UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

Commission file number

NETGEAR, Inc.

(408) 907-8000
(Registrant’s telephone number including area code)

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

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

     The number of outstanding shares of the registrant’s Common Stock, $0.001 par value, was 30,259,859 as of April 27, 2004.

TABLE OF CONTENTS

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PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

NETGEAR, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)

(1)

The balance sheet at December 31, 2003 has been derived from the audited financial statements.

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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NETGEAR INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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NETGEAR, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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NETGEAR, Inc.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. Organization and Basis of Presentation

     NETGEAR, Inc. was incorporated in Delaware in January 1996. NETGEAR, Inc. together with its subsidiaries (collectively, NETGEAR” or the “Company”) designs, develops and markets networking products that address the specific needs of small businesses and homes, enabling customers to share Internet access, peripherals, files and digital content and applications among multiple personal computers. The Company’s products include Ethernet networking products, broadband products, and wireless networking products that are sold through distributors, traditional retailers, on-line retailers, direct marketing resellers, or DMRs, value added resellers, or VARs, and broadband service providers.

     The accompanying unaudited interim condensed consolidated financial statements include the accounts of NETGEAR, Inc., and its wholly owned subsidiaries. They have been prepared in accordance with established guidelines for interim financial reporting and with the instructions of Form 10-Q and Article 10 of regulation S-X. All significant intercompany balances and transactions have been eliminated in consolidation. The balance sheet at December 31, 2003 has been derived from audited financial statements at such date. In the opinion of management, the consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) to fairly state the Company’s financial position, results of operations and cash flows for the period indicated. The interim consolidated financial statements should be read in conjunction with the notes to the consolidated financial statements included in the Company’s Annual report on Form 10-K for the fiscal year ended December 31, 2003.

     The Company’s fiscal year begins on January 1 of the year stated and ends on December 31 of the same year. The Company reports its interim results on a fiscal quarter basis rather than on a calendar quarter basis. Under the fiscal quarter basis, each of the first three fiscal quarters ends on the Sunday closest to the calendar quarter end, with the fourth quarter ending on December 31.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates and operating results for the three months ended March 28, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

     The Company’s significant accounting policies are disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. The Company’s significant accounting policies have not materially changed during the three months ended March 28, 2004.

2. Stock-based Compensation

     Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” the Company accounts for employee stock options under Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and follows the disclosure-only provisions of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s common stock and the exercise price of options to purchase that stock. For purposes of estimating the compensation cost of the Company’s option grants in accordance with SFAS No. 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. Had compensation cost for the Company’s stock-based compensation plan been determined based on the fair value at the grant dates for the awards under a method prescribed by SFAS No. 123, using the following assumptions; risk free interest rate of 2.68%, expected life of four years, no dividends and volatility of 52% for the three months ended March 28, 2004 and the three months ended March 30, 2003, the Company’s net income would have been changed to the pro forma amounts indicated (in thousands, except per share data):

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3. Product Warranties

     The Company provides for future warranty obligations upon product delivery based on the number of installed units, historical experience and the Company’s judgment regarding anticipated rates of warranty claims. Changes in the Company’s warranty liability, which is included as a component of “Other accrued liabilities” in the condensed consolidated balance sheet, during the periods are as follows (in thousands):

4. Shipping and Handling Fees and Costs

     The Company includes shipping and handling fees billed to customers in net revenue. Shipping and handling costs associated with inbound freight are included in cost of revenue. Shipping and handling costs associated with outbound freight are included in sales and marketing expenses and totaled $1.6 million for the three months ended March 28, 2004, and $740,000 for the three months ended March 30, 2003.

5. Balance Sheet Components

     Accounts receivable, net:

Inventories:

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Other accrued liabilities:

6. Net Income Per Common Share

     Immediately prior to the effective date of the Company’s initial public offering on July 30, 2003, the Company’s outstanding Preferred Stock was automatically converted into 20,228,480 shares of common stock. Prior to July 30, 2003, the holders of Series A, B and C Preferred Stock were entitled to participate in all dividends paid on common stock, as and when declared by the Board of Directors, on an as-if converted basis. In accordance with EITF Topic D-95, “Effect of Participating Convertible Securities on the Computation of Basic Earnings per Share,” the Company has included the impact of Preferred Stock in the computation of basic earnings per share using the “two class” method. Under this method, an earnings allocation formula is used to determine the amount of net income to be allocated to each class of stock (the two classes being common stock and Preferred Stock). Basic net income is calculated by dividing the amount of net income that is apportioned to common stock by the weighted average number of shares of common stock outstanding during the period. In fiscal periods when there were no shares of common stock outstanding, basic net income per share is presented as there were potential common shares outstanding during the period. This per share data is based on the net income which would be attributable to one share of common stock during each period, after apportioning the net income to reflect the participation rights of the preferred stockholders. Diluted net income per share is computed using the if-converted method for the preferred stock, if dilutive.

     Net income per share applicable to each class of stock (common stock and preferred stock) is as follows (in thousands, except per share data):

Anti-dilutive common stock options and warrants amounting to 149,297 and none were excluded from the weighted average shares outstanding from the diluted per share calculation for the three months ended March 28, 2004 and March 30, 2003, respectively.

7. Segment Information, Operations by Geographic Area and Significant Customers

     Operating segments are components of an enterprise about which separate financial information is available and is regularly evaluated by management, namely the chief operating decision maker of an organization, in order to make operating and resource allocation decisions. By this definition, the Company primarily operates in one business segment, which is the development,

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marketing and sale of networking products for the small business and home markets. NETGEAR’s headquarters and most of its operations are located in the United States. The Company also conducts sales, marketing and customer service activities through sales offices in Europe, Middle-East and Africa, or EMEA, and Asia Pacific. Geographic revenue information is based on the location of the reseller or distributor. Long-lived assets, primarily fixed assets, are reported below based on the location of the asset.

     Net revenue consists of (in thousands):

     Long-lived assets consist of (in thousands):

     Significant customers (as a percentage of revenue):

8. Commitments

Guarantees and Purchase Commitments

     We enter into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of the orders are cancelable by giving notice 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are non-cancelable within 30 days prior to the expected shipment date. At March 28, 2004, we had approximately $34.4 million in non-cancelable purchase commitments with suppliers.

Indemnification

     During 2001, the Company entered into an agreement with a law firm with respect to legal consultative and other services in international jurisdictions. Under the agreement, the Company agreed to indemnify the law firm to the fullest extent permitted by law against claims, suits and legal and other expenses incurred by the service provider in the course of providing such services. The terms of the indemnity agreement remain in effect until modified by the parties to the agreement. The maximum amount of potential future indemnification is unlimited. To date the Company has not received any claims against this agreement and believes the fair value of the indemnification agreement is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of March 28, 2004.

     The Company also, as permitted under Delaware law and in accordance with its Bylaws, indemnifies its officers and directors for certain events or occurrences, subject to certain limits, while the officer is or was serving at the Company’s request in such capacity.

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The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has Director and Officer insurance that limits its exposure and enables it to recover a portion of any future amounts paid. To date the Company has not received any claims. As a result, the Company believes the fair value of these indemnification agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of March 28, 2004.

     In its sales agreements, the Company typically agrees to indemnify its distributors and resellers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date the Company has neither received any claims nor paid any amounts to settle claims or defend lawsuits. As a result, the Company believes the estimated fair value of these agreements is minimal. Accordingly, the Company has no liabilities recorded for these agreements as of March 28, 2004.

9. Related Party Transactions

Manufacturing Agreement

     A substantial portion of the Company’s products are manufactured by Delta Electronics, which is associated with Delta International Holding Ltd., a shareholder of NETGEAR. Product purchases from Delta Electronics amounted to $11.3 million for the three month period ended March 28, 2004 as compared to $30.2 million for the three months ended March 30, 2003. Payables related to these purchases amounted to $6.3 million and $6.4 million at March 28, 2004 and December 31, 2003, respectively, and are included in payables to related parties in the accompanying balance sheets.

Receivable From Shareholders

     The receivable from related parties represents receivables from the Company’s shareholders primarily as a result of a secondary offering completed in April of 2004 as filed with the Securities and Exchange Commission on Registration Statement on Form S-1. The selling stockholders who participated in the secondary offering agreed in principle to reimburse the Company for all reasonable expenses associated with the offering. As such the Company has recorded a receivable from related parties as of March 28, 2004 in the accompanying balance sheets.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-looking Statements

     This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are based upon current expectations that involve risks and uncertainties. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. For example, the words “believes,” “anticipates,” “plans,” “expects,” “intends” and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a discrepancy include, but are not limited to, those discussed in “Other Factors Affecting Operating Results” and “Liquidity and Capital Resources” below. All forward-looking statements in this document are based on information available to us as of the date hereof and we assume no obligation to update any such forward-looking statements. The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and the accompanying notes contained in this quarterly report. Unless expressly stated or the context otherwise requires, the terms “we,” “our,” “us” and “NETGEAR” refer to NETGEAR, Inc. and its subsidiaries.

Overview

     We design, develop and market technologically advanced, branded networking products that address the specific needs of small business and home users. We supply innovative networking products that meet the ease-of-use, quality, reliability, performance and affordability requirements of these users. From our inception in January 1996 until May 1996, our operating activities related primarily to research and development, developing relationships with outsourced design, manufacturing and technical support partners, testing prototype designs, staffing a sales and marketing organization and establishing relationships with distributors and resellers. We began product shipments during the quarter ended June 30, 1996, and recorded net revenue of $4.0 million in 1996. In

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2003, our net revenue was $299.3 million and our net income was $13.1 million.

     We were incorporated in January 1996 as a wholly owned subsidiary of Bay Networks, Inc. to focus exclusively on providing networking solutions for small businesses and homes. In August 1998, Nortel Networks purchased Bay Networks, including its wholly owned subsidiary NETGEAR. We remained a wholly owned subsidiary of Nortel Networks until March 2000 when we sold a portion of our capital stock to Pequot Private Equity Fund II, L.P. as part of a joint effort by us and Nortel Networks to reduce Nortel Networks’ ownership interest in us. In September 2000, Nortel Networks sold a portion of its ownership interest in us to Shamrock Holdings of California, Inc., which is a related party to Shamrock Capital Growth Fund, L.P.; Blue Ridge Limited Partnership and an affiliated fund; Halyard Capital Fund, LP; The Abernathy Group Institutional HSN Fund, L.P. and an affiliated fund; and Delta International Holding Ltd. In February 2002, Nortel Networks sold its remaining ownership interest in NETGEAR to us in exchange for cash, non-cash consideration, and a $20.0 million promissory note. In July 2003 we completed our initial public offering of common stock. We sold 8,050,000 shares of common stock at an offering price of $14.00 per share. We received net proceeds of approximately $101.8 million after deducting the underwriting discount and offering expenses payable by us. A portion of the proceeds has been used to fully repay the $20.0 million promissory note.

     Our extensive product line currently includes over 100 different products. These products are available in multiple configurations to address the needs of our customers in each geographic region in which our products are sold. Our products are grouped into three major segments within the small business and home markets: Ethernet networking products, broadband products and wireless networking products. Ethernet networking products include switches, network interface cards, or NICs, and print servers. Broadband products include routers and gateways. Wireless networking products include wireless access points, wireless NICs and media adapters. Since we originally launched our business in 1996 with the shipment of Ethernet networking products and a single broadband product, we have continually introduced new products in response to market demand. For example, in 2003, we introduced approximately 48 new products.

     Our products are sold through multiple sales channels worldwide, including traditional retailers, online retailers, direct market resellers, or DMRs, value added resellers, or VARs, and, broadband service providers. Our retail channel includes traditional retail locations domestically and internationally, such as Best Buy, Circuit City, CompUSA, Costco, Fry’s Electronics, Staples, Office Depot, MediaMarkt (Germany, Austria), PC World (U.K.) and FNAC (France). Online retailers include Amazon.com and Buy.com. Our direct market resellers include CDW Corporation and PC Connection. We have over 8,000 VARs in North America, and more than 3,000 internationally. In addition, we also sell our products through broadband service providers, such as Time—Warner Cable and Comcast in domestic markets and Telstra in Australia and Tele Denmark. Some of these retailers and resellers purchase directly from us while most are fulfilled through approximately 67 wholesale distributors around the world. A substantial portion of our net revenue to date has been derived from a limited number of wholesale distributors, the largest of which are Ingram Micro, Inc. and Tech Data Corporation. We expect that these wholesale distributors will continue to contribute a significant percentage of our net revenue for the foreseeable future.

Results of Operations

     The following table sets forth the consolidated statements of operations and the percentage change for the three months ended March 28, 2004 with the comparable reporting period in the preceding year.

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     The following table sets forth the condensed consolidated statements of operations, expressed as a percentage of net revenue, for the periods indicated:

Quarter Ended March 28, 2004 Compared to Quarter Ended March 30, 2003.

Net Revenue

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      Net revenue increased $20.7 million, or 30.6%, to $88.4 million for the quarter ended March 28, 2004, from $67.7 million for the quarter ended March 30, 2003. The increase in revenue was attributable to increased gross shipments of our broadband and wireless products, partially offset by provisions made for rebates and cooperative marketing programs associated with increased retail product sales, price protection and sales returns. Net revenue for the three months ended March 28, 2004 included a net benefit of $1.4 million due to a $1.9 million reduction in requirements for warranty obligations, partially offset by a $450,000 increase in provisions for expected end-user rebates. The benefit from the reduction in required warranty obligations resulted from a change in the estimate of the time taken to receive the returns from customers, which is used to compute the warranty returns obligation. However, there was minimal impact on the gross margin because the gross profit from the net revenue increase was offset by an increase in estimated costs to repair or liquidate inventory relating to warranty returns.

      In the quarter ended March 28, 2004 revenue generated within North America, EMEA and Asia Pacific was 54.7%, 35.8% and 9.5%, respectively. The comparable net revenue for the quarter ended March 30, 2003 was 54.2%, 36.1% and 9.7%, respectively. The increase in net revenue over the prior year comparable quarter for each region was 31.9%, 29.5% and 27.1%, respectively. The geographic mix of consolidated net revenue remained relatively constant over the prior comparable quarter.

Cost of Revenue and Gross Margin

      Cost of revenue increased $11.7 million, or 24%, to $60.9 million for the quarter ended March 28, 2004, from $49.2 million for the quarter ended March 30, 2003. In addition, our gross margin improved to 31.1% for the quarter ended March 28, 2004, from 27.3% for the quarter ended March 30, 2003. This improvement in gross margin of 3.8% was due primarily to a favorable shift in product mix, especially of newer products which often carry higher gross margins, as well as due to operational efficiency and supply chain management programs that reduced in-bound freight costs. We also took advantage of rebates and prompt payment discounts from our suppliers, which increased $1.1 million, to a benefit of $1.2 million in the three months ended March 28, 2004 from a benefit of $108,000 in the three months ended March 30, 2003, and contributed to our margin growth. These improvements in gross margin were partially offset by an increase in cooperative marketing costs and end-user rebates and additional provisions to write down inventory resulting from anticipated warranty returns. Cooperative marketing costs and end-user rebates are recorded as a reduction in net revenue.

Operating Expenses
Research and Development

      Research and development expenses increased $327,000, or 16%, to $2.3 million for the quarter ended March 28, 2004, from $2.0 million for the quarter ended March 30, 2003. The increase was primarily due to higher employee related costs for new and existing employees of $186,000. As of March 28, 2004 we had research and development related headcount of 30 employees as compared to 28 as of March 30, 2003. The increase was also due to additional general overhead costs of $92,000 as well as increased product development costs of $54,000.

Sales and Marketing

      Sales and marketing expenses increased $3.8 million, or 35%, to $14.8 million for the quarter ended March 28, 2004, from $11.0 million for the quarter ended March 30, 2003. Of this increase, $1.6 million was due to increased sales volume, product promotion, advertising, outside technical support expenses and increased operating costs in international locations due to the weakening of the U.S. dollar in relation to the Euro and the British pound. In addition, salary and related expenses for additional sales and marketing personnel increased by $1.1 million, as a result of headcount growth from 87 employees as of March 30, 2003 to 118 as of March 28, 2004, especially due to expansion in certain regions such as China, and freight out charges increased by $819,000 in support of higher revenue.

General and Administrative

      General and administrative expenses increased $1.3 million, or 67%, to $3.2 million for the quarter ended March 28, 2004, from $1.9 million for the quarter ended March 30, 2003. This increase was primarily due to increased director and officer insurance costs of $330,000, fees for professional services, composed of systems consulting and accounting and legal, including costs associated with Sarbanes-Oxley 404 compliance, aggregating $580,000 and an increase in employee related costs of $307,000, including employment taxes resulting from the exercise of stock options.

Amortization of Deferred Stock-based Compensation

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      During the quarter ended March 28, 2004, we recorded charges of $42,000 in cost of revenue, $118,000 in research and development expenses, $188,000 in sales and marketing expenses, and $97,000 in general and administrative expenses related to amortization of deferred stock-based compensation. During the quarter ended March 30, 2003, we recorded a recovery of $11,000 in cost of revenue, and charges of $96,000 in research and development expenses, $109,000 in sales and marketing expenses, and $151,000 in general and administrative expenses related to the amortization of deferred stock-based compensation. The remaining balance of $3.6 million will continue to be amortized on a straight line basis until 2007.

Interest Income, Interest Expense and Other Expense, Net

      The aggregate of interest income, interest expense, and other expense, net amounted to net other income of $120,000 for the quarter ended March 28, 2004, compared to net expense of $411,000 for the quarter ended March 30, 2003. This change was primarily due to a decrease of $361,000 in imputed interest expense associated with the Nortel Networks note, following the repayment of the note in August 2003, and having earned $223,000 in interest income from the investment of IPO proceeds for the first quarter of 2004. This was partially offset by an increase in foreign exchange losses.

Provision for Income Taxes

      Provision for income taxes increased $1.5 million, to $2.8 million for the quarter ended March 28, 2004, from $1.2 million for the quarter ended March 30, 2003. The effective tax rate for the quarter ended March 28, 2004 was approximately 40% as compared to an effective rate of 43% for the quarter ended March 30, 2003.

Net Income

      Net income increased $2.5 million, to $4.2 million for the quarter ended March 28, 2004 from $1.6 million for the quarter ended March 30, 2003. This increase was due to an increase in gross profit of $9.0 million, offset by an increase in operating expenses of $5.5 million and an increase in the provision for income taxes of $1.5 million.

Liquidity and Capital Resources

      As of March 28, 2004 we had cash, cash equivalents and short-term investments totaling $89.5 million. Short term investments accounted for $12.3 million of this balance.

      Our cash balance increased from $61.2 million as of December 31, 2003, to $77.1 million as of March 28, 2004. Operating activities during the three months ended March 28, 2004 generated cash of $9.6 million primarily from working capital. Accounts receivable decreased by $2.6 million during the three months ended March 28, 2004. Our days sales outstanding decreased from 81 days as of December 31, 2003 to 71 days as of March 28, 2004. The combined decrease in accounts payable and payables to related parties of $7.9 million was offset by an increase in other accrued liabilities of $7.2 million. Investing activities for this period used $413,000 million due primarily to purchases of property and equipment. Financing activities for this period provided cash of $6.8 million due to proceeds from the exercise of stock options.

      Inventory remained relatively constant at $39.1 at March 28, 2004 as compared to $39.3 as of December 31, 2003. In the quarter ended March 28, 2004 we experienced inventory turns of approximately 6.2 times, down slightly from 6.3 times in the quarter ended December 31, 2003.

      We lease office space and equipment under non-cancelable operating leases with various expiration dates through January 2009. The terms of the facility lease provide for rental payments on a graduated scale. We recognize rent expense on a straight-line basis over the lease period, and have accrued for rent expense incurred but not paid.

      We enter into various inventory-related purchase agreements with suppliers. Generally, under these agreements, 50% of the orders are cancelable by giving notice 46 to 60 days prior to the expected shipment date and 25% of orders are cancelable by giving notice 31 to 45 days prior to the expected shipment date. Orders are non-cancelable within 30 days prior to the expected shipment date. At March 28, 2004, we had approximately $34.4 million in non-cancelable purchase commitments with suppliers.

Contractual Obligations and Off-Balance Sheet Arrangements

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      The following table describes our commitments to settle contractual obligations and off-balance sheet arrangements in cash as of March 28, 2004 (in thousands):

      Based on our current plans and market conditions, we believe that our existing cash and our credit facility will be sufficient to satisfy our anticipated cash requirements for the next twelve months. We currently have a revolving line of credit agreement with a bank that allows the Company to borrow up to a maximum of $20.0 million, including amounts drawn under letters of credit, although this agreement is set to expire in July of 2004. We cannot be certain that our planned levels of revenue, costs and expenses will be achieved. If our operating results fail to meet our expectations or if we fail to manage our inventory, accounts receivable or other assets, we could be required to seek additional funding through public or private financings or other arrangements. In addition, as we continue to expand our product offerings, channels and geographic presence, we may require additional working capital. In such event, adequate funds may not be available when needed or may not be available on favorable or commercially reasonable terms, which could have a negative effect on our business and results of operations. Currently we are maintaining a large portion of the remaining proceeds in short-term investment accounts.

Critical Accounting Policies and Estimates

      For a description of what we believe to be the critical accounting policies that affect our more significant judgments and estimates used in the preparation of our consolidated financial statements, refer to our Annual Report on Form 10-K for the year ended December 31, 2003. There have been no changes in our critical accounting policies since December 31, 2003.

Risk Factors Affecting Future Results

      The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are not material may also impair our business operations.

Risks Related to Our Business and Industry

We expect our operating results to fluctuate on a quarterly and annual basis, which could cause our stock price to fluctuate or decline.

      Our operating results are difficult to predict and may fluctuate substantially from quarter-to-quarter or year-to-year for a variety of reasons, many of which are beyond our control. If our actual revenue were to fall below our estimates or the expectations of public market analysts or investors, our quarterly and annual results would be negatively impacted and the price of our stock could decline. Other factors that could affect our quarterly and annual operating results include those listed in this risk factors section of this Form 10-Q and others such as:

	•		changes in the pricing policies of or the introduction of new products or product enhancements by us or our competitors;
	•		changes in the terms of our contracts with customers or suppliers;
	•		slow or negative growth in the networking product, personal computer, Internet infrastructure, home electronics and related technology markets, as well as decreased demand for Internet access;
	•		changes in or consolidation of our sales channels and wholesale distributor relationships or failure to manage our sales channel inventory and warehousing requirements;
	•		delay or failure to fulfill orders for our products on a timely basis;
	•		our inability to accurately forecast our contract manufacturing needs;
	•		delays in the introduction of new or enhanced products by us or market acceptance of these products;

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	•		an increase in price protection claims, redemptions of marketing rebates, product warranty returns or allowance for doubtful accounts;
	•		operational disruptions, such as transportation delays or failure of our order processing system, particularly if they occur at the end of a fiscal quarter; and
	•		seasonal patterns of higher sales during the second half of our fiscal year, particularly retail-related sales in our fourth quarter.

      As a result, period-to-period comparisons of our operating results may not be meaningful, and you should not rely on them as an indication of our future performance. In addition, our future operating results may fall below the expectations of public market analysts or investors. In this event, our stock price could decline significantly.

Our future success is dependent on the acceptance of networking products in the small business and home markets into which we sell substantially all of our products. If the acceptance of networking products in these markets does not continue to grow, we will be unable to increase or sustain our net revenue, and our business will be severely harmed.

      We believe that growth in the small business market will depend, in significant part, on the growth of the number of personal computers purchased by these end users and the demand for sharing data intensive applications, such as large graphic files. We believe that acceptance of networking products in the home will depend upon the availability of affordable broadband Internet access and increased demand for wireless products. Unless these markets continue to grow, our business will be unable to expand, which could cause the value of your investment to decline. Moreover, if networking functions are integrated more directly into personal computers and other Internet-enabled devices, such as electronic games or personal video recorders, and these devices do not rely upon external network-enabling devices, sales of our products could suffer. In addition, if the small business or home markets experience a recession or other cyclical effects that diminish or delay networking expenditures, our business growth and profits would be severely limited, and our business could be more severely harmed than those companies that primarily sell to large business customers.

Some of our competitors have substantially greater resources than we do, and to be competitive we may be required to lower our prices or increase our advertising expenditures or other expenses, which could result in reduced margins and loss of market share.

      We compete in a rapidly evolving and highly competitive market, and we expect competition to intensify. Our principal competitors in the small business market include 3Com Corporation, Allied Telesyn International, Dell Computer Corporation, D-Link Systems, Inc., Hewlett-Packard Company, the Linksys division of Cisco Systems and Nortel Networks. Our principal competitors in the home market include Belkin Corporation, D-Link, the Linksys division of Cisco Systems and Microsoft Corporation. Other current and potential competitors include numerous local vendors such as Corega International SA and Melco, Inc./ Buffalo Technology in Japan and TP-Link in China. Our potential competitors also include consumer electronics vendors who could integrate networking capabilities into their line of products.

      Many of our existing and potential competitors have longer operating histories, greater name recognition and substantially greater financial, technical, sales, marketing and other resources, including Cisco Systems and Microsoft. These competitors may, among other things, undertake more extensive marketing campaigns, adopt more aggressive pricing policies, obtain more favorable pricing from suppliers and manufacturers and exert more influence on the sales channel than we can. In June 2003, Cisco Systems acquired The Linksys Group, a major competitor of ours. Cisco Systems has substantial resources that it may direct to developing or purchasing advanced technology, which might be superior to ours. In addition, it may direct substantial resources to expand its Linksys division’s distribution channel and to increase its advertising expenditures or otherwise use its resources to successfully compete. Any of these actions could cause us to materially increase our expenses, and could result in our being unable to successfully compete, which would harm our results of operations. We anticipate that current and potential competitors will also intensify their efforts to penetrate our target markets. These competitors may have more advanced technology, more extensive distribution channels, stronger brand names, greater access to shelf space in retail locations, bigger promotional budgets and larger customer bases than we do. These companies could devote more capital resources to develop, manufacture and market competing products than we could. If any of these companies are successful in competing against us, our sales could decline, our margins could be negatively impacted, and we could lose market share, any of which could seriously harm our business and results of operations.

The average selling prices of our products typically decrease rapidly over the sales cycle of the product, which may negatively affect our gross margins.

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      Our products typically experience price erosion, a fairly rapid reduction in the average selling prices over their respective sales cycles. In order to sell products that have a falling average selling price and maintain margins at the same time, we need to continually reduce product and manufacturing costs. To manage manufacturing costs, we must collaborate with our third-party manufacturers to engineer the most cost-effective design for our products. In addition, we must carefully manage the price paid for components used in our products. We must also successfully manage our freight and inventory costs to reduce overall product costs. We also need to continually introduce new products with higher sales prices and gross margins in order to maintain our overall gross margins. If we are unable to manage the cost of older products or successfully introduce new products with higher gross margins, our net revenue and overall gross margin would likely decline.

If we fail to continue to introduce new products and product enhancements that achieve broad market acceptance on a timely basis, we will not be able to compete effectively and we will be unable to increase or maintain net revenue and gross margins.

      We operate in a highly competitive, quickly changing environment, and our future success depends on our ability to develop and introduce new products and product enhancements that achieve broad market acceptance in the small business and home markets. Our future success will depend in large part upon our ability to identify demand trends in the small business and home markets and quickly develop, manufacture and sell products that satisfy these demands in a cost effective manner. Successfully predicting demand trends is difficult, and it is very difficult to predict the effect introducing a new product will have on existing product sales. We will also need to respond effectively to new product announcements by our competitors by quickly introducing competitive products.

      We have experienced delays in releasing new products and product enhancements in the past, which resulted in lower quarterly net revenue than expected. For example, in 2000, we introduced a proprietary wireless networking solution. Later, we decided to re-design our products to be compliant with the 802.11 standard promulgated by the Institute of Electrical and Electronic Engineers. As a result, we introduced our wireless local area networking, or LAN, 802.11b products in the first quarter of 2001, six months behind some of our competitors. In addition, we have experienced unanticipated delays in product introductions beyond announced release dates. Any future delays in product development and introduction could result in:

	•		loss of or delay in revenue and loss of market share;
	•		negative publicity and damage to our reputation and brand;
	•		decline in the average selling price of our products; and
	•		adverse reactions in our sales channel, such as reduced shelf space or reduced online product visibility.

We depend substantially on our sales channel, and our failure to maintain and expand our sales channel would result in lower sales and reduced net revenue.

      To maintain and grow our market share, net revenue and brand, we must maintain and expand our sales channel. We sell our products through our sales channel, which consists of traditional retailers, on-line retailers, direct market resellers, or DMRs, value added resellers, or VARs, and, recently, broadband service providers. These entities typically purchase our products through our wholesale distributors. We sell to small businesses primarily through DMRs, VARs and retail locations, and we sell to our home users primarily through retail locations, online retailers and broadband service providers. We have no minimum purchase commitments or long-term contracts with any of these third parties.

      Traditional retailers have limited shelf space and promotional budgets, and competition is intense for these resources. A competitor with more extensive product lines and stronger brand identity, such as Microsoft or Cisco Systems, may have greater bargaining power with these retailers. The competition for retail shelf space may increase, which would require us to increase our marketing expenditures simply to maintain current levels of retail shelf space. The recent trend in the consolidation of online retailers and DMR channels has resulted in intensified competition for preferred product placement, such as product placement on an online retailer’s home page. Expanding our presence in the VAR channel may be difficult and expensive. We compete with established companies that have longer operating histories and longstanding relationships with VARs that we would find highly desirable as sales channel partners. If we were unable to maintain and expand our sales channel, our growth would be limited and our business would be harmed.

      We must also continuously monitor and evaluate emerging sales channels. If we fail to establish a presence in an important developing sales channel, such as selling networking products through broadband service providers such as cable operators and

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telecommunications carriers, our business could be harmed.

We rely on a limited number of wholesale distributors and direct customers for most of our sales, and if they refuse to pay our requested prices or reduce their level of purchases, our net revenue could decline.

      We sell a substantial portion of our products through wholesale distributors, including Ingram Micro, Inc. and Tech Data Corporation. During the three months ended March 28, 2004, sales to Ingram Micro and its affiliates accounted for 27% of our net revenue and sales to Tech Data and its affiliates accounted for 18% of our net revenue. We expect that a significant portion of our net revenue will continue to come from sales to a small number of wholesale distributors for the foreseeable future. In addition, because our accounts receivable are concentrated with a small group of purchasers, the failure of any of them to pay on a timely basis, or at all, would reduce our cash flow. We have no minimum purchase commitments or long-term contracts with any of these distributors. These purchasers could decide at any time to discontinue, decrease or delay their purchases of our products. In addition, the prices that they pay for our products are subject to negotiation and could change at any time. If any of our major wholesale distributors reduce their level of purchases or refuse to pay the prices that we set for our products, our net revenue and operating results could be harmed. If our wholesale distributors increase the size of their product orders without sufficient lead-time for us to process the order, our ability to fulfill product demands would be compromised.

If we do not effectively manage our sales channel inventory and product mix, we may incur costs associated with excess inventory, or lose sales from having too few products.

      If we are unable to properly monitor, control and manage our sales channel inventory and maintain an appropriate level and mix of products with our wholesale distributors and within our sales channel, we may incur increased and unexpected costs associated with this inventory. We currently have particularly limited visibility as to the inventory levels of our Asia Pacific wholesale distributors and sales channel. We generally allow wholesale distributors and traditional retailers to return a limited amount of our products in exchange for other products. Under our price protection policy, if we reduce the list price of a product, we are often required to issue a credit in an amount equal to the reduction for each of the products held in inventory by our wholesale distributors and retailers. If our wholesale distributors and retailers are unable to sell their inventory in a timely manner, we might lower the price of the products, or these parties may exchange the products for newer products. If we improperly forecast demand for our products we could end up with too many products and be unable to sell the excess inventory in a timely manner, if at all, or, alternatively we could end up with too few products and not be able to satisfy demand. This problem is exacerbated because we attempt to closely match inventory levels with product demand leaving limited margin for error. If these events occur, we could incur increased expenses associated with writing off excessive or obsolete inventory or lose sales and therefore suffer declining gross margins.

We depend on a limited number of third-party contract manufacturers for substantially all of our manufacturing needs. If these contract manufacturers experience any delay, disruption or quality control problems in their operations, we could lose market share and our brand may suffer.

      All of our products are manufactured, assembled, tested and packaged by a limited number of original design manufacturers, or ODMs, and original equipment manufacturers, or OEMs. Substantially all of our products are manufactured by Ambit Microsystems, Cameo Communications Corporation, Delta Networks, Inc., SerComm Corporation and Z-Com, Inc. We rely on our contract manufacturers to procure components and, in some cases, subcontract engineering work. Some of our products are manufactured by a single contract manufacturer. We do not have any long-term contracts with any of our third-party contract manufacturers. Some of these third-party contract manufacturers produce products for our competitors. The loss of the services of any of our primary third-party contract manufacturers could cause a significant disruption in operations and delays in product shipments. Qualifying a new contract manufacturer and commencing volume production is expensive and time consuming.

      Our reliance on third-party contract manufacturers also exposes us to the following risks over which we have limited control:

	•		unexpected increases in manufacturing and repair costs;
	•		inability to control the quality of finished products;
	•		inability to control delivery schedules; and
	•		potential lack of adequate capacity to manufacture all or a part of the products we require.

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      All of our products must satisfy safety and regulatory standards and some of our products must also receive government certifications. Our ODM and OEM contract manufacturers are primarily responsible for obtaining most regulatory approvals for our products. If our ODMs and OEMs fail to obtain timely domestic or foreign regulatory approvals or certificates, we would be unable to sell our products and our sales and profitability could be reduced, our relationships with our sales channel could be harmed, and our reputation and brand would suffer.

If we are unable to provide our third-party contract manufacturers an accurate forecast of our component and material requirements, we may experience delays in the manufacturing of our products and the costs of our products may increase.

      We provide our third-party contract manufacturers with a rolling forecast of demand, which they use to determine our material and component requirements. Lead times for ordering materials and components vary significantly and depend on various factors, such as the specific supplier, contract terms and demand and supply for a component at a given time. Some of our components have long lead times, such as local access network repeaters, switching fabric chips, physical layer transceivers, connector jacks and metal and plastic enclosures. If our forecasts are less than our actual requirements, our contract manufacturers may be unable to manufacture products in a timely manner. If our forecasts are too high, our contract manufacturers will be unable to use the components they have purchased on our behalf. The cost of the components used in our products tends to drop rapidly as volumes increase and the technologies mature. Therefore, if our contract manufacturers are unable to promptly use components purchased on our behalf, our cost of producing products may be higher than our competitors due to an over supply of higher-priced components. Moreover, if they are unable to use components ordered at our direction, we will need to reimburse them for any losses they incur.

If disruptions in our transportation network occur or our shipping costs substantially increase, we may be unable to sell our products and our operating expenses could increase.

      We are highly dependent upon the transportation systems we use to ship our products, including surface and air freight. Our attempts to closely match our inventory levels to our product demand intensify the need for our transportation systems to function effectively and without delay. The transportation network is subject to disruption from a variety of causes, including labor disputes or port strikes, acts of war or terrorism and natural disasters. For example, in September 2002, a major strike disrupted ports on the West Coast, which halted the transportation of our product shipments, resulting in our inability to meet some customer orders in a timely manner. Labor disputes among freight carriers are common, especially in EMEA, and we expect labor unrest and its effects on shipping our products to be a continuing challenge for us. Since September 11, 2001, the rate of inspection of international freight by governmental entities has substantially increased, and has become increasingly unpredictable. If our delivery times increase unexpectedly for these or any other reasons, our ability to deliver products on time would be materially adversely affected and result in delayed or lost revenue. In addition, if the recent increases in fuel prices were to continue, our transportation costs would likely further increase. Moreover, the cost of shipping our products by air freight is greater than other methods. From time to time in the past, we have shipped products using air freight to meet unexpected spikes in demand or to bring new product introductions to market quickly. If we rely more heavily upon air freight to deliver our products, our overall shipping costs will increase. A prolonged transportation disruption or a significant increase in the cost of freight could severely disrupt our business and harm our operating results.

We obtain several key components from limited or sole sources, and if these sources fail to satisfy our supply requirements, we may lose sales and experience increased component costs.

      Any shortage or delay in the supply of key product components would harm our ability to meet scheduled product deliveries. Many of the semiconductors used in our products are specifically designed for use in our products and are obtained from sole source suppliers on a purchase order basis. In addition, some components that are used in all our products are obtained from limited sources. These components include connector jacks, plastic casings and physical layer transceivers. We also obtain switching fabric semiconductors, which are used in our Ethernet switches and Internet gateway products, from a limited number of suppliers. Our contract manufacturers purchase these components on our behalf on a purchase order basis, and we do not have any contractual commitments or guaranteed supply arrangements with our suppliers. If demand for a specific component increases, we may not be able to obtain an adequate number of that component in a timely manner. In addition, if our suppliers experience financial or other difficulties or if worldwide demand for the components they provide increases significantly, the availability of these components could be limited. It could be difficult, costly and time-consuming to obtain alternative sources for these components, or to change product designs to make use of alternative components. In addition, difficulties in transitioning from an existing supplier to a new supplier could create delays in component availability that would have a significant impact on our ability to fulfill orders for our products. If we are unable to obtain a sufficient supply of components, or if we experience any interruption in the supply of components, our product shipments could be reduced or delayed. This would affect our ability to meet scheduled product deliveries,

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damage our brand and reputation in the market, and cause us to lose market share.

We rely upon third parties for technology that is critical to our products, and if we are unable to continue to use this technology and future technology, our ability to sell technologically advanced products would be limited.

      We rely on third parties to obtain non-exclusive patented hardware and software license rights in technologies that are incorporated into and necessary for the operation and functionality of our products. Because the intellectual property we license is available from third parties, barriers to entry may be lower than if we owned exclusive rights to the technology we license and use. On the other hand, if a competitor or potential competitor enters into an exclusive arrangement with any of our key third-party technology providers, our ability to develop and sell products containing that technology would be severely limited. Our licenses often require royalty payments or other consideration to third parties. Our success will depend in part on our continued ability to have access to these technologies, and we do not know whether these third-party technologies will continue to be licensed to us on commercially acceptable terms or at all. If we are unable to license the necessary technology, we may be forced to acquire or develop alternative technology of lower quality or performance standards. This would limit and delay our ability to offer competitive products and increase our costs of production. As a result, our margins, market share, and operating results could be significantly harmed.

If we are unable to secure and protect our intellectual property rights, our ability to compete could be harmed.

      We rely upon third parties for a substantial portion of the intellectual property we use in our products. At the same time, we rely on a combination of copyright, trademark, patent and trade secret laws, nondisclosure agreements with employees, consultants and suppliers and other contractual provisions to establish, maintain and protect our intellectual proprietary rights. Despite efforts to protect our intellectual property, unauthorized third parties may attempt to design around, copy aspects of our product design or obtain and use technology or other intellectual property associated with our products. For example, one of our primary intellectual property assets is the NETGEAR name, trademark and logo. We may be unable to stop third parties from adopting similar names, trademarks and logos, especially in those international markets where our intellectual property rights may be less protected. Furthermore, our competitors may independently develop similar technology or design around our intellectual property. Our inability to secure and protect our intellectual property rights could significantly harm our brand and business, operating results and financial condition.

We could become subject to litigation, including litigation regarding intellectual property rights, which could be costly and subject us to significant liability.

      The networking industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding infringement of patents, trade secrets and other intellectual property rights. In particular, leading companies in the data communications markets, some of which are competitors, have extensive patent portfolios with respect to networking technology. From time to time, third parties, including these leading companies, have asserted and may continue to assert exclusive patent, copyright, trademark and other intellectual property rights against us demanding license or royalty payments or seeking payment for damages, injunctive relief and other available legal remedies through litigation. We could become subject to lawsuits and be forced to defend against claims brought by third parties who allege infringement of their intellectual property rights. These include third parties who claim to own patents or other intellectual property that cover industry standards that our products comply with. From time to time we are contacted by third parties that allege we are wrongfully using their intellectual property. For example, we have been contacted by Cactus Services, Inc., CSIRO, Ericsson AB, ipValue, Motorola, Network-1 Security Solutions and Vertical Networks, each of which is seeking royalties or compensation from us. Several of the parties claim that we need to acquire a license because our products allegedly infringe on their intellectual property by virtue of the fact that our products comply with various industry-wide standards. If we are unable to resolve these matters or obtain licenses on acceptable or commercially reasonable terms, we could be sued. The cost of any necessary licenses could significantly harm our business, operating results and financial condition. Also, at any time, any of these companies, or any other third-party could initiate litigation against us, which could divert management attention, be costly to defend, prevent us from using or selling the challenged technology, require us to design around the challenged technology and cause the price of our stock to decline. In addition, third parties, some of which are potential competitors, may initiate litigation against our manufacturers, suppliers or members of our sales channel, alleging infringement of their proprietary rights with respect to existing or future products. In the event successful claims of infringement are brought by third parties, and if we are unable to obtain licenses or to independently develop alternative technology on a timely basis, we may be subject to an indemnification obligation or unable to offer competitive products, and be subject to increased expenses. As a result, our business, operating results and financial condition could be significantly harmed.

If our products contain defects or errors, we could incur significant unexpected expenses, experience product returns and lost sales, experience product recalls, suffer damage to our brand and reputation, and be subject to product liability or other claims.

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      Our products are complex and may contain defects, errors or failures, particularly when first introduced or when new versions are released. Some errors and defects may be discovered only after a product has been installed and used by the end user. For example, in the quarter ended September 29, 2002, we recalled some of our 48 port 10/100 Mbps Ethernet switches due to an intermittent connectivity issue with a connector. In addition, we have recently received returns of a limited number of our Wall Plug Ethernet Bridge products. We have initiated testing of this product to determine if a manufacturing process change is appropriate, in which case we would consider a recall of units of this product. We believe that any recall of the product would not have a material impact on our financial statements, and we believe we may be entitled to indemnification from our third-party manufacturers for any such action.

      If our products contain defects or errors, we could experience decreased sales and increased product returns, loss of customers and market share, and increased service, warranty and insurance costs. In addition, our reputation and brand could be damaged, and we could face legal claims regarding our products. A successful product liability or other claim could result in negative publicity and further harm our reputation, result in unexpected expenses and adversely impact our operating results.

We intend to implement an international restructuring, which may strain our resources and increase our operating expenses.

      By the end of 2004, we plan to reorganize our foreign subsidiaries and entities to manage and optimize our international operations. Our implementation of this project will require substantial efforts by our staff and could result in increased staffing requirements and related expenses. Failure to successfully execute the restructuring or other factors outside of our control could negatively impact the timing and extent of any benefit we receive from the restructuring. The restructuring will also require us to amend a number of our customer and supplier agreements, which will require the consent of our third-party customers and suppliers. In addition, there could be unanticipated interruptions in our business operations as a result of implementing these changes that could result in loss or delay in revenue causing an adverse effect on our financial results.

We intend to expand our operations and infrastructure, which may strain our operations and increase our operating expenses.

      We intend to expand our operations and pursue market opportunities domestically and internationally to grow our sales. For example, we are intensifying our efforts to sell our products in China. We expect that this expansion will strain our existing management information systems, and operational and financial controls. In addition, as we continue to grow, our expenditures will likely be significantly higher than our historical costs. We may not be able to install adequate controls in an efficient and timely manner as our business grows, and our current systems may not be adequate to support our future operations. The difficulties associated with installing and implementing these new systems, procedures and controls may place a significant burden on our management, operational and financial resources. In addition, as we grow internationally, we will have to expand and enhance our communications infrastructure. If we fail to continue to improve our management information systems, procedures and financial controls or encounter unexpected difficulties during expansion, our business could be harmed.

Our sales and operations in international markets expose us to operational, financial and regulatory risks.

      International sales comprise a significant amount of our overall net revenue. International sales were 42% in 2003 and 45% in the three months ended March 28, 2004. We anticipate that international sales may grow as a percentage of net revenue. We have committed resources to expanding our international operations and sales channels and these efforts may not be successful. International sales are subject to a number of risks. For example, we recognize revenue from our international sales when our products reach the country of destination. As a result, if these products are delayed in transit, we are unable to recognize revenue.

      International operations are subject to a number of other risks, including:

	•		political and economic instability, international terrorism and anti-American sentiment, particularly in emerging markets;
	•		preference for locally branded products, and laws and business practices favoring local competition;
	•		exchange rate fluctuations;
	•		increased difficulty in managing inventory;
	•		delayed revenue recognition;
	•		less effective protection of intellectual property; and
	•		difficulties and costs of staffing and managing foreign operations.

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We currently do not engage in any currency hedging transactions. Except for sales to Japan and Singapore, our international sales are currently invoiced in United States dollars. Nonetheless, as we expand our international operations, we are exploring the option of allowing both invoicing and payment in additional foreign currencies and our exposure to losses in foreign currency transactions may increase. Moreover, the costs of doing business abroad may increase as a result of adverse exchange rate fluctuations. For example, if the United States dollar declined in value relative to a local currency, we could be required to pay more for our expenditures in that market, including salaries, commissions, local operations and marketing expenses, each of which is paid in local currency. In addition, we may lose customers if exchange rate fluctuations, currency devaluations or economic crises increase the local currency price of our products or reduce our customers’ ability to purchase products.

If we lose the services of our Chairman and Chief Executive Officer, Patrick C.S. Lo, or our other key personnel, we may not be able to execute our business strategy effectively.

      Our future success depends in large part upon the continued services of our key technical, sales, marketing and senior management personnel. In particular, the services of Patrick C.S. Lo, our Chairman and Chief Executive Officer, who has led our company since its inception, are very important to our business. All of our executive officers or key employees are at will employees, and we do not maintain any key person life insurance policies. The loss of any of our senior management or other key research, development, sales or marketing personnel, particularly if lost to competitors, could harm our ability to implement our business strategy and respond to the rapidly changing needs of the small business and home markets.

Natural disasters, mischievous actions or terrorist attacks could delay our ability to receive or ship our products, or otherwise disrupt our business.

      Our corporate headquarters are located in Northern California and one of our warehouses is located in Southern California, regions known for seismic activity. In addition, substantially all of our manufacturing occurs in a geographically concentrated area in mainland China, where disruptions from natural disasters, health epidemics and political, social and economic instability may affect the region. If our manufacturers or warehousing facilities are disrupted or destroyed, we would be unable to distribute our products on a timely basis, which could harm our business. Moreover, if our computer information systems or communication systems, or those of our vendors or customers, are subject to disruptive hacker attacks or other disruptions, our business could suffer. We have not established a formal disaster recovery plan. Our back-up operations may be inadequate and our business interruption insurance may not be enough to compensate us for any losses that may occur. A significant business interruption could result in losses or damages and harm our business. For example, much of our order fulfillment process is automated and the order information is stored on our servers. If our computer systems and servers go down even for a short period at the end of a fiscal quarter, our ability to recognize revenue would be delayed until we were again able to process and ship our orders, which could cause our stock price to decline significantly.

Our stock price may be volatile and your investment in our common stock could suffer a decline in value.

      With the current uncertainty about economic conditions in the United States, there has been significant volatility in the market price and trading volume of securities of technology and other companies, which may be unrelated to the financial performance of these companies. These broad market fluctuations may negatively affect the market price of our common stock.

      Some specific factors that may have a significant effect on our common stock market price include:

	•		actual or anticipated fluctuations in our operating results or our competitors’ operating results;
	•		actual or anticipated changes in our growth rates or our competitors’ growth rates;
	•		conditions in the financial markets in general or changes in general economic conditions;
	•		our ability to raise additional capital; and
	•		changes in stock market analyst recommendations regarding our common stock, other comparable companies or our industry generally.

The large number of shares eligible for public sale could cause our stock price to decline.

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      A small number of stockholders own a substantial number of shares of our stock. Many of our largest holders have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. Moreover, substantially all of the common stock issued upon exercise of options under our stock option plans and employee stock purchase plan can be freely sold in the public market. If any of these holders cause a large number of securities to be sold in the public market, the sales could reduce the trading price of our common stock. These sales also could impede our ability to raise future capital.

Concentration of ownership among our existing executive officers, directors and principal stockholders may prevent new investors from influencing significant corporate decisions and may result in a lower trading price for our stock than if ownership of our stock was less concentrated.

      Our executive officers, directors and principal stockholders beneficially own, in total, approximately 28.5% of our outstanding common stock. As a result, these stockholders, acting together, could have the ability to exert substantial influence over all matters requiring approval by our stockholders, including the election and removal of directors and any proposed merger, consolidation or sale of all or substantially all of our assets and other corporate transactions. This concentration of control could be disadvantageous to other stockholders with interests different from those of our officers, directors and principal stockholders. For example, our officers, directors and principal stockholders could delay or prevent an acquisition or merger even if the transaction would benefit other stockholders. In addition, this significant concentration of share ownership may adversely affect the trading price for our common stock because investors often perceive disadvantages in owning stock in companies with controlling stockholders.

Some provisions of our charter and by-laws may delay or prevent transactions that many stockholders may favor, and may have the effect of entrenching management.

      Some provisions of our certificate of incorporation and by-laws may discourage, delay or prevent a merger or acquisition that our stockholders may consider favorable, including transactions in which stockholders might otherwise receive a premium for their shares. These provisions include:

	•		authorization of the issuance of “blank check” preferred stock without the need for stockholder approval;
	•		elimination of the ability of stockholders to call special meetings of stockholders or act by written consent; and
	•		advance notice requirements for proposing matters that can be acted on by stockholders at stockholder meetings.

      In addition, some provisions of Delaware law may also discourage, delay or prevent someone from acquiring us or merging with us. Such provisions of Delaware law and the provisions of our certificate of incorporation may have the effect of entrenching management by making it more difficult to remove directors.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

      The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we may invest in may have market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including money market funds and government debt securities. The average duration of all of our investments in 2003 was less than one year. Due to the short-term nature of these investments, we believe we currently have no material exposure to interest rate risk arising from our investments.

      Inflation has not had a significant impact on our operations during the periods presented.

      We transact business in various foreign countries. All foreign currency cash flow requirements are met using spot foreign exchange transactions. We currently do not hedge any of our local currency cash flows, however we may in the future review the potential for hedging local currency cash flows.

Item 4. Controls and Procedures

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      Evaluation of disclosure controls and procedures. Our management evaluated, with the participation of our chief executive officer and our chief financial officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our chief executive officer and our chief financial officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal control over financial reporting. There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. We are aware that any system of controls, however well designed and operated, can only provide reasonable, and not absolute, assurance that the objectives of the system are met, and that maintenance of disclosure controls and procedures is an ongoing process that may change over time.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings

      We are not currently a party to any material legal proceedings. We may be subject to various claims and legal actions arising in the ordinary course of business from time to time.

Item 6. Exhibits and Reports on Form 8-K.

      (a) Exhibits.

      (b) Reports on Form 8-K

      Report on Form 8-K filed February 17, 2004 under Item 7 and Item 12, for the purpose of furnishing our financial results for the fiscal quarter ended December 31, 2003.

      Report on Form 8-K filed January 26, 2004 under Item 5, Item 7 and Item 9, regarding our intention to file a registration statement on behalf of certain selling stockholders.

      Report on Form 8-K filed January 26, 2004 under Item 7 and Item 12, for the purpose of furnishing our financial results for the fiscal quarter ended December 31, 2003.

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      Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: May 12, 2004

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