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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

Quarterly Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934

WATCHGUARD TECHNOLOGIES, INC.

(Exact Name of Registrant as Specified in Its Charter)

505 Fifth Ave. South, Suite 500, Seattle WA 98104-3892

(Address of Principal Executive Offices) (Zip Code)

Registrant’s telephone number, including area code:  (206) 521-8340

Not Applicable

(Former name, former address and former fiscal year, if changed since last 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 the filing requirements for the past 90 days.    Yes  x    No  ¨

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

32,843,029 shares of WatchGuard common stock were outstanding as of May 6, 2003.

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WATCHGUARD TECHNOLOGIES, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2003

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PART I.    FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(unaudited)

See accompanying notes.

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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)

See accompanying notes.

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WATCHGUARD TECHNOLOGIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)

See accompanying notes.

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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1—DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

Description of Business

WatchGuard Technologies, Inc. (WatchGuard) is a leading provider of Internet security solutions designed to protect enterprises that use the Internet for electronic commerce and secure communications.

Interim Financial Information

The accompanying consolidated unaudited financial statements of WatchGuard, which include the December 31, 2002 balance sheet that was derived from audited consolidated financial statements, have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the unaudited financial statements include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation. Operating results for the three-month period ended March 31, 2003 are not necessarily indicative of the results that may be expected for future quarters or for the year ending December 31, 2003. The financial statements should be read in conjunction with the financial statements and related notes for the year ended December 31, 2002 included in WatchGuard’s annual report on Form 10-K, filed with the Securities and Exchange Commission (SEC) on March 26, 2003.

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Revenue Recognition

WatchGuard recognizes revenue in accordance with accounting standards for software companies, including Statement of Position (SOP) 97-2, “Software Revenue Recognition,” as amended by SOP 98-9, and related interpretations, including Technical Practice Aids. In December 1999, the SEC issued Staff Accounting Bulletin (SAB) 101, “Revenue Recognition in Financial Statements.” SAB 101 summarizes certain of the SEC’s views in applying generally accepted accounting principles to revenue recognition in financial statements. WatchGuard believes its current revenue recognition policies and practices are consistent with the current accounting standards.

WatchGuard generates revenues through sales of its Firebox and RapidStream “Secured by Check Point” products, including related software licenses, subscriptions for its LiveSecurity Service, which includes access to technical support, software updates (if and when available), threat responses, expert editorials, support flashes, virus alerts and interactive training, and sales of ServerLock products. Software license revenues are generated from licensing the rights to use WatchGuard’s products directly to end-users, from sublicense fees from resellers and distributors and from sales of its managed security solution products to Internet service providers and other service providers that utilize WatchGuard’s products to provide managed security services to their customers.

Revenues from software license agreements are generally recognized upon delivery of software if persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence of fair value for undelivered elements of the arrangement has been established. Vendor-specific objective evidence is typically based on the price charged when an element is sold separately or, if an element is not sold separately, on the price established by authorized management, if it is probable that the price, once established, will not change before market introduction. WatchGuard uses the residual method, as defined in SOP 98-9, to allocate revenues to delivered elements once it has established vendor-specific objective evidence for all undelivered elements. Under the residual method, any discount in the arrangement is allocated to the delivered element.

WatchGuard provides allowances for estimated returns and return rights and pricing protection rights, which are offered to most customers. WatchGuard also provides allowances for promotional rebates offered to its customers. A customer’s return rights are generally limited to the lesser of its on-hand inventory or a percentage of the customer’s purchases for the previous quarter. Pricing protection rights, offered to many of WatchGuard’s customers, are generally limited to 60 to 90 days after notification of a price change. Revenues are reduced by the provision for estimated returns and allowances at the time the sales are made.

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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

The promotional rebates vary by type and term and are earned by customers in accordance with various conditions. WatchGuard accounts for promotional rebates given to customers in accordance with the Emerging Issues Task Force (EITF) Issue 01-09, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Product,” which requires that sales incentives given to customers or resellers be accounted for as a reduction of revenue unless a vendor receives a benefit that is identifiable and can be reasonably estimated. WatchGuard accrues the maximum amount possible unless historical trends indicate a lower rate of accrual is adequate.

Revenues from some distribution arrangements are not recognized until the distributors sell the products to their customers, including those who have unlimited stock return and rotation rights. Revenues from LiveSecurity Service subscriptions are recognized ratably over the term of the contract, typically 90 days to two years. WatchGuard’s payment terms typically range from 30 to 60 days.

Principles of Consolidation

The consolidated financial statements include the accounts of WatchGuard and its wholly owned subsidiaries. All significant intercompany accounts and transactions are eliminated in consolidation.

Net Loss Per Share

Basic and diluted net loss per share is calculated using the average number of shares of common stock outstanding. Other common stock equivalents, including stock options, are excluded from the computation because their effect is antidilutive.

Comprehensive Loss

WatchGuard’s investments consist of corporate and government debt securities, are considered available-for-sale, and are stated at fair value, with unrealized gains and losses included as a component of stockholders’ equity. During the three-month periods ended March 31, 2002 and March 31, 2003, there were no material realized gains or losses on securities available-for-sale. All such investments mature within two years, with the weighted average life of the investment portfolio being approximately one year. The following table sets forth the components of comprehensive loss (in thousands):

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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Recent Accounting Pronouncements

In June 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (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 nullifies EITF Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 generally requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred rather than at the date of an entity’s commitment to an exit plan. As the provisions of SFAS 146 are effective for exit and disposal activities initiated after December 31, 2003, and WatchGuard did not undertake these activities in the three months ended March 31, 2003, SFAS 146 did not have a material impact on WatchGuard’s consolidated financial statements.

At the November 21, 2002 meeting, the EITF of the FASB reached a consensus on EITF Issue 00-21, “Revenue Arrangements with Multiple Deliverables,” which addresses revenue recognition for arrangements that may involve the delivery or performance of multiple products, services and/or rights to use assets. The final consensus will be applicable to agreements entered into in fiscal periods beginning after June 15, 2003, with early adoption permitted. To the extent that an arrangement is within the scope of other existing higher-level authoritative literature that provides guidance regarding whether or how to separate multiple-deliverable arrangements into separate units of accounting, such as SOP 97-2, the arrangement should be accounted for in accordance with that literature. As WatchGuard accounts for the multiple-elements revenue arrangements in accordance with SOP 97-2, it does not believe the adoption of EITF Issue 00-21 will have a material impact on its financial position or results of operation.

Reclassifications

Certain prior-period items have been reclassified to conform to the current-period presentation.

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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 3—BALANCE SHEET ACCOUNT DETAIL

Trade Accounts Receivable, Net

Trade accounts receivable, net consisted of the following (in thousands):

Inventories, Net

Inventories, net consisted of the following (in thousands):

Accrued Expenses and Other Liabilities

Accrued expenses consisted of the following (in thousands):

Accrued Restructuring and Acquisition Costs

Accrued restructuring and acquisition costs consisted of the following (in thousands):

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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 4—BUSINESS RESTRUCTURINGS

During 2001 and 2002, WatchGuard recorded restructuring charges of $3.7 million and $8.1 million, respectively. At March 31, 2003, the remaining balance of the restructuring liabilities was $6.0 million. No adjustments to the remaining liabilities were required in the three-month period ended March 31, 2003.

2001 Restructuring

In the second quarter of 2001, WatchGuard announced a restructuring plan designed to streamline operations and reduce operating costs. All costs related to this restructuring have been paid or settled, except for certain liabilities related to abandoned facilities which are as follows (in thousands):

2002 Restructuring

In the second quarter of 2002, WatchGuard implemented a restructuring plan primarily designed to eliminate redundancies and excess headcount resulting from the acquisition of RapidStream, Inc., which included a reduction in workforce, consolidation of excess facilities and elimination of technology-related contracts that are no longer required or part of WatchGuard’s strategy. As a result of this restructuring, WatchGuard recorded a $6.7 million restructuring charge in 2002.

As part of this reorganization, WatchGuard implemented a workforce reduction of 36 employees, which represented approximately 10% of WatchGuard’s post-acquisition employee base and included employees from all of WatchGuard’s functional areas. All such employees were terminated prior to June 30, 2002. Other costs associated with the reorganization consist of contract terminations and the consolidation of excess facilities. Costs that related to ongoing operations were not included as restructuring charges. Restructuring charges for severance and termination benefits were paid by December 31, 2002, while accrued amounts related to losses for the lease buyout or sublease of abandoned facilities of approximately $4.1 million at March 31, 2003 are expected to be realized through 2010. Contract termination costs were paid during the quarter ended March 31, 2003, except for certain legal fees that will be paid by June 30, 2003.

The accrued liability relating to this restructuring as of December 31, 2002 and activity recorded through March 31, 2003 is as follows (in thousands):

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WATCHGUARD TECHNOLOGIES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 5—STOCK-BASED COMPENSATION

WatchGuard accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principle Board Opinion 25, “Accounting for Stock Issued to Employees,” and related interpretations. Compensation cost for stock options is measured as the excess, if any, of the fair value of WatchGuard’s common stock at the date of grant over the stock option exercise price.

The following pro forma information regarding stock-based compensation has been determined as if WatchGuard had accounted for its employee stock options and employee stock purchase plan shares under the fair market value method of SFAS 123. The fair value of the employee stock options was estimated at the date of grant, using a minimum value option pricing model through the date of WatchGuard’s initial public offering in July 1999 and using the Black-Scholes pricing model thereafter. The estimated fair value of the options is amortized over their vesting periods.

WatchGuard’s pro forma information is as follows (in thousands, except per share data):

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

The following discussion and analysis provides information that we believe is relevant to an assessment and understanding of WatchGuard’s financial condition and results of operations. The discussion should be read in conjunction with the consolidated financial statements and the notes thereto. References to “we,” “our” and “us” in this quarterly report refer to WatchGuard Technologies, Inc. and our wholly owned subsidiaries.

Forward-Looking Statements

Our disclosure and analysis in this quarterly report on Form 10-Q contain forward-looking statements, which provide our current expectations or forecasts of future events. Forward-looking statements in this quarterly report include, without limitation:

Words such as “believes,” “anticipates” and “intends” may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking. Forward-looking statements are subject to known and unknown risks and uncertainties and are based on potentially inaccurate assumptions that could cause actual results to differ materially from those expected or implied by the forward-looking statements. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the factors described below under the heading “Important Factors That May Affect Our Operating Results, Our Business and Our Stock Price” in this quarterly report. Other factors besides those described in this quarterly report could also affect actual results. You should carefully consider those factors in evaluating our forward-looking statements.

You should not unduly rely on these forward-looking statements, which speak only as of the date of this quarterly report. We undertake no obligation to publicly revise any forward-looking statement to reflect circumstances or events after the date of this quarterly report, or to reflect the occurrence of unanticipated events. You should, however, review the factors and risks we describe in the reports we file from time to time with the SEC.

Overview

WatchGuard is a leading provider of Internet security solutions designed to protect enterprises that use the Internet for electronic commerce and secure communications. Our mission is to provide enterprises worldwide with stronger Internet security solutions by offering integrated, multi-layered defenses and tools that protect against known and future threats in a smart way by including simplified implementation and management and proactive security with our LiveSecurity Service.

Our award-winning products and services include our high-performance Firebox and RapidStream firewall and VPN appliances for access control, secure communications and (with certain of our Firebox products) network-based intrusion protection capabilities, and our ServerLock technology and anti-virus solution for content and application security for servers and desktops with host-based intrusion protection capabilities. Our innovative subscription-based LiveSecurity Service delivers threat responses, software updates, expert editorials, support flashes and virus alerts, which enables our customers, with minimal effort, to protect their data and communications in a continuously changing environment.

Our core market spans the small- to medium-sized enterprise, or SME, market, from companies at the lower end where ease-of-use is a key requirement, to companies at the high end, including those with high-speed connections supporting virtual private networks, or VPNs, between the corporate headquarters and geographically dispersed branch offices, where performance, scalability and networking features are key requirements. In addition, with the introduction of our RapidStream line of “Secured by Check Point” appliances, we also have the opportunity to leverage the established presence of Check Point Software Technologies Ltd., or Check Point, in the large enterprise market.

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We sell our Internet security solutions indirectly to end-users through thousands of distributors and resellers, with customers located in over 125 countries. We also sell directly and indirectly to a number of service providers that implement our managed security solution.

Since January 2002, we have continued to invest heavily in the development of our products as follows:

Critical Accounting Policies

Our discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our financial statements, including those related to

We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates if our assumptions change or if actual circumstances differ from those in our assumptions.

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We believe the following critical accounting policies affect the more significant judgments and estimates used in preparing our consolidated financial statements.

Revenue Recognition

Revenue recognition rules for software companies are very complex. Although we follow very specific and detailed guidelines in measuring revenue, certain judgments affect the application of our revenue policy. The complexity of the revenue recognition rules and estimates inherent in the revenue recognition process makes revenue results difficult to predict, and any shortfall in revenues or delay in recognizing revenues could cause our operating results to vary significantly from quarter to quarter and could result in future operating losses.

We generate revenues through:

Product revenues include:

Revenues from products are generally recognized upon delivery if persuasive evidence of an arrangement exists, collection is probable, the fee is fixed or determinable, and vendor-specific objective evidence of fair value for undelivered elements of the arrangement has been established. While we generally recognize product revenues upon shipment, revenues on product sales for some of our major distributors are recorded when these distributors have sold the product to their customers.

Service revenues primarily include the initial fees for our LiveSecurity Service subscriptions, which have periods ranging from 90 days to one year and are sold as part of our security solutions, and for LiveSecurity Service subscription renewals, which have periods ranging from one to two years, from our enterprise customers and end-users. These service fees provide our customers access to our LiveSecurity Service for product updates, security threat responses, general security information and technical support. These service fees also enable our service provider customers access to the LiveSecurity Service and the ability to manage and update a specific number of their customers’ security appliances. Service subscription revenues are recognized ratably on a monthly basis, generally over periods ranging from 90 days to two years.

When service fees are bundled with the sales of our products in multiple element arrangements, the elements of those arrangements are unbundled using our objective evidence of the fair value of the undelivered elements represented by our customary pricing for each element when sold in separate transactions. Since customers receive the services over a period of time, WatchGuard determines the fair value of the service portion of the arrangement as an undelivered element, based on the renewal price of the service. Changes in the composition of such multiple-element arrangements, our ability to identify the existence of the vendor-specific objective evidence for the elements in the arrangement or our ability to estimate the fair value of elements in the arrangement could materially impact the amount of earned and unearned revenue.

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We have established cash and noncash allowances for estimated returns, return rights and pricing protection rights. We have also established an allowance for promotional rebates that may be earned by our customers. We estimate these reserves and adjust them periodically based on historical rates of returns and allowances, as well as the expected effect of current promotional programs and new product introductions. We estimate the allowance for promotional rebates based on the maximum amounts potentially available to the customers, unless we accumulate sufficient historic evidence for individual customers with respect to their realization of rebates. If new or expanded promotional programs are introduced, or new products are announced, additional allowances may be required. Alternatively, if actual promotional rebates fall below maximum exposure levels, we may reduce the allowances and recognize additional revenue.

Bad Debts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Significant judgment is required when we assess the ultimate realization of receivables, including the probability of collection and the creditworthiness of each customer. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances might be required.

Inventory Valuation

Our inventories are stated at the lower of cost or market, with cost being determined on a first-in, first-out basis. We write our inventories down to estimated market value based on assumptions about future demand and market conditions. Variation in market trends, customer preferences and introduction of new products that replace existing products or technological advances could, however, significantly affect these estimates and result in additional inventory write-downs.

Restructuring

In 2001 and 2002, we recorded significant accruals related to our restructuring plans. These accruals included estimates related to the abandonment of excess facilities. We had to adjust the restructuring accruals due to continued poor real estate market conditions in the areas where these excess facilities are located. The actual costs related to the restructuring may differ from our estimate if it takes us longer than expected to find suitable tenants for excess facilities or if there are further changes in the real estate market in those areas where excess facilities are located. Any additional adjustments resulting from these factors could have a material effect on our financial condition and operating results.

Business Combinations Purchase Price Allocation

We account for our business combinations using the purchase method of accounting prescribed by SFAS 141. We allocate the total consideration paid in an acquisition to the fair value of the acquired company’s identifiable assets and liabilities. The remainder of consideration is allocated to goodwill.

We identify and record separately the intangible assets acquired as part of goodwill based on the specific criteria for separate recognition established in SFAS 141, namely:

We recognize current technology as a separate intangible asset acquired and assign the value to this technology based on the income valuation approach, reflecting the present value of the projected net cash flows expected to be generated from future commercial sales of products incorporating this current technology. WatchGuard capitalizes the acquired technology that had reached the phase of technological feasibility.

Apart from the capitalized current technology, we also identify the value of the research and development efforts spent on the technology that has not yet reached the technological feasibility stage and does not have alternative future uses. We base this value of the in-process research and development on several factors, including the state of the development of each project, the time and cost needed to complete the project, expected income and associated risks related to the viability of the potential changes in future target markets. The value of the in-process research and development is expensed at the time of acquisition per SFAS 2.

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Accounting for Goodwill and Other Intangibles

Our business acquisitions have resulted in, and future acquisitions typically will result in, the recording of goodwill, which represents the excess of the purchase price over the fair value of assets acquired, as well as capitalized technology and other definite-lived intangible assets.

Pursuant to SFAS 142, we test purchased goodwill for impairment at least annually. Application of the goodwill impairment test may require judgments, including those inherent in the determination of fair value of the reporting unit in which the goodwill resides and the resulting determination of the implicit value of the goodwill. Significant judgments required to estimate the fair value include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these estimates and assumptions could materially affect the determination of fair value.

Separable intangible assets that do not have indefinite lives are amortized over their useful lives ranging between three and five years. In accordance with SFAS 144, these assets are also periodically reviewed for the existence of facts and circumstances, both internal and external, which may suggest potential impairment. The determination of whether these intangible assets are impaired involves significant judgments based on short- and long-term projections of future performance. Certain of these forecasts reflect assumptions regarding our ability to continue to develop and ultimately to commercialize the products based on these intangible assets, as well as our projections of future cash flows from these products. Changes in strategy and/or market conditions may result in impairment adjustments.

Results of Operations

The following table provides financial data for the periods indicated as a percentage of total revenues:

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Three Months Ended March 31, 2002 and 2003

Revenues

We categorize our revenues into three geographic regions: the Americas, Europe/Middle East/Africa, or EMEA, and Asia Pacific, or APAC. Revenue information by geographic region, in dollars and as a percentage of total revenues, was as follows (dollars in thousands):

Revenue information for customers representing more than 10% of total revenues, in dollars and as a percentage of total revenues, was as follows (dollars in thousands):

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The product revenues dollar increase was primarily due to larger unit volumes in connection with new product introductions, such as Firebox Vclass products in the second quarter of 2002 and SOHO 6 products in the third quarter of 2002 and, to a lesser extent, in connection with further additions of new products to the Firebox Vclass and Firebox lines in the first quarter of 2003. The dollar growth in product revenues is also attributed to the improved sales channel performance in the Americas and EMEA markets. The growth of international revenues was partially slowed by the decrease in sales in the Asia-Pacific region in the first quarter of 2003, as compared to the first quarter of 2002. In the first quarter of 2003, we were in the early stages of the realignment of our APAC business focused on improving the performance of our sales channels and localization of some of our products. Given these realignment efforts and the current economic uncertainty and deferral in spending by businesses on information technology, it is difficult to predict revenue levels in future quarters, which may remain depressed or fluctuate more than they have historically. We may be unable to maintain or increase the demand for our products, our revenues may not continue to grow at the same rate as in the past or at the rate expected, and we may be unable to achieve similar results in future periods.

The dollar increase in service revenues was primarily related to a growing installed base of customers purchasing LiveSecurity Service renewals in addition to initial service subscriptions included as part of the product bundle. The increase in service revenues as a percentage of total revenues is primarily due to $600,000 of service revenue in the first quarter of 2003 that was generated from LiveSecurity services that were provided through certain managed security customers to their end-users in prior periods, but were identified by WatchGuard through a license compliance initiative as being previously unreported. Although we may realize additional service revenues as a result of our license compliance initiatives, we expect a slower growth rate of service revenues through the remainder of 2003 as compared to corresponding periods of 2002.

The provision for estimated sales returns, price protection rights and promotional rebates was $1.1 million, or 7% of total revenues before the provision in the first quarter of 2002, and $1.7 million, or 7% of total revenues before the provision in the first quarter of 2003. The higher provision in absolute dollars in the first three months of 2003 as compared to the same period of 2002 corresponds to higher product sales. We expect to introduce new products and promotional programs through the remainder of 2003, which may affect our reserve for sales returns and allowances.

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Cost of Revenues and Gross Margin

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Gross margins are impacted by various factors, including the volume discount level contained in our channel partner agreements, the cost of our Firebox and RapidStream “Secured by Check Point” appliances, the expense associated with provision for inventory reserves, lower of cost or market assessment of inventory carrying value, fixed manufacturing overhead, the mix of product and services sales, which may include hardware and software products and service subscriptions, or both, the cost of royalties associated with our products, promotional programs, and the cost of our technical support organization and LiveSecurity Service.

Cost of product revenues includes the cost of manufacturing our security appliances, distribution operations, product packaging and third-party product licensing fees. The dollar increase in cost of product revenues was primarily due to the increase in units sold. The decrease in cost of product revenues as a percentage of total product revenues was primarily due to the introduction of new products in the second and third quarters of 2002 with higher product margins and a lower provision for inventory reserves. We expect a dollar increase in cost of product revenues for the remainder of 2003 if we achieve the expected increase in shipments. We expect product gross margins to increase in the future in dollar amount, primarily as a result of increased sales combined with a more favorable product mix aimed at a greater quantity of higher-margin products. However, our gross margins may be adversely affected in the future by competitive selling pressures, the impact on the existing inventory values when replacement products are introduced and availability of key components. Our margins as a percentage of revenues could be negatively affected by the continued economic uncertainty, resulting in the downward pressure on the prices of the technology-based products.

Cost of service revenues includes the costs of our technical support organization and costs associated with our LiveSecurity Service. The percentage and dollar decrease in cost of service revenues and the resulting improved gross margin reflect operational and cost efficiencies we have realized at the same time that we have expanded our customer base. The percentage decrease in cost of service revenues in the first quarter of 2003 is also partially attributable to $600,000 of service revenue generated, without significant additional costs, from our license compliance initiative, discussed above. We expect service costs to increase in absolute dollar amount as our user base expands in the remainder of 2003. In the longer term, as revenues from LiveSecurity Service subscriptions grow, we expect our service margins to increase on an absolute dollar basis.

Operating Expenses

Sales and Marketing