Edgar Filing: NAVISITE INC

Form 10-Q - Navisite, inc.

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q


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

For the quarterly period ended April 30, 2006


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

For the transition period from to

Commission file number: 000-27597

NAVISITE, INC.

(Exact name of registrant as specified in its charter)


Delaware		52-2137343
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)


400 Minuteman Road
Andover, Massachusetts		01810
(Address of principal executive offices)		(Zip Code)

(978) 682-8300
(Registrant’s telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.


Yes þ		No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o

Accelerated filer o

Non-accelerated filer þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).


Yes o		No þ

As of June 8, 2006, there were 28,876,559 shares outstanding of the registrant’s common stock, par value $.01 per share.

NAVISITE, INC.
TABLE OF CONTENTS
REPORT ON FORM 10-Q
FOR THE QUARTER ENDED APRIL 30, 2006


	PAGE
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements		3
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
Item 3. Quantitative and Qualitative Disclosures About Market Risk		37
Item 4. Controls and Procedures		38

PART II. OTHER INFORMATION
Item 1. Legal Proceedings		38
Item 4. Submission of Matters to a Vote of Security Holders		40
Item 6. Exhibits
Ex-10.1 - Credit & Guaranty Agreement
EX-10.2 - Amendment No. 1 to Credit & Guaranty Agreement
EX-10.3 - Pledge and Security Agreement
EX-10.4 - Warrant Purchase Agreement
EX-10.5 - Warrant No. 1
EX-10.6 - Warrant No.2
EX-10.7 - Amended & Restated Loan Agreement
EX-10.8 - Loan Agreement
EX-10.9 - Atlantic Fund Guaranty
EX-10.10 - Subordination Agreement
EX-31.1 - Sec 302 Certification of CEO
EX-32.1 - Sec 302 Cerification of CFO
EX-32.1 - Sec 906 Certification of CEO
EX-32.2 - Sec 906 Certification of CFO

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

NAVISITE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except par value)


	April 30,			July 31,
	2006			2005
ASSETS
Current assets:
Cash and cash equivalents	$	732		$	6,816
Accounts receivable, less allowance for doubtful accounts of $2,131 and $2,887 at April 30, 2006 and July 31, 2005, respectively		12,146			10,688
Unbilled accounts receivable		510			363
Due from related party		43			101
Prepaid expenses and other current assets		9,002			2,806

Total current assets		22,433			20,774
Property and equipment, net		15,354			15,199
Customer lists, less accumulated amortization of $16,938 and $13,228 at April 30, 2006 and July 31, 2005, respectively		12,853			16,563
Goodwill		43,159			43,159
Other assets		7,240			4,383
Restricted cash		969			1,099

Total assets	$	102,008		$	101,177


LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Accounts receivable financing line, net	$	—		$	20,347
Notes payable, current portion		1,171			1,145
Notes payable to the AppliedTheory Estate		6,000			6,000
Note payable to related party		—			3,000
Convertible notes payable to Waythere (formerly Surebridge)		—			35,361
Capital lease obligations, current portion		1,978			1,259
Accounts payable		8,730			8,122
Accrued expenses and other current liabilities		12,702			20,794
Deferred revenue and customer deposits		3,152			2,306

Total current liabilities		33,733			98,334
Capital lease obligations, less current portion		423			1,105
Accrued lease abandonment costs, less current portion		820			1,359
Long term liabilities		3,208			1,304
Deferred tax liability		2,218			1,338
Note payable to related party		3,000			—
Note payable, less current portion		59,387			409

Total liabilities		102,789			103,849

Commitments and contingencies (Note 11)
Stockholders’ equity (deficit):
Preferred stock, $0.01 par value; Authorized 5,000 shares; Issued and outstanding: no shares at April 30, 2006 and July 31, 2005		—			—
Common stock, $0.01 par value; Authorized 395,000 shares; Issued and outstanding: 28,709 at April 30, 2006 and 28,487 at July 31, 2005		287			285
Deferred compensation		—			(633	)
Accumulated other comprehensive income		193			156
Additional paid-in capital		465,563			453,458
Accumulated deficit		(466,824	)		(455,938	)

Total stockholders’ equity (deficit)		(781	)		(2,672	)

Total liabilities and stockholders’ equity (deficit)	$	102,008		$	101,177

See accompanying notes to condensed consolidated financial statements.

NAVISITE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)


	Three Months Ended						Nine Months Ended
	April 30,			April 30,			April 30,			April 30,
	2006			2005			2006			2005
Revenue	$	27,850		$	26,762		$	79,524		$	83,969
Revenue, related parties		73			34			144			102

Total revenue		27,923			26,796			79,668			84,071


Cost of revenue (includes stock-based compensation expense under SFAS 123R of $236 and $730 for three and nine months ended April 30, 2006, respectively, $0 for comparable periods of 2005.)		19,125			18,881			55,495			62,335
Impairment, restructuring and other		—			381			—			415

Total cost of revenue		19,125			19,262			55,495			62,750


Gross profit		8,798			7,534			24,173			21,321

Operating expenses:
Selling and marketing (includes stock-based compensation expense under SFAS 123R of $93 and $258 for three and nine months ended April 30, 2006, respectively, $0 for comparable periods of 2005.)		4,281			3,469			11,485			10,063
General and administrative (includes stock-based compensation expense under SFAS 123R of $663 and $2,124 for three and nine months ended April 30, 2006, respectively, $0 for comparable periods of 2005.)		5,441			5,373			16,421			17,783
Impairment, restructuring and other		136			(448	)		513			1,057

Total operating expenses		9,858			8,394			28,419			28,903


Loss from operations		(1,060	)		(860	)		(4,246	)		(7,582	)
Other income (expense):
Interest income		137			21			191			49
Interest expense		(2,377	)		(1,996	)		(6,369	)		(5,821	)
Other income (expense), net		145			89			418			165


Loss before income tax expense		(3,155	)		(2,746	)		(10,006	)		(13,189	)
Income tax expense		(293	)		(287	)		(880	)		(1,052	)

Net loss	$	(3,448	)	$	(3,033	)	$	(10,886	)	$	(14,241	)


Basic and diluted net loss per common share	$	(0.12	)	$	(0.11	)	$	(0.38	)	$	(0.51	)


Basic and diluted weighted average number of common shares outstanding		28,554			28,463			28,505			28,108

See accompanying notes to condensed consolidated financial statements.

NAVISITE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)


	Nine Months Ended
	April 30,			April 30,
	2006			2005
Cash flows from operating activities:
Net loss	$	(10,886	)	$	(14,241	)
Adjustments to reconcile net loss to net cash provided by (used for) operating activities:
Depreciation and amortization		9,477			11,085
Impairment of long-lived assets related to abandoned leases		—			760
Gain on disposal of assets		—			(13	)
Costs associated with abandoned leases		513			713
Amortization of warrants		158			80
Non-cash stock compensation		3,112			578
Provision for bad debts		50			1,820
Avasta settlement in common stock		—			490
Deferred income tax expense		880			1,051
Changes in operating assets and liabilities, net of impact of acquisitions:
Accounts receivable		(1,508	)		1,198
Unbilled accounts receivable		(147	)		1,133
Due from related party		58			(7	)
Prepaid expenses and other current assets, net		(2,222	)		1,399
Long term assets		(873	)		393
Accounts payable		607			2,509
Long-term liabilities		778			3,388
Accrued expenses, deferred revenue, customer deposits and other current liabilities		(7,710	)		(9,739	)

Net cash provided by (used for) operating activities		(7,713	)		2,597


Cash flows from investing activities:
Purchase of property and equipment		(4,327	)		(3,305	)
Proceeds from the sale of equipment		—			433

Net cash used for investing activities		(4,327	)		(2,872	)


Cash flows from financing activities:
Restricted cash		(6,400	)		540
Proceeds from exercise of stock options		527			89
Proceeds from notes payable		70,436			1,003
Repayment of notes payable		(22,460	)		(1,206	)
Payments on note payable to Waythere, Inc. (formerly Surebridge)		(34,611	)		(800	)
Payments on capital lease obligations		(1,536	)		(980	)

Net cash provided by (used for) financing activities		5,956			(1,354	)


Net decrease in cash		(6,084	)		(1,629	)
Cash and cash equivalents, beginning of period		6,816			3,195

Cash and cash equivalents, end of period	$	732		$	1,566


Supplemental disclosure of cash flow information:
Cash paid for interest	$	9,550		$	2,188
Equipment purchased under capital lease agreements	$	1,578		$	296

See accompanying notes to condensed consolidated financial statements.

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(1) Description of Business

NaviSite, Inc. (“NaviSite”, “the Company”, “we”, “us” or “our”) provides information technology (IT) hosting, outsourcing and professional services for mid- to large-sized organizations. Leveraging our set of technologies and subject matter expertise, we deliver cost-effective, flexible solutions that provide responsive and predictable levels of service for our clients’ business. Over 950 companies across a variety of industries rely on NaviSite to build, implement and manage their mission-critical systems and applications. NaviSite is a trusted advisor committed to ensuring the long-term success of our customers’ business applications and technology strategy. NaviSite has 14 state-of-the-art data centers and 8 major office locations across the U.S., U.K. and India. Substantially all revenue is generated from customers in the United States.

(2) Summary of Significant Accounting Policies

(a) Basis of Presentation and Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements include the accounts and operations of NaviSite, Inc. and its wholly-owned subsidiaries and have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and notes required by U.S. generally accepted accounting principles for complete financial statements and thus should be read in conjunction with the audited consolidated financial statements included in our Annual Report on Form 10-K filed on October 31, 2005. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting only of those of a normal recurring nature, necessary for a fair presentation of the Company’s financial position, results of operations and cash flows at the dates and for the periods indicated. The results of operations for the three and nine months ended April 30, 2006 are not necessarily indicative of the results expected for the remainder of the fiscal year ending July 31, 2006.

All significant intercompany accounts and transactions have been eliminated in consolidation.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities 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. Actual results could differ from those estimates. Significant estimates made by management include the useful lives of fixed assets and intangible assets, recoverability of long-lived assets, the collectability of receivables and other assumptions for sublease and lease abandonment reserves.

(b) Revenue Recognition

Revenue consists of monthly fees for Web site and Internet custom and packaged application management, hosting, colocation and professional services. The Company also derives revenue from the sale of software and related maintenance contracts. Reimbursable expenses charged to clients are included in revenue and cost of revenue. Application management, hosting and colocation revenue (other than installation fees) is billed and recognized over the term of the contract, generally one to three years, based on actual usage. Payments received in advance of providing services are deferred until the period such services are provided. Revenue from professional services, application management, hosting and colocation revenue is recognized on either a time and material basis as the services are performed or under the percentage of completion method for fixed-price contracts. We generally sell our professional services under contracts with terms ranging from one to five years. When current contract estimates indicate that a loss is probable, a provision is made for the total anticipated loss in the current period. Contract losses are determined to be the amount by which the estimated service costs of the contract exceed the estimated revenue that will be generated by the contract. Unbilled accounts receivable represents revenue for services performed that have not been billed. Billings in excess of revenue recognized are recorded as deferred revenue until the applicable revenue recognition criteria are met. Revenue from the sale of software is recognized when persuasive evidence of an arrangement exists, the product has been delivered, the fees are fixed and determinable and collection of the resulting receivable is reasonably assured. In instances where the Company also

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

provides application management and hosting services in conjunction with the sale of software, software revenue is deferred and recognized ratably over the expected customer relationship period. If we determine that collection of a fee is not reasonably assured, we defer the fee and recognize revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash.

(c) Cash and Cash Equivalents and Restricted Cash

The Company considers all highly liquid securities with original maturities of three months or less to be cash equivalents. The Company had restricted cash of $7.5 million and $1.2 million as of April 30, 2006 and July 31, 2005, including $6.5 million and $0.1 million which is classified as short-term on the Consolidated Balance Sheet as of April 30, 2006 and July 31, 2005, respectively and is included in “Prepaid expenses and other current assets”. The April 30, 2006 balance primarily represents cash held in escrow for payment to the AppliedTheory Estate against the Note Payable and cash collateral requirements for standby letters of credit associated with several of the Company’s facility and equipment leases. The July 31, 2005 balance represents cash collateral requirements for standby letters of credit associated with several of the Company’s facility and equipment leases.

(d) Property and Equipment

Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Leasehold improvements and assets acquired under capital leases are amortized using the straight-line method over the shorter of the lease term or estimated useful life of the asset. Assets acquired under capital leases in which title transfers to us at the end of the agreement are amortized over the useful life of the asset. Expenditures for maintenance and repairs are charged to expense as incurred.

(e) Long-lived Assets, Goodwill and Other Intangibles

The Company follows the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” This statement requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to undiscounted future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell.

The Company reviews the valuation of goodwill in accordance with SFAS No. 142 “Goodwill and Other Intangible Assets.” Under the provisions of SFAS No. 142, goodwill is required to be tested for impairment annually in lieu of being amortized. This testing is done on the last day of the fourth quarter of each year. Furthermore, goodwill is required to be tested for impairment on an interim basis if an event or circumstance indicates that it is more likely than not an impairment loss has been incurred. An impairment loss shall be recognized to the extent that the carrying amount of goodwill exceeds its implied fair value. Impairment losses shall be recognized in operations. The Company’s valuation methodology for assessing impairment requires management to make judgments and assumptions based on historical experience and projections of future operating performance. If these assumptions differ materially from future results, the Company may record impairment charges in the future.

(f) Financial Instruments and Concentration of Credit Risk

Our financial instruments include cash, accounts receivable, obligations under capital leases, software agreements, notes payable, accounts payable, and accrued expenses. As of April 30, 2006, the carrying cost of these instruments approximated their fair value. The financial instruments that potentially subject us to concentration of credit risk consist primarily of accounts receivable. Concentration of credit risk with respect to trade receivables is limited due to the large number of customers across many industries that comprise our customer base. One third-party customer accounted for 10% and 8% of our total revenue for the nine months ended April 30, 2006 and 2005, respectively. Accounts receivable included approximately $1.7 million due from this third-party customer at April 30, 2006.

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(g) Comprehensive Income (Loss)

Comprehensive income (loss) is defined as the change in equity of a business enterprise during a period of time from transactions and other events and circumstances from non-owner sources. The Company reports accumulated other comprehensive income (loss), resulting from foreign currency translation adjustment, on the Condensed Consolidated Balance Sheet.

(h) Income Taxes

We account for income taxes under the asset and liability method in accordance with SFAS No. 109, “Accounting for Income Taxes”. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

(i) Stock Based Compensation

In December 2004, the Financial Accounting Standards Board (FASB) issued a Statement, “Share-Based Payment, an amendment of FASB Statements Nos. 123 and 95” (SFAS 123R), that addresses the accounting for share-based payment transactions in which a company receives employee services in exchange for either equity instruments of the company or liabilities that are based on the fair value of the company’s equity instruments or that may be settled by the issuance of such equity instruments. The statement eliminates the ability to account for share-based compensation transactions using the intrinsic value method and generally requires that such transactions be accounted for using a fair value based method and recognized as expense in the Consolidated Statement of Operations. In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107 regarding the Staff’s interpretation of SFAS 123R. This interpretation provides the Staff’s views regarding interpretations between SFAS 123R and certain SEC rules and regulations and provides interpretations of the valuation of share-based payments for public companies. The interpretive guidance is intended to assist companies in applying the provisions of SFAS 123R and investors and users of financial statements in analyzing the information provided.

Following the guidance prescribed in SAB 107, on August 1, 2005, NaviSite adopted SFAS 123R using the modified prospective method, and accordingly, we have not restated the consolidated results of income from prior interim periods and fiscal years. Under SFAS 123R, we are required to measure compensation cost for all stock based awards at fair value on date of grant and recognize compensation expense over the service period that the awards are expected to vest. For US grants, the Company generally grants options under its equity plan that vest as to 25% of the original number of shares on the six month anniversary of the date of grant and thereafter in equal monthly amounts over the three year period commencing on the six month anniversary of the date of grant. In February 2006, the Company issued its first option grants to its India employees. The options vest as to 33.33% of the original number of shares on the ninth month following the date of the grant and thereafter in equal monthly amounts over the three year period commencing on the ninth month following the date of grant.

Prior to the adoption of SFAS 123R, we recognized compensation cost for stock options issued with exercise prices set below market prices on the date of grant. During the three and nine months ended April 30, 2005, we recognized compensation expense of approximately $198,000 and $578,000, respectively, for stock options in our Consolidated Statement of Operations. The following table illustrates the effect on net loss and net loss per common share if we had applied the fair value recognition provisions of SFAS 123 to stock based compensation.

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


	Three Months Ended			Nine Months Ended
	April 30, 2005			April 30, 2005
	(in thousands, except			(in thousands, except
	per share data)			per share data)
Net Loss, as reported	$	(3,033	)	$	(14,241	)
Add: Stock based employee compensation expense from the Amended and Restated 2003 Stock Incentive Plan included in reported net loss	$	198		$	578
Deduct: Total stock based employee compensation expense determined under fair value based method for all awards	$	(1,989	)	$	(4,348	)

Net Loss, as adjusted	$	(4,824	)	$	(18,011	)


Net Loss per common share:
Basic and diluted-as reported	$	(0.11	)	$	(0.51	)
Basic and diluted-as adjusted	$	(0.17	)	$	(0.64	)

Upon adoption of SFAS 123R, we recognized the compensation expense associated with awards granted after August 1, 2005 and the unvested portion of previously granted awards that remain outstanding as of August 1, 2005, in our Consolidated Statement of Operations for the first quarter of fiscal year 2006. During the quarter ended April 30, 2006, we recognized approximately $236,000 in cost of revenue compensation expense, $93,000 in sales and marketing compensation expense and $663,000 in general and administrative compensation expense for stock options. For the nine months ended April 30, 2006, we recognized approximately $730,000 in cost of revenue compensation expense, $258,000 in sales and marketing compensation expense and $2,124,000 in general and administrative compensation expense for stock options.

The total remaining unrecognized compensation cost related to nonvested awards is $4.9 million. The weighted average period over which the cost is expected to be recognized is 2.09 years.

Consistent with our valuation method for the disclosure-only provisions of SFAS 123, we are using the Black-Scholes option pricing model to value the compensation expense associated with our stock-based awards under SFAS 123R. In addition, we estimate forfeitures when recognizing compensation expense, and we will adjust our estimate of forfeitures when they are expected to differ. For the three months ended April 30, 2006, we estimated that 5% of options granted will be forfeited before the first vesting tranche. Forfeitures after the first vesting tranche are estimated to not be material. Prior to the quarter ended April 30, 2006, we estimated that 15% of options granted would be forfeited before the first vesting tranche. This change in accounting estimate was reflected by recognizing an immaterial cumulative adjustment in compensation cost in the quarter ended April 30, 2006.

The fair value of each stock option grant was estimated on the date of grant using the Black-Scholes option pricing model, assuming no expected dividends and the following weighted average assumptions. The expected volatility is based upon the historical volatility of the Company’s stock price. Upon exercise of options, the Company issues shares of common stock.


	Three Months Ended						Nine Months Ended
	April 30,						April 30,
	2006			2005			2006			2005
Risk-free interest rate		4.74	%		3.11	%		4.48	%		3.10	%
Expected volatility		106.07	%		126.55	%		105.83	%		126.44	%
Expected life(years)		2.62			2.11			2.37			2.11
Weighted average fair value of options granted	$	1.31		$	1.87		$	1.04		$	1.87

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The following table reflects stock option activity under the Company’s equity plans for the nine months ending April 30, 2006.


						Weighted
				Weighted		Average
	Number			Average		Remaining		Aggregate
	of			Exercise		Contractual		Intrinsic
	Shares			Price		Term		Value
Options outstanding, beginning of year		6,086,655		$	3.26		—		—
Granted		1,938,125		$	1.66		—		—
Exercised		(221,421	)	$	2.38		—		—
Forfeited or Expired		(978,002	)	$	3.93		—		—
Options Outstanding, April 30, 2006		6,825,357		$	2.74		8.56	$	10,856,486
Options Exercisable, April 30, 2006		3,295,745		$	3.38		7.98	$	3,835,446

(j) Net Loss Per Share

Basic net loss per share is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Diluted net loss per share is computed using the weighted average number of common and diluted common equivalent shares outstanding during the period, using either the “if-converted” method for convertible preferred stock and notes or the treasury stock method for warrants and options, unless amounts are anti-dilutive.

For the three and nine months ended April 30, 2006 and 2005, net loss per basic and diluted share is based on weighted average common shares and excludes any common stock equivalents, as they would be anti-dilutive due to the reported losses. For the three and nine months ended April 30, 2006, there were 1,932,517 and 213,706 dilutive shares, respectively, related to warrants and employee stock options that were excluded as they have an anti-dilutive effect due to the net loss during these periods. For the three and nine months ended April 30, 2005, there were 176,524 and 469,402 dilutive shares, respectively, related to warrants, employee stock options and unissued shares related to the Avasta settlement that were excluded as they have an anti-dilutive effect due to the net loss during these periods.

(k) Segment Reporting

We currently operate in one segment, managed IT services. The Company’s chief operating decision maker reviews financial information at a consolidated level. The Company has determined that reporting revenue at a service offering level is impracticable.

(l) Foreign Currency

The functional currencies of our wholly-owned subsidiaries are the local currencies. The financial statements of the subsidiaries are translated into U.S. dollars using period end exchange rates for assets and liabilities and weighted average exchange rates during corresponding periods for revenue, cost of revenue and expenses. Translation gains and losses are deferred and accumulated as a separate component of stockholders’ equity (“Accumulated other comprehensive income”).

(m) Reclassifications

Certain fiscal quarter 2005 balances have been reclassified to conform to the fiscal quarter 2006 financial statement presentation.

(n) Recent Accounting Pronouncements

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections: A

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Replacement of APB Opinion No. 20 and SFAS No. 3.” This statement changes the requirements for the accounting for and reporting of a voluntary change in accounting principle, and also applies to instances when an accounting pronouncement does not include specific transition provisions. The statement replaces the previous requirement that voluntary changes be recognized by including the cumulative effect of the change in net income of the period of the change. The statement requires retrospective application of a new accounting principle to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. The statement is effective for changes and corrections made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of the statement to have a material effect on its financial condition, results of operations or cash flows.

In March 2005, the FASB issued Interpretation (“FIN”) No. 47, “Accounting for Conditional Asset Retirement Obligations—an Interpretation of FASB Statement No. 143.” This Interpretation clarifies the timing of liability recognition for legal obligations associated with an asset retirement when the timing and (or) method of settling the obligation are conditional on a future event that may or may not be within the control of the entity. FIN No. 47 is effective no later than the end of fiscal years ending after December 15, 2005. We do not believe the adoption of FIN No. 47 will have a material impact on our consolidated financial statements or results of operations.

In November 2005, the FASB issued FSP FAS123(R)-3, Transition Election to Accounting for the Tax Effects of Share-Based Payment Awards. This FSP requires an entity to follow either the transition guidance for the additional-paid-in-capital pool as prescribed in SFAS No. 123(R), Share-Based Payment, or the alternative transition method as described in the FSP. An entity that adopts SFAS No. 123(R) using the modified prospective application may make a one-time election to adopt the transition method described in this FSP. An entity may take up to one year from the later of its initial adoption of SFAS No. 123(R) or the effective date of this FSP to evaluate its available transition alternatives and make its one-time election. This FSP became effective in November 2005. We continue to evaluate the impact that the adoption of this FSP could have on our financial statements.

In February 2006, the FASB issued Statement of Financial Accounting Standard No.155, or SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statements No. 133 and 140”. SFAS No. 155 (1) permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that would otherwise require bifurcation, (2) clarifies which interest-only strips and principal-only strips are not subject to the requirements of FASB Statement No. 133, (3) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an imbedded derivative requiring bifurcation, (4) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives, and (5) amends FASB Statement No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest in other than another derivative financial instrument. SFAS No. 155 is effective January 1, 2007 and we are currently evaluating the effect, if any, that this pronouncement will have on our future financial results.

(3) Liquidity

As of April 30, 2006, our principal sources of liquidity included cash and cash equivalents, a revolving credit facility of $3 million provided by Silver Point and a term loan agreement with Atlantic Investors LLC for a maximum amount of $5 million. We had a working capital deficit of $11.3 million, including cash and cash equivalents of $0.7 million at April 30, 2006, as compared to a working capital deficit of $77.6 million, including cash and cash equivalents of $6.8 million, at July 31, 2005.

The total net change in cash and cash equivalents for the nine months ended April 30, 2006 was a decrease of $6.1 million. The primary uses of cash during the nine months ended April 30, 2006 included $7.7 million of cash used for operating activities, $4.3 million for purchases of property and equipment and approximately $58.6 million in repayments on notes payable and capital lease obligations. Our financing activities during the nine months ended April 30, 2006 provided approximately $71.0 million of cash consisting primarily of $70.0 million in proceeds from a term loan, $ 0.5 million in proceeds received from exercise of stock options and $0.4 million in proceeds from notes payable. Net cash used for operating activities of $7.7 million during the nine months ended April 30, 2006, resulted primarily from funding our $10.9 million net loss and $11.0 million of net changes in operating assets and liabilities, which was partially offset by non-cash charges of approximately $14.2 million. At April 30, 2006, we had

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

an accumulated deficit of $466.8 million. We have reported losses from operations since incorporation. At July 31, 2005, we had an accumulated deficit of $455.9 million.

Our revolving credit facility with Silver Point allows for maximum borrowing of $3.0 million and expires on April 11, 2011. Outstanding amounts will bear interest at either: (a) 7% per annum plus, the greater of (i) Prime Rate, and (ii) the Federal Funds Effective Rate plus 3% or (b) 8% plus the floating rate of LIBOR. Interest is payable in arrears on the last day of the month for Base Rate loans, and the last day of the chosen interest period (one, two or three months) for LIBOR Rate loans. As of April 30, 2006, we had no amounts outstanding under this revolving credit facility with Silver Point.

Our term loan with Atlantic Investors LLC allows for maximum borrowing of $5.0 million. All outstanding amounts under the Atlantic Term Loan shall be paid in full no later than the date that is 90 days after the earlier of: (a) April 11, 2011, and (b) the date all obligations under the Silver Point Credit Facility have been paid in full. Credit advances under the Atlantic Term Loan shall bear interest at either: (a) 7% per annum plus, the greater of (i) Prime Rate, and (ii) the Federal Funds Effective Rate plus 3% or (b) 8% plus the floating rate of LIBOR. Interest may be paid in cash or quarterly by promissory notes executed by the Company on behalf of Atlantic. As of April 30, 2006, we had no amounts outstanding under our Term Loan with Atlantic Investors LLC.

The audit report on our fiscal year 2005 consolidated financial statements from KPMG LLP, our independent registered public accounting firm, contains KPMG’s opinion that our recurring losses from operations since inception and accumulated deficit, as well as other factors, raise substantial doubt about our ability to continue as a going concern. While we cannot give any assurance that we will continue as a going concern, we believe that we have developed and are implementing an operational plan that aligns our cost structure with our projected revenue growth. We anticipate that we will continue to incur net losses in the future. We have taken several actions we believe will allow us to continue as a going concern, including closing and integrating strategic acquisitions and bringing costs more in line with projected revenue. We may need to find sources of additional financing, in order to remain a going concern.

Our operating forecast incorporates growth projections from industry analysts for the markets in which we participate. Our forecast also incorporates the future cash flow benefits expected from our continued efforts to increase efficiencies and reduce redundancies. Our cash flow estimates are based upon attaining certain levels of sales, maintaining budgeted levels of operating expenses, collections of accounts receivable and maintaining our current borrowing lines with Silver Point and Atlantic among other assumptions, including the improvement in the overall macroeconomic environment. However, there can be no assurance that we will be able to meet such assumptions. Our operating forecast does not depend upon our ability to make additional acquisitions which could be impacted by our current stock price. Our sales estimate includes revenue from new and existing customers, which may not be realized, and we may be required to further reduce expenses if budgeted sales are not attained. We may be unsuccessful in reducing expenses in proportion to any shortfall in projected sales and our estimate of collections of accounts receivable may be hindered by our customers’ ability to pay. In addition, we are currently involved in various pending and potential legal proceedings. While we believe that the allegations against us in each of these matters are without merit, and/or that we have a meritorious defense in each, we are not able to predict the final outcomes of these matters and the effect, if any, on our business, financial condition, results of operations or cash flows. If we are ultimately unsuccessful in any of these matters, we could be required to pay substantial amounts of cash to the other parties. The amount and timing of any such payments could adversely affect our business, financial condition, results of operations or cash flows.

(4) Impairment of Long-Lived Assets

During the nine months ended April 30, 2005, the Company recorded a $0.8 million impairment charge for property and equipment, consisting primarily of unamortized leasehold improvements related to our 10 Maguire Road facility in Lexington, MA. The impairment charge is included in “Impairment, restructuring and other” in the accompanying Condensed Consolidated Statements of Operations (see Note 11). No impairment charges related to long-lived assets were recorded during the nine months ended April 30, 2006.

(5) Property and Equipment

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Property and equipment at April 30, 2006 and July 31, 2005 are summarized as follows:


	April 30,			July 31,
	2006			2005
	(In thousands)
Office furniture and equipment	$	3,282		$	3,159
Computer equipment		43,667			38,690
Software licenses		11,121			10,658
Leasehold improvements		9,770			9,369

		67,840			61,876
Less: Accumulated depreciation and amortization		(52,486	)		(46,677	)

Property and equipment, net	$	15,354		$	15,199

The estimated useful lives of our fixed assets are as follows: office furniture and equipment, 5 years; computer equipment, 3 years; software licenses, 3 years or life of the license; and leasehold improvements, shorter of the useful life or the life of the lease.

Equipment valued at approximately $0.4 million and $1.6 million was purchased under capital leases during the three and nine months ended April 30, 2006.

(6) Intangible Assets

The gross carrying amount and accumulated amortization as of April 30, 2006 and July 31, 2005 for customer lists related to prior acquisitions are as follows:


	April 30,			July 31,
	2006			2005
	(In thousands)
Gross carrying amount	$	29,791		$	29,791
Less: Accumulated amortization		(16,938	)		(13,228	)

Customer lists, net	$	12,853		$	16,563

Intangible asset amortization expense for the three and nine months ended April 30, 2006 and 2005 aggregated $1.2 million and $3.7 million, and $1.4 million and $4.3 million, respectively. Customer lists are being amortized over estimated useful lives ranging from five to eight years. The amount reflected in the table below for fiscal year 2006 includes year to date amortization. Amortization expense related to intangible assets for the next five years is as follows:


Year Ending July 31,	(In thousands)
2006	$	4,876
2007	$	3,932
2008	$	3,044
2009	$	1,868
2010	$	1,005

(7) Goodwill

We perform our annual impairment analysis of goodwill on the last day of our fiscal fourth quarter.

(8) Investment in Debt Securities

In a privately negotiated transaction with Fir Tree Recovery Master Fund, LP and Fir Tree Value Partners, LDC, pursuant to an Assignment Agreement dated October 11, 2002 and in a series of open market transactions from certain other third-party holders, we acquired an aggregate principal amount of approximately $36.3 million face value, 10% convertible senior notes (Interliant Notes) due in 2006 of Interliant, Inc. (Interliant) for a total consideration of approximately $2.0 million. Interliant was a provider of managed services, which filed a petition under Chapter 11 of Title 11 of the United States Bankruptcy Code in the Southern District of New York (White Plains) on August 5, 2002, and we made this investment with the intention of participating in the reorganization/sale of Interliant.

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

On May 16, 2003, the Bankruptcy Court confirmed us as the successful bidder for the purchase of the Interliant Assets. We used $624,000 of the first projected distributions to be made on our Interliant Notes as partial payment for the assets acquired. As such, we have reduced the carrying value of the Interliant Notes by this amount. On September 30, 2004, the Third Amended Plan of Liquidation of Interliant and its affiliated debtors became effective. As a result of unfavorable facts and circumstances occurring in the fourth quarter of fiscal year 2005, as learned from bankruptcy counsel, which negatively impacted the recoverability of our investment, the Company recorded an impairment charge in the amount of $1.1 million, in the fourth quarter of fiscal year 2005, reducing the carrying value of the Interliant Notes to approximately $0.2 million. The final amount and timing of any distributions we will receive on our Interliant Notes has not been determined. It may be greater or less than the remaining $0.2 million carrying value which is included in “Other assets” on our Consolidated Balance Sheets.

(9) Accrued Expenses and Other Current Liabilities

Accrued expenses and other current liabilities consist of the following:


	April 30,		July 31,
	2006		2005
	(In thousands)
Accrued payroll, benefits and commissions	$	3,820	$	3,846
Accrued legal		712		1,361
Accrued accounts payable		2,382		2,896
Accrued interest		821		5,494
Accrued contract termination fees		491		429
Accrued lease abandonment costs, current portion		1,653		2,435
Accrued taxes		1,076		1,075
Other accrued expenses and current liabilities		1,747		3,258

	$	12,702	$	20,794

(10) Debt

Debt consists of the following:


	April 30,		July 31,
	2006		2005
	(In thousands)
Accounts receivable financing line, net	$	—	$	20,347
The Senior Secured Term Loan		59,879		—
Notes payable to the AppliedTheory Estate		6,000		6,000
Notes payable to the Atlantic Investors		3,000		3,000
Notes payable to landlord		537		1,157
Convertible notes payable to Waythere, Inc. (formerly Surebridge)		—		35,361
Other notes payable		142		397

Total		69,558		66,262
Less current portion		7,171		65,853

Long-term debt	$	62,387	$	409

(a) Term Loan and Revolving Credit Facility

On April 11, 2006, we entered into a senior secured Term Loan and senior secured Revolving Credit Facility (the Credit Facility) with a financial institution, (the Lender) to repay certain maturing debt and increase borrowing available for corporate purposes. The Credit Facility consists of a $70 million five year single-draw Term Loan and a $3.0 million Revolving Credit Facility. Borrowings under the Term Loan are guaranteed by the Company and all of its subsidiaries. During the first twelve months of the loan, we are required to make quarterly interest only payments to the Lender and commencing one year after closing date of the loan, we are scheduled to

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

make quarterly repayments of the principal. The maturity date of the Term Loan is April 11, 2011. The Lender is entitled to prepayment of the outstanding balance under the Term Loan, if any, upon the occurrence of various events, including among others, if the Company sells assets and does not reinvest the proceeds in assets, receives cash proceeds from the incurrence of any indebtedness, has excess cash, or closes an equity financing transaction, provided that the first $10 million plus 50% of the remaining net proceeds from an equity financing shall not be subject to the mandatory prepayment requirement. Generally, prepayments are subject to a prepayment premium ranging from 8%-1% depending upon the timing of the prepayment. The unpaid amount of the Term Loan and accrued interest and all other obligations shall become due and payable immediately upon occurrence and continuation of any event of default. Under the Term Loan agreement, we must comply with various financial and non-financial covenants. The financial covenants include among others, minimum fixed charge coverage ratio, maximum consolidated leverage ratio, minimum consolidated EDITDA and maximum annual capital expenditure. The primary non-financial covenants limit our ability to pay dividends, make investments, engage in transactions with affiliates, sell assets, conduct mergers or acquisitions, incur indebtedness or liens, alter capital structure and sell stock.

Outstanding amounts of the Term Loan bear interest at either: (a) 7% per annum plus, the greater of (i) Prime Rate, and (ii) the Federal Funds Effective Rate plus 3% or (b) 8% plus the floating rate of LIBOR. To the extent interest payable on the Term Loan (a) exceeds the LIBOR Rate plus 5% in year one or (b) exceeds the LIBOR Rate plus 7% for the years thereafter, such amounts will be capitalized and added to the outstanding principal amount of the Term Loan and shall incur interest. Outstanding amounts under the Revolving Credit Facility bear interest at either: (a) 7% per annum plus, the greater of (i) Prime Rate, and (ii) the Federal Funds Effective Rate plus 3% or (b) 8% plus the floating rate of LIBOR. Interest is payable in arrears on the last day of the month for Base Rate loans, and the last day of the chosen interest period (one, two or three months) for LIBOR Rate loans. We are required, under our senior secured term loan facility with Silver Point Finance, to purchase interest rate protection which shall effectively limit the unadjusted LIBOR component of the interest costs of our loan with respect to not less than 70% of the principal amount at a rate of not more than 6.5% per annum, which was entered into in May 2006 for a cost of approximately $0.3 million.

As of April 30, 2006, we had $70.1 million outstanding under the Term Loan and had accrued approximately $0.4 million in interest related to this Term Loan. The amount borrowed was used to repay our accounts receivable financing line with Silicon Valley Bank, convertible notes and interest payable to Waythere, Inc. (formerly Surebridge, Inc.) and to pay transaction fees and expenses relating to the loan. In addition, $6.4 million of the borrowed amount is being held in an escrow account to payoff notes payable and accrued interest to the AppliedTheory Estate. As of April 30, 2006, we had not yet borrowed under the Credit Facility.

In connection with the Credit Facility, the Company issued two warrants to purchase an aggregate of 3,514,933 shares of common stock of the Company at an exercise price of $0.01 per share. These warrants may not be exercised until after 90 days following the closing date of the Credit Facility and will expire on April 11, 2016. The warrants were fair valued using the Black-Scholes option-pricing model and are recorded in our Consolidated Balance Sheets as a discount to the loan amount, based on a relative fair value of $9.1 million and will be amortized into interest expense, using the effective interest method over the five-year term of the Credit Facility.

Based upon the guidance in SFAS 133, the Company concluded that the prepayment penalty of the Credit Facility met the definition of an embedded derivative and was required to be accounted for separately. The embedded derivative feature was bi-furcated and the fair market value of the embedded derivative was determined using a probability weighted discounted cash flow analysis. As of April 30, 2006, the embedded derivative value was calculated to be approximately $1.3 million and was included as a reduction to the Term Loan in the Consolidated Balance Sheets. The embedded derivative is recorded at fair market value with changes in value to be recognized during the period of change. The debt discount recorded as a result of the embedded derivate will be amortized into interest expense over the five-year term of the Credit Facility.

(b) Note Payable to Atlantic Investors, LLC

On January 29, 2003, we entered into a $10.0 million Loan and Security Agreement (Atlantic Loan) with Atlantic Investors, LLC (Atlantic), a related party. The Atlantic Loan bears an interest rate of 8% per annum. On April 11, 2006, the Company entered into an Amended and Restated Loan Agreement with Atlantic, in connection

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

with and as a condition precedent to the Credit Facility with Silver Point, which amended and restated the existing loan agreement between the Company and Atlantic dated January 29, 2003. Under the Atlantic amendment and related transaction documents, Atlantic agreed to reduce the availability of the Atlantic Loan to the amount outstanding as of April 11, 2006 of $3.0 million and approximately $0.7 million of accrued interest, agreed that this indebtedness shall be an unsecured obligation of the Company, agreed to subordinate this indebtedness to amounts owed by the Company to Silver Point and agreed to extend the maturity date of the loan to the earlier of the date that is 90 days after the earlier of: (a) April 11, 2011, and (b) the date all obligations under the Silver Point Credit Facility have been paid in full.

In the event the Company’s outstanding repayment obligations under the Atlantic Loan are not paid in full on or before the date that is 90 days after the closing date of the Silver Point transaction, Atlantic shall have the right, but not the obligation, at all times thereafter until Atlantic receives full payment, of converting such outstanding amounts into shares of the Company’s common stock by dividing (i) the dollar value of the outstanding obligation by (ii) $2.81 (the fair value on the date of issue), rounded to the nearest whole share.

At April 30, 2006, we had $3.0 million outstanding under the Atlantic Loan. This amount is shown as Long Term Note Payable to Related Party on our Consolidated Balance Sheet. On April 30, 2006, we had approximately $0.7 million in accrued interest related to this note.

(c) Term Loan with Atlantic Investors, LLC

On April 11, 2006, we entered into an unsecured subordinated Term Loan Agreement with Atlantic Investors LLC, in connection with and as a condition precedent to the Silver Point credit facility, whereby the Company established a subordinated term loan facility with Atlantic (the “Atlantic Term Loan”) in the amount not to exceed $5 million. Credit advances under the Atlantic Term Loan shall bear interest at either: (a) 7% per annum plus, the greater of (i) Prime Rate, and (ii) the Federal Funds Effective Rate plus 3%, or (b) 8% plus the floating rate of LIBOR. Interest may, at the Company’s option, be paid in cash or quarterly by promissory notes executed by the Company on behalf of Atlantic. All outstanding amounts under the Atlantic Term Note shall be paid in full by the Company no later than the date that is 90 days after the earlier of: (a) April 11, 2011, and (b) the date all obligations under the Credit Facility have been paid in full.

We plan to use the proceeds of the Atlantic Term Loan, if needed, for general corporate and working capital purposes of the Company and its subsidiaries. As of April 30, 2006, there were no borrowings outstanding under the Atlantic Term Loan.

(d) Notes Payable to the AppliedTheory Estate

As part of CBTM’s acquisition of certain AppliedTheory assets, CBTM entered into two unsecured promissory notes totaling $6.0 million (Estate Liability) due to the AppliedTheory Estate on June 13, 2006. The Estate Liability bears interest at 8% per annum, which is due and payable annually. At April 30, 2006, we had approximately $0.4 million in accrued interest related to these notes. At April 30, 2006, we had borrowed $6.4 million from Silver Point Finance as part of the Term Loan and placed it in an escrow account reserved to repay these notes. This $6.4 million in escrow is included in “Prepaid expenses and other current assets” on our Consolidated Balance Sheets.

(e) Notes Payable to Landlord

As part of an amendment to our 400 Minuteman Road lease, $2.2 million of our future payments to the landlord of our 400 Minuteman Road facility was transferred into a note payable (Landlord Note). The Landlord Note bears interest at an annual rate of 11% and calls for 36 equal monthly payments of principal and interest, with the final payment due on November 1, 2006. The $2.2 million represents leasehold improvements made by the landlord, on our behalf, to the 400 Minuteman location in order to facilitate the leasing of a portion of the facility (First Lease Amendment), as well as common area maintenance and property taxes associated with the space.

In addition, during fiscal year 2004, we paid $120,000 and we entered into a separate $150,000 note

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(Second Landlord Note) with the landlord for additional leasehold improvements to facilitate a subleasing transaction involving a specific section of the 400 Minuteman location. The Second Landlord Note bears interest at an annual rate of 11% and calls for 36 equal monthly payments of principal and interest, with the final payment due on March 1, 2007.

(11) Commitments and Contingencies

(a) Leases

Abandoned Leased Facilities: During the third quarter of fiscal year 2006, we recorded lease impairment charges of approximately $0.1 million due to revisions in sublease assumptions for previously abandoned facilities. During the first nine months of fiscal year 2005, we recorded $0.7 million of lease impairment charges, resulting from costs associated with the abandonment of administrative space at 10 Maguire Road, in Lexington, MA, an adjustment relating to a lease modification for one of our Syracuse facilities and revisions in assumptions associated with other impaired facilities.

All lease impairment expense amounts recorded are included in the captions “Impairment, restructuring and other” in the accompanying Condensed Consolidated Statements of Operations.

Details of activity in the lease exit accrual by facility for the nine months ended April 30, 2006 are as follows (in thousands):


						Purchase
	Balance at					Accounting			Payments, less
Lease Abandonment	July 31,					and Other			accretion of			Balance at
Costs for:	2005		Expense			Adjustments			interest			April 30, 2006
Andover, MA	$	796	$	—		$	—		$	(158	)	$	638
Chicago, IL		866		—			7			(148	)		725
Houston, TX		699		123			—			(325	)		497
Syracuse, NY		255		151			—			(253	)		153
Syracuse, NY		36		11			—			(24	)		23
San Jose, CA		582		240			—			(449	)		373
Atlanta, GA		124		—			15			(84	)		55
Atlanta, GA		66		—			—			(57	)		9
Lexington, MA		370		(12	)		(15	)		(343	)		—

	$	3,794	$	513		$	7		$	(1,841	)	$	2,473

We are obligated under various capital and operating leases for facilities and equipment. Future minimum annual rental commitments under capital and operating leases and other commitments are as follows as of April 30, 2006:


			Less than										After
Description	Total		1 Year		Year 2		Year 3		Year 4		Year 5		Year 5
	(In thousands)
Short/Long-term debt	$	79,791	$	7,171	$	5,409	$	8,600	$	11,200	$	47,411	$	—
Interest on debt		36,586		7,770		7,053		6,496		5,625		9,642		—
Capital leases		2,598		2,156		415		27		—		—		—
Operating leases		39		39		—		—		—		—		—
Bandwidth commitments		2,465		1,743		604		118		—		—		—
Maintenance for hardware/software		261		237		23		1		—		—		—
Property leases ^{(a, b)}		45,424		9,918		8,752		6,670		4,440		1,983		13,661

	$	167,164	$	29,034	$	22,256	$	21,912	$	21,265	$	59,036	$	13,661

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(a)Amounts exclude certain common area maintenance and other property charges that are not included within the lease payment.

(b)On February 9, 2005, the Company entered into an Assignment and Assumption Agreement with a Las Vegas-based company, whereby this company purchased from us the right to use 29,000 square feet in our Las Vegas data center, along with the infrastructure and equipment associated with this space. In exchange, we received an initial payment of $600,000 and will receive $55,682 per month over two years. This agreement shifts the responsibility for management of the data center and its employees, along with the maintenance of the facility’s infrastructure, to this Las Vegas-based company. Pursuant to this Agreement, we have subleased back 2,000 square feet of space, allowing us to continue servicing our existing customer base in this market. Commitments related to property leases include an amount related to the 2,000 square feet sublease. With respect to the property lease commitments listed above, certain cash is restricted pursuant to terms of lease agreements with landlords. At April 30, 2006, this restricted cash of approximately $1.1 million on the accompanying Condensed Consolidated Balance Sheet consisted of certificates of deposit and a treasury note and are recorded at cost, which approximates fair value.

(b) Legal Matters

IPO Securities Litigation

On or about June 13, 2001, Stuart Werman and Lynn McFarlane filed a lawsuit against us, BancBoston Robertson Stephens, an underwriter of our initial public offering in October 1999, Joel B. Rosen, our then chief executive officer, and Kenneth W. Hale, our then chief financial officer. The suit was filed in the United States District Court for the Southern District of New York. The suit generally alleges that the defendants violated federal securities laws by not disclosing certain actions allegedly taken by Robertson Stephens in connection with our initial public offering. The suit alleges specifically that Robertson Stephens, in exchange for the allocation to its customers of shares of our common stock sold in our initial public offering, solicited and received from its customers’ agreements to purchase additional shares of our common stock in the aftermarket at pre-determined prices. The suit seeks unspecified monetary damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between October 22, 1999 and December 6, 2000. Three other substantially similar lawsuits were filed between June 15, 2001 and July 10, 2001 by Moses Mayer (filed June 15, 2001), Barry Feldman (filed June 19, 2001), and Binh Nguyen (filed July 10, 2001). Robert E. Eisenberg, our president at the time of the initial public offering in 1999, also was named as a defendant in the Nguyen lawsuit.

On or about June 21, 2001, David Federico filed in the United States District Court for the Southern District of New York a lawsuit against us, Mr. Rosen, Mr. Hale, Robertson Stephens and other underwriter defendants including J.P. Morgan Chase, First Albany Companies, Inc., Bank of America Securities, LLC, Bear Stearns & Co., Inc., B.T. Alex. Brown, Inc., Chase Securities, Inc., CIBC World Markets, Credit Suisse First Boston Corp., Dain Rauscher, Inc., Deutsche Bank Securities, Inc., The Goldman Sachs Group, Inc., J.P. Morgan & Co., J.P. Morgan Securities, Lehman Brothers, Inc., Merrill Lynch, Pierce, Fenner & Smith, Inc., Morgan Stanley Dean Witter & Co.,

Robert Fleming, Inc. and Salomon Smith Barney, Inc. The suit generally alleges that the defendants violated the anti-trust laws and the federal securities laws by conspiring and agreeing to raise and increase the compensation received by the underwriter defendants by requiring those who received allocation of initial public offering stock to agree to purchase shares of manipulated securities in the after-market of the initial public offering at escalating price levels designed to inflate the price of the manipulated stock, thus artificially creating an appearance of demand and high prices for that stock, and initial public offering stock in general, leading to further stock offerings. The suit also alleges that the defendants arranged for the underwriter defendants to receive undisclosed and excessive brokerage commissions and that, as a consequence, the underwriter defendants successfully increased investor interest in the manipulated initial public offering of securities and increased the underwriter defendants’ individual and collective underwritings, compensation, and revenue. The suit further alleges that the defendants violated the federal securities laws by issuing and selling securities pursuant to the initial public offering without disclosing to investors that the underwriter defendants in the offering, including the lead underwriters, had solicited and received excessive and undisclosed commissions from certain investors. The suit seeks unspecified monetary damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between October 22, 1999 and June 12, 2001.

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Those five cases, along with lawsuits naming more than 300 other issuers and over 50 investment banks which have been sued in substantially similar lawsuits, have been assigned to the Honorable Shira A. Scheindlin (the “Court”) for all pretrial purposes (the “IPO Securities Litigation”). On September 6, 2001, the Court entered an order consolidating the five individual cases involving us and designating Werman v. NaviSite, Inc., et al., Civil Action No. 01-CV-5374 as the lead case. A consolidated, amended complaint was filed thereafter on April 19, 2002 (the “Class Action Litigation”) on behalf of plaintiffs Arvid Brandstrom and Tony Tse against underwriter defendants Robertson Stephens (as successor-in-interest to BancBoston), BancBoston, J.P. Morgan (as successor-in-interest to Hambrecht & Quist), Hambrecht & Quist and First Albany and against us and Messrs. Rosen, Hale and Eisenberg (collectively, the “NaviSite Defendants”). Plaintiffs uniformly allege that all defendants, including the NaviSite Defendants, violated the federal securities laws (i.e., Sections 11 and 15 of the Securities Act, Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5) by issuing and selling our common stock pursuant to the October 22, 1999 initial public offering, without disclosing to investors that some of the underwriters of the offering, including the lead underwriters, had solicited and received extensive and undisclosed agreements from certain investors to purchase aftermarket shares at pre-arranged, escalating prices and also to receive additional commissions and/or other compensation from those investors. At this time, plaintiffs have not specified the amount of damages they are seeking in the Class Action Litigation.

Between July and September 2002, the parties to the IPO Securities Litigation briefed motions to dismiss filed by the underwriter defendants and the issuer defendants, including NaviSite. On November 1, 2002, the Court held oral argument on the motions to dismiss. The plaintiffs have since agreed to dismiss the claims against Messrs. Rosen, Hale and Eisenberg without prejudice, in return for their agreement to toll any statute of limitations applicable to those claims. By stipulation entered by the Court on November 18, 2002, Messrs. Rosen, Hale and Eisenberg were dismissed without prejudice from the Class Action Litigation. On February 19, 2003, an opinion and order was issued on defendants’ motion to dismiss the IPO Securities Litigation, essentially denying the motions to dismiss of all 55 underwriter defendants and of 185 of the 301 issuer defendants, including NaviSite.

On June 30, 2003, our Board of Directors considered and authorized us to negotiate a settlement of the pending Class Action Litigation substantially consistent with a memorandum of understanding negotiated among proposed class plaintiffs, the issuer defendants and the insurers for such issuer defendants. Among other contingencies, any such settlement would be subject to approval by the Court. Plaintiffs filed on June 14, 2004, a motion for preliminary approval of the Stipulation And Agreement Of Settlement With Defendant Issuers And Individuals (the “Preliminary Approval Motion”). On February 15, 2005, the Court approved the Preliminary Approval Motion in a written opinion which detailed the terms of the settlement stipulation, its accompanying documents and schedules, the proposed class notice and, with a modification to the bar order to be entered, the proposed settlement order and judgment. A further conference was held on April 13, 2005, at which time the Court considered additional submissions but did not make final determinations regarding the exact form, substance and program for notifying the proposed settlement class. On August 31, 2005, the Court entered a further Preliminary Order in Connection with Settlement Proceedings (the “Preliminary Approval Order”), which granted preliminary approval to the issuer’s settlement with the plaintiffs in the IPO Securities Litigation. The Court subsequently held a Fed. R. Civ. P. 23 fairness hearing on April 24, 2006 in order to consider the written and oral submissions addressing whether the Court should enter final approval of the settlement; the matter was taken under advisement and remains pending with the Court. If the proposed issuers’ settlement is completed and then approved by the Court without further modifications to its material terms, we and the participating insurers acting on our behalf may be responsible for providing funding of approximately $3.4 million towards the total amount plaintiffs are guaranteed by the proposed issuer’s settlement to recover in the IPO Securities Litigation. The amount of the guarantee allocable to us could be reduced or eliminated in its entirety in the event that plaintiffs are able to recover more than the total amount of such overall guarantee from settlements with or judgments obtained against the non-settling defendants. Even if no additional recovery is obtained from any of the non-settling defendants, the settlement amount allocable to us is expected to be fully covered by our existing insurance policies and is not expected to have a material effect on our business, financial condition, results of operations or cash flows.

We believe that the allegations against us are without merit and, if the settlement is not approved by the Court and finalized, we intend to vigorously defend against the plaintiffs’ claims. Due to the inherent uncertainty of litigation, we are not able to predict the possible outcome of the suits and their ultimate effect, if any, on our business, financial condition, results of operations or cash flows.

NAVISITE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(12) Income Tax Expense

The Company recorded $0.3 million and $0.9 million of deferred income tax expense during the three and nine months ended April 30, 2006, respectively, as compared to $0.3 million and $1.1 million of deferred income tax expenses during the comparable periods of fiscal year 2005. No income tax benefit was recorded for the losses incurred due to a valuation allowance recognized against deferred tax assets. The deferred tax expenses resulted from tax goodwill amortization related to the Surebridge acquisition in June 2004 and the acquisition of certain Applied Theory assets by Clearblue Technologies Management, Inc. prior to the pooling of interest in December 2002. Accordingly, the acquired goodwill and intangible assets for both acquisitions are amortizable for tax purposes over fifteen years. For financial statement purposes, goodwill is not amortized for either acquisition but is tested for impairment annually. Tax amortization of goodwill results in a taxable temporary difference, which will not reverse until the goodwill is impaired or written off for book purposes. The resulting taxable temporary difference may not be offset by deductible temporary differences currently available, such as net operating loss carryforwards, which expire within a definite period.

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

This Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, that involve risks and uncertainties. All statements other than statements of historical information provided herein are forward-looking statements and may contain information about financial results, economic conditions, trends and known uncertainties. Our actual results could differ materially from those discussed in the forward-looking statements as a result of a number of factors, which include those discussed in this section and elsewhere in this report under the heading “Certain Risk Factors that May Affect Future Results” and the risks discussed in our other filings with the Securities and Exchange Commission. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s analysis, judgment, belief or expectation only as of the date hereof. We undertake no obligation to publicly revise these forward-looking statements to reflect events or circumstances that arise after the date hereof.

Overview

NaviSite provides IT hosting, outsourcing and professional services for mid- to large-sized organizations. Leveraging our set of technologies and subject matter expertise, we deliver cost-effective, flexible solutions that provide responsive and predictable levels of service for our clients’ business. NaviSite provides services throughout the information technology lifecycle. The Company is dedicated to delivering quality services and meets rigorous standards, including SAS 70, Microsoft Gold, and Oracle Certified Partner certifications.

We believe that by leveraging economies of scale utilizing our global delivery approach, industry best practices and process automation, our services enable our customers to achieve significant savings. In addition, we are able to leverage our application services platform, NaviView^TM, to enable software to be delivered on-demand over the Internet, providing an alternative delivery model to the traditional licensed software model. As the platform provider for an increasing number of independent software vendors, we enable solutions and services to a wider and growing customer base.

Our services include:

Hosting Services

	•		Managed services — Support provided for hardware and software located in a data center. Services include business continuity and disaster recovery, connectivity, content distribution, database administration and performance tuning, desktop support, hardware management, monitoring, network management, security management, server and operating system management and storage management.

	•		Application management services — Defined services provided for specific packaged applications that are incremental to managed services. Services can include monitoring, diagnostics and problem resolution. Frequently sold as a follow-on to a professional services project.

	•		Colocation — Physical space offered in a data center. In addition to providing the physical space, NaviSite offers environmental support, specified power with back-up power generation and network connectivity options.

	•		Software as a Service — Enablement of Software as a Service to the ISV community.

Outsourcing Services

	•		Planning Services — Services include IT assessment, enterprise architecture planning, Web strategy, performance assessment and tuning.

	•		Development Services — Services include eBusiness/Web solutions, enterprise integration, business intelligence, content management and user interface design

•

Management Services — Services include custom application management and remote infrastructure management.

Professional Services

	•		For leading enterprise software applications such as Oracle, PeopleSoft, JD Edwards and Siebel Systems, NaviSite Professional Services helps organizations plan, implement and maintain these applications.

	•		Optimize scalable, business-driven software solutions. Specific services include planning, implementation, maintenance, optimization and compliance services.

We provide these services to a range of vertical industries, including financial services, healthcare and pharmaceutical, manufacturing and distribution, publishing, media and communications, business services, public sector and software, through our direct sales force and sales channel relationships.

Our managed application services are facilitated by our proprietary NaviView^TM collaborative application management platform. Our NaviView^TM platform enables us to provide highly efficient, effective and customized management of enterprise applications and information technology. Comprised of a suite of third-party and proprietary products, NaviView^TM provides tools designed specifically to meet the needs of customers who outsource their IT needs. We also use this platform for electronic software distribution for software vendors and to enable software to be delivered on-demand over the Internet, providing an alternative delivery model to the traditional licensed software model.

We believe that the combination of NaviView^TM with our physical infrastructure and technical staff gives us a unique ability to provision on-demand application services for software providers for use by their customers. NaviView^TM is application and operating platform neutral as its on-demand provisioning capability is not dependent on the individual software application. Designed to enable enterprise software applications to be provisioned and used as an on-demand solution, the NaviView^TM technology allows us to offer new solutions to our software vendors and new products to our current customers.

We currently operate in 13 data centers in the United States and one data center in the United Kingdom. We believe that our data centers and infrastructure have the capacity necessary to expand our business for the foreseeable future. Our services combine our developed infrastructure with established processes and procedures for delivering hosting and application management services. Our high availability infrastructure, high performance monitoring systems, and proactive and collaborative problem resolution and change management processes are designed to identify and address potentially crippling problems before they are able to disrupt our customers’ operations.

We currently service approximately 920 hosted customers. Our hosted customers typically enter into service agreements for a term of one to three years, which provide for monthly payment installments, providing us with a base of recurring revenue. Our revenue increases by adding new customers or additional services to existing customers. Our overall base of recurring revenue is affected by new customers, renewals and terminations of agreements with existing customers.

In recent years, we have grown through business acquisitions and have restructured our operations. Specifically, in December 2002, we completed a common control merger with CBTM; in February 2003, we acquired Avasta; in April 2003, we acquired Conxion; in May 2003, we acquired assets of Interliant; in August 2003 and April 2004, we completed a common control merger with certain subsidiaries of CBT; and in June 2004, we acquired substantially all of the assets and liabilities of Surebridge, Inc. (now known as Waythere, Inc.). In January 2005, we formed NaviSite India Private Limited, a New Delhi-based operation which is intended to expand our international capability. NaviSite India will provide a range of software services, including design and development of custom and e-commerce solutions, application management, problem resolution management and the deployment and management of IT networks, customer specific infrastructure and data center infrastructure. We expect to make

additional acquisitions to take advantage of our available capacity, which will have significant effects on our financial results in the future.

Results of Operations for the Three and Nine Months Ended April 30, 2006 and 2005

The following table sets forth the percentage relationships of certain items from our Condensed Consolidated Statements of Operations as a percentage of total revenue.


	Three Months Ended						Nine Months Ended
	April 30,						April 30,
	2006			2005			2006			2005
Revenue		99.7	%		99.9	%		99.8	%		99.9	%
Revenue, related parties		0.3	%		0.1	%		0.2	%		0.1	%

Total revenue		100.0	%		100.0	%		100.0	%		100.0	%


Cost of revenue		68.5	%		70.5	%		69.7	%		74.1	%
Impairment, restructuring and other		0.0	%		1.4	%		0.0	%		0.5	%

Total cost of revenue		68.5	%		71.9	%		69.7	%		74.6	%


Gross profit		31.5	%		28.1	%		30.3	%		25.4	%

Operating expenses:
Selling and marketing		15.3	%		12.9	%		14.4	%		12.0	%
General and administrative		19.5	%		20.1	%		20.6	%		21.1	%
Impairment, restructuring and other		0.5	%		(1.7	)%		0.6	%		1.3	%

Total operating expenses		35.3	%		31.3	%		35.7	%		34.4	%

Loss from operations		(3.8	)%		(3.2	)%		(5.3	)%		(9.0	)%

Other income (expense):
Interest income		0.5	%		0.1	%		0.2	%		0.1	%
Interest expense		(8.5	)%		(7.4	)%		(8.0	)%		(6.9	)%
Other income (expense), net		0.5	%		0.3	%		0.5	%		0.2	%

Loss before income tax expense		(11.3	)%		(10.2	)%		(12.6	)%		(15.7	)%
Income tax expense		(1.0	)%		(1.1	)%		(1.1	)%		(1.3	)%

Net loss		(12.3	)%		(11.3	)%		(13.7	)%		(16.9	)%

Comparison of the Three and Nine Months Ended April 30, 2006 and 2005

Revenue

We derive our revenue from managed IT services, including hosting, colocation and application services comprised of a variety of service offerings and professional services, to mid-market companies and organizations, including mid-sized companies, divisions of large multi-national companies and government agencies.

Total revenue for the three months ended April 30, 2006 increased 4.1% to approximately $27.9 million from approximately $26.8 million for the three months ended April 30, 2005. The overall growth of $1.1 million in revenue was mainly due to the increased sales to new and existing customers. Revenue from related parties during the three months ended April 30, 2006 and 2005 totaled $73,000 and $34,000, respectively.

Total revenue for the nine months ended April 30, 2006 decreased 5.4% to approximately $79.5 million from approximately $84.0 million for the nine months ended April 30, 2005. Approximately $3.2 million of the overall reduction of $4.5 million is attributable to the sale of the Microsoft Business Solutions Software Resell and Professional Services Practice in July 2005, with the remaining decrease in revenue attributable to net lost customer revenue. Revenue from related parties during the nine months ended April 30, 2006 and 2005 totaled $144,000 and $102,000, respectively.

One unrelated customer accounted for 10% and 8% of our total revenue during the first nine months of fiscal year 2006 and 2005, respectively.

Cost of Revenue

Cost of revenue consists primarily of salaries and benefits for operations personnel, bandwidth fees and related Internet connectivity charges, equipment costs and related depreciation and costs to run our data centers, such as rent and utilities.

Total cost of revenue for the three months ended April 30, 2006, decreased approximately 1.0% to $19.1 million from approximately $19.3 million for the three months ended April 30, 2005. As a percentage of revenue, total cost of revenue decreased from 71.9% of revenue for the three months ended April 30, 2005 to 68.5% of revenue for the three months ended April 30, 2006. The decrease in cost of revenue of $0.2 million resulted primarily from decreased salary expense resulting from a reduction in headcount, a decrease in hardware and software maintenance costs, costs related to the sale of our MBS practice, depreciation and amortization and facilities related charges, partially offset by the effect of implementing SFAS 123R. During the three months ended April 30, 2005, we recorded a $381,000 lease abandonment charge related to certain data center leases as a component of total cost of revenue. No such charge was recorded during the same period of fiscal year 2006.

Total cost of revenue for the nine months ended April 30, 2006, decreased approximately 11.6% to $55.5 million from approximately $62.8 million for the nine months ended April 30, 2005. As a percentage of revenue, total cost of revenue decreased from 74.6% of revenue for the nine months ended April 30, 2005 to 69.7% of revenue for the nine months ended April 30, 2006. The decrease in cost of revenue of $7.3 million resulted primarily from decreased salary expense resulting from a reduction in headcount, a decrease in hardware and software maintenance costs, costs related to the sale of our MBS practice, depreciation and amortization and facilities related charges, partially offset by the effect of implementing SFAS 123R. During the first nine months of fiscal year 2005, we recorded a $415,000 lease abandonment charge related to certain data center leases as a component of total cost of revenue. No such charge was recorded during the same period of fiscal year 2006.

Gross Profit

Gross profit of $8.8 million for the three months ended April 30, 2006 increased approximately $1.3 million, or 16.8%, from a gross profit of approximately $7.5 million for the three months ended April 30, 2005. Gross profit for the third fiscal quarter of 2006 represented 31.5% of total revenue, as compared to 28.1% of total revenue for the third fiscal quarter of 2005.

Gross profit of $24.2 million for the nine months ended April 30, 2006 increased approximately $2.9 million, or 13.6%, from a gross profit of approximately $21.3 million for the nine months ended April 30, 2005. Gross profit for the first nine months of fiscal year 2006 represented 30.3% of total revenue, as compared to 25.4% of total revenue for the comparable period last year. The gross profit increase for the three and nine month period was primarily due to the decrease in cost of revenue as discussed above.

Operating Expenses

Selling and Marketing. Selling and marketing expense consists primarily of salaries and related benefits, commissions and marketing expenses such as advertising, traveling, product literature, trade shows, and marketing and direct mail programs.

Selling and marketing expense increased 23.4% to approximately $4.3 million, or 15.3% of total revenue, during the three months ended April 30, 2006 from approximately $3.5 million, or 12.9% of total revenue, during the three months ended April 30, 2005. The increase of approximately $0.8 million resulted primarily from the effect of implementing SFAS 123R, and the increase of marketing program spending, partially offset by a decrease in headcount related expenses.

Selling and marketing expense increased 14.1% to approximately $11.5 million, or 14.4% of total revenue, during the nine months ended April 30, 2006 from approximately $10.1 million, or 12.0% of total revenue, during the nine months ended April 30, 2005. The increase of approximately $1.4 million resulted primarily from the effect of implementing SFAS 123R, and the increase of marketing program spending, partially offset by a decrease in headcount related expenses.

General and Administrative. General and administrative expense includes the costs of financial, human resources, IT and administrative personnel, professional services, bad debt and corporate overhead.

General and administrative expense of approximately $5.4 million during the three months ended April 30, 2006 and 2005, slightly decreased as a percentage of total revenue from 20.1% to 19.5%. The decrease of approximately 0.6% was primarily the result of decreased salary expense resulting from a decreased headcount, decrease in bad debt expense and increase in revenue, partially offset by the effect of implementing SFAS 123R.

General and administrative expense decreased 7.7% to approximately $16.4 million, or 20.6% of total revenue, during the nine months ended April 30, 2006 from approximately $17.8 million, or 21.1% of total revenue, during the nine months ended April 30, 2005. The decrease of approximately $1.4 million was primarily the result of decreased salary expense resulting from a decreased headcount and decrease in bad debt expense, partially offset by the effect of implementing SFAS 123R.

Operating Expenses — Impairment, Restructuring and Other

Costs associated with the abandonment of leased facilities and the impairment of property and equipment included in impairment, restructuring and other expense within operating expenses were approximately $0.1 million during the three months ended April 30, 2006, as compared to a gain of approximately $0.4 million during the three months ended April 30, 2005. The $0.1 million charge during the third fiscal quarter of 2006 related to revised assumptions associated with our impaired facilities. During the three months ended April 30, 2005, the Company settled an impairment for our La Jolla, CA facility, which resulted in a $0.6 million credit, partially offset by revised assumptions associated with our impaired facilities.

Costs associated with the abandonment of leased facilities and the impairment of property and equipment included in impairment, restructuring and other expense within operating expenses were approximately $0.5 million during the nine months ended April 30, 2006, as compared to approximately $1.1 million during the nine months ended April 30, 2005. The $0.5 million charge recorded during the first nine months of fiscal year 2006 related to revised assumptions associated with our impaired facilities. The $1.1 million charge recorded during the first half of fiscal year 2005 related to revised assumptions associated with our impaired facilities, the abandonment of an administrative facility and an impairment charge for property and equipment, consisting primarily of leasehold improvements, relating to the same location, which was partially offset by a credit in third quarter as explained above.

Interest Income

During the three and nine months ended April 30, 2006, interest income increased 552.4% and 289.8%, respectively, from the comparable prior periods to approximately $137,000 and $191,000, respectively. The increase of $116,000 and $142,000 for the three and nine month periods is mainly due to an increase in the rate of interest on

our security deposits, interest earned on our escrow account and interest on a settlement awarded by the court in favor of the Company.

Interest Expense

During the three and nine months ended April 30, 2006, interest expense increased 19.1% and 9.4%, respectively, from the comparable prior year periods to approximately $2.4 million and $6.4 million, respectively. The increase of $0.4 million and $0.5 million for the three and nine month periods is primarily related to amounts drawn during the third quarter on our Term Loan, the addition of capital leases and an increase in the rate of interest on our financing line with SVB.

Income Tax Expense

Liquidity and Capital Resources

As of April 30, 2006, our principal sources of liquidity included cash and cash equivalents, a revolving credit facility of $3 million provided by Silver Point and a term loan agreement with Atlantic Investors LLC, for a maximum amount of $5 million. We had a working capital deficit of $11.3 million, including cash and cash equivalents of $0.7 million at April 30, 2006, as compared to a working capital deficit of $77.6 million, including cash and cash equivalents of $6.8 million, at July 31, 2005.

The total net change in cash and cash equivalents for the nine months ended April 30, 2006 was a decrease of $6.1 million. The primary uses of cash during the nine months ended April 30, 2006 included $7.7 million of cash used for operating activities, $4.3 million for purchases of property and equipment and approximately $58.6 million in repayments on notes payable and capital lease obligations. Our financing activities during the nine months ended April 30, 2006 provided approximately $71.0 million of cash consisting primarily of $70.0 million in proceeds from a term loan, $0.5 million in proceeds received from exercise of stock options and $0.4 million in proceeds from notes payable. Net cash used for operating activities of $7.7 million during the nine months ended April 30, 2006, resulted primarily from funding our $10.9 million net loss and $11.0 million of net changes in operating assets and liabilities, which was partially offset by non-cash charges of approximately $14.2 million. At April 30, 2006, we had an accumulated deficit of $466.8 million. We have reported losses from operations since incorporation. At July 31, 2005, we had an accumulated deficit of $455.9 million.

(a) April 11, 2011, and (b) the date all obligations under Silver Point Credit Facility have been paid in full. Credit advances under the Atlantic Term Loan shall bear interest at either: (a) 7% per annum plus, the greater of (i) Prime Rate, and (ii) the Federal Funds Effective Rate plus 3% or (b) 8% plus the floating rate of LIBOR. Interest may be paid in cash or quarterly by promissory notes executed by the Company on behalf of Atlantic. As of April 30, 2006, we had no amounts outstanding under our Term Loan with Atlantic Investors LLC.

Recent Accounting Pronouncements

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections: A Replacement of APB Opinion No. 20 and SFAS No. 3.” This statement changes the requirements for the accounting for and reporting of a voluntary change in accounting principle, and also applies to instances when an accounting pronouncement does not include specific transition provisions. The statement replaces the previous requirement that voluntary changes be recognized by including the cumulative effect of the change in net income of the period of the change. The statement requires retrospective application of a new accounting principle to prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. The statement is effective for changes and corrections made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of the statement to have a material effect on its financial condition, results of operations or cash flows.

additional-paid-in-capital pool as prescribed in SFAS No. 123(R), Share-Based Payment, or the alternative transition method as described in the FSP. An entity that adopts SFAS No. 123(R) using the modified prospective application may make a one-time election to adopt the transition method described in this FSP. An entity may take up to one year from the later of its initial adoption of SFAS No. 123(R) or the effective date of this FSP to evaluate its available transition alternatives and make its one-time election. This FSP became effective in November 2005. We continue to evaluate the impact that the adoption of this FSP could have on our financial statements.

Contractual Obligations and Commercial Commitments


			Less than						More than
Description	Total		1 Year		1-3 Years		4-5 Years		5 Years
	(In thousands)
Short/Long-term debt	$	79,791	$	7,171	$	14,009	$	58,611	$	—
Interest on debt		36,586		7,770		13,549		15,267		—
Capital leases		2,598		2,156		442		—		—
Operating leases		39		39		—		—		—
Bandwidth commitments		2,465		1,743		722		—		—
Maintenance for hardware/software		261		237		24		—		—
Property leases ^(a-b)		45,424		9,918		15,422		6,423		13,661

	$	167,164	$	29,034	$	44,168	$	80,301	$	13,661

(a)Amounts exclude certain common area maintenance and other property charges that are not included within the lease payment.

With respect to the property lease commitments listed above, certain cash is restricted pursuant to terms of lease agreements with landlords. At April 30, 2006, this restricted cash of approximately $1.1 million on the accompanying Condensed Consolidated Balance Sheet consisted of certificates of deposit and a treasury note and are recorded at cost, which approximates fair value.

Off-Balance Sheet Financing Arrangements

The Company does not have any off-balance sheet financing arrangements other than operating leases, which are recorded in accordance with generally accepted accounting principles.

Critical Accounting Policies

We prepare our consolidated financial statements in accordance with generally accepted accounting principles in the United States of America. As such, management is required to make certain estimates, judgments and assumptions that it believes are reasonable based on the information available. These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the periods presented. The significant accounting policies which management believes are the most critical to aid in fully understanding and evaluating our reported financial results include revenue recognition, allowance for doubtful accounts and impairment of long-lived assets. Management reviews the estimates on a regular basis and makes adjustments based on historical experiences, current conditions and future expectations. The reviews are performed regularly and adjustments are made as required by current available information. We believe these estimates are reasonable, but actual results could differ from these estimates.

Revenue Recognition. Revenue consists of monthly fees for Web site and Internet custom and packaged application management, hosting, colocation and professional services. The Company also derives revenue from the sale of software and related maintenance contracts. Reimbursable expenses charged to clients are included in revenue and cost of revenue. Application management, hosting and colocation revenue (other than installation fees) is billed and recognized over the term of the contract, generally one to three years, based on actual usage. Payments received in advance of providing services are deferred until the period such services are provided. Revenue from professional services, application management, hosting and colocation revenue is recognized on either a time-and material basis as the services are performed or under the percentage of completion method for fixed-price contracts. We generally sell our professional services under contracts with terms ranging from one to five years. When current contract estimates indicate that a loss is probable, a provision is made for the total anticipated loss in the current period. Contract losses are determined to be the amount by which the estimated service costs of the contract exceed the estimated revenue that will be generated by the contract. Unbilled accounts receivable represents revenue for services performed that have not been billed. Billings in excess of revenue recognized are recorded as deferred revenue until the applicable revenue recognition criteria are met. Revenue from the sale of software is recognized when persuasive evidence of an arrangement exists, the product has been delivered, the fees are fixed and determinable and collection of the resulting receivable is reasonably assured. In instances where the Company also provides application management and hosting services in conjunction with the sale of software, software revenue is deferred and recognized ratably over the expected customer relationship period. If we determine that collection of a fee is not reasonably assured, we defer the fee and recognize revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash.

Existing customers are subject to ongoing credit evaluations based on payment history and other factors. If it is determined subsequent to our initial evaluation and at any time during the arrangement that collectability is not reasonably assured, revenue is recognized as cash is received. Due to the nature of our service arrangements, we provide written notice of termination of services, typically 10 days in advance of disconnecting a customer. Revenue for services rendered during this notification period is generally recognized on a cash basis as collectability is not considered probable at the time the services are provided.

Allowance for Doubtful Accounts. We perform periodic credit evaluations of our customers’ financial conditions and generally do not require collateral or other security against trade receivables. We make estimates of the uncollectability of our accounts receivables and maintain an allowance for doubtful accounts for potential credit losses. We specifically analyze accounts receivable and consider historical bad debts, customer and industry concentrations, customer credit-worthiness, current economic trends and changes in our customer payment patterns when evaluating the adequacy of the allowance for doubtful accounts. We specifically reserve for 100% of the balance of customer accounts deemed uncollectible. For all other customer accounts, we reserve for 20% of the balance over 90 days old and 2% of all other customer balances. Changes in economic conditions or the financial viability of our customers may result in additional provisions for doubtful accounts in excess of our current estimate.

Impairment of Long-lived Assets. We review our long-lived assets, subject to amortization and depreciation, including customer lists and property and equipment, for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. Factors we consider important that could trigger an interim impairment review include:

	•		significant underperformance relative to expected historical or projected future operating results;

	•		significant changes in the manner of our use of the acquired assets or the strategy of our overall business;

	•		significant negative industry or economic trends;

	•		significant declines in our stock price for a sustained period; and

	•		our market capitalization relative to net book value.

Recoverability is measured by a comparison of the carrying amount of an asset to future undiscounted cash flows expected to be generated by the asset. If the assets were considered to be impaired, the impairment to be recognized would be measured by the amount by which the carrying value of the assets exceeds their fair value. Fair value is determined based on discounted cash flows or appraised values, depending on the nature of the asset. Assets to be disposed of are valued at the lower of the carrying amount or their fair value less disposal costs. Property and equipment is primarily comprised of leasehold improvements, computer and office equipment and software licenses. Intangible assets consist of customer lists.

We review the valuation of our goodwill in the fourth quarter of each fiscal year. If an event or circumstance indicates that it is more likely than not an impairment loss has been incurred, we review the valuation of goodwill on an interim basis. An impairment loss is recognized to the extent that the carrying amount of goodwill exceeds its implied fair value. Impairment losses are recognized in operation.

Risk Factors That May Affect Future Results

We operate in a rapidly changing environment that involves a number of risks, some of which are beyond our control. Forward-looking statements in this report and those made from time to time by us through our senior management are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements concerning the expected future revenues, earnings or financial results or concerning project plans, performance, or development of products and services, as well as other estimates related to future operations are necessarily only estimates of future results and we cannot assure you that actual results will not materially differ from expectations. Forward-looking statements represent management’s current expectations and are inherently uncertain. We do not undertake any obligation to update forward-looking statements. If any of the following risks actually occurs, our business, financial condition and operating results could be materially adversely affected.

We have a history of losses and may never achieve or sustain profitability and may not continue as a going concern. We have never been profitable and may never become profitable. Since our incorporation in 1998, we have experienced operating losses and negative cash flows for each annual period. As of April 30, 2006, we had incurred losses since our incorporation resulting in an accumulated deficit of approximately $466.8 million. During the fiscal quarter ended April 30, 2006, we had a net loss of approximately $3.4 million. The audit report from KPMG LLP, our independent registered public accounting firm, relating to our fiscal year 2005 financial statements contains KPMG’s opinion that our recurring losses from operations since inception and accumulated deficit, as well as other factors, raise substantial doubt about our ability to continue as a going concern. We anticipate that we will continue to incur net losses in the future. We also have significant fixed commitments, including with respect to real estate, bandwidth commitments and equipment leases. As a result, we can give no assurance that we will achieve profitability or be capable of sustaining profitable operations. If we are unable to reach and sustain profitability, we risk depleting our working capital balances and our business may not continue as a going concern.

Our financing agreement with Silver Point Finance includes various covenants and restrictions that may negatively affect our liquidity and our ability to operate and manage our business. As of April 30, 2006, we owed Silver Point Finance approximately $70.1 million under our financing agreement. The financing agreement:

	•		restricts our ability to create or incur additional indebtedness;

	•		restricts our ability to create, incur, assume or permit to exist any lien or security interest in, any of our assets, excluding certain limited exemptions;

	•		restricts our ability to make investments including joint ventures, with certain limited exemptions;

	•		requires that we meet financial covenants for fixed charges, leverage, adjusted EBITDA, capital expenditures and minimum bookings;

	•		restricts our ability to enter into any transaction of merger, consolidation or liquidation;

	•		restricts our ability to enter into any transaction with any holder of more than 5% of any class of capital stock except in the ordinary course of business; and

	•		restricts our ability to amend our organizational documents.

If we breach our senior secured term loan facility with Silver Point Finance, a default could result. A default, if not waived, could result in, among other things, us not being able to borrow additional amounts from Silver Point Finance. In addition, all or a portion of our outstanding amounts may become due and payable on an accelerated basis, which would adversely affect our liquidity and our ability to manage our business. The principal amounts of our senior secured term loan facility with Silver Point Finance are to be repaid in consecutive quarterly installments of increasing amounts beginning on April 30, 2007, while interest-only payments are to be made in consecutive quarterly installments beginning in July 2006. All amounts due and outstanding under the financing agreement are due to be repaid in full by April 11, 2011. In addition, our senior secured term loan facility with Silver Point Finance exposes us to interest rate fluctuations which could significantly increase the interest we pay Silver Point Finance. We are required, under our senior secured term loan facility with Silver Point Finance, to purchase interest rate protection which shall effectively limit the unadjusted LIBOR component of the interest costs of our loan with respect to not less than 70% of the principal amount at a rate of not more than 6.5% per annum. Had our senior secured term loan facility with Silver Point Finance been outstanding for the full quarter, a hypothetical 100 basis point increase in our LIBOR rate would have resulted in an approximate $0.2 million increase in our interest expense for the three months ended April 30, 2006.

A significant portion of our revenue comes from one customer and, if we lost this customer, it would have a significant adverse impact on our business results and cash flows. The New York State Department of Labor represented approximately 10% of our consolidated revenue for the nine months ended April 30, 2006. The New York State Department of Labor has multiple contracts with us and has been a long-term customer of ours, but we cannot assure you that we will be able to retain all of the contracts with this customer. We also cannot assure you that we will be able to maintain the same level of service to this customer or that our revenue from this customer will not significantly decline in future periods. On August 16, 2005, we entered into a new agreement with the New York State Department of Labor with a two year term which is set to expire on June 14, 2007. The New York State Department of Labor is not obligated under our new agreement to buy a minimum amount of services from us or designate us as its sole supplier of any particular service. Further, The New York State Department of Labor has the right to terminate the new agreement at any time by providing us with 60 days notice. If we were to lose this customer or suffer a material reduction in the revenue generated from this customer, it would have a significant adverse impact on our business results and cash flows.

Atlantic Investors, LLC may have interests that conflict with the interests of our other stockholders and, as our majority stockholder, can prevent new and existing investors from influencing significant corporate decisions. Atlantic Investors, LLC owns approximately 60% of our outstanding capital stock. Following the closing of our senior secured term loan facility with Silver Point Finance on April 11, 2006, Atlantic Investors’ ownership was approximately 43% on a fully diluted basis. In addition, Atlantic Investors holds a promissory note in the principal amount of $3.0 million, the maturity date of which was extended, pursuant to an amended loan agreement dated April 11, 2006, to 90 days after the maturity date of the Silver Point Finance loan facility. As of April 30, 2006, we had recorded accrued interest on this note in the amount of $0.7 million. Atlantic Investors has the power, acting alone, to elect a majority of our Board of Directors and has the ability to control our management and affairs and determine the outcome of any corporate action requiring stockholder approval. Regardless of how our other stockholders may vote, Atlantic Investors has the ability to control the election of directors and to determine whether to engage in a merger, consolidation or sale of our assets and any other significant corporate transaction. Under Delaware law, Atlantic Investors is able to exercise its voting power by written consent, without convening a meeting of the stockholders. Atlantic Investors’ ownership of a majority of our outstanding common stock may have the effect of delaying, deterring or preventing a change in control of us or discouraging a potential acquiror from attempting to obtain control of us, which could adversely affect the market price of our common stock.

Members of our management group also have significant interests in Atlantic Investors, LLC, which may create conflicts of interest. Some of the members of our management group also serve as members of the management group of Atlantic Investors, LLC and its affiliates. Specifically, Andrew Ruhan, our Chairman of the Board, holds a 10% equity interest in Unicorn Worldwide Holdings Limited, a managing member of Atlantic Investors. Arthur Becker, our President and Chief Executive Officer and a member of our Board of Directors, is the managing member of Madison Technology LLC, a managing member of Atlantic Investors. As a result, these officers and directors may face potential conflicts of interest with each other and with our stockholders. They may be presented with situations in their capacity as our officers or directors that conflict with their fiduciary obligations to Atlantic Investors, which in turn may have interests that conflict with the interests of our other stockholders.

Our common stockholders may suffer dilution in the future upon exercise of outstanding convertible securities or the issuance of additional securities in potential future acquisitions or financings. In connection with our financing agreement with Silver Point Finance we issued warrants to Silver Point Finance to purchase an aggregate of 3,514,933 shares of our common stock. If the warrants are exercised, Silver Point Finance may obtain a significant equity interest in NaviSite and other stockholders may experience significant and immediate dilution.

We may need to raise additional capital through various other equity or debt financings, and such capital may not be available on favorable terms or at all. Our stockholders will also experience dilution to the extent that additional shares of our common stock are issued in potential future acquisitions or financings.

Acquisitions may result in disruptions to our business or distractions of our management due to difficulties in integrating acquired personnel and operations, and these integrations may not proceed as planned. Since December 2002, we have acquired CBTM (accounted for as an “as if pooling”), Avasta, Conxion, selected assets of Interliant, all of the shares of ten wholly-owned subsidiaries of CBT (accounted for as an “as if pooling”) and substantially all of the assets and liabilities of Surebridge. We intend to continue to expand our business through the acquisition of companies, technologies, products and services. Acquisitions involve a number of special problems and risks, including:

	•		difficulty integrating acquired technologies, products, services, operations and personnel with the existing businesses;

	•		difficulty maintaining relationships with important third parties, including those relating to marketing alliances and providing preferred partner status and favorable pricing;

	•		diversion of management’s attention in connection with both negotiating the acquisitions and integrating the businesses;

	•		strain on managerial and operational resources as management tries to oversee larger operations;

	•		inability to retain and motivate management and other key personnel of the acquired businesses;

	•		exposure to unforeseen liabilities of acquired companies;

	•		potential costly and time-consuming litigation, including stockholder lawsuits;

	•		potential issuance of securities in connection with an acquisition with rights that are superior to the rights of holders of our common stock, or which may have a dilutive effect on our common stockholders;

	•		the need to incur additional debt or use cash; and

	•		the requirement to record potentially significant additional future operating costs for the amortization of intangible assets.

As a result of these problems and risks, businesses we acquire may not produce the revenues, earnings or business synergies that we anticipated, and acquired products, services or technologies might not perform as we expected. As a result, we may incur higher costs and realize lower revenues than we had anticipated. We may not be able to successfully address these problems and we cannot assure you that the acquisitions will be successfully identified and completed or that, if acquisitions are completed, the acquired businesses, products, services or technologies will generate sufficient revenue to offset the associated costs or other harmful effects on our business. In addition, our limited operating history with our current structure resulting from recent acquisitions makes it very difficult for you and us to evaluate or predict our ability to, among other things, retain customers, generate and sustain a revenue base sufficient to meet our operating expenses, and achieve and sustain profitability.

A failure to meet customer specifications or expectations could result in lost revenues, increased expenses, negative publicity, claims for damages and harm to our reputation and cause demand for our services to decline. Our agreements with customers require us to meet specified service levels for the services we provide. In addition, our customers may have additional expectations about our services. Any failure to meet customers’ specifications or expectations could result in:

	•		delayed or lost revenue;

	•		requirements to provide additional services to a customer at reduced charges or no charge;

	•		negative publicity about us, which could adversely affect our ability to attract or retain customers; and

	•		claims by customers for substantial damages against us, regardless of our responsibility for the failure, which may not be covered by insurance policies and which may not be limited by contractual terms of our engagement.

Our ability to successfully market our services could be substantially impaired if we are unable to deploy new infrastructure systems and applications or if new infrastructure systems and applications deployed by us prove to be unreliable, defective or incompatible. We may experience difficulties that could delay or prevent the successful development, introduction or marketing of hosting and application management services in the future. If any newly introduced infrastructure systems and applications suffer from reliability, quality or compatibility problems, market acceptance of our services could be greatly hindered and our ability to attract new customers could be significantly reduced. We cannot assure you that new applications deployed by us will be free from any reliability, quality or compatibility problems. If we incur increased costs or are unable, for technical or other reasons, to host and manage new infrastructure systems and applications or enhancements of existing applications, our ability to successfully market our services could be substantially limited.

Any interruptions in, or degradation of, our private transit Internet connections could result in the loss of customers or hinder our ability to attract new customers. Our customers rely on our ability to move their digital content as efficiently as possible to the people accessing their Web sites and infrastructure systems and applications. We utilize our direct private transit Internet connections to major network providers, such as Level 3, Global Crossing and XO Communications, as a means of avoiding congestion and resulting performance degradation at public Internet exchange points. We rely on these telecommunications network suppliers to maintain the operational integrity of their networks so that our private transit Internet connections operate effectively. If our private transit Internet connections are interrupted or degraded, we may face claims by, or lose, customers, and our reputation in the industry may be harmed, which may cause demand for our services to decline.

If we are unable to maintain existing and develop additional relationships with software vendors, the sales and marketing of our service offerings may be unsuccessful. We believe that to penetrate the market for managed IT services we must maintain existing and develop additional relationships with industry-leading software vendors. We license or lease select software applications from software vendors, including IBM, Microsoft, Micromuse and Oracle. Our relationships with Microsoft and Oracle are critical to the operations and success of our business. The loss of our ability to continue to obtain, utilize or depend on any of these applications or relationships could substantially weaken our ability to provide services to our customers. It may also require us to obtain substitute software applications that may be of lower quality or performance standards or at greater cost. In addition, because we generally license applications on a non-exclusive basis, our competitors may license and utilize the same software applications. In fact, many of the companies with which we have strategic relationships currently have, or could enter into, similar license agreements with our competitors or prospective competitors. We cannot assure you that software applications will continue to be available to us from software vendors on commercially reasonable terms. If we are unable to identify and license software applications that meet our targeted criteria for new application introductions, we may have to discontinue or delay introduction of services relating to these applications.

Our network infrastructure could fail, which would impair our ability to provide guaranteed levels of service and could result in significant operating losses. To provide our customers with guaranteed levels of service, we must operate our network infrastructure 24 hours a day, seven days a week without interruption. We must, therefore, protect our network infrastructure, equipment and customer files against damage from human error, natural disasters, unexpected equipment failure, power loss or telecommunications failures, terrorism, sabotage or other intentional acts of vandalism. Even if we take precautions, the occurrence of a natural disaster, equipment failure or other unanticipated problem at one or more of our data centers could result in interruptions in the services we provide to our customers. We cannot assure you that our disaster recovery plan will address all, or even most, of

the problems we may encounter in the event of a disaster or other unanticipated problem. We have experienced service interruptions in the past, and any future service interruptions could:

	•		require us to spend substantial amounts of money to replace equipment or facilities;

	•		entitle customers to claim service credits or seek damages for losses under our service level guarantees;

	•		cause customers to seek alternate providers; or

	•		impede our ability to attract new customers, retain current customers or enter into additional strategic relationships.

Our dependence on third parties increases the risk that we will not be able to meet our customers’ needs for software, systems and services on a timely or cost-effective basis, which could result in the loss of customers. Our services and infrastructure rely on products and services of third-party providers. We purchase key components of our infrastructure, including networking equipment, from a limited number of suppliers, such as IBM, Cisco Systems, F5 Networks, Microsoft and Oracle. We cannot assure you that we will not experience operational problems attributable to the installation, implementation, integration, performance, features or functionality of third-party software, systems and services. We cannot assure you that we will have the necessary hardware or parts on hand or that our suppliers will be able to provide them in a timely manner in the event of equipment failure. Our ability to timely obtain and continue to maintain the necessary hardware or parts could result in sustained equipment failure and a loss of revenue due to customer loss or claims for service credits under our service level guarantees.

We could be subject to increased operating costs, as well as claims, litigation or other potential liability, in connection with risks associated with Internet security and the security of our systems. A significant barrier to the growth of e-commerce and communications over the Internet has been the need for secure transmission of confidential information. Several of our infrastructure systems and application services use encryption and authentication technology licensed from third parties to provide the protections necessary to ensure secure transmission of confidential information. We also rely on security systems designed by third parties and the personnel in our network operations centers to secure those data centers. Any unauthorized access, computer viruses, accidental or intentional actions and other disruptions could result in increased operating costs. For example, we may incur additional significant costs to protect against these interruptions and the threat of security breaches or to alleviate problems caused by these interruptions or breaches. If a third party were able to misappropriate a consumer’s personal or proprietary information, including credit card information, during the use of an application solution provided by us, we could be subject to claims, litigation or other potential liability.

Third-party infringement claims against our technology suppliers, customers or us could result in disruptions in service, the loss of customers or costly and time-consuming litigation. We license or lease most technologies used in the infrastructure systems and application services that we offer. Our technology suppliers may become subject to third-party infringement or other claims and assertions, which could result in their inability or unwillingness to continue to license their technologies to us. We cannot assure you that third parties will not assert claims against us in the future or that these claims will not be successful. Any infringement claim as to our technologies or services, regardless of its merit, could result in delays in service, installation or upgrades, the loss of customers or costly and time-consuming litigation.

We may be subject to legal claims in connection with the information disseminated through our network, which could divert management’s attention and require us to expend significant financial resources. We may face liability for claims of defamation, negligence, copyright, patent or trademark infringement and other claims based on the nature of the materials disseminated through our network. For example, lawsuits may be brought against us claiming that content distributed by some of our customers may be regulated or banned. In these and other instances, we may be required to engage in protracted and expensive litigation that could have the effect of diverting management’s attention from our business and require us to expend significant financial resources. Our general liability insurance may not cover any of these claims or may not be adequate to protect us against all liability that may be imposed. In addition, on a limited number of occasions in the past, businesses, organizations and individuals have sent unsolicited commercial e-mails from servers hosted at our facilities to a number of people, typically to advertise products or services. This practice, known as “spamming,” can lead to statutory liability as well as

complaints against service providers that enable these activities, particularly where recipients view the materials received as offensive. We have in the past received, and may in the future receive, letters from recipients of information transmitted by our customers objecting to the transmission. Although we prohibit our customers by contract from spamming, we cannot assure you that our customers will not engage in this practice, which could subject us to claims for damages.

If we fail to attract or retain key officers, management and technical personnel, our ability to successfully execute our business strategy or to continue to provide services and technical support to our customers could be adversely affected and we may not be successful in attracting new customers. We believe that attracting, training, retaining and motivating technical and managerial personnel, including individuals with significant levels of infrastructure systems and application expertise, is a critical component of the future success of our business. Qualified technical personnel are likely to remain a limited resource for the foreseeable future and competition for these personnel is intense. The departure of any of our executive officers, particularly Arthur P. Becker, our Chief Executive Officer and President, or core members of our sales and marketing teams or technical service personnel, would have negative ramifications on our customer relations and operations. The departure of our executive officers could adversely affect the stability of our infrastructure and our ability to provide the guaranteed service levels our customers expect. Any officer or employee can terminate his or her relationship with us at any time. In addition, we do not carry life insurance on any of our personnel. Over the past two years, we have had significant reductions-in-force and departures of several members of senior management due to redundancies and restructurings resulting from the consolidation of our acquired companies. In the event of future reductions or departures of employees, our ability to successfully execute our business strategy, or to continue to provide services to our customers or attract new customers, could be adversely affected.

The unpredictability of our quarterly results may cause the trading price of our common stock to fluctuate or decline. Our quarterly operating results may vary significantly from quarter-to-quarter and period-to-period as a result of a number of factors, many of which are outside of our control and any one of which may cause our stock price to fluctuate. The primary factors that may affect our operating results include the following:

	•		a reduction of market demand and/or acceptance of our services;

	•		an oversupply of data center space in the industry;

	•		our ability to develop, market and introduce new services on a timely basis;

	•		the length of the sales cycle for our services;

	•		the timing and size of sales of our services, which depends on the budgets of our customers;

	•		downward price adjustments by our competitors;

	•		changes in the mix of services provided by our competitors;

	•		technical difficulties or system downtime affecting the Internet or our hosting operations;

	•		our ability to meet any increased technological demands of our customers; and

	•		the amount and timing of costs related to our marketing efforts and service introductions.

Due to the above factors, we believe that quarter-to-quarter or period-to-period comparisons of our operating results may not be a good indicator of our future performance. Our operating results for any particular quarter may fall short of our expectations or those of stockholders or securities analysts. In this event, the trading price of our common stock would likely fall.

If we are unsuccessful in pending and potential litigation matters, our financial condition may be adversely affected. We are currently involved in various pending and potential legal proceedings, including a class action lawsuit related to our initial public offering. If we are ultimately unsuccessful in any of these matters, we could be required to pay substantial amounts of cash to the other parties. The amount and timing of any of these payments could adversely affect our financial condition.

If the markets for outsourced information technology infrastructure and applications, Internet commerce and communication decline, there may be insufficient demand for our services and, as a result, our business strategy and objectives may fail. The increased use of the Internet for retrieving, sharing and transferring information among businesses and consumers is developing, and the market for the purchase of products and services over the Internet is still relatively new and emerging. Our industry has experienced periods of rapid growth, followed by a sharp decline in demand for products and services, which related to the failure in the last few years of

many companies focused on developing Internet-related businesses. If acceptance and growth of the Internet as a medium for commerce and communication declines, our business strategy and objectives may fail because there may not be sufficient market demand for our managed IT services.

If we do not respond to rapid changes in the technology sector, we will lose customers. The markets for the technology-related services we offer are characterized by rapidly changing technology, evolving industry standards, frequent new service introductions, shifting distribution channels and changing customer demands. We may not be able to adequately adapt our services or to acquire new services that can compete successfully. In addition, we may not be able to establish and maintain effective distribution channels. We risk losing customers to our competitors if we are unable to adapt to this rapidly evolving marketplace.

The market in which we operate is highly competitive and is likely to consolidate, and we may lack the financial and other resources, expertise or capability needed to capture increased market share or maintain market share. We compete in the managed IT services market. This market is rapidly evolving, highly competitive and likely to be characterized by over-capacity and industry consolidation. Our competitors may consolidate with one another or acquire software application vendors or technology providers, enabling them to more effectively compete with us. Many participants in this market have suffered significantly in the last several years. We believe that participants in this market must grow rapidly and achieve a significant presence to compete effectively. This consolidation could affect prices and other competitive factors in ways that would impede our ability to compete successfully in the managed IT services market.

Further, our business is not as developed as that of many of our competitors. Many of our competitors have substantially greater financial, technical and market resources, greater name recognition and more established relationships in the industry. Many of our competitors may be able to:

	•		develop and expand their network infrastructure and service offerings more rapidly;

	•		adapt to new or emerging technologies and changes in customer requirements more quickly;

	•		take advantage of acquisitions and other opportunities more readily; or

	•		devote greater resources to the marketing and sale of their services and adopt more aggressive pricing policies than we can.

We may lack the financial and other resources, expertise or capability needed to maintain or capture increased market share in this environment in the future. Because of these competitive factors and due to our comparatively small size and our lack of financial resources, we may be unable to successfully compete in the managed IT services market.

Difficulties presented by international economic, political, legal, accounting and business factors could harm our business in international markets. We operate a data center in the United Kingdom. Revenue from our foreign operations accounted for approximately 3.9% of our total revenue during the nine months ended April 30, 2006. We recently expanded our operations to India, which could eventually broaden our customer service support. Although we expect to focus most of our growth efforts in the United States, we may enter into joint ventures or outsourcing agreements with third parties, acquire complementary businesses or operations, or establish and maintain new operations outside of the United States. Some risks inherent in conducting business internationally include:

	•		unexpected changes in regulatory, tax and political environments;

	•		longer payment cycles and problems collecting accounts receivable;

	•		geopolitical risks such as political and economic instability and the possibility of hostilities among countries or terrorism;

	•		reduced protection of intellectual property rights;

	•		fluctuations in currency exchange rates or imposition of restrictive currency controls;

	•		our ability to secure and maintain the necessary physical and telecommunications infrastructure;

	•		challenges in staffing and managing foreign operations;

	•		employment laws and practices in foreign countries;

	•		laws and regulations on content distributed over the Internet that are more restrictive than those currently in place in the United States; and

•

significant changes in immigration policies or difficulties in obtaining required immigration approvals.

Any one or more of these factors could adversely affect our international operations and consequently, our business.

We may become subject to burdensome government regulation and legal uncertainties that could substantially harm our business or expose us to unanticipated liabilities. It is likely that laws and regulations directly applicable to the Internet or to hosting and managed application service providers may be adopted. These laws may cover a variety of issues, including user privacy and the pricing, characteristics and quality of products and services. The adoption or modification of laws or regulations relating to commerce over the Internet could substantially impair the growth of our business or expose us to unanticipated liabilities. Moreover, the applicability of existing laws to the Internet and hosting and managed application service providers is uncertain. These existing laws could expose us to substantial liability if they are found to be applicable to our business. For example, we provide services over the Internet in many states in the United States and elsewhere and facilitate the activities of our customers in these jurisdictions. As a result, we may be required to qualify to do business, be subject to taxation or be subject to other laws and regulations in these jurisdictions, even if we do not have a physical presence, employees or property in those states.

The price of our common stock has been volatile, and may continue to experience wide fluctuations. Since January 2005, our common stock has closed as low as $1.19 per share and as high as $5.45 per share. The trading price of our common stock has been and may continue to be subject to wide fluctuations due to the risk factors discussed in this section and elsewhere in this report. Fluctuations in the market price of our common stock may cause an investor in our common stock to lose some or all of his investment. In addition, should the market price of our common stock be below $1.00 per share for an extended period, or if we fail to satisfy any other Nasdaq continued listing requirement, Nasdaq may delist our common stock, which would have an adverse effect on the trading of our common stock. A delisting of our common stock from Nasdaq could materially reduce the liquidity of our common stock and result in a corresponding material reduction in the price of our common stock. In addition, a delisting could harm our ability to raise capital through alternative financing sources on terms acceptable to us, or at all, and may result in the potential loss of confidence by suppliers, customers and employees.

Anti-takeover provisions in our corporate documents may discourage or prevent a takeover. Provisions in our certificate of incorporation and our by-laws may have the effect of delaying or preventing an acquisition or merger in which we are acquired or a transaction that changes our Board of Directors. These provisions:

	•		authorize the board to issue preferred stock without stockholder approval;

	•		prohibit cumulative voting in the election of directors;

	•		limit the persons who may call special meetings of stockholders; and

	•		establish advance notice requirements for nominations for the election of directors or for proposing matters that can be acted on by stockholders at stockholder meetings.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We do not enter into financial instruments for trading purposes. We have not used derivative financial instruments or derivative commodity instruments in our investment portfolio or entered into hedging transactions, however, we are required to purchase, within 30 days from the closing of our senior secured term loan facility with Silver Point Finance, interest rate protection which shall effectively limit the unadjusted LIBOR component of the interest costs of our loan with respect to not less than 70% of the principal amount at a rate not more than 6.5% per annum. Our exposure to market risk associated with risk-sensitive instruments entered into for purposes other than trading purposes is not material to NaviSite. We currently have no significant foreign operations and therefore face no material foreign currency exchange rate risk. Our interest rate risk at April 30, 2006 was limited mainly to the London Interbank Offered Rate (LIBOR) on our outstanding loan with our senior secured term loan facility with Silver Point Finance. At April 30, 2006 we had no open derivative positions with respect to our borrowing arrangements. Had our senior secured term loan facility with Silver Point Finance been outstanding for the full quarter, a hypothetical 100 basis point increase in our LIBOR rate would have resulted in an approximate $0.2 million increase in our interest expense for the three months ended April 30, 2006.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures. Based on management’s evaluation (with the participation of NaviSite’s principal executive officer and principal financial officer) as of the end of the period covered by this report, NaviSite’s principal executive officer and principal financial officer have concluded that NaviSite’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)) are effective to ensure that information required to be disclosed by NaviSite in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that the information is accumulated and communicated to its management, including to its principal executive officer and principal financial officer as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control Over Financial Reporting. There was no change in NaviSite’s internal control over financial reporting during the third fiscal quarter that has materially affected, or is reasonably likely to materially affect, NaviSite’s internal control over financial reporting.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings

IPO Securities Litigation

seeks unspecified monetary damages and certification of a plaintiff class consisting of all persons who acquired shares of our common stock between October 22, 1999 and June 12, 2001.

litigation, we are not able to predict the possible outcome of the suits and their ultimate effect, if any, on our business, financial condition, results of operations or cash flows.

Item 4. Submission of Matters to a Vote of Security Holders.

On January 27, 2006, our Board of Directors approved, subject to stockholder approval, an amendment (the “Stock Plan Amendment”) to the Company’s Amended and Restated 2003 Stock Incentive Plan, as amended (the “2003 Plan”). The Stock Plan Amendment increased the maximum number of shares of common stock that may be issued under the 2003 Plan from 6,800,000 to 11,800,000 shares (subject to adjustment in the event of stock splits and other similar events).

On February 23, 2006, Atlantic Investors, LLC, our majority stockholder, delivered to us an executed written consent of stockholders, among other things, approving the Stock Plan Amendment. On or about March 15, 2006, we mailed an information statement on Schedule 14C to our stockholders pursuant to which we provided to our stockholders the notice required by Section 228 of the Delaware General Corporation Law regarding the written consent executed by Atlantic Investors and other information required to be included in the information statement by the rules and regulations of the Securities and Exchange Commission. Stockholder approval of the Stock Plan Amendment was effective as of April 6, 2006.

On April 11, 2006, we entered into a financing agreement with Silver Point Finance, LLC whereby Silver Point provided to us a $70 million senior secured term loan facility and a $3 million senior secured revolving credit facility. In connection with the financing agreement, we issued two warrants to purchase an aggregate of 3,514,933 shares of our common stock to Silver Point. The warrants are subject to potential weighted-average anti-dilution adjustments that could result in additional shares being issuable upon exercise of the warrants. The warrants also contain a limitation on the maximum number of shares issuable under the warrants, such that absent stockholder approval, the warrants may not be exercised for more than 5,728,108 shares of common stock, which is equal to approximately 19.999% of the outstanding shares of our common stock as of the date of issuance of the warrants. This conversion cap is intended to ensure the issuance of the warrants complies with NASD Rules governing The Nasdaq Capital Market. We agreed to use our best efforts to obtain stockholder approval of the issuance of the common stock upon exercise of the warrants for the purpose of terminating the effectiveness of the conversion cap. The warrants expire on April 11, 2016.

On April 11, 2006, Atlantic Investors delivered to us an executed written consent of stockholders approving the issuance of the shares of the common stock upon exercise of the warrants. On or about May 15, 2006, we mailed an information statement on Schedule 14C to our stockholders pursuant to which we provided to our stockholders the notice required by Section 228 of the Delaware General Corporation Law regarding the written consent executed by Atlantic Investors and other information required to be included in the information statement by the rules and regulations of the Securities and Exchange Commission. Stockholder approval of the issuance of the shares of the common stock upon exercise of the warrants was effective as of June 4, 2006.

SIGNATURE

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


June 14, 2006	NAVISITE, INC.

		By:	/s/ John J. Gavin, Jr.

			John J. Gavin Jr.
			(Principal Financial and Accounting Officer)

EXHIBIT INDEX


Exhibit
Number		Description
10.1		Credit and Guaranty Agreement, dated as of April 11, 2006, by and among the Registrant, Avasta, Inc., ClearBlue Technologies Management, Inc., ClearBlue Technologies/Chicago-Wells, Inc., ClearBlue Technologies/Las Vegas, Inc., ClearBlue Technologies/Los Angeles, Inc., ClearBlue Technologies/Milwaukee, Inc., ClearBlue Technologies/Oak Brook, Inc., ClearBlue Technologies/Vienna, Inc., ClearBlue Technologies/Dallas, Inc., ClearBlue Technologies/NewYork, Inc., ClearBlue Technologies/San Francisco, Inc., ClearBlue Technologies/Santa Clara, Inc., Conxion Corporation, Intrepid Acquisition Corp., Lexington Acquisition Corp., ManagedOps.com, Inc., Surebridge Acquisition Corp., Surebridge Services, Inc., SiteROCK Corporation, NaviSite Acquisition Subsidiary, Inc., ClickHear, Inc., SilverPoint Finance, LLC, Field Point I, Ltd., Field Point III, Ltd. and SPF CDO I, LLC.

10.2		Amendment No. 1 to Credit and Guaranty Agreement, dated as of June 2, 2006, by and among the Registrant, Avasta, Inc., ClearBlue Technologies Management, Inc., Clearblue Technologies/Chicago-Wells, Inc., Clearblue Technologies/Las Vegas, Inc., Clearblue Technologies/Los Angeles, Inc., Clearblue Technologies/Milwaukee, Inc., Clearblue Technologies/Oak Brook, Inc., Clearblue Technologies/Vienna, Inc., Clearblue Technologies/Dallas, Inc., Clearblue Technologies/New York, Inc., Clearblue Technologies/San Francisco, Inc., Clearblue Technologies/Santa Clara, Inc., Conxion Corporation, Intrepid Acquisition Corp., Lexington Acquisition Corp., ManagedOps.com, Inc., Surebridge Acquisition Corp., Surebridge Services, Inc., SiteROCK Corporation, NaviSite Acquisition Subsidiary, Inc., ClickHear, Inc., Silver Point Finance, LLC, Field Point I, Ltd., Field Point III, Ltd. and SPF CDO I, LLC.

10.3		Pledge and Security Agreement, dated as of April 11, 2006, by and among the Registrant, Avasta, Inc., ClearBlue Technologies Management, Inc., ClearBlue Technologies/Chicago-Wells, Inc., ClearBlue Technologies/Las Vegas, Inc., ClearBlue Technologies/Los Angeles, Inc., ClearBlue Technologies/Milwaukee, Inc., ClearBlue Technologies/Oak Brook, Inc., ClearBlue Technologies/Vienna, Inc., ClearBlue Technologies/Dallas, Inc., ClearBlue Technologies/NewYork, Inc., ClearBlue Technologies/San Francisco, Inc., ClearBlue Technologies/Santa Clara, Inc., Conxion Corporation, Intrepid Acquisition Corp., Lexington Acquisition Corp., ManagedOps.com, Inc., Surebridge Acquisition Corp., Surebridge Services, Inc., SiteROCK Corporation, NaviSite Acquisition Subsidiary, Inc., ClickHear, Inc., SilverPoint Finance, LLC, Field Point I, Ltd., Field Point III, Ltd. and SPF CDO I, LLC.

10.4		Warrant Purchase Agreement, dated as of April 11, 2006, by and among the Registrant, SPCP Group, L.L.C. and SPCP Group III LLC.

10.5		Warrant, dated as of April 11, 2006, issued by the Registrant to SPCP Group, L.L.C.

10.6		Warrant, dated as of April 11, 2006, issued by the Registrant to SPCP Group III LLC.

10.7		Amended and Restated Loan Agreement, dated as of April 10, 2006, by and between the Registrant and Atlantic Investors, LLC.

10.8		Loan Agreement, dated as of April 10, 2006, by and between the Registrant and Atlantic Investors, LLC.

10.9		Atlantic Fund Guaranty, dated as of April 11, 2006, delivered by Unicorn Worldwide Holdings Limited in favor of the Registrant.

10.10		Subordination Agreement, dated as of April 11, 2006, by and among the Registrant, Avasta, Inc.,


Exhibit
Number		Description
		ClearBlue Technologies Management, Inc., ClearBlue Technologies/Chicago-Wells, Inc., ClearBlue Technologies/Las Vegas, Inc., ClearBlue Technologies/Los Angeles, Inc., ClearBlue Technologies/Milwaukee, Inc., ClearBlue Technologies/Oak Brook, Inc., ClearBlue Technologies/Vienna, Inc., ClearBlue Technologies/Dallas, Inc., ClearBlue Technologies/NewYork, Inc., ClearBlue Technologies/San Francisco, Inc., ClearBlue Technologies/Santa Clara, Inc., Conxion Corporation, Intrepid Acquisition Corp., Lexington Acquisition Corp., ManagedOps.com, Inc., Surebridge Acquisition Corp., Surebridge Services, Inc., SiteROCK Corporation, NaviSite Acquisition Subsidiary, Inc., ClickHear, Inc., Silver Point Finance, LLC, Atlantic Investors, LLC and Unicorn Worldwide Holdings Limited.

10.11		Separation Agreement, dated as of April 3, 2006, by and between the Registrant and Arthur P. Becker is incorporated herein by reference to Exhibit 99.1 to the Registrant’s Current Report on Form 8-K dated April 6, 2006 (File No. 000-27597).

10.12		Separation Agreement, dated as of April 6, 2006, by and between the Registrant and John J. Gavin, Jr. is incorporated herein by reference to Exhibit 99.2 to the Registrant’s Current Report on Form 8-K dated April 6, 2006 (File No. 000-27597).

10.13		Separation Agreement, dated as of April 3, 2006, by and between the Registrant and Monique Cormier is incorporated herein by reference to Exhibit 99.3 to the Registrant’s Current Report on Form 8-K dated April 6, 2006 (File No. 000-27597).

10.14		Amendment No. 2 to the Amended and Restated 2003 Stock Incentive Plan is incorporated herein by reference to Appendix II to the Registrant’s Definitive Schedule 14C filed March 14, 2006 (File No. 000-27597).

31.1		Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of the Chief Financial Officer 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.