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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

For the transition period from                             to                              

Commission file number 000-29335

WITNESS SYSTEMS, INC.
(Exact Name of Registrant as Specified in its Charter)

Registrant's telephone number, including area code 770-754-1900

        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 ý    No o

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o    No ý

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

WITNESS SYSTEMS, INC.
FORM 10-Q
INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
(unaudited)

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

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WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

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

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WITNESS SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

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

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WITNESS SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2003
(unaudited)

1. General and Basis of Presentation

        Witness Systems, Inc. provides an integrated contact center performance optimization software suite that enables global enterprises to capture customer intelligence and optimize workforce performance. The solution is comprised of business-driven and/or full-time customer interaction recording, performance analysis and e-learning management applications that are designed to enhance the quality of customer interactions across multiple communications media, including the telephone, e-mail and internet. The Company is headquartered in Roswell, Georgia with other offices in the United States, Australia, Brazil, Canada, China, Germany, Hong Kong, India, Japan, Malaysia, Mexico, the Netherlands, Singapore and the United Kingdom. The Company was originally incorporated in 1988 in Georgia and was reincorporated in Delaware in 1997.

        The unaudited interim condensed consolidated financial statements include the accounts of Witness Systems, Inc. (the "Company" or "Witness"). During the first quarter of 2003, the Company acquired Eyretel plc ("Eyretel"), a U.K.-based provider of compliance and recording solutions for customer contact centers. Their results of operations have, accordingly, been consolidated in these unaudited interim condensed consolidated financial statements commencing as of March 22, 2003. All significant intercompany accounts and transactions have been eliminated in the consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation.

        The financial statements herein have been prepared in accordance with the requirements of Form 10-Q and, therefore, do not include all information and footnotes required by generally accepted accounting principles in the United States. However, in the opinion of management, all adjustments (which, except as disclosed elsewhere herein, consist only of normal recurring accruals) necessary for a fair presentation of the results of operations for the relevant periods have been made. Results for the interim periods are not necessarily indicative of the results to be expected for the year. These financial statements should be read in conjunction with the summary of significant accounting policies and the notes to the consolidated financial statements included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2002, filed with the U.S. Securities and Exchange Commission.

2. Significant Accounting Policies

        The Company recognizes revenue in accordance with Statement of Position ("SOP") 97-2, Software Revenue Recognition, and SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions. Revenue is primarily derived from licensing software and providing related services including maintenance.

        Product revenue, which includes software and hardware, is recognized when persuasive evidence of an agreement exists, delivery of the product has occurred, the fee is fixed or determinable, and collection is probable. The Company recognizes product revenue using the residual method whereby revenue is recognized in a multiple element arrangement when vendor specific objective evidence of fair value exists for all of the undelivered elements in the arrangement, but does not for one or more of the delivered elements in the arrangement. The Company defers revenue in an amount equal to the fair value of its undelivered elements, normally services (including maintenance), and recognizes the difference between the total arrangement fee and the amount deferred for the undelivered elements as product revenue.

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        Services revenue includes installation, training, consulting, maintenance and reimbursable travel expenses. Revenue from installation, training and consulting services is recognized upon performance of the related services and is offered and billed as separate elements of contracts. Reimbursable travel expenses revenue is recognized upon incurrence of the related expenses. The functionality of the software and any hardware sold is not dependent on installation and training services. Maintenance is offered as a separate element and generally includes the right to unspecified upgrades on a when-and-if available basis. Maintenance revenue, which is generally billed in advance, is deferred and recognized ratably over the term of the related contract. Specified upgrades are not typically offered to customers.

        Accounts receivable include amounts due from customers for which revenue has been recognized. The Company performs ongoing evaluations of its customers and continuously monitors collections and payments and estimates an allowance for doubtful accounts based on a percentage of its accounts receivable, its historical experience and any specific customer collection issues that it has identified. Account balances are charged off against the allowance after reasonable means of collection have been exhausted and the potential for recovery is considered remote. Deferred revenue consists of amounts collected from customers for products and services that have not met the criteria for revenue recognition.

3. Net (Loss) Income Per Share

        The following table presents the computation of basic and diluted net income (loss) per share for the three and six months ended June 30, 2003 and 2002 (in thousands, except per share amounts):

        For the three and six months ended June 30, 2003, the Company has excluded all outstanding stock options from the calculation of diluted net loss per common share because all such securities were anti-dilutive. The total number of options excluded from the calculation of diluted net loss per share for the three and six months ended June 30, 2003 was 774,581 and 563,888, respectively. For the three and six months ended June 30, 2002, the Company has excluded approximately 1.9 million and 1.6 million outstanding stock options, respectively, from the calculation of diluted net income per common share because such securities were anti-dilutive.

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4. Comprehensive (Loss) Income

        The following table presents the components of total comprehensive (loss) income and accumulated other comprehensive loss (in thousands):

5. Eyretel Acquisition

        During the first quarter of 2003, the Company acquired controlling interest in Eyretel plc and completed the acquisition during the second quarter of 2003. The price paid was for 25 pence per share for a total purchase price of approximately £35.2 million, or $55.5 million, excluding shares owned by Eyretel's employee stock option trust at the time of acquisition. The acquisition is intended to extend the Company's leadership in the global contact center performance optimization market, offering customers a comprehensive range of software and services. The Company commenced the consolidation of Eyretel's results on March 22, 2003, the date the Company assumed majority ownership of Eyretel. The acquisition was accounted for using the purchase method of accounting.

        The following summarizes the total estimated purchase price for Eyretel as of June 30, 2003 (in thousands):

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        Under the purchase method of accounting, the total purchase price is allocated to Eyretel's net tangible and intangible assets based upon their estimated fair values as of the date of the acquisition. The purchase price allocation for this acquisition is based on preliminary estimates and valuations and may be revised at a later date when additional information concerning asset and liability valuations is finalized. The preliminary purchase price allocation is as follows (in thousands):

        The Company estimated that $7.8 million of the purchase price of Eyretel represented acquired in-process research and development ("IPR&D") that had not yet reached technological feasibility and had no alternative future use. Accordingly, these amounts were immediately charged to expense upon consummation of the acquisition. An independent third-party appraiser calculated the value of the IPR&D by utilizing a discounted cash flow methodology, focusing on the income-producing capabilities of the in-process technologies and taking into consideration: 1) stage of completion; 2) complexity of work to date and to complete; 3) anticipated product development and introduction schedules; 4) forecasted product sales cycles; 5) internal and external risk factors; 6) revenue and operating expense estimates; 7) contributory asset charges; and 8) costs already incurred and the expected costs to complete.

        The identifiable intangible assets were valued by an independent third-party appraiser using either an income or cost approach taking into consideration the nature, risks, historical patterns, economic characteristics, and future considerations of the assets. The identifiable intangible assets include acquired technology of $13.6 million, distribution channels of $5.3 million, customer list of $2.6 million and trademarks of $1.3 million. The acquired technology and trademarks are being amortized over three years and the distribution channels and customer list are being amortized over five years.

        The Company's Board of Directors has agreed to pay a special bonus of £1.0 million to the former chief executive of Eyretel, now the Company's Chief Operating Officer ("COO"), in association with the Eyretel acquisition. The special bonus is generally payable in March 2004 and March 2005 but may be payable in advance of these dates under certain circumstances, such as a change of control.

        Supplemental pro forma information reflecting the acquisition of Eyretel as if it occurred on January 1, 2002 is as follows (in thousands, except per share amounts):

        The above pro forma results include pro forma adjustments for the amortization expense of intangible assets arising from the acquisition and the reversal of interest income. In addition, the pro forma results for the six months ended June 30, 2003 exclude the IPR&D charge and certain merger-related and other costs directly attributable to the acquisition.

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        The following table summarizes the Company's restructuring activity (in thousands):

        The 2003 restructuring accrual resulted from Eyretel headcount reductions and the closing of certain Eyretel facilities.

6. Merger-Related Costs

        The Company reported merger-related costs of $4.6 million for the six-months ended June 30, 2003. These merger-related costs included $0.9 million for a sterling-based forward exchange contract to hedge the dollar cost of the acquisition, $2.0 million of expenses related to integrating Eyretel's software products, training personnel on products acquired and consolidating the operations of Eyretel with the Company, $1.0 million of expenses related primarily to consulting fees and certain other merger and employee costs. The merger-related costs also include$0.7 million of accruals for severance of Witness employees and the closing of Witness facilities that are considered redundant as summarized below (in thousands):