BLUE COAT SYSTEMS INC - 10-Q Quarterly Report

	July 31, 2002			April 30, 2002
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	15,529		$	12,480
Short-term investments		16,420			27,466
Accounts receivable, net		7,100			6,100
Inventories		2,040			1,988
Prepaid expenses and other current assets		1,134			1,576

Total current assets		42,223			49,610

Property and equipment, net		4,990			6,047
Restricted investments		1,991			1,991
Other assets		1,084			1,066

Total assets	$	50,288		$	58,714


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,176		$	2,558
Accrued payroll and related benefits		2,395			2,594
Deferred revenue		6,517			6,153
Other accrued liabilities		6,036			8,562

Total current liabilities		17,124			19,867

Accrued restructuring reserve		6,376			7,182
Deferred revenue		1,322			1,401

Total liabilities		24,822			28,450

Commitments

Stockholders’ equity:
Common stock		4			4
Additional paid-in capital		883,947			883,964
Treasury stock		(908	)		(895	)
Notes receivable from stockholders		(32	)		(57	)
Deferred stock compensation		(2,473	)		(3,622	)
Accumulated deficit		(855,086	)		(849,123	)
Accumulated other comprehensive income (loss)		14			(7	)

Total stockholders’ equity		25,466			30,264

Total liabilities and stockholders’ equity	$	50,288		$	58,714

	Three Months Ended July 31,
	2002			2001
Net sales	$	11,035		$	20,443
Cost of goods sold		4,585			8,211

Gross profit		6,450			12,232

Operating expenses:
Research and development		3,545			9,730
Sales and marketing		6,491			9,387
General and administrative		1,411			2,153
Stock compensation		1,126			7,847
Goodwill amortization		—			16,452
Asset impairment		—			62,944

Total operating expenses		12,573			108,513


Operating loss		(6,123	)		(96,281	)
Interest income		149			832
Other income (expense)		42			(22	)


Net loss before income taxes		(5,932	)		(95,471	)
Provision for income taxes		(31	)		(135	)

Net loss	$	(5,963	)	$	(95,606	)


Basic and diluted net loss per common share	$	(0.14	)	$	(2.36	)

Shares used in computing basic and diluted net loss per common share		43,438			40,585

	Three Months Ended July 31,
	2002			2001
Operating Activities
Net loss	$	(5,963	)	$	(95,606	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		748			1,095
Stock compensation		1,126			7,847
Goodwill amortization		—			16,452
Asset impairment		—			62,944
Interest on notes receivable from stockholders		(6	)		(10	)
Changes in operating assets and liabilities:
Accounts receivable		(1,000	)		(1,201	)
Inventories		(51	)		1,301
Prepaid expenses and other current assets		442			905
Other assets		(18	)		65
Deferred Revenue		284			(281	)
Accounts payable		(382	)		(2,156	)
Accrued liabilities		(2,742	)		(3,908	)

Net cash used in operating activities		(7,562	)		(12,553	)

Investing Activities
Purchases of property and equipment		(480	)		(1,148	)
Proceeds from sale of investments, net		11,067			2,386

Net cash provided by investing activities		10,587			1,238

Financing Activities
Net proceeds from issuance of common stock		6			207
Proceeds from repayment of notes receivable		24			232
Repurchase of employee stock		(6	)		—

Net cash provided by financing activities		24			439

Net increase (decrease) in cash and cash equivalents		3,049			(10,877	)
Cash and cash equivalents at beginning of period		12,480			55,356

Cash and cash equivalents at end of period	$	15,529		$	44,479

Treasury stock retirement/cancellation	$	—		$	190

The condensed consolidated financial statements include our accounts and those of our wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated. The accompanying condensed consolidated financial statements and related notes as of July 31, 2002, and for the three-month period then ended, are unaudited, but include all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our consolidated financial position, operating results, and cash flows for the interim date and periods presented. Certain prior year amounts in the condensed consolidated statements of cash flows have been reclassified to conform to the current period presentation. Results for the three months ended July 31, 2002 are not necessarily indicative of results for the entire fiscal year or future periods.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted as permitted under the Securities and Exchange Commission’s (SEC) rules and regulations. These condensed consolidated financial statements and notes included herein should be read in conjunction with our audited consolidated financial statements and notes for the year ended April 30, 2002, included in the Company’s Annual Report on Form 10-K filed with the SEC on July 29, 2002.

The preparation of the condensed consolidated financial statements and the related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. For us, these estimates include returns and allowances, valuation reserves for inventories, accrual of warranty costs, impairment charges related to long-lived assets, restructuring reserves, useful lives assigned for depreciation and amortization, income taxes, and contingencies. Actual results will differ from those estimates, and such differences could be material to the consolidated financial position and results of operations.

We generally recognize product revenue upon shipment, assuming that evidence of an arrangement exists, the fee is determinable and collectibility is probable, unless we have future obligations for installation or must obtain customer acceptance, in which case revenue is deferred until these obligations are met. Probability of collection is assessed on a customer by customer basis. Customers are subjected to a credit review process that evaluates the customers’ financial position and ultimately their ability to pay. If it is determined from the outset of an arrangement that collection is not probable based upon our review process, revenue is not recognized until cash receipt. In the case of shipments to our distributors who have limited rights of return and stock rotation, we defer revenue until a point of sale report is received from the distributor confirming that our products and services have been sold to a reseller or an end user. Maintenance contract revenue is initially deferred when the customer purchases a maintenance contract and recognized evenly over the life of the contract. Maintenance contract revenue recognized for the three months ended July 31, 2002 and 2001 was $2.0 million and $1.8 million, respectively.

In February 2002, our Board of Directors approved a restructuring program to significantly reduce our operating expenses and to further align our organization with market conditions, future revenue expectations and our planned future product direction at that time. In connection with this restructuring plan, we implemented a reduction in workforce of approximately 200 employees. We accrued approximately $12.9 million in the fourth quarter ended April 30, 2002, comprised of employee severance costs of approximately $2.7 million, facilities closure and lease abandonment costs of approximately $9.5 million and contract termination costs of approximately $0.7 million. All employees were notified of their termination prior to April 30, 2002. Estimates related to sublease costs and income are based on assumptions regarding sublease rates and the time required to locate sub-lessees, which were derived from market trend information provided by a commercial real estate broker. These estimates will be reviewed on a periodic basis and to the extent that these assumptions materially change due to changes in the market, the ultimate restructuring expense for the abandoned facility will be adjusted. As of July 31, 2002, substantially all severance costs related to domestic and international employees had been paid and $9.5 million remained accrued for lease abandonment and contract termination costs. The lease abandonment costs will be paid over the respective terms through 2007.

In August 2001, our Board of Directors approved a restructuring program in response to the continued economic slowdown that negatively impacted first quarter of fiscal 2002 demand for our products, as potential customers deferred spending on Internet and intranet infrastructure. In order to streamline our cost structure and better position us for growth, we implemented a reduction in workforce of approximately 80 positions. We incurred $2.6 million in restructuring costs in the quarter ended October 31, 2001 to complete this effort, which included employee severance costs of approximately $1.7 million and certain contract termination costs of approximately $0.9 million. As of July 31, 2002, these severance payments and contract termination payments were completed.

	Abandoned Space			Severance Related			Contract Termination and Other			Total
Reserve balances, April 30, 2002	$	9,503		$	406		$	969		$	10,878
Cash payments		(599	)		(379	)		(382	)		(1,360	)

Reserve balances, July 31, 2002		8,904			27			587			9,518
Less: current portion included in other accrued liabilities		2,887			27			228			3,142

Accrued restructuring reserve	$	6,017		$	—		$	359		$	6,376

In June and July 2001, a series of putative securities class actions were filed on behalf of persons who purchased our stock between November 18, 1999 and June 8, 2001 in the U.S. District Court for the Southern District of New York. These cases have been consolidated under the case captioned Colbert Birnet, LP v. CacheFlow, Inc., et al., Civil Action No. 1-01-CV-5143. The complaints generally allege that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering of securities and maintained artificially high after-market prices. The complaints seek unspecified damages against the underwriters, our company, and certain of our current and former directors and officers. The Court has appointed a lead plaintiff for the consolidated cases. On April 19, 2002 plaintiffs filed an amended complaint. Various plaintiffs have filed similar actions asserting virtually identical allegations against over 300 other public companies, their underwriters, and their officers and directors arising out of each company’s public offerings. The lawsuits against our company, along with these other related securities class actions currently pending in the Southern District of New York, have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings and are collectively captioned In re Initial Public Offering Securities Litigation Civil Action No. 21-MC-92. We intend to defend against the allegations in the complaints vigorously and we believe the outcome would not have a material adverse effect on the business, results of operations, or financial condition of our company. In the future, other types of securities class action lawsuits could be filed against us. Securities class action litigation could result in substantial costs and divert our management’s attention and resources, which could seriously harm our business.

On August 1, 2001, Network Caching Technology L.L.C. filed suit against CacheFlow and others in the U.S. District Court for the Northern District of California. The case is captioned Network Caching Technology, L.L.C.,v. Novell, Inc., Volera, Inc., Akamai Technologies, Inc., CacheFlow, Inc., and Inktomi Corporation, Civil Action No. CV-01-2079. The complaint alleges infringement of certain U.S. patents. The complaint seeks unspecified compensatory and treble damages and to permanently enjoin the defendants from infringing the patents in the future. We intend to defend against the allegations in the complaint vigorously and believe that the allegations in the lawsuit are without merit; however, if a judgment were issued against us, it could have a material adverse effect on our business, results of operations, or financial condition.

In May 2002, we adopted Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, which requires goodwill to be tested for impairment under certain circumstances, and written down when impaired, rather than being amortized as previous standards required. Furthermore, SFAS 142 requires purchased intangible assets other than goodwill to be amortized over their useful lives unless these lives are determined to be indefinite. As of April 30, 2002, the enterprise level goodwill recorded in connection with our Springbank Networks, Inc. and Entera, Inc. acquisitions was fully written off and there was no remaining goodwill balance to be amortized or impaired in the three months ended July 31, 2002. For the three months ended July 31, 2001, our market capitalization had fallen below our net book value. Management performed an impairment assessment of long-lived assets and determined that certain enterprise level goodwill recorded in connection with our Springbank Networks, Inc. and Entera, Inc. acquisitions was not fully recoverable. As a result, we recorded a $62.9 million impairment charge in the quarter ended July 31, 2001 to reduce goodwill to its estimated fair value based on the market value method. The estimate of fair value was based upon our average market capitalization, which was calculated using our average closing stock price surrounding July 31, 2001.

We report comprehensive income (loss) in accordance with the Financial Accounting Standards Board’s (FASB) SFAS No. 130, “Reporting Comprehensive Income.” Included in other comprehensive income (loss) for us are adjustments to record unrealized gains and losses on available-for-sale securities. These adjustments are accumulated in “Accumulated other comprehensive income (loss)” in the stockholder’s equity section of the balance sheet. The comprehensive net loss for the three-month period ended July 31, 2002 and 2001 was $5.9 million and $95.5 million, respectively.

Basic net loss per common share and diluted net loss per common share are presented in conformity with the FASB’s SFAS No. 128, “Earnings Per Share” (SFAS 128), for all periods presented. In accordance with SFAS 128, basic and diluted net loss per common share has been computed using the weighted-average number of shares of common stock outstanding during the period, less the weighted average number of shares of common stock issued to founders, investors, service providers and employees that are subject to repurchase.

We operate in one segment to design, develop, market and support web security appliances. Our sales consisted of three product categories: web security products, legacy products and services. Total international revenue consisted of sales from our U.S. operations to non-affiliated customers in other geographic regions. During the three months ended July 31, 2002 and 2001, there were no intra-enterprise sales, and no material long-lived assets were located in our foreign operations during the three months ended July 31, 2002 and 2001.

On August 14, 2002, we received a Nasdaq Staff Determination letter indicating that our Common Stock would be delisted from the Nasdaq National Market because we were not in compliance with the minimum $1 per share bid price requirement for continued listing as set forth in Nasdaq Marketplace Rule 4450(a)(5) and such noncompliance had extended beyond the 90-day grace period provided by Nasdaq Marketplace Rules. On August 15, 2002, pursuant to Nasdaq Marketplace Rule 4820, we appealed the Staff Determination and requested an oral hearing in person before a Listing Qualifications Panel to review the Staff Determination. On August 20, 2002, we received a letter from Nasdaq granting our request and setting a hearing date of September 19, 2002. In addition, the delisting action referenced in the August 14, 2002 letter has been stayed pending a decision by the Listing Qualifications Panel. On September 12, 2002, we will conduct our annual meeting of our stockholders. Our stockholders are being asked to approve a reverse stock split of our common stock in ratios of 1-for-5, 1-for-10, and 1-for-15. If one or more of the reverse splits is approved, the Board of Directors will determine which one, if any, of the approved reverse splits to implement. If a reverse stock split is implemented, we anticipate that our common stock will then meet the minimum bid price per share of $1.00 pursuant to Nasdaq Marketplace Rule 4450(a)(5), although there can be no assurance that the Nasdaq Listings Qualification Panel will grant our request for continued listing on the Nasdaq National Market after the hearing, even if we are able to comply with Nasdaq Marketplace Rule 4450(a)(5). If none of the reverse splits is approved, or if our Board of Directors chooses not to implement a reverse split, we expect to apply to transfer our common stock from the Nasdaq National Market to the Nasdaq SmallCap Market. However, there can be no assurance that we will be permitted to move to the Nasdaq SmallCap Market.

The discussion in this report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this Report that are not purely historical are 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, including statements on future revenue expectations, sales channel development, future operating results, future cash usage and product acceptance, as well as statements on our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those indicated in such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, uncertainty in future operating results, inability to raise additional capital, compliance with Nasdaq’s listing standards, macroeconomic conditions, competition, new product introduction, key employee retention and transitions, fluctuations in quarterly operating results, product concentration, technological changes, uncertainty in the web security appliance market, litigation, and other risks discussed in this item under the heading “Factors Affecting Future Operating Results” and the risks discussed in our other recent Securities and Exchange Commission filings.

	Three Months Ended July 31,
	2002		2001
Net sales	100.0	%	100.0	%
Cost of goods sold	41.5		40.2

Gross profit	58.5		59.8

Operating expenses:
Research and development	32.1		47.6
Sales and marketing	58.8		45.9
General and administrative	12.8		10.5
Stock compensation	10.2		38.4
Goodwill amortization	—		80.5
Impairment of assets	—		307.9

Total operating expenses	113.9		530.8

Operating loss	(55.4	)	(471.0	)
Interest income	1.4		4.1
Other income (expense)	0.4		(0.1	)

Net loss before income taxes	(53.6	)	(467.0	)
Provisions for income taxes	(0.3	)	(0.7	)

Net loss	(53.9	)	(467.7	)

Net loss available to common stockholders	(53.9	)%	(467.7	)%

Blue Coat^™ Systems, Inc. (formerly Cacheflow Inc.), also referred to in this report as “we” or the “Company”, was incorporated in Delaware on March 16, 1996. On August 21, 2002, we changed our name from CacheFlow Inc. to Blue Coat Systems, Inc. We are focused on the enterprise web security appliance market. Our web security appliances, called Port 80 Security Appliances, are designed to protect organizations against emerging web threats targeting the open holes in the existing security infrastructure. Our products are designed to enable enterprises to utilize their web resources while minimizing their security risks and reducing their network management costs.

The company’s initial products, introduced in May of 1998, utilized caching technology to improve user response time for accessing Internet content. These systems were used by service providers and enterprises throughout the world and achieved a market leadership position. By 1999, the caching market began evolving into two distinct segments – enterprises looking for proxy caches, to securely connect employees to the Internet, and service providers looking for increased bandwidth savings and response time for their subscribers. During this timeframe, service provider customers represented the majority of our revenues. We continued, however, to enhance our competitive position in both market segments through internal development and external acquisitions. By early 2001, the demand for extending our enterprise proxy caches started to grow, while the service provider market decreased significantly. We accelerated our development and marketing efforts around our enterprise business, resulting in the delivery of our Port 80 Security Appliances in June 2002.

We believe that Web traffic now comprises the majority of enterprise network traffic. The threats related to protecting and securing those web applications has driven organizations to rethink the consequences of an inadequate security infrastructure. The existing security infrastructure was not designed to protect against web threats, including malicious mobile code such as the Code Red virus or the Nimda virus. To protect their businesses, these enterprise organizations need the capability to easily understand and control web applications, content and users. This capability is enabled by a new layer of security infrastructure, the web security appliance, which polices the primary access point through which these threats enter the enterprise network, port 80.

We have incurred net losses in each quarter since inception. As of July 31, 2002, we had an accumulated deficit of $855.1 million, which consisted of $133.2 million of pro-forma net losses and the following non-recurring items: $411.7 million of asset impairment, $132.0 million of stock compensation expenses, $128.5 million of goodwill amortization, $32.2 million of acquired in-process technology, $17.3 million of restructuring expenses and $0.2 million of treasury stock retirement. Our net losses for the three months ended July 31, 2002 and 2001 were $6.0 million and $95.6 million, respectively. These losses resulted from charges related to the impairment of certain intangible and long-lived assets, the amortization of deferred stock compensation and goodwill, and significant costs incurred in the development and sale of our products and services. Additionally, we experienced a significant decline in the demand for our products starting in the quarter ended January 31, 2001, which have continued through the quarter ended July 31, 2002. We believe this decline in revenue substantially resulted from the weakening global economy and a corresponding reduction in information technology spending. Unless there are positive changes in current macroeconomic conditions, we expect that the lowered levels of demand since January 31, 2001 will continue throughout fiscal 2003. As a result, we expect to incur additional operating losses and continued negative cash flows from operations at least through fiscal year 2003. Our limited operating history makes the prediction of future operating results difficult. We believe that period-to-period comparisons of our operating results should not be relied upon as predictive of future performance. Our prospects must be considered in light of the risks, expenses and difficulties encountered by companies at an early stage of development, particularly companies in new and rapidly evolving markets. We may not be successful in addressing these risks and difficulties. See “Liquidity and Capital Resources” below for further discussion.

Our discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosure of contingent assets and liabilities. We evaluate, on an ongoing basis, our estimates and judgments, including those related to sales returns, bad debts, excess inventory and purchase commitments, investments, intangible assets, lease losses and restructuring accruals, income taxes, and contingencies. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances. Actual results may differ from those estimates and such differences could be significant.

Revenue Recognition and Allowances. We generally recognize product revenue upon shipment, assuming that evidence of an arrangement exists, the fee is determinable and collectibility is probable, unless the Company has future obligations for installation or must obtain customer acceptance, in which case revenue is deferred until these obligations are met. Probability of collection is assessed on a customer by customer basis. Customers are subjected to a credit review process that evaluates the customers’ financial position and ultimately their ability to pay. If it is determined from the outset of an arrangement that collection is not probable based upon our review process, revenue is not recognized until cash receipt. During the three months ended July 31, 2002 and 2001, the Company deferred certain revenue based on this criteria and revenue from certain customers was recognized based upon cash receipts.

We also maintain a separate allowance for doubtful accounts for estimated losses resulting from the unanticipated inability of our customers to make required payments. We analyze accounts receivable and historical bad debts, customer concentrations, customer solvency, current economic and geographic trends, and changes in customer payment terms and practices when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make payments, additional allowances may be required.

Inventory write-down. We record write-downs for estimated excess and obsolete inventory. These write-downs are equal to the difference between the cost of the inventory and its estimated fair value, which is determined based upon assumptions about future demand and market conditions. Although we strive to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and related purchase commitments, and our reported results. If actual market conditions are less favorable than those projected, additional write-downs and other charges against earnings may be required.

We performed a comprehensive analysis of our real estate facility requirements and identified excess facility space, which has subsequently been offered for sublease. Based upon the results of our analysis, we recorded charges related to estimated facilities lease losses, net of expected sublease income during fiscal 2002. In determining the net facilities charge, various assumptions were made, including the time period over which the facilities will be vacant, expected sublease terms and expected sublease rates. The charges recorded were estimates in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies,” and represented the low end of an estimated range that may be adjusted upon the occurrence of future triggering events. Triggering events may include, but are not limited to, changes in estimated time to sublease the facilities, sublease terms, sublease rates, and lease termination. Should operating lease rental rates decline or should it take longer than expected to find a suitable tenant to sublease the facility, adjustments to the facilities lease losses liabilities may be necessary in future periods based upon the then-current actual events and circumstances.

Net Sales. Net sales decreased to $11.0 million for the three months ended July 31, 2002 from $20.4 million for the three months ended July 31, 2001. This decrease was primarily attributable to fewer unit sales and a purchasing trend towards our lower end systems, which have lower average sales prices than our higher end systems, partially offset by increased service and other product revenue. As a result of our focus on increasing the use of indirect distribution channels, one of our distributors accounted for 18% of our net sales during the three months ended July 31, 2002. No customer accounted for more than 10% of our net sales during the three months ended July 31, 2001.

Net sales for the three months ended July 31, 2002 from our web security products were $6.9 million, or 62.6% of net sales, our legacy products were $2.0 million, or 18.5% of net sales, and services were $2.1 million, or 18.9% of net sales. Net sales for the three months ended July 31, 2001 from our web security products were $10.3 million, or 50.3% of net sales, our legacy products $8.3 million, or 40.6% of net sales, and services were $1.9 million, or 9.1% of net sales. Unless macroeconomic conditions improve sooner than anticipated, our visibility to the near-term demand for our products is limited, however, modest growth is expected in fiscal 2003.

Gross Profit. Gross profit decreased to $6.5 million for the three months ended July 31, 2002 from $12.2 million for the three months ended July 31, 2001. This decrease in gross profit was primarily attributable to the decrease in sales for the three months ended July 31, 2002. Our gross margin percentage decreased slightly to 58.5% for the three months ended July 31, 2002 from 59.8% for the three months ended July 31, 2001. This slight decrease in our gross margin percentage was principally the result of fixed manufacturing overhead costs applied to lower volumes.

Our gross margin has been and will continue to be affected by a variety of factors, including competition, fluctuations in demand for our products, the timing and size of customer orders and product implementations, the mix of direct and indirect sales, the mix and average selling prices of products, new product introductions and enhancements, component costs, manufacturing overhead costs, service margin and product configuration. If actual orders do not match our forecasts we may have excess or inadequate inventory of some materials and components or we could incur cancellation charges or penalties, which would increase our costs or prevent or delay product shipments and could seriously harm our business.

Research and Development. Research and development expenses consist primarily of salaries and benefits, and prototype and testing costs. Research and development expenses decreased to $3.5 million for the three months ended July 31, 2002 from $9.7 million for the three months ended July 31, 2001. This decrease in research and development expenses in absolute dollars was primarily attributable to decreased staffing and associated support for engineers as the result of the restructuring effort to reduce costs during the fourth quarter of fiscal 2002. Research and development headcount decreased to 78 at July 31, 2002 from 219 at July 31, 2001. As a percentage of net sales, research and development expenses decreased to 32.1% for the three months ended July 31, 2002 from 47.6% for the three months ended July 31, 2001. This decrease in research and development expenses as a percentage of net sales occurred even with the lower revenue experienced in the first quarter of fiscal 2003, reflecting our efforts to lower expenditures given the reduced revenue that we are experiencing. Should growth in demand for our products resume, and after we realize potential efficiencies within our research and development organization, we expect to increase our research and development expenses in absolute dollars in an effort to enhance existing and introduce new products. However, we may implement additional cost-cutting programs to reduce our research and development expenses in future periods. Through July 31, 2002, all research and development costs have been expensed as incurred.

Sales and Marketing. Sales and marketing expenses consist primarily of salaries and benefits, commissions and advertising and promotional expenses. Sales and marketing expenses decreased to $6.5 million for the three months ended July 31, 2002 from $9.4 million for the three months ended July 31, 2001. This decrease in sales and marketing expenses in absolute dollars was primarily related to reduced headcount. Sales and marketing headcount decreased to 87 at July 31, 2002 from 152 at July 31, 2001. As a percentage of net sales, sales and marketing expenses increased to 58.8% for the three months ended July 31, 2002 from 45.9% for the three months ended July 31, 2001. This increase in sales and marketing expenses as a percentage of net sales results from the decline in net sales compared to the first quarter of our fiscal 2002 partially offset by reduced sales and marketing expenses. Should growth in demand for our products resume, and after we realize potential efficiencies within our sales and marketing organization, we expect to increase our sales and marketing expenses in absolute dollars in an effort to expand domestic and international markets, introduce new products and establish and expand new distribution channels. However, we may implement additional cost-cutting programs to reduce our sales and marketing expenses in future periods.

General and Administrative. General and administrative expenses decreased to $1.4 million for the three months ended July 31, 2002 from $2.2 million for the three months ended July 31, 2001. This decrease in general and administrative expenses in absolute dollars was primarily attributable to decreased staffing and associated expenses as the result of the restructuring effort to reduce costs during the fourth quarter of fiscal 2002. General and administrative headcount decreased to 27 at July 31, 2002 from 57 at July 31, 2001. As a percentage of net sales, general and administrative expenses increased to 12.8% for the three months ended July 31, 2002 from 10.5% for the three months ended July 31, 2001. This increase in general and administrative expenses as a percentage of net sales primarily results from the decline in net sales compared to the first quarter of our fiscal 2002 partially offset by reduced general and administrative expenses. Should growth in demand for our products resume, and after we have realized potential efficiencies within our current general and administrative organization, we expect general and administrative expenses to increase in absolute dollars as we continue to increase headcount to manage expanding operations and facilities. However, we may implement additional cost-cutting programs to reduce our general and administrative expenses in future periods.

Goodwill Amortization. No goodwill amortization was taken during the three months ended July 31, 2002 since the enterprise level goodwill recorded in connection with our Springbank Networks, Inc. and Entera, Inc. acquisitions was fully written off as of April 30, 2002. Goodwill amortization expense was $16.5 million for the three months ended July 31, 2001. The goodwill expense was attributable to our acquisitions of SpringBank Networks, Inc. on June 5, 2000, and Entera, Inc. on December 15, 2000, which were accounted for as purchase business combinations. The SpringBank and Entera acquisitions resulted in goodwill of $177.0 million and $359.3 million, respectively, and each amount was amortized over three years on a straight-line basis. See “Impairment of assets” below.

Impairment of assets. As discussed further in Note 4 “Impairment of Assets” of the condensed consolidated financial statements above, during our first quarter ended July 31, 2001, we performed an impairment assessment of our tangible and intangible assets and determined that the enterprise level goodwill associated with the acquisitions of SpringBank and Entera was impaired. As a result, a $62.9 million impairment charge was recorded to write our net book value down to its market value as of July 31, 2001.

We cannot assure that our most recent restructuring program will achieve all of the expense reductions and other benefits that we anticipate. In addition, anticipated savings from the reduced headcount or facility consolidations have been, and may in the future be, mitigated by subsequent increases in headcount and subsequent facilities additions related to our operating requirements. See Note 2 “Restructuring Charges” of the condensed consolidated financial statements for further discussions.

From inception, we financed our operations and the purchase of property and equipment through private sales of preferred stock, with net proceeds of $37.9 million, through bank loans and equipment leases, and in November 1999, through an initial public offering of our common stock, with net proceeds of $126.5 million. At July 31, 2002, we had $15.5 million in cash and cash equivalents, $16.4 million in short-term investments, $2.0 million in restricted investments and $25.1 million in working capital.

Net cash used in operating activities was $7.6 million for the three months ended July 31, 2002 and $12.6 million for the three months ended July 31, 2001. For the three months ended July 31, 2002, we used cash primarily to fund our net losses from operations, to fund growth in accounts receivable, and to pay off accrued liabilities, which included $1.4 million of payments against accrued restructuring liabilities related to severance, terminated and vacated real estate leases, and other contract termination obligations. We expect to make payments of approximately $3.1 million against our accrued restructuring liabilities over the next 12 months.

Net cash provided by investing activities was $10.6 million for the three months ended July 31, 2002 and $1.2 million for the three months ended July 31, 2001. Net cash provided by investing activities for the three months ended July 31, 2002 was primarily attributable to net sales of short-term securities, offset by purchases of property, plant and equipment. We expect that, in the future, any cash in excess of current requirements will continue to be invested in high quality, interest-bearing securities.

As of July 31, 2002, we continue to have no outstanding debt and we do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities, nor did we have any commitment or intent to provide additional funding to any such entities. As such, we are not materially exposed to any market, credit, liquidity or financing risk that could arise if we had engaged in such relationships.

We have suffered recurring losses from operations and currently project such losses to continue for fiscal 2003. Our current business plan for 2003 reflects continued initiatives to increase revenue, reduce overhead, and realize the benefit of recent reductions in employee headcount and occupancy costs. The plan projects that the amount of the quarterly net loss will decline from quarter to quarter with net income projected to begin in fiscal 2004. As a result, current cash and short-term investment balances are projected to be sufficient to fund the excess of expenses over revenue for fiscal 2003. In our review of our operating requirements, we determined that even with a reduction of revenue in excess of 50% from fiscal 2002, we would still have sufficient working capital to meet our working capital and capital expenditure requirements through at least fiscal 2003. If revenues decrease below that level without further expense reduction or if cash is needed for unanticipated uses, we may need additional capital sooner than expected. Although we cannot guarantee that planned results will be obtained in fiscal 2003 or that sufficient debt or equity capital will be available to us under acceptable terms, if at all, we believe that our planned revenue and expense assumptions can be realized. However, if we are not successful in generating sufficient cash flow from operations or in raising additional capital when required in sufficient amounts and on terms acceptable to us, we will eventually be unable to continue our operations. If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our existing stockholders will be reduced.

In May 2002, we adopted Statements of Financial Accounting Standards No. 141, “Business Combinations” (Statement 141), and No. 142, “Goodwill and Other Intangible Assets” (Statement 142). Statement 141 eliminates the pooling-of-interests method of accounting for business combinations except for qualifying business combinations that were initiated prior to July 1, 2001. Statement 141 further clarifies the criteria to recognize intangible assets separately from goodwill. The requirements of Statement 141 are effective for any business combination accounted for by the purchase method that is completed after June 30, 2001. Under Statement 142, goodwill and indefinite lived intangible assets are no longer amortized but are reviewed annually (or more frequently if impairment indicators arise) for impairment. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives. The amortization provisions of Statement 142 apply to goodwill and intangible assets acquired after June 30, 2001. With respect to goodwill and intangible assets acquired prior to July 1, 2001, companies are required to adopt Statement 142 in their fiscal year beginning after December 15, 2001. As of July 31, 2002, we did not have any business combinations or remaining goodwill on our balance sheet. As such, the adoption of these statements did not have an impact on our financial position and results of operations.

In May 2002, we adopted Statement of Financial Accounting Standards No. 144 (Statement 144), “Accounting for the Impairment or Disposal of Long-Lived Assets,” which is effective for companies with fiscal year ends beginning after December 15, 2001. Statement 144 supersedes FASB Statement No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,” and the accounting and reporting provisions relating to the disposal of a segment of a business of Accounting Principles Board Opinion No. 30. The adoption of this statement did not have a material impact on our financial position and results of operations.

In connection with the engagement of our independent auditors, our audit committee has reviewed both the audit and non-audit services provided pursuant to the engagement to ensure that our auditors satisfy the independence requirements mandated by generally accepted accounting principles and the SEC. Our audit committee had the opportunity to formally approve the non-audit services provided by our auditors, as required under a new federal law that was enacted July 30, 2002.

We incurred net losses of $6.0 million and $95.6 million for the three months ended July 31, 2002 and 2001, respectively. As of July 31, 2002, we had an accumulated deficit of $855.1 million, which consisted of $133.2 million of pro-forma net losses and the following non-recurring items: $411.7 million of asset impairment, $132.0 million of stock compensation expenses, $128.5 million of goodwill amortization, $32.2 million of acquired in-process technology, $17.3 million of restructuring expenses and $0.2 million of treasury stock retirement. We have not had a profitable quarter since our inception and we expect to continue to incur net losses on a quarterly and annual basis in the future. We expect to continue to incur significant operating expenses and, as a result, we will need to generate significant revenues if we are to achieve profitability. We may never achieve profitability.

At July 31, 2002, we had approximately $15.5 million in cash and cash equivalents, $16.4 million in short-term investments, and $2.0 million in restricted investments. We believe that these amounts will enable us to meet our capital requirements for at least the next twelve months. However, if cash is needed for unanticipated needs, we may need additional capital during that period. The development and marketing of new products will require a significant commitment of resources. In addition, if the market for web security appliances develops at a slower pace than anticipated or if we fail to establish significant market share and achieve a meaningful level of sales, we could be required to raise substantial additional capital. We cannot be certain that additional capital will be available to us on favorable terms, or at all. If we were unable to raise additional capital when we require it, our business would be seriously harmed.

Although we believe that a reverse stock split is the most effective means to avoid a delisting of our common stock from the Nasdaq National Market, we cannot predict whether a reverse stock split will in fact increase or maintain the bid price for our common stock above $1.00 per share. The history of similar stock split combinations for companies in like circumstances is varied. In addition, there can be no assurance that even if Nasdaq’s minimum bid price maintenance standard were satisfied, we would continue to be able to meet our other quantitative continued listing criteria, or that our common stock would not be delisted by Nasdaq for other reasons.

The delisting of our common stock from the Nasdaq National Market could adversely affect our ability to attract new investors and attract and retain employees, may result in decreased liquidity of our outstanding shares of common stock (and a resulting inability of our stockholders to sell our common stock), and, consequently, could reduce the price at which our shares trade. In addition, the delisting of our common stock could deter broker-dealers from making a market in or otherwise generating interest in our common stock, and might deter certain persons from investing in our common stock. There can be no assurance that

We have existing commitments to lease office space in Sunnyvale, CA and Redmond, WA in excess of our needs for the foreseeable future. The commercial real estate market in the San Francisco Bay Area and the Seattle Area has developed such a large excess inventory of office space that we now believe we could be unable to sublease a substantial portion of our excess office space in the near future. Accordingly, in the fourth quarter of fiscal 2002, we recorded an excess facilities charge of $9.5 million, which represented the remaining lease commitments for vacant facilities, net of expected sublease income. As of July 31, 2002, $8.9 million of this accrued liability remains on the balance sheet. If current market conditions for the commercial real estate market remain the same or worsen, we may be required to record additional charges.

U.S. economic growth slowed significantly in the past two years. In addition, there is uncertainty relating to the prospects for near-term U.S. economic growth, as well as the extent to which the U.S. slowdown will impact international markets. This slowdown and uncertainty contributed to delays in decision-making by our existing and potential customers and a resulting decline in our sales in the second half of fiscal 2001 and all of fiscal 2002. Continued uncertainty or a continued slowdown could result in a further decline in our sales and our operating results could again be below our expectations and the expectations of public market analysts and investors. Our stock price has materially declined over the past two years and our stock price may continue to decline in the event that we fail to meet the expectations of public market analysts or investors in the future.

The market for web security appliances is intensely competitive, evolving and subject to rapid technological changes. Primary competitive factors that have typically affected our market include product features such as reliability, scalability, and ease of use, as well as price and customer support. The intensity of competition is expected to increase in the future. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any one of which could seriously harm our business. We may not be able to compete successfully against current or future competitors and we cannot be certain that competitive pressures we face will not seriously harm our business. Our competitors vary in size and in the scope and breadth of the products and services they offer. We encounter competition from a variety of companies, including primarily Cisco Systems, Network Appliance, Tumbleweed Communications and various others. In addition, we expect additional competition from other established and emerging companies as the market for web security appliances continues to develop and expand.

Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers than we do. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry. As a result, our competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, marketing, promotion and sale of their products than we can. The products of our competitors may have features and functionality that our products do not have. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the market acceptance of their products. In addition, our competitors may be able to replicate our products, make more attractive offers to existing and potential employees and strategic partners, more quickly develop new products or enhance existing products and services or bundle web security appliances in a manner that we cannot provide. Accordingly,

We need to develop and introduce new products and enhancements to existing products on a timely basis that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated needs of our customers. We intend to extend the offerings under our product family in the future, both by introducing new products and by introducing enhancements to our existing products. However, we may experience difficulties in doing so, and our inability to timely and cost-effectively introduce new products and product enhancements, or the failure of these new products or enhancements to achieve market acceptance, could seriously harm our business. Furthermore, the reduction of approximately 100 research and development personnel resulting from the February 2002 restructuring, may make this even more difficult. Life cycles of our products are difficult to predict, because the market for our products is new and evolving and characterized by rapid technological change, frequent enhancements to existing products and new product introductions, changing customer needs and evolving industry standards. The introduction of competing products that employ new technologies and emerging industry standards could render our products and services obsolete and unmarketable or shorten the life cycles of our products and services. The emergence of new industry standards might require us to redesign our products. If our products are not in compliance with industry standards that become widespread, our customers and potential customers may not purchase our products.

Our business could be seriously disrupted if we do not maintain the continued service of our senior management, research and development and sales personnel. We have experienced and may continue to experience transition in our management team. All of our employees are employed on an “at-will” basis. Our ability to conduct our business also depends on our continuing ability to attract, hire, train and retain a number of highly skilled managerial, technical, sales, marketing and customer support personnel. New hires frequently require extensive training before they achieve desired levels of productivity, so a high employee turnover rate could seriously impair our ability to operate and manage our business.

Because customers have differing views on the strategic importance of implementing web security appliances, the time required to educate customers and sell our products can vary widely. As a result, the evaluation, testing, implementation and acceptance procedures undertaken by customers can vary, resulting in a variable sales cycle, which typically ranges from one to nine months. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing expenses and expend significant management efforts. In addition, purchases of our products are frequently subject to unplanned processing and other delays, particularly with respect to larger customers for whom our products represent a very small percentage of their overall purchase activity. Large customers typically require approvals at a number of management levels within their organizations, and, therefore, frequently have longer sales cycles. We may experience order deferrals or loss of sales as a result of lengthening sales cycles.

Our net sales and operating results are likely to vary significantly from quarter to quarter. We believe that quarter-to-quarter comparisons of our operating results should not be relied upon as indicators of future performance. It is likely that in some future quarter or quarters, our operating results will be below the expectations of public market analysts or investors. When this occurs, the price of our common stock could decrease significantly. A number of factors are likely to cause variations in our net sales and operating results, including factors described elsewhere in this “Factors Affecting Future Operating Results” section.

We changed our name from CacheFlow Inc. to Blue Coat Systems, Inc. on August 21, 2002. In conjunction with the name change, the ticker symbol for our common stock, which is listed on the Nasdaq National Market, was changed from CFLO to BCSI. Although we have not experienced any material disruptions to our business as a result of the name change, the name change may lead to some confusion among potential and existing customers regarding our history and our business. In particular, our ability to secure new customers may be made more difficult because we are no longer in an immediate position to leverage any goodwill and name recognition associated with our former name.

We evaluate and modify our distribution strategy from time to time to meet market requirements. For the three months ended July 31, 2002, we did begin to increase our distributor sales; however, there is no guarantee that we will continue to accomplish our goal to increase our focus on indirect distribution channels, which could significantly decrease sales. Any direct channel new hire or new distribution partner will require extensive training and typically take several months to achieve productivity. Competition for qualified sales personnel and distribution partners is intense, and we might not be able to hire the kind and number of candidates we are targeting. If we fail to manage existing sales channels and create additional sales capabilities, our business will be seriously harmed.

Many of our indirect channel partners do not have minimum purchase or resale requirements and carry products that are competitive with our products. These resellers may not give a high priority to the marketing of our products or may not continue to carry our products. They may give a higher priority to other products, including the products of competitors. We may not retain any of our current indirect channel partners or successfully recruit new indirect channel partners. Events or occurrences of this nature could seriously harm our business.

For the three months ended July 31, 2002, sales to customers outside of the United States and Canada accounted for approximately 49% of our net sales. We expect international customers to continue to account for a significant percentage of net sales in the future, but we may fail to maintain or increase international market demand for our products. The downsizing of our international operations as the result of the August 2001 and February 2002 restructuring plans may further hinder our ability to increase our market concentration internationally. Also, because our international sales are currently denominated in United States dollars, an increase in the value of the United States dollar relative to foreign currencies could make our products more expensive and, therefore, potentially less competitive in international markets, and this would decrease our international sales. Our ability to generate international sales depends on our ability to maintain our international operations, including efficient use of existing resources and effective channel management, and recruit additional international resellers. To the extent we are unable to do so in a timely manner, our growth, if any, in international sales will be limited and our business could be seriously harmed.

We prepare and release quarterly unaudited financial statements prepared in accordance with generally accepted accounting principles (“GAAP”). We also disclose and discuss certain pro forma financial information in the related earnings release and investor conference call. This pro forma financial information excludes special charges, including the amortization of purchased intangibles, deferred stock compensation, in-process research and development expense, restructuring costs and excess facilities and asset impairment charges. We believe the disclosure of the pro forma financial information helps investors more meaningfully evaluate the results of our ongoing operations. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K, and our quarterly earnings releases, and to compare the GAAP financial information with the pro forma financial results disclosed in our quarterly earnings releases and investor calls, and read the associated reconciliation.

We currently purchase from Mitac Corporation (“Mitac”) the chassis (box) with certain printed-circuit boards and base components for most of our current products. Any Mitac manufacturing disruption could impair our ability to fulfill orders. Our future success could depend, in part, on our ability to have others manufacture our products cost-effectively and in sufficient volumes. We also rely on several other third-party manufacturers to build portions of our products. If we are unable to manage the relationships with these manufacturers effectively or if these manufacturers fail to meet our future requirements for timely delivery, our business would be seriously harmed. These manufacturers fulfill our supply requirements on the basis of individual purchase orders or agreements with us. Accordingly, these manufacturers are not obligated to continue to fulfill our supply requirements, and the prices we are charged for these components could be increased on short notice. Any interruption in the operations of any one of these manufacturers would adversely affect our ability to meet our scheduled product deliveries to our customers, which could cause the loss of existing or potential customers and would seriously harm our business. In addition, the products that these manufacturers build for us may not be sufficient in quality or in quantity to meet our needs. Our delivery requirements could be higher than, or lower than, the capacity of these manufacturers, which would likely result in manufacturing delays, which could result in lost sales and the loss of existing and potential customers. We cannot be certain that these manufacturers or any other manufacturer will be able to meet the technological or delivery requirements of our current products or any future products that we may develop and introduce. The inability of these manufacturers or any other of our contract manufacturers in the future to provide us with adequate supplies of high-quality products, or the loss of any of our contract manufacturers in the future, would cause a delay in our ability to fulfill customer orders while we attempt to obtain a replacement manufacturer. Delays associated with our attempting to replace or our inability to replace one of our manufacturers would seriously harm our business.

We have no long-term contracts or arrangements with any of our vendors that guarantee product availability, the continuation of particular payment terms or the extension of credit limits. We have experienced in the past, and may experience in the future, problems with our contract manufacturers, such as inferior quality, insufficient quantities and late delivery of product. To date, these problems have not materially adversely affected us. We may not be able to obtain additional volume purchase or manufacturing arrangements on terms that we consider acceptable, if at all. If we enter into a high-volume or long-term supply arrangement and subsequently decide that we cannot use the products or services provided for in the agreement, our business will be harmed. We cannot assure you that we can effectively manage our contract manufacturers or that these manufacturers will meet our future requirements for timely delivery of products of sufficient quality or quantity. Any of these difficulties could harm our relationships with customers and cause us to lose orders.

We currently purchase several key parts and components used in the manufacture of our products from limited sources of supply. For example, we purchase custom power supplies and Intel hardware for use in all of our products. The introduction by Intel or others of new versions of their hardware, particularly if not anticipated by us, could require us to expend significant resources to incorporate this new hardware into our products. In addition, if Intel or others were to discontinue production of a necessary part or component, we would be required to expend significant resources in locating and integrating replacement parts or components from another vendor. Qualifying additional suppliers for limited source components can be time-consuming and expensive. Any of these events would be disruptive to us and could seriously harm our business. Further, financial or other difficulties faced by these suppliers or unanticipated demand for these parts or components could limit the availability of these parts or components. Any interruption or delay in the supply of any of these parts or components, or the inability to obtain these parts or components from alternate sources at acceptable prices and within a reasonable amount of time, would seriously harm our ability to meet our scheduled product deliveries to our customers.

We use rolling forecasts based on anticipated product orders, product order history and backlog to determine our materials requirements. Lead times for the parts and components that we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for a component at a given time. If actual orders do not match our forecasts, we may have excess or inadequate inventory of some materials and components or we could incur cancellation charges or penalties, which would increase our costs or prevent or delay product shipments and could seriously harm our business.

Our products may contain undetected errors. These errors may cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. The occurrence of these problems could result in the delay or loss of market acceptance of our products and would likely seriously harm our business. All of our products operate on our internally developed operating system. As a result, any error with our operating system will affect all of our products. We have experienced minor errors in the past in connection with new products and product enhancements. We expect that errors will be found from time to time in new or enhanced products after commencement of commercial shipments.

We depend significantly on our ability to develop and maintain the proprietary aspects of our technology. To protect our proprietary technology, we rely primarily on a combination of contractual provisions, confidentiality procedures, patents, trade secrets, copyright and trademark laws and patents. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology, duplicate our products or design around patents that may be issued to us or our other intellectual property.

There can be no assurance or guarantee that any products, services or technologies that we are presently developing, or will develop in the future, will result in intellectual property that is protectable under law, whether in the United States or a foreign jurisdiction, that this intellectual property will produce competitive advantage for us or that the intellectual property of competitors will not restrict our freedom to operate, or put us at a competitive disadvantage.

We rely on technology that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. If we are unable to continue to license any of this software on commercially reasonable terms, we will face delays in releases of our software or will be required to drop this functionality from our software until equivalent technology can be identified, licensed or developed, and integrated into our current product. Any of these delays could seriously harm our business.

There has been a substantial amount of litigation in the technology industry regarding intellectual property rights and we are currently defending a suit, which alleges infringement of certain U.S. patents by us. (See Note 3 of the Condensed Consolidated Financial Statements) While we believe the case is without merit, it does show it is possible that third parties may claim that we, or our current or potential future products, infringe their intellectual property. We expect that companies in the Internet and networking industries will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could seriously harm our business.

Our operations are susceptible to outages due to fire, floods, power loss, telecommunications failures and other events beyond our control. In addition, a substantial portion of our facilities, including our headquarters, are located in Northern California, an area susceptible to earthquakes. We do not carry earthquake insurance for earthquake-related losses. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems. We do not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any of these events. Any such event could have a material adverse effect on our business, operating results and financial condition.

Sales of our products depend on increased demand for web security appliances. The market for web security appliances is a new and rapidly evolving market. If the market for web security appliances fails to grow as we anticipate, or grows more slowly than we anticipate, our business will be seriously harmed. In addition, our business will be harmed if the market for web security appliances continues to be negatively impacted by uncertainty surrounding macro-economic growth. Because this market is new, we cannot predict its potential size or future growth rate, if any.

To maintain our competitive position in a market characterized by rapid rates of technological advancement, we must continue to invest significant resources in research and development. There is no guarantee that we will accurately predict the direction in which the web security appliance market will evolve. Failure on our part to anticipate the direction of the market and develop products that meet those emerging needs will significantly impair our business and operating results and our financial condition will be materially adversely affected.

To date, our prior caching products and web security appliances and related services have accounted for all of our net sales. We anticipate that revenues from our current product family and services will continue to constitute substantially all of our net sales for the foreseeable future. As a result, a decline in the prices of, or demand for, our current product family and services, or their failure to achieve broad market acceptance, would seriously harm our business.

Our Port 80 Security Appliances are specially designed to only secure web based protocols such as http, https, ftp, and streaming. While we believe that the majority of traffic traveling over the networks of our target customers is web based, a significant amount of their network traffic is not. Our products do not protect non-web protocols. Our target customers may not wish to purchase an additional security device that only handles network traffic that is web protocol based. As a result, our target customers may decide not to purchase our products and our business would be seriously harmed.

Sales of our products depend on the increased use and widespread adoption of the Internet. Our business would be seriously harmed if the use of the Internet does not increase as anticipated. The resolution of various issues concerning the Internet will likely affect the use and adoption of the Internet. These issues include security, reliability, capacity, congestion, cost, ease of access and quality of service. Even if these issues are resolved, if the market for Internet-related products and services fails to develop, or develops at a slower pace than anticipated, our business would be seriously harmed.

trademark infringement, personal injury, invasion of privacy or other legal theories based on the nature, content or copying of these materials. It is also possible that if any information provided through any of our products contains errors, third parties could make claims against us for losses incurred in reliance on this information. Our insurance may not cover potential claims of this type or be adequate to protect us from all liability that may be imposed.

Our customers install our web security appliance solutions directly into their network infrastructures. Any errors, defects or other performance problems with our products could negatively impact the networks of our customers or other Internet users, resulting in financial or other damages to these groups. These groups may then seek damages from us for their losses. If a claim were brought against us, we may not have sufficient protection from statutory limitations or license or contract terms with our customers, and any unfavorable judicial decisions could seriously harm our business. However, a product liability claim brought against us, even if not successful, would likely be time-consuming and costly. A product liability claim could seriously harm our business reputation.

In June and July 2001, a series of putative securities class actions were filed on behalf of persons who purchased our stock between November 18, 1999 and June 8, 2001 in the U.S. District Court for the Southern District of New York. These cases have been consolidated under the case captioned Colbert Birnet, LP v. CacheFlow, Inc., et al., Civil Action No. 1-01-CV-5143. The complaints generally allege that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering of securities and maintained artificially high after-market prices. The complaints seek unspecified damages against the underwriters, our company, and certain of our current and former directors and officers. The Court has appointed a lead plaintiff for the consolidated cases. On April 19, 2002 plaintiffs filed an amended complaint. Various plaintiffs have filed similar actions asserting virtually identical allegations against over 300 other public companies, their underwriters, and their officers and directors arising out of each company’s public offerings. The lawsuits against our company, along with these other related securities class actions currently pending in the Southern District of New York, have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings and are collectively captioned In re Initial Public Offering Securities Litigation Civil Action No. 21-MC-92. We intend to defend against the allegations in the complaints vigorously and we believe the outcome would not have a material adverse effect on the business, results of operations, or financial condition of our company. In the future, other types of securities class action lawsuits could be filed against us. Securities class action litigation could result in substantial costs and divert our management’s attention and resources, which could seriously harm our business.

On August 1, 2001, Network Caching Technology L.L.C. filed suit against CacheFlow and others in the U.S. District Court for the Northern District of California. The case is captioned Network Caching Technology, L.L.C.,v. Novell, Inc., Volera, Inc., Akamai Technologies, Inc., CacheFlow, Inc., and Inktomi Corporation, civil Action No. CV-01-2079. The complaint alleges infringement of certain U.S. patents. The complaint seeks unspecified compensatory and treble damages and to permanently enjoin the defendants from infringing the patents in the future. We intend to defend against the allegations in the complaint vigorously and believe that the allegations in the lawsuit are without merit; however, if a judgment were issued against us, it could have a material adverse effect on our business, results of operations, or financial condition.

We develop products in the United States and sell them throughout the world. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Since all of our sales are currently made in United States dollars, a strengthening of the dollar could make our products less competitive in foreign markets. If any of the events described above were to occur, our net sales could be seriously impacted, since a significant portion of our net sales are derived from international operations. Net sales from international operations represented 49% and 59% of total net sales for the three-month periods ended July 31, 2002 and 2001.

As of July 31, 2002, we had approximately $33.2 million invested primarily in certificates of deposit, and fixed-rate, short-term corporate and U.S. government debt securities which are subject to interest rate risk and will decrease in value if U.S. market interest rates increase. We do not hold any derivative investments and maintain a strict investment policy, which is intended to ensure the safety and preservation of our invested funds by limiting default risk, market risk, and reinvestment risk. As of July 31, 2002, no significant changes have occurred since our Annual Report on Form 10-K for the year ended April 30, 2002.

In June and July 2001, a series of putative securities class actions were filed on behalf of persons who purchased our stock between November 18, 1999 and June 8, 2001 in the U.S. District Court for the Southern District of New York. These cases have been consolidated under the case captioned Colbert Birnet, LP v. CacheFlow, Inc., et al., Civil Action No. 1-01-CV-5143. The complaints generally allege that various investment bank underwriters engaged in improper and undisclosed activities related to the allocation of shares in our initial public offering of securities and maintained artificially high after-market prices. The complaints seek unspecified damages against the underwriters, our company, and certain of our current and former directors and officers. The Court has appointed a lead plaintiff for the consolidated cases. On April 19, 2002 plaintiffs filed an amended complaint. Various plaintiffs have filed similar actions asserting virtually identical allegations against over 300 other public companies, their underwriters, and their officers and directors arising out of each company’s public offerings. The lawsuits against our company, along with these other related securities class actions currently pending in the Southern District of New York, have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings and are collectively captioned In re Initial Public Offering Securities Litigation Civil Action No. 21-MC-92. We intend to defend against the allegations in the complaints vigorously and we believe the outcome would not have a material adverse effect on the business, results of operations, or financial condition of our company.

On August 1, 2001, Network Caching Technology L.L.C. filed suit against CacheFlow and others in the U.S. District Court for the Northern District of California. The case is captioned Network Caching Technology, L.L.C.,v. Novell, Inc., Volera, Inc., Akamai Technologies, Inc., CacheFlow, Inc., and Inktomi Corporation, civil Action No. CV-01-2079. The complaint alleges infringement of certain U.S. patents. The complaint seeks unspecified compensatory and treble damages and to permanently enjoin the defendants from infringing the patents in the future. We intend to defend against the allegations in the complaint vigorously and believe that the allegations in the lawsuit are without merit; however, if a judgment were issued against us, it could have a material adverse effect on our business, results of operations, or financial condition.

On November 19, 1999, the Company completed the initial public offering of its common stock. The shares of common stock sold in the offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (No. 333-87997). The offering closed on November 24, 1999 after we had sold all of the 5,750,000 shares of common stock registered under the Registration Statement. The initial public offering price was $24 per share for an aggregate initial public offering of $138 million. After deducting the underwriting discounts and commissions and the offering expenses, the net proceeds to the Company from the offering were approximately $126.5 million, which have been invested in investment grade securities. During the three months ended July 31, 2002, approximately $8 million was used for general corporate purposes.

CLASS		OUTSTANDING AT August 31, 2002
Common Stock, par value $0.0001		44,110,176

		PAGE
PART I. FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets as of July 31, 2002 and April 30, 2002	1

	Condensed Consolidated Statements of Operations for the three months ended July 31, 2002 and 2001	2

	Condensed Consolidated Statements of Cash Flows for the three months ended July 31, 2002 and 2001	3

	Notes to Condensed Consolidated Financial Statements	4-9

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10-27

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	27

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	27-28

Item 2.	Changes in Securities and Use of Proceeds	28

Item 6.	Exhibits and Reports on Form 8-K	28

SIGNATURES		29

CERTIFICATIONS	Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002	30-31

	July 31, 2002		April 30, 2002
Raw materials	$	566	$	416
Work-in-process		122		128
Finished goods		1,352		1,444

Total	$	2,040	$	1,988

	Three Months Ended July 31,
	2002		2001
North America	$	5,585	$	8,390
Europe		2,893		4,646
Asia		2,557		7,407

Total	$	11,035	$	20,443

	Three Months Ended July 31,
	2002		2001
Web Security	$	6,912	$	10,277
Legacy		2,037		8,310
Service		2,086		1,856

Total	$	11,035	$	20,443

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Number		Description
99.1		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

99.2		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

BLUE COAT SYSTEMS, INC.

/s/ ROBERT VERHEECKE
Robert Verheecke Chief Financial and Accounting Officer

By:		/s/ BRIAN NESMITH
		President and Chief Executive Officer
		Blue Coat Systems, Inc.

By:		/s/ ROBERT VERHEECKE
		Chief Financial Officer
		Blue Coat Systems, Inc.