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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004.

or

For the transition period from              to             .

Commission File Number: 000-26477

CYBERSOURCE CORPORATION

(Exact name of Registrant as specified in its charter)

1295 CHARLESTON ROAD

MOUNTAIN VIEW, CALIFORNIA 94043

(Address of Principal Executive Offices) (Zip Code)

Registrant’s Telephone Number, Including Area Code: (650) 965-6000

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  x    No  ¨

As of October 29, 2004, there were 33,273,157 shares of common stock, par value $0.001 per share, outstanding.

This Report on Form 10-Q includes 32 pages with the Index to Exhibits located on page 27.

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CYBERSOURCE CORPORATION

INDEX TO REPORT ON FORM 10-Q

FOR QUARTER ENDED SEPTEMBER 30, 2004

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CYBERSOURCE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

See notes to condensed consolidated financial statements.

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CYBERSOURCE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)

See notes to condensed consolidated financial statements.

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CYBERSOURCE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

See notes to condensed consolidated financial statements.

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CYBERSOURCE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of CyberSource Corporation and its wholly-owned subsidiaries (collectively, “CyberSource” or the “Company”) 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, they do not include all the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. 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 the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. In the opinion of management, all adjustments (consisting primarily of normal recurring accruals and restructuring charges, see Note 3) considered necessary for a fair presentation have been included. Operating results for the three and nine-month periods ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report filed on Form 10-K with the Securities and Exchange Commission on March 11, 2004, SEC File No. 000-26477.

Accounting for Stock-Based Compensation

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFAS 148”). SFAS 148 amends Statement of Financial Accounting Standards 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”) to provide alternative methods of transition to the fair value method of accounting for stock-based employee compensation. In addition, SFAS 148 requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. As permitted under SFAS 148, the Company adopted the disclosure only provisions and has continued to follow the intrinsic value method of accounting for employee stock options in accordance with Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees.”

Had compensation cost been determined using the fair value method, the Company’s net income (loss) and basic and diluted net income (loss) per share would have been adjusted to the pro forma amounts indicated below (in thousands, except per share amounts):

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For stock options and employee stock purchase plan shares granted during the three and nine months ended September 30, 2004 and 2003, the Company determined the fair value at the date of grant or purchase using the Black-Scholes valuation model and the following weighted average assumptions:

The weighted average fair value of options granted was $2.94 and $1.46 per share for options granted during the three months ended September 30, 2004 and 2003, respectively. The weighted average fair value for shares purchased under the employee stock purchase plan was $1.66 and $0.77 per share during the three months ended September 30, 2004 and 2003, respectively.

The weighted average fair value of options granted was $2.95 and $1.05 per share for options granted during the nine months ended September 30, 2004 and 2003, respectively. The weighted average fair value for shares purchased under the employee stock purchase plan was $1.39 and $0.66 per share during the nine months ended September 30, 2004 and 2003, respectively.

The pro forma impact of options on the net income (loss) and basic and diluted net income (loss) per share for the three and nine months ended September 30, 2004 and 2003 is not representative of the effects on net income (loss) for future periods, as future periods will include the effects of options vesting as well as the impact of multiple periods of stock option grants.

Net Loss Per Share

If the Company had reported net income for the three and nine months ended September 30, 2003, diluted earnings per share would have included the shares used in the computation of net loss per share as well as additional common equivalent shares related to outstanding options to purchase approximately 1,525,881 shares of common stock at September 30, 2003. The common equivalent shares from options would be determined on a weighted average basis using the treasury stock method.

2. SEGMENT INFORMATION

The Company views its operations as principally three segments: (i) e-commerce transaction services and support, (ii) enterprise software and (iii) professional services. The Company manages its business based on the revenues of these segments. The following table presents revenues and cost of revenues for the Company’s segments for the three and nine-month periods ended September 30, 2004 and 2003. There were no inter-segment sales or transfers. The Company’s Chief Executive Officer (“CEO”) reviews the revenues from each of the Company’s reportable segments. All of the Company’s expenses, with the exception of cost of revenues, are managed by and reported to the CEO on a consolidated basis. The Company does not report operating expenses, depreciation and amortization, interest income (expense), income taxes, capital expenditures or identifiable assets by its segments to the CEO. Revenues and cost of revenues are as follows (in thousands):

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Additionally, no customer accounted for more than 10.0% of the Company’s revenues during the three and nine months ended September 30, 2004 and 2003.

3. RESTRUCTURING CHARGES

Third Quarter 2003 Restructuring

In the third quarter of fiscal 2003, the Company incurred restructuring charges totaling approximately $0.2 million as a result of its realignment of resources to better manage and control its business. The charges represented the reduction of the Company’s workforce by 7 employees of which 4 were in sales and marketing; 2 were in product development; and 1 was in operations. The following table summarizes these costs and activities during the three months ended September 30, 2003 (in thousands):

Fourth Quarter 2001 Restructuring

In the fourth quarter of fiscal 2001, the Company incurred $8.0 million of restructuring charges resulting from its realignment of resources to better manage and control its business. Specific actions included reducing the Company’s workforce worldwide by 95 employees and consolidating excess facilities, including the closure of the Company’s St. Louis, Missouri facility and the exiting of under-utilized space in its Mountain View, California and Austin, Texas facilities. During fiscal 2002, the Company reassessed its initial estimate of probable costs and the sublease timeline associated with subleasing excess leased facilities. The reassessment was prompted by a further decline in the real estate market in the cities where those facilities are located. After considering information provided to the Company by its real estate advisors, the Company concluded it was probable these facilities could not be subleased at rates originally considered nor could they be subleased in the timeframe originally planned. As a result, the Company recorded an additional charge of $2.0 million during the fourth quarter of fiscal 2002 relating to the facilities located in Mountain View, California and Austin, Texas. This additional charge considered then current lease rates for similar facilities as well as costs associated with the estimated added holding period through December 2003. During fiscal 2003, the Company again reassessed its revised estimate of future sublease income and the related sublease timeline associated with subleasing excess leased facilities. After considering information provided to the Company by its real estate advisors, the Company concluded it was probable these facilities could not be subleased in the timeframe assumed in December 2002. As a result, the Company recorded an additional charge of $0.3 million relating to the facilities located in Mountain View, California and Austin, Texas. The additional charge considers current lease rates for similar facilities as well as costs associated with the estimated added holding period through December 2004. The following table summarizes the costs and activities during the first nine months of fiscal 2004, related to the fourth quarter 2001 restructuring accrual (in thousands):

As of September 30, 2004, the remaining accrued restructuring related charges included redundant facilities costs, which will be paid over the respective remaining lease term of up to three years.

4. COMPREHENSIVE LOSS

The components of comprehensive income (loss) are as follows (in thousands):

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5. LEGAL MATTERS

In July and August 2001, various class action lawsuits were filed in the United States District Court, Southern District of New York, against the Company, its Chairman and CEO, a former officer, and four brokerage firms that served as underwriters in its initial public offering. The actions were filed on behalf of persons who purchased the Company’s stock issued pursuant to or traceable to the initial public offering during the period from June 23, 1999 through December 6, 2000. The action alleges that the Company’s underwriters charged secret excessive commissions to certain of their customers in return for allocations of the Company’s stock in the offering. The two individual defendants are alleged to be liable because of their involvement in preparing and signing the registration statement for the offering, which allegedly failed to disclose the supposedly excessive commissions. On December 7, 2001, an amended complaint was filed in one of the actions to expand the purported class to persons who purchased the Company’s stock issued pursuant to or traceable to the follow-on public offering during the period from November 4, 1999 through December 6, 2000. The lawsuit filed against the Company is one of several hundred lawsuits filed against other companies based on substantially similar claims. On April 19, 2002, a consolidated amended complaint was filed to consolidate all of the complaints and claims into one case. The consolidated amended complaint alleges claims that are virtually identical to the amended complaint filed on December 7, 2001 and the original complaints. In October 2002, the Company’s officer and a former officer that were named in the amended complaint were dismissed without prejudice. In July 2002, the Company, along with other issuer defendants in the case, filed a motion to dismiss the consolidated amended complaint with prejudice. On February 19, 2003, the court issued a written decision denying the motion to dismiss with respect to CyberSource. On July 2, 2003, a committee of the Company’s Board of Directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. The settlement would provide, among other things, a release of the Company and of the individual defendants for the conduct alleged in the action to be wrongful in the Amended Complaint. The Company would agree to undertake other responsibilities under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims the Company may have against its underwriters. Any direct financial impact of the proposed settlement is expected to be borne by the Company’s insurers. The committee agreed to approve the settlement subject to a number of conditions, including the participation of a substantial number of other Issuer Defendants in the proposed settlement, the consent of the Company’s insurers to the settlement, and the completion of acceptable final settlement documentation. Furthermore, the settlement is subject to a hearing on fairness and approval by the court overseeing the IPO litigations. While there can be no assurances as to the outcome of the lawsuit, the Company does not presently believe that an adverse outcome in the lawsuit would have a material effect on its financial condition, results of operations or cash flows.

On August 11, 2004, the Company filed suit in the Northern District of California against Retail Decisions, Inc. (“ReD US”) and Retail Decisions Plc (“ReD UK”) (collectively, “ReD”), Case No. 3:04-CIV-03268, alleging that ReD infringes the Company’s U.S. Patent No. 6,029,154 (the “‘154 Patent”). The Company served ReD US with the complaint on August 12, 2004, and the Company served ReD UK with the complaint on August 13, 2004. On September 30, 2004, ReD responded to the Company’s complaint. ReD filed a motion to stay the case for 90 days pending a determination by the U.S. Patent and Trademark Office (“PTO”) as to whether it will grant ReD’s request that the PTO reexamine the ‘154 Patent. ReD also filed a motion for a more definite statement by the Company with respect to the Company’s allegation that ReD is willfully infringing the ‘154 Patent. In addition, ReD UK filed a motion to dismiss the action against it on the ground that it is not subject to personal jurisdiction in the Northern District of California. On October 27, 2004, ReD filed a request for reexamination with the PTO, based on prior art ReD discovered that allegedly invalidates the patent. The PTO must respond within 90 days of filing whether it will grant ReD’s request for reexamination. Based on the Company’s review of the cited prior art references and the reexamination request, even if the PTO grants ReD’s request for reexamination, the Company does not believe that the PTO will invalidate the ‘154 Patent. On October 28, 2004, the Company filed an opposition to ReD’s motion to stay the case for 90 days and an opposition to ReD’s motion for a more definite statement with respect to willful infringement. Based on ReD UK’s representation that ReD US is the sole entity that develops, operates, and distributes the eBitGuard service, the Company has agreed to dismiss ReD UK while reserving the right to reinstitute action against ReD UK in the event the Company later discovers that ReD UK is subject to the court’s personal jurisdiction. In return, ReD UK has agreed that if the Company later establishes that personal jurisdiction existed, the Company could re-file against ReD UK in this action without prejudice to its damages claim. The Company also filed an amended complaint, removing ReD UK as a named defendant and restating the willful infringement claim. A hearing on the motions is scheduled to be held on November 18, 2004. While there can be no assurances as to the outcome of the lawsuit, the Company does not presently believe that an adverse outcome in the lawsuit would have a material effect on our financial condition, results of operations, or cash flows.

The Company is currently party to various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these matters cannot be predicted with certainty, the Company does not believe that the outcome of any of these claims or any of the above mentioned legal matters will have a material adverse effect on its consolidated financial position, results of operations or cash flow.

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6. COMMON STOCK REPURCHASE PROGRAM

On January 22, 2003, the Board of Directors authorized management to use up to $10.0 million over a twelve-month period beginning at January 22, 2003 to repurchase additional shares of the Company’s common stock. During the period beginning January 22, 2003 and ended January 21, 2004, the Company repurchased 483,700 shares at an average price of $2.55 per share, net of repurchase costs. All of the repurchased shares were cancelled and returned to the status of authorized, unissued shares.

On January 21, 2004, the Board of Directors authorized management to use up to $10.0 million over a twelve-month period beginning at January 21, 2004 to repurchase additional shares of the Company’s common stock. During the period beginning January 21, 2004 and ended September 30, 2004, the Company repurchased 930,200 shares at an average price of $4.61 per share, net of repurchase costs. All of the repurchased shares were cancelled and returned to the status of authorized, unissued shares.

7. GUARANTEES

Under the terms of our standard contract with each of our customers, we agree to indemnify each customer against certain liabilities and damages to the extent such liabilities and damages arise from claims that such customer’s use of our software or services infringes intellectual property rights of a third party. These terms are common in the high technology industry. We do not record a liability for potential litigation claims related to indemnification obligations with our customers. We do not believe the likelihood of a material obligation is probable.

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

This Report on Form 10-Q contains 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, as amended, including statements regarding our expectations, estimations, intentions, beliefs or strategies regarding the future. In addition, our senior management might make forward looking statements orally to analysts, investors, the media and others. In this Report, for example, our forward-looking statements include, without limitation, statements regarding: (a) our belief that cash and short-term investment balances will be sufficient to meet our working capital and capital requirements for at least the next twelve months; (b) our expectation that, to the extent we do not generate positive cash flow from operations, we would be prepared to use the net proceeds of our 1999 equity financings to fund sales and marketing activities, to fund product development, to fund continued operations, and to fund the repurchase of shares of our stock in the open market; (c) our conclusion that, due to the nature of our short-term investments, which are primarily government bonds, there is no material market risk exposure with respect to such investments; (d) our expectation that product development expenses will increase in absolute dollars as we continue to develop newly offered services and other related internal systems; (e) our expectation that sales and marketing and general and administrative expenses in the three months ended December 31, 2004, will be consistent with the three months ended September 30, 2004; (f) our belief that the uncertainty regarding the ability to realize our deferred tax assets may diminish to the point where it is more likely than not that our deferred tax assets will be realized, at which point, we would reverse all or a portion of our valuation allowance, thus resulting in an income tax benefit; (g) that, as part of our future business strategy, we may pursue strategic acquisitions of complementary businesses or technologies that would provide additional product or service offerings, additional industry expertise, a broader client base or an expanded geographic presence; (h) that to remain competitive, we must continue to enhance and improve the responsiveness, functionality and features of our products and services and the underlying network infrastructure; (i) our success depending on our ability to grow, or scale, our commerce transaction systems to accommodate increases in the volume of traffic on our systems, especially during peak periods of demand; (j) our future growth also depending in part on our proprietary technology and licensed technology, the success of our relationships with existing and future sales alliances that market our products and services to their merchant accounts and our ability to both internally develop and license leading technologies to enhance our existing products and services; (k) the rapid growth in the use of and interest in the Internet; (l) the increase in the significance of the Internet as a commercial marketplace; (m) our belief that our systems and processes would enable us to comply with the Fair Credit Reporting Act if we were deemed a consumer reporting agency; (n) our belief that the potential adverse effects of such lawsuit would be borne by insurers; (o) our belief that litigation outcomes of class action lawsuits and other claims would not have a material effect on our consolidated financial condition, results of operations or cash flows; and (p) our belief that a material obligation is improbable under provisions whereby we indemnify each of our customers against certain liabilities and damages; and (q) that we may reverse accrued liabilities in the future.

Actual results could differ materially from those projected in any forward-looking statement for the reasons and factors detailed below under the sub-heading “Factors That May Affect Future Operating Results” and in other sections of this Report. All forward-looking statements included in this Form 10-Q are based on information available to us on the date of this Report, and we assume no obligation to update the forward-looking statements, or to update the reasons why actual results could differ from those projected in the forward-looking statements. See the section below captioned “Factors That May Affect Future Operating Results,” as well as such other risks and uncertainties as are detailed in our Securities and Exchange Commission reports and filings for a discussion of the factors that could cause actual results to differ materially from the forward-looking statements. Such factors include but are not limited to the following: (1) if we do not realize sufficient revenues, and sufficiently limit expenses, we may not achieve ongoing profitability; (2) other companies may enter the market and provide competing products and services, which may reduce demand for our products and services; (3) security breaches could damage our reputation, injure our business prospects and expose us to a risk of loss or litigation and possible liability; and (4) if a proposed Financial Accounting Standards Board draft position is adopted and we are required to expense stock option grants, our profitability would be reduced, as would our ability to use stock options as an employee recruitment and retention tool.

The following discussion should be read in conjunction with the audited consolidated financial statements and the notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Report on Form 10-K, filed with the Securities and Exchange Commission on March 11, 2004 (SEC File No. 000-26477).

OVERVIEW

We derive substantially all of our revenues from Internet commerce transaction processing fees, professional services, support services and the sale of enterprise software licenses and related maintenance. Transaction revenues are recognized in the period in which the transactions occur. Our Internet transaction processing service revenues are derived from contractual relationships providing revenues on a per transaction basis, generally subject to a monthly minimum or maintenance fee. In general, these contractual relationships provide for a one-year term with automatic renewal and can be canceled by either party at any time with

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sixty days prior notice. Professional services revenue and support service fees are recognized as the related services are provided and costs are incurred. For enterprise software license arrangements where maintenance is the only undelivered element, we defer the vendor-specific evidence of fair value (“VSOE”) for the maintenance and recognize the residual amount of the arrangement fee as software license revenue in the period in which the contract is signed, the software is delivered and the fee is collectible. Maintenance revenue is then recognized ratably over the maintenance period. We have incurred significant losses since our inception, and through September 30, 2004 had incurred cumulative losses of approximately $320.8 million.

CRITICAL ACCOUNTING POLICIES

Our financial statements are based on the selection and application of significant accounting policies, which require management to make significant estimates and assumptions. We believe that the following are some of the more critical judgment areas in the application of our accounting policies that currently affect our financial condition and results of operations.

Revenue Recognition

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements (“SAB 101”), SEC Staff Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”) and Statement of Position 97-2, Software Revenue Recognition (“SOP 97-2”). SAB 104 and SOP 97-2 require that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed or determinable; and (4) collectibility is reasonably assured. Determination of criteria (4) is based on management’s judgments regarding the collectibility of those fees. Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

We derive a significant portion of our professional services revenue from fixed-price contracts, which require the accurate estimation of the cost, scope and duration of each engagement. Revenue and the related costs for these projects are recognized using the percentage-of-completion method. Estimates are made regarding time to complete the projects and revisions to estimates are reflected in the period in which changes become known. If we do not accurately estimate the resources required or the scope of work to be performed, or do not manage our projects properly within the planned periods of time or satisfy obligations under the contracts, then future professional service margins may be significantly and negatively affected or losses on existing contracts may need to be recognized.

Restructuring and Other Non-Recurring Charges

In previous fiscal years, we recorded significant restructuring charges. These restructuring charges included estimates pertaining to employee separation costs and the settlements of contractual obligations resulting from our actions. In addition, we have estimated facility exit costs for certain under-utilized facilities and have made assumptions regarding a potential sublessee’s future rental rate, as well as the amount of time required to identify a sublessee. The actual costs may differ from these estimates.

Accounts Receivable

We maintain allowances for doubtful accounts for estimated losses resulting from the potential inability of our customers to make required payments as well as for potential sales returns. If the financial condition of our customers was to deteriorate, resulting in their inability to make payments, additional allowances may be required. These estimates are based on historical bad debt experience and other known factors. If the historical data we used to determine these estimates does not properly reflect future losses, additional allowances may be required.

Legal Contingencies

We are currently involved in certain legal proceedings and are required to assess the likelihood of any adverse judgments or outcomes of these proceedings as well as potential ranges of probable losses. A determination of the amount of accruals required, if any, for these contingencies are made after careful analysis. As discussed in Note 5 in the notes to condensed consolidated financial statements, as of September 30, 2004, we do not believe our current proceedings will have a material impact on our consolidated financial condition, results of operations or cash flows. However, future results of operations for any particular quarterly or annual period could be materially affected by changes in our assumptions or as a result of the effectiveness of our strategies related to these proceedings.

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RESULTS OF OPERATIONS

The following table sets forth certain items in our condensed consolidated statements of operations expressed as a percentage of revenue for the periods indicated:

THREE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

Revenues. Revenues were $9.2 million for the three months ended September 30, 2004, as compared to $6.9 million for the three months ended September 30, 2003, an increase of approximately $2.3 million or 32.7%. Transaction and support revenues were $7.2 million for the three months ended September 30, 2004, as compared to $5.3 million for the three months ended September 30, 2003, an increase of approximately $1.9 million or 35.9%. We processed approximately 109.4 million transactions during the three months ended September 30, 2004 as compared to approximately 72.2 million processed during the three months ended September 30, 2003. The increase in revenue and transactions processed is due primarily to an increase in transaction volumes processed by our existing customers and, to a lesser extent, the growth of our customer base. Transaction and support revenues increased less relative to the increase in total transactions processed due primarily to the increase in transaction volumes of our higher-volume customers that receive greater discounts as their transaction volumes increase. Enterprise software license and maintenance revenues were $0.8 million during the three months ended September 30, 2004, as compared to $1.1 million for the three months ended September 30, 2003, a decrease of approximately $0.3 million or 30.0%. The decrease is due primarily to a decrease in the number of new enterprise software licenses sold during the three months ended September 30, 2004, as compared to the three-month period ending September 30, 2003. Professional services revenues increased to $1.2 million for the three months ended September 30, 2004, an increase of approximately 131.8%, as compared to $0.5 million for the three months ended September 30, 2003, due to an increase in the number of professional services projects from both new and existing customers. No customer accounted for more than 10.0% of our revenues during the three months ended September 30, 2004 and 2003.

Cost of Revenues. Transaction and support cost of revenues consists primarily of costs incurred in the delivery of e-commerce transaction services, including personnel costs in our operations and merchant support functions, depreciation of capital equipment used in our network infrastructure, and other third party costs, including costs related to the hosting of our servers at hosting centers in the United States and the United Kingdom. Transaction and support cost of revenues was $2.5 million or 34.9% of transaction and support revenues for the three months ended September 30, 2004 as compared to $1.9 million or 36.3% of transaction and support revenues for the three months ended September 30, 2003. The increase in absolute dollars is primarily due to higher costs, including personnel costs, related to our global payment product. The decrease as a percentage of transaction and support revenues is primarily due to the relative increase in transaction and support revenues for the three months ended September 30, 2004 compared to the relative increase in the three months ended September 30, 2003. Enterprise software cost of revenues is composed of customer support personnel costs, fulfillment costs and third party license fees. Enterprise software cost of revenues was $0.2 million or 24.2 % of enterprise software revenues for the three months ended September 30, 2004 as compared to $0.1 million or 11.6% of enterprise software revenues for the three months ended September 30, 2003. The increase

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in absolute dollars is primarily due to an increase in third party license fees. The increase as a percentage of enterprise software revenues is primarily due to the increase in third party license fees and a decrease in enterprise software revenues for the three months ended September 30, 2004 compared to the three months ended September 30, 2003. Professional services cost of revenues consists principally of personnel-related costs and expenses, and a portion of allocated overhead costs related to providing professional services. Professional services cost of revenues was $0.6 million or 45.2% of professional services revenues for the three months ended September 30, 2004 as compared to $0.2 million or 43.8% of professional services revenues for the three months ended September 30, 2003. The increase in absolute dollars is due to higher personnel-related costs resulting from an increase in utilization of personnel necessary to support our professional services projects. During the three months ended September 30, 2004, we reversed $48,000 in accrued liabilities that had previously been recorded as cost of revenues in prior years.

Product Development. Product development expenses consist primarily of compensation and related costs of employees engaged in the research, design and development of new services and, to a lesser extent, facility costs and related overhead. Product development expenses were $1.6 million for the three months ended September 30, 2004, as compared to $1.9 million for the three months ended September 30, 2003, a decrease of approximately $0.3 million or 17.3%. The decrease is primarily due to decreases in overhead and personnel costs, which decreased by approximately $0.2 million and $0.1 million, respectively. The decrease in personnel costs is due in part to an increase in product development personnel utilization on professional services projects as compared to the same period last year. To the extent product development personnel are utilized on professional services projects, the related compensation expense is classified as cost of sales accordingly. As a percentage of revenue, product development expenses decreased to 17.3% in the three months ended September 30, 2004, as compared to 27.8% for the three months ended September 30, 2003. The decrease is primarily due to the decrease in product development expenses combined with the increase in revenue from existing and new customers during the three months ended September 30, 2004. We expect that product development expenses will increase in absolute dollars during the three months ending December 31, 2004 as we continue to develop newly offered services. During the three months ended September 30, 2004, we reversed $23,000 in accrued liabilities that had previously been recorded as product development expenses in prior years.

Sales and Marketing. Sales and marketing expenses consist primarily of compensation of sales and marketing personnel, market research and advertising costs and, to a lesser extent, facility costs and related overhead. Sales and marketing expenses were $2.5 million for the three months ended September 30, 2004, as compared to $2.8 million for the three months ended September 30, 2003, a decrease of approximately $0.2 million or 8.3%. The decrease is in part due to an increase in utilization of professional services personnel as compared to the same period last year. To the extent professional services personnel are not utilized on professional services projects, they are redeployed in support of sales efforts and the related compensation expense is classified as sales and marketing expense accordingly. As a percentage of revenue, sales and marketing expenses decreased to 27.4% in the three months ended September 30, 2004, as compared to 39.6% for the three months ended September 30, 2003. The decrease is primarily due to the decrease in sales and marketing expenses combined with the increase in revenue from existing and new customers during the three months ended September 30, 2004. We expect that sales and marketing expenses in the three months ending December 31, 2004, will be consistent with the three months ended September 30, 2004. During the three months ended September 30, 2004, we reversed $62,000 in accrued liabilities that had previously been recorded as sales and marketing expenses in prior years.

General and Administrative. General and administrative expenses consist primarily of compensation for administrative personnel, fees for outside professional services and, to a lesser extent, facility costs and related overhead and bad debt expense. General and administrative expenses were $1.4 million for the three months ended September 30, 2004 as compared to $1.2 million for the three months ended September 30, 2003. The increase is due primarily to an increase in legal costs and accounting fees related to Sarbanes-Oxley Section 404 compliance. As a percentage of revenue, general and administrative expenses decreased to 15.2% in the three months ended September 30, 2004, as compared to 17.2% for the three months ended September 30, 2003. The decrease is primarily due to the increase in revenue from existing and new customers during the three months ended September 30, 2004. We expect that general and administrative expenses in the three months ending December 31, 2004, will be consistent with the three months ended September 30, 2004. During the three months ended September 30, 2004, we reversed $51,000 in accrued liabilities that had previously been recorded as general and administrative expenses in prior years. We will continue to assess the necessity of all of our accrued liabilities and, as a result, may reverse amounts in future quarters.

Restructuring Charges. During the three months ended September 30, 2003, we recorded a restructuring charge of approximately $0.2 million. The charge is a result of reducing our workforce by 7 employees of which 4 were in sales and marketing; 2 were in product development; and 1 was in operations. When we updated our restructuring charge in December 2003 related to exiting the under-utilized space in our Mountain View facility, we had assumed that a sublessee would be identified by December 31, 2004. During the fourth quarter, we will re-evaluate our assumptions and estimates related to the restructuring charge. This may result in an additional restructuring charge in the fourth quarter.

Loss on Investment in Joint Venture. On March 1, 2000, we entered into a joint venture agreement with Japanese partners Marubeni Corporation and Trans-Cosmos, Inc. to establish CyberSource K.K. to provide e-commerce transaction services to the

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Japanese market. As of June 30, 2002, we had recognized losses to the extent of our historical investment. In 2003, we made additional contributions to the joint venture totaling approximately $0.2 million, all of which were recorded as losses in the period the contribution occurred. For the three months ended September 30, 2004, we made no additional contributions.

Interest Income, Net. Interest income consists of interest earnings on cash, cash equivalents and short-term investments and was $0.2 million for the three months ended September 30, 2004, consistent with the $0.2 million for the three months ended September 30, 2003.

Income Tax Provision. We recorded a provision for income tax expense of $19,000 for the three months ended September 30, 2004. This provision consists of amounts accrued for our estimated 2004 domestic federal and state income tax liability as well as an estimate of the foreign income tax expense to which our foreign subsidiary is subject. This provision is based upon our estimated 2004 net income before income taxes and takes into consideration the utilization of our net operating loss carry forwards. To the extent our estimate of 2004 net income before income tax changes, our provision for income taxes will change as well. Historically, we have not recorded a provision for income tax expense because we had been generating net losses. Furthermore, we have not recorded an income tax benefit for prior years primarily due to continued substantial uncertainty regarding our ability to realize our deferred tax assets. Based upon available objective evidence, there has been sufficient uncertainty regarding the ability to realize our deferred tax assets which warrants a full valuation allowance in our financial statements. The factors considered include prior losses and lack of carry-back potential to realize our deferred tax assets. Based on our estimates for 2004 and beyond, we believe the uncertainty regarding the ability to realize our deferred tax assets may diminish to the point where it is more likely than not that our deferred tax assets will be realized. At such point, we would reverse all or a portion of our valuation allowance which will result in an income tax benefit.

NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

Revenues. Revenues were $26.3 million for the nine months ended September 30, 2004, as compared to $19.8 million for the nine months ended September 30, 2003, an increase of approximately $6.5 million or 32.8%. Transaction and support revenues were $20.3 million for the nine months ended September 30, 2004, as compared to $15.6 million for the nine months ended September 30, 2003, an increase of approximately $4.7 million or 30.0%. We processed approximately 309.1 million transactions during the nine months ended September 30, 2004 as compared to approximately 205.5 million processed during the nine months ended September 30, 2003. The increase in revenue and transactions processed is due primarily to an increase in transaction volumes processed by our existing customers and, to a lesser extent, the growth of our customer base. Transaction and support revenues increased less relative to the increase in total transactions processed due primarily to the increase in transaction volumes of our higher-volume customers that receive greater discounts as their transaction volumes increase. Enterprise software license and maintenance revenues were $2.7 million during the nine months ended September 30, 2004, as compared to $3.0 million for the nine months ended September 30, 2003, a decrease of $0.4 million or 12.2%. The decrease is due primarily to a decrease in the number of new enterprise software sales that occurred during the nine months ended September 30, 2004, as compared to the nine-month period ending September 30, 2003. Professional services revenues increased to $3.4 million for the nine months ended September 30, 2004, an increase of approximately 181.2%, as compared to $1.2 million for the nine months ended September 30, 2003, due to an increase in the number of professional services projects that occurred during the nine months ended September 30, 2004. No customer accounted for more than 10.0% of our revenues during the nine months ended September 30, 2004 and 2003.

Cost of Revenues. Transaction and support cost of revenues was $6.4 million or 31.6% of transaction and support revenues for the nine months ended September 30, 2004 as compared to $6.1 million or 39.0% of transaction and support revenues for the nine months ended September 30, 2003. The increase in absolute dollars is primarily due to higher costs related to our global payment product. The decrease as a percentage of transaction and support revenues is primarily due to the increase in revenue from existing and new customers during the nine months ended September 30, 2004. Enterprise software cost of revenues was $0.4 million for the nine months ended September 30, 2004, consistent with the $0.4 million for the nine months ended September 30, 2003. As a percentage of enterprise software revenues, enterprise software cost of revenues increased to 14.6% of enterprise software revenues for the nine months ended September 30, 2004, as compared to 12.9% for the nine months ended September 30, 2003. The increase as a percentage of enterprise software revenues is primarily due to a decrease in enterprise software revenues for the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003. Professional services cost of revenues was $1.5 million or 44.6% of professional services revenues for the nine months ended September 30, 2004 as compared to $0.6 million or 49.7% of professional services revenues for the nine months ended September 30, 2003. The increase in absolute dollars is due to higher personnel-related costs resulting from an increase in utilization of personnel necessary to support our professional services projects. The decrease in professional services cost of revenues as a percentage of professional services revenues is primarily due to an increase in higher-margin professional services projects during the nine months ended September 30, 2004. During the nine months ended September 30, 2004, we reversed $144,000 in accrued liabilities that had previously been recorded as cost of revenues in prior years.

Product Development. Product development expenses were $4.9 million for the nine months ended September 30, 2004, as compared to $5.8 million for the nine months ended September 30, 2003, a decrease of approximately $0.9 million or 15.0%.

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The decrease is primarily due to a decrease in overhead costs which decreased by approximately $0.5 million and, to a lesser extent, the reclassification of personnel costs to cost of sales related to product development personnel utilized on professional services projects. As a percentage of revenue, product development expenses decreased to 18.7% in the nine months ended September 30, 2004, as compared to 29.2% for the nine months ended September 30, 2003. The decrease is primarily due to the decrease in product development expenses combined with the increase in revenue from existing and new customers during the nine months ended September 30, 2004. During the nine months ended September 30, 2004, we reversed $69,000 in accrued liabilities that had previously been recorded as product development expenses in prior years.

Sales and Marketing. Sales and marketing expenses were $7.6 million for the nine months ended September 30, 2004, as compared to $8.8 million for the nine months ended September 30, 2003, a decrease of approximately $1.2 million or 13.9%. The decrease is primarily due to an increase in utilization of professional services personnel as compared to the same period last year. To the extent professional services personnel are not utilized on professional services projects, they are redeployed in support of sales efforts and the related compensation expense is classified as sales and marketing expense accordingly. As a percentage of revenue, sales and marketing expenses decreased to 28.8% in the nine months ended September 30, 2004, as compared to 44.3% for the nine months ended September 30, 2003. The decrease is primarily due to the decrease in sales and marketing expenses combined with the increase in revenue from existing and new customers during the nine months ended September 30, 2004. During the nine months ended September 30, 2004, we reversed $186,000 in accrued liabilities that had previously been recorded as sales and marketing expenses in prior years.

General and Administrative. General and administrative expenses were $4.2 million for the nine months ended September 30, 2004, as compared to $3.9 million for the nine months ended September 30, 2003, an increase of approximately $0.3 million or 6.9%. The increase is primarily due to an increase in legal costs and accounting fees related to Sarbanes-Oxley Section 404 compliance during the nine months ended September 30, 2004. As a percentage of revenue, general and administrative expenses decreased to 15.8% in the nine months ended September 30, 2004, as compared to 19.6% for the nine months ended September 30, 2003. The decrease is primarily due to the increase in revenue from existing and new customers during the nine months ended September 30, 2004. During the nine months ended September 30, 2004, we reversed $153,000 in accrued liabilities that had previously been recorded as general and administrative expenses in prior years. We will continue to assess the necessity of all of our accrued liabilities and, as a result, may reverse amounts in the future.

Restructuring Charges. During the nine months ended September 30, 2003, we subleased a portion of our St. Louis facility for which we previously recorded a restructuring charge and therefore, recorded a $0.2 million recovery. This recovery was offset by $0.3 million in restructuring charges due to minor reductions in headcount. When we updated our restructuring charge in December 2003 related to exiting the under-utilized space in our Mountain View facility, we had assumed that a sublessee would be identified by December 31, 2004. During the fourth quarter, we will re-evaluate our assumptions and estimates related to the restructuring charge. This may result in an additional restructuring charge in the fourth quarter.

Interest Income, Net. Interest income was $0.5 million for the nine months ended September 30, 2004, consistent with the $0.5 million for the nine months ended September 30, 2003.

Income Tax Provision. We recorded a provision for income tax expense of $55,000 for the nine months ended September 30, 2004.

LIQUIDITY AND CAPITAL RESOURCES

Our cash, cash equivalents and short-term investments decreased by $0.5 million from $44.4 million at December 31, 2003 to $43.9 million at September 30, 2004. The decrease is primarily due to $4.3 million of cash used to repurchase our common stock and purchases of capital equipment of $0.7 million, offset by cash received as a result of stock option exercises of our common stock of $2.4 million, our net income of $1.8 million and cash received as a result of the Miva loan payment of $0.6 million during the nine months ended September 30, 2004.

Net cash provided by our operating activities was $1.3 million for the nine months ended September 30, 2004, as compared to cash used in our operating activities of $4.2 million for the nine months ended September 30, 2003. The increase is primarily due to the increase in our operating income, offset by an increase in accounts receivable and decreases in depreciation and other accrued liabilities.

Net cash used in investing activities was $2.5 million during the nine months ended September 30, 2004, as compared to $3.4 million for the nine months ended September 30, 2003. Net cash used in investing activities during the nine months ended September 30, 2004 was composed primarily of $58.1 million of cash used for purchases of short-term investments, offset by $55.6 million received from maturities of short-term investments. The decrease compared to the nine months ended September 30, 2003 is primarily due to an increase in short-term investment maturities of $4.2 million and cash received from the Miva loan payoff of $0.6 million, offset to a certain extent by increases in short-term investment purchases of $3.5 million and property and equipment purchases of $0.7 million during the nine months ended September 30, 2004.

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Net cash used in financing activities was $1.7 million during the nine months ended September 30, 2004, as compared to $96,000 for the nine months ended September 30, 2003. The decrease is primarily due to cash used to repurchase our common stock of $4.3 million, offset by cash received as a result of stock option exercises of our common stock of $2.4 million during the nine months ended September 30, 2004.

We believe that our current cash and short-term investment balances will be sufficient to meet our working capital and capital requirements for at least the next twelve months. Our future capital requirements will depend on many factors including the level of investment we make in new businesses, new products or new technologies. To the extent that our current cash balance and any future earnings are insufficient to fund our future activities, we would need to obtain additional equity or debt financing. Additional funds may not be available or, if available, we may not be able to obtain them on terms favorable to us.

The following is a table summarizing our significant commitments as of September 30, 2004, consisting of future minimum lease payments under all non-cancelable and operating leases:

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FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

Set forth below, elsewhere in this Quarterly Report on Form 10-Q, and in other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this report. The occurrence of any of the developments or risks identified below may make the occurrence of one or more of the other risk factors below more likely to occur.

We Have a Limited Operating History and Are Subject to the Risks Encountered by Early-Stage Companies

We have a limited operating history, and our business and prospects must be considered in light of the risks and uncertainties to which early-stage companies are particularly exposed. These risks include:

These risks are discussed in more detail below. We cannot assure you that our business strategy will be successful or that we will successfully address these risks and the risks detailed below.

We Have a History of Losses, May Incur Future Losses and Cannot Assure You that We Will Achieve Ongoing Profitability

We cannot be certain that we will realize sufficient revenues, and sufficiently limit expenses, to achieve ongoing profitability.

We have incurred significant net losses since our inception. We incurred net losses of $75.0 million in 2000, $185.0 million in 2001, $12.5 million in 2002 and $5.4 million in 2003. As of September 30, 2004, we had incurred cumulative losses of $320.8 million.

The Expected Fluctuations of Our Quarterly Results Could Cause Our Stock Price to Fluctuate or Decline

We expect that our quarterly operating results will fluctuate significantly in the future based upon a number of factors, many of which are not within our control. We base our operating expenses on anticipated market growth and our operating expenses are relatively fixed in the short term. As a result, if our revenues are lower than we expect, our quarterly operating results may not meet the expectations of public market analysts or investors, which could cause the market price of our common stock to decline.

Our quarterly results may fluctuate in the future as a result of many factors, including the following:

Other factors that may affect our quarterly results are set forth elsewhere in this section. As a result of these factors, our revenues are not predictable with any significant degree of certainty.

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Due to the uncertainty surrounding our revenues and expenses, we believe that quarter-to-quarter comparisons of our historical operating results should not be relied upon as an indicator of our future performance.

Our Stock Price May Fluctuate Substantially

The market price for our common stock may be affected by a number of factors, including the following:

These factors and fluctuations, as well as general economic, political and market conditions may materially adversely affect the market price of our common stock.

The Intense Competition in Our Industry Could Reduce or Eliminate the Demand for Our Products and Services

The market for our products and services is intensely competitive and subject to rapid technological change. We expect competition to intensify in the future. Our primary source of competition comes from online merchants that develop custom systems. These online merchants, who have made large initial investments to develop custom systems, may be less likely to adopt an outsourced transaction processing strategy or purchase our software. We also face competition from developers of other systems for commerce transaction processing such as Clear Commerce, E-One Global (an affiliate of First Data Corporation), Fair, Isaac, Lightbridge, Paymetrics, Retail Decisions, TrinTech and VeriSign. In addition, Visa and MasterCard have announced an Internet payment authentication process with password protection which is designed to reduce the potential for unauthorized card use on the internet, which may compete with our fraud screen services. Further, other companies, including financial services and credit companies such as First Data Corporation may enter the market and provide competing services. In the future, we may also compete with large Internet-centric companies that derive a significant portion of their revenues from e-Commerce and may offer, or provide a means for others to offer, e-Commerce transaction services.

Many of our competitors have longer operating histories, substantially greater financial, technical, marketing or other resources, or greater name recognition than we do. Our competitors may be able to respond more quickly than we can to new or emerging technologies and changes in customer requirements. Competition could seriously impede our ability to sell additional products and services on terms favorable to us. Our current and potential competitors may develop and market new technologies that render our existing or future products and services obsolete, unmarketable or less competitive. For example, Visa and MasterCard have introduced cardholder authentication solutions that, if widely adopted by consumers, may reduce demand for our fraud screening services. Our current and potential competitors may make strategic acquisitions or establish cooperative relationships among themselves or with other solution providers, thereby increasing their ability to address the needs of our existing or prospective customers. Our current and potential competitors may establish or strengthen cooperative relationships with our current or future channel partners, thereby limiting our ability to sell products and services through these channels. We expect that competitive pressures may result in the reduction of our prices or our market share or both, which could materially and adversely affect our business, results of operations or financial condition.

We May Pursue Strategic Acquisitions and Our Business Could be Materially Adversely Affected if We Fail to Adequately Integrate Acquired Businesses

As part of our future business strategy, we may pursue strategic acquisitions of complementary businesses or technologies that would provide additional product or service offerings, additional industry expertise, a broader client base or an expanded geographic presence. If we do not successfully integrate a strategic acquisition, or if the benefits of the transaction do not meet the expectation of financial or industry analysts, the market price of our common stock may decline. Any future acquisition could result in the use of significant amounts of cash, dilutive issuances of equity securities, or the incurrence of debt or amortization expenses related to goodwill and other intangible assets, any of which could materially adversely affect our business, operating results and financial condition. In addition, acquisitions involve numerous risks, including:

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Potential System Failures and Lack of Capacity Issues Could Negatively Affect Demand for Our Services

Our ability to deliver services to our merchants depends on the uninterrupted operation of our commerce transaction processing systems. Our systems and operations are vulnerable to damage or interruption from:

Despite the fact that we have implemented redundant servers in third-party hosting centers located in Santa Clara, California, and Mesa, Arizona, we may still experience service interruptions for the reasons listed above and a variety of other reasons. If our redundant servers are not available, we may not have sufficient business interruption insurance to compensate us for resulting losses. We have experienced periodic interruptions, affecting all or a portion of our systems, which we believe will continue to occur from time to time. For example, on November 12, 1999, our services were unavailable for approximately ten hours due to an internal system problem. We have also subsequently experienced service interruptions of lesser duration. In addition, any interruption in our systems that impairs our ability to provide services could damage our reputation and reduce demand for our services.

Our success also depends on our ability to grow, or scale, our commerce transaction systems to accommodate increases in the volume of traffic on our systems, especially during peak periods of demand. We may not be able to anticipate increases in the use of our systems or successfully expand the capacity of our network infrastructure. Our inability to expand our systems to handle increased traffic could result in system disruptions, slower response times and other difficulties in providing services to our merchant customers, which could materially harm our business.

A Breach of Our eCommerce Security Measures Could Reduce Demand for Our Services

A requirement of the continued growth of e-Commerce is the secure transmission of confidential information over public networks. We rely on public key cryptography, an encryption method that utilizes two keys, a public and a private key, for encoding and decoding data, and digital certificate technology, or identity verification, to provide the security and authentication necessary for secure transmission of confidential information. Regulatory and export restrictions may prohibit us from using the most secure cryptographic protection available and thereby expose us to an increased risk of data interception. A party who is able to circumvent security measures could misappropriate proprietary information or interrupt our operations. Any compromise or elimination of security could reduce demand for our services.

We may be required to expend significant capital and other resources to protect against security breaches and to address any problems they may cause. Concerns over the security of the Internet and other online transactions and the privacy of users may also inhibit the growth of the Internet and other online services generally, and the Web in particular, especially as a means of conducting commercial transactions. Because our activities involve the storage and transmission of proprietary information, such as credit card numbers, security breaches could damage our reputation and expose us to a risk of loss or litigation and possible liability. Our security measures may not prevent security breaches, and failure to prevent security breaches may disrupt our operations.

We Could Incur Chargeback or Merchant Fraud Losses

CyberSource has potential liability for certain transactions processed primarily through our Global Payment Suite if the payments associated with such transactions are rejected, refused, or returned for reasons such as consumer fraud or billing disputes. For instance, if a billing dispute between a merchant and payer is not ultimately resolved in favor of the merchant, the disputed transaction may be charged back to the merchant’s bank and credited to the payer’s account. If the charged back amount cannot be recovered from the merchant’s account, or if the merchant refuses or is financially unable to reimburse its bank for the charged back amount, we may bear the loss for the amount of the refund paid to the payer’s bank. We could also incur fraud losses as a result of merchant fraud. Merchant fraud occurs when a merchant, rather than a customer, intentionally uses a stolen or counterfeit card, card number, or other bank account number to process a false sales transaction, or knowingly fails to deliver merchandise or services in an otherwise valid transaction. We may be responsible for any losses for certain transactions if we are unable to collect from the merchant.

We have established systems and procedures designed to detect and reduce the impact of consumer fraud and merchant fraud, but we cannot assure you that these measures are or will be effective. To date, we have not incurred any losses relating to charged back transactions.

Changes in Accounting Standards Regarding Stock Option Plans Could Limit the Desirability of Granting Stock Options, Which Could Harm Our Ability to Attract and Retain Employees, and Could Also Reduce Our Profitability

The Financial Accounting Standards Board has issued an exposure draft that would require all companies to treat the value of stock options granted to employees as an expense. The U.S. Congress and other governmental and regulatory authorities have also considered requiring companies to expense stock options. If this change were to become mandatory, we and other companies would be required to record a compensation expense equal to the value of each stock option granted. This expense would likely be recognized over the vesting period of the stock option. Currently, we are generally not required to record compensation expenses in connection with stock option grants. If we are required to expense stock option grants, it would reduce the attractiveness of granting stock options because the additional expense associated with these grants would reduce our profitability. However, stock options are an important employee recruitment and retention tool, and we may not be able to attract and retain key personnel if we reduce the scope of our employee stock option program. Accordingly, in the event we are required to expense stock option grants, our profitability likely would be reduced, as would our ability to use stock options as an employee recruitment and retention tool.

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If We Are Not Able to Fully Utilize Relationships With Our Sales Alliances, We May Experience Lower Revenue Growth and Higher Operating Costs

Our future growth will depend in part on the success of our relationships with existing and future sales alliances that market our products and services to their merchant accounts. If these relationships are not successful or do not develop as quickly as we anticipate, our revenue growth may be adversely affected. Accordingly, we may have to increase our sales and marketing expenses in an attempt to secure additional merchant accounts.

Our Market is Subject to Rapid Technological Change and to Compete We Must Continually Enhance Our Systems to Comply with Evolving Standards

To remain competitive, we must continue to enhance and improve the responsiveness, functionality and features of our products and services and the underlying network infrastructure. The Internet and the e-Commerce industry are characterized by rapid technological change, changes in user requirements and preferences, frequent new product and service introductions embodying new technologies, and the emergence of new industry standards and practices that could render our technology and systems obsolete. Our success will depend, in part, on our ability to both internally develop and license leading technologies to enhance our existing products and services and develop new products and services. We must continue to address the increasingly sophisticated and varied needs of our merchants, and respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis. The development of proprietary technology involves significant technical and business risks. We may fail to develop new technologies effectively or to adapt our proprietary technology and systems to merchant requirements or emerging industry standards. If we are unable to adapt to changing market conditions, merchant requirements or emerging industry standards, our business would be materially harmed.

Revenues from Professional Services May Decrease

In the year ended December 31, 2000, we experienced strong growth in the demand for our professional services and were engaged to complete a large project with related revenue in the amount of approximately $3.7 million. Since then, we have not been engaged, and in the future may not be engaged, for additional projects of similar or larger size, and the demand for professional services may decrease. For instance, professional services revenue decreased from $3.6 million for the year ended December 31, 2002 to $2.0 million for the year ended December 31, 2003. In addition, given prior reductions in our professional services workforce, if we are engaged on larger projects, we may not be able to hire the resources necessary to meet future demand.

The Demand for Our Products and Services Could Be Negatively Affected by a Reduced Growth of e-Commerce or Delays in the Development of the Internet Infrastructure

Sales of goods and services over the Internet do not currently represent a significant portion of overall sales of goods and services. We depend on the growing use and acceptance of the Internet as an effective medium of commerce by merchants and customers in the United States and internationally. Rapid growth in the use of and interest in the Internet is a relatively recent development. In particular, the sale of goods and services over the Internet has gained acceptance more slowly outside of the United States. We cannot be certain that acceptance and use of the Internet will continue to develop or that a sufficiently broad base of merchants and consumers will adopt, and continue to use, the Internet as a medium of commerce.

The increase in the significance of the Internet as a commercial marketplace may occur more slowly than anticipated for a number of reasons, including potentially inadequate development of the necessary network infrastructure or delayed development of enabling technologies and performance improvements. If the number of Internet users, or the use of Internet resources by existing users, continues to grow, it may overwhelm the existing Internet infrastructure. Delays in the development or adoption of new standards and protocols required to handle increased levels of Internet activity could also have a detrimental effect. These factors could result in slower response times or adversely affect usage of the Internet, resulting in lower numbers of commerce transactions and lower demand for our products and services.

If We Lose Key Personnel, We May Not be Able to Successfully Manage Our Business and Achieve Our Objectives

We believe our future success will depend upon our ability to retain our key management personnel, including William S. McKiernan, our Chief Executive Officer, and other key members of management because of their experience and knowledge regarding the development, special opportunities and challenges of our business. None of our current key employees is subject to an employment contract. We may not be successful in attracting and retaining key employees in the future.

We May Not Be Able to Adequately Protect Our Proprietary Technology and May Be Infringing Upon Third-Party Intellectual Property Rights

Our success depends upon our proprietary technology. We rely on a combination of patent, copyright, trademark and trade secret rights, confidentiality procedures and licensing arrangements to establish and protect our proprietary rights.

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As part of our confidentiality procedures, we enter into non-disclosure agreements with our employees, contractors, vendors and potential customers and alliances. Despite these precautions, third parties could copy or otherwise obtain and use our technology without authorization, or develop similar technology independently. Effective protection of intellectual property rights may be unavailable or limited in foreign countries. We cannot assure you that the protection of our proprietary rights will be adequate or that our competitors will not independently develop similar technology, duplicate our products and services or design around any patents or other intellectual property rights we hold.

We also cannot assure you that third parties will not claim that the technology employed in providing our current or future products and services infringe upon their rights. We have not conducted any search to determine whether any of our products and services or technologies may be infringing upon patent rights of third parties. As the number of products and services in our market increases and functionalities increasingly overlap, companies such as ours may become increasingly subject to infringement claims. In addition, these claims also might require us to enter into royalty or license agreements. Any infringement claims, with or without merit, could absorb significant management time and lead to costly litigation. If required to do so, we may not be able to obtain royalty or license agreements, or obtain them on terms acceptable to us.

We May Not Be Able to Secure Funding in the Future Necessary to Operate Our Business as Planned

We require substantial working capital to fund our business. We have had significant operating losses and, until recently, negative cash flow from operations since inception. We believe that our existing capital resources will be sufficient to meet our capital requirements for at least the next twelve months. However, our capital requirements depend on several factors, including the rate of market acceptance of our products and services, the ability to expand our customer base, the growth of sales and marketing and other factors. If capital requirements vary materially from those currently planned, we may require additional financing. If additional funds are raised through the issuance of equity securities, the percentage ownership of our stockholders will be reduced, and these equity securities may have rights, preferences or privileges senior to those of the holders of our common stock. Additional financing may not be available when needed on terms favorable to us or at all. If adequate funds are not available or are not available on acceptable terms, we may be unable to develop or enhance our products and services, take advantage of future opportunities or respond to competitive pressures.

We May Become Subject to Government Regulation and Legal Uncertainties That Would Adversely Affect Our Financial Results

We are not currently subject to direct regulation by any domestic or foreign governmental agency, other than regulations applicable to businesses generally, export control laws and laws or regulations directly applicable to e-Commerce. However, due to the increasing usage of the Internet, it is possible that a number of laws and regulations may be applicable or may be adopted in the future with respect to conducting business over the Internet covering issues such as:

For example, we believe that our fraud screen service may require us to comply with the Fair Credit Reporting Act (the “Act”). As a precaution, we have implemented processes that we believe will enable us to comply with the Act if we were deemed a consumer reporting agency. Complying with the Act requires us to provide information about personal data stored by us. Failure to comply with the Act could result in claims being made against us by individual consumers and the Federal Trade Commission.

Furthermore, the growth and development of the market for e-Commerce may prompt more stringent consumer protection laws that may impose additional burdens on those companies conducting business online. The adoption of additional laws or regulations may decrease the growth of the Internet or other online services, which could, in turn, decrease the demand for our products and services and increase our cost of doing business.

The applicability of existing laws governing issues such as property ownership, copyrights, encryption and other intellectual property issues, taxation, libel, export or import matters and personal privacy to the Internet is uncertain. The vast majority of

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laws were adopted prior to the broad commercial use of the Internet and related technologies. As a result, they do not contemplate or address the unique issues of the Internet and related technologies. Changes to these laws intended to address these issues, including some recently proposed changes in the United States regarding taxation and encryption and in the European Union regarding contract formation and privacy, could create uncertainty in the Internet marketplace and impose additional costs and other burdens. These uncertainties, costs and burdens could reduce demand for our products and services or increase the cost of doing business due to increased litigation costs or increased service delivery costs.

Our International Business Exposes Us to Additional Foreign Risks

Products and services provided to merchants outside the United States accounted for 6.9%, 7.7% and 9.0% of our revenues in 2002, 2003 and during the nine months ended September 30, 2004, respectively. In March 2000, we entered into a joint venture agreement with Japanese partners Marubeni Corporation and Trans-Cosmos, Inc. and established CyberSource K.K. to provide commerce transaction services to the Japanese market. Conducting business outside of the United States is subject to additional risks that may affect our ability to sell our products and services and result in reduced revenues, including:

In addition, some software contains encryption technology that renders it subject to export restrictions and we may become liable to the extent we violate these restrictions. We might not successfully market, sell and distribute our products and services in local markets and we cannot be certain that one or more of these factors will not materially adversely affect our future international operations, and consequently, our business, financial condition and operating results.

Also, sales of our products and services conducted through our subsidiary in the United Kingdom are denominated in Pounds Sterling. We may experience fluctuations in revenues or operating expenses due to fluctuations in the value of the Pound Sterling relative to the U.S. Dollar. We do not currently enter into transactions with the specific purpose to hedge against currency exchange fluctuations.

The Anti-Takeover Provisions in Our Certificate of Incorporation Could Adversely Affect the Rights of the Holders of Our Common Stock

Anti-takeover provisions of Delaware law and our Certificate of Incorporation may make a change in control more difficult to finalize, even if a change in control would be beneficial to the stockholders. These provisions may allow the Board of Directors to prevent changes in our management and controlling interests. Under Delaware law, our Board of Directors may adopt additional anti-takeover measures in the future.

One anti-takeover provision that we have is the ability of our Board of Directors to determine the terms of preferred stock and issue preferred stock without the approval of the holders of the common stock. Our Certificate of Incorporation allows the issuance of up to 5,610,969 shares of preferred stock. As of September 30, 2004, there are no shares of preferred stock outstanding. However, because the rights and preferences of any series of preferred stock may be set by the Board of Directors in its sole discretion without approval of the holders of the common stock, the rights and preferences of this preferred stock may be superior to those of the common stock. Accordingly, the rights of the holders of common stock may be adversely affected.

Our Fraud Detection Services and Marketing Agreement With Visa U.S.A. Can Be Terminated

In July 2001, we entered into a new agreement with Visa U.S.A. to jointly develop and promote the CyberSource Advanced Fraud Screen Service Enhanced by Visa for use in the United States. Under the terms of the agreement, Visa has agreed to promote and market the new product to its member financial institutions and Internet merchants. The agreement expires in July 2005, but can be terminated by either party after the first year with ninety days prior written notice. After July 2005, the agreement renews automatically for additional periods of one year, unless terminated by either party.

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Recently Enacted and Proposed Changes in Securities Laws and Regulations are Likely to Increase Our Costs

The Sarbanes-Oxley Act of 2002 that became law in July 2002 requires changes in some of our corporate governance and securities disclosure or compliance practices. That Act also requires the SEC to promulgate new rules on a variety of subjects, in addition to rule proposals already made, and Nasdaq has proposed revisions to its requirements for companies that are Nasdaq-listed. We expect these developments to increase our legal compliance costs, and to make some activities more time-consuming. We are presently evaluating and monitoring regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result.

Failure to Achieve and Maintain Effective Internal Controls in Accordance with Section 404 of the Sarbanes-Oxley Act Could Have a Material Adverse Effect on Our Business and Stock Price

We are in the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our Independent Auditors addressing these assessments. The threshold for what constitutes a significant deficiency in internal control under Section 404 of the Sarbanes-Oxley Act has been set quite low and, during the course of our testing, we may find one or more material weaknesses or significant deficiencies. Furthermore, there is no guarantee that we will be able to remedy any deficiencies we may find in a cost effective manner and in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. In addition, if we fail to maintain the adequacy of our internal controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act. Failure to achieve and maintain an effective internal control environment could have a material adverse effect on our stock price.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We provide our services to customers primarily in the United States and, to a lesser extent, in Europe and elsewhere throughout the world. As a result, our financial results could be affected by factors, such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. All sales are currently made in U.S. dollars or pounds sterling. A strengthening of the dollar or the pound sterling could make our products less competitive in foreign markets. Our interest income is sensitive to changes in the general level of U.S. interest rates.

Due to the nature of our short-term investments, which are primarily government bonds, we have concluded that there is no material market risk exposure with respect to such investments.

ITEM 4. CONTROLS AND PROCEDURES

The Company’s Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) have evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of September 30, 2004 (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, the Company’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company required to be included in the Company’s periodic filings under the Exchange Act. In addition, there have been no significant changes in the Company’s internal control over financial reporting or in other factors that could significantly affect this control subsequent to the date of the previously mentioned evaluation.

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PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In July and August 2001, various class action lawsuits were filed in the United States District Court, Southern District of New York, against us, our Chairman and CEO, a former officer, and four brokerage firms that served as underwriters in our initial public offering. The actions were filed on behalf of persons who purchased our stock issued pursuant to or traceable to the initial public offering during the period from June 23, 1999 through December 6, 2000. The action alleges that our underwriters charged secret excessive commissions to certain of their customers in return for allocations of our stock in the offering. The two individual defendants are alleged to be liable because of their involvement in preparing and signing the registration statement for the offering, which allegedly failed to disclose the supposedly excessive commissions. On December 7, 2001, an amended complaint was filed in one of the actions to expand the purported class to persons who purchased our stock issued pursuant to or traceable to the follow-on public offering during the period from November 4, 1999 through December 6, 2000. The lawsuit filed against us is one of several hundred lawsuits filed against other companies based on substantially similar claims. On April 19, 2002, a consolidated amended complaint was filed to consolidate all of the complaints and claims into one case. The consolidated amended complaint alleges claims that are virtually identical to the amended complaint filed on December 7, 2001 and the original complaints. In October 2002, our officer and a former officer that were named in the amended complaint were dismissed without prejudice. In July 2002, we, along with other issuer defendants in the case, filed a motion to dismiss the consolidated amended complaint with prejudice. On February 19, 2003, the court issued a written decision denying the motion to dismiss with respect to CyberSource. On July 2, 2003, a committee of our Board of Directors conditionally approved a proposed partial settlement with the plaintiffs in this matter. The settlement would provide, among other things, a release of us and of the individual defendants for the conduct alleged in the action to be wrongful in the Amended Complaint. We would agree to undertake other responsibilities under the partial settlement, including agreeing to assign away, not assert, or release certain potential claims we may have against our underwriters. Any direct financial impact of the proposed settlement is expected to be borne by our insurers. The committee agreed to approve the settlement subject to a number of conditions, including the participation of a substantial number of other Issuer Defendants in the proposed settlement, the consent of our insurers to the settlement, and the completion of acceptable final settlement documentation. Furthermore, the settlement is subject to a hearing on fairness and approval by the court overseeing the IPO litigations. While there can be no assurances as to the outcome of the lawsuit, we do not presently believe that an adverse outcome in the lawsuit would have a material effect on our financial condition, results of operations or cash flows.

On August 11, 2004, we filed suit in the Northern District of California against Retail Decisions, Inc. (“ReD US”) and Retail Decisions Plc (“ReD UK”) (collectively, “ReD”), Case No. 3:04-CIV-03268, alleging that ReD infringes our U.S. Patent No. 6,029,154 (the “‘154 Patent”). We served ReD US with the complaint on August 12, 2004, and we served ReD UK with the complaint on August 13, 2004. On September 30, 2004, ReD responded to our complaint. ReD filed a motion to stay the case for 90 days pending a determination by the U.S. Patent and Trademark Office (“PTO”) as to whether it will grant ReD’s request that the PTO reexamine the ‘154 Patent. ReD also filed a motion for a more definite statement by us with respect to our allegation that ReD is willfully infringing the ‘154 Patent. In addition, ReD UK filed a motion to dismiss the action against it on the ground that it is not subject to personal jurisdiction in the Northern District of California. On October 27, 2004, ReD filed a request for reexamination with the PTO, based on prior art ReD discovered that allegedly invalidates the patent. The PTO must respond within 90 days of filing whether it will grant ReD’s request for reexamination. Based on our review of the cited prior art references and the reexamination request, even if the PTO grants ReD’s request for reexamination, we does not believe that the PTO will invalidate the ‘154 Patent. On October 28, 2004, we filed an opposition to ReD’s motion to stay the case for 90 days and an opposition to ReD’s motion for a more definite statement with respect to willful infringement. Based on ReD UK’s representation that ReD US is the sole entity that develops, operates, and distributes the eBitGuard service, we have agreed to dismiss ReD UK while reserving the right to reinstitute action against ReD UK in the event we later discover that ReD UK is subject to the court’s personal jurisdiction. In return, ReD UK has agreed that if we later establish that personal jurisdiction existed, we could re-file against ReD UK in this action without prejudice to its damages claim. We also filed an amended complaint, removing ReD UK as a named defendant and restating the willful infringement claim. A hearing on the motions is scheduled to be held on November 18, 2004. While there can be no assurances as to the outcome of the lawsuit, we do not presently believe that an adverse outcome in the lawsuit would have a material effect on our financial condition, results of operations, or cash flows.

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

Of the remaining $3.9 million of net proceeds as of June 30, 2004 from the second public offering in November 1999, we used $3.9 million to repurchase shares to the Company’s common stock during the three months ended September 30, 2004. On January 21, 2004, the Board of Directors authorized management to use up to $10.0 million over the next twelve months to

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repurchase shares of the Company’s common stock. During the nine months ended September 30, 2004, the Company repurchased 930,200 shares at an average price of $4.61 per share for a total cost of $4.3 million, net of repurchase costs. From October 1, 2004 to October 31, 2004, the Company did not repurchase any shares.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

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

None.

ITEM 5. OTHER INFORMATION

In accord with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002, the Company is responsible for disclosing the non-audit services approved in the third quarter of fiscal year 2004 by the Company’s Audit Committee to be performed by Ernst & Young, the Company’s independent registered public accounting firm. Non-audit services are defined in the law as services other than those provided in connection with an audit or a review of the financial statements of the Company. The non-audit services approved by the Audit Committee in the third quarter are each considered by the Company to be audit-related services which are closely related to the financial audit process. Each of the services has been pre-approved by the Audit Committee and the Committee’s Chairman has been given the authority to pre-approve additional services pursuant to limited authority delegated by the Committee.

ITEM 6. EXHIBITS