SONICWALL INC - 10-Q Quarterly Report

(Former name, former address and former fiscal year, if changed since last report)

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

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

(1) Amounts as of December 31, 2002 have been derived from the audited financial statements as of the same date.

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

The accompanying condensed consolidated financial statements have been prepared by SonicWALL, Inc. (the “Company”), are unaudited and reflect all adjustments which are normal, recurring and, in the opinion of management, necessary for a fair presentation of the financial position and the results of operations of the Company for the interim periods presented. The statements have been prepared in accordance with the regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not include all information and footnotes required by generally accepted accounting principles. The results of operations for the three months ended March 31, 2003 are not necessarily indicative of the operating results to be expected for the full fiscal year or future operating periods. The information included in this report should be read in conjunction with the audited consolidated financial statements and notes thereto for the fiscal year ended December 31, 2002, the critical accounting policies, and the risk factors as set forth in the Company’s Annual Report on Form 10-K. These publicly available documents are available on the SEC’s website at http://www.sec.gov. You may also read and copy any document we file at the SEC’s public reference room in Washington, D.C., New York, NY and Chicago, IL. Please call the SEC at 1-800-SEC-0330 for further information on the public reference rooms.

The consolidated financial statements include the balances of the Company and its wholly-owned subsidiaries Sonic Systems International, Inc., a Delaware corporation, Phobos Corporation, a Utah corporation, SonicWALL Switzerland, SonicWALL Norway and SonicWALL B.V., a subsidiary in The Netherlands. Sonic Systems International, Inc. is intended to be a sales office but to date has not had any significant transactions. All intercompany accounts and transactions have been eliminated in consolidation.

The following is a reconciliation of the numerators and denominators of the basic and diluted net loss per share computations for the periods presented:

Potentially dilutive securities of 10,098,576 and 13,082,911 for the three-months ended March 31, 2003 and 2002, respectively, consisting of options, warrants and restricted stock were not included in the computation of diluted net loss per share because their effect would be anti-dilutive.

Comprehensive loss includes unrealized gains and losses on investment securities that have been reflected as a component of shareholders’ equity and have not affected net loss. The amount of income tax expense or benefit allocated to unrealized gains or losses on investment securities is equivalent to the effective tax rate in each of the respective periods. Comprehensive loss is comprised, net of tax, as follows (in thousands):

Accumulated other comprehensive loss, as presented on the accompanying condensed consolidated balance sheets, consists of the unrealized gains and losses on available-for-sale securities.

During the second quarter of 2002, the Company’s management approved and initiated a restructuring plan designed to reduce its cost structure and integrate certain Company functions. Accordingly, the Company recognized a restructuring charge of approximately $4.0 million during 2002. The restructuring charge consisted of $858,000 for workforce reduction costs across all geographic regions and functions, $1.9 million for excess facilities consolidation costs related to lease commitments for space no longer needed to support ongoing operations and $1.2 million for fixed asset impairments consisting primarily of leasehold improvements, computer equipment and related software, and furniture and fixtures.

During the first quarter of 2003, the Company recorded additional restructuring charges related to the 2002 restructuring plan totaling $162,000, consisting of $187,000 related to properties abandoned in connection with facilities consolidation, offset by $25,000 reversal for severance accrual for an employee who has remained with the Company. The additional facilities charges resulted from revisions of the Company’s estimates of future sublease income due to further deterioration of real estate market conditions. The estimated facility costs were based on the Company’s contractual obligations, net of assumed sublease income, based on current comparable rates for leases in their respective markets. Should facilities operating lease rental rates continue to decrease in these markets or should it take longer than expected to find a suitable tenant to sublease these facilities, the actual loss could exceed this estimate. Future cash outlays are anticipated through December 2005, unless the Company negotiates to exit the leases at an earlier date.

The following table sets forth an analysis of the components of the second quarter of fiscal 2002 restructuring charge and the payments made against the reserve through March 31, 2003 (in thousands):

The Company has adopted the disclosure-only provisions of SFAS No. 123. Accordingly, no compensation cost has been recognized for the Company’s stock option plan and the fair value of purchase rights issued under the ESPP in the accompanying statements of operations. Had compensation cost for the Company’s stock option plan and ESPP been determined based on the fair market value at the grant dates for stock options and purchase rights granted consistent with the provisions of SFAS No. 123, the Company’s net loss would have been changed to the pro forma amounts indicated below:

In January 2003, the Company offered a voluntary stock option exchange program to its employees. The plan allowed employees, at their election, to cancel all or any portion of their unexercised stock options with exercise prices equal to or greater than $10.00 per share effective February 7, 2003, provided that, should an employee participate, any options granted to that employee within the six-month period preceding February 7, 2003 would be automatically cancelled. In exchange, the employee will be granted on August 11, 2003, provided they are still employed by the Company at that time, new options to purchase a number of shares equal to the number of shares underlying the cancelled options. The exercise price per share of the new options will be as quoted on the Nasdaq National Market at the close of business on the new option grant date. Members of the SonicWALL Board of Directors, SonicWALL executive officers and certain other employees are not eligible to participate in the program.

SonicWALL expects there will be no compensation charge as a result of the stock option exchange program.

The Company outsources its manufacturing function to one third-party contract manufacturer and at March 31, 2003 it has purchase obligations to this vendor totaling $6.7 million. The Company is contingently liable for any inventory owned by the contract manufacturer that becomes excess and obsolete.

The Company’s standard warranty period for hardware is one to two years and includes repair or replacement guarantees for units with product defects. The Company’s software products carry a 90 day warranty and include technical assistance, insignificant bug fixes and feature updates. The standard warranty period is one to two years. The Company estimates the accrual for future warranty costs based upon its historical cost experience and its current and anticipated product failure rates. If actual product failure rates or replacement costs differ from its estimates, revisions to the estimated warranty obligations would be required. However the Company concluded that no adjustment to pre-existing warranty accruals were necessary in the three months ended March 31, 2003. A reconciliation of the changes to the Company’s warranty accrual as of March 31, 2003 was as follows:

On December 5, 2001, a securities class action complaint was filed in the U.S. District Court for the Southern District of New York against the Company, three of its officers and directors, and certain of the underwriters in the Company’s initial public offering in November 1999 and its follow-on offering in March 2000. Similar complaints were filed in the same court against numerous public companies that conducted initial public offerings (“IPOs”) of their common stock since the mid-1990s. All of these lawsuits were consolidated for pretrial purposes before Judge Shira Scheindlin. On April 19, 2002, plaintiffs filed an amended complaint. The amended complaint alleges claims under the Securities Act of 1933 and the Securities Exchange Act of 1934, and seeks damages or rescission for misrepresentations or omissions in the prospectuses relating to, among other things, the alleged receipt of excessive and undisclosed commissions by the underwriters in connection with the allocation of shares of

common stock in the Company’s public offerings. On July 15, 2002, the issuers filed an omnibus motion to dismiss for failure to comply with applicable pleading standards. On October 8, 2002, the Court entered an Order of Dismissal as to all of the individual defendants in the SonicWALL IPO litigation, without prejudice. On February 19, 2003, the Court denied the motion to dismiss the Company’s claims. The Company intends to defend the action vigorously. No estimate can be made of the possible loss or possible range of loss, if any, associated with the resolution of this contingency. As a result, no loss has been accrued in our financial statements as of March 31, 2003.

The Company is party to routine litigation incident to its business. The Company believes that none of these legal proceedings will have a material adverse effect on its consolidated financial statements take as a whole or its results of operations, financial position and cash flows.

In accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”), the Company will annually analyze the carrying value of goodwill and will adjust the carrying value if the assets’ value has been impaired. In addition, the Company will periodically evaluate if there are any events or indicator circumstances that would require an impairment assessment of the carrying value of the goodwill between each annual impairment assessment. For the three months ended March 31, 2003, no indicators of goodwill impairment were identified. The Company has elected to perform its annual impairment analysis during the fourth quarter of each year.

The gross carrying amounts and accumulated amortization of intangible assets are as follows (in thousands):

In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (“SFAS No. 146”), Accounting for Costs Associated with Exit or Disposal Activities, which nullifies Emerging Issues Task Force (“EITF”) Issue No. 94-3 (“EITF No. 94-3”), Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and states that an entity’s commitment to exit plan, by itself, does not create a present obligation that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of SFAS No. 146 are effective for exit or disposal activities initiated after December 31, 2002. The Company does not expect the adoption of SFAS No. 146 to have a material impact upon its financial position, cash flows or results of operations.

In November 2002, the EITF reached a consensus on Emerging Issues Task Force Issue No. 00-21 (“EITF No. 00-21”), Accounting for Revenue Arrangements with Multiple Deliverable, on a model to be used to determine when a revenue arrangement with multiple deliverables should be divided into separate units of accounting and, if separation is appropriate, how the arrangement consideration should be allocated to the identified accounting units. The EITF also reached a consensus that this guidance should be effective for all revenue arrangements entered into in fiscal periods beginning after June 15, 2003, which for the Company would result in an adoption in the quarter ending September 30, 2003. The Company is currently assessing what the impact of the guidance would be on its financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN No. 46”), Consolidation of Variable Interest Entities, and Interpretation of ARB No. 51. FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN No. 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN No. 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company is currently assessing what the impact of the guidance would be on its financial statements.

This Form 10-Q contains forward-looking statements which relate to future events or our future financial performance. In many cases you can identify forward-looking statements by terminology such as “may”, “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “intend” or “continue,” or the negative of such terms and other comparable terminology. In addition, forward-looking statements in this document include, but are not limited to, those regarding: our sales efforts with respect to the enterprise market; product revenues and percentage of revenues derived from our different products; increased market opportunity for upgrade and subscription products and our dedication of resources with respect to upgrade and subscription products; expanded subscription revenue; revenue trends from license and service revenues; revenue trends resulting from the increased bundling and VPN functionality in our firewall products; expenditures for research and development, sales and marketing, and general and administrative functions; and our belief that existing cash, cash equivalents and short-term investments will be sufficient to meet our cash requirements for at least the next twelve months. These statements are only predictions, and they are subject to risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of a variety of factors, including, but not limited to, those set forth herein under the heading “Risk Factors” and also under the heading “Risk Factors” in our Form 10-K filed with the Securities and Exchange Commission. References to “we,” “our,” and “us” refer to SonicWALL, Inc. and its subsidiaries.

SonicWALL designs, develops, manufactures and sells Internet security infrastructure products designed to provide secure Internet access to broadband customers, enable secure Internet-based connectivity for distributed organizations and process secure transactions for enterprises and service providers. We believe our access security appliances provide high performance, robust, reliable, easy-to-use and affordable Internet firewall security and virtual private networking (“VPN”) functionalities. We also sell value-added security applications for our access security appliances including content filtering and anti-virus protection on an annual subscription basis. Our transaction security products provide high performance SSL acceleration and offloading that enable service providers and enterprises to deploy e-commerce and web-based applications without degrading web server performance. We sell our products primarily to customers in the small to medium enterprise, e-commerce, service provider, branch office and telecommuter markets. As of March 31, 2003, we have sold more than 350,000 of our Internet security appliances worldwide.

From inception through 1996, we derived substantially all of our revenue from the development and marketing of networking products for Apple Macintosh computers. These products enabled Apple Macintosh computers to connect to computer networks using Ethernet communications standards. In 1998, we made a strategic business decision to concentrate our resources in the Internet security market. As a result, we stopped shipments of our Ethernet product line during December 1999. In October 1997, we introduced our first Internet security appliance, the SonicWALL DMZ, and began volume shipments in 1998. We have since focused all our development, marketing and sales efforts on the Internet security appliance market, and we have progressively introduced a broad line of Internet security products and services from 1998 through 2002.

Our SonicWALL product line provides our customers with comprehensive integrated security including firewall, VPN, anti-virus, content filtering and SSL encryption and decryption functionality, giving users affordable Internet security and secure Internet transactions. SonicWALL delivers appliance solutions that we believe are high performance, easy to install and cost-effective. With current suggested retail prices ranging from $495 to $9,995, our products are designed to enable customers to reduce purchase costs and avoid hiring costly information technology personnel for Internet security. By using an embedded single purpose operating system and a solid state hardware design without moving parts, our products maximize reliability and uptime. The SonicWALL access security products can be used in networks ranging in size from one to more than 15,000 users and are fully compatible with VPN technology from more expensive enterprise security solutions offered by, among others, Check Point Software, Nokia, Nortel Networks and Cisco.

On November 14, 2000, we acquired Phobos Corporation (“Phobos”) for $211.5 million in a transaction accounted for as a purchase. Phobos designed, developed and sold scaleable SSL solutions for Internet service providers, application service providers, e-commerce companies and web hosting and enterprise network operations centers. Under the terms of the merger, 0.615 shares of our common stock were exchanged for each share of outstanding Phobos common stock at November 14, 2000, the closing date of the merger. In connection with the merger, we issued 9,906,000 shares of our common stock, and options and warrants to purchase 2,294,000 shares of our common stock. The total purchase price was based upon the average fair value of our common stock for five trading days surrounding the date the acquisition was announced. In addition, we paid $30 million in cash to the shareholders of Phobos based upon their pro-rata ownership percentage in Phobos. The merger agreement also provided for up to an additional $20 million in cash to be payable upon achievement of certain quarterly revenue targets during 2001, of which $4 million was earned and recorded as additional goodwill. Payments in the amount of $3 million and $1 million were made in 2001 and 2002, respectively. During the quarter ended June 30, 2002, we received 317,244 shares of our common

stock back from Phobos in connection with the settlement and termination of the escrow fund, which resulted in a reduction of goodwill of approximately $5 million.

On March 8, 2001, we acquired Ignyte Technology, Inc. (“Ignyte”) in a transaction accounted for as a purchase. Ignyte provided in-depth consulting, design and support for enterprise networking customers, as well as management of their Internet security needs. As of the acquisition date we recorded the fair value of Ignyte’s assets and liabilities. The total purchase price of $10.2 million was based upon the average fair value of our common stock for five trading days surrounding the date the acquisition was announced. The purchase price consisted of $685,000 in cash consideration, $600,000 in closing costs and 735,000 shares issued for common stock and options of Ignyte valued at approximately $9 million.

On October 25, 2001, we acquired substantially all of the assets and certain liabilities of RedCreek Communications, Inc. (“RedCreek”) in a transaction accounted for as a purchase. RedCreek developed and sold standards-based Internet security products for corporate data communications networks that enable the secure transmission of data between offices over the Internet. At the closing of the acquisition, we paid $12.5 million in cash, assumed certain current accounts payable and other liabilities of RedCreek, and forgave repayment of bridge loan amounts payable by RedCreek to us that were used by RedCreek to fund its operating expenses from the date the purchase agreement was signed until the closing of the acquisition. We also assumed RedCreek’s 2001 stock option plan and 206,500 options valued at $2.2 million issued thereunder. In the event RedCreek products achieve certain quarterly sales targets during 2001 to 2003, we are obligated to pay additional purchase consideration of up to $4.5 million in cash, which payments would be recorded, if and when payable, as adjustments to goodwill. As of March 31, 2003, no additional payments have been earned.

During the course of 2001, we completed several minor transactions for the acquisition of certain technologies and personnel for an aggregate purchase consideration of 257,000 shares of common stock valued at approximately $4.3 million and approximately $2.6 million in cash consideration. During the quarter ended December 31, 2002, we issued $500,000 in cash and 50,000 shares of our common stock related to one of our acquisitions in 2001.

During the second quarter of 2002, we approved and initiated a restructuring plan designed to reduce our cost structure and integrate certain company functions. Accordingly, we recognized a restructuring charge of approximately $4.0 million during 2002. The restructuring charge consisted of $858,000 for workforce reduction costs across all geographic regions and functions, $1.9 million for excess facilities consolidation costs related to lease commitments for space no longer needed to support ongoing operations and $1.2 million for fixed asset impairments consisting primarily of leasehold improvements, computer equipment and related software, and furniture and fixtures.

During the first quarter of 2003, we recorded additional restructuring charges related to the 2002 restructuring plan totaling $162,000, consisting of $187,000 related to properties abandoned in connection with facilities consolidation, offset by $25,000 reversal for severance accrual for an employee who has remained with us. The additional facilities charges resulted from revisions of our estimates of future sublease income due to further deterioration of real estate market conditions. The estimated facility costs were based on our contractual obligations, net of assumed sublease income, based on current comparable rates for leases in their respective markets. Should facilities operating lease rental rates continue to decrease in these markets or should it take longer than expected to find a suitable tenant to sublease these facilities, the actual loss could exceed this estimate. Future cash outlays are anticipated through December 2005, unless we negotiate to exit the leases at an earlier date.

The following table sets forth an analysis of the components of the second quarter of fiscal 2002 restructuring charge and the payments made against the reserve through March 31, 2003 (in thousands):

As a result of the restructuring, we expect to reduce compensation related expenses by approximately $1.7 million per quarter. We also expect to reduce facility related operating expenses in the amount of $209,000 per quarter, through the lease term expiring at the end of fiscal 2003. In the period from when the restructuring was initiated through March 31, 2003, we realized the expected benefits of these efforts.

The following table sets forth certain consolidated financial data for the periods indicated as a percentage of total revenue:

Product revenue. Revenue from sales of our products decreased to $14.3 million in the three months ended March 31, 2003 from $19.6 million in the three months ended March 31, 2002. The decrease in product revenues was across all geographies, and related primarily to a decrease in revenue from our PRO product line. We believe the decrease in PRO product line sales relates to increased competition in the mid-tier of our market. During the first quarter of 2003, we introduced new PRO products, our PRO 230 and PRO 330, which were designed to include new features to more effectively compete with other products in the market. These new products were not released into our Asia Pacific markets until late in the quarter, and this factor together with a weak Asian economy contributed to a 38% decrease in total revenues, or $1.1 million, from this region in the first quarter of 2003 compared to 2002. In addition, our OEM product revenues decreased by approximately $1 million in the first quarter of 2003 compared to 2002, which primarily related to lower sales of our SSL appliances to Cisco Systems. Our Small to Medium Enterprise (“SME”) products, including our TELE, SOHO and PRO product lines, represented approximately 94% of product revenues in the first quarter of 2003, compared to 87% of product revenues in the first quarter of 2002. Our transaction security and large network access security products, including our SSL and GX product lines and VPN products acquired from Redcreek, represented approximately 6% of product revenues in the first quarter of 2003 compared to 10% in the first quarter of 2002, a decrease of $1.1 million. In the first quarter of 2002, we generated approximately 3%, or $600,000, of product revenues from certain legacy products of acquired entities that have generally been brought to end of life within the first year of combined operations. These revenues have been generated from network infrastructure products that are not part of our long-term strategy. In the first quarter of 2003, we had insignificant product revenues from legacy products.

We anticipate going forward that a majority of our product revenues will continue to be generated from the SME access security market. We will continue to reach this market through our distribution and OEM channels. We have an enterprise sales team to address the needs of large enterprises. In addition to selling our GX and Global Management products, we believe that successful penetration of these accounts is a means of furthering our penetration of the SME market, as the perimeter of these networks are the branch office and telecommuter opportunities of the SME market. Our enterprise sales team and an OEM partner are also selling our transaction security products into medium and large enterprises. We expect transaction security revenues to represent less than 10% of product revenues in 2003, because we believe the size of the transaction security market is much smaller than the SME access security market.

License and service revenue. Revenue from licenses and services decreased to $6.1 million in the three months ended March 31, 2003 from $8.5 million in the three months ended March 31, 2002. License and service revenue is comprised primarily of licenses and services such as VPN upgrades, node upgrades, anti-virus protection and content filtering services that are sold into the installed base of access security appliances. In addition, we generate license and service revenues from extended service contracts, licensing of our Global Management software, licensing of our VPN ASIC, licensing of our firewall software, and professional services related to training, consulting and engineering services.

We expect the market opportunity for our subscription products sold to our installed base to increase as our installed base grows. We are dedicating increased sales and marketing resources to sell into our installed base, and we are also focusing resources on marketing renewals for existing subscriptions. In the first quarter of 2003, revenues from our two primary subscription products, content filtering and anti-virus protection, increased to $2.3 million from $1.8 million in the first quarter of 2002. In addition, in December 2001, we introduced new subscription service offerings across our product lines to provide our customers maintenance releases of our firmware and technical support. These offerings were very new to the market in the first quarter of 2002. In the first quarter of 2003, revenue from service contracts increased to approximately $1.7 million from approximately $600,000 in the first quarter of 2002, primarily due to this expanded offering and increased marketing efforts to our installed base.

Historically, a significant component of our license and services revenues have been VPN upgrades, which have been offered to our customers as separately licensed products after their initial purchase of an appliance. We continue to offer VPN upgrades to our customers that purchase products without bundled VPN functionality. However, there has been a trend in our market to offer VPN functionality as a bundled feature in a firewall product, and in response to this trend we have offered our customers the opportunity to purchase our products with bundled VPN functionality. The result of this trend has been a decline in our VPN upgrade license revenues. VPN upgrades represented 13% and 22% of license and service revenues in the first quarter of 2003 and 2002, respectively, a $1.1 million decrease. We expect this trend to continue as more of our customers choose to purchase VPN functionality through our bundled offerings.

Revenues from the licensing of our software and ASIC technology are more difficult to predict. Unlike our upgrade and subscription products marketed to our installed base, we do not have dedicated sales and marketing resources to pursue licensing transactions for our technology, but rather we pursue these opportunities as they arise. We generated approximately $2.3 million of revenues from the licensing of our software and ASIC technology in the first quarter of 2002, and generated insignificant revenues from the licensing of these products in the first quarter of 2003. This decrease related to the fact that we have not entered into any new license agreements for our ASIC technology. We do not believe that we will generate additional license revenues from our ASIC technology in the future due to the maturity of the underlying technology and competitive technologies available on the market. In addition, we generated minimal revenues from our OEM agreement with Netgear, under which they licensed our firewall software for integration into their products

Cost of product revenue; gross margin. Cost of product revenue includes all costs associated with the production of our products, including cost of materials, manufacturing and assembly costs paid to contract manufacturers and related overhead costs associated with our manufacturing operations personnel. Additionally, warranty costs and inventory provisions or write-downs are included in cost of product revenue. Cost of product revenue decreased to $5.8 million in the three months ended March 31, 2003 from $6.9 million in the three months ended March 31, 2002, primarily related to a decrease in units shipped of approximately 5,000 units. Gross margin from product sales decreased to $8.4 million, or 59% of product revenue, for the three months ended March 31, 2003 from $12.7 million, or 65% of product revenue, in the three months ended March 31, 2002. The decrease in product gross margin is primarily attributable to lower average selling prices. Our average selling prices decreased due to competitive pricing pressure on our PRO products. In addition, we incurred price protection and other reserves related to the introduction of our PRO 230 and PRO 330 products. Finally, our gross margins were impacted by a higher mix of our product revenues being generated from our lower end TELE and SOHO products, some of which generate lower gross margins than our PRO products.

Cost of license and service revenue; gross margin. Cost of license and service revenue includes all costs associated with the production and delivery of our license and service products, including cost of packaging and materials and related costs paid to contract manufacturers, technical support costs related to our service contracts, co-location costs related to certain subscription products and personnel costs related to the delivery of training, consulting and professional services. Cost of license

and service revenue increased to $1.6 million in the three months ended March 31, 2003 from $1 million in the three months ended March 31, 2002. This increase related primarily to technical support costs to support our increased service contract offerings.

Gross margin from license and service sales decreased to $4.5 million, or 74% of license and service revenue, for the three months ended March 31, 2003 from $7.5 million, or 88% of license and service revenue, in the three months ended March 31, 2002. This decrease related primarily to a decrease in sales of certain high gross margin products, including VPN upgrades and ASIC and firewall software licensing revenue, and increased sales of our lower gross margin service contract offerings.

Our gross margin has been and will continue to be affected by a variety of factors, including among others competition; the mix and average selling prices of products; new product introductions and enhancements; fluctuations in manufacturing volumes; the cost of components and manufacturing labor; and the costs of providing technical support services under our service contracts. We must manage each of these factors effectively in order to maintain our gross margins levels.

Research and development. Research and development expenses primarily consist of personnel costs, contract consultants, outside testing services and equipment and supplies associated with enhancing existing products and developing new products. Research and development expenses decreased by 16% to $4.3 million in the three months ended March 31, 2003 from $5.1 million in the three months ended March 31, 2002. These expenses represented 21.2% and 18.2%, respectively, of revenue for such periods. The decrease in absolute dollars was primarily as a result of our restructuring plan, which was implemented in the second quarter of 2002 whereby salaries and related benefits decreased by approximately $640,000 as a result of termination of certain engineering personnel. In addition, we reduced our spending on fees paid to outside consultants by $180,000 in connection with our cost reduction efforts. We plan to increase our absolute dollar investments in research and development in the remainder of 2003 to expedite the development of certain key technologies that we believe are necessary for us to remain competitive. In particular we plan to increase our headcount during the remainder of 2003 to expedite the development of new PRO products, new subscription services and a new generation of our firmware.

Sales and marketing. Sales and marketing expenses primarily consist of personnel costs, including commissions, costs associated with the development of our business and corporate identification, costs related to customer support, travel, tradeshows, promotional and advertising costs. Sales and marketing expenses decreased 11% to $10.3 million in the three months ended March 31, 2003 from $11.5 million in the three months ended March 31, 2002. These expenses were 50.6% and 41.0% of net sales for such periods, respectively. The decrease in absolute dollars was primarily related to our restructuring plan, which was implemented in the second quarter of 2002 whereby salaries and related benefits decreased by approximately $1.1 million as a result of termination of certain sales and marketing personnel. In addition, our co-op advertising costs decreased by approximately $500,000 as a result of the decrease in revenues. These decreases were offset by an increase of approximately $320,000 for our customer service costs related to a larger installed base. We expect to direct our sales and marketing expenses toward the expansion of domestic and international markets, introduction of new products and establishment and expansion of new distribution channels and OEM relationships.

General and administrative. General and administrative expenses were $2.5 million for the three months ended March 31, 2003, compared to $2.8 million for the three months ended March 31, 2002. These expenses represented 12.5% and 10% of total revenue for such periods, respectively. The decrease in absolute dollars was primarily as a result of our restructuring plan, which was implemented in the second quarter of 2002 whereby salaries and related benefits decreased by approximately $320,000. In addition we had a reduction in our allowance for doubtful accounts of approximately $200,000 related to a reduction in accounts receivable of approximately $4 million during the three months ended March 31, 2003. These decreases were offset by increased professional fees related in part to increased costs of corporate governance related to implementation of the Sarbanes-Oxley Act and increased insurance costs totaling approximately $220,000. We believe that general and administrative expenses will increase in absolute dollars and remain relatively stable as a percentage of total revenue as we incur costs related to new regulatory and corporate governance matters.

Amortization of goodwill and purchased intangibles. Amortization of goodwill and purchased intangibles represents the excess of the aggregate purchase price over the fair market value of the net tangible assets acquired by us in a business acquisition accounted for by us as a purchase. Purchased intangible assets, including existing technology, are being amortized over the estimated useful lives of three to six-year periods. In accordance with SFAS No. 142 “Goodwill and Other Intangible Assets,” goodwill and intangibles related to acquired workforce are no longer being amortized effective January 1, 2002. Amortization of purchased intangibles was $2.5 million for the three months ended March 31, 2003 compared to $2.6 million for the three months ended March 31, 2002. The primary reason for the reduction was due to complete amortization of some of the purchased intangible assets acquired under the RedCreek acquisition. Amortization for the three months ended March 31, 2003 primarily consisted of $2.4 million, $49,000 and $38,000 relating to the amortization of intangibles associated with the acquisitions of Phobos, RedCreek, and Ignyte, respectively. Amortization for the three months ended March 31, 2002 primarily consisted of $2.4

million, $87,000 and $38,000 relating to the amortization of purchased intangibles associated with the acquisitions of Phobos, RedCreek and Ignyte, respectively.

Restructuring charges. As previously discussed, during the second quarter of 2002, we implemented a restructuring plan designed to reduce our cost structure and integrate certain company functions. The execution of the restructuring was completed as of the second quarter of 2002; however during the quarter ended March 31, 2003 we recorded additional restructuring charges totaling $162,000, consisting of $187,000 related to properties abandoned in connection with facilities consolidation, offset by $25,000 reversal for severance accrual for an employee who has remained with the Company. The additional facilities charges resulted from revisions of our estimates of future sublease income due to the further deterioration of real estate market conditions. We may adjust our restructuring related estimates in the future, if necessary. No similar expenses were incurred during the three months ended March 31, 2002.

Stock-based compensation. Stock-based compensation was $143,000 and $628,000 for the three months ended March 31, 2003 and 2002, respectively. These amounts primarily relate to the recognition of stock compensation of unvested options assumed in the Phobos and RedCreek acquisitions. We are amortizing deferred stock compensation over the vesting periods of the applicable options.

Interest income and other expense, net. Interest income and other expense, net consists primarily of interest income on our cash, cash equivalents and short-term investments, and was $1.3 million for the three months ended March 31, 2003 compared to $1.7 million in the three months March 31, 2002. The fluctuations in the short-term interest rates directly influence the interest income recognized by us. Interest rates for the three months ended March 31, 2003 decreased over the corresponding period of the prior fiscal year, resulting in lower interest income.

Benefit from income taxes. The benefit from income taxes in the three months ended March 31, 2003 was $1.9 million as compared to $170,000 in the three months ended March 31, 2002. In both periods, the benefit for income taxes is based on an estimated effective rate for each of the respective calendar years. Our effective tax rate of 33% and 23% for the three months ended March 31, 2003 and 2002, respectively, differs from the statutory federal and state tax rates for the three months ended March 31, 2003 and 2002 due principally to the effect of amortization of stock-based compensation, goodwill and intangibles, which are permanent, non-deductible book/tax differences.

For the three months ended March 31, 2003, our cash, cash equivalents and short-term investments, consisting principally of commercial paper, corporate bonds, U.S. government securities and money market funds, increased by $2.1 million to $235 million as compared to an increase of $4.2 million to $231.4 million for the three month period ended March 31, 2002. Our working capital decreased for the three months ended March 31, 2003 by $1.6 million to $232.2 million as compared to an increase of $3.5 million to $228 million for the three months ended March 31, 2002.

For the three months ended March 31, 2003, cash generated from operating activities totaled $2.4 million compared to $6.3 million in the same period of the prior year. For the three month period ended March 31, 2003, cash provided by operating activities was the result of collection of accounts receivables and increases in accounts payable which was offset by payments of accrued liabilities, increases of prepaid expenses and net loss adjusted by non-cash items. For the three-month period ended March 31, 2002, cash provided by operating activities was a result of net loss adjusted by non-cash items and collection of accounts receivable offset by increases in inventory.

For the three months ended March 31, 2003, we generated cash from investing activities totaling $35.3 million, principally as a result of the net sale and maturity of $36.2 million of short-term investments offset by $831,000 used to purchase property and equipment. Net cash used in investing activities for the three months ended March 31, 2002 was $22.2 million, principally as a result of the net purchase of approximately $19.8 million of short-term investments and $940,000 of property and equipment. In addition, $1.4 million was used for the repayment of liabilities assumed upon the acquisitions of other businesses.

Financing activities provided $662,000 and $2.1 million for the three months ended March 31, 2003 and 2002, respectively. The decrease in cash provided by financing activities relates to a decrease in sales of common stock, due to a decrease in quantity of stock options exercised for the three months ended March 31, 2003, compared to the three months ended March 31, 2002.

We believe our existing cash, cash equivalents and short-term investments will be sufficient to meet our cash requirements at least through the next twelve months. However, we may be required, or could elect, to seek additional funding prior to that time. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support product development efforts and expansion of sales and marketing, the timing of introductions of new products and enhancements to existing products, and market acceptance of our products. We cannot assure you that additional equity or debt financing will be available on acceptable terms or at all. Our sources of liquidity beyond twelve months, in management’s opinion, will be our then current cash balances, funds from operations and whatever long-term credit facilities we can arrange. We have no other agreements or arrangements with third parties to provide us with sources of liquidity and capital resources beyond twelve months.

We do not have any other debt, long-term obligations or long-term capital commitments. See Note 10 to the December 31, 2002 Consolidated Financial Statements filed on Form 10-K for information regarding our operating leases. As of December 31, 2002, our aggregate future minimum lease commitments through 2006 totaled $6 million.

We outsource our manufacturing function to one third-party contract manufacturer and at March 31, 2003 we had purchase obligations to this vendor totaling $6.7 million. We are contingently liable for any inventory owned by the contract manufacturer that becomes excess and obsolete.

In June 2002, the FASB issued Statement of Financial Accounting Standards No. 146 (“SFAS No. 146”), Accounting for Costs Associated with Exit or Disposal Activities, which nullifies Emerging Issues Task Force (“EITF”) Issue No. 94-3 (“EITF No. 94-3”), Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and states that an entity’s commitment to exit plan, by itself, does not create a present obligation that meets the definition of a liability. SFAS No. 146 also establishes that fair value is the objective for initial measurement of the liability. The provisions of SFAS No. 146 are effective for exit or disposal activities initiated after December 31, 2002. We do not expect the adoption of SFAS No. 146 to have a material impact upon our financial position, cash flows or results of operations.

In November 2002, the EITF reached a consensus on Emerging Issues Task Force Issue No. 00-21 (“EITF No. 00-21”), Accounting for Revenue Arrangements with Multiple Deliverable, on a model to be used to determine when a revenue arrangement with multiple deliverables should be divided into separate units of accounting and, if separation is appropriate, how the arrangement consideration should be allocated to the identified accounting units. The EITF also reached a consensus that this guidance should be effective for all revenue arrangements entered into in fiscal periods beginning after June 15, 2003, which for us would result in an adoption in the quarter ending September 30, 2003. We are currently assessing what the impact of the guidance would be on our financial statements.

In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN No. 46”), Consolidation of Variable Interest Entities, and Interpretation of ARB No. 51. FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN No. 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN No. 46 must be applied for the first interim or annual period beginning after June 15, 2003. We are currently assessing what the impact of the guidance would be on our financial statements.

You should carefully review the following risks associated with owning our common stock. Our business, operating results or financial condition could be materially adversely affected by any of the following risks. You should also refer to the other information set forth in this report and incorporated by reference herein, including our financial statements and the related notes. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

We have difficulty predicting our future operating results or profitability due to volatility in general economic conditions and the Internet security market.

Overall weakness in the general economy and volatility in the demand for Internet security products are two of the many factors underlying our inability to predict our revenue for a given period. We base our spending levels for product development, sales and marketing, and other operating expenses largely on our expected future revenue. A large proportion of our expenses are fixed for a particular quarter or year, and therefore, we may be unable to decrease our spending in time to compensate for any unexpected quarterly or annual shortfall in revenue. As a result, any shortfall in revenue could adversely affect our operating results. For the three months ended March 31, 2003, we reported a net loss of $3.9 million. We do not know if we will be able to achieve profitability in the future.

We depend on two major distributors for a significant amount of our revenue, and if they or others cancel or delay purchase orders, our revenue may decline and the price of our stock may fall.

To date, sales to two distributors have accounted for a significant portion of our revenue. For the three month period ended March 31, 2003, approximately 93% of our sales were to distributors and resellers, and Ingram Micro and Tech Data accounted for approximately 35% and 8% of our revenue, respectively. For the year ended December 31, 2002, approximately 91% of our sales were to distributors and resellers, and Ingram Micro and Tech Data accounted for approximately 21% and 26% of our revenue, respectively. For the year ended December 31, 2001, approximately 88% of our sales were to distributors, and Ingram Micro and Tech Data accounted for approximately 27% and 19% of our revenue, respectively. In addition, for the three months ended March 31, 2003 our top 10 customers accounted for 68% of our total revenues. For the year ended December 31, 2002 and 2001 our top 10 customers accounted for 70% or more of total revenues. We anticipate that sales of our products to relatively few customers will continue to account for a significant portion of our revenue. Although we have limited one-year agreements with Ingram Micro and Tech Data and certain other large distributors, these contracts are subject to termination at any time. We cannot assure you that any of these customers will continue to place orders with us, that orders by these customers will continue at the levels of previous periods or that we will be able to obtain large orders from new customers. If any of the foregoing should occur, our revenues will likely decline and our business will be adversely affected. In addition, as of March 31, 2003 Ingram Micro and Tech Data represented $3.8 million and $730,000, respectively of our accounts receivable balance, constituting 36% and 7%, respectively of our total receivables. As of December 31, 2002, Ingram Micro and Tech Data represented $2 million and $5.5 million, respectively, of our accounts receivable balance, constituting 14% and 37%, respectively, of total receivables. The failure of any of these customers to pay us in a timely manner could adversely affect our balance sheet, our results of operations and our creditworthiness, which could make it more difficult to conduct business.

Average selling prices of our products may decrease, which may reduce our gross margins.

The average selling prices for our products may decline as a result of competitive pricing pressures, a change in our product mix, promotional programs and customers who negotiate price reductions in exchange for longer-term purchase commitments. For example, in 2002, we experienced pricing issues relating to our PRO product line due to rebates and incentives offered to our customers as well as a shift in mix between certain product lines. Together, these two factors reduced our overall average selling prices, and our product revenue for the year ended December 31, 2002 declined. In addition, competition has increased over the past year, and we expect competition to further increase in the future, thereby leading to increased pricing pressures. Furthermore, we anticipate that the average selling prices and gross margins for our products will decrease over product life cycles. We cannot assure you that we will be successful in developing and introducing on a timely basis new products with enhanced features, or that these products, if introduced, will enable us to maintain our average selling prices and gross margins at current levels. If the average selling prices of our products decline, our revenue will likely decline and our operating results will be adversely affected.

If we are unable to compete successfully in the highly competitive market for Internet security products and services, our business will fail.

The market for Internet security products is worldwide and highly competitive. Competition in our market has significantly increased over the past year, and we expect competition to further intensify in the future. There are few substantial barriers to entry, and additional competition from existing competitors and new market entrants will likely occur in the future. Current and potential competitors in our markets include, but are not limited to the following, all of which sell worldwide or have a presence in most of the major markets for such products:

Competitors to date have generally targeted the security needs of enterprises of every size with firewall, VPN and SSL products that range in price from approximately $300 to more than $15,000. We may experience increased competitive pressure on some of our products, resulting in both lower prices and gross margins. Many of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, marketing and other resources than we do. In addition, our competitors may bundle products competitive to ours with other products that they may sell to our current or potential customers. These customers may accept these bundled products rather than separately purchasing our products. If any of the foregoing were to occur, our business could be adversely affected.

Rapid changes in technology and industry standards could render our products and services unmarketable or obsolete, and we may be unable to successfully introduce new products and services.

To succeed, we must continually introduce new products and change and improve our products in response to new competitive product introductions, rapid technological developments and changes in operating systems, broadband Internet access, application and networking software, computer and communications hardware, programming tools, computer language technology and other security threats. Product development for Internet security appliances requires substantial engineering time and testing. Releasing new products and services prematurely may result in quality problems, and delays may result in loss of customer confidence and market share. In the past, we have on occasion experienced delays in the scheduled introduction of new and enhanced products and services, and we may experience delays in the future. We may be unable to develop new products and services or achieve and maintain market acceptance of them once they have come to market. Furthermore, when we do introduce new or enhanced products and services, we may be unable to manage the transition from the older products and services to minimize disruption in customer ordering patterns, avoid excessive inventories of older products and deliver enough new products and services to meet customer demand. If any of the foregoing were to occur, our business could be adversely affected.

We offer retroactive price protection to our major distributors and if we fail to balance their inventory with end user demand for our products, our allowance for price protection may be inadequate. This could adversely affect our results of operations.

We provide our major distributors with price protection rights for inventories of our products held by them. If we reduce the list price of our products, our major distributors receive refunds or credits from us that reduce the price of such products held in their inventory based upon the new list price. As of December 31, 2002, we estimated that approximately $8 million of our products in our distributors’ inventory are subject to price protection, which represented approximately 7.1% of our revenue for the year ended December 31, 2002. We have incurred approximately $600,000 of credits under our price protection policies in 2002. Future credits for price protection will depend on the percentage of our price reductions for the products in inventory and our ability to manage the level of our major distributors’ inventory. If future price protection adjustments are higher than expected, our future results of operations could be materially adversely affected.

We are dependent on international sales for a substantial amount of our revenue. We face the risk of international business and associated currency fluctuations, which might adversely affect our operating results.

International revenue represented 35% of total revenue for the three months ended March 31, 2003, 34% of total revenue for the year ended December 31, 2002 and 32% of total revenue for the year ended December 31, 2001. For the three month period ended March 31, 2003, revenue from Japan represented 6% of our total revenue, and revenue from all other international regions collectively represented approximately 29% of our total revenue. For the year ended December 31, 2002, revenue from Japan represented 8% of our total revenue, and revenue from all other international regions collectively represented approximately 26% of our total revenue. We expect that international revenue will continue to represent a substantial portion of our total revenue in the foreseeable future. Our risks of doing business abroad include our ability to maintain distribution relationships on favorable terms, and if we are unable to do so, revenue may decrease from our international operations. Because our sales are denominated in U.S. dollars, the weakness of a foreign country’s currency against the dollar could increase the price of our products in such country and reduce our product unit sales by making our products more expensive in the local currency. We are subject to the risks of conducting business internationally, including potential foreign government regulation of our technology, general geopolitical risks associated with political and economic instability, changes in diplomatic and trade relationships, and foreign countries’ laws affecting the Internet generally.

Delays in deliveries from our component suppliers could cause our revenue to decline and adversely affect our results of operations.

Our products incorporate certain components or technologies that are available from single or limited sources of supply. Specifically, our products rely upon components from, among others, Motorola, Toshiba, IBM, Intel, HiFn and Broadcom and incorporate software products from third-party vendors. We do not have long-term supply arrangements with any vendor, and any disruption in the supply of these products or technologies may adversely affect our ability to obtain necessary components or technology for our products. If this were to happen, our product shipments may be delayed or lost, resulting in a decline in sales and a loss of revenue. In addition, our products utilize components that have in the past been subject to market shortages and price fluctuations. If we experience price increases in our product components, we will experience declines in our gross margin.

We depend on two partners to provide us with the anti-virus and content filtering software, and if they experience delays in product updates or provide us with products of substandard quality, our revenue may decline and our products are services may become obsolete.

We have arrangements with two partners to license their anti-virus and content filtering products. Our partners may fail to provide us with updated products or experience delays in providing us with updated products. In addition, our partners may provide us with products of substandard quality. If this happens, we may be unable to include these anti-virus and content filtering products in the products that we sell to our customers or our products might not contain the most advanced technology. Consequently, our customers may purchase products from one of our competitors, or sales to our customers may be delayed. In such a case, our revenues will be adversely affected. Anti-virus and content filtering revenue accounted for 11%, 7% and 5% of total revenue for the three months ended March 31, 2003, and for the years ended December 31, 2002 and 2001, respectively.

We rely primarily on one contract manufacturer for all of our product manufacturing and assembly, and if we cannot obtain its services, we may not be able to ship products.

We outsource all of our hardware manufacturing and assembly primarily to one third-party manufacturer and assembly house, Flash Electronics, Inc. Flash Electronics manufactures our products in both the U.S. and China. We do not have a long-term manufacturing contract with this vendor, and our operations could be disrupted if we have to switch to a replacement vendor or if our hardware supply is interrupted for an extended period. In addition, we provide forecasts of our demand to Flash Electronics up to six months prior to scheduled delivery of products to our customers. If we overestimate our requirements, Flash Electronics may have excess inventory, which would increase our costs. If we underestimate our requirements, Flash Electronics may have an inadequate component inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenues. In addition, lead times for materials and components that we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for each component at a given time. We may also experience shortages of components from time to time, which also could delay the manufacturing of our products. If any of the foregoing occur, we could lose customer orders and revenue could decline.

Recent changes to our senior management may have an adverse effect on our ability to execute our business strategy.

Our future success will depend largely on the efforts and abilities of our current senior management to execute our business plan. In July 2002, Cosmo Santullo, our former Chief Executive Officer, resigned. At that time, William Roach, Senior Vice President of Partners, Alliances and Strategic Accounts, was appointed to the role of Interim President and Chief Executive Officer. In March 2003, Matthew Medeiros joined SonicWALL as our President and Chief Executive Officer. Five other executives have also departed within the last six months. Changes in our senior management and any future departures of key employees may be disruptive to our business and may adversely affect our operations. For example, due to the recent changes in the position of chief executive officer, we may elect to adopt different business strategies or plans. There is no assurance that these new plans, if adopted, would be successful, and if any new strategies do not produce the desired results, our business may suffer.

We must be able to hire and retain sufficient qualified employees or our business will be adversely affected.

Our future depends in part on our ability to hire and retain key engineering, operations, finance, information systems, customer support and sales and marketing personnel. We do not have employment contracts with any of our employees, who may leave us at any time. We cannot assure that we will be able to hire and retain a sufficient number of qualified personnel to meet our business needs.

We may experience competition from products developed by companies with whom we currently have OEM relationships.

We have entered into arrangements with original equipment manufacturers (“OEMs”) to sell our products, and these OEMs sell our technologies under their brand name. Our OEM revenues represented approximately 7%, 9% and 12% of total revenues for the three months ended March 31, 2003, and for the years ended December 31, 2002 and 2001, respectively. Some of our OEM partners are also competitors of ours, as those OEM partners have

developed their own products that will compete against the products jointly-produced by our OEM partners and us. This increased competition could result in decreased sales of our product to our OEM customers, decreased revenues, lower prices and/or reduced gross margins. If any of the foregoing occur, our business may suffer.

Failure to expand our market share in the large enterprise market would harm expected revenues and results of operations.

Our experience in the larger enterprise market is relatively new and we did not achieve our expected level of penetration of large enterprise networks in 2002. As a result, our revenues were less than originally expected. Therefore, if potential large enterprise customers do not purchase our products in the expected volumes, our revenues would be below our expectations and our results of operations would suffer.

Our revenue growth is dependent on the continued growth of broadband access services and if such services are not widely adopted or we are unable to address the issues associated with the development of such services, our sales will be adversely affected.

Sales of our products depend on the increased use and widespread adoption of broadband access services, such as cable, DSL, Integrated Services Digital Network, or ISDN, Frame Relay and T-1. These broadband access services typically are more expensive in terms of required equipment and ongoing access charges than are Internet dial-up access providers. Our business, prospects, results of operations and financial condition would be adversely affected if the use of broadband access services does not increase as anticipated or if our customers’ access to broadband services is limited. Critical issues concerning use of broadband access services are unresolved and will likely affect the use of broadband access services. These issues include security, reliability, bandwidth, congestion, cost, ease of access and quality of service. Even if these are resolved, if the market for products that provide broadband access to the Internet fails to develop, or develops at a slower pace than we anticipate, our business would be materially adversely affected.

We may be unable to adequately protect our proprietary rights, which may limit our ability to compete effectively.

We currently rely on a combination of patent, trademark, copyright, and trade secret laws, confidentiality provisions and other contractual provisions to protect our proprietary rights. Despite our efforts to protect our proprietary rights, unauthorized parties may misappropriate or infringe on our patents, trade secrets, copyrights, trademarks, service marks and similar proprietary rights. As of December 31, 2002, we have filed 14 United States patent applications, and we plan to aggressively pursue additional patent protection. Our pending patent applications may not result in the issuance of any patents. Even if we obtain such patents, that will not guarantee that our patent rights will be valuable, create a competitive barrier, or will be free from infringement. Furthermore, if any patent is issued, it might be invalidated or circumvented or otherwise fail to provide us any meaningful protection. We face additional risk when conducting business in countries that have poorly developed or inadequately enforced intellectual property laws. In any event, competitors may independently develop similar or superior technologies or duplicate the technologies we have developed, which could substantially limit the value of our intellectual property.

Potential intellectual property claims and litigation could subject us to significant liability for damages and invalidation of our proprietary rights.

The computer industry has seen frequent litigation over intellectual property rights. We may face infringement claims from third parties in the future, or we may resort to litigation to protect our intellectual property rights or trade secrets. We expect that infringement claims will be more frequent for Internet participants as the number of products, services and competitors grows and the functionality of products and services overlaps. Any litigation, regardless of its success, would probably be costly and require significant time and attention of our key management and technical personnel. An adverse result in litigation could also force us to:

If any of the above occur, our revenues could decline and our business could suffer.

We may have to defend lawsuits or pay damages in connection with any alleged or actual failure of our products and services.

Our products and services provide and monitor Internet security. If a third party were able to circumvent our security measures, such a person or entity could misappropriate the confidential information or other property of end users using our products and services or interrupt their operations. If that happens, affected end users or others may sue us for product liability, tort or breach of warranty claims. Although we attempt to reduce the risk of losses from claims through contractual warranty disclaimers and liability limitations, these provisions may be unenforceable. Some courts, for example, have found contractual limitations of liability in standard computer and software contracts to be unenforceable in some circumstances. Defending a lawsuit, regardless of its merit, could be costly and could divert management attention. Although we currently maintain business liability insurance, this coverage may be inadequate or may be unavailable in the future on acceptable terms, if at all. Our business liability insurance has no specific provisions for potential liability for Internet security breaches.

A security breach of our internal systems or those of our customers could harm our business.

Because we provide Internet security, we may become a greater target for attacks by computer hackers. We will not succeed unless the marketplace is confident that we provide effective Internet security protection. Networks protected by our products may be vulnerable to electronic break-ins. Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques. Although we have not experienced any act of sabotage or unauthorized access by a third party of our internal network to date, if an actual or perceived breach of Internet security occurs in our internal systems or those of our end-user customers, regardless of whether we cause the breach, it could adversely affect the market perception of our products and services. This could cause us to lose current and potential customers, resellers, distributors or other business partners.

If our products do not interoperate with our end customers’ networks, installations could be delayed or cancelled, which could significantly reduce our revenues.

Our products are designed to interface with our end user customers’ existing networks, each of which has different specifications and utilizes multiple protocol standards. Many of our end user customers’ networks contain multiple generations of products that have been added over time as these networks have grown and evolved. Our products must interoperate with all of the products within these networks as well as with future products that might be added to these networks in order to meet our end customers’ requirements. If we find errors in the existing software used in our end customers’ networks, we may elect to modify our software to fix or overcome these errors so that our products will interoperate and scale with their existing software and hardware. If our products do not interoperate with those within our end user customers’ networks, installations could be delayed or orders for our products could be cancelled, which could significantly reduce our revenues.

If an original equipment manufacturer customer cancels, reduces or delays purchases, our revenue may decline and our business could be adversely affected.

We currently have formed OEM relationships with two primary original equipment manufacturers, 3Com and Cisco. If we fail to sell to such OEMs in the quantities expected, or if an OEM terminates our relationship, this could adversely affect our reputation, the perception of our products and technology in the marketplace or the growth of our business, and your investment in our common stock may decline in value.

In November 2000, we completed the acquisition of Phobos Corporation and since then we have completed acquisitions of several smaller companies. We may make additional acquisitions or investments in other companies, products or technologies in the future. If we acquire other businesses in the future, we will be required to integrate operations, train, retain and motivate the personnel of these entities as well. We may be unable to maintain uniform standards, controls, procedures and policies if we fail in these efforts. Similarly, acquisitions may cause disruptions in our operations and divert management’s attention from day-to-day operations, which could impair our relationships with our current employees, customers and strategic partners.

We may have to incur debt or issue equity securities to pay for any future acquisitions. The issuance of equity securities for any acquisition could be substantially dilutive to our shareholders. In addition, our profitability has suffered because of acquisition-related costs, amortization costs and impairment losses for acquired goodwill and other intangible assets.

Undetected product errors or defects could result in loss of revenue, delayed market acceptance and claims against us.

We offer a one and two year warranty periods on our products, allowing the end user to receive a repaired or replacement product for any defective unit. Our products may contain undetected errors or defects. If there is a product failure, we may have to replace all affected products without being able to record revenue for the replacement units, or we may have to refund the purchase price for such units if the defect cannot be resolved. Despite extensive testing, some errors are discovered only after a product has been installed and used by customers. Any errors discovered after commercial release could result in loss of revenue and claims against us. Such product defects can negatively impact our products’ reputation and result in reduced sales.

If we are unable to meet our future capital requirements, our business will be harmed.

We expect our cash on hand, cash equivalents and commercial credit facilities to meet our working capital and capital expenditure needs for at least the next twelve months. However, at any time, we may decide to raise additional capital to take advantage of strategic opportunities available or attractive financing terms. If we issue equity securities, shareholders may experience additional dilution or the new equity securities may have rights, preferences or privileges senior to those of existing holders of common stock. If we cannot raise funds, if needed, on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, which could have a material adverse effect on our business, operating results and financial condition.

Governmental regulations affecting Internet security could affect our revenue.

Any additional governmental regulation of imports or exports or failure to obtain required export approval of our encryption technologies could adversely affect our international and domestic sales. The United States and various foreign governments have imposed controls, export license requirements and restrictions on the import or export of some technologies, especially encryption technology. In addition, from time to time, governmental agencies have proposed additional regulation of encryption technology, such as requiring the escrow and governmental recovery of private encryption keys. Additional regulation of encryption technology could delay or prevent the acceptance and use of encryption products and public networks for secure communications. This, in turn, could decrease demand for our products and services. In addition, some foreign competitors are subject to less stringent controls on exporting their encryption technologies. As a result, they may be able to compete more effectively than we can in the United States and the international Internet security market.

In particular, in light of recent terrorist activity, governments could enact additional regulation or restrictions on the use, import or export of encryption technology. Additional regulation of encryption technology could delay or prevent the acceptance and use of encryption products and public networks for secure communications. This might decrease demand for our products and services. In addition, some foreign competitors are subject to less stringent controls on exporting their encryption technologies. As a result, they may be able to compete more effectively than we can in the domestic and international network security market.

Because they own approximately 24% of our stock, our officers and directors can significantly influence all matters requiring shareholder approval.

As of December 31, 2002, our officers and directors, in the aggregate, beneficially owned approximately 24% of our outstanding common stock. These shareholders, if acting together, would be able to significantly influence all matters requiring shareholder approval, including the election of directors, mergers or other forms of business combinations.

The market price of our common stock has been highly volatile and has fluctuated significantly in the past. We believe that it may continue to fluctuate significantly in the future in response to the following factors, some of which are beyond our control:

The long sales and implementation cycles for our products may cause revenues and operating results to vary significantly.

An end customer’s decision to purchase our products often involves a significant commitment of its resources and a lengthy evaluation and product qualification process. Throughout the sales cycle, we often spend considerable time educating and providing information to prospective customers regarding the use and benefits of our products. Budget constraints and the need for multiple approvals within enterprises, carriers and government entities may also delay the purchase decision. Failure to obtain the required approval for a particular project or purchase decision may delay the purchase of our products. As a result, the sales cycle for our security systems is typically 60 to 90 days. Additionally, some of our products are highly complex systems designed for use in large enterprise markets. These systems and products require us to maintain a sophisticated sales force, engage in extensive negotiations, and provide high-level engineering support to complete sales. If these systems and products are not successful with enterprise customers, our revenue could be below our expectations and our operating results could be adversely affected.

Even after making the decision to purchase our products, our end customers may not deploy our products broadly within their networks. The timing of implementation can vary widely and depends on the skill set of the end customer, the size of the network deployment, the complexity of the end customer’s network environment and the degree of hardware and software configuration necessary to deploy our products. End customers with large networks usually expand their networks in large increments on a periodic basis. Large deployments and purchases of our security systems also require a significant outlay of capital from end customers.

The inability to obtain any third-party license required to develop new products and product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost, which could seriously harm our business, financial condition and results of operations.

From time to time, we may be required to license technology from third parties to develop new products or product enhancements. Third-party licenses may not be available to us on commercially reasonable terms or at all. The inability to obtain any third-party license required to develop new products or product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost, which could seriously harm our business, financial condition and results of operations.

If our estimates or judgments relating to our critical accounting policies are based on assumptions that change or prove to be incorrect, our operating results could fall below expectations of securities analysts and investors, resulting in a decline in our stock price.

Our discussion and analysis of financial condition and results of operations in this quarterly report is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. On an ongoing basis, we evaluate significant estimates used in preparing our financial statements, including those related to: sales returns and allowances; bad debt; inventory reserves; warranty reserves; restructuring reserves; intangible assets; and deferred taxes.

We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, as provided in our discussion and analysis of financial condition and results of operations in this quarterly report, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Examples of such estimates include, but are not limited to, those associated with valuation allowances and accrued liabilities, specifically sales returns and other allowances, allowances for doubtful accounts and warranty reserves. SFAS No. 142 requires that goodwill and other indefinite lived intangibles no longer be amortized to earnings, but instead be reviewed for impairment on an annual basis or on an interim basis if circumstances change or if events occur that would reduce the fair value of a reporting unit below its carrying value. In 2002, we incurred a $87.6 million goodwill impairment charge. Actual results may differ from these and other estimates if our assumptions change or if actual circumstances differ from those in our assumptions, which could cause our operating results to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.

Seasonality and concentration of revenues at the end of the quarter could cause our revenues to fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.

The growth rate of our domestic and international sales has been and may continue to be lower in the summer months, when businesses often defer purchasing decisions. Also, as a result of customer buying patterns and the efforts of our sales force to meet or exceed quarterly and year-end quotas, historically we have received a substantial portion of a quarter’s sales orders and earned a substantial portion of a quarter’s revenues during its last month of each quarter. If expected revenues at the end of any quarter are delayed, our revenues for that quarter could fall below the expectations of securities analysts and investors, resulting in a decline in our stock price.

Our business is especially subject to the risks of earthquakes, floods and other natural catastrophic events, and to interruption by manmade problems such as computer viruses or terrorism.

Our corporate headquarters, including certain of our research and development operations and our manufacturing facilities, are located in the Silicon Valley area of Northern California, a region known for seismic activity. Additionally, certain of our facilities, which include one of our manufacturing facilities, are located near rivers that have experienced flooding in the past. A significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on our business, operating results, and financial condition. In addition, 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. Any such event could have a material adverse effect on our business, operating results, and financial condition. In addition, the effects of war or acts of terrorism could have a material adverse effect on our business, operating results, and financial condition. The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to these economies and create further uncertainties. To the extent that such disruptions or uncertainties result in delays, curtailment or cancellations of customer orders, or the manufacture or shipment of our products, our revenues, gross margins and operating margins may decline and make it necessary for us to gain significant market share from our competitors in order to achieve our financial goals and achieve or maintain profitability.

Charter and bylaw provisions limit the authority of our shareholders, and therefore minority shareholders may not be able to significantly influence our governance or affairs.

Our board of directors has the authority to issue shares of preferred stock and to determine the price, rights, preferences, privileges, and restrictions, including voting rights, of those shares without any further vote or action by shareholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock.

Our charter documents limit the persons who may call special meetings of the shareholders, prohibit shareholder actions by written consent, prohibit cumulative voting for directors and establish advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted on by shareholders at shareholder meetings. As a result, minority shareholder representation on the board of directors may be difficult to establish.

We face risks associated with changes in telecommunications regulation and tariffs.

Changes in telecommunications requirements in the United States or other countries could affect the sales of our products. In particular, we believe it is possible that there may be changes in U.S. telecommunications regulations in the future that could slow the expansion of the service providers’ network infrastructures and materially adversely affect our business, operating results, and financial condition. Future changes in tariffs by regulatory agencies or application of tariff requirements to currently untariffed services could affect the sales of our products for certain classes of customers. Additionally, in the United States, our products must comply with various Federal Communications Commission requirements and regulations. In countries outside of the United States, our products must meet various requirements of local telecommunications authorities. Changes in tariffs or failure by us to obtain timely approval of products could have a material adverse effect on our business, operating results, and financial condition.

Our business may suffer due to increased international political instability.

The recent increased international political instability as demonstrated by enhanced security measures, terrorist threats, the conflict in Iraq, and increasing tension in the Middle East and Korea, may have a detrimental effect on our business. Such activities, either domestically or internationally, may affect the economy and consumer confidence and spending within the United States and by our international customers and adversely affect our business. Increased political instability may harm our ability to obtain adequate insurance at reasonable rates or require us to take extra security precautions for our operations and computer database systems. In addition, our ability to engage in transactions to purchase key components or sell our products in foreign jurisdictions may be impaired if foreign countries impose import or export restrictions on the United States as a result of the war in Iraq. If the international political instability continues or increases, our business, results of operations and the market price of our common stock could be adversely affected.

Given our presence in Asia and Canada, the outbreak of SARS may negatively impact our operating results.

The recent outbreak of severe acute respiratory syndrome (SARS) that began in China, Hong Kong, Singapore, and Vietnam, and has since spread to Canada and other areas of the world, could have a negative impact on our operations. In particular, we have both customers, suppliers and sales personnel located in the affected areas of Asia and Canada, and therefore, our normal operating processes could be hindered by a number of SARS-related factors, including, but not limited to:

If the number of cases continues to rise or spread to other areas, our sales and operating results could be harmed.

Our exposure to market risk for changes in interest rates relates primarily to our cash, cash equivalents and short-term investments. In accordance with Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” we classified our short-term investments as available-for-sale. Consequently, investments are recorded on the balance sheet at the fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss), net of tax. As of March 31, 2003, our cash, cash equivalents and short-term investments included money-markets securities, corporate bonds, municipal bonds and commercial paper which are subject to no interest rate risk when held to maturity, but may increase or decrease in value if interest rates changes prior to maturity.

As stated in our investment policy, we are averse to principal loss and ensure the safety and preservation of our invested funds by limiting default and market risk. We mitigate default risk by investing in only investment-grade instruments. We do not use derivative financial instruments in our investment portfolio.

Due to the short duration of our investment portfolio, we believe an immediate 10% change in interest rates would be immaterial to our financial condition or results of operations.

The following table presents the amounts of our short-term investments that are subject to market risk by range of expected maturity and weighted average interest rates as of March 31, 2003:

We consider our exposure to foreign currency exchange rate fluctuations to be minimal. We invoice substantially all of our foreign customers from the United States in U.S. dollars and substantially all revenue is collected in U.S. dollars. For the three months ended March 31, 2003, we earned approximately 35% of our revenue from international markets, which in the future may be denominated in various currencies. As a result, in the future our operating results may become subject to significant fluctuations

based upon changes in the exchange rates of some currencies in relation to the U.S. dollar and diverging economic conditions in foreign markets. In addition, because our sales are denominated in U.S. dollars, the weakness of a foreign country’s currency against the dollar could increase the price of our products in such country and reduce our product unit sales by making our products more expensive in the local currency. Although we will continue to monitor our exposure to currency fluctuations, we cannot assure you that exchange rate fluctuations will not affect adversely our financial results in the future. In addition, we have minimal cash balances denominated in foreign currencies. We do not enter into forward exchange contracts to hedge exposures denominated in foreign currencies and do not use derivative financial instruments for trading or speculative purposes.

Our chief executive officer and our chief financial officer, after evaluating our “disclosure controls and procedures” (as defined in Securities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-14 (c) and 15d-14 (c) as of the date within 90 days before filing date of the Quarterly Report on Form 10-Q (the “Evaluation Date”) have concluded that as of the Evaluation Date, our disclosure controls and procedures are effective. Subsequent to the Evaluation Date, there were no significant changes in our internal controls or in other factors that could significantly affect our disclosure controls and procedures, nor were there any significant deficiencies or material weaknesses in our internal controls. As a result, no corrective actions were required or undertaken.

On December 5, 2001, a securities class action complaint was filed in the U.S. District Court for the Southern District of New York against us, three of our officers and directors, and certain of the underwriters in our initial public offering in November 1999 and our follow-on offering in March 2000. Similar complaints were filed in the same court against numerous public companies that conducted initial public offerings (“IPOs”) of their common stock since the mid-1990s. All of these lawsuits were consolidated for pretrial purposes before Judge Shira Scheindlin. On April 19, 2002, plaintiffs filed an amended complaint. The amended complaint alleges claims under the Securities Act of 1933 and the Securities Exchange Act of 1934, and seeks damages or rescission for misrepresentations or omissions in the prospectuses relating to, among other things, the alleged receipt of excessive and undisclosed commissions by the underwriters in connection with the allocation of shares of common stock in our public offerings. On July 15, 2002, the issuers filed an omnibus motion to dismiss for failure to comply with applicable pleading standards. On October 8, 2002, the Court entered an Order of Dismissal as to all of the individual defendants in the SonicWALL IPO litigation, without prejudice. On February 19, 2003, the Court denied the motion to dismiss our claims. We intend to defend the action vigorously.

We are party to routine litigation incident to our business. We believe that none of these legal proceedings will have a material adverse effect on our consolidated financial statements take as a whole or our results of operations, financial position and cash flows.

PricewaterhouseCoopers LLP, the Company’s independent auditors provide certain tax advisory services. These services have been approved by the Audit Committee of the Company’s Board of Directors.

A current report on Form 8-K was filed with the Securities and Exchange Commission by SonicWALL on April 23, 2003 to announce its financial results for the fiscal quarter ending March 31, 2003.

Pursuant to the requirements of the Securities and Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Sunnyvale, State of California.

SONICWALL, INC.

By:		/s/ MICHAEL J. SHERIDAN

		Michael J. Sheridan, Senior Vice President of Strategy and Secretary, Chief Financial Officer (Principal Financial Officer, and Chief Accounting Officer and Authorized Signer)

/s/ MATTHEW MEDEIROS

Matthew Medeiros

Chief Executive Officer

/s/ MICHAEL J. SHERIDAN

Michael J. Sheridan

Senior Vice President of Strategy and Secretary,

Chief Financial Officer

TITLE OF EACH CLASS		OUTSTANDING AT MARCH 31, 2003
Common Stock, no par value		67,632,260 Shares

		Page
PART I.	FINANCIAL INFORMATION	3

ITEM 1.	Financial Statements	3

ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13

ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk	28

ITEM 4.	Controls and Procedures	29

PART II.	OTHER INFORMATION	29

ITEM 1.	Legal Proceedings	29

ITEM 2.	Changes in Securities and Use of Proceeds	29

ITEM 3.	Defaults Upon Senior Securities	29

ITEM 4.	Submission of Matters to a Vote of Security Holders	29

ITEM 5.	Other Information	29

ITEM 6.	Exhibits and Reports on Form 8-K	29

SIGNATURES		31

CERTIFICATIONS		32

Condensed Consolidated Balance Sheets as of March 31, 2003 (unaudited) and December 31, 2002		4

Condensed Consolidated Statements of Operations for the three-months ended March 31, 2003 and 2002 (unaudited)		5

Condensed Consolidated Statements of Cash Flows for the three-months ended March 31, 2003 and 2002 (unaudited)		6

Notes to Condensed Consolidated Financial Statements (unaudited)		7

	March 31, 2003			December 31, 2002
	(Unaudited)			(1)
ASSETS
Current Assets:
Cash and cash equivalents	$	163,875		$	125,530
Short-term investments		71,084			107,354
Accounts receivable, net		9,550			13,274
Inventories		5,752			5,765
Deferred income taxes		15,128			14,065
Prepaid expenses and other current assets		3,861			3,416

Total current assets		269,250			269,404
Property and equipment, net		6,135			6,175
Goodwill		97,953			97,953
Purchased intangibles and other assets, net		29,030			31,566

	$	402,368		$	405,098


LIABILITIES AND SHAREHOLDERS’ EQUITY
Current Liabilities:
Accounts payable	$	7,421		$	6,802
Accrued restructuring		1,340			1,442
Accrued payroll and related benefits		4,237			4,780
Other accrued liabilities		4,690			4,960
Deferred revenue		14,854			13,394
Income taxes payable		4,537			4,265

Total current liabilities		37,079			35,643
Deferred income taxes		11,275			12,272

Total liabilities		48,354			47,915

Shareholders’ Equity:
Common stock		464,820			464,210
Deferred stock-based compensation		(197	)		(364	)
Accumulated other comprehensive income		194			267
Accumulated deficit		(110,803	)		(106,930	)

Total shareholders’ equity		354,014			357,183

	$	402,368		$	405,098

	Three Months Ended March 31,
	2003			2002
Revenue:
Product	$	14,251		$	19,603
License and service		6,055			8,499

Total revenue		20,306			28,102

Cost of revenue:
Product, excluding amortization of stock-based compensation of $3 and $20, respectively		5,837			6,885
License and service		1,584			982

Total cost of revenue		7,421			7,867

Gross margin		12,885			20,235

Operating expenses:
Research and development, excluding amortization of stock-based compensation of $41 and $163, respectively		4,303			5,112
Sales and marketing, excluding amortization of stock-based compensation of $128 and $381, respectively		10,268			11,524
General and administrative, excluding amortization (recovery) of stock-based compensation of $(29) and $64, respectively		2,534			2,807
Amortization of purchased intangibles		2,541			2,578
Restructuring charges		162			—
Amortization of stock-based compensation		143			628

Total operating expenses		19,951			22,649

Loss from operations		(7,066	)		(2,414	)
Interest income and other expense, net		1,293			1,685

Loss before income taxes		(5,773	)		(729	)
Benefit from income taxes		1,900			170

Net loss	$	(3,873	)	$	(559	)

Net loss per share:
Basic and Diluted	$	(0.06	)	$	(0.01	)

Shares used in computing net loss per share:
Basic and Diluted		67,557			66,751

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	Three Months Ended March 31,
	2003			2002
Cash flows from operating activities:
Net loss	$	(3,873	)	$	(559	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		3,411			3,398
Provision for (recovery of) doubtful accounts		(188	)		32
Amortization of stock-based compensation		143			628
Non-cash restructuring charges		162			—
Changes in operating assets and liabilities, net of effects of businesses acquired:
Accounts receivable		3,913			2,511
Inventories		13			(862	)
Deferred income taxes		(2,027	)		(939	)
Prepaid expenses and other current assets		(445	)		185
Other assets		(4	)		(5	)
Accounts payable		619			(430	)
Accrued restructuring		(264	)		—
Accrued payroll and related benefits		(543	)		136
Other accrued liabilities		(298	)		230
Deferred revenue		1,460			1,197
Income taxes payable		272			732

Net cash provided by operating activities		2,351			6,254

Cash flows from investing activities:
Purchase of property and equipment		(831	)		(940	)
Maturity and sale of short-term investments		83,729			43,344
Purchase of short-term investments		(47,566	)		(63,188	)
Acquisitions, net of cash acquired		—			(1,446	)

Net cash provided by (used in) investing activities		35,332			(22,230	)

Cash flows from financing activities:
Proceeds from exercise of stock options and warrants		662			2,128

Net cash provided by financing activities		662			2,128

Net increase (decrease) in cash and cash equivalents		38,345			(13,848	)
Cash and cash equivalents at beginning of period		125,530			60,908

Cash and cash equivalents at end of period	$	163,875		$	47,060

Supplemental disclosure of non-cash investing and financing activities:
Deferred stock compensation, net of cancellations	$	(52	)	$	(470	)
Unrealized loss on short-term investments, net of taxes	$	73		$	228

	March 31, 2003		December 31, 2002
Raw materials	$	1,501	$	1,869
Finished goods		4,251		3,896

	$	5,752	$	5,765

	Employee Severance Benefits		Facility Costs		Asset Impairments		Total
Restructuring provision:
Employee severance benefits	$	858	$	—	$	—	$	858
Facility costs		—		1,944		—		1,944
Asset impairments		—		—		1,167		1,167

Total	858			1,944			1,167			3,969
Cash paid		(833	)		(527	)		(58	)		(1,418	)
Non-cash charges		—			—			(1,109	)		(1,109	)

Reserve balance at December 31, 2002		25			1,417			—			1,442
Cash paid		—			(264	)		—			(264	)
Adjustments		(25	)		187			—			162

Reserve balance at March 31, 2003	$	—		$	1,340		$	—		$	1,340

	Three Months Ended March 31,
	2003			2002
	(in thousands)
Net loss:
As reported	$	(3,873	)	$	(559	)
Expensed stock compensation under the intrinsic value, net of related tax effect		143			628
Stock-based compensation expense that would have been included in the determination of net loss had the fair value method been applied, net of related tax effect		(5,500	)		(9,298	)

Pro forma net loss	$	(9,230	)	$	(9,229	)

Net loss per share—basic and diluted:
As reported	$	(0.06	)	$	(0.01	)

Pro forma	$	(0.14	)	$	(0.14	)

	Shares			Weighted Average Exercise Price
Price	Vested	Unvested	Total	Vested		Unvested		Total
$10.75–$19.00	774,739	944,008	1,718,747	$	14.79	$	14.98	$	14.89
$19.01–$38.00	216,951	130,049	347,000		24.78		23.69		24.37
$38.01–$52.06	88,073	46,927	135,000		49.67		50.56		49.98

	1,079,763	1,120,984	2,200,747	$	19.64	$	17.48	$	18.54

	Three months Ended March 31, 2003
	(in thousands)
	(Unaudited)
Beginning balance	$	979
Accruals for warranties issued		310
Settlements made during the period		(273	)

Ending balance	$	1,016

	Amortization Period	Gross Carrying Amount		March 31, 2003			Net		Gross Carrying Amount		December 31, 2002			Net
	Amortization Period	Gross Carrying Amount		Accumulated Amortization			Net		Gross Carrying Amount		Accumulated Amortization			Net
Existing technology	52-72 months	$	26,970	$	(10,616	)	$	16,354	$	26,970	$	(9,481	)	$	17,489
Non-compete agreements	36 months		7,019		(5,547	)		1,472		7,019		(4,962	)		2,057
Customer base	36-72 months		18,140		(7,399	)		10,741		18,140		(6,585	)		11,555
Other	2-52 months		400		(333	)		67		400		(327	)		73

Total intangibles		$	52,529	$	(23,895	)	$	28,634	$	52,529	$	(21,355	)	$	31,174

Fiscal Year
2003 (second, third and fourth quarter)	$	7,336
2004		7,632
2005		7,356
2006		6,310

Total	$	28,634

	Maturing In
	Less than one year			More than one year			Total
	(in thousands, except percentage data)
Short-term investments	$	3,779		$	67,305		$	71,084
Weighted average interest rate		2.50	%		2.51	%

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.