10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2004

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

COMMISSION FILE NO. 000-26937

QUEST SOFTWARE, INC.

(Exact name of registrant as specified in its charter)

California	33-0231678
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

8001 Irvine Center Drive Irvine, California	92618
(Address of principal executive offices)	(Zip code)

Registrant’s telephone number, including area code: (949) 754-8000

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 Rule 12b-2 of the Exchange Act)

Yes  x    No  ¨

The number of shares outstanding of the Registrant’s Common Stock, no par value, as of April 30, 2004, was 94,341,818.

QUEST SOFTWARE, INC.

FORM 10-Q

TABLE OF CONTENTS

		Page Number
PART I. FINANCIAL INFORMATION
Item 1.	Financial Statements (unaudited)
	Condensed Consolidated Balance Sheets as of December 31, 2003 and March 31, 2004	2
	Condensed Consolidated Statements of Operations for the Three Months Ended March 31, 2003 and 2004	3
	Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2003 and 2004	4
	Condensed Consolidated Statements of Comprehensive Operations for the Three Months Ended March 31, 2003 and 2004	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	28
Item 4.	Controls and Procedures	29
PART II. OTHER INFORMATION
Item 1.	Legal Proceedings	30
Item 6.	Exhibits and Reports on Form 8-K	31
SIGNATURES		32

PART I—FINANCIAL INFORMATION

Item 1: Financial Statements

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

	December 31, 2003			March 31, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	67,470		$	65,956
Short-term marketable securities		26,736			18,107
Accounts receivable, net		58,535			50,987
Prepaid expenses and other current assets		6,846			11,267
Deferred income taxes		15,074			3,954
Total current assets		174,661			150,271
Property and equipment, net		31,950			47,331
Long-term marketable securities		184,160			180,688
Goodwill		239,840			325,232
Amortizing intangible assets, net		25,159			50,796
Deferred income taxes		10,126			12,626
Other assets		1,915			2,097
Total assets	$	667,811		$	769,041
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,180		$	5,216
Obligation under repurchase agreement		—			67,500
Accrued compensation		17,384			17,648
Other accrued expenses		27,939			26,532
Income taxes payable		9,082			10,484
Current portion of deferred revenue		73,957			84,514
Total current liabilities		132,542			211,894
Long-term liabilities:
Long-term portion of deferred revenue		9,416			11,513
Other long-term liabilities		1,677			2,092
Total long-term liabilities		11,093			13,605
Commitments and contingencies (Notes 3, 5 and 10)
Shareholders’ equity:
Preferred stock, no par value, 10,000 shares authorized; no shares issued or outstanding		—			—
Common stock, no par value, 150,000 shares authorized; 93,309 and 94,187 shares issued and outstanding at December 31, 2003 and March 31, 2004, respectively		588,203			610,252
Accumulated deficit		(47,073	)		(46,687	)
Accumulated other comprehensive income		260			1,165
Unearned compensation		—			(3,974	)
Note receivable from sale of common stock		(17,214	)		(17,214	)
Net shareholders’ equity		524,176			543,542
Total liabilities and shareholders’ equity	$	667,811		$	769,041

See accompanying notes to condensed consolidated financial statements.

2

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

	Three Months Ended March 31,
	2003		2004
Revenues:
Licenses	$	42,722	$	47,028
Services		28,477		35,499
Total revenues		71,199		82,527
Cost of revenues:
Licenses		933		1,097
Services		5,195		6,403
Amortization of purchased intangible assets		2,130		1,431
Total cost of revenues		8,258		8,931
Gross profit		62,941		73,596
Operating expenses:
Sales and marketing		36,129		36,124
Research and development		17,185		18,158
General and administrative		6,551		8,260
In-process research and development		—		6,700
Amortization of purchased intangible assets		867		730
Total operating expenses		60,732		69,972
Income from operations		2,209		3,624
Other income, net		1,860		667
Income before income tax provision		4,069		4,291
Income tax provision		1,535		3,905
Net income	$	2,534	$	386
Net income per share:
Basic	$	0.03	$	0.00
Diluted	$	0.03	$	0.00
Weighted average shares:
Basic		90,974		93,802
Diluted		92,922		97,970

See accompanying notes to condensed consolidated financial statements.

3

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Three Months Ended March 31,
	2003			2004
Cash flows from operating activities:
Net income	$	2,534		$	386
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		6,919			5,402
Compensation expense associated with stock options		495			170
Deferred income taxes		110			3
Provision for bad debts		138			(23	)
In-process research and development		—			6,700
Changes in operating assets and liabilities, net of effects of acquisitions:
Accounts receivable		11,232			9,807
Prepaid expenses and other current assets		991			(2,331	)
Other assets		948			(3	)
Accounts payable		89			493
Accrued compensation		(1,101	)		(1,116	)
Other accrued expenses		(5,274	)		(4,796	)
Income taxes payable		1,789			2,802
Deferred revenue		3,210			4,843
Other liabilities		(145	)		415
Net cash provided by operating activities		21,935			22,752
Cash flows from investing activities:
Purchases of property and equipment		(2,883	)		(16,586	)
Cash paid for acquisition, net of cash acquired		—			(94,283	)
Purchases of marketable securities		(42,375	)		—
Sales and maturities of marketable securities		22,475			13,005
Net cash used in investing activities		(22,783	)		(97,864	)
Cash flows from financing activities:
Proceeds from repurchase agreement		—			67,500
Repayment of capital lease obligations		(91	)		(92	)
Proceeds from the exercise of stock options		195			4,288
Proceeds from employee stock purchase plan		2,286			2,723
Net cash provided by financing activities		2,390			74,419
Effect of exchange rate changes on cash and cash equivalents		(418	)		(821	)
Net (decrease) increase in cash and cash equivalents		1,124			(1,514	)
Cash and cash equivalents, beginning of period		64,283			67,470
Cash and cash equivalents, end of period	$	65,407		$	65,956
Supplemental disclosures of condensed consolidated cash flow information:
Cash paid for:
Interest	$	22		$	51
Income taxes	$	60		$	380
Supplemental schedule of non-cash investing and financing activities:
Unrealized gain (loss) on available-for-sale securities	$	(170	)	$	905
Tax benefit related to stock option exercises	$	1,510		$	1,540

See Note 3 for details of assets acquired and liabilities assumed in purchase transactions.

See accompanying notes to condensed consolidated financial statements.

4

QUEST SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS

(In thousands)

(Unaudited)

	Three Months Ended March 31,
	2003			2004
Net income	$	2,534		$	386
Other comprehensive loss:
Unrealized gain (loss) on available-for-sale securities, net of tax		(170	)		905
Comprehensive income	$	2,364		$	1,291

See accompanying notes to condensed consolidated financial statements.

5

QUEST SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Basis of Presentation

Our accompanying unaudited condensed consolidated financial statements as of March 31, 2004 and for the three months ended March 31, 2003 and 2004, reflect all adjustments (consisting of normal recurring accruals) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. Certain reclassifications have been made to the March 31, 2003 balances in order to conform to the March 31, 2004 presentation.

These financial statements should be read in conjunction with the audited financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003.

Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for any future period.

2. Stock Option Plans

The following table summarizes information about stock options outstanding as of March 31, 2004 (in thousands, except for per share data):

	Number of Shares		Weighted- Average Exercise Price
Balance at December 31, 2003	22,919		$	12.84
Options assumed in the Aelita acquisition (Note 3)	1,089			3.79
Granted	218			15.36
Exercised	(530	)		8.07
Canceled	(352	)		14.63
Balance at March 31, 2004	23,344			12.95
Options exercisable as of March 31, 2004	7,875			13.50

The weighted-average fair value of options granted during the three months ended March 31, 2004 was $7.00.

We account for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” As permitted by SFAS No. 123, as amended by SFAS No. 148, we have chosen to continue to account for our stock-based compensation plans under APB Opinion No. 25 and provide the expanded disclosures specified in SFAS No. 123, as amended by SFAS No. 148. Had compensation cost been determined using the fair value method our net income would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data):

	Three Months Ended March 31,
	2003			2004
Net income:
As reported	$	2,534		$	386
Add: Stock-based compensation expense included in reported net income, net of related tax effects		307			109
Deduct: Total stock-based compensation determined under fair value based method for all awards, net of related tax effects		(6,624	)		(6,854	)
Pro forma	$	(3,783	)	$	(6,359	)
Basic net income (loss) per share:
As reported		0.03			0.00
Pro forma		(0.04	)		(0.07	)
Diluted net income (loss) per share:
As reported		0.03			0.00
Pro forma		(0.04	)		(0.07	)

6

For purposes of estimating the compensation cost of our option grants in accordance with SFAS No. 123, as amended by SFAS No. 148, the fair value of each option grant is estimated on the date of grant or assumption using the Black-Scholes option-pricing model. The weighted-average fair value calculations are based on the following assumptions:

	Three Months Ended March 31,
	2003		2004
Risk-free interest rates	4.0	%	2.8	%
Expected life (in years)	5		5
Expected stock volatility	54	%	45	%
Expected dividends	None		None

3. Acquisitions

We acquired Aelita Software Corporation, a leading provider of systems management solutions for Microsoft Active Directory and Microsoft Exchange products, on March 17, 2004. The acquisition expands our product portfolio of solutions to simplify, automate and secure increasingly complex Microsoft infrastructures. The purchase price for Aelita was $117.3 million, consisting of cash of $102.0 million, the assumption of Aelita stock options valued at $13.4 million and direct acquisition costs of $1.9 million. Intrinsic value of unvested stock options of $4.0 million has been allocated to unearned compensation and will be recognized as non-cash compensation expense over the remaining future vesting period of four years. Of the cash paid for this acquisition, $15.8 million was deposited in escrow to satisfy certain indemnification obligations of the selling shareholders. Goodwill in the amount of $66.6 million and $18.8 million was assigned to the license and service segments, respectively, of our business and is not expected to be deductible for tax purposes. Goodwill allocation of 78% to licenses and 22% to services is based on both historical and projected relative contribution from licenses and services revenues.

In connection with the acquisition, we began to formulate a reorganization plan. As a result of the reorganization plan, we recognized approximately $1.0 million as liabilities assumed in the purchase business combination representing severance related charges for affected Aelita employees. These liabilities were included in the allocation of the purchase price in accordance with SFAS No. 141, “Business Combinations,” and EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” Execution of the reorganization plan is in its early stages and further workforce reductions are expected pending further review of headcount and resource needs. These actions are expected to be completed by June 30, 2004, and when taken, additional charges will be recorded as an adjustment to goodwill.

The acquisition was accounted for as a purchase with the purchase price of $117.3 million allocated to assets (liabilities) as follows (in thousands):

Current assets	$	12,079
Fixed assets		1,468
Other non-current assets		178
Goodwill		85,392
Acquired technology with estimated useful lives of 1 – 5 years		16,500
Customer list with an estimated useful life of 2 years		5,100
Maintenance contracts with an estimated useful life of 5 years		2,600
Non-compete agreements with an estimated useful life of 4 years		3,000
Trademark with an estimated useful life of 2 years		600
In-process research and development		6,700
Deferred taxes		(8,620	)
Deferred revenue		(7,811	)
Other liabilities		(3,898	)
Unearned compensation		4,008
	$	117,296

7

The merger agreement requires us to make certain payments to the former shareholders of Aelita in the event assumed Aelita options are prematurely forfeited within eighteen months of the acquisition date. The amount of these payments are equal to 50% of the aggregate value of the spread between the exercise price per share of each forfeited option as of the date of forfeiture and the lower of the price of our common stock as reported on the Nasdaq National Market on either (a) the acquisition closing date, or (b) the trading day immediately preceding the date which the option was forfeited. This represents contingent consideration and in accordance with the provisions of SFAS No. 141, “Business Combinations”, will result in a reduction to common stock when paid.

In connection with the Aelita acquisition, $6.7 million was allocated to IPR&D and expensed immediately upon completion of the acquisition (as a charge not deductible for tax purposes), because the technological feasibility of products under development had not been established and no future alternative uses existed. We identified and valued seven In-Process Research and Development (IPR&D) projects. Four of the projects were over 75% complete and the remaining three were less than 30% complete at the date of acquisition and the estimated cost to complete all projects was $1.2 million. Four projects were directed toward the development of improvements to an existing product and the others for products that were in pre-production. The IPR&D for the improvements to the existing products represented 69% of the total value of IPR&D acquired, while the products in pre-production represented the balance of 31%. At the date of acquisition improvements to the existing products were anticipated to be completed during the remaining three quarters of 2004 while the pre-production products were expected to be completed by the beginning of 2005.

The fair value of the IPR&D was determined using the income approach. Under the income approach, expected future after-tax cash flows from each of the projects or product families (projects) under development are estimated and discounted to their net present value at an appropriate risk-adjusted rate of return. Each project was analyzed to determine the technological innovations included in the project; the existence and utilization of core technology; the complexity, cost and time to complete the remaining development efforts; the existence of any alternative future use or current technological feasibility; and the stage of completion in development. Future cash flows for each project were estimated based on forecasted revenues and costs, taking into account the expected life cycles of the products and the underlying technology, relevant market sizes and industry trends. Future cash flows from the significant acquired projects were expected to commence at various dates within three to twelve months of acquisition. The estimated future cash flows for each were discounted to approximate fair value. Discount rates, ranging from 25% to 30% for developed technology and IPR&D, were derived from a weighted average cost of capital analysis, adjusted upward to reflect additional risks inherent in the development process, including the probability of achieving technological success and market acceptance. The IPR&D charge includes the fair value of the portion of IPR&D completed as of the date of acquisition.

We acquired the outstanding shares of eCritical Inc. (“eCritical”), a provider of performance management solutions for network-enabled applications in April 2003, and Discus Data Solutions, Inc. (“Discus”), a provider of infrastructure management solutions for the Microsoft environment in May 2003.

Actual results of operations of the companies acquired in 2003 and of Aelita acquired in the three months ended March 31, 2004 are included in the condensed consolidated financial statements from the dates of acquisition. The pro forma results of operations data for the three months ended March 31, 2003 and 2004 presented below assume that the acquisitions made in 2003 and 2004 had been made on January 1, 2003 and include amortization of identified intangibles from that date. The pro forma data is presented for informational purposes only and is not necessarily indicative of the results of future operations nor of the actual results that would have been achieved had the acquisitions taken place at the beginning of each fiscal year (in thousands):

	Three Months Ended March 31,
	2003		2004
Revenues	80,002		89,073
Net loss	(9,320	)	(3,448	)
Net loss per share—basic and diluted	(0.10	)	(0.04	)

8

4. Goodwill and Amortizing Intangible Assets

Amortizing intangible assets as of December 31, 2003 and March 31, 2004, respectively, are comprised of the following (in thousands):

	December 31, 2003							Weighted Average Amortization Period	March 31, 2004							Weighted Average Amortization Period
	Gross Carrying Amount		Accumulated Amortization			Net			Gross Carrying Amount		Accumulated Amortization			Net
Acquired technology	$	50,062	$	(28,639	)	$	21,423	4.5	$	66,562	$	(30,070	)	$	36,492	4.5
Customer lists		6,351		(3,944	)		2,407	3.2		11,451		(4,441	)		7,010	2.6
Existing maintenance contracts		—		—			—	—		2,600		(20	)		2,580	5.0
Non-compete agreements		2,325		(2,108	)		217	2.2		5,325		(2,239	)		3,086	3.2
Trademarks		1,450		(338	)		1,112	5.0		2,050		(422	)		1,628	4.1
	$	60,188	$	(35,029	)	$	25,159		$	87,988	$	(37,192	)	$	50,796

Amortization expense for amortizing intangible assets was $3.1 million and $2.2 million for the three months ended March 31, 2003 and 2004, respectively. Estimated annual amortization expense related to amortizing intangible assets by fiscal year is as follows: remaining three quarters of 2004—$10.8 million; 2005—$12.7 million; 2006—$10.1 million; 2007—$8.5 million; 2008—$6.8 million; thereafter—$1.9 million. All intangible assets currently recorded will be fully amortized by the end of 2009.

The changes in the carrying amount of goodwill by reportable operating segment for the three months ended March 31, 2004 are as follows (in thousands):

	Licenses		Services		Total
Balance as of December 31, 2003	$	182,623	$	57,217	$	239,840
Goodwill acquired during the three months ended March 31, 2004 (Note 3)		66,606		18,786		85,392
Balance as of March 31, 2004	$	249,229	$	76,003	$	325,232

5. Obligation Under Repurchase Agreement

We entered into a repurchase agreement in March 2004, utilizing $67.5 million of our investment securities as collateral. The cash proceeds of this transaction were used to provide funding for our acquisition of Aelita and our purchase of a new office facility. The repurchase agreement both entitles and obligates us to repurchase the securities from the transferee (“buyer-lender”) and the buyer-lender does not have a right to pledge or sell the collateralized securities to a third party. Accordingly, our obligations under the repurchase agreement are accounted for as short-term borrowings and recorded as a liability on the balance sheet. Our obligations under the repurchase agreement bear interest at 1.07% and will mature in June 2004, and require maintenance of a customary market collateral margin.

6. Income Tax Provision

The effective income tax rate for the three months ended March 31, 2004 was 91% compared to 40% in the comparable period of 2003. The increase in the tax rate in the first quarter of 2004 was due to a permanent difference between GAAP pre-tax income and taxable income as a result of the $6.7 million non-deductible write-off of Aelita’s in-process research and development. For the remainder of 2004, we expect an effective tax rate of approximately 36%.

7. Net Income Per Share

We compute net income per share in accordance with SFAS No. 128, “Earnings per Share.” Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution of securities by including other common stock equivalents, including stock options, in the weighted-average number of common shares outstanding for a period, if dilutive.

The following table summarizes our earnings per share computation for the three months ended March 31, 2003 and 2004 (in thousands, except per share data):

	Three Months Ended March 31,
	2003		2004
Net income	$	2,534	$	386
Weighted average shares – basic		90,974		93,802
Incremental common shares attributable to shares issuable under employee stock plans		1,948		4,168
Weighted average shares – diluted		92,922		97,970
Net income per share – basic and diluted	$	0.03	$	0.00

9

For the three months ended March 31, 2003 and 2004, options to purchase 12.5 million and 3.2 million shares of common stock with a weighted average price of $17.44 and $30.09, respectively, were anti-dilutive because the exercise price of the options was greater than the average fair market value of our common stock for the period then ended.

7. Shareholders’ Equity

In January 2004, 345,083 shares of common stock were purchased under our Employee Stock Purchase Plan at a price of $7.98 per share.

8. Geographic and Segment Information

Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by our chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing performance. Our operating segments are managed separately because each segment represents a strategic business unit that offers different products or services.

Our reportable operating segments are Licenses and Services. The Licenses segment develops and markets licenses to use our software products. The Services segment provides after-sale support for software products and fee-based training and consulting services related to our software products.

We do not separately allocate operating expenses to these segments, nor do we allocate specific assets to these segments. Therefore, segment information reported includes only revenues, cost of revenues, and gross profit, as this information and the geographic information described below are the only information provided to the chief operating decision maker on a segment basis.

Reportable segment data for the three months ended March 31, 2003 and 2004, is as follows (in thousands):

	Licenses		Services		Total
Three months ended March 31, 2003
Revenues	$	42,722	$	28,477	$	71,199
Cost of Revenues		3,063		5,195		8,258
Gross profit	$	39,659	$	23,282	$	62,941
Three months ended March 31, 2004
Revenues	$	47,028	$	35,499	$	82,527
Cost of Revenues		2,528		6,403		8,931
Gross profit	$	44,500	$	29,096	$	73,596

Revenues are attributed to geographic areas primarily based on the location of the entity to which the products or services were delivered. Revenues, gross profit, income (loss) from operations and long-lived assets concerning principal geographic areas in which we operate are as follows (in thousands):

	North America (1)			Europe (2)			Other International			Total
Three months ended March 31, 2003
Revenues	$	53,953		$	15,520		$	1,726		$	71,199
Gross profit		51,080			10,556			1,305			62,941
Income (loss) from operations		3,152			(1,546	)		603			2,209
Long-lived assets		426,101			3,329			8,523			437,953
Three months ended March 31, 2004
Revenues	$	59,849		$	20,227		$	2,451		$	82,527
Gross profit		52,029			19,126			2,441			73,596
Income (loss) from operations		(1,619	)		6,963			(1,720	)		3,624
Long-lived assets		609,577			2,057			7,136			618,770

10

(1) Principally represents operations in the United States.

(2) Our subsidiary located in the United Kingdom accounted for $6.2 million and $8.9 million of total European revenues during the three months ended March 31, 2003 and 2004, respectively.

9. Commitments and Contingencies

On July 2, 2002, Computer Associates International, Inc. (“CA”) filed a complaint against us and four of our employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in connection with the development of the database administration component of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. The complaint was amended in May 2003 to add another Quest employee as a defendant and to assert breach of contract claims against three of the individual defendants. In October 2003, CA filed a motion for preliminary injunction. We responded to this motion in January 2004, arguing that CA cannot meet the requirements for injunctive relief. In connection with our response, we sought leave to assert a counterclaim for a declaratory judgment of invalidity of CA’s copyright registrations. Rulings on these motions are not expected until late in the second quarter of 2004. If CA’s motion is granted, we would be preliminarily enjoined from licensing Quest Central for DB2. We are vigorously defending CA’s claims and do not believe that this matter will have a material adverse effect on our results of operations or financial condition.

After we announced on July 23, 2003 that we would restate certain financial results as a result of our discovery of a computational error relating to an error in the method used to translate foreign currency denominated accounts into U.S. Dollars at historical rates, numerous separate complaints purporting to be class actions were filed in the United States District Court for the Central District of California alleging that we and some of our officers and directors violated provisions of the Securities Exchange Act of 1934. Orders designating a lead plaintiff and consolidating the federal class action complaints were issued by the U. S. District Court in late October 2003, and an amended consolidated class action complaint was filed in January 2004. The consolidated amended complaint contains varying allegations, including allegations that we made materially false and misleading statements with respect to our financial results for 2002 and the quarter ended March 31, 2003 included in our filings with the SEC and press releases. On May 10, 2004, during a hearing on our motion to dismiss the amended consolidated class action complaint, the U.S. District Court issued its tentative ruling granting our motion to dismiss and permitting the plaintiff to amend its complaint within 60 days. In addition, one complaint purporting to be a derivative action has been filed in California state court against some of our directors and officers. This complaint is based on the same facts and circumstances described in the class action complaints and generally alleges that the named directors and officers breached their fiduciary duties by failing to oversee adequately our financial reporting. Our motion to dismiss the derivative action is scheduled to be heard by the California Superior Court in July 2004. Each of the complaints generally seek an unspecified amount of damages. The cases are in the preliminary stages and we are vigorously defending these claims; however, it is not possible for us to quantify the extent of our potential liability, if any. Accordingly, no amounts have been accrued in the accompanying financial statements. An unfavorable outcome in any of these cases could have a material adverse effect on our business, financial condition, results of operations and cash flow. In addition, defending any litigation may be costly and divert management’s attention from the day-to-day operations of our business.

We are a party to other litigation, which we consider to be routine and incidental to our business. Management does not expect the results of any of these actions to have a material adverse effect on our results of operations or financial condition.

In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, and (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant

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payments for obligations of this nature, and no liabilities have been recorded for these obligations in the accompanying consolidated balance sheets as the fair value of these obligations issued during the three months ended March 31, 2004 was not significant to our financial position, results of operations, or cash flows.

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Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations also should be read in conjunction with the consolidated financial statements and notes to those statements included elsewhere in this Report. Certain statements in this Report, including statements regarding our business strategies, operations, financial conditions and prospects, are forward-looking statements. Use of the words “believe,” “expect,” “anticipate,” “will,” “contemplate,” “would” and similar expressions that contemplate future events may identify forward-looking statements.

Numerous important factors, risks and uncertainties affect our operations and could cause actual results to differ materially from those expressed or implied by these or any other forward-looking statements made by us or on our behalf. Readers are urged to carefully review and consider the various disclosures made in this Report, including those described under “Risk Factors,” and in other filings with the SEC, that attempt to advise interested parties of certain risks and factors that may affect our business. Readers are cautioned not to place undue reliance on these forward-looking statements, which are based on current expectations and reflect management’s opinions only as of the date thereof. We do not assume any obligation to revise or update forward-looking statements. Finally, our historic results should not be viewed as indicative of future performance.

Overview

We provide application management software solutions that maximize the availability, performance and manageability of our customers’ business critical applications and their associated databases and other components. Many of our products also increase the cost effectiveness of a customer’s IT investments, including personnel, software and hardware.

Our revenues consist of software license fees and service fees. Our software-licensing model is primarily based on perpetual license fees, and our license fees are calculated either on a per-server basis or, for our SQL and J2EE development, report management and Microsoft administration tools, on a per user basis. Service revenues primarily represent the ratable recognition of software maintenance contract fees, which entitle a customer to technical support via telephone and the internet and product enhancements on a when and if available basis. These maintenance contracts have annual terms. Customers purchase a software maintenance contract for the first year when they license a product and have the option of renewing the maintenance contract annually thereafter. Service revenues also include revenues from consulting and training services.

Acquisition of Aelita Software Corporation

In March 2004, we completed the acquisition of Aelita Software Corporation, a privately-held software vendor. Aelita develops, markets and supports products that improve the productivity, system availability and security of Microsoft Active Directory and Microsoft Exchange products. With this acquisition of Aelita, we added breadth and depth to our Microsoft expertise and product portfolio and will now deliver a more comprehensive set of product solutions that enable customers to manage today’s complex Microsoft infrastructures throughout their entire lifecycle. In connection with the acquisition, we recorded a charge totaling $6.7 million for the fair value of purchased in-process research and development (IPR&D). We recorded this charge because the technological feasibility of products under development at the date of acquisition had not been established and no future alternative uses existed. The charge represented the estimated fair value of the incomplete research and development products based on discounted cash flows. Management is primarily responsible for estimating the fair value of IPR&D, which was determined with the assistance of an independent appraiser.

Results of operations from Aelita and other acquisitions are included in our consolidated statements of operations from the respective dates of acquisition. For more information concerning our acquisitions during the periods presented herein, see Note 3 of “Notes to Condensed Consolidated Financial Statements.”

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Results of Operations

Except as otherwise indicated, the following are percentage of total revenues:

	Three Months Ended March 31,
	2003		2004
Revenues:
Licenses	60.0	%	57.0	%
Services	40.0		43.0
Total revenues	100.0		100.0
Cost of revenues:
Licenses	1.3		1.3
Services	7.3		7.8
Amortization of purchased intangible assets	3.0		1.7
Total cost of revenues	11.6		10.8
Gross profit	88.4		89.2
Operating expenses:
Sales and marketing	50.7		43.8
Research and development	24.1		22.0
General and administrative	9.2		10.0
In-process research and development	—		8.1
Amortization of purchased intangible assets	1.2		0.9
Total operating expenses	85.2		84.8
Income from operations	3.2		4.4
Other income, net	2.6		0.8
Income before income taxes	5.8		5.2
Income tax provision	2.2		4.7
Net income	3.6	%	0.5	%
As a percentage of related revenues:
Cost of licenses	2.2	%	2.3	%
Cost of services	18.2	%	18.0	%

Comparison of Three Months Ended March 31, 2003 and 2004

Revenues

Total revenues and year-over-year changes are as follows (in thousands, except for percentages):

	Three Months Ended March 31,
	2003		2004		Percentage Change
Revenues:
Licenses	$	42,722	$	47,028	10.1	%
Services		28,477		35,499	24.7	%
Total revenues	$	71,199	$	82,527	15.9	%

        License Revenues—The $4.3 million growth in license revenues in 2004 included a $2.3 million contribution from Aelita and an approximately $1.5 million contribution from the impact of the devaluation of the U.S. Dollar relative to certain foreign currencies, primarily the Euro and the British Pound. We saw growth in sales year-over-year primarily in our Application Performance Management and Microsoft Infrastructure Management products. In the first quarter of 2004, license revenues in North America increased by 4.5%, from $32.1 million to $33.6 million. License revenues outside of North America increased by 26.9%, from $10.6 million to $13.4 million in the first quarter of 2004.

Service Revenues—Support renewals from a larger installed base of products and customers were the primary driver of service revenue growth. Service revenues also benefited from a contribution of approximately $0.5 million from the impact of the devaluation of the U.S. Dollar in the first quarter of 2004 compared to the same period in 2003, relative to certain foreign currencies, primarily the Euro and the British Pound and approximately $0.7 million

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in services revenues from the Aelita acquisition. Professional services as a percentage of total service revenues represented 12.5% in the first quarter of 2004 and 8.9% in the comparable period of 2003. In the first quarter of 2004, service revenues in North America increased by 20.1%, from $21.9 million to $26.3 million. Service revenues outside of North America increased by 39.7%, from $6.6 million to $9.2 million in the first quarter of 2004.

Cost of Revenues

Total cost of revenues and year-over-year changes are as follows (in thousands, except for percentages):

	Three Months Ended March 31,
	2003		2004		Percentage Change
Cost of revenues:
Licenses	$	933	$	1,097	17.6	%
Services		5,195		6,403	23.3	%
Amortization of purchased intangible assets		2,130		1,431	(32.8	)%
Total cost of revenues	$	8,258	$	8,931	8.1	%

Cost of Licenses—Cost of licenses primarily consists of third-party software royalties, product packaging, documentation, duplication, delivery and personnel. Cost of licenses as a percentage of license revenues was 2.3% for the first quarter of 2004, compared with 2.2% in 2003. A higher level of sales revenue from licenses of royalty-bearing products was the primary reason for the increase in license costs. We expect that cost of licenses as a percentage of license revenues will remain relatively constant throughout the remainder of 2004.

Cost of Services—Cost of services primarily consists of personnel, outside consultants, facilities and systems costs used in providing support, consulting and training services. Cost of services as a percentage of service revenues declined to 18.0% for 2004, compared to 18.2% for 2003. The increase in the absolute amounts of cost of services is primarily due to an increase in fees paid to outside professional services consultants in support of product deployments.

Amortization of Purchased Intangible Assets—Amortization of purchased intangible assets includes amortization of the fair value of acquired technology associated with acquisitions made from 2000 through the first quarter of 2004. The decrease is due to purchased intangible assets related to acquisitions made in 2000 that became fully amortized by the end of 2003. We expect amortization of purchased intangible assets to be at least $2.2 million per quarter throughout the remaining quarters of 2004. See Note 4 of the “Notes to Condensed Consolidated Financial Statements” for estimated future amortization expense. The useful lives of the acquired technologies range from one to seven years. See “Critical Accounting Policies and Estimates” for additional discussion regarding accounting for intangible assets.

Operating Expenses

Total operating expenses and year-over-year changes are as follows (in thousands, except for percentages):

	Three Months Ended March 31,
	2003		2004		Percentage Change
Operating expenses:
Sales and marketing	$	36,129	$	36,124	—	%
Research and development		17,185		18,158	5.7	%
General and administrative		6,551		8,260	26.1	%
In-process research and development		—		6,700	100.0	%
Amortization of purchased intangible assets		867		730	(15.8	)%
Total operating expenses	$	60,732	$	69,972	4.2	%

Sales and Marketing—Sales and marketing expenses consist primarily of the following types of costs related to our sales and marketing activities: compensation and benefits; sales commissions; facilities and systems; recruiting; trade shows; travel and entertainment; and marketing communications. Headcount reductions in our pre-sales and marketing organizations during the last half of 2003 resulted in lower personnel related costs in the first quarter of 2004, as well as reduced spending on advertising and tradeshows. These reductions were offset by higher costs from the U.S. Dollar devaluation in the first quarter of 2004 compared to the same period in 2003, contributing

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approximately $1.6 million to total sales and marketing expenses, and approximately $1.0 million of additional expenses from the acquisition of Aelita. We expect marketing communications and program expenses in the remaining quarters of 2004 to be approximately $1.0 million higher than in the three months ended March 31, 2004.

Research and Development—Research and development expenses consist primarily of compensation and benefit costs for software developers, software product managers, quality assurance and technical documentation personnel, associated facilities and systems costs and payments made to outside software development consultants in connection with our ongoing efforts to enhance our core technologies and develop additional products. Research and development expenses as a percentage of total revenues were 22.0% in the first quarter of 2004 compared to 24.1% in the comparable period of 2003. The devaluation of the U.S. Dollar to the Australian and Canadian Dollars in the first quarter of 2004 compared to the same period in 2003 contributed $0.5 million to the increase in research and development expenses, because we have significant development facilities in Australia and Canada. In addition, the acquisition of Aelita contributed $0.4 million to the increase in total research and development expenses.

General and Administrative—General and administrative expenses consist primarily of compensation and benefit costs for our executive, finance, legal, administrative and information services personnel, professional fees, and associated facilities and systems costs. General and administrative expenses as a percentage of total revenues were 10.0% in 2004 and 9.2% in the comparable period of 2003. The absolute dollar increase in general and administrative expenses is primarily attributable to higher compensation expenses and increased litigation defense costs.

Amortization of Purchased Intangible Assets—Amortization of purchased intangible assets includes the amortization of customer lists, trademarks, non-compete agreements and maintenance contracts associated with acquisitions. The decrease is due to intangible assets related to acquisitions made in 2000 that were fully amortized by the end of 2003, offset slightly by intangible asset amortization related to the acquisition of Aelita in March 2004. We expect amortization of purchased intangible assets to be approximately $1.5 million per quarter throughout the remaining quarters of 2004.

Other Income, Net

Other income, net includes interest income on our investment portfolio and gains and losses from foreign exchange fluctuations, as well as gains or losses on other financial assets. Other income, net decreased from $1.9 million in the first quarter of 2003 to $0.7 million in the comparable period of 2004. Interest income increased 16.0% from $1.7 million in the first quarter of 2003 to $1.9 million in the comparable period of 2004. Foreign currency losses of $1.0 million were included in other income, net in the first quarter of 2004 as compared to a $0.7 million gain included in the comparable period of 2003. Foreign currency losses were primarily a result of translation losses on accounts receivable, cash and intra-company receivables denominated in the Australian Dollar, Euro and the British Pound. The adjustments to these balance sheet items are calculated under Statement of Financial Accounting Standards (“SFAS”) No. 52, “Foreign Currency Translation,” by comparing the currency spot rates on March 31, 2004 to the spot rates on December 31, 2003. On this basis the U.S. Dollar strengthened against the Euro, the British Pound and the Australian Dollar.

Income Tax Provision

Provision for income taxes increased to $3.9 million in the first quarter of 2004 from $1.5 million in the comparable period of 2003, representing an increase of $2.4 million or 155.3%. The effective income tax rate for the three months ended March 31, 2004 was 91% compared to 40% in the comparable period of 2003. The increase in the tax rate in the first quarter of 2004 was due to a permanent difference between GAAP pre-tax income and taxable income as a result of the $6.7 million non-deductible write-off of Aelita’s in-process research and development. For the remainder of 2004, we expect an effective tax rate of approximately 36%.

Liquidity and Capital Resources

As of March 31, 2004, cash and cash equivalents and short-term marketable securities were $84.1 million and we held $180.7 million of long-term investment grade corporate and government securities.

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Operating Activities

Net cash provided by operating activities increased to $22.8 million in the first quarter of 2004, compared with $21.9 million in the comparable period of 2003. The increase in cash from operating activities in the first quarter of 2004 was driven primarily by an increase in cash collected on prior year-end accounts receivable and an increase in sales during the current quarter, partially offset by an increase in prepaid expenditures.

Investing Activities

We used $97.9 million in investing activities in the first quarter of 2004, consisting primarily of $94.3 million net cash paid for acquisitions and $16.6 million in capital expenditures, partially offset by $13.0 million net cash received from sales and maturities of marketable securities. We used $22.8 million in investing activities in the first quarter of 2003, consisting primarily of $19.9 million net cash paid for purchases of marketable securities and $2.9 million in capital expenditures. Capital expenditures in the first quarter of 2004 consisted of $14.9 million to purchase a building and the remainder for information technology hardware and software purchases. In March 2004, we purchased a building in Aliso Viejo, California comprising approximately 78,000 square feet. We also entered into an agreement to lease approximately 57,000 square feet of space in an adjacent building for a ten-year term commencing in December 2005. The lease agreement includes an option, exercisable until November 15, 2004, to purchase this building for a purchase price of approximately $18.6 million. We intend to move all of our Irvine operations into these two buildings in stages over the next six quarters. Relocation costs and costs of improvements are expected to be approximately $18.0 million. In the future, we expect cash will continue to be generated from our operations. We plan to use cash generated from operations to close out our existing repurchase position within the next twelve months and invest in new short and long-term marketable securities consistent with past investment practices. We will continue to evaluate a variety of other strategic investment and acquisition opportunities.

Financing Activities

Financing activities generated $74.4 million in the first quarter of 2004, primarily from net proceeds of $67.5 million from a repurchase agreement as described in Note 5 of the “Notes to Condensed Consolidated Financial Statements” and $7.0 million from issuances of our common stock under employee stock option and stock purchase plans. Financing activities generated $2.4 million in the first quarter of 2003, of which $2.5 million was generated from issuances of our common stock under employee stock option and stock purchase plans, offset by the use of $0.1 million for capital lease obligations.

At March 31, 2004, we had borrowings of $67.5 million outstanding under a repurchase agreement with a borrowing rate of 1.07% and a remaining term to maturity of 71 days.

In December 2000, our Board of Directors authorized a stock repurchase program under which we may purchase up to two million shares of our common stock. Under the repurchase program, we may purchase shares from time to time at varying prices in open market or private transactions. In October 2001, our Board of Directors increased the total number of shares authorized for repurchase under the stock repurchase program from two million shares to five million. As of March 31, 2004, we had repurchased approximately 1.7 million shares of our common stock under this program for an aggregate cost of approximately $58.0 million. Repurchases help offset dilution from stock issued under our employee stock option and employee stock purchase plans. No shares of common stock were repurchased under this plan during the first quarter of 2003 or 2004.

Based on our current operating plan, we believe that our existing cash, cash equivalents and investment balances and cash flows from operations will be sufficient to finance our working capital, debt service and capital expenditure requirements through at least the next 12 months. If we are not able to generate or sustain positive cash flow from operations, we would be required to use existing cash, cash equivalents and investment balances to support our working capital. Our ability to generate cash from operations is subject to substantial risks described below under the caption “Risk Factors.”

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect our reported assets, liabilities, revenues and expenses. On an on-going basis, we

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evaluate our estimates, including those related to revenue recognition, accounts receivable, intangible assets and deferred income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. This forms the basis of judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies and the related judgments and estimates affect the preparation of our condensed consolidated financial statements.

Revenue Recognition

We derive revenues from two primary sources: (1) software licenses and (2) services, which include post-contract customer support, consulting and education. We utilize written contracts as the means to establish the terms and conditions by which our products and services are sold to our customers. We license our products primarily through our direct sales force and indirectly through resellers.

We recognize revenue in accordance with the American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” and related interpretations, SOP 98-9 “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin No. 101 (“SAB 101”), “Revenue Recognition in Financial Statements,” and other related pronouncements. Based on our reading and interpretation of SOP 97-2, SOP 98-9, SAB 101 and other related pronouncements, we believe that our current sales contract terms and business arrangements have been properly reported. The AICPA and its Software Revenue Recognition Task Force continue to issue interpretations and guidance for applying the relevant standards to a wide range of sales contract terms and business arrangements that are prevalent in the software industry. Future interpretations of existing accounting standards or changes in our business practices could result in future changes in our revenue accounting policies that could have a material adverse effect on our business, financial condition and results of operations.

Our software products are “off-the-shelf” products that do not require modification or customization. Revenues from sales of software licenses to customers are recognized when:

(1) Persuasive evidence of an arrangement exists—We consider a written contract, signed by both the customer and us, to be persuasive evidence of an arrangement;

(2) Delivery has occurred—We deem delivery to have occurred when all products or services that are essential to the functionality are delivered to the customer;

(3) The fee is fixed or determinable—We deem our fee to be fixed or determinable when we have a signed contract that states the agreed upon fee for our software and/or services. We consider arrangements with 80% or more of the payments due within six months and the balance due within the next six months to be fixed and determinable. Arrangements with payment terms extending beyond these customary payment terms are considered neither to be fixed nor determinable, and revenue from such arrangements is recognized as payments are received. We do not grant customers a right of return; and

(4) Collection is probable—We assess the probability of collection on a customer-by-customer basis, based on the customer’s payment history and our evaluation of the customer’s financial position. If we determine that collection is not probable, we recognize revenue upon receipt of payment.

Our software license sales include an implicit first year annual customer support fee, which is recognized ratably over the one-year term of the arrangement. A customer’s renewal of annual customer support is priced as a percentage of the net software license fees, generally 20% to 25% of the initial purchase price.

We also offer product implementation and training services, which are sold separately under consulting engagement contracts. Revenues from these arrangements are accounted for separately from new software license revenues because the arrangements qualify as service transactions as defined in SOP 97-2 and are recognized as the services are performed.

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For arrangements with multiple elements, we allocate revenue to each element of a transaction based upon its fair value as determined in reliance on “vendor-specific objective evidence,” or “VSOE.” VSOE of fair value for all elements of an arrangement is based upon the normal pricing and discounting practices for those products and services when sold separately. When multiple elements are sold to a customer in a single contract, the revenues from such multiple-element arrangements are allocated to each element based upon the residual method. Under the residual method, revenue is recognized for all delivered elements when (1) there is VSOE of the fair values of all undelivered elements and (2) all revenue recognition criteria of SOP 97-2, as amended, are satisfied. Under the residual method of accounting, any discount in the arrangement is allocated to the delivered elements. If we cannot objectively determine the fair value of any undelivered element included in bundled software and service arrangements, we defer revenue until all elements are delivered, services have been performed or until fair value can objectively be determined.

We sell our products primarily through direct sales. For indirect sales transactions sold through distributors or resellers, we recognize revenue using the sell-through method, meaning recognized revenues are associated with specific end user customer orders. In addition, we defer recognition on indirect sales until receipt of payment unless we have a payment history with the reseller or distributor with no late payment experiences.

Accounts Receivable

We maintain allowances for sales returns and doubtful accounts for estimated losses resulting from the unwillingness or inability of our customers to make required payments. This requires us to make estimates of future product returns, annual support cancellations and write-offs of bad debt accounts related to current period revenues. The amount of our reserves is based on historical experience and our analysis of the accounts receivable. As a percentage of current period revenues, charges against sales allowances for bad debt, sales returns and annual support cancellations were insignificant in both of the three months ended March 31, 2004 and 2003.

If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required which would result in an additional general and administrative expense in the period such determination was made. Additionally, if significant product performance issues were to arise resulting in our accepting sales returns, additional allowances may be required which would result in a reduction of revenue in the period such determination was made. Our standard licensing agreement does not permit customers to return products unless we have breached the product warranty and are unable to cure the breach. Our product warranties are typical industry warranties that a product will perform in accordance with established product requirements. While such amounts have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past.

Intangible Assets

As required by Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” we do not amortize goodwill. All current and future acquired goodwill will be subject to impairment tests annually, or earlier if indicators of potential impairment exist, using a fair-value-based approach. All other intangible assets will continue to be amortized over their estimated useful lives and assessed for impairment under SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”

Under SFAS No. 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. We performed our annual impairment review during the fourth quarter of 2003 and as a result determined that the carrying value of goodwill was less than the estimated fair value. In calculating the fair value of the reporting units (licenses and services), the Market Approach (Guideline Company Method) was the methodology deemed the most reliable and used for impairment analysis. We will perform subsequent annual impairment reviews during the fourth quarter of each year, or earlier if indicators of potential impairment exist. Future impairment reviews may result in charges against earnings to write down the value of goodwill.

Purchased intangible assets are recorded at the estimated fair value on the purchase date and amortized using the straight-line method over estimated useful lives of two years to seven years. The net carrying amount of purchased intangible assets was considered recoverable at March 31, 2004. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” purchased intangible assets are reviewed for

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events or changes in circumstances, which indicate that their carrying value may not be recoverable. We periodically review the carrying value of these assets to determine whether or not impairment to such value has occurred. In the event that in the future it is determined that the purchased intangible assets value has been impaired, an adjustment will be made resulting in a charge for the write-down in the period in which the determination is made.

Income Taxes

We are required to estimate income taxes in each of the jurisdictions in which we operate as part of the process of preparing the consolidated financial statements. We recognize deferred income tax assets and liabilities based upon the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Such deferred income taxes primarily relate to the timing of the recognition of certain revenue items and the timing of the deductibility of certain reserves and accruals for income tax purposes. We regularly review the deferred tax assets for recoverability and establish a valuation allowance when it is more likely than not that some portion or all of the deferred tax assets will not be realized. If we are unable to generate sufficient future taxable income, or if there is a material change in the actual effective tax rates or time periods within which the underlying timing differences become taxable or deductible, we could be required to establish an additional valuation allowance against the deferred tax assets, which could result in a substantial increase in our effective tax rate and have a materially adverse impact on our operating results. U.S. income taxes were not provided for on undistributed earnings from certain non-U.S. subsidiaries. Those earnings are considered to be permanently reinvested.

Accounting for Stock-Based Compensation

We account for stock based employee compensation plans under the recognition and measurement principles of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Certain options granted under those plans had an exercise price less than the fair value of the underlying common stock on the date of grant. Unearned stock-based employee compensation costs associated with these options are reflected in net income as the options vest. The expense equals the difference between the fair market value of our common stock on the grant date and the exercise price of the stock options and is recognized ratably over the vesting period of the stock options, currently four to five years.

Pro forma information regarding net income and earnings per share is required by SFAS No. 123 “Accounting for Stock Based Compensation.” This information is required to be determined as if we had accounted for employee stock options and stock purchase plans under the fair value method of SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.”

Had employee stock based compensation cost been determined using the fair value method our net income would have been adjusted to the pro forma amounts indicated below (in thousands, except per share data):

	Three Months Ended March 31,
	2003			2004
Net income:
As reported	$	2,534		$	386
Add: Stock-based compensation expense included in reported net income, net of related tax effects		307			109
Deduct: Total stock-based compensation determined under fair value based method for all awards, net of related tax effects		(6,624	)		(6,854	)
Pro forma	$	(3,783	)	$	(6,359	)
Basic net income (loss) per share:
As reported		0.03			0.00
Pro forma		(0.04	)		(0.07	)
Diluted net income (loss) per share:
As reported		0.03			0.00
Pro forma		(0.04	)		(0.07	)

The fair value of options and shares issued pursuant to the Employee Stock Purchase Plan at the grant date was estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in

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estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility rates trended into future years. Because our 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 existing models do not necessarily provide a reliable single measure of the fair value of our options.

The effects of applying pro forma disclosures of net income and earnings per share are not likely to be representative of the pro forma effects on net income and earnings per share in the future years, because the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.

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RISK FACTORS

An investment in our shares involves risks and uncertainties. You should carefully consider the factors described below before making an investment decision in our securities. The risks described below are the risks that we currently believe are material risks of business and the industry in which we compete.

Our business, financial condition and results of operations could be adversely affected by any of the following risks. If we are adversely affected by such risks, then the trading price of our common stock could decline, and you could lose all or part of your investment.

Our quarterly operating results may fluctuate in future periods and, as a result, we may fail to meet expectations of investors and analysts, causing our stock price to fluctuate or decline

Our revenues and operating results may vary significantly from quarter to quarter due to a number of factors. These factors include the following:

• the size and timing of customer orders. See “—The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in our revenues.”

• the discretionary nature of our customers’ purchasing decisions and budget cycles;

• the timing of revenue recognition for sales of software products and services;

• the extent to which our customers renew their maintenance contracts with us;

• exposure to general economic conditions and reductions in corporate IT spending;

• changes in our level of operating expenses and our ability to control costs;

• our ability to attain market acceptance of new products and services and enhancements to our existing products;

• changes in our pricing policies or the pricing policies of our competitors;

• the relative growth rates of competing operating system, database and application platforms;

• the unpredictability of the timing and level of sales through our indirect sales channels;

• costs related to acquisitions of technologies or businesses, including amortization costs for intangible assets with indefinite lives; and

• the timing of releases of new versions of third-party software products that our products support or with which our products compete.

Fluctuations in our results of operations are likely to affect the market price of our common stock and may not be related to or indicative of our long-term performance.

The size and timing of our customer orders may vary significantly from quarter to quarter which could cause fluctuations in our revenues and operating results

Our license revenues in any quarter are substantially dependent on orders booked and delivered in that quarter. Our revenues in a given quarter could be adversely affected if we are unable to complete one or more large license agreements, or if the contract terms were to prevent us from recognizing revenue during that quarter. The sales cycles for certain of our software products, such as Vista Plus and SharePlex, can last from three to nine months and often require pre-purchase evaluation periods and customer education. Also, we have often booked a large amount of our sales in the last month, weeks or days of each quarter and delays in the closing of sales near the end of a quarter could cause quarterly revenue to fall short of anticipated levels. Finally, while a portion of our revenues each

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quarter is recognized from previously deferred revenue, our quarterly performance will depend primarily upon entering into new contracts to generate revenues for that quarter. These factors may cause significant periodic variation in our license revenues. In addition, we incur or commit to operating expenses based on anticipated revenue levels, and generally do not know whether revenues in any quarter will meet expectations until the end of that quarter. Accordingly, if our revenue growth rates slow or our revenues decline, our operating results could be seriously impaired because many of our expenses are relatively fixed in nature and cannot be easily or quickly changed.

General economic conditions and reduced levels of corporate IT spending may continue to affect revenue growth rates and impact our business

Our business and operating results are subject to the effects of changes in general economic conditions. Recent unfavorable economic conditions have resulted in continued reduced corporate IT spending in the industries that we serve and a softening of demand for computer software, not only in the database and application market segments we support but also in the product segment in which we compete. If these economic conditions do not improve, or we experience continued deterioration in general economic conditions or further reduced corporate IT spending, our business and operating results could continue to be adversely impacted.

Many of our products are vulnerable to direct competition from Oracle

We compete with Oracle in the market for database management solutions and the competitive pressure continues to increase. We expect that Oracle’s commitment to and presence in the database management product market will increase in the future and therefore substantially increase competitive pressures. We believe that Oracle will continue to incorporate database management technology into its server software offerings, possibly at no additional cost to its users. Competition from Oracle with certain of our Database Management products including SharePlex and Quest Central for Oracle has increased over the last two years and continues to increase with Oracle’s introduction of the next version of its database, known as Oracle 10G. Oracle 10G is claimed to have enhanced capabilities in the functions competitive with Quest Central for Oracle and with the Oracle monitoring capabilities of Foglight. If Oracle 10G does provide capabilities closely equivalent to those of Quest Central for Oracle, our revenues from that product line would likely be materially adversely affected.

In some cases these platform vendor-provided tools are bundled with the platform and in other cases they are separately chargeable products, albeit at significantly lower price points. The inclusion of the functionality of our software as standard features of the underlying database solution or application supported by our products or sale at much lower cost could erode our revenues, particularly if the competing products and features were of comparable capability to our products. Even if the functionality provided as standard features or lower costs by these system providers is more limited than that of our software, there can be no assurance that a significant number of customers would not elect to accept more limited functionality in lieu of purchasing our products. Moreover, there is substantial risk that the mere announcements of competing products or features by large competitors such as Oracle could result in the delay or cancellation of customer orders for our products in anticipation of the introduction of such new products or features.

Many of our products are dependent on database or application technologies of others; if these technologies lose market share or become incompatible with our products, or if these vendors acquire or form strategic relationships with our competitors, the demand for our products could suffer

We believe that our success has depended in part, and will continue to depend in part for the foreseeable future, upon our relationships with providers of major database and enterprise software programs, including Oracle, IBM, Microsoft, SAP, Siebel and PeopleSoft. Our competitive advantage consists in substantial part on the integration between our products and products provided by these major software providers, and our extensive knowledge of their products and technologies. If these companies for any reason decide to promote technologies and standards that are not compatible with our technologies, or if they lose market share for their database or application products, our business, operating results and financial condition would be materially adversely affected. Furthermore, these major software vendors could attempt to increase their presence in the markets we serve by acquiring or forming strategic alliances with our competitors, and may be in better position to withstand and respond to the current factors impacting this industry. These companies have longer operating histories, larger installed bases of customers and substantially greater financial, distribution, marketing and technical resources than we do, as well

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as well-established relationships with many of our present and potential customers. As a result, we may not be able to compete effectively with these companies in the future, which could materially adversely affect our business, operating results and financial condition.

Our success depends on our ability to develop new and enhanced products that achieve widespread market acceptance

Our future success depends on our ability to address the rapidly changing needs of our customers by developing and introducing new products, product updates and services on a timely basis, by extending the operation of our products on new platforms and by keeping pace with technological developments and emerging industry standards. In order to grow our business, we are committing substantial resources to developing software products and services for the applications management market. If this market does not continue to develop as anticipated, or demand for our products in this market does not materialize or occurs more slowly than we expect, or if our development efforts are delayed or unsuccessful, we will have expended substantial resources and capital without realizing sufficient revenues, and our business and operating results could be adversely affected.

Our operating results may be negatively impacted by fluctuations in foreign currency exchange rates

Our international operations are generally conducted through our international subsidiaries, with the associated revenues and related expenses, and balance sheets, denominated in the currency of the country in which the international subsidiaries operate. As a result, our operating results may be harmed by fluctuations in exchange rates between the U.S. Dollar and other foreign currencies. The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our exposure to fluctuations in foreign currency exchange rates.

Our international operations and our planned expansion of our international operations expose us to certain risks

We maintain research and development operations in Canada, Australia, Israel and Russia, and continue to expand our international sales activities as part of our business strategy. As a result, we face increasing risks from our international operations, including, among others:

• difficulties in staffing and managing foreign operations;

• longer payment cycles;

• seasonal reductions in business activity in Europe;

• increased financial accounting and reporting burdens and complexities;

• potentially adverse tax consequences;

• potential loss of proprietary information due to piracy, misappropriation or weaker laws regarding intellectual property protection;

• delays in localizing our products;

• political unrest or terrorism, particularly in areas in which we have facilities;

• compliance with a wide variety of complex foreign laws and treaties; and

• licenses, tariffs and other trade barriers.

Operating in international markets also requires significant management attention and financial resources and will place additional burdens on our management, administrative, operational and financial infrastructure. We cannot be certain that our investments in establishing facilities in other countries will produce desired levels of revenue or profitability. In addition, we have limited experience in developing localized versions of our products and marketing and distributing them internationally.

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Acquisitions of companies or technologies may result in disruptions to our business and diversion of management attention

We have in the past made and we expect to continue to make acquisitions of complementary companies, products or technologies, including Sitraka and our most recent acquisition of Aelita. Any additional acquisitions will require us to assimilate the operations, products and personnel of the acquired businesses and train, retain and motivate key personnel from the acquired businesses. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may subject us to liabilities and risks that are not known or identifiable at the time of the acquisition or may cause disruptions in our operations and divert management’s attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners. We may have to use cash, incur debt or issue equity securities to pay for any future acquisitions. Use of cash or debt may affect our liquidity and use of cash would reduce our cash reserves. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability may suffer because of acquisition-related costs or amortization costs for intangible assets with indefinite useful lives. In consummating acquisitions, we are also subject to risks of entering geographic and business markets in which we have no or limited prior experience. If we are unable to fully integrate acquired businesses, products or technologies with our existing operations, we may not receive the intended benefits of an acquisition.

We face risks associated with governmental contracting

We derive a portion of our revenues from contracts with the United States government and its agencies and from contracts with state and local governments or agencies. Demand and payment for our products and services are impacted by public sector budgetary cycles and funding availability, with funding reductions or delays adversely impacting public sector demand for our products and services. Public sector customers may also change the way they procure new contracts and may adopt new rules or regulations governing contract procurement, including required competitive bidding or use of “open source” products, where available. These factors may limit the growth of or reduce the amount of revenues we derive from the public sector, which could negatively affect our results of operations.

Our efforts to constrain costs may strain our management, administrative, operational and financial infrastructure

We are experiencing slower growth and are focused on increasing our operating margins. These efforts place a strain on our management, administrative, operational and financial infrastructure. Our ability to manage our operations while reducing operating costs requires us to continue to improve our operational, financial and management controls and reporting systems and procedures. Although we achieved a year over year increase in our margins from the first quarter of 2003 to the comparable quarter in 2004, there can be no guarantees that we will be successful in achieving our profitability targets in any future quarterly or annual period.

We may not generate increased business from our current customers, which could slow our revenue growth in the future

Most of our customers initially make a purchase of our products for a single department or location. Many of these customers may choose not to expand their use of our products. If we fail to generate expanded business from our current customers, our business, operating results and financial condition could be materially adversely affected. In addition, as we deploy new modules and features for our existing products or introduce new products, our current customers may choose not to purchase this new functionality or these new products. Moreover, if customers elect not to renew their maintenance agreements, our service revenues would be materially adversely affected.

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Our operating results may be affected if we are required to change our accounting for employee stock options

We currently account for the issuance of stock options under Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB No. 25, no compensation expense is recognized for options granted to employees where the exercise price equals the market price of the underlying stock on the date of grant. Certain proposals related to treating the grant of an employee stock option as an expense are currently under consideration by accounting standards organizations and governmental authorities. If such proposals are adopted and we are required to change the way we account for stock options, our operating results could be negatively impacted as a result of the additional expenses associated with stock options. See Note 2 of the “Notes to Condensed Consolidated Financial Statements” for a more detailed presentation of our accounting for stock-based compensation plans.

Failure to develop strategic relationships could harm our business by denying us selling opportunities and other benefits

Our current collaborative relationships may not prove to be beneficial to us, and they may not be sustained. We also may not be able to enter into successful new strategic relationships in the future, which could have a material adverse effect on our business, operating results and financial condition. We could lose sales opportunities if we fail to work effectively with these parties. Moreover, we expect that maintaining and enhancing these and other relationships will become a more meaningful part of our business strategy in the future. However, many of our current partners are either actual or potential competitors with us. In addition, many of these third parties also work with competing software companies and we may not be able to maintain these existing relationships, due to the fact that these relationships are informal or, if written, are terminable with little or no notice.

Failure to adequately protect our intellectual property rights could harm our competitive position

Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology. We generally rely on a combination of trademark, trade secret, patent, copyright law and contractual restrictions to protect the proprietary aspects of our technology.

Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, and to determine the validity and scope of the proprietary rights of others. Any such resulting litigation, whether successful or unsuccessful, could result in substantial costs and diversion of management and financial resources, which could harm our business.

Our means of protecting our proprietary rights may prove to be inadequate and competitors may independently develop similar or superior technology. Policing unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will prevent misappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. We also believe that, because of the rapid rate of technological change in the software industry, trade secret and copyright protection are less significant than factors such as the knowledge, ability and experience of our employees, frequent product enhancements and the timeliness and quality of customer support services.

Third parties may claim that our software products or services infringe on their intellectual property rights, exposing us to litigation that, regardless of merit, may be costly to defend

Our success and ability to compete are also dependent on our ability to operate without infringing upon the proprietary rights of others. Third parties may claim that our current or future products infringe their intellectual property rights. Any such claim, with or without merit, could have a significant effect on our business and financial results. See “Legal Proceedings” in Part II, Item 1, of this Report, for information concerning copyright infringement and trade secret misappropriation claims initiated against Quest by Computer Associates International, Inc. This and any future third party claim could be time consuming, divert management’s attention from our business operations and result in substantial litigation costs, including any monetary damages and customer indemnification obligations, which may result from such claims. In addition, parties making these claims may be able to obtain injunctive or other equitable relief affecting our ability to license the products that incorporate the challenged intellectual property. As a result of such claims, we may be required to obtain licenses from third parties, develop alternative technology or redesign our products. We cannot be sure that such licenses would be available on terms acceptable to us, if at all. If a successful claim is made against us and we are unable to develop or license alternative technology, our business and financial results and position could be materially adversely affected.

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Our business will suffer if our software contains errors

The software products we offer are inherently complex. Despite testing and quality control, we cannot be certain that errors will not be found in current versions, new versions or enhancements of our products after commencement of commercial shipments. Significant technical challenges also arise with our products because our customers purchase and deploy our products across a variety of computer platforms and integrate it with a number of third-party software applications and databases. If new or existing customers have difficulty deploying our products or require significant amounts of customer support, our operating margins could be harmed. Moreover, we could face possible claims and higher development costs if our software contains undetected errors or if we fail to meet our customers’ expectations. As a result of the foregoing, we could experience:

• loss of or delay in revenues and loss of market share;

• loss of customers;

• damage to our reputation;

• failure to achieve market acceptance;

• diversion of development resources;

• increased service and warranty costs;

• legal actions by customers against us which could, whether or not successful, increase costs and distract our management; and

• increased insurance costs.

In addition, a product liability claim, whether or not successful, could harm our business by increasing our costs and distracting our management.

We incorporate software licensed from third parties into some of our products and any significant interruption in the availability of these third-party software products or defects in these products could reduce the demand for, or prevent the shipping of, our products

Certain of our software products contain components developed and maintained by third-party software vendors. We expect that we may have to incorporate software from third-party vendors in our future products. We may not be able to replace the functionality provided by the third-party software currently offered with our products if that software becomes obsolete, defective or incompatible with future versions of our products or is not adequately maintained or updated. Any significant interruption in the availability of these third-party software products or defects in these products could harm our sales unless and until we can secure an alternative source. Although we believe there are adequate alternate sources for the technology licensed to us, such alternate sources may not provide us with the same functionality as that currently provided to us.

Natural disasters or power outages could disrupt our business

A substantial portion of our operations is located in California, and we are subject to risks of damage and business disruptions resulting from earthquakes, floods, fires and similar events, as well as from power outages. We have in the past experienced limited and temporary power losses in our California facilities due to power shortages, and we expect in the future to experience additional power losses. While the impact to our business and operating results has not been material, we cannot assure you that power losses will not adversely affect our business in the future, or that the cost of acquiring sufficient power to run our business will not increase significantly. Since we do not have sufficient redundancy in our networking infrastructure, a natural disaster or other unanticipated problem could have an adverse effect on our business, including both our internal operations and our ability to communicate with our customers or sell and deliver our products.

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The demand for our products will depend on our ability to adapt to rapid technological change

Our future success will depend on our ability to continue to enhance our current products and to develop and introduce new products on a timely basis that keep pace with technological developments and satisfy increasingly sophisticated customer requirements. Rapid technological change, frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and evolving industry standards characterize the market for our products and services. The introduction of products embodying new technologies and the emergence of new industry standards can render our existing products obsolete and unmarketable. As a result of the complexities inherent in today’s computing environments and the performance demanded by customers for embedded databases and Web-based products, new products and product enhancements can require long development and testing periods. As a result, significant delays in the general availability of such new releases or significant problems in the installation or implementation of such new releases could have a material adverse effect on our business, operating results and financial condition. We may not be successful in:

• developing and marketing, on a timely and cost-effective basis, new products or new product enhancements that respond to technological change, evolving industry standards or customer requirements;

• avoiding difficulties that could delay or prevent the successful development, introduction or marketing of these products; or

• achieving market acceptance for our new products and product enhancements.

We may not be able to attract and retain personnel

Our future success depends on the continued service of our executive officers and other key administrative, sales and marketing and support personnel, many of whom have recently joined our company. In addition, the success of our business is substantially dependent on the services of our Chief Executive Officer and other executive officers. There has in the past been and there may in the future be a shortage of personnel that possess the technical background necessary to sell, support and develop our products effectively. Competition for skilled personnel is intense, and we may not be able to attract, assimilate or retain highly qualified personnel in the future. Our business may not be able to grow if we cannot attract qualified personnel. Hiring qualified sales, marketing, administrative, research and development and customer support personnel is very competitive in our industry, particularly in Southern California where Quest is headquartered.

Item 3: Quantitative and Qualitative Disclosures About Market Risks

We transact business in a number of different foreign countries around the world. In most instances, revenues are collected and operating expenses are paid in the local currency of the country in which we are transacting. Accordingly, we are exposed to incremental volatility in sales and earnings within these countries due to fluctuations in foreign exchange rates.

Our exposure to foreign exchange risk is directly proportional to the magnitude of foreign net profits and losses denominated in currencies other than the U.S. Dollar, as well as our net foreign investment in non-U.S. Dollar assets. These exposures have the potential to produce either gains or losses. Our cumulative currency gains or losses in any given period are typically lessened by the economic benefits of diversification and low correlation between different currencies, but there can be no assurance that this pattern will continue to be true in future periods.

The foreign currencies to which we currently have the most significant exposure are the Canadian Dollar, the British Pound, the Euro and the Australian Dollar. To date, we have not used derivative financial instruments to hedge our foreign exchange exposures, nor do we use such instruments for speculative trading purposes. We regularly monitor the potential cost and benefits of hedging foreign exchange exposures with derivatives and there remains the possibility that our foreign exchange hedging practices could change accordingly in time.

Interest Rate Risk

Our exposure to market interest-rate risk relates primarily to our investment portfolio. We have not used derivative financial instruments to hedge the market risks of our investments. We place our investments with high-quality issuers and, by policy, limit the amount of credit exposure to any one issuer other than the United States

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government and its agencies. Our investments in marketable securities consist primarily of investment-grade bonds and United States government and agency securities. Investments purchased with an original maturity of three months or less are considered to be cash equivalents. We classify all of our investments as available-for-sale. Available-for-sale securities are carried at fair value, with unrealized gains and losses, net of tax, reported in a separate component of shareholders’ equity.

Information about our investment portfolio is presented in the table below, which states the amortized book value and related weighted-average interest rates by year of maturity (in thousands):

	Amortized Book Value		Weighted Average Rate
Investments maturing by March 31,
2005 (a)	$	83,838	1.41	%
2006		36,011	1.89	%
2007		69,116	2.17	%
2008		22,000	2.88	%
Thereafter		52,620	4.16	%
Total portfolio	$	263,585	2.34	%

(a) Includes cash and cash equivalents of $66.0 million.

We maintain a level of cash and cash equivalents such that we have generally been able to hold our investments to maturity. Accordingly, changes in the market interest rate would not have a material effect on the fair value of such investments.

Item 4: Controls and Procedures

Our management, with the participation of the chief executive officer and chief financial officer, has performed an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934). Based on such evaluation, our chief executive officer and chief financial officer concluded that, as of March 31, 2004, our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in the reports that we file under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosure.

No changes in our internal control over financial reporting have come to our management’s attention that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II—OTHER INFORMATION

Item 1: Legal Proceedings

On July 2, 2002, Computer Associates International, Inc. (“CA”) filed a complaint against us and four of our employees in the U.S. District Court for the Northern District of Illinois alleging copyright infringement and trade secret misappropriation in connection with the development of the database administration component of our Quest Central for DB2 product and seeking injunctive relief and unspecified money damages. The complaint was amended in May 2003 to add another Quest employee as a defendant and to assert breach of contract claims against three of the individual defendants. In October 2003, CA filed a motion for preliminary injunction. We responded to this motion in January 2004, arguing that CA cannot meet the requirements for injunctive relief. In connection with our response, we sought leave to assert a counterclaim for a declaratory judgment of invalidity of CA’s copyright registrations. Rulings on these motions are not expected until late in the second quarter of 2004. If CA’s motion is granted, we would be preliminarily enjoined from licensing Quest Central for DB2. We are vigorously defending CA’s claims and do not believe that this matter will have a material adverse effect on our results of operations or financial condition.

After we announced on July 23, 2003 that we would restate certain financial results as a result of our discovery of a computational error relating to an error in the method used to translate foreign currency denominated accounts into U.S. Dollars at historical rates, numerous separate complaints purporting to be class actions were filed in the United States District Court for the Central District of California alleging that we and some of our officers and directors violated provisions of the Securities Exchange Act of 1934. Orders designating a lead plaintiff and consolidating the federal class action complaints were issued by the U. S. District Court in late October 2003, and an amended consolidated class action complaint was filed in January 2004. The consolidated amended complaint contains varying allegations, including allegations that we made materially false and misleading statements with respect to our financial results for 2002 and the quarter ended March 31, 2003 included in our filings with the SEC and press releases. On May 10, 2004, during a hearing on our motion to dismiss the amended consolidated class action complaint, the U.S. District Court issued its tentative ruling granting our motion to dismiss and permitting the plaintiff to amend its complaint within 60 days. In addition, one complaint purporting to be a derivative action has been filed in California state court against some of our directors and officers. This complaint is based on the same facts and circumstances described in the class action complaints and generally alleges that the named directors and officers breached their fiduciary duties by failing to oversee adequately our financial reporting. Our motion to dismiss the derivative action is scheduled to be heard by the California Supreme Court in July 2004. Each of the complaints generally seek an unspecified amount of damages. The cases are in the preliminary stages and we are vigorously defending these claims; however, it is not possible for us to quantify the extent of our potential liability, if any. Accordingly, no amounts have been accrued in the accompanying financial statements. An unfavorable outcome in any of these cases could have a material adverse effect on our business, financial condition, results of operations and cash flow. In addition, defending any litigation may be costly and divert management’s attention from the day-to-day operations of our business.

We are a party to other litigation, which we consider to be routine and incidental to our business. Management does not expect the results of any of these actions to have a material adverse effect on our results of operations or financial condition.

In the normal course of our business, we enter into certain types of agreements that require us to indemnify or guarantee the obligations of other parties. These commitments include (i) intellectual property indemnities to licensees of our software products, (ii) indemnities to certain lessors under office space leases for certain claims arising from our use or occupancy of the related premises, or for the obligations of our subsidiaries under leasing arrangements, (iii) indemnities to customers, vendors and service providers for claims based on negligence or willful misconduct of our employees and agents, and (iv) indemnities to our directors and officers to the maximum extent permitted under applicable law. The terms and duration of these commitments varies and, in some cases, may be indefinite, and certain of these commitments do not limit the maximum amount of future payments we could become obligated to make thereunder; accordingly, our actual aggregate maximum exposure related to these types of commitments cannot be reasonably estimated. Historically, we have not been obligated to make significant payments for obligations of this nature, and no liabilities have been recorded for these obligations in the accompanying consolidated balance sheets as the fair value of these obligations issued during the three months ended March 31, 2004 was not significant to our financial position, results of operations, or cash flows.

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Item 6: Exhibits and Reports on Form 8-K

(a) EXHIBITS

Exhibit Number	Exhibit Title
10.1	Employment Agreement between Aelita Software Corporation, Quest Software, Inc. and Ratmir Timashev, as amended.
31.1	Certification of the Chief Executive Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
31.2	Certification of the Chief Financial Officer Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934, as amended.
32.1	Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) REPORTS ON FORM 8-K

1. On January 28, 2004, we filed a Current Report on Form 8-K relating to the announcement of our operating results for the quarter and year ended December 31, 2003.

2. On February 11, 2004, we filed a Current Report on Form 8-K relating to the announcement of a definitive agreement to acquire Aelita Software Corporation.

3. On March 15, 2004, we filed a Current Report on Form 8-K reporting that David Doyle had entered into a Rule 10b5-1 trading plan for the sale of Quest Software securities.

4. On April 1, 2004, we filed a Current Report on Form 8-K reporting the completion of our acquisition of Aelita Software Corporation on March 17, 2004.

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SIGNATURES

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

	QUEST SOFTWARE, INC.
Date: May 10, 2004	/S/    M. BRINKLEY MORSE
	M. Brinkley Morse Vice President, Finance and Operations and Chief Financial Officer
	/S/    KEVIN E. BROOKS
	Kevin E. Brooks Vice President and Corporate Controller

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EX-10.1

Exhibit 10.1

EMPLOYMENT AGREEMENT

EMPLOYMENT AGREEMENT, dated as of this 4th day of October, 2002, between Aelita Software Corporation, a Delaware corporation with its principle place of business at 6500 Emerald Parkway, Suite 400, Dublin, Ohio 43016 (the “Company”), and Ratmir Timashev (the “Executive”).

R E C I T A L S:

WHEREAS, the Company recognizes that the future growth, profitability and success of the Company’s business will be substantially and materially enhanced by the employment of the Executive by the Company;

WHEREAS, the Company desires to employ the Executive and the Executive has indicated his willingness to provide his services, on the terms and conditions set forth herein;

NOW, THEREFORE, on the basis of the foregoing premises and in consideration of the mutual covenants and agreements contained herein, the parties hereto agree as follows:

Section 1.  Employment. The Company hereby agrees to employ the Executive and the Executive hereby accepts employment with the Company, on the terms and subject to the conditions hereinafter set forth. Subject to the terms and conditions contained herein, the Executive shall serve as President and Chief Executive Officer of the Company and, in such capacity, shall report directly to the Board of Directors and shall have such duties as are typically performed by a President and Chief Executive Officer of a corporation, together with such additional duties, commensurate with the Executive’s position as President and Chief Executive Officer of the Company, as may be assigned to the Executive from time to time by the Board of Directors of the Company. The principal location of the Executive’s employment shall be at the Company’s principal executive office located in Dublin, Ohio, although the Executive understands and agrees that he may be required to travel from time to time for business reasons.

Section 2.  Term. Unless terminated pursuant to Section 6 hereof, the Executive’s employment hereunder shall be for a two year period and commence on the date hereof and shall continue during the period ending on the second anniversary of the date hereof (the “Initial Term”). Thereafter, the Employment Term shall renew automatically for consecutive periods of one year unless either party shall provide notice of nonrenewal not less than

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ninety (90) days prior to an anniversary date of this Agreement. The Initial Term, together with any renewal pursuant to this Section 2, is referred to herein as the “Employment Term.” The Employment Term shall terminate upon expiration of the Employment Term, or earlier upon any termination of the Executive’s employment pursuant to Section 6.

Section 3.   Compensation. During the Employment Term, the Executive shall be entitled to the following compensation and benefits:

(a)  Salary. As compensation for the performance of the Executive’s services hereunder, the Company shall pay to the Executive a salary (the “Salary”) of $180,000 per annum with increases, if any, as may be approved in writing by the Board of Directors. The Salary shall be payable in accordance with the payroll practices of the Company as the same shall exist from time to time. In no event shall the Salary be decreased more than fifteen percent during the Employment Term.

(b)  Bonus Plan. The Executive shall be eligible to receive an annual cash bonus (“Bonus”) which shall be in an amount and subject to the achievement of certain targets as determined by the Board of Directors. For the calendar year 2002 the Executive will be eligible to receive a Bonus of $150,000 based upon achievement of the targets set forth in Exhibit A attached hereto. For subsequent years the Board of Directors will establish the Bonus amount and related targets. Any Bonus amounts due the Executive under this Section 3(b) will be paid on or promptly after January 31 of the year subsequent to the year to which the targets relate.

(c)  Benefits. In addition to the Salary and Bonus the Executive shall be entitled to participate in health, insurance, profit sharing and other benefits provided to other senior executives of the Company on terms no less favorable than those available to such senior executives of the Company. The Executive shall also be entitled to the same number of vacation days, holidays, sick days and other benefits as are generally allowed to other senior executives of the Company in accordance with the Company policy in effect from time to time. The Executive shall also be entitled to air travel at the Business Class level for all flights overseas.

Section 4.  Exclusivity. During the Employment Term, the Executive shall devote his full time to the business of the Company, shall faithfully serve the Company, shall in all respects conform to and comply with the lawful and reasonable directions and instructions given to him by the Board of Directors in accordance with the terms of this Agreement, shall use his best efforts to promote and serve the interests of the Company and shall not engage in any other business activity, whether or not such activity shall be engaged in for pecuniary profit, except that the Executive may (i) participate in the activities

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of professional trade organizations related to the business of the Company, (ii) participate in activities as may be approved in writing by the Board of Directors, and (iii) engage in personal investing activities, provided that activities set forth in these clauses (i), (ii) and (iii), either singly or in the aggregate, do not interfere in any material respect with the services to be provided by the Executive hereunder. Other activities require written consent by the Board of Directors of the Company.

Section 5.  Reimbursement for Expenses. The Executive is authorized to incur reasonable expenses in the discharge of the services to be performed hereunder, including expenses for travel, entertainment, lodging and similar items in accordance with the Company’s expense reimbursement policy, as the same may be modified by the Board of Directors from time to time. The Company shall reimburse the Executive for all such proper expenses upon presentation by the Executive of itemized accounts of such expenditures in accordance with the financial policy of the Company, as in effect from time to time.

Section 6.  Termination and Default.

(a)  Death. The Executive’s employment shall automatically terminate upon his death and upon such event, the Executive’s estate shall be entitled to receive the amounts specified in Section 6(f) below.

(b)  Disability. If the Executive is unable to perform the duties required of him under this Agreement because of illness, incapacity, or physical or mental disability, the Employment Term shall continue and the Company shall pay all compensation required to be paid to the Executive hereunder, unless the Executive is unable to perform the duties required of him under this Agreement for an aggregate of 120 days (whether or not consecutive) during any 12-month period during the term of this Agreement, in which event the Executive’s employment shall terminate.

(c)  Cause. The Company may terminate the Executive’s employment at any time, with or without Cause. In the event of termination pursuant to this Section 6(c) for Cause, the Company shall deliver to the Executive written notice setting forth the basis for such termination, which notice shall specifically set forth the nature of the Cause which is the reason for such termination. Termination of the Executive’s employment hereunder shall be effective upon delivery of such notice of termination. For purposes of this Agreement, “Cause” shall mean: (i) the Executive’s failure (except where due to a disability contemplated by subsection (b) hereof), neglect or refusal to perform his duties hereunder which failure, neglect or refusal shall not have been corrected by the Executive within 30 days of receipt by the Executive of written notice from the Company of such failure,

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neglect or refusal, which notice shall specifically set forth the nature of said failure, neglect or refusal, (ii) any willful or intentional act of the Executive that has the effect of injuring the reputation or business of the Company or its affiliates in any material respect; (iii) any continued or repeated absence from the Company, unless such absence is (A) approved or excused by the Board of Directors or (B) is the result of the Executive’s illness, disability or incapacity (in which event the provisions of Section 6(b) hereof shall control); (iv) use of illegal drugs by the Executive or repeated drunkenness; (v) conviction of the Executive for the commission of a felony; or (vi) the commission by the Executive of an act of fraud or embezzlement against the Company.

(d) Good Reason. The Executive may terminate his employment for “Good Reason” following a Substantial Breach (as hereinafter defined), but only if such Substantial Breach shall not have been corrected by the Company within thirty (30) days of receipt by the Company of written notice from the Executive of the occurrence of such Substantial Breach, which notice shall specifically set forth the nature of the Substantial Breach which is the reason for such resignation. The term “Substantial Breach” means (i) the failure by the Company to pay to the Executive the Salary and Bonus, if any, in accordance with Sections 3(a) and 3(b) hereof; (ii) the failure by the Company to allow the Executive to participate in the Company’s employee benefit plans generally available from time to time to senior executives of the Company; (iii) the failure of any successor to all or substantially all of the business and/or assets of the Company to assume this Agreement; provided, however, that the term “Substantial Breach” shall not include a termination of the Executive’s employment hereunder pursuant to Sections 6(b) or (c) hereof; (iv) the substantial and material diminution in the Executive’s duties, responsibilities, reporting relationship or position; (v) a greater than fifteen percent reduction of the Salary; or (vi) the Company’s requiring the Executive to relocate his principal location of employment to any place outside of a 50 mile driving distance of the Executive’s current work site, without the consent of the Executive. The date of termination of the Executive’s employment under this Section 6(d) shall be the effective date of any resignation specified in writing by the Executive, which shall not be less than thirty (30) days after receipt by the Company of written notice of such resignation, provided that such resignation shall not be effective pursuant to this Section 6(d) and the Substantial Breach shall be deemed to have been cured if such Substantial Breach is corrected by the Company during such 30-day period.

(e) Resignation. The Executive shall have the right to terminate his employment at any time by giving notice of his resignation other than for Good Reason upon 30 days’ written notice to the Company.

(f) Payments. In the event that the Executive’s employment terminates for any reason, including expiration of the Term by reason of nonrenewal as provided in Section 2 hereof, the Company shall pay to the Executive all amounts accrued but unpaid hereunder through the date of termination in respect of Salary or unreimbursed expenses. In the event the Executive’s employment is terminated by the Company without Cause (other

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than an election not to renew the Employment Term pursuant to Section 2 hereof), or by the Executive with Good Reason, in addition to the amounts specified in the foregoing sentence, (i) the Executive shall continue to receive the Salary (less any applicable withholding or similar taxes) at the rate in effect hereunder on the date of such termination periodically, in accordance with the Company’s prevailing payroll practices, for a period of twelve months following the date of such termination (the “Severance Term”), (ii) to the extent permissible under the Company’s health plans, the Executive shall continue to receive any health benefits on the same basis as such health benefits were provided to such Executive as of the date of such termination in accordance with Section 3(c) hereof during the Severance Term; and (iii) any unexercised options which were fully vested as of the date of the Executive’s termination shall remain exercisable through the expiration of the Severance Term, notwithstanding any contrary provisions of the Aelita Software Corporation Omnibus Stock Option Plan or any agreement under which options have been granted to the Executive. In the event the Executive accepts other employment, engages in his own business or performs consulting services for 20 or more hours per week prior to the last date of the Severance Term, the Executive shall forthwith notify the Company and the Company shall be entitled to set off from amounts due the Executive under this Section 6(f) the amounts paid to the Executive in respect of such other employment, business activity or consulting services. Amounts owed by the Company in respect of the Salary or reimbursement for expenses under the provisions of Section 5 hereof shall, except as otherwise set forth in this Section 6(f), be paid promptly upon any termination.

(g) Survival of Operative Sections. Upon any termination of the Executive’s employment, the provisions of Sections 6(f) and 7 through 18 of this Agreement shall survive to the extent necessary to give effect to the provisions thereof.

Section 7. Secrecy and Non-Competition.

(a) No Competing Employment. The Executive acknowledges that the agreements and covenants contained in this Section 7 are essential to protect the value of the Company’s business and assets and by his current employment with the Company and its subsidiaries, the Executive has obtained and will obtain such knowledge, contacts, know-how, training and experience and there is a substantial probability that such knowledge, know-how, contacts, training and experience could be used to the substantial advantage of a competitor of the Company and to the Company’s substantial detriment. Therefore, the Executive agrees that for the period commencing on the date of this Agreement and ending on the first anniversary of the termination of the Executive’s employment hereunder (such period is hereinafter referred to as the “Restricted Period”) with respect to any State in which the Company is engaged in business during the Employment Term, the Executive shall not participate or engage, directly or indirectly, for himself or on behalf of or in conjunction with any person, partnership, corporation or other entity, whether as an employee, agent, officer, director, shareholder, partner, joint venturer, investor or otherwise, in any business activities if such activities consist of any activities undertaken or expressly contemplated to be undertaken by the Company or any of its subsidiaries or by the Executive at any time during the Employment Term.

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(b) Nondisclosure of Confidential Information. The Executive, except in connection with his employment hereunder, shall not disclose to any person or entity or use, either during the Employment Term or at any time thereafter, any information not in the public domain or generally known in the industry, in any form, acquired by the Executive while employed by the Company or any predecessor to the Company’s business or, if acquired following the Employment Term, such information which, to the Executive’s knowledge, has been acquired, directly or indirectly, from any person or entity owing a duty of confidentiality to the Company or any of its subsidiaries or affiliates, relating to the Company, its subsidiaries or affiliates, including but not limited to information regarding customers, vendors, suppliers, trade secrets, training programs, manuals or materials, technical information, contracts, systems, procedures, mailing lists, know-how, trade names, improvements, price lists, financial or other data (including the revenues, costs or profits associated with any of the Company’s products or services), business plans, code books, invoices and other financial statements, computer programs, software systems, databases, discs and printouts, plans (business, technical or otherwise), customer and industry lists, correspondence, internal reports, personnel files, sales and advertising material, telephone numbers, names, addresses or any other compilation of information, written or unwritten, which is or was used in the business of the Company or any subsidiaries or affiliates thereof. The Executive agrees and acknowledges that all of such information, in any form, and copies and extracts thereof, are and shall remain the sole and exclusive property of the Company, and upon termination of his employment with the Company, the Executive shall return to the Company the originals and all copies of any such information provided to or acquired by the Executive in connection with the performance of his duties for the Company, and shall return to the Company all files, correspondence and/or other communications received, maintained and/or originated by the Executive during the course of his employment.

(c) No Interference. During the Restricted Period, the Executive shall not, whether for his own account or for the account of any other individual, partnership, firm, corporation or other business organization (other than the Company), directly or indirectly solicit, endeavor to entice away from the Company or its subsidiaries, or otherwise directly interfere with the relationship of the Company or its subsidiaries with any person who, to the knowledge of the Executive, is employed by or otherwise engaged to perform services for the Company or its subsidiaries (including, but not limited to, any independent sales representatives or organizations) or who is, or was within the then most recent twelve-month period, a customer or client, of the Company, its predecessors or any of its subsidiaries. The placement of any general classified or “help wanted” advertisements and/or general solicitations to the public at large shall not constitute a violation of this Section 7(c) unless the Executive’s name is contained in such advertisements or solicitations.

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(d) Inventions, etc. The Executive hereby sells, transfers and assigns to the Company or to any person or entity designated by the Company all of the entire right, title and interest of the Executive in and to all inventions, ideas, disclosures and improvements, whether patented or unpatented, and copyrightable material, made or conceived by the Executive, solely or jointly, during his employment by the Company which relate to methods, apparatus, designs, products, processes or devices, sold, leased, used or under consideration or development by the Company, or which otherwise relate to or pertain to the business, functions or operations of the Company or which arise from the efforts of the Executive during the course of his employment for the Company. The Executive shall communicate promptly and disclose to the Company, in such form as the Company requests, all information, details and data pertaining to the aforementioned inventions, ideas, disclosures and improvements; and the Executive shall execute and deliver to the Company such formal transfers and assignments and such other papers and documents as may be necessary or required of the Executive to permit the Company or any person or entity designated by the Company to file and prosecute the patent applications and, as to copyrightable material, to obtain copyright thereof. Any invention relating to the business of the Company and disclosed by the Executive within one year following the termination of his employment with the Company shall be deemed to fall within the provisions of this paragraph unless proved to have been first conceived and made following such termination.

Section 8. Injunctive Relief. Without intending to limit the remedies available to the Company, the Executive acknowledges that a breach of any of the covenants contained in Section 7 hereof may result in material irreparable injury to the Company or its subsidiaries or affiliates for which there is no adequate remedy at law, that it will not be possible to measure damages for such injuries precisely and that, in the event of such a breach or threat thereof, the Company shall be entitled to obtain a temporary restraining order and/or a preliminary or permanent injunction, without the necessity of proving irreparable harm or injury as a result of such breach or threatened breach of Section 7 hereof, restraining the Executive from engaging in activities prohibited by Section 7 hereof or such other relief as may be required specifically to enforce any of the covenants in Section 7 hereof.

Section 9. Extension of Restricted Period. In addition to the remedies the Company may seek and obtain pursuant to Section 8 of this Agreement, the Restricted Period shall be extended by any and all periods during which the Executive shall be found by a court to have been in violation of the covenants contained in Section 7 hereof.

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Section 10. Representations and Warranties of the Executive. The Executive represents and warrants to the Company as follows:

(a) This Agreement, upon execution and delivery by the Executive, will be duly executed and delivered by the Executive and (assuming due execution and delivery hereof by the Company) will be the valid and binding obligation of the Executive enforceable against the Executive in accordance with its terms.

(b) Neither the execution and delivery of this Agreement, the consummation of the transactions contemplated hereby nor the performance of this Agreement in accordance with its terms and conditions by the Executive (i) requires the approval or consent of any governmental body or of any other person or (ii) conflicts with or results in any breach or violation of, or constitutes (or with notice or lapse of time or both would constitute) a default under, any agreement, instrument, judgment, decree, order, statute, rule, permit or governmental regulation applicable to the Executive. Without limiting the generality of the foregoing, the Executive is not a party to any non-competition, non-solicitation, no hire or similar agreement that restricts in any way the Executive’s ability to engage in any business or to solicit or hire the employees of any person.

The representations and warranties of the Executive contained in this Section 10 shall survive the execution and delivery of this Agreement and the consummation of the transactions contemplated hereby.

Section 11. Successors and Assigns; No Third-Party Beneficiaries.

(a) This Agreement shall inure to the benefit of, and be binding upon, the successors and assigns of each of the parties, including, but not limited to, the Executive’s heirs and the personal representatives of the Executive’s estate; provided, however, that neither party shall assign or delegate any of the obligations created under this Agreement without the prior written consent of the other party. Notwithstanding the foregoing, the Company shall have the unrestricted right to assign this Agreement and to delegate all or any part of its obligations hereunder to (i) any of its subsidiaries or affiliates, or (ii) any purchaser of all or substantially all of the Company’s business or assets or any successor to the Company or any assignee thereof (whether direct or indirect, by purchase, merger, consolidation or otherwise), without obtaining the written consent of the Executive, but in the event of an assignment as set forth in subsections (i) or (ii) herein, such assignee shall expressly assume all obligations of the Company hereunder and the Company shall remain fully liable for the performance of all of such obligations in the manner prescribed in this Agreement. The Company shall provide prompt written notice to the Executive upon such assignment.

(b) Nothing in this Agreement shall confer upon any person or entity not a party to this Agreement, or the legal representatives of such person or entity, any rights or remedies of any nature or kind whatsoever under or by reason of this Agreement.

Section 12. Waiver and Amendments. Any waiver, alteration, amendment or

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modification of any of the terms of this Agreement shall be valid only if made in writing and signed by the parties hereto; provided, however, that any such waiver, alteration, amendment or modification is consented to on the Company’s behalf by the Board of Directors. No waiver by either of the parties hereto of their rights hereunder shall be deemed to constitute a waiver with respect to any subsequent occurrences or transactions hereunder unless such waiver specifically states that it is to be construed as a continuing waiver.

Section 13. Severability and Governing Law. The Executive acknowledges and agrees that the covenants set forth in Section 7 hereof are reasonable and valid in geographical and temporal scope and in all other respects. If any of such covenants or such other provisions of this Agreement are found to be invalid or unenforceable by a final determination of a court of competent jurisdiction (a) the remaining terms and provisions hereof shall be unimpaired and (b) the invalid or unenforceable term or provision shall be deemed replaced by a term or provision that is valid and enforceable and that comes closest to expressing the intention of the invalid or unenforceable term or provision. THIS AGREEMENT SHALL BE GOVERNED BY AND CONSTRUED IN ACCORDANCE WITH THE LAWS OF THE STATE OF OHIO APPLICABLE TO CONTRACTS MADE AND TO BE PERFORMED ENTIRELY WITHIN SUCH STATE.

Section 14. Notices.

(a) All communications under this Agreement shall be in writing and shall be delivered by hand or mailed by overnight courier or by registered or certified mail, postage prepaid:

(1) if to the Executive, at 2482 Stoneleigh Court, Dublin, Ohio 43016 or at such other address as the Executive may have furnished the Company in writing,

(2) if to the Company, at Aelita Software Corporation, 6500 Emerald Parkway, Suite 400, Dublin, Ohio, 43016, marked for the attention of the Board of Directors, or at such other address as it may have furnished in writing to the Executive, or

(b) Any notice so addressed shall be deemed to be given: if delivered by hand, on the date of such delivery; if mailed by courier, on the first business day following the date of such mailing; and if mailed by registered or certified mail, on the third business day after the date of such mailing.

Section 15. Section Headings. The headings of the sections and subsections of this Agreement are inserted for convenience only and shall not be deemed to constitute a part thereof, affect the meaning or interpretation of this

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Agreement or of any term or provision hereof.

Section 16. Entire Agreement. This Agreement constitutes the entire understanding and agreement of the parties hereto regarding the employment of the Executive. This Agreement supersedes all prior negotiations, discussions, correspondence, communications, understandings and agreements between the parties relating to the subject matter of this Agreement.

Section 17. Severability. In the event that any part or parts of this Agreement shall be held illegal or unenforceable by any court or administrative body of competent jurisdiction, such determination shall not effect the remaining provisions of this Agreement which shall remain in full force and effect.

Section 18. Counterparts. This Agreement may be executed in one or more counterparts, each of which shall be deemed an original and all of which together shall be considered one and the same agreement.

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IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first above written.

AELITA SOFTWARE CORPORATION
By:	/S/ WILLIAM H. LARGENT
	Name: William H. Largent
	Title: Chief Operating Officer
Ratmir Timashev
/S/ RATMIR TIMASHEV

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AGREEMENT AND AMENDMENT TO

EMPLOYMENT AGREEMENT

This AGREEMENT AND AMENDMENT TO EMPLOYMENT AGREEMENT (“Amendment”) is made as of March 17, 2004, by and between QUEST SOFTWARE, INC., a California corporation (“Quest”) and AELITA SOFTWARE CORPORATION, a Delaware corporation (the “Company”) on one side (together, the “Employer”), and RATMIR TIMASHEV (“Executive”) on the other side. Capitalized terms not otherwise defined herein shall have the meanings ascribed to them in the Employment Agreement and the Merger Agreement (each as defined below).

RECITALS

WHEREAS, pursuant to an Agreement and Plan of Merger dated January 28, 2004, among Quest, Answer Acquisition Corp., a Delaware corporation and wholly-owned subsidiary of Quest (“Merger Sub”), certain of the Company’s stockholders and Insight Venture Partners, LLC (as the Stockholders’ Representative) (the “Merger Agreement”), Quest will acquire the Company by means of a merger of Merger Sub (the “Merger”), with and into the Company, with the Company as the surviving corporation in the Merger (the “Surviving Corporation”); and

WHEREAS, Quest and the Executive desire to enter into an employment relationship pursuant to which the Executive will be employed by Quest effective as of the Effective Time (as defined in the Merger Agreement) ; and

WHEREAS, concurrently with execution and delivery of this Agreement, (a) the Executive and Quest are entering into a Proprietary Information and Inventions Agreement, and (b) the Executive is entering into (i) a Noncompetition and Nonsolicitation Agreement for the benefit of Quest, the Surviving Corporation and their respective affiliates; and

WHEREAS, the Company and Executive have entered into that certain Employment Agreement, dated as of October 3, 2002 (the “Employment Agreement”); and

WHEREAS, the Company and Executive wish to amend the Employment Agreement in the manner provided herein in order to induce Quest and Merger Sub to consummate the Merger and the Contemplated Transactions.

AGREEMENT

NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, and intending to be legally bound, Employer and Executive hereby agree as follows:

1. The introductory paragraph of the Employment Agreement is hereby amended and restated to read as follows:

Following “(the “Company”)” insert “a wholly owned subsidiary of Quest Software, Inc., a California corporation (“Quest”)”.

2. Section 1 of the Employment Agreement is hereby amended and restated to read as follows:

In the first sentence, substitute “Quest” for “the Company”.

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3. Section 2 of the Employment Agreement is hereby amended and restated to read in its entirety as follows:

“Section 2. Term. Unless terminated pursuant to Section 6 hereof, the Executive’s employment hereunder shall continue until December 31, 2005 (“Employment Term”).”

4. Sections 3 through 18 of the Employment Agreement are hereby amended and restated to read as follows:

Substitute “Quest” for “the Company”.

5. Section 4 of the Employment Agreement is hereby amended and restated to read in its entirety as follows:

Section 4. Exclusivity. During the Employment Term, the Executive shall devote his full time to the business of the Company, shall faithfully serve the Company, shall in all respects conform to and comply with the lawful and reasonable directions and instructions given to him by the Board of Directors in accordance with the terms of this Agreement, shall use his best efforts to promote and serve the interests of the Company and shall not engage in any other business activity, whether or not such activity shall be engaged in for pecuniary profit, except that the Executive may (i) participate in the activities of professional trade organizations related to the business of the Company, (ii) participate in activities as may be approved in writing by the Board of Directors, (iii) engage in personal investing activities, provided that Executive shall not become financially interested in any entity known by him to compete with the Company in any line of business engaged in (or planned to be engaged in) by the Company; and (iv) serve as a member of the board of directors or advisory boards (or their equivalents in the case of a non-corporate entity) of non-competing businesses and charitable organizations, provided that activities set forth in these clauses (i), (ii), (iii) and (iv), either singly or in the aggregate, do not interfere in any material respect with the services to be provided by the Executive hereunder.

6. Section 6(f) of the Employment Agreement is hereby amended and restated to read in its entirety as follows:

“(f) Termination Payments and Severance. In the event that the Executive’s employment terminates for any reason, the Company shall promptly pay to the Executive all amounts accrued but unpaid hereunder through the date of termination in respect of Salary or unreimbursed expenses. In the event the Executive’s employment is terminated by the Company without Cause (other than the expiration of the Employment Term pursuant to Section 2 hereof), or by the Executive with Good Reason, in addition to the amounts specified in the foregoing sentence, and provided that Executive has executed a binding general release of claims in the form attached hereto as Exhibit A, (i) any options that were not previously vested as of the date of such termination shall immediately vest in full, and (ii) all unexercised vested options shall remain exercisable, notwithstanding any contrary provisions of the Aelita Software Corporation Omnibus Stock Option Plan or any agreement under which options have been granted to the Executive, for a period to be determined as follows: (A) if Executive’s employment termination occurs before the fifth anniversary of the Effective Time, then vested options shall remain exercisable for five (5) years following termination of employment; or (B) if Executive’s employment termination occurs after the fifth anniversary of the Effective Time, then vested options shall remain exercisable for thirty (30) days following termination of employment.”

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7. Section 7(a) of the Employment Agreement is hereby amended and restated as follows:

By deleting the last sentence and replacing it with the following:

“Therefore, the Executive agrees that for the period commencing on the date of this Agreement and ending on the first anniversary of the termination of the Executive’s employment hereunder (such period is hereinafter referred to as the “Restricted Period”) with respect to any State in which the Company is engaged in business during the Employment Term, the Executive shall not participate or engage, directly or indirectly, for himself or on behalf of or in conjunction with any person, partnership, corporation or other entity, whether as an employee, agent, officer, director, shareholder, partner, joint venturer, investor or otherwise, in any business activities which involve Microsoft systems management or Oracle database management.

8. Section 7(c) of the Employment Agreement is hereby amended and restated to read as follows:

In the first sentence, insert “hire, engage” between “indirectly” and “solicit”.

9. Section 16 of the Employment Agreement is hereby amended and restated to read as follows:

In the first sentence, substitute “, the Proprietary Information and Inventions Agreement, and the Noncompetition and Nonsolicitation Agreement altogether constitute” for “constitutes”.

10. The Employment Agreement is hereby amended and restated as follows:

Insert Exhibit A, as set forth in its entirety in Exhibit A to this Amendment.

11. All other terms of the Employment Agreement shall remain in full force and effect.

12. The parties agree that the adjustments in Executive’s duties, responsibilities, reporting relationship and position resulting from the Merger and the Company’s becoming a subsidiary corporation of Quest do not constitute a Substantial Breach or otherwise trigger Good Reason for termination as defined in Section 6(d) of the Employment Agreement, provided, that following any such adjustment, Executive’s duties, responsibilities, reporting relationship and position are consistent with those typically assigned to an executive officer of a subsidiary corporation.

13. This Amendment shall take effect as of the Effective Time, and is conditioned on the successful closing of the Merger. If the Merger does not close, this Amendment shall be null and void, and even if executed by the parties, shall not be binding.

14. This Amendment shall be governed by and construed under the laws of the State of Ohio, without regard to conflict of laws principles.

15. This Amendment may be executed in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument.

[SIGNATURE PAGE FOLLOWS]

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IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of the date first above written.

QUEST SOFTWARE, INC.
By:
	Name:
	Title:
EXECUTIVE:
Ratmir Timashev
2482 Stoneleigh Court,
Dublin, Ohio 43016
Telephone:
Facsimile:
AELITA SOFTWARE CORPORATION
By:
	Name:
	Title:

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EX-31.1

Exhibit 31.1

CERTIFICATION

I, Vincent C. Smith, certify that:

1. I have reviewed this Quarterly Report on Form 10-Q of Quest Software, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: May 10, 2004

/s/    VINCENT C. SMITH

Vincent C. Smith,

Chief Executive Officer

EX-31.2

Exhibit 31.2

CERTIFICATION

I, M. Brinkley Morse, certify that:

1. I have reviewed this Quarterly Report on Form 10-Q of Quest Software, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: May 10, 2004

/s/    M. BRINKLEY MORSE

M. Brinkley Morse,

Vice President, Finance and Operations and

Chief Financial Officer

EX-32.1

Exhibit 32.1

Certification of Chief Executive Officer Pursuant to

18 U.S.C. Section 1350, as Adopted Pursuant to

Section 906 of the Sarbanes-Oxley Act of 2002

I, Vincent C. Smith, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report of Quest Software, Inc. on Form 10-Q for the three months ended March 31, 2004, fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Report fairly presents, in all material respects, the financial condition and results of operations of Quest Software, Inc.

Date: May 10, 2004	By:	/s/    VINCENT C. SMITH
	Name:	Vincent C. Smith
	Title:	Chief Executive Officer

EX-32.2

Exhibit 32.2

Certification of Chief Financial Officer Pursuant to

18 U.S.C. Section 1350, as Adopted Pursuant to

Section 906 of the Sarbanes-Oxley Act of 2002

I, M. Brinkley Morse, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Quarterly Report of Quest Software, Inc. on Form 10-Q for the three months ended March 31, 2004, fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Report fairly presents, in all material respects, the financial condition and results of operations of Quest Software, Inc.

Date: May 10, 2004	By:	/s/    M. BRINKLEY MORSE
	Name:	M. Brinkley Morse
	Title:	Vice President, Finance and Operations and Chief Financial Officer