. Our competitors include large software and systems companies as well as small publicly traded and privately-held companies.

Because some of our current competitors have pre-existing relationships with our current and potential customers, we might not be able to achieve sufficient market penetration to achieve or sustain profitability. These existing relationships can also make it difficult for us to obtain additional customers due to the substantial investment that these potential customers might have already made based on our competitors’ technology. Furthermore, our competitors may be able to devote substantial resources aimed at preventing us from establishing or enhancing our customer relationships.

Our competitors and other companies may form strategic relationships with each other to compete with us. These relationships may take the form of strategic investments, joint-marketing agreements, licenses or other contractual arrangements, any of which may increase our competitors’ ability to address customer needs with their product offerings. Our competitors and other companies may consolidate with one another or acquire other

technology providers, enabling them to offer a broader array of products and more effectively compete with us. This consolidation could affect prices and other competitive factors in ways that could impede our ability to compete successfully and harm our business. In addition, to the extent that we seek to expand our product lines, managerial and technical personnel skills and capacity through acquisitions, the trend in the software industry toward consolidation may result in our encountering competition, and paying higher prices, for acquired businesses.

Our business is subject to changing regulation of corporate governance and public disclosure that has increased both our costs and the risk of noncompliance.

We are subject to rules and regulations of federal, state and financial market exchange entities charged with the protection of investors and the oversight of companies whose securities are publicly traded. These entities, including the Public Company Accounting Oversight Board, the SEC and NASDAQ, have recently issued new requirements and regulations and continue to develop additional regulations and requirements in response to recent laws enacted by Congress, most notably the Sarbanes-Oxley Act of 2002.

Our efforts to comply with these new regulations have resulted in, and are likely to continue to result in, increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. Any failure to timely implement the reforms required by these new laws and regulations could significantly harm our business, operating results and financial condition. In particular, if we do not adequately manage and evolve our financial reporting and managerial systems and processes, our ability to manage and grow our business may be harmed.

Unfavorable economic conditions and reductions in information technology spending could limit our ability to grow our business.

Our business and operating results are subject to the effects of changes in general economic conditions and changes in the information technology market. In addition, fears of continued global recession, war and acts of terrorism may continue to impact global economies negatively. We believe that the current economic conditions, as well as the recent decline in worldwide economic conditions, have led to reduced IT spending. If these conditions worsen, demand for our products may be reduced.

Our management is required to make forecasts with respect to economic trends and general business conditions in order to develop budgets, plan research and development strategies and perform a wide variety of general management functions. To the extent that our forecasts are incorrect, our performance may suffer because of a failure to properly align our corporate strategy with economic conditions.

If we do not develop our direct sales organization, we will have difficulty acquiring customers.

Our products require a sophisticated sales effort targeted at a limited number of key people within our prospective customers’ organizations. Because the market for our technology and services is new, many prospective customers are unfamiliar with the products we offer. As a result, our sales effort requires highly trained sales personnel. We may need to expand our sales organization in order to increase market awareness of our products to a greater number of organizations and, in turn, to generate increased revenue. We are in the process of developing our direct sales force, and we may require additional qualified sales personnel. Competition for these individuals is intense, and we may not be able to hire the type and number of sales personnel we need. Moreover, even after we hire these individuals, they require extensive training and time to become productive. If we decide, but are unable, to expand our direct sales force and train new sales personnel as rapidly as necessary, we may not be able to increase market awareness and sales of our products, which may prevent us from growing our revenue and achieving and maintaining profitability.

Future changes in accounting standards or our interpretation of current standards, particularly changes affecting revenue recognition, could cause unexpected fluctuations in reported revenue.

Future changes in accounting standards or our interpretation of current standards, particularly those affecting revenue recognition, could require us to change our accounting policies. These changes could cause deferral of revenue recognized in current periods to subsequent periods or accelerate recognition of deferred revenue to current periods, each of which could impair our ability to meet securities analysts’ and investors’ expectations, which could cause a decline in our stock price.

Changes in the accounting treatment of stock options will adversely affect our results of operations and could negatively impact our ability to attract and retain employees.

Changes in the accounting treatment for stock options will require us to account for employee stock options as compensation expense on our financial statements commencing February 1, 2006. In December 2004, the Financial Accounting Standard Board issued a new statement, which requires all share-based payments to employees, including grants of employee stock options, to be recognized as an expense in the financial statements based on their fair values. The new rules will be effective for us beginning February 1, 2006. We are currently evaluating option valuation methodologies and assumptions permitted by the FASB for purposes of implementing the change in accounting treatment. This change will materially and adversely affect our reported results of operations and our timing to achieve profitability.

We have historically used stock options and other forms of equity compensation as key components of our employee compensation program in order to align employees’ interests with the interests of our stockholders, encourage employee retention, and provide competitive compensation packages. The changing regulatory landscape could make it more difficult and expensive for us to grant stock options to employees in the future. In light of these changes, we may modify our equity compensation strategy to emphasize equity incentives other than stock options, including increased use of certain performance-related features. If employees believe that the incentives that they would receive under a modified strategy are less attractive, we may find it difficult to attract, retain and motivate employees. To the extent that new regulations make it more difficult or expensive to grant equity instruments to employees, we may incur increased compensation costs, further change our equity compensation strategy or find it increasingly difficult to attract, retain and motivate employees, each of which could materially and adversely affect our business, financial condition or results of operations.

Our operating results may suffer if we fail to achieve benefits from our strategic relationships.

We have formed in the past, and intend to continue to form in the future, strategic relationships with other technology companies in order to obtain a broader reach for our products and services. We cannot guarantee that any new customer relationships or revenue will result from these strategic relationships. In fact, we may not achieve any benefits from these relationships or similar relationships with other companies. In addition, in the event that our strategic partners experience financial difficulties, we may not be able to realize any benefits from these relationships.

If we do not develop our distribution channels our ability to increase revenue and grow our business may be limited.

Our ability to sell our products may be limited if we fail to develop our distribution channels. In addition to our existing relationships, we intend to establish other indirect channels to increase the number of customers licensing our products. Moreover, our channel partners must market and sell our products effectively and be qualified to provide timely and, in some cases, cost-effective customer support and service, which requires us to provide proper training and technical support. If our channel partners do not effectively market and sell our products or choose to place greater emphasis on products of their own or those offered by our competitors, our ability to grow our business and sell our products may be negatively affected.

If we do not develop and maintain productive relationships with systems integrators, our ability to deploy our software, generate sales leads and increase our revenue sources may be limited.

We intend to develop and rely on additional relationships with a number of computing and systems integration firms to enhance our sales, support, service and marketing efforts, particularly with respect to the implementation and support of our products, as well as to help generate sales leads and assist in the sales process. Many such firms have similar, and often more established, relationships with our competitors. These systems integrators may not be able to provide the level and quality of service required to meet the needs of our customers. If we are unable to develop and maintain effective relationships with systems integrators, or if they fail to meet the needs of our customers, our business could be adversely affected.

Because our success depends on our proprietary technology, if third parties infringe our intellectual property or if we are unable to rely upon the legal protections for our technology, we may be forced to expend significant resources enforcing our rights or suffer competitive injury.

Our success depends in large part on our proprietary technology. We have a number of issued patents and pending patent applications, and we currently rely on a combination of copyright, trademark, trade secret and other laws and restrictions on disclosure to protect our intellectual property rights. These legal protections afford only limited protection, and our means of protecting our proprietary rights may not be adequate.

Our intellectual property may be subject to even greater risk in foreign jurisdictions, as the laws of many countries do not protect proprietary rights to the same extent as the laws of the United States. If we cannot adequately protect our intellectual property, our competitive position may suffer.

We may be required to spend significant resources to monitor and police our intellectual property rights. We may not be able to detect infringement and may lose our competitive position in the market before we are able to ascertain any such infringement. In addition, competitors may design around our proprietary technology or develop competing technologies. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement. Any such litigation could result in significant costs and diversion of resources, including the attention of senior management.

If our products infringe on the intellectual property rights of others, we could face costly litigation, which could cause us to pay substantial damages and limit our ability to use our technology or sell some or all of our products.

Other companies, including our competitors, may obtain patents or other proprietary rights that could prevent, limit or interfere with our ability to make, use or sell our products. As a result, we may be found to infringe on the proprietary rights of others. Similarly, although we believe that we are in compliance with the terms and conditions of the open source licenses that we use in conjunction with our technology, we could be found to be non-compliant or infringing upon the rights of others if these open source technologies prove to be proprietary. Intellectual property litigation or claims could force us to do one or more of the following:

• engage in costly litigation and pay substantial damages to customers or third parties;

• stop licensing technologies that incorporate the challenged intellectual property;

• terminate existing contracts with customers or with channel partners;

• contribute portions of our proprietary technology to the open source community;

• obtain a license from the holder of the infringed intellectual property right, which may not be available on reasonable terms or at all; or

• redesign our technology and products, if feasible.

If we are forced to take any of the foregoing actions, our business and financial condition may be seriously harmed. In addition, the occurrence of any of these conditions could have the effect of increasing our costs and reducing our revenue. Our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed.

Our business will suffer if we do not enhance our products or introduce new products and upgrades to meet changing customer requirements.

The market for our products and services is characterized by rapid technological change, uncertain product life cycles, changes in customer demands, evolving industry standards and increased complexity and interdependence of our applications. Any delays in responding to these changes and developing and releasing enhanced or new products and upgrades could hinder our ability to retain existing and obtain new customers. In particular, our technology is designed to support a variety of hardware and software products that we believe to be proven and among the most widely used. We cannot be certain, however, that present and future customers will continue to use these products. Even if they do, new versions of these products are likely to be released and we will need to adapt our technology to these new versions. We must, therefore, constantly modify and enhance our technology to keep pace with changes made to our customers’ hardware and software configurations. If we fail to promptly modify or enhance our technology in response to evolving customer needs and demands, fail to introduce new products and upgrades or fail to fully develop our new product offerings, our technology may not achieve widespread acceptance and could become obsolete, which would significantly harm our business.

As we introduce new products or technologies into existing customer environments, we may experience performance and functionality problems associated with incompatibility among different versions of hardware, software and networking products. To the extent that such problems occur, we may face adverse publicity, loss of

sales, loss of customer satisfaction and delay in market acceptance of our products or customer claims against us, any of which could harm our business.

We may require additional capital to fund our operations or may elect to raise additional capital if the market permits.

We believe that our current cash balances, including cash and cash equivalents, and cash flow from operations will be sufficient to meet our working capital and capital expenditure requirements for at least the next 12 months. However, if our licensing revenue does not meet our expectations, if we encounter unforeseen expenses or if our business plan changes, we may require additional equity or debt financing. In addition, we may elect to raise additional capital if market conditions permit in order to increase our cash balance and expand our business. If we elect to raise additional capital in the future, we cannot be sure that we will be able to secure additional financing on acceptable terms, or at all. If we elect to raise additional capital through means of an equity financing, existing holders of our common stock will suffer dilution. Additionally, holders of any future debt instruments or preferred stock may have rights senior to those of the holders of our common stock. Any debt financing we raise could involve substantial restrictions on our ability to conduct our business and to take advantage of new opportunities.

We rely on third-party software to develop and deliver our products to our customers, and the loss of access to this software could harm our business.

As part of our normal operations in connection with the development and delivery of our software, we license software from third-party commercial vendors. These products may not continue to be available on commercially reasonable terms, or at all. The loss of these products could result in delays in the sale of our software until equivalent technology, if available, is identified, procured and integrated, and these delays could result in lost revenue. Further, to the extent that we incorporate these products into our software and the vendors from whom we purchase these products increase their prices, our gross margins could be negatively impacted.

Defects or security flaws in our products or claims asserted against us could result in the loss of customers, a decrease in revenue, unexpected expenses, loss of competitive market share and liability claims.

Our products depend on complex software, both internally developed and licensed from third parties. Also, our customers may use our products with other companies’ products that also contain complex software. If our software does not meet performance requirements, our customer relationships will suffer. Complex software often contains errors and is susceptible to computer viruses and may contain security vulnerabilities. Any failure or poor performance of our software or the third party software with which it is integrated could result in:

• delayed or diminished market acceptance of our software products;

• delays in product shipments;

• unexpected expenses and diversion of resources to identify the source of errors or to correct errors;

• damage to our reputation; or

• liability claims and loss of future maintenance revenue.

Although our agreements with customers contain provisions designed to limit our exposure to potential liability claims, these provisions may not be effective to the extent warranty exclusions or similar limitations of liability are unenforceable. In addition, the extent of these limitations may require negotiation. If any claim is made against us, we may be required to expend significant cash resources in defense and settlement of the claim.

If we are unable to retain our executive officers or key technical personnel, we may not be able to successfully manage our business or achieve our objectives.

Our business and operations are substantially dependent on the performance of our key employees, all of whom are employed on an at-will basis. If we lose the services of one or more of our executive officers or key technical employees, in particular, Marc L. Andreessen, our Chairman, Benjamin A. Horowitz, our President and Chief Executive Officer, or Timothy A. Howes, our Chief Technical Officer, or if one or more of them decides to join a competitor or otherwise compete directly or indirectly with us, we may not be able to successfully manage our business or achieve our business objectives.

Our business will suffer if we are unable to retain our highly qualified employees.

Our future success depends on our ability to retain our highly qualified technical, sales and managerial personnel. Our failure to retain our qualified personnel could seriously disrupt our operations and increase our costs by forcing us to use more expensive outside consultants and by reducing the rate at which we can increase revenue. As our customer base and revenue grows, we may need to hire additional qualified personnel. Competition for qualified personnel can be intense, and we may not be able to attract, train, integrate or retain a sufficient number of qualified personnel if we need to do so in the future. In addition, we are dedicating significant resources in connection with ongoing management assessment of internal controls pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and may be required to hire additional staff members to assist in these efforts.

Important components of the compensation of our personnel are stock options and restricted stock, which typically vest over a four-year period. We may face significant challenges in retaining our employees if the value of our stock declines. To retain our employees, we expect to continue to grant new options subject to vesting schedules, which will be dilutive to the investments of our existing stockholders. Some of our employees hold options with exercise prices that are higher than the price at which our common stock is currently trading. If our stock price does not increase in the future, we may need to exchange options for new options or restricted stock, issue new options or grant additional shares of stock to motivate and retain our employees. To the extent we issue additional options or shares of restricted stock, existing stockholders will experience dilution. Furthermore, potential changes in practices regarding accounting for stock options could result in significant accounting charges, which could raise our costs and impair our ability to use stock options for compensation purposes.

Our stock price has been volatile and could decline.

The market price of our common stock has fluctuated significantly in the past, will likely continue to fluctuate in the future and may decline. The market for technology stocks has been extremely volatile and frequently reaches levels that bear no relationship to the past or present operating performance of those companies. Delays in closing sales or completing installations could result in material variations in our quarterly results and quarter-to-quarter growth in the foreseeable future. In addition, the stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market price for the common stock of technology companies. Furthermore, our common stock is relatively thinly traded, which contributes significantly to the volatility of our stock price. Due to the low trading volume of our stock, stockholders may not be able to purchase or sell shares, particularly large blocks of shares, as quickly and as inexpensively as if the trading volume were higher. This could result in greater volatility in our stock price.

Among the factors that could affect our stock price are:

• variations in our quarter-to-quarter operating results;

• the loss of any of our significant customers or our failure to obtain new customers or renew existing contracts;

• announcements by us or our competitors of significant contracts, new or enhanced products or services, acquisitions, distribution partnerships, joint ventures or capital commitments;

• changes in our financial estimates or investment recommendations by securities analysts following our business;

• our sale of common stock or other securities in the future;

• changes in economic and capital market conditions for companies in our sector;

• changes in the enterprise software markets;

• changes in market valuations or earnings of our competitors;

• changes in business or regulatory conditions;

• interest rates and other factors affecting the capital markets;

• fluctuations in the trading volume of our common stock; and

• the occurrence of any of the adverse events discussed elsewhere in these Risk Factors.

Insiders have substantial control over us and this could delay or prevent a change in control and could negatively affect your investment.

As of May 31, 2005, our officers and directors and their affiliates beneficially own, in the aggregate, approximately 24% of our outstanding common stock. These stockholders are able to exercise significant influence over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, which could have the effect of delaying or preventing a third party from acquiring control over us and could affect the market price of our common stock. In addition, the interests of certain large stockholders may not always coincide with our interests or the interests of other stockholders, and, accordingly, these stockholders could approve transactions or agreements that would not otherwise be approved by other stockholders generally.

Substantial sales of our common stock or sales by insiders could depress our stock price.

If our stockholders sell substantial amounts of our common stock in the public market, or if any of our officers or directors were to sell shares of our commons stock held by them, the market price of our common stock could fall. As of May 31, 2005, we had 98,400,114 shares of common stock outstanding. In connection with the completion of our acquisition of Tangram in February 2004, we issued approximately 1.1 million shares of our common stock and registered those shares with the SEC. Furthermore, in connection with the completion of our acquisition of Rendition Networks in February 2005, we issued approximately 2.53 million shares of our common stock to the stockholders of Rendition Networks. Sales of any of these shares could depress our stock price. In addition, if certain venture capital firms that continue to hold our outstanding stock were to distribute their shares to their limited partners, the subsequent sale of shares by those limited partners could depress our stock price.

We have implemented anti-takeover provisions that could make it more difficult to acquire us.

Our certificate of incorporation, our bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors, even if doing so would be beneficial to our stockholders. These provisions include:

• classifying our board of directors into three groups so that the directors in each group will serve staggered three-year terms, which would make it difficult for a potential acquirer to gain immediate control of our board of directors;

• authorizing the issuance of shares of undesignated preferred stock without a vote of stockholders;

• prohibiting stockholder action by written consent; and

• limitations on stockholders’ ability to call special stockholder meetings.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk. We have limited exposure to financial market risks, including changes in interest rates. An increase or decrease in interest rates would not significantly increase or decrease interest expense on our debt obligations due to the fixed nature of our debt obligations. Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since we primarily invest in money market instruments. However, due to the short-term nature of our investments, we believe that we are not subject to any material market risk exposure. A hypothetical 100 basis point increase in interest rates would result in less than a $100,000 decrease (less than 1%) in the fair value of our available-for-sale securities.

Foreign Currency Risk. As we expand into foreign markets, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets we plan to target. To date, our exposure to foreign currency risk has not been material. Most of our sales are currently made in U.S. dollars. Strengthening of the dollar could make our services less competitive in the foreign markets we may target in the future.

ITEM 4. CONTROLS AND PROCEDURES

Conclusions Regarding Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Based on this evaluation, our chief executive officer and chief financial officer, as of April 30, 2005, concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective to ensure that information required to be disclosed by us in this report was recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms for this report.

Changes in Internal Control Over Financial Reporting. There were no changes in our internal control over the financial reporting during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting.

Limitation on Effectiveness of Controls. It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met. The design of any control system is based, in part, upon the benefits of the control system relative to its costs. Control systems can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. In addition, over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of these and other inherent limitations of control systems, there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

As of the date of filing of this Quarterly Report on Form 10-Q, we were not involved in any material legal proceedings. In the future, we may be subject to legal proceedings. Any litigation, even if not successful against us, could result in substantial costs and divert management’s attention and other resources away from the operation of our business.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

(a) Exhibits

Exhibit Number		Description

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*
32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002*

* This exhibit is furnished with this Quarterly Report on Form 10-Q and is not deemed filed with the Securities and Exchange Commission and is not incorporated by reference in any filing of Opsware Inc. under the Securities Act of 1933 or the Securities Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation language in any such filings.

		OPSWARE INC.


		/s/ Sharlene P. Abrams
		Sharlene P. Abrams
		Chief Financial Officer
		(Duly Authorized Officer and Principal
		Financial and Accounting Officer)


Dated: June 9, 2005

		Page

PART I	FINANCIAL INFORMATION	2

ITEM 1	FINANCIAL STATEMENTS	2

	CONDENSED CONSOLIDATED BALANCE SHEETS	2

	CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS	3

	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS	4

	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	5

ITEM 2	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	21

ITEM 3	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	41

ITEM 4	CONTROLS AND PROCEDURES	41

PART II	OTHER INFORMATION	42

ITEM 1	LEGAL PROCEEDINGS	42

ITEM 2	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	42

ITEM 3	DEFAULTS UPON SENIOR SECURITIES	42

ITEM 4	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	42

ITEM 5	OTHER INFORMATION	42

ITEM 6	EXHIBITS	42

	SIGNATURE	43