Quarterly Report on Form 10-Q

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 a 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 Securities Exchange Act of 1934). YES x NO ¨

The number of shares of Registrant’s Common Stock outstanding as of July 30, 2004 was 93,146,117.

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

The accompanying condensed consolidated financial statements include the accounts of Mercury Interactive Corporation and its subsidiaries. We have a wholly-owned research and development and sales subsidiary incorporated in Israel. In addition, we have sales subsidiaries and offices in the Americas; Europe, the Middle East, and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, Mexico, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. All significant intercompany accounts and transactions have been eliminated.

These interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information, and the rules and regulations of the Securities and Exchange Commission for interim financial statements and accounting policies, consistent, in all material respects, with those applied in preparing our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003. The unaudited financial information furnished herein reflects all adjustments, consisting only of normal recurring adjustments, that in our opinion are necessary to fairly state our consolidated financial position, the results of operations, and cash flows for the periods presented. This Quarterly Report on Form 10-Q should be read in conjunction with our audited financial statements for the year ended December 31, 2003, included in the 2003 Form 10-K. The condensed consolidated statements of operations for the three and six months ended June 30, 2004 are not necessarily indicative of results to be expected for any subsequent periods or for the entire year ending December 31, 2004.

At the 2004 Annual Meeting of the stockholders held in May 2004, the stockholders approved an increase in the number of authorized shares of common stock of Mercury from 240 million to 560 million shares.

We consider all debt securities with remaining maturities of less than one year to be short-term investments and all debt securities with remaining maturities greater than one year to be long-term investments. In accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities, we have categorized our debt securities as “held to maturity” securities. These debt securities, which all have contractual maturities of less than three years, are carried at cost plus accrued interest. Marketable equity securities are classified as available-for-sale and are reported at fair value, based on quoted market prices, with unrealized gains or losses, net of tax, recorded as a component of “Accumulated other comprehensive income or loss” in our consolidated statement of stockholders’ equity. The cost basis of securities sold is based on the specific identification method. We evaluate whether or not any of our marketable equity securities has experienced an other-than-temporary decline in fair value on a regular basis. As part of the evaluation process, we consider factors such as earnings/revenue outlook, operational performance, management/ownership changes, competition, and stock price performance. If we determine that a decline in fair value of a marketable equity security below carrying value is other-than-temporary, it is our policy to record a loss on investment in our consolidated statement of operations and write down the marketable equity security to its fair value. Gains are recognized in our consolidated statement of operations when they are realized.

Property and equipment are stated at cost less accumulated depreciation. Depreciation and amortization are provided using the straight-line method over the estimated economic lives of assets, which are five to seven years for office furniture and equipment, two to three years for computers and related equipment, three years for internal use software, seven to ten years for building improvements, and thirty years for buildings. Leasehold improvements are depreciated using the straight-line method over the estimated economic lives or the remaining lease terms, whichever is shorter.

Investments in non-consolidated companies consist of minority equity investments in publicly traded companies, privately held companies, and private equity funds. We make these investments for business and strategic purposes. These investments are accounted

for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. Our investments in publicly traded companies were classified as available-for-sale in accordance with SFAS No. 115 and were included as “Short-term investments” in our consolidated balance sheet. We periodically monitor our investments for impairment and will record reductions in carrying values for investments in privately held companies and private equity funds if and when necessary. The evaluation process is based on information that we request from these privately held companies. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings/revenue outlook, operational performance, management/ownership changes, and competition. If we determine that the carrying value of an investment is at an amount above fair value, or if a company has completed a financing with new third-party investors based on a valuation significantly lower than the carrying value of our investment and the decline is other-than-temporary, it is our policy to record a loss on investment in our consolidated statement of operations. In calculating the loss on our investments, we take into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors.

In January 2003, the Financial Accounting Standard Board (FASB) issued FASB Interpretation (FIN) No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51, which relates to the identification of, and financial reporting for, variable-interest entities. FIN No. 46 requires that if an entity is the primary beneficiary of a variable interest entity, the assets, liabilities, and results of operations of the variable interest entity should be included in the consolidated financial statements of the entity. The provisions of FIN No. 46 are effective immediately for all arrangements entered into after January 31, 2003. For those arrangements entered into prior to February 1, 2003, the provisions of FIN No. 46 are required to be adopted at the beginning of the first interim or annual period beginning after June 15, 2003. In December 2003, the FASB issued FIN No. 46(R). The FASB deferred the effective date for variable-interest entities that are non-special purpose entities created before February 1, 2003, to the first interim or annual reporting period that ends after March 15, 2004. The adoption of FIN No. 46(R) did not have a material impact on our financial position or results of operations.

We account for stock-based compensation for our employees using the intrinsic value method presented in Accounting Principles Board (APB) Statement No. 25, Accounting for Stock Issued to Employees, and related interpretations, and comply with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation, and with the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure Amendment of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise price. No stock-based compensation has been recorded for stock options granted to our employees because we have granted stock options to our employees at fair market value of the underlying stock on the date of grant. We account for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (EITF) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. We do not issue stock options to non-employees, except for our non-employee members of our Board of Directors. In accordance with FIN No. 44, Accounting for Certain Transactions Involving Stock Compensation, an interpretation of APB No. 25, we value stock options assumed in a purchase business combination at the date of acquisition at their fair value calculated using the Black-Scholes option-pricing model. The fair value of assumed options is included as a component of the purchase price. The intrinsic value attributable to unvested options is recorded as unearned stock-based compensation and amortized over the remaining vesting period of the stock options.

Pro forma information regarding net income (loss) and earnings (loss) per share is required by SFAS No. 123. This information is required to be determined as if we had accounted for our employee stock options and stock purchase plans under the fair value based method of SFAS No. 123, as amended by SFAS No. 148. The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands, except per share amounts):

We calculate stock-based compensation expense under the fair value based method for shares issued pursuant to the 1998 Employee Stock Purchase Plan (ESPP) based upon actual shares issued, except for the period since the most recent purchase in February 2004. We estimate the number of shares issuable under the 1998 ESPP based upon actual contributions made by employees for the period from February 16 through June 30, 2004 and the lower of the fair market value of our common stock on February 16, 2004 or June 30, 2004.

We amortize unearned stock-based compensation expense using the straight-line method over the vesting periods of the related options, which is generally four years for non-qualified and incentive stock options. Stock-based employee compensation expense determined under the fair value based method for non-qualified options issued pursuant to the stock option plans is tax affected. Stock-based employee compensation expense determined under the fair value based method for incentive stock options issued pursuant to the stock option plans and shares issued pursuant to the 1998 ESPP is not tax affected.

The fair value of stock options and shares issued pursuant to the stock option plans and the 1998 ESPP at the grant date were estimated using the Black-Scholes option-pricing model, with the following weighted average assumptions, for the three and six months ended June 30, 2004 and 2003:

The Black-Scholes option-pricing model was developed for use in 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. 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. Based upon the above assumptions, the weighted average fair value per share of options granted under the option plans during the three and six months ended June 30, 2004 was $29.81, and $29.49 respectively. The weighted average fair value per share of options granted under the option plans during the three and

six months ended June 30, 2003 was $24.29 and $21.20, respectively. The weighted average fair value per share of options granted under the 1998 ESPP during the three and six months ended June 30, 2004 was $19.02 and $16.85, respectively. The weighted average fair value per share of options granted under the 1998 ESPP during the three and six months ended June 30, 2003 was $14.03 and $11.28, respectively.

Revenue consists of fees for licenses and subscription licenses of our software products, maintenance fees, and professional service fees. We apply the provisions of Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition, With Respect to Certain Transactions, to all transactions involving the sale of software products and services. In addition, we apply the provisions of the EITF Issue No. 00-03, Application of AICPA SOP No. 97-2 to Arrangements that Include the Right to Use Software Stored on Another Entity’s Hardware, to our managed services software transactions. We also apply EITF No. 01-09, Accounting for Consideration Given by Vendor to a Customer or a Reseller of the Vendor’s Products to account for transactions related sales incentives.

License revenue consists of license fees charged for the use of our products licensed under perpetual or multiple-year arrangements in which the fair value of the license fee is separately determinable from undelivered items such as maintenance and professional services. We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed or determinable, and collection of the resulting receivable is probable. Delivery generally occurs when product is delivered to a common carrier. At the time of the transaction, we assess whether the fee associated with our revenue transactions is fixed or determinable based on the payment terms associated with the transaction and whether or not collection is probable. If a significant portion of a fee is due after our normal payment terms, which are generally within 30-60 days of the invoice date in the U.S., APAC and Japan (slightly longer in EMEA), we account for the fee as not being fixed or determinable. In these cases, we recognize revenue at the earlier of cash collection or as the fees become due. We assess collection based on a number of factors, including past transaction history with the customer. We do not request collateral from our customers. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash. For all sales, except those completed over the Internet, we use either a customer order document or a signed license or service agreement as evidence of an arrangement. For sales over the Internet, we use a credit card authorization as evidence of an arrangement.

Subscription revenue, including managed service revenue, represents license fees to use one or more software products, and to receive maintenance support (such as hotline support and product updates) for a limited period of time. Since subscription licenses include bundled products and services, which are sold as a combined product offering and for which the fair value of the license fee is not separately determinable from maintenance, both product and service revenue is generally recognized ratably over the term of the subscription. Customers do not pay a set up fee associated with a subscription arrangement.

Maintenance revenue consists of fees charged for post-contract customer support, which are determinable based upon vendor specific objective evidence of fair value. Maintenance fee arrangements include ongoing customer support and rights to product updates on an if and when available basis. Payments for maintenance are generally made in advance and are nonrefundable. Revenue is recognized ratably over the period of the maintenance contract.

Professional service revenue consists of fees charged for product training and consulting services, which are determinable, based upon vendor specific objective evidence of fair value. Professional service revenue is recognized as the services are provided.

For arrangements with multiple elements (for example, license and undelivered maintenance and support), we allocate revenue to each component of the arrangement using the residual value method based on the fair value of the undelivered elements, which is specific to Mercury. This means that we defer revenue from the arrangement fee equivalent to the fair value of the undelivered elements. Fair values for the ongoing maintenance and support obligations within an arrangement are based upon renewal rates quoted in contracts, and, in the absence of stated renewal rates, upon separate sales of renewals to other customers. Fair value of services, such as training or consulting, is based upon separate sales by us of these services to other customers. Most of our arrangements involve multiple elements. Our arrangements do not generally include acceptance clauses. However, if an arrangement includes an acceptance provision, revenue is deferred until the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

We derive a portion of our business from sales of our products through our alliance partners, which include value-added resellers and major systems integration firms.

We expense the costs of producing advertisements at the time production occurs and expense the cost of communicating advertising in the period during which the advertising space or airtime is used. For the three and six months ended June 30, 2004, advertising expenses totaled $2.4 million and $4.1 million, respectively. For the three and six months ended June 30, 2003, advertising expenses totaled $2.8 million and $5.1 million, respectively.

Certain reclassifications have been made to the December 31, 2003 balances to conform to the June 30, 2004 presentation, namely the classification of deferred tax assets and liabilities. Certain reclassifications have been made to the consolidated statements of operations for the three and six months ended June 30, 2003 to conform to the presentation adopted for the three and six months ended June 30, 2004.

In November 2003, the EITF reached a consensus on disclosure guidance previously discussed under EITF Issue No. 03-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. The consensus provided for certain disclosure requirements that were effective for fiscal years ending after December 15, 2003. We adopted the disclosure requirements during the year ended December 31, 2003.

In March 2004, the EITF reached a consensus on recognition and measurement guidance previously discussed under EITF Issue No. 03-01. The consensus clarified the meaning of other-than-temporary impairment and its application to debt and equity investments accounted for under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and other investments accounted for under the cost method. The recognition and measurement guidance for which the consensus was reached in March 2004 is to be applied to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. The consensus reached in March 2004 also provided for certain disclosure requirements associated with cost method investments that were effective for fiscal years ending after June 15, 2004. We do not believe that the consensus on the recognition and measurement guidance will have an impact on our results of operations.

Our license agreements and reseller agreements do not offer our customers or vendors the unilateral right to terminate or cancel the contract and receive a cash refund. In addition, the terms of our license agreements do not offer customers price protection.

We do provide for sales returns based upon estimates of potential future credits, warranty cost of product and services, and write-offs of bad debts related to current period product revenues. We analyze historical credits, historical bad debts, current economic trends, average deal size, changes in customer demand, and acceptance of our products when evaluating the adequacy of the sales reserve. Revenues for the period are reduced to reflect the provision for sales returns.

The following table summarizes changes in our sales reserve during the three and six months ended June 30, 2004 and 2003 (in thousands):

On January 30, 2004, we sold two of our four buildings we own in Sunnyvale, California at the carrying value to a third party for $2.7 million in cash. In April 2004, we completed our move into our new leased headquarters in Mountain View, California and have placed one of the two remaining buildings we own for sale. As a result of our move and our decision to sell one of these two buildings, we took a charge to write down the net book value of the building that is held for sale to its appraised market value. We took into account the cost to maintain the facility until sold and sales commissions related to the sale of the building when we calculated the charge. Accordingly, we reclassified the building as asset held for sale. Asset held for sale was included in “Prepaid expenses and other assets” in our consolidated balance sheet as of June 30, 2004. In connection with our move into our consolidated headquarters, we also vacated two leased facilities from the Kintana acquisition. In the second quarter of 2004, we recorded a charge for the remaining lease payments, as well as associated costs to protect and maintain the leased facilities prior to returning these leased facilities to the lessor. These lease agreements expire in September 2004 and December 2005. Due to the short duration of the remaining lease terms, it is not likely that we can sublease the facilities; as such, no sublease income was included in the facilities lease costs calculation. We also wrote off leasehold improvements and recorded the disposal of fixed assets, net of cash proceeds, associated with these facilities. The total excess facilities charge recorded in the second quarter of 2004 was $9.2 million.

At June 30, 2004, our equity investments in non-consolidated companies were composed of investments in privately held companies of $4.6 million, a private equity fund of $7.1 million, and a warrant to purchase common stock of Motive, Inc. of $0.8 million. At December 31, 2003, our equity investments in non-consolidated companies were composed of investments in privately held companies of $7.5 millions, a private equity fund of $6.0 millions, and the Motive warrant of $0.4 million. Through June 30, 2004, we have made capital contributions to a private equity fund totaling $7.9 million. We have committed to make additional capital contributions up to $7.1 million in the future. For the three months ended June 30, 2004, we did not record any losses on our investments in privately held companies nor the private equity fund. Unrealized gain related to a change in the fair value of the Motive warrant was $0.1 million for the three months ended June 30, 2004. For the six months ended June 30, 2004, we recorded a loss of $0.5 million on one of our investments in privately held companies. The loss was partially offset by an unrealized gain of $0.4 million related to a change in fair value of the Motive warrant. For the three months ended June 30, 2003, we recorded a loss of $0.6 million on one of our investments in privately held companies and a loss of $0.2 million on our investment in the private equity fund. For the six months ended June 30, 2003, we recorded a loss of $1.1 million on two of our investments in privately held companies and a loss of $0.2 million on our investment in the private equity fund. In calculating the loss on our investments, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors. We calculated the fair value of the warrant using the Black-Scholes option-pricing model with the following assumptions: risk-free interest rate of 3.92%, contractual life of 5 years, volatility of 75% and zero dividend rate. We had not exercised the warrant at June 30, 2004. We believe that the carrying value of our investments in non-consolidated companies approximated their fair value at June 30, 2004 and December 31, 2003.

In February 2004, one of the privately held companies in which we had an equity investment was acquired by a public company. We received $1.5 million cash and common stock of that company. Cash proceeds received by us were recorded as a return of investment in the privately held company. The common stock we received from the public company was recorded at the carrying value of our investment in the privately held company, net of cash received, and was treated as available-for-sale marketable equity securities. Unrealized gains related to the available-for-sale marketable equity securities was included as a component of “Accumulated other comprehensive loss,” until the common stock was sold. On May 7, 2004, we sold the common stock of the public company for $1.7 million in cash, resulting in a realized gain of approximately $0.3 million.

On August 15, 2003, we acquired Kintana, a leading provider of Information Technology (IT) governance software and services for an aggregate purchase price of $267.4 million. Kintana’s IT governance expands our product line to include products which enable our customers to govern and manage the priorities, processes, and people required to run IT as a business. We recorded goodwill of $217.2 million, intangible assets of $44.3 million, in-process research and development (IPR&D) of $10.7 million, and unearned stock-based compensation of $1.3 million as a result of the Kintana acquisition.

The acquired IPR&D is related to the next generation of Kintana’s IT governance software products including changes to existing applications and the addition of new applications. The value of IPR&D was determined through the discounted cash flow approach. The expected future cash flow attributable to the in-process technology is discounted at 23%. This rate takes into account that the product leverages core and current technology found in the versions of the existing software, the increasing complexity and criticality of distributed software applications, the demand for faster turnaround of new distributed applications and enhancements, the expected growth in the industry, the continuing introduction of new functionality into the products, and the percentage of completion of approximately 35%. As of June 30, 2004, the IPR&D projects were completed.

The transaction was accounted for as a purchase and, accordingly, the operating results of Kintana have been included in our accompanying condensed consolidated statements of operations from the date of acquisition. The following unaudited pro forma information presents the combined results of Mercury and Kintana as if the acquisition had occurred as of the beginning of 2003, after applying certain adjustments, including amortization of intangible assets, amortization of unearned stock-based compensation, rent expense adjustment associated with unfavorable operating leases assumed by us, and interest income, net of related tax effects. IPR&D of $10.7 million has been excluded from the following presentation as it is a non-recurring charge (in thousands, except per share amounts):

On May 5, 2003, we acquired all of the outstanding stock and assumed the unvested stock options of Performant, a provider of Java 2 Enterprise Edition (J2EE) diagnostics software for an aggregate purchase price of $22.5 million. Performant’s technology pinpoints performance problems at the application code level. The Performant acquisition allows our customers to diagnose J2EE performance issues across the application delivery and application management cycles from pre-production testing to production operations. We recorded goodwill of $17.2 million, intangible assets of $3.4 million, IPR&D of $1.3 million, and unearned stock-based compensation of $0.3 million as a result of the Performant acquisition.

The acquired IPR&D is related to the development of the Microsoft version of the diagnostics software or .NET. The value of IPR&D was determined through the discounted cash flow approach. The expected future cash flow attributable to the in-process technology was discounted at 29%, taking into account the percentage of completion of approximately 46%, the rate technology changes in the industry, product life cycles, the future markets, and various projects’ stage of development. The IPR&D projects are currently expected to be completed in the next three to six months and the estimated costs to complete the project are insignificant during that time.

The transaction was accounted for as a purchase and, accordingly, the operating results of Performant have been included in our accompanying condensed consolidated statements of operations from the date of acquisition. The following unaudited pro forma information presents the combined results of Mercury and Performant as if the acquisition had occurred as of the beginning of 2003, after applying certain adjustments, including amortization of intangible assets, amortization of unearned stock-based compensation, and interest income, net of related tax effects. IPR&D of $1.3 million has been excluded from the following presentation as it is a non-recurring charge (in thousands, except per share amounts):

In conjunction with the acquisition of Performant, we committed to a license agreement for certain technology. The agreement was entered into in August 2000 and remains in effect until April 2018. The total estimated commitment is approximately $0.2 million, although the maximum commitment could reach approximately $0.8 million. We have paid $21,000 through June 30, 2004.

In conjunction with the acquisition of Performant, we entered into a milestone bonus plan related to certain research and development activities. The plan entitles each eligible employee to receive bonuses, in the form of cash payments, based on the achievement of certain performance milestones by applicable target dates. The commitment will be earned equally over time as milestones are achieved and expensed as incurred. For the three and six months ended June 30, 2004, we recorded $1.1 million and $2.1 million, respectively, as “Integration and other related charges” in our condensed consolidated statement of operations, associated with the milestone bonus plan. The maximum total payment under the plan is $5.5 million, of which $3.7 million has been paid through June 30, 2004.

The changes in the carrying amount of goodwill for the six months ended June 30, 2004 are as follows (in thousands):

We increased our goodwill from the Kintana acquisition due to additional payments for pre-acquisition liabilities.

The weighted average amortization period of existing technology is 38 months, patents and core technology is 56 months, employment agreements is 18 months, maintenance and support contracts is 72 months, customer contracts and other intangible assets are 36 months, and domain name is 60 months. The weighted average amortization period of all intangible assets is 46 months. The aggregate amortization expense of intangible assets was $3.7 million and $7.7 million for the three and six months ended June 30, 2004, respectively. The aggregate amortization expense of intangible assets was $0.7 million and $1.2 million for the three and six months ended June 30, 2003, respectively.

Future amortization expense of intangible assets at June 30, 2004 is as follows (in thousands):

In July 2000, we issued $500.0 million in Convertible Subordinated Notes (2000 Notes). The 2000 Notes mature on July 1, 2007 and bear interest at a rate of 4.75% per annum, payable semiannually on January 1 and July 1 of each year. The 2000 Notes are subordinated in right of payment to all of our future senior debt. The 2000 Notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. We may redeem the 2000 Notes, in whole or in part, at any time on or after July 1, 2003. Accrued interest to the redemption date will be paid by us in any such redemption. We had not redeemed any portion of the 2000 Notes at June 30, 2004. From December 2001 through June 30, 2002, we retired $200.0 million face value of the 2000 Notes. The face value of the 2000 Notes was $300.0 million at June 30, 2004 and December 31, 2003.

In connection with the issuance of our 2000 Notes, we incurred $14.6 million of issuance costs, which primarily consisted of investment banker, legal, and other professional fees. In conjunction with the retirement of a portion of our 2000 Notes, we wrote-off $3.8 million of debt issuance costs. The remaining costs are being amortized using a straight-line method over the remaining term of the 2000 Notes. Amortization expense related to the issuance costs was $0.3 million and $0.6 million for the three and six months ended June 30, 2004, respectively. Amortization expense related to the issuance costs was $0.4 million and $0.8 million for the three and six months ended June 30, 2003, respectively. At June 30, 2004 and December 31, 2003, net debt issuance costs associated with our 2000 Notes were $4.0 million and $4.6 million, respectively.

In April 2003, we issued $500.0 million of Zero Coupon Convertible Notes (2003 Notes) due on May 1, 2008 in a private offering. The 2003 Notes do not bear interest, have a zero yield to maturity and may be convertible into our common stock. Holders of the 2003 Notes may convert their 2003 Notes prior to maturity only if:

Upon conversion, we have the right to deliver cash instead of shares of our common stock. We may not redeem the 2003 Notes prior to their maturity.

In connection with the issuance of our 2003 Notes, we incurred $11.9 million of issuance costs, which primarily consisted of investment banker, legal, and other professional fees. These costs are being amortized using a straight-line method over the term of the 2003 Notes. Amortization expense related to the issuance costs was $0.6 million and $1.3 million for the three and six months ended June 30, 2004, respectively. Amortization expense related to the issuance costs was $0.4 million for each of the three and six months ended June 30, 2003. At June 30, 2004 and December 31, 2003, net debt issuance costs associated with our 2003 Notes were $9.1 million and $10.4 million, respectively.

On June 30, 2003, we entered into a non-exclusive agreement (amended in February 2004) to license technology from Motive. The agreement is non-transferable, except in the case of a merger, acquisition, spin-out or other transfer of all or substantially all of the business, stock or assets to which the agreement relates. The licensed technology will be combined with our other existing Mercury products, which should be generally available in the latter half of 2004. The agreement is in effect until

December 31, 2006 with a right to renew and an option to purchase a fully paid up, perpetual license to the technology prior to July 1, 2008. Under the original agreement, we had committed to royalty payments totaling $15.0 million, of which $8.0 million had been paid as of December 31, 2003. In accordance with the addendum, the remaining royalty balance of $7.0 million was accelerated and was paid in February 2004. We recorded such payments as prepaid royalties. Prepaid royalties are included in “Prepaid expenses and other assets” in our consolidated balance sheet and will be amortized to cost of license and subscription at the greater of the actual revenue over total forecasted revenue or straight line over the estimated useful life of the licensed technology.

In December 2003, we entered into a severance agreement with a former executive officer. In accordance with the agreement, the former executive officer is entitled to salary and bonus through October 3, 2005 totaling $1.5 million. Under the agreement, we also accelerated the vesting of options to purchase 374,479 shares of common stock with exercise prices ranging from $29.29 to $60.88. The exercise period of these accelerated options and the vested portion of options to purchase 255,208 shares of common stock with an exercise price of $60.88 was extended through October 3, 2005. Accrued salaries and bonuses related to this executive severance agreement were $1.0 million and $1.5 million at June 30, 2004 and December 31, 2003, respectively.

We lease facilities for sales offices in the U.S. and foreign locations under non-cancelable operating leases that expire through 2015. Certain of these leases contain renewal options. We lease certain equipment under various lease agreements with lease terms ranging from month-to-month up to one year. On October 21, 2003, we entered into a lease agreement for our new headquarters facility. The lease began on January 1, 2004 and expires on February 20, 2014. Future minimum payments under the facilities, including the two vacant facilities from the Kintana acquisition, and equipment leases with non-cancelable terms in excess of one year at June 30, 2004 are as follows (in thousands):

At June 30, 2004, we had four irrevocable letter of credit agreements totaling $1.4 million with Wells Fargo & Company (Wells Fargo). Wells Fargo is a related party to us as one of the members of our Board of Directors is an executive officer of Wells Fargo. Two of the agreements are related to facility lease agreements assumed by us in conjunction with the acquisition of Kintana in 2003. One of the agreements has an automatic annual renewal provision under which the expiration date cannot be extended beyond March 1, 2006 and the other agreement expires in September 2004. The third agreement is related to a facility lease agreement assumed by us in conjunction with the acquisition of Freshwater in 2001. This agreement has an automatic annual renewal provision under which the expiration dates cannot be extended beyond August 31, 2006. The fourth agreement is related to the facility lease agreement for our new headquarters in Mountain View, California and this agreement automatically renews annually after January 1, 2005 unless we provide a termination notice to Wells Fargo. At June 30, 2004, no amounts had been drawn on the letters of credit.

From time to time, we may have certain contingent liabilities that arise in the ordinary course of our business activities. We accrue for contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. Our former Vice President of Tax, Uzi Sasson, filed a complaint on August 4, 2004, alleging that we wrongfully terminated his employment. We believe these claims are without merit and intend to vigorously defend the lawsuit. In the opinion of management, there are no pending claims of which the outcome is expected to result in a material adverse effect on our financial position, results of operations, or cash flows.

As permitted under Delaware law, we have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is

for the officer’s or director’s term in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that limits our exposure and enables us to recover a portion of some future amounts to be paid, as allowed by law. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

We enter into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners, subsidiaries and/or customers, in connection with any U.S. patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements at June 30, 2004.

We may, at our discretion and in the ordinary course of business, subcontract the performance of any of our services. Accordingly, we enter into standard indemnification agreements with our customers, whereby they are indemnified for other acts, such as personal property damage, of our subcontractors. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have general and umbrella insurance policies that enable us to recover a portion of any amounts paid. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements at June 30, 2004.

When, as part of an acquisition, we acquire all of the stock or all of the assets and liabilities of a company, we assume the liability for certain events or occurrences that took place prior to the date of acquisition. We are not aware of any potential obligations arising as a result of acquisitions and we are therefore unable to determine the maximum potential payments we could be required to make for such obligations at this time. Accordingly, we have no liabilities recorded for these types of agreements at June 30, 2004.

We have arrangements with certain vendors whereby we guarantee the expenses incurred by certain of our employees. The term is from execution of the arrangement until cancellation and payment of any outstanding amounts. We would be required to pay any unsettled employee expenses upon notification from the vendor. The maximum potential amount of future payments we could be required to make under these arrangements is insignificant. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements at June 30, 2004.

We warrant that our software products will perform in all material respects in accordance with our standard published specifications in effect at the time of delivery of the licensed products to the customer for the life of the product. Additionally, we warrant that our maintenance services will be performed consistent with generally accepted industry standards through completion of the agreed upon services. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history. We have not incurred significant expense under our product or services warranties. As a result, we believe the estimated fair value on these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements at June 30, 2004.

Earnings per share are calculated in accordance with the provisions of SFAS No. 128, Earnings per Share. SFAS No. 128 requires the reporting of both basic earnings per share, which is the weighted-average number of common shares outstanding for the period, excluding unvested restricted common stock and diluted earnings per share, which includes the weighted-average number of common shares outstanding and all dilutive potential common shares outstanding including unvested restricted common stock, using the treasury stock method.

The following table summarizes our earnings per share computations (in thousands, except per share amounts):

For the three and six months ended June 30, 2004, options to purchase 6,620,000 shares and 6,396,000 shares of common stock with a weighted average exercise price of $59.98 and $60.45, respectively, were considered anti-dilutive because the options’ exercise price was greater than the average fair market value of our common stock for the periods then ended. For the three and six months ended June 30, 2003, options to purchase 9,124,000 and 9,617,000 shares of common stock with a weighted average exercise price of $54.26 and $53.33, respectively, were considered anti-dilutive because the options’ exercise price was greater than the average fair market value of our common stock for the periods then ended. For each of the three and six months ended June 30, 2004 and 2003, common stock reserved for issuance upon conversion of the outstanding 2000 Notes for 2,697,000 shares were not included in diluted earnings per share because the conversion would be anti-dilutive. When the 2003 Notes are required to be included in our earnings per share calculations, 9,673,050 shares would be included in the diluted weighted average common shares and equivalent for the diluted net income per share calculation.

The effective tax rates for the three and six months ended June 30, 2004 and 2003 differ from statutory tax rates principally because of our participation in taxation programs in Israel. This tax structure is dependent upon continued reinvestment in our Israeli operations. Other factors that cause the effective tax rate and statutory tax rates to differ include the treatment of charges for amortization of intangible assets, stock-based compensation, and in-process research and development.

We report components of comprehensive income in our annual consolidated statements of shareholders’ equity. Comprehensive income consists of net income, foreign currency translation adjustments, and change in unrealized gain from available-for-sale marketable equity securities. Total comprehensive income for the three and six months ended June 30, 2004 and 2003 is as follows (in thousands):

We comply with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The standard requires us to recognize all derivatives on the balance sheet at fair value. Derivatives that are not hedges must be adjusted to fair value through the statements of operations. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or recognized in other comprehensive income (loss) until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. The accounting for gains or losses from changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship, as well as on the type of hedging relationship.

We enter into forward contracts to manage foreign currency exposures related to certain foreign currency denominated intercompany balances attributable to subsidiaries and foreign offices in the Americas, EMEA, APAC, and Japan. Additionally, we may adjust our foreign currency hedging position by taking out additional contracts, terminating, or offsetting existing forward contracts. These adjustments may result from changes in the underlying foreign currency exposures. We have not entered into forward contracts for speculative or trading purposes. The criteria used for designating a forward contract as a hedge considers its effectiveness in reducing risk by matching the hedging instruments to underlying transactions. Gains or losses on forward contracts are recognized in other income or expense in the same period as gains or losses on the underlying transactions. In May 2004, we effected a change to enter into hedge contracts of one-fiscal month duration to improve the overall effectiveness of our hedge strategy. We had outstanding forward contracts with notional amounts totaling $22.0 million and $31.5 million at June 30, 2004 and December 31, 2003, respectively. The forward contracts in effect at June 30, 2004 matured on July 30, 2004 and were hedges of certain foreign currency transaction exposures in the Australian Dollar, British Pound, Danish Kroner, Euro, Hong Kong Dollar, Indian Rupee, Japanese Yen, Korean Won, Norwegian Kroner, Singapore Dollar, South African Rand, and Swiss Franc.

We utilize forward exchange contracts of one fiscal-month duration to offset various non-functional currency exposures. Currencies hedged under this program include the Canadian Dollar, Hong Kong Dollar, Israeli Shekel, and Singapore Dollar. Increases or decreases in the value of these non-functional currency assets are offset by gains or losses on the forward exchange contracts to mitigate the risk associated with foreign exchange market fluctuations. We had outstanding forward contracts with notional amounts totaling $20.9 million and $42.6 million at June 30, 2004 and December 31, 2003, respectively. These forward exchange contracts contain credit risk in that the counterparties may be unable to meet the terms of the agreements. However, we minimize such risk of loss by limiting these agreements to major financial institutions. We also monitor closely the potential risk of loss with any one financial institution. We do not expect any material losses as a result of default by counterparties.

form of cash or cash equivalents to GSCM in the amount of $6.0 million as continuing security for our obligations under the swap (irrespective of movements in the value of the swap) and from time to time additional collateral can change hands between Mercury and GSCM as swap rates and equity prices fluctuate. We accounted for the initial collateral and any additional collateral as restricted cash in our consolidated balance sheet. If the price of our common stock exceeds the original conversion or redemption price of the 2000 Notes, we will be required to pay the fixed rate of 4.75% and receive a variable rate on the $300.0 million principal amount of the 2000 Notes. If we call the 2000 Notes at a premium (in whole or in part), or if any of the holders of the 2000 Notes elected to convert the 2000 Notes (in whole or in part), we will be required to pay a variable rate and receive the fixed rate of 4.75% on the principal amount of such called or converted 2000 Notes.

Our interest rate swap qualifies under SFAS No. 133 as a fair-value hedge. We record the fair value of our interest rate swap and the change in the fair value of the underlying 2000 Notes attributable to changes in the LIBOR in our consolidated balance sheet. We record the ineffectiveness arising from the difference between the two fair values in our consolidated statement of operations as “Other income (expense), net.” At June 30, 2004 and December 31, 2003, the fair value of the swap was approximately $5.2 million and $11.6 million, respectively, and the change in the fair value of our 2000 Notes attributable to changes in the LIBOR during the period resulted in a decrease in the carrying value of our 2000 Notes of $4.8 million and $11.2 million, respectively. The unrealized gains or losses on the interest rate swap were less than $0.1 million for three and six months ended June 30, 2004. The unrealized gains on interest rate swap were less than $0.1 million for the three and six months ended June 30, 2003. At June 30, 2004 and December 31, 2003, our total restricted cash associated with the swap was $6.0 million.

We have credit exposure with respect to GSCM as counterparty under the swap. However, we believe that the risk of such credit exposure is limited because GSCM is an affiliate of a major U.S. investment bank and because its obligations under the swap are guaranteed by the Goldman Sachs Group L.P.

For the three and six months ended June 30, 2004, we recorded interest expense of $1.2 million and $2.5 million, respectively, and interest income of $3.6 million and $7.1 million, respectively, as a result of our interest rate swap. For the three and six months ended June 30, 2003, we have recorded interest expense of $1.3 million and $2.8 million, respectively, and interest income of $3.6 million and $7.1 million, respectively, as a result of our interest rate swap. Our net interest expense, including the interest paid on our 2000 Notes, was $1.2 million and $2.5 million for the three and six months ended June 30, 2004. Our net interest expense, including the interest paid on our 2000 Notes, was $1.3 million and $2.8 million for the three and six months ended June 30, 2003, respectively.

We have four reportable operating segments: the Americas, EMEA, APAC, and Japan. These segments are organized, managed, and analyzed geographically and operate in one industry segment: the development, marketing, and selling of integrated application delivery, application management, and IT governance solutions. Our chief decision makers evaluate operating segment performance based primarily on net revenues and certain operating expenses.

Long-lived assets, which consist primarily of property and equipment, for our operating segments are as follows (in thousands):

International sales represented 38% and 37% of the total revenues from third parties for the three and six months ended June 30, 2004, respectively, and 37% for both the three and six months ended June 30, 2003. Revenues from the U.S. were 60% and 61% of the net revenues from third parties for the three and six months ended June 30, 2004, respectively, and 61% and 60% for the three and six months ended June 30, 2003, respectively. The subsidiary located in the U.K. accounted for 11% of the total revenues from third parties for both the three and six months ended June 30, 2004 and 12% for both the three and six months ended June 30, 2003. Operations located in the U.S. accounted for 76% and 74% of the consolidated identifiable assets at June 30, 2004 and December 31, 2003, respectively. Operations located in Israel accounted for 21% and 19% of the consolidated identifiable assets at June 30, 2004 and December 31, 2003, respectively.

Although we operate in one industry segment, our chief decision makers evaluate net revenues from the sale of our software products and services of our application delivery and application management, and IT governance solutions. The following tables present revenues for application delivery, application management, and IT governance for the three and six months ended June 30, 2004 and 2003 (in thousands):

On May 12, 2004, we entered into a definitive agreement to acquire all of the outstanding shares of Appilog, Inc. and assume all outstanding vested stock options. The acquisition was completed on July 1, 2004. The total purchase price of approximately $61.9 million consists of $50.8 million in cash, $0.7 million in direct merger costs, and $10.4 million related to stock options exchanged. The purchase price will be allocated to the tangible and intangible assets acquired and liabilities assumed based on their respective fair values at the acquisition date.

On July 27, 2004, our Board of Directors approved a new program to repurchase up to $400.0 million of our common stock over the next two years. The specific timing and amount of repurchases will vary based on market conditions, securities law limitations, and other factors. Since the inception of our new stock repurchase program through August 6, 2004, we have repurchased 3,072,000 shares of our common stock at an average price of $35.59 for an aggregate purchase price of $109.3 million.

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

The following discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors.” Our business may have changed since the date hereof, and we undertake no obligation to update these forward-looking statements.

Mercury is the leading provider of software and services for the Business Technology Optimization (BTO) marketplace. BTO is a business strategy for aligning information technology (IT) and business goals while optimizing the quality, performance, and business availability of strategic software applications and systems. Our application delivery, application management, and IT governance products and services, and the Mercury Optimization Centers are designed to help our customers increase the business value of IT with BTO.

We have aligned our enterprise software business model with the way we believe customers want to license and deploy enterprise software today. We believe our customers value a choice between perpetual software licenses and flexible term or subscription based contracts. Customers also have the choice between running software in-house or having software delivered as a hosted or managed service. Mercury’s enterprise software business model enables our customers to license the right software, for the right period of time, and have it deployed the right way—while giving Mercury the right financial incentives to renew and expand our relationships with customers.

We believe that the success of our model can be seen in our financial results which include significant growth in revenue and deferred revenue. To understand our financial results, it is important to understand our changing business model and its impact on the consolidated statement of operations and the consolidated balance sheet. We continue to offer many of our products, including our IT governance products, on a perpetual license basis. We have continued to expand the number of offerings structured as subscription based contracts. The majority of these types of contracts are required to be recorded initially as deferred revenue in the consolidated balance sheet and then recognized in subsequent periods over the term of the contract as subscription revenue in our consolidated statement of operations (see below under Business Model). Therefore, to understand the full growth of our business, one must look at both revenue and the change in deferred revenue.

Revenue consists of fees for the license and subscription of our software products, maintenance fees, and professional service fees. License revenue consists of license fees charged for the use of our products under perpetual or multiple-year arrangements in which the fair value of the license fee is separately determinable from maintenance and/or professional services. Subscription revenue, including managed service revenue, represents license fees to use one or more software products, and to receive maintenance support (such as hotline support and product updates) for a limited period of time. Since subscription licenses include bundled products and services, which are sold as a combined offering and for which the fair value of the license fee is not separately determinable from maintenance, both product and service revenue is generally recognized ratably over the term of the subscription. Maintenance revenue consists of fees charged for post-contract customer support, which are determinable based upon renewal rates quoted in the contracts, and, in the absence of stated renewal rates, upon separate sales of renewals to other customers. Professional service revenue consists of fees charged for product training and consulting services, which are determinable based upon separate sales of these services to other customers without bundling of other elements.

Due to the different treatment of subscription and perpetual licenses under applicable accounting rules, each type of license has a different impact on our consolidated financial statements. When a customer purchases a subscription license, the majority of the revenue will be recorded as deferred revenue in our consolidated balance sheet. The amount recorded as deferred revenue is equal to the portion of the license fee that has been invoiced or paid but not recognized as revenue. Deferred revenue is reduced as revenue is recognized. Under perpetual licenses (and some multiple-year arrangements for which separate vendor specific objective evidence of fair value exists for undelivered elements), a higher proportion of license revenue is recognized in the quarter that the product is delivered, with a lesser proportion recorded as deferred revenue. Vendor specific objective evidence of fair value is established by the price charged when that element is sold separately. Therefore, an order for a subscription license, or a perpetual license bundled with a subscription license, will result in significantly lower current-period revenue than an equal-sized order under a perpetual license. Conversely, an order for a subscription license will result in higher revenues recognized in future periods than an equal-sized order for a perpetual license. Further, generally, if a perpetual license is sold at the same time as a subscription based license to the same customer, then the two become bundled together and are recognized over the term of the contract.

Our license revenue in any given quarter is dependent upon the volume of perpetual license orders delivered during the current quarter and the amount of subscription revenue amortized from deferred revenue from prior quarters and, to a small degree, revenue recognized on subscription orders received during the current quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain mix of perpetual licenses and subscription licenses. The precise mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected subscription licenses) or may exceed them (if we deliver more-than-expected perpetual licenses). If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets. Our ability to achieve our revenue targets is also impacted by the mix of domestic and international sales, together with fluctuations in foreign exchange rates. If there is an increase in value of other currencies relative to the U.S. dollar, our revenues from international sales may be positively impacted. On the other hand, if there is a decrease in value of other currencies relative to the U.S. dollar, our revenues from international sales may be negatively impacted.

Cost of license and subscription includes direct costs to produce and distribute our products, such as costs of materials, product packaging and shipping, equipment depreciation, production personnel, and outsourcing services. It also includes costs associated with our managed services business, including personnel-related costs, fees to providers of Internet bandwidth and related infrastructure, and depreciation expense of managed services equipment. Cost of maintenance includes direct costs of providing product customer support, largely consisting of personnel costs and related expenses, and the cost of providing upgrades to our customers. We have not broken out the costs associated with license and subscription because these costs cannot be separated between license and subscription cost of revenue. Cost of professional services includes direct costs of providing product training and consulting, largely consisting of personnel costs and related expenses and costs of outsourcing service. License and subscription, maintenance, and professional services costs also include allocated facility expenses and allocated IT infrastructure expenses.

The costs associated with subscription licenses, which include the cost of products and services, are expensed as incurred over the subscription term. In addition, we defer the portion of our commission expense related to subscription licenses and maintenance contracts and amortize the expense over the term of the subscription or maintenance contracts. See “Critical Accounting Policies and Estimates” for a full description of our estimation process for accrued liabilities.

The following table sets forth, as a percentage of total revenues, certain condensed consolidated statements of operations data for the periods indicated. These operating results are not necessarily indicative of the results for any future period.

Certain reclassifications have been made to the consolidated statements of operations for the three and six months ended June 30, 2003 to conform to the presentation adopted for the three and six months ended June 30, 2004.

The following table summarizes license fees, subscription fees, maintenance fees, and professional service fees for the periods indicated (in thousands, except percentages):

The increase in licence fee revenue for the three and six months ended June 30, 2004 was due to an increased sales volume and average size of individual sale. For the three months ended June 30, 2004, the increase in license fee revenue was primarily attributable to the sale of IT governance products of $6.0 million and an increase in application delivery license sales of $5.8 million. For the six months ended June 30, 2004, the increase in license fee revenue was primarily attributable to the sale of IT governance products of $16.7 million and an increase in application delivery license sales of $6.5 million. We expect our license fee revenue to continue to increase in absolute dollars for the remainder of 2004.

The increase in subscription fee revenue for the three and six months ended June 30, 2004 was primarily due to an increased average size of individual sale. For the three months ended June 30, 2004, the increase in subscription fee revenue was attributable to a continuous growth in license sales of application delivery products on a subscription basis of $7.6 million and an increase in license sales of application management products of $4.2 million, which are primarily offered on a subscription basis. For the six months ended June 30, 2004, the increase in subscription fee revenue was attributable to a continuous growth in license sales of application delivery products of $16.7 million on a subscription basis and an increase in license sales of application management products of $11.7 million, which are primarily offered on a subscription basis. As we continue to offer more products on a subscription basis and as more customers license our products on a subscription basis, we expect sales of our subscription fee revenue to increase in absolute dollars for the remainder of 2004.

The increase in maintenance fee revenue for the three and six months ended June 30, 2004 was primarily attributable to renewals of existing maintenance contracts and sales of first year maintenance contracts for application delivery licensed products and maintenance fees for IT governance products. For the three months ended June 30, 2004, the increase of maintenance fee revenue related to application delivery products, IT governance products, and application management products was $6.1 million, $2.8 million, and $0.5 million, respectively. For the six months ended June 30, 2004, the increase of maintenance fee revenue related to application delivery products, IT governance products, and application management products was $14.8 million, $4.9 million, and $1.0 million, respectively. We expect maintenance fee revenue to continue to increase in absolute dollars for the remainder of 2004.

For the three months ended June 30, 2004, the increase in professional service fee revenue was primarily attributable to $5.1 million in consulting fees for service engagements related to IT governance products and higher professional service fees of $1.8 million and $0.6 million associated with application management products and application delivery products. For the six months ended June 30, 2004, the increase in professional service fee revenue was primarily attributable to $9.3 million in consulting fees for service engagements related to IT governance products and higher professional service fees of $4.3 million associated with application management products. The professional service fee revenue grew as a result of our continuous effort to expand our training and consulting services to our customers who license our products. We expect our professional service fee revenue to continue to increase in absolute dollars for the remainder of 2004.

International sales include revenues from Europe, the Middle East and Africa (EMEA), Asia Pacific (APAC), and Japan. International revenues for the three months ended June 30, 2004, compared to the three months ended June 30, 2003, were affected favorably by a weakening of the U.S. dollar relative to other currencies, primarily the Euro and British Pound. Total revenues from international sales for the three months ended June 30, 2004 were $61.1 million, an increase of $17.5 million, compared to the three months ended June 30, 2003. $4.0 million of this increase was due to fluctuations in foreign exchange rates. International sales represented 38% and 37% of our total revenues for the three months ended June 30, 2004 and 2003, respectively. Our international revenues increased 40% in absolute dollars for the three months ended June 30, 2004, compared to the same period in 2003, mainly due to a continuous weakening of the U.S. dollar relative to other currencies, primarily the Euro and British Pound, and an increase in sales in EMEA of $8.4 million and APAC of $4.2 million.

International revenues for the six months ended June 30, 2004, compared to the six months ended June 30, 2003, were affected favorably by a weakening of the U.S. dollar relative to other currencies, primarily the Euro and British Pound. Total revenues from international sales for the six months ended June 30, 2004 were $118.1 million, an increase of $33.0 million, compared to the six months ended June 30, 2003. $11.1 million of this increase was due to fluctuations in foreign exchange rates. International sales represented 37% of our total revenues for the six months ended June 30, 2004 and 2003. Our international revenues increased 39% in absolute dollars for the six months ended June 30, 2004, compared to the same period in 2003, due to a continuous weakening of the U.S. dollar relative to other currencies, primarily the Euro and British Pound, and an increase in sales in EMEA of $15.2 million and APAC of $6.7 million.

The following table summarizes cost of revenues for the periods indicated (in thousands, except percentages):

The increase in cost of license and subscription for the three and six months ended June 30, 2004 was primarily attributable to higher personnel-related costs as a result of growth in headcount and an increase in outsourcing expense related to delivery of our ProTune products. Personnel-related costs increased by $1.4 million and $2.6 million for the three and six months ended June 30, 2004, respectively. Outsourcing expense increased by $0.5 million and $1.5 million for the three and six months ended June 30, 2004, respectively. Based upon our expected revenue growth as described in “Revenues,” we expect cost of license and subscription to continue to increase in absolute dollars for the remainder of 2004.

The increase in cost of maintenance for the three months ended June 30, 2004 was primarily due to higher personnel-related costs of $0.9 million as a result of additional headcount to support our overall growth in business. The increase in cost of maintenance for the six months ended June 30, 2004 was primarily due to higher personnel-related costs of $1.9 million as a result of additional headcount and an increase in allocated facility expenses of $0.5 million. Our facility expenses increased primarily due to the lease for our new headquarters. Based upon our expected revenue growth as described in “Revenues,” we expect cost of maintenance to continue to increase in absolute dollars for the remainder of 2004.

The increase in cost of professional services for the three and six months ended June 30, 2004 was attributable to higher personnel-related costs as a result of growth in headcount and an increase in outsourcing expense. For the three and six months ended June 30, 2004, personnel-related costs increased by $3.8 million and $7.6 million, of which $2.7 million and $5.2 million was related to Kintana employees who joined us as part of that acquisition in 2003, respectively. The increase in outsourcing expense was primarily due to growth in professional services and our continuous effort to offer more training and consulting services to our customers who license our products. Outsourcing expense increased by $2.7 million and $5.0 million for the three and six months ended June 30, 2004, respectively. Based upon our expected revenue growth as described in “Revenues,” we expect cost of professional services to continue to increase in absolute dollars for the remainder of 2004.

The following table summarizes operating expenses for the periods indicated (in thousands, except percentages):

Marketing and selling expense consists of employee salaries and related costs, sales commissions, marketing programs, sales training, allocated facility expenses, and allocated IT infrastructure expenses. The increase in marketing and selling expense for the three and six months ended June 30, 2004 was primarily attributable to higher personnel-related costs due to growth in headcount, higher commission expense as a result of an increase in revenues together with growth in headcount, and higher professional service cost. The increase was also attributable to an increase in allocated facility expenses, allocated IT infrastructure expenses, spending on marketing programs, and sales training. Facility expenses and IT infrastructure expenses increased due to the lease for our new headquarters. For the three months ended June 30, 2004, personnel-related costs and commission expense increased by $10.7 million and $4.9 million, respectively, of which personnel-related costs of $3.2 million and commission expense of $1.7 million were related to Kintana employees who joined us as part of that acquisition in 2003. In addition, for the three months ended June 30, 2004, allocated facility expenses, allocated IT infrastructure expenses, spending on marketing programs, and professional service cost increased by $1.0 million, $0.9 million, $0.9 million, and $0.5 million, respectively.

For the six months ended June 30, 2004, personnel-related costs and commission expense increased by $21.0 million and $11.3 million, respectively, of which personnel-related costs of $6.4 million and commission expense of $2.5 million were related to Kintana employees who joined us as part of that acquisition in 2003. In addition, for the six months ended June 30, 2004, allocated facility expenses, sales training, professional service cost, allocated IT infrastructure expenses, and spending on marketing programs increased by $2.5 million, $1.7 million, $1.6 million, $1.2 million and $0.5 million, respectively. We expect marketing and selling expense to continue to increase in absolute dollars for the remainder of 2004.

Research and development expense consists of employee salaries and related costs, consulting costs, equipment depreciation, allocated facility expenses, and allocated IT infrastructure expenses associated with the development of new products, enhancements of existing products, and quality assurance procedures. For the three months ended June 30, 2004, the increase in research and development expense was primarily attributable to higher personnel-related costs of $3.0 million as a result of growth in headcount, of which $2.2 million was related to Kintana employees who joined us as part of that acquisition in 2003. The increase was also attributable to higher allocated facility expenses of $0.7 million and higher allocated IT infrastructure expenses of $0.6 million due to our move to the new leased headquarters. The impact from foreign exchange rate fluctuation for the Israeli Shekel to the U.S. dollar was insignificant for the three months ended June 30, 2004.

For the six months ended June 30, 2004, the increase in research and development expense was primarily attributable to higher personnel-related costs of $6.2 million as a result of growth in headcount, of which $4.3 million was related to Kintana employees who joined us as part of that acquisition in 2003, higher allocated facility expenses of $1.4 million and higher allocated IT infrastructure expenses of $0.8 million due to our move to the new leased headquarters. The increase was also attributable to a $1.1 million devaluation of the U.S. dollar to the Israeli Shekel as a substantial portion of our research and development expense was in Israeli Shekel. Based on our product development plan, we expect research and development expense to increase in absolute dollars for the remainder of 2004.

General and administrative expense consists of employee salaries and related costs, and fees for audit, tax, legal and consulting services, as well as allocated facility expenses and allocated IT infrastructure expenses. For the three months ended June 30, 2004, the increase in general and administrative expenses was primarily attributable to higher personnel-related costs of $1.2 million as a result of growth in headcount and additional professional service fees for audit, tax, and other consulting services of $0.3 million.

For the six months ended June 30, 2004, the increase in general and administrative expenses was primarily attributable to higher personnel-related costs of $2.4 million as a result of growth in headcount, additional professional service fees for audit, tax, and other consulting services of $1.5 million, and an increase in allocated facility expenses of $0.5 million due to the lease for our new headquarters. We expect general and administrative expenses to continue to increase in absolute dollars for the remainder of 2004 due to a projected increase in headcount and fees for compliance with the Sarbanes-Oxley Act of 2002.

Stock-based compensation for the three and six months ended June 30, 2004 and 2003 primarily consisted of amortization of unearned stock-based compensation associated with assumed options from the acquisitions of Kintana and Performant in 2003. We expect to record amortization of unearned stock-based compensation of $0.3 million for the remainder of 2004, $0.4 million for 2005, $0.3 million for 2006, and less than $0.1 million for 2007.

Acquisition related charges of $1.3 million for the six months ended June 30, 2003 were related to the acquired in-process research and development from the acquisition of Performant in May 2003. Upon the completion of the acquisition of Appilog on July 1, 2004, we expect to record a one-time charge of approximately $0.8 million to $1.0 million related to acquired in-process research and development in the third quarter of 2004.

Integration and other related charges for the three and six months ended June 30, 2004 were attributable to a milestone bonus plan related to certain research and development activities, that was signed in conjunction with the acquisition of Performant in 2003. The plan entitles each eligible employee to receive bonuses, in the form of cash payments, based on the achievement of certain performance milestones by applicable target dates. The commitment will be earned over time as milestones are achieved and expensed as a charge to the consolidated statement of operations. The maximum total payment under the plan is $5.5 million, of which $3.7 million has been paid through June 30, 2004. On July 1, 2004, we completed the acquisition of Appilog. We do not expect the integration costs related to the Appilog integration to be significant.

The increase in amortization of intangible assets was primarily due to a full quarter of amortization of intangible assets related to acquisitions of Performant in May 2003 and Kintana in August 2003, purchase of existing technology in the third quarter of 2003, and acquisition of a domain name in the fourth quarter of 2003.

Intangible assets are amortized on a straight-line basis over their useful lives or based on actual usage, whichever best represents the distribution of the economic value of the intangible assets.

Future amortization expense of intangible assets at June 30, 2004 is as follows (in thousands):

Amortization expense of intangible assets related to the Appilog acquisition is expected to be in the range of $0.5 to $0.6 million per quarter.

Also see notes 5 and 6 to the condensed consolidated financial statements for additional information regarding the acquisitions completed in 2003 and the intangible assets acquired in each acquisition.

Excess facilities charge of $9.2 million for the three and six months ended June 30, 2004 was primarily related to the write-down of a vacant building we own that has been placed for sale and the remaining lease payments for two leased facilities from the Kintana acquisition. In April 2004, we completed our move from our two buildings we own in Sunnyvale, California to our new leased headquarters in Mountain View, California. As a result of our move and our decision to vacate and sell one of the buildings we own in Sunnyvale, California, we took a charge to write down the net book value of the building that is held for sale to its appraised market value. We took into account the cost to maintain the facility until sold and sales commissions related to the sale of the building when we calculated the charge. In connection with our move into our consolidated headquarters, we also vacated two leased facilities from the Kintana acquisition. We recorded a charge for the remaining lease payments, as well as associated costs to protect and maintain the leased facilities prior to returning these leased facilities to the lessor. These lease agreements expire in September 2004 and December 2005. Due to the short duration of the remaining lease terms, it is not likely that we can sublease the facilities; as such, no sublease income was included in the facilities lease costs calculation. The excess facilities charge also included the write-off of leasehold improvements and the disposal of fixed assets, net of cash proceeds, associated with these facilities.

The following table summarizes non-operating income (expense) for the periods indicated (in thousands, except percentages):

The increase in interest income for the three and six months ended June 30, 2004 was attributable to interest earned on higher cash, cash equivalents, and investment balances in the first and second quarters of 2004 compared to the same quarters in 2003. In April 2003, we raised additional funds of $488.1 million, net of issuance costs of $11.9 million, from the issuance of Zero Coupon Convertible Notes (2003 Notes). Cash, cash equivalents, and investments were $1,390.3 million and $1,241.7 million at June 30, 2004 and 2003, respectively.

Interest expense for the three and six months ended June 30, 2004 and 2003 primarily consisted of interest expense associated with the interest rate swap and the Convertible Subordinated Notes (2000 Notes) we issued in July 2000.

In 2002, we entered into an interest rate swap arrangement with Goldman Sachs Capital Markets, L.P. The interest rate swap is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) with respect to $300.0 million of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on the 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The interest rate swap qualifies for hedge accounting treatment in accordance with Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities and the related amendment.

Also, see Notes 7 and 14 to the condensed consolidated financial statements for additional information regarding our 2000 Notes and the related interest rate swap activities.

Other expense, net primarily consists of net gain or loss on investments in non-consolidated companies and a warrant, amortization of debt issuance costs associated with the issuance of our 2003 Notes and 2000 Notes, and currency gains or losses. For the three months ended June 30, 2004, the increase in other expense, net was primarily attributable to an increase in currency losses of $1.0 million and amortization of debt issuance costs related to our 2003 Notes of $0.2 million. The increase was partially offset by a reduction in loss on investments in privately held companies and a private equity fund of $0.8 million, an unrealized gain on the change in fair value of the Motive warrant of $0.1 million, and realized gain on the sale of available-for-sale marketable equity securities of $0.3 million. For the six months ended June 30, 2004, the increase in other expense, net was primarily attributable to an increase in currency losses of $0.4 million and amortization of debt issuance costs related to our 2003 Notes of $0.7 million. The increase was partially offset by a reduction in loss on investments in privately held companies and a private equity fund of $0.8 million, an unrealized gain on the change in fair value of the Motive warrant of $0.4 million, and realized gain on the sale of available-for-sale marketable equity securities of $0.3 million.

The fair value of the Motive warrant was calculated by using the Black-Scholes option-pricing model, which requires subjective assumptions such as the expected stock price volatility of the company. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. A decline in the U.S. stock market and the market price of Motive’s common stock could contribute to volatility in our reported results of operations. In calculating the loss on our investments in privately held companies and private equity funds, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors.

Also, see Notes 7 and 14 to the condensed consolidated financial statements for additional information regarding our 2000 and 2003 Notes and the related interest rate swap activities.

Historically, our operations resulted in a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investments. The tax holidays and rate reductions, which we will be able to realize under programs currently in effect, expire at various dates through 2013. Future provisions for taxes will depend upon the mix of worldwide income and the tax rates in effect for various tax jurisdictions. The effective tax rates for the three and six months ended June 30, 2004 and 2003 differ from statutory tax rates principally because of our participation in taxation programs in Israel. We intend to continue to increase our investment in our Israeli operations consistent with our overall tax strategy. Other factors that cause the effective tax rate and statutory tax rates to differ include the treatment of charges for amortization of intangible assets, stock-based compensation, and in-process research and development. U.S. income taxes and foreign withholding taxes were not provided for on undistributed earnings for certain non-U.S. subsidiaries. We intend to invest these earnings indefinitely in operations outside the U.S.

In 2002, we sold the economic rights of Freshwater’s intellectual property to our Israeli subsidiary. As a result of this intellectual property sale, we have recorded a current tax payable and a prepaid tax asset in the amount of $25.5 million, which will be amortized to income tax expense over eight years, which approximates the period over which the expected benefit is expected to be realized. We intend to migrate the economic ownership of the technology acquired from Performant and Kintana to our Israeli subsidiary in 2004, which may lead to a temporary increase in our effective tax rate. At June 30, 2004 and December 31, 2003, we had a prepaid tax asset of $17.5 million and $19.1 million, respectively.

At June 30, 2004, our principal source of liquidity consisted of $1,390.3 million of cash and investments, compared to $1,233.7 million at December 31, 2003. The June 30, 2004 balance included $167.7 million of short-term, and $648.6 million of long-term investments in high quality financial, government, and corporate securities. During the six months ended June 30, 2004, we generated $103.1 million of cash from operating activities, compared to $91.4 million during the six months ended June 30, 2003. The increase in cash from operations during the six months ended June 30, 2004, compared to the six months ended June 30, 2003 was primarily due to an overall growth in our business.

During the six months ended June 30, 2004, cash proceeds from investing activities consisted of the sale of vacant facilities and assets of $2.6 million, sale of available-for-sale marketable equity securities of $1.7 million, and return on investment in one of the privately held companies of $1.5 million. Cash used for investing activities during the six months ended June 30, 2004 primarily consisted of net purchases of investments of $131.7 million, acquisition of property and equipment of $19.3 million, and an additional investment in a private equity fund of $1.5 million. Cash used in the acquisition of property and equipment in the first and second quarters of 2004 was primarily attributable to leasehold improvements and IT infrastructure for our new headquarters in Mountain View, California and new foreign offices. Cash was also used to purchase land in Israel in February 2004 for $2.2 million.

During the six months ended June 30, 2004, our primary financing activities consisted of cash proceeds of $66.9 million from common stock issued under our employee stock option and stock purchase plans.

In June 2003, we entered into a non-exclusive agreement (amended in February 2004) to license technology from Motive. The agreement is non-transferable, except in the case of a merger, acquisition, spin-out, or other transfer of all or substantially all of the business, stock, or assets to which the agreement relates. The licensed technology will be combined with our other existing Mercury products, which should be generally available in the latter half of 2004. The agreement is in effect until December 31, 2006 with a right to renew and an option to purchase a fully paid up, perpetual license to the technology prior to July 1, 2008. Under the original agreement, we had committed to royalty payments totaling $15.0 million, of which $8.0 million had been paid as of December 31, 2003. In accordance with the addendum, the remaining royalty balance of $7.0 million was accelerated and was paid in February 2004. We recorded such payments as prepaid royalties.

At June 30, 2004, we have committed to make additional capital contributions to a private equity fund totaling $7.1 million.

At June 30, 2004, we had four irrevocable letter of credit agreements totaling $1.4 million with Wells Fargo & Company (Wells Fargo). Wells Fargo is a related party to us as one of the members of Board of Directors is an executive officer of Wells Fargo. Two of the agreements are related to facility lease agreements assumed by us in conjunction with the acquisition of Kintana in 2003. One of the agreements has an automatic annual renewal provision under which the expiration date cannot be extended beyond March 1, 2006 and the other agreement expires in September 2004. The third agreement is related to a facility lease agreement assumed by us in conjunction with the acquisition of Freshwater in 2001. This agreement has an automatic annual renewal provision under which the expiration dates cannot be extended beyond August 31, 2006. The fourth agreement is related to the facility lease agreement for our new headquarters in Mountain View, California and this agreement automatically renews annually after January 1, 2005 unless we provide a termination notice to Wells Fargo. At June 30, 2004, no amounts had been drawn on the letters of credit.

We lease facilities for sales offices in the U.S. and foreign locations under non-cancelable operating leases that expire through 2015. Certain of these leases contain renewal options. In addition, we lease certain equipment under various lease agreements with lease terms ranging from month-to-month up to one year. On October 21, 2003, we entered into a lease agreement for our new headquarters facility. The lease began on January 1, 2004 and expires on February 20, 2014. In April 2004, we moved from the two Kintana facilities to our new headquarters in Mountain View, California. Future lease payments associated with these two facilities are included in the following table.

Future payments due under debt, lease, and royalty agreements at June 30, 2004 are as follows (in thousands):

In July 2000, we issued $500.0 million in Convertible Subordinated Notes due on July 1, 2007. The 2000 Notes bear interest at a rate of 4.75% per annum and are payable semiannually on January 1 and July 1 of each year. The 2000 Notes are subordinated in right of payment to all of our future senior debt. The 2000 Notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. The entire outstanding principal amount of the 2000 Notes will become due and payable at maturity. We may redeem the 2000 Notes, in whole or in part, at any time on or after July 1, 2003. Accrued interest to the redemption date will be paid by us in any such redemption. We did not redeem any portion of the 2000 Notes at June 30, 2004. From December 2001 through June 30, 2002, we retired $200.0 million face value of the 2000 Notes. The face value of the 2000 Notes was $300.0 million at June 30, 2004 and December 31, 2003.

In 2002, we entered into an interest rate swap arrangement of $300.0 million, with a maturity date of July 2007, to hedge the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) of our 2000 Notes. The value of the interest rate swap is determined using various inputs, including forward interest rates, and time to maturity. Our interest rate swap was recorded as an asset in our consolidated balance sheets as of June 30, 2004 and December 31, 2003, but it has decreased in value over the past six months. If market changes continue to negatively impact the value of the swap, the swap may become a liability in our consolidated balance sheet. In the event we chose to terminate the swap before maturity, and the swap value was unfavorable, we would be obligated to pay to our counterparty in cash, the market value of the swap at termination date. Also, see Notes 7 and 14 to the condensed consolidated financial statements for additional information regarding our 2000 and 2003 Notes and the related interest rate swap activities.

In April 2003, we issued $500.0 million of Zero Coupon Convertible Notes due on May 1, 2008 in a private offering. The 2003 Notes do not bear interest, have a zero yield to maturity and may be convertible into our common stock. Holders of the 2003 Notes may convert their 2003 Notes prior to maturity only if the sale price of our common stock reaches specified thresholds or if specified corporate transactions have occurred. Upon conversion, we have the right to deliver cash instead of shares of our common stock. We may not redeem the 2003 Notes prior to their maturity. See Note 7 to the condensed consolidated financial statements for further details on the conversion provisions for the 2003 Notes.

Historically, a significant amount of our income and cash flow was generated in Israel where tax rate incentives have been extended to encourage foreign investment. We may have to pay significantly more income taxes if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased or if we choose to repatriate cash balances from Israel to other foreign jurisdictions. In addition, our future tax provisions will depend on the mix of our worldwide income and the tax rates in effect for various tax jurisdictions.

As of June 30, 2004, we did not have any purchase commitments other than obligations incurred in the normal course of business. These amounts are accrued when services or goods are received.

For the six months ended June 30, 2004 and 2003, our source of funding was mainly from cash generated by our operations. Since our operating results may fluctuate significantly, a decrease in customer demand or a decrease in the acceptance of our future products and services may impact our ability to generate positive cash flow from operations.

We continue to derive a significant portion of our overall business growth through the growth of our application management product offerings which are primarily offered on a subscription basis. The shift in the mix of license types does not impact our collections cycle as we typically invoice the customers up front for the full license amount and cash is generally received within 30-60 days from the invoice date in the U.S., APAC, and Japan (slightly longer in EMEA). Our quarterly operating results are affected by

the mix of license types entered into in connection with the sale of products. As revenue associated with our subscription licenses is generally recognized ratably over the term of the license, the shift in mix will also result in deferred revenue becoming a larger component of our cash provided by operations. We believe that the shift to a subscription revenue model will continue in the future as we have continued to expand the number of offerings structured as subscription based contracts. Further, generally, if a perpetual license is sold at the same time as a subscription based license to the same customer, then the two become bundled together and are recognized over the term of the contract. This shift may cause us to experience a decrease or a lower rate of growth in recognized revenue in a given period, as well as continued growth in deferred revenue. Deferred revenue at June 30, 2004 was $327.3 million compared to $280.6 million at December 31, 2003. The increase included subscription fees of $22.9 million and maintenance fees of $15.2 million. However, we expect the mix of licenses to continue to fluctuate.

In the future, we expect cash will continue to be generated from our operations. We expect to spend additional cash of approximately $4.0 million to $5.0 million on leasehold improvements and IT infrastructure for our new leased campus, and other related costs during the remainder of 2004. Except for cash spent for our new leased campus, we do not expect the level of cash used in investing activities to acquire property and equipment in 2004 to change significantly from 2003. We currently plan to reinvest our cash generated from operations in new short- and long-term investments in high quality financial, government, and corporate securities or other investments, consistent with past investment practices, and therefore net cash used in investing activities may increase. Cash could be used in the future for acquisitions or strategic investments. For example, we expect to pay approximately $51.5 million in cash, including $0.7 million of direct merger costs to acquire Appilog. Cash could also be used to repurchase additional equity or retire or redeem additional debt. For example, since the inception of our new stock repurchase program through August 6, 2004, cash used to repurchase our common stock under our new stock repurchase program was $109.3 million. There are no transactions, arrangements, or other relationships with non-consolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of our requirements for capital resources.

Assuming there is no significant change in our business, we believe that our current cash and investment balances and cash flow from operations will be sufficient to fund our cash needs for at least the next twelve months.

On May 12, 2004, we entered into a definitive agreement to acquire all of the outstanding shares of Appilog and assume all outstanding vested stock options. The acquisition was completed on July 1, 2004. The total purchase price of approximately $61.9 million consists of $50.8 million in cash, $0.7 million in direct merger costs, and $10.4 million related to stock options exchanged. The purchase price will be allocated to the tangible and intangible assets acquired and liabilities assumed based on their respective fair values at the acquisition date.

Our former Vice President of Tax, Uzi Sasson, filed a complaint on August 4, 2004, alleging that we wrongfully terminated his employment. We believe these claims were without merit and intend to vigorously defend the lawsuit.

The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our financial statements. The U.S. Securities and Exchange Commission has defined the most critical accounting policies as the ones that are most important to the portrayal of our financial condition and results, and require us to make our most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain.

We discuss these policies further, as well as the estimates and judgments involved. We also have other key accounting policies. We believe that these other policies either do not generally require us to make estimates and judgments that are as difficult or as subjective, or it is less likely that they would have a material impact on our reported results of operations for a given period.

Our revenue recognition policy is detailed in Note 1 to the condensed consolidated financial statements. We have made significant judgments related to revenue recognition; specifically, in connection with each transaction involving our arrangements, we must evaluate whether our fee is “fixed or determinable” and we must assess whether “collectibility is probable.” These judgments are discussed below.

With respect to each arrangement, we must make a judgment as to whether the arrangement fee is fixed or determinable. If the fee is fixed or determinable, then revenue is recognized upon delivery of software or over the period of arrangements with our customers (assuming other revenue recognition criteria are met). If the fee is not fixed or determinable, then the revenue recognized in each quarter (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees had been fixed or determinable.

A determination that an arrangement fee is fixed or determinable also depends upon the payment terms relating to such an arrangement. Our customary payment terms are generally within 30-60 days of the invoice date in the U.S., APAC, and Japan (slightly longer in EMEA). Arrangements with payment terms extending beyond the customary payment terms are considered not to be fixed or determinable. A determination of whether the arrangement fee is fixed or determinable is particularly relevant to revenue recognition on perpetual licenses. The amount and timing of our revenue recognized in any period may differ materially if we make different judgments.

To recognize revenue, we must make a judgment of the collectibility of the arrangement fee. Our judgment of the collectibility is applied on a customer-by-customer basis. We generally sell to customers for which there is a history of successful collection. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash. The amount and timing of revenue recognized in any period may differ materially if we make different judgments.

The preparation of financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Use of estimates and assumptions include, but are not limited to, the sales reserve and prepaid commissions.

We must make estimates of potential future credits, warranty cost of product and services, and write-off of bad debts related to current period product revenues. We analyze historical returns, historical bad debts, current economic trends, average deal size, changes in customer demand, and acceptance of our products when evaluating the adequacy of the sales reserves. Revenue for the period is reduced to reflect the provision for sales returns. As a percentage of current period revenues, charges against sales reserves were insignificant for the three and six months ended June 30, 2004. Significant management judgments and estimates are made and used in connection with establishing the sales reserve in any accounting period. Material differences may result in the amount and timing of our revenues for any period if we make different judgments or use different estimates. At June 30, 2004 and December 31, 2003, sales reserves were $5.5 million and $6.1 million, respectively.

We are required to make estimates of the future sales commission expense associated with our revenues that will be recognized in future periods. We analyze historical commission rates, composition of the future revenues, and expected timing of revenue recognition of such future amounts. We make significant judgments and estimates in connection with establishing the prepaid commission in any accounting period. Material differences may result in the amount and timing of our sales commission expense for any period if we make different judgments or use different estimates. At June 30, 2004 and December 31, 2003, prepaid commissions were $28.4 million and $23.4 million, respectively.

We assess the impairment of long-lived assets and certain identifiable intangible assets to be held and used whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

We determine the recoverability of long-lived assets and certain identifiable intangible assets based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Such estimation process is highly subjective and involves significant management judgment. Determination of impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets and certain identifiable intangible assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. In the second quarter of 2004, we recorded an impairment charge of $6.7 million associated with one of the two buildings we own that has been placed for sale. If our estimates or the related assumptions change in the future, we may be required to record an impairment charge on long-lived assets and certain intangible assets to reduce the carrying amount of these assets. Net intangible assets and long-lived assets were $110.1 million and $118.3 million at June 30, 2004 and December 31, 2003, respectively.

We assess the impairment of goodwill on an annual basis, and potentially more frequently if events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

When we determine that the carrying value of goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure this impairment based on a projected discounted cash flow. We performed an annual impairment review during the fourth quarter in both 2003 and 2002. We did not record an impairment charge based on our reviews. If our estimates or the related assumptions change in the future, we may be required to record an impairment charge on goodwill to reduce its carrying amount to its estimated fair value.

As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax expense in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future. Our taxes could increase if these tax rate incentives are not renewed upon expiration, tax rates applicable to us are increased, authorities challenge our tax strategy, or our tax strategy is impacted by new laws or rulings.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance for the

majority portion of the net operating losses related to the income tax benefits arising from the exercise of employees’ stock options. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance, which could materially impact our financial position and results of operations.

From time to time, we hold equity investments in publicly traded companies, privately held companies, and private equity funds for business and strategic purposes. These investments are accounted for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. We periodically monitor our equity investments for impairment and will record reductions in carrying values if and when necessary. For equity investments in privately held companies and private equity funds, the evaluation process is based on information that we request from these companies and funds. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings/revenue outlook, operational performance, management/ownership changes, and competition. If we determine that the carrying value of an investment is at an amount above fair value, or if a company has completed a financing with new unrelated third party investors based on a valuation significantly lower than the carrying value of our investment and the decline is other-than-temporary, it is our policy to record a loss on investment in our consolidated statement of operations. Estimating the fair value of non-marketable equity investments in technology companies is inherently subjective and may contribute to significant volatility in our reported results of operations.

For equity investments in publicly traded companies, we record a loss on investment in our consolidated statement of operations when we determine the decline in fair value below the carrying value is other-than-temporary. The ultimate value realized on these equity investments is subject to market price volatility until they are sold. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, earnings/revenue outlook, operational performance, management/ownership changes, competition, and stock price performance. Our on-going review may result in additional impairment charges in the future which could significantly impact our results of operations.

At June 30, 2004, our equity investments in non-consolidated companies were composed of investments in privately held companies of $4.6 million, a private equity fund of $7.1 million, and a warrant to purchase common stock of Motive of $0.8 million. At June 30, 2004, our total capital contributions to the private equity fund were $7.9 million. We have committed to make additional capital contributions to this private equity fund up to $7.1 million in the future. If the companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies, we may not be able to sell these investments. In addition, even if we are able to sell these investments, we cannot assure that we will be able to sell them at a gain or even recover our investment. A decline in the U.S. stock market and the market prices of publicly traded technology companies will adversely affect our ability to realize gains or a return of our capital on many of these investments. For the three months ended June 30, 2004, we did not record any losses on our investments in privately held companies nor the private equity fund. Unrealized gain related to a change in the fair value of the Motive warrant was $0.1 million for the three months ended June 30, 2004. For the six months ended June 30, 2004, we recorded a loss of $0.5 million on one of our investments in privately held companies. The loss was partially offset by an unrealized gain of $0.4 million related to a change in fair value of the Motive warrant. For the three months ended June 30, 2003, we recorded a loss of $0.6 million on one of our investments in privately held companies and a loss of $0.2 million on our investment in the private equity fund. For the six months ended June 30, 2003, we recorded a loss of $1.1 million on two of our investments in privately held companies and a loss of $0.2 million on our investment in the private equity fund.

The warrant is treated as a derivative instrument due to a net settlement provision. The warrant is recorded at its fair value on each reporting period. We calculate the fair value of the warrant using the Black-Scholes option-pricing model. The option-pricing model requires the input of highly subjective assumption such as the expected stock price volatility. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. A decline in the U.S. stock market and the market price of Motive’s common stock could contribute to volatility in our reported results of operations.

We account for stock-based compensation for our employees using the intrinsic value method presented in Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations, and comply with the disclosure provisions of Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based Compensation, and with the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure Amendment of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise price. No stock-based compensation has been recorded for stock options granted to our employees because we have granted stock options to our employees equal to the market price of the underlying stock on the date of grant. In accordance with Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation, an interpretation of APB No. 25, we account for the fair value of stock options assumed in a purchase business combination at the date of acquisition at their fair value calculated using the Black-Scholes option-pricing model. The fair value of assumed options is included as a component of the purchase price. The intrinsic value attributable to unvested options is recorded as unearned stock-based compensation and amortized over the remaining vesting period of the stock options.

In 2001 and 2003, we recorded unearned stock-based compensation primarily due to assumed stock options in conjunction with our acquisitions of Freshwater, Performant, and Kintana. We amortize unearned stock-based compensation using the straight-line method over the remaining vesting periods of the related options. If we amortize unearned stock-based compensation using the graded vesting method, which results in higher expense being recognized in the earlier period, our financial position and results of operations could be different.

On March 31, 2004, the Financial Accounting Standards Board (FASB) issued an exposure draft on proposed standard for the accounting of stock options. The proposed standard requires public companies to value employee stock options and stock issued under employee stock purchase plans using the fair value based method on the grant date and record stock-based compensation expense. The fair value based models that companies are allowed to use could be different from the Black-Scholes option-pricing model, which is currently used by us to calculate the pro forma effect on net income and earnings per share if we had applied SFAS No. 123 to employee option grants. (See Note 1 to our condensed consolidated financial statements for the disclosure of the pro forma net income (loss) and earnings (loss) per share for the three and six months ended June 30, 2004 and 2003, if we had applied SFAS No. 123.) However, the actual impact to our results of operations upon adoption of the proposed standard could be materially different from the pro forma information included in Note 1 to our condensed consolidated financial statements due to differences in the option-pricing model used, estimates and assumptions required, and options to be included in the calculation upon adoption. The fair value based models require the input of highly subjective assumptions and do not necessarily provide a reliable single measure of the fair value of our stock options. We closely monitor the status of this proposed standard and will evaluate the impact on our financial position and results of operations at such time when the final standard is issued.

To mitigate our exposure on foreign currencies fluctuations, we enter into forward contracts to manage foreign currency exposures related to certain foreign currency denominated intercompany balances attributable to subsidiaries and foreign offices in the Americas, EMEA, APAC, and Japan against fluctuations in exchange rates. We have not entered into forward contracts for speculative or trading purposes. We enter into forward contracts based on our estimation of when revenue will be earned and cash will be collected. If the timing between when revenue is earned and cash is collected is different from our estimates, we will recognize gains or losses on forward contracts as a result of our hedging ineffectiveness. Based on any gains and losses our financial position and results of operations may be significantly impacted.

In addition to the other information included in this Quarterly Report on Form 10-Q, you should carefully consider the risks described below before deciding to invest in us or maintain or increase your investment. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that we currently deem not significant may also affect our business operations. If any of these risks actually occur, our business, financial condition, or results of operations could be seriously harmed. In that event, the market price of our common stock could decline and you may lose all or part of your investment.

Our future success may be impaired and our operating results will suffer if we cannot respond to rapid market and technological changes by introducing new products and services and continually improving the performance, features, and reliability of our existing products and services and responding to competitive offerings. The market for our software products and services is characterized by:

To maintain our competitive position, we must continue to enhance our existing products, including our software products and services for our application management and application delivery, and IT governance solutions. We must also continue to develop new products and services, functionality, and technology that address the increasingly sophisticated and varied needs of our customers and prospective customers. The development of new products and services, and enhancement of existing products and services, entail significant technical and business risks and require substantial lead-time and significant investments in product development. In addition, many of the markets in which we operate are seasonal. If we fail to anticipate new technology developments, customer requirements, or industry standards, or if we are unable to develop new products and services that adequately address these new developments, requirements, and standards in a timely manner, our products and services may become obsolete, our ability to compete may be impaired, our revenue could decline, and our operating results may suffer.

We expect our quarterly revenue and operating results to fluctuate, and it is difficult to predict our future revenue and operating results. Our revenue and operating results have varied in the past and are likely to vary significantly from quarter to quarter in the future. These fluctuations are due to a number of factors, many of which are outside of our control, including:

In addition, the timing of our software product revenues is difficult to predict and can vary substantially from product to product and customer to customer. We base our operating expenses on our expectations regarding future revenue levels. The timing of larger orders and customer buying patterns are difficult to forecast, therefore we may not learn of shortfalls in revenue or earnings or other failures to meet market expectations until late in a particular quarter. As a result, if total revenues for a particular quarter are below our expectations, we would not be able to proportionately reduce operating expenses for that quarter.

We have experienced seasonality in our orders and revenues which may result in seasonality in our earnings. The fourth quarter of the year typically has the highest orders and revenues for the year and higher orders and revenues than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers being typically higher in the third and fourth quarters, from our application management business being typically strongest in the fourth quarter and weakest in the first quarter, however, and to a lesser extent, from the structure of our sales commission program. In addition, the tendency of some of our customers to wait until the end of a fiscal quarter to finalize orders has resulted in higher order volumes towards the end of the quarter. We expect this seasonality to continue in the future. In the first quarter of 2004, we experienced higher orders and revenues than the fourth quarter of 2003. We do not believe that these results are indicative of a shift in the future seasonality trends that we have typically experienced in the past.

Due to these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. If our operating results are below the expectations of investors or securities analysts, the trading prices of our securities could decline.

Our revenue targets are dependent on a projected mix of orders in a particular quarter and any failure to achieve revenue targets because of a shift in the mix of orders could adversely affect our quarterly revenue and operating results. Our license revenue in any given quarter is dependent upon the volume of perpetual orders shipped during the quarter and the amount of subscription revenue amortized from deferred revenue and, to a small degree, the amount recognized on subscription orders received during the quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain license mix of perpetual licenses and subscription licenses. The precise mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected subscription licenses) or may exceed them (if we deliver more-than-expected perpetual licenses). In addition, if we achieve the target license mix but the overall level of orders is below the target level, then we will not meet our revenue targets which will adversely affect our operating results. In 2002, we began to effect a change in the mix of software license types to a higher percentage of subscription licenses in our application management and application delivery products. We believe that this shift will continue in the future as we offer more products on a subscription basis and more of our customers license our products a subscription basis. Further, generally, if a perpetual license is sold at the same time as a subscription based license to the same customer, then the two become bundled together and are recognized over the term of the contract. This shift may cause us to experience a decrease in recognized revenue in a given period, as well as continued growth of deferred revenue. In addition, while subscription licenses represent a potential source of renewable license revenue, there is also the risk that customers will not renew their licenses at the end of a term.

We expect to face increasing competition in the future, which could cause reduced sales levels and result in price reductions, reduced gross margins, or loss of market share. The market for our business technology optimization products and services is extremely competitive, dynamic, and subject to frequent technological change. There are few substantial barriers of entry in our market. The Internet has further reduced these barriers of entry, allowing other companies to compete with us in our markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of current and potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities.

In the market for application delivery solutions, our principal competitors include Compuware, Empirix, IBM Software Group, and Segue Software. In the new and rapidly changing market for application management solutions, our principal competitors include established providers of systems, storage, and network management software such as BMC Software, Computer Associates, HP OpenView (a division of Hewlett-Packard), Tivoli (a division of IBM), and Veritas, and providers of managed services such as Keynote Systems. Additionally, we face potential competition in this market from existing providers of application delivery solutions such as Segue Software and Compuware. In the market for IT governance solutions, our principal competitors include enterprise application vendors such as SAP, PeopleSoft, Oracle, Lawson, and Changepoint (which was recently acquired by Compuware), as well as point tool vendors such as Niku and Primavera.

Although we believe that our products and services currently compete favorably with respect to these factors, the markets for application management, application delivery, and IT governance are new and rapidly evolving. We may not be able to maintain our competitive position, which could lead to a decrease in our revenues and adversely affect our operating results. The software industry is increasingly experiencing consolidation and this could increase the resources available to our competitors and the scope of their product offerings. For example, our former application delivery competitor Rational Software was acquired by IBM Software Group, which has substantially greater financial and other resources than we have. Our competitors and potential competitors may develop more advanced technology, undertake more extensive marketing campaigns, adopt more aggressive pricing policies, or make more attractive offers to distribution partners and to employees.

If we fail to maintain our existing distribution channels and develop additional channels in the future, our revenue could decline. We derive a portion of our business from sales of our products and services through distribution channels, such as global software vendors, systems integrators, or value-added resellers. We generally expect that sales of our products through these channels will continue to account for a substantial portion of our revenue for the foreseeable future. We may not experience increased revenue from new channels and may see a decrease from our existing channels, which could harm our business.

The loss of one or more of our systems integrators or value-added resellers, or any reduction or delay in their sales of our products and services could result in reductions in our revenue in future periods. In addition, our ability to increase our revenue in the future depends on our ability to expand our indirect distribution channels.

Our dependence on indirect distribution channels presents a number of risks, including:

The continued growth of our business may be adversely affected if we fail to form and maintain strategic relationships and business alliances. Our development, marketing, and distribution strategies rely increasingly on our ability to form strategic relationships with software and other technology companies. These business relationships often consist of cooperative marketing

programs, joint customer seminars, lead referrals, and cooperation in product development. Many of these relationships are not contractual and depend on the continued voluntary cooperation of each party with us. Divergence in strategy or change in focus by, or competitive product offerings by, any of these companies may interfere with our ability to develop, market, sell, or support our products, which in turn could harm our business. Further, if these companies enter into strategic alliances with other companies or are acquired, they could reduce their support of our products. Our existing relationships may be jeopardized if we enter into alliances with competitors of our strategic partners. In addition, one or more of these companies may use the information they gain from their relationship with us to develop or market competing products.

If we do not adequately manage and evolve our financial reporting and managerial systems and processes, our ability to manage and grow our business may be harmed. Our ability to successfully implement our business plan and comply with regulations, including Sarbanes-Oxley Act of 2002, requires an effective planning and management process. We expect that we will need to continue to improve existing, and implement new, operational and financial systems, procedures and controls to manage our business effectively in the future. Any delay in the implementation of, or disruption in the transition to, new or enhanced systems, procedures or controls, could harm our ability to accurately forecast sales demand, manage our supply chain and record and report financial and management information on a timely and accurate basis.

Our increasing efforts to sell enterprise-wide software products and services could expose us to revenue variations and higher operating costs. We increasingly focus our efforts on sales of enterprise-wide solutions, which consist of our entire Mercury Optimization Centers product suite and related professional services, and managed services, rather than on the sale of component products. As a result, each sale requires substantial time and effort from our sales and support staff as well as involvement by our professional services and managed services organizations and our systems integrator partners. Large individual sales, or even small delays in customer orders, can cause significant variation in our revenues and adversely affect our results of operations for a particular period. The timing of large orders is usually difficult to predict and, like many software and services companies, many of our customers typically complete transactions in the last month of a quarter.

If we are unable to manage rapid changes, our operating results could be adversely affected. We have, in the past, experienced significant growth in revenue, employees, and number of product and service offerings and we believe this growth may continue. This growth has placed a significant strain on our management and our financial, operational, marketing, and sales systems. We are implementing and plan to implement in the future a variety of new or expanded business and financial systems, procedures, and controls, including the improvement of our sales and customer support systems. The implementation of these systems, procedures, and controls may not be completed successfully, or may disrupt our operations or our data may not be transitioned properly. Any failure by us to properly manage these transitions could impair our ability to attract and service customers and could cause us to incur higher operating costs and experience delays in the execution of our business plan.

We have also in the past experienced reductions in revenue that required us to rapidly reduce costs. If we fail to reduce staffing levels when necessary, our costs would be excessive and our business and operating results could be adversely affected.

The success of our business depends on the efforts and abilities of our senior management and other key personnel. We depend on the continued services and performance of our senior management and other key personnel. We do not have long-term employment agreements with any of our key personnel. The loss of any of our executive officers or other key employees could hurt our business. The loss of senior personnel can result in significant disruption to our ongoing operations, and new senior personnel must spend a significant amount of time learning our business and our systems in addition to performing their regular duties. Additionally, our inability to attract new senior executives and key personnel could significantly impact our business results.

Our international sales and operations subject us to risks that can adversely affect our revenue and operating results. International sales have historically accounted for a significant percentage of our revenue and we anticipate that such sales will continue to be a significant percentage of our revenue. As a percentage of our total revenues, international sales were 38% and 37% for the three and six months ended June 30, 2004, respectively, and 37% for both the three and six months ended June 30, 2003. We face risks associated with our international operations, including:

Any of these risks could harm our international operations and reduce our international sales. For example, some countries in Europe, the Middle East and Africa already have laws and regulations related to technologies used on the Internet that are more strict than those currently in force in the U.S. Any or all of these factors could cause our business and operating results to be harmed.

Because our research and development operations are primarily located in Israel, we may be affected by volatile political, economic, and military conditions in that country and by restrictions imposed by that country on the transfer of technology. Our operations depend on the availability of highly skilled scientific and technical personnel in Israel. Our business also depends on trading relationships between Israel and other countries. In addition to the risks associated with international sales and operations generally, our operations could be adversely affected if major hostilities involving Israel should occur or if trade between Israel and its current trading partners were interrupted or curtailed.

These risks are compounded due to the restrictions on our ability to manufacture or transfer outside of Israel any technology developed under research and development grants from the government of Israel without the prior written consent of the government of Israel. If we are unable to obtain the consent of the government of Israel, we may not be able to take advantage of strategic manufacturing and other opportunities outside of Israel.

We are subject to the risk of increased taxes if tax rate incentives in Israel are altered or if there are other changes in tax laws or rulings. Historically, our operations resulted in a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investment. Our taxes could increase if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased. Tax authorities could challenge the manner in which profits are allocated between our subsidiaries and us, and we may not prevail in any such challenge. If the profits recognized by our subsidiaries in jurisdictions where taxes are lower became subject to income taxes in other jurisdictions, our worldwide effective tax rate would increase. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future.

Other factors that could increase our effective tax rate include the effect of changing economic conditions, business opportunities, and changes in tax laws and rulings. We have in the past and may continue in the future to retire amounts outstanding under our 2000 Notes. To the extent that these repurchases are completed below the par value of the 2000 Notes, we may generate a taxable gain from these repurchases. These gains may result in an increase in our effective tax rate. Merger and acquisition activities, if any, could result in nondeductible expenses, which may increase our effective tax rate. In addition, we intend to migrate the economic ownership of the technology acquired from Performant and Kintana to our Israeli subsidiary in 2004, which may lead to a temporary increase in our effective tax rate.

Our financial results may be positively or negatively impacted by foreign currency fluctuations. A substantial portion of our research and development activities are performed in Israel. In addition, our foreign operations are generally transacted through our international sales subsidiaries and offices in the Americas; Europe, the Middle East and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, Mexico and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. As a result, these sales and related expenses are denominated in currencies other than the U.S. dollar. Because our financial results are reported in U.S. dollars, our results of operations may be positively or adversely impacted by fluctuations in the rates of exchange between the U.S. dollar and other currencies, including:

We attempt to limit foreign exchange exposure through operational strategies and by using forward contracts to offset the effects of exchange rate changes on intercompany trade balances. This requires us to estimate when revenue will be earned and cash will be collected. We may not be successful in making these estimates. If these estimates are overstated or understated during periods of currency volatility, we could experience material currency gains or losses on forward contracts and our financial position and results of operations may be significantly impacted.

Acquisitions may be difficult to integrate, disrupt our business, dilute stockholder value, or divert the attention of our management and may result in financial results that are different than expected. In July 2004, we acquired Appilog, Inc. In August 2003, we acquired Kintana. In addition, in May 2003, we completed our acquisition of Performant and in May 2001, we acquired Freshwater Software. In the event of any future acquisitions, we could:

If we fail to achieve the financial and strategic benefits of past and future acquisitions, our operating results will suffer.

In addition, for purchase acquisitions completed to date, the development of these technologies remains a significant risk due to the remaining efforts to achieve technical feasibility, changing customer markets, and uncertainty of new product standards. Efforts to develop these acquired technologies into commercially viable products consist of planning, designing, experimenting, and testing activities necessary to determine that the technologies can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share or a lost opportunity to capitalize on emerging markets, and could have a material adverse impact on our business and operating results.

In the normal course of business, we frequently engage in discussions with parties relating to possible acquisitions. As a result of such transactions, our financial results may differ from the investment community’s expectations in a given quarter. Further, if market conditions or other factors lead us to change our strategic direction, we may not realize the expected value from such transactions. If we do not realize the expected benefits or synergies of such transactions, our consolidated financial position, results of operations, cash flows, and stock price could be negatively impacted.

If we are required to account for stock options under our employee stock plans as a compensation expense, our net income and our earnings per share would be significantly reduced or may reflect a loss. There has been an increasing public debate about the proper accounting treatment for equity-based compensation, such as employee stock options and employee stock purchase plan shares, and whether they should be treated as a compensation expense and, if so, how to properly value such charges. On March 31, 2004, the Financial Accounting Standards Board issued an exposure draft on a proposed standard for the accounting of stock options. The proposed standard requires public companies to value employee stock options and stock issued under employee stock purchase plans using the fair value based method on the grant date and record stock-based compensation expense. If we elected or were required to record an expense for our employee stock plans using the fair value based method, we would be required to recognize significant stock-based compensation charges. We currently calculate stock-based compensation expense using the Black-Scholes option-pricing model and disclose the pro forma impact on net income (loss) and net income (loss) per share in Note 1 to our condensed consolidated financial statements for the three and six months ended June 30, 2004 and 2003. Although we are not currently required to record any

stock-based compensation expense using the fair value based model in connection with employee option grants that have an exercise price at or above fair market value and for shares issued under our employee stock purchase plan, it is possible that future accounting standards will require us to treat all stock-based compensation as a compensation expense in our consolidated statements of operations using the fair value based method.

Investments may become impaired and require us to take a charge against earnings. At June 30, 2004, our equity investments in non-consolidated companies were composed of investments in privately held companies of $4.6 million, a private equity fund of $7.1 million, and a warrant to purchase common stock of Motive of $0.8 million. At June 30, 2004, our total capital contributions to this private equity fund were $7.9 million. We have committed to make additional capital contributions to this private equity fund up to $7.1 million in the future. We may be required to incur charges for the impairment of value of our investments. For example, for the three months ended June 30, 2004, we did not record any losses on our investments in private companies nor the private equity fund. For the six months ended June 30, 2004, we recorded a loss of $0.5 million on one of our investments in privately held companies. Unrealized gain related to a change in fair value of the Motive warrant was $0.1 million and $0.4 million for the three and six months ended June 30, 2004, respectively. For the three and six months ended June 30, 2003, we recorded a loss of $0.6 million and $1.1 million on our investments in privately held companies, respectively, and a loss of $0.2 million on our investment in the private equity fund for both periods. In calculating the loss on our investments, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors. We closely monitor the financial health of the private companies in which we hold minority equity investments. We may continue to make investments in other companies. If we determine in accordance with our standard accounting policies that an impairment has occurred, then additional losses would be recorded.

The Motive warrant is treated as a derivative instrument due to a net settlement provision. The warrant is recorded at its fair value on each reporting date by using the Black-Scholes option-pricing model. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. Estimating the fair value of the warrant requires management judgment and may have an impact on our financial positions and results of operations.

If we fail to adequately protect our proprietary rights and intellectual property, we may lose a valuable asset, experience reduced revenue, and incur costly litigation to protect our rights. Our success depends in large part on our proprietary technology. We rely on a combination of patents, copyrights, trademarks, service marks, trade secret, and contractual restrictions (including confidentiality provisions and licensing arrangements) to establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our products and services and use information that we regard as proprietary to create products and services that compete with ours. Some license provisions protecting against unauthorized use, copying, transfers, and disclosures of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the U.S. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase. If we fail to successfully enforce our intellectual property rights, our competitive position could suffer, which could harm our operating results. In addition, we are not significantly dependent on any of our patents as we do not generally license our patents to other companies and do not receive any revenue as a direct result of our patents.

In many cases, we enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products.

Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversions of our management resources, which could result in lower revenue, higher operating costs, and adversely affect our operating results.

Third parties could assert that our products and services infringe their intellectual property rights, which could expose us to litigation that, with or without merit, could be costly to defend. We may from time to time be subject to claims of infringement of other parties’ proprietary rights. We could incur substantial costs in defending ourselves and our customers against these claims. Parties making these claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the U.S. and abroad and could result in an award of substantial damages against us. In the event of a claim of infringement, we may be required to obtain licenses from third parties, develop alternative technology, or to alter our products or processes or cease activities that infringe the intellectual property rights of third parties. If we are required to obtain licenses, we cannot be sure that we will be able to do so at a commercially reasonable cost, or at all. Defense of any lawsuit or failure to obtain required licenses could delay shipment of our products and increase our costs. In addition, any such lawsuit could result in our incurring significant costs or the diversion of the attention of our management.

If we fail to obtain or maintain early access to third-party software, our future product development may suffer. Software developers have, in the past, provided us with early access to pre-generally available versions of their software in order to have input into the functionality and to ensure that we can adapt our software to exploit new functionality in these systems. Some companies, however, may adopt more restrictive policies in the future or impose unfavorable terms and conditions for such access. These restrictions may result in higher research and development costs for us in connection with the enhancement and modification of our existing products and the development of new products or may prevent us from being able to develop products which will work with such new systems, which could harm our business.

We have adopted anti-takeover defenses that could delay or prevent an acquisition of our company, including an acquisition that would be beneficial to our stockholders. We have adopted a Preferred Shares Rights Agreement (which we refer to as our Shareholder Rights Plan) on July 5, 1996, as amended. In connection with the Shareholder Rights Plan, our Board of Directors declared and paid a dividend of one preferred share purchase right for each share of our common stock outstanding on July 15, 1996. In addition, each share of common stock issued after July 15, 1996 was issued, or will be issued, with an accompanying preferred stock purchase right. Because the rights may substantially dilute the stock ownership of a person or group attempting to take us over without the approval of our Board of Directors, the Shareholder Rights Plan could make it more difficult for a third party to acquire us (or a significant percentage of our outstanding capital stock) without first negotiating with our Board of Directors regarding such acquisition.

Our Board of Directors also has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present plans to issue shares of preferred stock.

In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which will prohibit us from engaging in a business combination with an interested stockholder for a period of three years after the date that the person became an interested stockholder unless, subject to certain exceptions, the business combination or the transaction in which the person became an interested stockholder is approved in a prescribed manner.

Furthermore, certain provisions of our Amended and Restated Certificate of Incorporation may have the effect of delaying or preventing changes in our control or management, which could adversely affect the market price of our common stock.

Leverage and debt service obligations for $800.0 million in outstanding Notes may adversely affect our cash flow. On April 29, 2003, we issued our 2003 Notes, with a principal amount of $500.0 million, in a private placement, and in July 2000, we completed the offering of the 2000 Notes with a principal amount of $500.0 million. From December 2001 through June 30, 2004, we retired $200.0 million face value of our 2000 Notes. We continue to carry a substantial amount of outstanding indebtedness, primarily the 2000 Notes and the 2003 Notes. There is the possibility that we may be unable to generate cash sufficient to pay the principal of, interest on, and other amounts in respect of our indebtedness when due. Our leverage could have significant negative consequences, including:

In November 2002, we entered into an interest rate swap with Goldman Sachs Capital Markets, L.P. (GSCM) with respect to $300.0 million of our 2000 Notes. This interest rate swap could expose us to greater interest expense for our 2000 Notes.

In addition, the 2003 Notes would be included in our diluted net income per share calculation if our common stock price reaches a specified threshold or if specified corporate transactions have occurred and if we elect to settle in stock instead of cash. In this case, 9,673,050 shares would be included in the diluted weighted average common shares and equivalents. In June 2004, the Emerging Issues Task Force issued a draft on Statement No. 04-08, Accounting Issues Related to Certain Features of Contingently Debt and the Effect on Diluted Earnings per Share, to address the threshold question of whether a market price contingency needs to be substantive for the dilutive effect of contingently convertible debt to be excluded from diluted earnings per share. If the proposed accounting standard is finalized and the conversion feature of our 2003 Notes is determined to be nonsubstantive, we will be required to include 9,673,050 shares in the diluted weighted average common shares and equivalents to calculate our diluted net income per share in the future periods, as required, by the proposed accounting standard.

Finally, our newly approved stock repurchase program approved by the Board of Directors on July 27, 2004, pursuant to which we may repurchase up to $400.0 million of our common stock may leave us with less cash to repay our 2000 Notes and 2003 Notes.

Economic, political, and market conditions may adversely affect demand for our products and services. Our customers’ decisions to purchase our products and services are discretionary and subject to their internal budgets and purchasing processes. We believe that the slowdown in the economy and the weakening of business conditions have caused and may continue to cause customers to reassess their immediate technology needs, lengthen their purchasing decision-making processes, require more senior level internal approvals of purchases, and defer purchasing decisions, and accordingly, have reduced and could reduce demand in the future for our products and services. In addition, the war on terrorism and the potential for other hostilities in various parts of the world have caused political uncertainties and volatility in the financial markets. Under these circumstances, there is a risk that our existing and potential customers may decrease spending for our products and services. If demand for our products and services is reduced, our revenue growth rates and operating results will be adversely affected.

The price of our common stock may fluctuate significantly, which may result in losses for investors and possible lawsuits. The market price for our common stock has been and may continue to be volatile. For example, during the 52-week period ended July 30, 2004, the closing sale prices of our common stock as reported on the NASDAQ National Market ranged from a high of $54.00 to a low of $35.07. We expect our stock price to be subject to fluctuations as a result of a variety of factors, including factors beyond our control. These factors include:

Because of this volatility, we may fail to meet the expectations of our stockholders or of securities analysts at some time in the future, and the trading prices of our securities could decline as a result. In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many high-technology companies. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. Any negative change in the public’s perception of software or internet software companies could depress our stock price regardless of our operating results. Because the 2000 Notes and 2003 Notes are convertible into shares of our common stock, volatility or depressed prices for our common stock could have a similar effect on the trading price of these Notes. Holders who receive common stock upon conversion also will be subject to the risk of volatility and depressed prices of our common stock. In addition, the existence of these Notes may encourage short selling in our common stock by market participants because the conversion of these Notes could depress the price of our common stock.

Our exposure to market rate risk includes risk of change in interest rate, foreign exchange rate fluctuations, and loss in equity investments.

We mitigate market risk associated with our investments by placing our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer or issue. In addition, we have classified all of our debt securities investments as “held to maturity.” Marketable equity securities are classified as available-for-sale short-term investments. At June 30, 2004, we did not hold any marketable equity securities. At June 30, 2004, $574.0 million, or 41% of our cash, cash equivalents, and investment portfolio have original maturities of less than 90 days, and an additional $167.7 million, or 12% carried original maturities of less than one year. All investments mature, by policy, in less than three years. Information about our investment portfolio in debt securities is presented in the table below, which states notional amounts and related weighted-average interest rates. Amounts represent maturities from the reporting date to the dates shown below for each twelve-month periods (in thousands):

Our long-term investments include $604.4 million of government agency instruments, which have callable provisions and accordingly may be redeemed by the agencies should interest rates fall below the coupon rate of the investments.

The fair value of our 2000 Notes fluctuates based upon changes in the price of our common stock, changes in interest rates, and changes in our creditworthiness. The fair market value of our 2000 Notes at June 30, 2004 was $297.0 million while the face value and book value was $300.0 million and $304.8 million, respectively. To mitigate the risk of fluctuation in the fair value of our 2000 Notes, we entered into an interest rate swap arrangement. The fair value of our 2003 Notes fluctuates based upon changes in the price of our common stock and changes in our creditworthiness. The fair market value of the 2003 Notes at June 30, 2004 was $556.9 million while the face value and the book value was $500.0 million. See Note 7 to the condensed consolidated financial statements for transactions regarding our 2000 and 2003 Notes.

In November 2002, we merged our January and February 2002 interest rate swaps with Goldman Sachs Capital Markets, L.P. (GSCM) into a single interest rate swap with GSCM to improve the overall effectiveness of our interest rate swap arrangement. The November interest rate swap of $300.0 million, with a maturity date of July 2007, is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on our 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The gain or loss from changes in the fair value of the interest rate swap is expected to be highly effective at offsetting the gain or loss from changes in the fair value attributable to changes in the LIBOR throughout the life of our 2000 Notes. The interest rate swap creates a market exposure to changes in the LIBOR. If the LIBOR increases or decreases by 1%, our interest expense would increase or decrease by $750,000 quarterly on a pretax basis. The value of the interest rate swap is determined using various inputs, including forward interest rates, and time to maturity. Our interest rate swap was recorded as an asset in our consolidated balance sheets as of June 30, 2004 and December 31, 2003, but it has decreased in value over the past six months. If market changes continue to negatively impact the value of the swap, the swap may become a liability in our consolidated balance sheet. In the event we chose to terminate the swap before maturity, and the swap value was unfavorable, we would be obligated to pay to our counterparty in cash, the market value of the swap at termination date. According to the terms of the swap, we are required to provide initial collateral in the form of cash or cash equivalents to GSCM in the amount of $6.0 million as continuing security for our obligations under the swap (irrespective of movements in the value of the swap) and from time to time additional collateral can change hands between Mercury and GSCM as swap rates and equity prices fluctuate. We accounted for the initial collateral and any additional collateral as restricted cash on our consolidated balance sheets. If the price of our common stock exceeds the original conversion or redemption price of the 2000 Notes, we will be required to pay the fixed rate of 4.75% and receive a variable rate on the $300.0 million principal amount of the 2000 Notes. If we call the 2000 Notes at a premium (in whole or in part), or if any of the holders of the 2000 Notes elected to convert the 2000 Notes (in whole or in part), we will be required to pay a variable rate and receive the fixed rate of 4.75% on the principal amount of such called or converted our 2000 Notes.

We have credit exposure with respect to GSCM as counterparty under the swap. However, we believe that the risk of such credit exposure is limited because GSCM is an affiliate of a major U.S. investment bank and because its obligation under the swap is guaranteed by the Goldman Sachs Group L.P.

Also, see Notes 7 and 14 to the condensed consolidated financial statements for additional information regarding our 2000 Notes and the interest rate swap activities.

A portion of our business is conducted in currencies other than the U.S. dollar. Our operating expenses in each of these countries are in the local currencies, which mitigates a significant portion of the exposure related to local currency revenue. We enter into foreign exchange forward contracts to minimize the short-term impact of foreign currency fluctuations on foreign currency denominated intercompany balances attributable to subsidiaries and foreign offices in the Americas; Europe, the Middle East, and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, Mexico, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. We had outstanding forward contracts with notional amounts totaling $22.0 million and $31.5 million at June 30, 2004 and December 31, 2003, respectively. The forward contracts in effect at June 30, 2004 mature on July 30, 2004 and were hedges of certain foreign currency transaction exposures in the Australian Dollar, British Pound, Danish Kroner, Euro, Hong Kong Dollar, Indian Rupee, Japanese Yen, Korean Won, Norwegian Kroner, Singapore Dollar, South African Rand, and Swiss Franc.

We also utilize forward exchange contracts of one fiscal-month duration to offset various non-functional currency exposures. Currencies hedged under this program include the Canadian Dollar, Hong Kong Dollar, Israeli Shekel, and Singapore Dollar. We had outstanding forward contracts with notional amounts totaling $20.9 million and $42.6 million at June 30, 2004 and December 31, 2003, respectively.

Gains or losses on forward contracts are recognized as “Other income (expense), net” in our consolidated statement of operations in the same period as gains or losses on the underlying transactions. Net gains or losses on forward contracts and the underlying transactions did not have any material impact to our financial position. We do not believe an immediate increase of 10% in the exchange rates of the U.S. dollar to other foreign currencies would have a material impact on our operating results or cash flows.

From time to time, we have equity investments in public companies, privately held companies, and private equity funds for business and strategic purposes. At June 30, 2004, our investments in privately held companies and a private equity fund were $4.6 million and $7.1 million, respectively. Through June 30, 2004, we have made capital contributions to the private equity fund totaling $7.9 million and we have committed to pay up to $7.1 million in the future.

If the privately held companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies, we may not be able to sell these investments. In addition, even if we are able to sell these investments, we cannot assure that we will be able to sell them at a gain or even recover our investment. A decline in the U.S. stock market and the market prices of publicly traded technology companies will adversely affect our ability to realize gains or a return of our capital on our investments in these public and private companies. We have a policy to review our equity investments portfolio. If we determine that the decline in value in one of our equity investments is other-than-temporary, we record a loss on investment in our consolidated statement of operations to write down these equity investments to the market value.

For the three months ended June 30, 2004, we did not record any losses on our investments in privately held companies nor the private equity fund. For the six months ended June 30, 2004, we recorded a loss of $0.5 million on one of our investments in privately held companies. In calculating the loss on our investments, we took into account the latest valuation of each of the companies based on recent sales of equity securities to unrelated third party investors.

In addition, we have a warrant to purchase common stock of Motive, Inc. The warrant is treated as a derivative instrument due to a net settlement provision. The Motive warrant is marked to market at each reporting date using the Black-Scholes option-pricing model. In June 2004, Motive completed an initial public offering and is listed in the U.S. stock market. Any significant fluctuations in the common stock price of Motive may have an impact on our financial positions and results of operations. The fair value of the warrant was $0.8 million and $0.4 million as of June 30, 2004 and December 31, 2003, respectively.

We filed or furnished the following Current Reports on Form 8-K during the quarter ended June 30, 2004:

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Mercury Interactive Corporation, a corporation organized and existing under the laws of the State of Delaware, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

MERCURY INTERACTIVE CORPORATION

(Registrant)


By:		/s/ Douglas P. Smith
		Douglas P. Smith, Executive Vice President and Chief Financial Officer Principal Financial Officer

By:		/s/ Bryan J. LeBlanc
		Bryan J. LeBlanc, Vice President, Finance and Operations Principal Accounting Officer


		Page
PART I.	FINANCIAL INFORMATION

Item 1.	Unaudited Financial Statements

	Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003	1

	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2004 and 2003	2

	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003	3

	Notes to Condensed Consolidated Financial Statements	4

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	20

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	44

Item 4.	Controls and Procedures	46

PART II.	OTHER INFORMATION

Item 4.	Submission of Matters to a Vote of Stockholders	47

Item 6.	Exhibits and Reports on Form 8-K	48

Signatures		49


	June 30, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	573,960		$	549,278
Short-term investments		167,690			157,082
Trade accounts receivable, net of sales reserves of $5,459 and $6,117, respectively		147,484			142,908
Prepaid expenses and other assets		77,659			64,485

Total current assets		966,793			913,753
Long-term investments		648,628			527,348
Property and equipment, net		72,657			73,203
Investments in non-consolidated companies		12,479			13,928
Debt issuance costs, net		13,111			14,965
Goodwill		347,779			347,616
Intangible assets, net		37,443			45,126
Restricted cash		6,000			6,000
Interest rate swap		5,184			11,557
Other assets		18,268			17,456

Total assets	$	2,128,342		$	1,970,952

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	18,486		$	17,584
Accrued liabilities		104,163			96,637
Deferred tax liabilities, net		28,253			28,367
Income taxes payable		40,328			35,404
Short-term deferred revenue		239,757			212,716

Total current liabilities		430,987			390,708
Convertible notes		804,803			811,159
Long-term deferred revenue		87,574			67,909
Other long-term payables, net		2,598			807

Total liabilities		1,325,962			1,270,583

Commitments and contingencies (Note 8 and 9)
Stockholders’ equity:
Preferred stock		—			—
Common stock		186			181
Additional paid-in capital		536,969			468,150
Treasury stock		(16,082	)		(16,082	)
Notes receivable from issuance of common stock		(4,639	)		(6,580	)
Unearned stock-based compensation		(963	)		(1,533	)
Accumulated other comprehensive loss		(6,062	)		(6,219	)
Retained earnings		292,971			262,452

Total stockholders’ equity		802,380			700,369

Total liabilities and stockholders’ equity	$	2,128,342		$	1,970,952


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Revenues:
License fees	$	59,942		$	48,004		$	117,515		$	92,790
Subscription fees		34,628			22,487			70,535			41,761

Total product revenues		94,570			70,491			188,050			134,551
Maintenance fees		48,143			38,745			95,032			74,330
Professional service fees		16,334			8,820			32,771			19,560

Total revenues		159,047			118,056			315,853			228,441

Costs and expenses:
Cost of license and subscription		9,883			6,757			19,702			13,307
Cost of maintenance		3,952			2,829			7,544			5,508
Cost of professional services (excluding stock-based compensation)		14,855			7,460			28,398			14,080
Marketing and selling (excluding stock-based compensation)		76,248			55,806			150,211			108,491
Research and development (excluding stock-based compensation)		17,763			13,120			35,049			24,709
General and administrative (excluding stock-based compensation)		12,024			9,722			24,269			18,822
Stock-based compensation*		183			195			392			384
Acquisition related charges		—			1,280			—			1,280
Integration and other related charges		1,131			917			2,110			917
Amortization of intangible assets		3,744			699			7,684			1,157
Excess facilities charge		9,178			—			9,178			—

Total costs and expenses		148,961			98,785			284,537			188,655
Income from operations		10,086			19,271			31,316			39,786
Interest income		9,803			8,968			19,063			17,735
Interest expense		(4,811	)		(4,921	)		(9,622	)		(9,921	)
Other expense, net		(1,640	)		(1,606	)		(2,845	)		(3,046	)

Income before provision for income taxes		13,438			21,712			37,912			44,554
Provision for income taxes		1,827			4,777			7,393			9,475

Net income	$	11,611		$	16,935		$	30,519		$	35,079

Net income per share (basic)	$	0.13		$	0.20		$	0.33		$	0.41

Net income per share (diluted)	$	0.12		$	0.19		$	0.31		$	0.39

Weighted average common shares (basic)		92,448			85,610			91,949			85,322

Weighted average common shares and equivalents (diluted)		98,237			90,506			98,006			89,945

* Stock-based compensation:
Cost of professional services	$	25		$	7		$	62		$	7
Marketing and selling		84			105			171			212
Research and development		69			73			149			139
General and administrative		5			10			10			26

	$	183		$	195		$	392		$	384


	Six months ended June 30,
	2004			2003
Cash flows from operating activities:
Net income	$	30,519		$	35,079
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		10,092			8,143
Sales reserves		(242	)		(1,236	)
Unrealized (gain) loss on interest rate swap		18			(92	)
Amortization of intangible assets		7,684			1,157
Stock-based compensation		392			384
Loss on investments in non-consolidated companies		455			1,339
Loss on disposals of assets		275			—
Gain on sale of available-for-sale securities		(336	)		—
Unrealized gain on warrant		(392	)		—
Write-off of in-process research and development		—			1,280
Excess facilities charge		9,178			—
Tax benefit from employee stock options		1,592			—
Deferred income taxes		(2,663	)		1,076
Changes in assets and liabilities, net of effect of acquisitions:
Trade accounts receivable		(4,306	)		13,157
Prepaid expenses and other assets		(8,580	)		(2,558	)
Accounts payable		646			(308	)
Accrued liabilities		5,128			1,048
Income taxes payable		4,910			2,061
Deferred revenue		46,657			30,883
Other long-term payables		2,057			—

Net cash provided by operating activities		103,084			91,413

Cash flows from investing activities:
Maturities of investments		637,470			1,180,168
Purchases of investments		(769,152	)		(1,285,356	)
Proceeds from sale of available-for-sale securities		1,696			—
Proceeds from return on investment in non-consolidated company		1,525			—
Purchases of investments in non-consolidated companies		(1,500	)		(750	)
Cash paid in conjunction with the acquisition of Performant		—			(21,925	)
Cash paid in conjunction with the acquisition of Kintana		(163	)		—
Net proceeds from sale of vacant facilities and assets		2,640			—
Acquisition of property and equipment, net		(19,280	)		(7,633	)

Net cash used in investing activities		(146,764	)		(135,496	)

Cash flows from financing activities:
Proceeds from issuance of convertible notes, net		—			488,198
Proceeds from issuance of common stock under stock option and employee stock purchase plans		66,918			23,533
Collection of notes receivable from issuance of common stock		1,436			2,446

Net cash provided by financing activities		68,354			514,177

Effect of exchange rate changes on cash		8			825

Net increase in cash and cash equivalents		24,682			470,919
Cash and cash equivalents at beginning of period		549,278			349,123

Cash and cash equivalents at end of period	$	573,960		$	820,042


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Net income, as reported	$	11,611		$	16,935		$	30,519		$	35,079
Add:
Stock-based compensation expense included in reported net income		183			195			392			384
Deduct:
Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(28,176	)		(33,127	)		(57,516	)		(65,582	)

Pro forma net loss	$	(16,382	)	$	(15,997	)	$	(26,605	)	$	(30,119	)

Net income per share (basic), as reported	$	0.13		$	0.20		$	0.33		$	0.41

Net loss per share (basic), pro forma	$	(0.18	)	$	(0.19	)	$	(0.29	)	$	(0.35	)

Net income per share (diluted), as reported	$	0.12		$	0.19		$	0.31		$	0.39

Net loss per share (diluted), pro forma	$	(0.18	)	$	(0.19	)	$	(0.29	)	$	(0.35	)


	Stock option plans				ESPP				Stock option plans				ESPP
	Three months ended June 30,								Six months ended June 30,
	2004		2003		2004		2003		2004		2003		2004		2003
Expected life (years)	4.00		4.00		0.50		0.50		4.00		4.00		0.50		0.50
Risk-free interest rate	3.78	%	2.61	%	1.64	%	0.94	%	3.03	%	2.96	%	1.23	%	2.17	%
Volatility	84	%	89	%	84	%	89	%	85	%	89	%	84	%	89	%
Dividend yield	None		None		None		None		None		None		None		None


	Three months ended June 30,						Six months ended June 30,
	2004			2003			2004			2003
Sales reserve:
Beginning balance	$	6,274		$	6,599		$	6,117		$	7,431
Decrease in sales reserve (increase in revenues)		(479	)		(829	)		(242	)		(1,236	)
Write-off of accounts receivable against reserve		(332	)		(518	)		(409	)		(957	)
Currency translation adjustments		(4	)		60			(7	)		74

Ending balance	$	5,459		$	5,312		$	5,459		$	5,312


	Three months ended June 30, 2003		Six months ended June 30, 2003
Net revenues	$	128,760	$	251,915
Net income	$	13,628	$	29,968
Net income per share (basic)	$	0.16	$	0.34
Net income per share (diluted)	$	0.15	$	0.33


	Three months ended June 30, 2003		Six months ended June 30, 2003
Net revenues	$	118,071	$	228,572
Net income	$	17,164	$	33,718
Net income per share (basic)	$	0.20	$	0.40
Net income per share (diluted)	$	0.19	$	0.38


Balance at December 31, 2003	$	347,616
Additional goodwill amount for acquisition of Kintana		163

Balance at June 30, 2004	$	347,779


	June 30, 2004						December 31, 2003
	Gross Carrying Amount		Accumulated Amortization		Net		Net
Intangible assets:
Existing technology	$	20,166	$	8,578	$	11,588	$	14,685
Patents and core technology		13,330		3,746		9,584		10,985
Maintenance and support contracts		6,106		891		5,215		5,724
Employment agreements		720		560		160		400
Customer contracts and other		14,093		4,167		9,926		12,255
Domain name		1,135		165		970		1,077

	$	55,550	$	18,107	$	37,443	$	45,126


Year ending December 31,
2004 (remainder of fiscal year)	$	6,896
2005		13,471
2006		10,067
2007		3,818
2008		2,555
Thereafter		636

	$	37,443


Year ending December 31,
2004 (remainder of year)	$	9,074
2005		15,901
2006		10,729
2007		7,856
2008		5,807
Thereafter		25,027

	$	74,394


	Three months ended June 30,				Six months ended June 30,
	2004		2003		2004		2003
Revenues from third parties:
Americas (including U.S. of $95,420, $72,217, $192,199, and $138,007, respectively)	$	97,946	$	74,474	$	197,756	$	143,303
EMEA (including U.K. of $17,400, $13,579, $36,007 and $27,319, respectively)		48,514		35,908		93,538		69,266
APAC		9,053		5,332		17,487		10,097
Japan		3,534		2,342		7,072		5,775

	$	159,047	$	118,056	$	315,853	$	228,441


	June 30, 2004		December 31, 2003
Property and equipment, net:
Americas (including U.S. of $37,030 and $40,750, respectively)	$	37,061	$	40,801
EMEA (including Israel of $30,971 and $28,288, respectively)		33,769		31,001
APAC		1,502		1,011
Japan		325		390

	$	72,657	$	73,203


	Three Months ended June 30,				Increase/ (Decrease)				Six Months ended June 30,				Increase/ (Decrease)
	2004		2003		in Dollars		in Percentage		2004		2003		in Dollars		in Percentage
Revenues:
License fees	$	59,942	$	48,004	$	11,938	25	%	$	117,515	$	92,790	$	24,725	27	%
Subscription fees		34,628		22,487		12,141	54	%		70,535		41,761		28,774	69	%
Maintenance fees		48,143		38,745		9,398	24	%		95,032		74,330		20,702	28	%
Professional service fees		16,334		8,820		7,514	85	%		32,771		19,560		13,211	68	%

Total revenues	$	159,047	$	118,056	$	40,991	35	%	$	315,853	$	228,441	$	87,412	38	%


	Zero Coupon Senior Convertible Notes due 2008 (2003 Notes)		4.75% Convertible Subordinated Notes due 2007 (2000 Notes) (a)		Non- Cancelable Operating Leases		Royalty Agreements		Total
2004 (remainder of year)	$	—	$	—	$	9,074	$	1,223	$	10,297
2005		—		—		15,901		210		16,111
2006		—		—		10,729		210		10,939
2007		—		300,000		7,856		210		308,066
2008		500,000		—		5,807		160		505,967
Thereafter		—		—		25,027		100		25,127

Total	$	500,000	$	300,000	$	74,394	$	2,113	$	876,507


	June 30,									Total			Fair Value
	2005			2006			2007			Total			Fair Value
Investments maturing within 30 days at June 30, 2004:
Fixed rate	$	316,159		$	—		$	—		$	316,159		$	316,161
Weighted average rate		1.36	%		—			—			1.36	%		—
Investments maturing 30 days after June 30, 2004:
Fixed rate	$	309,990		$	159,926		$	488,702		$	958,618		$	955,072
Weighted average rate		1.67	%		2.30	%		2.40	%		2.15	%		—

Total investments	$	626,149		$	159,926		$	488,702		$	1,274,777		$	1,271,233

Weighted average rate		1.54	%		2.30	%		2.40	%		1.97	%		—


Nominee	For	Withheld
Amnon Landan	76,403,725	2,881,219
Igal Kohavi	74,826,916	4,458,028
Clyde Ostler	67,124,780	12,160,164
Yair Shamir	70,929,770	8,355,174
Giora Yaron	71,235,862	8,049,082
Anthony Zingale	66,573,773	12,711,171


2.1		Agreement and Plan of Merger dated as of May 12, 2004 among Appilog, Inc., Appilog Logview Ltd., Mercury Interactive Corporation, Alaska Merger Corporation and Amnon Shoham as Stockholders’ Representative
2.2		Amendment No. 1 dated as of June 24, 2004 to the Agreement and Plan of Merger dated as of May 12, 2004 among Appilog, Inc., Appilog Logview Ltd., Mercury Interactive Corporation, Alaska Merger Corporation and Amnon Shoham as Stockholders’ Representative
3.1		Certificate of Amendment of Restated Certificate of Incorporation
3.2		Corrected Certificate of Amendment of Restated Certificate of Incorporation
31.1		Certification of the Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2		Certification of the Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1		Certification of the 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 the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002