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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2004

Commission File Number: 0-24983

NetSolve, Incorporated

(Exact name of the registrant as specified in its charter)

9500 Amberglen Boulevard

Austin, Texas 78729

(Address of principal executive offices, including zip code)

(512) 340-3000

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 126-2).    Yes  ¨    No  x

Number of shares outstanding of the issuer’s common stock, $.01 par value, as of August 6, 2004: 11,677,855

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NETSOLVE, INCORPORATED

INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

NETSOLVE, INCORPORATED

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

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

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NETSOLVE, INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands except per share data)

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

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NETSOLVE, INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

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

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NETSOLVE, INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2004

Information with respect to the three months ended June 30, 2003 and 2004 is unaudited.

1. Organization and Description of the Company

NetSolve, Incorporated, a Delaware corporation, (the “Company”) engages in the business of providing information technology (IT) infrastructure management services. These services include ongoing IT infrastructure management services and, to a lesser extent, network configuration and design and installation and implementation coordination services. The Company also resells CPE maintenance contracts and data network equipment manufactured by selected leading suppliers of these products. The Company also licenses its software to an entity in Japan. The Company’s IT infrastructure management services are designed to allow its customers to selectively outsource IT infrastructure management in order to simplify the timely migration to new technologies, increase network reliability, performance and security while reducing overall IT infrastructure operating costs.

2. Basis of Presentation

The quarterly financial information presented herein should be read in conjunction with the Company’s annual financial statements for the year ended March 31, 2004, which can be found in the Company’s annual report on Form 10-K, as filed on June 9, 2004 (File No. 000-24983). The accompanying unaudited interim financial statements reflect all adjustments (which include only normal, recurring adjustments) that are, in the opinion of management, necessary to state fairly the results for the periods presented. The results for such periods are not necessarily indicative of the results to be expected for the full fiscal year.

3. Earnings Per Share

The Company’s earnings per share data are presented in accordance with SFAS 128, Earnings Per Share. Basic net loss per share is computed by dividing the net loss available to common stockholders for the period by the weighted average number of common shares outstanding during the period, excluding shares subject to repurchase or forfeiture. Pursuant to Statement of Financial Accounting Standards No. 128, the effect of the assumed exercise of stock options and contingently issued shares has not been included as it is antidilutive.

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NETSOLVE, INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

June 30, 2004

4. Contingencies

In December 2001, the Company and certain of its officers and directors, as well as the underwriters of its initial public offering (“IPO”) and hundreds of other companies (“Issuers”), directors and officers and IPO underwriters, were named as defendants in a series of class action shareholder complaints filed in the United States District Court for the Southern District of New York. Those cases are now consolidated under the caption In re Initial Public Offering Securities Litigation, Case No. 91 MC 92. In the amended complaint, the plaintiffs allege that the Company, certain of our officers and directors and our IPO underwriters violated section 11 of the Securities Act of 1933 based on allegations that the Company’s registration statement and prospectus failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The complaint also contains a claim for violation of section 10(b) of the Securities Exchange Act of 1934 based on allegations that this omission constituted a deceit on investors. The plaintiffs seek unspecified monetary damages and other relief.

In February 2003, the Court issued a decision denying the motion to dismiss the Section 11 claims against the Company and almost all of the other Issuers, and granting the motion to dismiss the Section 10(b) claim against the Company. The Court dismissed the Section 10(b) claim against the Company without leave to amend. In June 2003, the Issuers and plaintiffs reached a tentative settlement agreement that would, among other things, result in the dismissal with prejudice of all claims against the Issuers and their officers and directors in the IPO lawsuits. A special committee of disinterested directors appointed by the board of directors received and analyzed the settlement proposal and determined that, subject to final documentation, the settlement proposal should be accepted. Although the Company has approved this settlement proposal in principle, it remains subject to a number of procedural conditions, including formal approval by the Court. It is not feasible to predict or determine the final outcome of this proceeding, and if the outcome were to be unfavorable, the Company’s business, financial condition, cash flow and results of operations could be materially adversely affected.

5. Stock-Based Compensation Plans

Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, (“Statement 123”), prescribes accounting and reporting standards for all stock-based compensation plans, including employee stock options. As allowed by Statement 123, the Company has elected to continue to account for its employee stock-based compensation using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The Company has calculated the fair value of options granted in these periods using the Black-Scholes option-pricing model and has determined the pro forma impact on net loss.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, this option valuation model requires the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the Black-Scholes model does not necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period.

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NETSOLVE, INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

June 30, 2004

The following weighted-average assumptions were used to estimate the fair value of options:

The following table illustrates the effect on net loss and loss per share if the Company had applied the fair value recognition provisions of Statement 123 to stock-based employee compensation (in thousands, except per share data):

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NETSOLVE, INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

June 30, 2004

6. Recent Pronouncements

In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin NO. 51. FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity (“VIE”), the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity.

In October 2003, the FASB issued Staff Position No. 46-6, “Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities,” (“FSP FIN 46-6”) in which the FASB agreed to defer, for public companies, the required effective dates to implement FIN 46 for interests held in a variable interest entity or potential VIE that was created before February 1, 2003. As a result of FSP FIN 46-6, a public entity need not apply the provisions of FIN 46 to an interest held in a VIE or potential VIE until the end of the first interim or annual period ending after December 15, 2003, if the VIE was created before February 1, 2003 and the public entity has not issued financial statements reporting that VIE in accordance with FIN 46, other than in the disclosures required by FIN 46. FIN 46 may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated.

In December 2003, the FASB published a revision to FIN 46 to clarify some of the provisions and to exempt certain entities from its requirements. Under the new guidance, special effective date provisions apply to enterprises that have fully or partially applied FIN 46 prior to issuance of the revised interpretation. Otherwise, application of Interpretation 46R (“FIN 46R”) is required in financial statements of public entities that have interests in structures that are commonly referred to as special-purpose entities (“SPEs”) for periods ending after December 15, 2003. Application by public entities, other than small business issuers, for all other types of VIEs other than SPEs is required in financial statements for periods ending after March 15, 2004. The adoption of FIN 46 did not have a material impact on our results of operations or financial position.

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

Forward-looking Statements

This report and other presentations made by us contain “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. We sometimes identify forward-looking statements with such words as “expects,” “anticipates,” “intends,” “believes” or similar words indicating future events. They include, among others, statements relating to trends and projections in revenue and orders from customers for our services, company growth, sales, margin and expenses, cash flow needs and the drivers behind those trends and projections and orders from customers for our services. Although we believe that in making any such statement our expectations are based on reasonable assumptions, any such statement involves known and unknown risks and uncertainties and is qualified in its entirety by reference to the risks discussed below under RISK FACTORS and to the following factors, among others, that could cause our actual results to differ materially from those projected in such forward-looking statements: general and economic business conditions; conditions affecting the industries served by the Company; the effect of national and international political and economic conditions; the size and growth potential of the IT infrastructure management industry; trends in sales of our services and products and resulting revenues; our ability to retain current customer arrangements and develop new arrangements; our ability to develop new service offerings and the market acceptance of such offerings; our ability to maintain and develop new arrangements with resellers and network equipment manufactures; the level of any stock repurchases we may undertake; payments requested by customers regarding our WAN guarantee or any of our other services guarantees; the amount of any added costs from anticipated new sales, exploration of potential business opportunities, marketing and development efforts, our reliance on resellers, the continued development of new service offerings and competition; the outcome of pending litigation; revenues derived from AT&T and other customers; our ability to attract and retain a qualified workforce; our ability to protect our intellectual property rights; and the impact of changes in accounting rules.

Any forward-looking statement speaks only as of the date on which such statement was made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement was made or to reflect the occurrence of unanticipated events. New factors emerge from time to time and it is not possible for us to predict all of such factors, nor can we assess the impact of each such factor or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement.

Overview

We provide a range of IT infrastructure management services that allow enterprises and carriers to outsource some or all IT infrastructure-specific activities in order to increase IT infrastructure availability, performance and security while reducing overall IT infrastructure operations cost, and simplifying timely migration to new technologies. We have also licensed our software in Japan. Our first software licensing agreement occurred in the quarter ended September 30, 2001. This agreement allows another organization to utilize our technology to provide remote IT infrastructure management services to its customers in Japan. We expect the agreement will be finalized in the second quarter of fiscal year 2005. Additionally, on October 1, 2001, we announced the offering of remote IT infrastructure management for Cisco Systems, Inc. Architecture for Voice, Video and Integrated Data (AVVID) Internet Protocol Telephony (IPT).

Revenues

Our revenues consist of IT infrastructure management services revenues as well as maintenance and equipment resales. Our IT infrastructure management services include both recurring and nonrecurring revenues:

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infrastructure management services revenues are typically based on a fixed monthly fee per customer site or device and are recognized in the period in which the services are rendered. For the three months ended June 30, 2004, approximately 90% of IT infrastructure management services revenues were from recurring services.

Our IT infrastructure management services revenues are derived from contracts with telecommunications carriers, system integrators and value-added resellers of networking equipment and services, and enterprises to which we sell directly through our sales force. Our services include both initial implementation and project management services for a one-time fee per location as well as ongoing management services for a fixed monthly fee per managed device. IT infrastructure management services revenues also include software licensing, usage royalties, maintenance fees and professional fees. Our contracts with end users are generally for terms of 24 to 36 months, although customers may cancel services prior to the end of the service terms. Cancellations due to reasons other than closings of managed locations, which to date have not been material, are generally subject to cancellation fees ranging from 20% to 80% of the recurring charges payable for the remainder of the service term. Cancellation fees as a percentage of IT infrastructure management services revenues were less than 1% in fiscal year 2004 and in the three months ended June 30, 2004. We recognize revenues from cancellation fees on a cash basis unless collection is assured. Our contracts with resellers typically extend from 12 to 36 months and, in most cases, require that we continue providing services throughout the term of the reseller’s contract with the end user. In these cases, we continue to recognize revenues upon performance of the services, even if performance occurs after the term of the contract with the reseller.

Our IT infrastructure management services for WANs typically include a guarantee providing end-to-end network availability for at least 99.5% of the time in any given month. In the event the guaranteed availability is not achieved during a particular month, we generally are obligated to refund a portion, and in some cases all, of our WAN management fees for that month. This guarantee covers some components of the end user’s WAN, such as the transport services provided by the end user’s carrier, that are not directly under our control. As a result, we may, in some instances, refund amounts to customers for circumstances beyond our control. We establish a reserve against guarantees we offer for these WAN services. Historically, guarantee payments have not been material in relation to IT infrastructure management services revenues. However, in the future, refunds made under our guarantees or otherwise could have a material adverse impact on the results of our operations.

We derive maintenance and equipment revenues from the resale of customer premise equipment (CPE) maintenance contracts and from the resale of customer premise equipment, or CPE, to certain of our IT infrastructure management services resellers or customers. CPE is networking equipment which usually resides at the customer’s location and includes routers, CSUs, and LAN switches. We utilize CPE produced by Cisco and, to a lesser extent, by Bay/Nortel, Visual Networks and others. We recognize equipment revenues in the period the CPE is shipped to the customer. However, if the transaction is financed through our lease financing subsidiary, we recognize the revenues upon sale of the underlying lease contract on a nonrecourse basis. We recognize revenues from CPE maintenance contracts on a monthly basis as the services are provided. We generally only resell CPE to our IT infrastructure management services customers. Although we believe some of our customers will continue to purchase CPE from us, our strategy is to focus on our IT infrastructure management services which generate higher margins. We therefore anticipate that revenues from CPE sales will not be significant, and could decline, as we seek to manage our mix of revenues.

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We have derived a significant portion of our revenues from one reseller, AT&T, which is discussed below. In addition, in the three months ended June 30, 2004, we derived 11% of our total revenue from IBM. No other customers or resellers accounted for more than 10% of our revenues in any of the last three fiscal years or in the three months ended June 30, 2004.

At the beginning of fiscal year 2004, we had three primary reseller agreements with AT&T, one for Managed Router Service; one for Managed DSU Service marketed by AT&T as part of its Frame Relay Plus offering; and one for the management of the WAN for one large end user – The Home Depot. AT&T has sold our services to their customers in conjunction with AT&T’s overall network solution offering using AT&T’s trade and brand names. As with our other reseller arrangements, we receive our revenues for the resale of our services to AT&T customers directly from AT&T. AT&T accounted for 52% of our total revenues in fiscal year 2003, 39% of our total revenues in fiscal year 2004, and 24% of our total revenues in the three months ended June 30, 2004.

In February of 2003, we were notified by AT&T of its intention to terminate the Managed Router Service agreement over an eight-month transition period beginning July 1, 2003. In May 2003, we were notified by AT&T of its intention to terminate the Home Depot agreement in July of 2003. Primarily as a result of these terminations, total revenues from AT&T decreased to $17.9 million in fiscal year 2004 from $26.1 million in fiscal year 2003, and decreased to $2.4 million in the three months ended June 30, 2004 from $5.8 million in the three months ended June 30, 2003.

The agreement for Frame Relay Plus Service provides for NetSolve to deliver the services for the original end-user service term of each order (subject to certain exceptions specifically set forth in the agreement), up to a maximum service term of 36 months, and further provides AT&T the option to continue the services on a month-to-month basis following the expiration of the service term for individual end users. The Frame Relay Plus Service agreement with AT&T was renewed in July 2003 and terminated on June 30, 2004 with respect to placing new orders for service. Services under this agreement accounted for 23% of our total revenues in fiscal year 2003, 22% of our total revenues in fiscal year 2004, and 23% of our total revenues in the three months ended June 30, 2004. As of June 30, 2004, we are providing this service to 620 of AT&T’s end user customers and expect total revenues of $2.3 million in the quarter ending September 30, 2004. Should AT&T elect not to renew this agreement during the quarter ending September 30, 2004, a portion of this revenue could be at risk. We anticipate that this agreement will be renewed effective in October 2004 at a discount to the pricing under the current agreement.

Historically, we have generated substantially all of our revenues from sales to customers in the United States, although we manage devices in multiple locations around the world for these U.S. based customers.

We anticipate that we will grow the Company’s revenue by developing new services internally; expanding the number of reseller channels; increasing the effectiveness of our existing reseller channels; and expanding our sales and marketing function as new order rates become more predictable. We may also elect to enhance our future growth prospects by engaging in merger and acquisition (M&A) activities on an opportunistic basis.

Results of Operations

Three months ended June 30, 2003 compared to three months ended June 30, 2004

Revenues

Total revenues. Total revenues decreased 19% from $12.5 million in the three months ended June 30, 2003 to $10.1 million in the three months ended June 30, 2004.

IT infrastructure management services. Revenues from IT infrastructure management services decreased 12%, from $10.1 million in the three months ended June 30, 2003 to $8.8 million in the three months ended June 30, 2004, representing 80% of total revenues in the three months ended June 30, 2003 and 87% of total revenues in the three months ended June 30, 2004. The dollar decrease was due primarily to the termination of the AT&T Managed

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Router Service and Home Depot Agreements discussed above and to a lesser extent a decrease in implementation services due to a decrease in the level of new installations from carrier agreements utilizing those services. This decrease was partially offset by increased revenue from software licensing fees and an increase in the number of managed devices under contract through direct sales and non-AT&T channels. In the near term, revenue growth in IT infrastructure management services is expected to be relatively flat with a decrease in the level of software licensing revenues offset by an increase in the number of managed devices under contract.

Maintenance and equipment. Revenues from maintenance and equipment decreased 48%, from $2.5 million in the three months ended June 30, 2003 to $1.3 million in the three months ended June 30, 2004. Revenues from maintenance and equipment decreased primarily due to the termination of the AT&T Managed Router Service and Home Depot Agreements discussed above. We expect maintenance and equipment revenue to decrease slightly from the first quarter of fiscal year 2005 following the completion of the AT&T transition.

Costs of revenues

Cost of IT infrastructure management services. Cost of IT infrastructure management services includes salary and other costs of personnel, depreciation of equipment utilized to manage customer networks, the network management infrastructure utilized to provide IT infrastructure management services, and the costs of third-party providers of CPE installation services. Cost of IT infrastructure management services is expensed as incurred. Cost of IT infrastructure management services decreased 11%, from $6.2 million in the three months ended June 30, 2003 to $5.5 million in the three months ended June 30, 2004, representing 62% of IT infrastructure management services revenues in the three months ended June 30, 2003 and 63% in the three months ended June 30, 2004. The dollar decrease was due primarily to a decrease in the number of employees, a decrease in employee severance payments and education expenses and to a lesser extent a decrease in depreciation expense on equipment used to provide IT infrastructure management services. We expect costs of IT infrastructure management services in the second quarter of fiscal year 2005 to be similar to the first quarter as a percentage of revenue.

Cost of maintenance and equipment. Cost of maintenance and equipment includes the purchase of maintenance contracts and CPE from manufacturers and distributors for resale to resellers and end users. These costs are expensed in the period the related revenues are recognized. Cost of maintenance and equipment decreased 53%, from $1.8 million in the three months ended June 30, 2003 to $852,000 in the three months ended June 30, 2004, representing 73% of maintenance and equipment revenues in the three months ended June 30, 2003 and 66% of maintenance and equipment revenues in the three months ended June 30, 2004. The decrease in dollars and as a percentage of revenue was primarily due to the decrease in lower margin maintenance revenue as a result of the termination of the AT&T Managed Router Service and Home Depot Agreements discussed above. We expect costs of maintenance and equipment as a percentage of revenue to increase in the second quarter of fiscal year 2005 compared to the first quarter of fiscal year 2005.

Operating expenses

Development. Development expenses consist primarily of salaries and related costs of development personnel, including contract programming services. Development employees are responsible for developing internal software systems, selecting and integrating purchased software applications, developing software tools for our IT infrastructure management services, developing our Web-enabled software applications that provide customers access to IT infrastructure management information, and defining and developing operating processes for new services. Development expenses decreased 26% from $1.5 million in the three months ended June 30, 2003 to $1.1 million in the three months ended June 30, 2004, representing 12% of total revenues in the three months ended June 30, 2003 and 11% in the three months ended June 30, 2004. The decrease in dollars and as a percentage of revenue was primarily due to a decrease in contract programming services. We expect development expenses to remain relatively flat as a percent of revenue in the near term.

Selling and marketing. Selling and marketing expenses consist primarily of salaries, commissions, travel and costs associated with creating awareness of our services. Sales and marketing expenses increased 4%, from $2.1

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million in the three months ended June 30, 2003 to $2.2 million in the three months ended June 30, 2004, representing 17% of total revenues in the three months ended June 30, 2003 and 22% in the three months ended June 30, 2004. The increase in dollars and as a percentage of revenue was due to our decision to increase spending in this area in an effort to expand and increase new business. The increase in spending was due primarily to the addition of sales personnel. This increase was partially offset by a decrease in spending on marketing programs. We expect selling and marketing expenses to remain relatively flat as a percent of revenue in the near term.

General and administrative. General and administrative expenses consist primarily of expenses related to our human resources, finance and executive departments. Included in human resources spending is a majority of costs of recruiting and relocating new employees. General and administrative expenses decreased 25%, from $1.5 million in the three months ended June 30, 2003 to $1.1 million in the three months ended June 30, 2004, representing 12% of total revenues in the three months ended June 30, 2003 and 11% in the three months ended June 30, 2004. The dollar and percentage decrease was due primarily to approximately $276,000 related to exploration of potential M&A activities which occurred in the previous year and to a lesser extent decreased costs related to a decrease in the number of general and administrative personnel. We expect general and administrative expenses to remain relatively flat as a percent of revenue in the near term excluding potential one time costs of approximately $300,000 for a special project.

Other income, net

Other income, net consists primarily of interest income earned on our cash balances. Other income, net decreased from $165,000 in the three months ended June 30, 2003 to $72,000 in the three months ended June 30, 2004, representing 1% of total revenues in the three months ended June 30, 2003 and 2004. The decrease was primarily due to lower average interest rates earned on invested cash during the three months ended June 30, 2004 compared to the three months ended June 30, 2003 and to a lesser extent lower average cash balances.

Income Tax

During the quarter ended June 30, 2004 we recorded an income tax benefit of approximately $204,000, which includes a current foreign income tax provision of $26,000 and a deferred domestic income tax benefit of $230,000.

As of June 30, 2004, we had net operating loss carryforwards of approximately $6.9 million available to offset future net income for U.S. federal income tax purposes. These net operating loss carryforwards will expire beginning in 2005, if not utilized. We have alternative minimum tax credit carryforwards of $302,000 which do not expire. We also have foreign tax credits of $338,000 that expire beginning in 2006 if not utilized. Our utilization of these net operating loss and tax credit carryforwards may be subject to a substantial annual limitation due to the “change in ownership” provisions of the Internal Revenue Code. The annual limitation may result in the expiration of the net operating losses before utilization.

A valuation allowance has been provided to offset a portion of the deferred tax assets related to foreign tax credits. At this time, the Company believes that it is more likely than not that the balance of the deferred tax assets will be utilized. Future operating results and projections could alter these conclusions, potentially resulting in the recording of an additional benefit or a valuation allowance.

Quarterly results of operations

Results of operations have varied from quarter to quarter. Accordingly, we believe that period-to-period comparisons of results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Our operating results may fluctuate as a result of many factors, including our ability to renew or retain existing end user and reseller relationships, our ability to successfully enter into new reseller or end user relationships, our ability to develop and market new service offerings, the cost of introducing such offerings and the profitability thereof, and the level and nature of competition. Further, we may be unable to adjust spending rapidly enough to compensate for any significant fluctuations in the number of new managed devices implemented in a given

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period. Any significant shortfall in the number of new managed devices could therefore seriously damage our business. Finally, there can be no assurance that we will continue to be profitable in the future or, if we are profitable, that our levels of profitability will not vary significantly between quarters.

Liquidity and capital resources

Net cash provided by operating activities during the three month periods ended June 30, 2003 and June 30, 2004 was $2.6 million and $831,000, respectively.

We used $1.6 million during the three months ended June 30, 2003 and $279,000 in the three months ended June 30, 2004 to purchase capital assets used in the delivery of our network management services. We currently have no material commitments for capital expenditures.

We have approval from our Board of Directors to purchase up to an aggregate of six million shares of our common stock, including those previously repurchased. Since the inception of the stock repurchase program, the Company has repurchased 4.5 million shares of its common stock at an aggregate price of approximately $30.9 million. The extent and timing of any additional repurchases will depend on market conditions and other business considerations. Repurchased shares may be held in treasury for general corporate purposes, including use in connection with the Company’s stock option plans, or may be retired. There were no repurchases of our common stock in the three months ended June 30, 2004.

As of June 30, 2004, we had $40.8 million in cash and short-term investments, $3.4 million in net accounts receivable and $44.9 million in working capital. We believe that our current cash balances, together with cash generated from operations, will be sufficient to fund our anticipated working capital needs, capital expenditures and stock buy back program. Our current cash balances are kept in short-term, investment-grade, interest-bearing securities pending their use. In the event our plans or assumptions change or prove to be inaccurate, or if we consummate any unplanned acquisitions of businesses or assets, we may be required to seek additional sources of capital. Sources of additional capital may include public and private equity and debt financings, sales of nonstrategic assets and other financing arrangements.

As of June 30, 2004, we have no debt or off-balance sheet debt. As of June 30, 2004, we have noncancelable operating lease obligations of approximately $3.3 million. At June 30, 2004, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we were engaged in such relationships.

Critical Accounting Policies

General

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and assumptions are reviewed periodically. Actual results may differ from these estimates under different assumptions or conditions.

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Revenue Recognition

IT infrastructure management services revenues are recognized in the period services are provided by NetSolve, whether sold directly or through resellers, based upon rates established by contract. These amounts are adjusted to the extent of any reserves affecting the realization of these revenues as described below. The typical contract terms are from 24 to 36 months and provide for one-time services, consisting primarily of project implementation services at a fixed fee per customer site or device, as well as recurring services which are provided at a fixed monthly fee per customer site or device over the life of the contract. Revenues for project implementation services are recognized upon completion of the assignment or service, and recurring revenues are recognized on a monthly basis as the services are performed. Revenue from software licensing arrangements is deferred and amortized on a straight-line basis over the licensing agreement’s term. Revenue from software royalty fees are based on a flat fee per device and are recognized monthly. Equipment revenues are recognized in the period the equipment is shipped to the customer. Equipment revenues from assets leased by the Company’s lease financing subsidiary are recognized upon the sale of the equipment and the related lease to a third-party lessor on a nonrecourse basis following installation of the equipment. Other revenues, which consist primarily of equipment maintenance services, are recognized in the period services are provided.

Receivables

We continuously monitor collections and payments from our customers and maintain allowances for doubtful accounts based upon our historical experience and any specific customer collection issues that we have identified. While losses due to bad debt have historically been within our expectations, there can be no assurance that we will continue to experience the same level of bad debt losses that we have in the past. In addition, a significant amount of our revenues and accounts receivable are concentrated in AT&T and IBM. A significant change in the liquidity or financial position of either of these companies could have a material adverse impact on the collectability of our accounts receivable and our future operating results, including a reduction in future revenues and additional allowances for doubtful accounts.

Availability Reserve

The Company’s remote IT infrastructure management services for WANs typically include a guarantee providing end-to-end network availability for at least 99.5% of the time in any given month. In the event the guaranteed availability is not achieved, the Company generally is obligated to refund its WAN management fees for that month. The Company provides a reserve based on the estimated costs of these refunds. Historically, guarantee payments have not been significant.

Risk Factors

We may be unable to implement our business strategy and achieve profitability.

We may not operate profitably. Our ability to regain profitability depends, among other things, on our ability to implement our business strategy, which includes broadening and increasing the effectiveness of our base of reseller channels and broadening our service offerings, and on increasing sales of our services while maintaining sufficient gross profit margins. We must, among other things:

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Our revenues will decline significantly and our business will be adversely affected if we are not successful in renewing the AT&T Frame Relay Plus agreement or if AT&T discontinues, or materially reduces, that business with us.

Our Frame Relay Plus agreement with AT&T is not an exclusive arrangement. We cannot assure that AT&T will renew that agreement or that any renewal will be on favorable terms. Even if this agreement is renewed, the anticipated price reductions could significantly reduce the gross margins from this business in both dollar and percentage of revenue terms. Further, even with a renewal of this agreement, AT&T may not continue to sell our services to existing or additional AT&T customers or continue to utilize our services following the June 30, 2004 expiration of the service terms set forth in this agreement. A reduction in this business from any cause would result in diminished revenues for an extended period of time as we attempted to replace that business.

Our quarterly results may fluctuate and cause the price of our common stock to fall.

Our revenues and results of operations are difficult to predict and may fluctuate significantly from quarter to quarter. If either our revenues or results of operations fall below the expectations of investors or public market analysts, the price of our common stock could fall dramatically.

Our revenues are difficult to forecast and may fluctuate for a number of reasons including:

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Most of our expenses, particularly employee compensation and rent, are relatively fixed. As a result, variations in the timing of revenues could significantly affect our results of operations from quarter to quarter and could result in quarterly losses.

We must establish relationships with additional resellers in order to increase our revenues and become consistently profitable.

We expect to continue to rely on resellers such as data networking value-added resellers and integrators and, to a lesser extent, telecommunications carriers to market our services. We must establish, develop and maintain these alternative sales channels in order to increase our revenues and become consistently profitable. We must maintain a positive relationship with Cisco to maintain and add relationships with their resellers, many of which are current or potential resellers of our services. We have a limited history of developing these sales channels, and we have established productive relationships with only a few resellers. While we have gained additional experience in managing sales through resellers, we have not yet achieved consistent results from such sales. Except for AT&T and IBM, these resellers have not generated significant sales of our services to date and may not succeed in marketing our services in the future.

Our agreements with resellers, including AT&T and IBM, generally do not require that the resellers sell any minimum level of our services and generally do not restrict the resellers’ development or sale of competitive services. We cannot be sure that these resellers will dedicate resources or give priority to selling our services. In addition, resellers may seek to make us reduce the prices for our services in order to lower the total price of their equipment, software or service offerings. Our resellers could use their own internal resources or third parties to replace our services as end user order terms expire.

Our future operating results may vary by season, which will make it difficult to predict our future performance.

As a result of seasonal factors, we believe that quarter-to-quarter comparisons of our results of operations are not necessarily meaningful. These factors may adversely affect our operating results or cause our operating results to fluctuate, resulting in a decrease in our stock price. Quarterly results of operations should not be relied upon to predict our future performance.

Our bookings may be slower during the months of July and August due to the vacation schedules of our resellers’ sales and marketing employees. This situation may lead to lower levels of revenues earned during the following fiscal quarter, which ends December 31.

Our revenues during our third and fourth fiscal quarters may be more volatile and difficult to predict due to the budgeting and purchasing cycles of our end users. End users often purchase our services at the same time they purchase new network equipment such as routers. As a result, the timing of their large capital expenditures could affect the timing of their purchases of our services. Some end users may not be able to purchase network equipment and our services near the end of a calendar year due to depleted budgets. Other end users may accelerate purchases in order to use an unspent portion of their budget.

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The market for our services is still evolving, and our business will be seriously damaged if the market does not develop as we expect.

Our long-term viability depends significantly upon the acceptance and use of IT infrastructure management services. The market for remote IT infrastructure management services is still evolving. This market environment makes it more difficult to determine the size and growth of the market and to predict how this market will develop. Changes in technology, the ability of manufacturers of networking equipment to reduce operating complexity, the availability of qualified information technology professionals and other factors that make internal IT infrastructure management more cost-effective than remote IT infrastructure management would adversely affect the market for our services. We may also incur fixed costs associated with new services which could lower our earnings if the sales of these services fail to meet our expectations. Our business may be seriously damaged if this market fails to grow, grows more slowly than we expect or develops in some way that is different from our expectations.

Reseller relationships may adversely affect our business by weakening our relationships with end users, decreasing the strength of our brand name and limiting our ability to sell services directly to resellers’ customers.

Our strategy of selling our services primarily through resellers may result in our having weaker relationships with the end users of our services. This may inhibit our ability to gather customer feedback that helps us improve our services, develop new services and monitor customer satisfaction. We may also lose brand identification and brand loyalty, since our services may be identified by private label names or may be marketed differently by our resellers. A failure by any of our resellers to provide their customers with satisfactory products, services or customer support could injure our reputation and seriously damage our business. Our agreements with resellers may limit our ability to sell our services directly to the resellers’ customers in the future. If our resellers do not compete successfully against their competitors, we will typically lose such sales opportunities to those competitors.

Any material decrease in sales of our WAN management services will significantly reduce our total revenues and adversely affect our business.

Competitive pressures, general declines in the levels of new wide area network, or WAN, installations or other factors that adversely affect sales of our WAN management services or that cause significant decreases in the prices of our WAN management services could significantly limit or reduce our revenues. Sales of our ProWatch for WANs and similar WAN management services accounted for 81% of our recurring network management services revenues in fiscal year 2004 and 74% in the three months ended June 30, 2004. Likewise, a substantial portion of our nonrecurring network management services and equipment maintenance resale revenues depend on the successful sale of these WAN management services. We expect that these WAN management services will continue to generate a significant portion of our revenues for the foreseeable future. Our financial performance therefore depends directly on continued market acceptance of our WAN management services, and our ability to reduce costs and introduce enhanced versions of these services that make these services more efficient and economical as the market matures.

Our failure to develop and sell additional services could impair our financial results and adversely affect our business.

Our future financial performance will depend in part on our ability to develop, introduce and sell new and enhanced IT infrastructure management services other than WAN management services, including services that:

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Although we have developed new services, such as IT infrastructure management services for local area networks, or LANs, servers, network security services and IP Telephony, we have not derived significant revenues from these services to date. We cannot be sure that we will be successful selling these services or developing additional services on time or on budget. The development of new services is a complex and uncertain process. The rapidly evolving market for remote IT infrastructure management services makes it difficult to determine whether a market will develop for any particular IT infrastructure management service. If we succeed in increasing the percentage of our revenues that is derived from resellers, we may have weaker relationships with the end users of our services, making it even more difficult for us to identify services acceptable to our target market. We cannot assure that future technological or industry developments will be compatible with our business strategy or that we will be successful in responding to these changes in a timely or cost-effective manner. Our failure to develop and sell services other than WAN management services could seriously damage our business.

Our business may be harmed if we lose the services of any member of our management team without appropriate succession and transition arrangements.

Our ability to continue to build our business and meet our goals going forward depends to a significant degree on the skills, experience and efforts of each member of our management team. We do not have employment contracts requiring any of our personnel, including the members of our management team, to continue their employment for any period of time, and we do not maintain key man life insurance on any of our personnel, including our executive officers. The loss of the expertise of any member of our management team without appropriate succession and transition arrangements could seriously damage our business.

We made a number of changes in our management team in the last fiscal year, and our business will be harmed if our new management team is unable to implement our strategy.

During fiscal years 2003 and 2004, we made several changes and additions to our management team, including a new chief executive officer, and new leaders over our service delivery, marketing, sales, development, program management and human resources areas. We believe that the individuals now comprising our management team bring experience to help us create, implement and drive our business strategy, and add breadth and depth of capability to our organization. While each new member of our management team has demonstrated capabilities in previous positions at other organizations, they are new to NetSolve. The effective execution of our business strategy will depend in large part on how well our management team and other personnel perform in their positions.

In order to support our business, we must continue to hire information technology professionals, who are in short supply.

We derive all of our revenues from IT infrastructure management services and related resales of equipment. These services can be extremely complex, and in general only highly qualified, highly trained IT professionals have the skills necessary to develop and provide these services. In order to continue to support our current and future business, we need to attract, motivate and retain a significant number of qualified IT professionals. Qualified IT professionals are in short supply, and we face significant competition for these professionals, from not only our competitors but also our end users, marketing partners and other companies throughout the IT infrastructure services industry. Other employers may offer IT professionals significantly greater compensation and benefits or more attractive career paths or geographic locations than we are able to offer. Any failure on our part to hire, train and retain a sufficient number of qualified IT professionals would seriously damage our business.

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We could incur significant costs if we are unable to retain our information technology professionals.

Because of the limited availability of highly qualified, highly trained IT professionals, we seek to hire persons who have obtained college bachelor’s degrees and then train those persons to provide our services. As a result, we invest a significant amount of time and money in training these new employees before they begin to support our business. We do not enter into employment agreements requiring these employees to continue in our employment for any period of time. Departures of trained employees could limit our ability to generate revenues and would require us to incur additional costs in training new employees.

We currently compete largely with our customers’ internal solutions and see increasing competition from other IT infrastructure management services companies.

To compete successfully, we must respond promptly and effectively to the challenges of technological change, evolving standards and our competitors’ innovations by continuing to enhance our services, as well as our sales programs and channels. Any pricing pressures, reduced margins or loss of market share resulting from increased competition, or our failure to compete effectively, could seriously damage our business.

We face competition from different sources. Currently, a major source of competition is the internal network administration organizations of our end users and resellers. These organizations may have developed tools and methodologies to manage their network processes and may be reluctant to adopt applications offered by third parties like us.

If the market for outsourced IT infrastructure management services grows as we expect, we believe this market will become highly competitive. Competition is likely to increase significantly as new IT infrastructure management services companies enter the market and current competitors expand their service and product lines. Many of these potential competitors are likely to enjoy substantial competitive advantages, as do some of our current competitors, including:

If our operations are interrupted, we may lose customers and revenues.

We must be able to operate our network management infrastructure 24 hours a day, 365 days a year without interruption. If our operations are interrupted, we may lose customers and revenues. All of our IT infrastructure management services are provided remotely from our network management center, which is located at a single site in Austin, Texas. We currently have a geographically separate disaster recovery location with redundant systems. However, in order to operate without undue risk of interruption, we must guard against:

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Any interruptions could:

Our revenues would decline and our business would be adversely affected if the networking equipment and carrier services we support become obsolete or are otherwise not used by a large part of our target market.

As part of our strategy, we have elected to support only selected providers of network equipment and carrier services. For example, we support routers manufactured by 3Com, Bay/Nortel and Cisco, but not by other equipment providers. Our services cannot be used by companies with networking equipment and carrier services that we do not support. Our business would be seriously damaged if, in the future, the networking equipment manufacturers and carrier services that we support were not the predominant providers to our target market or if their equipment or services became unavailable or significantly more expensive. Technological advances that make obsolete any of the networking equipment and carrier services that we support, or that offer significant economic or functional advantages over the equipment and services, also could limit or reduce our revenues or could force us to incur significant costs attempting to support other networking equipment and carrier services.

We may be unable to protect our intellectual property, and we could incur substantial costs enforcing our intellectual property against infringers or defending claims of infringement made by others.

Our business and financial performance depends to a significant degree upon our software and other proprietary technology. The software industry has experienced widespread unauthorized reproduction of software products. We have three patents. The steps we have taken may not be adequate to deter competitors from misappropriating our proprietary information, and we may not be able to detect unauthorized use and take appropriate steps to enforce our intellectual property rights.

We could be the subject of claims alleging infringement of third-party intellectual property rights. In addition, we may be required to indemnify our distribution partners and end users for similar claims made against them. Any infringement claim could require us to spend significant time and money in litigation, pay damages, develop non-infringing intellectual property or acquire licenses to intellectual property that is the subject of the infringement claims. As a result, any infringement claim could seriously damage our business.

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company invests its cash in money market funds or instruments which meet high credit quality standards specified by the Company’s investment policy. The Company does not use financial instruments for trading or other speculative purposes.

Item 4. CONTROLS AND PROCEDURES

We carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon that evaluation, our principal executive officer and principal financial officer concluded that disclosure controls and procedures were effective, in all material respects, to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported in a timely manner. There has been no change in our internal control over financial reporting during the period covered by this report, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

In December 2001, the Company and certain of its officers and directors, as well as the underwriters of its initial public offering (“IPO”) and hundreds of other companies (“Issuers”), directors and officers and IPO underwriters, were named as defendants in a series of class action shareholder complaints filed in the United States District Court for the Southern District of New York. Those cases are now consolidated under the caption In re Initial Public Offering Securities Litigation, Case No. 91 MC 92. In the amended complaint, the plaintiffs allege that the Company, certain of our officers and directors and our IPO underwriters violated section 11 of the Securities Act of 1933 based on allegations that the Company’s registration statement and prospectus failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The complaint also contains a claim for violation of section 10(b) of the Securities Exchange Act of 1934 based on allegations that this omission constituted a deceit on investors. The plaintiffs seek unspecified monetary damages and other relief.

In February 2003, the Court issued a decision denying the motion to dismiss the Section 11 claims against the Company and almost all of the other Issuers, and granting the motion to dismiss the Section 10(b) claim against the Company. The Court dismissed the Section 10(b) claim against the Company without leave to amend. In June 2003, the Issuers and plaintiffs reached a tentative settlement agreement that would, among other things, result in the dismissal with prejudice of all claims against the Issuers and their officers and directors in the IPO lawsuits. A special committee of disinterested directors appointed by the board of directors received and analyzed the settlement proposal and determined that, subject to final documentation, the settlement proposal should be accepted. Although the Company has approved this settlement proposal in principle, it remains subject to a number of procedural conditions, including formal approval by the Court. It is not feasible to predict or determine the final outcome of this proceeding, and if the outcome were to be unfavorable, the Company’s business, financial condition, cash flow and results of operations could be materially adversely affected.

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

NetSolve held its Annual Meeting of Stockholders on July 14, 2004. The following item was presented to the stockholders with the following results:

Item 5. OTHER INFORMATION

Pursuant to Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002, we are responsible for disclosing the approval of non-audit services by the audit committee of our board of directors (the “Audit Committee”) to be performed by Ernst & Young LLP, our independent auditors. Non-audit services are defined as services other than those provided in connection with an audit or a review of our financial statements. The services approved by the Audit Committee are each considered by the Audit Committee to be audit-related services that are closely related to the financial audit process. Each of the services was pre-approved by the Audit Committee.

The Audit Committee has pre-approved additional engagements of Ernst & Young LLP for the non-audit services of preparation of state and federal tax returns.

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Item 6. EXHIBITS AND REPORTS ON FORM 8-K

On April 22, 2004, the Company filed a Form 8-K reporting under Item 12 “Results of Operation and Financial Condition” the Company’s press release, dated April 22, 2004, regarding its 2004 fiscal year-end and fourth quarter results of operations and financial condition.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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