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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002

or

Commission File Number _-_____

PACKETEER, INC.
(Exact name of Registrant as specified in its charter)

10495 North De Anza Boulevard, Cupertino, CA 95014
(Address of principal executive offices)

Registrant’s telephone number, including area code: (408) 873-4400

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

Yes [X]      No [   ]

     The number of shares outstanding of Registrant’s common stock, $0.001 par value, was 30,499,229 at November 4, 2002.

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     In addition to historical information, this Form 10-Q contains forward-looking statements regarding our strategy, financial performance and revenue sources that involve a number of risks and uncertainties, including those discussed below at “Factors That May Affect Future Results” and in the “Risk Factors” section of Packeteer’s Annual Report on Form 10-K as filed with the SEC on March 22, 2002. Forward-looking statements in this report include, but are not limited to, those relating to the general expansion of our business, including the expansion of our network product lines, our ability to develop multiple applications, our planned introduction of new products and services, the possibility of acquiring complementary businesses, products, services and technologies, our development of relationships with providers of leading Internet technologies, our competition, the sufficiency of our cash, cash equivalents and investments and our business model targets. While this outlook represents our current judgment on the future direction of the business, such risks and uncertainties could cause actual results to differ materially from any future performance suggested below. Readers are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Form 10-Q. Packeteer undertakes no obligation to publicly release any revisions to forward-looking statements to reflect events or circumstances arising after the date of this document.

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PACKETEER, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
(unaudited)

See accompanying notes to condensed consolidated financial statements

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PACKETEER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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PACKETEER, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

See accompanying notes to condensed consolidated financial statements.

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PACKETEER, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. BASIS OF PRESENTATION

     The accompanying unaudited condensed consolidated financial statements have been prepared by Packeteer, Inc., pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and include the accounts of Packeteer, Inc. and its wholly-owned subsidiaries (“Packeteer” or collectively the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to such rules and regulations. While in the opinion of the Company’s management, the unaudited financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of interim periods presented, these financial statements and notes should be read in conjunction with its audited consolidated financial statements and notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001 filed with the SEC on March 22, 2002.

     The results of operations for the three and nine months ended September 30, 2002 are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending December 31, 2002.

2. GOODWILL AND OTHER INTANGIBLE ASSETS — ADOPTION OF FASB STATEMENT 142

     The following table presents the impact of SFAS No. 142, “Goodwill and Other Intangible Assets,” on net income (loss) and net income (loss) per share had the standard been in effect for the first nine months of fiscal 2001:

     During the third quarter of 2001, the Company performed an assessment of the carrying value of the goodwill and other intangible assets related to its acquisition of Workfire Technologies International, Inc. pursuant to the Company’s stated policy. Management’s determination of the existence of impairment indicators included continued general economic slowing, broad based declines in the values of networking technologies and a review of current, historical and future projections of cash flows related to these assets. The conclusion of the assessment was a determination that the carrying value of the goodwill and other intangible assets exceeded its fair value. The fair value was determined based on Company projections of the present value of future net cash flows to be generated over the expected lives of these assets. Accordingly, the Company recorded an impairment charge of $52.6 million during the third quarter of 2001 for the entire unamortized balance.

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3. CONTINGENCY

     In November 2001, Packeteer, certain company officers and directors, and its underwriters were named as defendants in a securities class-action lawsuit filed in the United States District Court for the Southern District of New York. The complaint, captioned Antoniono v. Packeteer, Inc. et. al., alleges violations of Sections 11, 12(a)2 and 15 of the Securities Act of 1933, as amended, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder on behalf of a purported class of purchasers of Packeteer common stock between July 27, 1999 and December 6, 2000. The plaintiffs seek unspecified damages.

     Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 300 other issuers. These cases have all been assigned to the Hon. Shira A. Scheindlin for coordination and decisions on pretrial motions, discovery, and related matters other than trial. We believe that we have meritorious defenses to the lawsuit and will defend ourselves vigorously in the litigation. An unfavorable resolution of the actions could have a material adverse effect on our business, results of operations and financial condition. The Company has considered the requirements of SFAS No. 5, “Accounting for Contingencies,” and due to the facts and circumstances of this case, no accrual for this contingency has been recorded.

4. INCOME TAXES

     Our income tax provision for the quarter and nine months ended September 30, 2002 is primarily attributable to income taxes payable in foreign jurisdictions. The effective tax rate for the three and nine months ended September 30, 2002, and the expected annual rate for 2002 is approximately 10%. There was no corresponding provision in the same periods of the prior year due to the Company’s consolidated net loss for the quarter and nine months ended September 30, 2001.

5. NET INCOME (LOSS) PER SHARE

     Basic net income (loss) per share has been computed using the weighted-average number of shares of common stock outstanding during the period, less the weighted-average number of shares of common stock that are subject to repurchase. Diluted net income (loss) per share has been computed using the weighted average number of common and potential common shares outstanding during the period. All warrants for common stock, outstanding stock options and shares subject to repurchase have been excluded from the calculation of diluted net loss per share for periods where their inclusion would be antidilutive.

     The following table presents the calculation of basic and diluted net income (loss) per share:

6. COMPREHENSIVE INCOME (LOSS)

     The Company reports comprehensive income or loss in accordance with the provisions of SFAS No. 130, “Reporting Comprehensive Income.” SFAS No. 130 establishes standards for reporting comprehensive income and loss and its components in

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financial statements. The difference between reported net income (loss) and comprehensive income (loss) was not considered material for the periods presented.

7. SEGMENT REPORTING

     The Company has adopted the provisions of SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” The Company’s chief operating decision maker is considered to be the Company’s CEO. The CEO reviews financial information presented on a consolidated basis substantially similar to the consolidated financial statements. Therefore, the Company has concluded that it operates in one segment and accordingly has provided only the required enterprise-wide disclosures.

     The Company operates in the United States and internationally and derives its revenue from the sale of products and software licenses. The Company’s sales, marketing, and development efforts have been focused on the PacketShaper family of products and PacketWise^TM software. For the three months ended September 30, 2002, sales to three customers, Alternative Technology, Inc., Westcon Inc. and Macnica Inc. accounted for 23% 16% and 14% of total net revenues, respectively. For the nine months ended September 30, 2002, sales to the same three customers, Alternative Technology, Westcon and Macnica accounted for 20%, 15% and 11% of total net revenues, respectively. In the prior year, for the three months ended September 30, 2001, sales to Alternative Technology and Westcon accounted for 26% and 11% of net revenues, respectively. For the nine months ended September 30, 2001, one customer, Alternative Technology, accounted for 21% of net revenues.

     Geographic Information

     Revenues reflect the destination of the shipped product.

     Long-lived assets are primarily located in North America. Assets located outside North America are not significant.

8. RECENT ACCOUNTING PRONOUNCEMENTS

     In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 143 (SFAS 143), “Accounting for Asset Retirement Obligations.” SFAS 143 addresses the financial accounting and reporting for obligations and retirement costs related to the retirement of tangible long-lived assets. Packeteer is required to adopt SFAS 143 for our fiscal year beginning January 1, 2003. Adoption of this statement is not expected to have an impact on the Company’s results of operations or financial position.

     In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145 (SFAS 145), “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” SFAS 145 requires that early extinguishments of debt that are normal and an important part of ongoing activities not be accounted for as extraordinary items. This Statement also requires that modifications of capital lease agreements by lessees giving rise to new operating lease agreements be accounted for as sale-leasebacks. Generally, SFAS No. 145 is effective for transactions occurring after May 15, 2002. The adoption of this standard is expected to have no impact to the Company.

     In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (SFAS 146), “Accounting for Costs Associated With Exit or Disposal Activities.” SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and requires the costs to be recorded at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability has been incurred. Packeteer is required to adopt SFAS 146 for any exit or disposal activities initiated after December 31, 2002. At this time we do not believe the adoption of SFAS 146 will have a material impact on the Company’s results of operations or financial condition.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     OVERVIEW

     Packeteer is a leading provider of application performance infrastructure systems designed to provide enterprises and service providers a layer of control for applications delivered across intranets, extranets and the Internet. Packeteer’s products — powered by PacketWise® software — are designed to ensure end-to-end quality of service (QoS) for networked applications and managed services, enhancing users’ quality of experience through comprehensive bandwidth, traffic, content, service-level and policy management. Packeteer’s PacketShaper family of products, the PacketShaper® and AppVantage™ systems, integrates application discovery, analysis, control and reporting technologies that are required for proactive application performance and bandwidth management. The AppCelera™ family of Internet acceleration appliances employs secure socket layer (“SSL”) acceleration and advanced content compression, transformation and caching technologies to improve response times of mission critical enterprise, eBusiness and eCommerce web applications.

     Packeteer’s products are deployed by Global 2000 corporations and service providers, and sold through an established network of more than 100 resellers, distributors, system-integrators and OEMs in more than 50 countries. Our products are built on hardware platforms based on Intel-compatible microprocessor technologies. In addition, PacketWise software is licensed by major communications industry partners who integrate the software into specific strategic networking solutions. We primarily use indirect channels, resellers, distributors, system integrators and OEMS, to leverage the reach of our sales force and to obtain worldwide coverage. Our sales and marketing efforts are used to develop brand awareness and support our indirect channels. We have subsidiaries in Hong Kong, Japan, Singapore, Korea, The Netherlands, England, Germany, France, Spain, Denmark, Australia, Caymans and Canada. To date, we have shipped more than 22,000 units.

     We were incorporated in January 1996. From our inception through January 1997, our operating activities related primarily to establishing a research and development organization, developing and testing prototype designs, establishing a sales and marketing organization and developing customer, vendor and manufacturing relationships. We shipped our first product in February 1997. Since then, we have focused on developing additional products and product enhancements, building our worldwide indirect sales channel and establishing our sales, marketing and customer support organizations. Prior to fiscal 2002, we incurred significant losses and as of September 30, 2002, had an accumulated deficit of $105.3 million.

     We have a limited operating history. We have incurred losses since we commenced operations in 1996 and, though we have achieved profitability for the three and nine months ended September 30, 2002, profitability could remain difficult to sustain. We expect to continue to invest in sales and marketing and product development activities and, as a result, will need to continue to grow revenues to continue to achieve and maintain profitability.

CRITICAL ACCOUNTING POLICIES

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to inventory valuation, valuation of long-lived assets, valuation allowances including sales return reserves and allowance for doubtful accounts, and other liabilities, specifically warranty reserves. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates.

     The items in our financial statements requiring the most significant estimates and judgment are as follows:

     Revenue recognition. Product revenue consists primarily of sales of our PacketShaper, AppVantage and AppCelera products, which include hardware, as well as software licenses. Service revenue consists primarily of maintenance revenue and, to a lesser extent, training revenue.

     The Company applies the provisions of Statement of Position 97-2, “Software Revenue Recognition,” as amended by Statement of Position 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions,” to all transactions involving the sale of hardware and software products. Revenue is generally recognized when all of the following criteria are met as set forth in paragraph 8 of SOP 97-2:

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	•		persuasive evidence of an arrangement exists,
	•		delivery has occurred,
	•		the fee is fixed or determinable, and
	•		collectibility is reasonably assured.

     Receipt of a customer purchase order is persuasive evidence of an arrangement. Sales through our distribution channel are evidenced by an agreement governing the relationship together with purchase orders on a transaction-by-transaction basis.

     Delivery generally occurs when product is delivered to a common carrier from Packeteer or its designated fulfillment house. For maintenance contracts, delivery is deemed to occur ratably over the contract period.

     The Company’s fees are typically considered to be fixed or determinable at the inception of the arrangements and are negotiated at the outset of an arrangement, and are generally based on specific products and quantities to be delivered. In the event payment terms are provided that differ significantly from our standard business practices, the fees are deemed to not be fixed or determinable and revenue is recognized as the fees become due and payable.

     We assess collectibility based on a number of factors, including credit worthiness and past transaction history of the customer.

     Our revenue recognition policy is modified under certain circumstances as follows: Product revenue on sales to major new distributors is recorded based on sell-through to the end user customers until such time as the Company has established significant experience with the distributor’s product exchange activity. Additionally, when the Company introduces a new product into its distribution channel for which there is no historical customer demand or acceptance history, revenue is recognized on the basis of sell-through to end user customers until such time as demand or acceptance history has been established.

     The Company has analyzed all of the elements included in its multiple element arrangements and has determined that it has sufficient vendor specific objective evidence (VSOE) to allocate revenue to the maintenance component of its product and to training. VSOE is based upon separate sales of maintenance renewals and training to customers. Accordingly, assuming other revenue recognition criteria are met, revenue from product sales is recognized upon delivery using the residual method in accordance with SOP 98-9, revenue from maintenance is recognized ratably over the maintenance term and revenue from training is recognized when the training has taken place. To date, training revenues have not been material.

     Inventory valuation. Inventories consist primarily of finished goods and are stated at the lower of cost (on a first-in, first-out basis) or market. We currently contract with SMTC Corporation for the manufacture of all of our products. We record inventory reserves for excess and obsolete inventories based on historical usage and forecasted demand. Factors which could cause our forecasted demand to prove inaccurate include our reliance on indirect sales channels and the variability of our sales cycle; the potential of announcements of our new products or enhancements to replace or shorten the life cycle of our current products, or cause customers to defer their purchases; loss of sales due to product shortages; and the potential of new or alternative technologies achieving widespread market acceptance and thereby rendering our existing products obsolete. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made.

     Valuation of Long-Lived and Intangible Assets. As required by SFAS 144, “Accounting for Impairment or Disposal of Long Lived Assets”, the Company regularly performs reviews to determine if the carrying value of its long-lived assets is impaired. The purpose of the review is to identify any facts or circumstances, either internal or external, which indicate that the carrying value of the assets cannot be recovered. Such facts or circumstances might include significant underperformance relative to expected historical or projected future operating results or significant negative industry or economic trends. If such indicators are present, we determine whether the sum of the estimated undiscounted cash flows attributable to the assets in question is less than their carrying value. If less, we recognize an impairment loss based on the excess carrying amount of the assets over their respective fair values. If quoted market prices for assets are not available, the fair value is estimated based on the present value of expected future cash flows. The fair value of the asset then becomes the asset’s new carrying value.

     Sales return reserve and allowance for doubtful accounts. In accordance with SFAS 48, “Revenue Recognition When Right of Return Exists”, management must use judgment and make estimates of potential future product returns related to current period product revenue. When providing for sales return reserves, we analyze historical return rates, as they are the primary indicators for estimating future returns. Material differences may result in the amount and timing of our revenue if for any period actual returns

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differ from management judgments or estimates. The sales return reserve liability balances at September 30, 2002 and December 31, 2001 were $924,000 and $331,000, respectively. We must also make estimates of the uncollectibility of accounts receivable. When evaluating the adequacy of the allowance for doubtful accounts, we review the aged receivables on an account-by-account basis, taking into consideration such factors as age of the receivables, customer history and estimated continued credit-worthiness, as well as general economic and industry trends. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances could be required. The allowance for doubtful accounts was $79,000 and $132,000 at September 30, 2002 and December 31, 2001, respectively.

     Warranty reserves. Upon shipment of products to our customers, we provide for the estimated cost to repair or replace products that may be returned under warranty. Our warranty period is typically 12 months from the date of shipment to the end user customer. For existing products, the reserve is estimated based on actual historical experience. For new products, the required reserve is based on historical experience of similar products until such time as sufficient historical data has been collected on the new product. Factors that may impact our warranty costs in the future include our reliance on our contract manufacturer to provide quality product in a timely manner and the fact that our products are complex and may contain undetected defects, errors or failures in either the hardware or the software. To date, these problems have not materially adversely affected us. Warranty reserves amounted to $322,000 and $552,000 at September 30, 2002 and December 31, 2001, respectively.

     RESULTS OF OPERATIONS

     The following table sets forth certain financial data as a percentage of total net revenues for the periods indicated. These historical operating results are not necessarily indicative of the results for any future period.

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     REVENUES

     Product revenues consist primarily of sales of our PacketShaper, AppVantage and AppCelera products. Service revenues consist primarily of maintenance revenues and, to a lesser extent, training revenues.

     Total net revenues of $14.0 million in the three months ended September 30, 2002 increased $3.1 million, or 28%, from the $10.9 million reported in the same quarter of the prior year. Total net revenues increased to $39.4 million in the nine months ended September 30, 2002, from $35.2 million in the same period of the prior year, an increase of 12%. Product revenues of $12.0 million for the quarter increased $2.5 million, or 26%, from the $9.5 million for the three months ended September 30, 2001. Units shipped in the three months ended September 30, 2002 increased 25% over the number of units shipped in the same period in 2001. Product revenues for the nine months ended September 30, 2002 increased to $33.9 million, from $31.4 million for the same period of the prior year, an 8% increase, primarily as a result of a 7% increase in units shipped. To a lesser extent, a favorable product mix also contributed to the reported increase in sales year-to-date, as sales of our higher end product continue to represent a higher percentage of the reported revenue. There were no significant selling price changes during any of the periods presented. Service revenues increased to $2.0 million in the three months ended September 30, 2002, from $1.4 million in the second quarter of fiscal 2001, an increase of 40%. Service revenues for the nine months ended September 30, 2002 increased to $5.5 million, from $3.7 million in the first nine months of fiscal 2001, an increase of 47%. These increases were mainly due to increases in the number of units on maintenance contracts.

     For the quarter ended September 30, 2002, total net revenues in North America of $6.5 million increased from $5.0 million in the same period last year, and accounted for 46% of total net revenues, consistent with the same period last year. Net revenues in Asia Pacific of $4.6 million for the quarter ended September 30, 2002, accounted for 33% of total net revenues compared to $2.9 million and 27% for the same period last year. Net revenues in Europe, the Middle East and Africa, “EMEA”, of $3.0 million, accounting for 21% of third quarter sales, were consistent in absolute dollars but down as a percentage of net revenues from 27% reported for the three months ended September 30, 2001. For the nine months ended September 30, 2002, net revenues in North America of $16.9 million increased from $15.6 million for the same period last year and accounted for 43% of total net revenues, a decline of 1% from the same period last year. Net revenues in Asia Pacific, totaling $12.8 million in the nine months ended September 30, 2002, accounted for 32% of first nine months total net revenues, representing an increase of 6% over the first nine months of fiscal 2001 due to strong sales in Japan. EMEA net revenues of $9.7 million accounted for 25% of total net revenues for the nine months ended September 30, 2002, and were down in both absolute dollars and as a percentage of sales when compared to $10.3 million and 29% reported for the nine months ended September 30, 2001.

     During the three months ended September 30, 2002, three customers, Alternative Technology, Inc., Westcon, Inc., and Macnica Inc. accounted for 23%, and 16% and 14% of total net revenues, respectively. For the nine months ended September 30, 2002, the same three customers, Alternative Technology, Westcon, and Macnica accounted for 20%, 15% and 11% of total net revenues, respectively. For the three months ended September 30, 2001, sales to Alternative Technology and Westcon accounted for 26% and 11% of net revenues, respectively. For the nine months ended September 30, 2001, one customer, Alternative Technology, accounted for 21% of net revenues. Sales to the top 10 indirect channel partners accounted for 67% and 57% of total net revenues for the nine months ended September 30, 2002 and 2001, respectively. At September 30, 2002, two customers, Alternative Technology and Westcon, accounted for 35% of accounts receivable.

     We believe that our current value proposition, which enables our enterprise customers to get more value out of existing network resources and improved performance of their critical applications, should allow us to continue to grow our business in 2002. Our growth rate and total net revenue depend significantly on continued growth of the application traffic and bandwidth solutions market, our ability to develop and maintain strong partnering relationships with our indirect channel partners and our ability to expand or enhance our product offerings or respond to technological change. Our growth in service revenues is dependent upon increasing the number of units on maintenance contracts, which is dependent on both growing our installed customer base and renewing existing maintenance contracts. Our future profitability and rate of growth, if any, will be directly affected by the continued acceptance of our product in the marketplace, as well as the timing and size of orders, shipments, product mix, average selling price of our products and general economic conditions. Our failure to successfully convince the market of our value proposition and maintain strong relationships with our indirect channel partners to ensure the success of their selling efforts on our behalf, would adversely impact our total net revenues and operating results.

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     COST OF REVENUES

     Our cost of revenues (excluding amortization of acquired technology) consists of the cost of finished products purchased from our turnkey contract manufacturer, overhead costs and service support costs. Our cost of revenues, $3.2 million in the three months ended September 30, 2002, was unchanged from the $3.2 million reported in the same period of fiscal 2001. For the nine months ended September 30, 2002, cost of revenues decreased $1.5 million, or 14%, to $9.4 million from $10.9 million for the same period in 2001. The decrease in costs was due to reductions in manufacturing costs and other product costs. The cost of revenues represented 23% and 24% of net revenues for the three and nine months ended September 30, 2002 respectively, compared to 29% and 31% in the three and nine months ended September 30, 2001, respectively.

     Product costs for the third quarter of 2002, remained constant at $2.4 million, the same as reported in the third quarter of 2001. Manufacturing costs increased $292,000 from the same quarter of fiscal 2001 due to increased units shipped. However, overhead costs, specifically warranty and parts costs, were down $349,000 from the second quarter of 2001. For the nine months ended September 30, 2002, product costs decreased 16%, to $7.2 million from $8.6 million for the same period in 2001. Overhead costs, specifically warranty and parts costs, were down $1.4 million compared to the first nine months of fiscal 2001. Although we expect our overhead costs to increase in absolute dollars in future quarters, as a percent of revenues we do not expect them to return to fiscal 2001 levels. To maintain our product gross margins, we must continue to develop and introduce on a timely basis, new products and enhancements and reduce product costs as we did in 2001.

     Service costs increased $84,000, from $721,000 in the third quarter of fiscal 2001 to $805,000 in the current quarter, an increase of 12%. The increased service costs in this quarter are due to service fees and supplies related to an agreement previously entered into by the Company for the outsourcing of certain maintenance and support services. For the nine months ended September 30, 2002, service costs decreased 7%, or $152,000, to $2.2 million from $2.3 million for the same period in 2001. This change is a result of decreases in consulting fees and personnel related costs. We expect service costs to increase in absolute dollars in future quarters primarily as a result of increased service fees related to outsourcing of certain maintenance and support services.

     AMORTIZATION OF ACQUIRED TECHNOLOGY

     Amortization of acquired technology relates to the acquired developed technologies of Workfire Technologies International, Inc.. The acquisition occurred in September 2000. Due to the impairment write-off in the third quarter of fiscal 2001, there was no amortization during the current fiscal year. The amortization of acquired technology was $1.2 million in the nine month period ended September 30, 2001, representing 3% of net revenues.

     RESEARCH AND DEVELOPMENT

     Research and development expenses consist primarily of salaries and related personnel expenses, consultant fees and prototype expenses related to the design, development, testing and enhancement of the PacketShaper, AppVantage and AppCelera products and PacketWise software. Excluding the effects of stock-based compensation of $26,000 and $113,000 for the three months ended September 30, 2002 and 2001, respectively, research and development expenses of $2.7 million in the three months ended September 30, 2002, were down $567,000, or 17% from the $3.3 million reported for the quarter ended September 30, 2001. These decreases in expenses were primarily due to a decrease in program related charges, and to a lesser extent, a reduction in depreciation expense. Excluding the effects of stock-based compensation of $158,000 and $570,000 for the nine months ended September 30, 2002 and 2001, respectively, research and development expenses of $8.1 million decreased $1.1 million, or 12%, from the $9.2 million in the same period in the prior year. For the nine months of fiscal 2002, the decrease in expenses was primarily due to decreased personnel related costs, and to a lesser extent a reduction in depreciation expense, partially offset by an increase in distributed costs. Personnel costs declined as a result of staffing changes made in June of 2001 as part of overall corporate cost control measures. Distributed costs include expenses related to facilities, communications and technology, which are allocable to all functional areas of the Company. The increase in distributed costs is discussed below under the heading “GENERAL AND ADMINISTRATIVE.” Research and development expenses represented 19% and 20% of total net revenues for the quarter and nine months ended September 30, 2002, respectively, compared to 30% and 26% of total net revenues for the quarter and nine months ended September 30, 2001, respectively. As of September 30, 2002, all research and development costs have been expensed as incurred. We believe that continued investment in research and development is critical to attaining our strategic product and cost control objectives. We currently expect to experience somewhat higher spending levels in the upcoming quarters, but continue to target our spending to approximate our current long-term business model target of 18% to 20% of revenues going forward.

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     SALES AND MARKETING

     Sales and marketing expenses consist primarily of salaries, commissions and related personnel expenses for those engaged in the sales and marketing of our products as well as related trade show, promotional and public relations expenses. Excluding the effects of stock-based compensation of $35,000 and $102,000 in the three months ended September 30, 2002 and 2001, respectively, sales and marketing expenses increased to $5.8 million in the three months ended September 30, 2002, from $5.2 million in the same quarter in the prior year, an increase of 11%. Increases in personnel costs, specifically recruiting and commissions, and distributed costs were partially offset by decreases in depreciation expense and supplies costs. Excluding the effects of stock-based compensation of $116,000 and $345,000 for the nine months ended September 30, 2002 and 2001, respectively, sales and marketing expenses decreased slightly to $16.8 million in the nine months ended September 30, 2002, from the $16.9 million in the first nine months of the prior year. Decreases were primarily in travel costs, depreciation expense and marketing activities, specifically tradeshows, channel programs and public relations expenses, partially offset by an increase in distributed costs, which is discussed below under the heading “GENERAL AND ADMINISTRATIVE.” Sales and marketing expenses represented 41% and 43% of total net revenues for the three and nine-month periods ended September 30, 2002, respectively, compared to 48% of total net revenues in the three and nine months ended September 30, 2001. We intend to continue to invest in appropriate sales and marketing campaigns and therefore expect our absolute dollar expenses to increase in the future. We continue to work towards our long-term business model target showing sales and marketing expenses in the range of 26% to 28% of revenues, but do not expect to achieve this on a quarterly basis for at least the next one to two years.

     GENERAL AND ADMINISTRATIVE

     General and administrative expenses consist primarily of salaries and related personnel expenses for administrative personnel, professional fees and other general corporate expenses. Excluding the effects of stock-based compensation of $12,000 and $22,000 for the three months ended September 30, 2002 and 2001, respectively, general and administrative expenses declined to $1.2 million in the three months ended September 30, 2002, from $1.4 million in the same quarter of the prior year, a decrease of 20%. Excluding the effects of stock-based compensation of $38,000 and $86,000 for the nine months ended September 30, 2002 and 2001 respectively, general and administrative expenses were $3.4 million, down 20% from the $4.3 million in the first nine months of the prior year. For both the quarter and nine months ending September 30, 2002, decreases in professional services and distributed costs were partially offset by increased personnel costs related to the CEO transition and search occurring during the second and third quarters of 2002. Decreases in distributed costs are due to a change in the allocation of the expenses associated with our Information Technology group (“IT”). Prior to fiscal 2002, only a small portion of IT costs were allocated out of general and administrative expenses. Beginning in fiscal 2002, based on improved tracking and reporting of IT services, a greater portion of IT costs were allocated to other departments to better reflect the services performed by this group. In the three and nine month periods ended September 30, 2002 respectively, approximately $160,000 and $480,000 of additional IT costs were allocated from general and administrative expenses into cost of revenues, research and development and sales and marketing. Comparable figures for the prior year are not available.

     General and administrative expenses represented 8% and 9% of total net revenues for the three and nine-month periods ended September 30, 2002 compared to 13% and 12% of total net revenues in the same periods of the prior year, respectively. This percentage decrease was due to lower expenses as well as increased total net revenues. Without the change in allocation of IT costs, general and administrative expenses would have been 9% and 10% of total net revenues in the three and nine-month periods ended September 30, 2002, respectively. We expect to see general and administrative expenses continue to decline as a percentage of revenue and expect to reach our long-term business model target of 6% to 7% of revenue within the next twelve to eighteen months.

     STOCK-BASED COMPENSATION

     Stock-based compensation resulted primarily from stock option grants to employees and options assumed in the Workfire acquisition. Stock-based compensation is being amortized in accordance with FASB Interpretation No. 28 over the vesting period of the individual options, generally four years. We recorded stock-based compensation expense of $73,000 and $237,000 in the three months ended September 30, 2002 and 2001, respectively. For the nine months ended September 30, 2002 and 2001, stock based compensation expense was $312,000 and $1.0 million, respectively. There is $92,000 remaining to be amortized in future periods.

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     AMORTIZATION OF GOODWILL AND OTHER INTANGIBLE ASSETS

     In connection with the Workfire acquisition completed in September 2000, we recorded goodwill and other intangible assets of approximately $66.1 million, which was being amortized on a straight-line basis over a three-year period. Amortization of this goodwill and other intangibles totaled an aggregate of $12.3 million in the nine-month period ended September 30, 2001. Because of the impairment write-off in the third quarter of 2001, no goodwill remained on the balance sheet. Accordingly, there was no amortization or transition adjustment in the corresponding periods of fiscal 2002.

     IMPAIRMENT OF GOODWILL AND OTHER INTANGIBLES

     In September 2000, the Company purchased Workfire Technologies International, Inc. for approximately $72.8 million, mostly in Packeteer common stock. Substantially all of the purchase price was allocated to goodwill and other intangibles.

     During the third quarter of 2001, the Company performed an assessment of the carrying value of the goodwill and other intangible assets related to its acquisition of Workfire. The assessment was performed pursuant to SFAS No. 121 based on management’s determination of the existence of impairment indicators including continued general economic slowing, the general decline in technology valuations and a review of current, historical and future projections of cash flows related to these assets. The conclusion of the assessment was a determination that the carrying value of the goodwill and other intangible assets exceeded its fair value. The fair value was determined based on Company projections of the present value of future net cash flows expected to be generated from these assets. Accordingly, the Company recorded an impairment charge of $52.6 million during the quarter for the entire balance.

     OTHER INCOME, NET

     Other income, net consists primarily of interest income from our cash and investments, less interest expense related to our line of credit, debt and capital lease obligations, and other expenses. Other income, net decreased to $309,000 in the three months ended September 30, 2002 from $696,000 in the same quarter in the prior year, a decrease of 56%. Other income, net was $727,000 for the nine-month period ended September 30, 2002, a decrease of $976,000 from the $1.7 million for the nine months ended September 30, 2001, a decrease of 57%. These decreases were a result of lower yields on invested funds due to declining interest rates and increased foreign currency transaction losses, partially offset by lower interest expenses due to decreased levels of debt.

     INCOME TAX PROVISION

     Our income tax provision for the quarter and nine months ended September 30, 2002 is primarily attributable to income taxes payable in foreign jurisdictions. The effective tax rate for the three and nine months ended September 30, 2002, and the expected annual rate for 2002 is approximately 10%. There was no corresponding provision in the same periods of the prior year due to the Company’s consolidated net loss for the quarter and nine months ended September 30, 2001.

     LIQUIDITY AND CAPITAL RESOURCES

     Since inception, we have financed our operations primarily from the sale of preferred and common stock and other financing activities such as bank credit against accounts receivable, subordinated debt offerings and equipment leasing and loans. Cash, cash equivalents and investments totaled $64.2 million at September 30, 2002, an increase of $2.0 million from December 31, 2001.

     Net cash provided by operating activities was $2.7 million in the nine months ended September 30, 2002, compared with net cash used in operations of $169,000 for the same period of the prior year. The increase in operating cash flows was primarily due to net income reported in the current period, compared to a net loss in the first nine months of fiscal 2001.

     Net cash used in investing activities was $15.3 million in the nine months ended September 30, 2002 compared to net cash provided by investing activities of $26.3 million for the same period in the prior year, primarily reflecting transactions in marketable securities. Fixed asset purchases were $764,000 for the nine months ended September 30, 2002, compared to $833,000 for the same period in the prior year.

     Net cash provided by financing activities was $21,000 in the nine months ended September 30, 2002, compared to $253,000 used in financing activities for the same period in the prior year. In the nine months ended September 30, 2002, proceeds generated by issuance of common stock totaled $1.5 million. This was offset by $1.5 million of payments on lease obligations, the note payable and a portion of borrowings under the line of credit. In the nine months ended September 30, 2001, proceeds generated by issuance of

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common stock totaled $2.1 million while net proceeds from the note payable generated $489,000. This was offset by repayments under the line of credit of $2.4 million, and lease obligations repayments totaling $542,000.

     We have entered into capital leases and notes payable to finance the acquisition of computer software, hardware and furniture. As of September 30, 2002, approximately $1.1 million was outstanding under capital lease obligations and $373,000 was outstanding on a note payable. We also have a revolving credit facility against accounts receivable, which provides for borrowings of up to $10.0 million. As of September 30, 2002, the outstanding balance on the line was $1.0 million. This facility expires in May 2003. Borrowings under this facility bear interest at the prime rate, which was 4.75% as of September 30, 2002, and are secured by substantially all the assets of the Company. The Company is required to maintain certain financial covenants related to working capital and quarterly maximum net loss amounts. At September 30, 2002, the Company was in compliance with these covenants.

     The following summarizes Packeteer’s commitments under debt and lease obligations, including interest where applicable, as of September 30, 2002, and the effect such obligations are expected to have on its liquidity and cash flow in future periods (in thousands):

     We expect to experience growth in our working capital needs for the foreseeable future in order to execute our business plan. We anticipate that operating activities, as well capital expenditures related to a facilities move anticipated in the fourth quarter of this year, will constitute a partial use of our cash resources. In addition, we may utilize cash resources to fund acquisitions or investments in complementary businesses, technologies or products. We believe that our current cash, cash equivalents and investments of $64.2 million at September 30, 2002 and available borrowings under our credit facilities will be sufficient to meet our anticipated cash requirements for working capital and capital expenditures for at least the foreseeable future. However, we may need to raise additional funds if our estimates of revenues, working capital or capital expenditure requirements change or prove inaccurate or in order for us to respond to unforeseen technological or marketing hurdles or to take advantage of unanticipated opportunities. These funds may not be available at the time or times needed, or be available on terms acceptable to us. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities to develop new products or to otherwise respond to competitive pressures.

     RECENT ACCOUNTING PRONOUNCEMENTS

     The impact of recent accounting pronouncements is discussed in Note 8 of the notes to the unaudited condensed consolidated financial statements.

     FACTORS THAT MAY AFFECT FUTURE RESULTS

     You should carefully consider the risks described below before making an investment decision. If any of the following risks actually occur, our business, financial condition or results of operations could be materially and adversely affected. In such case, the trading price of our common stock could decline, and you may lose all or part of your investment.

OUR LIMITED OPERATING HISTORY AND THE RAPIDLY EVOLVING MARKET WE SERVE MAKES EVALUATING OUR BUSINESS PROSPECTS DIFFICULT

     We were incorporated in January 1996 and began shipping our products commercially in February 1997. Because of our limited operating history and the uncertain nature of the rapidly changing market that we serve, we believe the prediction of future results of operations is difficult. As an investor in our common stock, you should consider the risks and difficulties that we face as an early stage company in a new and rapidly evolving market. Some of the specific risks we face include our ability to:

•

execute our sales and marketing strategy;

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	•		maintain current and develop new relationships with key resellers, distributors, systems integrators and original equipment manufacturers, or OEMs; and
	•		expand our domestic and international sales efforts.

WE HAVE A HISTORY OF LOSSES AND PROFITABILITY COULD BE DIFFICULT TO SUSTAIN

     We have incurred losses since we commenced operations in 1996 and, though we achieved profitability for the three and nine months ended September 30, 2002, profitability could be difficult to sustain. We may not generate a sufficient level of revenues to offset our expenditures or be able to adjust spending in a timely manner to respond to any unanticipated decline in revenues. We incurred net losses of $71.0, $9.4 and $10.9 million in 2001, 2000 and 1999 respectively. As of September 30, 2002, we had an accumulated deficit of $105.3 million. If revenues grow slower than we anticipate or if operating expenditures exceed our expectations or cannot be adjusted accordingly, we may experience additional losses on a quarterly and annual basis.

IF THE APPLICATION TRAFFIC AND BANDWIDTH MANAGEMENT SOLUTIONS MARKET FAILS TO GROW, OUR BUSINESS WILL FAIL

The market for application performance infrastructure solutions is in an early stage of development and its success is not guaranteed. Therefore, we cannot accurately assess the size of the market, the products needed to address the market, the optimal distribution strategy, or the competitive environment that will develop. In order for us to be successful, our potential customers must recognize the value of more sophisticated bandwidth management solutions, decide to invest in the management of their networks and the performance of important business software applications and, in particular, adopt our bandwidth management solutions.

THE AVERAGE SELLING PRICES OF OUR PRODUCTS COULD DECREASE RAPIDLY WHICH MAY NEGATIVELY IMPACT REVENUES AND GROSS MARGINS

     We may experience substantial period-to-period fluctuations in future operating results due to the erosion of our average selling prices. The average selling prices of our products could decrease in the future in response to competitive pricing pressures, increased sales discounts, new product introductions by us or our competitors, or other factors. Therefore, to maintain our gross margins, we must develop and introduce on a timely basis new products and product enhancements and continually reduce our product costs. Our failure to do so would cause our revenue and gross margins to decline.

OUR FUTURE OPERATING RESULTS MAY NOT MEET ANALYSTS’ EXPECTATIONS AND MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD ADVERSELY AFFECT OUR STOCK PRICE

     We believe that period-to-period comparisons of our operating results cannot be relied upon as an indicator of our future performance. Our operating results may be below the expectations of public market analysts or investors in some future quarter. If this occurs, the price of our common stock would likely decrease. Our operating results are likely to fluctuate in the future on both a quarterly and an annual basis due to a number of factors, many of which are outside our control. Factors that could cause our operating results to fluctuate include variations in:

	•		the timing and size of orders and shipments of our products;
	•		the amount and timing of revenues from OEMs;
	•		the mix of products we sell;
	•		the mix of channels through which those products are sold;
	•		the average selling prices of our products; and
	•		the amount and timing of our operating expenses.

In the past, we have experienced fluctuations in operating results. These fluctuations resulted primarily from variations in the mix of products sold and variations in channels through which products were sold. Research and development expenses, specifically prototype expenses, consulting fees and other program costs, have fluctuated relative to the specific stage of product development of

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the various projects underway. Sales and marketing expenses have fluctuated due to increased personnel expenses, expenditures related to trade shows and the launch of new products. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for detailed information on our operating results.

IF OUR INTERNATIONAL SALES EFFORTS ARE UNSUCCESSFUL, OUR BUSINESS WILL FAIL TO GROW

     The failure of our indirect partners to sell our products internationally will harm our business. Sales to customers outside of North America accounted for 54% and 57% of total net revenues in the three and nine months ended September 30, 2002 and more than half of our total net revenues in both fiscal 2001 and 2000. Our ability to grow will depend in part on the continued expansion of international sales, which will require success on the part of our resellers, distributors, systems integrators and OEMs in marketing our products.

     We intend to expand operations in our existing international markets and to enter new international markets, which will demand management attention and financial commitment. We may not be able to successfully sustain and expand our international operations. In addition, a successful expansion of our international operations and sales in foreign markets will require us to develop relationships with suitable indirect channel partners operating abroad. We may not be able to identify, attract or retain these indirect channel partners.

     Furthermore, to increase revenues in international markets, we will need to continue to establish foreign operations, to hire additional personnel to run these operations and to maintain good relations with our foreign indirect channel partners. To the extent that we are unable to successfully do so, our growth in international sales will be limited.

     Our international sales are currently all U.S. dollar-denominated. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets. In the future, we may elect to invoice some of our international customers in local currency. Doing so will subject us to fluctuations in exchange rates between the U.S. dollar and the particular local currency and could negatively affect our financial performance.

IF WE ARE UNABLE TO DEVELOP AND MAINTAIN STRONG PARTNERING RELATIONSHIPS WITH OUR INDIRECT CHANNEL PARTNERS, IF THEIR SALES EFFORTS ON OUR BEHALF ARE NOT SUCCESSFUL, OR IF THEY FAIL TO PROVIDE ADEQUATE SERVICES TO OUR END-USER CUSTOMERS, OUR SALES MAY SUFFER AND OUR REVENUES MAY NOT INCREASE

     We rely primarily on an indirect distribution channel consisting of resellers, distributors, systems integrators and OEMs for our revenues. Because many of our indirect channel partners also sell competitive products, our success and revenue growth will depend on our ability to develop and maintain strong cooperative relationships with significant indirect channel partners, as well as on the sales efforts and success of those indirect channel partners.

     We cannot assure you that our indirect channel partners will market our products effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. In order to support and develop leads for our indirect distribution channels, we plan to continue to expand our field sales and support staff as needed. We cannot assure you that this internal expansion will be successfully completed, that the cost of this expansion will not exceed the revenues generated or that our expanded sales and support staff will be able to compete successfully against more extensive and well-funded sales and marketing operations of any of our current or potential competitors. In addition, our indirect channel agreements are generally not exclusive and one or more of our channel partners may compete directly with another channel partner for the sale of our products in a particular region or market. This may cause such channel partners to stop or reduce their efforts in marketing our products. Our inability to effectively establish or manage our distribution channels would harm our sales.

     In addition, our indirect channel partners may provide services to our end-user customers that are inadequate or do not meet expectations. Such failures to provide adequate services could result in customer dissatisfaction with us or our products and services due to delays in maintenance and replacement, decreases in our customers’ network availability and other losses. These occurrences could result in the loss of customers and repeat orders and could delay or limit market acceptance of our products, which would negatively affect our sales and results of operations.

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OUR RELIANCE ON SALES OF OUR PRODUCTS BY OTHERS MAKES IT DIFFICULT TO PREDICT OUR REVENUES AND RESULTS OF OPERATIONS

     The timing of our revenues is difficult to predict because of our reliance on indirect sales channels and the variability of our sales cycle. The length of our sales cycle for sales through our indirect channel partners to our end users may vary substantially depending upon the size of the order and the distribution channel through which our products are sold. We expect to continue to have difficulties in predicting revenues from OEMs because we are unable to forecast unit sales of their products that incorporate our technology.

     If revenues forecasted in a particular quarter do not occur in that quarter, our operating results for that quarter could be adversely affected. Furthermore, because our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term, a substantial reduction or delay in sales of our products or the loss of any significant indirect channel partner could harm our business.

SALES TO LARGE CUSTOMERS WOULD BE DIFFICULT TO REPLACE IF LOST

     A limited number of indirect channel partners have accounted for a large part of our revenues to date and we expect that this trend will continue. Because our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term, any significant reduction or delay in sales of our products to any significant indirect channel partner or unexpected returns from these indirect channel partners could harm our business. For the three months ended September 30, 2002, sales to three customers, Alternative Technology, Inc., Westcon Inc. and Macnica Inc. accounted for 23% 16% and 14% of total net revenues, respectively. For the nine months ended September 30, 2002, sales to the same three customers, Alternative Technology, Westcon and Macnica accounted for 20%, 15% and 11% of total net revenues, respectively. In the prior year, for the three months ended September 30, 2001, sales to Alternative Technology and Westcon accounted for 26% and 11% of net revenues, respectively. For the nine months ended September 30, 2001, one customer, Alternative Technology, accounted for 21% of net revenues. We expect that our largest customers in the future could be different from our largest customers today. End users can stop purchasing and indirect channel partners can stop marketing our products at any time. We cannot assure you that we will retain these indirect channel partners or that we will be able to obtain additional or replacement partners. The loss of one or more of our key indirect channel partners or the failure to obtain and ship a number of large orders each quarter could harm our operating results and liquidity.

WE FACE RISKS RELATED TO INVENTORIES OF OUR PRODUCTS HELD BY OUR DISTRIBUTORS

     Many of our distributors maintain inventories of our products. We work closely with these distributors to monitor channel inventory levels so that appropriate levels of products are available to resellers and end users. However, if distributors reduce their levels of inventory or if they do not maintain sufficient levels to meet customer demand, our sales could be negatively impacted.

     Additionally, although we monitor and track channel inventory with our distributors, overstocking could occur if the demand for our products were to rapidly decline due to economic downturns, increased competition, underperformance of distributors or the introduction of new products by our competitors or ourselves. This could cause sales and cost of sales to fluctuate from quarter to quarter.

OUR PRODUCTS CURRENTLY CONSIST OF THE PACKETSHAPER, APPVANTAGE AND APPCELERA SYSTEMS AND PACKETWISE SOFTWARE, AND ALL OF OUR CURRENT REVENUES AND A SIGNIFICANT PORTION OF OUR FUTURE GROWTH DEPEND ON THEIR COMMERCIAL SUCCESS

     All of our current revenues and a significant portion of our future growth depend on the commercial success of our PacketShaper, AppVantage and AppCelera products and PacketWise software, which are the primary products that we currently offer. If our target customers do not widely adopt, purchase and successfully deploy the PacketShaper, AppVantage and AppCelera products or PacketWise software, our revenues will not grow significantly or at all.

INTRODUCTION OF OUR NEW PRODUCTS MAY CAUSE CUSTOMERS TO DEFER PURCHASES OF OUR EXISTING PRODUCTS WHICH COULD HARM OUR OPERATING RESULTS

     If and when we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products, customers may defer purchasing our existing products. These actions could harm our operating results by unexpectedly decreasing sales, increasing our inventory levels of older products and exposing us to greater risk of product excess or obsolescence.

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OUR RELIANCE ON SMTC CORPORATION FOR ALL OF OUR MANUFACTURING REQUIREMENTS COULD CAUSE US TO LOSE ORDERS IF THIS THIRD PARTY MANUFACTURER FAILS TO SATISFY OUR COST, QUALITY AND DELIVERY REQUIREMENTS

     We currently contract with SMTC Corporation for all our manufacturing requirements. Any manufacturing disruption could impair our ability to fulfill orders. Our future success will depend, in significant part, on our ability to have SMTC or others manufacture our products cost-effectively and in sufficient volumes. We face a number of risks associated with our dependence on third-party manufacturers including:

	•		reduced control over delivery schedules;
	•		the potential lack of adequate capacity during periods of excess demand;
	•		manufacturing yields and costs;
	•		quality assurance;
	•		increases in prices; and
	•		the potential misappropriation of our intellectual property.

     We have no long-term contracts or arrangements with any of our vendors that guarantee product availability, the continuation of particular payment terms or the extension of credit limits. We have experienced in the past, and may experience in the future, problems with our contract manufacturer, such as inferior quality, insufficient quantities and late delivery of product. To date, these problems have not materially adversely affected us. We may not be able to obtain additional volume purchase or manufacturing arrangements on terms that we consider acceptable, if at all. If we enter into a high-volume or long-term supply arrangement and subsequently decide that we cannot use the products or services provided for in the agreement, our business will be harmed. We cannot assure you that we can effectively manage our contract manufacturer or that this manufacturer will meet our future requirements for timely delivery of products of sufficient quality or quantity. Any of these difficulties could harm our relationships with customers and cause us to lose orders.

In the future, we may seek to use additional contract manufacturers. We may experience difficulty in locating and qualifying suitable manufacturing candidates capable of satisfying our product specifications or quantity requirements. Further, new third-party manufacturers may encounter difficulties in the manufacture of our products resulting in product delivery delays.

MOST OF THE COMPONENTS FOR OUR PRODUCTS COME FROM SINGLE OR LIMITED SOURCES, AND WE COULD LOSE SALES IF THESE SOURCES FAIL TO SATISFY OUR SUPPLY REQUIREMENTS

     Almost all of the components used in our products are obtained from single or limited sources. Our products have been designed to incorporate a particular set of components. As a result, our desire to change the components of our products or our inability to obtain suitable components on a timely basis would require engineering changes to our products before we could incorporate substitute components.

     We do not have any long-term supply contracts to ensure sources of supply. If our contract manufacturer fails to obtain components in sufficient quantities when required, our business could be harmed. Our suppliers also sell products to our competitors. Our suppliers may enter into exclusive arrangements with our competitors, stop selling their products or components to us at commercially reasonable prices or refuse to sell their products or components to us at any price. Our inability to obtain sufficient quantities of single-sourced or limited-sourced components, or to develop alternative sources for components or products would harm our ability to maintain and expand our business.

POTENTIAL NEW ACCOUNTING PRONOUNCEMENTS ARE LIKELY TO IMPACT OUR FUTURE FINANCIAL POSITION AND RESULTS OF OPERATIONS

     Proposed initiatives could result in changes in accounting rules, including legislative and other proposals to account for employee stock options as compensation expense. These and other potential changes could materially increase the expenses we report under generally accepted accounting principles, and adversely affect our operating results.

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ANY ACQUISITIONS WE MAKE COULD RESULT IN DILUTION TO OUR EXISTING SHAREHOLDERS AND DIFFICULTIES IN SUCCESSFULLY MANAGING OUR BUSINESS

     We continually evaluate strategic acquisitions of other businesses. Our consummation of the acquisition of other businesses would subject us to a number of risks, including the following:

	•		difficulty in integrating the acquired operations and retaining acquired personnel;
	•		limitations on our ability to retain acquired distribution channels and customers;
	•		diversion of management’s attention and disruption of our ongoing business; and
	•		limitations on our ability to successfully incorporate acquired technology and rights into our product and service offerings and maintain uniform standards, controls, procedures, and policies.