PACKETEER INC - 10-K Annual Report

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

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

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

Based on the closing sale price of the common stock on the Nasdaq National Market on June 30, 2003, the aggregate market value of the voting common stock held by non-affiliates of the Registrant was $360,307,604. Shares of common stock held by each officer and director and by each person known by the Registrant to own 10% or more of the outstanding common stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

The number of shares outstanding of Registrant’s common stock, $0.001 par value, was 32,803,380 at February 27, 2004.

Information required by Part III, Items 10, 11, 12, 13 and 14, of this Form 10-K is incorporated by reference from the Registrant’s definitive Proxy Statement for the Registrant’s 2004 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after December 31, 2003.

In addition to historical information, this Annual Report on Form 10-K contains forward-looking statements regarding our strategy, financial performance and revenue sources that involve a number of risks and uncertainties, including those discussed below in “Risk Factors.” Forward-looking statements in this report include, but are not limited to, those relating to future revenues and revenue growth, markets for our products, our ability to continue to innovate and obtain patent protection, operating expense targets, future profits and liquidity, our planned introduction of new products and services, the possibility of acquiring complementary businesses, products, services and technologies, our international expansion plans and our development of relationships with providers of leading Internet technologies. While this outlook represents our current judgment on the future direction of the business, such risks and uncertainties could cause actual results to differ materially from any future performance suggested below. Readers are cautioned not to place undue reliance on the forward-looking statements, which speak only as of the date of this Annual Report. Packeteer undertakes no obligation to publicly release any revisions to forward-looking statements to reflect events or circumstances arising after the date of this document. See “Risk Factors.”

Packeteer is a leading provider of application traffic management systems designed to deliver a broad set of visibility, control, and compression capabilities to enterprise customers and service providers. For enterprise customers, the system is designed to enable Information Technology, or IT, organizations to effectively align application and network resources with the priorities of the business, while providing measurable cost savings in wide area network, or WAN, infrastructure investments. For service providers, the Packeteer systems are designed to 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.

The Packeteer application traffic management system consists of a family of appliances with performance capabilities that make them capable of deployment within large data centers as well as smaller remote sites throughout a distributed enterprise. Each appliance can be configured to deliver the full range of application traffic management solutions, from visibility with PacketSeeker®, to control with PacketShaper®, to compression with PacketShaper Xpress^TM. In addition, each appliance can be managed individually or in context of a completely integrated policy-based application traffic management system distributed across multiple locations, using our ReportCenter^TM or PolicyCenter^TM software products.

Packeteer’s products are deployed at more than 5,000 enterprises and service providers worldwide, and are sold through an established network of more than 100 resellers, distributors and system-integrators in more than 50 countries, complemented by our direct sales organization. Our sales force and marketing efforts are used to develop brand awareness, drive demand for system solutions and support our indirect channels.

We were incorporated in Delaware in January 1996 and began shipping our products in February 1997. To date we have shipped more than 30,000 units. We have subsidiaries or branch offices in Australia, Canada, Denmark, France, Germany, Hong Kong, Japan, Singapore, Spain, South Korea, the Netherlands and the United Kingdom. In this report, “Company”, “Packeteer,” “we,” “us,” and “our” refer to Packeteer, Inc. and its subsidiaries. Investors may access our filings with the Securities and Exchange Commission on our website, which is located on the Internet at www.packeteer.com, but the information on our website does not constitute part of this Annual Report.

The Internet and Transmission Control Protocol/ Internet Protocol, or TCP/ IP, have enabled a new generation of interactive applications to allow information to be exchanged and business processes to be

distributed beyond the traditional boundaries of the enterprise. As a result, these distributed applications empower companies to conduct business with employees, customers, partners and suppliers regardless of their physical location. Protocols are predefined mechanisms for computers to communicate over networks. TCP/ IP is a two-layer program. The higher layer, TCP, manages the assembly of a file into smaller packets that are transmitted over the Internet and received by a TCP layer that reassembles the packets into the original message. The lower layer, IP, handles the address part of each packet so it gets to the right destination.

The emergence of Internet computing has created new challenges for IT managers. As more core business applications, such as SAP, Oracle, and Siebel, become distributed and web-enabled, and the use of video over IP and voice over IP increases, the amount of network data increases dramatically. This increase in data makes it difficult for businesses to ensure the performance of their applications. Further, enterprise users access graphic-intensive web sites, download large files, view streaming media presentations, monitor news and stock quotes and access peer-to-peer applications, instant messaging and other critical and non-critical information over the Internet. The resulting traffic deluge impacts network resources that serve point-of-sale, order processing, enterprise resource planning, supply-chain management and other vital business functions.

Unlike early non-interactive applications that did not require real-time responsiveness, today’s business applications depend on timely access to data and real-time transaction responses to ensure productivity and a high quality of experience for end users. The shift toward real-time, delay-sensitive data is accelerating as corporations begin to converge database transactions and multimedia traffic onto their enterprise networks. TCP/ IP is unable to differentiate between traffic types and is designed so that each transmission attempts to consume all available bandwidth. These characteristics, which make TCP/ IP suitable for non-interactive traffic, threaten the performance of today’s mission-critical applications.

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

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

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

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

Adding bandwidth and infrastructure to over-provision the network. This approach requires expensive upgrades to WAN access links and associated network equipment. Additional bandwidth may be unavailable in many international markets. Moreover, incremental increases in bandwidth may only temporarily alleviate network congestion, and do not ensure that the additional bandwidth is available to mission critical applications, leaving the following problems unresolved:


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

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

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

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

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


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

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

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

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

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

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


	•	Latency, or the amount of time it takes a packet to travel from source to destination, which can negatively affect performance;

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

	•	Difficulty in configuring and maintaining compression tunnels.

Installing network management tools. Several vendors provide software that analyzes and monitors network traffic. While these products enable network administrators to determine how bandwidth is being


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

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

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

Packeteer is a leading provider of application traffic management systems designed to deliver a broad set of visibility, control and compression capabilities to enterprise customers and service providers. For enterprise customers, the system is designed to enable IT organizations to effectively align applications and network resources with the priorities of the business. For service providers, the Packeteer system is designed to provide a platform for delivering application-intelligent network services that control QoS, expand revenue opportunities and offer compelling differentiation from other potential solutions. Packeteer’s application traffic management system is based on the following:


	•	Visibility. Before an organization can control application performance on the WAN, it needs to know what is running on its network and how the network is performing. Packeteer’s monitoring capabilities involve automatic identification and classification of traffic through Layer 7, the applications layer, which is the highest layer in the industry standard Open Systems Interconnection, or OSI, model. This application-layer insight is designed to enable organizations to analyze application performance and network utilization accurately. Packeteer’s performance analysis determines response times, delays, link utilization, and other crucial metrics. Depending on the size of the Packeteer deployment, performance analysis may be captured via onboard or centralized reporting.

	•	Control. Once an organization knows what is running on its network and how the network is performing, it can use Packeteer’s control capabilities to set policies that align application performance in support of business needs. PacketShaper systems allow mission-critical applications to perform efficiently and reliably by allocating varying amounts of bandwidth to applications depending on their relative importance. For instance, network managers can tailor policy management and bandwidth allocation to suit the requirements of particular applications or traffic, such as Citrix, SAP, Siebel, Video over IP and Voice over IP. Meanwhile, peer-to-peer file sharing, casual web browsing and other unsanctioned traffic can be eliminated or minimized, depending on an organization’s available network resources and business priorities.

	•	Compression. Once an organization sets controls to protect critical applications and contain non-critical traffic, the next step is to deploy compression to stretch the current network capacity and further improve application performance by ensuring that the extra capacity goes to critical applications first. PacketShaper Xpress provides a software option that utilizes application-intelligent


		compression, latency management and tunnel management to accelerate policy-managed business traffic.

	•	Centralized Management. Packeteer systems provide reports describing current and historical network performance. Comprehensive reports, graphs and tables enable network managers to refine bandwidth management policies, evaluate efficiency and plan capacity. Packeteer systems automatically measure per- transaction response times for each application. Managers can set, enforce and monitor service-level agreements, which quantify desired QoS for a particular application or customer. Packeteer’s PolicyCenter, a Windows based software solution, is designed to simplify deployment of multiple Packeteer appliances by centralizing policy and software upgrade distribution and providing a summary view of all managed appliances. Packeteer’s ReportCenter, also a Windows based software solution, is designed to provide centralized analysis and reporting for large PacketSeeker and PacketShaper system deployments.

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


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

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

	•	Permit Easy Deployment. Packeteer systems install easily, and automatically start to discover, classify and analyze network traffic and suggest policies to optimize performance. They complement the existing network infrastructure, require no router reconfiguration or desktop changes and are designed not to disrupt network connectivity in the event of software or hardware failure.

	•	Increase Effective Bandwidth. Packeteer systems intelligently increase effective bandwidth and, through integration with our advanced monitoring and shaping capabilities, enable the additional bandwidth to be utilized by mission-critical applications.

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

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

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

Focus on Bandwidth Management Needs of Enterprises. We are focused on providing high performance, easy-to-use and cost-effective bandwidth management solutions to enterprises whose businesses are based on networked applications and Internet computing. For these businesses, managing mission-critical application performance and optimizing the value of the network will continue to be competitive requirements. As the Internet proliferates and new Internet-based applications and services emerge, we believe businesses will continue to adopt Internet computing business models at a rapid rate and that effective bandwidth management will become an increasingly important requirement for maintaining an efficient enterprise

network. We believe we have established a differentiated market position based on our development of a comprehensive solution that provides for effective bandwidth management and our early market leadership and brand awareness. We intend to continue to direct our development, sales and marketing efforts toward addressing the bandwidth management needs of the Internet computing market.

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

Expand Presence in the Managed Application Services Market. We are actively pursuing opportunities in the managed application services market and currently have several managed application service provider customers, including NTT Communications, Equant and AT&T using our managed application service features. Our software’s application discovery and policy based application management features are designed to enable managed application service providers to quickly and cost-effectively deliver secure, measured and performance-assured application services tailored to the needs of specific markets and customers. Such features enable service providers to deliver managed services which provide ongoing visibility into customer network traffic and enhance the application performance of their customers’ priority applications.

Continue to Build Indirect Distribution Channels. We currently have over 100 resellers, distributors and systems integrators that sell our products in over 50 countries. These relationships include: ADN Distribution GmbH, Alternative Technology, Comstor PTE Ltd., Equant, Intechnology plc, Kanematsu USA, Macnica, Inc., and Westcon, Inc. We intend to continue to develop and support new reseller and distribution relationships, as well as to establish additional indirect channels with service providers and systems integrators. We believe this strategy will enable us to increase the worldwide deployment of our products.

Extend Bandwidth Management Technology Leadership. Our technological leadership is based on our sophisticated traffic classification, flexible policy setting capabilities, precise rate control expertise, compression technologies and ability to measure response time and network performance. We intend to invest our research and development resources to increase performance by handling higher speed WAN connections, increase functionality by identifying and managing additional applications or traffic types and increase modularity by taking individual components of our PacketWise® software together or on a stand-alone basis with our existing bandwidth management solutions. We also plan to invest our research and development resources to develop new leading-edge technologies for emerging markets. These development plans include extending our bandwidth management solutions to incorporate in-depth application-management techniques that will improve performance over the Internet and reduce bandwidth requirements. We plan to extend our current portfolio by offering PacketWise-defined solutions that target the specific needs of three primary market opportunities: enterprise bandwidth management, application service-level management and service provider bandwidth management.

Packeteer’s application traffic management system is designed to solve network and application performance problems through a family of appliances with multiple software options that provide visibility into application performance and network utilization, control over network performance and network utilization, and compression to accelerate performance and increase WAN capacity.

PacketSeeker is designed to provide application traffic monitoring that builds on the Company’s industry-leading Layer 7 traffic classification, analysis and reporting technology to provide visibility into network utilization and application performance. PacketSeeker distinguishes itself from “passive” monitoring solutions

PacketShaper is designed to provide application-based traffic and bandwidth management to deliver predictable, efficient performance for applications running over the WAN and Internet. PacketShaper is designed to provide effective application QoS using state-of-the-art bandwidth, traffic, service-level and policy management technology. PacketShaper ISP is designed to enable service providers to create differentiated services through fast and efficient bandwidth provisioning and management. The PacketShaper family currently includes models in the 1500, 2500, 6500, 8500 and 9500 series.

PacketShaper Xpress is designed to provide application traffic acceleration by leveraging Packeteer’s expertise in advanced Web acceleration and content compression technology to create a “universal” traffic acceleration solution that is highly efficient, scalable and simple to administer. Combining Layer 7 classification, traffic shaping and application-intelligent acceleration raises the level of control customers have over the performance of their network applications and associated bandwidth costs.

PolicyCenter is a directory-based policy management application that is designed to enable Packeteer’s enterprise and service provider customers to broadly deploy, scale and manage application QoS throughout the network, PolicyCenter is a lightweight directory access protocol, or LDAP, directory-enabled application running under Windows that enables customers to centrally administer and update policies, software versions, and device status for Packeteer-based networks.

ReportCenter is an application that is designed to aggregate metrics from large deployments and create organization-wide reports to manage trends and provide support for capacity planning and usage analysis, ReportCenter lowers the cost of ownership for large deployments of PacketWise-enabled appliances, improves the quality of information and eases administrative overhead.

We differentiate our solution by combining our knowledge of enterprise applications with our expertise in underlying network protocols. We have invested heavily in developing proprietary software and related technologies and, as of December 31, 2003, we have 12 issued U.S. patents and 39 pending U.S. patent applications. In particular, we have developed technology in these major areas: sophisticated traffic discovery and classification, application-based response time measurement, flexible policy definition and enforcement, precise traffic flow management and intelligent compression algorithms. These technologies help define Packeteer’s core value proposition and meet customer requirements for an application traffic management system capable of delivering comprehensive visibility, control and compression technologies.

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

Relying only on more basic traffic classification prevents network managers from discovering important traffic trends and limits policy setting. Sophisticated application traffic types such as Voice over IP, Oracle and Citrix cannot be identified using rudimentary traffic classification schemes. Packeteer systems identify traffic markers, detect changing or dynamic port assignments and track transactions with changing port assignments. This sophisticated traffic classification allows network managers with Packeteer systems to set policies and control the traffic related to an individual application, session, client, server or traffic type. Packeteer systems permit a network manager to isolate each published application running on a centralized server and can also

differentiate among various applications using the same port. This ability to individually classify applications is a highly valuable tool for network managers, since both non-critical applications such as web browsing and music downloading through peer-to-peer applications and mission-critical applications such as Citrix, Oracle or SAP and critical web sites may all be assigned to the same TCP port number on a network but can be individually classified using a Packeteer system.

Packeteer systems need no assistance from network managers to automatically detect and identify over 400 different traffic types. Without a sophisticated identification and classification capability, managers are usually unaware of the diversity of their own network traffic. In addition, managers can use our technology to define proprietary applications so that their traffic can be recognized and reported. Our technology is differentiated by its ability to recognize older enterprise protocols, such as AppleTalk, DECnet, IPX and SNA. We frequently enhance our classification capability to include new traffic types. Any traffic category can be made even more specific by adding more detailed criteria — for example, Oracle traffic to or from a particular database.

Some of the traffic types that Packeteer’s technology automatically detects and classifies are listed below. The traffic types are named either with their associated protocol or application and are grouped according to the class of application that generated that traffic. Each traffic type has an associated protocol that allows it to be recognized on the network.

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

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

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


	•	Per-session rate policies. These policies enable network managers to limit or guarantee bandwidth to each individual session of an application’s traffic. Per-session policies allocate each session an appropriate amount of bandwidth and prevent one large session from inappropriately impacting others. Network managers specify a minimum-guaranteed rate and allow the session scaled access to additional available bandwidth. For example, a bandwidth cap for traffic prevents web browsers from competing for bandwidth required by mission-critical applications. Likewise, a guaranteed rate for audio or video streams ensures that they are not interrupted by traffic that tends to consume any available bandwidth.

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

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

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

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


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

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

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

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

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

The Packeteer system merges application traffic management with acceleration using compression, active tunnel management and latency management. As a result, increased WAN capacity is utilized by mission-critical applications by allocating the newly created virtual bandwidth to the prioritized applications. Packeteer manages by:


	•	making compression decisions based on application type;

	•	utilizing application specific algorithms and;

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

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

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

We sell all of our products primarily through an established network of more than 100 distributors, resellers and system integrators in more than 50 countries, complemented by our direct sales organization. In 2003, sales to Alternative Technology, Inc., Westcon, Inc. and Macnica, Inc. accounted for 22%, 14% and 10% of net revenues, respectively. In 2002, sales to the same three customers accounted for 21%, 13% and 11% of net revenues, respectively. In 2001, Alternative Technology, Inc. accounted for 22% of net revenues. No other customer accounted for 10% or more of revenues in 2001. Sales to the top 10 indirect channel partners accounted for 65%, 66% and 59%, of net revenues in 2003, 2002 and 2001, respectively.

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

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

We use a rolling six-month forecast based on anticipated product orders to determine our material requirements. Lead times for the materials and components we order vary significantly and depend on factors such as specific supplier, contract terms and demand for a component at a given time. We submit purchase orders for quantities needed within the next 60 days. SMTC or Packeteer may terminate the contract without cause at any time. At that time, the terminating party must honor all open purchase orders. We believe that we carry sufficient finished goods and component inventory to cover a portion of the transition lead-time if we need to secure additional manufacturing capacity.

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

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


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

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

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


	•	industry tradeshows, technical conferences and technology seminars; and

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


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

	•	Alliance Partners. Our Alliance Partners unite Packeteer with organizations whose product offerings provide strategic value to our customers. Our Alliance Partners include systems integrators and service providers as well as technology vendors whose products complement Packeteer’s application traffic management solutions. In exchange, Packeteer presents Alliance Partners with the opportunity to extend to their customers our industry-leading application performance and QoS solutions. For example, system integrators offer IT consulting, network integration, system management and IT outsourcing services. They choose Packeteer solutions to help their customers ensure the performance of their business critical applications and align IT resources with business needs in a cost effective manner. In addition to meeting customers’ bandwidth needs, service providers offer Packeteer products and value-added services such as application performance, on-going performance monitoring and advanced application performance management. Technology vendors’ complementary products interoperate and integrate with Packeteer’s application traffic management solutions to help customers leverage their existing investments by integrating best-of-breed products. Some of our Alliance Partners are Citrix, Equant, HP, InfoVista, NTT and Polycom.

As of December 31, 2003, our worldwide sales and marketing organization consisted of 87 individuals, including managers, sales representatives and technical and administrative support personnel. We have domestic sales offices located in California, Colorado, Illinois, Massachusetts, New Jersey, Texas and Washington. In addition, we have international sales offices located in Australia, Denmark, France, Germany, Hong Kong, Japan, Singapore, South Korea, Spain, the Netherlands and the United Kingdom. In addition, we are planning to expand our operations in the Asia Pacific region in 2004.

We believe there is a strong international market for our application traffic management solutions. Our international sales are conducted primarily through our overseas offices. Sales to customers outside of North America accounted for 56%, 58% and 55% of our net revenues in 2003, 2002 and 2001, respectively.

As of December 31, 2003, our research and development organization consisted of 71 employees providing expertise in different areas of our software: control and compression technologies, classification, central management, user interface and platform engineering. Since inception, we have focused our research and development efforts on developing and enhancing our application traffic management solutions.

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

We compete in a rapidly evolving and highly competitive sector of the Internet application infrastructure system market. We expect competition to persist and intensify in the future from a number of different sources. Increased competition could result in reduced prices and gross margins for our products and could require increased spending by us on research and development, any of which could harm our business. We compete with Cisco, other switch/router vendors and several small private companies that sell products that utilize competing technologies to provide monitoring or bandwidth management or compression. None of these companies offer an integrated visibility, control and compression solution such as Packeteer’s application traffic management system. Our products compete for information technology budget allocations with products that offer monitoring technologies, such as probes and related software. Additionally, we face indirect competition from companies that offer enterprises and service providers’ increased bandwidth and infrastructure upgrades that increase the capacity of their networks, and thereby may lessen or delay the need for bandwidth management.

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


	•	expertise and in-depth knowledge of applications;

	•	timeliness of new product introductions;

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

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

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

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

	•	compatibility with industry standards;

	•	products that do not increase latency and packet loss;

	•	size and scope of distribution network;

	•	brand name; and

	•	access to customers and size of installed customer base.

We rely on a combination of patent, copyright and trademark laws, and on trade secrets, confidentiality provisions and other contractual provisions to protect our proprietary rights. These measures afford only limited protection. As of December 31, 2003, we have 12 issued U.S. patents and 39 pending U.S. patent applications. We cannot assure you that our means of protecting our proprietary rights in the U.S. or abroad will be adequate or that competitors will not independently develop similar technologies. Our future success depends in part on our ability to protect our proprietary rights to the technologies used in our principal products. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to obtain and use trade secrets or other information that we regard as proprietary. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the U.S. We cannot assure you that any issued patent will preserve our proprietary position, or that competitors or others will not develop technologies similar to or superior to our technology. Our failure to enforce and protect our intellectual property rights could harm our business, operating results and financial condition.

From time to time, third parties, including our competitors, have asserted patent, copyright and other intellectual property rights to technologies that are important to us. We expect that we will increasingly be subject to infringement claims as the number of products and competitors in the application-adaptive bandwidth management market grows and the functionality of products overlaps. The results of any litigation matter are inherently uncertain. In the event of an adverse result in any litigation with third parties that could

arise in the future, we could be required to pay substantial damages, including treble damages if we are held to have willfully infringed, to cease the manufacture, use and sale of infringing products, to expend significant resources to develop non-infringing technology, or to obtain licenses to the third-party technology. Licenses may not be available from any third-party that asserts intellectual property claims against us on commercially reasonable terms, or at all. In addition, litigation frequently involves substantial expenditures and can require significant management attention, even if we ultimately prevail.

As of December 31, 2003, Packeteer employed a total of 222 full-time employees. Of the total number of employees, 71 were in research and development, 71 in sales and system engineering, 16 in marketing, 40 in customer support and operations and 24 in administration. Our employees are not represented by any collective bargaining agreement with respect to their employment by Packeteer.

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

We have an accumulated deficit of $92.4 million at December 31, 2003. Although we earned net income of $11.3 million and $3.7 million in 2003 and 2002, respectively, we incurred net 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.

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.

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. Revenue fluctuations resulted primarily from variations in the volume and mix of products sold and variations in channels through which products were sold. Operating expenses in total may fluctuate between quarters due to the timing of spending. For example, 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 the timing of specific events such as sales meetings or tradeshows, or the launch of new products. Additionally, operating costs outside the United States are incurred in local currencies, and are remeasured from the local currency to the U.S. dollar upon consolidation. As exchange rates vary, these operating costs, when remeasured, may differ from our prior performance and our expectations. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for detailed information on our operating results.

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 application traffic management solutions market is characterized by ongoing 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 or alternative compression technologies could also significantly reduce demand for our product. Our future success will depend in 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.

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

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

competition or make our products obsolete. If any technology that is competing with ours is or becomes more reliable, higher performing, less expensive or has other advantages over our technology, then the demand for our products and services would decrease, which would harm our business.

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.

The failure of our indirect partners to sell our products internationally will harm our business. Sales to customers outside of North America accounted for 56%, 58% and 55% of net revenues in 2003, 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 resellers, distributors and systems integrators in marketing our products.

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

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

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

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

We cannot assure you that our indirect channel partners will market our products effectively or continue to devote the resources necessary to provide us with effective sales, marketing and technical support. In order to support and develop leads for our indirect distribution channels, we plan to continue to expand our field sales and support staff as needed. We cannot assure you that this internal expansion will be successfully completed, that the cost of this expansion will not exceed the revenues generated or that our expanded sales and support staff will be able to compete successfully against the significantly more extensive and well-funded sales and marketing operations of many of our current or potential competitors. In addition, our indirect

channel agreements are generally not exclusive and one or more of our channel partners may compete directly with another channel partner for the sale of our products in a particular region or market. This may cause such channel partners to stop or reduce their efforts in marketing our products. Our inability to effectively establish or manage our distribution channels would harm our sales.

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

A limited number of indirect channel partners have accounted for a large part of our revenues to date and we expect that this trend will continue. Because our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term, any significant reduction or delay in sales of our products to any significant indirect channel partner or unexpected returns from these indirect channel partners could harm our business. In 2003, sales to Alternative Technology, Inc., Westcon, Inc. and Macnica, Inc. accounted for 22%, 14% and 10% of net revenues, respectively. In 2002, sales to the same three customers accounted for 21%, 13% and 11% of net revenues, respectively. In 2001, Alternative Technology, Inc. accounted for 22% of net revenues. No other customer accounted for 10% or more of revenues in 2001. 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.

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.

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.

Most of our revenues have been derived from sales of our application traffic management systems and related maintenance and training services. We currently expect that our system-related revenues will continue to account for a substantial percentage of our revenues in 2004 and for the foreseeable future thereafter. Our future operating results are significantly dependent upon the continued market acceptance of our products and enhanced applications. Our business will be harmed if our products do not continue to achieve market acceptance or if we fail to develop and market improvements to our products or new and enhanced products. A decline in demand for our application traffic management systems as a result of competition, technological change or other factors would harm our business.

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.

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 for a lapse in quality assurance procedures;

	•	increases in prices; and

	•	the potential misappropriation of our intellectual property.

We have no long-term contracts or arrangements with SMTC that guarantee product availability, the continuation of particular payment terms or the extension of credit limits. We have experienced in the past, and may experience in the future, problems with our contract manufacturer, such as inferior quality, insufficient quantities and late delivery of product. To date, these problems have not materially adversely affected us. We may not be able to obtain additional volume purchase or manufacturing arrangements with SMTC 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 SMTC or that SMTC will meet our future requirements for timely delivery of products of sufficient quality or quantity. Any of these difficulties could harm our relationships with customers and cause us to lose orders.

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

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 with any of our vendors 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.

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.

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


	•	difficulty in integrating the acquired operations and retaining acquired personnel;

	•	limitations on our ability to retain acquired distribution channels and customers;

	•	diversion of management’s attention and disruption of our ongoing business; and

	•	limitations on our ability to successfully incorporate acquired technology and rights into our product and service offerings and maintain uniform standards, controls, procedures, and policies.

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

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

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

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

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

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

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

Our success depends significantly upon our proprietary technology and our failure or inability to protect our proprietary technology would result in significant harm to our business. We rely on a combination of patent, copyright and trademark laws, and on trade secrets, confidentiality provisions and other contractual provisions to protect our proprietary rights. These measures afford only limited protection. As of December 31, 2003 we have 12 issued U.S. patents and 39 pending U.S. patent applications. Currently, none of our technology is patented outside of the United States. Our means of protecting our proprietary rights in the U.S. or abroad may not be adequate and competitors may independently develop similar technologies. Our future success will depend in part on our ability to protect our proprietary rights and the technologies used in our principal products. Despite our efforts to protect our proprietary rights and technologies unauthorized parties may attempt to copy aspects of our products or to obtain and use trade secrets or other information that we regard as proprietary. Legal proceedings to enforce our intellectual property rights could be burdensome and expensive and could involve a high degree of uncertainty. These legal proceedings may also divert management’s attention from growing our business. In addition, the laws of some foreign countries do not protect our proprietary rights as fully as do the laws of the U.S. Issued patents may not preserve our proprietary position. If we do not enforce and protect our intellectual property, our business will suffer substantial harm.

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

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

We currently anticipate that our existing cash and investment balances will be sufficient to meet our liquidity needs for the foreseeable future. However, we may need to raise additional funds if our estimates of revenues, working capital or capital expenditure requirements change or prove inaccurate or in order for us to respond to unforeseen technological or marketing hurdles or to take advantage of unanticipated opportunities.

In addition, we expect to review potential acquisitions that would complement our existing product offerings or enhance our technical capabilities. While we have no current agreements or negotiations underway with respect to any such acquisition, any future transaction of this nature could require potentially significant amounts of capital. These funds may not be available at the time or times needed, or available on terms acceptable to us. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities to develop new products or to otherwise respond to competitive pressures.

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

We lease approximately 69,000 square feet of administrative and research and development facilities in Cupertino, California under a lease that expires November 2007. We also lease sales offices in various locations throughout the United States. Our international leased offices include a research and development

facility located in Canada, and sales and marketing offices in Australia, France, Germany, Hong Kong, Japan, Singapore, South Korea, Spain, The Netherlands and the United Kingdom. We believe that our future growth can be accommodated by current facilities or by leasing the necessary additional space. We are planning to expand our operations in the Asia Pacific region in 2004.

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 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.

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

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

As of February 27, 2004, there were approximately 350 registered holders of our common stock. We have never declared or paid any dividends on our capital stock. We currently expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future.

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

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

Packeteer is a leading provider of application traffic management systems designed to deliver a broad set of visibility, control, and compression capabilities to enterprise customers and service providers. For enterprise customers, the system is designed to enable IT organizations to effectively align application and network resources with the priorities of the business, while providing measurable cost savings in WAN infrastructure investments. For service providers, the Packeteer systems are designed to 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.

Packeteer’s products are deployed at more than 5,000 enterprises and service providers worldwide, and are sold through an established network of more than 100 resellers, distributors and system-integrators in more than 50 countries, complemented by our direct sales force. Our sales force and marketing efforts are used to develop brand awareness, drive demand for system solutions and support our indirect channels.

We have a limited positive operating history. As of December 31, 2003, we had an accumulated deficit of $92.4 million. Although we earned net income of $11.3 million and $3.7 million in 2003 and 2002, respectively, we incurred losses since we commenced operations in 1996 until 2002, and 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. With the increase in our install base, we plan to continue to invest in our customer support group. We plan to continue to invest in the development and support of our reseller and distributor relationships. We also plan to continue to invest in appropriate marketing campaigns and expand our international sales operations. We plan to continue to invest in research and development activities to enhance existing products and develop new features in response to customer demands. We will also add to our infrastructure to support our growing business.

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 grow our business again in 2004. Our growth rate and net revenues depend significantly on continued growth in the application traffic solutions market, our ability to develop and maintain strong partnering relationships with our indirect channel partners and our ability to expand or enhance our current product offerings or respond to technological change. Our growth in service revenues is dependent upon increasing the number of units under maintenance, which is dependent on both growing our install base and renewing existing maintenance contracts. Our future profitability and rate of growth, if any, will be directly affected by the continued acceptance of our product in the marketplace, as well as the timing and size of orders and shipments, product mix, average selling price of our products and general economic conditions. Our failure to successfully convince the market of our value proposition and maintain strong relationships with our indirect channel partners to ensure the success of their selling efforts on our behalf, would adversely impact our net revenues and operating results.

We derive our revenue from two sources, product revenues and service revenues. Product revenues consist primarily of sales of our application traffic management systems. Service revenues consist primarily of maintenance revenues and, to a lesser extent, training revenues. Product revenues accounted for 83%, 86% and 88% of our revenues in 2003, 2002 and 2001, respectively. Service revenues continue to increase as our installed base grows, accounting for 17%, 14% and 12% of revenues in 2003, 2002 and 2001, respectively. Maintenance revenues are recognized on a monthly basis, over the life of the contract. The typical subscription and support term is twelve months, although multi-year contracts are sold.

Cost of Revenues. Our cost of revenues (excluding amortization of acquired technology) consists of the cost of finished products purchased from our contract manufacturer, overhead costs and service support costs.

For finished product, we outsource all of our manufacturing to one contract manufacturer, SMTC. We design and develop a majority of the key components of our products, including printed circuit boards and software. In addition, we determine the components that are incorporated into our products and select the appropriate suppliers of these components. Our overhead costs consist primarily of personnel related costs for our product operations and order fulfillment groups and other product costs such as warranty and fulfillment charges. Service support costs consist primarily of personnel related costs for our customer support and training groups, as well as fees paid to third-party service providers to facilitate next business day replacement for end user customers located outside the United States. Additionally, we allocate overhead such as facilities, depreciation and IT costs to all departments based on headcount and usage. As such, general overhead costs are reflected in each cost of revenue and operating expense category.

We must continue to work closely with our contract manufacturer as we develop and introduce new products and try to reduce production costs for existing products. To the extent our customer base continues to grow, we intend to continue to invest additional resources in our customer support group and expect that our fees to third-party service providers will continue to increase as our international install base grows.

Research and Development. Research and development expenses consist primarily of salaries and related personnel expenses, allocated overhead, consultant fees and prototype expenses related to the design,

development, testing and enhancement of our products and software. We have historically focused our research and development efforts on developing and enhancing our application traffic management solutions. We expect that in the future, our research and development spending will increase in absolute dollars as we continue to develop and maintain competitive products and enhance our current products by adding innovative features that differentiate our products from those of our competitors. We believe that continued investment in research and development is critical to attaining our strategic product and cost control objectives. We expect somewhat higher absolute spending levels in the upcoming quarters to bring us more in line with our current long-term business model target of 18% of net revenues by the end of 2004.

Sales and Marketing. Sales and marketing expenses consist primarily of salaries, commissions and related personnel expenses for those engaged in the sales, marketing and support of the product, as well as related trade show, promotional and public relations expenses and allocated overhead. Although continuing to decrease as a percentage of net revenues, sales and marketing is our largest cost, accounting for 36%, 42% and 48% of net revenues for 2003, 2002 and 2001, respectively. We plan to significantly increase sales and marketing headcount in 2004, as we continue to expand our global presence. We intend to continue to invest in appropriate sales and marketing campaigns and therefore expect sales and marketing expenses in absolute dollars to increase in the future. Particularly, we have introduced new channel marketing programs, replacing previous channel rebate programs, and will see the impact of these changes in operating expenses during 2004. We expect that sales and marketing expenses will continue to exceed our revised long-term business model target of 30% to 32% of net revenues 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, allocated overhead and other general corporate expenses. Within the next twelve months, we expect general and administrative expenses 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 the Sarbanes-Oxley Act of 2002.

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 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.

We believe that of our significant accounting policies, which are described in Note 1 of the Notes to Consolidated Financial Statements, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, we believe the accounting policies below are the most critical to aid in fully understanding and evaluating our consolidated results of operations and financial condition.

The Company applies the provisions of Statement of Position, or 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:

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.

Generally, product revenue is recognized upon shipment. However, 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, or VSOE of fair value to allocate revenue to the maintenance component of its product and to training. VSOE is based upon separate sales of maintenance renewals and training to customers. Accordingly, assuming other revenue recognition criteria are met, revenue from product sales is recognized upon delivery using the residual method in accordance with SOP 98-9. Revenue from maintenance is recognized ratably over the maintenance term and revenue from training is recognized when the training has taken place. To date, training revenues have not been material.

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

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 we believe they are the primary indicator for estimating future returns. Material differences may result in the amount and timing of our revenue if for any period actual returns differ from our judgments or estimates. The sales return reserve balances at December 31, 2003 and 2002 were $713,000 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 was $149,000 and $145,000 at December 31, 2003 and 2002, respectively.

Warranty reserves. Upon shipment of products to our customers, we provide for the estimated cost to repair or replace products that may be returned under warranty. Our warranty period is typically 12 months from the date of shipment to the end user customer. For existing products, the reserve is estimated based on actual historical experience. For new products, the warranty reserve is based on historical experience of similar products until such time as sufficient historical data has been collected on the new product. Factors that may impact our warranty costs in the future include our reliance on our contract manufacturer to provide quality products and the fact that our products are complex and may contain undetected defects, errors or failures in either the hardware or the software. To date, these problems have not materially adversely affected us. Warranty reserves amounted to $303,000 and $284,000 at December 31, 2003 and 2002, respectively.

The following table includes selected consolidated statements of operations data for all quarters of the periods indicated (in thousands):

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

Net revenues for 2003 were $72.7 million, an increase of 32% over 2002. Gross profit was $55.7 million, or 77% of net revenues, and operating income was $11.6 million. During the comparable period a year ago, net revenues were $55.0 million, gross profit was $42.2 million, or 77% of net revenues, and operating income was $3.2 million.

The increase in revenues was attributable to both an increase in the number of units shipped and the number of units under maintenance contracts. During 2003, we continued to invest in our operations, with operating expenses of $44.1 million increasing $5.2 million, or 13%, from $38.9 million reported in 2002. In particular, we added personnel in operations, sales and research and development.

During 2003, we generated $15.1 million of cash from operating activities, compared to $5.4 million generated in 2002. At December 31, 2003 we had cash, cash equivalents and investments of $86.7 million, accounts receivable of $11.0 million and deferred revenues of $9.6 million.

Net revenues increased to $72.7 million in 2003 from $55.0 million in 2002 and from $46.7 million in 2001. The increase from 2002 to 2003 was $17.7 million, or 32%, and the increase from 2001 to 2002 was $8.3 million, or 18%. Product revenues increased to $60.3 million in 2003 from $47.2 million in 2002 and from $41.1 million in 2001. The increase from 2002 to 2003 of $13.1 million, or 32%, was primarily due to an increase in the number of units shipped, particularly our 6500 model. The increase in product revenues from 2001 to 2002 of $6.1 million, or 15%, was primarily due to a favorable product mix, as sales of our higher end products represented a higher percentage of our reported revenues in 2002 than 2001 and to a lesser extent, an increase in the number of units shipped. There were no significant changes in selling prices during any of the periods presented.

Service revenues increased to $12.4 million in 2003 from $7.8 million in 2002 and from $5.6 million in 2001. The increase from 2002 to 2003 of $4.6 million, or 59%, and the increase from 2001 to 2002 of $2.2 million, or 39%, was due primarily to increases in the number of units under maintenance contracts.

For 2003, net revenues in North America increased to $31.7 million, from $23.1 million in 2002 and $20.8 million in 2001. Sales in North America accounted for 44%, 42% and 45% of net revenues for 2003, 2002 and 2001, respectively. Net revenues in Asia Pacific were $21.6 million, $18.0 million and $12.1 million, or 29%, 33% and 26% of net revenues in 2003, 2002 and 2001, respectively. The increase in 2002 was due to

strong sales in Japan. Net revenues in Europe, the Middle East and Africa, or EMEA, of $19.4 million, $13.9 million and $13.8 million, represented 27%, 25% and 29% of net revenues in 2003, 2002 and 2001, respectively.

In 2003, sales to Alternative Technology, Inc., Westcon, Inc. and Macnica, Inc. accounted for 22%, 14% and 10% of net revenues, respectively. In 2002, sales to the same three customers accounted for 21%, 13% and 11% of net revenues, respectively. In 2001, Alternative Technology, Inc. accounted for 22% of net revenues. No other customer accounted for 10% or more of revenues in 2001. Sales to the top 10 indirect channel partners accounted for 65%, 66%, and 59%, of net revenues for 2003, 2002 and 2001, respectively. At December 31, 2003, three customers accounted for 42% of accounts receivable.

Our cost of revenues increased to $17.0 million in 2003 from $12.9 million in 2002 and $13.9 million in 2001. The cost of revenues represented 23%, 23% and 30% of net revenues in 2003, 2002, and 2001, respectively.

Product costs increased to $12.5 million in 2003 from $9.8 million in 2002 and $10.9 million in 2001. From 2002 to 2003, manufacturing costs increased $1.5 million due to an increase in units shipped and other product costs, specifically warranty, rework and fulfillment charges, increased $940,000. Despite theses increases, product costs, as a percentage of product sales, remained consistent from 2002 to 2003. The $1.1 million decrease in product costs from 2001 to 2002 was due to a decrease in per unit manufacturing costs as a result of lower component prices, as well as a decrease in other product costs, specifically warranty and parts costs.

Service costs increased to $4.5 million in 2003 compared to $3.0 million in both 2002 and 2001. The increased service costs in 2003 compared to 2002 and 2001 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 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.

Amortization of acquired technology in 2001 relates to the acquired developed technologies of Workfire Technologies International, Inc. (Workfire). The acquisition occurred in September 2000. Due to the impairment write-off in the third quarter of 2001, which is described in greater detail below under “IMPAIRMENT OF GOODWILL AND OTHER INTANGIBLES” , there was no amortization during 2002 or 2003. The amortization of acquired technology was $1.2 million during 2001.

Excluding the effects of stock-based compensation of $19,000, $183,000 and $663,000 in 2003, 2002 and 2001, respectively, research and development expenses increased to $12.2 million in 2003 from $10.7 million in 2002 and $11.7 million in 2001. The increase of $1.5 million, or 14%, from 2002 to 2003 was primarily related to a $1.2 million increase in personnel costs as a result of headcount increases. Headcount increased from 63 at December 2002 to 71 at December 2003. The decrease of $1.0 million, or 9%, in expenses from 2001 to 2002 was primarily due to a decrease in program related charges, mainly a $578,000 decrease in project materials, and to a lesser extent, a $265,000 reduction in depreciation expense, partially offset by an increase in distributed costs. Distributed costs include expenses related to facilities, communications and technology, which are allocable to all functional areas of the Company. The increase in distributed expenses is discussed below under the heading “GENERAL AND ADMINISTRATIVE”. Research and development expenses represented 17%, 20% and 25% of net revenues in 2003, 2002 and 2001, respectively. As of December 31, 2003, all research and development costs have been expensed as incurred.

Excluding the effects of stock-based compensation of $151,000 and $442,000 in 2002 and 2001 respectively, sales and marketing expenses increased to $26.4 million in 2003, from $23.3 million in 2002, and from $22.4 million in 2001. The increase of $3.1 million, or 13%, from 2002 to 2003 reflects $2.1 million in additional personnel costs, mainly salaries, commissions, recruiting and $553,000 in increased travel costs, as well as a $541,000 increase in marketing programs in connection with building our sales force and distribution channels. From 2001 to 2002, increases in personnel costs of $1.5 million, mainly commissions and recruiting, and distributed costs, were partially offset by decreases in depreciation expense, supplies costs and marketing activities of $205,000, $138,000 and $800,000, respectively. The increase in distributed costs is discussed below under the heading “GENERAL AND ADMINISTRATIVE”. Sales and marketing expenses represented 36%, 42% and 48% of net revenues in 2003, 2002 and 2001, respectively.

Excluding the effects of stock-based compensation of $51,000 and $128,000 in 2002 and 2001 respectively, general and administrative expenses increased to $5.5 million in 2003 from $4.6 million in 2002 and decreased from $5.7 million in 2001. The increase in expenses from 2002 to 2003 was primarily attributable to a $632,000 increase in professional service fees. For 2002 compared to 2001, decreases in professional services of $526,000 and distributed costs were partially offset by a $464,000 increase in personnel costs, primarily related to the CEO transition and search occurring during the second and third quarters of 2002. Decreases in distributed costs were due to a change in the allocation of the expenses associated with our Information Technology group (IT). Prior to 2002, only a small portion of IT costs were allocated out of general and administrative expenses. Beginning in 2002, based on improved tracking and reporting of IT services, a greater portion of IT costs were allocated to other departments to better reflect the services performed by this group. When compared with 2001, during 2002 approximately $640,000 of additional IT costs were allocated from general and administrative expenses into cost of revenues, research and development and sales and marketing. IT expenses in 2003 were allocated in the same manner as in 2002.

General and administrative expenses represented 8%, 8% and 12% of net revenues in 2003, 2002, and 2001, respectively. This percentage decrease in 2003 and 2002 compared to 2001 was due to lower expenses, including the change in allocation of IT costs, as well as increased revenues.

In connection with the Workfire acquisition completed in September 2000, we recorded goodwill and other intangible assets of approximately $66.1 million, which was being amortized on a straight-line basis over a three-year period. Amortization of this goodwill and other intangibles totaled an aggregate of $11.0 million in 2001. There was no amortization during 2003 and 2002, due to an impairment charge discussed below.

We may have additional acquisitions in future periods that could give rise to the acquisition of additional goodwill. Under the provisions of the Statement of Financial Accounting Standards (SFAS) 142, “Goodwill and Other Intangible Assets,” any future goodwill will be accounted for using an impairment-only approach.

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

During the third quarter of 2001, the Company performed an assessment of the carrying value of the goodwill and other intangible assets related to its acquisition of Workfire pursuant to the Company’s stated policy as described in Note 1 to the Financial Statements. Management’s determination of the existence of impairment indicators included continued general economic slowing, broad based declines in the values of networking technologies and a review of current, historical and future projections of cash flows related to these assets. The conclusion of the assessment was a determination that the carrying value of the goodwill and other intangible assets exceeded its fair value. The fair value was determined based on Company projections of the

present value of future net cash flows to be generated over the expected lives of these assets. Accordingly, the Company recorded an impairment charge of $52.6 million during the third quarter of 2001 for the entire unamortized balance.

Amortization of stock-based compensation resulted primarily from stock options grants to employees and options assumed in the Workfire acquisition. Stock-based compensation was being amortized to expense in accordance with Financial Accounting Standards Board (FASB) Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option Award Plans,” over the vesting period of the individual options, generally four years. We recorded stock-based compensation expense of $19,000, $385,000 and $1.2 million in 2003, 2002 and 2001, respectively. All stock-based compensation was fully amortized as of June 30, 2003.

Interest and other income, net consists primarily of interest income from our cash and investments and totaled $842,000, $1.2 million and $2.6 million in 2003, 2002 and 2001, respectively. The decrease in interest income from 2002 to 2003 and from 2001 to 2002 is the result of lower yields on invested funds.

Interest expense consists primarily of interest expense related to our note payable, capital lease obligations and former line of credit. Interest expense totaled $141,000, $265,000, and $569,000 in 2003, 2002 and 2001, respectively. The decrease in interest expense from 2002 to 2003, and from 2001 to 2002, was attributable to decreased levels of debt.

Our income tax provision for 2003 is primarily attributable to income taxes payable in foreign jurisdictions. The effective rate for both 2002 and 2003 is approximately ten percent. There was no corresponding provision in 2001 due to the Company’s consolidated net loss. As of December 31, 2003, we had net operating loss carryforwards of approximately $49.9 million and $22.7 million for federal and state income tax purposes, respectively. These carryforwards, if not utilized, expire at various dates beginning in 2006. See Note 9 of Notes to Consolidated Financial Statements.

During the past three years, we have had sufficient financial resources to meet our operating requirements, to fund our capital spending and to repay our bank line of credit.

We expect to experience growth in our working capital needs for at least the next twelve months in order to execute our business plan. We anticipate that operating activities, as well as planned capital expenditures, will constitute a partial use of our cash resources. In addition, we may utilize cash resources to fund acquisitions or investments in complementary businesses, technologies or products. We believe that our current cash, cash equivalents and investments of $86.7 million at December 31, 2003 will be sufficient to meet our anticipated cash requirements for working capital and capital expenditures for at least the next twelve months. However, we may need to raise additional funds if our estimates of revenues, working capital or capital expenditure requirements change or prove inaccurate or in order for us to respond to unforeseen technological or marketing hurdles or to take advantage of unanticipated opportunities. These funds may not be available at the time or times needed, or available on terms acceptable to us. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities to develop new products or to otherwise respond to competitive pressures.

We have contractual obligations in the form of operating and capital leases and notes payable. These are described in further detail in Notes 6 and 7 of the Notes to the Consolidated Financial Statements. Additionally, we have purchase obligations reflecting open purchase order commitments. The following chart details our contractual obligations as of December 31, 2003 (in thousands):

Overview. Cash, cash equivalents and investments increased $21.2 million during 2003 to $86.7 million. The increase during the year was primarily due to net cash provided by operating activities of $15.1 million and cash provided by financing activities, specifically proceeds from the issuance of stock through option exercises and the Employee Stock Purchase Plan, totaling $9.1 million. This increase was partially offset by $1.7 million cash used in financing activities to repay debt and capital lease obligations.

Operating Activities. Cash provided by operating activities was $15.1 million in 2003, up from $5.4 million in 2002 and $416,000 in 2001. The increase was primarily due to net income reported in 2003 and 2002, compared to net losses in 2001.

Investing Activities. Cash used in investing activities was $43.0 million and $10.0 million in 2003 and 2002, respectively, primarily reflecting transactions in marketable securities. Cash provided by investing activities was $25.2 million in 2001. During 2001, the activity in our portfolio generated net cash proceeds of $25.7 million, which was reinvested in short-term securities. Capital expenditures were $1.0 million, $2.9 million and $1.0 million in 2003, 2002, and 2001, respectively. The increase in capital expenditures in 2002 included $2.0 million related to our headquarters move in December of that year. Capital expenditures during 2004 are expected to remain at 2003 levels.

Financing Activities. Cash provided by financing activities included $9.1 million, $2.5 million and $2.3 million in proceeds from employee option exercises and the Employee Stock Purchase Plan for the years 2003, 2002 and 2001, respectively. Cash used in financing activities included $1.7 million in both 2003 and 2002, and $2.1 million in 2001 to repay borrowings under our line of credit, note payable and capital lease obligations. We paid down the remaining balance on our line of credit during the first quarter of 2003 and allowed the line to expire in May 2003. Both the note payable and our remaining capital lease obligations will be completely repaid during 2004.

The impact of recent accounting pronouncements is discussed in Note 1 of the Notes to Consolidated Financial Statements.

Our exposure to market risks for changes in interest rates and principal relates primarily to investments in debt securities issued by U.S. government agencies and corporate debt securities. We place our investments with high credit quality issuers and, by policy, limit the amount of the credit exposure to any one issuer. Our investment securities are classified as available-for-sale and consequently are recorded on the balance sheet at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss). We do not use derivative financial instruments. In general our policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with less than three months to maturity from date of purchase are considered to be cash equivalents; investments with maturities between three and twelve months are considered to be short-term investments; and investments with maturities in excess of twelve months from the balance sheet date are considered to be long-term investments. The following table presents the amortized cost, fair value and related weighted-average interest rates by year of maturity for our investment portfolio as of December 31, 2003 and comparable fair values as of December 31, 2002 (in thousands).

We develop products in the United States and sell in North America, Asia, Europe and the rest of the world. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in worldwide markets. All sales are currently made in U.S. dollars; and as a result, a strengthening of the dollar could make our products less competitive in foreign markets. All operating costs outside the United States are incurred in local currencies, and are remeasured from the local currency to U.S. dollars upon consolidation. As exchange rates vary, these operating costs, when remeasured, may differ from our prior performance and our expectations. We have no foreign exchange contracts, option contracts or other foreign currency hedging arrangements.

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

We have audited the accompanying consolidated balance sheets of Packeteer, Inc. and subsidiaries (the Company) as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Packeteer, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 3 to the Consolidated Financial Statements, effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.

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

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

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

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

Product revenues consist primarily of sales of our PacketShaper products, which include hardware, as well as software licenses to distributors and resellers. Service revenues consist primarily of maintenance revenue and, to a lesser extent, training revenue.


	•	persuasive evidence of an arrangement exists,

	•	delivery has occurred,

	•	the fee is fixed or determinable, and

	•	collectibility is probable.

Generally, product revenue is recognized upon shipment. However, product revenue on sales to major new distributors are recorded based on sell-through to the end user customers until such time as the Company has established significant experience with the distributor’s product exchange activity. Additionally, when the Company introduces new product into its distribution channel for which there is no historical customer demand or acceptance history, revenue is recognized on the basis of sell-through to end user customers until such time as demand or acceptance history has been established.

The Company has analyzed all of the elements included in its multiple element arrangements and has determined that it has sufficient vendor specific objective evidence (VSOE) of fair value to allocate revenue to the maintenance component of its product and to training. VSOE is based upon separate sales of maintenance renewals and training to customers. Accordingly, assuming other revenue recognition criteria are met, revenue from product sales is recognized upon delivery using the residual method in accordance with SOP 98-9. Revenue from maintenance is recognized ratably over the maintenance term and revenue from training is recognized when the training has taken place.

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

The following provides additional details on the sales return reserves (in thousands):

Certain distributors and resellers can earn rebates under several Packeteer programs. The rebates earned are recorded as a reduction to revenues in accordance with Emerging Issues Task Force (EITF) 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products). For established programs, the Company’s estimates for rebates are based on historical usage rates. For new programs, rebate reserves are calculated to cover the Company’s maximum exposure until such time as historical usage rates are developed.

The allowance for doubtful accounts reduces trade receivables to their net realizable value. When evaluating the adequacy of the allowance for doubtful accounts, management reviews the aged receivables on an account-by-account basis, taking into consideration such factors as the age of the receivables, customer history and estimated continued credit-worthiness, as well as general economic and industry trends.

The following provides additional details on the allowance for doubtful accounts (in thousands):

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

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

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

Management determines the appropriate classification of investment securities at the time of purchase and reevaluates such designation as of each balance sheet date. As of December 31, 2003 and 2002, all investment securities are designated as “available-for-sale.” These available-for-sale securities are carried at fair value based on quoted market prices, with the unrealized gains (losses) reported as a separate component of stockholders’ equity. The Company periodically reviews the realizability of its investments when impairment indicators exist with respect to the investment. If an other-than-temporary impairment of the investments is deemed to exist, the carrying value of the investment would be written down to its estimated fair value.

Inventories consist primarily of finished goods and are stated at the lower of cost (on a first-in, first-out basis) or market. We record inventory reserves for excess and obsolete inventories based on historical usage and forecasted demand. If future demand or market conditions are less favorable than our projections, additional inventory write-downs may be required and would be reflected in cost of sales in the period the revision is made.

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

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

circumstances, either internal or external, which indicate that the carrying value of the assets cannot be recovered. Such facts or circumstances might include significant underperformance relative to expected historical or projected future operating results or significant negative industry or economic trends. If such indicators are present, we determine whether the sum of the estimated undiscounted cash flows attributable to the assets in question is less than their carrying value. If less, we recognize an impairment loss based on the excess carrying amount of the assets over their respective fair values. If quoted market prices for assets are not available, the fair value is estimated based on the present value of expected future cash flows. The fair value of the asset then becomes the asset’s new carrying value.

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

Accumulated depreciation and amortization includes accumulated amortization of approximately $1.3 million and $2.0 million on equipment under capital lease as of December 31, 2003 and 2002, respectively.

Advertising and sales promotion costs are expensed as incurred. These costs were $318,000, $166,000 and $345,000 for the years ended December 31, 2003, 2002 and 2001, respectively.

Upon shipment of products to its customers, the Company provides for the estimated cost to repair or replace products that may be returned under warranty. The Company’s warranty period is typically 12 months from the date of shipment to the end user customer. For existing products, the reserve is estimated based on actual historical experience. For new products, the required reserve is based on historical experience of similar products until such time as sufficient historical data has been collected on the new product.

The following provides a reconciliation of changes in Packeteer’s warranty reserve (in thousands):

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

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

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. In 2003, sales to Alternative Technology, Inc., Westcon, Inc. and Macnica, Inc. accounted for 22%, 14% and 10% of net revenues, respectively. In 2002, sales to the same three customers accounted for 21%, 13% and 11% of net revenues, respectively. In 2001, Alternative Technology, Inc., accounted for 22% of net revenues. No other customer accounted for 10% or more of revenues in 2001. The loss of one or more of our key indirect channel partners could harm our operating results.

The Company uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The measurement of deferred tax assets is reduced, if necessary, by a valuation allowance for any tax benefits of which future realization is uncertain.

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

Compensation expense for pro forma purposes is reflected over the vesting period.

For pro forma purposes, the fair value of the Company’s stock option awards was estimated using the Black-Scholes option-pricing model, assuming no expected dividends and the following weighted-average assumptions for the years ended December 31:

The weighted-average fair value of the options granted under the 1999 Plan during 2003, 2002 and 2001 was $6.81, $2.68 and $7.08, respectively.

To comply with pro forma reporting requirements of SFAS 123, compensation cost is also estimated for the fair value of the Employee Stock Purchase Plan (ESPP) issuances, which are included in the pro forma totals above. The fair value of purchase rights granted under the ESPP is estimated on the date of grant using the Black-Scholes option-pricing model, assuming no expected dividends and the following weighted average assumptions for the years ended December 31:

The weighted-average fair value of the purchase rights granted under the ESPP during 2003, 2002 and 2001 was $1.94, $2.80 and $7.50, respectively.

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

The functional currency for the Company’s foreign subsidiaries is the U.S. dollar. Accordingly, the entities remeasure monetary assets and liabilities at period-end exchange rates, while non-monetary items are remeasured at historical rates. Income and expense accounts are remeasured at the average rates in effect during the year. Remeasurement adjustments are recognized in income as transaction gains or losses in the year of occurrence. To date, the effect of such amounts on net income has not been significant.

The Company reports comprehensive income or loss in accordance with the provisions of SFAS 130, “Reporting Comprehensive Income.” SFAS 130 establishes standards for reporting comprehensive income and loss and its components in financial statements. For the Company, the primary differences between reported net income (loss) and comprehensive income (loss) are unrealized gains or losses on securities available for sale. Tax effects of the components of other comprehensive income (loss) are not considered material for any periods presented.

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

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

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

For the years ended December 31, 2003 and 2002, certain employee stock options and warrants were excluded from the computation because the exercise price was greater that the average market price. For 2001 all employee options and warrants were excluded from the computation as, due to the net losses, the effect would have been anti-dilutive.

In June 2001, the FASB issued SFAS 143, “Accounting for Asset Retirement Obligations.” SFAS 143 addresses the financial accounting and reporting for obligations and retirement costs related to the retirement of tangible long-lived assets. Packeteer adopted SFAS 143 January 1, 2003. Adoption of this statement did not have an impact on the Company’s results of operations or financial position.

In June 2002, the FASB issued SFAS 146, “Accounting for Costs Associated With Exit or Disposal Activities.” SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and requires the costs to be recorded at their fair values when a liability has been incurred. Under previous guidance, certain exit costs were accrued upon management’s commitment to an exit plan, which is generally before an actual liability has been incurred. Packeteer adopted SFAS 146 January 1, 2003. Adoption of this statement did not have an impact on the Company’s results of operations or financial position.

In November 2002, the 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 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 in the third quarter of 2003 did not have a material impact on the Company’s results of operations or financial position, as the Company’s revenue transactions are generally subject to SOP 97-2.

In January 2003, the FASB issued FASB Interpretation No. (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. As the Company does not have any ownership interests in Variable Interest Entities, the adoption of FIN 46 did not have an 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 did not have an impact on the Company’s 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 consolidated financial statements.

In November 2003, the EITF reached a consensus on portions of EITF 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. The consensus was that certain quantitative and qualitative disclosures should be required for debt and marketable equity securities classified as available-for-sale or held-to-maturity under Statements 115 and 124 that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The disclosures should include the aggregate amount of unrealized losses and the aggregate related fair value of investments with unrealized losses, categorized by type of security and segregated by the length of time the individual securities have been in a continuous unrealized loss position. Additional information in narrative form should provide sufficient detail to support the conclusion that the impairments are not other-than-temporary. These disclosures are effective for fiscal years ending after December 15, 2003. Adoption of these portions of EITF 03-01 did not have a material impact on the Company’s results of operations or financial condition.

The following table presents the impact of SFAS 142, “Goodwill and Other Intangible Assets,” on net income (loss) and net income (loss) per share had the standard been in effect for 2001(in thousands, except per share amounts):

During the third quarter of 2001, the Company performed an assessment of the carrying value of the goodwill and other intangible assets related to its acquisition of Workfire pursuant to the Company’s stated policy. Management’s determination of the existence of impairment indicators included continued general economic slowing, broad based declines in the values of networking technologies and a review of current, historical and future projections of cash flows related to these assets. The conclusion of the assessment was a

determination that the carrying value of the goodwill and other intangible assets exceeded its fair value. The fair value was determined based on Company projections of the present value of future net cash flows to be generated over the expected lives of these assets. Accordingly, the Company recorded an impairment charge of $52.6 million during the third quarter of 2001 for the entire unamortized balance.

The Company’s cash equivalents and investments consist of the following at December 31, 2003 and 2002 (in thousands):

The amortized cost and estimated fair value of the Company’s investments as of December 31, 2003, shown by contractual maturity date, are as follows (in thousands):

The following table shows our investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003 (in thousands).

Securities listed are composed of US Treasury obligations and obligations of US government agencies. The individual securities included in the table above have been in a continuous loss position for periods ranging from one to seven months. At this time, we believe that, due to the nature of the investments, the short time period that these unrealized loss positions have existed, and Packeteer’s ability and intent to hold the investments through these short-term loss positions, factors would not indicate that these unrealized losses should be viewed as “other-than-temporary” under the guidance of EITF 03-01.

The Company had a revolving credit facility that provided for borrowings of up to $10.0 million. Advances were limited to the lesser of the maximum line or the borrowing base, which was 80% of eligible domestic receivables and 90% of eligible international receivables. Additionally, the Company was required to maintain certain financial covenants related to working capital and quarterly net income (loss) amounts. The outstanding principal balance accrued interest at a per annum rate equal to the prime rate and was secured by all present and future collateral of the Company. As of December 31, 2002, the outstanding balance on the line was $1.0 million. During the first quarter of 2003, the Company repaid the outstanding balance and the Company allowed the line to expire in May 2003.

In August 2001, the Company secured a $551,000 equipment loan. Borrowings under this agreement are collateralized by the purchased equipment, bear interest at the rate of 11.1%, and are repayable in monthly installments over a three-year period. At December 31, 2003, approximately $139,000 was outstanding under this note.

The Company leases its facility and certain equipment under non-cancelable lease agreements that expire at various dates through 2010. Some of these arrangements contain renewal options, and require the Company to pay taxes, insurance and maintenance costs. Rent expense was $1.9 million, $1.8 million and $1.4 million for the years ended December 31, 2003, 2002 and 2001, respectively. As of December 31, 2003, the future minimum rental payments under capital and operating leases are as follows (in thousands):

Total interest paid for our capital lease obligations, note payable and revolving line of credit was $110,000, $251,000 and $543,000 for 2003, 2002 and 2001, respectively.

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 consolidated financial statements.

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

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

Our income tax provision for 2003 and 2002 is primarily attributable to income taxes payable in foreign jurisdictions. The Company recorded no income tax provision or benefit in 2001, as the Company reported a net loss.

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

The types of temporary differences that give rise to significant portions of the Company’s net deferred tax assets at December 31 are set forth below (in thousands):

The net change in the total valuation allowance was a decrease of $0.4 million and increase of $1.6 million for the years ended December 31, 2003 and 2002, respectively. Although we reported net income in 2003 and 2002, the Company has previously reported net losses since inception, therefore it has provided a full valuation allowance on its deferred tax assets. Management believes that, based on a number of factors, the available objective evidence creates sufficient uncertainty regarding the realizability of the deferred tax assets such that a full valuation allowance has been recorded.

Approximately $12.8 million of the valuation allowance for deferred tax assets is attributable to employee stock option deductions, the benefit from which will be allocated to additional paid-in capital when, and if, it is subsequently realized.

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

At December 31, 2003 the Company has net operating loss carryforwards for federal and California income tax purposes of approximately $49.9 million and $22.7 million, respectively. If not utilized, the federal net operating loss carryforwards will begin to expire in 2011, and the California net operating loss carryforwards will begin to expire in 2006. At December 31, 2003, the Company had federal and California research credit carryforwards of approximately $2.0 million and $1.8 million, respectively. If not utilized, the federal research credit carryforwards will begin to expire in 2011. The California research credit carryforwards can be carried forward indefinitely. Changes in the Company’s ownership, as defined under Section 382 of the Internal Revenue Code, could result in certain limitations on the annual amount of net operating losses that may be utilized.

Income taxes paid were $672,000, $89,000 and $40,000 for 2003, 2002 and 2001, respectively.

The Company’s Board of Directors has authorized 5,000,000 shares of preferred stock. The authorized preferred stock shares are undesignated and the Board has the authority to issue and to determine the rights, preference and privileges thereof.

The Company’s Board of Directors has authorized 85,000,000 shares of common stock.

As of December 31, 2003, 45,000 warrants to purchase common stock were outstanding and exercisable with a $6.25 exercise price per share and an expiration date in May 2009.

In May 1999, the Company’s Board of Directors adopted the 1999 Employee Stock Purchase Plan (the “ESPP”). The ESPP became effective July 27, 1999. At that time, 500,000 shares were reserved for issuance under this plan. The number of shares reserved under this ESPP automatically increases annually beginning on January 1, 2000 by the lesser of one million shares or 2% of the total number of shares of common stock outstanding. The ESPP permits participants to purchase common stock through payroll deductions of up to 15% of an employee’s compensation, including commissions, overtime, bonuses and other incentive compensation. The purchase price per share is equal to 85% of the fair market value per share on the participant’s entry date into the offering period or, if lower, 85% of the fair market value per share on the semi-annual purchase date. As of December 31, 2003, 687,000 shares had been issued under the plan and 2.1 million were available for future issuance. The fair value of the discount and look-back features are considered compensation for purposes of computing the Company’s pro-forma earnings for stock based compensation.

The 1999 Stock Incentive Plan (the “1999 Plan”) is intended to serve as the successor program to our 1996 Equity Incentive Plan (the “1996 Plan”). In May 1999, the Company’s Board of Directors approved the 1999 Plan, which became effective on July 27, 1999, under which 900,000 shares were reserved for issuance. Previously, 515,000 shares were authorized under the 1996 Plan. In addition, any shares not issued under the 1996 Plan will also be available for grant under the 1999 Plan. The number of shares reserved under the 1999 Plan automatically increases annually beginning on January 1, 2000 by the lesser of three million shares or 5% of the total number of shares of common stock outstanding. Under the 1999 Plan, eligible individuals may be granted options to purchase common shares or may be issued shares of common stock directly. The 1999 Plan is administered by the Compensation Committee of the Board of Directors, which sets the terms and conditions of the options. Non-statutory stock options and incentive stock options are exercisable at prices not less than 85% and 100%, respectively, of the fair value on the date of grant. The options become 25% vested one year after the date of grant with 1/48 per month vesting thereafter and expire at the end of 10 years from date of grant or sooner if terminated by the Board of Directors. The options may include a provision whereby the option holder may elect at any time to exercise the option prior to the full vesting of the option. Unvested shares so purchased shall be subject to a repurchase right by the Company at the original purchase price. Such right shall lapse at a rate equivalent to the vesting period of the original option. As of December 31, 2003, there were no outstanding shares subject to repurchase. As of December 31, 2003, options for 16.3 million shares had been issued and 2.0 million were available for future grant.

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

A summary of stock option activity under 1999 Plan follows (in thousands, except per share data):

The following tables summarize information about stock options outstanding under the 1999 Plan as of December 31, 2003 (in thousands, except per share data):

In the year ended December 31, 2003, 51,250 shares were issued as a result of the exercise of non-plan options granted before the July 28, 1999 initial public offering. As of December 31, 2003, there were 9,333 non-plan options outstanding with a weighted average exercise price of $0.25 per share.

In connection with options granted in 1999 and 1998, the Company recorded deferred stock-based compensation of $3.9 million and $787,000, respectively, representing the difference between the exercise price and the fair value of the Company’s common stock at the date of grant. In 2000, the Company recorded deferred stock-based compensation of $1.1 million related to employee options assumed in the Workfire acquisition. The amounts were being amortized over the vesting period for the individual options, generally four years. Amortization of stock-based compensation of $19,000, $385,000 and $1.2 million was recognized during the years ended December 31, 2003, 2002 and 2001, respectively. All stock-based compensation was fully amortized as of June 30, 2003.

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

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

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

The Company has adopted the provisions of SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” The Company’s chief operating decision maker is considered to be the Company’s CEO. The CEO reviews financial information presented on a consolidated basis substantially similar to the consolidated financial statements. Therefore, the Company has concluded that it operates in one segment and accordingly has provided only the required enterprise-wide disclosures.

The Company operates in the United States and internationally, and derives its revenue from the sale of products and software licenses and maintenance contracts related to these products. Sales outside of North America accounted for 56%, 58% and 55% of the Company’s total revenues in 2003, 2002, and 2001, respectively.

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

We have performed an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of the end of the period covered by this annual report. There has been no change in our internal control over financial reporting during the quarter ended December 31, 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Pursuant to General Instruction G to Form 10-K, the information required by Items 10, 11, 12, 13 and 14 of Part III is incorporated by reference to our definitive Proxy Statement with respect to our 2004 Annual Meeting of Stockholders to be filed pursuant to Regulation 14A with the Securities and Exchange Commission not later than 120 days after December 31, 2003.

See the Consolidated Financial Statements beginning on page 38 of this Form 10-K.

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

The Company filed a Current Report on Form 8-K dated October 16, 2003, furnishing under Item 12 a press release reporting the Company’s results of operations for the three and nine months ended September 30, 2003.

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Cupertino, State of California, on this 5^th day of March, 2004.

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

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


(1)	Filed herewith.

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

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

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

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

(6)	Incorporated by reference from Packeteer’s 10-K dated March 21, 2003.


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

		for the fiscal year ended December 31, 2003

or

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

		for the transition period from to .


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


Part I
	Item 1.	Business	1
	Item 2.	Properties	23
	Item 3.	Legal Proceedings	24
	Item 4.	Submission of Matters to a Vote of Security Holders	24
Part II
	Item 5.	Market For Registrant’s Common Stock and Related Stockholder Matters	24
	Item 6.	Selected Financial Data	25
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26
	Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	36
	Item 8.	Financial Statements and Supplementary Data	36
	Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	59
	Item 9A.	Controls and Procedures	59
Part III
	Item 10.	Directors and Executive Officers of the Registrant
	Item 11.	Executive Compensation
	Item 12.	Security Ownership of Certain Beneficial Owners and Management
	Item 13.	Certain Relationships and Related Transactions
	Item 14.	Principal Accountant Fees and Services
Part IV
	Item 15.	Exhibits, Financial Statement Schedules, and Reports on Form 8-K	59
Signatures			60
EXHIBIT 10.25
EXHIBIT 21.1
EXHIBIT 23.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2


Client/Server CVS FIX (Finance) Folding@Home INFOC-RTMS INT-1 (Unisys Interact) MATIP (Airline) MeetingMaker NetIQ AppMngr OpenConnect JCP PEPGate (Attachmate) Unisys-TCPA Content Delivery Ariel Backweb Chaincast EntryPoint Kontiki Marimba NewsStand PointCast WebShots Database and ERP Baan FileMaker Pro JDENet (JD Edwards) MS SQL Oracle (7,8,9i) Oracle JVM Oracle EM PostgreSQL Progress SAP Directory Services CRS DHCP DNS DPA Finger Ident Kerberos LDAP RADIUS RRP SSDP TACACS whois WINS		E-mail and Collaboration Biff ccMAIL DCOM (MsExchange) Groupwise (Novell) IMAP LotusNotes MSSQ OSI POP3 SMTP File Server AFS CIFS-TCP CU-Dev lockd Microsoft-ds NetBIOS-IP NFS Novell NetWare5 rsync SunND Games Asheron’s Call Battle.net Diablo II Doom EverQuest Half-Life Kali LucasArts (Jedi) MSN Zone Mythic Quake I, II, & III SonyOnline Tribes I,II Unreal Warcraft III Yahoo! Games Healthcare* DICOM HL7 Host Access ATSTCP Attachmate Persoft Persona SHARESUDP SMTBF TN3270 TN5250		Internet ActiveX FTP, Passive FTP Gopher HTTP HTTP Tunnel IP, IPv6, IPIP, UDP, TCP IRC Mime type NNTP Socks2http SSHTCP SSL TFTP UUCP URL Web browser type Legacy LAN and Non-IP AFP AppleTalk DECnet FNA, FNAonTCP IPX LAT MOP-DL/RC NetBEUI PPPoE SLP SNA Messaging AOL IM, Talk, Image,File, ISP,... ICQ IRC Lotus IM MSN Messenger Windows-POPUP Yahoo! Messenger MiddleWare CORBA Java RMI SmartSockets SunRPC (dyn port) JavaClient MultiMedia MPEG (Audio, Video) Multi-cast NetShow NetMeeting QuickTime Real (Audio, Video) RTP RTSP SHOUTcast Streamworks VideoFrame WebEx WinampStream WinMedia		Music P2P Aimster Apple-iTunes AudioGalaxy Rhapsody Mac Satellite Bit Torrent Blubster DirectConnect EDonkey Emule Overnet FileRogue Filetopia Furthurnet Gnutella Acquisition Ares BearShare Furi Gnotella Gnucleus gtk-gnutella LimeWire MyNapster Mactella Morpheus Mutella Nap Share Phex Qtraxmax Qtella Shareaza toadnode XoloX Groove Hotline iMesh KaZaA KaZaA Lite Napster Amster audioGnome File Navigator Gnapster Grokster gtk napster jnapster MacStar Maxter My Napster Napigator NapMX Napster Fast Search Napster/2 Napster, MacOSX OpenNap Rapster Snap Spotlight WebNap WinMX PeerEnabler Scour Tripnosis Winny		Network Management Cisco Discovery Day-Time ICMP(by packet type) IPComp Microsoft SMS NTP RSVP SMS SNMP SYSLOG Time Server Print IPP LPR TN3287 TN5250p Routing AURP BGP CBT DRP EGP EIGRP IGMP IGP MPLS (+tag, +app) OSPF PIM RARP RIP Spanning Tree VLAN (802.1p/q) Security Protocol DLS DPA GRE IPMobility IPSEC ISAKMP/IKE key exch L2TP PPTP RC5DES SOCKS Proxy SSH SSL (+shell) swIPe Session GoToMyPC pcAnywhere REXEC rlogin rsh Telnet Timbuktu VNC Xwindows		Thin Client or Server Based Citrix Published Apps, Nfuse, IMA RDP/Terminal Server Voice over IP CiscoCTI Clarent CUSeeMe Dialpad H.323 I-Phone MCK Commun. Megaco Micom VIP MGCP Net2Phone RTP RTCP SIP Skinny (SCCP) T.120 VDOPhone


	High		Low

2003:
Fourth Quarter	$	20.86	$	12.85
Third Quarter		18.33		11.01
Second Quarter		16.74		9.44
First Quarter		10.19		7.25


	*Intelligent Compression Algorithms to Enhance Performance*


	*We have a history of losses and profitability will be difficult to sustain*


	*If the application traffic management solutions market fails to grow, our business will fail*


	*Our future operating results may not meet analysts’ expectations and may fluctuate significantly, which could adversely affect our stock price*


	If we do not expand or enhance our product offerings or respond effectively and on a timely basis to technological change, our business may not grow or we may lose customers and market share


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


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


	*If our international sales efforts are unsuccessful, our business will fail to grow*


	If we are unable to develop and maintain strong partnering relationships with our indirect channel partners, or if their sales efforts on our behalf are not successful, or if they fail to provide adequate services to our end user customers, our sales may suffer and our revenues may not increase


	*Sales to large customers would be difficult to replace if lost*


Item 1.	*Business*


	*The Emergence of Internet Computing*


	*Limitations of Existing Approaches*


	*Application-Based Response Time Measurement*


	*Our reliance on sales of our products by others makes it difficult to predict our revenues and results of operations*


	*We face risks related to inventories of our products held by our distributors*


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


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


	*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*


	*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*


	*Potential new accounting pronouncements are likely to impact our future financial position and results of operations*


	*Any acquisitions we make could result in dilution to our existing stockholders and difficulties in successfully managing our business*


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


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


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


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


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


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


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


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


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


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


	High		Low

2002:
Fourth Quarter	$	8.28	$	3.35
Third Quarter		5.35		2.66
Second Quarter		7.50		4.13
First Quarter		7.93		5.47



			Years Ended December 31,

			2003		2002		2001			2000			1999


			(In thousands, except per share data)
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Net revenues			$	72,723	$	55,014	$	46,661		$	41,097		$	18,441
Product and service costs				17,036		12,852		13,867			12,585			5,286
Amortization of acquired technology				—		—		1,199			678			—

Gross profit				55,687		42,162		31,595			27,834			13,155
Operating expenses:
	Research and development*			12,183		10,694		11,697			8,760			5,164
	Sales and marketing*			26,433		23,269		22,417			18,614			13,737
	General and administrative*			5,494		4,585		5,704			4,824			2,936
	Amortization of goodwill			—		—		11,017			6,424			—
	Impairment of goodwill and intangibles			—		—		52,552			—			—
	Amortization of stock-based compensation			19		385		1,233			1,683			3,088

		Total operating expenses		44,129		38,933		104,620			40,305			24,925

Income (loss) from operations				11,558		3,229		(73,025	)		(12,471	)		(11,770	)
Other income, net				701		915		2,037			3,402			894

Income (loss) before provision for income taxes				12,259		4,144		(70,988	)		(9,069	)		(10,876	)
Provision for income taxes				1,226		415		—			300			—

Net income (loss)			$	11,033	$	3,729	$	(70,988	)	$	(9,369	)	$	(10,876	)

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

Diluted net income (loss) per share			$	0.32	$	0.12	$	(2.40	)	$	(0.35	)	$	(0.71	)

Shares used in computing basic net income (loss) per share				31,634		30,205		29,559			27,152			15,343