NETSCREEN TECHNOLOGIES INC - 10-Q Quarterly Report

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

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

As of January 30, 2004, 92,482,834 shares of the registrant’s common stock, $0.001 par value, were outstanding.

NetScreen Technologies, Inc. (the “Company” or “NetScreen”) was incorporated in Delaware on October 30, 1997. NetScreen develops, markets and sells a broad family of high-performance, cost-effective, purpose-built network security solutions. The Company’s security solutions integrate key security technologies in appliances and systems that can be deployed at multiple points in the network. These solutions provide the layers of network and application level security to implement secure network-to-network, user-to-network and user-to-user communication with encryption, access control, authentication and attack detection and prevention.

The accompanying condensed consolidated financial statements of NetScreen Technologies, Inc. have been prepared, without audit, in accordance with generally accepted accounting principles in the United States (“GAAP”) and the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted in accordance with these rules and regulations. The information in this report should be read in conjunction with the Company’s financial statements and notes thereto included in its Annual Report on Form 10-K filed with the SEC on December 24, 2003.

In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to summarize fairly the Company’s financial position, results of operations and cash flows for the interim periods presented. The operating results for the three month period ended December 31, 2003 are not necessarily indicative of the results that may be expected for the year ending September 30, 2004 or for any other future period.

The Company derives revenues primarily from sales of its hardware-based security systems and appliances and maintenance arrangements and, to a lesser extent, from sales of software products and services. The Company generally recognizes revenues when persuasive evidence of an arrangement exists, delivery or customer acceptance, where applicable, has occurred, the fee is fixed or determinable and collection is probable. For newly introduced technically complex products, the Company defers revenues from the sale of these products until they have successfully performed in the marketplace and sales returns are not unusually high. The determination of which products are complex and the timing of the end of deferral for particular products, can be expected to vary.

The Company defers revenues on sales to its distributors until the distributor has sold the products to its customers. The Company’s agreements with distributors provide for limited stock rotation and price protection rights. Stock rotation rights provide distributors with the right to exchange unsold inventory for alternate products of equal or greater value. Price protection rights grant distributors the right to credit on purchases in the event of decreases in the prices of the Company’s products. The Company’s agreements with value-added resellers typically do not include stock rotation or price protection rights. At the time of shipment to value-added resellers, the Company reserves for estimated returns and exchanges. These revenue reserves are estimated and adjusted periodically based on historical rates of returns and allowances, inventory levels for value-added resellers that submit inventory or sell-through reports, the volume of sales to value-added resellers that the Company ships directly to end customers and for sales to value-added resellers that do not submit inventory or sell-through reports, accounts receivable balances, payment history and other related factors.

The Company defers a portion of its product revenues based on the value of certain maintenance arrangements included with each product sale and recognizes these revenues over the applicable maintenance period. The Company also derives a portion of its revenues from sales of separate extended maintenance arrangements. The Company sells extended hardware maintenance, faster hardware replacements for defective units, software maintenance as well as world-wide technical support with access 24 hours a day, seven days a week. These arrangements are sold as a bundle or as separate support offerings providing only hardware maintenance, technical support or software maintenance. For bundled arrangements, revenue is allocated among the elements at the time of sale based on their fair values as determined by the prices charged by the Company when each element is sold separately (renewal rate). Revenue from extended maintenance arrangements is recognized over the period of coverage purchased by the customer.

The Company has a large, diversified customer base, which includes customers located in foreign countries. The Company monitors the creditworthiness of its customers but has experienced losses related to its accounts receivable in the past. The Company records an allowance for doubtful accounts based on past history, current economic conditions and the composition of its accounts receivable aging and, in some cases, makes allowances for specific customers based on several factors, such as the creditworthiness of those customers and payment history.

The Company regularly records a sales return reserve that approximates the aggregate dollar amount of expected future returns and allowances. The sales return reserve is calculated based on past return history, product mix, channel mix and, in some cases, allowances for specific customers based on several factors such as return rights included in the Company’s agreements with customers.

Given the volatility of the networking market, the rapid obsolescence of technology and short product life cycles, the Company writes down inventories to net realizable value based on backlog and forecasted demand.

The Company’s hardware products carry a one-year warranty that includes factory repair services or replacement parts as needed. The Company accrues estimated expenses for warranty obligations at the time that products are shipped based on historical product repair and replacement information.

The Company reviews property, plant and equipment, goodwill and other intangible assets for impairment whenever events or circumstances indicate the carrying amount of the assets may not be recoverable. At a minimum, this review is conducted annually. The Company’s review is based on its best estimate of a variety of factors, including future market growth, forecasted revenues and costs and a strategic review of its business and operations. In the event the Company determines that an asset is impaired in the future, an adjustment to the value of the asset would be charged to earnings in the period such determination is made.

The consolidated financial statements include the Company’s accounts and those of its wholly owned subsidiaries. Upon consolidation, all significant intercompany accounts and transactions have been eliminated.

Foreign currency transactions of foreign operations are measured using U.S. dollars as the functional currency. Accordingly, monetary accounts (principally cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities) are remeasured using the foreign exchange rate at the balance sheet date. Accounts related to operations and non-monetary balance sheet items are remeasured at the rate in effect at the date of the transaction. The effects of foreign currency remeasurement are reported in current operations and were immaterial for all periods presented.

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

For financial statement purposes, the Company is required to make estimates and judgments in determining its income taxes in each of the jurisdictions in which it operates. The Company estimates its current income tax exposure in conjunction with making judgments when assessing its deferred tax assets and liabilities, which stem from the differing treatment of items for tax and accounting purposes.

Comprehensive income (loss) includes certain unrealized gains and losses that are recorded as a component of stockholders’ equity and excluded from the determination of net income (loss). The Company’s only component of accumulated other comprehensive income (loss) was unrealized losses on investments of approximately $(144,000) in the three months ended December 31, 2003. Accumulated other comprehensive income was approximately $90,000 and $234,000 at December 31, 2003 and September 30, 2003, respectively.

The Company considers all highly liquid investments with maturity of three months or less at the date of purchase to be cash equivalents. The carrying value of cash and cash equivalents approximated fair value at December 31, 2003 and September 30, 2003.

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents, short-term investments and accounts receivable. The Company places all of its cash equivalents with high credit-rated issuers. Carrying amounts of financial instruments held by the Company, which include cash equivalents, short-term investments, restricted cash, accounts receivable, accounts payable and accrued expenses, approximate fair value due to their short duration. The Company performs ongoing credit evaluations of its customers, generally requires customers to prepay for maintenance and maintains reserves for potential losses. The Company’s customer base is composed of businesses throughout the Americas, which consists of North and South America, Asia and the Pacific Rim (APAC) and Europe, the Middle East and Africa (EMEA).

The Company capitalizes eligible software costs as its products achieve technological feasibility, subject to net realizable value considerations. SFAS No. 86, “Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,” requires the capitalization of certain software development costs once technological feasibility is established, which the Company defines as the completion of a working model. Development costs incurred after the establishment of technological feasibility have not been material and, therefore, have been expensed.

The Company’s policy is to expense advertising costs as incurred. The Company’s advertising costs were approximately $638,000 and $140,000 for the three months ended December 31, 2003 and 2002, respectively.

The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. Expenses associated with stock-based compensation are amortized ratably over the vesting periods of the individual awards consistent with the method described in Financial Accounting Standards Board (“FASB”) Interpretation No. 28. The Company provides additional pro forma disclosures as required under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.” Options granted to consultants and other non-employees are accounted for in accordance with Emerging Issues Task Force Consensus No. 96-18, “Accounting for Equity Investments That Are Issued to Other Than Employees for Acquiring, or In Conjunction with Selling, Goods or Services,” and valued using the Black-Scholes method prescribed by SFAS 123. The options are subject to periodic revaluation over their vesting periods.

The following table illustrates the effect on net income (loss) applicable to common stockholders and net income (loss) per share applicable to common stockholders as if the fair value recognition provisions of SFAS 123 had been applied to all outstanding and unvested stock-based awards in each period (in thousands, except per share amounts):

The following weighted average assumptions were used in determining the fair value of the Company’s employee and non-employee option plans:

The fair value for the Company’s employee stock purchase plan during the three months ended December 31, 2003 was estimated using an expected life of 0.81 years, expected price volatility of 54%, a risk-free interest rate of 1.41% and no dividend yield. The fair value for the employee stock purchase plan during the three months ended December 31, 2002 was estimated using an expected life of 0.47 years, expected price volatility of 84%, a risk-free interest rate of 1.94% and no dividend yield.

The option valuation models were developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions. Because the Company’s employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period ending after March 15, 2004.

The adoption of FIN 46 has not and is not expected to have a material impact on the Company’s results of operations or financial position.

In December 2003, the FASB issued FASB Statement No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” (“SFAS 132”). This statement establishes standards that require companies to provide more details about their plan assets, benefit obligations, cash flows, benefit costs and other relevant information. For example, companies now are required to provide a breakdown of plan assets by category, such as equity, debt and real estate. In addition to expanded annual disclosures, companies are required to report the various elements of pension and other postretirement benefit costs on a quarterly basis. This statement is effective for fiscal years ending after December 15, 2003. The adoption of SFAS 132, as revised in 2003, is not expected to have an impact on the Company’s results of operations or financial position.

Inventories are stated at the lower of standard cost, which approximates actual cost (first-in, first-out method) or market value (estimated net realizable value). The valuation of inventories at the lower of standard cost or market value requires the use of estimates regarding the amount of inventory that will be sold and the prices at which current inventory will be sold. These estimates are dependent on the Company’s assessment of current and expected orders from its customers.

In accordance with SFAS No. 128, “Earnings per Share,” basic net income per share is calculated using the weighted-average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted net income per share for the three months ended December 31, 2003 and 2002 gives effect to the dilutive effect of common stock equivalents consisting of stock options and shares subject to repurchase using the treasury stock method.

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

On November 14, 2003, the Company completed its acquisition of Neoteris, Inc., a provider of secure sockets layer virtual private networking (SSL VPN) solutions. The acquisition of Neoteris expanded NetScreen’s product portfolio to include SSL VPN devices, and allowed NetScreen to enter the SSL VPN market. The preliminary purchase price was $267.1 million and the transaction has been accounted for as a purchase. The Company agreed to pay a total of $20.0 million in cash and issue 9.7

million shares of its common stock with an accounting value of $219.7 million for all of the outstanding stock of Neoteris. The common stock issued in the acquisition was valued for financial reporting purposes using the average closing price of the Company’s common stock on The Nasdaq National Market from two days before to two days after the date the transaction was announced, which was $22.68 per share. The Company also assumed all of the outstanding stock options of Neoteris, which were converted into options to purchase 1.2 million shares of the Company’s common stock. The accounting value of the stock options assumed was $25.9 million. The options were valued using the Black-Scholes option pricing model using a volatility factor of 68%, expected lives of three years, a risk-free interest rate of 2.06% and a per share value of $22.68. The total purchase price also includes an estimate of the direct costs associated with the transaction totaling $1.5 million. The Company agreed to pay Neoteris stockholders and option holders up to an additional $30 million in cash upon the achievement of certain revenue milestones, which, if this occurs, will increase the purchase price and goodwill. Neoteris is included in the consolidated results of the Company beginning November 14, 2003.

The acquisition has been accounted for under the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations.” Under the purchase method of accounting, the total purchase price is allocated to the tangible and intangible assets acquired and the liabilities assumed based on their estimated fair values. The excess of the purchase price over those fair values is recorded as goodwill. The fair values assigned to the tangible and intangible assets acquired and liabilities assumed are based on estimates and assumptions provided by management, and other information compiled by management, including independent valuations, prepared by independent valuation specialists, that utilize established valuation techniques appropriate for the high technology industry. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill will be reviewed periodically for impairment.

The allocation of the purchase price has been revised from the allocation reported on the Company’s Current Report on Form 8-K/A filed with the SEC on January 28, 2004 to reflect an increase of $21.3 million in the fair value of net tangible assets acquired and an equal but offsetting reduction of goodwill.

Neoteris had incurred operating losses prior to the date of acquisition. The potential value of the combined companies, products and technologies contributed to a purchase price that resulted in the recognition of goodwill. The total purchase price and purchase price allocation is preliminary and is subject to change as the Company finalizes the costs of the acquisition, its integration plans and estimates and assumptions used in the valuation of the tangible and intangible assets acquired.

A summary of intangible assets at December 31, 2003 is as follows (in thousands):

Intangible assets are amortized on a straight-line basis over their estimated useful lives of two months to ten years. The estimated future amortization of intangible assets is as follows (in thousands):

The following unaudited pro forma financial information presents the combined results of operations of NetScreen and Neoteris as if the acquisition had occurred on October 1, 2002. Due to different fiscal years, the unaudited pro forma financial information for 2003 was derived from NetScreen’s audited statement of operations for the three months ended December 31, 2003 and Neoteris’ unaudited statement of operations for the three months ended October 31, 2003, pro rated for the portion of NetScreen’s statement of operations prior to the November 14, 2003 acquisition date. The unaudited pro forma financial information for 2002 was derived from NetScreen’s audited consolidated statement of operations for the three months ended December 31, 2002 and Neoteris’ unaudited statement of operations for the three months ended October 31, 2002.

Adjustments of $2.3 million for the three months ended September 30, 2003 and $7.5 million for the three months ended September 30, 2002 have been made to the combined results of operations, reflecting the amortization of the intangible assets acquired and deferred stock compensation associated with the Neoteris unvested restricted stock and stock options assumed by NetScreen. The unaudited pro forma basic and diluted net loss per share computations are based upon the weighted average outstanding common stock of NetScreen during the periods presented, plus the number of shares of NetScreen common stock issued to complete the acquisition as if the acquisition had occurred on October 1, 2002. The unaudited pro forma financial information is not intended to represent or be indicative of the consolidated results of operations or financial condition that NetScreen would have reported had the acquisition been completed as of the dates presented, and should not be taken as representative of the future consolidated results of operations.

Unaudited pro forma financial information is as follows (in thousands, except per share amounts):

The Company’s hardware products carry a one-year warranty that includes factory repair services or replacement parts as needed. The Company’s software products carry a three-month maintenance agreement. The Company accrues estimated expenses for warranty obligations at the time that products are shipped based on historical product repair and replacement information. Factors that affect the Company’s warranty liability include the number of installed units, historical rates of warranty claims and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.

Changes in the Company’s estimated product warranty liability during the three months ended December 31, 2003 were as follows (in thousands):

Generally, the Company indemnifies, under pre-determined conditions and limitations, its customers for infringement of third-party intellectual property rights by its products or services. The Company seeks to limit its liability for such indemnity to an amount not to exceed the sales price of the products or services. The Company does not believe, based on information available to it, that it is probable that any material amounts will be paid under these guarantees.

The Company’s products are manufactured, tested and shipped to customers by three contract manufacturers. The Company has contracts with each of the contract manufacturers, each of which allows for termination for convenience. The Company’s obligations under these contracts include all purchase orders it has issued, portions of which are cancelable, and certain components procured on the Company’s behalf by the contract manufacturers. At December 31, 2003, the Company had outstanding purchase orders totaling $7.5 million.

The Company is subject to legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, the Company does not expect that the ultimate costs to resolve these matters will have a material adverse affect on its consolidated financial position, results of operations or cash flows.

In connection with the November 2003 acquisition of Neoteris and the September 2002 acquisition of OneSecure, Inc., the Company assumed non-cancelable operating leases for offices which will not be occupied by the Company. The Company has recorded a restructuring liability for the net present value of these duplicate facilities, net of expected sublease income. The

liability for the net present value of future net lease payments for the excess facilities, will decrease as required lease payments are made as follows:

During the three months ended December 31, 2003, the Company made payments on the non-cancelable operating leases that were included in restructuring liabilities. The net present value of the amounts paid during the three months ended December 31, 2003 was approximately $159,000.

The Company operates in one business segment, the sale of integrated network security solutions. The Company sells its products and services to customers in the Americas, APAC and EMEA. Revenues by geographic region were as follows (in thousands):

No single customer accounted for 10% or more of total revenues in the three months ended December 31, 2003. One customer accounted for 11% of total revenues in the three months ended December 31, 2002.

On February 9, 2004, the Company signed a definitive agreement to be acquired by Juniper Networks, Inc. in a stock-for-stock merger transaction. Under the terms of the agreement, Company stockholders will receive 1.404 shares of Juniper common stock for each outstanding share of NetScreen common stock. The completion of the acquisition is contingent upon customary conditions of closing, including regulatory clearances and the approval of the stockholders of both companies. The acquisition is expected to close during the Company’s fiscal 2004 third quarter.

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

This Management’s Discussion and Analysis of Financial Condition and Results of Operations section should be read in conjunction with the accompanying condensed consolidated financial statements and related notes appearing elsewhere in this report. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. In many cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “potential,” “intend” or “continue,” or comparable terminology. These forward-looking statements include our expectations about revenue, revenue mix, channel mix, cost of revenues, gross margin and various operating expenses. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including, but not limited to, those presented below, under the caption “Factors That May Affect Our Business and Future Results of Operations and Financial Condition,” and elsewhere in this report. You should carefully review the risks described in other documents we file from time to time with the Securities and Exchange Commission, including our Annual Report on Form 10-K for the period ended September 30, 2003, which was filed on December 24, 2003, as well as other periodic reports that we will file in 2004. We undertake no obligation to update any forward-looking statements for any reason, except as required by law, even if new information becomes available or other events occur in the future.

We develop, market and sell a broad family of integrated network security solutions for enterprises, carriers and government entities. Our security solutions provide key technologies such as firewall, virtual private networking (VPN), denial of service protection, antivirus and intrusion detection and prevention in a line of easy-to-manage security systems and appliances. Our products are based on industry standard communication protocols and can be combined with our management software so that they can be easily integrated into networks, easily managed and will interoperate with other security devices and applications.

On February 9, 2004, we signed a definitive agreement to be acquired by Juniper Networks, Inc., in a stock-for-stock merger transaction. Under the terms of the agreement, our stockholders will receive 1.404 shares of Juniper common stock for each outstanding share of our common stock. The completion of the acquisition is contingent upon customary conditions of closing, including regulatory clearances and the approval of the stockholders of both companies. The acquisition is expected to close during our fiscal 2004 third quarter. We cannot assure you that the acquisition will close on a timely basis or at all. In addition, if the acquisition closes, we cannot assure you that we will be able to successfully integrate our business, products, technologies or personnel with those of Juniper or meet our financial or other strategic objectives.

On November 14, 2003, we completed our acquisition of Neoteris, Inc., a provider of secure sockets layer virtual private networking (SSL VPN) solutions. We agreed to pay $20.0 million in cash and issued 9.7 million shares of our common stock for all the outstanding stock of Neoteris. We also assumed all of the outstanding stock options of Neoteris, which were converted into options to purchase 1.2 million shares of our common stock. We have agreed to pay Neoteris stockholders and option holders up to an additional $30 million in cash upon the achievement of certain revenue milestones. Neoteris’ results of operations are included in our consolidated results of operations beginning November 14, 2003. We recorded substantial goodwill and other intangible assets in connection with the acquisition. In accordance with provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” goodwill resulting from the acquisition will not be amortized, but will be reviewed periodically for impairment. The other intangible assets will be amortized on a straight-line basis over their estimated useful lives of two months to four years. We also recorded substantial deferred stock compensation as a result of this acquisition. Achieving the anticipated benefits of the merger will depend in part upon whether the operations, products and technology of Neoteris can be integrated with our operations, products and technology in a timely and cost-effective manner. The process of combining the two companies is a complex, expensive and time-consuming process and may cause an interruption of, or loss of momentum in, the development and sales activities and operations of both companies. We cannot assure you that any part or all of the integration will be accomplished on a timely basis, or at all.

We derive a substantial portion of our revenues from outside the Americas, which consists of North and South America. Revenues from outside the Americas were 55.4% of our total revenues in the three months ended December 31, 2003, compared to 66.1% of our total revenues in the three months ended December 31, 2002. Specifically, revenues from Asia and the Pacific Rim (APAC) accounted for approximately 30.1% and 44.7% of our total revenues in the three months ended December 31, 2003 and 2002, respectively. Revenues from Europe, the Middle East and Africa (EMEA) accounted for approximately 25.3% and 21.4% of our total revenues in the three months ended December 31, 2003 and 2002, respectively. We have experienced and may continue to experience fluctuations in revenues from outside the Americas due to differences in buying patterns, regional or country-specific economic conditions and government initiatives. We cannot assure you that we will be able to maintain or increase the demand for our products in international markets or that regional challenges such as economic downturns, regulatory hurdles or the

outbreak of hostilities will not have an adverse impact on our performance in international markets. In addition, since our sales are currently priced in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets and our accounts receivable more difficult to collect.

We derive revenues primarily from sales of our hardware-based security systems and appliances and from sales of maintenance arrangements and services. We achieved profitability on a generally accepted accounting principles (GAAP) basis for the first time in fiscal 2003. Prior to fiscal 2003, we incurred losses in each fiscal period since our inception. As of December 31, 2003, we had an accumulated deficit of $74.7 million. There can be no assurance that our revenues will continue to grow at the same rate as in the past, at the rate we expect or that we will achieve similar results in future periods. There can also be no assurance that we will maintain profitability in future periods.

Cost of product revenues consists of the costs associated with manufacturing, assembling and testing our products, related overhead costs, compensation and other costs related to manufacturing support and logistics. We rely on contract manufacturers to manufacture, assemble, test and fulfill orders for our hardware products. Accordingly, a significant portion of our cost of product revenues consists of payments to these contract manufacturers. Cost of maintenance and service revenues consists of customer support costs, training and professional service expenses and warranty-related costs.

Our gross margin has been, and will continue to be, affected by a variety of factors, including competition, the mix and average selling prices of products, maintenance and services, new product introductions and enhancements, the cost of components and manufacturing labor, fluctuations in manufacturing volumes, component shortages and the mix of distribution channels through which our products are sold. Our gross margin will be adversely affected by price declines if we are unable to reduce costs on existing products and do not continue to introduce new products with higher margins.

Research and development expenses consist of salaries and related expenses for development and engineering personnel, fees paid to consultants, license fees paid to third parties and prototype costs related to the design, development, testing and enhancement of our ASICs, security systems and appliances, ScreenOS, IDP software, Instant Virtual Extranet platform, management applications and VPN client software. We expense our research and development costs as they are incurred. Several components of our research and development effort require significant expenditures, the timing of which can cause significant quarterly variability in our expenses. We are devoting substantial resources to the continued development of new products. To meet the changing requirements of our customers, we will need to fund investments in several development projects in parallel. As a result, we expect our research and development expenses to increase in absolute dollars in the future.

Sales and marketing expenses consist of salaries, commissions and related expenses for personnel engaged in marketing, sales and sales support functions and costs associated with promotional and other marketing activities. We intend to expand our sales operations substantially, both domestically and internationally, in order to increase sales of our products. In addition, we believe part of our future success will be dependent upon establishing successful relationships with a variety of additional resellers in other countries. We expect that sales and marketing expenses will increase in absolute dollars as we expand our sales efforts in additional domestic and international locations, hire additional sales and marketing personnel and initiate additional marketing programs.

General and administrative expenses consist of salaries and related expenses for executive, finance, accounting, legal and human resources personnel, professional fees and corporate expenses. We expect general and administrative expenses to increase in absolute dollars as we employ additional personnel and incur additional costs related to the growth of our business and our operation as a public company, including new corporate governance requirements.

We account for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”).

Expenses associated with stock-based compensation are being amortized ratably over the vesting periods of the individual awards consistent with the method described in FASB Interpretation No. 28. During the three months ended December 31, 2003 and 2002, we recorded amortization of deferred stock compensation of $7.1 million and $6.1 million, respectively. This deferred stock compensation expense relates to stock options granted to individuals in all cost of revenues and operating expense categories and has been included in those categories. At December 31, 2003, $53.0 million of deferred stock compensation related to employee stock options remained unamortized. This amount will be amortized as follows (in thousands):

The methods, estimates and judgments we use in applying our accounting policies have a significant impact on the results we report in our financial statements. Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Our most critical accounting estimates include: the assessment of technical complexity and market acceptance of technically complex products, which impact revenue recognition; deferral of revenue for distributors and value-added resellers and revenue reserves, which impact revenue recognition; potential return rates and probability of collections, which impact accounts receivable and warranty reserves; the valuation of inventory, which impacts cost of sales and gross margin; the assessment of recoverability of goodwill and other intangible assets, which impacts write-offs of goodwill and identified intangible assets; and the assessment of our realization of deferred tax assets, which impacts income taxes.

We derive our revenues primarily from sales of our hardware-based security systems and appliances and maintenance arrangements and, to a lesser extent, from sales of software products and services. We generally recognize revenue when persuasive evidence of an arrangement exists, delivery or customer acceptance, where applicable, has occurred, the fee is fixed or determinable and collectibility is probable. We defer a portion of product revenues based on the value of basic maintenance services bundled with each product sale. For these bundled arrangements, revenue is allocated among each element of the bundle at the time of sale based on the fair value of each element of the bundle. The fair value of each element is determined by reference to the prices we charge when each element is sold separately. Maintenance revenue is deferred and recognized over the applicable maintenance period. We also derive a portion of our revenues from sales of separate extended maintenance arrangements.

For newly introduced technically complex products, we defer recognition of revenues from the sale of these products until they have successfully performed in the marketplace and sales returns are not unusually high. Determining which products are sufficiently technically complex to merit this revenue deferral requires us to exercise judgment, as does the determination of when products have achieved sufficient acceptance in the market so that deferral is no longer appropriate. The determination of which products are complex and the timing of the end of deferral for particular products, can be expected to vary. If we define technically complex products too broadly, we will defer revenue unnecessarily; if we define these products too narrowly, revenue will be recognized earlier but product returns and warranty claims will be higher in future periods.

We sell to value-added resellers and distributors. We derived 89.4% of our total revenues from value-added resellers and distributors in the three months ended December 31, 2003. We defer revenue on sales to our distributors until the distributor has sold our products to its customers. Our agreements with distributors provide for limited stock rotation and price protection rights. Stock rotation rights provide distributors with the right to exchange unsold inventory for alternate products of equal or greater value. Price protection rights grant distributors the right to credit on purchases in the event of decreases in the prices of our products. Our agreements with value-added resellers typically do not include stock rotation or price protection rights. At the time of shipment to value-added resellers, we reserve for estimated returns and exchanges. These revenue reserves are estimated and adjusted periodically based on historical rates of returns and allowances, inventory levels for value-added resellers that submit inventory or sell-through reports, the volume of sales to value-added resellers that we ship directly to end customers and for sales to value-added resellers that do not submit inventory or sell-through reports, accounts receivable balances, payment history and other related factors. These reserves require us to exercise our judgment in determining if historical experience applies to new products and to new distributors and value-added resellers. If our estimate of returns and exchanges is too low, additional charges will be incurred in future periods and these additional charges could have a material adverse effect on our financial position and results of operations.

We record sales return and warranty reserves based on estimates of expected future returns and allowances and expected future repair and replacement costs. We record a sales return reserve that approximates the aggregate amount of expected future returns and allowances. Our sales return reserve is based on past return history, product mix, channel mix and, in some cases, allowances for specific customers based on several factors such as return rights included in our agreements with these customers. Our warranty reserve approximates the aggregate amount of estimated future repair and replacement costs for our products under warranty. Our warranty reserve is based on historical product repair and replacement information. In the event we determine that our current or future sales returns and allowances and product repair and replacement costs exceed our estimates, an adjustment to these reserves would be charged to earnings in the period such determination is made.

We have a large, diversified customer base, which includes customers located in foreign countries. We monitor the creditworthiness of our customers but have experienced losses related to our accounts receivable in the past. We record an allowance for doubtful accounts based on past history, current economic conditions and the composition of our accounts receivable aging and, in some cases, make allowances for specific customers based on several factors, such as the creditworthiness of those customers and payment history. These allowances require our subjective judgment. Actual write-offs may differ from the allowances for doubtful accounts and this difference may have a material effect on our financial position and results of operations.

Given the volatility of the networking market, the rapid obsolescence of technology and short product life cycles, we write down inventories to net realizable value based on backlog and forecasted demand. However, backlog is subject to revisions, cancellations and rescheduling. If actual demand is lower than our forecasted demand and we fail to reduce manufacturing output accordingly, we could be required to record additional inventory write-downs, which would have a negative effect on our gross margin.

Valuation of Long-Lived Assets Including Goodwill and Other Intangible Assets

We review property, plant and equipment, goodwill and other intangible assets for impairment whenever events or circumstances indicate the carrying amount of the assets may not be recoverable. At a minimum, this review is conducted annually. Our review is based on our best estimate of a variety of factors, including future market growth, forecasted revenues and costs and a strategic review of our business and operations. In the event we determine that an asset is impaired in the future, an adjustment to the value of the asset would be charged to earnings in the period such determination is made.

For financial statement purposes, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This involves making estimates and judgments in determining our current income tax exposure along with assessing temporary differences, which results from the differing treatment of items for tax and accounting purposes. These temporary differences result in deferred tax assets and liabilities, which are included in our balance sheet. We then determine the likelihood that the deferred tax assets will be realized. We record a valuation allowance to reduce deferred tax assets if it is more likely than not that a portion or the entire deferred tax asset will not be realized. The realization of deferred tax assets depends upon taxable income. In order to determine whether all or a portion of the deferred tax asset should be reduced by a valuation allowance, we consider the following sources of taxable income: future taxable income; prudent and feasible tax planning strategies; and existing temporary differences that will reverse in future periods that give rise to realization. As of December 31, 2003, we believe that all of our net recorded deferred tax assets will be realized. In the event we were to determine that we would be able to realize deferred tax assets in the future in excess of the net recorded deferred tax assets, an adjustment to the net deferred tax assets would increase net income (or decrease net loss) in the period when such determination was made. Likewise, should we determine that we are not able to realize all or part of our net recorded deferred tax assets in the future, an adjustment to deferred tax assets would be charged to earnings in the period when such determination was made.

Product Revenues. Revenues from sales of our products increased 52.9% to $64.9 million in the three months ended December 31, 2003 from $42.5 million in the three months ended December 31, 2002. Revenues from sales of our products were 80.1% and 83.1% of total revenues for the three months ended December 31, 2003 and 2002, respectively. The dollar increase was primarily attributable to increased sales of all product categories, principally an increase in revenue recognized from our high-range and low-range products, including revenue from shipments made in the quarter, deferred revenue recognized from shipments in prior quarters and revenue from sales of SSL VPN products. Hardware revenue units increased to approximately 43,000 units in the three months ended December 31, 2003 from approximately 28,000 units in the three months ended December 31, 2002.

Maintenance and Service Revenues. Revenues from maintenance and services increased 86.7% to $16.1 million in the three months ended December 31, 2003 from $8.6 million in the three months ended December 31, 2002. Revenues from maintenance and services were 19.9% and 16.9% of total revenues for the three months ended December 31, 2003 and 2002, respectively. The dollar increase was the result of the higher volume of products shipped and the related recognition of revenues associated with the portion of product revenues attributable to maintenance and services over the applicable maintenance period, as well as increased customer purchases of enhanced service offerings and renewals of maintenance contracts across a larger installed base of customers.

No single customer accounted for 10% or more of our total revenues in the three months ended December 31, 2003. One customer accounted for 11% of our total revenues in the three months ended December 31, 2002.

We cannot assure you that our revenues will continue to increase in absolute dollars at the rate at which they have grown in recent periods or at all.

Product Cost of Revenues. Product cost of revenues increased 59.2% to $14.8 million in the three months ended December 31, 2003 from $9.3 million in the three months ended December 31, 2002. This increase primarily reflects the greater quantity of products sold and an increase in the amortization of intangible assets related to our acquisition of Neoteris. Product cost of revenues included stock-based compensation and amortization of intangible assets of $1.7 million and approximately $597,000 for the three months ended December 31, 2003 and 2002, respectively.

Product Gross Margin. Product gross margin, including stock-based compensation and amortization of intangible assets, as a percentage of product revenues declined to 77.2% in the three months ended December 31, 2003 from 78.1% in the three months ended December 31, 2002. The decrease in product gross margin was primarily attributable to an increase in the amortization of intangible assets related to our acquisition of Neoteris. We expect our selling prices and product gross margin percentage to decline over time.

Maintenance and Service Cost of Revenues. Maintenance and service cost of revenues increased 75.8% to $4.2 million in the three months ended December 31, 2003 from $2.4 million in the three months ended December 31, 2002. This increase was primarily related to the expansion of our customer support infrastructure and the larger installed base of products for which we provide service and, to a lesser extent, increased third party professional services costs. Maintenance and service cost of revenues included stock-based compensation of approximately $341,000 and $277,000 in the three months ended December 31, 2003 and 2002, respectively.

Maintenance and Service Gross Margin. Maintenance and service gross margin, including stock-based compensation, as a percentage of maintenance and service revenues was 73.6% in the three months ended December 31, 2003 compared to 72.0% in the three months ended December 31, 2002. The increase in maintenance and service gross margin was primarily attributable to our ability to support higher service revenues with our organization and support infrastructure. We expect our maintenance and service gross margin percentage to decline over time.

Research and Development Expenses. Research and development expenses increased 39.0% to $13.6 million in the three months ended December 31, 2003 from $9.8 million in the three months ended December 31, 2002. Research and development expenses represented 16.8% and 19.2% of total revenues for the three months ended December 31, 2003 and 2002, respectively. The dollar increase was primarily attributable to increased personnel costs and related support costs as a result of increased headcount, including personnel hired as a result of our acquisition of Neoteris. Research and development expenses included stock-based compensation and amortization of intangible assets of $2.7 million and $2.0 million for the three months ended December 31, 2003 and 2002, respectively.

Sales and Marketing Expenses. Sales and marketing expenses increased 56.3% to $31.5 million in the three months ended December 31, 2003 from $20.2 million in the three months ended December 31, 2002. Sales and marketing expenses were 38.9% and 39.5% of total revenues for the three months ended December 31, 2003 and 2002, respectively. The dollar increase was primarily related to the expansion of our sales and marketing organizations, including personnel hired as a result of our acquisition of Neoteris, and also includes increased compensation-related expenses resulting from the growth of our sales force, higher commissions expense associated with increased revenues and, to a lesser extent, increased marketing-related program costs. Sales and marketing expenses included stock-based compensation and amortization of intangible assets of $3.2 million and $2.7 million in the three months ended December 31, 2003 and 2002, respectively.

General and Administrative Expenses. General and administrative expenses increased 42.4% to $6.0 million in the three months ended December 31, 2003 from $4.2 million in the three months ended December 31, 2002. General and administrative expenses were 7.4% and 8.2% of total revenues for the three months ended December 31, 2003 and 2002, respectively. The dollar increase was primarily related to increased personnel costs and related support costs as a result of increased headcount. General and administrative expenses included stock-based compensation of $1.1 million and approximately $724,000 in the three months ended December 31, 2003 and 2002, respectively.

Stock-based Compensation. During the three months ended December 31, 2003 and 2002, we recorded stock-based compensation expense of $7.1 million and $6.1 million, respectively. As of December 31, 2003, $53.0 million of deferred stock compensation remained to be amortized over the next sixteen quarters, including $41.7 million in deferred stock compensation related to our acquisition of Neoteris.

Amortization of Intangible Assets. During the three months ended December 31, 2003 and 2002, we recorded amortization of intangible assets of $2.0 million and approximately $244,000, respectively. The amortization of intangible assets is associated with the acquisitions of Neoteris in November 2003 and OneSecure, Inc. in September 2002. Amortization will continue until fiscal 2012. As of December 31, 2003, $38.4 million of intangible assets remained unamortized.

Interest and other income, net, was $1.1 million in both of the three months ended December 31, 2003 and 2002. The impact of higher average cash, cash equivalents and short-term investment balances was offset by lower average investment income yield.

We recorded an income tax provision of $5.7 million and $3.1 million for the three months ended December 31, 2003 and 2002, respectively. For the three months ended December 31, 2003, the provision for income taxes represented federal, state and foreign taxes and also reflected the impact of non-deductible deferred stock-based compensation expense for an effective tax rate of 47%. The effective tax rate for the period differs from the statutory federal income tax rate of 35% due primarily to state taxes, stock-based compensation charges, and research and development credits.

As of December 31, 2003, our principal source of liquidity was $379.2 million of cash, cash equivalents and short-term investments. At that date, we had future minimum lease payments under non-cancelable operating leases of $13.7 million, we had outstanding purchase orders totaling $7.5 million and we had long-term debt and restructuring obligations, including the current portion, of $4.8 million.

In connection with the acquisition of Neoteris, we agreed to pay up to an additional $30.0 million to the stockholders and option holders of Neoteris upon the achievement of certain revenue milestones. We expect to make these additional payments, if earned, in the three months ending June 30, 2005.

We lease our corporate headquarters in Sunnyvale, California. Rent payments under the lease are approximately $263,000 per month and commenced February 14, 2003.

We acquired Neoteris in November 2003 and OneSecure in September 2002. In connection with the acquisitions, we assumed non-cancelable operating leases for offices that will not be occupied by us. We have recorded a restructuring liability for the net present value of these duplicate facilities, net of expected sublease income, for the periods we expect these facilities will be unoccupied.

We have entered into several leases for domestic and foreign sales office facilities. The leases expire at various dates through August 2007. The related cost of the leases is approximately $179,000 per month.

We have contracts with our contract manufacturers, each of which allows for termination for convenience. Our obligations under these contracts include all purchase orders it has issued, portions of which are cancelable, and certain components procured on our behalf by the contract manufacturers. At December 31, 2003, we had outstanding purchase orders totaling $7.5 million.

A summary of our obligations and commitments as of December 31, 2003 are as follows (in thousands):

In addition to other information in this report, the following risk factors should be carefully considered in evaluating us and our business because these factors may have a significant impact on our business, operating results or financial condition. Actual results could differ materially from those projected in the forward-looking statements contained in this report as a result of the risk factors discussed below and elsewhere in this report.

There are numerous risks associated with our recently announced and pending acquisition by Juniper Networks.

On February 9, 2004, we announced that we have entered into a definitive agreement to be acquired by Juniper Networks in a stock-for-stock merger transaction. The transaction is subject to a number of risks, including risks related to:

In addition, if the merger is not consummated for any reason, we may be subject to a number of risks, including:

We do not know whether the acquisition will close, or, if it closes, that we will be able to successfully integrate our business, products, technologies or personnel with those of Juniper Networks or meet our financial or other strategic objectives. Any failure to do so could seriously harm our business, financial condition and results of operations.

Prolonged weakness in the Internet infrastructure, network security and related markets may decrease our revenues and margins.

The market for our products depends on economic conditions affecting the broader Internet infrastructure, network security and related markets. Weakness in these markets may cause enterprises and carriers to delay or cancel security projects, reduce their overall or security-specific information technology budgets or reduce or cancel orders for our products. In this environment, distributors, value-added resellers and carriers may experience financial difficulty, cease operations and fail to budget or reduce budgets for the purchase of our products. This, in turn, may lead to longer sales cycles, delays in purchase decisions, difficulties with collection and may also result in price pressures, causing us to realize lower revenues, gross margins and operating margins. In addition, general economic uncertainty caused by potential hostilities involving the United States, terrorist activities, the decline in specific markets such as the service provider market in the United States and the general decline in capital spending in the information technology sector make it difficult to predict changes in the purchase and network requirements of our customers and the markets we serve. We believe that a prolonged weakness in these markets could cause some businesses to curtail or eliminate capital spending on information technology. If capital spending in our markets declines, our revenues, gross margins and operating margins may decline and we may not be able to achieve our financial goals and maintain profitability.

The market for network security products is highly competitive and we expect competition to intensify in the future. Competitors may gain market share and introduce new competitive products for the same markets and customers currently served by our products. These products may have better performance, lower prices and broader acceptance than our products.

Current and potential competitors in our market include the following, all of which sell worldwide or have a presence in most of the major geographical markets for their products:

Many of our current or potential competitors have longer operating histories, greater name recognition, larger customer bases and significantly greater financial, technical, sales, marketing and other resources than we do. In addition, some of our competitors currently combine their products with other companies’ networking and security products to compete with our products. These competitors also often combine their sales and marketing efforts to compete with our products. This competition may result in reduced prices, lower gross and operating margins and longer sales cycles for our products. If any of our larger competitors were to commit greater technical, sales, marketing and other resources to our markets, or reduce prices for their products over a sustained period of time, our ability to successfully sell our products, increase revenue or meet our expectations or investor expectations could be adversely affected.

We may not be successful in integrating the operations of Neoteris or any other future acquisitions.

On November 14, 2003 we completed the acquisition of Neoteris. Achieving the anticipated benefits of this merger will depend in part upon whether we can integrate the operations, products and technology of Neoteris with our operations, products and technology in a timely and cost-effective manner. The process of combining two companies is complex, expensive and time consuming and may cause an interruption of, or loss of momentum in, the product development and sales activities and operations of both companies. We cannot assure you that any part or all of the integration will be accomplished on a timely basis, or at all. Assimilating Neoteris or any other companies we may acquire in the future, involves a number of other risks, including, but not limited to:

In addition, the integration of certain operations following any merger will require the time and attention of our management, which may distract attention from the day-to-day business of the combined company. Failure to effectively integrate the operations of Neoteris or any other companies we may acquire in the future could have an adverse effect on our business, financial condition and results of operations.

Our business may suffer due to risks associated with international sales and operations.

Revenues from outside of the Americas were 55.4% of our total revenue for the three months ended December 31, 2003 and 60.6% of our total revenue for the year ended September 30, 2003. We expect revenues from outside of the Americas will continue to represent a substantial portion of our total revenues for the foreseeable future.

We may not be able to maintain or increase international market demand or international revenues from our products. For example, general economic conditions in international markets can fluctuate and downturns in these markets could have a significant adverse impact on our ability to meet public market expectations and sustain profitability. Also, as agreements with international distributors expire, we may be unable to renew our distributor agreements on favorable terms or make alternative arrangements with other distributors. If we are unable to maintain or increase international market demand and revenues from our products, our revenues and operating results would be adversely affected.

We intend to continue expanding our existing international operations and to enter new international markets. This expansion will require significant management attention and financial resources. We currently have limited experience in marketing and distributing our products internationally and in developing versions of our products that comply with local standards. In addition, international operations are subject to other inherent risks, including:

The unpredictability of our quarterly results may cause the trading price of our common stock to decline.

Our quarterly revenues and operating results have varied in the past and will likely continue to vary in the future due to a number of factors, many of which are outside of our control. Any of these factors could cause the price of our common stock to decline. The primary factors that may affect our revenues and operating results include the following:

Our operating expenses are largely based on anticipated revenues and a high percentage of our expenses are, and will continue to be, fixed in the short term. As a result, lower than anticipated revenues for any reason could cause significant variations in our operating results from quarter to quarter and, because of our rapidly growing operating expenses, could result in substantial operating losses.

Due to the factors summarized above, we believe that quarter-to-quarter comparisons of our operating results are not necessarily a good indication of our future performance. Also, it is likely that, in some future quarters, our operating results will be below the expectations of public market analysts and investors. In this event, the price of our common stock would likely decline.

Failure to successfully develop and introduce new products or product enhancements to address market requirements and evolving standards in the network security industry could cause our revenues to decline and impact our margins.

The market for network security products is characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. We expect to introduce new products and

enhancements to existing products to address current and evolving customer requirements and general networking trends and vulnerabilities. In addition, we expect to introduce products and product enhancements to address the needs of customers with varying needs, which may involve different levels of technological complexity and require different levels of support than we have delivered in the past. For example, we expect to extend our product offerings to address the needs of new customers and customer requirements, such as customers in the small and medium enterprise market and customers seeking antivirus protection in our solutions. Such expansions may lead to increased competition with other larger security solution providers as well as startup companies. Additionally, some of the new products and enhancements may require us to develop new hardware architectures and ASICs that involve complex, expensive and time consuming processes. In developing and introducing our products, we make assumptions about the features, security standards, performance criteria and support levels that our customers will demand. If our assumptions are wrong, market acceptance of our products may be below our expectations, our competitors may gain an advantage and our ability to sell our solutions my be impaired. In addition, if we implement features and enhancements that increase our costs of production, or if we offer products to markets that desire fewer capabilities and we scale back our product features and reduce prices accordingly, our gross margins and operating margins may decline. Likewise, we may not be able to develop new products or product enhancements in a timely manner, or at all. Failing to develop or introduce new products and product enhancements might cause our existing products to be less competitive, may adversely affect our ability to sell solutions to address large customer deployments and, as a consequence, our revenues, gross margins and operating results could be adversely affected.

We also expect to develop products with strategic and technology partners and to incorporate third-party security capabilities into our products to address the needs of our customers. Such development and integration efforts are difficult, time consuming and expensive, and there can be no assurance that we will complete them successfully. In addition, we may not succeed in our efforts to market the product lines and technology acquired in connection with the acquisition of Neoteris, to combine the technology of OneSecure into our own products, or to enhance OneSecure’s line of IDP appliances, or offer a viable combined hardware or management product that addresses the needs of our customers. In addition, if competitors introduce products embodying new technologies, our products could be rendered obsolete, which would have a direct, adverse effect on our market share and revenues. Any failure of our future products or product enhancements to achieve market acceptance could cause our revenue to be below our or investor expectations and our revenues, gross margins and operating results could be adversely affected.

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

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

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

Our reliance on third parties to manufacture, assemble, test and fulfill orders for our products could cause a delay in our ability to fill orders, which might cause us to lose sales.

Flash Electronics, Inc. manufactures, assembles, tests and fulfills orders for the NetScreen-50, NetScreen-25, NetScreen-204, NetScreen-208, NetScreen-IDP 1000, NetScreen-IDP 500, NetScreen-IDP 100 and NetScreen-IDP 10 products at its Fremont, California facility. Solectron Corporation manufactures, assembles, tests and fulfills orders for the NetScreen-5400, NetScreen-5200, NetScreen-500, NetScreen-SA 5000, NetScreen-SA 3000, NetScreen-SA 1000 and NetScreen-SM 3000 products at its San Jose, California facility and the NetScreen-5XP and NetScreen-5XT products at its facility in China. Another third party manufactures, assembles and tests the NetScreen-5GT at its facility in Taiwan. Solectron Corporation fulfills orders for the NetScreen-5GT at its San Jose, California facility. If we should fail to manage our relationship with these manufacturers

effectively, or if they experience delays, disruptions or quality control problems in their manufacturing and order fulfillment operations, our ability to ship products to our customers could be delayed.

The absence of dedicated capacity with our contract manufacturers means that, with little or no notice, they could refuse to continue manufacturing some or all of our products. Qualifying a new contract manufacturer and commencing volume production is expensive and time-consuming. If we are required or choose to change contract manufacturers, we could lose revenues and damage our customer relationships.

Our proprietary GigaScreen and GigaScreen-II ASICs, which are key to the functionality of many of our hardware-based products, are fabricated by foundries operated by Toshiba America Electronic Components, Inc. We have no long-term contract with Toshiba and purchase our ASICs on a purchase order basis. If Toshiba materially delays its supply of ASICs to us, or requires us to find an alternate supplier and we are not able to do so on a timely and reasonable basis, our revenue and operating results would be adversely affected.

Our reliance on third-party manufacturers also exposes us to the following risks outside our control:

We currently purchase several key components, including semiconductors, from single or limited sources. We carry very little inventory of some of our products and product components, and we rely on our suppliers to deliver necessary components to our contract manufacturers in a timely manner based on the forecasts we provide. Some of the semiconductors we require are very complex, and we may not be able to develop an alternate source in a timely manner, which could hurt our ability to deliver our products to our customers. We also purchase power supplies from a single source and purchase other custom components from other sole or limited sources. If we are unable to buy these components on a timely basis, we will not be able to deliver products to our customers and our revenue and operating results would be adversely affected.

At various times, some of the key components for our products, such as flash memory, have been in short supply. Delays in receiving components would harm our ability to deliver our products on a timely basis. In addition, because we rely on purchase orders rather than long-term contracts with our suppliers, we cannot predict with certainty our ability to procure components in the longer term. If we receive a smaller allocation of components than is necessary to manufacture products in quantities sufficient to meet customer demand, customers could choose to purchase competing products.

If we fail to develop or maintain relationships with value-added resellers or distribution partners, or if our value-added resellers or distribution partners are not successful in their sales efforts, sales of our products may decrease and our operating results would suffer.

We derived 89.4% of our total revenues from value-added resellers and distributors in the three months ended December 31, 2003. In the year ended September 30, 2003 we derived 92.1% of our total revenues from value-added resellers and distributors. We expect our revenues to continue to depend in large part on the performance of these third-party distributors and resellers. In addition, our value-added resellers and distributors may be unsuccessful in selling our products and services, may sell products and services that are competitive with ours, may devote more resources to competitive products and may cease selling our products and services altogether. The loss of or reduction in sales to our value-added resellers or distributors could materially reduce our revenues. In addition, we believe part of our future success will depend upon establishing successful relationships with a variety of additional resellers in other countries. If we fail to develop and maintain additional relationships with these distribution partners, or if these partners are not successful in their sales efforts, sales of our products may decrease and our operating results would suffer.

A breach of network security could harm public perception of our products, which could cause us to lose revenues.

If an actual or perceived breach of network security occurs in one of our end customer’s network systems, regardless of whether the breach is attributable to our products, the market perception of the effectiveness of our products could be harmed. This could cause us to lose current and potential end customers or cause us to lose current and potential value-added resellers and distributors. Because the techniques used by computer hackers to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate these techniques.

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

We offer a warranty on all of our products, allowing the end customer to have any defective unit repaired, or to receive a replacement product for it during the warranty period. Our products may contain undetected errors or defects. If there is a broad product failure across our customer base, we may decide to replace all affected products or we may decide to refund the purchase price for defective units. Such defects and actions may adversely affect our ability to record revenue for units. Some errors are discovered only after a product has been installed and used by end customers. Any errors discovered after commercial release could result in loss of revenues and claims against us.

If we are unable to fix errors or other problems that later are identified after full deployment, in addition to the consequence described above, we could experience:

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

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

If we fail to predict our manufacturing requirements accurately, we could incur additional costs or experience manufacturing delays, which could reduce our gross margins or cause us to lose sales.

Our contract manufacturers are not obligated to supply products to us for any specific period, in any specific quantity or at any certain price, except as may be provided in a particular purchase order. We provide forecasts of our demand to our contract manufacturers up to six months prior to scheduled delivery of products to our customers. If we overestimate our requirements, our contract manufacturers may have excess inventory, which would increase our costs. If we underestimate our requirements, our contract manufacturers may have an inadequate component inventory, which could interrupt manufacturing of our products and result in delays in shipments and revenues. In addition, lead times for materials and components that we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for each component at a given time. We may also experience shortages of components from time to time, which also could delay the manufacturing of our products or increase our costs of production.

We achieved profitability on a GAAP basis for the first time in the three months ended December 31, 2002. Prior to the three months ended December 31, 2002, we had incurred significant losses since our inception in October 1997. We may incur losses in the future. As of December 31, 2003, we had an accumulated deficit of $74.7 million. We had net income of $51.5 million for the year ended September 30, 2003, and net losses applicable to common stockholders of $41.1 million for the year ended September 30, 2002 and $34.2 million for the year ended September 30, 2001. We expect to continue to incur increasing sales and marketing, research and development and general and administrative expenses. As a result, we will need to continue generating higher revenues to maintain profitability. Revenue growth depends on many factors, including those described elsewhere in these “Factors That May Affect Our Business and Future Results of Operations and Financial Condition.” Our revenues may not grow, our gross margins and operating margins may decline and we may not maintain profitability.

We depend on our key personnel to manage our business effectively in a rapidly changing market, and if we are unable to retain key personnel, our ability to execute our business strategy would be impaired.

Our future success depends upon the continued services of our executive officers and other key engineering, sales, marketing and support personnel. None of our officers or key employees are bound by an employment agreement for any specific term, and no one is constrained from terminating his or her employment relationship with us at any time. The loss of the services of one or more of our key employees could make it difficult to meet key business objectives, such as timely and effective product introductions, and could harm our business.

We may experience difficulties with our systems of management and internal controls that could harm our business.

Our ability to sell our products and implement our business plan successfully in a volatile and growing market requires effective management, information technology and financial systems, and a system of internal processes and controls. Growth in future operations may cause strain on our systems, processes and controls. To meet these challenges, we will need to improve our management and information technology systems as well as our internal controls for financial reporting. We will also need to scale these systems and controls to meet the requirements of our growth in international markets and continue to expand, train and manage our workforce worldwide. If we do not meet these challenges, we may be unable to expand our business or to meet competitive challenges and it will be more difficult to manage our operations.

We are exposed to fluctuations in currency exchange rates that could negatively impact our results of operations.

Our international sales are currently denominated in U.S. dollars. As a result, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less price competitive in international markets, affect our customers’ ability to pay amounts due and negatively impact our revenues from international operations. Additionally, in the future we may elect to invoice some of our international customers in local currency, which could subject our revenues related to such customers to fluctuations in exchange rates between the U.S. dollar and the local currency.

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

Because our products and services provide and monitor network security and may protect valuable information, we could face claims for product liability, tort or breach of warranty. Anyone who circumvents our security measures could misappropriate the confidential information or other property of end customers using our products, or interrupt their operations. If that happens, affected end customers or others may sue us. In addition, we may face liability for breaches caused by faulty installation of our products by our service and support organizations. Provisions in our contracts relating to warranty disclaimers and liability limitations may be unenforceable. Some courts, for example, have found contractual limitations of liability in standard computer and software contracts to be unenforceable in some circumstances. Defending a lawsuit, regardless of its merit, could be costly and could divert management attention. Our business liability insurance coverage may be inadequate or future coverage may be unavailable on acceptable terms or at all.

If we fail to protect our intellectual property rights, end customers or potential competitors might be able to use our technologies to develop their own solutions, which could weaken our competitive position or reduce our revenues.

We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. As of January 31, 2003, we had twenty-three patent applications pending in the United States relating to our products, three of which have been extended to other countries. Our pending patent applications may not result in the

issuance of any patents. Even if we obtain such patents, that will not guarantee that our patent rights will be valuable, create a competitive barrier or will be free from infringement. Furthermore, if any patent is issued, it might be invalidated or circumvented or otherwise fail to provide us any meaningful protection. We also enter into confidentiality agreements with our employees, consultants and corporate partners, and control the use, access to and distribution of our software, documentation and other proprietary information. Unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our products is difficult, and the steps we have taken may not prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States.

We could become subject to litigation regarding intellectual property rights that could be costly and result in the loss of significant rights.

In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. We may become a party to litigation in the future to protect our intellectual property or as a result of an alleged infringement of another party’s intellectual property. Claims for alleged infringement and any resulting lawsuit, if successful, could subject us to significant liability for damages and invalidation of our proprietary rights. These lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management time and attention. Any potential intellectual property litigation could also force us to do one or more of the following:

If we are forced to take any of these actions, our business might be seriously harmed. Our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that could be imposed.

The inability to obtain any third-party license required to develop new products and product enhancements or the failure to maintain third party licenses used in current product offerings could seriously harm our business, financial condition and results of operations.

From time to time, we may be required to license technology from third parties to develop new products or product enhancements. We also currently license third party technology in our product offerings, such as antivirus technology incorporated in our NetScreen-5GT platform. Third-party licenses may not be available to us on commercially reasonable terms or at all. The inability to obtain any third-party license required to develop new products or product enhancements or the failure to maintain third party licenses used in current product offerings could require us to obtain substitute technology of lower quality or performance standards or at greater cost, which could seriously harm our business, financial condition and results of operations.

We will record substantial expenses related to our issuance of stock options that will have a material negative impact on our results of operations.

We have granted stock options under our stock option plans since November 1997. We are required to recognize, as a reduction of stockholders’ equity, deferred stock compensation expense equal to the difference between the deemed fair market value of our common stock for financial reporting purposes and the exercise price of these options at the date of grant. This expense is amortized over the vesting period of the applicable options, generally four years, using the straight-line vesting method. At December 31, 2003, $53.0 million of deferred stock compensation related to employee stock options remained unamortized. The resulting amortization expense will have a material negative impact on our results of operations in future periods through the three months ending December 31, 2007.

Governmental regulations affecting the import or export of products could negatively affect our revenues.

Governmental regulation of imports or exports or failure to obtain required export approval of our encryption technologies could harm our international and domestic sales. The United States and various foreign governments have imposed controls, export license requirements and restrictions on the import or export of some technologies, especially encryption technology. In addition, from time to time, governmental agencies have proposed additional regulation of encryption technology, such as requiring the escrow and governmental recovery of private encryption keys.

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

Earthquakes, other natural disasters and power shortages may damage our facilities or the facilities of third parties on which we depend.

Our corporate headquarters and some of our third-party manufacturers are located near major earthquake faults that have experienced earthquakes in the past. An earthquake or other natural disaster near our headquarters or near one or more of the facilities of third parties upon which we rely could disrupt our operations or the operations of those parties. In addition, critical systems and services are provided by IBM in Toronto, Canada. A natural disaster or other disruption of operations at IBM’s Toronto facilities could harm our ability to transact and report business. None of these disruptions would be covered by insurance, and the supply of our products could be limited, our business could be hampered and our financial condition and results of operations could be harmed.

The market prices of the securities of technology-related companies have been extremely volatile. Thus, the market price of our common stock is likely to be subject to wide fluctuations. If our revenues do not grow or grow slower than investors anticipate, if operating or capital expenditures exceed our expectations and cannot be reduced appropriately, if our gross margin or operating margin declines or declines faster than investors anticipate, or if some other event adversely affects us, the market price of our common stock could decline. In addition, if the market for technology-related stocks or the stock market in general experiences a loss in investor confidence or otherwise fails, the market price of our common stock could decline for reasons unrelated to our business, results of operations and financial condition. The market price of our stock also might decline in reaction to events that affect other companies in our industry even if these events do not directly affect us. General political or economic conditions, such as an outbreak of war, a recession or interest rate or currency rate fluctuations, could also cause the market price of our common stock to decline. Our common stock has experienced, and is likely to continue to experience, these fluctuations in price, regardless of our performance.

Management could invest or spend our cash or cash equivalents and investments in ways that might not enhance our results of operations or market share.

We have made no specific allocations of our cash or cash equivalents and investments. Consequently, management will retain a significant amount of discretion over the application of our cash or cash equivalents and investments and could spend the proceeds in ways that do not improve our operating results or increase our market share. In addition, these proceeds may not be invested to yield a favorable rate of return.

Provisions in our charter documents might deter a company from acquiring us, which could inhibit a stockholder from receiving an acquisition premium for their shares.

We have adopted a classified board of directors. Our board is divided into three classes that serve staggered three-year terms. Only one class of directors will be elected each year, while the directors in the other classes will continue on our board for the remainder of their terms. This classification of our board could make it more difficult for a third party to acquire, or could discourage a third party from acquiring, control of NetScreen since it would make it more difficult and time-consuming to replace our then current directors. In addition, our stockholders are unable to call special meetings of stockholders, to act by written consent, to remove any director or the entire board of directors without a supermajority vote or to fill any vacancy on our board of directors. Our stockholders must also meet advance notice requirements for stockholder proposals. Our board may also issue preferred stock without any vote or further action by the stockholders. These provisions and other provisions under Delaware law could make it more difficult for a third party to acquire us, even if doing so would benefit our stockholders.

We develop products in the United States and sell them worldwide. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. Since our sales are currently priced in U.S. dollars, a strengthening of the dollar could make our products less competitive in foreign markets.

As of December 31, 2003, our investment portfolio consisted of money market funds, corporate-backed debt obligations, municipal bonds and U.S. government discount notes. We place investments with high quality issuers and limit the amount of credit exposure to any one issuer. These securities are subject to interest rate risks. Based on our portfolio content and our ability to hold investments to maturity, we believe that, a hypothetical 10% increase or decrease in interest rates would not materially affect our interest income, although we cannot assure you of this.

We carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-14 of the Securities Exchange Act of 1934 (the “Exchange Act”). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of December 31, 2003, the end of the quarter covered by this report, our disclosure controls and procedures were effective at the reasonable assurance level in timely alerting them to material information relating to NetScreen (including its consolidated subsidiaries) required to be included in our Exchange Act filings.

During the quarter ended December 31, 2003, there were no significant changes in our internal controls over financial reporting that materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within NetScreen have been detected. These inherent limitations include, but are not limited to, the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

We are subject to legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

(d) The Securities and Exchange Commission declared our first registration statement, filed on Form S-1 under the Securities Act of 1933 (File No. 333-71048), relating to our initial public offering (IPO) of our common stock, effective on December 11, 2001. We are furnishing the following information with respect to the use of proceeds from our IPO:

On October 6, 2003, we filed a report on Form 8-K under Item 5 reporting that we had signed a definitive agreement to acquire Neoteris, Inc.

On October 29, 2003, we filed a report on Form 8-K dated October 29, 2003, that furnished (not filed) under Item 12 the press release entitled “NetScreen Technologies, Inc. Reports Record Fiscal Fourth Quarter and 2003 Results” relating to our results for the three months and fiscal year ended September 30, 2003.

On November 26, 2003, we filed a report on Form 8-K under Item 2 reporting our consummation of our November 14, 2003 acquisition of Neoteris, Inc.

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.


NETSCREEN TECHNOLOGIES, INC.

By:		/s/ REMO E. CANESSA

		Remo E. Canessa Chief Financial Officer and Corporate Secretary (Duly Authorized and Principal Financial Officer)


		Page
PART I—FINANCIAL INFORMATION

Item 1.	Financial Statements:

	a. Condensed Consolidated Balance Sheets as of December 31, 2003 (Unaudited) and September 30, 2003	3

	b. Condensed Consolidated Statements of Operations for the three months ended December 31, 2003 and 2002 (Unaudited)	4

	c. Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2003 and 2002 (Unaudited)	5

	d. Notes to Condensed Consolidated Financial Statements (Unaudited)	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	32

Item 4.	Controls and Procedures	32

PART II—OTHER INFORMATION

Item 1.	Legal Proceedings	33

Item 2.	Changes in Securities and Use of Proceeds	33

Item 3.	Defaults upon Senior Securities	33

Item 4.	Submission of Matters to a Vote of Security Holders	33

Item 5.	Other Information	33

Item 6.	Exhibits and Reports on Form 8-K	33

SIGNATURE		34


	December 31, 2003			September 30, 2003*
	(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	73,597		$	53,914
Short-term investments		305,622			286,738
Restricted cash		38			38
Accounts receivable, net of allowances for doubtful accounts and sales returns of $10,750 and $9,777 at December 31, 2003 and September 30, 2003		37,722			35,874
Refundable income taxes		48			943
Inventories		2,924			2,501
Deferred income taxes		27,220			28,368
Other current assets		6,048			6,613

Total current assets		453,219			414,989
Property and equipment		11,370			10,667
Restricted cash		139			823
Deferred income taxes		1,439			5,640
Intangible assets		38,370			4,781
Goodwill		229,119			54,271
Other assets		762			552

Total assets	$	734,418		$	491,723

Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	9,804		$	8,230
Accrued expenses		24,485			17,204
Accrued compensation		12,963			12,234
Deferred revenue		63,750			54,364
Current portion of restructuring liabilities		1,019			648
Current portion of debt and capital lease obligations		—			72

Total current liabilities		112,021			92,752
Restructuring liabilities, less current portion		3,754			2,042

Total liabilities		115,775			94,794

Commitments and contingencies

Stockholders’ equity:
Preferred stock, $0.001 par value: Authorized shares—10,000,000 at December 31, 2003 and September 30, 2003 Issued and outstanding shares — none at December 31, 2003 and September 30, 2003		—			—
Common stock, $0.001 par value: Authorized shares—500,000,000 at December 31, 2003 and September 30, 2003 Issued and outstanding shares—92,259,894 and 81,987,529 at December 31, 2003 and September 30, 2003		92			82
Additional paid-in capital		746,137			493,668
Accumulated deficit		(74,656	)		(81,030	)
Accumulated other comprehensive gain		90			234
Deferred stock compensation		(52,972	)		(15,977	)
Stockholders’ notes receivable		(48	)		(48	)

Total stockholders’ equity		618,643			396,929

Total liabilities and stockholders’ equity	$	734,418		$	491,723


	Three Months Ended December 31,
	2003			2002
Revenues:
Product	$	64,922		$	42,451
Maintenance and service		16,095			8,619

Total revenues		81,017			51,070

Cost of revenues:
Product (A) (B)		14,778			9,283
Maintenance and service (A)		4,249			2,417

Total cost of revenues		19,027			11,700

Gross margin		61,990			39,370

Operating expenses:
Research and development (A) (B)		13,597			9,782
Sales and marketing (A) (B)		31,522			20,162
General and administrative (A)		5,970			4,191

Total operating expenses		51,089			34,135

Income from operations		10,901			5,235
Interest and other income, net		1,126			1,063

Income before income taxes		12,027			6,298
Provision for income taxes		(5,653	)		(3,086	)

Net income	$	6,374		$	3,212

Basic net income per share	$	0.07		$	0.04

Shares used in computing basic net income per share		86,539			77,003

Diluted net income per share	$	0.07		$	0.04

Shares used in computing diluted net income per share		90,730			82,893

(A) Includes stock-based compensation of the following:
Cost of product revenues	$	280		$	411
Cost of maintenance and service revenues		341			277
Research and development		2,689			1,983
Sales and marketing		2,709			2,697
General and administrative		1,064			724

Total stock-based compensation	$	7,083		$	6,092

(B) Includes amortization of intangible assets of the following:
Cost of product revenues	$	1,425		$	186
Research and development		23			23
Sales and marketing		538			35

Total amortization of intangible assets	$	1,986		$	244


	Three Months Ended December 31,
	2003			2002
Operating activities
Net income	$	6,374		$	3,212
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,374			1,275
Amortization of deferred stock compensation		7,083			6,092
Tax benefits from employee stock option plans		2,635			—
Other		—			8
Changes in operating assets and liabilities:
Accounts receivable (net of allowances)		1,905			(1,629	)
Refundable income taxes		895			—
Inventories		(44	)		453
Deferred income taxes		1,440			—
Other current assets		(220	)		(1,058	)
Other assets		(53	)		159
Accounts payable		1,548			304
Accrued expenses		(1,790	)		1,078
Accrued compensation		(850	)		111
Accrued income taxes		213			2,817
Restructuring liabilities		17			(36	)
Deferred revenue		7,779			9,150

Net cash provided by operating activities		30,306			21,936


Investing activities
Purchase of property and equipment		(1,600	)		(2,165	)
Cash used in business combination, net of cash acquired		(5,135	)		(474	)
Purchases of short-term investments		(178,106	)		(122,079	)
Maturities of short-term investments		169,278			103,085

Net cash used in investing activities		(15,563	)		(21,633	)


Financing activities
Principal payments on debt and capital lease obligations		(72	)		(566	)
Restricted cash		684			172
Proceeds from issuance of common stock under stock option and stock purchase plans, net of repurchases		4,328			4,529
Repayment of stockholders’ notes		—			90

Net cash provided by financing activities		4,940			4,225

Net increase in cash and cash equivalents		19,683			4,528
Cash and cash equivalents at beginning of period		53,914			11,153

Cash and cash equivalents at end of period	$	73,597		$	15,681


	Three Months Ended December 31,
	2003			2002
Net income	$	6,374		$	3,212
Add: Stock-based employee compensation expense included in reported net income applicable to common stockholders, net of related tax effects		7,083			6,092
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(16,566	)		(10,767	)

Net loss	$	(3,109	)	$	(1,463	)

Shares used in computing basic net income (loss) per share		86,539			77,003

Shares used in computing diluted net income per share		90,730			82,893

Shares used in computing diluted net loss per share		86,539			77,003

Earnings per share:
Basic net income per share – as reported	$	0.07		$	0.04

Basic net loss per share – pro forma	$	(0.04	)	$	(0.02	)

Diluted net income per share – as reported	$	0.07		$	0.04

Diluted net loss per share – pro forma	$	(0.04	)	$	(0.02	)


	December 31, 2003		September 30, 2003
Raw materials	$	778	$	481
Finished goods		2,146		2,020

	$	2,924	$	2,501


Common stock	$	219,723
Outstanding Neoteris stock options		25,850
Cash to be paid to stockholders and option holders		20,001
Estimated direct costs of the acquisition		1,504

Total preliminary purchase price	$	267,078


Cash and cash equivalents	$	9,606
Short-term investments		10,200
Accounts receivable, net		3,753
Accrued expenses		(5,064	)
Deferred revenue		(1,607	)
Restructuring liabilities		(2,066	)
Deferred income taxes		(3,909	)
Other assets and liabilities, net		1,356

Fair value of net tangible assets acquired		12,269
Developed technology		22,100
Trademark		1,950
Customer base		5,675
Purchase orders		650
Non-compete agreements		5,200
Goodwill		175,099
Deferred stock compensation		44,135

Total preliminary purchase price	$	267,078


	Amortization Period	Gross		Accumulated Amortization			Net
Related to Neoteris, Inc.:
Developed technology	48 months	$	22,100	$	(691	)	$	21,409
Trademark	48 months		1,950		(61	)		1,889
Customer base	48 months		5,675		(177	)		5,498
Purchase orders	2 months		650		(487	)		163
Non-compete agreements	24 months		5,200		(325	)		4,875

Sub-total			35,575		(1,741	)		33,834

Related to OneSecure, Inc.:
Purchased technology	60 months		2,450		(633	)		1,817
Technology patent application	120 months		2,550		(329	)		2,221
Non-compete agreements	36 months		550		(237	)		313
Value-added reseller relationships	60 months		250		(65	)		185

Sub-total			5,800		(1,264	)		4,536

Total		$	41,375	$	(3,005	)	$	38,370


Year ending September 30:
2004 (remaining nine months)	$	8,421
2005		11,002
2006		8,551
2007		8,204
2008		1,185
2009 and thereafter		1,007

Total	$	38,370


	Three months ended December 31
	2003		2002
Revenues	$	84,562	$	53,108
Net income (loss) applicable to common stockholders		2,846		(5,958	)
Basic net income (loss) per share applicable to common stockholders	$	0.03	$	(0.07	)
Diluted net income (loss) per share applicable to common stockholders	$	0.03	$	(0.07	)


Balance at September 30, 2002	$	1,693
Additions charged to cost of revenues during the period		350
Settlements made during the period		(336	)

Balance at September 30, 2003		1,707
Additions charged to cost of revenues during the period		60
Settlements made during the period		(46	)

Balance at December 31, 2003	$	1,721


Year ending December 31:
2004	$	1,019
2005		1,151
2006		1,130
2007		971
Thereafter		502

Total net present value	$	4,773


Year ending September 30:
2004 (remaining nine months)	$	21,662
2005		19,407
2006		8,556
2007		3,322
2008		25


Total deferred stock compensation	$	52,972


					Payments Due by Period
	Total		Less Than One Year		One to Three Years		Four to Five Years		After Five Years
Restructuring liabilities, net present value	$	4,773	$	1,019	$	3,252	$	502	$	—
Inventory purchase commitments		7,456		7,456		—		—		—
Operating leases		15,318		4,546		9,720		1,052		—

Total contractual cash obligations	$	27,547	$	13,021	$	12,972	$	1,554	$	—


Gross proceeds from our IPO	$	184,000,000

Offering expenses:
Underwriting fees		12,880,000
Other offering expenses		2,481,000

Total offering expenses		15,361,000

Net proceeds from our IPO	$	168,639,000



Exhibit 31.1		Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

Exhibit 32.1		Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Exhibit 32.2		Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


Exhibit No.		Description
31.1		Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.