Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

x    Annual Report Pursuant To Section 13 or 15(d)

of The Securities Exchange Act of 1934

For the fiscal year ended June 30, 2004

OR

¨    Transition Report Pursuant To Section 13 or 15(d)

of The Securities Exchange Act of 1934

For the transition period from                          to                        

Commission File Number 000-26757

NetIQ CORPORATION

(Exact name of Registrant as specified in its charter)

(408) 856-3000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:    None

Securities registered pursuant to Section 12(g) of the Act:

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

As of December 31, 2003, the aggregate market value of Registrant’s voting stock held by non-affiliates was approximately $753.4 million based upon the closing sales price of the Common Stock as reported on the Nasdaq National Stock Market on such date. Shares of Common Stock held by officers, directors and holders of more than ten percent of the outstanding Common Stock have been excluded from this calculation because such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of August 31, 2004, the Registrant had outstanding 55,321,457 shares of Common Stock.

Certain sections of Registrant’s definitive Proxy Statement for the 2004 Annual Meeting of Stockholders to be held on November 18, 2004 are incorporated by reference in Part III of this Annual Report on Form 10-K to the extent stated herein.

Table of Contents

NetIQ Corporation

INDEX TO ANNUAL REPORT ON FORM 10-K

FOR YEAR ENDED JUNE 30, 2004

2

Table of Contents

The statements contained in this Annual Report on Form 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, intentions, strategies, and expected operating results and financial condition. Forward-looking statements also include statements regarding events, conditions and financial trends that may affect our future plans of operations, business strategy, results of operations and financial position. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Investors are cautioned that any forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties and that actual results may differ materially from those included within the forward-looking statements as a result of various factors. These forward-looking statements are made in reliance upon the safe harbor provision of The Private Securities Litigation Reform Act of 1995. Factors that could cause or contribute to such differences include, but are not limited to, those described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, under the heading “Factors That May Affect Future Operating Results” and elsewhere in this Annual Report on Form 10-K.

PART I

ITEM 1.    BUSINESS

Overview

We are a provider of cross-platform systems and security management software and web analytics software and services.

Our systems and security management solutions enable organizations to monitor and proactively manage their information technology (IT) infrastructure to assure the performance, availability, security, and more-efficient utilization of their IT environments. While our business initially focused on management of systems and applications running on the Microsoft Windows operating system, we have expanded our business to include cross-platform systems management solutions and security management solutions for the Windows, UNIX, Linux and IBM iSeries operating systems, as well as web analytics software and services. We also offer software to test, migrate and administer Microsoft Windows and active directory systems as well as voice over internet protocol systems. As a result, organizations currently are able to manage and secure many of their applications, servers and operating systems using our products.

Our web analytics offerings, which are available as hosted services or software-based solutions, enable organizations to track, report and analyze web site traffic and usage. Our offerings are used by web site owners to convert web site visitors into customers and to improve the returns generated on their investments in online marketing.

We were founded and incorporated as a California corporation in June 1995, reincorporated in Delaware and completed our initial public offering in July 1999. We acquired Mission Critical Software, Inc. in May 2000, WebTrends Corporation in March 2001 and PentaSafe Security Technologies, Inc. in December 2002. In September 2000 we entered into a licensing agreement with Microsoft Corporation whereby we granted Microsoft a perpetual license to our Operations Manager product technology and source code for $175 million paid in quarterly installments through August 2003. For additional information on these and other recent developments see “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Through a link on our web site, www.netiq.com, we provide free of charge access to our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Proxy Statements, as soon as reasonably practicable after the reports are electronically filed with or furnished to the Securities and Exchange Commission.

3

Table of Contents

Markets and Products

Today’s organizations are highly dependent on computer systems to conduct their operations. The typical information technology environment is characterized by distributed information systems and networks that support multiple business-critical applications for financial reporting, human resources, enterprise resource planning, supply chain management, customer relationship management and email, as well as other industry-specific applications. In addition to the internal networks that connect employees to these geographically dispersed computing services, the Internet has become an essential medium for connecting businesses with customers, suppliers, investors and employees.

The critical nature and growing complexity of these systems have placed increasing pressure on systems managers and chief information officers to ensure the reliability and availability of their computer systems. Organizations must keep their information technology infrastructures secure and available 24 hours per day, 7 days per week, and must be able to support widely distributed global organizations with varying technological requirements. Failure to ensure business-appropriate service levels can result in substantial costs, including loss of productivity and revenue. We offer products in the following four key areas:

Systems Management.

The primary function of our systems management software is to promptly identify and provide notification and an automated response to system problems such as application failures, system software crashes, hardware failures, slow response times and insufficient resource capacity. Our software continually monitors the performance, responsiveness and availability of systems and applications, and evaluates the capabilities of network services. These functions enable systems administrators to respond to actual or threatened performance degradation, and to plan and budget for additions, upgrades and configuration changes.

Windows,UNIX and Linux Management.    Windows server operating systems represent a large share of the platforms that organizations use for deploying their mission critical applications. Many applications, however, continue to run on UNIX and the Linux operating system continues to gain market momentum. The growth and deployment of varied systems and applications in highly complex computing environments have expanded and further complicated the challenges of managing the performance and availability of information technology systems. These challenges range from basic tasks, such as monitoring central processing unit utilization, memory and disk-space availability, to complex tasks such as monitoring Internet traffic, application response times and IT service levels. We offer the following products to address these challenges:

4

Table of Contents

VoIP and Network Management.    Increasingly, companies are migrating voice communications onto Internet protocol-based computer network infrastructures using a technology called Voice over Internet Protocol or VoIP. Because network performance is essential to continuous and consistent availability of all critical services throughout the infrastructure, systems administrators continually monitor application performance and routinely test the impact of new applications, such as VoIP, on the network to identify and correct potential performance problems prior to deployment of new systems and upgrades to existing systems. Pre-deployment tests of a network to predict performance and assess readiness and post-deployment monitoring to maintain consistent performance are critical for a smooth VoIP implementation and high quality operations. We offer the following network management solutions and VoIP products:

    In July 2003, we granted Ixia exclusive distribution rights to our Chariot products in the United States and Canada through December 31, 2004, as well as a perpetual license to the source code for the Chariot products to develop and distribute derivative products. In addition to the license rights, Ixia was granted an option to purchase assets associated with our Chariot products. The purchase option expires on January 15, 2005. To date, Ixia has not exercised this option.

Security Management.

Today’s organizations face expanding security threats to their information technology systems as they rely on information technology to conduct critical business operations; as they gather, store and utilize growing amounts of highly sensitive customer and operational data; and as electronic attacks on information technology systems proliferate. Simultaneously, privacy legislation, such as HIPAA, and internal control legislation, such as Sarbanes-Oxley, are increasing the need for organizations to deploy a range of information technology security solutions. To meet today’s information technology security challenges, we offer security management solutions that combine vulnerability management with security event detection, as well as products for content security. Our security management products include:

5

Table of Contents

Windows Administration.

We provide administration solutions that allow organizations to securely delegate administrative tasks, automate user account provisioning, implement end-user self-service, and enable auditing and policy enforcement. Our products for Windows administration include:

Web Analytics.

In recent years, there has been an increased focus on building external and internal web sites for business functions, including eCommerce, information distribution, and customer/employee self-service. As a result, web sites have become an integral part of overall business strategy, facilitating communications with customers, vendors, employees, and investors. Successful web-based strategies require an understanding of how visitors interact with the company’s Internet and intranet sites and how various online and offline initiatives

6

Table of Contents

translate into bottom line results. Businesses need a means of forecasting, tracking, and integrating historical visitor data with other corporate and market databases in order to optimize these business functions, thereby reducing costs and growing revenues through higher returns on marketing investments. We offer the following products to address these challenges:

Sales and Distribution

Our products are sold through the following:

Our products are also co-marketed or integrated and sold with the offerings of certain strategic partners, which include Internet service providers, original equipment manufacturers, system integrators, and others.

Field and Inside Sales.    We market our software and services through our 14 domestic and 21 international field sales offices.

During fiscal 2004, our direct sales organization was organized to reflect a named account focus. The field team is organized into three tiers; Major Account Managers, Account Managers and Corporate Sales Representatives. Both the Major Account Managers and Account Managers are field sales positions and they typically support enterprise clients. The Corporate Sales Representatives are inside sales personnel who support small to medium businesses. Our field and inside sales representatives are supported by system engineers and product specialists who assist with pre-sales activities.

Typically, our field sales process includes an initial sales presentation in person or over the phone, a product demonstration, a product evaluation period, a closing meeting and a purchasing process. Our sales process normally takes 30 to 180 days depending on the product, but this process can be longer for larger customers or enterprise-wide opportunities. A majority of our sales are from repeat customers who often purchase additional software and complementary NetIQ products as their environments become more complex, their needs change, and as we introduce new offerings.

Value Added Resellers, System Integrators, Distributors and Original Equipment Manufacturers.    The NetIQ Authorized Reseller Program provides training, technical support and priority communications, and facilitates joint sales and marketing activities with our channel partners. Our channel sales representatives focus on managing the sales activities of our regional channel partners and the branch sales offices of our national reseller partners. As of June 30, 2004 we had over 700 third-party channel partners who resold our products and

7

Table of Contents

provided services to our customers worldwide. Our top ten channel partners represented approximately 21%, 16% and 14% of our worldwide license revenue, in the aggregate, during fiscal 2004, 2003 and 2002, respectively.

International Revenue.    International revenue represented 36%, 23%, and 18% of total revenue during fiscal 2004, 2003 and 2002, respectively. Total revenue includes domestic revenue from the Microsoft agreement of $5.0 million, $60.0 million and $85.0 million during fiscal 2004, 2003 and 2002, respectively. As we expanded our international sales efforts and as revenue from Microsoft decreased in accordance with our agreement, the percentage of our revenues derived from international sources increased. During fiscal 2004 a majority of our international business was conducted in U.S. dollars.

Pricing.    We typically license our software to customers under non-exclusive, perpetual license agreements priced on a per-server or per-user basis. Our hosted web analytics service, WebTrends 7 On Demand, typically is sold on a page-view basis and customers are charged based on usage and time. Original purchases of maintenance and renewal maintenance are priced at specified percentages of the related list prices or license fees as specified in the contract. Training and consulting services generally are priced on a daily rate.

Marketing

Our marketing programs are designed to inform customers about the capabilities and benefits of our products and services, to connect our sales force with prospective customers and to attract third parties who can serve as distributors and resellers of our products and services. Our marketing efforts include participation in industry trade shows, technical conferences, technology seminars, preparation of competitive analyses, sales training, publication of technical and educational articles in industry journals, targeted database-driven direct response communications, advertising, public relations, and analyst and press tours.

We often work with third parties to expand the market for our products. We have cooperative business relationships with developers of Windows and UNIX-based systems, including Dell Computer Corporation, Hewlett-Packard Company, International Business Machines Corporation, Microsoft Corporation, Oracle Corporation, Sun Microsystems, Inc., and Unisys Corporation. We have similar relationships with developers of applications and technologies, including Akamai Technologies, Inc., Check Point Software Technologies Ltd., Cisco Systems, Inc., Research in Motion Limited, Trend Micro Inc., and VERITAS Software Corporation. As part of these relationships, we may cooperate in our engineering efforts or develop joint marketing programs with these partners.

We have a range of relationships with systems integration and consulting organizations that may recommend or sell our products to their customers or where we cooperate in serving joint customers. Examples of these relationships include Accenture, Avanade Inc., Electronic Data Systems Corp., HP Services, IBM Global Services, Siemens AG and Wipro.

Customer Support and Services

Customers typically purchase software maintenance with each new product license. Software maintenance generally includes software updates, telephone and e-mail support as well as customer self service on our web site. Customers are typically provided an option to renew their maintenance agreements on an annual basis. Our technical support organization provides product support to our current customers and to prospective customers in connection with product sales. Our support offerings are two tiered and our premium level offering includes support availability 24 hours per day, 7 days per week.

Our professional services group provides implementation and other services. Our training courses focus on enabling customers and partners to successfully implement, use and extend our products in their respective environments in a timely and cost-effective manner. End-user training is provided on a regularly scheduled basis at our training facilities in Houston, Texas, Portland, Oregon and Staines, United Kingdom and through our authorized training partners.

8

Table of Contents

Research and Development

Our research and development organizations are responsible for the design, development and release of our products. These groups are organized into product management, development, quality assurance, documentation and localization disciplines by major product family. Members from each discipline form separate product teams that work closely with sales, marketing and customer support to better understand market needs and user requirements. Additionally, we have an information feedback loop with our customers designed to enable us to respond to and address their changing systems and security management and web analytics requirements. We also purchase or license third-party technology to shorten our time to market. The focus of our research and development efforts is to bring new products and services as well as new versions of existing products to market quickly in order to keep pace with the rapid evolution of technology and increasing customer demands. During fiscal 2004, 2003 and 2002 research and development costs were $68.1 million, $71.1 million and $61.0 million, respectively.

Competition

The markets for systems and security management software solutions and web analytics solutions are intensely competitive, and we expect competition to increase in the future. While there are few substantial barriers to entry at the low end, we expect to see increasing consolidation in the software industry, including among our competitors, which could increase the resources available to our competitors and the scope of their product offerings. Our competitors and potential competitors may have more name and brand recognition, develop more advanced technology, undertake more extensive sales and marketing campaigns, adopt more aggressive pricing policies and sales terms, and be able to leverage more extensive financial, customer and partner resources.

Our principal competitors include:

We also expect future product consolidation to be an important competitive factor, and that competitors may bundle their products with products similar to ours, or incorporate functionality into existing products that could render certain of our products unmarketable or obsolete. For example, Microsoft is a competitor of ours in certain markets and has a history of adding functionality to new versions of Windows in ways that may impair the success of formerly complementary products. Customer perception of this pattern could also adversely affect or delay sales of our products.

In addition, our ability to sell our products depends, in part, on their compatibility with other third-party products, such as operating systems and messaging, Internet and database applications. Some third-party

9

Table of Contents

software developers may change their products so that they compete with our products or are no longer compatible with our products. In particular, our business continues to be largely focused on the Microsoft Windows environment and Microsoft has typically provided to us pre-release notification of feature enhancements to its products and necessary development tools and information. If Microsoft stops this practice, we may be unable to coordinate our product offerings with Microsoft or to otherwise capitalize on new Microsoft product releases and feature enhancements.

Intellectual Property

Our success is heavily dependent on our ability to create proprietary technology and to protect and enforce our intellectual property rights in that technology, as well as our ability to defend against adverse claims of third parties with respect to our technology and intellectual property. We rely primarily on a combination of patent, copyright and trademark laws, trade secrets, confidentiality procedures and contractual provisions to protect our intellectual property rights in our products and services. These laws and procedures provide only limited protection. We presently have 18 issued or allowed patents in the United States, 24 pending patent applications in the United States, 6 issued or allowed foreign patents, and 24 pending patent applications in certain foreign jurisdictions. However, these patents may not provide sufficiently broad protection or they may not be enforceable in actions against alleged infringers. In addition, despite precautions that we take, it may be possible for unauthorized third parties to copy or reverse engineer aspects of our current or future products, to independently develop similar or superior technology, or to design around the patents we own. Policing unauthorized use and transfer of our software is difficult and software piracy currently is and can be expected to continue to be a persistent problem. In licensing our products, other than in enterprise license transactions, we typically rely on “shrink wrap” or “clickwrap” licenses that are not signed by licensees. Such licenses may be unenforceable, in whole or in part, under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect our intellectual property rights to as great an extent as do the laws of the United States. It may be necessary to enforce our intellectual property rights through the process of litigation, arbitration or other adversarial proceedings. As well, third parties may bring actions against us alleging intellectual property infringement, such as that brought by BMC against us and discussed under Legal Proceedings. The participation in such proceedings could be costly and distracting to management, and there is no assurance that we would prevail.

Employees

As of June 30, 2004 we had 1,322 employees, 526 of whom were in sales and marketing, 401 in research and development, 194 in customer support and services, and 201 in general and administration. None of our employees is represented by a collective bargaining agreement. We have not experienced any work stoppages and consider our relations with our employees to be good.

10

Table of Contents

Executive Officers

The following table sets forth information regarding our executive officers as of June 30, 2004.

Charles M. Boesenberg joined NetIQ as President and Chief Executive Officer in January 2002, was named Chairman of the Board of Directors in August 2002 and in April 2004 Mr. Boesenberg’s title was changed to Chief Executive Officer and Chairman of the Board of Directors. Prior to joining NetIQ, he was President of Post PC Ventures, a management and investment group from March 2000 to December 2001. From December 1998 to February 2000, Mr. Boesenberg served as President and Chief Executive Officer of Integrated Systems, Inc., a provider of embedded systems software. Before joining Integrated Systems, Mr. Boesenberg was President and Chief Executive Officer of Magellan Corporation, which was the surviving corporation of a merger with Ashtech, Inc., a position that he assumed in January 1995 with Ashtech. Magellan specializes in satellite navigation and communication products. Mr. Boesenberg has held senior executive positions with a number of technology companies including International Business Machines Corporation and Apple Computer, Inc. Mr. Boesenberg served as a member of the Board of Directors of Symantec Corporation, a provider of Internet security technology, from June 1994 until September 12, 2002, but did not participate in Symantec Corporation board meetings after assuming his position with NetIQ. Mr. Boesenberg currently serves as a member of the Board of Directors of Maxtor Corporation, a provider of hard disk drive storage products and solutions, where he serves on the Compensation Committee. Mr. Boesenberg served as a member of the Board of Directors of Epicor Software, a provider of integrated enterprise software solutions for mid-market companies, from December 2000 until May 2003. Mr. Boesenberg holds a B.S. in mechanical engineering from the Rose Hulman Institute of Technology and a M.S. in business administration from Boston University.

James A. Barth was named Senior Vice President, Finance and Administration, and Chief Financial Officer of NetIQ in November 2001, and for the period November 2000 to November 2001 he served as Senior Vice President, Finance, Chief Financial Officer and Secretary of NetIQ. From March 1999 to November 2000, he served as Vice President, Finance, Chief Financial Officer and Secretary of NetIQ. From November 1997 until March 1999, Mr. Barth served as the Vice President, Chief Financial Officer and Secretary of Interlink Computer

11

Table of Contents

Sciences, a developer of enterprise networking software designed for the IBM mainframe platform. From October 1994 to November 1997, Mr. Barth served as Executive Vice President, Chief Financial Officer and Secretary of MagiNet, a provider of interactive entertainment and information systems. Mr. Barth also served as the Chief Financial Officer of Rational Software from July 1982 to March 1994. Mr. Barth holds a B.S. in business administration from the University of California at Los Angeles and is a certified public accountant.

Marc B. Andrews was named Senior Vice President and General Manager of our Systems and Security Management business unit in January 2004 and for the period July 2002 through January 2004 he served as our Vice President and as General Manager for NetIQ Ltd, our UK subsidiary. Prior to joining NetIQ, Mr. Andrews was employed by BMC Software Inc., where he served as Vice President of Marketing for Europe, the Middle East and Africa from April 2001 through June 2002. Mr. Andrews also served as the Director of Strategic Business Unit Marketing at BMC for Europe, the Middle East and Africa from January 2000 through March 2001 and prior to that he served as the Regional Director of BMC in Dubai, United Arab Emirates from 1997 through 1999.

Betsy E. Bayha joined NetIQ as Vice President, General Counsel and Secretary in November 2001. Prior to joining NetIQ, Ms. Bayha was in private practice representing high technology corporations for more than 20 years. Ms. Bayha was a partner at General Counsel Associates from November 1994 through October 2001. From December 1986 through October 1994, Ms. Bayha was a partner at the international law firm of Coudert Brothers. Prior to 1986, Ms. Bayha held various positions with private law firms. Ms. Bayha holds a J.D. from Harvard Law School, an M.A. in public administration from The Ohio State University and a B.A. in economics from Oakland University.

Holly E. Files served as Senior Vice President, Worldwide Support and Services from April 2003 until her departure in June 2004, and for the period of February 2002 through March 2003 she served as our Vice President, Worldwide Services and Support. From July 2001 until February 2002, she served as the Chief Information Officer of 800.com. Ms. Files served as Vice President of Worldwide Services for WebTrends Corporation from November 1998 and continued in that position after it was acquired by NetIQ until July 2001. From July 1997 until November 1998, she served as Executive Director of Operations at Radiant Systems/RapidFire, a point-of-sale systems provider for the retail sector.

Gregory L. Drew was named Senior Vice President and General Manager, Web Analytics business unit in October 2003 and for the period April 2003 to October 2003 he served as Senior Vice President, Web Analytics Sales and Marketing. In April 2002 Mr. Drew founded DrewVentures, LLC, a management consulting firm specializing in advising clients on marketing, sales, customer service, operations and Internet strategies and he served as the Managing Partner from April 2002 until March 2003. In January 1998, Mr. Drew founded 800 Electronics and served as the President, Chief Executive Officer and Chairman of the Board from October 1998 until April 2002. From January 1997 until December 1997 Mr. Drew was employed by Now Software as Vice President, General Manager, End User Products Group and Vice President Worldwide Sales from April 1996 until December 1996. Mr. Drew has also held a variety of positions at Clientele Software, Central Point Software and Hewlett Packard Company. Mr. Drew is a graduate of Farleigh Dickenson University, with a B.S. in business management.

David J Ehrlich was named Senior Vice President, Corporate Strategy and Development in January 2004, after joining NetIQ as Vice President, Corporate Development in February 2003. Prior to joining NetIQ, Mr. Ehrlich was a consultant to the CEO and Board of Visual Networks from January 2002 until January 2003, and held the position of Senior Vice President, Product Marketing, Strategy, and Business Development at Visual Networks from November 2000 to January 2002, and Vice President from September 1998 to November 2000. Prior to joining Visual Networks, Mr. Ehrlich held various management positions at McKinsey & Company Inc., Orbyx Global Trade Group, Inc., and Wells Fargo Bank. Mr. Ehrlich holds an M.B.A from Harvard University and an B. A. and a M. S. in industrial engineering from Stanford University.

Mark P. Marron joined NetIQ as Senior Vice President, Worldwide Sales in August 2001. Prior to joining NetIQ, from 1999 to August 2001, Mr. Marron served as General Manager Worldwide Channel Sales for

12

Table of Contents

Computer Associates International Inc., a provider of software and services that enable organizations to manage their IT environments. From 1997 to 1999, he served as Senior Vice President of Channel Sales and Operations for Europe, the Middle East and Africa, from 1993 to 1997, he served as Senior Vice President of Channel Sales for United States and from 1991 to 1993, he served as Vice President of Telesales at Computer Associates International, Inc. From 1989 to 1991 he served as District Sales Manager/Account Manager at On-Line Software International, and from 1988 to 1989, he was National Account Manager at Information Sciences, Inc. Mr. Marron holds a B.S. in computer science from Montclair State University.

Olivier J. Thierry was named Senior Vice President Marketing and Alliances in January 2004. Prior to being named to his current position with NetIQ Mr. Thierry served as Vice President of International Marketing for NetIQ from June 2001 until January of 2004. From February 1998 until June 2001 Mr. Thierry served as Vice President of Marketing and Product Management for Mission Critical Software, Inc. and continued in that position after it was acquired by NetIQ in May, 2000. He received his Bachelor of Commerce degree with a joint major in both Marketing and Computers and Systems from McGill University.

Richard M. Schell was named Chief Technology Officer in February 2004. From April 2003 until June 2004 Dr. Schell was Executive Vice President Products and for the period June 2002 through March 2003 he served as our Chief Technology Officer and General Manager, Performance and Availability Management. From February 2001 to June 2002, Dr. Schell was self-employed. Dr. Schell served as the Chief Executive Officer of iSharp, a provider of hosted solutions to monitor and administer site infrastructure performance, from September 1999 to February 2001, when the company filed for bankruptcy protection. From October 1994 to February 1998, he served as Senior Vice President, Product Development, at Netscape Communications, a provider of open client, server and integrated applications software. He holds an A.B., M.S. and a Ph.D. in computer science from the University of Illinois.

Richard H. Van Hoesen joined NetIQ in February 2003 as Vice President, Finance and was named Chief Accounting Officer in April 2004. From February 2000 until January 2003 Mr. Van Hoesen was Vice President and CFO at privately-held XACCT Technologies, Inc., a network-mediation software company. Mr. Van Hoesen held the position of Senior Vice President and General Manager from January 1999 through January 2000 of the Micro Focus business unit of Merant Inc. which was formed as a merger between Micro Focus PLC and Intersolv, Inc. From March 1998 until January 2000, Mr. Van Hoesen was Senior Vice President and Chief Financial Officer of Micro Focus PLC. Mr. Van Hoesen holds a B.S. in industrial engineering from Lehigh University and an M.B.A. from the Wharton School of the University of Pennsylvania.

13

Table of Contents

ITEM 2.    PROPERTIES

Our corporate and administrative headquarters and certain research and development and sales and marketing personnel are located at the 85,000 square foot facility that we own in San Jose, California.

We lease properties in the following locations to house our additional research and development, sales and marketing, and general and administrative personnel:

We also lease various other smaller properties in the United States and foreign countries primarily for our sales and marketing personnel. A majority of these leases are for a period of less than one year. We believe that our properties are in good condition, adequately maintained and suitable for the conduct of our business. Certain of our lease agreements provide options to extend the lease for additional specified periods. For additional information regarding our obligations under leases, see Note 13 to our Consolidated Financial Statements.

ITEM 3.    LEGAL PROCEEDINGS

In January 2003 BMC Software, Inc. (BMC) filed suit against us in the U.S. District Court for the Southern District of Texas (Court) for patent and trademark infringement. In August 2003 the Court ordered the litigation stayed, pending arbitration. In September 2003 BMC submitted to the American Arbitration Association a statement of claim seeking a declaratory judgment that BMC’s claims are not subject to arbitration and alleging that it believes that at least AppManager and our former operations manager product, the underlying technology of which is licensed to Microsoft, infringe the BMC patent. In October 2003 we submitted our initial answer, denying the claims of infringement asserted by BMC. In November 2003 we filed an amended answer and counterclaim alleging that BMC infringes a valid patent that we own. BMC has denied the allegations in our counterclaim. Each party seeks injunctive relief, compensatory and treble damages, interest, and attorneys’ fees with respect to its claims. Currently, discovery is in the very early stages.

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

Not applicable.

14

Table of Contents

PART II

ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our Common Stock is traded on the Nasdaq National Stock Market under the trading symbol “NTIQ”. The following table presents the range of high and low closing prices for our common stock for the two years ended June 30, 2004:

The number of record holders of the shares of our common stock was 264 as of August 31, 2004, which does not include stockholders whose shares are held in trust by other entities. The actual number of stockholders is greater than this number of holders of record. Based on the number of annual reports requested by brokers, we estimate that we have approximately 11,000 beneficial owners of our common stock.

We have never declared or paid any cash dividends on shares of our common stock and do not expect to do so in the foreseeable future. We anticipate that all future earnings, if any, generated from operations will be retained to develop and expand our business. Any future decision to pay cash dividends will depend on our growth, profitability, financial condition and other factors our Board of Directors may deem relevant.

15

Table of Contents

ITEM 6.    SELECTED FINANCIAL DATA

The following selected historical consolidated financial data should be read in conjunction with our Consolidated Financial Statements, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K.

16

Table of Contents

ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The statements contained in this Annual Report on Form 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, intentions, strategies, and expected operating results and financial condition. Forward-looking statements also include statements regarding events, conditions and financial trends that may affect our future plans of operations, business strategy, results of operations and financial position. All forward-looking statements included in this document are based on information available to us on the date hereof and we assume no obligation to update any such forward-looking statements. Investors are cautioned that any forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties and actual results may differ materially from those included within the forward-looking statements as a result of various factors. These forward-looking statements are made in reliance upon the safe harbor provision of The Private Securities Litigation Reform Act of 1995. Factors that could cause or contribute to such differences include, but are not limited to, those described under the heading “Factors That May Affect Future Operating Results” below and elsewhere in this Annual Report on Form 10-K.

Overview

We provide cross-platform systems and security management software, web analytics software and related services.

Our systems and security management solutions enable organizations to monitor, and proactively manage their IT infrastructure to assure the performance, availability, security, and more-efficient utilization of their IT environments. While our business initially was focused on management of systems and applications running on the Microsoft Windows operating system, we have expanded our business to include cross-platform systems management solutions and security management solutions for the Windows, UNIX, Linux and IBM iSeries operating systems, as well as offering web analytics software solutions.

Our strategy broadened after entering into an agreement with Microsoft in September 2000. Pursuant to this agreement we granted to Microsoft a non-exclusive perpetual license to our operations manager product and technology in exchange for $175 million in license revenue, payable in scheduled installments over three years, plus payment of an additional $15 million in marketing funds over three years. Microsoft has further developed this technology and offers basic systems management functionality for some versions of its Windows operating systems and some Microsoft applications. Following entry into the agreement with Microsoft, we began a broad diversification program to develop additional revenue streams and to extend our principal systems management product suite, AppManager. Revenue from customers other than Microsoft grew 19% from fiscal 2002 to fiscal 2003 but declined 7% from fiscal 2003 to 2004. AppManager license revenue, which represented approximately 40% of all non-Microsoft license revenue in fiscal 2004, has remained relatively flat since fiscal 2001. Excluding the fees from Microsoft, total revenue growth from fiscal 2002 through fiscal 2004 has been derived principally from increases in revenue from the provision of maintenance and other services.

Since fiscal 2001, to maintain the AppManager license revenue stream, we expanded its capabilities to provide support for other operating systems, principally UNIX and Linux, and increased support of non-Microsoft applications. To extend beyond systems management, we acquired WebTrends Corporation in March 2001, adding software solutions for tracking, reporting and analyzing web site traffic and usage to our product portfolio, and we have further expanded these product solutions since that time.

We also focused our expansion strategy on developing and acquiring security management products due to the anticipated convergence of systems and security management technologies and our perception of customer needs. We used an existing technology to develop products to manage security events. We acquired security firewall monitoring technology as part of the WebTrends acquisition and in December 2002 we acquired PentaSafe Security

17

Table of Contents

Technologies, Inc. and Marshal Software, Ltd., both companies with security management technologies. During the balance of fiscal 2003 and in fiscal 2004 we integrated and further developed these products and technologies, releasing a focused set of security management products in the fourth quarter of fiscal 2004.

From fiscal 2001 through fiscal 2003, our revenue benefited substantially from license fees from the Microsoft agreement; $25.0 million (15% of total revenue) in fiscal 2001, $80.0 million (29% of total revenue) in fiscal 2002, and $65.0 million (21% of total revenue) in fiscal 2003. The last payment of $5.0 million (2% of total revenue) was received in the first quarter of fiscal 2004.

Our operating margin also benefited from the license fees from the Microsoft agreement as costs related to this revenue stream were insignificant. However, as part of our expansion strategy we increased spending, particularly in research and development, in fiscal 2002 and fiscal 2003, to develop and refine our products and those acquired through our acquisitions. Through the development and acquisition of a comprehensive security management product portfolio, and the convergence of systems and security management markets, we have positioned NetIQ to benefit from growth of the security management market.

Prior to fiscal 2004, we focused on marketing our systems management products principally to system or network administrators, and customer purchase approval levels were generally below the level of the chief information officer. As we expanded our product offerings and focused on broader solutions, it became increasingly important to develop broad-based relationships with our customers and to cultivate relationships at higher levels in our customers’ information technology (IT) organization. Beginning in July 2003 we refocused our sales strategy from territory-based to a named-account-based approach to better address the needs of customers and to focus our sales efforts more on product suites rather than individual products. As a result of the reorganization of our sales team following our acquisition of PentaSafe, the changing focus of our sales organization and the soft spending environment for IT products generally, we had high turnover of sales personnel and the productivity of our sales force did not meet our expectations during the second half of fiscal 2003 and through fiscal 2004. During fiscal 2004, we implemented expanded product, solution and process training. As our sales strategy matured throughout fiscal 2004, turnover of sales personnel abated significantly.

As a result of the decreasing revenue received under the Microsoft agreement, integration and restructuring costs related to our acquisitions and low sales force productivity, our operating margins were under heavy pressure during the 2003 and 2004 fiscal years. Also, because our growth strategy was dominated by acquisitions, some of which were consummated at high valuations prior to the decline in stock prices after fiscal 2002, our financial results were subjected to revaluation charges and impairments of goodwill. Upon our adoption, in July 2003, of Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible Assets, we evaluated the fair value of goodwill and took a transitional impairment charge of $579.3 million, characterized as the cumulative effect of a change in accounting principle. During fiscal 2003 and fiscal 2004, we incurred further impairment charges of $330.5 million and $150.8 million, respectively, leaving a balance of $124.1 million in goodwill at June 30, 2004.

In connection with our acquisition of PentaSafe in December 2002 and the resizing of the combined businesses, we adopted a plan to eliminate redundant positions in both the NetIQ and PentaSafe workforces and to vacate excess facilities. We terminated the employment of 55 employees of PentaSafe and accrued $1.7 million related to severance benefits which we accounted for as part of the acquisition of PentaSafe. We also terminated the employment of 52 NetIQ employees and vacated certain of our leased facilities, resulting in a charge of $5.3 million, reflected as a restructuring charge in the second quarter of fiscal 2003. In the fourth quarter of fiscal 2003, we announced a further reduction in force designed to lower operating costs and to better support the convergence of the systems management and security management markets, by combining our systems and security management business units and streamlining our organizational structure. As a result, we terminated the employment of 108 employees, including four senior executives. Total severance costs of $1.5 million relating to this reduction in force were recorded as sales and marketing, research and development and general and administrative expenses in fiscal 2003.

18

Table of Contents

In October 2003 we announced a more sharply focused strategy for fiscal 2004 and identified five key priorities: (1) refine and narrow our focus to five major product lines in our systems and security management business, (2) renew contact with and re-sell AppManager to our existing customers, (3) sell to our current AppManager customers our other major product lines, (4) revise our marketing and sales strategy for Windows Administration products, and (5) improve sales force productivity and operating performance.

The strategic focus in fiscal 2004 was largely successful. We refocused our systems and security management development teams, sales force and partners around five key product areas: AppManager Suite, VigilEnt Security Manager, Security Manager and VigilEnt Log Analyzer, Windows Administration products and our Marshal family of content security solutions. Our efforts resulted in major product releases in each of these areas, the enhancement and re-branding of VigilEnt Security Manager as NetIQ Vulnerability Manager, the consolidation and enhancement of Security Manager and VigilEnt Log Analyzer as NetIQ Security Manager and the training of sales teams, partners and customers. Recently, we further narrowed our product priority to three major systems and security management product areas, (1) AppManager Suite, (2) NetIQ Security Manager, and (3) NetIQ Vulnerability Manager, in addition to our WebTrends 7 products. Each of these major products has been recently upgraded. We also sold or licensed others to further develop and distribute lower volume products such as SQL tools, Chariot, and some AppManager modules, freeing up development resources to focus on the major product areas. Finally, we acquired the Group Policy Administrator and Group Policy Guardian products within the Windows Administration product family and WebPosition Gold in the Web Analytics product family.

Our senior executives, sales personnel and product management personnel developed programs to work with our existing AppManager accounts, ensuring they understood the benefits and capabilities of the AppManager suite of products. This resulted in increased maintenance renewals for AppManager products as well as increased sales of new licenses, including licenses for our UNIX/Linux cross-platform management products. In the fourth quarter of fiscal 2004, revenue for AppManager products was up year over year. As a result of greater involvement with our customers and renewed success of AppManager Suite, about half of our larger transactions in the third and fourth quarters also included other products, typically security management products. In addition, by repositioning Windows Administration products, revenue in the fourth quarter of fiscal 2004 for these products was up substantially year over year.

Improving sales force productivity is continuing to receive our greatest attention. We believe that our major account focus is appropriate and is enhancing our relationships within accounts. As well, turnover of sales personnel declined every quarter during fiscal 2004, and our program of significant additional product and process training appears to be improving sales capability. The first sign of our improved sales productivity has been the rise in sales pipeline, which represents all of our sales opportunities, throughout fiscal 2004, which we expect to result in further improvements in order rate in fiscal 2005.

In June 2004, we restructured our business in an effort to enhance our customers’ experience with NetIQ products and services by creating a more efficient business and to enable better collaboration between key functions. Our security management development activities and our systems and security technical support operations were consolidated in Houston, Texas. To better align our internal information systems with our business units we also reorganized our IT department. In connection with this restructuring, we terminated the employment of 86 employees and vacated a facility in Portland Oregon and a facility in Auckland, New Zealand, resulting in a restructuring charge of $2.5 million. In the financial statements this charge is partially offset by a $504,000 recovery of the fiscal 2003 restructuring charge. We anticipate improving operating performance in fiscal 2005 as a result of this restructuring.

Our growth strategy has become more focused on growing revenue from internally developed products and solutions since we believe we have many of the technology building blocks necessary to develop valuable solutions for our customers. However, we intend to continue to acquire small companies, products and technologies as well as to enter into strategic alliances that complement our overall technology and solutions strategy.

19

Table of Contents

Critical Accounting Policies and Estimates

The accompanying discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. We believe there are several accounting policies that are critical to understanding our consolidated financial statements, as these policies affect the reported amounts of revenue and expenses and involve management’s judgment regarding significant estimates. The critical accounting policies and estimates are described below.

Revenue Recognition

We primarily generate revenue from licensing software and providing related services. We recognize revenue in accordance with accounting principles generally accepted in the United States of America, as set forth in American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition, and AICPA SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions, and Securities and Exchange Commission Staff Accounting Bulletin No. 104, Revenue Recognition, and other related pronouncements. In accordance with these statements, we recognize revenue upon meeting each of the following criteria:

We recognize software revenue using the residual method. Under the residual method revenue is recognized if vendor-specific objective evidence of fair value (VSOE) exists for all of the undelivered elements in an arrangement and all other revenue recognition criteria are met. VSOE is based on the price generally charged when the element is sold separately. In situations where vendor-specific objective evidence of fair value for an undelivered element does not exist, the entire amount of revenue from the arrangement is deferred and recognized when fair value can be established for all undelivered elements or when all elements are delivered and all other revenue recognition criteria are met.

Service revenue includes maintenance revenue, usage and subscription-based revenue from our hosted services offerings and revenue from consulting and training services.

We defer license revenue until all of the criteria noted above are met. We defer maintenance revenue and recognize it ratably over the maintenance term, typically one year. We defer advance payments for hosted services and recognize such revenue based upon page views or ratably over the term of the contract. We defer consulting and training revenues and recognize them as those services are performed.

We generally recognize revenue from sales made through distributors, resellers, and original equipment manufacturers at the time these partners report that they have sold the software or, alternatively, when we drop-ship the product to the end-user, in each case after all revenue recognition criteria have been met. We recognize revenue from sales made to international master distributors of web analytics products when sold to the master distributor once all revenue recognition criteria have been met. Additionally, we monitor master distributor inventory levels, accounts receivable aging, and the distributor credit history and current credit rating in order to determine that collection is probable. We also maintain an allowance for potential sales returns.

20

Table of Contents

When licenses and services are sold together, we recognize license fees upon shipment, provided that (1) the above criteria have been met, (2) payment of the license fee is not dependent upon the performance of the services, and (3) the services do not provide significant customization of the software and are not essential to the functionality of the software for which a license was sold. For arrangements that do not meet the above criteria, we defer revenue recognition until all of the criteria are met.

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires us 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 revenue and expenses during the reported period. We base our estimates and judgments on historical experience and on various assumptions that we believe are reasonable under current circumstances. However, future events are subject to change and our best estimates and judgments may require further adjustments; therefore actual results could differ from our current estimates. Significant estimates made in the accompanying financial statements are:

21

Table of Contents

Results of Operations

Total Revenue.    Total revenue and year-over-year changes are as follows (in thousands, except percentages):

Total revenue decreased by $48.6 million or 16%, from fiscal 2003 to 2004 and increased by $32.0 million or 11% from fiscal 2002 to 2003.

Software License Revenue.    Total software license revenue decreased by $64.5 million or 31% from fiscal 2003 to 2004, primarily due to a $55.0 million decrease in revenue under the Microsoft agreement during fiscal 2004. Software license revenue, excluding revenue from the Microsoft agreement, decreased $9.5 million or 7% from fiscal 2003 to 2004. This decrease was primarily a result of low productivity of the sales organization, confusing product positioning regarding some of our security management products, lack of integration of our security management products, a delay in releasing a new version of our WebTrends software and the continued challenging economic environment. In addition, an increasing percentage of our WebTrends customers are using our hosted service rather than buying our software, resulting in a shift from license revenues to service revenues.

22

Table of Contents

The decrease in license revenue from 2004 to 2003 together with improved maintenance revenue and other service revenue resulted in a decline of license revenue as a percentage of total revenue.

Total software license revenue decreased by $2.1 million or 1% from fiscal 2002 to 2003, primarily due to a $25.0 million decrease in revenue under the Microsoft agreement during fiscal 2003. This decrease was partially offset by inclusion of license revenue from our acquisitions of PentaSafe and Marshal and growth in our non-Microsoft revenue for a total increase in non-Microsoft revenue of $22.9 million, or 19% during the same period. Software license revenue, excluding revenue from the Microsoft agreement, as a percentage of total revenue has declined 6% from fiscal 2002 to 2003. The decrease in the percentage of software license revenue to total revenue resulted in part due to the inclusion of a full year of WebTrends hosted service revenue and an increase in maintenance revenue.

Pursuant to the schedule of payments set forth in the agreement with Microsoft, software license revenue from Microsoft began a sequential decline in the quarter ended December 31, 2002 with the final payment received during the first quarter of fiscal 2004.

Service Revenue.    Service revenue consists of revenue from the sale of maintenance service agreements, consulting services and training services, as well as the sale of hosted web analytics services. Maintenance revenue represented 86%, 83% and 81% of total service revenue in fiscal 2002, 2003 and 2004, respectively. The declining percentage of maintenance revenue is due to increases in hosted services revenue and consulting and training revenue. Service revenue increased by $15.9 million and $34.1 million, or 15% and 48%, from fiscal 2003 to 2004 and from fiscal 2002 to 2003, respectively. The increase was primarily due to additional maintenance fees associated with new software licenses, renewals by our existing customers, and the inclusion of the operations of PentaSafe and Marshal from December 2002 onwards. Service revenue increased in absolute terms due to the compounding effect of our base of installed licenses, a significant majority of our customers renewing their maintenance service agreements and increases in revenue from our hosted web analytics service. Service revenue grew more rapidly in fiscal 2003 over 2002, than in fiscal 2004 over 2003 due to the inclusion in fiscal 2003 of the existing service agreements from PentaSafe and Marshal compared to the overall slower license revenue growth in fiscal 2004. We expect our service revenue to continue to grow as a percentage of total revenue in fiscal 2005 as the license revenue from Microsoft ceased in August 2003, our installed base increases, and existing customers renew maintenance contracts.

Total Cost of Revenue.    Total cost of revenue and year-over-year changes are as follows (in thousands, except percentages):

Total cost of revenue decreased by $2.8 million or 4% from fiscal 2003 to 2004 and increased by $27.3 million or 33%, from fiscal 2002 to 2003.

Cost of Software License Revenue.    Cost of software license revenue includes royalties paid to third parties personnel costs and costs associated with software packaging, documentation such as user manuals and CDs, and

23

Table of Contents

production, as well as shipping. Cost of software license revenue as a percentage of related license revenue increased from 2% during fiscal 2002 and 5% during fiscal 2003 to 7% during fiscal 2004. The increase primarily is due to the decline in revenue from Microsoft, which did not have any costs associated with it and to increases in royalty expense and fulfillment costs from fiscal 2002 to fiscal 2003. Cost of software license revenue decreased by $825,000 from fiscal 2003 to fiscal 2004 due to a net decrease in royalty expense as a result of our acquisition of technology that was previously subject to a royalty agreement. Although the purchased technology is being amortized, other technology became fully amortized during the period as an offset. We expect cost of software license revenue to decrease as revenue associated with purchased technology increases while amortization of the cost remains fixed. We also expect to realize increased costs savings associated with the broader implementation of electronic software delivery which was completed in the fourth quarter of 2004, which significantly reduces the need for packaging and delivery.

Cost of Service Revenue.    Cost of service revenue consists primarily of personnel costs and expenses incurred in providing telephonic support, on-site consulting services, training services, and costs associated with our hosted service. Cost of service revenue as a percentage of related service revenue decreased from 33% during fiscal 2002 to 28% during fiscal 2003 and to 27% during fiscal 2004.

The improvement in our services gross margin in fiscal 2004 and fiscal 2003 is primarily attributable to greater efficiencies in providing technical support services and to increased maintenance revenue as a significant majority of our customers renewed their maintenance agreements.

We expect service revenue to increase in absolute dollars as our installed license base grows and, as a consequence, our cost of service revenue to increase in absolute dollars. We also intend to increase the number of consulting service employees and to sell additional services to better enable our customers to take greater advantage of the new features and functionality of our products.

Amortization and Impairment of Purchased Technology.    Purchased technology consists of developed software capitalized in our acquisitions and is amortized using the straight-line method over the estimated useful life, generally three years. Amortization increased from $21.1 million during fiscal 2002 to $25.4 million during fiscal 2003 due to additional amounts capitalized in acquisitions and decreased to $20.6 million during fiscal 2004 due to amounts capitalized in prior acquisitions becoming fully amortized. Additionally, we recorded a charge of $798,000 during the fourth quarter of fiscal 2003 related to discontinuance of the VigilEnt User Manager technology purchased as part of the PentaSafe acquisition. We expect to amortize approximately $12.4 million of purchased technology during fiscal 2005, absent further acquisitions or impairments.

Operating Expenses

Sales and Marketing.    Our sales and marketing expenses consist primarily of personnel costs, including salaries and employee commissions, and expenses relating to travel, advertising, public relations, seminars, marketing programs, trade shows, lead generation activities and proportionately allocated facilities and information technology costs, net of payments from Microsoft for product promotions.

Sales and marketing expenses and year-over-year changes are as follows (in thousands, except percentages and headcount):

Sales and marketing expense decreased by $7.9 million or 6%, from fiscal 2003 to 2004. The decrease in absolute dollars resulted principally from our lower revenue during the current period, resulting in the payment

24

Table of Contents

of lower commissions and bonuses, combined with our implementation of cost savings measures. Sales and marketing expense increased by $24.2 million or 22%, from fiscal 2002 to 2003. The increase in absolute dollars resulted principally from our acquisitions of PentaSafe and Marshal during fiscal 2003, and from hiring additional field sales and support, inside sales and marketing personnel, expanding our sales infrastructure, increasing the number of third-party channel partners, and higher sales commissions. Sales and marketing as a percentage of revenue increased to 47% in fiscal 2004 from 43% and 39% in fiscal 2003 and fiscal 2002, respectively. The increase in the percentages was principally the result of the reduction of revenue from Microsoft in each fiscal year, which revenue did not require significant sales or marketing expenditures. During fiscal 2005, we expect sales and marketing expenses to increase and to remain at about the same percentage of total revenue as in fiscal 2004.

Research and Development.    Our research and development expenses consist primarily of salaries and other personnel-related costs, consulting fees, depreciation and proportionately allocated facilities and information technology costs. To date, we have expensed all research and development costs as incurred in accordance with Statement of Financial Accounting Standards (SFAS) No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed, as technological feasibility is established at the time our software development process is completed.

Research and development expenses and year-over-year changes are as follows (in thousands, except percentages and headcount):

Research and development expenses decreased by $3.0 million or 4% from fiscal 2003 to 2004. This decrease in absolute dollars resulted principally from lower overall headcount and payment of lower bonuses partially offset by the effect of annual base salary increases that took place in November 2003. Research and development expense increased $10.1 million from fiscal 2002 to 2003 or 17%. This increase resulted principally from increases in headcount, including personnel from our acquisitions of PentaSafe and Marshal. Our strategy since signing the license agreement with Microsoft in September 2000 was to increase spending in research and development through fiscal 2003. As a result, we have brought to market a number of new products. During fiscal 2005, we expect research and development expenses to remain relatively unchanged from spending levels reported in fiscal 2004 resulting in a small decrease as a percentage of total revenue as total revenue is expected to increase from fiscal 2004 over 2005. The consolidation of research and development for security management products in fiscal 2004, together with the release of major updates for the large majority of our products in fiscal 2004 is expected to allow us to focus a greater number of existing personnel on new product areas.

General and Administrative.    Our general and administrative expenses consist primarily of personnel costs for finance and administration, as well as directors and officers insurance, professional services expenses, such as legal and accounting fees, and proportionately allocated facilities and information technology costs.

General and administrative expense and year-over-year changes are as follows (in thousands, except percentages and headcount):

25

Table of Contents

General and administrative expenses increased by $2.9 million and $4.9 million, or 12% and 26%, from fiscal 2003 to 2004 and from fiscal 2002 to 2003, respectively. The increase in fiscal 2004 is primarily due to an increase in legal expense, additional costs associated with Sarbanes-Oxley legislation compliance, increased premiums associated with directors and officers insurance, increased fees paid to board members and an overall increase in other professional fees required to manage and support our business. In fiscal 2003, we also incurred higher legal expense than in fiscal 2002, as well as higher premiums for directors and officers insurance. In fiscal 2002, general and administrative expenses included $1.5 million associated with a warrant issued to an executive search firm in March 2002 for recruiting services in connection with recruiting our chief executive officer. During fiscal 2005, we expect our general and administrative expenses to remain at approximately the same absolute spending levels as reported in fiscal 2004.

Employee Stock-Based Compensation.    Deferred employee stock-based compensation represents the intrinsic value of unvested options assumed in acquisitions and the charges associated with the grant of options at less than fair market value. The deferred amount is being amortized over the vesting periods of the assumed and granted options, generally four years. During fiscal 2004, 2003 and 2002, we recognized employee stock-based compensation expense of $318,000 $796,000 and $3.2 million, respectively. The decrease in fiscal 2004 and 2003 is due to the decrease in amortization of deferred employee stock based compensation related to the assumption of WebTrends options, which has decreased over time in accordance with the vesting periods. During fiscal 2005, we expect to amortize approximately $1.0 million of deferred employee stock-based compensation.

Amortization of Other Intangible Assets.    Amortization of other intangible assets includes amortization of capitalized values relating to customer contracts, customer lists, patents, and trade name intangibles from our acquisitions. Other intangible assets are amortized using the straight-line method over their estimated useful life, generally three years. Amortization decreased from $20.2 million during fiscal 2002 to $18.5 million during fiscal 2003 and to $14.9 million during fiscal 2004. The decrease in the amortization during fiscal 2003 and fiscal 2004 resulted from the full amortization of amounts capitalized in previous acquisitions, partially offset by intangible assets capitalized in connection with our acquisitions in December 2002 and March and April of 2004. During fiscal 2005, we expect to amortize approximately $8.7 million of other intangible assets, absent further acquisitions.

Impairment and Amortization of Goodwill.    During fiscal 2002 we amortized $751.8 million of goodwill recognized in our acquisitions. We adopted SFAS No. 142, Goodwill and Other Intangible Assets, on July 1, 2002 and accordingly stopped amortizing goodwill on that date. Upon adoption of SFAS No. 142, we recorded a one-time, non-cash transitional impairment charge of $579.3 million to reduce the carrying value of our goodwill from previous acquisitions. The charge is reflected as the cumulative effect of a change in accounting principle in the accompanying consolidated statements of operations. There was no income tax effect resulting from the change in accounting principle.

We conducted our first annual review for impairment of goodwill as of April 30, 2003 and recorded a non-cash charge of $330.5 million. The impairment charge is attributable to our revised forecast for operating profits and cash flows.

Revenue for the three months ended September 30, 2003 was significantly lower than we anticipated. Because a significant portion of our revenues historically has been generated during the last month of each fiscal quarter, the actual drop-off in revenue compared with plan was not evident until the end of the quarter. Accordingly, as of September 30, 2003 we reduced our forecasted future operating profits and cash flows. This significant change in estimated future results required us to perform an interim review of goodwill for impairment, as prescribed by SFAS No. 142. This resulted in a further non-cash impairment charge of $150.8 million during the three months ended September 30, 2003. We completed our annual test of impairment as of April 30, 2004 and noted no further impairment.

26

Table of Contents

In assessing the carrying amount of goodwill as of July 1, 2002, April 30, 2003, September 30, 2003 and April 30, 2004 the fair values of the reporting units were estimated using a combination of the discounted cash flows and comparable transactions methodologies.

Write-off of Acquired In-Process Research and Development Costs.    During fiscal 2004 and 2003 we expensed $773,000 and $1.4 million, respectively, for in-process research and development costs related to acquisitions. These values were established by applying the income approach, which considers the present value of the projected free cash flows expected to be generated by the products. These costs were charged to operations at the date of the acquisition as the uncompleted development projects had not reached technological feasibility and did not have alternative future uses at those dates. No such charges were recorded during fiscal 2002.

Restructuring Charge.    During fiscal 2004, we recorded a restructuring charge of $2.5 million related to an effort to enhance our customers’ experience with NetIQ products and services, to create a more efficient business structure and to better enable collaboration between key functions. During fiscal 2003, we recorded a restructuring charge of $5.3 million related to a plan to terminate employment of 52 employees and vacate certain of our facilities that will no longer be used due to resizing the combined business after the acquisition of PentaSafe. No such charge was recorded during fiscal 2002. The $2.5 million charge in fiscal 2004 was offset by a recovery of $504,000 related to the expected recovery of personnel and facility reserves related to the fiscal 2003 restructuring charge.

Total Other Income, Net

For fiscal 2004, 2003 and 2002, total other income, net was $665,000, $10.8 million and $18.7 million, respectively. The decrease in interest income is primarily the result of lower interest income earned on our cash and cash equivalents and short-term investments, due to the continuing decline in the yield on new investments as earlier investments mature, as well as lower cash and investment balances due to our use of cash. Foreign exchange gains and losses have fluctuated as a result of changes in foreign exchange rates affecting the remeasurement of US dollar denominated monetary accounts held in foreign subsidiaries with local functional currencies, particularly euro. Impairments of long-term investments included in fiscal 2004 a charge of $4.1 million from a write down of an investment and in fiscal 2003 a charge of $1.4 million resulting from a write down of an investment in an affiliate, based on management’s assessments that the declines in value were other than temporary.

Income Taxes.    We recorded income tax expense of $3.8 million, $2.0 million, and $15.8 million in fiscal 2004, 2003, and 2002, respectively. The increase in income tax expense in fiscal 2004 compared to 2003 is primarily due to an increase in foreign taxes payable. The decrease in the income tax expense in fiscal 2003 compared to fiscal 2002 is a result of the decrease in taxable income and a reduction in our effective tax rate from 39% during fiscal 2002 to 38% in fiscal 2003. The tax benefit associated with dispositions from employee stock plans reduced federal and certain state income taxes payable other than federal alternative minimum tax to zero, in fiscal 2004, 2003 and 2002.

Recent Accounting Pronouncements

In December 2002, the Emerging Issue Task Force (EITF) reached a consensus on EITF No. 00-21, “Revenue Arrangements with Multiple Deliverables.” This issue addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. In some

27

Table of Contents

arrangements, the different revenue-generating activities (deliverables) are sufficiently separable and there exists sufficient evidence of their fair values to separately account for some or all of the deliverables (that is, there are separate units of accounting). In other arrangements, some or all of the deliverables are not independently functional, or there is not sufficient evidence of their fair values to account for them separately. This issue addresses when and, if so, how an arrangement involving multiple deliverables should be divided into separate units of accounting. This issue does not change otherwise applicable revenue recognition criteria. The guidance in this issue is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of this accounting standard did not have a significant impact on our financial position and results of operations.

The Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities,” in January 2003, and a revised interpretation of FIN No. 46 (FIN 46-R) in December 2003. FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity 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. The adoption of FIN No. 46-R did not have an impact on our financial position, results of operations or cash flows as we have no variable interest entities.

In April 2003, the FASB issued SFAS No. 149, “Amendment of SFAS No. 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. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative. It also clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is generally effective for contracts entered into or modified after June 30, 2003. The adoption of this accounting standard did not have a significant impact on our financial position, results of operations and cash flow.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”, which requires that certain financial instruments be presented as liabilities that were previously presented as equity or as temporary equity. Such instruments include mandatory redeemable preferred and common stock, and certain options and warrants. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and was effective at the beginning of the first interim period beginning after June 15, 2003. In November 2003, the FASB issued FASB Staff Position No. 150-3, Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under SFAS No. 150, which defers the effective date for various provisions of SFAS No. 150. As of June 30, 2004, we had no financial instruments within the scope of this pronouncement.

In November 2003, the EITF reached an interim consensus on Issue 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” to require additional disclosure requirements for securities classified as available-for-sale or held-to-maturity for fiscal years ending after December 15, 2003. Those additional disclosures have been incorporated into the accompanying footnotes. In March 2004, the EITF reached a final consensus on this issue to provide additional guidance which companies must follow in determining whether investment securities have an impairment which should be considered other-than-temporary. The guidance is applicable for reporting periods beginning after June 15, 2004. The adoption of this accounting standard did not have a significant impact on our financial position, results of operations or cash flow.

Liquidity and Capital Resources

As of June 30, 2004, we had $57.8 million in cash and cash equivalents and $229.8 million in short-term investments, for a total of $287.6 million compared to a total of $313.4 million as of June 30, 2003 a decrease of $25.8 million. The primary reasons for the decline during fiscal 2004 were the use of approximately

28

Table of Contents

$21.6 million in our stock repurchase program, net of proceeds from the sale of common stock, and the use of $27.9 million in investing activities. These uses were partially offset by $31.0 million of cash flows provided by operations.

Cash flows from operations have been positive in each year presented even though we have sustained net losses as reflected on the statement of operations and comprehensive loss. Net losses of $191.4 million, $908.7 million and $730.5 million in fiscal 2004, 2003 and 2002, respectively, have been largely the result of non-cash charges relating to depreciation and amortization and impairments of goodwill and long-term investments. Depreciation and amortization represents depreciation and amortization of costs related to physical assets such as our headquarters building, leasehold improvements in leased facilities and computer and other equipment, as well as amortization of goodwill in fiscal 2002 and amortization of purchased technology and other intangible assets in each of the three fiscal years presented.

Amortization of goodwill in fiscal 2002 was $751.8 million. Upon the adoption of SFAS 142 effective July 1, 2003, we ceased amortization of goodwill and recorded a transitional impairment of $579.3 million reflected as the cumulative effect of a change in accounting principle. In fiscal 2003 and 2004, we recorded additional impairments of goodwill of $330.5 million and $150.8 million, respectively, as we re-evaluated our business prospects and future cash flows. Goodwill remaining on the balance sheet at June 30, 2004 was $124.1 million.

Our investing activities resulted in net cash outflows of $27.9 million, $48.1 million and $53.2 million in fiscal 2004, 2003 and 2002, respectively. The principal uses of cash during fiscal 2004 were the acquisition of product and technology previously licensed and the acquisition of a small business for a combined amount of $23.1 million. Other principal uses of cash during fiscal 2004, 2003 and 2002, were acquisitions of property and equipment of $7.4 million, $15.3 million and $15.6 million, respectively. The larger amounts spent in fiscal 2003 and 2002 included purchases related to major new programs for sales force automation and enterprise resource planning. Cash outflows also included purchases of short-term investments of $203.8 million, $183.0 million and $305.5 million in fiscal 2004, 2003 and 2002, respectively, and long-term investments of $3.0 million, $5.0 million and $2.8 million during fiscal 2004, 2003 and 2002, respectively. The principal sources of cash from investing activities during fiscal 2004, 2003 and 2002 were proceeds from the sales and maturities of short-term investments of $209.5 million, $357.3 million and $270.9 million, respectively.

Our financing activities resulted in net cash outflows of $21.6 million and $72.2 million during fiscal 2004 and 2002, respectively, and a net cash inflow of $13.8 million in fiscal 2003. During 2004 and 2002, we used cash of $36.9 million and $88.6 million to repurchase our common stock in open market transactions. In September 2004 our Board of Directors approved the repurchase of up to an additional $50.0 million of our common stock in open market transactions during the succeeding 12 months. Sources of cash during these periods were principally from exercises of stock options and issuance of shares under our employee stock purchase plan.

Long-term Obligations and Commitments

The following summarizes our contractual obligations and commitments as of June 30, 2004 and the effect such obligations and commitments are expected to have on our liquidity and cash flows in future periods (in thousands, including lease payments accrued as part of our restructuring liability, facility reserve, and goodwill):

Also, see Note 13 to the Consolidated Financial Statements for additional information regarding our long-term obligations.

29

Table of Contents

We believe that our cash and cash equivalent balances, short-term investments, and cash flows generated by operations will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. Thereafter, we may require additional funds to support our working capital requirements, or for other purposes, and may seek to raise such additional funds through public or private equity financings or from other sources; however, we may not be able to obtain adequate or favorable financing at that time.

From time to time, in the ordinary course of business, we may evaluate potential acquisitions of businesses, products or technologies. A portion of our cash may be used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. We have no current plans, agreements, or commitments, and are not currently engaged in any negotiations with respect to such material or significant transactions.

Employee Stock Options

Our stock option program is a broad-based, long-term retention program that is intended to attract and retain talented employees and align stockholder and employee interests. We consider our option program critical to our operation and productivity and substantially all of our employees participate in our option program. During fiscal 2004, 79% of the options granted, were granted to employees other than our five mostly highly compensated executive officers. Options granted under the plans expire no later than 10 years from the grant date and generally vest within 4 years. Since August 2002, employee options granted were for a term of not more than seven years. We also have an employee stock purchase plan under which employees are entitled to purchase a limited number of shares at 85% of fair market value. See Note 10 to the Consolidated Financial Statements for additional information regarding our stock option plans.

We have assumed other option plans in connection with our acquisitions. Generally, these options were granted under terms similar to the terms of our stock option plans at prices adjusted to reflect the relative exchange ratios in the acquisition.

The following information is presented to reflect the activity, including grants to our listed officers and status of our outstanding options to enhance stock option disclosures and dilution.

Options granted to employees, including officers and non-employee directors, and the dilutive effect of options granted are summarized as follows:

30

Table of Contents

A summary of stock option activity under our plans is as follows: