Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2005

OR

For the transition period from              to             

Commission File Number: 000-27241

KEYNOTE SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (650) 403-2400

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  ¨

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

Table of Contents

KEYNOTE SYSTEMS, INC.

TABLE OF CONTENTS

2

Table of Contents

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

Index to Unaudited Condensed Consolidated Financial Statements

3

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

See accompanying notes to the condensed consolidated financial statements

4

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)

(Unaudited)

See accompanying notes to the condensed consolidated financial statements

5

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes to the condensed consolidated financial statements

6

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(1) Basis of Presentation

The accompanying interim unaudited condensed consolidated balance sheets, and condensed consolidated statements of operations and cash flows reflect all normal recurring adjustments that are, in the opinion of management, necessary for a fair presentation of the financial position of Keynote Systems, Inc. and subsidiaries (the “Company”) as of March 31, 2005, and the results of operations and cash flows for the interim periods ended March 31, 2005 and 2004.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”), and therefore, do not include all information and footnotes necessary for a complete presentation of the Company’s results of operations, financial position and cash flows. This report should be read in conjunction with the consolidated financial statements and notes thereto for the fiscal year ended September 30, 2004 included in the Company’s Report on Form 10-K as filed with the SEC.

The results of operations and cash flows for any interim period are not necessarily indicative of the Company’s results of operations and cash flows for any other future interim period or for a full fiscal year.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates made in preparing the consolidated financial statements relate to the allowance for doubtful accounts, billing allowance and income taxes. Actual results could differ from those estimates, and such differences may be material to the financial statements.

Excess occupancy costs are fixed costs associated with the portion of the Company’s headquarters’ building, which is not occupied by the Company, such as property taxes, insurance and depreciation. These particular costs, which are reduced by rental income from the sublease of space in its headquarters’ building, represent the fixed costs of operating the Company’s headquarters’ building acquired in September 2002 and are based on the actual unoccupied square footage, which was determined to be 60% and 70% of the total rentable square footage of the headquarters’ building during the three and six months ended March 31, 2005 and 2004, respectively.

Certain amounts in fiscal 2004 as reported on the Condensed Consolidated Balance Sheet, Condensed Consolidated Statement of Operations, and Condensed Consolidated Statement of Cash Flows have been reclassified to conform to current year presentation. The Company reclassified approximately $9.4 million in auction rate securities from cash and cash equivalents to short-term investments on the fiscal 2004 consolidated balance sheet. The Company also reclassified $7.8 million and $3.6 million in auction rate securities from cash and cash equivalents to short-term investments as of March 31, 2004 and September 30, 2003, respectively, which decreased cash flows from investing activities by $4.2 million in the condensed consolidated statement of cashflows for the six months ended March 31, 2004. The reclassification of short-term investments is based on the latest interpretation of cash equivalents pursuant to Statement of Financial Accounting Standards No. 95 (“SFAS 95”), “Statement of Cash Flows.”

(2) Stock-Based Compensation Plans

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004) (“SFAS No. 123R”), “Share-Based Payment,” and in March 2005, the SEC released Staff Accounting Bulletin (“SAB”) No. 107, Topic 14: Share-Based Payment, that address the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. These new rules eliminate the ability to account for share-based compensation transactions using the intrinsic value method under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and generally would require instead that such transactions be accounted for using a fair-value-based method. The Company is currently evaluating these new rules to determine which fair-value-based model and transitional provision it will follow upon adoption. The options for transition methods as prescribed in these new rules include either the modified prospective or the modified retrospective methods. The modified prospective method requires that compensation expense be recorded for all unvested stock options and restricted stock as the requisite service is rendered beginning with the first quarter of adoption, while the modified retrospective method requires that compensation expense be recorded for stock options and restricted stock for all periods presented. SFAS 123R and SAB 107 will be effective for the Company beginning in its first quarter of fiscal year 2006. Although the Company will continue to evaluate the application of SFAS 123R and SAB 107, management expects the adoption to have a material impact on the Company’s results of operations.

The Company currently measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion No. 25. The Company applies the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” as if the fair-value-based method had been applied in measuring compensation expense. Under APB Opinion No. 25, no compensation expense is recognized, when the exercise price of the Company’s employee stock options equals or exceeds the market price of the underlying common stock on the grant date.

As required under SFAS No. 123, the pro forma effects of stock-based compensation on net income and income per share for employee stock options granted and employee stock purchase plan share purchases have been estimated at the date of grant and beginning of the period, respectively, using a Black Scholes option pricing model. For purposes of pro forma disclosures, the estimated fair value of the options and shares is amortized to pro forma net income over the options’ vesting period and the shares plan period.

The Black-Scholes option valuation model was developed for use in estimating the fair value of freely traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly sensitive assumptions including the expected life of options and the Company’s expected stock price volatility. Because the Company’s employee stock options and employee stock purchase plan shares have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not provide a reliable measure of the fair value of the Company’s employee stock options.

7

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

The Company’s pro forma information for the three and six months ended March 31, 2005 and 2004, is as follows (in thousands, except per share amounts):

No tax effects were included in the determination of pro forma net income (loss) because the deferred tax asset resulting from stock-based employee compensation would be offset by an additional valuation allowance for deferred tax assets. The effects on pro forma disclosures of applying SFAS No. 123 may not be representative of the effects on pro forma disclosures in future periods.

The fair value of each option was estimated on the date of grant using the Black-Scholes option pricing model. Weighted-average assumptions for options granted and stock purchases are as follows:

3) Revenue Recognition

Revenue consists of subscription services revenue and professional services revenue. Subscription services revenue consists of fees from subscriptions to the Company’s e-business performance measurement services and performance management solutions. Subscription services revenue also consists of the subscription to use its technology for its WebEffective Intelligence Platform. Subscription services revenue is deferred upon invoicing and is recognized ratably over the service period,

8

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

commencing on the day service is first provided, generally ranging from one to twelve months. For some customers, subscription services revenue is invoiced monthly upon completion of the services. Subscription revenue related to the use of the WebEffective Intelligence Platform to conduct evaluations is recognized upon completion of each evaluation. Deferred revenue is comprised of all unearned revenue that has been collected in advance, primarily unearned subscription services revenue, and is recorded as deferred revenue on the balance sheet until the revenue is earned. Any uncollected deferred revenue reduces the balance of accounts receivable. The Company does not generally grant refunds. All discounts granted reduce revenue. Revenue is not recognized for free trial periods. Professional services revenue consists of fees generated by the Company’s professional services, and is recognized as the services are performed, typically over a period of one to three months. For most consulting projects that span more than one month, the Company recognizes revenue as milestones or deliverables are completed.

(4) Comprehensive Income

Comprehensive income includes net income, unrealized gains and losses on short-term investments in debt securities and foreign currency translation. The unrealized gains and losses on short-term investments in debt securities and foreign currency translation are excluded from earnings and reported as a component of stockholders’ equity. The functional currency of the Company’s foreign operations is the applicable local currency or United States dollar. Gains and losses from foreign currency transactions are reflected in the condensed consolidated statements of operations as incurred. The components of comprehensive income are as follows (in thousands):

The tax effect on the foreign currency translation gain (loss) is immaterial.

(5) Financial Instruments and Concentration of Risk

The carrying value of the Company’s financial instruments, including cash and cash equivalents, short-term investments, accounts receivable, accounts payable, accrued expenses and capital lease obligations, approximates fair market value due to their short-term nature. Financial instruments that subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, short-term investments and accounts receivable.

Credit risk is concentrated in North America, but exists in Europe as well. The Company generally requires no collateral from customers; however, throughout the collection process, it conducts an ongoing evaluation of customers’ ability to pay. The Company’s accounting for its allowance for doubtful accounts is determined based on historical trends, experience and current market and industry conditions. Management regularly reviews the adequacy of the Company’s allowance for doubtful accounts by considering the aging of accounts receivable, the age of each invoice, each customer’s expected ability to pay and the Company’s collection history with each customer. Management reviews invoices greater than 60 days past due to determine whether an allowance is appropriate based on the receivable balance. In addition, the Company maintains a reserve for all other invoices, which is calculated by applying a percentage to the outstanding accounts receivable balance, based on historical collection trends as well as specifically identified accounts that are deemed uncollectible. In addition to the allowance for doubtful accounts, the Company maintains a billing allowance which represents the reserve for potential billing adjustments that are recorded as a reduction of revenue. The Company’s accounting for billing allowance represents a percentage of revenue based on historical trends and experience.

The allowance for doubtful accounts and billing allowance represent management’s best current estimate, but changes in circumstances relating to accounts receivable and billing adjustments, including unforeseen declines in market conditions and collection rates and the number of billing adjustments, may result in additional allowances or recoveries in the future. The Company believes that it has adequately reserved for doubtful accounts and potential billing adjustments as of the date of each balance sheet presented herein.

As of March 31, 2005 and 2004, no single customer accounted for more than 10% of the Company’s total accounts receivable. For the three and six months ended March 31, 2005 and 2004, no single customer accounted for more than 10% of the Company’s total revenue during each period. For the three months ended March 31, 2005 and 2004, the ten largest customers accounted for approximately 37% and 34% of total revenue, respectively. For the six months ended March 31, 2005 and 2004, the ten largest customers accounted for approximately 35% and 32% of total revenue, respectively.

9

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

(6) Investments

The Company classifies all of its short-term investments as available-for-sale. These investments mature in two years or less, and consist of investment-grade corporate and government debt securities and issuances and auction rate securities with Moody’s ratings of A2 or better. Investments classified as available-for-sale are recorded at fair market value with the related unrealized gains and losses included in accumulated other comprehensive income (loss), a component of stockholders’ equity. Realized gains and losses are recorded based on specific identification. There were no realized gains or losses during the quarter ended March 31, 2005. The Company considers all highly liquid investments held at major banks, commercial paper, United States government agency discount notes, money market mutual funds and other money market securities with original maturities of three months or less to be cash equivalents. The following table summarizes the Company’s short-term investments as of March 31, 2005 (in thousands):

The following table summarizes the contractual maturities of fixed maturity investments available for sale as of March 31, 2005 (in thousands). Expected maturities of debt securities and issuances and auction rate securities will differ from contractual maturities of the debt securities and issuances and auction rate securities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties.

The following table summarizes the Company’s short-term investments as of September 30, 2004 (in thousands):

7) Goodwill and Identifiable Intangible Assets

The following table represents the changes in goodwill during the six months ended March 31, 2005 (in thousands):

10

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

As of March 31, 2005, the net carrying value of identifiable intangible assets was approximately $4.9 million (net of accumulated amortization of approximately $13.1 million). The components of identifiable intangible assets are as follows (in thousands):

Assuming no additional acquisitions and no impairment, the amortization expense for existing intangible assets as of March 31, 2005 is estimated to be approximately $1.1 million for the remainder of fiscal 2005, approximately $1.5 million for fiscal 2006, approximately $1.2 million for fiscal 2007, and approximately $1.1 million for fiscal 2008.

(8) Net Income Per Share

Basic net income per share is computed using the weighted-average number of outstanding shares of common stock, excluding shares of restricted stock subject to repurchase, summarized below. Diluted net income per share is computed using the weighted-average number of shares of common stock outstanding and, when dilutive, potential shares from options to purchase common stock using the treasury stock method.

The following table sets forth the computation of basic and diluted income per share (in thousands, except per share amounts):

11

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

The following potential shares of common stock have been excluded from the computation of diluted net income per share because the effect would have been antidilutive (in thousands):

The weighted-average exercise price of excluded outstanding stock options was $24.23 and $46.42 for the three months ended March 31, 2005 and 2004 and $25.90 and $45.80 for the six months ended March 31, 2005 and 2004, respectively. The weighted average purchase price of restricted stock was $2.06 for the three and six months ended March 31, 2005 and 2004.

(9) Acquisitions

On February 1, 2005, the Company acquired Hudson Williams Europe (“HWE”), a privately held e-business performance consulting firm based in the Netherlands, for a purchase price of approximately $260,000 plus direct transaction costs of $131,000. An initial cash payment of approximately $210,000 was made to HWE as of the closing date. Pursuant to the Asset Purchase Agreement, approximately $50,000 of the purchase price is being held back and will be released on January 31, 2006. An additional contingent consideration cash payment of up to approximately $130,000 could be made if profitability targets are achieved by HWE through June 30, 2005. The Company believes that this acquisition will provide its European customers the same range of management solutions that it has been offering in North America. The purchase price allocation was based on the estimated fair value of the assets and liabilities acquired at the acquisition date, including customer-based intangible assets acquired. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands):

In September 2004, the Company acquired Vividence Corporation (“Vividence”), a provider of web-based customer experience management for an initial cash payment of $20.0 million plus direct transaction costs of $572,000. The initial purchase price of $20.0 million, payable in cash, was reduced by approximately $400,000 which represented the preliminary difference between Vividence’s total assets and liabilities (“net assets”) as of the acquisition date after certain adjustments as defined in the Agreement and Plan of Reorganization dated September 10, 2004 (“Agreement and Plan”). In the second quarter of fiscal 2005, the Company and the Shareholders’ Representative of Vividence finalized the amount representing the net assets as of the acquisition date, resulting in a final net asset shortfall of approximately $38,000. This reduction in the purchase price has been recorded as a reduction of goodwill. An additional contingent consideration payment of up to $6 million in cash could be made if certain revenue and profitability targets are achieved by the acquired business through September 30, 2005. The Company believes that this acquisition will enhance and broaden its customer experience management solutions for enterprise customers as well as allow it to target e-business marketing executives within Fortune 500 companies such as usability and market research managers. The Company and the Shareholders’ Representative of Vividence are working with a third party tax consultant in resolving several pre-acquisition sales and use tax matters. Any payment, if the tax matter is resolved by September 2005, would be the subject to a claim against the escrow by the Company. Based on its preliminary analysis, the Company believes that the matter will be resolved by September 2005 for a range between $350,000 to $750,000, although there can be no assurance as to the final outcome.

The preliminary purchase price allocation was based on the estimated fair value of the assets and liabilities acquired at the acquisition date, including technology-based and customer-based intangible assets acquired. For the three months ended March 31, 2005, total net adjustments decreased from $239,000 to $201,000, reflecting the final net asset shortfall of $38,000 as noted above. This reduction in prepaid and other assets combined with the decrease in purchase price and liabilities assumed had the net impact of increasing goodwill. The following table summarizes the revised estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands):

12

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

The in-process research and development expense of $241,000 is related to the estimated fair value of an acquired in-process research and development project in connection with the acquisition of Vividence. This project is related to Vividence’s technology for its web-based customer research, which had not yet reached technological feasibility and had no alternative future use. The estimated fair value of this project was determined based on the avoided cost approach as of the acquisition date where the fair value of the acquired technology was equal to the costs which an acquirer would avoid spending in developing a similar functional technology. This amount was immediately expensed as of the acquisition date during the three months ended September 30, 2004. This web-based customer research technology became generally available in February 2005.

13

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

In April 2004, the Company acquired NetRaker Corporation (“NetRaker”), a provider of online customer experience management solutions that help e-business managers measure, evaluate and improve the design and navigability of their websites. The total price of approximately $3.7 million included a $2.6 million initial cash payment made in April 2004, a second payment of approximately $530,000 based on the final calculation of the NetRaker net assets as of the closing date, and approximately $553,000 of direct acquisition costs. The Company believes this acquisition will enhance and broaden its customer experience management solutions for enterprise customers as well as allow it to target e-business marketing executives within Fortune 500 companies, such as usability and market research managers.

The preliminary purchase price allocation was based on the estimated fair value of the assets and liabilities of the business at the acquisition date, including technology-based and customer-based intangible assets acquired. Pursuant to the Agreement and Plan of Reorganization dated April 2, 2004 (“Agreement and Plan”), an additional contingent cash payment of up to $7.9 million could be made if certain revenue and profitability targets are achieved by the acquired business during the 12 months ended March 31, 2005. The Company estimates that a cash payment of approximately $1.7 million was earned by the acquired business pursuant to the earnout provisions of the Agreement and Plan. However, two of the former stockholders of Netraker are disputing the amounts to be paid under the Agreement and Plan as described under Part II, Item 1 of the quarterly report. Although the Company believes these claims are without merit, the outcome of this matter is currently not determinable. The estimated additional payment has been recorded as an addition to goodwill as of March 31, 2005. An adjustment of $16,000 was made in the three months ended December 31, 2004 between goodwill and deferred revenue to reflect an adjustment in a contract that was entered into prior to the Company’s acquisition of NetRaker. The following table summarizes the revised estimated fair value of the assets acquired and liabilities assumed at the date of acquisition (in thousands):

In January 2005, pursuant to the Asset Purchase Agreement dated July 22, 2003, an additional contingent cash payment of approximately $128,000 was made to Candescent Software Inc. (“Candescent”) based on the achievement of certain revenue and profitability targets attained by the purchased business, Streamcheck. This additional payment was recorded as an addition to goodwill as of September 30, 2004.

14

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

(10) Income Taxes

The Company’s effective tax rate for the three months ended March 31, 2005 and 2004 was 6.5% and 10.0%, respectively. The Company’s effective tax rate for the six months ended March 31, 2005 and 2004 was 6.5% and 8%, respectively.

On October 22, 2004, the American Jobs Creation Act (“the AJCA”) was signed into law. The AJCA includes a deduction of 85% of certain foreign earnings that are repatriated, as defined in the AJCA. The Company may elect to apply this provision to qualifying earnings repatriations in the future. The Company is currently evaluating the effects of the repatriation provision; however, the Company does not expect to be able to complete this evaluation until after Congress or the Treasury Department provide additional clarifying language on key elements of the provision. The Company expects to complete its evaluation of the effects of the repatriation provision within a reasonable period of time following the publication of the additional clarifying language. When the Company completes its evaluation, any changes in the current position on the repatriation of undistributed earnings could result in the recognition of deferred tax liabilities at that time.

(11) Commitments and Contingencies

(A) Leases

The Company leases certain of its facilities and equipment under noncancellable capital and operating leases, which expire on various dates through April 2015. As of March 31, 2005, future minimum payments under the leases are as follows (in thousands):

Rent expense for the three months ended March 31, 2005 and 2004 was approximately $241,000 and $102,000, respectively. Rent expense for the six months ended March 31, 2005 and 2004 was approximately $371,000 and $197,000, respectively.

(B) Commitments

The Company has contingent commitments to 116 bandwidth and collocation providers amounting to $630,000 for 100 locations that represent one to twelve months commitments. The commitments become due if the Company terminates any of these agreements prior to their expiration. At present, the Company does not intend to terminate any of these agreements prior to their expiration.

(C) Legal Proceedings

Beginning on August 16, 2001, several class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company, certain of its officers, and the underwriters of its initial public offering. These lawsuits were essentially identical, and were brought on behalf of those who purchased the Company’s securities between September 24, 1999 and August 19, 2001. These complaints alleged generally that the underwriters in certain initial public offerings, including the Company’s, allocated shares in those initial public offerings in unfair or unlawful ways, such as requiring the purchaser to agree to buy in the aftermarket at a higher price or to buy shares in other companies with higher than normal commissions. The complaint also alleged that the Company had a duty to disclose the activities of the underwriters in the registration statement relating to its initial public offering. The plaintiffs’ counsel and the issuer defendants’ counsel have reached a preliminary settlement agreement whereby the issuers and individual defendants were dismissed from the case, without any payments by the Company. The settlement was preliminarily approved and awaits final approval by the Court. No amount is accrued as of March 31, 2005 and September 30, 2004, as the Company anticipates that it will be dismissed from the case as a result of the settlement.

On February 15, 2005, individuals George A. Papazian and Douglas K. van Duyne filed the action Papazian, et al. v. Keynote Systems, Inc., et al., Case No. CIV 444884 in Superior Court of San Mateo County against the Company and its Chief Executive Officer, Umang Gupta. The complaint asserts claims of fraud, breach of contract, and unfair business practices against Keynote and fraud against Mr. Gupta in connection with the Company’s April 2, 2004 acquisition of Netraker Corporation. The complaint also alleges that the Company precluded plaintiffs from maximizing their earn-out under the terms of the acquisition agreement. The complaint seeks rescission of the agreement, unspecified monetary and punitive damages, and equitable relief in the form of restitution and disgorgement of any profits.

On March 28, 2005, the Company and Mr. Gupta demurred to the complaint and moved to strike portions thereof. The hearing on its motions is currently scheduled for May 11, 2005. Written discovery has not commenced. No trial date has been set. Because of the preliminary stage of this litigation, it is difficult for the Company to assess the eventual outcome of this matter, although management believes the claims are without merit and the Company intends to vigorously defend this matter. Nevertheless, the costs of any litigation, regardless of the outcome can be significant, and the Company cannot assure you that it will not incur significant expenses in defense of this claim.

The Company is subject to legal proceedings, claims, and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows.

15

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

(12) Stock Repurchase Program

The Company’s Board of Directors approved a program to repurchase shares of its common stock in January 2001. Pursuant to the stock repurchase program, a total of 10.6 million shares had been repurchased as of March 31, 2005, for approximately $92.4 million.

On January 27, 2005, the Company entered into an agreement with UBS Securities LLC (“UBS”) to establish a trading plan (the “Trading Plan”) intended to qualify under Rule 10b5-1 of the Securities Exchange Act of 1934 (the “Exchange Act”). The Trading Plan instructs UBS to repurchase for the Company, in accordance with Rule 10b-18 of the Exchange Act, up to 2 million shares of the Company’s common stock, representing approximately 10% of the Company’s outstanding common stock, over a period of twelve months commencing as early as March 1, 2005. For the three and six months ended March 31, 2005, the Company repurchased approximately 200,000 shares for $2.3 million in connection with purchases in the open market. For the three and six months ended March 31, 2004, the Company did not repurchase any of its common stock

As of March 31, 2005, the Company had authorization to repurchase up to approximately $37.6 million of its common stock pursuant to this stock repurchase program.

16

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)

(13) Geographic and Segment Information

The Company has determined that it operates in a single reportable operating segment: the development and sale of services to measure, test, assure and improve the quality of service of web sites. While the Company operates under one operating segment, management reviews revenue under two categories – performance measurement services revenue (“measurement services”) and performance management solutions revenue (“management solutions”). Management continues to allocate resources based on the one operating segment.

The following table identifies which services fall under measurement services and management solutions and where they are recorded in the condensed consolidated statements of operations listed in alphabetical order:

The following table summarizes measurement services and management solutions revenue (in thousands):

17

Table of Contents

KEYNOTE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)—(Continued)