This section contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of a variety of factors and risks including the impact of the weakness in the U.S. and international economies on our business, our inability to manage our future growth effectively or profitably, fluctuations in our revenue and quarterly results, our license renewal rate, the impact of competition and our ability to maintain margins or market share, the limited market for our common stock, the volatility of the market price of our common stock, the performance of our products, our ability to respond to rapidly evolving technology and customer requirements, our ability to protect our proprietary technology, the security of our software, our dependence on our management team and key personnel, our ability to hire and retain future key personnel, or our ability to maintain an effective system of internal controls. These and other risks are more fully described herein and in our other filings with the Securities and Exchange Commission.

This section should be read in combination with the accompanying audited consolidated financial statements and related notes prepared in accordance with United States generally accepted accounting principles.

Overview

Bridgeline Digital enables its customers to maximize the performance of their mission critical websites, intranets, and online stores. Bridgeline is the developer of the award-winning iAPPS® Web Engagement Management (WEM) product platform and related digital solutions. The iAPPS platform deeply integrates Web Content Management, eCommerce, eMarketing, and web Analytics capabilities within the heart of websites or eCommerce web stores to help marketers deliver online experiences that attract, engage, and convert their customers across all digital channels. Bridgeline's iAPPS platform combined with its digital services assists customers in maximizing on-line revenue, improving customer service and loyalty, enhancing employee knowledge, and reducing operational costs.

The iAPPS platform is delivered through a Cloud-based SaaS ("Software as a Service") multi-tenant business model, whose flexible architecture provides customers with state of the art deployment providing maintenance, daily technical operation and support; or via a traditional perpetual licensing business model, in which the iAPPS software resides on a dedicated server in either the customer's facility or Bridgeline's co-managed hosting facility.

In 2012, KMWorld Magazine Editors selected Bridgeline Digital as one of the 100 Companies That Matter in Knowledge Management and also selected iAPPS as a Trend Setting Product in 2012. iAPPS Content Manager and iAPPS Commerce were selected as finalists for the 2011 and 2012 CODiE Awards for Best Content Management Solution and Best Electronic Commerce Solution, globally. iAPPS Content Manager was the winner of the 2010 CODiE Award for Best Content Management Solution, globally. B2B Interactive has selected Bridgeline Digital as one of the Top Interactive Technology companies in the United States.

Bridgeline Digital was incorporated under the laws of the State of Delaware on August 28, 2000.

Locations

The Company's corporate office is located in Burlington, Massachusetts. The Company maintains regional field offices serving the following geographical locations: Atlanta, GA; Baltimore, MD; Boston, MA; Chicago, IL; Dallas, TX; Denver, CO; New York, NY; Philadelphia, PA; and Tampa, FL. The Company has one wholly-owned subsidiary, Bridgeline Digital Pvt. Ltd. located in Bangalore, India.

Sales and Marketing

Bridgeline employs a direct sales force and each sale takes on average 60 to 180 days to complete. Our direct sales force focuses its efforts selling to medium-sized and large companies. These companies are generally categorized in the following vertical markets: (i) financial services, (ii) consumer products and goods (iii) health services and life sciences, (iv) high technology, (software and hardware), (v) retail brand names, (vi) transportation and storage, and (vii) associations and foundations.

We have nine geographic locations in the United States with full-time professional direct sales personnel. Our geographic locations are in the metropolitan Atlanta, Baltimore, Boston, Chicago, Dallas, Denver, New York, Philadelphia, and Tampa areas.

We have a value added reseller channel to supplement our direct sales force for our iAPPS platform. Our value added resellers are generally located in territories where we do not have a direct sales force.

We have dedicated business development professionals whose mission is to identify and establish strategic alliances for iAPPS and iAPPS ds. In June 2012, Bridgeline announced a strategic alliance with UPS Logistics. Bridgeline and UPS Logistics signed a multi-year agreement to offer B2B and B2C eCommerce web stores with an end-to-end eCommerce offering comprised of Bridgeline's eCommerce Fulfilled™ solution and UPS Logistics and fulfillment services. The combined Bridgeline and UPS Logistics offering provides customers with the ability to manage the eCommerce and supply chain fulfillment needs and was designed to benefit mid-market and larger online web stores who seek end to end solutions.

In July of fiscal 2012 Bridgeline signed a multi-year agreement with a large national franchise network of over 4,300 locations who will license the iAPPS ds platform.

We believe pursuing other significant alliances will enhance the sales and distribution opportunities of iAPPS related intellectual property.

Acquisitions

Bridgeline will continue to evaluate expanding its distribution of iAPPS and its interactive development capabilities throughout North America through acquisitions. Due to the nature of our sales process and delivery requirements, we believe local staff is required in order to maximize market-share objectives.

We believe the web application development market in North America and Europe is growing and fragmented. We believe established yet small web application development companies have the ability to market, sell and install our iAPPS platform in their local metropolitan markets. We believe these companies also have a .NET customer base and a niche presence in the local markets in which they operate. We believe there is an opportunity for us to acquire companies that specialize in web application development that are based in large North American cities in which we currently do not operate. We believe that by acquiring certain of these companies and applying our business practices and efficiencies, we can accelerate our time to market of the iAPPS platform.

During the fiscal year ended September 30, 2012 we completed two acquisitions. On October 3, 2011, we completed the acquisition of Magnetic Corporation ("Magnetic"), a Tampa, Florida based interactive technology company. We acquired all of the outstanding capital stock of Magnetic for consideration consisting of
(i) $150 thousand in cash (ii) assumption of $130 thousand of indebtedness and
(iii) contingent consideration of up to $600 thousand in cash and 166,666 shares of Bridgeline Digital common stock. The contingent consideration is payable quarterly over the 12 consecutive calendar quarters following the acquisition, contingent upon the acquired business achieving certain quarterly revenue and quarterly operating income targets during the period. The contingent common stock has been issued and is being held in escrow pending satisfaction of the applicable targets. To the extent that either the quarterly revenue targets or the quarterly operating income targets are not met in a particular quarter, the earn-out period will be extended for up to four additional quarters.

On May 31, 2012, we completed the acquisition of Marketnet, Inc. ("Marketnet"), an interactive technology company based in Dallas, Texas. Bridgeline acquired all of the outstanding capital stock of Marketnet for consideration consisting of (i) $20 thousand in cash, (ii) assumption of debt of $244 thousand and (ii) contingent consideration of up to $650 thousand in cash and 204,331 shares of Bridgeline Digital common stock. This contingent consideration is payable quarterly over the 12 consecutive calendar quarters following the acquisition, contingent upon the acquired business achieving certain quarterly revenue and quarterly operating income targets during the period. To the extent that either the quarterly revenue target or the quarterly operating income target is not met in a particular quarter, the earn-out period will be extended for up to four additional quarters. Marketnet is also eligible to earn additional bonus equity consideration of 200,000 shares, if annual net revenues of the acquired business exceed a certain threshold in any fiscal year through September 30, 2015. The contingent common stock has been issued and is being held in escrow pending satisfaction of the applicable targets.

Each of Magnetic and Marketnet's operating results are reflected in the condensed consolidated financial statements as of the acquisition date.

We did not complete any acquisitions in the fiscal year ended September 30, 2011.

We may make additional acquisitions in the foreseeable future. These potential acquisitions are consistent with our iAPPS platform distribution strategy and growth strategy by providing Bridgeline with new geographical distribution opportunities, an expanded customer base, an expanded sales force and an expanded developer force. In addition, integrating acquired companies into our existing operations allows us to consolidate the finance, human resources, legal, marketing, research and development of the acquired businesses with our own internal resources, hence reducing the aggregate of these expenses for the combined businesses and resulting in improved operating results.

Customer Information

We currently have over 500 active customers. For the years ended September 30, 2012 and 2011 no one customer represented 10% or more of the Company's total revenue.

Summary of Results of Operations

Total revenue for the fiscal year ended September 30, 2012 ("fiscal 2012") increased to $26,296 thousand from $26,267 thousand for the fiscal year ended September 30, 2011 ("fiscal 2011"). Loss from operations for fiscal 2012 was ($602) thousand compared with loss from operations of ($547) thousand for fiscal 2011. We had a net loss for fiscal 2012 of ($945) thousand compared with a net loss of ($782) thousand for fiscal 2011. Loss per share for fiscal 2012 was ($0.07) compared with loss per share of ($0.06) for fiscal 2011.

Highlights of Fiscal 2012

Highlights of fiscal 2012 include the achievement of record revenues, record iAPPS license sales and key iAPPS product releases and updates:

· Bridgeline achieved record revenues in fiscal 2012 of $26,296,000.
· Total iAPPS related revenue increased 37% to $16.6 million in fiscal 2012 from $12.1 million in fiscal 2011.
· Recurring revenue, which reflects amounts that are contractually due to Bridgeline, increased 27% to $4.2 million in fiscal 2012 from $3.3 million in fiscal 2011.
· Bridgeline sold a record number of iAPPS licenses within fiscal 2012. The 267 new iAPPS licenses during fiscal 2012 was a 25% increase compared to licenses sold during fiscal 2011.

· In the third quarter of fiscal 2012 Bridgeline announced that United Parcel Service ("UPS") signed a multi-year partnership agreement with Bridgeline to offer B2B and B2C eCommerce web stores with an end-to-end offering comprised of Bridgeline's eCommerce Fulfilled™ solution and UPS logistics and fulfillment services.
· In the fourth quarter of fiscal 2012 Bridgeline announced the release of new poduct, iAPPS distributed subscription ("iAPPS ds"), a platform that empowers large franchise and dealer networks with state-of-the-art web engagement management while providing superior oversight of corporate branding. iAPPS ds deeply integrates content management, eCommerce, eMarketing and web analytics and is a self-service web platform that is offered to each authorized franchise or dealer for a monthly subscription fee.
· In July of fiscal 2012 Bridgeline signed a multi-year agreement with a large national franchise network of over 4,300 locations who will license the iAPPS ds platform.
· Bridgeline released two versions of the iAPPS platform during fiscal 2012. In the first quarter of fiscal 2012 Bridgeline released iAPPS version 4.7 which provided many international eCommerce enhancements including multilingual and multi-currency support along with improvements in how iAPPS handles international fulfillment, tax and regulations logistics. In the third quarter of fiscal 2012 Bridgeline released iAPPS version 4.8 which offered full integration of front- and back-end eCommerce capabilities with built-in warehouse management and inventory control.

· During the fiscal year Bridgeline continued its geographic expansion strategy with two acquisitions; Magnetic Corporation and Marketnet, Inc. These acquisitions expanded Bridgeline's footprint into the Tampa and Dallas regions.

RESULTS OF OPERATIONS

                                                      Year Ended September 30,
                                                                        $               %
(dollars in thousands)                   2012           2011          Change         Change

Revenue
Web application development
services
iAPPS application development
services                              $   13,493     $    9,531     $    3,962              42 %
% of total revenue                            51 %           36 %
Other application development
services                                   7,775         12,342         (4,567 )           (37 %)
% of total revenue                            30 %           47 %
Subtotal web application
development services                      21,268         21,873           (605 )            (3 %)
% of total revenue                            81 %           83 %
Managed service hosting                    2,517          2,006            511              25 %
% of total revenue                            10 %            8 %
Subscription and perpetual licenses        2,511          2,388            123               5 %
% of total revenue                             9 %            9 %
Total revenue                             26,296         26,267             29               0 %

Cost of revenue

Web application development
services
iAPPS application development cost         6,342          4,485          1,857              41 %
% of iAPPS application development
revenue                                       47 %           47 %
Other application development cost         4,607          7,386         (2,779 )           (38 %)
% of other application development
revenue                                       59 %           60 %
Subtotal web application
development services                      10,949         11,871           (922 )            -8 %
% of Web application development
services revenue                              51 %           54 %
Managed service hosting                      372            443            (71 )           (16 %)
% of managed service hosting                  15 %           22 %
Subscription and perpetual licenses          450            681           (231 )           (34 %)
% of subscription and perpetual
licenses revenue                              18 %           29 %
Total cost of revenue                     11,771         12,995         (1,224 )            -9 %
Gross profit                              14,525         13,272          1,253               9 %
Gross profit margin                         55.2 %         50.5 %

Operating expenses
Sales and marketing                        7,730          6,738            992              15 %
% of total revenue                            29 %           26 %
General and administrative                 3,931          3,880             51               1 %
% of total revenue                            15 %           15 %
Research and development                   1,456          1,866           (410 )           (22 %)
% of total revenue                             6 %            7 %
Depreciation and amortization              1,729          1,340            389              29 %
% of total revenue                             7 %            5 %
Impairment of intangible asset               281              -            281              NA
% of total revenue                             1 %            0 %
Total operating expenses                  15,127         13,824          1,303               9 %
% of total revenue                            58 %           53 %

Loss from operations                        (602 )         (552 )          (50 )             9 %
Interest income (expense), net              (276 )         (211 )          (65 )            31 %
Loss before income taxes                    (878 )         (763 )         (115 )            15 %
Provision for income taxes                    68             24             44             183 %
Net loss                              $     (946 )   $     (787 )   $     (159 )            20 %

Adjusted EBITDA                       $    1,964     $    1,527     $      437              29 %

Revenue

Our revenue is derived from three sources: (i) web application development services (ii) managed service hosting and (iii) subscription and perpetual licenses.

Web Application Development Services

Web application development services revenue is comprised of iAPPS development related services and other web development related services generated from non iAPPS related engagements. Total revenue from web application development services decreased $605 thousand, or 3%, to $21.3 million for the year ended September 30, 2012 ("fiscal 2012). However, revenue from iAPPS related application development services increased $4.0 million, or 42% to $13.5 million compared to the year ended September 30, 2011 ("fiscal 2011") as we continue to concentrate on selling higher-margin iAPPS engagements to both new and existing customers. The decrease in web application development services revenue compared to the prior period is due to a decrease in non-iAPPS application development services revenues of $4.6 million attributable to a stoppage in non-iAPPS related development services from a customer due to a loss of their funding, as well as our decision to stop servicing low margin non-iAPPS opportunities.

Web application development services revenue as a percentage of total revenue decreased to 81% from 83% in the prior period. The decrease is attributable to a larger mix of iAPPS license related revenue and managed service hosting revenue as compared to sales of web application development services.

Managed Service Hosting

Revenue from managed service hosting increased $511 thousand, or 25%, to $2.5 million from $2.0 million in fiscal 2011. The increase is attributable to incremental revenues generated from our fiscal 2012 acquisitions and, to a lesser extent, revenue from iAPPS related hosting arrangements for perpetual licenses sold.

Managed services revenue as a percentage of total revenue increased to 10% from 8% in fiscal 2011 due to the incremental revenue from our acquisitions.

Subscription and Perpetual Licenses

Revenue from subscription and perpetual licenses increased $123 thousand, or 5%, to $2.5 million from $2.4 million in fiscal 2011. The increase is due primarily to a higher amount of subscription license revenues and annual maintenance renewals.

Subscription and perpetual license revenue as a percentage of total revenue remained at 9% in fiscal 2012.

Costs of Revenue

Total cost of revenue for the fiscal year ended September 30, 2012 decreased $1.2 million, or 9%, to $11.8 million from $13.0 million in fiscal 2011.

Cost of Web Application Development Services

Cost of web application development services decreased $0.9 million, or 8%, compared to fiscal 2011. The cost of total web application development services as a percentage of total web application development services revenue decreased to 51% from 54% in fiscal 2011. This decrease is a result of our decision to stop servicing lower margin non-iAPPS engagements and, to a lesser extent, a decreased use of subcontractors.

Cost of iAPPS application development services increased $1.9 million to $6.3 million, an increase of 41% when compared to fiscal 2011. The increase is a result of iAPPS application development service revenue increasing 42% when compared to fiscal 2011. Cost of iAPPS application development services as a percentage of iAPPS application development revenue remained steady at 47% in each of fiscal 2012 and fiscal 2011.

Cost of other application development services for fiscal 2012 decreased $2.8 million to $4.6 million, a decrease of 38% when compared to fiscal 2011. The cost of other application development services as a percentage of other application development service revenue decreased to 59% in fiscal 2012 from 60% in fiscal 2011. This decrease is a result of our decision to stop servicing lower margin non-iAPPS engagements and to a lesser extent a decreased use of subcontractors.

Cost of Managed Service Hosting

Cost of managed service hosting decreased $71 thousand or 16% when compared to fiscal 2011. The cost of managed services as a percentage of managed services revenue decreased to 15% from 22% in fiscal 2011. The decrease in the amount of managed service hosting costs is due to efforts to streamline costs by ending engagements with lower margin hosting customers, and our continued investments in our co-managed network operation center to support our core iAPPS customer base.

Cost of Subscription and Perpetual License

Cost of subscription and perpetual licenses decreased $231 thousand, or 34% when compared to fiscal 2011. The cost of subscription and perpetual licenses as a percentage of subscription and perpetual license revenue decreased to 18% from 29% in fiscal 2011. The decrease is due to a decrease in amortization of software costs associated with the initial development of iAPPS and, to a lesser extent cost efficiencies realized on our iAPPS SaaS environment. We expect amortization of software costs to increase in fiscal 2013 due to costs capitalized in the fourth quarter of fiscal 2012. These costs are related to significant enhancements to our iAPPS platform that will be released in fiscal 2013 and to a lesser extent costs associated with the development of iAPPS ds.

Gross Profit

Gross profit increased $1.3 million, or 9%, when compared with fiscal 2011. This increase is due to our focus on higher margin iAPPS engagements and a decrease in amortization of software costs.

Operating Expenses

Sales and Marketing Expenses

Sales and marketing expenses increased $1.0 million, or 15%, to $7.7 million compared to fiscal 2011. This increase is primarily attributable to increases associated with costs related to our acquisitions of Magnetic and Marketnet, including personnel costs and marketing costs to promote our iAPPS products.

General and Administrative Expenses

General and administrative expenses relatively flat when compared to fiscal 2011. General and administrative expense represented 15% for both fiscal 2012 and 2011. General and administrative expenses decreased $1.1 million for the adjustment of contingent earnout payments from prior acquisitions that will not be achieved, offset by increases in personnel costs and increases in staffing.

Research and Development

Research and development expense decreased by $410 thousand, or 22%, to $1.5 million compared with fiscal 2011, after capitalization of software development costs. Capitalized software development costs were $480 thousand and $59 thousand for fiscal 2012 and 2011, respectively. The decrease is due to the aforementioned increase in capitalized software and development costs related to enhancements to our existing iAPPS platform and the development of iAPPS ds.

Depreciation and Amortization

Depreciation and amortization expense increased by $389 thousand, or 29%, to $1.7 million compared to fiscal 2011. Depreciation and amortization increased to 7% of total revenue compared to 5% of total revenue for fiscal 2011. This increase is primarily attributable to additional depreciation expense related to leasehold improvements and investments made in our co-managed network operation center. Incremental amortization expense as a result of our fiscal 2012 acquisitions was offset by a decrease in amortization for intangibles acquired before fiscal 2010 that reached the end of their useful life.

Impairment of Intangible Assets

The increase in fiscal 2012 compared to 2011 is attributable to an impairment charge recorded in the first quarter of fiscal 2012. We incurred a charge to operations of $281 thousand for impairment charges related to an intangible asset assumed from our fiscal 2010 acquisition of e.Magination and its wholly-owned subsidiary e.Magination IG, LLC. In the first quarter of fiscal 2012, the Company stopped servicing low margin non-iAPPS opportunities acquired from e.Magination IG, LLC. It was therefore determined that a portion of the customer list was impaired.

Income (Loss) from Operations

The loss from operations was ($602) thousand for fiscal 2012 compared to a loss from operations of ($547) for fiscal 2011. This increase in loss from operations is primarily due to an increase in selling and marketing expenses as a result of our fiscal 2012 acquisitions and the aforementioned impairment of the intangible asset, offset by the increase in gross profit.

Interest Income (Expense), net

Interest income (expense), net increased to a $275 thousand net expense for fiscal 2012 from a $211 thousand net expense for 2011. The increase in net expense in fiscal 2012 is attributable to increased interest expense incurred due to the Company's borrowing on its term loan faciltity near the end of fiscal 2011.

Provision for Income Taxes

The provision for income tax expense was $68 thousand for fiscal 2012 compared to $24 thousand for fiscal 2011. Income tax expense represents the estimated liability for Federal, state and foreign income taxes owed by the Company, including the alternative minimum tax. The increase in fiscal 2012 is due to an increase in foreign income taxes related to our India subsidiary. The Company has net operating loss carryforwards and other deferred tax benefits that are available to offset future taxable income. A valuation allowance is established if it is more likely than not that all or a portion of the deferred tax asset will not be realized. Accordingly, the Company has established a full valuation allowance against its net deferred tax asset at September 30, 2012 and 2011.

The Federal net operating loss (NOL) carryforward of approximately $6.0 million as of September 30, 2012 expires on various dates through 2028. Internal Revenue Code Section 382 places a limitation on the amount of taxable income which can be offset by NOL carryforwards after a change in control of a loss corporation. . . .