NETIQ CORP - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

Form 10-Q

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

For the Quarterly Period Ended December 31, 2004

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

For the transition period from to

Commission File Number 000-26757

NetIQ CORPORATION

(Exact name of Registrant as specified in its charter)


Delaware		77-0405505
(State or other jurisdiction of incorporation or organization)		(I.R.S. employer identification no.)

3553 North First Street, San Jose, CA		95134
(Address of principal executive offices)		(Zip Code)

(408) 856-3000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the 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 January 31, 2005, the Registrant had outstanding 54,767,268 shares of Common Stock.

NETIQ CORPORATION

INDEX TO QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED December 31, 2004


		Page

PART I FINANCIAL INFORMATION

ITEM 1.	FINANCIAL STATEMENTS	3

	CONDENSED CONSOLIDATED BALANCE SHEETS	3

	CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)	4

	CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS	5

	NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	6

ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	12

ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	32

ITEM 4.	CONTROLS AND PROCEDURES	32

PART II OTHER INFORMATION

ITEM 1.	LEGAL PROCEEDINGS	33

ITEM 6.	EXHIBITS	33

	SIGNATURE	34

PART I FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

NetIQ CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)


	December 31, 2004			June 30, 2004⁽¹⁾
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	68,932		$	57,841
Short-term investments		225,457			229,781
Accounts receivable, net		35,501			31,081
Prepaid expenses and other		5,797			5,269

Total current assets		335,687			323,972

Property and equipment, net		48,118			49,706
Other intangible assets, net		28,806			39,040
Other assets		1,970			2,489
Long-term investments		3,714			4,614
Goodwill		124,614			124,081

Total assets	$	542,909		$	543,902


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	7,512		$	8,278
Accrued compensation and related benefits		14,918			14,374
Other liabilities		12,323			11,812
Deferred revenue, current portion		65,126			61,174
Restructuring liability, current portion		297			929

Total current liabilities		100,176			96,567

Deferred revenue, net of current portion		2,638			5,442
Restructuring liability, net of current portion		261			393

Total liabilities		103,075			102,402

Stockholders’ equity:
Common stock-$0.001 par value; 250,000,000 shares authorized, 55,061,459 issued and outstanding at December 31, 2004; 55,216,057 issued and outstanding at June 30, 2004		2,903,295			2,905,610
Deferred employee stock-based compensation		(678	)		(313	)
Accumulated deficit		(2,461,697	)		(2,462,825	)
Accumulated other comprehensive loss		(1,086	)		(972	)

Total stockholders’ equity		439,834			441,500

Total liabilities and stockholders’ equity	$	542,909		$	543,902

⁽¹⁾	Derived from audited consolidated financial statements.

See notes to condensed consolidated financial statements.

NetIQ CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE INCOME (LOSS)

(In thousands, except per share amounts)

(Unaudited)


	Three Months Ended December 31,						Six Months Ended December 31,
	2004			2003			2004			2003
Software license revenue	$	36,849		$	34,012		$	69,849		$	69,037
Service revenue		33,658			29,949			65,400			57,780

Total revenue		70,507			63,961			135,249			126,817

Cost of software license revenue		1,167			2,564			2,515			5,353
Cost of service revenue		8,787			7,671			17,329			15,467
Amortization of purchased technology		3,095			5,801			6,190			11,602

Total cost of revenue		13,049			16,036			26,034			32,422

Gross profit		57,458			47,925			109,215			94,395
Operating expenses:
Sales and marketing		31,300			30,869			62,076			58,893
Research and development		16,020			16,465			32,161			32,989
General and administration		8,121			6,391			14,558			13,486
Amortization of other intangible assets		2,179			4,263			4,344			8,526
Employee stock-based compensation		325			85			500			186
Restructuring credit		(27	)		(138	)		(8	)		(504	)
Impairment of goodwill		—			—			—			150,842

Total operating expenses		57,918			57,935			113,631			264,418

Loss from operations		(460	)		(10,010	)		(4,416	)		(170,023	)

Other income (expenses):
Interest income		1,352			1,395			2,546			2,767
Gain on sale of long-term investment		4,100			—			4,100			—
Impairment of long-term investment		—			—			—			(4,100	)
Other income (expenses), net		810			(542	)		556			(605	)

Total other income (expenses)		6,262			853			7,202			(1,938	)

Income (loss) before income taxes		5,802			(9,157	)		2,786			(171,961	)
Income tax expense		795			1,090			1,658			1,900

Net income (loss)	$	5,007		$	(10,247	)	$	1,128		$	(173,861	)

Other comprehensive income (loss), net of income taxes:
Foreign currency translation adjustment		(97	)		192			(18	)		530
Unrealized loss on short-term investments		(243	)		(295	)		(96	)		(320	)

Comprehensive income (loss)	$	4,667		$	(10,350	)	$	1,014		$	(173,651	)

Basic earnings per share:
Net earnings (loss) per share	$	0.09		$	(0.18	)	$	0.02		$	(3.07	)

Diluted earnings per share:
Net earnings (loss) per share	$	0.09		$	(0.18	)	$	0.02		$	(3.07	)

Shares used to compute basic earnings (loss) per share		54,958			56,870			55,051			56,588
Shares used to compute diluted earnings (loss) per share		55,859			56,870			55,675			56,588

See notes to condensed consolidated financial statements.

NetIQ CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)


	Six Months Ended December 31,
	2004			2003
Cash flows from operating activities:
Net income (loss)	$	1,128		$	(173,861	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		17,525			28,219
Amortization of employee stock-based compensation		500			186
Loss on sale of investments and property and equipment		36			153
Impairment of goodwill		—			150,842
Gain on sale of long-term investment		(4,100	)		—
Impairment of long-term investment		—			4,100
Changes in:
Accounts receivable		(5,167	)		8,902
Prepaid expenses and other		(10	)		312
Accounts payable		(1,012	)		(473	)
Accrued compensation and related benefits		216			(4,648	)
Other liabilities		417			(1,132	)
Restructuring liability		(764	)		(1,947	)
Deferred revenue		1,224			12,363

Net cash provided by operating activities		9,993			23,016

Cash flows from investing activities:
Purchases of property and equipment, net		(5,298	)		(4,051	)
Proceeds from sales of property and equipment		42			10
Cash used in acquisitions		(533	)		—
Purchases of short-term investments		(73,029	)		(101,351	)
Proceeds from maturities of short-term investments		72,341			91,366
Proceeds from sale of long-term investment		5,000			—
Proceeds from sales of short-term investments		4,912			580
Purchase of technology		(300	)		—
Other		106			(78	)

Net cash provided by (used in) investing activities		3,241			(13,524	)

Cash flows from financing activities:
Proceeds from sale of common stock		3,540			8,747
Repurchase of common stock		(6,721	)		(2,054	)

Net cash provided by (used in) financing activities		(3,181	)		6,693

Effect of exchange rate changes on cash		1,038			863

Net increase in cash and cash equivalents		11,091			17,048
Cash and cash equivalents, beginning of period		57,841			76,095

Cash and cash equivalents, end of period	$	68,932		$	93,143

Supplemental disclosure of cash flow information:
Cash paid for interest	$	11		$	32
Cash paid for income taxes	$	105		$	603

See notes to condensed consolidated financial statements.

NetIQ CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Six Months Ended December 31, 2004 and 2003

(Unaudited)

1. Basis of Presentation

Interim Financial Information—The accompanying financial statements include the accounts of NetIQ Corporation and its subsidiaries. We have subsidiaries in Canada, Europe, Asia Pacific, and South America.

These interim unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the rules and regulations of the Securities and Exchange Commission for interim financial statements. In the opinion of management, the condensed consolidated financial statements include all adjustments (consisting only of normal recurring accruals) that management considers necessary for a fair presentation of our financial position, operating results and cash flows for the interim periods presented. All intercompany accounts and transactions have been eliminated in consolidation. Operating results and cash flows for interim periods are not necessarily indicative of results to be expected for the entire fiscal year ending June 30, 2005.

These interim financial statements and notes should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2004.

2. Recently Issued Accounting Pronouncement

On December 16, 2004, the FASB issued Statement No. 123 (revised 2004) (“SFAS No. 123(R)”), Share-Based Payment. SFAS No. 123(R) will require us to measure the cost of all employee stock-based compensation awards based on the fair value of those awards on the grant date and to record that cost as compensation expense over the period during which the employee is required to perform service in exchange for the award (generally one to four years). Excess tax benefits, as defined by SFAS 123(R), will be recognized as an addition to paid-in capital. SFAS No. 123(R) will be effective with our fiscal quarter beginning July 1, 2005. The company is currently evaluating the expected impact that the adoption of SFAS No. 123(R) will have on its results of operations and cash flows.

3. Stock Based Compensation Plans

We account for stock-based compensation for our employee stock plans in accordance with provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Unvested options assumed in acquisitions are accounted for in accordance with the provisions of Financial Accounting Standards Board Interpretation No. 44 (FIN 44), Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB Opinion No. 25, and the related deferred employee stock-based compensation is amortized ratably over the vesting periods.

Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, requires the disclosure of pro forma earnings as if we had adopted the SFAS No. 123 fair value method since our inception. The fair value of stock-based awards to employees is calculated using the Black-Scholes option pricing model, even though this model was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the terms and characteristics of our stock option awards. The Black-Scholes model also requires the use of subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values.

NetIQ CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Six Months Ended December 31, 2004 and 2003

(Unaudited)

The weighted-average fair value of stock-based compensation to our employees is based on the single option valuation approach. Forfeitures are recognized as they occur, and it is assumed no dividends will be declared. The weighted-average fair value calculations are based on the following assumptions:


	Three Months Ended December 31,				Six Months Ended December 31,
	2004		2003		2004		2003
Estimated life (in years)	4.3		4.3		4.3		4.0-4.3
Risk-free interest rate	3.3	%	2.9	%	3.2-3.3	%	2.8-2.9	%
Volatility	65	%	62	%	38-65	%	62-70	%

For pro forma purposes, the estimated fair value of stock-based compensation awards to employees is amortized using the straight-line method over the vesting period of the options. Our pro forma results are as follows (in thousands, except per share amounts):


	Three Months Ended December 31,						Six Months Ended December 31,
	2004			2003			2004			2003
Reported net income (loss)	$	5,007		$	(10,247	)	$	1,128		$	(173,861	)
Employee stock-based compensation included in reported net income (loss)		325			85			500			186
Employee stock-based compensation determined under the fair value method for all awards, net of income taxes		(15,265	)		(15,809	)		(27,459	)		(32,706	)

Pro forma net loss	$	(9,933	)	$	(25,971	)	$	(25,831	)	$	(206,381	)

Basic earnings (loss) per share:
As reported	$	0.09		$	(0.18	)	$	0.02		$	(3.07	)
Pro forma	$	(0.18	)	$	(0.46	)	$	(0.47	)	$	(3.65	)
Diluted earnings (loss) per share:
As reported	$	0.09		$	(0.18	)	$	0.02		$	(3.07	)
Pro forma	$	(0.18	)	$	(0.46	)	$	(0.46	)	$	(3.65	)

4. Allowance for Uncollectible Accounts and Sales Returns

Accounts receivable are presented net of allowance for uncollectible accounts and sales returns. Changes in the allowance for uncollectible accounts and sales returns during the six months ended December 31, 2004 are as follows (in thousands):


	Uncollectible Accounts		Sales Returns
Balances, June 30, 2004	$	671	$	863

Increase in allowance		17		579
Recoveries and (write-offs), net		110		(310	)

Balances, December 31, 2004	$	798	$	1,132

NetIQ CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Six Months Ended December 31, 2004 and 2003

(Unaudited)

5. Other Intangible Assets

Other intangible assets consist of the following (in thousands):


	Carrying Amount		Accumulated Amortization		Net

	December 31, 2004
Purchased technology	$	99,936	$	79,962	$	19,974
Customer contracts		24,829		17,033		7,796
Customer lists		43,078		42,759		319
Publishing rights		1,262		866		396
Tradenames		3,190		2,869		321

Total	$	172,295	$	143,489	$	28,806


	June 30, 2004
Purchased technology	$	99,636	$	73,968	$	25,668
Customer contracts		24,829		12,895	$	11,934
Customer lists		43,078		42,686	$	392
Publishing rights		1,262		656	$	606
Tradenames		3,190		2,750	$	440

Total	$	171,995	$	132,955	$	39,040

Estimated future amortization of other intangible assets as of December 31, 2004 is as follows (in thousands):


Fiscal year ending June 30,	Purchased Technology*		Other Intangible Assets
2005 (remaining 6 months)	$	6,240	$	4,329
2006		8,784		3,921
2007		4,325		135
2008		596		29
2009		425		22

Total	$	20,370	$	8,436

*	Includes publishing rights

6. Long-term Investments

During the three months ended December 31, 2004, @Stake, Inc., a company in which we held a long-term investment, was acquired by a third party. Under the terms of the acquisition agreement, we received a $5.0 million payment which resulted in a $4.1 million gain which has been included in other income as of December 31, 2004.

7. Goodwill

The $533,000 change in goodwill during the six months ended December 31, 2004 resulted from an earn-out payment made under a business combination entered into during fiscal 2004.

NetIQ CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Six Months Ended December 31, 2004 and 2003

(Unaudited)

8. Other Liabilities

Other liabilities consist of (in thousands):


	December 31, 2004		June 30, 2004
Accrued sales and marketing costs	$	3,620	$	4,120
Sales tax payable		716		933
Facility reserve		296		379
Other		7,691		6,380

Other liabilities	$	12,323	$	11,812

At December 31, 2004 and June 30, 2004 our facility reserve represented the expected future costs under a lease agreement for unoccupied office space in Portland, Oregon, which expires in December 2006.

9. Restructuring Liability

Fiscal 2004 restructuring

During the three months ended June 30, 2004 we recorded a restructuring charge of $2.5 million related to restructuring of our information technology group and operations and continued cost reduction efforts.

Pursuant to the restructuring plan, we notified 86 employees that their employment would be terminated. As of December 31, 2004, 83 of these employees had left our employment and 3 employees had their termination rescinded. As of December 31, 2004, $1.7 million had been paid as termination benefits and related costs pursuant to the restructuring.

As part of the restructuring plan, we determined that we no longer required certain office space in Portland, Oregon, and established an accrual of $764,000 for fair value of the facilities consolidation. The amounts accrued for facilities consolidation at December 31, 2004 represent the total remaining liability under the lease, net of estimated sub-lease income.

We lease approximately 12,000 square feet of office space in Manukau, New Zealand under a lease expiring April 2005. The space was vacated in July of 2004 and a subsequent adjustment of $92,000 was made to the restructuring liability to reflect the estimated remaining obligation under this lease.

The following summarizes the 2004 restructuring plan activity (in thousands):


	Employee Severance and Other Related Benefits			Facilities Consolidation			Total
Restructuring charge (Quarter ended June 30, 2004)	$	1,738		$	764		$	2,502
Cash payments		(1,377	)		(78	)		(1,456	)

Restructuring liability at June 30, 2004		361			686			1,047
Cash payments		(231	)		(97	)		(328	)
Adjustments to restructuring, net		(73	)		92			19

Restructuring liability at September 30, 2004		57			681			738
Cash payments		(57	)		(96	)		(153	)
Adjustments to restructuring, net		—			(27	)		(27	)

Restructuring liability at December 31, 2004	$	—		$	558		$	558

NetIQ CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Six Months Ended December 31, 2004 and 2003

(Unaudited)

Fiscal 2003 restructuring

Payments made during the six months ended December 31, 2004 represent the final payments due under the Houston lease obligation, net of sublease income.

The following summarizes the 2003 restructuring plan activity (in thousands):


	Employee Severance and Other Related Benefits		Facilities Consolidation			Total
Restructuring liability at June 30, 2004	$	—	$	275		$	275

Cash payments, net of sub-lease income		—		(275	)		(275	)

Restructuring liability at September 30, 2004	$	—	$	—		$	—

10. Earnings Per Share

The following is a reconciliation of the shares used to compute basic and diluted earnings per share (in thousands):


	Three Months Ended December 31,				Six Months Ended December 31,
	2004		2003		2004		2003
Weighted average common shares outstanding	55,058		57,190		55,131		56,958
Weighted average common shares outstanding subject to repurchase	(100	)	(320	)	(80	)	(370	)

Shares used to compute basic earnings (loss) per share	54,958		56,870		55,051		56,588

Weighted average common shares outstanding subject to repurchase under the treasury stock method	47		—		42		—
Common equivalent shares related to outstanding options	854		—		582		—

Shares used to compute diluted earnings (loss) per share	55,859		56,870		55,675		56,588

During the three and six months ended December 31, 2003 we had securities outstanding which could potentially dilute earnings per share by 16,777 and 16,827, respectively. However, we excluded these securities from the computation of diluted earnings per share because the effect of including them would have been antidilutive.

11. Indemnification and Contingencies

Indemnification—We enter into standard indemnification agreements with many of our customers and certain other business partners in the ordinary course of business. These agreements include provisions for indemnifying the customer against any claim brought by a third-party to the extent any such claim alleges that a NetIQ product infringes a patent, copyright or trademark, misappropriates a trade secret, or violates any other proprietary rights of that third-party. It is not possible to estimate the maximum potential amount of future payments we could be required to make under these indemnification agreements. To date, we have not incurred significant costs to defend lawsuits or settle claims related to indemnification agreements. We have not recorded any liabilities for these indemnification agreements at December 31, 2004 or June 30, 2004.

NetIQ CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Six Months Ended December 31, 2004 and 2003

(Unaudited)

At our discretion and in the ordinary course of business, we perform and subcontract the performance of certain services. Accordingly, we enter into standard indemnification agreements with our customers to indemnify them for damage caused by our employees and subcontractors. It is not possible to estimate the maximum potential amount of future payments we could be required to make under these indemnification agreements. We maintain insurance policies that may enable us to recover a portion of any such claim. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. We have not recorded any liabilities for these indemnification agreements at December 31, 2004 or June 30, 2004.

As permitted under Delaware law, we have agreements indemnifying our executive officers, directors and some other employees for certain events and occurrences while the officer, director and employee is, or was, serving at our request in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is not estimable. We maintain directors and officers liability insurance designed to enable us to recover a portion of any future amounts paid. We have not recorded any liabilities for these indemnification agreements at December 31, 2004 or June 30, 2004.

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

We may also be a potential defendant in lawsuits and claims arising in the ordinary course of business. While the outcomes of such claims, lawsuits, or other proceedings cannot be predicted with certainty, management expects that such liability, to the extent not reimbursed by insurance or otherwise, will not have a material adverse effect on our financial condition or results of operations.

12. Major Customer

At December 31, 2004 and at June 30, 2004, no single customer represented 10% of our accounts receivable.

No single customer accounted for more than 10% of our revenue during the three and six months ended December 31, 2004 or 2003.

13. Subsequent Events

In January 2005, Ixia finalized the exercise of its option to purchase our remaining assets associated with the Chariot products. Under the terms of our agreement with Ixia, we received a $2.5 million payment in consideration of our transfer of those assets, which resulted in a gain of $2.9 million. The gain will be reflected in our financial results as of March 31, 2005.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

Overview

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

Our systems and security management solutions enable organizations to assure the performance, availability and security of the services delivered by their information technology (IT) infrastructures. While we initially focused on developing and marketing software to manage systems and applications running on the Microsoft Windows operating system, we have expanded our core business to include cross-platform systems management, security management and vulnerability management solutions, as well as software to test, migrate and administer Microsoft Windows and active directory environments. We also offer software to test and manage voice over internet protocol (VoIP) systems.

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

Special Considerations in Reviewing Fiscal 2005 and Fiscal 2004 Results

Our financial results for the six months ended December 31, 2004 and 2003 were affected by certain significant events that should be considered in comparing these periods.

In August 2003, we received the final $5.0 million license payment in accordance with our license agreement with Microsoft, pursuant to which Microsoft received a perpetual, non-exclusive license to our Operations Manager technology and source code. We received a total of $175.0 million in license fees from Microsoft starting in November 2000 and ending in August 2003. Under the terms of the agreement, Microsoft also paid us an additional $5.0 million per year to market joint solutions of the parties, which served to reduce our sales and marketing expenses when such expenses were incurred. The last marketing payment under this agreement was received during the six months ended December 31, 2003. All marketing funds received by us from Microsoft had been exhausted as of December 31, 2004.

Over the last three years we have invested in the development and acquisition of new products to replace the declining revenues from Microsoft and to otherwise grow our business. However, we have not yet been able to fully replace the Microsoft revenue stream with revenue from new products and services. Our ability to do so will depend on a variety of factors, including general economic conditions, spending in the IT sector, competition

and market acceptance of our new products. In addition, during the term of the agreement with Microsoft, our operating results benefited from the relatively low cost of revenue and operating expenses associated with the revenue from Microsoft. Our overall gross margins and operating margins have declined as the Microsoft revenue has been phased out, and we do not expect to achieve the same relatively low costs of revenue and operating expenses with respect to any replacement revenue we earn in future periods.

Due to a revenue shortfall in the quarter ended September 30, 2003 we performed an impairment analysis on the fair value of goodwill. We determined that the shortfall related primarily to our acquired and internally developed security products and that future revenue would not meet the forecast then in effect. Accordingly, we recorded a goodwill impairment charge of $150.8 million in September 2003. No such impairment charge was recorded for the six months ended December 31, 2004.

We repurchased 607,280 and 127,218 shares of our common stock during the six months ended December 31, 2004 and 2003 for $6.7 million and $2.1 million, respectively, pursuant to repurchase programs approved by our Board of Directors in September 2004 and October 2003. The September 2004 program authorizes the repurchase of up to $50 million of our outstanding common stock in open market transactions from time to time over a 12 month period. The October 2003 program, which authorized the repurchase of up to 5% of our outstanding common stock in open market transactions over a 12 month period, was concluded as of June 30, 2004.

Comparison of Three and Six Months Ended December 31, 2004 and 2003

Total Revenue. Total revenue and period-over-period changes are as follows (dollars in thousands):


	Three Months Ended December 31,				Percentage Change		Six Months Ended December 31,				Percentage Change
	2004		2003		Percentage Change		2004		2003		Percentage Change
Software license revenue	$	36,849	$	34,012	8	%	$	69,849	$	64,037	9	%
Software license revenue under Microsoft agreement		—		—	N/A	%		—		5,000	(100	)%

Total software license revenue		36,849		34,012	8	%		69,849		69,037	1	%
Service revenue		33,658		29,949	12	%		65,400		57,780	13	%

Total revenue	$	70,507	$	63,961	10	%	$	135,249	$	126,817	7	%


	Revenue as % of Total Revenue Inclusive of Microsoft Revenue Three Months Ended December 31,				Revenue as % of Total Revenue Exclusive of Microsoft Revenue Six Months Ended December 31,
	2004		2003		2004		2003
Software license revenue	52	%	53	%	52	%	50	%
Software license revenue under Microsoft agreement	N/A		N/A		N/A		4	%

Total software license revenue	52	%	53	%	52	%	54	%
Service revenue	48	%	47	%	48	%	46	%

Total revenue	100	%	100	%	100	%	100	%

Total revenue increased by $6.5 million or 10% and $8.4 million or 7% during the three and six months ended December 31, 2004, compared with the three and six months ended December 31, 2003. Software license revenue represented 52% of total revenue for the three and six months ended December 31, 2004 and 53% and 54% of total revenue for the three and six months ended December 31, 2003, with service revenue representing the balance.

Pursuant to the schedule of payments set forth in the agreement with Microsoft the final $5.0 million license payment was received from Microsoft in August 2003.

Software License Revenue. Total software license revenue increased $2.8 million or 8% and $812,000 or 1% during the three and six months ended December 31, 2004 compared with the three and six months ended December 31, 2003. Excluding revenue from Microsoft, software license revenue increased by $5.8 million or 9% during the six month period ended December 31, 2004 when compared with the same period during the prior year. We believe the increase in non-Microsoft license revenue was substantially due to increases in sales productivity resulting from the maturation of the named - account sales model we implemented in July 2003 as well as the increased average tenure of our sales force.

Service Revenue. Service revenue consists of revenue from the sale of maintenance service agreements, consulting services and training services, as well as the sale of hosted web analytics services. Service revenue increased by $3.7 million or 12% and $7.6 million or 13% during the three and six months ended December 31, 2004 compared with the three and six months ended December 31, 2003. The increase was primarily due to maintenance fees associated with new software licenses and renewals by our existing customers and an increase in WebTrends hosted service revenue.

Total Cost of Revenue. Total cost of revenue and period-over-period changes are as follows (dollars in thousands):


	Three Months Ended December 31,						Six Months Ended December 31,
	2004			2003			2004			2003
Cost of software license revenue	$	1,167		$	2,564		$	2,515		$	5,353
As percentage of license revenue		3	%		8	%		4	%		8	%

Cost of service revenue		8,787			7,671			17,329			15,467
As percentage of service revenue		26	%		26	%		26	%		27	%

Amortization of purchased technology		3,095			5,801			6,190			11,602

Total cost of revenue	$	13,049		$	16,036		$	26,034		$	32,422

As percentage of total revenue		19	%		25	%		19	%		26	%

Total cost of revenue decreased by 19% or $3.0 million and 20% or $6.4 million during the three and six months ended December 31, 2004 when compared with the three and six months ended December 31, 2003.

Cost of Software License Revenue. Cost of software license revenue includes royalties paid to third parties, personnel and other costs associated with software packaging, documentation such as user manuals and CDs, and production, as well as shipping. Cost of software license revenue as a percentage of related license revenue decreased from 8% during the three and six months ended December 31, 2003 to 3% and 4% during the three and six months ended December 31, 2004. The percentage decrease was primarily due to a decrease in royalty expense as result of our acquisition, in March 2004, of certain technology previously subject to quarterly royalty payments. Such costs were previously included in the cost of software and from the purchase date forward the amortization of the purchase price has been recorded as amortization of purchased technology. We expect our cost of software license revenue to remain relatively constant during the three months ending March 31, 2005 compared with the three months ended December 31, 2004.

Cost of Service Revenue. Cost of service revenue consists primarily of personnel costs and expenses incurred in providing telephonic support, on-site consulting services, training services, and costs associated with our hosted service. Cost of service revenue as a percentage of related service revenue was relatively constant as a percentage of related service revenue for the three and six months ending December 31, 2004 and December 31, 2003. We expect our cost of service revenue, in absolute dollars, to remain relatively constant in absolute dollars during the three months ending March 31, 2005 compared with the three months ended December 31, 2004.

Amortization of Purchased Technology. Purchased technology consists of developed software capitalized in our acquisitions or purchased separately and is amortized using the straight-line method over the estimated useful life, generally three years. Amortization decreased from $5.8 million and $11.6 million during the three and six months ended December 31, 2003 to $3.1 million and $6.2 million during the three and six months ended December 31, 2004. The decrease in the amortization is due to amounts capitalized in prior acquisitions becoming fully amortized, which was partially offset by additional amortization resulting from the acquisition of certain technology in March 2004. We expect to amortize approximately $3.1 million of purchased technology during the three months ending March 31, 2005, absent further acquisitions or impairments.

Operating Expenses

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

Sales and marketing expenses and period-over-period changes are as follows (dollars in thousands):


	Three Months Ended December 31,						Six Months Ended December 31,
	2004			2003			2004			2003
Sales and marketing expenses	$	31,300		$	30,869		$	62,076		$	58,893
Percentage change from comparable prior period		1	%					5	%
As a percentage of total revenue		44	%		48	%		46	%		46	%

Headcount at December 31		497			520			497			520

Sales and marketing expenses increased by $431,000 or 1% and $3.2 million or 5% during the three and six months ended December 31, 2004 compared with the corresponding period a year earlier. The increase in absolute dollars for the three months ending December 31, 2004 compared to the three months ending December 31, 2003 was principally a result of increased commission expense due to an increase in revenue. For the six months ended December 31, 2004 and December 31, 2003 sales and marketing expense increased in absolute dollars primarily as a result of higher non-Microsoft revenue and an increase in sales during the current periods, which resulted in higher commission expense. Sales and marketing as a percentage of revenue decreased from 48% during the three months ended December 31, 2003 to 44% during the three months ended December 31, 2004 and remained constant for the six months ended December 31, 2003 and December 31, 2004. During the three months ending March 31, 2005, we expect sales and marketing expenses to stay relatively flat in absolute dollars.

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

Research and development expenses and period-over-period changes are as follows (dollars in thousands):


	Three Months Ended December 31,						Six Months Ended December 31,
	2004			2003			2004			2003
Research and development	$	16,020		$	16,465		$	32,161		$	32,989
Percentage change from comparable period		(3	)%					(3	)%
As a percentage of total revenue		23	%		26	%		24	%		26	%

Headcount at December 31		374			437			374			437

Research and development expenses decreased by $445,000 or 3% and $828,000 or 3% during the three and six months ended December 31, 2004 compared with the three and six months ended December 31, 2003. This decrease in absolute dollars resulted principally from lower overall headcount. We anticipate research and development spending to remain relatively constant in absolute dollars during the three months ending March 31, 2005 compared to the three months ended December 31, 2004.

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

General and administrative expense and period-over-period changes are as follows (dollars in thousands):


	Three Months Ended December 31,						Six Months Ended December 31,
	2004			2003			2004			2003
General and administrative	$	8,121		$	6,391		$	14,558		$	13,486
Percentage change from comparable period		27	%					8	%
As a percentage of total revenue		12	%		10	%		11	%		11	%

Headcount at December 31		200			191			200			191

General and administrative expenses increased by $1.7 million or 27% and $1.1 million or 8% during the three and six months ended December 31, 2004 compared with the three and six months ended December 31, 2003. The increase in absolute dollars in the three month period was primarily due to increased legal fees for litigation, defined targets being met under the profit sharing plan and the management incentive plans, which resulted in payments under those plans, and an increase in payments for outside services, primarily associated with our Sarbanes-Oxley 404 compliance activities. We anticipate general and administrative costs to decrease slightly in absolute dollars during the three months ending March 31, 2005 compared with the three months ended December 31, 2004.

Amortization of Other Intangible Assets. Amortization of other intangible assets includes amortization of capitalized values relating to customer contracts, customer lists, patents, and trade name intangibles from our acquisitions. Other intangible assets are amortized using the straight-line method over their estimated useful life, generally three years. Amortization decreased from $4.3 million and $8.5 million during the three and six months ended December 31, 2003 to $2.2 million and $4.3 million during the three and six months ended December 31, 2004. The decrease occurred because previously capitalized acquisition related intangibles had been fully amortized by June 2004. During the three months ending March 31, 2005 we expect to amortize approximately $2.2 million of other intangible assets, absent further acquisitions or impairments.

Employee Stock-Based Compensation. Deferred employee stock-based compensation represents the intrinsic value of unvested options assumed in acquisitions and the charges associated with the grant of restricted stock and options at less than fair market value. The deferred amount is being amortized over the vesting periods of the restricted stock grant and the assumed and granted options, generally one to four years. During the three and six months ended December 31, 2003, we recognized employee stock-based compensation expense of $85,000 and $186,000 compared with $325,000 and $500,000 during the three and six months ended December 31, 2004. The increase was due to a restricted stock grant made during the six months ended December 31, 2004. During the three months ending March 31, 2005 we expect to amortize approximately $240,000 of deferred employee stock-based compensation, absent further acquisitions or grants at less than fair market value.

Restructuring Charge. During the three months ended June 30, 2004, we recorded a restructuring charge of $2.5 million related to a plan to terminate the employment of certain employees and to vacate certain of our

facilities related to restructuring our information technology group and operations and continued cost reduction efforts. During the first quarter of fiscal year 2005 we included the costs associated with the lease for our New Zealand facility in the restructuring charge which was partially offset by a reduction in employee related costs resulting in an increase in the liability. During the three months ended December 31, 2004, we entered into a sublease for the portion of the Portland facility for which we previously had recorded a restructuring charge. As a result our restructuring liability was decreased.

Total Other Income (Expenses). Total other income (expenses) is primarily composed of interest income on our cash, cash equivalents and short-term investments, foreign exchange gains and losses, and gains on and impairment of long-term investment. Interest income during the three and six months ended December 31, 2004 was $1.4 million and $2.6 million compared with $1.4 million and $2.8 million during the three and six months ended December 31, 2003. During the three and six months ended December 31, 2004 we recorded other income of $810,000 and $546,000 consisting primarily of foreign exchange gains and losses on U.S. dollars held in subsidiaries with non-U.S. dollar local functional currencies. During the three and six months ended December 31, 2003 we recorded a $4.1 million charge related to an impairment of a long-term investment based on management’s assessment that there was a decline in value of that long-term investment that was other than temporary. During the three and six months ending December 31, 2004 a company in which we held a long-term investment was acquired. Under the terms of the acquisition agreement, we received a payment of $5 million for our interest, which resulted in a $4.1 million gain which has been recorded in other income.

Income Taxes. We recorded income tax expense of $795,000 and $1.7 million during the three and six months ended December 31, 2004 compared with income tax expense of $1.1 million and $1.9 million during the three and six months ended December 31, 2003. Tax expense is booked based on the estimated tax obligation for the entire year and includes foreign income tax, state franchise tax and federal alternative minimum tax.

Liquidity and Capital Resources

At December 31, 2004, we held $68.9 million in cash and cash equivalents and $225.5 million in short-term investments, for a total of $294.4 million compared with $287.6 million as of June 30, 2004, an increase of $6.8 million. The primary reasons for the increase were the cash generated from operations of $10.0 million, $5.0 million due to the acquisition of a company in which we held a long-term investment and the sale of common stock for $3.5 million. These increases were partially offset by the repurchase of shares of our common stock pursuant to our stock repurchase program for a total purchase price of $6.7 million and capital expenditures of $5.3 million during the six month period.

Our operating activities, adjusted for non-cash charges, resulted in net cash inflows of $10.0 million and $23.0 million during the six months ended December 31, 2004 and 2003, respectively. During the six months ended December 31, 2004, the primary non-cash charges were depreciation and amortization of $17.5 million and the $4.1 million gain resulting from the acquisition of a company in which we held a long-term investment. During the six months ended December 31, 2003, the primary non-cash charges were the impairment of goodwill of $150.8 million, depreciation and amortization of $28.2 million and impairment of long-term investment of $4.1 million. In addition, changes in assets and liabilities used cash during the six months ended December 31, 2004 as compared with providing cash during the six months ended December 31, 2003.

Our investment activities resulted in net cash inflows of $3.2 million for the six month period ended December 31, 2004 and a net cash outflow of $13.5 million for the six month period ended December 31, 2003. During the six months ended December 31, 2004 and 2003, primary uses of cash from investing activities were acquisitions of property and equipment of $5.3 million and $4.1 million, respectively, principally for computer hardware and software and the purchases of short-term investments of $73.0 million and $101.4 million, respectively. The principal sources of cash during the six months ended December 31, 2004 and 2003 were maturities and sales of short-term investments of $77.3 million and $91.9 million, respectively.

During the six months ended December 31, 2004 and 2003 financing activities used $6.7 million and $2.1 million in cash, respectively for the purchase of common stock pursuant to our stock repurchase programs. Financing activities generated cash of $3.5 million and $8.7 million during the six months ended December 31, 2004 and 2003, respectively, from proceeds from the sale of common stock under our stock option plans.

As of December 31, 2004, we had no significant debt.

Long-term Obligations

The following summarizes our long-term obligations as of December 31, 2004 and the effect we expect such obligations to have on our liquidity and cash flows in future periods (in thousands, including lease payments accrued as part of our goodwill, facility reserve, and restructuring liability):


	Payments Due by Period
	Total		Less Than 1 Year		1 - 3 Years		4 - 5 Years		After 5 Years
Operating leases	$	31,104	$	5,688	$	11,657	$	5,278	$	8,481
Future minimum royalty payments		3,504		953		2,551		—		—

Total long-term obligations and commitments	$	34,608	$	6,641	$	14,208	$	5,278	$	8,481

Assuming there is no significant change in our business, we believe that our cash and cash equivalent balances, short-term investments, and cash flows generated from operations will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next 12 months.

From time to time, in the ordinary course of business, we may evaluate potential acquisitions of businesses, products or technologies. A portion of our cash may be used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. In addition, we may use cash to repurchase additional shares under Board authorized share repurchase programs.

Critical Accounting Policies and Estimates

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

Revenue Recognition

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

•

Existence of persuasive evidence of an arrangement. Persuasive evidence generally is a purchase order, license agreement or other contract.

•

Delivery of product and authorization keys. Delivery has occurred when the customer is given online access to the software and the authorization keys needed to activate the software are made available to the customer.

•

Fee is fixed or determinable. A fee is deemed to be fixed or determinable when it is not subject to subsequent refund or adjustment.

•

Collection is deemed probable.

•

Vendor-specific objective evidence exists to allocate fees to the undelivered elements of the arrangement.

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

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

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

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

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

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. We base our estimates and judgments on historical experience and on various assumptions that we believe are reasonable under current circumstances. However, future events are subject to change and the best estimates and judgments routinely require adjustments therefore actual results could differ from our current estimates. Significant estimates made in the accompanying financial statements are:

•

Allowance for Uncollectible Accounts—We provide an allowance for uncollectible accounts receivable based on our assessment of the collectibility of specific customer accounts and an analysis of the remaining accounts receivable. Changes in the allowance are included as a component of general and administrative expense on the income statement. The allowance for uncollectible accounts was $798,000 at December 31, 2004. If actual collections differ significantly from our estimates, we may experience a decrease or increase in our general and administrative expenses.

•

Allowance for Sales Returns—We provide an allowance for sales returns based on historical trends in product returns. Revenue is recognized net of the provision for sales returns. The allowance for sales returns was $1.1 million at December 31, 2004. If actual returns differ significantly from our estimates, it may result in a decrease or increase in future revenue.

•

Other Intangible Assets—We record intangible assets when we acquire companies or technology. The cost of the acquisition is allocated to the assets and liabilities acquired, including identifiable intangible assets, with the remaining amount being classified as goodwill. Certain identifiable intangible assets such as purchased technology and customer lists are amortized over time, while in-process research and development is recorded as a charge on the date of acquisition and goodwill is capitalized, subject to periodic review for impairment. Accordingly, the allocation of the acquisition cost to identifiable intangible assets has a significant impact on our future operating results. The allocation process requires extensive use of estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets. Should conditions be different than management’s current assessment, material write-downs of the fair value of intangible assets may be required. We periodically review the estimated remaining useful lives of our other intangible assets. A reduction in the estimate of remaining useful life could result in accelerated amortization expense or a write-down in future periods. As such, any future write-downs of these assets would adversely affect our gross and operating margins.

•

Goodwill—We periodically assess goodwill for impairment. Accordingly, goodwill recorded in business combinations may significantly affect our future operating results to the extent impaired, but the magnitude and timing of any such impairment is uncertain. When we conduct our annual evaluation of goodwill, as of April 30, or if in the interim impairment indicators are identified with respect to goodwill, the fair value of goodwill is re-assessed using valuation techniques that require significant management judgment. Should conditions be different than management’s last assessment, significant write-downs of goodwill may be required. Goodwill as of December 31, 2004 is $124.6 million, and any future write-downs of goodwill will adversely affect our operating margin.

•

Restructuring Liabilities and Facility Reserves—We regularly evaluate the utilization of our facilities and when future use of a specific facility is no longer required and no longer occupied, we record a charge for the remaining costs, net of any sublease or other recoveries anticipated. In connection with our significant acquisitions and from time to time in an effort to better respond to customer needs, to reduce operating costs or to facilitate better collaboration between organizations, we also restructure our operating activities and organizations, eliminating redundancies in personnel and facilities. Establishing reserves for unoccupied facilities typically is more dependent on the exercise of judgment than a reserve for personnel termination, as sublease rental income or other recoveries are more difficult to estimate than severance benefits or salary continuation payments. At December 31, 2004 we had $558,000 reserved for unoccupied facilities.

•

Provision for Income Taxes—The provision for income taxes includes taxes currently payable and changes in deferred tax assets and liabilities. We record deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts and the tax basis of assets and liabilities. If we do not generate sufficient taxable income, the realization of deferred tax assets could be impaired resulting in additional income tax expense. As a result, we record a valuation allowance to reduce net deferred tax assets to amounts that are more likely than not to be recognized. Deferred tax assets are principally the result of the tax benefit of disqualifying dispositions of stock options, which will be credited to equity when realized. We have established a valuation allowance to fully reserve these deferred tax assets due to the uncertainty regarding their realization.

Employee Stock Options

Our stock option program is a broad-based, long-term retention program that is intended to attract and retain talented employees and align stockholder and employee interests. We consider our option program critical to our operation and productivity and most of our employees participate in our option program. During the three months ended December 31, 2004, 88% of the shares subject to options granted were to employees other than our five most highly compensated executive officers. Options granted under the plans expire no later than 10 years from the grant date and generally vest within four years. Since August 2002, employee options granted were for a term of not more than seven years. We also have an employee stock purchase plan under which employees are entitled to purchase a limited number of shares at 85% of fair market value. See Note 10 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended June 30, 2004 for additional information regarding our stock option plans.

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

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


	Six Months Ended December 31, 2004		Year Ended June 30,
	2005		2004		2003
Total options granted	3,508,416		6,774,998		2,124,750	⁽¹⁾
Less options cancelled	(1,530,260	)	(3,259,892	)	(5,821,744	)⁽²⁾

Net options (cancelled) granted	1,978,156		3,515,106		(3,696,994	)

Net (cancellations) grants as a percentage of outstanding shares ⁽³⁾	3.6	%	6.2	%	(6.8	)%
Grants to top five listed officers ⁽⁴⁾ as a percentage of total options granted	12.4	%	21.2	%	15.3	%
Grants to top five listed officers as a percentage of outstanding shares ⁽³⁾	0.8	%	2.5	%	0.6	%
Cumulative options held by top five listed officers as a percentage of total options outstanding ⁽⁵⁾	22.1	%	22.5	%	19.4	%

⁽¹⁾	Excludes 3,848,214 options assumed in connection with an acquisition and 2,848,145 options regranted as part of our 2003 tender offer.

⁽²⁾	Excludes 2,848,145 options regranted as part of our 2003 tender offer.

⁽³⁾	Outstanding shares at the beginning of each fiscal year.

⁽⁴⁾	“Listed Officers” are our Chief Executive Officer (CEO) and each of the four other most highly compensated executive officers as of June 30, 2004 that are still employed by us.

⁽⁵⁾	Outstanding options at the end of each period.

Summary of stock option activity under our plans is as follows:


	Shares Available for Options		Options Outstanding
	Shares Available for Options		Shares		Weighted- Average Exercise Price
Outstanding, June 30, 2003	5,709,798		12,614,884		$	21.26
Granted	(6,774,998	)	6,774,998		$	13.69
Exercised	—		(888,285	)	$	9.98
Cancelled	3,259,892		(3,259,892	)	$	19.85
Expired	(854,912	)	—			—
Additional shares reserved	2,600,000		—			—

Outstanding, June 30, 2004	3,939,780		15,241,705		$	18.86
Granted—Stock Options	(3,508,416	)	3,508,416		$	9.33
Granted—Restricted Stock	(100,000	)	—			—
Exercised	—		(57,003	)	$	8.30
Cancelled	1,530,260		(1,530,260	)	$	19.55
Expired	(123,975	)	—			—
Additional shares reserved	2,600,000		—			—

Outstanding, December 31, 2004	4,337,649		17,162,858		$	16.88

Summary of outstanding in-the-money and out-of-the-money options as of December 31, 2004 is as follows:


	Exercisable			Unexercisable			Total
	Shares	Weighted Average Exercise Price		Shares	Weighted Average Exercise Price		Shares	Weighted Average Exercise Price
In-the-Money	1,269,173	$	8.71	4,004,430	$	9.63	5,273,603	$	9.41
Out-of-the-Money ⁽¹⁾	7,142,731	$	22.89	4,746,524	$	16.15	11,889,255	$	20.20

Total Options Outstanding	8,411,904	$	20.75	8,750,954	$	13.16	17,162,858	$	16.88

⁽¹⁾	Out-of-the-money options have an exercise price equal to or above the closing price of $12.21 on December 31, 2004.

Options granted to top five listed officers during the three months ended December 31, 2004 are as follows:


	Number of Securities Underlying Option Granted	Percentage of Total Options Granted to Employees ⁽¹⁾		Exercise Price Per Share		Expiration Date	Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation for Option Term
Name	Number of Securities Underlying Option Granted	Percentage of Total Options Granted to Employees ⁽¹⁾		Exercise Price Per Share		Expiration Date	5%		10%
Charles M. Boesenberg (CEO)	150,000	4.28	%	$	8.95	8/06/2011	$	546,532	$	1,273,653
Mark P. Marron	75,000	2.14	%	$	8.95	8/06/2011	$	273,266	$	636,826
Marc Andrews	75,000	2.14	%	$	8.95	8/06/2011	$	273,266	$	636,826
Betsy E. Bayha	60,000	1.71	%	$	8.95	8/06/2011	$	218,613	$	509,461
Gregory L. Drew	75,000	2.14	%	$	8.95	8/06/2011	$	273,266	$	636,826

Total	435,000	12.4	%

⁽¹⁾	Based on a total of 3,508,416 options granted to employees during the six months ending December 31, 2004.

Option exercises during the three months ended December 31, 2004 and remaining option holdings for top five listed officers as of December 31, 2004 are as follows:


Name	Shares Acquired on Exercise	Value Realized		Number of Securities Underlying Unexercised Options at December 31, 2004		Value of Unexercised In-the-Money Options at December 31, 2004 ⁽¹⁾
Name	Shares Acquired on Exercise	Value Realized		Exercisable	Unexercisable	Exercisable		Unexercisable
Charles M. Boesenberg (CEO)	—	$	—	1,825,198	825,002	$	—	$	489,000
Mark P. Marron	—	$	—	173,637	201,563	$	—	$	244,500
Marc Andrews	—	$	—	76,848	223,352	$	—	$	244,500
Betsy E. Bayha	—	$	—	81,449	145,417	$	—	$	195,600
Gregory L. Drew	—	$	—	93,950	151,250	$	90,125	$	308,875

⁽¹⁾	Option values based on stock price of $12.21 at December 31, 2004.

The following table summarizes common stock subject to future issuance under our equity compensation plans as of December 31, 2004:


	Stock to be issued upon exercise of outstanding options ⁽¹⁾	Weighted-average exercise price		Stock remaining available for future issuance under equity compensation plans
Plans approved by stockholders ⁽²⁾	12,620,290	$	17.11	3,424,332	⁽³⁾
Plans not approved by stockholders ⁽⁴⁾	3,361,932	$	17.83	913,317

Total	15,982,222			4,337,649

⁽¹⁾	Does not include an aggregate of 1,180,636 shares of common stock to be issued upon exercise of options assumed in connection with our acquisitions. No additional awards will be granted under these plans.

⁽²⁾	Includes the 1995 Stock Plan and the 1999 Employee Stock Purchase Plan (Purchase Plan).

⁽³⁾	Does not include 2,650,091 shares of common stock reserved for issuance pursuant to the Purchase Plan.

⁽⁴⁾	Includes the 2002 Stock Plan, the Amended and Restated 1998 Stock Incentive Compensation Plan, including the Approved UK Sub Plan, and the Mission Critical Software, Inc. 1997 Stock Plan.

Factors That May Affect Future Operating Results

In addition to the other information contained in this Quarterly Report on Form 10-Q, the following risk factors should be carefully considered. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem less significant also may impair our business operations. The occurrence of any of the following risks could materially and adversely affect our business, financial condition and operating results.

Success in our markets requires rapid innovation and response to market changes, and we may be unable to remain competitive.

The markets for both our systems and security management software solutions and our web analytics software solutions are characterized by rapid technological innovation, with frequent product introductions and enhancements. To maintain our competitive position, we must continue to develop new products and services, and to enhance the features, functionality and performance of our existing products and services. The development of new products and services, and the enhancement of existing products and services, requires significant investment and planning, and entails significant risk of technical failure. If we are unable to successfully and timely innovate in response to the offerings of our competitors and the requirements of our customers, our products and services may become obsolete, our ability to compete may be impaired and our operating results may suffer.

We expect to face increasing competition in the future, which could result in loss of market share, decreased prices, reduced gross margins and diminished profits.

The market for our systems and security management software solutions and our web analytics software solutions are intensely competitive, and we expect competition to increase in the future. There are few substantial barriers to entry at the low end to prevent new entrants to our market. Moreover, many of our competitors and potential competitors have substantially greater financial and other resources than we have or may enjoy other competitive advantages. As a consequence, these competitors may have greater name and brand recognition, develop more advanced technology, deliver more compelling solutions, bring solutions to market more rapidly, undertake more extensive sales and marketing campaigns, adopt more aggressive pricing policies and sales terms, and be able to leverage more extensive financial, customer and partner resources.

Our principal competitors include:

•

providers of network and systems management products, such as BMC Software, Inc., Computer Associates International, Inc., Hewlett-Packard Company, International Business Machines Corporation and Microsoft Corporation;

•

providers of security management solutions, such as ArcSight, BindView Corporation, Computer Associates International, Inc., Configuresoft, Inc., International Business Machines Corporation, Internet Security Systems, Inc., McAfee, Inc., netForensics Inc., and Symantec Corporation;

•

providers of administration products, such as BindView Corporation and Quest Software, Inc.;

•

providers of content security solutions, such as Clearswift Limited, Postini Corporation, SurfControl plc, Symantec Corporation, Trend Micro, Inc., Tumbleweed Communications Corp., and Websense, Inc.;

•

providers of web analytics solutions, such as Coremetrics, Inc., Digital River, Inc., International Business Machines Corporation, NetRatings, Inc., Omniture Inc., Sane Solutions, LLC, SPSS Inc., and WebSideStory, Inc.; and

•

customers’ internal information technology departments that develop or integrate systems management, security management, or web analytics tools for their particular needs.

Due to the competitive nature of our markets, we have experienced increasing pressure on product and service pricing, and we may be required to continue to lower our prices to remain competitive. Our failure to effectively compete with our competitors, on the basis of price, technology, available solution sets or otherwise, could lead to our inability to achieve forecasted revenue and adversely affect our operating results.

The trend towards consolidation in the software industry could impede our ability to compete effectively.

We have seen increasing consolidation in the software industry, as software firms seek to offer broader arrays of products and product functionality, to integrate hardware and software solutions, and to achieve greater economies of scale. The firms resulting from these consolidations may have greater resources, more compelling product offerings and greater pricing flexibility than our existing competitors, making it more difficult for us to compete effectively, including on the basis of price, sales and marketing programs, technology, and available solution sets. In addition, the industry trend towards consolidation may impact customers’ perceptions of the viability of smaller software firms and consequently their willingness to purchase from such firms

The trend towards product integration and bundling could impede our ability to compete effectively.

We have seen increasing integration and bundling of software products in the systems and security market into solution sets or bundles, and expect future integration and bundling to be an important competitive factor. We anticipate that competitors may bundle their products with products similar to ours, or incorporate functionality into their existing products that could render certain of our products unmarketable or obsolete. Microsoft is a competitor for certain of our products and has an established business practice of adding functionality to new versions of Windows in ways that can impair the success of formerly complementary products. For instance, if Microsoft were to incorporate Microsoft Operations Manager with its Windows operating system, the demand for our AppManager product could be affected. Customer perception of this pattern could also adversely affect or delay sales of our products. If we are unable to sufficiently differentiate our products from the integrated or bundled products of our competitors, such as by price or enhanced functionality or performance, we may see a decrease in demand for those products.

We expect our quarterly revenue and operating results to fluctuate for a number of reasons, and it is difficult to predict our future revenue and operating results.

Our revenue and operating results have varied in the past and are likely to vary significantly from period to period in the future. These fluctuations are due to a number of factors, many of which are outside of our control, including:

•

general economic conditions and the discretionary nature of our customers’ purchasing practices, IT budgets and budget cycles;

•

the timing of new product introductions or enhancements by us, our competitors and our platform vendors, which may result in purchase deferrals by our customers in anticipation of new products;

•

competitive conditions in our industry, including new products, product announcements and programs offered by our competitors;

•

changes in our pricing policies or those of our competitors;

•

our ability to introduce new products and enhancements and the timing of their release;

•

our ability to complete specific sales transactions in a given quarter or fiscal year;

•

changes in the mix of products or services sold in a quarter;

•

fluctuation in the number and size of orders in a quarter;

•

unanticipated operating expense; and

•

our ability to recognize revenues from the fees we charge to our customers.

We base our operating expenses on our expectations regarding future revenues. However, a significant portion of our revenues historically have been generated during the last month of each fiscal quarter, with a substantial portion of sales occurring in the last week and on the last day of the fiscal quarter. Since we may not learn of shortfalls in anticipated revenue until late in a particular quarter, we may be unable to proportionately reduce operating expenses for that quarter. As a consequence, our operating results may fail to meet the expectations of our investors or securities analysts, and the market price of our stock could decline.

Our license bookings historically have been seasonal, with the second and fourth quarter of our fiscal year typically having the largest volume in new license bookings. We believe that this seasonality results from the budgeting, procurement and work cycles of our customers, and from the structure of our direct sales incentive and compensation program. We expect this seasonality to continue in the future

Given the above factors, we believe that sequential financial comparisons are not necessarily meaningful, and should not be relied upon as indicative of our future performance.

If we are unable to sufficiently align our expenses with revenue we will be unable to achieve an acceptable operating profit.

The market price of our stock is, in part, dependent on our ability to achieve a level of operating profit that meets the expectations of investors and securities analysts. Since our inception, we have incurred significant net losses. During fiscal 2004, 2003 and 2002, we reported GAAP net losses of $191.4 million, $908.7 million and $730.5 million, respectively. These losses principally resulted from amortization and impairment of goodwill, amortization of purchased technology and other intangible assets, and other acquisition-related charges. While we reported net income of $1.1 million during the first six months of fiscal 2005, there can be no assurance that we will not suffer losses in the future.

We continue to adopt a number of measures to better align our expenses with anticipated revenue, including various reductions in headcount, the closure of facilities and reorganization of our business into two separate business units to better address their distinct operational requirements. In addition, we have taken steps to improve the efficiency of our sales force. However, while these measures have contributed to improved operating profitability, we have not been wholly successful in achieving an operating profit commensurate with that of many of our peers, and we continue to focus on reduction of our operating expenses, as well as seeking to grow revenue. The organizational and operational changes that we believe are necessary to achieve an acceptable operating profit may cause disruptions to our business or negatively impact customer service and satisfaction and our ability to grow our revenue. Such changes also may not result in the intended operational improvements and cost reductions, and may adversely affect our business, results of operations and financial condition.

If we are unable to timely complete our assessment of internal controls over financial reporting, our stock price may be adversely affected.

Under Section 404 of the Sarbanes-Oxley Act of 2002, our management is required to complete an assessment of the effectiveness of our internal controls for financial reporting and to assert that such controls are

effective. In addition, our independent auditors must issue opinions on the adequacy of management’s assessment and on the effectiveness of our controls over financial reporting. These activities must be completed by the close of our fiscal year on June 30, 2005.

We have undertaken a variety of activities to prepare for compliance with the requirements of Section 404. We believe that such activities will enable our management to perform the assessment and provide the required assertion and consequently our auditors will be able to provide the required opinions concurrent with their report on our financial statements. However, we can give no assurance that such activities will be completed in a timely manner and on a successful basis. If our management is unable to make the required assertion or if our auditors are unable to issue the required opinions, this may reflect negatively on our internal controls over financial reporting and adversely affect the price of our stock.

Changes in financial accounting standards or practices, including those that require us to recognize employee stock options as a compensation expense, could substantially and adversely our financial results.

The accounting rules applicable to our business have undergone significant changes in recent years, and future changes in accounting regulations and related interpretations and policies, particularly those related to expensing of employee stock options, could cause us to account for our business in ways that may adversely affect our financial results and investor perception of those results.

As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, currently we apply Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations in accounting for our employee stock–based compensation. Under APB No. 25, no compensation expense is recognized for options granted to employees where the exercise price equals the market price of the underlying stock on the date of grant. On December 16, 2004, the Financial Accounting Standards Board (FASB) issued Statement No. 123 (R), Share-Based Payment. Statement 123(R) requires that, commencing July 1, 2005, we recognize compensation expense in an amount equal to the fair value of share-based payments, such as stock options and restricted stock, granted to employees. This is expected to have a material impact on our consolidated results of operations.

We expect that our implementation of the change proposed by FASB Statement 123(R) will result in a reduction of our operating income or an increase in our operating losses as a result of these non-cash expenses. In such an event, investor perception of our results of operations may be adversely affected and our stock price may fall.

Our investments in products and companies, including through internal development and acquisition, present many risks, and we may not realize the financial and strategic goals that were contemplated at the time of the investment.

We have made substantial investments in developing and acquiring new products, services and technologies, and have made investments in and acquisitions of other companies. We intend to continue to make investments in products, services and technologies, and may in the future acquire or make investments in companies we perceive to be complementary or to have synergies with our business. The risks we may encounter in connection with such investments include:

•

the investment may not further our business strategy, we may pay more than the investment proves to be worth, the technology may not be feasible or may fail to be popular with customers, or economic conditions may change, all of which may diminish the value of the investment to us;

•

we may fail to anticipate new technology development, customer requirements or industry standards, or may be unable to develop or purchase new products, services and technologies that adequately address these developments, requirements or standards in a timely manner;

•

we may have difficulty integrating the investment with our business, marketing and sales strategies;

•

we may have difficulty integrating any acquired technologies, operations or personnel, into our existing business and product lines; and

•

our ongoing business may be disrupted by transition or integration issues arising from the investment.

Our failure to realize the anticipated benefits or synergies of our investments may adversely affect our operating results, consolidated financial position, cash flows and stock price. Our earnings may be adversely affected by amortization of purchased technology and other intangible assets, other acquisition or investment related charges, and impairment charges associated with goodwill. As well, we may be required to record charges for impairment if a product or technology is discontinued, if we pay more than an investment is worth, or if an investment subsequently declines in value. In the past we have taken significant impairment charges as a consequence of revised forecasts for future operating profits and cash flows from our investments and the decline in our market capitalization. We will be required to record additional charges if in future periods we discontinue additional products, or determine that our remaining goodwill has become further impaired or that our investments have further declined in value.

The consideration paid in connection with an investment or acquisition also affects our immediate operating results and financial condition. To the extent we issue shares of stock or other rights to purchase stock, such as options, the stock holdings of existing stockholders will be diluted and earnings per share may decrease. To the extent we pay cash for future investments or acquisitions, our cash reserves will be commensurately reduced.

The development and enhancement of many of our products requires early access to third party technology.

Our ability to sell our products depends, in part, on the compatibility of our products with other third-party products, such as operating systems and messaging, Internet and database applications, which may require that we have access to third party technology to develop and test our products and new versions of our products. Some of these third-party software developers may change their products so that they are no longer compatible with our products. In particular, our business continues to be largely focused on the Microsoft Windows environment and Microsoft has typically provided to us pre-release notification of feature enhancements to its products and necessary development tools and information. If Microsoft stops this practice, we may be unable to coordinate our product offerings with Microsoft or to otherwise capitalize on new Microsoft product releases and feature enhancements.

We incorporate software licensed from third parties into some of our products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for, or prevent the sale or use of, our products.

Certain of our software products contain components developed and maintained by commercial third-party software vendors or available through the “open source” software community. We also expect that we may incorporate software from commercial third-party vendors and open source software in our future products. Software obtained from commercial third-party vendors is typically made available for a specific term, with no guaranty of renewal. Our business would be disrupted if this software, or functional equivalents of this software, were either no longer available to us or no longer offered to us on commercially reasonable terms. In either case, we would be required to either redesign our software to function with alternate third-party software or open source software, or develop these components ourselves, which would result in increased costs and could result in delays in our software shipments. Alternatively, we might be forced to limit the features available in our current or future software offerings.

Our business requires the creation of technology and the effective protection and enforcement of our intellectual property rights in that technology.

Our success is heavily dependent on our ability to create proprietary technology and to protect and enforce our intellectual property rights in that technology, as well as our ability to defend against adverse claims of third parties with respect to our technology and intellectual property. We rely on a combination of patents, copyrights and

trademarks, service marks, trade secrets, confidentiality procedures and contractual provisions (including confidentiality and licensing restrictions) to protect our intellectual property rights in our products and services. These laws and procedures provide only limited protection, and may not provide sufficiently broad protection or be enforceable in actions against alleged infringers. In particular, the laws of some foreign countries do not protect our intellectual property rights to as great an extent as do the laws of the United States, and some of our license provisions may be unenforceable under the laws of certain jurisdictions. In addition, despite precautions that we take, it may be possible for unauthorized third parties to copy or reverse engineer aspects of our current or future products or to independently develop similar or superior technology or design around the patents we own.

It occasionally is necessary to enforce or defend our intellectual property rights through the process of litigation, arbitration or other adversarial proceedings. Such proceedings can be costly and potentially distracting to management, and even if successful, can adversely affect our operating results.

Sales of our products may be adversely affected by software piracy.

Policing unauthorized use and transfer of our software is difficult. Although we are unable to quantify the extent of piracy of our software products, certain of our products have been subject to software piracy and our exposure to software piracy is expected to increase as we expand our international operations.

Third parties could assert that our products infringe their intellectual property rights.

Third parties may claim that our current or future products infringe their intellectual property rights, and these claims, even if without merit, could harm our business by increasing our costs, reducing our revenue or by creating customer concern or confusion that results in reduced sales. This is particularly true in the patent area, as an increasing number of U.S. patents covering computer software have been issued during the past few years. Patent owners may claim that one or more of our products infringes a patent held by the claimant. For example, in January 2003, one of our competitors, BMC Software, Inc., initiated a lawsuit alleging that one or more of our products infringed a BMC patent. These claims now have been submitted to arbitration. Although we believe these claims to be without merit, the costs of defense have been significant. The intensely competitive nature of our industry and the importance of technology to our competitors’ businesses may enhance the likelihood of being subject to third-party claims of this nature. Any such claims, even if without merit, could be time consuming, result in potentially significant litigation costs or damages, cause product shipment delays and require us to enter into royalty or licensing agreements. Royalty or license agreements may not be available on commercially favorable terms or at all. Such claims could also force us either to stop selling, incorporating or using products or services that incorporate the challenged intellectual property or to redesign those products or services that incorporate such technology. We expect that software developers will increasingly be subject to infringement claims as the number of products and competitors in the software industry grows, the functionality of products in different industry segments overlaps, and the number of issued software patents increases.

Errors in our products could result in significant costs to us and could impair our ability to sell our products.

Because our software products are complex, they may contain errors that could be detected at any point in a product’s life cycle. These errors could materially and adversely affect our business reputation, result in significant costs to us, and impair our ability to sell our products in the future. The costs incurred in correcting any product errors may be substantial and could decrease our profit margins. While we expect to continually test our products for errors and work with customers through our customer support services organization to identify and correct bugs, errors in our products may be found in the future. Because it is difficult to simulate the highly complex computing environments in which our customers use our products and because of the increasing functionality of our product offerings, testing may be complicated and fail to identify all errors. Moreover, because our products support and interoperate with third-party operating systems and applications, any errors or bugs in that software may result in problems with the performance of our products and may require cooperation from the third-party to resolve.

Detection of significant errors may result in, among other things, lost or delayed market acceptance and sales of our products, diversion of development resources, injury to our reputation, and increased service and warranty costs. Errors in our software also may result in expensive and time-consuming litigation, and the potential award of substantial damages. While our software license agreements typically contain provisions designed to limit our liability for damages resulting from errors in our software, there is no assurance that such provisions will be effective in limiting our liability. We presently carry errors and omissions insurance against such claims, but there is no assurance that such insurance coverage will be adequate to cover any losses as a result of errors or will be available in the future on commercially reasonable terms.

Our international sales and operations subject us to additional risks that can adversely affect our operating results.

We derive a substantial and increasing amount of our revenues from customers outside the United States and are continuing to expand our international operations. We have support and administrative services operations in Galway, Ireland, Tokyo, Japan and Staines, United Kingdom, and sales and support offices in a number of other foreign locations. Our international operations subject us to a variety of risks, including:

•

the overlap of different tax regimes;

•

the difficulty of managing and staffing foreign offices;

•

differing regulatory and legal requirements and employment schemes, including with respect to separation and redundancies, and our ability to identify and timely comply with such requirements and schemes;

•

longer payment cycles and difficulties in collecting accounts receivable;

•

fluctuations in currency exchange rates and difficulties in transferring funds from certain countries;

•

the need to localize and internationalize our products and licensing programs;

•

significant reliance on our distributors and other resellers who do not offer our products exclusively;

•

import and export licensing requirements, including export controls on encryption technology;

•

political and economic instability in some countries, including terrorism and wars;

•

seasonal reductions in business activity during the summer months in Europe and certain other regions;

•

laws restricting the use and transfer of personally identifiable information about our customers, employees and other individuals;

•

reduced protection for intellectual property rights in some countries; and

•

increased travel and infrastructure costs associated with multiple international locations.

Any of these risks could harm our international operations and reduce our international sales, and adversely affect our operating results.

Our financial results may be positively or negatively impacted by foreign currency fluctuations.

To date, a substantial portion of our sales have been denominated in U.S. dollars, and we have not used risk management techniques or “hedged” the risks associated with fluctuations in foreign currency exchange rates. In the six months ended December 31, 2004 we recorded a gain of approximately $473,000 consisting primarily of foreign exchange gains and losses on U.S. dollars and other foreign currency receivables held in subsidiaries with local functional currencies, in particular euros. In the future, if we do not engage in hedging transactions, our results of operations could be subject to further fluctuations resulting in losses or gains from fluctuations in foreign currency exchange rates to the extent our sales are denominated in foreign currencies and the dollar fluctuates in value relative to such currencies.

We are increasingly relying on indirect distribution channels to generate revenue.

To further increase our revenues, we have increasingly relied on indirect distribution channels as a means of growing product sales, including with respect to international sales. These relationships, both domestically and internationally, are typically non-exclusive and can be terminated upon short notice. This strategy presents a number of risks and uncertainties including:

•

the ability of resellers or integrators to cease marketing or integrating our products with little or no notice;

•

the ability of our resellers or integrators to market or use competitive products or services from third parties and to promote such third-party products or services in preference to ours;

•

the effectiveness of our resellers and integrators in marketing our products;

•

the difficulty in attracting and replacing high quality resellers and integrators;

•

the potential of conflicts between our direct and indirect sales channels resulting in lost sales and customer confusion or dissatisfaction;

•

financial difficulties that resellers or integrators may experience (and which may lead to payment problems); and

•

risk associated with accurately reporting revenue arising from these indirect distribution channels.

We face challenges in the retention of key management, technical and sales personnel.

We depend on certain key management, technical and sales personnel and on our ability to attract and retain highly qualified personnel. Given recent competitive pressures, we anticipate that our ability to retain key personnel will become more difficult should the economy improve and make more positions available, thus enhancing employee mobility. In addition, our ability to attract and retain personnel may be made more difficult by anticipated changes in the accounting treatment of stock-based compensation, which may limit our ability to use broad-based stock option grants as a means to attract and retain qualified personnel. The volatility or lack of improvement in our stock price may also affect our ability to attract and retain key personnel, who may expect to realize value from our stock options. In addition, our cash incentive plan is based upon company performance and failure to achieve our established targets may limit the amount or eliminate the payment of cash incentive compensation and further impact our ability to retain key personnel.

Our success will depend to a significant extent on our ability to retain the services of our key personnel. We do not have employment contracts for a defined term with our employees, including our key personnel. If we lose the services of one or more of our key personnel, including if one or more of our key employees decided to join a competitor or otherwise compete directly or indirectly with us, our business and ability to successfully implement our business objectives could be negatively affected.

We continue to make substantial changes in our information systems, which could disrupt our business and adversely affect our operating results.

We are continuously engaged in the process of improving our information systems, including modifying and refining our customer relationship management system and enterprise resource planning system to better meet our needs and to provide the enhanced reporting required by increased competitive pressures and regulatory requirements. Most recently, we commenced a process to centralize our internal information systems, which will require migrating a number of our existing applications and systems. Disruption caused by the migration, or the failure, poor performance or errors of any of our systems could impact our ability to sell and deliver our products or could result in our inability to maintain our internal controls to the standards required by applicable law, any of which could in turn materially and adversely impact our business, including our ability to meet our revenue and expense targets. Moreover, notwithstanding our investment in maintenance and upgrades, our enterprise systems may not fully meet our needs in the future. If we determine to replace them, we may write off the remaining value of the associated assets.

Natural disasters and targeted attacks on our networks and data centers may disrupt our business.

We rely on our network and data center infrastructure for internal communications, communications with customers and partners, direct sales of our software products, sales lead generation and direct provision of fee-based services, including our WebTrends hosted service. That infrastructure and our other facilities are vulnerable to damage from human error, physical or electronic security breaches, power loss and other utility failures, fire, earthquake, flood, sabotage, vandalism and similar events. In addition, continued attempts to exploit security vulnerabilities in infrastructure products pose a threat to the stability of our IT infrastructure. Despite precautions, a natural disaster or other incident could result in interruptions in our service or significant damage, and affect our provision of services and fulfillment of product orders, our ability to process product orders and invoices, and our ability otherwise timely conduct our business operations.

Changes in our market may affect our operating results by changing the manner in which we are required to account for sales.

There have been various changes in the enterprise software market that may affect the manner in which we do business. We currently sell most of our software licenses on a “perpetual” basis, which enables us to recognize the majority of revenue received in connection with the sale promptly upon consummation of the sale. However, certain software vendors are moving towards a subscription-based model in which periodic fees are charged for use of the software. If customers increasingly demand that we sell licenses to our software on a subscription basis, or otherwise charge a periodic fee for its use, or if we experience accelerated adoption of our WebTrends hosted service, it will delay our recognition of revenue for those sales and will decrease the revenues attributable to such sales during the reporting period in which the sale is made (although the deferred revenue will be recognized in subsequent periods). If substantial portions of our license sales are converted to a subscription basis, this could materially affect our revenues during the initial quarters in which the change is implemented.

The price of our stock may fluctuate significantly, which may result in losses for investors.

Our stock price has been volatile and we expect that it will continue to fluctuate in the future. The value of an investment in our stock could decline due to the impact of a number of factors upon our stock price, many of which are outside of our control and are unrelated to our actual operating results. These factors include:

•

changes in the market valuations of technology and software companies;

•

changes in general economic conditions;

•

the effects of war and terrorist attacks;

•

actual or anticipated variations in our operating results and revenues;

•

announcements of new products, investments or developments by us or our competitors;

•

industry and product consolidation;

•

changes by securities analysts of their estimates of our earnings or valuation; and

•

the failure of our performance to meet the expectations of securities analysts.

We have various mechanisms in place that may discourage takeover attempts.

Certain provisions of our certificate of incorporation and bylaws and certain provisions of Delaware law could delay or make difficult a change in control that a stockholder may consider favorable. Our certificate of incorporation allows our Board of Directors to designate and issue one or more series of preferred stock that may have rights preferences and privileges superior to our common stock without any action by our stockholders. Our bylaws limit the ability of a stockholder to call a special meeting. We have a classified Board of Directors, with staggered, three-year terms, that may lengthen the time required to gain control of the Board of Directors. In addition, certain of our officers are parties to a Change of Control Agreement or other agreements with us that

provide for the acceleration of stock option vesting and the payment of certain compensation in the event such officer’s employment is terminated within a specified period after a change of control. In addition, our 1995 and 2002 Stock Plans provide for acceleration of stock option vesting in the event an employee’s employment is terminated within a specified period after a change of control. Any of these provisions could dissuade a potential acquirer from seeking to acquire control of NetIQ, which in turn could result in our stockholders not being able to participate in premiums that may otherwise have been offered in a potential acquisition.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We do not use derivative financial instruments in our investment portfolio and have no foreign exchange contracts. Our financial instruments consist of cash and cash equivalents, short-term investments, trade accounts, and accounts payable. We consider investments in highly liquid debt instruments purchased with a remaining maturity of three months or less to be cash equivalents. Our exposure to market risk for changes in interest rates relates primarily to our short-term investments; thus, fluctuations in interest rates would not have a material impact on the fair value of these securities.

Our business is transacted principally in U.S. dollars. During the six months ended December 31, 2004, 19% of the total amount of our invoices was in currencies other than the U.S. dollar. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to local currency denominated revenue and operating expenses in Australia, Belgium, Canada, Denmark, France, Germany, Ireland, Italy, Japan, New Zealand, Singapore, South Korea, Spain, Sweden, Switzerland, and the United Kingdom. We believe that a natural hedge exists in some local currencies, as local currency denominated revenue offsets some of the local currency denominated operating expenses. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis. However, as of December 31, 2004, we had no hedging contracts outstanding.

At December 31, 2004 we had $68.9 million in cash and cash equivalents and $225.5 million in short-term investments. Based on our cash, cash equivalents and short-term investments at December 31, 2004 a 10% change in interest rates would change our annual interest income and cash flows by approximately $735,000.

ITEM 4. CONTROLS AND PROCEDURES

(a)

Disclosure Controls and Procedures. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in the reports that we file or submit under the Exchange Act.

(b)

There has been no change in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our first fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

We have a disclosure controls committee comprised of key individuals from a variety of disciplines in the company that are involved in the disclosure and reporting process. The committee meets regularly to ensure the timeliness, accuracy and completeness of the information required to be disclosed in our filings.

In designing and evaluating our disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, are subject to inherent limitations. These limitations include the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.

PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

ITEM 6. EXHIBITS

(a) Exhibits


Exhibit Number		Description

10.1		Management Incentive Plan (Incorporated by reference to Exhibit 10.1 to the registrant’s current report on Form 8-K filed with the SEC on October 22, 2004)

31.1		Certification of Chief Executive Officer Pursuant to Section 302(a) of The Sarbanes-Oxley Act of 2002

31.2		Certification of Chief Financial Officer Pursuant to Section 302(a) of The Sarbanes-Oxley Act of 2002

32		Certification Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, NetIQ Corporation has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of San Jose, State of California, on the 4^th day of February, 2005.


NETIQ CORPORATION

By:		/s/ RICHARD H. VAN HOESEN
		Richard H. Van Hoesen
		Senior Vice President and Chief Financial Officer

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