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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
 
 
 
FORM 10-Q
 
(Mark One)
 
x
 
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Quarterly Period Ended September 30, 2002
 
or
 
¨
 
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the Transition Period From                      to                     .
 
 
Commission file number 0-27074
 
 
SECURE COMPUTING CORPORATION
(Exact name of registrant as specified in its charter)
 
 
Delaware
   
52-1637226
(State or other jurisdiction of
incorporation or organization)
   
(I.R.S. employer
identification no.)
4810 Harwood Road,
        San Jose, CA        
   
95124
(Address of principal executive offices)
   
(Zip code)
 
 
(800) 379-4944
Registrant’s telephone number, including area code
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes    x    No    ¨
 
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date: Common Stock, $.01 par value – 29,495,790 issued and outstanding as of November 6, 2002.

Table of Contents
 
SECURE COMPUTING CORPORATION
 
INDEX
 
PART I
      
Page No.
Item 1.
        
       
3
       
4
       
5
       
6-8
Item 2.
      
9-13
Item 3.
      
13
Item 4.
      
13
PART II
        
Item 1.
      
14
Item 2.
      
14
Item 3.
      
14
Item 4.
      
14
Item 5.
      
14
Item 6.
      
14
       
15
       
16-17
 

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Table of Contents
PART 1.     FINANCIAL INFORMATION
SECURE COMPUTING CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands except share amounts)
 
    
September 30,
2002
(Unaudited)
     
December 31, 2001
(See Note)
  
ASSETS
                  
Current assets
                  
Cash and cash equivalents
   
$
11,840
 
   
$
15,956
 
Investments
   
 
7,563
 
   
 
5,085
 
Accounts receivable, net
   
 
10,960
 
   
 
11,006
 
Inventories, net
   
 
792
 
   
 
757
 
Other current assets
   
 
3,726
 
   
 
3,190
 
    
  
Total current assets
   
 
34,881
 
   
 
35,994
 
Property and equipment, net
   
 
6,035
 
   
 
5,792
 
Goodwill
   
 
15,879
 
   
 
—  
 
Other assets, net
   
 
3,187
 
   
 
3,047
 
    
  
Total assets
   
$
59,982
 
   
$
44,833
 
    
  
LIABILITIES AND STOCKHOLDERS’ EQUITY
                  
Current liabilities
                  
Accounts payable
   
$
2,280
 
   
$
1,859
 
Accrued payroll
   
 
2,852
 
   
 
3,523
 
Other accrued expenses
   
 
4,715
 
   
 
1,601
 
Litigation settlement accrual
   
 
7,258
 
   
 
—  
 
Deferred revenue
   
 
15,111
 
   
 
9,154
 
    
  
Total current liabilities
   
 
32,216
 
   
 
16,137
 
Stockholders’ equity
                  
Common stock, par value $.01; 50,000,000 shares authorized;
issued and outstanding – September 30, 2002 – 29,495,423 and
December 31, 2001 – 28,830,992
   
 
295
 
   
 
288
 
Additional paid-in capital
   
 
155,620
 
   
 
148,585
 
Accumulated deficit
   
 
(127,564
)
   
 
(119,687
)
Foreign currency translation
   
 
(585
)
   
 
(490
)
    
  
Total stockholders’ equity
   
 
27,766
 
   
 
28,696
 
    
  
Total liabilities and stockholders’ equity
   
$
59,982
 
   
$
44,833
 
    
  
 
Note: The balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.
 
See accompanying notes to condensed consolidated financial statements.

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SECURE COMPUTING CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 
(Unaudited, in thousands except per share amounts)
 
    
Three Months Ended
September 30
     
Nine Months Ended
September 30,
  
    
2002
   
2001
     
2002
     
2001
  
Products and services revenue
   
$
16,708
   
$
12,511
 
   
$
44,750
 
   
$
34,175
 
Advanced Technology contracts revenue
   
 
959
   
 
983
 
   
 
2,983
 
   
 
3,127
 
    
  
  
  
    
 
17,667
   
 
13,494
 
   
 
47,733
 
   
 
37,302
 
Cost of revenue
   
 
1,955
   
 
2,045
 
   
 
5,506
 
   
 
6,749
 
    
  
  
  
Gross profit
   
 
15,712
   
 
11,449
 
   
 
42,227
 
   
 
30,553
 
Operating expenses:
                                  
Selling and marketing
   
 
9,493
   
 
8,564
 
   
 
27,778
 
   
 
26,366
 
Research and development
   
 
3,894
   
 
3,555
 
   
 
11,080
 
   
 
10,828
 
General and administrative
   
 
1,371
   
 
1,100
 
   
 
3,796
 
   
 
3,233
 
Separation costs
   
 
568
   
 
—  
 
   
 
568
 
   
 
—  
 
    
  
  
  
    
 
15,326
   
 
13,219
 
   
 
43,222
 
   
 
40,427
 
    
  
  
  
Operating income/(loss)
   
 
386
   
 
(1,770
)
   
 
(995
)
   
 
(9,874
)
Other non-recurring expense
   
 
—  
   
 
—  
 
   
 
(7,258
)
   
 
—  
 
Interest and other income
   
 
89
   
 
234
 
   
 
376
 
   
 
658
 
    
  
  
  
Income/(loss) before income taxes
   
 
475
   
 
(1,536
)
   
 
(7,877
)
   
 
(9,216
)
Income tax expense
   
 
—  
   
 
—  
 
   
 
—  
 
   
 
—  
 
    
  
  
  
Net income/(loss)
   
$
475
   
$
(1,536
)
   
$
(7,877
)
   
$
(9,216
)
    
  
  
  
Net income/(loss) per share – basic
   
$
0.02
   
$
(0.05
)
   
$
(0.27
)
   
$
(0.33
)
    
  
  
  
Shares used in computing net income/(loss) per share – basic
   
 
29,374
   
 
28,366
 
   
 
29,184
 
   
 
27,938
 
    
  
  
  
Net income/(loss) per share – diluted
   
$
0.02
   
$
(0.05
)
   
$
(0.27
)
   
$
(0.33
)
    
  
  
  
Shares used in computing net income/(loss) per share – diluted
   
 
29,705
   
 
28,366
 
   
 
29,184
 
   
 
27,938
 
    
  
  
  
 
See accompanying notes to condensed consolidated financial statements.

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SECURE COMPUTING CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
 
(Unaudited, in thousands)
 
    
Nine Months Ended September 30,
  
    
2002
     
2001
  
Operating activities
                  
Net loss
   
$
(7,877
)
   
$
(9,216
)
Adjustments to reconcile net loss to net cash used in operating activities:
                  
Depreciation
   
 
2,046
 
   
 
1,789
 
Amortization
   
 
183
 
   
 
238
 
Loss on disposals of property and equipment
   
 
9
 
   
 
102
 
Loss on disposals of intangible assets
   
 
—  
 
   
 
148
 
Changes in operating assets and liabilities, net of the effects of the Gauntlet acquisition:
                  
Accounts receivable
   
 
375
 
   
 
(684
)
Inventories
   
 
(35
)
   
 
(212
)
Other current assets
   
 
(536
)
   
 
(211
)
Accounts payable
   
 
421
 
   
 
(1,019
)
Payroll related accruals
   
 
(671
)
   
 
(404
)
Accrued liabilities and reserves
   
 
327
 
   
 
160
 
Litigation settlement accrual
   
 
7,258
 
   
 
—  
 
Deferred revenue
   
 
(3,180
)
   
 
1,495
 
    
  
Net cash used in operating activities
  
 
(1,680
)
   
 
(7,814
)
Investing activities
                  
Proceeds from sales of investments
   
 
4,610
 
   
 
13,831
 
Purchase of investments
   
 
(7,088
)
   
 
(5,936
)
Purchase of property and equipment, net
   
 
(1,585
)
   
 
(2,135
)
Increase in intangibles and other assets
   
 
(320
)
   
 
(487
)
    
  
Net cash (used in)/provided by investing activities
   
 
(4,383
)
   
 
5,273
 
Financing activities
                  
Costs associated with issuance of preferred stock
   
 
—  
 
   
 
(53
)
Proceeds from issuance of common stock
   
 
2,042
 
   
 
3,156
 
Proceeds from exercise of warrants
   
 
—  
 
   
 
2,082
 
    
  
Net cash provided by financing activities
   
 
2,042
 
   
 
5,185
 
    
  
Effect of exchange rate changes
   
 
(95
)
   
 
(51
)
    
  
(Decrease)/increase in cash and cash equivalents
   
 
(4,116
)
   
 
2,593
 
Cash and cash equivalents beginning of period
   
 
15,956
 
   
 
12,496
 
    
  
Cash and cash equivalents ending of period
   
$
11,840
 
   
$
15,089
 
    
  
 
See accompanying notes to condensed consolidated financial statements.

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Table of Contents
SECURE COMPUTING CORPORATION
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share amounts)
(Unaudited)
 
1.
 
Organization
 
We develop and sell computer software products and services designed to provide secure access control for all users engaging in business over public networks, including the Internet, intranets, and extranets. Our solutions enable our customers to control, manage, and personalize access for millions of customers, employees, and partners connecting to their business.
 
2.
 
Condensed Consolidated Financial Statements
 
The accompanying condensed consolidated financial statements have been prepared by us without audit and reflect all adjustments (consisting only of normal and recurring adjustments and accruals) which are, in our opinion, necessary to present a fair statement of the results for the interim periods presented. The consolidated financial statements include our accounts and those of our subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The statements have been prepared in accordance with the regulations of the Securities and Exchange Commission, but omit certain information and footnote disclosures necessary to present the statements in accordance with accounting principles generally accepted in the United States. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for the full fiscal year. The December 31, 2001 Condensed Consolidated Balance Sheet is derived from our audited Consolidated Balance Sheet as of December 31, 2001. These condensed financial statements should be read in conjunction with the Consolidated Financial Statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2001, as filed with the Securities and Exchange Commission.
 
3.
 
Significant Accounting Policies
 
Results of operations are translated using the average exchange rates throughout the period. Translation gains or losses, net of applicable deferred taxes, are accumulated as a separate component of stockholders’ equity and included in comprehensive income. During the third quarter of 2002, total comprehensive income amounted to $435 compared to a total comprehensive loss of $1,294 for third quarter of 2001. During the first nine months of 2002 and 2001, total comprehensive loss amounted to $7,972 and $9,266, respectively.
 
4.
 
Recently Issued Accounting Standards
 
In June 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 141, “Business Combinations,” effective for all business combinations initiated after June 30, 2001. The Statement eliminates the pooling-of-interest methods of accounting for business combinations and further clarifies the criteria to recognize intangible assets separately from goodwill. Adoption of this Statement did not have an effect on the accounting treatment of assets we have acquired in business combinations prior to the effective date of this Statement.
 
In June 2001, the FASB issued Statement No. 142, “Goodwill and Other Intangible Assets,” effective for the year ending December 31, 2002. Under this Statement, goodwill and indefinite-lived intangible assets are no longer amortized but are reviewed at least annually for impairment. Adoption of this Statement will not have an effect on the accounting treatment of assets presented in our Financial Statements prior to the effective date.
 
In July 2002, the FASB issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. This Statement nullifies EITF No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity,” which required a liability be recognized at the commitment date to an exit plan. We are required to adopt the provisions of this Statement effective for exit or disposal activities initiated after December 31, 2002. All restructuring activities prior to December 31, 2002 are accounted for under EITF 94-3.

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SECURE COMPUTING CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(In thousands, except share and per share amounts)
(Unaudited)
 
5.
 
Acquisition of the Gauntlet™ Firewall and VPN Business
 
In February 2002, we completed our acquisition of the assets of the GauntletTM firewall and VPN business from Network Associates, Inc. As a result of the acquisition, we expect to be the worldwide leader in application-layer firewalls. The purchase price was 300,354 shares of common stock valued at $5 million. The value of the common shares was determined based on the average market price of our common shares over the period including the five days before the terms of the acquisition were agreed to and announced. The transaction was accounted for as a purchase in accordance with FASB Statement No. 141, “Business Combinations,” as described in Note 4, “Recently Issued Accounting Standards.” Accordingly, the net assets and results of operations have been included in our financial statements from the date of acquisition.
 
The following unaudited pro forma financial information was prepared in accordance with FASB Statement No. 141 and assumes the acquisition had occurred at the beginning of the periods presented. The unaudited pro forma financial information is provided for informational purposes only and does not purport to be indicative of our future results.
 
    
Nine Months Ended
September 30,
  
    
2002
     
2001
  
Products and services revenue
   
$
46,032
 
   
$
50,167
 
Net loss
   
$
(8,173
)
   
$
(6,718
)
Net loss per share – basic and diluted
   
$
(0.28
)
   
$
(0.24
)
 
6.
 
Segment Information
 
We have two reportable segments consisting of Products and Services and Advanced Technology. Our Products and Services segment markets a range of solutions providing personalized access control over any public network. Our Advanced Technology Division is a self-funded organization whose mission is to develop new technologies and products that meet the emerging needs of the Department of Defense (DoD) and the commercial sector. Our strategy is to focus only on development contracts that add value to our products and services offerings. As a result, we continue to innovate, providing state-of-the-market products for organizations of all types and sizes. Cash, investments, deferred tax assets, and general and administrative expenses cannot be readily identified to the two business segments, therefore, they are presented separately in a corporate segment.
 
We evaluate segment performance based on gross profit. Resources are allocated based on contractual requirements as the Advanced Technology segment is reimbursed on a cost plus basis from the various agencies of the United States government. The accounting policies of the reportable segments are the same as those described in Note 1, “Summary of Significant Accounting Policies” included in our Annual Report on Form 10-K for the year ended December 31, 2001. Revenue is recognized at time of shipment or recognized ratably over the service period for the Products and Services segment. For Advanced Technology, contract revenue is recognized on the basis of costs incurred for the government contracts serviced by Advanced Technology and intersegment transfers are recorded at cost; there are no intercompany profits or losses recorded on intersegment transfers.
 
Our reportable segments are business units that offer distinct products and services to very different customer groups. The reportable segments are each managed separately because they require different managerial skill sets and are focused toward different markets.

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SECURE COMPUTING CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS – (Continued)
(In thousands, except share and per share amounts)
(Unaudited)
 
Significant components of our segments are as follows:
 
Nine Months Ended September 30, 2002
   
Products and Services Segment
   
Advanced Technology Segment
     
Corporate
     
Total
  
Revenues from external customers
   
$
44,750
   
$
2,983
 
   
$
—  
 
   
$
47,733
 
Depreciation expense
   
 
2,015
   
 
11
 
   
 
20
 
   
 
2,046
 
Segment gross profit
   
 
41,390
   
 
837
 
   
 
—  
 
   
 
42,227
 
Segment operating income/(loss)
   
 
3,800
   
 
(999
)
   
 
(3,796
)
   
 
(995
)
Interest and other income
   
 
—  
   
 
—  
 
   
 
376
 
   
 
376
 
Segment assets
   
 
21,424
   
 
498
 
   
 
38,060
 
   
 
59,982
 
Expenditures for long lived assets
   
 
18,480
   
 
—  
 
   
 
21
 
   
 
18,501
 
    
  
  
  
 
Nine Months Ended September 30, 2001
   
Products and Services Segment
     
Advanced Technology Segment
     
Corporate
     
Total
  
Revenues from external customers
   
$
34,175
 
   
$
3,127
 
   
$
—  
 
   
$
37,302
 
Depreciation expense
   
 
1,699
 
   
 
67
 
   
 
23
 
   
 
1,789
 
Segment gross profit
   
 
29,653
 
   
 
900
 
   
 
—  
 
   
 
30,553
 
Segment operating loss
   
 
(5,233
)
   
 
(1,408
)
   
 
(3,233
)
   
 
(9,874
)
Interest and other income
   
 
—  
 
   
 
—  
 
   
 
658
 
   
 
658
 
Segment assets
   
 
16,472
 
   
 
847
 
   
 
23,802
 
   
 
41,121
 
Expenditures for long-lived assets
   
 
2,596
 
   
 
19
 
   
 
6
 
   
 
2,621
 
    
  
  
  
 
International sales accounted for 25 percent of total revenue for both of the nine months ended September 30, 2002 and 2001. Major foreign markets for our products include Europe, the Pacific Rim, and Latin America. In each market, we have independent channel partners who are responsible for marketing, selling and supporting our products to resellers and end-users within their defined territories.
 
The following table summarizes information about our international and domestic sales and operations:
 
    
Nine Months Ended
September 30,
    
2002
   
2001
Revenues:
United States sales
   
$
35,767
   
$
27,976
International sales
   
 
11,966
   
 
9,326
    
  
    
$
47,733
   
$
37,302
    
  

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SECURE COMPUTING CORPORATION
Management’s Discussion and Analysis of
Financial Condition and Results of Operations
 
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
 
The following discussion contains forward-looking statements, including statements regarding our expectations, beliefs, intentions or strategies regarding the future. These statements are not guarantees of future performance and are subject to risks, uncertainties, and other factors, some of which are beyond our control and difficult to predict and could cause actual results to differ materially from those expressed or forecasted in the forward-looking statements. Forward-looking statements reflect our view only as of the date of this report. We cannot guarantee future results, levels of activity, performance, or achievements.
 
In addition, the following information should be read in conjunction with the condensed consolidated financial statements and notes thereto included in Item 1 of this Quarterly Report, the risk factors detailed in our Annual Report on Form 10-K for the year ended December 31, 2001 and our Registration Statement on Form S-3 filed with the Securities and Exchange Commission on April 19, 2002, as well as the factors identified in Forward Looking Statements below.
 
RESULTS OF OPERATIONS
 
Comparison of Three Months Ended September 30, 2002 and 2001.
 
Revenue.    Our revenue increased 31 percent to $17.7 million for the third quarter of 2002 up from $13.5 million in the same period of 2001. Products and services revenue was $16.7 million for the quarter, an increase of 34 percent over 2001. The year over year products and services revenue growth was driven primarily by an increase in our number of channel partners, our acquisition of the Gauntlet firewall business and entering the firewall appliance market during 2002. For the fourth quarter of 2002, we expect year over year revenue growth of 20 percent. As a result, the entire year 2002 product and services revenue growth is expected to be 28 percent. Advanced Technology contract revenue was $1.0 million for the quarter, consistent with the same period in 2001 and consistent with our strategy of focusing only on funded development contracts that add value to our commercial product offerings. Advanced Technology revenue is projected to remain fairly constant at approximately $1 million, in the fourth quarter of 2002.
 
Gross Profit.    Gross profit as a percentage of revenue increased from 85 percent in the third quarter of 2001 to 89 percent in 2002. This improvement was driven primarily by our success in growing our higher margin software revenue. For the fourth quarter, we expect aggregate gross profit to be consistent with the third quarter of 2002.
 
Operating Expenses.    Operating expenses consist of selling and marketing, research and development, general and administrative expenses, and separation costs. Total operating expenses increased 16 percent to $15.3 million in the third quarter of 2002, an increase from $13.2 million in the same period of 2001. The increased spending levels resulted primarily from investment in a stronger sales presence, continued investment in next generation product development, and increased headcount related to our acquisition of the Gauntlet firewall business. As a percentage of revenue, total operating expense was 87 percent for the quarter compared to 98 percent in the same period of 2001. Excluding third quarter separation costs, operating expenses are expected to grow sequentially by approximately 2 percent in the fourth quarter of 2002.
 
Selling and Marketing.    Selling and marketing expenses consist primarily of salaries, commissions, and benefits related to personnel engaged in selling, marketing and customer support functions, along with costs related to advertising, promotions, public relations, travel and allocations of information technology, facilities and human resources expenses. Selling and marketing expense increased 11 percent to $9.5 million in the third quarter of 2002, an increase from $8.6 million in the same period of 2001. The increased spending levels resulted primarily from investment in a stronger sales presence. As a percentage of revenue, selling and marketing expense was 54 percent for the quarter compared to 63 percent in the same period of 2001.
 
Research and Development.    Research and development expenses consist primarily of salaries and benefits for our product development personnel and allocations of information technology, facilities and human resources

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expenses. Research and development expense increased by 10 percent to $3.9 million in the third quarter of 2002 from $3.6 million in the same period of 2001. The increase resulted primarily from our continued investment in next generation product development and increased headcount related to the acquisition of the Gauntlet firewall business in the first quarter of 2002. As a percentage of revenue, research and development expense was 22 percent for the quarter compared to 26 percent in 2001.
 
General and Administrative.    General and administrative expense consists primarily of salaries, benefits, and related expenses for our executive, finance, and legal personnel along with allocated information technology, facilities and human resources expenses. General and administrative expense increased 25% to $1.4 million in the third quarter of 2002 from $1.1 million in the same period of 2001. As a percentage of revenue, general and administrative expenses were 8 percent for the third quarter of 2002 consistent with the third quarter of 2001.
 
Separation Costs.    In addition to normal operating expenses, we incurred $568,000 of expenses in the third quarter of 2002 related to a 6% reduction in headcount, which occurred in July of 2002.
 
Interest and Other Income.    Net interest and other income was $89,000 in the third quarter of 2002, a decrease from $234,000 in the same period of 2001. The decrease reflects lower average cash and investment balances as well as lower average interest rates in 2002 as compared to 2001.
 
Income Taxes.    We recognized no income tax expense for either of the periods in 2002 or 2001. We believe it is more likely than not that deferred tax assets, which total $2.7 million at September 30, 2002, will be realized. The computations of our deferred tax assets and valuation allowance are based on taxable income we expect to earn on existing government contracts, commercial products, and projected interest income. The amount of the deferred tax assets considered realizable could be reduced in the near term if estimates of future taxable income are reduced.
 
Comparison of Nine Months Ended September 30, 2002 and 2001.
 
Revenue.    Our revenue increased 28 percent to $47.7 million for the first nine months of 2002 up from $37.3 million in the same period of 2001. Products and services revenue was $44.8 million for the nine months, an increase of 31 percent over the same nine months of 2001. The year over year products and services revenue growth was driven primarily by an increase in our number of channel partners, our acquisition of the Gauntlet firewall business and entering the firewall appliance market during 2002. For the fourth quarter of 2002, we expect year over year revenue growth of 20 percent. As a result, the entire year 2002 product and services revenue growth is expected to be 28 percent. Advanced Technology contract revenue was $3.0 million for the first nine months of 2002, a decrease of 5 percent from the first nine months of 2001 as we continue our focus on development contracts that add value to our products and services offerings. Advanced Technology revenue is projected to remain fairly constant at approximately $1 million in the fourth quarter of 2002.
 
Gross Profit.    Gross profit as a percentage of revenue increased from 82 percent in the first nine months of 2001 to 89 percent in 2002. This improvement was driven primarily by our success in growing our higher margin software revenue. For the fourth quarter, we expect aggregate gross profit to be consistent with the third quarter of 2002.
 
Operating Expenses.    Operating expenses consist of selling and marketing, research and development, general and administrative expenses, and separation costs. Operating expenses increased 7 percent to $43.2 million in the first of nine months of 2002 up from $40.4 million in the same period of 2001. The increased spending levels resulted primarily from investment in a stronger sales presence, continued investment in next generation product development, and increased headcount related to our acquisition of the Gauntlet firewall business. As a percentage of revenue, total operating expense was 91 percent for the first nine months of 2002 compared to 108 percent in the same period of 2001. Excluding third quarter separation costs, operating expenses are expected to grow sequentially by approximately 2 percent in the fourth quarter of 2002.
 
Selling and Marketing.    Selling and marketing expenses consist primarily of salaries, commissions, and benefits related to personnel engaged in selling, marketing and customer support functions, along with costs related to advertising, promotions, public relations, travel and allocations of information technology, facilities and human resources expenses. Selling and marketing expense increased 5 percent to $27.8 million in the first of nine months of 2002 up from $26.4 million in the same period of 2001. The increased spending levels resulted primarily from investment in a stronger sales presence.

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Research and Development.    Research and development expenses consist primarily of salaries and benefits for our product development personnel and allocations of information technology, facilities and human resources expenses. Research and development expense increased 2 percent to $11.1 million in the first nine months of 2002 up from $10.8 million in the same period of 2001. The increase resulted primarily from our continued investment in next generation product development and increased headcount related to the acquisition of the Gauntlet firewall business in the first quarter of 2002.
 
General and Administrative.    General and administrative expenses consist primarily of salaries, benefits, and related expenses for our executive, finance, and legal personnel along with allocated information technology, facilities and human resources expenses. General and administrative expense increased 17 percent to $3.8 million in the first nine months of 2002 up from $3.2 million in the same period of 2001.
 
Separation Costs.    In addition to normal operating expenses, we incurred $568,000 of expenses in the third quarter of 2002 related to a 6% reduction in headcount, which occurred in July of 2002.
 
Non-recurring Expense.    Non-recurring expense of $7.3 million in the second quarter of 2002 pertains to a one-time charge for a litigation settlement. In July 2002, we reached a settlement of the class action securities lawsuit that was brought in United States District Court for the Northern District of California on behalf of persons who acquired our common stock between November 10, 1998 and March 31, 1999.
 
Subject to court approval, the class action case settled for $10.1 million. $2.8 million in cash will be covered by our insurance. The $7.3 million balance of the settlement will be contributed by us in common stock or in a combination of common stock and cash at the date of distribution. The final allocation of the contribution will be determined by us at our sole option.
 
Interest and Other Income.    Net interest and other income was $376,000 in the first nine months of 2002, a decrease from $658,000 in the same period of 2001. The decrease reflects lower average cash and investment balances as well as lower average interest rates in 2002 as compared to 2001.
 
Income Taxes.    We recognized no income tax expense in the first nine months of 2002 or 2001. We believe it is more likely than not that deferred tax assets, which total $2.7 million at September 30, 2002, will be realized. The computations of our deferred tax assets and valuation allowance are based in part on taxable income we expect to earn on existing government contracts and projected interest income. The amount of the deferred tax assets considered realizable could be reduced in the near term if estimates of future taxable income are reduced.
 
LIQUIDITY AND CAPITAL RESOURCES
 
Our total cash, cash equivalents and short term investments decreased by $1.6 million from $21.0 million at December 31, 2001 to $19.4 million at September 30, 2002. This decrease is primarily due to cash used in operating activities, capital additions and investments. The cash used for these factors was partially offset by cash received from the exercise of stock options and sales of common stock through our employee stock purchase plan. We expect to generate cash in the fourth quarter of 2002 and end the year with a total cash, cash equivalent, and short term investment balance in excess of $21.0 million.
 
Net cash used in operating activities, net of the effects of the acquisition of the Gauntlet firewall business, for nine months ended September 30, 2002 was approximately $1.7 million. This usage was comprised of net loss of $7.9 million, offset by net non-cash related expenses of $2.2 million and a net increase of $4.2 million in liabilities, net of the slight decrease in current assets.
 
Net cash used for investing activities of $4.4 million during the nine months ended September 30, 2002 net of the effects of the acquisition of the Gauntlet firewall business, consisted primarily of $1.6 million of cash used for capital additions, which were made up of computer equipment, technology upgrades, and leasehold improvements, and net purchase of investments of $2.5 million. We expect to invest another $500,000 throughout the remainder of 2002 mainly for computer equipment and technology upgrades.
 
Net cash provided by financing activities of $2.0 million during the nine months ended September 30, 2002 consisted primarily of proceeds received from the exercise of stock options and sales of common stock through our employee stock purchase plan.

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As of September 30, 2002, we had working capital of $2.7 million. We anticipate using available cash to fund growth in operations, invest in capital equipment, acquire businesses, and to license technology or products related to our line of business.
 
We believe that we have sufficient financial resources available to fund our current working capital and capital expenditure requirements for at least the next 12 months. We intend to continue to invest our cash in excess of current operating requirements in interest bearing, short term investments.
 
FORWARD LOOKING STATEMENTS
 
Certain statements made above, which are summarized below, are forward-looking statements that involve risks and uncertainties, and actual results may be materially different. Factors that could cause actual results to differ include those identified below:
 
·
 
For the fourth quarter of 2002, we expect year over year revenue growth of 20 percent. As a result, the entire year 2002 product and services revenue growth is expected to be 28 percent. We may be unable to meet this expectation for a variety of reasons, including generally soft market conditions for our products and services and other general economic uncertainties and weaknesses in geographic regions of the world, delays or difficulties in the development and inability to obtain market acceptance of our new products, and introduction of products by competitors.
 
·
 
Advanced Technology revenue is projected to remain fairly constant at approximately $1 million in the fourth quarter of 2002. Meeting this expectation depends upon our ability to obtain new government contract awards and maintain the current government contracts revenue, which might not occur for a variety of reasons, including an inability to staff engineers to our current contract requirements or customer delays or cancellations of contract awards.
 
·
 
For the fourth quarter, we expect aggregate gross profit to be consistent with the third quarter of 2002. Meeting this expectation depends upon our ability to maintain a higher level of products and services revenue. We may be unable to meet this expectation for a variety of reasons, including generally soft market conditions for the Company’s products and services and other general economic uncertainties and weaknesses in geographic regions of the world, delays or difficulties in the development and inability to obtain market acceptance of our new products, and introduction of products by competitors.
 
·
 
Excluding third quarter separation costs, operating expenses are expected to grow sequentially by approximately 2 percent in the fourth quarter of 2002. This expectation depends on us maintaining the current anticipated level of spending, which may not occur due to unexpected increases in such costs or because of a need to accelerate expenditures, or decreased products and services revenue. Additionally, meeting this expectation depends upon our ability to control costs and achieve a higher level of revenue. We may be unable to meet this expectation for a variety of reasons, including generally soft market conditions for our products and services, development and acceptance of our new products, and introduction of products by competitors.
 
·
 
We believe it is more likely than not that deferred tax assets, which total $2.7 million at September 30, 2002, will be realized. This expectation depends primarily on our estimates of future taxable income. The amount of deferred tax assets considered realizable could be reduced in the near term if estimates of future taxable income are reduced.
 
·
 
We expect to generate cash in the fourth quarter of 2002 and end the year with a total cash, cash equivalent, and short term investment balance in excess of $21.0 million. Meeting this expectation depends upon our ability to control costs and achieve a higher level of revenue. We may be unable to meet this expectation for a variety of reasons, including generally soft market conditions for our products and services, development and acceptance of our new products, and introduction of products by competitors, unexpected increases in personnel and operating expenses, the need for additional funds to react to changes in the marketplace, and currently unplanned acquisitions.
 
·
 
We believe that we have sufficient financial resources available to fund our current working capital and capital expenditure requirements for at least the next twelve months. Several factors may affect the availability of sufficient cash resources to fund our product development and marketing and sales plans for the next twelve months, including:

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·
 
our ability to generate revenue as currently expected;
 
 
·
 
unexpected expenses, such as increases in personnel and operating expenses;
 
 
·
 
the need for additional funds to react to changes in the marketplace;
 
 
·
 
currently unplanned acquisitions.
 
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
We do not have material exposure to quantitative and qualitative market risks because we do not own any risk sensitive financial instruments.
 
CONTROLS AND PROCEDURES
 
Our Chief Executive Officer and Chief Financial Officer have concluded, based on their evaluation within 90 days of the filing date of this report, that our disclosure controls and procedures are effective for gathering, analyzing and disclosing the information we are required to disclose in our reports filed under the Securities Exchange Act of 1934. There have been no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.

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SECURE COMPUTING CORPORATION
PART II
OTHER INFORMATION
 
ITEM 1.     Legal Proceedings
 
Beginning on April 2, 1999, several purported securities class action complaints were filed and consolidated in the United States District Court for the Northern District of California against us and certain of our present and former directors and officers by persons who acquired our stock between November 10, 1998 and March 31, 1999. Plaintiffs alleged that defendants made false and misleading statements about our business condition and prospects in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. Plaintiffs sought unspecified monetary damages. The court denied defendants’ motion to dismiss and defendants answered and denied all allegations of wrongdoing. In July 2002, we reached a settlement of the class action. Subject to court approval, the class action settled for $10.1 million. $2.8 million in cash will be covered by our insurance. The $7.3 million balance of the settlement will be contributed by us in common stock or in a combination of common stock and cash at the date of distribution. The final allocation of the contribution will be determined by us at our sole option.
 
On February 11, 2002, a purported derivative action was filed in California Superior Court, Santa Clara County, against certain of our current and former officers and directors. We are named as nominal defendant. The derivative action makes essentially the same factual allegations as the securities class actions and alleges various causes of action, including that the defendants breached their corporate fiduciary duties. Although we believe there are meritorious defenses to this action and intend to defend ourselves vigorously, an unfavorable resolution could have a material adverse effect on our business, results of operations and financial condition.
 
ITEM 2.     Changes in Securities
 
None
 
ITEM 3.     Defaults upon Senior Securities
 
Not applicable
 
ITEM 4.     Submission of Matters to a Vote of Security Holders
 
None
 
ITEM 5.     Other Information
 
None
 
ITEM 6.     Exhibits and Reports on Form 8-K
 
 
(a)
 
Exhibits
 
Exhibit 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
Exhibit 99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
(b)
 
Reports on Form 8-K:
 
A form 8-K was not filed during the quarter ended September 30, 2002.

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SECURE COMPUTING CORPORATION
 
SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
   
SECURE COMPUTING CORPORATION
DATE:    November 13, 2002
  
By:
  
/s/    TIMOTHY J. STEINKOPF
           
Timothy J. Steinkopf
Senior Vice President and Chief
Financial Officer
(Duly authorized officer and Principal
Financial Officer)
 

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CERTIFICATION
 
Pursuant to Sarbanes-Oxley Act Section 302
 
I, John McNulty, certify that:
 
1. I have reviewed this quarterly report on Form 10-Q of Secure Computing Corporation;
 
2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
 
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
 
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
 
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
 
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
 
6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
/s/    JOHN MCNULTY
 
John McNulty
Chief Executive Officer
November 13, 2002

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CERTIFICATION
 
Pursuant to Sarbanes-Oxley Act Section 302
 
I, Timothy J. Steinkopf, certify that:
 
1. I have reviewed this quarterly report on Form 10-Q of Secure Computing Corporation;
 
2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
 
3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
 
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
 
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
 
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
 
c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
 
5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
 
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
 
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
 
6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
 
/s/    TIMOTHY J. STEINKOPF
 
Timothy J. Steinkopf
Senior Vice President and Chief Financial Officer
November 13, 2002

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