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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

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.

Yes [X]             No [   ]

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

Yes [X]             No [   ]

     The number of shares outstanding of Registrant’s common stock, $0.001 par value, was 32,075,002 at October 23, 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)

(1)		This information is derived from Packeteer, Inc.’s audited consolidated financial statements.
		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 nine months ended September 30, 2003 are not necessarily indicative of results that may be expected for any other interim period or for the full year ending December 31, 2003.

2.

STOCK-BASED COMPENSATION

     The Company adopted Statement of Financial Accounting Standards (SFAS) No. 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. The following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data).

3.

CONTINGENCIES

     In November 2001, a putative class action lawsuit was filed in the United States District Court for the Southern District of New York against the Company, certain officers and directors of the Company, and the underwriters of the Company’s initial public offering. An amended complaint, captioned In re Packeteer, Inc. Initial Public Offering Securities Litigation, 01-CV-10185 (SAS), was filed on April 20, 2002.

     The amended complaint alleges violations of the federal securities laws on behalf of a purported class of those who acquired the Company’s common stock between the date of the Company’s initial public offering, or IPO, and December 6, 2000. The amended complaint alleges that the description in the prospectus for the Company’s IPO was materially false and misleading in describing the compensation to be earned by the underwriters of the Company’s IPO, and in not describing certain alleged arrangements among

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underwriters and initial purchasers of the Company’s common stock. The amended complaint seeks damages and certification of a plaintiff class consisting of all persons who acquired shares of the Company’s common stock between July 27, 1999 and December 6, 2000.

     In July 2002, the Company and the individual defendants joined in an omnibus motion to dismiss challenging the legal sufficiency of plaintiffs’ claims. The motion was filed on behalf of hundreds of issuer and individual defendants named in similar lawsuits. Plaintiffs opposed the motion, and the Court heard oral argument on the motion in early November 2002. On February 19, 2003, the Court issued an Opinion and Order denying the motion to dismiss as to the Company. In addition, in October 2002, the individual defendants were dismissed without prejudice.

     A special committee of the board of directors has authorized the Company to negotiate a settlement of the pending claims substantially consistent with a memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers. Any such settlement would be subject to approval by the Court. If the settlement is not approved, we intend to vigorously defend ourselves against plaintiffs’ allegations. We do not currently believe that the outcome of this proceeding will have a material adverse impact on our financial condition, results of operations or cash flows.

     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. This warranty reserve approximates the aggregate amount of expected replacement and repair costs for our products. Our warranty reserve is based on historical product repair and replacement information. The following provides a reconciliation of the changes in Packeteer’s warranty reserve from December 31, 2002 to September 30, 2003 (in thousands):

     Additionally, our distributor and reseller agreements generally include a provision for indemnifying such parties against certain liabilities if our products are claimed to infringe a third party’s intellectual property rights. To date we have not incurred any costs as a result of such indemnifications and have not accrued any liabilities related to such obligations in the accompanying condensed consolidated financial statements.

5.

INCOME TAXES

     Our income tax provisions for the periods ended September 30, 2003 and 2002 are primarily attributable to income taxes payable in foreign jurisdictions. The effective tax rate for the nine-month periods ended September 30, 2003 and 2002 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. At September 30, 2003 and 2002, there were 352,305 and 1,789,202 shares, respectively, issuable upon exercise of stock options and warrants excluded from the computation because the exercise price was greater than the average market price.

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     The following table presents the calculation of basic and diluted net income per share (in thousands, except per share amounts):

7.

COMPREHENSIVE INCOME

     The Company reports comprehensive income in accordance with the provisions of SFAS 130, “Reporting Comprehensive Income.” SFAS 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 SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” The Company’s chief operating decision maker is considered to be the Company’s Chief Executive Officer (CEO). The CEO reviews financial information presented on a consolidated basis substantially similar to the accompanying condensed 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 revenues from the sale of products and software licenses and maintenance contracts related to these products. During the three months ended September 30, 2003, three customers, Alternative Technology, Inc., Westcon, Inc. and Macnica Inc, accounted for 20%, 12% and 11% of total net revenues, respectively. For the nine months ended September 30, 2003, two customers, Alternative Technology, Inc. and Westcon, Inc. accounted for 22% and 13% of total net revenues, respectively. Sales to three customers, Alternative Technology, Inc., Westcon Inc. and Macnica Inc. accounted for 23%, 16% and 14% of total net revenues, respectively, for the three months ended September 30, 2002 and 20%, 15% and 11% of total net revenues, respectively, for the nine months ended September 30, 2002.

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     Geographic information (in thousands):

     Net 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 did not 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 (FIN) 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 did not have a material impact on the Company’s results of operations or financial condition.

     In April 2003, the FASB issued SFAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS 133, “Accounting for Derivative Instruments and Hedging Activities". SFAS 149 provides greater clarification of the characteristics of a derivative instrument so that contracts with similar characteristics will be accounted for consistently. In general, SFAS 149 is effective for contracts entered into or modified after September 30, 2003, and for hedging relationships designated after September 30, 2003. As the Company does not currently have any derivative financial instruments, the adoption of SFAS 149 will not have an impact on the Company’s condensed consolidated financial statements.

     In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS 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. SFAS 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 SFAS 150 did not have an impact on the Company’s condensed consolidated financial statements.

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

     OVERVIEW

     Packeteer is a leading provider of application 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 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 and system-integrators 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 29,000 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 positive operating history. As of September 30, 2003, we had an accumulated deficit of $95.7 million. We achieved profitability throughout 2002 and for the three and nine months ended September 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 condensed 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 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

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•

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 with 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.

     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 September 30, 2003 and December 31, 2002 were $425,000 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 the 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 September 30, 2003 and December 31, 2002 was $117,000 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

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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 September 30, 2003 and December 31, 2002 were $313,000 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.

     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 $18.4 million in the three months ended September 30, 2003 increased $4.4 million, or 31%, from the $14.0 million reported in the same three months of the prior year. Total net revenues of $52.7 million increased $13.3 million, or 34%, in the nine months ended September 30, 2003, from $39.4 million in the same period of the prior year. Product revenues of $15.1 million for the three months ended September 30, 2003 increased $3.1 million, or 26%, from $12.0 million for the three months ended September 30, 2002. Product revenues of $43.9 million for the nine months ended September 30, 2003 increased $10.0 million, or 29%, from $33.9 million for the same period of the prior year. For both the three and nine-month periods ended September 30, 2003, the increase in product revenues 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.

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     Service revenues of $3.3 million in the three months ended September 30, 2003, increased $1.3 million, or 62%, from the $2.0 million reported in the same three months of the prior year. Service revenues of $8.8 million for the nine months ended September 30, 2003 increased $3.3 million, or 60%, from $5.5 million in the same period of the prior year. The increase is mainly due to an increase in the number of units on maintenance contracts.

     For the three months ended September 30, 2003, net revenues in North America of $7.7 million increased $1.2 million, from $6.5 million in the same period last year, and accounted for 42% of total net revenues, compared to 46% for the same period last year. Net revenues in Asia Pacific of $5.9 million for the three months ended September 30 2003, accounted for 32% of total net revenues compared to $4.6 million or 33% of total net revenues for the same period last year. Net revenues in Europe, the Middle East and Africa, or “EMEA”, of $4.8 million for the three months ended September 30, 2003, accounted for 26% of total net revenues, compared to $3.0 million and 21% of total net revenues for the three months ended September 30, 2002. For the nine months ended September 30, 2003, net revenues in North America of $22.7 million increased $5.8 million from the $16.9 million reported in the nine months ended September 30, 2002 and accounted for 43% of total net revenues, the same percentage as reported in the nine months ended September 30, 2002. Net revenues in Asia Pacific, totaled $16.0 million in the nine months ended September 30, 2003, an increase of $3.2 million from the $12.8 million reported for the nine months ended September 30, 2002, and accounted for 30% of total net revenues, compared to 33% for the same period last year. EMEA net revenues of $14.0 million for the nine months ended September 30, 2003 accounted for 27% of revenues and increased $4.3 million from the $9.7 million, or 25% of net revenues, reported in the nine months ended September 30, 2002.

     During the three months ended September 30, 2003, three customers, Alternative Technology, Inc., Westcon, Inc. and Macnica Inc, accounted for 20%, 12% and 11% of total net revenues, respectively. For the nine months ended September 30, 2003, two customers, Alternative Technology, Inc. and Westcon, Inc. accounted for 22% and 13% of total net revenues, respectively. For the three months ended September 30, 2002, three customers, Alternative Technology, Inc., Westcon, Inc., and Macnica Inc. accounted for 23%, 16% and 14% of total net revenues, respectively. For the nine months ended September 30, 2002, the same three customers accounted for 20%, 15% and 11% of total net revenues, respectively. At September 30, 2003, three customers accounted for 30% of accounts receivable.

     Despite our belief that worldwide economic growth and IT spending will remain relatively flat for the remainder of 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 the fourth quarter of 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.

     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 was $4.3 million in the three months ended September 30, 2003, an increase of $1.1 million, or 34%, from the $3.2 million reported in the same period of the prior year. For the nine months ended September 30, 2003, cost of revenues increased $2.9 million, or 31%, to $12.3 million from $9.4 million for the same period in the prior year. 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 23% of total net revenues for the three and nine months ended September 30, 2003, consistent with 23% and 24% for the three and nine months ended September 30, 2002, respectively.

     Product costs for the three months ended September 30, 2003 increased by $783,000, or 33%, to $3.2 million from the $2.4 million reported in the same period of the prior year. For the three months ended September 30, 2003, manufacturing costs increased $455,000 from the same period of the prior year due primarily to an increase in units shipped and to a lesser extent, product mix. Other product costs, specifically warranty, rework and fulfillment costs, were up $278,000 from the same period of the prior year. For the nine months ended September 30, 2003, product costs increased $1.9 million, or 26%, to $9.1 million from $7.2 million for the same period in the prior year. For the nine months ended September 30, 2003, manufacturing costs increased $1.0 million over the nine months

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ended September 30, 2002 due primarily to an increase in units shipped and, to a lesser extent, product mix. Other product costs, specifically warranty, rework and fulfillment costs were up $736,000 from the same period of the prior year. Despite these increases, product costs as a percentage of product sales, 21% for the three and nine months ended September 30, 2003, remained consistent with the 20% and 21% of product sales reported for the three and nine months ended September 30, 2002, respectively.

     Service costs for the three months ended September 30, 2003 increased by $291,000, or 36%, to $1.1 million from $805,000 reported for the same period of the prior year. For the nine months ended September 30, 2003, service costs increased $1.0 million, or 49%, to $3.2 million from $2.2 million for the same period in the prior year. The increased service costs in both the three and nine months ended September 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 the prior year. 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 $26,000 for the three months ended September 30, 2002, research and development expenses of $3.0 million in the three months ended September 30, 2003, were up $313,000, or 11%, from the $2.7 million reported for the three months ended September 30, 2002. Excluding the effects of stock-based compensation of $19,000 and $158,000 for the nine months ended September 30, 2003 and 2002, respectively, research and development expenses of $8.9 million increased $778,000, or 10%, from the $8.1 million in the same period in the prior year. Increased costs for the three and nine month periods ended September 30, 2003 over the same periods in the prior year, are primarily attributable to increased salaries and related personnel expenses. Research and development expenses represented 16% and 19% of total net revenues for the three months ended September 30, 2003 and 2002, respectively. Research and development expenses represented 17% and 20% of total net revenues for the nine months ended September 30, 2003 and 2002, respectively. As of September 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 $35,000 in the three months ended September 30, 2002, sales and marketing expenses increased to $6.5 million in the three months ended September 30, 2003, an increase of $721,000, or 12%, from the $5.8 million reported for the three months ended September 30, 2002. Increases included personnel costs, specifically salaries and commissions, and travel related costs. Excluding the effects of stock-based compensation of $116,000 for the nine months ended September 30, 2002, sales and marketing expenses for the nine months ended September 30, 2003 of $19.4 million increased $2.6 million, or 15%, from the $16.8 million for the same period last year. Increases in personnel costs, specifically salaries, recruiting and commissions, as well as higher travel costs, accounted for most of the increase. Sales and marketing expenses represented 36% and 41% of total net revenues for the three months ended September 30, 2003 and 2002, respectively. Sales and marketing expenses represented 37% and 43% of total net revenues for the nine months ended September 30, 2003 and 2002, respectively. 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 expect that sales and marketing expenses will continue to exceed our long-term business model target of 26% to 28% of revenues for at least the next twelve to eighteen months, although our quarterly spending targets assume gradual reductions in total expenses as a percent of revenues.

     GENERAL AND ADMINISTRATIVE

     General and administrative expenses consist primarily of salaries and related personnel expenses for administrative personnel, professional fees and other general corporate expenses. Excluding the effects of stock-based compensation of $12,000 for the three months ended September 30, 2002, general and administrative expenses increased to $1.4 million in the three months ended September 30, 2003, from $1.2 million in the same period of the prior year, an increase of $205,000, or 18%. Increases included personnel costs, specifically salaries, and consulting fees. Excluding the effects of stock-based compensation of $38,000 for the nine months ended September 30, 2002, general and administrative expenses for the nine months ended September 30, 2003 were $4.1

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million, up $631,000, or18%, from the $3.4 million for the same period in the prior year. For the nine months ending September 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 7% and 8% of total net revenues for the three months ended September 30, 2003 and 2002, respectively. General and administrative expenses represented 8% and 9% of total net revenues for the nine months ended September 30, 2003 and 2002, respectively. Within the next twelve months, we expect to reach our long-term business model target of 6% to 7% of revenues, although this may be delayed slightly as we continue to 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 FIN 28 over the vesting period of the individual options, generally four years. We recorded stock-based compensation expense of $0 and $73,000 in the three months ended September 30, 2003 and 2002, respectively. For the nine months ended September 30, 2003 and 2002, stock based compensation expense was $19,000 and $312,000, respectively. All stock-based compensation was 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 decreased to $72,000 in the three months ended September 30, 2003 from $309,000 for the same period in the prior year, a decrease of 77%. Other income, net of $541,000 for the nine-month period ended September 30, 2003 decreased $186,000 from the $727,000 for the same period in the prior year, a decrease of 26%. This decrease was primarily a result of lower interest income due to lower interest rates, offset by lower interest expenses due to decreased levels of debt.

     INCOME TAX PROVISION

     Our income tax provisions for the three and nine months ended September 30, 2003 and 2002, respectively, are primarily attributable to income taxes payable in foreign jurisdictions. The effective tax rate for the three and nine months ended September 30, 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 $79.5 million at September 30, 2003, an increase of $14.0 million from December 31, 2002.

     Net cash provided by operating activities was $10.1 million in the nine months ended September 30, 2003, compared with net cash provided by operations of $2.7 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 nine months ended September 30, 2002.

     Net cash used in investing activities increased to $22.5 million in the nine months ended September 30 2003, compared to net cash used in investing activities of $15.3 million for the same period in the prior year, primarily reflecting a greater movement of funds from cash and cash equivalents to investments with longer terms to maturity. Fixed asset purchases were $468,000 for the nine months ended September 30, 2003, compared to $764,000 for the same period in the prior year.

     Net cash provided by financing activities was $4.5 million in the nine months ended September 30, 2003, compared to $21,000 provided by financing activities for the same period in the prior year. In the nine months ended September 30, 2003, proceeds generated by issuance of common stock totaled $6.0 million, partially offset by $578,000 of payments on lease obligations, and notes payable. Additionally, during the current year we paid down the $1.0 million balance remaining on our line of credit as of December 31, 2002.

     We have entered into capital leases and notes payable to finance the acquisition of computer software, hardware and furniture. As of September 30, 2003, approximately $564,000 was outstanding under capital lease obligations and $189,000 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.

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     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 September 30, 2003, and the effect such obligations are expected to have on its liquidity and cash flow in future periods (in thousands):