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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

or

Commission File Number 000-26785

PACKETEER, INC.

10201 North De Anza Boulevard, Cupertino, CA 95014
(Address of principal executive offices)

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

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

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

     The number of shares outstanding of Registrant’s common stock, $0.001 par value, was 31,774,181 at July 24, 2003.

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     In addition to historical information, this Form 10-Q contains forward-looking statements regarding our strategy, financial performance and revenue sources that involve a number of risks and uncertainties, including those discussed below at “Factors That May Affect Future Results” and in the “Risk Factors” section of Packeteer’s Annual Report on Form 10-K as filed with the SEC on March 21, 2003. Forward-looking statements in this report include, but are not limited to, those relating to the general expansion of our business, including the expansion of our network product lines, our ability to develop multiple applications, our planned introduction of new products and services, the possibility of acquiring complementary businesses, products, services and technologies, our development of relationships with providers of leading Internet technologies, our competition, the sufficiency of our cash, cash equivalents and investments and our business model targets. While this outlook represents our current judgment on the future direction of the business, such risks and uncertainties could cause actual results to differ materially from any future performance suggested below. Readers are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Form 10-Q. Packeteer undertakes no obligation to publicly release any revisions to forward-looking statements to reflect events or circumstances arising after the date of this document.

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PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

See accompanying notes to condensed consolidated financial statements

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

See accompanying notes to condensed consolidated financial statements.

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

See accompanying notes to condensed consolidated financial statements.

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

1. BASIS OF PRESENTATION

     The accompanying unaudited condensed consolidated financial statements have been prepared by Packeteer, Inc., pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and include the accounts of Packeteer, Inc. and its wholly-owned subsidiaries (“Packeteer” or collectively the “Company”). All significant intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted pursuant to such rules and regulations. Certain previously reported amounts have been reclassified to conform to the current presentation format. While in the opinion of the Company’s management, the unaudited condensed financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair statement of interim periods presented, these financial statements and notes should be read in conjunction with its audited consolidated financial statements and notes thereto, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002 filed with the SEC on March 21, 2003.

     The results of operations for the three and six months ended June 30, 2003 are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending December 31, 2003.

2. STOCK-BASED COMPENSATION

     The Company adopted Financial Accounting Standard (FAS) 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”, which amended FAS 123, “Accounting for Stock-Based Compensation”, in December 2002. As permitted under FAS 148, Packeteer has elected to continue to follow the intrinsic value method in accounting for its stock-based employee compensation arrangements. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation.

3. CONTINGENCY

     In November 2001, Packeteer, certain company officers and directors, and its underwriters were named as defendants in a securities class-action lawsuit filed in the United States District Court for the Southern District of New York. The complaint captioned Antoniono v. Packeteer, Inc. et. al., alleges violations of Sections 11, 12(a)2 and 15 of the Securities Act of 1933, as amended, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder on behalf of a purported class of purchasers of Packeteer common stock between July 27, 1999 and December 6, 2000. The plaintiffs seek unspecified damages. Various plaintiffs have filed similar actions asserting virtually identical allegations against more than 300 other issuers. These cases have all been assigned to the Hon. Shira A. Scheindlin. 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 denied the motion.

     The Company has recently decided to accept a settlement proposal presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against the defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of the IPO cases, and for the assignment or surrender of certain claims the

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Company may have against the underwriters. The Packeteer defendants will not be required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlement exceeds the amount of the insurance coverage, a circumstance which the Company does not believe will occur. The settlement will require approval of an unspecified percentage of issuers by July 31, 2003. The settlement also will require approval of the Court, which cannot be assured, after class members are given the opportunity to object to the settlement or opt out of the settlement.

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

4. GUARANTEES

     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 from December 31, 2002 to June 30, 2003. The Company provides no other guarantees.

5. INCOME TAXES

     Our income tax provisions for the periods ended June 30, 2003 and 2002 are primarily attributable to income taxes payable in foreign jurisdictions. The effective tax rate for the six-month periods ended June 30, 2003 and 2002, and the expected annual rate for the remainder of fiscal 2003, is approximately 10%.

6. NET INCOME PER SHARE

     Basic net income per share has been computed using the weighted-average number of common shares outstanding during the period, less the weighted-average number of common shares that are subject to repurchase. Diluted net income per share has been computed using the weighted average number of common and potential common shares outstanding during the period.

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

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7. COMPREHENSIVE INCOME

     The Company reports comprehensive income in accordance with the provisions of FAS 130, “Reporting Comprehensive Income.” FAS 130 establishes standards for reporting comprehensive income and its components in financial statements. The difference between reported net income and comprehensive income is not considered material for the periods presented.

8. SEGMENT REPORTING

     The Company has adopted the provisions of FAS 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 accompanying 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. During the three months ended June 30, 2003, two customers, Alternative Technology, Inc. and Westcon, Inc., accounted for 24% and 13% of total net revenues, respectively. For the six months ended June 30, 2003, the same two customers accounted for 23% and 14% of total net revenues, respectively. The same two customers also accounted for 19% and 16% of total net revenues, respectively, for the three months ended June 30, 2002 and 19% and 14% of total net revenues, respectively, for the six months ended June 30, 2002.

     Geographic Information

     Revenues reflect the destination of the shipped product.

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

9. RECENT ACCOUNTING PRONOUNCEMENTS

     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 that revenue on any item in a revenue arrangement with multiple deliverables that is 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. Adoption of this Statement is not expected to have a material impact on the Company’s results of operations or financial condition.

     In January 2003, the Financial Accounting Standards Board (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 Company does not have any ownership interests in Variable Interest Entities. The adoption of FIN 46 will not have a material impact on the Company’s results of operations or financial condition.

     In April 2003, the FASB issued FAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. FAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments

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embedded in other contracts and for hedging activities under FAS 133, “Accounting for Derivative Instruments and Hedging Activities”. FAS 149 provides greater clarification of the characteristics of a derivative instrument so that contracts with similar characteristics will be accounted for consistently. In general, FAS 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. As the Company does not currently have any derivative financial instruments, the adoption of FAS 149 will not have an impact on the Company’s consolidated financial statements.

     In May 2003, the FASB issued FAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. FAS 150 clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity and requires that those instruments be classified as liabilities in statements of financial position. Previously, many of those financial instruments were classified as equity. FAS 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. As the Company does not have any of these financial instruments, the adoption of FAS 150 is not expected to have any impact on the Company’s consolidated financial statements.

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

     OVERVIEW

     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™ and PacketShaper Xpress™ systems, integrates application discovery, analysis, control, acceleration and reporting technologies that are required for proactive application performance and bandwidth management. Our AppCelera™ 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.

     Our 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, 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 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, England, France, Germany, Hong Kong, Japan, Korea, Singapore, Spain, and The Netherlands. From inception to date, we have shipped more than 27,000 units.

     We were incorporated in January 1996 and 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.

     We have a limited operating history. As of June 30, 2003, we had an accumulated deficit of $98.7 million. We achieved profitability throughout fiscal 2002 and for the three and six months ended June 30, 2003. However, as we incurred losses since we commenced operations until 2002, 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.

CRITICAL ACCOUNTING POLICIES

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to inventory valuation, valuation allowances including sales return reserves and allowance for

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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 family of 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 (“SOP”) 97-2, “Software Revenue Recognition,” as amended by SOP 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 arrangement 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 Manufacturing Corporation, or 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.

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     Sales return reserve and allowance for doubtful accounts. In accordance with FAS 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 June 30, 2003 and December 31, 2002 were $768,000 and $875,000, 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 at June 30, 2003 and December 31, 2002 was $142,000 and $145,000, 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 at June 30, 2003 and December 31, 2002 amounted to $299,000 and $284,000, respectively.

     RESULTS OF OPERATIONS

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

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     NET REVENUES

     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 of $17.5 million in the three months ended June 30, 2003 increased $4.4 million, or 33%, from the $13.1 million reported in the same quarter of the prior year. Total net revenues increased to $34.3 million in the six months ended June 30, 2003, from $25.4 million in the same period of the prior year, an increase of 35%. Product revenues of $14.6 million for the three months ended June 30, 2003 increased $3.3 million, or 29%, from $11.3 million for the three months ended June 30, 2002. Product revenues for the six months ended June 30, 2003 increased 31% to $28.7 million from $21.9 million for the same period of the prior year. For both the three and six-month periods ended June 30, 2003, the increase is primarily a result of increased shipments of our higher end products, particularly the PacketShaper 6500 models. There were no significant selling price changes during any of the periods presented.

     Service revenues increased to $2.9 million in the three months ended June 30, 2003, from $1.8 million in the three months ended June 30, 2002, an increase of 61%. Service revenues for the six months ended June 30, 2003 increased to $5.5 million, from $3.5 million in the six months ended June 30, 2002, an increase of 59%. The increase is mainly due to an increase in the number of units on maintenance contracts.

     For the three months ended June 30, 2003, net revenues in North America of $7.1 million increased $1.1 million, from $6.0 million in the same period last year, and accounted for 41% of total net revenues, compared to 46% for the same period last year. Net revenues in Asia Pacific of $5.2 million for the three months ended June 30 2003, accounted for 30% of total net revenues compared to $3.4 million or 26% of total net revenues for the same period last year. Net revenues in Europe, the Middle East and Africa, or “EMEA”, of $5.2 million for the three months ended June 30, 2003, accounted for 29% of total net revenues, compared to $3.6 million and 28% of total net revenues for the three months ended June 30, 2002. For the six months ended June 30, 2003, net revenues in North America of $15.0 million increased $4.6 million from the $10.4 million reported in the six months ended June 30, 2002 and accounted for 44% of total net revenues. Net revenues in Asia Pacific, totalled $10.0 million in the six months ended June 30, 2003, an increase of $1.8 million from the $8.2 million reported for the six months ended June 30, 2002, and accounted for 29% of total net revenues. EMEA net revenues of $ 9.2 million for the six months ended June 30, 2003 increased $2.4 million from the $6.8 million reported in the six months ended June 30, 2002 and accounted for 27% of first half of 2003 total net revenues, consistent with the first half of 2002.

     During the three months ended June 30, 2003, two customers, Alternative Technology, Inc. and Westcon, Inc., accounted for 24% and 13% of total net revenues, respectively. For the six months ended June 30, 2003, the same two customers accounted for 23% and 14% of total net revenues, respectively. The same two customers also accounted for 19% and 16% of total net revenues, respectively, for the three months ended June 30, 2002, and 19% and 14% of total net revenues, respectively, for the six months ended June 30, 2002. Sales to the top 10 indirect channel partners accounted for 66% of total net revenues in the first half of fiscal 2003 compared to 69% in the first half of fiscal 2002. At June 30, 2003, two customers accounted for 36% of accounts receivable.

     Despite our belief that worldwide 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 allow us to continue to grow our business in 2003. Our growth rate and total net revenue depend significantly on continued growth of the application traffic management solutions market, our ability to develop and maintain strong partnering relationships with our indirect channel partners and our ability to expand or enhance our product offerings or respond to technological change. Our growth in service revenues is dependent upon increasing the number of units on maintenance, which is dependent on both growing our installed customer base and renewing existing maintenance contracts. Our future profitability and rate of growth, if any, will be directly affected by the continued acceptance of our product in the marketplace, as well as the timing and size of orders, shipments, product mix, average selling price of our products and general economic conditions. Our failure to successfully convince the market of our value proposition and maintain strong relationships with our indirect channel partners to ensure the success of their selling efforts on our behalf, would adversely impact our net revenues and operating results.

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     COST OF REVENUES

     Our cost of revenues consists of the cost of finished products purchased from our turnkey contract manufacturer, overhead costs and service support costs. Our cost of revenues, $4.2 million in the three months ended June 30, 2003, increased $1.1 million, or 33%, from the $3.1 million reported in the same period of fiscal 2002. For the six months ended June 30, 2003, cost of revenues increased $1.8 million, or 30%, to $8.0 million from $6.2 million for the same period in 2002. The increase in costs was due to an increase in units shipped, as well as higher overhead costs and service support costs. The cost of revenues represented 24% of total net revenues for the three and six months ended June 30, 2003, consistent with 24% for the three and six months ended June 30, 2002.

     Product costs for the second quarter of 2003 increased by $610,000, or 25%, to $3.0 million from $2.4 million as reported in the second quarter of 2002. For the three months ended June 30, 2003, manufacturing costs increased $212,000 from the same quarter of fiscal 2002 due to increased units shipped. Other product costs, specifically warranty and rework costs, were up $344,000 from the second quarter of fiscal 2002. For the six months ended June 30, 2003, product costs increased $1.4 million, or 22%, to $5.9 million from $4.8 million for the same period in 2002. For the six months ended June 30, 2003, manufacturing costs increased $572,000 over the six months ended June 30, 2002 due to increased units shipped. Other product costs, specifically warranty, rework and parts costs were up $449,000 from the first half of 2002 as our contract manufacturer caught up on refurbishment of returned units. Despite these increases, product costs as a percentage of product sales decreased to 17% for the quarter and six months ended June 30, 2003, down 2% from the 19% reported in the same periods of 2002.

     Service costs for the second quarter of 2003 increased by $426,000, or 62%, to $1.1 million from $682,000 as reported in the second quarter of fiscal 2002. For the six months ended June 30, 2003, service costs increased 57%, or $769,000, to $2.1 million from $1.4 million for the same period in 2002. The increased service costs in the three months ended June 30, 2003 are due to increased personnel costs, as well as service fees related to an agreement previously entered into by the Company for the outsourcing of certain maintenance and support services beginning late in the third quarter of fiscal 2002. We expect service costs to continue at these higher levels as a result of this outsourcing arrangement, as well as the increase in the number of units under maintenance contracts.

     RESEARCH AND DEVELOPMENT

     Research and development expenses consist primarily of salaries and related personnel expenses, consultant fees and prototype expenses related to the design, development, testing and enhancement of the PacketShaper family of products and PacketWise software. Excluding the effects of stock-based compensation of $8,000 and $50,000 for the three months ended June 30, 2003 and 2002, respectively, research and development expenses of $3.0 million in the three months ended June 30, 2002, were up $412,000, or 16%, from the $2.6 million reported for the three months ended June 30, 2002. Excluding the effects of stock-based compensation of $19,000 and $132,000 for the six months ended June 30, 2003 and 2002, respectively, research and development expenses of $5.8 million increased $465,000, or 9%, from the $5.4 million in the same period in the prior year. Increased costs for the three and six month periods ended June 30, 2003 over the same periods in fiscal 2002, are primarily attributable to increased salaries and related personnel expenses, and to a lesser extent, project supplies and consulting. Research and development expenses represented 17% and 20% of total net revenues for the three months ended June 30, 2003 and 2002, respectively. Research and development expenses represented 17% and 21% of total net revenues for the six months ended June 30, 2003 and 2002, respectively. As of June 30, 2003, 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 approach the lower end of our current long-term business model target of 18% to 20% of revenues going forward.

     SALES AND MARKETING

     Sales and marketing expenses consist primarily of salaries, commissions and related personnel expenses for those engaged in the sales and marketing of our products as well as related trade show, promotional and public relations expenses. Excluding the effects of stock-based compensation of $37,000 in the three months ended June 30, 2002, sales and marketing expenses increased to $6.3 million in the three months ended June 30, 2003, from $5.7 million in the same quarter in the prior year, an increase of 12%. Increases included personnel costs, specifically salaries and benefits, recruiting and commissions, and advertising and promotional costs. Excluding the effects of stock-based compensation of $81,000 for the six months ended June 30, 2002, sales and marketing expenses increased to $12.8 million in the six months ended June 30, 2003, or 17%, from the $11.0 million in the first half of the prior year.

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Increases in personnel costs, specifically salaries and benefits, recruiting and commissions, as well as higher travel costs, accounted for most of the increase. Sales and marketing expenses represented 36% and 38% of total net revenues for the three and six month periods ended June 30, 2003 compared to 43% of total net revenues for the three and six months ended June 30, 2002. We intend to continue to invest in appropriate sales and marketing campaigns and therefore expect our absolute dollar expenses to increase in the future. We continue to work towards our long-term business model target showing sales and marketing expenses in the range of 26% to 28% of revenues, but do not expect to achieve this on a quarterly basis for at least the next twelve to eighteen months.

     GENERAL AND ADMINISTRATIVE

     General and administrative expenses consist primarily of salaries and related personnel expenses for administrative personnel, professional fees and other general corporate expenses. Excluding the effects of stock-based compensation of $13,000 for the three months ended June 30, 2002, general and administrative expenses increased to $1.4 million in the three months ended June 30, 2003, from $1.2 million in the same quarter of the prior year, an increase of 10%. Excluding the effects of stock-based compensation of $26,000 for the six months ended June 30, 2002, general and administrative expenses were $2.7 million, up 19% from the $2.3 million in the first half of the prior year. For the three and six months ending June 30, 2003, higher consulting and facilities expenses were partially offset by a decrease in personnel related expenses, as the second quarter of the prior year included costs related to the CEO transition and search. General and administrative expenses represented 8% of total net revenues for the three and six-month periods ended June 30, 2003 compared to 10% and 9% of total net revenues in the same periods of the prior year, respectively. We expect to see general and administrative expenses continue to decline as a percentage of revenue and expect to reach our long-term business model target of 6% to 7% of revenue within the next twelve months, although this may be delayed slightly as we incur the costs of complying with the requirements of Sarbanes-Oxley.

     STOCK-BASED COMPENSATION

     Stock-based compensation resulted primarily from stock option grants to employees and options assumed in the Workfire acquisition. Stock-based compensation was being amortized in accordance with FASB Interpretation No. 28 over the vesting period of the individual options, generally four years. We recorded stock-based compensation expense of $8,000 and $100,000 in the three months ended June 30, 2003 and 2002, respectively. For the six months ended June 30, 2003 and 2002, stock based compensation expense was $19,000 and $239,000, respectively. All stock-based compensation has been fully amortized as of June 30, 2003.

     OTHER INCOME, NET

     Other income, net consists primarily of investment income from our cash, cash equivalents and investments, less interest expense related to our line of credit, debt and capital lease obligations, and other expenses. Other income, net increased to $289,000 in the three months ended June 30, 2003 from $201,000 in the same in the prior year, an increase of 44%. Other income, net of $469,000 for the six-month period ended June 30, 2003 increased $51,000 from the $418,000 for the six months ended June 30, 2002, an increase of 12%. This increase was primarily a result of lower interest expenses due to decreased levels of debt.

     INCOME TAX PROVISION

     Our income tax provisions for the three and six months ended June 30, 2003 and 2002, respectively, are primarily attributable to income taxes payable in foreign jurisdictions. The effective tax rate for the three and six months ended June 2003 and the expected annual rate for 2003 is approximately 10%.

     LIQUIDITY AND CAPITAL RESOURCES

     Since inception, we have financed our operations primarily from the sale of preferred and common stock and other financing activities such as bank credit against accounts receivable, subordinated debt offerings and equipment leasing and loans. Cash, cash equivalents and investments totaled $76.3 million at June 30, 2003, an increase of $10.8 million from December 31, 2002.

     Net cash provided by operating activities was $7.6 million in the six months ended June 30, 2003, compared with net cash provided by operations of $1.2 million for the same period of the prior year. The increase in operating cash flows was primarily due to the increase in net income reported in the current period, compared to the six months ended June 30, 2002.

     Net cash used in investing activities increased to $15.3 million in the six months ended June 30 2003, compared to net cash used in investing activities of $623,000 for the same period in the prior year, primarily reflecting a greater movement of funds from cash and

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cash equivalents to investments with longer terms to maturity. Fixed asset purchases were $337,000 for the six months ended June 30, 2003, compared to $490,000 for the same period in the prior year.

     Net cash provided by financing activities was $3.8 million in the six months ended June 30, 2003, compared to $28,000 used by financing activities for the same period in the prior year. In the six months ended June 30, 2003, proceeds generated by issuance of common stock totaled $5.1 million, partially offset by $374,000 of payments on lease obligations, and notes payable. Additionally, during the first half of fiscal 2003 we paid down the $1.0 million balance remaining on our line of credit as of December 31, 2002. In the six months ended June 30, 2002, proceeds generated by issuance of common stock totaled $767,000, partially offset by repayments on the note payable of $84,000, lease obligation repayments totaling $387,000 and a $350,000 paydown on 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 June 30, 2003, approximately $720,000 was outstanding under capital lease obligations and $237,000 was outstanding on a note payable. The Company had a revolving credit facility against receivables, which provided for borrowings of up to $10.0 million. The balance outstanding on the line at December 31, 2002 was repaid in the first quarter of 2003 and the Company allowed the line to expire in May 2003.

     The following summarizes Packeteer’s commitments under debt and lease obligations, including interest where applicable, as of June 30, 2003, and the effect such obligations are expected to have on its liquidity and cash flow in future periods (in thousands):

     We expect to experience growth in our working capital needs for the foreseeable future in order to execute our business plan. We anticipate that operating activities and 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 $76.3 million at June 30, 2003 will be sufficient to meet our anticipated cash requirements for working capital and capital expenditures for at least the foreseeable future. However, we may need to raise additional funds if our estimates of revenues, working capital or capital expenditure requirements change or prove inaccurate or in order for us to respond to unforeseen technological or marketing hurdles or to take advantage of unanticipated opportunities. These funds may not be available at the time or times needed, or be available on terms acceptable to us. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities to develop new products or to otherwise respond to competitive pressures.

     RECENT ACCOUNTING PRONOUNCEMENTS

     The impact of recent accounting pronouncements is discussed in Note 9 of the notes to the unaudited condensed consolidated financial statements.

     FACTORS THAT MAY AFFECT FUTURE RESULTS

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

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

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

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	-		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 COULD BE DIFFICULT TO SUSTAIN

     As of June 30, 2003, we had an accumulated deficit of $98.7 million. Although we have achieved profitability throughout fiscal 2002 and for the three and six months ended June 30, 2003, we incurred losses since we commenced operations until 2002, and our 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.

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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 59% and 56% of our net revenues in the three months and six months ended June 30, 2003, respectively and 58% and 55% of our net revenues in fiscal 2002 and 2001, respectively. Our ability to grow will depend in part on the expansion of international sales, which will require success on the part of our distributors, resellers 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 ENDUSER CUSTOMERS, OUR SALES MAY SUFFER AND OUR REVENUES MAY NOT INCREASE

     We rely primarily on an indirect distribution channel consisting of distributors, resellers, 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.

SALES TO LARGE CUSTOMERS WOULD BE DIFFICULT TO REPLACE IF LOST

     A limited number of indirect channel partners have accounted for a large part of our revenues to date and we expect that this trend will continue. Because our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term, any significant reduction or delay in sales of our products to any significant indirect channel partner or unexpected returns from

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these indirect channel partners could harm our business. During the three months ended June 30, 2003, two customers, Alternative Technology, Inc. and Westcon, Inc., accounted for 24% and 13% of net revenues, respectively. For the six months ended June 30, 2003, the same two customers accounted for 23% and 14% of total net revenues, respectively. The same two customers also accounted for 19%, and 16% of total net revenues, respectively, for the three months ended June 30, 2002 and 19% and 14% of total net revenues, respectively, for the six months ended June 30, 2002. Sales to the top 10 indirect channel partners accounted for 66% of net revenues in the first half of fiscal 2003, compared to 69% in the first half of fiscal 2002. 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.

     We generally do not have significant unfulfilled product orders at any point in time. Substantially all of our revenues in any quarter depend upon customer orders that we receive and fulfill in that quarter. 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.

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

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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.

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;
	-		decreases in manufacturing yields and increases in costs;
	-		the potential lack of 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.

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     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.