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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

FOR THE QUARTERLY PERIOD ENDED JANUARY 31, 2003

OR

FOR THE TRANSITION PERIOD FROM _________________ TO _________________

COMMISSION FILE NUMBER 000-28139

BLUE COAT SYSTEMS, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE: (408) 220-2200

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

Indicate the number of shares outstanding of the issuer’s class of common stock, as of the latest practicable date.

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CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

See notes to condensed consolidated financial statements

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BLUE COAT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited; in thousands, except per share amounts)

See notes to condensed consolidated financial statements

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BLUE COAT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

See notes to condensed consolidated financial statements

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1.    Significant Accounting Policies

Basis of Presentation

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 January 31, 2003, and for the three- and nine-month periods 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 January 31, 2003 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.

On August 21, 2002, we changed our name from CacheFlow^® Inc. to Blue Coat^™ Systems, Inc. and this filing and all future SEC filings will be under the name Blue Coat Systems, Inc. The ticker symbol for our common stock has also been changed from CFLO to BCSI.

On September 16, 2002, we filed an amendment to our Certificate of Incorporation, implementing a one-for-five reverse split of our outstanding common stock. Our common stock began trading under the split adjustment at the opening of the Nasdaq Stock Market on September 16, 2002. Our number of authorized shares of common stock, however, remains at 200 million. We continue to have 10 million authorized but unissued shares of preferred stock. All share and per share amounts in these condensed consolidated financial statements and notes thereto reflect the reverse stock split for all periods presented.

Use of Estimates

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 sales returns and allowances, collectibility reserves for accounts receivable, valuation reserves for inventories, warranty reserves, lease losses and restructuring reserves and contingencies. Actual results will differ from these estimates, and such differences could be material to the consolidated financial position and results of operations.

Revenue Recognition

We recognize product revenue upon shipment, assuming that evidence of an arrangement exists, the fee is fixed and determinable and collectibility is probable, unless we have future obligations, for example, installation or 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 major distributors who have certain 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 was $2.5 million and $1.9 million, respectively, for the three months ended January 31, 2003 and 2002, and $6.8 million and $5.4 million, respectively, for the nine months ended January 31, 2003 and 2002.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Warranty Reserves

We accrue for warranty expenses at the time revenue is recognized and maintain a warranty accrual for estimated future warranty obligations based upon the relationship between historical and anticipated costs and sales volumes. The following summarizes our warranty reserve as of January 31, 2003:

Inventories

Inventories consisted of the following (in thousands):

New Accounting Pronouncements

In July 2002, the FASB approved Statement of Financial Accounting Standards (SFAS) No. 146 (Statement 146), “Accounting for Costs Associated with Exit or Disposal Activities.” Statement 146 addresses the financial accounting and reporting for obligations associated with an exit activity, including restructuring, or with a disposal of long-lived assets. Exit activities include, but are not limited to, eliminating or reducing product lines, terminating employees and contracts and relocating plant facilities or personnel. Statement 146 specifies that a company will record a liability for a cost associated with an exit or disposal activity only when that liability is incurred and can be measured at fair value. Therefore, commitment to an exit plan or a plan of disposal expresses only management’s intended future actions and, therefore, does not meet the requirement for recognizing a liability and the related expense. Statement 146 is effective prospectively for exit or disposal activities initiated after December 31, 2002, with earlier adoption encouraged. We have adopted Statement 146 for activities initiated after December 31, 2002 and the adoption of Statement 146 has not had a material impact on our financial position and results of operations.

In December 2002, the FASB issued SFAS No. 148 (Statement 148), “Accounting for Stock-Based Compensation—Transition and Disclosure” that amends SFAS No. 123, “Accounting for Stock-Based Compensation.” Statement 148 provides for (1) alternative methods of transition for an entity that voluntarily changes to the fair-value method of accounting for stock-based employee compensation; (2) requires more prominent disclosure of the effects of an entity’s accounting policy decisions with respect to stock-based employee compensation on reported income; and (3) amends APB Opinion No. 28, “Interim Financial Reporting,” to require disclosure of those effects in interim financial information. Statement 148 is effective for fiscal years ending after December 15, 2002, and for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. We have adopted the additional disclosure requirements of Statement 148 in our quarter ending January 31, 2003.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002. We have adopted FIN 45 in our quarter ending January 31, 2003 and it does not have a material impact on our financial position and results of operations.

In November 2002, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We will adopt this standard in May 2003 (beginning of our fiscal 2004) and believe that the adoption will not have a material impact on our financial position and results of operations.

Note 2.    Restructuring Charges

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 were 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 are 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. In July 2002, one of our facilities in California was subleased for the remainder of the lease term at a rental price that was consistent with our estimated restructuring plan. Our facility in Redmond, Washington was subleased in December 2002, for the remainder of the term of the original lease at a rental price consistent with our estimated restructuring plan. Due to its financial difficulties, in January 2003, our tenant in California surrendered the premises and vacated the property. The facility in California is again vacant and available for subleasing starting March 1, 2003. As a result, we have revised and increased our restructuring estimates for abandoned space by $1.6 million based on the new market trend information provided by a commercial real estate broker. We have also reduced our estimates for contract termination costs by $0.3 million, as we were able to negotiate lower settlement amounts than originally estimated. Our restructuring reserves increased by $1.3 million in the quarter ended January 31, 2003, consisting of $1.6 million of additional lease abandonment costs, offset by $0.3 million of decreased contract termination costs. As of January 31, 2003, substantially all severance costs related to domestic and international employees had been paid and $8.7 million remained accrued for lease abandonment and contract termination costs. The lease abandonment costs will be paid over the respective lease terms through 2007.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

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 planned 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, which included employee severance costs of approximately $1.7 million and certain contract termination costs of approximately $0.9 million. As of January 31, 2003, these severance payments and contract termination payments were completed.

The following table sets forth an analysis of the components of the restructuring charges and payments made through January 31, 2003 (in thousands):

Note 3. Litigation

In June and July 2001, a series of putative securities class actions were filed against the firms that underwrote the Company’s initial public offering, the Company, and some of the Company’s officers and directors in the U.S. District Court for the Southern District of New York. These cases have been consolidated under the case captioned In re CacheFlow, Inc. Initial Public Offering Securities Litigation., Civil Action No. 1-01-CV-5143. An additional putative securities class action has been filed in the United States District Court for the Southern District of Florida. The Company has not been served in that lawsuit. The complaints in these cases generally allege that the underwriters obtained excessive and undisclosed commissions in connection with the allocation of shares of common stock in the Company’s initial public offering, and maintained artificially high market prices through tie-in arrangements which required customers to buy shares in the after-market at pre-determined prices. The complaints allege that the Company and its current and former officers and directors violated Sections 11 and 15 of the Securities Act of 1933, and Sections 10(b) (and Rule 10b-5 promulgated thereunder) and 20(a) of the Securities Act of 1934, by making material false and misleading statements in the prospectus incorporated in the Company’s Form S-1 registration statement filed with the Securities and Exchange Commission in November 1999. Plaintiffs seek an unspecified amount of damages on behalf of persons who purchased the Company’s stock between November 19, 1999 and December 6, 2000. In the cases pending in New York 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 offering. The lawsuits against the 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 collectively captioned In re Initial Public Offering Securities Litigation Civil Action No. 21-MC-92. Defendants in these cases have filed omnibus motions to dismiss on common pleading issues. Oral argument on these omnibus motions to dismiss was held on

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

November 1, 2002. The Company’s officers and directors have been dismissed without prejudice in this litigation. On February 19, 2003, the Court denied in part and granted in part the motion to dismiss filed on behalf of defendants, including the Company. The Court’s order did not dismiss any claims against the Company. As a result, discovery may now proceed. The Company intends to defend against the allegations in the complaints vigorously and we believe the outcome would not have a material adverse effect on our business, results of operations or financial condition. 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. (NCT) 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. NCT and Akamai Technologies, Inc. have entered into a settlement agreement, the terms of which are unknown to us at this time. Discovery is continuing and 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.

From time to time and in the ordinary course of business, we may be subject to various other claims, charges and litigation. In the opinion of management, final judgments from such other pending claims, charges and litigation, if any, against us will not have a material adverse effect on our consolidated financial position, results of operations, or financial condition.

Note 4.    Impairment of Assets

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 No. 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- and nine-month periods ended January 31, 2003. For the three- and nine-month periods ended January 31, 2002, 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 impairment charges of $2.8 million and $123.5 million in the three- and nine-month periods ended January 31, 2002 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 our first, second and third fiscal quarters ended July 31, 2001, October 31, 2001 and January 31, 2002, respectively. If SFAS No. 142 had been effective for fiscal 2002, the adjusted net loss, excluding goodwill amortization of $2.2 million and $27.8 million for the three- and nine-month periods ended January 31, 2002, would have been $18.8 million and $176.0 million, respectively. The adjusted net loss per share for the three- and nine-month periods ended January 31, 2002 would have been $2.25 and $21.35, respectively.

Note 5.    Comprehensive Income (Loss)

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- and nine-month periods ended January 31, 2003 were $4.4 million and $15.4 million, respectively, and for the three- and nine-month periods ended January 31, 2002, were $20.7 million and $203.6 million, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 6.    Net Loss Per Common Share

Basic net loss per common share and diluted net loss per common share are presented in conformity with 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.

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

We have excluded all outstanding stock options and shares subject to repurchase from the calculation of diluted net loss per common share because all such securities are antidilutive for all periods presented.

If we had reported net income for the three and nine months ended January 31, 2003 and 2002, the calculation of diluted earnings per share for those periods would have included the effect of dilutive common stock options, computed using the treasury stock method. The calculation would have included the common stock equivalent effects of 410,922 and 317,292 stock options outstanding for the three months ended January 31, 2003 and 2002, respectively and 234,639 and 464,911 stock options outstanding for the nine months ended January 31, 2003 and 2002, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 7.    Stock Based Employee Compensation

In accordance with SFAS No. 123, “Accounting for Stock-Based Compensation”, we continue to apply the rules for stock-based compensation contained in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” using the intrinsic value method. The pro forma effect on net income and earnings per share of the fair value based method of accounting for stock-based compensation as required by SFAS No. 123 and SFAS No. 148 “Accounting for the Stock-Based Compensation—Transition and Disclosure” is disclosed below. The fair value for each stock-based award was estimated at the date of grant using the Black-Scholes option pricing model for the three and nine months ended January 31, 2003 and 2002.

Note 8.    Geographic and Product Category Information Reporting

We operate in one segment to design, develop, market and support web security appliances. Our sales consist of three product categories: web security products, legacy products and services. Total international revenue consists of sales from our U.S. operations to non-affiliated customers in other geographic regions. During the three- and nine-month periods ended January 31, 2003 and 2002, there were no intra-enterprise sales, and no material long-lived assets were located in our foreign operations during the three- and nine-month periods ended January 31, 2003 and 2002.

Sales are attributed to geographic areas based on the location of the customers. The following is a summary of net sales by geographic area (in thousands):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The following is a summary of net sales by product category (in thousands):

Note 9.    Lease Commitments

We lease certain facilities and equipment under non-cancelable operating leases. Certain of our facility leases provide for periodic rent increases based on the general rate of inflation. The following summarizes our future minimum non-cancelable operating lease payments at January 31, 2003:

Of the $10.8 million in total operating leases of abandoned space, $8.7 million is included in other accrued liabilities and accrued restructuring reserve on the Condensed Consolidated Balance Sheets at January 31, 2003. The difference of $2.3 million represents estimated sublease income.

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

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, future product development, 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, 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.

The following table sets forth, as a percentage of net sales, consolidated statements of operations data for the periods indicated:

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Overview

Blue Coat Systems, Inc. (formerly Cacheflow Inc.), also referred to in this report as “we”, “us” 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 the functionality of our enterprise proxy caches started to grow, while the service provider market opportunity 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 refer to our revenues that are bandwidth savings related as our Legacy business, and our revenues that are related to enterprise proxy caching and port 80 security as our Web Security business.

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 January 31, 2003, we had an accumulated deficit of $864.6 million, which consisted of $140.1 million of pro-forma net losses and the following non-recurring items: $411.7 million of asset impairment, $133.3 million of stock compensation expenses, $128.5 million of goodwill amortization, $32.2 million of acquired in-process technology, $18.6 million of restructuring expenses and $0.2 million of treasury stock retirement. Our net losses for the three months ended January 31, 2003 and 2002 were $4.4 million and $21.0 million, respectively, and for the nine months ended January 31, 2003 and 2002 were $15.5 million and $203.8 million, respectively. Our 2003 losses have resulted primarily from expenses incurred in the operations of our business, the amortization of deferred stock compensation, and an increase in our restructuring reserve. Our losses have decreased in the first nine months of fiscal year 2003 when compared to fiscal year 2002 due, in general, to significant reductions in operating expenses. These reductions have resulted from the restructurings implemented in August of 2001 and February of 2002. In the third quarter of fiscal year 2003 we reduced headcount further to gain additional efficiencies in our Research and Development, and Sales and Marketing areas. We experienced a significant decline in the demand for our products beginning in the quarter ended January 31, 2001, which continued through the quarter ended January 31, 2002. Since that time, our revenues have been relatively flat but have increased slightly in the past two quarters. We believe that 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 experienced over the past 12 months will continue at least through the end of fiscal year 2003. As a result, we expect to incur additional operating losses and continued negative cash flows from operations at least through the end of fiscal year 2003.

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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.

Critical Accounting Policies

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, as well as related disclosure of contingent assets and liabilities. We evaluate, on an ongoing basis, our estimates and judgments, including those related to sales returns and allowances, collectibility reserves for accounts receivable, bad debts, warranty reserves, excess inventory and purchase commitments, lease losses and restructuring accruals and contingencies. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances. Actual results will differ from those estimates and such differences could be significant.

We believe the accounting policies described below, among others, are the ones that most frequently require us to make estimates and judgments, and therefore are critical to the understanding of our results of operations:

Revenue Recognition and Allowances.    We 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, such as installation or 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 January 31, 2003 and January 31, 2002, we deferred certain revenue based on this criteria and revenue from certain customers was recognized based upon cash receipts.

In the case of shipments to our distributors who have certain rights of return and stock rotation, we defer revenue until a point of sale report is received from the distributor confirming that our products 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.

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.

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Warranty Reserves.    We accrue for warranty expenses at the time revenue is recognized and maintain a warranty accrual for estimated future warranty obligations based upon the relationship between historical and anticipated costs and sales volumes. If actual warranty expenses are greater than those projected, additional reserves and other charges against earnings may be required. If actual warranty expenses are less than projected, prior reserves could be reduced providing a positive impact on earnings.

Inventory Reserves.    We record reserves for all estimated excess and obsolete inventory. These reserves 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 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 reserves and other charges against earnings may be required. If market conditions are more favorable than projected, prior reserves for excess and obsolescence could be reduced providing a positive impact on earnings.

Restructuring Accruals.    In fiscal 2002, as a result of a continuing reduction in information technology spending rates, which negatively impacted our sales, we implemented two restructuring plans, one in February 2002 and the other in August 2001, which included reductions in workforce, contract terminations and a consolidation of facilities.

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, in fiscal 2002 we recorded charges related to estimated facilities lease losses, net of expected sublease income during fiscal 2002. In determining the net facilities lease loss 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 revised assumptions and the then-current actual events and circumstances.

In fiscal 2002, we also recorded charges for two reductions in workforce. See Note 2 “Restructuring Charges” of the condensed consolidated financial statements for further discussion.

Contingencies.    Management’s current estimated range of liability related to pending litigation is based on claims for which it is probable that a liability has been incurred and our management can estimate the amount and range of loss. We have recorded the minimum estimated liability related to those claims, where there is a range of loss. Because of the uncertainties related to both the determination of the probability of an unfavorable outcome and the amount and range of loss in the event of an unfavorable outcome, management is unable to make a reasonable estimate of the liability that could result from the remaining pending litigation. As additional information becomes available, we will assess the probability and the potential liability related to our pending litigations and revise our estimates, if necessary. Such revisions in our estimates of the potential liability could materially impact our results of operations and financial position.

Results of Operations

Net Sales.    Net sales increased to $11.7 million for the three months ended January 31, 2003 from $10.9 million for the three months ended January 31, 2002 primarily due to an increase in service revenue as well as a slight increase in product revenue. The slight increase in product revenue was characterized by a decrease in sales of our higher end systems and an increase in sales of our lower end systems and third party products. This trend is consistent with the decrease in our Legacy business and increase in our Web

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BLUE COAT SYSTEMS, INC.

Security business as discussed below. Net sales decreased to $34.0 million for the nine months ended January 31, 2003 from $44.5 million for the nine months ended January 31, 2002, which 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 17% of our net sales during the three months ended January 31, 2003. No customer accounted for more than 10% of our net sales during the three months ended January 31, 2003.

Net sales for the three months ended January 31, 2003 were $5.6 million from the U.S., or 48% of net sales, $3.7 million from Europe, or 31% of net sales, and $2.4 million from Asia, or 21% of net sales. Net sales for the three months ended January 31, 2002 were $5.2 million from the U.S., or 48% of net sales, $2.7 million from Europe, or 25% of net sales, and $3.0 million from Asia, or 27% of net sales.

Net sales for the three months ended January 31, 2003 were $7.9 million from our Web Security products, or 66% of net sales, $1.3 million from our Legacy products, or 11% of net sales, and $2.5 million from Services, or 22% of net sales. Net sales for the three months ended January 31, 2002 were $5.3 million from our Web Security products, or 48% of net sales, $3.7 million from our Legacy products, or 34% of net sales, and $1.9 million from Services, or 18% of net sales. Unless macroeconomic conditions improve sooner than anticipated, our visibility of the near-term demand for our products is limited; however, we currently anticipate that we may see modest net sales growth in the next several quarters.