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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended December 31, 2003

OR

For the transition period from                  to                 

Commission file number 0-28450

Netopia, Inc.

(Exact name of registrant as specified in its charter)

6001 Shellmound Street, 4^th Floor

Emeryville, California 94608

(Address of principal executive offices, including Zip Code)

(510) 420-7400

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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  ¨    No  x

As of December 31, 2003 there were 22,833,829 shares of the Registrant’s common stock outstanding.

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NETOPIA, INC.

Form 10-Q

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PART I — FINANCIAL INFORMATION

ITEM 1. UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NETOPIA, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Balance Sheets

See accompanying notes to unaudited condensed consolidated financial statements.

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NETOPIA, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Operations

See accompanying notes to unaudited condensed consolidated financial statements.

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NETOPIA, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

See accompanying notes to unaudited condensed consolidated financial statements.

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NETOPIA, INC. AND SUBSIDIARIES

Notes To Unaudited Condensed Consolidated Financial Statements

The unaudited condensed consolidated financial statements included in this Form 10-Q reflect all adjustments, consisting only of normal recurring adjustments which in the Company’s opinion are necessary to fairly present the Company’s consolidated financial position, results of operations and cash flows for the periods presented. These condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements included in the Company’s Annual Report on Form 10-K and other filings with the United States Securities and Exchange Commission (SEC). The consolidated results of operations for the period ended December 31, 2003 are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire fiscal year ending September 30, 2004.

Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans based on the fair market value of options granted. We have chosen to account for stock based compensation using the intrinsic value method prescribed in Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, because the grant price equals the market price on the date of grant for all options we have issued, no compensation expense is recognized for stock options issued to employees. In December 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 148, Accounting for Stock Based Compensation – Transition and Disclosure, which amends SFAS No. 123. SFAS No. 148 requires more prominent and frequent disclosures about the effects of stock-based compensation. We will continue to account for our stock based compensation according to the provisions of APB No. 25.

If we elected to use the fair value method of accounting for stock based compensation as prescribed by SFAS No. 123, the net loss and loss per share for the three months ended December 31, 2003 and 2002 would have been the pro forma amounts as follows:

The Black-Scholes Single Option weighted average fair value of employee stock options granted during the three months ended December 31, 2003 and 2002 was $8.73 and $1.52, respectively. The weighted average exercise price of employee stock options granted during the three months ended December 31, 2003 and 2002 was $8.74 and $1.56, respectively.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable while the Company’s

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employee stock options have characteristics significantly different from those of traded options. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. The fair value of each option grant and share purchased under the Purchase Plan are estimated on the date of grant or share purchase using the Black-Scholes option-pricing model with the following assumptions:

The expected lives of options under the Employee Stock Option and Employee Stock Purchase Plans are estimated at seven years and two years, respectively. In accordance with SFAS No. 123, the Company recognizes as an expense, the fair value of options and other equity instruments granted to non-employees. The Company uses the Black-Scholes option valuation model to determine the fair value of any options or other equity instruments granted to non-employees.

In December 2003, the SEC issued Staff Accounting Bulletin (SAB) 104, Revenue Recognition – Corrected Copy. SAB 104 revises or rescinds portions of the interpretative guidance included in Topic 13 of the codification of staff accounting bulletins in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The principal revisions relate to the rescission of material no longer necessary because of private sector developments in U.S. generally accepted accounting principles. The Company adopted the interpretive guidance in SAB 104 during the three months ended December 31, 2003. The Company’s application of the interpretive guidance in SAB 104 in the three months ended December 31, 2003 did not have a significant on the Company’s condensed consolidated financial statements.

JadeSail Systems, Inc. In October 2003, the Company acquired JadeSail Systems, Inc. (JadeSail), a provider of Internet Protocol (IP) services management and network equipment provisioning software. The Company and JadeSail, a California corporation, consummated the merger (the Merger) whereby Sailaway Merger Sub, Inc., a California corporation and a wholly-owned subsidiary of Netopia, merged with and into JadeSail pursuant to an Agreement and Plan of Merger and Reorganization dated as of October 3, 2003. JadeSail survived the Merger as a wholly owned subsidiary of Netopia. Netopia intends to incorporate the JadeSail technology into its EdgeManager platform thereby increasing functionality of the EdgeManager platform.

Under the terms of the Merger agreement, the Company issued shares of its common stock in exchange for all the outstanding common stock of JadeSail. The aggregate purchase price was approximately $1.4 million and consisted of (a) 160,000 shares of the Company’s common stock, which were valued using the average of the closing price of the Company’s common stock for the 5 day period beginning two days prior to and ending two days after the closing date, and (b) other transaction related expenses of approximately $0.2 million. The Company accounted for the transaction using the purchase method.

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The allocation of the purchase price is based upon the Company’s estimate of the fair value of the tangible and intangible assets acquired as follows:

The allocation of the total purchase price of JadeSail to its individual assets and assumed liabilities was based upon the Company’s estimate of the fair value thereof. In addition to the current assets and liabilities that were acquired, intangible assets were identified. These intangible assets were developed product technology, which represents the value of JadeSail’s proprietary know-how that was technologically feasible as of the acquisition date, and goodwill, which represents the excess of the purchase price over the fair value of the underlying net identifiable assets. The goodwill was attributed to the Company’s Web platforms reporting unit. The value of the developed product technology was determined based upon the value of the cash flows expected to be generated by technology that was feasible as of the acquisition date.

JadeSail’s operating results are included the Company’s condensed consolidated financial statements for the three months ended December 31, 2003. For comparative purposes the following summary, prepared on an unaudited pro forma basis, reflects the condensed consolidated statements of operations of the Company for the three months ended December 31, 2002 giving effect to the JadeSail acquisition and assuming that JadeSail had been acquired as of the beginning of the three months ended December 31, 2002:

The Company’s intangible assets at December 31, 2003 consist primarily of goodwill acquired in connection with the acquisitions of JadeSail, WebOrder and netOctopus which the Company is not amortizing, and other intangible assets acquired in connection with the JadeSail and Cayman acquisitions, which the Company is amortizing on a straight-line basis over their estimated useful lives.

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The following chart details the Company’s goodwill, maintained in its Web platforms reporting unit, as of December 31, 2003:

The following chart details the Company’s other intangible assets, by reporting unit, as of December 31, 2003:

Inventories consisted of the following:

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Warranty liability is recorded as a component of accrued liabilities on the Company’s condensed consolidated balance sheet. For the Company’s Internet equipment products, the Company generally provides a one-year warranty to domestic customers and a two-year warranty to international customers. The Company generally does not offer a warranty on its Web platforms products. On a monthly basis, the Company accrues its estimated warranty liability based upon a percentage of such months cost of revenues. On a quarterly basis, the Company analyzes its estimated warranty liability based upon historic return rates and records adjustments to its warranty liability as necessary. Warranty liability consisted of the following:

Basic net income (loss) per share is based on the weighted average number of shares of common stock outstanding during the period. Diluted net income (loss) per share is based on the weighted average number of shares of common stock outstanding during the period plus potential dilutive shares from options outstanding using the treasury stock method. The following chart details the Company’s per share calculations for the periods indicated:

Segment Information. The Company has adopted the provisions of SFAS No. 131, which establishes standards for the reporting by public business enterprises of information about operating segments, products and services, geographic areas, and major customers. The methodology for determining the information reported is based on the organization of operating segments and the related information that the Chief Operating Decision Maker (CODM) uses for operational decisions and assessing financial performance. Netopia’s Chief Executive Officer (CEO) is considered the Company’s CODM. For purposes of making operating decisions and assessing financial performance, the Company’s CEO reviews financial information presented on a consolidated basis accompanied by disaggregated information for revenues and gross margins by product group as well as revenues by geographic region and by customer. Operating expenses and assets are not disaggregated by product group for

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purposes of making operating decisions and assessing financial performance. The Company generates revenue from two groups of products and services. Disaggregated financial information regarding the operating segments is as follows:

Geographic Information. The Company sells its products and provides services worldwide through a direct sales force, independent distributors and value-added resellers. It currently operates in four regions: United States, Europe, Canada, and Asia Pacific and other. Revenues outside of the United States are primarily export sales denominated in United States dollars or Euros. Disaggregated financial information regarding the Company’s revenues by geographic region for the three months ended December 31, 2003 and 2002 is as follows:

The Company has no material operating assets outside the United States.

Customer Information. The Company sells its products to incumbent local exchange carriers (ILECs), competitive local exchange carriers (CLECs), distributors, Internet service providers (ISPs) and directly to end-users. Disaggregated financial information regarding the Company’s customers who accounted for 10% or more of the Company’s revenue for the three months ended December 31, 2003 and 2002 is as follows:

No other customers during the three months ended December 31, 2003 and 2002 accounted for 10% or more of the Company’s total revenues. For the three months ended December 31, 2003, there were three customers that each individually represented at least 5% of the Company’s revenues and in the aggregate, accounted for 46% of the Company’s total revenues. For the three months ended December 31, 2002, there were six customers that each individually represented at least 5% of the Company’s revenues and in the aggregate, accounted for 50% of the Company’s total revenues.

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The following table sets forth the accounts receivable balance for the customers identified above along with such data expressed as a percentage of total accounts receivable:

The Company has generally not experienced collection difficulties related to the customers identified above. Amounts due the Company from these customers are generally collected within the payment period customary in the normal course of business.

In fiscal year 2001, the Company purchased $2.0 million of Series D Preferred stock in MegaPath Networks Inc. (MegaPath). In fiscal year 2002, the Company purchased $0.4 million of Series E Preferred Stock in MegaPath. In fiscal year 2003, MegaPath completed an additional financing in which the Company invested $26,000. The Company owns approximately 4.0% of MegaPath. MegaPath offers high-speed DSL access and eCommerce and Web hosting services to small and medium size businesses. Although there is no public market for MegaPath’s stock, the Company believes that the market value of its investment in MegaPath is not less than the Company’s $1.0 million carrying value at December 31, 2003 because the fiscal year 2003 financing in which the Company participated, used the same valuation as the Series E Preferred Stock financing.

During the three months ended December 31, 2003 MegaPath purchased $0.3 million of the Company’s products. At December 31, 2003, MegaPath’s accounts receivable with the Company was $0.2 million.

The Company’s policy is to maintain accruals relating to restructurings for up to two years unless the Company has had definitive closure of the specific liabilities accrued prior to the two-year final review date. Detail of the Company’s remaining liabilities relating to its restructuring activities is as follows:

Credit Facility. In June 2002, the Company entered into a Loan and Security Agreement with Silicon Valley Bank (the Credit Facility). Pursuant to the Credit Facility, the Company may borrow up to $15.0 million from time to time from Silicon Valley Bank. The actual amount that can be borrowed at any time is determined using a formula relating to the amount of eligible accounts receivable and inventory at the borrowing date. On November 26, 2003 Silicon Valley Bank amended the tangible net worth covenant in the Credit Facility to provide that the Company must maintain a minimum tangible net worth of $30 million plus 50% of the Company’s net income in each fiscal quarter commencing with the first fiscal quarter ending December 31, 2003 and shall continue effective thereafter, as well as amending Collection of Accounts, Filing of the Transaction Reports, Limits on the Revolving Loans, Collateral Monitoring Fee and Interest Rate on the Loans as noted below. The Company must maintain an adjusted quick ratio, as defined as the ratio of (i) the Company’s unrestricted cash maintained at Silicon Valley Bank plus cash equivalents maintained at Silicon Valley Bank plus receivables and investments made on behalf of the Company through Silicon Valley

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Bank’s Investment Product Services Division (ISP Division) to (ii) the Company’s current liabilities plus the outstanding principal amount of any obligations less deferred revenues, of not less than 1.5 to 1 from January 1, 2003 to the end of the term.

The Credit Facility bears interest at a rate equal to the prime rate (the rate announced by Silicon Valley Bank as its “prime rate”) plus 0.75% per annum. Per the November 26, 2003 amendment, as long as no Default or Event of Default has occurred and is continuing, and as long as the Company maintains profitability as of the end of each fiscal quarter, the Credit Facility will bear interest equal to Silicon Valley Bank’s “prime rate” only. At December 31, 2003, the interest rate was 4.0%, Silicon Valley Bank’s “prime rate.” The Company may borrow under the Credit Facility in order to finance working capital requirements for new products and customers, and otherwise for general corporate purposes in the normal course of business.

As of December 31, 2003, the Company had no outstanding borrowings under this credit facility and had a borrowing availability of approximately $10.5 million.

Term Loan A. On February 25, 2003, Silicon Valley Bank made a term loan to the Company in the original principal amount of $0.2 million. The principal amount of Term Loan A is payable in twenty-four equal monthly payments of principal in the amount of $8,333.33 per month, commencing on March 1, 2003 and continuing until paid in full. $100,000 of the outstanding balance of Term Loan A is recorded as a current liability on the Company’s December 31, 2003 condensed consolidated balance sheet because that portion of the principal of Term Loan A will be repaid within one year of the balance sheet date. The remaining balance is recorded as a long-term liability. Term Loan A bears interest at a rate equal to Silicon Valley Bank’s prime rate plus 0.75% per annum. Per the November 26, 2003 amendment, as long as no Default or Event of Default has occurred and is continuing, and as long as the Company maintains profitability as of the end of each fiscal quarter, Term Loan A will bear interest equal to Silicon Valley Bank’s “prime rate” only. At December 31, 2003, the interest rate was 4.0%, Silicon Valley Bank’s “prime rate.” Upon the repayment of any portion of Term Loan A, such portion may not be re-borrowed. The outstanding principal balance of Term Loan A shall be reserved from the amount of credit facility otherwise available to the Company.

Term Loan B. On February 25, 2003, Silicon Valley Bank made a term loan to the Company in the original principal amount of $0.3 million. The principal amount of Term Loan B is payable in twenty-four equal monthly payments of principal in the amount of $12,500.00 per month, commencing on March 1, 2003 and continuing until paid in full. $150,000 of the outstanding balance of Term Loan B is recorded as a current liability on the Company’s December 31, 2003 condensed consolidated balance sheet because that portion of the principal of Term Loan B will be repaid within one year of the balance sheet date. The remaining balance is recorded as a long-term liability. Term Loan B bears interest at a rate equal to Silicon Valley Banks prime rate plus 1.00% per annum. Per the November 26, 2003 amendment, as long as no Default or Event of Default has occurred and is continuing, and as long as the Company maintains profitability as of the end of each fiscal quarter, Term Loan B will bear interest at a rate equal to Silicon Valley Bank’s “prime rate” only. At December 31, 2003, the interest rate was 4.0%, Silicon Valley Bank’s “prime rate.” Upon the repayment of any portion of Term Loan B, such portion may not be re-borrowed.

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Other income (loss), net consists of interest income the Company earns on its cash and cash equivalents, interest expense related to the Company’s borrowing under its credit facility and term loans and gains and losses on foreign currency transactions. The following table sets forth for the periods indicated, detail of the Company’s other income (loss), net:

PART I — FINANCIAL INFORMATION

Some of the information in this Form 10-Q contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “may,” “will,” “should,” “expect,” “anticipate,” “potential,” “believe,” “estimate,” “intends” and “continue” or similar words. You should read statements that contain these words carefully because they: (i) discuss our expectations about our future performance; (ii) contain projections of our future operating results or of our future financial condition; or (iii) state other “forward-looking” information. There will be events in the future that we are not able to predict or over which we have no control, which may adversely affect our future results of operations, financial condition or stock price. The risk factors described in this Form 10-Q, as well as any cautionary language in this Form 10-Q, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we described in our forward-looking statements. You should be aware that the occurrence of any of the risks, uncertainties, or events described in this Form 10-Q could seriously harm our business and that, upon the occurrence of any of these events, the trading price of our common stock could decline.

Company Overview

We develop, market and support broadband and wireless (Wi-Fi) products and services that enable our carrier and service provider customers to simplify and enhance the delivery of broadband services to their residential and business-class customers. Our product and service offerings enable carriers and broadband service providers to (i) deliver to their customers feature-rich modems, routers and gateways, (ii) utilize software that allows remote management of equipment located at their customers’ premises, and (iii) provide value added services to enhance revenue generation. Our broadband modems, routers and gateways are installed by customers of carriers and broadband service providers in order to obtain faster access to the Internet than is possible with dial-up connections. Our digital subscriber line (DSL) or broadband cable equipment are often bundled with backup, bonding, virtual private networking or VPN that allows more secure communications over the Internet, firewall protection, parental controls, Web content filtering, combined voice and data services, hosting of web sites that we call eSites, and hosting of web stores that we call eStores. Our netOctopus suite of server software products enable remote support and centralized management of installed broadband gateways, allowing carriers and broadband service providers to provide support to their customers on a remote basis. We also offer Timbuktu and eCare software products for help desk customers. These products allow business help desks to provide support on a remote basis when computer users experience problems or require additional of upgrade software with their desktop or laptop computers.

Broadband Equipment. We have developed a comprehensive family of broadband Internet modems, routers and gateways. The substantial majority of our revenues are generated from sales of our

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broadband Internet products, in particular our DSL modems, routers and gateways. During the three months ended December 31, 2003 and each of fiscal years 2003 and 2002, revenue from the sale of our broadband Internet products have accounted for 84%, 79% and 71%, respectively, of our total revenues. Our broadband equipment products allow the transport of high-speed data and enable telecommunications carriers to provide cost-effective and high-speed services over existing copper infrastructure. This family of products serves an array of wide area network (WAN) interfaces including DSL, cable and T1, and local area network (LAN) interfaces including Wi-Fi, Ethernet and Universal Serial Bus (USB). Our broadband Internet products are designed to deliver high performance, excellent reliability, scalability, and affordability, and to provide a platform from which our carrier and service provider customers can offer their customers additional services and applications. We believe key components of our success are comprehensive interoperability with leading central office DSL equipment, a common firmware platform across all versions of our broadband Internet products, and technology such as our 3-D Reach^™ technology which allows our Wi-Fi products to achieve greater and more reliable wireless coverage than is provided by many of our competitors. When reading our condensed consolidated statement of operations, revenues and cost of revenues related to the sale of our broadband Internet equipment are classified as “Internet equipment.”

Broadband Services. Our service delivery platform includes the netOctopus suite of server software products and systems management software products. The netOctopus suite includes: EdgeManager, which enables remote support and centralized management of installed broadband gateways and real-time customer support; eCare and Desktop Support, which enable broadband service providers and other enterprise customers to support their customers or employees by remotely viewing and operating the customer’s desktop computer; and, our Web eCommerce server solution that provides “no assembly required” Web sites and online stores that we call eSites and eStores, with a wide variety of vertical market content packages to suit many needs. Our customers for this product include franchisees to sole proprietors. Our systems management software includes Timbuktu, a systems management tool providing remote computer control, configuration, support and file transfer for both Macintosh and Windows based personal computers. We hold one United States patent relating to eCare and Timbuktu systems management software. The term of this patent is through August 2010. During the three months ended December 31, 2003 and each of fiscal years 2003 and 2002, revenue from the sale of our broadband services have accounted for 16%, 21% and 29%, respectively, of our total revenues. When reading our condensed consolidated statement of operations, revenues and cost of revenues related to the sale of our broadband services are classified as “Web platform licenses and services.”

We primarily market and sell our products in the United States, Canada, Europe and the Asia Pacific region through a field sales organization and through selected distributors. Our broadband equipment products are generally sold directly to our carrier and service provider customers or in some cases to distributors who then resell our products. Our broadband service products are generally sold directly to our customers. We primarily sell our products to:

Historically, we have primarily depended upon the ability of our customers to successfully offer DSL broadband services. Prior to our acquisition of Cayman in October 2001, our largest customers were CLECs. Many CLECs filed for protection under the Bankruptcy Act or ceased operations. Covad, which currently is our largest CLEC customer and historically has been among our largest customers, is expecting operating losses and negative cash flow to continue into 2004.

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As a result of financial and operational difficulties encountered by many of our CLEC customers, which primarily had the business market for DSL services, we acted aggressively to expand our customer base and markets served. As a result of our acquisition of Cayman, we have expanded our customer base to include two ILEC customers, SBC and BellSouth, to which we previously had not sold our broadband equipment, and have developed new products designed for the residential market for ADSL services, which have enabled us to win new customers such as Swisscom in Switzerland, EarthLink in the United States, and Eircom in Ireland. We expect that the success of our operations will remain substantially dependent upon our ability to develop and enhance products that meet the needs of both the residential and business market for ADSL and Wi-Fi services and requirements of our ILEC customers. Our major customers are significantly larger than we are, and are able to exert a high degree of influence over our business. For example, our larger customers may be able to reschedule or cancel orders without significant penalty and may force lengthy approval and purchase processes before purchasing our products.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. We review the accounting policies used in reporting our financial results on a regular basis. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our processes used to develop estimates, including those related to accounts receivable, inventories, investments and intangible assets. We base our estimates on historical experience, expectations of future results, and on various other assumptions that are believed to be reasonable for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates due to actual outcomes being different from those on which we based our assumptions. These estimates and judgments are reviewed by management on an ongoing basis and by the Audit Committee at the end of each quarter prior to the public release of our financial results. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements.

Revenue Recognition. We recognize revenue from the sale of broadband Internet equipment at the time of shipment to a third party customer when (a) the customer takes title of the goods; (b) the price to the customer is fixed or determinable; (c) the customer is obligated to pay the seller and the obligation is not contingent on resale of the product; (d) the customer’s obligation to us would not be changed in the event of theft or physical destruction or damage of the product; and (e) we do not have significant obligations for future performance to directly bring about resale of the product by the customer. At the date of shipment, assuming that the revenue recognition criteria specified above are met, we provide for an estimate of returns and warranty expense based on historical experience of returns of similar products and warranty costs incurred, respectively.

We recognize software revenue in accordance with Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended. We generally have multiple element arrangements for our software revenue including software licenses and maintenance. We allocate the arrangement fee to each of the elements based on the residual method utilizing vendor specific objective evidence (VSOE) for the undelivered elements, regardless of any separate prices stated within the contract for each element. VSOE for maintenance is generally based on the price the customer would pay when sold separately. Software license revenue is recognized when a non-cancelable license agreement has been signed or a properly authorized firm purchase order is received and the customer acknowledges an unconditional obligation to pay, the software product has been delivered, there are no uncertainties surrounding product acceptance, the fees are fixed and determinable, and collection is considered probable. Maintenance revenues, including revenues included in multiple element arrangements, are deferred and recognized ratably over

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the related contract period, generally twelve months. We recognize revenue from long-term software development contracts using the percentage of completion method in accordance with SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. Revenue is recognized based on our achievement, and the customer’s acceptance, of certain milestones agreed upon by both parties with consideration given to the number of hours expended as compared to hours budgeted. On a quarterly basis, we review costs incurred to date along with an estimate to complete and compare the sum of such amounts against the revenue expected from the arrangement to determine the need for an accrual for loss contracts.

We apply the provisions of Emerging Issues Task Force (EITF) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, to arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. Our enhanced web site services generally involve the delivery of multiple services. We allocate a portion of the arrangement fee to the undelivered element, generally web site hosting and maintenance, based on the residual method utilizing fair value for the undelivered elements, regardless of any separate prices stated within the contract for each element. Fair value for hosting and maintenance is based on the price the customer would pay when sold separately. Fair value for the delivered elements, primarily fulfillment services, is based on the residual amount of the total arrangement fees after deducting the fair value for the undelivered elements. Fulfillment revenue is recognized when a properly authorized firm purchase order is received and the customer acknowledges an unconditional obligation to pay, there are no uncertainties surrounding product acceptance, the fees are fixed and determinable, collection is considered probable and the fulfillment has been completed. Hosting and maintenance revenues are deferred and recognized ratably over the related service period, generally twelve months. We record unearned revenue for software and service arrangements when cash has been received from the customer and the arrangement does not qualify for revenue recognition under our revenue recognition policy. We record accounts receivable for software and service arrangements when the arrangement qualifies for revenue recognition and cash or other consideration has not been received from the customer.

Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Management specifically analyzes the aging of accounts receivable and also analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms, when evaluating the adequacy of the allowance for doubtful accounts in any accounting period. If the financial condition of our customers or channel partners were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

Excess and Obsolete Inventory. We assess the need for reserves on excess and obsolete inventory based upon monthly forward projections of sales of products. Inventories are recorded at standard cost based upon the first-in, first out (FIFO) method which approximates market. Cost includes material costs and applicable manufacturing overheads. The provision for potentially obsolete or slow moving inventory is made based upon management’s analysis of inventory levels, forecasted sales, expected product life cycles and market conditions. Once inventory is reserved, the reserve can only be relieved by the subsequent sale or scrapping of the inventory.

Warranty Liability. Our warranty liability is an estimate of our future product warranty returns. For our Internet equipment products, we generally provide a one-year warranty to domestic customers and a two-year warranty to international customers. We do not generally offer a warranty on our Web platforms products. On a monthly basis, we accrue for our estimated warranty liability based upon a percentage of such month’s cost of revenues. On a quarterly basis, we analyze our estimated warranty liability based upon historic return rates and record adjustments to the warranty liability as necessary.

Provision for Income Taxes. We recorded a provision for income tax expense for the three months ended December 31, 2003. This provision consists of amounts accrued for our estimated fiscal year 2004 domestic federal and state income tax liability as well as an estimate of the foreign income tax expense to which our foreign subsidiaries are subject. This provision is based upon our estimated fiscal year 2004 net income before income taxes and takes into consideration the utilization of our net operating loss carry

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forwards. To the extent our estimate of fiscal year 2004 net income before income tax changes, our provision for income taxes will change as well. Historically, we have not recorded a provision for income tax expense because we had been generating net losses. Furthermore, we have not recorded an income tax benefit for the fiscal years 2003 and 2002 primarily due to continued substantial uncertainty regarding our ability to realize our deferred tax assets. Based upon available objective evidence, there has been sufficient uncertainty regarding the ability to realize our deferred tax assets which warrants a full valuation allowance in our financial statements. The factors considered included prior losses, inconsistent profits, and lack of carry-back potential to realize our deferred tax assets. Based on our estimates for fiscal year 2004 and beyond, we believe the uncertainty regarding the ability to realize our deferred tax assets may diminish to the point where it is more likely than not that our deferred tax assets will be realized. At such point, we would reverse all or a portion of our valuation allowance which will result in an income tax benefit.

Goodwill. We test our goodwill for impairment annually or whenever events or changes in circumstances indicate that the carrying amount may be impaired. The impairment testing is performed in two steps: (i) the determination of impairment, based upon the fair value of a reporting unit as compared to its carrying value, and (ii) if there is an indication of impairment, this step measures the amount of impairment loss by comparing the implied fair value of goodwill with the carrying amount of that goodwill. We perform our annual impairment test, as required by SFAS No. 142, in our fiscal fourth quarter. (See Note 5 of Notes to Unaudited Condensed Consolidated Financial Statements.)

Impairment of Long-Lived Assets, Including Other Intangible Assets. We evaluate our long-lived assets, including other intangible assets in accordance with SFAS No. 144 and test our long-lived assets and other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future net cash flows expected to be generated by the asset group that represents the lowest level for which identifiable cash flows exist. If an asset group is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount exceeds the fair value of the assets and is allocated to the long-lived assets of the asset group on a pro rata basis. Fair value is estimated using the discounted cash flow method. Assets to be disposed of are reported at the lower of carrying values or fair values, less costs of disposal. (See Note 5 of Notes to Consolidated Financial Statements.)

Accounting for Stock-based Compensation. We maintain stock option plans under which we may grant incentive stock options and non-statutory stock options. SFAS No. 123, Accounting for Stock-Based Compensation, encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans based on the fair market value of options granted. We account for stock based compensation using the intrinsic value method prescribed in Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations. Because the grant price equals the market price on the date of grant for all options we issue, we do not recognize compensation expense for stock options granted to employees. In accordance with SFAS No. 123, we recognize as an expense, the fair value of options and other equity instruments granted to non-employees. We have not issued any stock options to non-employees since fiscal year 2001, excluding options issued to our directors. In December 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 148, Accounting for Stock Based Compensation – Transition and Disclosure, which amends SFAS No. 123. SFAS No. 148 requires more prominent and frequent disclosures about the effects of stock-based compensation. We will continue to account for our stock based compensation according to the provisions of APB No. 25.

Long-Term Investments. We periodically make strategic investments in companies whose stock is not currently traded on a stock exchange and for which no quoted price exists. The cost method of accounting is used to account for these investments, as we do not exert significant influence over these investments. We review these investments for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets might not be recoverable. Examples of events or changes in circumstances that may indicate to management that an impairment exists may be a significant decrease in the market value of the company, poor or deteriorating market conditions in the public and

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private equity capital markets, significant adverse changes in legal factors or within the business climate the company operates, and current period operating or cash flow losses combined with a history of operating or cash flow losses or projections and forecasts that demonstrate continuing losses associated with the company’s future business plans. Impairment indicators identified during the reporting period could result in a significant write down in the carrying value of the investment if we believe an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in significant additional impairment charges in the future.

Liquidity and Capital Resources

The following sections discuss the effects of changes in our balance sheets, cash flows and commitments on our liquidity and capital resources. As of December 31, 2003, our principal source of liquidity included cash and cash equivalents in the amount of $26.4 million, a credit facility with a maximum borrowing capacity of up to $15.0 million from which, at December 31, 2003, we had no outstanding borrowings, and two term loans from which we had amounts outstanding of $0.3 million.

Cash and Cash Equivalents. The following table sets forth our cash and cash equivalents as of December 31 and September 30, 2003.

For the three months ended December 31, 2003, cash and cash equivalents increased primarily due to the proceeds we received from the issuance of our common stock and our operating activities.

Net Cash Provided by Operating Activities

During the three months ended December 31, 2003, our operating activities provided $0.3 million of cash. Excluding the changes in operating assets and liabilities, our operating activities generated $2.4 million of cash primarily due to our net income, which was a result of increased revenues and gross profits generated by our Internet equipment products, and adding back non-cash charges of depreciation and amortization. Changes in our operating assets and liabilities used $2.1 million of cash primarily as a result of increased inventory purchases as well as increased accounts receivable balances partially offset by increased accounts payable balances. Our inventory increased as a result of increased ocean shipments of in-transit finished goods and accounts receivables increased as a result of increased purchases by our larger European customers to which we provided payments terms that are longer than our customary terms.

Net Cash Used in Investing Activities

During the three months ended December 31, 2003, our investing activities used approximately $0.5 million of cash. We purchased approximately $0.4 million of capital equipment primarily for use in our development and manufacturing operations and we used approximately $0.1 million in connection with our acquisition of JadeSail for certain professional fees and payments to shareholders.

Net Cash Provided from Financing Activities

During the three months ended December 31, 2003, we generated $4.4 million of cash primarily through employee stock option exercises. We expect that while our stock price remains above the average price of our outstanding stock options, which at December 31, 2003 was $4.34, employees will continue to exercise their stock options thereby generating cash. Additionally, we expect that purchases of our stock through our Employee Stock Purchase Plan (ESPP) will also generate cash.

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Commitments

As of December 31, 2003, we had commitments that consisted of facilities and equipment under operating lease agreements and both short and long-term borrowing obligations. These commitments and obligations are reflected in our financial statements once goods or services have been received or payments related to the obligations become due. The following is a schedule of our future minimum cash payments with respect to such commitments.