PACKETEER INC - 10-K Annual 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes þ No o

Based on the closing sale price of the common stock on the Nasdaq National Market System on June 28, 2002, the aggregate market value of the voting common stock held by non-affiliates of the Registrant was $102,465,770. Shares of common stock held by each officer and director and by each person known by the Registrant to own 10% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

The number of shares outstanding of Registrant’s common stock, $0.001 par value, was 31,016,186 at February 28, 2003.

Information required by Part III, Items 10, 11, 12 and 13, of this Form 10-K is incorporated by reference from the Registrant’s definitive Proxy Statement for the Registrant’s 2003 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after December 31, 2002.

In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements regarding our strategy, financial performance and revenue sources that involve a number of risks and uncertainties, including those discussed below in “Risk Factors.” Forward-looking statements in this report include, but are not limited to, those relating to our ability to develop multiple applications, our planned introduction of new products and services, the possibility of acquiring complementary businesses, products, services and technologies and our development of relationships with providers of leading Internet technologies. 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 Annual Report. 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. See “Risk Factors.”

Packeteer is a leading provider of application traffic management systems designed to enable enterprises to gain visibility and control of networked applications, extend network resources and align application performance with business priorities. For service providers, Packeteer systems provide a platform for delivering application-intelligent network services that control quality of service, or QoS, expand revenue opportunities and offer compelling differentiation from other potential solutions. Our PacketShaper family of products, including the PacketShaper®, PacketSeeker^TM and PacketShaper Xpress^TM, integrates application discovery, analysis, control, acceleration and reporting technologies that are required for proactive application performance and bandwidth management. Our AppCelera^TM family of Internet acceleration appliances employs secure socket layer (SSL) offload and advanced content compression, transformation and caching technologies to improve response times of mission critical enterprise, eBusiness and eCommerce web applications. Our ReportCenter and PolicyCenter software products are designed to enable management of large deployments of our PacketShaper systems.

Packeteer’s products are deployed by Global 2000 corporations and service providers, and are 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, our PacketWise® software is licensed by several communications industry partners who integrate the software into specific strategic networking solutions. We primarily use indirect channels to leverage the reach of our sales force to obtain worldwide coverage. Our sales force and marketing efforts are used to develop brand awareness and support our indirect channels. We have subsidiaries or branch offices in Australia, Caymans, Canada, Denmark, France, Germany, Hong Kong, Japan, Singapore, Spain, South Korea, The Netherlands and the United Kingdom. To date we have shipped more than 24,000 units.

We were incorporated in Delaware in January 1996 and began shipping our products in February 1997. In this report, “Company”, “Packeteer,” “we,” “us,” and “our” refer to Packeteer, Inc. and its subsidiaries. Investors may access our filings with the Securities and Exchange Commission on our website, which is located on the Internet at www.packeteer.com, but the information on our website does not constitute part of this Annual Report.

Today, both the Internet and its underlying protocol, TCP/IP, have grown to positions of prominence in enterprise networking. Protocols are predefined mechanisms for computers to communicate over networks. From its origins as a network connecting academic and government institutions, the Internet has evolved into an interactive communications and commerce platform supporting businesses’ daily operations. Originally

intended to accommodate non-interactive traffic such as file transfers and e-mail, the Internet and TCP/IP were designed with the basic goals of connectivity, versatility and bandwidth exploitation. With the evolution towards Internet computing, TCP/IP has become the communications fabric, or as it is commonly referred to in the technology industry, the underlying protocol of mission-critical enterprise networks. The Internet has enabled a new generation of interactive applications to deliver core business functions, including eCommerce, data access and information exchange, to a broad range of users. Leveraging the fundamental attributes of the Internet and TCP/IP, businesses, consumers and suppliers have become better connected. This rapid development of a vast connected economy has given rise to a new innovative business model, the Internet computing model.

The rapid emergence of Internet computing has had a significant effect on today’s enterprise networks and has created new challenges for information technology managers. As more interactive business applications are developed using web-enabled versions of enterprise software platforms, such as SAP, Oracle, PeopleSoft and Siebel, the amount of network data is increasing dramatically. eCommerce extends the confines of the enterprise network across the Internet, making application performance difficult to ensure. Enterprise users access graphic-intensive web sites, download large files, view streaming media presentations, monitor news and stock quotes and access other non-critical information over the Internet. The resulting traffic deluge impacts network resources that serve point-of-sale, order processing, enterprise resource planning, supply-chain management and other vital business functions.

Internet computing relies on TCP/ IP as the underlying protocol to support distributed enterprise applications and the delivery of electronic services. The Internet Protocol, or IP, provides for routing of packets across networks that utilize TCP/ IP as their underlying protocol. The Transmission Control Protocol, or TCP, provides flow control for, and reliable ordered delivery of, Internet Protocol packets. Unlike early non-interactive applications that did not require real-time responsiveness, today’s enterprise and eCommerce applications depend on timely access to data and real-time transaction responses to ensure productivity and a high quality of experience for end users. The shift toward real-time, delay-sensitive data is accelerating as corporations begin to converge database transactions and multimedia traffic onto their enterprise networks. TCP/ IP is unable to differentiate between traffic types and is designed so that each transmission attempts to consume all available bandwidth. These characteristics, which make TCP/ IP suitable for non-interactive traffic, threaten the performance of today’s mission-critical applications.

In recent years, the adoption of Fast Ethernet and Gigabit Ethernet technologies has reduced network congestion on the local area network, or LAN. Simultaneously, the deployment of fiber infrastructure in the service provider backbone has also reduced bandwidth contention in that portion of the network. However, the bridge between the two, the wide area network, or WAN, access link, has remained the slow, weak link in the chain, forming a bandwidth bottleneck. WAN access link capacity is often constrained, expensive and difficult to upgrade. When faced with bandwidth contention at the bottleneck, TCP/ IP provides neither a means to give preferential treatment to select applications nor a good mechanism to effectively control data flows because TCP flow control is handled only by end systems. TCP/ IP reacts to network congestion by discarding data packets and sporadically reducing packet transmissions from the host computer. In enterprise networks that are overwhelmed by increasing amounts of both non-critical and mission-critical traffic, unmanaged congestion at the WAN access link undermines application performance and can result in impaired productivity and lost revenues.

Today’s enterprise networks require solutions that ensure mission-critical application performance, increase network efficiency, and enable the convergence of data, voice and video traffic. Enterprises are seeking to align their networks with their business priorities by making them adaptive to the unique requirements of the growing mix of mission-critical applications. At the same time, they seek to leverage investments in application software and proactively control recurring network costs by optimizing bandwidth utilization.

Many existing and newly emerging telecommunications service providers are also seeking to address the needs of enterprises that are adopting Internet computing. Service providers have traditionally functioned as WAN bandwidth suppliers, leasing data lines and selling Internet access to businesses and consumers. In the face of heightened competition, service providers are seeking to differentiate themselves by offering tiered services in order to attract and retain customers and increase profitability. These offerings include web hosting, application outsourcing and managed network services. To deliver these services, service providers must be able to ensure network and application performance and better manage and allocate network resources.

Businesses and service providers currently employ several approaches in an attempt to alleviate network congestion at the WAN access link. These approaches include the following:

Adding bandwidth and infrastructure to over-provision the network. This approach requires expensive upgrades to WAN access links and associated network equipment. Moreover, incremental increases in bandwidth only temporarily alleviate network congestion, leaving the following problems unresolved:


	•	Increases in bandwidth tend to be consumed quickly by latent demand within LAN and backbone infrastructure, and often disproportionately by non-mission critical traffic;

	•	Deployment costs and increases in recurring service charges can be prohibitively expensive, especially for networks with many remote sites and for international networks;

	•	There is no application performance visibility to enable effective capacity planning; and

	•	Over-provisioning results in under-utilization of the network during non-peak periods.

Implementing queuing-based features. Queuing technologies provide some degree of prioritization and are frequently incorporated in routers, which are devices that forward data packets from one LAN or WAN to another. These implementations engage only after queues form, and attempt to provide QoS by reordering packets and then discarding packets when the queues overflow. Queuing-based approaches typically identify and prioritize traffic based on rudimentary characteristics such as port number, a simplistic mechanism to coordinate the transmission of application data, IP address or protocol type. While these approaches can alleviate some of the bandwidth contention problems, they are inadequate to handle an increasingly complex mix of interactive and real-time mission-critical applications for the following reasons:


	•	Queuing-based approaches do not control inbound traffic flowing from the WAN to the LAN;

	•	Queuing-based approaches are reactive in nature and can only address congestion after the fact, rather than preventing it from occurring;

	•	Congested queues result in packet loss, retransmissions and delays that waste bandwidth and undermine application response times;

	•	Limited traffic classification capabilities inadequately distinguish between different types of applications, resulting in sub-optimal prioritization of traffic; and

	•	Queuing does not directly control end-to-end application performance.

Deploying traditional compression technologies. Products are available which compress traffic. Although compression can increase available bandwidth, which effectively increases network capacity and avoids bandwidth upgrades, the network and application performance problems are not necessarily eliminated. As TCP/ IP protocol is inherently bursty, non critical applications, even though compressed, may still consume


	•	Latency, which can negatively affect performance;

	•	Non selective compression, which results in some already compressed application traffic being delayed with no discernable benefit to performance; and

	•	Difficulty in configuring and maintaining compression tunnels.

Installing network-management tools. Several vendors provide software that analyzes and monitors network traffic. While these products enable network administrators to determine how bandwidth is being utilized, thereby identifying where bandwidth management is required, they do not comprise a complete solution for the following reasons:


	•	Traditional network-management tools only monitor and report network performance and bandwidth utilization, offering no means of fixing or resolving performance problems; and

	•	As is the case with queuing-based approaches, traditional network management tools are reactive in nature in that they detect problems once they occur and do not prevent similar problems in the future.

As Internet computing is more widely adopted, both businesses and service providers are seeking ways to cost-effectively manage bandwidth, ensure application performance and increase network efficiency. As mission-critical applications compete with bandwidth-hungry non-critical traffic for limited network resources, enterprises require a solution that not only monitors and reports on network performance problems, but also provides the means to fix such problems. As the complexity of their network infrastructures increases, enterprises seek solutions that integrate easily into the existing network and are cost-effective to deploy and maintain. In response to growing competition, service providers are looking to create new revenue streams by offering differentiated network and application-based services that meet the needs of enterprise customers. Whether the solution is implemented by the enterprise or purchased from a service provider, effectively managing the performance of mission-critical applications is essential to businesses relying on Internet computing.

Packeteer is a leading provider of application traffic management systems that are designed to enable enterprises, service providers, and other organizations to align network resources with business priorities. Packeteer systems monitor, control, and accelerate application performance over WANs and the Internet. Our systematic, application-intelligent approach is designed to ensure that mission-critical applications perform efficiently and reliably and that existing network resources are extended to support business needs. Packeteer’s application traffic management system is based on the following:


	I. Application Traffic Monitoring: Packeteer’s monitoring capabilities serve as the backbone for PacketSeeker, an application-intelligent traffic monitoring system, as well as PacketShaper, a traffic management system that incorporates both monitoring and policy control. Packeteer’s monitoring capabilities involve automatic identification and classification of traffic through Layer 7, the applications layer, which is the highest layer in the industry standard OSI (Open Systems Interconnection) model. This application-layer insight is designed to enable organizations to analyze application performance and network utilization accurately. Packeteer’s performance analysis determines response times, delays, link utilization, and many more crucial metrics. Depending on the size of the Packeteer deployment, performance analysis may be captured via onboard or centralized reporting.

	II. Application Traffic Shaping: Packeteer’s PacketShaper systems allow the user to set policy control that aligns application performance in support of business needs. PacketShaper systems allow mission-critical applications to perform efficiently and reliably by allocating varying amounts of bandwidth to applications depending on their relative importance. For instance, network managers can


	tailor policy management and bandwidth allocation to suit the requirements of particular applications or traffic, such as Citrix, SAP, Siebel, Video over IP and Voice over IP. Meanwhile, peer-to-peer file sharing, casual web browsing, and other unsanctioned traffic can be eliminated or minimized, depending on an organization’s available network resources and business priorities.

	III. Application Traffic Acceleration: Packeteer also enhances application performance through its acceleration technologies. PacketShaper Xpress provides a software option that utilizes application-intelligent compression, latency management and tunnel management to accelerate policy-managed business traffic. Packeteer also offers AppCelera ICX, an intranet acceleration system that addresses the trend of application “webification”. Utilizing a combination of compression, conversion, and caching, AppCelera ICX optimizes content to suit each user’s connection speed and browser. Its content-intelligent approach overcomes inherent last-mile obstacles reducing potential latency.

	IV. Report Performance: PacketShaper systems provide reports describing current and historical network performance. Comprehensive reports, graphs and tables enable network managers to refine bandwidth management policies, evaluate efficiency and plan capacity. PacketShaper systems automatically measure per-transaction response times for each application. Managers can set, enforce and monitor service-level agreements, which quantify desired QoS for a particular application or customer. Packeteer’s ReportCenter is designed to provide centralized analysis and reporting for large PacketSeeker and PacketShaper system deployments.

Our application traffic management systems are designed to enable businesses and service providers to realize the following key benefits:


	•	Gain Network Performance Visibility and Insight. PacketSeeker and PacketShaper provide valuable historical and real-time information about application performance and network utilization through an easy-to-use browser interface. Network managers gain a better understanding of the nature of traffic running on their networks and the problems and inefficiencies associated with that traffic.

	•	Ensure Bandwidth to Mission-Critical Applications. Policy-based bandwidth allocation protects bandwidth for mission-critical applications such as SAP, Oracle, PeopleSoft and Siebel, preventing disruptions from bandwidth-hungry but less urgent applications such as file transfers, peer-to-peer file sharing or casual web browsing.

	•	Permit Easy Deployment. PacketShaper installs easily, and automatically starts to discover, classify and analyze network traffic and suggest policies to optimize performance. It complements the existing network infrastructure, requires no router reconfiguration or desktop changes and is designed not to disrupt network connectivity in the event of software or hardware failure.

	•	Increase Effective Bandwidth. PacketShaper Xpress intelligently increases effective bandwidth and, through integration with PacketShaper’s advanced monitoring and shaping capabilities, enables the additional bandwidth to be utilized by mission-critical applications.

	•	Enable Interactive Services. Voice over IP, or VoIP, videoconferencing and other streaming media require guaranteed bandwidth in order to achieve minimum quality requirements. By using PacketShaper to set minimum bandwidth guarantees and priority, enterprises and service providers can deliver smooth and predictable performance of these delay-sensitive multimedia services.

	•	Increase Network Efficiency. PacketShaper improves network efficiency and helps delay expensive capacity upgrades by managing non-critical traffic to reduce retransmission overhead and smooth the variability in bandwidth utilization.

	•	Accelerate Web Applications. AppCelera applies content compression and optimization technologies to reduce bandwidth utilization and improve response times for web-enabled applications.

Our objective is to be the leading provider of application traffic management systems that give enterprises and service providers a new layer of control for applications delivered across intranets, extranets and the Internet. Key elements of our strategy include:

Focus on Bandwidth Management Needs of Enterprises. We are focused on providing high performance, easy-to-use and cost-effective bandwidth management solutions to enterprises whose businesses are based on Internet computing. For these businesses, managing mission-critical application performance and optimizing the value of the network will continue to be competitive requirements. As the Internet proliferates and new Internet-based applications and services emerge, we believe businesses will continue to adopt Internet computing business models at a rapid rate and that effective bandwidth management will become an increasingly important requirement for maintaining an efficient enterprise network. We believe we have established a differentiated market position based on our development of a comprehensive solution that provides for effective bandwidth management and our early market leadership and brand awareness. We intend to continue to direct our development, sales and marketing efforts toward addressing the bandwidth management needs of the Internet computing market.

Expand Presence in Telecommunications Service Provider Market. We are actively pursuing opportunities in the telecommunications service provider market and currently have numerous telecommunications service provider customers, including: AT&T, Equant, Fujitsu Cable, Hughes Network Systems, NTT Communications and Singapore Cable. We believe service providers are under increasing pressure to attract new subscribers, reduce subscriber turnover, improve operating margins and develop new revenue streams. Specifically, service providers seek to differentiate themselves through value-added service offerings, such as web hosting, application outsourcing and application service-level management. We believe our PacketShaper and PacketWise solutions enable service providers to deliver these higher value services by enhancing network and application performance and better managing and allocating network resources. Our goal is to increase demand for our solutions with service providers by leveraging our strong enterprise presence.

Expand Presence in the Managed Application Services Market. We are actively pursuing opportunities in the managed application services market and currently have several managed application service provider customers, including NTT Communications, Equant and AT&T using our managed application service features. Our software’s policy based application subscriber management features are designed to enable managed application service providers to quickly and cost-effectively deliver secure, measured and performance-assured application services tailored to the needs of specific markets and customers. Such features deliver a clearly defined service demarcation point between service providers and their customers and delivery-chain partners; provide and enforce QoS application-specific service level agreements (SLAs); and enable application-specific billing.

Continue to Build Indirect Distribution Channels. We currently have over 100 resellers, distributors, systems integrators and OEMs, that sell our products in over 50 countries. These relationships include: Allasso, Alternative Technology; Equant, Kanematsu USA, Lan Systems Pty. Ltd., Macnica, Inc, Net One Systems Co., Ltd., Nissho Electronics Corporation, RBR Networks Pte. Ltd. and Westcon, Inc. We intend to continue to develop and support new reseller and distribution relationships, as well as to establish additional indirect channels with service providers, systems integrators and OEMs. We believe this strategy will enable us to increase the worldwide deployment of our products.

Extend Bandwidth Management Technology Leadership. Our technological leadership is based on our sophisticated traffic classification, flexible policy setting capabilities, precise rate control expertise, web content acceleration and compression technologies and ability to measure response time and network performance. We intend to invest our research and development resources to increase performance by handling higher speed WAN connections, increase functionality by identifying and managing additional applications or traffic types, and increase modularity by taking individual components of PacketWise together or on a stand-alone basis with our existing bandwidth management solutions. We also plan to invest our research and development resources to develop new leading-edge technologies for emerging markets. These development plans include extending our bandwidth management solutions to incorporate in-depth application-management techniques

that will improve performance over the Internet and reduce bandwidth requirements. We plan to extend our current portfolio by offering PacketWise-defined solutions that target the specific needs of three primary market opportunities: enterprise bandwidth management, application service-level management and service provider bandwidth management.

Packeteer’s family of products — powered by our PacketWise software — enable enterprises and service providers to measure, control, accelerate and validate the performance of networked applications and managed application services.

PacketSeeker System. PacketSeeker is an application traffic-monitoring system that builds on the Company’s industry-leading Layer-7 traffic classification, analysis and reporting technology. It features a new PacketCapture^TM capability that enables effective remote problem diagnosis. PacketSeeker further distinguishes itself from “passive” monitoring solutions currently available by giving the user the ability to seamlessly upgrade the software to become a PacketShaper when traffic shaping is required to enforce quality of service.

PacketShaper System. PacketShaper is an application-based traffic and bandwidth management system designed to deliver predictable, efficient performance for applications running over the WAN and Internet. The PacketShaper Enterprise Edition is designed to provide effective application QoS using state-of-the-art bandwidth, traffic, service-level and policy management technology. The PacketShaper ISP Edition is designed to enable service providers to create differentiated services through fast and efficient bandwidth provisioning and management. With over 24,000 units shipped worldwide to enterprises and service providers, PacketShaper is a market leader in application traffic management systems. The PacketShaper family currently includes the 1500, 2500, 4500, 6500 and 8500 Enterprise Editions and 4500, 6500 and 8500 ISP Editions.

PacketShaper Xpress System. The PacketShaper Xpress is a product that provides application traffic acceleration. By leveraging its expertise in advanced Web acceleration and content compression technology, Packeteer has created a “universal” traffic acceleration solution that is highly efficient, scalable and simple to administer. Combining Layer 7 classification, traffic shaping and application-intelligent acceleration raises the level of control customers have over the performance of their networked applications and associated bandwidth costs.

AppCelera System. A product designed to accelerate the performance of Internet applications, AppCelera ICX (Internet Content Accelerator) is an advanced content acceleration product that can reduce web response-times by up to 50% by accelerating web content delivery all the way to the user’s desktop. It combines content compression, transformation and caching technologies to improve web application performance across the bandwidth-constrained last mile connections while reducing both server and bandwidth resource consumption.

PolicyCenter^TM Software. A directory-based policy management application that enables Packeteer’s enterprise and service provider customers to broadly deploy, scale and manage application QoS throughout the network, PolicyCenter is an LDAP directory-enabled application running under Windows 2000 or Windows NT that enables customers to centrally administer and update PacketShaper policies, software versions, and device status for Packeteer-based networks.

ReportCenter^TM Software. An application that aggregates metrics from large deployments and creates organization–wide reports to manage trends and provide support for capacity planning and usage analysis, ReportCenter lowers the cost of ownership for large deployments of PacketWise-enabled appliances, improves the quality of information and eases administrative overhead.

We differentiate our solution by combining our knowledge of enterprise applications with our expertise in underlying network protocols. We have invested heavily in developing valuable, proprietary software and

related technologies. In particular, we have developed expertise and technology in these major areas: sophisticated traffic discovery and classification, flexible policy definition and enforcement, precise rate control, application-based response-time measurement, high-performance packet engines and scaleable configuration. We have tied together these technologies with an easy-to-use, web browser interface in order to insulate the end user from the sophistication of the underlying technology and to allow them to derive the benefits of the technology with minimal effort.

We believe the ability to automatically detect and classify an extensive collection of applications and protocols differentiates PacketSeeker and PacketShaper systems from other bandwidth management technologies. Sophisticated traffic classification is crucial to understanding network congestion and to targeting appropriate bandwidth-allocation policies. Network software or devices that claim QoS features typically offer rudimentary solutions that can identify traffic based only on protocol type or port numbers. This approach limits application-specific QoS capabilities because these products do not recognize the detailed information required to make intelligent classification decisions. PacketSeeker and PacketShaper systems discover and classify traffic by focusing on content and applications where value to the end user lies.

Relying only on more basic traffic classification prevents network managers from discovering important traffic trends and limits policy setting. Sophisticated traffic types such as voice calls over networks based on Internet Protocol, or VoIP, Oracle 8i, TN3270, Citrix, and Microsoft DCOM cannot be identified using rudimentary traffic classification schemes. PacketSeeker and PacketShaper systems identify traffic markers, detect changing or dynamic port assignments and track transactions with changing port assignments. This sophisticated traffic classification allows network managers with PacketShaper systems to set policies and control the traffic related to an individual application, session, client, server or traffic type. PacketSeeker and PacketShaper systems permit a network manager to isolate each published application running on a centralized server and can also differentiate among various applications using the same port. This ability to individually classify applications is a highly valuable tool for network managers, since both non-critical applications such as web browsing and music downloading through peer-to-peer applications and mission-critical applications such as Citrix, Oracle or SAP and critical web sites may all be assigned to the same TCP port number on a network but can be individually classified using a PacketShaper system.

Packeteer systems need no assistance from network managers to automatically detect and identify approximately 400 different traffic types. Without a sophisticated identification and classification capability, managers are usually unaware of the diversity of their own network traffic. In addition, managers can use our technology to define proprietary applications so that their traffic can be recognized and reported. Our technology is differentiated by its ability to recognize older enterprise protocols, such as AppleTalk, DECnet, IPX and SNA. We frequently enhance our classification capability to include new traffic types. Any traffic category can be made even more specific by adding more detailed criteria — for example, Oracle traffic to or from a particular database. Some of the traffic types which Packeteer’s technology automatically detects and classifies are listed below. The traffic types are named either with their associated protocol or application and are grouped according to the class of application that generated that traffic. Each traffic type has an associated protocol that allows it to be recognized on the network.

PacketShaper systems provide network managers flexible tools to tailor solutions for different applications or traffic types. Unlike queuing-based approaches, PacketShaper systems allow network managers to do more than just prioritize one traffic type over another. Our policy features offer the flexibility required to tune bandwidth to specific applications and dynamically utilize available bandwidth. These policy features, which may be used individually or in conjunction with each other, include:


	•	Per-session Rate Policies. These policies enable network managers to limit or guarantee bandwidth to each individual session of an application’s traffic. Per-session policies allocate each session an appropriate amount of bandwidth and prevent one large session from inappropriately impacting others. Network managers specify a minimum-guaranteed rate and allow the session scaled access to additional available bandwidth. For example, a bandwidth cap for traffic prevents web browsers from competing for bandwidth required by mission-critical applications. Likewise, a guaranteed rate for


		audio or video streams ensures that they are not interrupted by traffic that tends to consume any available bandwidth.

	•	Partitions. Partitions allow for the creation of a separate, exclusive channel within a WAN access link. Partitions represent aggregate bandwidth minimums or maximums governing how much of the network can be used by a single application or traffic category. Partitions can be fixed, creating dedicated virtual circuits, or burstable, creating virtual circuits whose unused bandwidth can be shared.

	•	Dynamic Subscriber Bandwidth Provisioning. Dynamic Subscriber Bandwidth Provisioning allocates bandwidth and enforces QoS policies automatically by mapping a subscriber’s traffic profile (e.g. source/ destination IP address, traffic type, URL, etc.) to a prescribed policy. This feature is a scaleable and easy-to-deploy solution that actively provisions minimum and maximum bandwidth to up to 20,000 subscribers accessing the network concurrently. Using a 5-to-1 over subscription model, not uncommon in today’s service provider market, bandwidth for as many as 100,000 subscribers can be managed with a single PacketShaper. This feature also gives service providers additional revenue opportunities through multi-tiered Internet access services (e.g. bronze, silver, gold) for dial-up, DSL, cable and wireless subscribers.

	•	Priority Policies. This policy feature enables network managers to assign one of eight possible priority levels to each application or traffic category. Priority policies are ideal for traffic that does not burst, non-IP traffic and traffic characterized by small, high-priority flows.

	•	Admission-control Policies. Network managers can use admission-control policy features to determine the response if a bandwidth guarantee cannot be satisfied. Such responses may include denying access, accommodating an additional user with less than guaranteed performance, or, for web requests, redirecting the request to another server. For example, if an online streaming-video service suffers a high-demand period and all available bandwidth is consumed, an admission-control policy could present a web page explaining that resources are busy. This allows a maximum number of users to receive a targeted service quality without degradation as new users seek to access the service.

	•	Discard and Never-admit Policies. These policies intentionally block traffic. Discard policies toss packets without sending feedback to the sender. Never-admit policies are similar to discard policies except that the policy informs the sender that service is blocked.

One of TCP/ IP’s primary weaknesses is an inability to guarantee QoS. Unlike systems network architecture, or SNA, and asynchronous transfer mode, or ATM, protocols, which have an embedded concept of rate, TCP/ IP’s attempt to consume all available bandwidth conflicts with the goal of predictable, consistent, mission-critical application performance. PacketShaper’s standards-based TCP rate control technology overcomes TCP/ IP’s shortcomings by proactively preventing congestion on both inbound and outbound traffic flows and increasing overall network throughput. Rather than discarding packets from a congested queue, TCP rate control paces packet delivery to prevent congestion. Rate control uses the remote user’s access speed and real-time network latency to calculate the optimal transmission speed. Evenly paced packet transmissions, instead of packet bursts which consume all available bandwidth, yield significant efficiency gains in the network. TCP rate control is a proactive and precise way to increase network efficiency by avoiding retransmissions and packet loss. TCP rate control also creates a smooth and even flow rate that maximizes throughput. By employing TCP rate control, PacketShaper systems manage the majority of traffic at the WAN access link before network congestion occurs.

For non-TCP-based traffic, such as UDP, or User Datagram Protocol, alternative rate-based management techniques must be implemented. Typically UDP does not rely on acknowledgments to signal successful receipt of data, and it therefore offers no means for flow control. By directly controlling other TCP flows, however, PacketShaper systems are designed to effectively make bandwidth available for UDP flows. The combination of per flow rate scheduling and explicit delay boundaries removes latency and variability, or jitter, for the UDP flows traversing the WAN access link.

For example, VoIP is a UDP-based application that is particularly latency-sensitive, requiring packets to be evenly spaced to eliminate jitter. PacketShaper enhances VoIP performance in two ways. First, PacketShaper manages competing traffic by using rate control to constrain bursty TCP traffic. In addition, a rate policy for VoIP gives a minimum bandwidth guarantee to each flow, ensuring that each voice stream gets the bandwidth it needs for predictable performance. When there is a lull in the conversation, any unused bandwidth is re-allocated to other traffic.

The PacketShaper system’s position in the enterprise network — monitoring and controlling all the traffic that passes — gives it an opportunity to provide accurate response-time measurements. Because it already handles and classifies every packet, the PacketShaper system can easily calculate the amount of time traffic spends traveling between a client and a server and the amount of time used by the server itself.

The PacketShaper system breaks each response-time measurement into network delay, which is the amount of time spent in transit, and server delay, which is the amount of time the server is used to process the request. It can highlight clients and servers with the slowest performance. The PacketShaper system allows network managers to set acceptability standards and then track whether performance adheres to the standards.

Sophisticated classification and control of high-speed traffic must be accomplished in an efficient manner. Adding significant delay in the process of managing traffic flows would negate the resulting performance improvements. Packeteer has developed expertise in the development of high-speed, software-based packet engines running on real-time operating systems that can efficiently process thousands of simultaneous high-speed connections with minimal delay. This core-engine software technology scales to take advantage of ever-increasing microprocessor performance to manage faster access links.

Large deployments require tools to ease the process of updating tens or hundreds of PacketShapers that are distributed throughout the network. To address these requirements, Packeteer offers its own centralized management tools, PolicyCenter and ReportCenter. In addition to working with PacketShaper systems, PolicyCenter and ReportCenter were designed to align with industry standards and therefore integrate with third-party tools such as InfoVista, HP Open View and Micromuse.

Traffic can be accelerated by compression. Compression reduces traffic primarily by eliminating repeated sequences. Although compression effectively increases network capacity and avoids bandwidth upgrades, introducing compression or bandwidth upgrades does not necessarily eliminate network and application performance problems. As TCP/ IP is an inherently bursty protocol, non-critical applications frequently consume all available bandwidth. Therefore, applying compression may increase the “virtual size” of a WAN connection, but does not ensure that mission-critical application traffic takes advantage of the newly created bandwidth. In addition, standard compression adds latency to the compressed traffic. This latency, which is caused by the act of compressing itself and by trying to compress traffic that cannot be compressed further, increases configuration and management complexity.

PacketShaper Xpress merges application traffic management with acceleration using compression, active tunnel management and latency management. The integration of PacketShaper Xpress with the PacketShaper traffic management technology is designed to ensure that increased WAN capacity is utilized by mission-


	•	making compression decisions based on application type;

	•	utilizing application specific algorithms, and;

	•	working with TCP rate control and other traffic management technology to manage flows of data through the compression engine to ensure consistent, predictable responses.

PacketShaper Xpress also reduces configuration and management complexity of compression through the use of the active tunnel management feature. This feature uses dynamic discovery and automatic establishment of tunnels to simplify deployment and ongoing maintenance costs.

While traffic management prioritizes mission-critical applications and smoothes bursty traffic, PacketShaper Xpress enhances performance by fostering greater throughput, faster performance, and increased network capacity.

Our technology includes several network appliances (hardware and software systems), represented by the AppCelera ICX-55, ICX-75 and ICX-75s, ICX-95 and ICX-95s that accelerate the transmission and rendering speed of Internet applications by compressing traffic from end-to-end and dynamically increasing the throughput of the low and medium speed connections, and in the case of the ICX-75s and ICX-95s, provide the ability to offload secure socket layer (SSL) processing. The software embedded in these appliances achieves these results by using dynamic, static and variant content caching together with content-aware compression and transformation techniques for an increase in performance. These products also determine the type of content, speed of access, and type of browser and automatically optimize the speed of delivery and rendering of information. By combining caching with compression, this technology accelerates delivery of business content and Internet applications to the user. AppCelera ICX is designed to accelerate content as it overcomes the worst sources of performance impact — first mile SSL overload and last-mile bandwidth constraints — that limit the effectiveness of stand-alone caches and load balancers.

We sell all of our products primarily through indirect channel partners. The following is a representative list of our indirect channel partners by geographic region:

The following is a representative list of end users that have deployed multiple PacketShapers:

In 2002, sales to Alternative Technology, Inc., Westcon, Inc., and Macnica, Inc. accounted for 21%, 13% and 11% of net revenues respectively. In 2001 and 2000, one customer, Alternative Technology, Inc., accounted for 22% and 12% of net revenues, respectively. No other customer accounted for 10% or more of revenues in 2001 or 2000. Sales to the top 10 indirect channel partners accounted for 66%, 59%, and 46% of net revenues for the years ended December 31, 2002, 2001 and 2000, respectively.

We outsource all of our manufacturing, including warranty repair, to one contract manufacturer, SMTC Manufacturing Corporation (SMTC) located in San Jose, California. The manufacturing processes and procedures for this manufacturer are ISO 9002 certified. Outsourcing our manufacturing enables us to reduce fixed costs and to provide flexibility in meeting market demand.

We design and develop a majority of the key components of our products, including printed circuit boards and software. In addition, we determine the components that are incorporated into our products and select the appropriate suppliers of these components. Product testing and burn-in is performed by our contract manufacturer using tests and automated testing equipment that we specify. We also use inspection testing and statistical process controls to assure the quality and reliability of our products.

We use a rolling six-month forecast based on anticipated product orders to determine our material requirements. Lead times for the materials and components we order vary significantly and depend on factors such as specific supplier, contract terms and demand for a component at a given time. We submit purchase orders for quantities needed within the next 90 days. SMTC or Packeteer may terminate the contract without cause at any time. At that time the terminating party must honor all open purchase orders.

We target our marketing and sales efforts at enterprises and service providers. Marketing and sales activities focus on reaching the corporate information technology organization managers responsible for the performance of mission-critical applications and maintenance of network performance in the enterprise. We also focus on reaching service providers that provide valued-added service offerings, such as application performance monitoring and management.

Our marketing programs support the sale and distribution of our products and educate existing and potential enterprise and service provider customers about the benefits of our application traffic management systems. Our marketing efforts include the following:


	•	publication of technical, educational and business articles in industry magazines;

	•	public speaking opportunities at international tradeshows, conferences and analyst events;


	•	electronic marketing including web site-based communication programs, electronic newsletters and on-line end-user seminars;

	•	industry tradeshows, technical conferences and technology seminars; and

	•	focused advertising, direct mail, public relations and analyst outreach.


	•	Channel Partners. Packeteer has teamed with value-added resellers and distributors in the industry that are distinguished by their ability to deliver comprehensive QoS solutions, their industry expertise, and their commitment to customer satisfaction. We have established an indirect distribution channel, which is comprised of a network of over 100 resellers, distributors and system integrators that sell our solutions in over 50 countries. These partners sell our systems and software products as well as other third-party products that are complementary to our application traffic management systems.

	•	Alliance Partners. Our Alliance Partners Program (APP) unites Packeteer with organizations whose product offerings enhance, extend and advance Packeteer technology in the marketplace. In exchange, Packeteer presents APP partners with the opportunity to extend to its customers our industry-leading application performance and quality of service solutions. The APP has three designations, differentiated by the partner’s customer focus: Technology Alliance Partner, Solutions Alliance Partner, and Strategic Integration Partner. Technology Alliance Partners include partnerships that provide customers with more sophisticated classification, control, reporting and management of their applications. Solutions Alliance Partners include companies whose product/ solution offerings require performance enhancing technologies, such as QoS or content acceleration. Strategic Alliance Partners include integration and consulting organizations that seek to offer Packeteer products as part of a whole solution offering. Some of these Alliance Partners include Citrix, Compaq Computer Corporation/ Hewlett Packard, Concord and InfoVista.

As of December 31, 2002, our worldwide sales and marketing organization consisted of 83 individuals, including managers, sales representatives and technical and administrative support personnel. We have domestic sales offices located in California, Illinois, Massachusetts, New Jersey and Texas. In addition, we have international sales offices located in Australia, Denmark, England, France, Germany, Hong Kong, Japan, Singapore, South Korea, Spain and The Netherlands.

We believe there is a strong international market for our application traffic management solutions. Our international sales are conducted primarily through our overseas offices. Sales to customers outside of North America accounted for 58%, 55% and 54% of our net revenues in 2002, 2001 and 2000, respectively.

As of December 31, 2002, our research and development organization consisted of 63 employees providing expertise in different areas of our software: core functionality, classification, central management, user interface and platform engineering. Since inception, we have focused our research and development efforts on developing and enhancing our application performance solutions.

Our customer service and support organization provides technical support services. Our technical support staff is strategically located in five regional service centers: California, Hong Kong, Japan, Australia and The Netherlands. These services, which may include telephone/ web support, next business day advance replacement and access to all software updates and upgrades, are typically sold as single or multi-year contracts to our resellers and end users. In addition, Packeteer has formal agreements with two third party service providers to facilitate next business day replacement for end-user customers outside the United States covered by maintenance agreements providing this service level. We believe that these programs will improve service levels and lead to increased customer satisfaction.

We compete in a rapidly evolving and highly competitive sector of the Internet application infrastructure system market. We expect competition to persist and intensify in the future from a number of different sources. Increased competition could result in reduced prices and gross margins for our products and could require increased spending by us on research and development, any of which could harm our business. We compete with Cisco, CheckPoint and several small private companies that sell products that utilize competing technologies to provide bandwidth management. In addition, our products and technology compete for information technology budget allocations with products that offer monitoring technologies, such as probes and related software. Lastly, we face indirect competition from companies that offer enterprises and service providers’ increased bandwidth and infrastructure upgrades that increase the capacity of their networks, and thereby may lessen or delay the need for bandwidth management.

We believe the principal competitive factors in the traffic management market are:


	•	expertise and in-depth knowledge of applications;

	•	timeliness of new product introductions;

	•	ability to integrate in the existing network architecture without requiring network reconfigurations or desktop changes;

	•	ability to ensure end-user performance in addition to aggregate performance of the WAN access link;

	•	ability to compress traffic without decreasing throughput, performance or network capacity;

	•	ability to integrate traffic classification, management, reporting and acceleration into a single platform;

	•	compatibility with industry standards;

	•	products that do not increase latency and packet loss;

	•	size and scope of distribution network;

	•	brand name; and

	•	access to customers and size of installed customer base.

We rely on a combination of patent, copyright and trademark laws, and on trade secrets, confidentiality provisions and other contractual provisions to protect our proprietary rights. These measures afford only limited protection. As of December 31, 2002 we have 11 issued U.S. patents and 34 pending U.S. patent applications. We cannot assure you that our means of protecting our proprietary rights in the U.S. or abroad will be adequate or that competitors will not independently develop similar technologies. Our future success depends in part on our ability to protect our proprietary rights to the technologies used in our principal products. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use trade secrets or other information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the U.S. We cannot assure you that any issued patent will preserve our proprietary position, or that competitors or others will not develop technologies similar to or superior to our technology. Our failure to enforce and protect our intellectual property rights could harm our business, operating results and financial condition.

From time to time, third parties, including our competitors, have asserted patent, copyright and other intellectual property rights to technologies that are important to us. We expect that we will increasingly be subject to infringement claims as the number of products and competitors in the application-adaptive bandwidth management market grows and the functionality of products overlaps. The results of any litigation matter are inherently uncertain. In the event of an adverse result in any litigation with third parties that could arise in the future, we could be required to pay substantial damages, including treble damages if we are held to have willfully infringed, to cease the manufacture, use and sale of infringing products, to expend significant

resources to develop non-infringing technology, or to obtain licenses to the third-party technology. Licenses may not be available from any third party that asserts intellectual property claims against us on commercially reasonable terms, or at all. In addition, litigation frequently involves substantial expenditures and can require significant management attention, even if we ultimately prevail.

As of December 31, 2002, Packeteer employed a total of 203 full-time employees. Of the total number of employees, 63 were in research and development, 67 in sales and system engineering, 16 in marketing, 30 in operations and 27 in administration. Our employees are not represented by any collective bargaining agreement with respect to their employment by Packeteer.

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;

	•	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 will be difficult to sustain

Although we earned a net income of $3.7 million in 2002, we incurred net losses of $71.0 and $9.4 million in 2001 and 2000 respectively. As of December 31, 2002, we had an accumulated deficit of $103.4 million. Our recent profitability could be difficult to sustain. 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 management solutions market fails to grow, our business will fail

The market for application traffic management 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.

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 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 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.

The average selling prices of our products could decrease rapidly which may negatively impact gross margins and revenues

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.

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 58%, 55% and 54% of our total net revenues in fiscal 2002, 2001 and 2000, respectively. Our ability to grow will depend in part on the expansion of international sales, which will require success on the part of our resellers, distributors and systems integrators 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, or 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 and systems integrators 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 the significantly more extensive and well-funded sales and marketing operations of many 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.

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. In 2002, sales to Alternative Technology, Inc., Westcon, Inc., and Macnica, Inc. accounted for 21%, 13% and 11% of net revenues respectively. In 2001 and 2000, one customer, Alternative Technology, Inc., accounted for 22% and 12% of net revenues, respectively. No other customer accounted for 10% or more of revenues in 2001 or 2000. 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.

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.

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.

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.

We have relied and expect to continue to rely on a limited number of products for a significant portion of our revenues

Most of our revenues have been derived from sales of our PacketShaper family of products and related maintenance and training services. We currently expect that PacketShaper-related revenues will continue to account for a substantial percentage of our revenues in fiscal 2003 and for the foreseeable future thereafter. Our future operating results are significantly dependent upon the continued market acceptance of our PacketShaper family of products and enhanced PacketShaper applications. Our business will be harmed if our PacketShaper products do not continue to achieve market acceptance or if we fail to develop and market improvements to our PacketShaper products or new and enhanced products. A decline in demand for our PacketShaper family of products as a result of competition, technological change or other factors would harm our business.

Introduction of our new products may cause customers to defer purchases of our existing products which could harm our operating results

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 obsolescence.

Our reliance on SMTC 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 for all of 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 manufacturers, 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. Any such changes could be costly and result in lost sales.

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.

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.

Furthermore, we may incur indebtedness or issue equity securities to pay for future acquisitions. The issuance of equity or convertible debt securities could be dilutive to our existing shareholders.

Our inability to attract and retain qualified personnel could significantly interrupt our business operations

Our future success will depend, to a significant extent, on the ability of our management to operate effectively, both individually and as a group. We are dependent on our ability to attract, retain and motivate high caliber key personnel. Competition for qualified personnel and management in the networking industry, including engineers, sales and service and support personnel, is intense, and we may not be successful in attracting and retaining such personnel. There may be only a limited number of persons with the requisite skills to serve in these key positions and it may become increasingly difficult to hire such persons. Competitors and others have in the past and may in the future attempt to recruit our employees. We do not have employment contracts with any of our personnel. Our business will suffer if we encounter delays in hiring these additional personnel.

We may be unable to compete effectively with other companies in our market sector who are substantially larger and more established and who have significantly greater resources than our company

We compete in a rapidly evolving and highly competitive sector of the networking technology market. We expect competition to persist and intensify in the future from a number of different sources. Increased competition could result in reduced prices and gross margins for our products and could require increased spending by us on research and development, sales and marketing and customer support, any of which could harm our business. We compete with Cisco Systems, Inc. and CheckPoint Software Technologies Ltd., which sell products incorporating competing technologies. We also compete with several small private companies that utilize competing technologies to provide bandwidth management and compression. In addition, our products and technology compete for information technology budget allocations with products that offer monitoring capabilities, such as probes and related software. Lastly, we face indirect competition from companies that offer enterprises and service providers increased bandwidth and infrastructure upgrades that increase the capacity of their networks, which may lessen or delay the need for traffic management solutions.

Some of our competitors are substantially larger than we are and have significantly greater financial, sales and marketing, technical, manufacturing and other resources and more established distribution channels. These competitors may be able to respond more rapidly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion and sale of their products than we can. We have encountered, and expect to encounter, customers who are extremely confident in and committed to the product offerings of our competitors. Furthermore, some of our competitors may make strategic acquisitions or establish cooperative relationships among themselves or with third parties to increase their ability to rapidly gain market share by addressing the needs of our prospective customers. These competitors may enter our existing or future markets with solutions that may be less expensive, provide higher performance or additional features or be introduced earlier than our solutions. Given the market opportunity in the traffic management solutions market, we also expect that other companies may enter or announce an intention to enter our market with alternative products and technologies, which could reduce the sales or market acceptance of our products and services, perpetuate intense price competition or make our products obsolete. If any technology that is competing with ours is or becomes more reliable, higher performing, less expensive or has other advantages over our technology, then the demand for our products and services would decrease, which would harm our business.

If we do not expand or enhance our product offerings or respond effectively to technological change, our business may not grow

Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address customer requirements in a cost-effective manner. We cannot assure you that our technological approach will achieve broad market acceptance or that other technologies or solutions will not supplant our approach. The traffic management solutions market is characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. The introduction of new products, market acceptance of products based on new or

alternative technologies, or the emergence of new industry standards, could render our existing products obsolete or make it easier for other products to compete with our products. Developments in router-based queuing schemes could also significantly reduce demand for our product. Alternative technologies, including packet-queuing and compression technologies, could achieve widespread market acceptance. Our future success will depend in large part upon our ability to:


	•	develop and maintain competitive products;

	•	enhance our products by adding innovative features that differentiate our products from those of our competitors;

	•	bring products to market on a timely basis at competitive prices;

	•	identify and respond to emerging technological trends in the market; and

	•	respond effectively to new technological changes or new product announcements by others.

We have in the past experienced delays in product development which to date have not materially adversely affected us. However, these delays may occur in the future and could result in a loss of customers and market share.

If we are unable to effectively manage our growth, we may experience operating inefficiencies and have difficulty meeting demand for our products

In the past, we have experienced rapid and significant expansion of our operations. If further rapid and significant expansion is required to address potential growth in our customer base and market opportunities, this expansion could place a significant strain on our management, products and support operations, sales and marketing personnel and other resources, which could harm our business.

In the future, we may experience difficulties meeting the demand for our products and services. The use of our products requires training, which is provided by our channel partners, as well as ourselves. If we are unable to provide training and support for our products in a timely manner, the implementation process will be longer and customer satisfaction may be lower. In addition, our management team may not be able to achieve the rapid execution necessary to fully exploit the market for our products and services. We cannot assure you that our systems, procedures or controls will be adequate to support the anticipated growth in our operations.

We may not be able to install management information and control systems in an efficient and timely manner, and our current or planned personnel, systems, procedures and controls may not be adequate to support our future operations.

Our products may have errors or defects that we find after the products have been sold, which could negatively affect our revenues and the market acceptance of our products and increase our costs

Our products are complex and may contain undetected defects, errors or failures in either the hardware or software. In addition, because our products plug into our end users’ existing networks, they can directly affect the functionality of the network. Furthermore, end users rely on our products to maintain acceptable service levels. We have in the past encountered errors in our products, which in a few instances resulted in network failures and in a number of instances resulted in degraded service. To date, these errors have not materially adversely affected us. Additional errors may occur in our products in the future. The occurrence of defects, errors or failures could result in the failure of our customer’s network or mission-critical applications, delays in installation, product returns and other losses to us or to our customers or end users. In addition, we would have limited experience responding to new problems that could arise with any new products that we introduce. These occurrences could also result in the loss of or delay in market acceptance of our products, which could harm our business.

We may also be subject to liability claims for damages related to product errors. While we carry insurance policies covering this type of liability, these policies may not provide sufficient protection should a claim be asserted. A material product liability claim may harm our business.

Failure to adequately protect our intellectual property would result in significant harm to our business

Our success depends significantly upon our proprietary technology and our failure or inability to protect our proprietary technology would result in significant harm to our business. We rely on a combination of patent, copyright and trademark laws, and on trade secrets, confidentiality provisions and other contractual provisions to protect our proprietary rights. These measures afford only limited protection. As of December 31, 2002 we have eleven issued U.S. patents and thirty-four pending U.S. patent applications. Currently, none of our technology is patented outside of the United States. Our means of protecting our proprietary rights in the U.S. or abroad may not be adequate and competitors may independently develop similar technologies. Our future success will depend in part on our ability to protect our proprietary rights and the technologies used in our principal products. Despite our efforts to protect our proprietary rights and technologies unauthorized parties may attempt to copy aspects of our products or to obtain and use trade secrets or other information that we regard as proprietary. Legal proceedings to enforce our intellectual property rights could be burdensome and expensive and could involve a high degree of uncertainty. These legal proceedings may also divert management’s attention from growing our business. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the U.S. Issued patents may not preserve our proprietary position. If we do not enforce and protect our intellectual property, our business will suffer substantial harm.

Claims by others that we infringe on their intellectual property rights could be costly to defend and could harm our business

We may be subject to claims by others that our products infringe on their intellectual property rights. These claims, whether or not valid, could require us to spend significant sums in litigation, pay damages, delay product shipments, reengineer our products or acquire licenses to such third-party intellectual property. We may not be able to secure any required licenses on commercially reasonable terms, or at all. We expect that we will increasingly be subject to infringement claims as the number of products and competitors in the traffic management solutions market grows and the functionality of products overlaps. Any of these claims or resulting events could harm our business.

If our products do not comply with evolving industry standards and government regulations, our business could be harmed

The market for traffic management solutions is characterized by the need to support industry standards as these different standards emerge, evolve and achieve acceptance. In the United States, our products must comply with various regulations and standards defined by the Federal Communications Commission and Underwriters Laboratories. Internationally, products that we develop must comply with standards established by the International Electrotechnical Commission as well as with recommendations of the International Telecommunication Union. To remain competitive we must continue to introduce new products and product enhancements that meet these emerging U.S. and international standards. However, in the future we may not be able to effectively address the compatibility and interoperability issues that arise as a result of technological changes and evolving industry standards. Failure to comply with existing or evolving industry standards or to obtain timely domestic or foreign regulatory approvals or certificates could harm our business.

Our growth and operating results would be impaired if we are unable to meet our future capital requirements

We currently anticipate that our existing cash and investment balances and available line of credit will be sufficient to meet our liquidity needs for 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.

In addition, we expect to review potential acquisitions that would complement our existing product offerings or enhance our technical capabilities. While we have no current agreements or negotiations underway

with respect to any such acquisition, any future transaction of this nature could require potentially significant amounts of capital. These funds may not be available at the time or times needed, or 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.

Certain provisions of our charter and of Delaware law make a takeover of Packeteer more difficult, which could lower the market price of the common stock

Our corporate documents and Section 203 of the Delaware General Corporation Law could discourage, delay or prevent a third party or a significant stockholder from acquiring control of Packeteer. In addition, provisions of our certificate of incorporation may have the effect of discouraging, delaying or preventing a merger, tender offer or proxy contest involving Packeteer. Any of these anti-takeover provisions could lower the market price of the common stock and could deprive our stockholders of the opportunity to receive a premium for their common stock that they might otherwise receive from the sale of Packeteer.

We lease approximately 69,000 square feet of administrative and research and development facilities in Cupertino, California under a lease that expires November 2007. We also lease sales offices in the following domestic locations: Bedminster, New Jersey; Dallas, Texas; Fall River, Massachusetts; Irvine, California; Schaumburg, Illinois; and Westlake Village, California. Our international leased offices include a research and development facility located in Canada, and sales and marketing offices in Australia, France, Germany, Hong Kong, Singapore, South Korea, Spain and The Netherlands. We believe that our future growth can be accommodated by current facilities or by leasing the necessary additional space.

In November 2001, Packeteer, certain company officers and directors, and underwriters of our initial public offering 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.

In October 2002, the plaintiffs agreed to dismiss the company’s officers and directors from the litigation without prejudice, in return for a tolling agreement. The Company moved to dismiss the claims against it. The Court recently denied the motion. As a result, the case may proceed to the discovery phase. We believe that we have meritorious defenses to the lawsuit and will defend ourselves vigorously in the litigation. We are not presently able to estimate the losses, if any, related to this lawsuit, and accordingly, as of December 31, 2002, no accrual for this contingency has been recorded.

We are routinely involved in legal and administrative proceedings incidental to our normal business activities and believe that these matters will not have a material adverse effect on our financial position, results of operations or cash flows.

Our common stock has been quoted on the Nasdaq National Market under the symbol “PKTR” since our initial public offering on July 28, 1999. Prior to this time, there was no public market for our common stock. The following table shows the high and low closing prices per share of our common stock as reported on the Nasdaq National Market for the periods indicated:

As of February 28, 2003, there were approximately 400 registered holders of our common stock. We have never declared or paid any dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. The covenants under our Loan and Security Agreement with Silicon Valley Bank prohibit us from paying cash dividends.

Craig W. Elliott, a director and our former President and CEO, and Brett D. Galloway, a director and our former Vice President of Corporate Development, have informed us that, in order to diversify their investment portfolios while avoiding conflicts of interest or the appearance of any such conflict that might arise from their position with the Company, they have established written plans in accordance with SEC Rule 10b5-1 for gradually liquidating a portion of their holdings of our common stock. Such plans call for sales of a specific number of shares of stock per month, subject to certain contingencies relating to prevailing stock price.

The selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements of Packeteer, Inc. and the notes thereto included elsewhere in this report. The historical results are not necessarily indicative of the operating results to be expected in the future.

The following discussion should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this report. Except for historical information, the discussion in this report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of a number of factors, including the risks described in the section titled “RISK FACTORS” beginning on page 16.

Packeteer is a leading provider of application traffic management systems designed to enable enterprises to gain visibility and control for networked applications, extend network resources and align application performance with business priorities. For service providers, Packeteer systems provide a platform for delivering application-intelligent network services that control quality of service, expand revenue opportunities and offer compelling differentiation. Packeteer’s products — powered by PacketWise software — are designed to ensure end-to-end 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 PacketSeeker, PacketShaper and PacketShaper Xpress 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 SSL offload 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 and system integrators, 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 or branch offices in Australia, Canada, Caymans, Denmark, France, Germany, Hong Kong, Japan, Singapore, South Korea, The Netherlands, and the United Kingdom. To date, we have shipped more than 24,000 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.

In order to further the growth of our business, we sold 4,600,000 shares of common stock in our initial public offering on July 28, 1999, which raised approximately $62.6 million net of fees and expenses.

We have a limited operating history. As of December 31, 2002, we had an accumulated deficit of $103.4 million. We achieved profitability throughout fiscal 2002. However, as we incurred losses since we commenced operations in 1996 until 2002, continued profitability could be difficult to sustain. We expect to continue to incur significant sales and marketing, product development and administrative expenses and, as a result, will need to generate significant quarterly revenues to maintain profitability.

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 under different assumptions or conditions.

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 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:


	•	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, 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 of the customer and past transaction history of the customer.

	Our standard revenue recognition policy includes modifications 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) of fair value 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 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 and Goodwill. 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 for 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.

	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 as described in Note 1 to the Financial Statements. 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.

	In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 142 changes the accounting for goodwill from an amortization method to an impairment-only approach. Any goodwill or other intangible assets recorded in the future will be tested for impairment on an annual basis according to the specific guidance in the statement.

	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 indicator for estimating future returns. Material differences may result in the amount and timing of our revenue if for any period actual returns differ from our judgments or estimates. The sales return reserve balances at December 31, 2002 and 2001 were $875,000 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 $145,000 and $132,000 at December 31, 2002 and 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 warranty 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 products 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 $284,000 and $552,000 at December 31, 2002 and 2001, respectively.

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

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

Total net revenues increased to $55.0 million in fiscal 2002 from $46.7 million in fiscal 2001 and from $41.1 million in fiscal 2000. Product revenues increased to $47.2 million in fiscal 2002 from $41.1 million in fiscal 2001 and from $38.1 million in fiscal 2000. The increase in product revenues from 2001 to 2002 was primarily due to a favorable product mix, as sales of our higher end products continue to represent a higher percentage of our reported revenues. To a lesser extent, an overall increase in the number of units shipped also

contributed to the increase in product revenues. The increase from 2000 to 2001 was due to a more favorable product mix, with sales of our PacketShaper 6500 models, introduced in the fourth quarter of fiscal 2000, showing the largest growth in 2001. There were no significant changes in selling prices during any of the periods presented. Service revenues increased to $7.8 million in fiscal 2002 from $5.6 million in fiscal 2001 and from $3.0 million in 2000 due mainly to increases in the number of units on maintenance contracts.

For fiscal 2002, total net revenues in North America increased to $23.1 million, from $20.8 million in fiscal 2001 and $18.8 million in fiscal 2000. Sales in North America accounted for 42%, 45% and 46% of net revenues for 2002, 2001 and 2000, respectively. Net revenues in Asia Pacific were $18.0 million, $12.1 million and $11.6 million, or 33%, 26% and 28% of net revenues in 2002, 2001 and 2000, respectively. The increase in 2002 was due to strong sales in Japan. Net revenues in Europe, the Middle East and Africa, “EMEA”, of $13.9 million, $13.8 million and $10.7 million, represented 25%, 29% and 26% of net revenues in fiscal 2002, 2001 and 2000, respectively.

In 2002, sales to three customers, Alternative Technology, Inc., Westcon, Inc., and Macnica, Inc. accounted for 21%, 13% and 11% of net revenues respectively. In 2001 and 2000, one customer, Alternative Technology, Inc., accounted for 22% and 12% of net revenues, respectively. No other customer accounted for 10% or more of revenues in 2001 or 2000. Sales to the top 10 indirect channel partners accounted for 66%, 59%, and 46% of net revenues for the years ended December 31, 2002, 2001 and 2000, respectively. At December 31, 2002, three customers accounted for 38% of accounts receivable.

Despite our belief that world-wide economic growth and IT spending will remain relatively flat for at least 2003, 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 continue to allow us to grow our business again in 2003. Our growth rate and net revenue depend significantly on continued growth in the application traffic 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 products on maintenance, which is dependent on both growing our installed 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 and 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 net revenues and operating results.

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 decreased to $12.9 million in fiscal 2002 from $13.9 million in fiscal 2001 and increased from $12.6 million in fiscal 2000. The cost of revenues represented 23%, 30% and 31% of net revenues in fiscal 2002, 2001, and 2000, respectively.

Product costs decreased to $9.8 million in fiscal 2002 from $10.9 million in fiscal 2001 and $10.7 million in fiscal 2000. Overhead costs, specifically warranty costs and parts costs, decreased $1.3 million in fiscal 2002 compared to fiscal 2001. This was partially offset by an increase in manufacturing costs, due to increased products shipped. Per unit manufacturing costs decreased in 2002, compared to 2001, due to lower component prices. The increase from 2000 to 2001 was due to increases in overhead costs, partially offset by reductions in manufacturing and other product costs. To maintain our 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 2002. 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.

Service costs remained unchanged at $3.0 million in fiscal 2002 compared to $3.0 million in fiscal 2001 and increased from $1.9 million in fiscal 2000. Decreased consulting costs in 2002 were offset by increased

service fees and supplies related to an agreement entered into in the third quarter of 2002 for the outsourcing of certain maintenance and support services. The increases from 2000 to 2001 are due to the costs of developing the service support organization to support the increased installed base. Prior to fiscal 2000, support activities were handled primarily by the sales organization. We expect service costs to increase in absolute dollars in future quarters primarily as a result of increased service fees related to the outsourcing of certain maintenance and support services.

Amortization of acquired technology relates to the acquired developed technologies of Workfire Technologies International, Inc. (Workfire). 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 during 2001 and $678,000 in 2000.

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 our products and software. Excluding the effects of stock-based compensation of $183,000, $663,000 and $558,000 for the years 2002, 2001 and 2000, respectively, research and development expenses decreased to $10.7 million in fiscal 2002 from $11.7 million in fiscal 2001 and increased from $8.8 million in fiscal 2000. The decreased expenses in 2002 were primarily due to a decrease in program related charges, mainly project materials, and to a lesser extent, a reduction in depreciation expense, partially offset by an increase in distributed costs. Distributed costs include expenses related to facilities, communications and technology, which are allocable to all functional areas of the Company. The increase in distributed expenses is discussed below under the heading “GENERAL AND ADMINISTRATIVE”. The increase in research and development expenses from fiscal 2000 to fiscal 2001 was due to increases in staffing and related personnel costs, as well as increases in project related materials. The increase in personnel related expenses was due to the inclusion of Workfire for all of fiscal 2001, compared to only three and one half months in fiscal 2000. Research and development expenses represented 20%, 25% and 21% of net revenues in fiscal 2002, 2001 and 2000, respectively. As of December 31, 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.

Sales and marketing expenses consist primarily of salaries, commissions and related personnel expenses for those engaged in the sales, marketing and support of the product as well as related trade show, promotional and public relations expenses. Excluding the effects of stock-based compensation of $151,000, $442,000 and $892,000 in 2002, 2001 and 2000 respectively, sales and marketing expenses increased to $23.3 million in fiscal 2002, from $22.4 million in fiscal 2001, and from $18.6 million in fiscal 2000. In 2002, increases in personnel costs, specifically commissions and recruiting, and distributed costs, were partially offset by decreases in depreciation expense, supplies costs and marketing activities. The increase in distributed costs is discussed below under the heading “GENERAL AND ADMINISTRATIVE”. The increases in fiscal 2001 compared to fiscal 2000 reflected the hiring of additional personnel in connection with building our sales force and distribution channels. Sales and marketing expenses represented 42%, 48% and 45% of net revenues for fiscal 2002, 2001, and 2000, respectively. We intend to continue to invest in appropriate sales and marketing campaigns and therefore expect sales and marketing expenses in absolute dollar expenses to increase in the future. We continue to work towards our long-term business model target of 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 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 $51,000, $128,000 and $233,000 in 2002, 2001 and 2000 respectively, general and administrative expenses decreased to $4.6 million in fiscal 2002 from $5.7 million in fiscal 2001 and from $4.8 million in fiscal 2000. For fiscal 2002, decreases in professional services and distributed costs were partially offset by increased personnel costs, primarily 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. During 2002, approximately $640,000 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. The increase in expenses from 2000 to 2001 included additional personnel costs and depreciation expenses.

General and administrative expenses represented 8% of net revenues in 2002, and 12% of net revenues for fiscal 2001 and 2000. This percentage decrease was due to lower expenses as well as increased revenues. Without the change in allocation of IT costs, general and administrative expenses would have been 10% of total net revenues in fiscal 2002. 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.

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 $11.0 million in 2001 and $6.4 million in 2000. There was no amortization during fiscal 2002, due to an impairment charge discussed below.

We may have additional acquisitions in future periods that could give rise to the acquisition of additional goodwill. Under the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”, any future goodwill will be accounted for using an impairment-only approach.

In September 2000, the Company purchased Workfire for approximately $72.8 million, mostly in Packeteer stock. Substantially all 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 pursuant to the Company’s stated policy as described in Note 1 to the Financial Statements. 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.

Amortization of stock-based compensation resulted primarily from stock options grants to employees and options assumed in the Workfire acquisition. Stock-based compensation is being amortized to expense in

accordance with FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option Award Plans,” over the vesting period of the individual options, generally four years. We recorded stock-based compensation expense of $385,000, $1.2 million and $1.7 million in fiscal 2002, 2001 and 2000, respectively, leaving $19,000 to be amortized in future periods.

Interest and other income consists primarily of interest income from our cash and investments and totaled $1.4 million, $3.2 million and $4.0 million for fiscal 2002, 2001 and 2000, respectively. The decrease in interest income from 2001 to 2002 and from 2000 to 2001 is the result of lower yields on invested funds.

Interest and other expense consists primarily of interest expense related to our line of credit, debt and capital lease obligations. Interest and other expense totaled $477,000 in 2002, $1.1 million in 2001 and $618,000 in 2000. The decrease in interest and other expenses from 2001 to 2002 was attributable to lower interest expense due to decreased levels of debt. Additionally, 2001 expenses included $545,000 loss on the disposition of $3.0 million of defaulted California Edison notes. The increase from 2000 to 2001 was due primarily to the $545,000 loss on the disposition of defaulted California Edison notes.

Our income tax provision for 2002 is primarily attributable to income taxes payable in foreign jurisdictions. The effective rate for 2002 is approximately ten percent. There was no corresponding provision in 2001 due to the Company’s consolidated net loss. In fiscal 2000, we recognized a $300,000 tax provision related to charges in lieu of income taxes associated with alternative minimum income tax. A corresponding credit was made to paid-in-capital. As of December 31, 2002, we had net operating loss carryforwards of approximately $52.3 million and $23.4 million for federal and state income tax purposes, respectively. These carryforwards, if not utilized, expire 2004 through 2022. See Note 11 of Notes to Consolidated Financial Statements.

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 $65.5 million at December 31, 2002, up from the $62.2 million reported at December 31, 2001.

Net cash provided by operating activities was $5.4 million in fiscal 2002, up from $416,000 net cash provided in fiscal 2001 and net cash used in operations of $1.1 million in fiscal 2000. The increase in operating cash flows was primarily due to net income reported in fiscal 2002, compared to net losses in 2001 and 2000.

Net cash provided by (used in) investing activities was $(10.0) million, $25.2 million and $1.4 million in 2002, 2001, and 2000, respectively primarily reflecting transactions in marketable securities. In 2002, the purchase of investments exceeded proceeds by $7.0 million. An additional $2.9 million was used to purchase fixed assets, including $2.0 related to our headquarters move in December 2002. In 2001, the activity in our portfolio generated net cash proceeds of $25.7 million, which was reinvested in short-term securities. In 2000, the net cash proceeds of $7.8 from portfolio activity were offset by disbursements related to purchases of fixed assets totaling $2.6 million and cash outlays related to our acquisition of Workfire totaling $3.3 million.

Net cash provided by financing activities was $754,000, $225,000 and $4.3 million in 2002, 2001, and 2000, respectively. In 2002, proceeds from issuance of stock totaled $2.5 million, which was partially offset by disbursements repaying lease obligations, notes payable and our line of credit. In 2001, proceeds from issuance of stock totaled $2.3 million, which was offset by disbursements repaying lease obligations, notes payable and the line of credit. In 2000, proceeds were generated by issuance of common stock, lease financing and increased borrowing under the line of credit.

We have entered into capital leases and notes payable to finance the acquisition of computer software, hardware and furniture. As of December 31, 2002, approximately $1.0 million was outstanding under capital lease obligations and $328,000 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 December 31, 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 4.25% as of December 31, 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 profit and loss amounts. At December 31, 2002, the Company was in compliance with these covenants.

A summary of future cash payments, including interest where applicable, due under debt and lease obligations as of December 31, 2002 (in thousands) is shown below. Capital lease obligations are equipment leases entered into in prior years. Operating leases relate to facilities and the note payable is an equipment loan entered into in August 2001.

Additionally, we had outstanding purchase order commitments with our contract manufacturer for completed products of approximately $1.2 million as of December 31, 2002. Packeteer expects these purchase orders to be fulfilled in the first quarter of 2003.

We have used a portion of the net initial public offering proceeds of $62.6 million to repay subordinated loans of $5.0 million in 1999 and to fund operations in 1999 and 2000, including expanding and enhancing our sales and marketing operations and product offerings. The balance remains invested as described in Note 4 of the notes to consolidated financial statements.

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 as planned capital expenditures, 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 $65.5 million at December 31, 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 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.

The impact of recent accounting pronouncements is discussed in Note 1 of the notes to consolidated financial statements.

Our exposure to market risks for changes in interest rates and principal relates primarily to investments in debt securities issued by U.S. government agencies and corporate debt securities. We place our investments with high credit quality issuers and, by policy, limit the amount of the credit exposure to any one issuer. Our investment securities are classified as available-for-sale and consequently are recorded on the balance sheet at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss).

We do not use derivative financial instruments. In general our policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with less than three months to maturity from date of purchase are considered to be cash equivalents; investments with maturities between three and twelve months are considered to be short-term investments; and investments with maturities in excess of twelve months are considered to be long-term investments. The following table presents the amortized cost, fair value and related weighted-average interest rates by year of maturity for our investment portfolio as of December 31, 2002 and comparable fair values as of December 31, 2001.

We develop products in the United States and sell in North America, Asia, Europe and the rest of the world. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in worldwide markets. All sales are currently made in U.S. dollars; however, a strengthening of the dollar could make our products less competitive in foreign markets. We have no foreign exchange contracts, option contracts or other foreign currency hedging arrangements.

The following consolidated financial statements, and the related notes thereto, of Packeteer and the Report of Independent Auditors are filed as a part of this Form 10-K.

We have audited the accompanying consolidated balance sheets of Packeteer, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders’ equity and comprehensive (loss) income, and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and the financial statement schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Packeteer, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY AND COMPREHENSIVE (LOSS) INCOME

Packeteer, Inc., along with its subsidiaries (collectively referred to herein as the “Company”) provides application traffic management systems designed to enable enterprises to gain visibility and control for networked applications, extend network resources and align application performance with business priorities. For service providers, Packeteer systems provide a platform for delivering application-intelligent network services that control quality of service, expand revenue opportunities and offer compelling differentiation. The Company was incorporated on January 25, 1996, and commenced principal operations in 1997, at which time the Company began selling its products and related services. The Company currently markets and distributes its products via a worldwide network of resellers, distributors and systems integrators.

The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain previously reported amounts have been reclassified to conform to the current presentation.

The preparation of consolidated financial statements in conformity with generally accepted accounting principles 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 under different assumptions or conditions.

Product revenue consists primarily of sales of our PacketShaper 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:


	•	persuasive evidence of an arrangement exists,

	•	delivery has occurred,

	•	the fee is fixed or determinable, and

	•	collectibility is reasonably assured.

This standard revenue recognition policy includes modifications under certain circumstances as follows: Product revenue on sales to major new distributors are 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 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) of fair value 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.

Management makes estimates of potential future product returns related to current period product revenue in accordance with SFAS 48, “Revenue Recognition When Right of Return Exists”. These sales return reserves are recorded as a reduction to revenue. The Company’s estimate for sales returns is based on its historical return rates.

The allowance for doubtful accounts reduces trade receivables to their net realizable value. When evaluating the adequacy of the allowance for doubtful accounts, management reviews 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.

The following provides additional details on the allowance for doubtful accounts:

Cost of revenues consists primarily of costs of product, overhead and maintenance support costs. The Company provides currently for the estimated costs that may be incurred under product warranties when products are shipped.

Amortization of acquired technology is also included in total cost of revenues. During the third quarter of 2001, the Company performed an assessment of the carrying value of goodwill and other intangibles, including acquired technology. Based on this review, we recorded an impairment charge that included the unamortized portion of the acquired technology. For further discussion, see Goodwill and Other Intangible Assets below.

The Company considers all highly liquid investments with a maturity of three months or less from date of purchase to be cash equivalents. Cash and cash equivalents consist primarily of cash on deposit with banks, money market instruments and investments in commercial paper that are stated at costs which approximate fair market value.

Management determines the appropriate classification of investment securities at the time of purchase and reevaluates such designation as of each balance sheet date. As of December 31, 2002 and 2001, all investment securities are designated as “available-for-sale.” Available-for-sale securities are carried at fair value based on quoted market prices, with the unrealized gains (losses) reported as a separate component of stockholders’ equity. The cost of investments sold is determined on the specific identification method.

Inventories consist primarily of finished goods and are stated at the lower of cost (on a first-in, first-out basis) or market. We record inventory reserves for excess and obsolete inventories based on historical usage and forecasted demand. 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.

Property and equipment, including equipment acquired under capital lease, are recorded at cost. Depreciation and amortization are provided using a straight-line method over the estimated useful lives of the assets, generally 18 months to four years. Leasehold improvements are amortized over the shorter of estimated useful lives of the assets or the lease term, generally five years.

The Company accounts for long-lived assets under SFAS 144, “Accounting for Impairment or Disposal of Long-Lived Assets”. Under SFAS 144, the Company regularly performs reviews to determine if the carrying value of its long-lived assets is impaired. The purpose for 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.

Advertising and sales promotion costs are expensed as incurred. These costs were $166,000, $345,000 and $316,000 for the years ended December 31, 2002, 2001 and 2000, respectively.

The Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets” and SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets” on January 1, 2002. SFAS No. 142 changes the accounting for goodwill from an amortization method to an impairment-only approach. As a result of the goodwill write-off in the third quarter of 2001, the adoption of SFAS No. 142 on January 1, 2002, had no effect on the Company’s results of operations or financial position. SFAS No. 144 requires that long-lived assets be measured at the lower of their carrying amount or fair value, less cost to sell. Adoption of this statement did not have a material impact on the Company’s results of operations or financial position.

Upon shipment of products to its customers, the Company provides for the estimated cost to repair or replace products that may be returned under warranty. The Company’s 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. Packeteer adopted the provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others”, in December 2002. For the required disclosures regarding a reconciliation of changes in the Company’s product warranty liabilities see Note 9.

Development costs incurred in the research and development of new products and enhancements to existing products are expensed as incurred. Costs for the development of new software products and enhancements to existing products are expensed as incurred until technological feasibility has been established, at which time any additional development costs would be capitalized in accordance with SFAS No. 86, “Accounting for Costs of Computer Software To Be Sold, Leased, or Otherwise Marketed.” To date, the Company’s software has been available for general release concurrent with the establishment of technological feasibility, and accordingly, no costs have been capitalized.

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash, cash equivalents, investments and accounts receivable. The Company’s cash, cash equivalents and investments are maintained with highly accredited financial institutions and investments are placed with high quality issuers. The Company believes no significant concentration of credit risk exists with respect to these financial instruments. Concentrations of credit risk with respect to trade receivables are limited as the Company performs ongoing credit evaluations of its customers. Based on management’s evaluation of potential credit losses, the Company believes its allowances for doubtful accounts are adequate.

The Company relies on one contract manufacturer for the production of its product. The inability of the manufacturer to fulfill supply requirements of the Company could negatively impact future results. If the Company’s contract manufacturer cannot manufacture its products at required volumes, on a cost effective basis, in a timely manner, or at all, the Company will have to secure additional manufacturing capacity. Even if this additional capacity is available on commercially acceptable terms, the qualification process could be lengthy and could cause disruptions to shipments. The Company attempts to mitigate these risks by working closely with this manufacturer regarding production planning and product introduction timing. Additionally, the Company believes that it carries sufficient finished goods and semi-finished goods inventory to cover a portion of the transition lead-time if it needs to secure additional manufacturing capacity.

The Company’s products, application traffic management systems, which are sold worldwide, are designed to resolve a broad spectrum of problems faced by enterprises and service providers. Accordingly, the Company’s future success depends upon the capital spending patterns of such customers and the continued demand by such customers for the Company’s products. The networking industry is characterized by rapidly changing technology, evolving industry standards, changes in end-user requirements and frequent new product introductions and enhancements.

The Company’s continued success will depend upon its ability to enhance existing products and to develop and introduce, on a timely basis, new products and features that keep pace with technology developments and emerging industry standards. Furthermore, as a result of its international sales, the Company’s operations are subject to risks of doing business abroad including, but not limited to, export duties, changes to import and export regulations, longer payment cycles, and greater difficulty in collecting accounts receivable. While to date these factors have not had an adverse material impact on the Company’s consolidated results of operations, there can be no assurance that there will not be such an impact in the future.

We develop products in the United States and sell in North America, Asia, Europe and the rest of the world. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in world-wide markets. All sales are currently made in U.S. dollars; however, a strengthening of the dollar could make our products less competitive in foreign markets. We have no foreign exchange contracts, option contracts or other foreign currency hedging arrangements.

The Company uses the asset and liability method of accounting for income taxes. Under this method, 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. 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 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. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits of which future realization is uncertain.

The Company’s stock-based employee compensation plans are described more fully in Note 12 to the consolidated financial statements. The Company adopted SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure”, which amended SFAS 123, “Accounting for Stock-Based Compensation”, in December 2002. As permitted under SFAS 148, Packeteer has elected to continue to follow the intrinsic value method in accounting for its stock-based employee compensation arrangements. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation.

Compensation expense for pro forma purposes is reflected over the vesting period. Note 12 contains the significant assumptions used in determining the underlying fair value of options.

The Company’s sales to international customers are U.S. dollar-denominated. As a result, there are no foreign currency gains or losses related to these transactions.

The functional currency for the Company’s foreign subsidiaries is the U.S. dollar. Accordingly, the entities remeasure monetary assets and liabilities at period-end exchange rates, while non-monetary items are remeasured at historical rates. Income and expense accounts are remeasured at the average rates in effect

during the year. Remeasurement adjustments are recognized in income as transaction gains or losses in the year of occurrence. To date, the effect of such amounts on net income has not been significant.

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 financial statements. For the Company, the primary differences between reported net income (loss) and comprehensive income (loss) are unrealized gains or losses on securities available for sale. Tax effects of the components of other comprehensive income or loss are not considered material for any periods presented.

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 and outstanding stock options 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:

The following table sets forth the potential common shares that were excluded from the net income (loss) computation as their effect would have been anti-dilutive.

For fiscal year 2002, certain employee stock options and warrants were excluded from the computation because the exercise price was greater that the average market price. For fiscal years, 2001 and 2000, all employee options and warrants were excluded from the computation as, due to the net losses, the effect would have been anti-dilutive.

The carrying value of cash, cash equivalents, accounts receivable, accounts payable and accrued expenses approximates their estimated fair value due to the relative short maturity of these instruments. The carrying value of long-term debt and capital lease obligations approximates estimated fair value based on the market interest rates available to the Company for debt of similar risk and maturities.

In June 2001, the FASB issued SFAS No. 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 June 2002, the FASB issued SFAS No. 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.

In November 2002, the Emerging Issues Task Force (EITF) issued EITF 00-21, Revenue Arrangements with Multiple Deliverables”. EITF 00-21 provides guidance on determining whether a revenue arrangement contains multiple deliverable items and if so, requires revenue be allocated amongst the different items based on fair value. EITF 00-21 also requires revenue on any item in a revenue arrangement with multiple deliverables not delivered completely must be deferred until delivery of the item is complete. EITF 00-21 is effective for all arrangements entered into in fiscal periods beginning after June 15, 2003. We have not yet determined the impact, if any this Statement will have on our consolidated financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities”. FIN 46 requires consolidation of variable interest entities by the entity’s primary beneficiary if the equity investors in the entity do not have the characteristics of a controlling financial interest or sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. FIN 46 must be applied beginning July 1, 2003 to variable entities existing prior to February 1, 2003. The

adoption of FIN 46 will not have a material impact on the Company’s results of operations or financial condition.

On September 13, 2000, Packeteer completed the acquisition of Workfire for a total purchase price of $72.8 million in a transaction accounted for as a purchase. Workfire develops software that delivers accelerated Internet services to Internet users. Packeteer exchanged 1,806,000 shares of Packeteer common stock with a fair value of $64.3 million for all of the outstanding stock of Workfire. Of the total common shares issued, 183,000 shares were placed in an escrow account to secure and collateralize the indemnification obligations of Workfire shareholders to Packeteer. Packeteer also assumed all of the outstanding stock options of Workfire with a fair value of approximately $5.2 million. The options were valued using the Black-Scholes option pricing model with the following assumptions: no dividends, 110% volatility, 4.5 years expected life, and 6.1% for the risk-free interest rate. In addition, Packeteer paid certain liabilities having an aggregate value of $1.8 million on behalf of Workfire.com, the sole shareholder of Workfire. There were also $1.5 million of direct transaction costs consisting primarily of professional fees related to this transaction.

The acquisition was accounted for under the purchase method of accounting in accordance with APB Opinion No. 16. Under the purchase method of accounting, the purchase price is allocated to the assets acquired and liabilities assumed based on their estimated fair values. The results of operations for Workfire have been included with the Company’s results since September 13, 2000.

The Company recognized stock-based compensation expense associated with unvested stock options issued to employees in conjunction with the acquisition. This amount is included as a component of stockholders’ equity and is being amortized by charges to operations over the vesting period of the options, consistent with the method described in FIN No 28. Amortization of stock-based compensation associated with this acquisition totaled $153,000, $555,000 and $310,000 for the years ended December 31, 2002, 2001 and 2000, respectively.

The following is a summary of the Workfire purchase price allocation (in thousands):

The following unaudited pro forma summary represents the Company’s consolidated results of operations for the year ended December 31, 2000 as if the preceding acquisition had been consummated at the beginning of fiscal 2000. The pro forma consolidated results of operations include certain pro forma adjustments, including amortization of goodwill and other intangible assets and amortization of deferred stock-based compensation.

Pro forma results for the year ended December 31, 2000 are as follows (in thousands, except per share data):

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 fiscal 2001 and 2000:

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 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.

The Company’s cash equivalents and investments consist of the following at December 31, 2002 and 2001:

The amortized cost and estimated fair value of the Company’s investments as of December 31, 2002, shown by contractual maturity date, are as follows (in thousands):

Property and equipment consisted of the following at December 31 (in thousands):

Accumulated depreciation and amortization includes accumulated amortization of approximately $2.0 million and $2.7 million on equipment under capital lease as of December 31, 2002 and 2001, respectively.

In January 2002, the Company renewed a revolving loan agreement with a maximum line of credit of $10.0 million. Advances are limited to the lesser of the maximum line or the borrowing base, which is 80% of eligible domestic receivables and 90% of eligible international receivables. Additionally, the Company is required to maintain certain financial covenants related to working capital and quarterly net income (loss) amounts. The outstanding principal balance accrues interest at a per annum rate equal to the prime rate (which was 4.25% at December 31, 2002) and is secured by all present and future collateral of the Company. As of December 31, 2002, the outstanding balance on the line was $1.0 million. The agreement expires in May 2003. As of December 31, 2002 the Company was in compliance with all terms of the revolving loan agreement.

In August 2001, the Company secured a $551,000 equipment loan. Borrowings under this agreement are collateralized by the purchased equipment, bear interest at the rate of 11.1%, and are repayable in monthly installments over a three-year period. At December 31, 2002, approximately $328,000 was outstanding under this note.

The Company leases its facility and certain equipment under non-cancelable lease agreements that expire at various dates through 2010. Rent expense was $1.8 million, $1.4 million, and $1.1 million for the years

ended December 31, 2002, 2001 and 2000, respectively. As of December 31, 2002, the future minimum rental payments under capital and operating leases are as follows (in thousands):

Packeteer has outstanding purchase order commitments for completed products of approximately $1.2 million at December 31, 2002. Packeteer expects the purchase orders to be fulfilled in the first quarter of 2003.

The Company records a liability for estimated warranty obligations at the date products are sold. Adjustments are made as new information becomes available. The provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others”, which Packeteer adopted in December 2002, require disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The following provides a reconciliation of changes in Packeteer’s warranty reserve. The Company provides no other guarantees.

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.

In October 2002, the plaintiffs agreed to dismiss the Company’s officers and directors from the litigation without prejudice, in return for a tolling agreement. The Company moved to dismiss the claims against it. The Court recently denied the motion. As a result, the case may proceed to the discovery phase. We believe that we have meritorious defenses to the lawsuit and will defend ourselves vigorously in the litigation. We are not presently able to estimate the losses, if any, related to this lawsuit, and accordingly, as of December 31, 2002, no accrual for this contingency has been recorded.

The Company is routinely involved in legal and administrative proceedings incidental to its normal business activities and believes that these matters will not have a material adverse effect on financial position, results of operations or cash flows.

Net income (loss) before income taxes is attributable to the following geographic locations for the periods ended December 31:

Our income tax provision for 2002 is primarily attributable to income taxes payable in foreign jurisdictions. The Company recorded no income tax provision or benefit in 2001, as the Company reported a net loss. The income tax provision of $300,000 for 2000 consists of charges in lieu of income taxes associated with alternative minimum tax.

The provision (benefit) for income taxes differs from the amount computed by applying the statutory federal tax rate to income (loss) before tax as follows (in thousands):

The types of temporary differences that give rise to significant portions of the Company’s net deferred tax assets are set forth below (in thousands):

The net change in the total valuation allowance was an increase of $1.6 million and $8.5 million for the years ended December 31, 2002 and 2001, respectively. Although we reported net income in fiscal 2002, the Company has previously reported net losses since inception, therefore it has provided a full valuation allowance on its deferred tax assets. Management believes that, based on a number of factors, the available objective evidence creates sufficient uncertainty regarding the realizability of the deferred tax assets such that a full valuation allowance has been recorded.

Approximately $9.5 million of the valuation allowance for deferred tax assets is attributable to employee stock option deductions, the benefit from which will be allocated to additional paid-in capital when and if subsequently realized.

Deferred tax liabilities have not been recognized for undistributed earnings of foreign subsidiaries because it is management’s intention to indefinitely reinvest such undistributed earnings outside the U.S.

At December 31, 2002 the Company has net operating loss carryforwards for federal and California income tax purposes of approximately $52.3 million and $23.4 million, respectively. If not utilized, the federal net operating loss carryforwards will begin to expire in 2011, and the California net operating loss carryforwards will begin to expire in 2004. In addition, the Company had net operating loss carryforwards of approximately $753,000 for Canadian income tax purposes. If not utilized, these carryforwards will begin to expire in 2005. At December 31, 2002, the Company had federal and California research credit carryforwards of approximately $1.7 million each. If not utilized, the federal research credit carryforwards will begin to expire in 2011. The California research credit carryforwards can be carried forward indefinitely.

Federal and California tax laws impose substantial restrictions on the utilization of net operating loss and tax credit carryforwards in the event of an “ownership change” as defined in Internal Revenue Code Section 382. The Company has not yet determined whether an ownership change has occurred due to significant stock transactions in the reporting years disclosed. If an ownership change occurred, utilization of the net operating loss carryforwards could be reduced significantly.

The Company’s Board of Directors has authorized 5.0 million shares of preferred stock. The authorized preferred stock shares are undesignated and the Board has the authority to issue and to determine the rights, preference and privileges thereof.

The Company’s Board of Directors has authorized 85.0 million shares of common stock.

As of December 31, 2002, 45,000 warrants to purchase common stock were outstanding and exercisable with a $6.25 average exercise price per share and an expiration date in May 2009.

In May 1999, the Company’s Board of Directors adopted the 1999 Employee Stock Purchase Plan (the “ESPP”). The ESPP became effective July 27, 1999. At that time, 500,000 shares were reserved for issuance under this plan. The number of shares reserved under this ESPP automatically increases annually beginning on January 1, 2000 by the lesser of one million shares or 2% of the total number of shares of common stock outstanding. The ESPP permits participants to purchase common stock through payroll deductions of up to 15% of an employee’s compensation, including commissions, overtime, bonuses and other incentive compensation. The purchase price per share is equal to 85% of the fair market value per share on the participant’s entry date into the offering period or, if lower, 85% of the fair market value per share on the semi-annual purchase date. As of December 31, 2002, 447,000 shares had been issued under the plan and 1.8 million were available for future issuance. The fair value of the discount and look-back features are considered compensation for purposes of computing the Company’s pro-forma earnings for stock based compensation.

The 1999 Stock Incentive Plan (the “1999 Plan”) is intended to serve as the successor program to our 1996 Equity Incentive Plan (the “1996 Plan”). In May 1999, the Company’s Board of Directors approved the 1999 Plan, which became effective on July 27, 1999, under which 900,000 shares were reserved for issuance. Previously, 515,000 shares were authorized under the 1996 Plan. In addition, any shares not issued under the 1996 Plan will also be available for grant under the 1999 Plan. The number of shares reserved under the 1999 Plan automatically increases annually beginning on January 1, 2000 by the lesser of three million shares or 5% of the total number of shares of common stock outstanding. Under the 1999 Plan, eligible individuals may be granted options to purchase common shares or may be issued shares of common stock directly. The 1999 Plan is administered by the Board of Directors, which sets the terms and conditions of the options. Non-statutory stock options and incentive stock options are exercisable at prices not less than 85% and 100%, respectively, of the fair value on the date of grant. The options become 25% vested one year after the date of grant with 1/48 per month vesting thereafter and expire at the end of 10 years from date of grant or sooner if terminated by the Board of Directors. The options may include a provision whereby the option holder may elect at any time to exercise the option prior to the full vesting of the option. Unvested shares so purchased shall be subject to a repurchase right by the Company at the original purchase price. Such right shall lapse at a rate equivalent to the vesting period of the original option. As of December 31, 2002, less than 1,000 shares were subject to repurchase.

In October 2001, the Company announced a voluntary stock option exchange program, or “Offer to Exchange”, for all employees except executive officers. Under the program, these employees had the opportunity to cancel certain outstanding options previously granted to them that had an exercise price at or above $5.00 in exchange for an equal number of new options to be granted at a future date. The Offer to Exchange was outstanding until 5:00 p.m., Pacific Daylight Time on November 30, 2001 (the “Expiration Date”). The exercise price of the new options was to be equal to the fair market value of the Company’s common stock on the date of grant, which was June 3, 2002. Participants electing to exchange any options were also required to exchange all options granted to him or her during the six months before the date of the Offer to Exchange and were precluded from receiving any options during the six months after the Expiration Date. Options totaling 1.5 million shares were canceled under this program in November 2001. Options totaling 1.4 million were reissued on June 3, 2002 at an option price of $6.10 per share, which was the fair market value on the date of grant.

The following tables summarize information about stock options outstanding under the 1996 and 1999 Plans as of December 31, 2002 (in thousands, except per share data):

In the year ended December 31, 2002, 10,250 shares were issued as a result of the exercise of non-plan options granted before the July 28, 1999 initial public offering. As of December 31, 2002, there were 61,000 non-plan options outstanding with a weighted average exercise price of $1.12 per share.

In connection with options granted in fiscal years 1999 and 1998, the Company has recorded deferred stock-based compensation of $3.9 million and $787,000, respectively, representing the difference between the exercise price and the fair value of the Company’s common stock at the date of grant. In fiscal year 2000, the Company recorded deferred stock-based compensation of $1.1 million related to employee options assumed in the Workfire acquisition. The amounts are being amortized over the vesting period for the individual options, generally four years. Amortization of stock-based compensation of $385,000, $1.2 million and $1.7 million was recognized during the years ended December 31, 2002, 2001 and 2000, respectively.

For proforma purposes, the fair value of the Company’s stock option awards was estimated assuming no expected dividends and the following weighted-average assumptions for the years ended December 31:

To comply with pro forma reporting requirements of SFAS 123, compensation cost is also estimated for the fair value of ESPP issuances, which are included in the pro forma totals above. The fair value of purchase rights granted under the ESPP is estimated on the date of grant using the Black-Scholes option pricing model with the same expected volatility as the above assumptions, an expected life of 0.5 years and risk-free interest rates of 1.46%, 1.77% and 5.24% for the years 2002, 2001 and 2000, respectively. The weighted-average fair value of the purchase rights granted under the ESPP during fiscal 2002, 2001 and 2000 was $2.80, $7.50 and $19.00, respectively.

The following table reflects the accumulated balances of other comprehensive income (loss) in thousands:

Tax effects of the components of other comprehensive income or loss are not considered material for any periods presented.

In 1997, the Company adopted a 401(k) plan (“401(k)”). Participation in the 401(k) is available to all employees. Entry date to the 401(k) is the first day of each month. Each participant may elect to contribute an amount up to 100% of his or her annual base salary plus commission and bonus, but not to exceed the statutory limit as prescribed by the Internal Revenue Code. The Company may make discretionary contributions to the 401(k). To date, no contributions have been made by the Company.

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 and maintenance contracts related to these products. In 2002, three customers accounted for 21%, 13% and 11% of net revenues respectively. In 2001 and 2000, one customer accounted for 22% and 12% of net revenues, respectively. Sales outside of North America accounted for 58%, 55% and 54% of the Company’s total revenues in 2002, 2001, and 2000, respectively.

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

Pursuant to General Instruction G to Form 10-K, the information required by Items 10, 11, 12, and 13 of Part III is incorporated by reference to our definitive Proxy Statement with respect to our 2003 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A with the Securities and Exchange Commission not later than 120 days after December 31, 2002.

Within the 90 day period prior to the filing date of this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as such term is defined under Rule 13a-14 promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of that date.

There have been no significant changes (including corrective actions with regard to significant deficiencies or material weaknesses) in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation referred to above.


	All financial statement schedules are omitted as the required information is inapplicable or the information is presented in the consolidated financial statements or related notes.

A Current Report on Form 8-K dated October 7, 2002, reporting under Item 5 — Other Events, was filed announcing Dave Côté had been appointed President and CEO of the Company.

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Cupertino, State of California, on this 20th day of March, 2003.

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below hereby constitutes and appoints, jointly and severally, Dave Côté and David Yntema, and each of them acting individually, as his attorney-in-fact, each with full power of substitution and resubstitution, for him or her in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K (including post-effective amendments), and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact, or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.


	1. I have reviewed this annual report on Form 10-K of Packeteer, Inc.;

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

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

	4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15 d-14) for the registrant and we have:


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

	(b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and

	(c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;


	5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors:


	(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

	(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


	6. The registrant’s other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.


	/s/ DAVE CÔTÉ _______________________________________ Dave Côté
	President and Chief Executive Officer


	1. I have reviewed this annual report on Form 10-K of Packeteer, Inc.;

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

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

	4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15 d-14) for the registrant and we have:


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

	(b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the “Evaluation Date”); and

	(c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;


	5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors:


	(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

	(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and


	6. The registrant’s other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.


(1)	Filed herewith.

(2)	Incorporated by reference from Packeteer’s Registration Statement on Form S-1 (Reg. No. 79333-79077), as amended.

(3)	Incorporated by reference from Packeteer’s 10-K dated March 23, 2000.

(4)	Incorporated by reference from Packeteer’s 10-Q dated November 13, 2000.

(5)	Incorporated by reference from Packeteer’s 10-K dated March 29, 2001.

(6)	Incorporated by reference from Packeteer’s 10-K dated March 22, 2002.

(7)	Incorporated by reference from Packeteer’s 10-Q dated August 13, 2002.


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

		For the fiscal year ended December 31, 2002


or

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

		For the transition period from to .


PART I
	Item 1. Business
	Item 2. Properties
	Item 3. Legal Proceedings
	Item 4. Submission of Matters to a Vote of Security Holders
PART II
	Item 5. Market for Registrant’s Common Stock and Related Stockholder Matters
	Item 6. Selected Financial Data
	Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 7a. Quantitative and Qualitative Disclosures About Market Risk
	Item 8. Financial Statements and Supplementary Data
	Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
PART III
	Item 14. Controls and Procedures
	Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
EXHIBIT 10.24
EXHIBIT 21.1
EXHIBIT 23.1
EXHIBIT 99.1
EXHIBIT 99.2


Part I
	Item 1.	Business	1
	Item 2.	Properties	24
	Item 3.	Legal Proceedings	24
	Item 4.	Submission of Matters to a Vote of Security Holders	24
Part II
	Item 5.	Market For Registrant’s Common Stock and Related Stockholder Matters	25
	Item 6.	Selected Financial Data	26
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
	Item 7a.	Quantitative and Qualitative Disclosures about Market Risk	36
	Item 8.	Financial Statements and Supplementary Data	37
	Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	61
Part III
	Item 10.	Directors and Executive Officers of the Registrant
	Item 11.	Executive Compensation
	Item 12.	Security Ownership of Certain Beneficial Owners and Management
	Item 13.	Certain Relationships and Related Transactions
	Item 14.	Controls and Procedures	61
	Item 15.	Exhibits, Financial Statement Schedules and Reports on Form 8-K	61
Signatures			62
Certifications			64


Client/ Server CORBA CVS Folding@Home FIX (Finance) Java Rmt Mthd MATIP (Airline) MeetingMaker NetIQ AppMngr OpenConnect JCP SunRPC (dyn port) Content Delivery AOL Backweb Chaincast EntryPoint Kontiki Marimba PointCast NewsStand WebShots ERP Baan JavaClient JD Edwards Oracle (7,8,9i) SAP Internet ActiveX FTP, Passive FTP Gopher HTTP Tunnel IP, IPIP, UDP, TCP IPv6 IRC Mime type NNTP Socks2http SSHTCP SSL TFTP UUCP URL Web browser Database FileMaker Pro MS SQL Oracle 7/8i Progress		Directory Services CRS DHCP DNS DPA Finger Ident Kerberos LDAP RADIUS SSDP TACACS WINS whois E-mail and Collaboration Biff cc:MAIL IMAP LotusNotes MSSQ Microsoft DCOM (MS Exchange) Novell GroupWise POP3 SMTP File Server AFS CVSup Lockd Microsoft-ds NetBIOS-IP NFS Novell NetWare5 rsync Games Asheron’s Call Battle.net Diablo II Doom EverQuest Kali Half-Life LucasArts (Jedi*) MSN Zone Dark Age of Camelot Quake I, II, & III SonyOnline Tribes I,II Unreal Warcraft III Yahoo! Games		Healthcare DICOM HL7 Host Access ATSTCP Attachmate SHARESUDP Persoft Persona SMTBF TN3270 TN5250 Legacy LAN and Non-IP AFP AppleTalk DECnet IPX FNA LAT NetBEUI MOP-DL/ RC PPPoE SNA Messaging AOL Instant Messenger ICQ IRC MSN Messenger Yahoo! Messenger Misc AOL MultiMedia Multi-cast NetShow NetMeeting QuickTime RTP Real Audio Streamworks RTSP MPEG ST2 SHOUTcast WebEx WindowsMedia		Music P2P Aimster AudioGalaxy Rhapsody Mac Satellite Blubster DirectConnect EDonkey Emule Overnet FileRogue Furthurnet Gnutella Acquisition Ares BearShare Furi Gnotella Gnucleus gtk-gnutella LimeWire MyNapster Mactella Morpheus Mutella Nap Share Phex Qtraxmax Qtella Shareaza toadnode XoloX Groove Hotline iMesh KaZaA KaZaA Lite Napster Amster audioGnome File Navigator Gnapster Grokster gtk napster jnapster MacStar Maxter My Napster Napigator NapMX Napster Fast Search Napster/2 Napster, MacOSX OpenNap Rapster Snap Spotlight WebNap WinMX Scour Tripnosis		Network Management Cisco Discovery Date-Time IPComp ICMP by packet type Microsoft SMS NTP RSVP SNMP SYSLOG Time Server Print LPR IPP TN5250p TN3287 Routing AURP BGP CBT DRP EGP EIGRP IGMP IGP MPLS (+tag, +app) OSPF PIM RARP RIP Spanning Tree VLAN (802.1p/q) Security Protocol DLS DPA GRE IPSEC ISAKMP/ IKE key exch L2TP PPTP SOCKS Proxy Session REXEC rlogin rsh Telnet Timbuktu VNC Xwindows		Thin Client or Server Based Citrix Published Apps, Nfuse, IMA RDP/ Terminal Server Voice over IP CiscoCTI Clarent CUSeeMe Dialpad H.323 I-Phone MCK Commun. Megaco Micom VIP MGCP Net2Phone RTP RTCP SIP Skinny (SCCP) T.120 VDOPhone


	Europe, The Middle East,
North America	Africa and Rest of World	Asia Pacific

Alternative Technology, Inc. Atrion Networking Corporation Combyte USA, Inc Compaq Computer Corporation/ HP Compunet Engineering, Inc. Equant OCD Network Systems Westcon, Inc.	ACAL Nederlands BV ADD Distribuciones Informat, SA ADN Distribution, GmbH Affina Systems, Inc. Allasso Centia Ltd. Computer Links AG Equant IB Solution Miel Network Alliance Ltd. Westcon, Inc.	AsiaSoft HK Ltd. Encom Information Systems Co., Ltd. Express Data Kanematsu Electronics Ltd. Lan Systems Pty Ltd. Macnica, Inc. Net One Systems Co., Ltd.. Nissho Electronics Corporation RBR Networks Pte. Ltd. Sunrise Information Co. Ltd. Transitions Systems


Delaware (State of incorporation)		77-0420107 (I.R.S. Employer Identification No.)



Enterprises		Service Providers

Adventis-Behring Altria Group, Inc. (formerly Philip Morris) Autodesk, Inc. Bank of Tokyo-Mitsubishi, Ltd. Beckman Coulter, Inc. Charter Communications, Inc. Cleveland Clinic Daewoo Securities Co., Ltd. Daito Trust Construction Co., Ltd. Edmonds School District E. I. du Pont Nemours and Company Fuji Photo Film Co., Ltd. Mizuho Bank, Ltd.	The Netherlands Agency for Energy and Environment Raytheon Company RHB Bank RMC Aggregates Stanford University Synopsys, Inc. TAFE, New South Wales Takashimaya Company Limited Telekom Austria U. S. Filter U. S. Air Force Standards Systems Group University of California Los Angeles VeriSign, Inc.	AT&T Equant Japan Telecom MCI/ WorldCom NTT Communications


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


Item 5.	*Market for Registrant’s Common Stock and Related Stockholder Matters*


		High		Low

Fiscal 2002:
	Fourth Quarter	$	8.28	$	3.35
	Third Quarter		5.35		2.66
	Second Quarter		7.50		4.13
	First Quarter		7.93		5.47
Fiscal 2001:
	Fourth Quarter		8.71		2.83
	Third Quarter		11.92		3.03
	Second Quarter		12.53		2.13
	First Quarter		20.13		3.03



			Years Ended December 31,

			2002			2001			2000			1999			1998


			(In thousands, except per share data)
Consolidated Statements of Operations Data:
Net revenues			$	55,014		$	46,661		$	41,097		$	18,441		$	7,230
Product and service costs				12,852			13,867			12,585			5,286			2,386
Amortization of acquired technology				—			1,199			678			—			—

Gross profit				42,162			31,595			27,834			13,155			4,844
Operating expenses:
	Research and development*			10,694			11,697			8,760			5,164			2,779
	Sales and marketing*			23,269			22,417			18,614			13,737			8,866
	General and administrative*			4,585			5,704			4,824			2,936			1,750
	Amortization of goodwill			—			11,017			6,424			—			—
	Impairment of goodwill and intangibles			—			52,552			—			—			—
	Amortization of stock-based compensation			385			1,233			1,683			3,088			537

		Total operating expenses		38,933			104,620			40,305			24,925			13,932

Net income (loss) from operations				3,229			(73,025	)		(12,471	)		(11,770	)		(9,088	)
Interest and other income				1,392			3,170			4,020			1,757			367
Interest and other expense				(477	)		(1,133	)		(618	)		(863	)		(78	)

Net income (loss) before income taxes				4,144			(70,988	)		(9,069	)		(10,876	)		(8,799	)
Provision for income taxes				415			—			300			—			—

Net income (loss)			$	3,729		$	(70,988	)	$	(9,369	)	$	(10,876	)	$	(8,799	)

Basic and diluted net income (loss) per share			$	0.12		$	(2.40	)	$	(0.35	)	$	(0.71	)	$	(1.54	)

Shares used in computing basic net income (loss) per share				30,205			29,559			27,152			15,343			5,709

Shares used in computing diluted net income (loss) per share				30,718			29,559			27,152			15,343			5,709


* Excludes amortization of deferred stock-based compensation of the following:
	Research and development		$	183		$	663		$	558		$	459		$	86
	Sales and marketing			151			442			892			2,184			436
	General and administrative			51			128			233			445			15



	December 31,

	2002		2001		2000		1999		1998


	(In thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents and investments	$	65,474	$	62,221	$	62,206	$	65,158	$	4,477
Working capital		52,665		52,723		51,958		51,285		3,501
Total assets		79,912		73,005		144,281		70,821		8,570
Long-term obligations		545		1,289		3,215		839		739
Total stockholders’ equity		63,401		56,624		124,133		59,120		3,759


Item 7.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*


	Capital Leases		Operating Leases		Note Payable		Total

2003	$	643	$	1,365	$	217	$	2,225
2004		490		1,205		145		1,840
2005		—		1,211		—		1,211
2006		—		1,425		—		1,425
2007		—		1,195		—		1,195
Thereafter		—		201		—		201

	$	1,133	$	6,602	$	362	$	8,097


Item 7a.	*Quantitative and Qualitative Disclosures About Market Risk*


	*Limitations of Existing Approaches*


	*Flexible Policy Definition and Enforcement*


	*Precise Rate Control*


	*Application-Based Response-Time Measurement*



		2002
										2001 Fair
		2003		2004		Total		Fair Value		Value


		(In thousands)
Cash equivalents		$	44,518		—	$	44,518	$	44,519	$	48,286
	Weighted-average rate		1.25%		—
Short-term investments			11,245		—		11,245		11,339		8,624
	Weighted-average rate		2.10%		—
Long-term investments			—	$	7,922		7,922		7,991		3,588
	Weighted-average rate		—		2.55%

Total investment portfolio		$	55,763	$	7,922	$	63,685	$	63,849	$	60,498


Item 8.	*Financial Statements and Supplementary Data*


	Page
	Number

Independent Auditors’ Report		37
Consolidated Balance Sheets as of December 31, 2002 and 2001		38
Consolidated Statements of Operations for the years ended December 31, 2002, 2001 and 2000		39
Consolidated Statements of Stockholders’ Equity and Comprehensive (Loss) Income for the years ended December 31, 2002, 2001 and 2000		40
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000		41
Notes to Consolidated Financial Statements		42


													Accumulated
													Other			Notes
		Common Stock					Additional			Deferred			Comprehensive			Receivable									Comprehensive
							Paid-in			Stock-Based			Income			from			Accumulated						(Loss)
		Shares			Amount		Capital			Compensation			(Loss)			Stockholders			Deficit			Total			Income


		(In thousands)
Balances as of December 31, 1999			26,792		$	27	$	88,848		$	(2,138	)	$	(58	)	$	(738	)	$	(26,821	)	$	59,120		$	(26,879	)
Stock-based compensation to non-employees			—			—		151			—			—			—			—			151
Issuance of common stock upon exercise of stock options			694			—		2,045			—			—			—			—			2,045
Charges in lieu of income taxes associated with alternative minimum income tax			—			—		300			—			—			—			—			300
Issuance of common stock pursuant to Employee Stock Purchase Plan			98			—		1,303			—			—			—			—			1,303
Issuance of common stock upon exercise of warrants, net			74			—		—			—			—			—			—			—
Issuance of common stock and stock options related to the Workfire acquisition			1,806			2		69,498			—			—			—			—			69,500
Repurchase of common stock			(30	)		—		(27	)		—			—			2			—			(25	)
Repayments of notes receivable from stockholders			—			—		—			—			—			550			—			550
Deferred compensation related to stock options issued in the acquisition of Workfire			—			—		—			(1,109	)		—			—			—			(1,109	)
Amortization of stock- based compensation			—			—		—			1,532			—			—			—			1,532
Comprehensive loss:
	Unrealized gain on investment		—			—		—			—			135			—			—			135			135
	Net loss		—			—		—			—			—			—			(9,369	)		(9,369	)		(9,369	)

Comprehensive loss																										(9,234	)

Balances as of December 31, 2000			29,434			29		162,118			(1,715	)		77			(186	)		(36,190	)		124,133			(36,113	)
Stock-based compensation to non-employees			—			—		51			—			—			—			—			51
Issuance of common stock upon exercise of stock options			401			1		840			—			—			—			—			841
Issuance of common stock pursuant to Employee Stock Purchase Plan			141			—		1,437			—			—			—			—			1,437
Repurchase of common stock			(25	)		—		(40	)		—			—			20			—			(20	)
Repayments of notes receivable from stockholders			—			—		—			—			—			83			—			83
Amortization of stock- based compensation			—			—		—			1,182			—			—			—			1,182
Reversal of unamortized deferred stock-based compensation for terminated employees			—			—		(133	)		133			—			—			—			—
Comprehensive loss:
	Unrealized gain on investments		—			—		—			—			10			—			—			10			10
	Other		—			—		—			—			(105	)		—			—			(105	)		(105	)
	Net loss		—			—		—			—			—			—			(70,988	)		(70,988	)		(70,988	)

Comprehensive loss																										(71,083	)

Balances as of December 31, 2001			29,951			30		164,273			(400	)		(18	)		(83	)		(107,178	)		56,624			(107,196	)
Stock-based compensation to non-employees			—			—		4			—			—			—			—			4
Issuance of common stock upon exercise of stock options			441			1		1,565			—			—			—			—			1,566
Issuance of common stock pursuant to Employee Stock Purchase Plan			207			—		885			—			—			—			—			885
Repayments of notes receivable from stockholders			—			—		—			—			—			29			—			29
Amortization of stock- based compensation			—			—		—			381			—			—			—			381
Comprehensive income:
	Unrealized gain on investments		—			—		—			—			78			—			—			78			78
	Other		—			—		—			—			105			—			—			105			105
	Net income		—			—		—			—			—			—			3,729			3,729			3,729

Comprehensive income																										3,912

Balances as of December 31, 2002			30,599		$	31	$	166,727		$	(19	)	$	165		$	(54	)	$	(103,449	)	$	63,401		$	(103,284	)


1.	Description of Business and Summary of Significant Accounting Policies


Property and equipment		$	349
Other assets			45
Lease obligations			(159	)
Accounts payable			(696	)
Deferred tax liability			(1,400	)
Deferred stock-based compensation			1,109
Developed and core technology			7,194
Assembled workforce			281
Goodwill			66,104

	Total	$	72,287


	2000

Revenues	$	41,097
Net loss		(27,717	)
Basic and diluted net loss per share		(0.98	)


3.	Goodwill and Other Intangible Assets — Adoption of FASB Statement 142



		Available-For-Sale Securities

				Gross		Gross
		Amortized		Unrealized		Unrealized			Estimated
		Cost		Gains		Losses			Fair Value


		(In thousands)
DECEMBER 31, 2002
Commercial paper, corporate bonds and notes and medium-term notes		$	46,498	$	12	$	—		$	46,510

	Total debt securities		46,498		12		—			46,510
Government securities			17,186		154		(1	)		17,339

		$	63,684	$	166	$	(1	)	$	63,849

Amounts included in cash and cash equivalents		$	44,518	$	1	$	—		$	44,519
Amounts included in short-term investments			11,245		94		—			11,339
Amounts included in long-term investments			7,921		71		(1	)		7,991

		$	63,684	$	166	$	(1	)	$	63,849

DECEMBER 31, 2001
Commercial paper, corporate bonds and notes and medium-term notes		$	55,418	$	141	$	(56	)	$	55,503

	Total debt securities		55,418		141		(56	)		55,503
Government securities			4,993		2		—			4,995

		$	60,411	$	143	$	(56	)	$	60,498

Amounts included in cash and cash equivalents		$	48,336	$	4	$	(54	)	$	48,286
Amounts included in short-term investments			8,539		87		(2	)		8,624
Amounts included in long-term investments			3,536		52		—			3,588

		$	60,411	$	143	$	(56	)	$	60,498



	December 31, 2002

	Amortized Cost		Fair Value

Mature in one year or less	$	55,763	$	55,858
Mature between one year through five years		7,921		7,991

	$	63,684	$	63,849


		2002		2001

Components		$	48	$	71
Completed products			2,243		2,118

	Inventories	$	2,291	$	2,189


	2002		2001

Computers and equipment	$	3,118	$	2,205
Equipment under capital lease		2,199		3,143
Furniture and fixtures		673		236
Leasehold improvements		1,540		79

		7,530		5,663
Less: accumulated depreciation and amortization		4,503		4,286

Property and equipment, net	$	3,027	$	1,377


Years Ending		Capital		Operating
December 31,		Lease		Lease

	2003	$	643	$	1,365
	2004		490		1,205
	2005		—		1,211
	2006		—		1,425
	2007		—		1,195
	Thereafter		—		201

Total future minimum lease payments			1,133	$	6,602

Less amounts representing interest at 6.47%-12.00%			130

Present value of future minimum lease payments under capital lease			1,003
Less current portion			598

Long-term portion		$	405



			For the Years Ended
			December 31,

			2002			2001			2000


			(In thousands)
Balance at beginning of year			$	552		$	577		$	313
	Provision for current year sales			227			531			747
		Adjustments of prior accrual estimates		(128	)		—			—
	Warranty costs incurred			(367	)		(556	)		(483	)

Balance at end of year			$	284		$	552		$	577


			2002			2001

Deferred tax assets:
	Various accruals and reserves not deductible for tax purposes		$	1,251		$	1,274
	Property and equipment			409			421
	Net operating loss carryforwards			19,574			18,535
	Tax credit carryforwards			2,853			2,237
	Capitalized start-up expenditures			—			22

		Gross deferred tax assets		24,087			22,489
Valuation allowance				(24,087	)		(22,489	)

Net deferred tax assets			$	—		$	—



					Options Outstanding
		Available
		For			Number of			Weighted-Average
		Grant			Shares			Exercise Price


		(In thousands, except per share data)
Balances as of December 31, 1999			1,155			2,727			5.68
	Shares made available for grant		1,340			—			—
	Repurchased		30			—			—
	Granted		(2,043	)		2,043			29.99
	Exercised		—			(606	)		3.07
	Cancelled		316			(316	)		16.70

Balances as of December 31, 2000			798			3,848			18.09
	Shares made available for grant		1,474			—			—
	Repurchased		25			—			—
	Granted		(2,203	)		2,203			9.84
	Exercised		—			(395	)		2.10
	Cancelled		2,440			(2,440	)		25.38

Balances as of December 31, 2001			2,534			3,216			8.88
	Shares made available for grant		1,498			—			—
	Granted		(2,420	)		2,420			5.49
	Exercised		—			(430	)		3.59
	Cancelled		196			(196	)		6.87

Balances as of December 31, 2002			1,808			5,010			7.77



		Options Outstanding
								Options Exercisable
				Weighted
				Average		Weighted		Number		Weighted
		Number		Remaining		Average		Exercisable		Average
Range of		Outstanding		Contractual		Exercise		at		Exercise
Exercise Prices		at 12/31/02		Life (Years)		Price		12/31/02		Price

	$0.25-$3.13		294		5.14	$	2.19		252	$	2.68
	$3.35-$3.50		1,194		7.92		3.50		563		3.50
	$3.70-$4.71		787		8.84		4.65		220		4.68
	$4.75-$6.06		287		9.03		5.13		66		5.06
	$6.10		1,320		7.69		6.10		748		6.10
	$6.13-$16.88		908		8.26		11.38		385		12.44
	$48.06		220		7.07		48.06		160		48.06

	$0.25-$48.06		5,010		7.93		7.77		2,394		8.74


*	These option grants relate to options assumed in the Workfire acquisition



	Options

	2002			2001			2000

Expected life (years)		3			4			4
Expected volatility		124	%		146	%		137	%
Risk-free interest rates		3.14	%		3.16	%		5.24	%


								Accumulated
		Gains (Losses)						Other
		on Marketable			Other			Comprehensive
		Securities			Adjustments			Income (Loss)

Balance December 31, 1999		$	(58	)	$	—		$	(58	)
	Current year change		135			—			135

Balance December 31, 2000			77			—			77
	Current year change		10			(105	)		(95	)

Balance December 31, 2001			87			(105	)		(18	)
	Current year change		78			105			183

Balance December 31, 2002		$	165		$	—		$	165