Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

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

of The Securities Exchange Act of 1934

For the fiscal year ended June 30, 2003

OR

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

of The Securities Exchange Act of 1934

For the transition period from                          to                        

Commission File Number 000-26757

NetIQ CORPORATION

(Exact name of Registrant as specified in its charter)

(408) 856-3000

(Registrant’s telephone number, including area code)

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨

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

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

As of December 31, 2002, the aggregate market value of Registrant’s voting stock held by non-affiliates was approximately $648.3 million based upon the closing sales price of the Common Stock as reported on the Nasdaq National Stock Market on such date. Shares of Common Stock held by officers, directors and holders of more than ten percent of the outstanding Common Stock have been excluded from this calculation because such persons may be deemed to be affiliates. The determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of December 31, 2002, the Registrant had outstanding 55,441,947 shares of Common Stock.

Certain sections of Registrant’s definitive Proxy Statement for the 2003 Annual Meeting of Stockholders to be held on November 13, 2003 are incorporated by reference in Part III of this Annual Report on Form 10-K to the extent stated herein.

Table of Contents

NetIQ Corporation

INDEX TO ANNUAL REPORT ON FORM 10-K

FOR YEAR ENDED JUNE 30, 2003

2

Table of Contents

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

PART I

ITEM 1.     BUSINESS

Overview

NetIQ is a leading provider of systems and security management and web analytics software solutions for assuring, analyzing and optimizing the performance, availability and security of our customers’ IT infrastructure and web sites. Historically focused on Microsoft Windows applications management, we have become a leading provider of software to test, migrate, administer, monitor, secure and analyze complex, distributed Windows-centric computer systems. Our UNIX and Linux modules introduced during fiscal 2002 and fiscal 2003 address our customers’ growing need to manage heterogeneous environments with cross-platform solutions, and enable them to manage more applications, servers and operating systems with our products. With the acquisition of PentaSafe Security Technologies, Inc. (PentaSafe) in December 2002, we now provide security management products running on AS/400 as well as on UNIX and Windows systems.

Businesses rely on proper functioning of their networks, operating systems, servers, applications, databases, and hardware. Our comprehensive, integrated solutions address two broad areas that are critical to managing the performance, availability, security, and utilization of this complex computing infrastructure:

Our Systems and security management business unit is comprised of our business units formerly known as Performance and Availability Management, and Security Management and Administration.

We provide free of charge through a link on our web site, www.netiq.com, access to our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, as well as amendments to those reports, and Proxy Statements, as soon as reasonably practicable after the reports are electronically filed with or furnished to the Securities and Exchange Commission.

Markets and Products

Today’s organizations are highly dependent on computer systems to conduct their business operations. The typical information technology environment is characterized by distributed information systems and networks that support multiple business-critical applications for financial reporting, human resources, enterprise resource planning, supply chain management, customer relationship management, and email, as well as industry specific

3

Table of Contents

applications. In addition to the internal networks connecting employees with these computing services in multiple locations, the Internet has become an essential medium for connecting businesses with customers, suppliers, investors, and employees.

The critical nature of these systems and their growing complexity has placed increasing pressure on systems managers and chief information officers to provide reliable and highly available operations. These infrastructures must be kept secure and available 24 hours per day, 7 days per week, and must be able to support widely distributed global organizations. Failure to ensure these service levels can result in substantial costs, including loss of productivity and corporate revenue.

To keep their infrastructures running smoothly, many companies employ large departments of skilled systems managers and administrators. This approach has proven expensive and ineffective for many companies due to the scarcity of such highly skilled staff, the high cost of recruiting and retaining them, and the increasingly complex environments they must manage. To improve management efficiency and effectiveness, businesses are increasingly using systems management software solutions such as those offered by NetIQ. We offer products in the following three broad areas:

Systems Management.    The primary function of our systems management software is to promptly identify and provide immediate notification of and automated response to system problems such as application failures, system software crashes, hardware failures, slow email response time, and insufficient capacity. Our software continually monitors the performance, responsiveness, and availability of systems and applications and evaluates the capabilities of network services so that systems administrators can plan and budget for additions, upgrades and configuration changes and respond to actual or threatened degradation.

Windows, UNIX and Linux Management.    Windows server operating systems (Windows NT Server, Windows 2000 Server editions, and Windows Server 2003) represent a large and growing share of the platforms that businesses turn to for deploying their mission critical applications. However, many applications continue to run on UNIX and other non-Windows platforms, and the Linux platform is gaining momentum in the marketplace, leading to the proliferation of complex, heterogeneous environments typically including multiple servers running multiple enterprise-wide applications, often from remote locations. The growth and deployment of varied systems and applications in highly complex computing environments have created a number of unique performance and systems management challenges. These challenges range from basic tasks, such as monitoring central processing unit utilization, memory and disk-space availability, to complex tasks such as monitoring Internet traffic, email response times, and database performance. We offer the following products to address these challenges:

VoIP and Network Management.    Because network performance is essential to continuous and consistent availability of all critical services throughout the infrastructure, systems administrators routinely test the impact

4

Table of Contents

of new applications on the network to identify and correct potential network performance problems and continually monitor application performance across the network to ensure that user requirements and service levels are being met. Increasingly, companies are migrating voice communications onto existing Internet protocol based computer network infrastructures by use of a technology called Voice over Internet Protocol or VoIP. Pre-deployment tests of the network to predict performance and assess readiness and post-deployment monitoring to maintain consistent performance are critical for a smooth VoIP implementation and high quality operations. We offer the following VoIP Management solutions:

    In July 2003, we granted Ixia exclusive distribution rights to our Chariot products in the United States and Canada through December 31, 2004, as well as a perpetual license to the source code for the Chariot products to develop and distribute derivative products. In addition to the license rights, Ixia was granted an option to purchase assets associated with our Chariot products. The option may be exercised commencing September 1, 2004 and expires on January 15, 2005.

Security Management.    The volume, complexity, importance and sensitivity of the data produced across the enterprise requires sophisticated automated policies for administering and securing the computing infrastructure against internal and external threats. To manage internal threats associated with the violation of user policies or the misuse of access, directory services, corporate resources and intellectual property, businesses typically use administration products. External threats are typically addressed with perimeter-based products such as firewalls, intrusion detection, and anti-virus servers. Traditionally, security and administration problems have been addressed separately using specific products to solve individual problems.

Policy and Compliance Management.    We provide solutions to manage security policy and compliance across an IT organization with the following products:

Administration and Identity Management.    We provide solutions that deliver more efficient and secure access by automating processes for provisioning user accounts, enabling users to perform self-service without

5

Table of Contents

involving an IT help desk and enabling IT operations to administer their security systems and identity repositories. We offer the following solutions to address these challenges:

Vulnerability and Configuration Management.    We provide leading solutions that deliver automated, multi-platform protection to configure systems and identify and correct vulnerabilities. These products proactively improve system availability by establishing security configuration baselines, continuously audit for security vulnerabilities and help correct exposures before they result in security breaches or costly downtime. We offer the following solutions to address these challenges:

Incident and Event Management.    We provide leading solutions that automate the management and analysis of log data, intrusions and events from multiple security devices. These products help organizations solve several related business security problems: detecting and preventing intrusions, managing security events in real-time, consolidating excessive security event logs for long-term log and trend analysis and managing multiple firewall reporting systems. We offer the following solutions to address these challenges:

Convergence of Systems and Security Management.    We believe that systems management and security management solutions are converging as enterprises seek to improve the efficiency and effectiveness of managing their environments and reduce their cost of operations. To respond to this need, we have embarked upon a strategy of “convergence” focused on unifying our systems and security management product lines.

6

Table of Contents

Currently, many of our security management and administration products share data and leverage common features such as reporting, discovery, and asset management. However, over the next twelve to eighteen months we expect to configure our products to offer significant consolidation of information onto the same computer console. In the longer term, we intend to offer the ability to use common agents that can be enabled to perform security, administration and systems management functions. This consolidation is expected to provide solutions that more effectively manage the breadth of problems enterprises face. We believe our integrated products will improve the efficiency and effectiveness of customers’ IT operations and provide them significant cost savings. As a leading provider of both security and systems management solutions, NetIQ believes it is uniquely positioned to take advantage of these trends and requirements.

Web Analytics.    In recent years, there has been an increased focus on building external and internal web sites for business functions (eCommerce, information distribution, and customer/employee self-service). As a result, web sites have become an integral part of overall business strategy, facilitating communications with customers, vendors, employees, and investors. Successful Web-based strategies require an understanding of how visitors interact with the company’s Internet and intranet sites and how various online and offline initiatives translate into bottom line results. Businesses need a means of forecasting, tracking, and integrating historical visitor data with other corporate and market databases in order to optimize these business functions, thereby reducing costs and growing revenues through higher returns on marketing investments. We offer the following products to address these challenges:

Relationship with Microsoft

On September 25, 2000 we entered into a licensing agreement with Microsoft Corporation whereby we granted Microsoft a perpetual, non-exclusive license to our Operations Manager product technology and source code for core operations management of Windows 2000 and Microsoft server applications. We have received a total of $175.0 million in license fees over a three-year period starting November 2000 and ending August 2003. License revenue from the Microsoft agreement was $25.0 million during fiscal 2001, $85.0 million during fiscal 2002, $60.0 million during fiscal 2003, and will be $5.0 million in the first quarter of fiscal 2004. Over the three-year period, Microsoft also agreed to spend $5.0 million per year and pay us an additional $5.0 million per year to market joint solutions of the parties. The amounts paid to us to market joint solutions are being recognized as a reduction of sales and marketing expenses as the related expenses are incurred.

Sales and Distribution

Our products are sold through the following:

7

Table of Contents

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

Field and Inside Sales.    We market our software and services through our domestic and international field sales offices in the following locations:

During fiscal 2003, our direct sales organization was organized to include geographically focused field sales representatives, teamed with inside sales representatives. Starting in fiscal 2004 we re-organized our field sales force to reflect principally a named account focus. Each of our sales representatives is supported by system engineers who assist with pre-sales activities.

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

Value Added Resellers, System Integrators, Distributors and Original Equipment Manufacturers.    The NetIQ Authorized Reseller Program provides training, technical support and priority communications, and facilitates joint sales and marketing activities with our channel partners. Our channel sales representatives focus on managing the sales activities of our regional channel partners and the branch sales offices of our national reseller partners. As of June 30, 2003 we had approximately 670 third-party channel partners who resold our products and provided services to our customers worldwide. Our top ten channel partners represented approximately 16% and 14% of our worldwide license revenue, in the aggregate, during fiscal 2003 and 2002, respectively.

International Revenue.    International revenue represented 23%, 18%, and 26% of total revenue during fiscal 2003, 2002 and 2001, respectively. Total revenue includes domestic revenue from the Microsoft agreement of $60.0 million, $85.0 million and $25.0 million during fiscal 2003, 2002 and 2001, respectively. We anticipate that as we expand our international sales efforts and as revenue from the Microsoft agreement ceases in August 2003, the percentage of revenue derived from international sources will increase. Currently, a majority of our international business is conducted in U.S. dollars. Our international operations are subject to a variety of risks—see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Future Operating Results” for more information regarding these risks.

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

Our ability to increase our market share and sell our products in new markets depends on many factors including our relationships with multiple indirect marketing channels in the United States and internationally,

8

Table of Contents

competitive conditions and changes in the way our products are priced. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Future Operating Results” for more information regarding these risks.

Marketing

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

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

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

Customer Support and Services

Customers typically purchase software maintenance which includes software updates with each new product license. Customers are provided an annual option to renew this maintenance agreement. Our technical support organization provides product support to our current customers and to prospective customers in connection with pre-sales evaluations. Our support offerings are two tiered and include 24 hours per day, 7 days per week in our premium level offering. Both tiers provide self-service support on our web site as well as telephone and email support.

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

Research and Development

Our research and development organizations are responsible for the design, development and release of our products. These groups are organized into product management, development, quality assurance, documentation and localization disciplines and by major product families. Members from each discipline form separate product teams that work closely with sales, marketing and customer support to better understand market needs and user requirements. Additionally, we have a well-developed information feedback loop with our customers designed to enable us to respond to and address their changing system and systems management requirements. We also purchase or license third-party technology to shorten the time to market. The focus of our research and development efforts is to bring new products and services as well as new versions of existing products to market

9

Table of Contents

quickly in order to keep pace with the rapid evolution of technology and increasing customer demands. During fiscal 2003, 2002 and 2001, research and development expenses were $71.1 million, $61.0 million and $39.6 million, respectively, representing 23%, 22% and 24%, respectively, of total revenue in each of those years.

Competition

The markets we address are rapidly evolving and highly competitive, and we expect competition in our markets to persist and intensify. Our competitors frequently introduce new products and continually enhance existing products. We believe the key criteria our customers apply when evaluating our products compared to those of our competition include functionality, performance, reliability, ease of installation and use; price and total cost of ownership of our products relative to those of our competitors; the breadth of our product lines; and the quality of our sales, support and service. We may not be able to compete successfully against current and future competitors and such inability would materially and adversely affect our business, future quarterly and annual operating results and financial condition. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Future Operating Results” for more information regarding these risks.

We currently face competition from a number of sources, including:

Intellectual Property

Our success is dependent in part upon our proprietary technology. We rely primarily on a combination of patent, copyright and trademark laws, trade secret protection, confidentiality procedures and contractual provisions to protect our intellectual property rights in our technology. These laws, procedures and agreements

10

Table of Contents

provide only limited protection. We presently have 15 issued patents in the United States, 20 pending patent applications in the United States, 3 issued foreign patents, and 24 pending patent applications in certain foreign jurisdictions. There is no assurance that our patent applications will result in issued patents or that our issued patents will be upheld if challenged. While we seek protection for our intellectual property rights in certain countries outside the United States where we do business, effective protection for our intellectual property rights may not be available in every country in which we market our products or services.

We license technology from third parties for our products and certain components of our products. We intend to continue to license technology from third parties to enhance our products and build our product portfolio.

We are not aware that any of our products infringe any valid and enforceable intellectual property rights of third parties. However, on January 30, 2003 BMC Software, Inc. (BMC) filed suit against us in the U.S. District Court for the Southern District of Texas alleging that our AppManager product infringes a BMC patent, and that we infringe a BMC trademark. This litigation has now been stayed and the court has ordered that BMC submit its claims to arbitration. We believe we have meritorious defenses to these allegations, and intend to defend any adversarial proceedings vigorously, although there is no assurance we will be successful. See “Legal Proceedings” for additional information regarding the matter.

We expect that software product developers such as NetIQ increasingly may be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any infringement claim brought against us by a third-party, with or without merit, could result in costly and time-consuming litigation, divert management’s attention and resources, and cause product delays or lost sales. Any such infringement claim could also require us to enter into royalty or licensing agreements that may not be available on terms acceptable to us, if at all. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Future Operating Results” for more information regarding these risks.

Employees

As of June 30, 2003 we had 1,364 employees, 529 of whom were in sales and marketing, 442 in research and development, 206 in customer support and services, and 187 in general and administration. None of our employees is represented by a collective bargaining agreement. We have not experienced any work stoppages and consider our relations with our employees to be good. For a discussion of our need to attract and retain additional qualified personnel, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Factors That May Affect Future Operating Results” for more information regarding these risks.

Executive Officers

The following table sets forth information regarding our executive officers as of June 30, 2003.

11

Table of Contents

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

James A. Barth was named Senior Vice President, Finance and Administration, and Chief Financial Officer of NetIQ in November 2001, and for the period November 2000 to November 2001 he served as Senior Vice President, Finance, Chief Financial Officer and Secretary of NetIQ. From March 1999 to November 2000, he served as Vice President, Finance, Chief Financial Officer and Secretary of NetIQ. From November 1997 until March 1999, Mr. Barth served as the Vice President, Chief Financial Officer and Secretary of Interlink Computer Sciences, a developer of enterprise networking software designed for the IBM mainframe platform. From October 1994 to November 1997, Mr. Barth served as Executive Vice President, Chief Financial Officer and Secretary of MagiNet, a provider of interactive entertainment and information systems. Mr. Barth also served as the Chief Financial Officer of Rational Software from July 1982 to March 1994. Mr. Barth holds a B.S. in business administration from the University of California at Los Angeles and is a certified public accountant.

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

Holly E. Files was named Senior Vice President, Worldwide Support and Services in April 2003, and for the period of February 2002 through March 2003 she served as our Vice President, Worldwide Services and Support. From July 2001 until February 2002, she served as the Chief Information Officer of 800.com. Ms. Files served as Vice President of Worldwide Services for WebTrends Corporation from November 1998 and continued in that position after it was acquired by NetIQ until July 2001. From July 1997 until November 1998, she served as Executive Director of Operations at Radiant Systems/RapidFire, a point-of-sale systems provider for the retail sector. Prior to her position at Radiant, Ms. Files served as Vice President of Technical Services for Clientele Software, a provider of CRM solutions, Director of Professional Services at ParcPlace/Digitalk, a supplier of object-oriented software engineering tools, and held management positions at several software companies.

Steven M. Kahan joined NetIQ as Senior Vice President, Marketing in December 2002 after PentaSafe was acquired. At PentaSafe, he served as Vice President of Marketing from September 2000 to December 2002. From June 1999 to September 2000, Mr. Kahan served as Chief Executive Officer of e-Security Inc., a provider of enterprise security management software. From August 1998 to June 1999, he served as Chief Operating Officer of Allen Systems Group, Inc., a provider of professional services and software solutions for information

12

Table of Contents

management, operations management, and applications management. From March 1995 to August 1998, he served as Director of Marketing at TriMark Technologies, Inc., a leading provider of software solutions for the life insurance industry, acquired by PeopleSoft, Inc. in June 1998. Prior his position at TriMark, Mr. Kahan was employed in various marketing positions by Andersen Consulting from December 1992 to February 1995 and by Knowledgeware from January 1985 to December 1992. In addition to his position at NetIQ, Mr. Kahan presently serves as Chairman of the Human Firewall Council, an organization of private and public sector security experts, and is on the Board of Advisors for the Center of Information Security Awareness of Kennesaw State University. Mr. Kahan holds a B.A. in communications from Illinois State University.

Thomas R. Kemp was named Senior Vice President, Corporate Strategy and Development in July 2002. Since joining NetIQ in January of 1996 as a founding team member, Mr. Kemp has held various management positions at NetIQ. From January 2002 to June 2002, he served as Senior Vice President and General Manager of Performance and Availability Management. From November 2000 to December 2001, Mr. Kemp served as Senior Vice President of Products, and from June 2000 to October 2000, he was Vice President of Products. From May 1997 to May 2000, Mr. Kemp served as Vice President of Marketing, and from January 1996 until April 1997, he served as Director of Products of NetIQ. From August 1993 to November 1995, he held various management positions at Compuware Corporation, a provider of software tools and professional services to boost business productivity. From July 1992 to July 1993, Mr. Kemp served as Manager of System Engineers at EcoSystems until its sale to Compuware. Prior to July 1992, he held various consulting and marketing positions at Oracle Corporation, a database management company. Mr. Kemp holds a B.S. in computer science and history from the University of Michigan.

Mark P. Marron joined NetIQ as Senior Vice President, Worldwide Sales in August 2001. Prior to joining NetIQ, from 1999 to August 2001, Mr. Marron served as General Manager Worldwide Channel Sales for Computer Associates International Inc., a provider of software and services that enable organizations to manage their IT environments. From 1997 to 1999, he served as Senior Vice President of Channel Sales and Operations for Europe, Middle East and Africa, from 1993 to 1997, he served as Senior Vice President of Channel Sales for United States and from 1991 to 1993, he served as Vice President of Telesales at Computer Associates International, Inc. From 1989 to 1991 he served as District Sales Manager/Account Manager at On-Line Software International, and from 1988 to 1989, he was National Account Manager at Information Sciences, Inc. Mr. Marron holds a B.S. in computer science from Montclair State University.

Daniel J. Meub was named Senior Vice President, General Manager, Web Analytics in February 2002. He served as Senior Vice President, eServices of NetIQ after WebTrends Corporation was acquired in March 2001. At WebTrends, Mr. Meub served as Chief Operating Officer from February 2000 to March 2001, Senior Vice President of Marketing and Sales from April 1999 to February 2000 and Vice President of Marketing from December 1998 to April 1999. From December 1996 to October 1998, Mr. Meub served as the President and Chief Executive Officer of Adaptive Solutions Inc., a supplier of forms processing software and imaging solutions for the health care and governmental markets, which filed a voluntary petition for bankruptcy protection. From January 1995 to November 1996, Mr. Meub served as the Executive Vice President of Marketing and Product Development of Now Software Inc., a supplier of time management and utility software. Mr. Meub has served in a variety of sales and marketing roles since 1976. Mr. Meub holds a B.A. from Stanford University and a M.B.A. from Northwestern University.

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

13

Table of Contents

ITEM 2.     PROPERTIES

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

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

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

ITEM 3.     LEGAL PROCEEDINGS

On January 30, 2003 BMC Software, Inc. (BMC) filed suit against us in the U.S. District Court for the Southern District of Texas (Court). The initial complaint alleged that unidentified NetIQ products infringe a BMC patent and that we are infringing a BMC trademark, and sought injunctive relief, compensatory and treble damages, interest, and attorneys’ fees. On May 1, 2003 subsequent to our filing of a motion for a more definite statement, BMC filed an amended complaint that principally restated the prior allegations and additionally alleged that our AppManager product infringes the BMC patent. On May 12, 2003 we filed a motion to compel arbitration and stay proceedings, arguing that the claims asserted by BMC’s complaint were subject to arbitration under arbitration clauses in two agreements earlier entered into between NetIQ and BMC. On August 22, 2003 the Court entered an order granting our motion and ruled that all proceedings in the lawsuit must be stayed and that BMC’s patent and trademark infringement claims must be submitted first to arbitration for resolution. We believe we have meritorious defenses to these claims and intend to contest any adversarial proceedings vigorously.

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

Not applicable.

14

Table of Contents

PART II

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

Our Common Stock is traded on the Nasdaq National Stock Market under the trading symbol “NTIQ”. The following table presents the range of high and low closing prices for our common stock for the two years ended June 30, 2003:

The number of record holders of the shares of our common stock was 249 as of August 31, 2003, which does not include stockholders whose shares are held in trust by other entities. The actual number of stockholders is greater than this number of holders of record. Based on the number of annual reports requested by brokers, we estimate that we have approximately 14,000 beneficial owners of our common stock.

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

15

Table of Contents

ITEM 6.     SELECTED FINANCIAL DATA

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

16

Table of Contents

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

 RESULTS OF OPERATIONS

Overview

NetIQ is a leading provider of systems and security management and web analytics software solutions for assuring, analyzing and optimizing the performance, availability and security of our customers’ IT infrastructure. Historically focused on Microsoft Windows applications management, we have become a leading provider of software to test, migrate, administer, monitor, secure and analyze complex, distributed Windows-centric computer systems. Our UNIX and Linux modules introduced during fiscal 2002 and fiscal 2003 address our customers’ growing need to manage heterogeneous environments with cross-platform solutions, and enable them to manage more applications, servers and operating systems with our products. With the acquisition of PentaSafe in December 2002, we now provide security management products running on AS/400 as well as UNIX and Windows systems.

Businesses rely on proper functioning of their networks, operating systems, servers, applications, databases, and hardware. Our comprehensive, integrated solutions address two broad areas that are critical to managing the performance, availability, security and utilization of this complex computing infrastructure:

Our Systems and security management business unit is comprised of our business units formerly known as Performance and Availability Management, and Security Management and Administration.

We were founded in June 1995 and completed our initial public offering in July 1999 with a follow-on offering in December 1999.

Significant Events

Acquisition of PentaSafe Security Technologies, Inc.

On December 9, 2002 we acquired all outstanding shares of PentaSafe Security Technologies, Inc. (PentaSafe) for cash of $185.0 million and approximately 4.2 million shares of common stock, valued at approximately $55.7 million. We also assumed warrants to purchase approximately 60,000 shares of our common stock valued at approximately $606,000, and assumed employee stock options to purchase approximately 3.8 million shares of our common stock valued at approximately $35.0 million, of which approximately $1.8 million was recorded as deferred employee stock-based compensation to be amortized over the remaining vesting period of the options. We also incurred approximately $5.2 million of direct acquisition costs, for a total purchase price of approximately $281.5 million. PentaSafe provided integrated security management software solutions designed to ensure continuous compliance with security policies as well as to defend against security threats. We acquired PentaSafe to accelerate our penetration of the security management market, broaden our customer base, and strengthen our security product portfolio and domain expertise.

Acquisition of Marshal Software Ltd.

On December 20, 2002 we acquired all of the outstanding shares of Marshal Software Ltd. (Marshal) for cash of $22.7 million and incurred approximately $300,000 of direct acquisition costs, for a total purchase price of approximately $23.0 million. Marshal provided enterprise content security solutions. We acquired Marshal to help us address our customers’ requirements for controlling and monitoring electronic data entering and leaving the organization and to add content security to our comprehensive range of solutions for messaging environments.

Other Acquisitions and Investments

In July 2002, we made a minority investment of $5.0 million in @Stake, Inc., a privately held services company. The investment is accounted for under the cost method.

17

Table of Contents

In January 2002, we acquired technology from Subquery Innovations, Inc. (Subquery) for an initial cash payment of $1.6 million. In addition, after it met specified milestones, we paid Subquery an additional $1.6 million in May 2003.

In December 2001, we made a minority investment of $2.8 million in Lumigent Technologies, Inc. (Lumigent), a privately held software company. The investment was accounted for under the equity method until May 2003. Commencing June 2003, we account for the investment under the cost method due to reduction of our ownership percentage resulting from additional stock issued by Lumigent in a subsequent financing. The value of this investment was written down by $1.4 million during fiscal 2003 due to management’s assessment that the decline in value reflected by the price of the financing was other-than-temporary.

On March 30, 2001 we acquired all of the outstanding shares of WebTrends Corporation (WebTrends) for 12.8 million shares of common stock valued at approximately $926.0 million, assumed employee stock options to purchase approximately 2.7 million shares of our common stock valued at approximately $133.0 million, of which $4.9 million was recorded as an increase in deferred employee stock-based compensation and is being amortized over the remaining vesting period of the options, and incurred approximately $11.0 million of direct merger costs for a total purchase price of approximately $1.1 billion. WebTrends provided web analytics and eBusiness intelligence software. The acquisition was accounted for using purchase accounting.

Reduction in Force

In April 2003, we announced a reduction in force designed to reduce operating costs and to better support the convergence of the systems management and security management markets, by combining our systems and security business units and streamlining our organizational structure. As a result, we terminated the employment of 108 employees, including four senior executives, substantially all of whom left the Company by June 30, 2003. The total severance costs of $1.5 million relating to this reduction in force were recorded as sales and marketing, research and development and general and administrative expenses during the quarter ended June 30, 2003.

Restructurings

Fiscal 2003—In light of our acquisition of PentaSafe in December 2002 and resizing of the combined businesses, we adopted a plan to eliminate redundant positions in both the NetIQ and PentaSafe workforces and to vacate excess facilities as follows:

PentaSafe

We terminated the employment of 55 employees of PentaSafe and accrued $1.7 million related to severance benefits. As of June 30, 2003, 52 of these employees have left the Company and the remaining 3 employees will terminate employment by August 2003. The cost of eliminating these positions was accounted for as part of the purchase price.

NetIQ

We terminated the employment of 52 employees of NetIQ and vacated certain of our leased facilities, resulting in a total charge of $5.3 million reflected as a restructuring charge in our statement of operations in fiscal 2003. As of June 30, 2003, 49 of these employees have left the Company and the remaining 3 employees will terminate employment by August 2003.

Fiscal 2001—Pursuant to our acquisition of WebTrends in March 2001 and resizing of the combined businesses, we adopted a plan to eliminate redundant positions in both the NetIQ and WebTrends workforces as follows:

WebTrends

We terminated the employment of 49 employees of WebTrends and accrued $1.5 million related to severance benefits. The cost of eliminating these positions was accounted for as part of the purchase price.

18

Table of Contents

NetIQ

We terminated the employment of 36 employees of NetIQ resulting in a total charge of $816,000 reflected as a restructuring charge in our statement of operations in fiscal 2001.

Newly Adopted Accounting Principle

We adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, on July 1, 2002. Upon adoption of SFAS No. 142, we recorded a one-time, non-cash transitional impairment charge of $579.3 million to reduce the carrying value of our goodwill from previous acquisitions.

Under SFAS No. 142 our annual evaluation of the carrying value of goodwill will be conducted each year as of April 30. Additionally, as required by SFAS No 142, we will perform evaluations more frequently if business conditions indicate an assessment in an interim period is warranted. We conducted our first annual review for impairment of goodwill as of April 30, 2003 and recorded a non-cash charge of $330.5 million. The impairment charge is attributable to our revised forecast for operating profits and cash flows and corresponds to the overall decline in our market capitalization.

Licensing agreement with Microsoft Corporation

On September 25, 2000 we entered into a licensing agreement with Microsoft Corporation whereby we granted Microsoft a perpetual, non-exclusive license to our Operations Manager product technology and source code for core operations management of Windows 2000 and Microsoft server applications. We have received a total of $175.0 million in license fees over a three-year period starting November 2000 and ending August 2003. License revenue from the Microsoft agreement was $25.0 million during fiscal 2001, $85.0 million during fiscal 2002, $60.0 million during fiscal 2003, and will be $5.0 million in the first quarter of fiscal 2004. Over the three-year period, Microsoft also agreed to spend $5.0 million per year and pay us an additional $5.0 million per year to market joint solutions of the parties. The amounts paid to us to market joint solutions are being recognized as a reduction of sales and marketing expenses as the related expenses are incurred.

Tender Offers

On November 13, 2002 we announced a voluntary stock option exchange program for our employees, excluding the Chief Executive Officer, Chief Financial Officer, Chief Operating Officer, and Chief Technology Officer. The program was intended to balance the need to retain employees while minimizing dilution to stockholders. The program reduced the term of re-issued options to five years, generally restricted exercisability for six months following the re-grant and, depending on the exercise price of the options tendered for exchange, gave employees fewer options than they had tendered. On December 18, 2002, employees tendered options to purchase a total of 5,276,953 shares in connection with the offer, and new options for 2,848,145 shares were granted on June 20, 2003 at an exercise price of $16.00 per share. In connection with this exchange, we retired 1,038,664 shares from the option plans to offset potential future dilution resulting from the potentially lower price of the new grants. The exchange did not result in any additional compensation charges or variable plan accounting.

On May 7, 2001 we announced a voluntary stock option exchange program for our non-executive employees. Under the program, employees were given the opportunity to cancel outstanding stock options previously granted to them in exchange for an equal number of new options to be granted at a future date. The exchange was limited to employees who held options with an exercise price equal to or greater than $50.00 per share. Options exercisable for a total of 1,364,957 shares were tendered by employees under the program. New options for a total of 1,304,606 shares were granted on December 10, 2001 at an exercise price of $35.11 per share. The exchange did not result in any additional compensation charges or variable plan accounting.

19

Table of Contents

Critical Accounting Policies and Estimates

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

Revenue Recognition

Revenue is generated from licensing software and providing 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. 101, Revenue Recognition in Financial Statements, and other related pronouncements. In accordance with these statements, revenue is recognized upon meeting each of the following criteria:

Software revenue is recognized using the residual method. Under the residual method revenue is recognized if vendor-specific objective evidence of fair value exists for all of the undelivered elements in an arrangement. Vendor-specific objective evidence of fair value is based on the price generally charged when the element is sold separately or, if not yet sold separately, is established by authorized management. 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 such elements are delivered.

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

License revenue is deferred when the criteria noted above are not met for revenue recognition purposes, and recognized, as appropriate, when all criteria for revenue recognition have been met. Maintenance revenue is deferred and recognized ratably over the maintenance term, typically one year. Advance payments for hosted services are deferred and revenue is recognized over the service period. Deferred consulting and training revenues are recognized as those services are performed.

Generally, sales made through distributors, resellers, and original equipment manufacturers are recognized 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. Sales made to international master distributors of web analytics products are recognized when sold to the master distributor once all revenue recognition criteria have been met. Additionally, we monitor master distributor inventory levels, accounts

20

Table of Contents

receivable aging, and the distributor credit history and current credit rating. We also maintain an allowance for potential sales returns.

When licenses and services are sold together, license fees are recognized 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 that was sold. For arrangements that do not meet the above criteria, license and related service revenues are recognized upon completion of all contractual obligations.

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. Actual results could differ from those estimates. Significant estimates made in the accompanying financial statements are:

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 intangible assets may be required. We recorded a charge of $798,000 during the fourth quarter of fiscal 2003 related to discontinuance of the VigilEnt User Manager technology purchased as part of the PentaSafe acquisition. We 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 in future periods.

During fiscal 2003, we reclassified amortization of purchased technology from operating expenses to cost of revenue for all periods presented. As such, any future amortization or write-downs of these assets would adversely affect our gross margin.

21

Table of Contents

Upon adoption of SFAS No. 142 in July 2002, we ceased amortization of approximately $918.2 million of goodwill. We also recorded a one-time, non-cash transitional impairment charge of $579.3 million because we determined that the carrying value of existing goodwill on July 1, 2002 exceeded its fair value by that amount. We conducted our first annual review for impairment of goodwill as of April 30, 2003 and recorded a non-cash charge of $330.5 million. The impairment charge is attributable to our revised forecast for operating profits and cash flows and corresponds to the overall decline in our market capitalization. At June 30, 2003, the carrying value of our goodwill was approximately $272.6 million. If we are required to write-down this goodwill in the future, our operating results will be adversely affected.

22

Table of Contents

Results of Operations

On December 20, 2002 we completed the acquisition of Marshal Software, Inc. On December 9, 2002 we completed the acquisition of PentaSafe Security Technologies, Inc. On March 30, 2001 we completed the acquisition of WebTrends Corporation. Results of these operations from the date of acquisition forward have been included in the consolidated financial statements.

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

Total revenue increased by $32.0 million and $111.3 million, or 11% and 67%, from fiscal 2002 to 2003 and from fiscal 2001 to 2002, respectively. Software license revenue represented 66%, 75% and 75% of total revenue for 2003, 2002 and 2001, respectively, with service revenue representing the balance of revenue for the same periods. We expect our service revenue to grow as a percentage of total revenue as the license revenue from the Microsoft agreement ceases, our installed base increases and existing customers renew maintenance contracts.

Software License Revenue.    Total software license revenue decreased by 1% from fiscal 2002 to 2003, primarily due to a $25.0 million decrease in revenue under Microsoft agreement during fiscal 2003. This decrease was partially offset by inclusion of license revenue from our acquisitions of PentaSafe and Marshal and growth in our non-Microsoft revenue for a total increase of $22.9 million, or 19% during the same period.

Total software license revenue increased by 65% from fiscal 2001 to 2002, primarily due to a $60.0 million increase in revenue under the Microsoft agreement during fiscal 2002 and the inclusion of the operations of WebTrends for all of fiscal 2002.

Pursuant to the schedule of payments set forth in the agreement with Microsoft, software license revenue from Microsoft began a sequential decline in the quarter ended December 31, 2002. The final $5.0 million under the agreement will be received during the first quarter of fiscal 2004.

Service Revenue.    Service revenue increased by $34.1 million and $29.1 million, or 48% and 71%, from fiscal 2002 to 2003 and from fiscal 2001 to 2002, respectively. The increase was primarily due to additional maintenance fees associated with new software licenses, renewals by our existing customers, and the inclusion of the operations of PentaSafe and Marshal partially during fiscal 2003 and WebTrends for all of fiscal 2002 and 2003. Service revenue increased in absolute terms due to the compounding effect of our base of installed licenses, a significant majority of our customers renewing their maintenance service agreements and inclusion of a greater amount of implementation service, and increases in revenue from our hosted web analytics service. We expect our service revenue to grow as a percentage of total revenue as the license revenue from Microsoft ceases in August 2003, our installed base increases, and existing customers renew maintenance contracts.

23

Table of Contents

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

Total cost of revenue increased by $16.2 million and $27.3 million, or 33% and 128%, from fiscal 2002 to 2003 and from fiscal 2001 to 2002, respectively.

Cost of Software License Revenue.    Our cost of software license revenue includes personnel costs and costs associated with software packaging, documentation such as user manuals and CDs, and production, as well as non-employee commissions and royalties. Cost of software license revenue as a percentage of related license revenue increased from 2% during fiscal 2001 and 2002 to 5% during fiscal 2003. The increase primarily is due to increases in royalty expense, fulfillment costs, and the decline in revenue from Microsoft, which does not have any costs associated with it. We expect cost of software license revenue to increase as a percentage of software license revenue in the future as the revenue from the Microsoft agreement ceases.

Cost of Service Revenue.    Cost of service revenue consists primarily of personnel costs and expenses incurred in providing telephonic support, on-site consulting services and training services. Costs associated with training consist principally of labor and travel expenses as well as training materials. Cost of service revenue as a percentage of related service revenue increased from 25% during fiscal 2001 to 33% during fiscal 2002, and decreased to 28% during fiscal 2003.

The improvement in our services gross margin in fiscal 2003 is primarily attributable to a majority of our customers renewing their maintenance agreements and greater efficiencies in providing technical support services. The decline in service gross margins in fiscal 2002 was primarily due to the addition of the WebTrends customer base, which requires more implementation services than our traditional customers and includes higher-cost operations relating to the subscription revenue from our hosted web analytics service.

We expect service revenue to increase in absolute dollars as our installed license base grows and, as a consequence, our cost of service revenue to increase in absolute dollars.

Amortization and Impairment of Purchased Technology.    Purchased technology consists of developed software capitalized in our acquisitions and is amortized using the straight-line method over the estimated useful life, generally three years. During fiscal 2003, we revised the classification of amortization of purchased technology from operating expenses to cost of revenue. The revision in expense classification was applied to all periods presented. Amortization increased from $9.0 million during fiscal 2001 to $21.1 million during fiscal 2002 and $24.6 million during fiscal 2003. The increase in the amortization was due to additional amounts capitalized in acquisitions. Additionally, we recorded a charge of $798,000 during the fourth quarter of fiscal 2003 related to discontinuance of the VigilEnt User Manager technology purchased as part of the PentaSafe acquisition. We expect to amortize approximately $19.1 million of purchased technology during fiscal 2004, absent further acquisitions or impairments.

24

Table of Contents

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.

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

Sales and marketing expenses increased by $24.2 million and $31.0 million, or 22% and 40%, from fiscal 2002 to 2003 and from fiscal 2001 to 2002, respectively. The increase in absolute dollars resulted principally from our acquisitions of PentaSafe and Marshal during fiscal 2003, and from hiring additional field sales and support, inside sales and marketing personnel, expanding our sales infrastructure, increasing the number of third-party channel partners, and higher sales commissions. Sales and marketing as a percentage of revenue decreased from 46% in fiscal 2001 to 39% in fiscal 2002, and increased to 43% in fiscal 2003. The fluctuation in the percentages was principally the result of the level of revenue from Microsoft in each fiscal year, which does not require significant sales or marketing effort. During fiscal 2004, we expect sales and marketing expenses to increase in absolute dollars, as a result of increase in non-Microsoft revenue and full year of operations for our fiscal 2003 acquisitions, partially offset by our workforce reductions.

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, all research and development costs have been expensed as incurred in accordance with SFAS No. 86, as our software development process is essentially completed concurrent with the establishment of technological feasibility.

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

Research and development expenses increased by $10.1 million and $21.4 million, or 17% and 54%, from fiscal 2002 to 2003 and from fiscal 2001 to 2002, respectively. This increase in absolute dollars resulted principally from increases in headcount, including personnel from our acquisitions of PentaSafe and Marshal. Our strategy since signing the license agreement with Microsoft in September 2000 has been to increase spending in research and development through fiscal 2003. As a result, we brought to market a number of new products. During fiscal 2004, we expect research and development expenses to increase in absolute dollars, as a result of full year of operations for our fiscal 2003 acquisitions, partially offset by our workforce reductions.

25

Table of Contents

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

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

General and administrative expenses increased by $4.9 million and $6.0 million, or 26% and 45%, from fiscal 2002 to 2003 and from fiscal 2001 to 2002, respectively. The increase in absolute dollars was primarily due to increased staffing necessary to manage and support our growth. In fiscal 2003, we also incurred higher legal expenses, as well as higher premiums for directors and officers insurance. In fiscal 2002, general and administrative expenses included $1.5 million associated with a warrant issued to an executive search firm in March 2002 for recruiting services in connection with recruiting our chief executive officer. During fiscal 2004, we expect our general and administrative expenses to increase in absolute dollars due to an increase in our directors and officers’ insurance premiums and full year of operations for our fiscal 2003 acquisitions, partially offset by our workforce reductions.

Employee Stock-Based Compensation.    Deferred employee stock-based compensation represents the intrinsic value of unvested options assumed in the acquisitions of PentaSafe and WebTrends and charges associated with the grant of options at less than fair market value prior to our initial public offering. The deferred amount is being amortized over the vesting periods of the assumed and granted options, generally four years. During fiscal 2003, 2002 and 2001, we recognized employee stock-based compensation expense of $796,000, $3.2 million and $2.0 million, respectively. The increase in expense in fiscal 2002, and the decrease in fiscal 2003 is due to the amortization of deferred employee stock based compensation related to the assumption of WebTrends options, which has decreased over time in accordance with the vesting periods. During fiscal 2004, we expect to amortize approximately $386,000 of deferred employee stock-based compensation.

Amortization of Other Intangible Assets.    Amortization of other intangible assets includes amortization of customer contracts, customer lists, patents and tradename intangibles capitalized in our acquisitions, but excludes amortization of purchased technology. Amortization of purchased technology is classified as cost of revenue in accordance with SFAS No. 86, Computer Software To Be Sold, Leased or Otherwise Marketed. Other intangible assets are amortized using the straight-line method over their estimated useful life, generally three years. Amortization increased from $8.7 million during fiscal 2001 to $20.2 million during fiscal 2002 and decreased to $18.5 million during fiscal 2003. The increase in the amortization during fiscal 2002 was due to additional amounts capitalized from acquisitions we completed in 2001. The decrease in the amortization during fiscal 2003 resulted from the full amortization of amounts capitalized in previous acquisitions, partially offset by intangibles assets capitalized from our acquisitions in December 2002. During fiscal 2004, we expect to amortize approximately $14.9 million of other intangible assets, absent further acquisitions.

Impairment and Amortization of Goodwill.    During fiscal 2002 and 2001 we amortized $751.8 million and $535.8 million of goodwill recognized in our acquisitions. We adopted SFAS No. 142, Goodwill and Other Intangible Assets, on July 1, 2002 and accordingly stopped amortizing goodwill on that date. Upon adoption of SFAS No. 142, we recorded a one-time, non-cash transitional impairment charge of $579.3 million to reduce the carrying value of our goodwill from previous acquisitions. The charge is non-operational in nature and is reflected as the cumulative effect of a change in accounting principle in the accompanying consolidated statements of operations. There was no income tax effect of the change in accounting principle.

26

Table of Contents

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

In calculating both impairment charges as of July 1, 2002 and April 30, 2003 the fair values of the reporting units were estimated using a combination of the discounted cash flows and comparable transactions methodologies.

Under SFAS No. 142 we are required to perform an annual test of impairment of goodwill. We have determined to perform this test as of April 30 each year. In addition to the annual test of impairment of goodwill we assess impairment of goodwill between annual tests, at each balance sheet date, if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount, which can result in additional non-cash charges.

Write-off of Acquired In-Process Research and Development Costs.    During fiscal 2003 and 2001 we expensed $1.4 million and $2.7 million, respectively, related to the acquisitions of PentaSafe and WebTrends, respectively. These costs associated with the purchase of in-process technology were charged to operations as the technologies had not reached technological feasibility and did not have alternative future uses at the date of acquisition. No such charges were recorded during fiscal 2002.

In connection with our acquisitions of PentaSafe in December 2002 and WebTrends in March 2001 we acquired technology consisting of both existing technology and in-process research and development. The valuation of acquired technology was made by applying the income approach, which considers the present value of the projected free cash flows that will be generated by the products, incorporating the acquired technologies under development, assuming they will be successfully completed. Projected free cash flows used in the income approach are based on PentaSafe and WebTrends past experience with typical product life cycles, and expected demand from PentaSafe and WebTrends customers, respectively, for new products. A discount rate of 25% was used to take into account the novelty of the technology, the extent of the company’s familiarity with the technology, the stage of completion and the risks surrounding the successful development and commercialization of each of the in-process research and development projects that were valued. The key elements of the acquired companies’ development processes include: design of user interface, developing code, integration with existing products, technical documentation, and testing. A project is considered technologically feasible when a prototype is available for beta or general release. These estimates are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur.

Costs incurred prior to establishment of technological feasibility are charged to research and development expense and have not been material through June 30, 2003. Such research and development costs to bring the remaining products from PentaSafe to technological feasibility in fiscal 2004 are not expected to have a material impact on our future results of operations or financial condition.

Restructuring Charge.    During fiscal 2003, we recorded a restructuring charge of $5.3 million related to a plan to terminate employment of 52 employees and vacate certain of our facilities that will no longer be used due to resizing the combined business after the acquisition of PentaSafe. During fiscal 2001, we recorded a restructuring charge of $816,000 related to our plan to terminate employment of 36 employees due to resizing the combined business after the acquisition of WebTrends. No such charge was recorded during fiscal 2002.

Total Other Income, Net.    For fiscal 2003, 2002 and 2001, total other income, net was $10.8 million, $18.7 million and $21.8 million, respectively. The decrease in total other income is primarily the result of lower interest income earned on our cash and cash equivalents and short-term investments, due to the continuing decline in the yield on new investments as earlier investments mature, as well as lower cash balances due to the use of cash in December 2002 for the acquisitions of PentaSafe and Marshal. In addition, total other income includes in fiscal 2003 a charge of $1.4 million related to an impairment of a long-term investment in an affiliate

27

Table of Contents

based on management’s assessment that the decline in value was other than temporary. During fiscal 2004, we expect interest income to decline due to lower cash and cash equivalents and short-term investments and continued decline in yields.

Income Taxes.    We recorded income tax expense of $2.0 million, $15.8 million and $10.6 million in fiscal 2003, 2002 and 2001, respectively. The decrease in the income tax expense incorporates a decrease in our effective tax rate from 39% during fiscal 2001 and 2002 to 38% during fiscal 2003, in addition to a decrease in taxable income. The tax benefit associated with dispositions from employee stock plans reduced federal and certain state income taxes payable to zero in fiscal 2003, 2002 and 2001.

Recent Accounting Pronouncements

In June 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance, principally Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. We adopted the provisions of SFAS No. 146 for restructuring activities after December 31, 2002. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred, while under EITF Issue No. 94-3, a liability for an exit cost was recognized at the date of the company’s commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, SFAS No. 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized.

In November 2002, the FASB issued Interpretation No. 45 (FIN 45), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 requires additional disclosure for guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations do not apply to product warranties or to guarantees accounted for as derivatives. We adopted FIN 45 effective January 1, 2003. Adoption of FIN 45 did not have a material impact on our financial position or results of operations.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and annual disclosure provisions of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. We adopted the disclosure requirements of SFAS No. 148 effective January 1, 2003.

Liquidity and Capital Resources

As of June 30, 2003 we had $76.1 million in cash and cash equivalents and $237.3 million in short-term investments, for a total of $313.4 million compared to $475.9 million as of June 30, 2002 a decrease of $162.5 million. The primary reason for the decline during fiscal 2003 was the use of approximately $202.3 million in our acquisitions of PentaSafe and Marshal in December 2002, offset partially by $47.1 million in cash flows from operations.

Our operating activities resulted in net cash inflows of $47.1 million, $99.3 million and $52.9 million, in fiscal 2003, 2002 and 2001, respectively. Sources of cash during these periods were primarily from net income

28

Table of Contents

after adjusting for non-cash charges. During fiscal 2003, primary non-cash charges were the cumulative effect of change in accounting principle of $579.3 million, impairment of goodwill of $330.5 million and depreciation and amortization of $58.3 million. During fiscal 2002 and 2001, the primary non-cash charge was depreciation and amortization of $804.9 million and $560.9 million, principally from the amortization of goodwill and other intangible assets. In addition, increases in assets and decreases in liabilities, net of acquired assets and liabilities, used cash during fiscal 2003. During fiscal 2002 and 2001 decreases in assets and increases in liabilities provided cash.

Our investing activities resulted in net cash outflows of $48.1 million, $53.2 million and $181.5 million in fiscal 2003, 2002 and 2001, respectively. The principal uses of cash during fiscal 2003 were acquisitions of PentaSafe and Marshal for net cash outflows of $202.3 million. Other principal uses of cash during fiscal 2003, 2002 and 2001, were acquisitions of property and equipment of $15.3 million, $15.6 million and $42.6 million, respectively, including the purchase in fiscal 2001 of a building for our corporate offices in San Jose, California at a total purchase price of $28.2 million. Cash outflows also included purchases of short-term investments of $183.0 million, $305.5 million and $397.6 million in fiscal 2003, 2002 and 2001, respectively, and long-term investments of $5.0 million and $2.8 million during fiscal 2003 and 2002, respectively. The principal sources of cash during fiscal 2003 and 2001 were proceeds from the sale of short-term investments of $132.7 million and $62.6 million, respectively, and during 2003, 2002 and 2001 were proceeds from maturities of short-term investments of $224.5 million, $270.9 million and $190.5 million, respectively. We also obtained net cash of $6.8 million from our acquisitions in fiscal 2001.

Financing activities resulted in net cash inflows of $13.8 million and $30.5 million during fiscal 2003 and 2001, respectively, and a net cash outflow of $72.2 million in fiscal 2002. Sources of cash during these periods were principally from exercises of stock options and issuance of shares under our employee stock purchase plan. During fiscal 2002, we used cash of $88.6 million to purchase treasury stock.

Long-term Obligations

The following summarizes our contractual obligations as of June 30, 2003 and the effect such obligations are expected to have on our liquidity and cash flows in future periods (in thousands, including lease payments accrued as part of our restructuring liability, facility reserve, and goodwill):

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

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

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

29

Table of Contents

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 essentially all of our employees participate in our option program. During fiscal 2003, 85% of the options granted, excluding options regranted as part of our tender offer, went 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 4 years. We also have an employee stock purchase plan under which employees are entitled to purchase a limited number of shares at 85% of fair market value. See Note 10 to the Consolidated Financial Statements for additional information regarding our stock option plans.

We have assumed 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.

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

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

During fiscal 2003 net cancellations of 3.7 million options includes 2.1 million options cancelled as a result of our 2003 tender offer and options cancelled for employees terminated under our restructuring and reduction in force.

30

Table of Contents

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

A summary of outstanding in-the-money and out-of-the-money options as of June 30, 2003 is as follows:

Options granted to top five listed officers during fiscal 2003 are as follows:

31

Table of Contents

Option exercises during fiscal 2003 and remaining option holdings for top five listed officers as of June 30, 2003 are as follows:

The following table summarizes common stock subject to future issuance under the Company’s equity compensation plans and warrant agreement as of June 30, 2003: