The following discussion of the financial condition and results of operations of Keynote Systems, Inc. (referred to herein as "we," "us," "Keynote" or "the Company") should be read in conjunction with the unaudited condensed consolidated financial statements and the notes thereto included in this report as well as the audited financial statements and notes thereto in our Annual Report on Form 10-K for the year ended September 30, 2012, and subsequent filings with the Securities and Exchange Commission.

Except for historical information, this Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934. These forward-looking statements include, among others, statements including the words "expects," "anticipates," "intends," "believes" and similar language. Our actual results may differ significantly from those projected in the forward-looking statements. Factors that might cause or contribute to these differences include, but are not limited to, those discussed in this section, the section entitled "Risk Factors" in Item 1A of Part II of this report, and in our annual report on Form 10-K for the fiscal year ended September 30, 2012 and elsewhere in that report. You should carefully review the risks described in other documents we file from time to time with the Securities and Exchange Commission, including the quarterly reports on Form 10-Q and current reports on Form 8-K that we may file during the current year. You are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this quarterly report on Form 10-Q. Except as required by law, we undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.

Overview

Keynote is a leading global provider of mobile and Web cloud testing and monitoring services. We maintain one of the world's largest on-demand quality testing and performance monitoring networks comprised of approximately 7,000 measurement computers and mobile devices in over 300 locations covering 180 countries. Our global network enables our customers to continuously test, monitor and assure the online and mobile experience. We deliver our products and services primarily through a cloud-based model on a subscription basis to world-class telecommunications and enterprise customers, representing a broad cross-section of industries. We offer a robust portfolio of cloud products and services to optimize the end-user customer experience. Our cloud products and services are grouped into three categories: Internet, Enterprise Mobile and Telecommunications Mobile.

We deliver our products and services primarily through a cloud-based model on a subscription basis (also referred to as Software-as-a-Service, or SaaS). Subscription fees range from monthly to multi-year commitments and vary based on the type of service selected, the number of measurements, transactions or devices monitored, the number of measurement locations and/or appliances, the frequency of the measurements, the communication protocols or services measured, privacy settings and any additional features ordered. Our System Integrated Test Environment ("SITE") and Test Center Enterprise ("TCE") systems, which include software and hardware, usually are offered via a software license fee model that is bundled with ongoing maintenance and support. Our engagement services, or professional services, complement and support our cloud products and services. Our engagement services provide our customers with a deeper and qualitative perspective of their performance data and are offered on per incident or per study basis.

Our net revenue increased by $0.8 million, or 3%, to $33.9 million for the three months ended December 31, 2012 from $33.1 million for the three months ended December 31, 2011. This increase was primarily due a $0.9 million increase in Internet revenue due to increased customer demand in conjunction with the stabilization of measurement pricing and a $0.6 million increase in Telecommunications Mobile revenues due to strong seasonal demand in the quarter. These increases were partially offset by $0.7 million in lower Enterprise Mobile revenues due to the loss of a single large customer and the early adoption stage of the mobile market. Our net income decreased by $2.2 million to $1.9 million for the three months ended December 31, 2012 from $4.1 million for the three months ended December 31, 2011. The decrease in net income was due primarily to an increase in total costs and expenses of $2.1 million from $27.6 million in the three months ended December 31, 2011 to $29.7 million in the three months ended December 31, 2012 due primarily to the benefit recorded in the prior year's quarter of $2.0 million for the change in fair value of acquisition-related contingent consideration.

We believe that important trends and challenges for our business include:

† Continuing to drive revenue growth, especially in mobile markets served by our Enterprise Mobile products and services, which we believe is a key factor in creating stockholder value;

† Meeting challenges faced due to the current global economic environment, especially in Europe, as this affects our customers' ability to purchase our products and services;

† Developing and marketing new products and services that respond to competitive and technological developments and changing customer needs;

† Growing our overall customer base and cross-selling our products within our existing customer base to support the growth of our revenue; and

† Controlling expenses in fiscal year 2013 to maintain profitability, particularly because of the economic uncertainties that continue to exist and the costs we are incurring to take advantage of growth opportunities, especially our investment in salespeople.

Refer to "Results of Operations," "Non-GAAP Financial Measures," "Liquidity and Capital Resources," and "Commitments" elsewhere in this section for a further discussion of the risks, uncertainties and trends in our business.

Critical Accounting Policies and Estimates

Our condensed consolidated financial statements and accompanying notes included elsewhere in this quarterly report on Form 10-Q are prepared in accordance with accounting principles generally accepted in the United States. These accounting principles require us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenue and expenses during the periods presented. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements:

† Revenue recognition;

† Fair value of assets acquired and liabilities assumed in a business combinations;

† Allowance for doubtful accounts and billing allowance;

† Goodwill, identifiable intangible assets and long-lived assets;

† Stock-based compensation; and

† Income taxes, deferred income tax assets and deferred income tax liabilities.

We believe that there have been no significant changes during the three months ended December 31, 2012 to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operation in our 2012 Annual Report on Form 10-K filed with the Securities and Exchange Commission. For a description of those critical accounting policies and estimates, please refer to our 2012 Annual Report on Form 10-K. On October 1, 2012, we adopted an accounting pronouncement on fair value measurements that are estimated using significant unobservable (Level 3) inputs, as well as an accounting pronouncement on the presentation of other comprehensive income. There have been no other changes in our critical accounting policies since the end of fiscal year 2012.

Results of Operations

The following table sets forth, as a percentage of total net revenue, certain condensed consolidated statements of operations data for the periods indicated. All information is derived from our condensed consolidated financial statements included in this report. The operating results are not necessarily indicative of the results for any future period.

                                                              Three months ended
                                                                 December 31,
                                                              2012         2011
Subscriptions and services revenue                               84.3         82.6
Systems licenses revenue                                         15.7         17.4
Net revenue                                                     100.0 %      100.0 %
Costs and expenses:
Costs of revenue:
Direct costs of revenue - subscriptions and services             22.4         21.8
Direct costs of revenue - systems licenses                        4.4          4.2
Development                                                      14.3         13.2
Operations                                                        8.1          7.5
Amortization of intangible assets - technology                    1.5          1.4
Sales and marketing                                              26.6         27.6
General and administrative                                       10.8         12.4
Change in fair value of acquisition-related contingent
consideration                                                       -         (6.0 )
Excess occupancy income                                          (1.5 )       (1.0 )
Amortization of intangible assets - other                         0.9          2.5
Total costs and expenses                                         87.5         83.6
Income from operations                                           12.5         16.4
Interest income and other, net                                   (0.4 )        0.2
Income before provision for income taxes                         12.1         16.6
Provision for income taxes                                       (6.4 )       (4.1 )
Net income                                                        5.7 %       12.5 %

The dollar amounts in the tables in this and the following sections are in thousands unless otherwise indicated.

Net Revenue



                                    For the three months ended December 31,
                                    2012             2011           % Change
Internet:
Web Measurement Subscriptions   $       9,518    $       8,119               17 %
Other Subscriptions                     4,120            4,295               (4 )
Engagements                             2,763            3,090              (11 )
Total Internet net revenue             16,401           15,504                6
Mobile:
Subscriptions                           5,646            5,593                1
Ratable Licenses                          397            1,583              (75 )
Systems Licenses                        5,319            5,755               (8 )
Maintenance and Support                 6,149            4,644               32
Total Mobile net revenue               17,511           17,575                -
Net revenue                     $      33,912    $      33,079                3 %

Subscription revenue is reflected in the above table as Web Measurement Subscriptions (which includes Application Perspective, Transaction Perspective, Streaming Perspective and Web Site Perspective products and services), Other Subscriptions (which includes all other Internet subscription products and services) and Mobile Subscriptions (which includes GlobalRoamer, Mobile Device Perspective, Mobile Web Perspective, TCE Interactive and Test Center Developer products and services). Licensing arrangements for monitoring and testing systems are reflected in the above table as Ratable Licenses (which includes SITE, TCE Automation and TCE Monitoring arrangements entered into prior to fiscal year 2011, which is when new accounting guidance for revenue recognition was adopted), Systems Licenses (which includes the hardware and software elements of SITE, TCE Automation and TCE Monitoring arrangements) and Maintenance and Support (which includes all the other elements of SITE, TCE Automation and TCE Monitoring arrangements, stand-alone consulting services agreements and maintenance agreement renewals).

Internet Net Revenue. Internet net revenue increased by $0.9 million for the three months ended December 31, 2012 compared to the three months ended December 31, 2011. Internet net revenue represented 48% and 47% of net revenue for the three months ended December 31, 2012 and 2011, respectively. The increase in Internet net revenue for the three months ended December 31, 2012 was mainly attributable to an increase of $1.4 million in our Internet Web Measurement Subscriptions due primarily to an increase in the number of measurements that our customers performed to test their Web sites, partially offset by a $0.3 million decrease in Internet Engagements due to lower demand for customer experience management ("CEM") engagements and a $0.2 million decrease in our Internet Subscriptions Other.

Mobile Net Revenue. Mobile net revenue decreased by $0.1 million for the three months ended December 31, 2012 compared to the three months ended December 31, 2011. Mobile net revenue represented 52% and 53% of net revenue for the three months ended December 31, 2012 and 2011, respectively. The decrease in Mobile net revenue for the three months ended December 31, 2012 was mainly attributable to a $1.2 million decrease in Ratable Licenses revenue due to the change in revenue recognition guidance at the beginning of fiscal 2011 and a $0.4 million decrease in Systems Licenses revenue due the timing of acceptances of some large projects in the prior year quarter. These decreases were partially offset by a $1.5 million increase in Maintenance and Support revenues as the customer base grew and renewed maintenance on installed systems.

No single customer accounted for more than 10% of net revenue for the three months ended December 31, 2012 and 2011. One customer accounted for 14% and 12% of our net accounts receivable as of December 31, 2012 and September 30, 2012, respectively. International sales, principally in Europe, were approximately 46% and 47% of net revenue for the three months ended December 31, 2012 and 2011, respectively.

Direct Costs of Revenue



                                                    For the three months ended December 31,
                                                    2012            2011           % Change
Direct costs of revenue - subscriptions and
services                                        $      7,609    $      7,193                  6 %
Direct costs of revenue - systems licenses             1,482           1,401                  6 %
Total direct costs of revenue                   $      9,091    $      8,594                  6 %

Direct costs of revenue-subscriptions and services is comprised of telecommunication and network fees for our measurement and data collection network, costs for employees and consultants assigned to consulting engagements and to install monitoring and testing systems, depreciation of equipment related to our measurement and data collection network, and costs of supplies.

Direct costs of revenue-system licenses, is comprised of the costs to build systems hardware sold to customers and was 28% and 24% of systems licenses revenue in the three months ended December 31, 2012 and 2011, respectively.

Direct costs of revenue increased $0.5 million for the three months ended December 31, 2012 compared to the three months ended December 31, 2011 and represented 27% and 26% of net revenue for the three months ended December 31, 2012 and 2011, respectively. The increase in direct costs of revenue - subscriptions and services was mainly attributable to $0.2 million of additional telecommunication and network fees and $0.1 million of equipment expenses due to higher monitoring volume associated with the increased revenue. The increase of $0.1 million in direct costs of revenue - systems licenses was due to a higher hardware component of the system licenses revenues than in the same quarter last year along with an increase in royalty expense related to one of the DeviceAnywhere products.

Development

For the three months ended December 31, 2012 2011 % Change Development $ 4,838 $ 4,379 10 %

Development expenses consist primarily of employee compensation, including stock-based compensation and other benefits, and other costs incurred by our development personnel. Development expenses increased $0.5 million for the three months ended December 31, 2012 compared to the three months ended December 31, 2011. The increase was mainly attributable to higher personnel costs associated with additional headcount primarily focused on mobile products and services.

Operations

For the three months ended December 31, 2012 2011 % Change Operations $ 2,749 $ 2,496 10 %

Operations expenses consist primarily of employee compensation, including stock-based compensation and other benefits, for management and technical support personnel. Our operations personnel manage and maintain our field measurement and data collection network; provide basic and extended customer support; and ensure the reliability of our services. Operations expenses increased $0.3 million for the three months ended December 31, 2012 compared to the three months ended December 31, 2011. The increase was mainly attributable to $0.2 million of higher personnel costs to support our data network and $0.1 million of equipment expenses related to our data network to support the higher subscriptions revenue.

Sales and Marketing

Sales and marketing expenses consist primarily of salaries, benefits, commissions and bonuses earned by sales and marketing personnel, stock-based compensation, lead-referral fees, marketing programs and travel expenses. Sales and marketing expenses were substantially the same for the three months ended December 31, 2012 as compared to the three months ended December 31, 2011.

General and Administrative

General and administrative expenses consist primarily of employee compensation, including stock-based compensation and other benefits; professional service fees, including accounting, auditing, legal and bank fees; insurance; and other general corporate expenses. General and administrative expenses decreased by $0.5 million for the three months ended December 31, 2012 compared to the three months ended December 31, 2011. The decrease was mainly attributable to $0.3 million of transaction expenses in connection with the acquisition of DeviceAnywhere that was included in the prior year quarter that did not repeat in this quarter and lower rent expense due to moving the DeviceAnywhere employees into our headquarter building in January 2012.

Change in estimated fair value of acquisition-related contingent consideration

At the acquisition date, a $2.0 million liability was recorded based on the estimated fair value of the acquisition-related contingent consideration to the former stockholders of DeviceAnywhere based on DeviceAnywhere achieving 2011 and 2012 revenue, bookings and EBITDA targets. During the three months ended December 31, 2011, we concluded that DeviceAnywhere would not achieve either the 2011 or the 2012 targets. Accordingly, we reversed the liability and recorded a benefit of $2.0 million in that period due to the change in estimate of the fair value of acquisition-related contingent consideration.

Excess Occupancy Income



                             For the three months ended December 31,
                             2012           2011            % Change
Rental income             $      (874 )  $      (741 )                18 %
Related expenses                  358            391                   8 %
Excess occupancy income   $      (516 )  $      (350 )                47 %

Excess occupancy income consists of rental income from the leasing of space not occupied by us in our headquarters building, net of related expenses, which consists of property taxes, insurance, building depreciation, leasing broker fees and tenant improvement amortization. The expenses associated with excess occupancy income are based on the actual square footage available for lease to third parties, which was 75% prior to January 1, 2012 and 65% subsequent to that date. The square footage available for lease to third parties decreased because DeviceAnywhere moved into our headquarters building in January 2012. The increase in excess occupancy income for the three months ended December 31, 2012 as compared to the three months ended December 31, 2011 was mainly attributable to new tenants occupying space in our building and annual tenant rent increases per the lease agreements. Expenses were relatively consistent for the periods presented.

Amortization of Identifiable Intangible Assets



                                                   For the three months ended December 31,
                                                  2012            2011             % Change
Amortization of identifiable
intangible assets - technology                 $       525    $         465                  13 %
Amortization of identifiable
intangible assets - other                              298              810                 (63 )%
Total amortization of
identifiable intangible assets                 $       823    $       1,275                 (35 )%

Amortization of intangible assets-technology mainly relates to purchased technology for our mobile products and is reflected in costs of revenue in our condensed consolidated statements of operations. Amortization of intangible assets-other relates to all other intangibles, including customer lists, trademarks and customer backlog, and is reflected in operating expenses in our condensed consolidated statements of operations.

Amortization of identifiable intangible assets-technology and amortization of identifiable intangible assets-other decreased by $0.5 million for the three months ended December 31, 2012 compared to the three months ended December 31, 2011 as a result of the backlog component of the identifiable intangible assets recorded in connection with the acquisition of DeviceAnywhere being fully amortized over a one year period ending in October 2012.

We review our identifiable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. No events or circumstances were identified in the period ended December 31, 2012 indicating that the carrying amount of these assets may not be recoverable.

Interest Income and Other Income (Expense), Net



                                   For the three months ended December 31,
                                  2012            2011             % Change
Interest income               $          25     $      46                    (46 )%
Other income (expense), net            (164 )          14                 (1,271 )%
Total                         $        (139 )   $      60                   (332 )%

Other income (expense), net primarily consists of foreign currency transaction gains and losses and interest expense. Interest income and other income (expense), net for the three months ended December 31, 2012 decreased by $0.2 million as compared to the three months ended December 31, 2011. Interest income decreased $21,000 primarily due to lower invested cash balances as a result of the acquisition of DeviceAnywhere on October 18, 2011. Other income (expense), net, decreased $0.2 million primarily due to foreign exchange rate fluctuations on settled transactions during the periods.

Provision for Income Taxes

Our effective tax rate for the three months ended December 31, 2012 and 2011 was 53% and 25%, respectively. The rate for the three months ended December 31, 2012 differs from the 35% United States federal statutory rate due in part to the relative mix of foreign and domestic earnings and enacted tax rates. Additionally, the effective tax rate was 12% higher than the statutory rate due to recording the effects of Section 162(m) limitations on deferred tax assets that should have been recorded in fiscal 2011 and 2012. The rate for the three months ended December 31, 2011 differs from the 35% United States federal statutory rate primarily due to the relative mix of foreign and domestic earnings, enacted tax rates, and the fact that the change in estimated fair value of acquisition-related contingent consideration is a non-taxable, discrete transaction in the quarter.

Stock-based Compensation Expense

Stock-based compensation expense, which is included in total costs and expenses by category for the three months ended December 31, 2012 was substantially the same as in the three months ended December 31, 2011.

Stock-based compensation related to employee stock options, restricted stock units and employee stock purchase rights was reflected in the condensed consolidated statements of operations as follows:

                                                         Three months ended
                                                            December 31,
                                                          2012         2011
. . .