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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended December 31, 2003

OR

(Commission file number: 000-30931)

OPNET TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)

7255 Woodmont Avenue

Bethesda, MD 20814

(Address of principal executive office)

(240) 497-3000

(Registrant’s telephone number, including area code)

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

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

At January 27, 2004, there were outstanding 19,931,208 shares of common stock of the registrant.

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PART 1. FINANCIAL INFORMATION

OPNET TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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OPNET TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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OPNET TECHNOLOGIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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OPNET TECHNOLOGIES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

OPNET Technologies, Inc. (“OPNET”, “we” or “us”) is a leading provider of management software for networks and applications. Our solutions address: application performance troubleshooting; network configuration auditing; network capacity and resiliency planning; application deployment planning; and network technology R&D. We sell our products to corporate enterprises, government and defense agencies, network service providers, and network equipment manufacturers. We market our product suite in North America primarily through a direct sales force and, to a lesser extent, several resellers and original equipment manufacturers. Internationally, we conduct research and development through our wholly-controlled subsidiary in Ghent, Belgium and market our products through our wholly-owned subsidiaries in Paris, France; Reading, United Kingdom; and Sydney, Australia; third-party distributors; and value-added resellers. OPNET is headquartered in Bethesda, MD and has offices in Cary, NC; Dallas, TX; and Santa Clara, CA.

The accompanying condensed consolidated financial statements include our results and the results of our wholly owned subsidiaries. All intercompany accounts and transactions have been eliminated in consolidation. The interim condensed consolidated financial statements included herein are unaudited and have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and applicable rules and regulations of the Securities and Exchange Commission (the “SEC”) regarding interim financial reporting. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Accordingly, these interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes thereto contained in the Company’s Annual Report on Form 10-K/A, Amendment No. 1, for the year ended March 31, 2003, filed with the SEC. The March 31, 2003 condensed consolidated balance sheet included herein was derived from the audited financial statements as of that date, but does not include all disclosures including notes required by GAAP. In the opinion of management, these interim condensed consolidated financial statements reflect all adjustments of a normal and recurring nature necessary to present fairly our results for the interim periods. The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amount of revenues and expenses during the reporting periods. Actual results could differ from those estimates. In addition, our operating results for the three and nine months ended December 31, 2003 may not be indicative of the operating results for the full fiscal year or any other future period.

Reclassifications. Fees and costs associated with the sale of periodic unspecified product updates (“license updates”) and technical support have been combined and presented as “Software license updates and technical support” in the accompanying condensed consolidated statements of operations. License update revenues of $2.2 million and $5.9 million for the three and nine months ended December 31, 2002, respectively, were reclassified from license revenues to software license updates and technical support revenues. Cost of license update revenues of $21,000 and $45,000 for the three and nine months ended December 31, 2002, respectively, were reclassified from cost of license revenues to cost of software license updates and technical support revenues. Technical support revenues of $1.1 million and $3.5 million for the three and nine months ended December 31, 2002, respectively, were reclassified from service revenues to software license updates and technical support revenues. Cost of technical support revenues of $358,000 and $1.2 million for the three and nine months ended December 31, 2002, respectively, were reclassified from cost of service revenues to cost of software license updates and technical support revenues.

Investments. We consider all highly liquid investments with maturities of three months or less when purchased to be cash equivalents. We have determined that all of our marketable securities are to be classified as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported in stockholders’ equity in the accompanying condensed consolidated balance sheets under the caption “Accumulated other comprehensive income.” The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity using the effective interest method. Such amortization is included in the “Interest and other income, net” line item on the accompanying condensed consolidated statements of operations. Realized gains and losses on available-for-sale securities are included in the “Interest and other income, net” line item on the condensed consolidated statements of operations. The cost of securities sold is based on the specific identification method. Interest and dividends on securities classified as available-for-sale are included in the “Interest and other income, net” line item on the condensed consolidated statements of operations.

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Indemnifications. Under the terms of substantially all of our license agreements, we have agreed to indemnify customers for costs and damages arising from claims against such customers based on allegations that our software products infringe the intellectual property rights of a third party. The indemnification is limited to the amount paid by the customer. To date, we have not had to reimburse any of our customers for any losses related to these indemnification provisions and no claims are outstanding as of December 31, 2003. For several reasons, including the lack of prior indemnification claims, we cannot determine the maximum amount of potential future payments, if any, related to such indemnification provisions. However, we do not believe that these indemnification provisions will have a material adverse effect on the Company’s operating performance or financial condition.

Our standard license agreement includes a warranty provision for software products. We generally warrant for the first ninety days after delivery that the software will operate substantially as stated in the then current documentation provided that the software is used in a supported computer system. We provide for the estimated cost of product warranties based on specific warranty claims, provided that it is probable that a liability exists and provided the amount can be reasonably estimated. To date, we have not had any material costs associated with these warranties.

Stock-Based Compensation. We account for stock-based compensation given to employees using the intrinsic value method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and accordingly, recognize compensation expense for fixed stock option grants only when the exercise price is less than the quoted market price of the shares on the date of the grant. Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” permits the use of either a fair-value based method or the intrinsic value method provided in APB Opinion No. 25 to account for employee stock-based compensation arrangements. Companies that elect to use the intrinsic value method provided in APB Opinion No. 25 are required to disclose the pro forma net income (loss) and earnings (loss) per share that would have resulted from the use of the fair value method. We have provided below the pro forma disclosures of the effect on net income and earnings per share for the three and nine months ended December 31, 2003 and 2002, as if SFAS No. 123 had been applied in measuring compensation expense for all periods.

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Subsequent to the issuance of our consolidated financial statements as of March 31, 2003, we concluded that a portion of the revenue from certain software arrangements should have been deferred to account for the value of certain free training offered to our customers. We also determined that amortization of acquired technology should be included as a cost of revenue rather than as an operating expense. As a consequence, our condensed consolidated financial statements for the three and nine months ended December 31, 2002, have been restated. For the three months ended December 31, 2002, this restatement increased our previously reported revenue from $11,696,000 to $11,804,000 and increased our previously reported net income from $753,000 to $834,000, but had no effect on our previously reported diluted earnings per common share of $0.04. For the nine months ended December 31, 2002, this restatement increased our previously reported revenue from $34,047,000 to $34,069,000 and increased our previously reported net income from $1,762,000 to $1,779,000, but had no effect on our previously reported diluted earnings per common share of $0.09. The restatement resulted in a decrease in new software license revenues of $142,000 and an increase in professional service revenues of $250,000 for the three months ended December 31, 2002. The restatement resulted in a decrease in new software license revenues of $573,000 and an increase in professional services revenues of $595,000 for the nine months ended December 31, 2002.

The effect of the reclassification of amortization of acquired technology was to increase previously reported cost of revenues and reduce previously reported gross profit by $126,000 and $377,000 for the three and nine months ended December 31, 2002, respectively. This change has no impact on net income.

A summary of the significant effects of the restatement is as follows:

Condensed Consolidated Statement of Operations Data:

Marketable securities as of December 31, 2003, consist of the following:

Our marketable securities have maturity dates of less than one year.

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Intangible assets consisted of the following:

In December 2003, we purchased a software product used primarily for modeling voice communications for approximately $179,000.

Acquired technology relating to the NetMaker and WDM NetDesign acquisitions resulted in amortization expense for the three months ended December 31, 2003 and 2002 of $125,000 and $126,000, respectively. Amortization expense for the nine months ended December 31, 2003 and 2002 was $375,000 and $377,000, respectively. Amortization expense from acquired technology is included in cost of revenues in the condensed consolidated statements of operations. We expect amortization expense of $509,000 in the fiscal year ending March 31, 2004, $536,000 in each of the fiscal years ending March 31, 2005 and 2006, $102,000 in the year ending March 31, 2007, $36,000 in the fiscal year ending March 31, 2008, and $26,000 in the fiscal year ending March 31, 2009.

Effective June 10, 2002, we entered into a credit facility with a commercial bank. The credit facility permits the use of funds for general corporate purposes and the issuance of letters of credit up to a maximum of $10.0 million in the aggregate. Borrowings under the credit facility are limited to 80% of eligible accounts receivable. We used the facility to issue an irrevocable letter of credit for approximately $2.8 million to satisfy the security deposit requirements for our corporate office lease. Upon a default, as defined in the corporate office lease agreement, and written notice from the landlord to us, the landlord has the right to draw upon the letter of credit in whole or in part. Interest is payable monthly, based on LIBOR plus the applicable margin ranging from 2% to 2.5% as stated in the loan agreement. The credit facility includes a fee in the amount of 0.25% per annum on the unused portion of the credit facility. The credit facility is collateralized by our accounts receivable. The loan agreement contains customary affirmative and negative covenants including a restriction on the payment of dividends and a financial covenant requiring that we not exceed a ratio of Funded Debt to EBITDA of 2.5:1.0 as such terms are defined in the loan agreement. The credit facility expires June 10, 2004. As of December 31, 2003, we had no borrowings under the available credit facility, and available borrowings at that date were $2.9 million.

During the nine months ended December 31, 2003, we received proceeds of approximately $2.1 million and issued 473,003 shares of common stock, pursuant to employee exercises of stock options. During the nine months ended December 31, 2003 employees purchased 37,515 shares of common stock under the OPNET 2000 Employee Stock Purchase Plan, resulting in proceeds to us of approximately $0.3 million.

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The following is a reconciliation of the amounts used in calculating basic and diluted net income per common share for the three and nine months ended December 31, 2003 and 2002:

We had options for the purchase of 474,500 and 2,141,464 common shares that were excluded from the diluted average shares outstanding for the three months ended December 31, 2003 and 2002, respectively, because they were antidilutive. We had options for the purchase of 1,449,692 and 2,169,464 common shares for the nine months ended December 31, 2003 and 2002, respectively, because they were antidilutive.

We operate in one industry segment, the development and sale of computer software programs and related services. Revenues from transactions with U.S. Government agencies were approximately 46% and 34% of total revenues for the three months ended December 31, 2003 and 2002, respectively. Revenues from transactions with U.S. Government agencies were approximately 46% and 38% for the nine months ended December 31, 2003 and 2002, respectively. Substantially all assets were held in the United States at December 31 and March 31, 2003. Revenues by geographic area and as a percentage of total revenues is as follows:

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Comprehensive income includes net income, foreign currency translation adjustments, and unrealized gain on marketable securities. Total comprehensive income is summarized as follows:

We are involved in various claims and legal proceedings arising from our normal operations. We do not expect those matters, individually or in the aggregate, to have a material effect on our financial condition or results of operations.

In November 2002, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” Interpretation No. 45 requires a guarantor to include disclosure of certain obligations, and if applicable, at the inception of the guarantee, recognize a liability for the fair value of other certain obligations undertaken in issuing a guarantee. The recognition requirement was effective for guarantees issued or modified after December 31, 2002. We adopted Interpretation No. 45 effective December 2002 and the applicable disclosures have been made.

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” Issue 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of Issue 00-21 apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003 but do not supersede existing authoritative guidance, including SOP 97-2. The adoption of Issue 00-21 did not have an impact on our consolidated results of operations or financial position.

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. Interpretation No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. We adopted the provisions of Interpretation No. 46 effective January 1, 2003. We do not have any variable interest entities; thus adoption of Interpretation No. 46 did not have an impact on our consolidated results of operations or financial position.

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In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging.” The statement requires that contracts with comparable characteristics be accounted for similarly and clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, except in certain circumstances, and for hedging relationships designated after June 30, 2003. We currently do not hedge foreign exchange rate risk nor have we entered into any derivative instruments or transactions that are subject to SFAS No. 133 or SFAS No. 149. We adopted SFAS No. 149, effective July 1, 2003. The adoption of this standard did not have an effect on our consolidated results of operations or financial position.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We are not currently a party to any of the types of financial instruments that are subject to SFAS No. 150.

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The following discussion and analysis relate to our financial condition and results of operations for the three and nine months ended December 31, 2003 and 2002, and should be read in conjunction with our condensed consolidated financial statements and the related notes included elsewhere in this report. You should also read the following discussion and analysis in conjunction with our consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our Annual Report on Form 10-K/A, Amendment No. 1, for the year ended March 31, 2003, filed with the SEC.

This report contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should,” “will,” and “would” or similar words. You should read statements that contain these words carefully because they discuss our future expectations, contain projections of our future results of operations or of our financial position, or state other forward-looking information. We believe that it is important to communicate our future expectations to our investors. However, there may be events in the future that we are not able to predict or control accurately. The factors listed in this section, as well as any cautionary language contained herein, provide examples of risks, uncertainties, and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. You should also carefully review the risks outlined in other documents that we file from time to time with the Securities and Exchange Commission, including our Quarterly Reports on Form 10-Q that we will file in fiscal 2004.

Overview

We derive revenues from three primary sources: (1) new software licenses, (2) software license updates and technical support, and (3) professional services, which include consulting and training services. New software license revenues represent all fees earned from granting customers licenses to use our software, and exclude revenues derived from software license updates, which are included in software license updates and technical support revenues. The majority of our new software license revenues consist of perpetual license sales of our software products. Software license updates and technical support revenues represent fees associated with the sale of license updates and technical support under our maintenance agreements. We offer professional services, generally under fixed-price agreements, primarily to provide product customization and enhancements and to facilitate the adoption of our technology.

Revenues from sales outside of the United States represented 15.0%, and 22.7% of our total revenues for the three months ended December 31, 2003 and 2002, respectively. Revenues from sales outside of the United States represented 18.0% and 19.3% of our total revenues for the nine months ended December 31, 2003 and 2002, respectively. Sales outside the United States were made through our international sales team as well as third-party distributors and value-added resellers, who generally are responsible for providing technical support and service to customers within their territory. We expect revenues from sales outside the United States to continue to account for a significant portion of our total revenues in the future. We believe that continued growth and profitability will require further expansion of our sales, marketing and customer service functions in international markets.

Reclassifications

Revenues and costs associated with the sale of license updates and technical support have been combined and presented as “Software license updates and technical support” in the accompanying condensed consolidated statements of operations. These reclassifications had no impact on total revenues, net income, or net income per common share for the three and nine months ended December 31, 2002. See Note 1 – “Significant Accounting Policies - Reclassifications” in the accompanying notes to our condensed consolidated financial statements for additional information regarding the reclassifications.

Restatement

As discussed in Note 2 to the condensed consolidated financial statements included under Item 1, we have restated our condensed consolidated financial statements for the three and nine months ended December 31, 2002. This Management’s Discussion and Analysis reflects the restatement.

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Results of Operations

The following table sets forth items from our statements of operations expressed as a percentage of total revenues for the periods indicated:

The following table sets forth, for each component of revenues, the cost of these revenues as a percentage of the related revenues for the periods indicated:

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Revenues

New Software License Revenues. New software license revenues were $7.1 million and $5.6 million for the three months ended December 31, 2003 and 2002, respectively, representing an increase of 27.2%. New software license revenues were $20.0 million and $15.8 million for the nine months ended December 31, 2003 and 2002, respectively, representing an increase of 26.2%. The growth in sales was primarily due to higher sales volumes to enterprise and U.S. Government customers of OPNET SP Guru and OPNET Modeler, which were available throughout all of the periods presented, as well as OPNET VNE Server, which was launched in June 2002.

We may experience a slower rate of growth, or even a decline, in overall new software license revenues in the near-term due to potentially lower spending levels by enterprise IT organizations, service providers and network equipment manufacturers as a result of a challenging economy.

Software License Updates and Technical Support Revenues. Software license updates and technical support revenues were $3.9 million and $3.2 million in the three months ended December 31, 2003 and 2002, respectively, representing an increase of 21.5%. Software license updates and technical support revenues were $10.9 million and $9.4 million in the nine months ended December 31, 2003 and 2002, respectively, representing an increase of 16.4%. Software license updates and technical support revenue growth rates are affected by the overall new software license revenue growth rates, as well as the renewal rate of annual maintenance contracts by existing customers. The increases reflect the growth in the overall customer installed base as compared to the prior periods.

We may experience a slower rate of growth, or even a decline, in overall software license updates and technical support revenues in the near-term due to potentially lower spending levels by enterprise IT organizations, service providers and network equipment manufacturers as a result of a challenging economy.

Professional Service Revenues. Professional service revenues were $3.4 million and $3.0 million in the three months ended December 31, 2003 and 2002 respectively. Consulting services revenue accounted for 87.4% and 88.1% of professional service revenues for the three months ended December 31, 2003 and 2002, respectively. Professional service revenues were $9.2 million and $8.9 million in the nine months ended December 31, 2003 and 2002, respectively. For the nine months ended December 31, 2003 and 2002, consulting services revenue accounted for 87.0% and 89.4% of professional service revenues, respectively. For the three and nine months ended December 31, 2003, the increases in professional services revenue were primarily due to higher demand for our consulting services. In January 2003, we were awarded a re-competed consulting contract with the U.S. Department of Defense that contributed 15.1% and 24.5% of professional service revenues for the three and nine months ended December 31, 2003, respectively. The funding under this contract for calendar year 2003 was $3.1 million. Under the first of four possible contract extensions, the funding under this contract for calendar 2004 is $3.5 million. The option years for calendar years 2005, 2006, and 2007 under this contract, may be exercised by the U.S. Department of Defense at its discretion. Engagements with U.S. government agencies contributed significantly to the demand for our consulting services for the three and nine months ended December 31, 2003 and 2002.

Our ability to increase professional service revenues will be dependent on our ability (i) to expand our installed base of customers, (ii) to maintain several large consulting contracts with the U.S. Government and (iii) to attract and retain additional qualified consultants, including those with security clearances.

International Revenues. Our international revenues decreased 19.4% to $2.2 million, or 15% of total revenues, for the three months ended December 31, 2003 from $2.7 million, or 22.7% of total revenues, for the three months ended December 31, 2002. Our international revenues increased 10.1% to $7.2 million, or 18.0% of total revenues, for the nine months ended December 31, 2003 from $6.6 million, or 19.3% of total revenues, for the nine months ended December 31, 2002. Our international revenues are primarily generated in Europe and Japan. The challenging global economy can lengthen our sales cycle for international customers and therefore impact the timing of sales orders. We believe that we will need to further expand our international sales, marketing and customer service functions to increase international revenues. We expect to continue experiencing fluctuations of international revenues in the future.

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Cost of Revenues

Cost of new software license revenues consists primarily of royalties, media, manuals, and distribution costs. Cost of software license updates and technical support revenues consists of royalties, media, distribution costs, and personnel-related costs in providing technical support to our customers. Cost of professional service revenues consists primarily of personnel-related costs in providing consulting and training to customers. Gross margin on new software license revenues is substantially higher than gross margin on professional service revenues, due to the low materials, packaging and other costs of software products compared with the relatively high personnel costs associated with providing professional services.

In connection with our acquisitions of NetMaker in March 2001 and WDM NetDesign in January 2002, we recorded acquired technology of $2.5 million. These acquired technologies are being amortized on a straight-line basis over five years. Amortization expense from acquired technology for the three months ended December 31, 2003 and 2002 was $125,000 and $126,000, respectively. Amortization expense from acquired technology for the nine months ended December 31, 2003 and 2002 was $375,000 and $377,000, respectively.

Cost of New Software License Revenues. Cost of new software license revenues was $126,000 and $205,000 for the three months ended December 31, 2003 and 2002, respectively. Gross margin on new software license revenues increased to 98.2% for the three months ended December 31, 2003 from 96.3% for the three months ended December 31, 2002. The increase in gross margins for the three months ended December 31, 2003 was due to an increase in revenue and proportionately fewer license sales requiring royalty payments. Cost of new software license revenues was $614,000 and $585,000 for the nine months ended December 31, 2003 and 2002, respectively. Gross margin on new software license revenues increased to 96.9% for the nine months ended December 31, 2003 from 96.3% for the nine months ended December 31, 2002.

Cost of Software License Updates and Technical Support Revenues. Cost of software license updates and technical support revenues was $445,000 and $379,000 for the three months ended December 31, 2003 and 2002, respectively. Gross margin on software license updates and technical support revenues increased to 88.7% for the three months ended December 31, 2003 from 88.3% for the three months ended December 31, 2002. Cost of software license updates and technical support revenues was $1.2 million and $1.3 million for the nine months ended December 31, 2003 and 2002, respectively. Gross margin on software license updates and technical support revenues increased to 89.1% for the nine months ended December 31, 2003 from 86.3% for the nine months ended December 31, 2002. The improvements in gross margin on software license updates and technical support revenues were due to higher revenues.

Cost of Professional Service Revenues. Cost of professional service revenues was $2.0 million and $1.2 million for the three months ended December 31, 2003 and 2002, respectively. Gross margin on professional service revenues decreased to 39.4% for the three months ended December 31, 2003 from 59.8% for the three months ended December 31, 2002. Cost of professional service revenues was $5.3 million and $3.5 million for the nine months ended December 31, 2003 and 2002, respectively. Gross margin on professional service revenues decreased to 42.6% for the nine months ended December 31, 2003 from 60.8% for the nine months ended December 31, 2002. The increase in cost of professional service revenues and the resulting lower gross margins were primarily due to an increase in headcount, overhead costs, recruiting expenses and certain other costs associated with specific consulting engagements. For the three months ended December 31, 2003, our gross margin decline was partially due to lower productivity associated with new hires in consulting to meet demand for our services and subcontractor costs incurred to meet demand for engagements requiring security clearances. We expect cost of professional services revenues as a percentage of professional services revenue to vary based primarily on the profitability of individual consulting engagements.

Operating Expenses

Research and Development. Research and development expenses were $3.1 million and $3.2 million for the three months ended December 31, 2003 and 2002, respectively, representing a decrease of 1.8%. Research and development expenses were $9.5 million and $9.6 million for the nine months ended December 31, 2003 and in 2002, respectively, representing a decrease of 1.3%. The decreases were the result of lower overhead costs, offset in part by higher personnel costs. We believe that a significant level of research and development investment will be required to maintain our competitive position and broaden our product lines, as well as enhance the features and functionality of our current products. We expect that the absolute dollar amount of these expenditures to grow but generally decrease as a percentage of total revenues in future periods. Our ability to decrease these expenses as a percentage of revenues, however, will depend upon our revenue growth, among other factors.

Sales and Marketing. Sales and marketing expenses were $5.0 million and $4.5 million for the three months ended December 31, 2003 and 2002, respectively, representing an increase of 9.6%. Sales and marketing expenses were $14.0 million and $13.5 million for the nine months ended December 31, 2003 and 2002, respectively, representing an increase of 4%. The increases were primarily due an increase in the average size of our direct sales force, higher sales commission cost associated with growth in revenues, and increases in recruiting and travel costs. We anticipate that we will continue to commit substantial resources to sales and marketing and that sales and marketing expenses may increase both in absolute dollars and as a percentage of total revenues in the future periods.

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General and Administrative. General and administrative expenses were $1.4 million and $1.3 million for the three months ended December 31, 2003 and 2002, respectively. General and administrative expenses were $4.2 million and $3.6 million for the nine months ended December 31, 2003 and 2002, respectively. The increases were primarily due to higher audit fees, annual shareholder meeting expenses, insurance costs and software maintenance costs associated with new financial systems that were deployed in April 2003. The increases were partially offset by lower bad debt expenses. We expect the dollar amount of general and administrative expenses to increase as we continue to expand our operations but generally decrease as a percentage of total revenues in future periods. Our ability to decrease these expenses as a percentage of revenues, however, will depend upon our revenue growth, among other factors.

Interest and Other Income, Net

Interest and other income, net were $135,000 and $192,000 for the three months ended December 31, 2003 and 2002, respectively. Interest and other income, net were $436,000 and $716,000 for the nine months ended December 31, 2003 and 2002, respectively. The decrease in each period was primarily due to lower yields on our cash, cash equivalents and marketable securities as a result of lower interest rates.

Provision for Income Taxes

Our effective tax rates were approximately 29% and 25% for the three months ended December 31, 2003 and 2002, respectively. The effective tax rates were 31% and 25% for the nine months ended December 31, 2003 and 2002, respectively. The effective tax rate differs from the statutory tax rate and varies from period to period due principally to the amount of income before taxes from various tax jurisdictions and the amount of tax credits available to us in each period from incremental research expenditures. In November 2003, Maryland approved our application for a research and development tax credit for fiscal year 2002 in the amount of approximately $84,000. The effective tax rates for the three and nine months ended December 31, 2003 were favorably impacted by the Maryland research and development tax credit.

We expect our effective tax rate in the near-term to range from 32% to 34%; however, future provisions for taxes will depend, among other things, on the mix and amount of worldwide income, the tax rates in effect for various tax jurisdictions and the amount of increased research tax credits.

Liquidity and Capital Resources

Since inception, we have funded our operations primarily through cash provided by operating activities and through the sale of equity securities. In August 2000, we completed our initial public offering in which we raised approximately $54.1 million, net of underwriting discounts and offering expenses payable by us. As of December 31, 2003, we had cash, cash equivalents and marketable securities totaling $78.6 million.

Cash provided by operating activities was $6.7 million and $5.6 million for the nine months ended December 31, 2003 and 2002, respectively. Cash provided by operating activities is primarily derived from net income, as adjusted for non-cash items such as depreciation and amortization expense and changes in operating assets and liabilities. The increase in cash provided by operating activities in the nine months ended December 2003 from the nine months ended December 31, 2002 was primarily attributable to higher net income and deferred revenue, due to our revenue growth. The increases were partially offset by an increase in accounts receivable resulting from our revenue growth and an increase in prepaid expenses.

Net cash used in investing activities was $45.4 million and $621,000 for the nine months ended December 31, 2003 and 2002, respectively. For the nine months ended December 31, 2003, funds were used to purchase marketable securities of $44.6 million. For the nine months ended December 31, 2003 and 2002, funds were used to purchase property and equipment of $610,000 and $621,000, respectively. In December 2003, we purchased a software product used primarily for modeling voice communications for approximately $179,000.

Cash provided by financing activities was $2.4 million and $742,000 for the nine months ended December 31, 2003 and 2002, respectively. Cash provided by financing activities reflects the proceeds received from the exercise of stock options and the sale of common stock under our 2000 Employee Stock Purchase Plan.

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