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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2004

or

For the transition period              to              .

Commission file number 000-31253

PHARSIGHT CORPORATION

(Exact name of Registrant as specified in its charter)

800 West El Camino Real

Mountain View, CA 94040

(Address of principal executive offices, including zip code)

(650) 314-3800

(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 Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

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

The number of shares of Registrant’s common stock outstanding as of August 6, 2004: 19,096,957

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PHARSIGHT CORPORATION

FORM 10-Q

QUARTERLY REPORT

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PHARSIGHT CORPORATION

CONDENSED BALANCE SHEETS

(In thousands, except share and per share amounts)

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

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PHARSIGHT CORPORATION

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

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

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PHARSIGHT CORPORATION

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

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

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PHARSIGHT CORPORATION

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)

1. BASIS OF PRESENTATION

The accompanying financial statements of Pharsight Corporation (“Pharsight,” “we,” “our,” “us”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with our financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2004.

The interim financial statements are unaudited but reflect all normal recurring adjustments which are, in the opinion of management, necessary for the fair presentation of the results of these periods. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reported period. The results of operations for the three months ended June 30, 2004 are not necessarily indicative of results to be expected for the fiscal year ending March 31, 2005, or any other period. Certain prior period amounts have been reclassified in greater detail to conform to the current period classification. The reclassification had no impact on our historical results of operations or financial position.

We operate in two reportable business segments: Software Products and Strategic Consulting. See Note 9.

2. REVENUE RECOGNITION

Our revenues are derived from two primary sources: (1) initial and renewal fees for term-based product licenses, and (2) services related to scientific and training consulting and software deployment.

Our revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” (or “SOP 97-2”) as amended by Statement of Position No. 98-4, “Deferral of the Effective Date of SOP 97-2, “Software Revenue Recognition,” (or “SOP 98-4”), and Statement of Position No. 98-9, “Modification of SOP No. 97-2 with Respect to Certain Transactions,” (or “SOP 98-9”). For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, collection of the receivable is reasonably assured, and no significant post-delivery obligations remain unfulfilled. If any of these criteria are not met, we defer revenue recognition until such time as all of the criteria are met. We do not currently offer, have not offered in the past, and do not expect to offer in the future, extended payment term arrangements. If we do not consider collectibility to be probable, we defer recognition of revenue until the fee is collected.

We have contracts from which we receive solely license and renewal fees consisting of one-year software licenses (initial and renewal fees) bundled with post contract support services, or PCS. We do not have vendor specific objective evidence to allocate the fee to the separate elements, as we do not sell PCS separately. We, therefore, do not present PCS revenue separately, and we do not believe other allocation methodologies, namely allocation based on relative costs, provide a meaningful and supportable allocation between license and PCS revenues. We recognize each of the initial and renewal license fees ratably over the one year period of the license during which the PCS is expected to be provided as required by paragraph 12 of SOP 97-2.

For arrangements consisting solely of services, we recognize revenue as services are performed. Arrangements for services may be charged at daily rates for different levels of consultants and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or upon acceptance, which approximates the level of services provided. For fixed fee arrangements, we recognize revenue based on the lower of (1) an estimation of the percentage of completion on contracts on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the project, or (2) hours incurred to date multiplied by our contracted per diem rates. For fixed fee contracts with payments based on milestones, we recognize revenue on partially completed milestones based on the lower of (1) an estimation of the percentage of completion on partially completed milestones on a monthly basis utilizing hours incurred to date as a percentage of total estimated hours to complete the milestone, or (2) hours incurred to date subsequent to the last fully-completed milestone, multiplied by our contracted per diem rates, not to exceed the total revenue to be earned upon achievement of such completed milestone. If we do not have a sufficient basis to measure progress toward completion, revenue is recognized when we receive final acceptance from the customer. When total cost estimates exceed revenues, we accrue for the estimated losses immediately based upon an average fully burdened daily rate applicable to the services organization delivering the services. The complexity of the estimation process and the issues related to the assumptions, risks and uncertainties inherent with the application of

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the percentage-of-completion method of accounting affect the amounts of revenue and related expenses reported in our consolidated financial statements. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

We enter into arrangements consisting of one-year licenses (bundled with PCS), renewal fees and scientific consulting services. The scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, in that they are not essential to the functionality of the delivered software, are described separately in the arrangement and are sold separately. As the only undelivered elements in these arrangements are services and PCS, and the PCS term (expressed or implied) and the period over which we expect the services to be performed are the same period, we recognize revenue based on the lesser of actual services performed and licenses delivered, or straight line over the period of the agreement. If the PCS term and the period over which we expect the services to be performed are not the same period, we recognize revenue based on the lesser of actual services performed and licenses delivered, or straight line over the longer of the PCS term or the period over which we expect the services to be performed. Vendor specific objective evidence of fair value of scientific services for purposes of revenue recognition in these multiple element arrangements is based on daily rates for different levels of consultants and out-of-pocket expenses.

We also have arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. For arrangements involving a significant amount of services related to installation and implementation of our software products, we recognize revenue for the entire arrangement ratably over the remaining period of the PCS term once the services are completed and accepted by the customer. We currently do not have vendor specific objective evidence for PCS.

3. NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share attributable to common stockholders is computed by dividing net income or loss attributable to common stockholders for the period by the weighted-average number of shares of vested common stock (i.e. not subject to a right of repurchase) outstanding during the period.

Diluted net income (loss) per share attributable to common stockholders is computed by dividing net income attributable to common stockholders for the period by the weighted-average number of shares of vested common stock outstanding and, where dilutive, weighted average number of shares of unvested common stock outstanding. Diluted net income (loss) per share attributable to common stockholders also gives effect, as applicable, to the potential dilutive effect of outstanding stock options and warrants to purchase common stock using the treasury stock method, and convertible preferred stock using the as-if-converted method, as of the beginning of the period presented or the original issuance date, if later.

All potential common equivalent shares including preferred stock (on an as-if-converted basis), have been excluded from the computation of diluted net loss attributable to common stockholders per share for all periods presented as the effect of including such shares would be antidilutive due to the net loss attributable to common stockholders recorded in each period presented.

The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):

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The number of unvested and potential common shares excluded from the calculation of net loss per share applicable to common stockholders at June 30, 2004 and 2003 is detailed in the following table (in thousands):

4. STOCK-BASED COMPENSATION

We generally grant stock options to our employees for a fixed number of shares with an exercise price equal to the fair market value of the stock on the date of grant. As permitted under the Statement of Financial Accounting Standard No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”) and Statement of Financial Accounting Standard No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (“FAS 148”), we have elected to follow the intrinsic value method of accounting as defined by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations in accounting for stock awards to employees. Accordingly, no compensation expense is recognized in our financial statements in connection with employee stock awards where the exercise price of the award is equal to the fair market value of the stock at the date of the award. When stock options are granted with an exercise price that is lower than the fair market value of the stock on the date of grant, the difference is recorded as deferred compensation and amortized to expense on a graded basis over the vesting term of the stock options.

As required by FAS 148, the following table illustrates the effect on net loss and net loss per share if we had accounted for our stock option and stock purchase plans under the fair value method of accounting (in thousands, except per share amounts):

We estimate the fair value of our options using the Black-Scholes option value model, which was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Our employee stock options have characteristics significantly different than those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimates. In management’s opinion, therefore, the existing models do not necessarily provide a reliable single measure of the fair value of our employee stock options. The fair value of options granted and the option component of the employee purchase plan shares were estimated at the date of grant, assuming no expected dividends, and with the following weighted average assumptions:

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In conjunction with the transfer of our securities from the Nasdaq National Market to the Over-The-Counter Bulletin Board system and in accordance with the terms of the Employee Stock Purchase Plan, we suspended new offerings under the Employee Stock Purchase Plan from January 2003 until February 2004, at which time the shares could be issued pursuant to a permit under applicable state laws.

5. COMPREHENSIVE LOSS

Comprehensive loss consists of net loss adjusted for the effect of unrealized holding gains or losses on available-for-sale securities. The unrealized gains and losses are not material for the periods presented, and consequently, net loss approximates comprehensive loss.

6. CONCENTRATIONS OF CREDIT RISK

We receive a substantial majority of our revenue from a limited number of customers. For the three months ended June 30, 2004 and 2003, sales to our top two customers accounted for 48% and 30% of total revenue, respectively, and sales to our top five customers in the same periods accounted for 62% and 49% of total revenue, respectively. For fiscal 2004, 2003 and 2002, sales to our top two customers accounted for 28%, 28% and 29% of total revenue, respectively, and sales to our top five customers in the same periods accounted for 50%, 50% and 49% of total revenue, respectively. One customer accounted for 31% and 17% of total revenues for the three months ended June 30, 2004 and 2003, respectively. Another customer accounted for 17% and 9% of total revenues for the three months ended June 30, 2004 and 2003, respectively.

Two customers comprised 48% and 14% of accounts receivable at June 30, 2004. Four customers comprised 22%, 20%, 14% and 14% of accounts receivable at March 31, 2004.

7. NOTES PAYABLE

In May 2004, we renegotiated, extended and expanded our accounts receivable credit facilities with Silicon Valley Bank for an additional year, providing for up to $3.0 million in borrowings, secured against 80% of eligible domestic accounts receivable. At June 30, 2004, $1.0 million of the accounts receivable facility had been utilized and a remaining secured term loan balance of $1.8 million was outstanding. Interest is accrued at 0.5% above prime and is payable monthly from the date of borrowing. The revolving credit facility expires in May 2005. Certain of our assets, excluding intellectual property, secure both the accounts receivable and term loan facilities. The following financial covenants apply to the extended Silicon Valley Bank credit facilities: net loss no greater than $500,000 in the first quarter of fiscal 2005, net income of at least $1.00 in the remaining three quarters of fiscal 2005; minimum modified quick ratio (defined as cash and cash equivalents plus accounts receivable, divided by total current liabilities, including all bank debt, but not including deferred revenue) of 1.5:1 for the months of April 2004 through July 2004, 1.75:1 for the months of August 2004 through November 2004, and 2:1 for the months of December 2004 and each month thereafter. We were in compliance with each of these covenants at June 30, 2004.

8. REDEEMABLE CONVERTIBLE PREFERRED STOCK

Series B Redeemable Convertible Preferred Stock

On June 1, 2004, (the “Valuation Date”), we issued a dividend in the form of 18,142 shares of Series B Preferred Stock to our Series A preferred shareholders, at the election of the Series A Preferred shareholders. The Series B Preferred has identical rights, preferences and privileges as the Series A Preferred, except that the Series B Preferred is not entitled to the dividend payment right. Due to the nature of the redemption features of the Series B Preferred, we have excluded the Series B Preferred from stockholders’ equity in our financial statements. (We refer the reader to the discussion of the Preferred Stock Financing in Note 8 – Preferred Stock, in the Notes to Financial Statements contained in Item 8 of our Annual Report on Form 10-K, filed on June 15, 2004.)

The amount of the Series B Preferred dividend was determined based on the estimated per share fair value of the Series B Preferred Stock. To record the fair value of the Series B Preferred Stock, we performed a valuation based on our 5-day average stock price

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leading up to and including the Valuation Date. Various factors including, but not limited to, deemed time to liquidity and form of dividend payment were considered in the valuation of the Series B Preferred Stock. The estimated fair value of the Series B Preferred Stock issued on June 1, 2004 was $102,000 or $5.61 per share of Series B Preferred Stock. The equivalent as-converted common stock per-share value was $1.40, representing a premium of 7.7% over our then common stock price of $1.30.

9. SEGMENT INFORMATION

Segment information is presented in accordance with SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” This standard is based on a management approach, which requires segmentation based upon our internal organization and reporting of revenue and operating income based upon internal accounting methods. Our financial reporting systems present various data for management to run the business, including internal profit and loss statements prepared on a basis not consistent with U.S. Generally Accepted Accounting Principles. Not all assets are allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for the Company to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.

Our Chief Operating Decision Maker (“CODM”), as defined by SFAS No. 131, is our Chief Executive Officer. The CODM allocates resources to and assesses the performance of each operating segment using information about their revenue and operating profit before interest and taxes. Our segments are designed to promote better alignment of strategic objectives between development, sales, marketing and services organizations; provide for more timely and rational allocation of development, sales and marketing resources within businesses; and for long-term planning efforts on key objectives and initiatives. The segments are used to allocate resources internally and provide a framework to determine management responsibility. Intersegment sales costs are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

We operate in two operating segments, which are also our reportable segments: Software Products and Strategic Consulting. These segments were determined based on how management and our CODM view and evaluate Pharsight’s business.

Our Software Products segment consists of software products and software deployment and integration services that provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform clinical testing needed to bring drugs to market. By applying mathematical modeling and simulation to all available information regarding the compound being tested, researchers can clarify and quantify which trial and treatment factors will influence the success of clinical trials.

Our Strategic Consulting segment consists of consulting, training and process redesign conducted by our clinical and decision scientists in the application and implementation of our core decision methodology. Our methodology enables customers to identify which uncertainties about a drug’s efficacy and safety are greatest and matter most, and then design development programs, trial sequences, and individual trials in such a way that those trial systematically reduce the identified uncertainties, in the most rapid and cost-effective manner possible.

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Summarized financial information on our reportable segments is shown in the following table (in thousands):

Corporate and reconciling amounts include adjustments to state operating income in accordance with U.S. GAAP and corporate level expenses not specifically attributed to a segment. Corporate and reconciling items for income (loss) from operations include unallocated general and administrative expenses of $50,000 and amortization of deferred stock compensation of $67,000 in the three months ended June 30, 2003. There were no reconciling items to income (loss) from operations in the three months ended June 30, 2004. There were no inter-segment revenues for the periods shown above

Reconciliation of income (loss) from operations to income (loss) before provision for income taxes (in thousands):

10. CONTINGENCIES AND GUARANTEES

Contingencies

From time to time and in the ordinary course of business, we may be subject to various claims, charges, and litigation. In the opinion of management, final judgments from such pending claims, charges, and litigation, if any, against us, would not have a material adverse effect on our financial position, result of operations, or cash flows.

Guarantees

From time to time, we enter into certain types of contracts that contingently require us to indemnify parties against third party claims. These obligations relate to certain agreements with our officers, directors and employees, under which we may be required to indemnify such persons for liabilities arising out of their employment relationship. Other obligations relate to certain commercial agreements with our customers, under which we may be required to indemnify such parties against liabilities and damages arising out of claims of patent, copyright, trademark or trade secret infringement by our software. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. Because the obligated amounts of these types of agreements often are not explicitly stated, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, we have not had to make any payments for these obligations, and no liabilities have been recorded for these obligations on our balance sheets as of June 30, 2004 or March 31, 2004.

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11. WARRANTIES

We generally provide a warranty for our software products and services to our customers for a period of 90 days and account for our warranties under the FASB’s Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“FAS 5”). Our software products’ media are generally warranted to be free of defects in materials and workmanship under normal use and the products are also generally warranted to substantially perform as described in certain documentation. We also provide for a limited performance warranty for our software products for a period of 90 days from the date of installation at the customer premises, if used as permitted under the signed agreement and in accordance with our documentation. The sole remedy that we provide is that we will, at our own expense, use commercially reasonable efforts to correct any reproducible error in the software during the warranty period, and if we determine that we are unable to correct the error, we will refund the license fee paid for the nonconforming component of the licensed software. Our services are generally warranted to be performed in a professional manner and to materially conform to the specifications set forth in a customer’s signed contract. In the event there is a failure of such warranties, we generally will correct or provide a reasonable work around or replacement product. We have not provided for a warranty accrual in all periods presented. To date, our product warranty expense has not been material.

12. CERTAIN RELATIONSHIPS & RELATED TRANSACTIONS

Arthur Reidel, Chairman of our Board of Directors, was also a member of the Board of Directors of Insightful Corporation prior to April 29, 2004, at which point he ceased to be a member of the Board of Directors of Insightful Corporation. We license from Insightful Corporation some of the technology that is included in our Trial Simulator^TM product line. Total royalty expenses related to our relationship with Insightful Corporation were $14,000 for the period from April 1, 2004 to April 29, 2004, the period during which Insightful Corporation was a related party and $24,000 for the three months ended June 30, 2003, respectively. The amount of accrued royalties related to our relationship with Insightful Corporation at June 30, 2004 and March 31, 2004 was $14,000 and $76,000, respectively, and is included in the accompanying balance sheets as a component of accrued expenses.

Arthur Reidel, Chairman of our Board of Directors, is also a Venture Partner of Lightspeed Venture Partners. Lightspeed Venture Partners is the venture group of The Weiss, Peck & Greer Entities, which in the aggregate hold 1,223,242 shares of common stock, representing approximately 6% of our outstanding shares.

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

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

The following discussion and certain other statements in this Quarterly Report on Form 10-Q contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are subject to the “safe harbor” created by those sections. These forward-looking statements are generally identified by words such as “may,” “will,” “should,” “could,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “assume,” “potential,” “continue,” “intend,” “hope,” “can,” or the negative of such terms or other comparable terminology. These statements are only predictions and involve known and unknown risks, uncertainties and other factors, including without limitation the business risks discussed under the caption “Item 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Future Results and Market Price of Stock” in this Quarterly Report on Form 10-Q. These forward-looking statements involve risks and uncertainties that could cause our or our industry’s actual results, levels of activity, performance or achievements to differ materially from any future results, levels of activities, performance or achievements expressed or implied in such forward-looking statements. These business risks should be considered in evaluating our prospects and future financial performance. Although we believe that expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Our expectations are as of the date we file this Quarterly Report on Form 10-Q, and we do not intend to update any of the forward-looking statements after the date we file this Quarterly Report on Form 10-Q to conform these statements to actual results, unless required by law.

Overview

Pharsight Corporation develops and markets software and services that help pharmaceutical and biotechnology companies improve their productivity and decision-making in drug development and commercialization. Our solution combines proprietary computer-based simulation, statistical and data analysis tools and data repositories with the sciences of pharmacology, drug and disease modeling, human genetics, biostatistics and strategic decision-making. Our offerings consist of a portfolio of scientific and decision consulting services, software products and related services. By integrating scientific, clinical and business decision criteria into a dynamic, model-based methodology, we help our customers optimize the value of their drug development programs and portfolios from discovery to post-launch marketing and any point in between. We use computer-based drug-disease models, dynamic predictive market models, clinical trial simulation and advanced valuation models to create a continuously evolving view of our customers’ development efforts and product portfolios.

The use of our software and methodology is on the leading edge of the traditional drug-development process, which is heavily dependent upon clinical trials and patient testing. Although our methodology does not displace the use of human trials in drug development, we believe our analysis software and our methodology renders human trials more efficient and relevant. The continued growth of our customer base, the increase in the number of contracts with our customers, and the increase in our average contract values over time have shown a trend which we believe demonstrates increased acceptance of our methodology and an increased demand for its use. We believe that this trend demonstrates a potential for long-term increased revenue growth, as well as long-term opportunities to expand the breadth and coverage of both our consulting services and software product offerings.

For reporting purposes, we operate in two business segments: Software Products and Strategic Consulting. Our Software Products segment consists of software products and software deployment and integration services that provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform clinical testing needed to bring drugs to market. Our Strategic Consulting segment consists of consulting, training and process redesign conducted by our clinical and decision scientists in the application and implementation of our core decision methodology. These segments were determined based on how management and our Chief Operating Decision Maker (or “CODM”), who is our Chief Executive Officer, view and evaluate Pharsight’s business.

Challenges and Risks

We achieved our first quarter of profitability in the fourth quarter of fiscal 2004. Prior to that time we had incurred losses since inception. We currently have an accumulated deficit of approximately $79.6 million. To meet increased demand for our products and services, we may be required to invest further in our operations, technology and infrastructure, which may result in our inability to sustain profitability. Although we believe we are currently experiencing increased demand for our consulting services, we may have difficulty expanding our capacity to deliver such services in a profitable manner, if at all.

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Although we achieved positive operating cash flow in the fourth quarter of fiscal 2004, and we believe that our current cash balances are sufficient to meet our working capital needs for the next twelve months, our ability to generate positive net cash flow and sustain positive operating cash flow on a quarterly and annual basis is based on a number of factors, including some which are outside of our control, such as the state of the overall economy, the demand for our products and the length and lack of predictability of our sales cycle. As a result, we may need to raise additional funds through public or private financings or other sources to fund our operations. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and to incur additional indebtedness.

In the three months ended June 30, 2004, we generated 53% of our total revenues, or $2.6 million, from software licenses, renewal fees and deployment services in our Software Products segment, compared to 48% of total revenues, or $1.8 million, in the three months ended June 30, 2003. While we expect that the overall long-term revenue trend in our software business will continue to increase in response to customer demand, the revenue in individual quarters may fluctuate significantly, based upon timing of completion of large software installations and related revenue recognition. Unanticipated delays in consulting projects or deployment schedules may have significant impact to the timing of revenue recognition and may have corresponding significant impact to our net income in that quarter.

We generate a significant portion of our revenue from a limited number of clients. We expect that a significant portion of our revenue will continue to depend on sales to a small number of clients. In addition, the worldwide pharmaceutical industry has undergone, and may in the future undergo, substantial consolidation, which may reduce the number of our existing and potential clients. The loss of one of our large clients would hurt our business and prevent us from sustaining profitability.

Our clients may also expand their internal drug development organizations to include functions and individuals that might perform services similar to those performed by our strategic consulting group. As a result, our consulting business could have difficulty sustaining its current levels of revenues, or increasing its revenues in the future. Similarly, our clients may develop their own competing software solutions, or may choose to purchase similar products from third parties other than Pharsight. This would hurt our business and prevent us from increasing or sustaining our software revenues.

Critical Accounting Policies and Estimates

We prepare our financial statements in accordance with U.S. generally accepted accounting principles (GAAP). These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The primary critical accounting policy that currently affects our financial condition and results of operations is revenue recognition. We believe that this accounting policy is critical to fully understand and evaluate our reported financial results.

Revenue Recognition

Judgments affecting revenue recognition. Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter. We recognize revenue in accordance with GAAP rules that have been prescribed for the software industry. The accounting rules related to revenue recognition are complex and are affected by continuing interpretations of the rules based, in part, on industry practices, which are subject to change. Consequently, the revenue recognition accounting rules require management to make significant judgments.

We do not record revenue on sales to customers whose ability to pay is in doubt at the time of sale. Rather, we recognize revenue on sales to customers as cash is collected. The determination of a customer’s ability to pay requires significant judgment. In this regard, management considers the geographical domicile and the financial viability of the customer in assessing a customer’s ability to pay.

We generally do not consider revenue arrangements with extended payment terms to be fixed or determinable and, accordingly, we do not generally recognize revenue on the majority of these arrangements until the customer payments become due. The determination of whether extended payment terms are fixed or determinable requires management to exercise significant judgment, including assessing such factors as the past payment history with the individual customer and evaluating the risk of concessions over an extended payment period. The determinations that we make can materially impact the timing of recognition of revenues. Our normal payment terms currently range from “net 30 days” to “net 60 days,” which are not considered by us to be extended payment terms.

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The majority of our PKS software arrangements include software deployment services. We defer revenue for software deployment services, along with the associated license revenue, until the services are completed. If there is significant uncertainty about the project completion or receipt of payment for the professional services, we defer revenue until the uncertainty is sufficiently resolved.

Additionally, for fixed fee contracts, with payments based on milestones or acceptance criteria, we recognize revenue as such milestones are achieved, or upon acceptance, which approximates the level of services provided. Management makes a number of estimates related to recognizing revenue for such contracts, as discussed further below. The complexity of the estimation process and the issues related to the assumptions, risks and uncertainties inherent with the application of the percentage-of-completion method of accounting affect the amounts of revenue and related expenses reported in our consolidated financial statements. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.

Related Party Transactions

Arthur Reidel, Chairman of our Board of Directors, was also a member of the Board of Directors of Insightful Corporation prior to April 29, 2004, at which point he was no longer a member of the Board of Directors of Insightful Corporation. We license from Insightful Corporation some of the technology that is included in our Trial Simulator^TM product line. Total royalty expenses related to our relationship with Insightful Corporation were $14,000 for the period from April 1, 2004 to April 29, 2004, the period during which Insightful Corporation was a related party and $24,000 for the three months ended June 30, 2003, respectively. The amount of accrued royalty expense related to our relationship with Insightful Corporation at June 30, 2004 and March 31, 2004 was $14,000 and $76,000, respectively, and is included in the accompanying balance sheets as a component of accrued expenses.

Arthur Reidel, Chairman of our Board of Directors, is also a Venture Partner of Lightspeed Venture Partners. Lightspeed Venture Partners is the venture group of The Weiss, Peck & Greer Entities, which in the aggregate hold 1,223,242 shares of common stock, representing approximately 6% of our outstanding shares.

Results of Operations

The following tables and discussion sets forth, for the periods given, selected financial data as a percentage of our revenue and the percentage of period-over-period change represented by the line items in our consolidated condensed statements of operations. The tables and the discussion below should be read in connection with the condensed financial statements and the notes thereto which appear elsewhere in this report, as well as with our financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2004. All percentage calculations set forth in this section have been made using figures presented in the condensed financial statements, and not from the rounded figures referred to in the text of this management discussion and analysis.

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Comparison of Three Months Ended June 30, 2004 and 2003

Total revenues

Total revenues increased in the first quarter of fiscal 2005 due to an increase in both new and renewal software license revenues, software deployment services, and strategic consulting services.

Software products revenues

License and renewal revenues. For the three month period ended June 30, 2004, desktop software products revenues increased to $1.5 million from $1.2 million in the same period in fiscal 2004, primarily as a result of an increase in our installed base. PKS software products revenues increased to $450,000 from $358,000 in the same period in fiscal 2004, largely as a result of an increase in the number of PKS customers. DMX software revenues were $175,000 in the three months ended June 30, 2004. DMX was introduced in our second fiscal quarter of fiscal 2004, and therefore did not contribute to revenues in the three months ended June 30, 2003.

Services revenues. Software services revenues were $529,000 for the three months ended June 30, 2004, compared to $192,000 in the same period in fiscal 2004. The increase in software services revenue in the first quarter of fiscal 2005 was largely driven by services revenues associated with our DMX software product, which had not yet been introduced in the comparable period of fiscal 2004.

Strategic consulting revenues

Strategic consulting services revenues were $2.4 million in the three months ended June 30, 2004, compared to $1.9 million in the same period of the prior fiscal year. The increase in strategic consulting services revenue in the first three months of fiscal 2005 compared to the same period of fiscal 2004 was driven by increases in both the number and average size of our consulting contracts.

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Cost of revenues and operating expenses

The amounts discussed below for costs of license and renewal revenues, cost of services revenues, research and development, sales and marketing, and general and administrative expenses exclude amortization of deferred stock-based compensation.

Total cost of revenues

Total cost of revenues in absolute dollars did not change significantly in fiscal 2005 as compared to fiscal 2004. The reduction as a percentage of revenues reflects lower per unit royalty costs on our software products, and increased efficiencies in the services organizations of our software products and strategic consulting groups.

Software products

Cost of license and renewal revenues. Cost of license and renewal revenues consists of royalty expense for third-party software included in our products, and cost of materials for both initial products and product updates provided for in our annual license agreements. Cost of license and renewal revenues was $93,000 for the three months ended June 30, 2004, compared to $110,000 in the same period in fiscal 2004. The decrease in cost of license and renewal revenues in the first quarter of fiscal 2005 in absolute dollars and as a percentage of revenues was due primarily to a decrease of $20,000 in royalty costs.

Cost of services revenues. Cost of service revenues consists of payroll and related costs, travel expenses, and facilities and overhead costs associated with our deployment services group. Cost of services revenue was $314,000 for the three months ended June 30, 2004, compared to $369,000 in the same period in fiscal 2004. Cost of services revenue in fiscal 2005 decreased in absolute dollars primarily due to redeployment of resources to research and development activities. The reduction in cost of services revenues as a percentage of revenues was related to increased efficiencies in the software deployment organization in fiscal 2005. In the first quarter of fiscal 2004, the software deployment organization was newly-established and had not fully ramped-up.

Strategic consulting

Cost of services for our strategic consulting segment consists of payroll and related costs, travel expenses, and facilities and overhead costs associated with our strategic consulting personnel. Cost of services was $1.437 million for the three months ended June 30, 2004, compared to $1.389 million in the same period of fiscal 2004. The increase in cost of services revenues in absolute dollars was primarily attributable to increased headcount and payroll-related costs. The decrease as a percentage of revenues was related to increased efficiencies in our strategic consulting organization.

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Research and development

Software products

The decrease in expenses in absolute dollars and as a percentage of revenue for the three month period of fiscal 2005 was related to a reduction of $101,000 in facilities and depreciation costs, partially offset by an increase of $49,000 in consulting fees.

Strategic consulting

The strategic consulting group does not engage in research and development activities, nor is any such expense allocable to the segment, therefore it does not incur research and development related expenses.

Sales and marketing

Total sales and marketing expense

Sales and marketing expenses in the three months ended June 30, 2004 did not change significantly in absolute dollars from the same period in fiscal 2004 but decreased as a percentage of revenues as a result of our ongoing cost containment efforts. The software products and strategic consulting segments both have dedicated sales and marketing resources, as well as a shared pool of sales and marketing resources which are allocated to the segments based on each segments’ revenue as a relative percentage of total revenues. Intersegment sales costs related to the shared pool of resources are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.

Software products

The increase in expense in absolute dollars in the three months ended June 30, 2004 was primarily the result of increased software sales headcount and related payroll costs, partially offset by a reduction in allocated sales and marketing costs resulting from lower facilities expenses. The decrease in expenses in as a percentage of revenue for the three months ended June 30, 2004 was related to ongoing cost containment efforts while revenues have increased.

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Strategic consulting

The decrease in expense in absolute dollars and as a percentage of revenues in the three months ended June 30, 2004 was primarily the result of a decrease in the allocation of shared sales and marketing expenses to the strategic consulting segment, as the strategic consulting segment contributed a relatively smaller percentage of total revenues.

General and administrative

Total general and administrative expense

General and administrative expenses were essentially unchanged during the first quarter of fiscal 2005 and decreased as a percentage of revenues compared to the same period in fiscal 2004 as a result of our ongoing cost containment efforts. General and administrative expenses not specifically associated with corporate initiatives are allocated based on each segments’ revenue as a relative percentage of total revenues. In the three months ended June 30, 2003, $50,000 of general and administrative expenses were not allocated to the segments.

Software products

The increase in expense in absolute dollars in the three months ended June 30, 2004 was primarily the result of an increase in the allocation of general and administrative costs to the software products segment as the result of a larger pool of allocable costs and as a result of the larger relative percentage of software products revenues to total revenues. The decrease in expenses in as a percentage of revenue for the three month period of fiscal 2005 was related to ongoing cost containment efforts while revenues have increased.

Strategic consulting

The decrease in expense in absolute dollars and as a percentage of revenues in the three months ended June 30, 2004 was primarily the result of a decrease in the allocation of general and administrative expenses to the strategic consulting segment, as the strategic consulting segment contributed a relatively smaller percentage of total revenues.

Amortization of deferred stock compensation

The deferred stock compensation expenses recorded in each period represent the relative amortization of the difference between the exercise price of certain stock options granted prior to our initial public offering in August 2000 and the then deemed fair value of our common stock, recognized using the graded method over the vesting period of the stock options. As of March 31, 2004, all deferred stock compensation was fully amortized. Therefore, there was no amortization of deferred stock compensation in the first three month period of fiscal 2005.

Liquidity and Sources of Capital

From our inception through the initial public offering of our common stock, we funded operations through the private sale of preferred stock, with net proceeds of approximately $38 million, limited borrowings and equipment leases. In August 2000, we completed our initial public offering of 3,000,000 shares of common stock, at a price of $10.00 per share, all of which were issued and sold by us for net proceeds of $26.4 million, net of underwriting discounts and commissions of $2.1 million and expenses of $1.5 million. We paid $6.1 million to holders of our Series C preferred stock at the closing of the offering as required by the terms of the Series C preferred stock. After this payment, our net proceeds were $20.3 million. In June and September of fiscal 2003, we completed a private placement of preferred stock to several of our investors, raising additional net proceeds of $7.2 million.

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Summarized cash, working capital and cash flow information is as follows (dollars in thousands):