BLUE COAT SYSTEMS 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 ¨ No x

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

The condensed consolidated financial statements include Blue Coat Systems, Inc.’s (the “Company’s”) accounts and those of the Company’s wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted as permitted under the Securities and Exchange Commission’s (“SEC’s”) rules and regulations. In the opinion of management, the accompanying condensed consolidated financial statements and related notes as of January 31, 2004, and for the three and nine month periods then ended, include all adjustments, consisting only of normal recurring adjustments, necessary for a fair presentation of the Company’s consolidated financial position, operating results and cash flows for the interim date and periods presented. Results for the three and nine months ended January 31, 2004 are not necessarily indicative of results for the entire fiscal year or future periods.

The condensed consolidated balance sheet as of April 30, 2003 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

These condensed consolidated financial statements and notes included herein should be read in conjunction with the Company’s audited consolidated financial statements and notes for the year ended April 30, 2003 included in the Company’s Annual Report on Form 10-K filed with the SEC on July 29, 2003.

On November 14, 2003, the Company completed its acquisition of Ositis Software, Inc. (“Ositis”). The estimated purchase price of approximately $8.7 million consisted of approximately 0.4 million shares of Blue Coat common stock valued at $6.8 million, approximately $1.1 million in cash, approximately $0.8 million in estimated direct transaction costs, and Ositis warrants assumed by the Company valued at approximately $43,000.

Ositis, a California Corporation, is a developer of Web security and Internet access technologies. Ositis offers software and appliance solutions that provide customers with a system to safeguard and connect networked devices. Ositis’ products include “WinProxy”, an Internet sharing solution, “eShield”, an appliance that includes anti-spam, anitivirus and Web filtering on one platform, and Access Now VBN for visitor-based network connectivity. Ositis’ operations were assumed as of the date of the acquisition and are included in the result of operations of the Company beginning on November 14, 2003 and, as a result, are not reflected in the results of operations for the three and nine months ended January 31, 2003. The acquisition was accounted for as a purchase in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Accounting for Business Combinations”; accordingly, the Company allocated the purchase price to the fair value of assets acquired and liabilities assumed.

The preliminary allocation of the estimated purchase price, based on the fair value of certain components, consisted of the following (in thousands):

Upon closing the acquisition of Ositis, the Company recorded approximately $1.6 million of deferred employee compensation. Of the $1.6 million, $0.2 million was recorded as a prepaid expense related to committed cash considerations and $1.4 million related to committed stock awards to be issued over the next twelve months, which was recorded as deferred stock compensation in the equity section of the Company’s balance sheet. These amounts will be amortized over a twelve month period beginning in November 2003. As of the three months ended January 31, 2004, the Company incurred compensation expense of $0.4 million related to amortization of prepaid employee compensation and deferred employee stock compensation, with the remaining $1.2 million to be amortized at $0.4 million per quarter through October 31, 2004.

As a result of the acquisition of Ositis, on November 14, 2003, the Company incurred lease termination costs, moving costs, and transition costs of approximately $0.6 million, considered part of the allocation of the purchase price of Ositis. The Company also incurred $0.1 million in transition costs during the three months ended January 31, 2004, related to nine Ositis employees who are transitioning their employment activities to existing Company employees and will be terminated upon completion of the transition. The planned reduction of the nine Ositis employees is part of integration efforts to eliminate redundancies and increase organizational efficiencies within the newly combined company. The Company estimates that the transition will be finalized by April 30, 2004 at an additional cost of approximately $64,000.

As part of the valuation analysis of Ositis, an understanding of the technology acquired and its future use after the acquisition was necessary. Accordingly, several factors were considered. These factors include: (i) whether or not the acquired technology had achieved technological feasibility; (ii) the time, costs and risks to complete the development of the technology; (iii) the roadmap for the technology post acquisition; (iv) the existence of any alternative use for the technology; (v) the use of any core technology; and (vi) the results of any enhancements or embellishments to the technology.

Using the above guidelines at the time of the acquisition, the Company’s management identified several intangible assets that were valued separately from goodwill. Acquired intangible assets and their estimated useful lives are as follows (in thousands):

To establish the value of the intangible assets, the Company used an income approach, which values an asset based on the earnings capacity of such asset based on the future cash flows that could potentially be generated by the asset over its estimated remaining life. These cash flows are discounted to their present value using a discount rate of 15.0% for the developed technology, 20.0% for the core technology and 25.0% for the in-process technology, that would provide sufficient return to a potential investor and an appropriate level of risk. The present value of the cash flows over the life of the asset is summed to equal the estimated value of the asset.

The Company’s primary purpose of acquiring Ositis is to expand its platform with controls for antivirus, as well as gain access to Ositis’ customer base. The Company believes that the intangible assets of Ositis would strengthen its product offerings and allow it to market a more compelling solution to its customers. For this analysis the Company classified Ositis’ existing products (WinProxy and eShield) as developed technology, since they were being utilized and sold in the marketplace.

Projects which qualify as in-process technology have not yet reached technological feasibility and have no alternative future use. Technological feasibility is defined as being equivalent to completion of a beta-phase working prototype in which there is no significant remaining risk relating to the development. As of the valuation date, Ositis was in the process of developing its next generation eShield appliance, which was expected to feature increased performance and more robust capabilities. The Company plans on releasing this product within the next twelve months. The Company is aware that this project has identifiable technological risk factors that indicate that even though successful completion is expected, it is not assured. Thus, although the Company intends to release the next generation as mentioned above, it cannot be certain that incurred in-process technology costs will ultimately provide any benefit, and so it has expensed the identified in-process technology in its operating results.

The Company, with the assistance of an independent valuation specialist, valued the customer base using the income approach. As in the valuation of the technology, the Company utilized a five-step process to value Ositis’ customer base: (i) revenue associated with the customer relationships was projected using maintenance revenue; (ii) cost of goods sold was then estimated for each period in which revenue was projected; (iii) the resulting net cash flow was tax affected and reduced further by charges for the use of fixed assets, working capital and other assets necessary to generate these cash flows. The cash flows were calculated by adding debt free net income, less returns on working capital, fixed assets and the other assets; (iv)

the resulting net cash flows were discounted at a rate commensurate with their risk, the same rate of return rate used for the core technology; (v) the Company summed the discounted cash flows to estimate their fair market values. The Company then estimated the tax benefits associated with the intangible asset and this benefit was included in the value of the customer base.

Amortization expense was approximately $0.3 million during the three months ended January 31, 2004, which included approximately $151,000 of expense relating to the immediate write off of in-process technology. Amortization expense for the fourth quarter of 2004 will be approximately $152,000. The amortization expense related to intangible assets in future periods is as follows (in thousands):

Unaudited pro forma continuing operations for the three and nine months ended January 31, 2004 and 2003, assuming the acquisition was completed on May 1, 2002, would be as follows (in thousands, except per share amounts):

The unaudited pro forma financial information is presented for informational purposes only, and is not necessarily indicative of what the Company’s operating results would have been, had the acquisition been completed on the date for which the pro forma results give effect (May 1, 2002). Included in the three and nine month periods ended January 31, 2003 were expenses related to the acquisition of Ositis, such as the amortization of intangible assets, stock compensation, and transition costs. As a result, the expenses included in the three and nine months ended January 31, 2003 were reversed in the three and nine months ended January 31, 2004.

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets”, goodwill is not amortized but is reviewed at least on an annual basis for impairment purposes.

The Company recorded $2.3 million of identifiable intangible assets upon the acquisition of Ositis on November 14, 2003, consisting of developed technology, core technology, in-process technology and customer base. The estimated useful lives of these intangible assets is 5 years, except for developed technology, which has a life of three years, and in-process technology, which was expensed and reflected in the Company’s operating results for the three and nine months ended January 31, 2004. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long Lived Assets”, identifiable intangible assets are reviewed for impairment whenever indicators of impairment are present.

Intangible assets subject to amortization consisted of the following as of January 31, 2004 (in thousands):

The preparation of condensed consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the dates of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results may differ from these estimates, and such differences could be material to the Company’s condensed consolidated financial position and results of operations. The Company’s critical accounting estimates include (i) revenue recognition and related receivable allowances, (ii) warranty reserves, (iii) inventory and related reserves, (iv) restructuring liabilities, (v) income taxes, and (vi) contingencies.

The Company recognizes appliance and WinProxy revenue upon delivery of the product, assuming that evidence of an arrangement between the customer and the Company exists, the fee to the customer is fixed or determinable and collectability of the sales price is probable, unless the Company has future obligations for installation or must obtain customer acceptance, in which case revenue is deferred until the obligations are met or acceptance is obtained. Revenues related to shipments to the Company’s distributors who have certain stock rotation rights are deferred until a point of sale report is received from the distributor confirming that the Company’s products have been sold to a reseller or an end user. Maintenance contract revenue is initially deferred and recognized ratably over the life of the contract.

Delivery is considered to have occurred for the Company’s appliances when the customer takes title to the product and assumes the risks and rewards of ownership. WinProxy software delivery is considered to have occurred upon delivery of the software key. Typically delivery of the WinProxy software key is made electronically.

Probability of collection is assessed on a customer by customer basis. The Company’s customers are subjected to a credit review process that evaluates the customers’ financial position and ability to pay for the Company’s products and services. If it is determined from the outset of an arrangement that collection is not probable based upon the Company’s review process, revenue is not recognized until cash receipt. During the course of the three months ended January 31, 2004 and 2003, the Company deferred certain revenue based on this criteria and revenue from certain customers was recognized based upon cash receipts.

The Company also performs ongoing credit evaluations of its customers’ financial condition and maintains an allowance for estimated credit losses. The Company analyzes accounts receivable and historical bad debts, customer concentrations, customer solvency, current economic and geographic trends, and changes in customer payment terms and practices when evaluating the adequacy of such allowance.

The Company’s customer agreements generally include certain provisions for indemnifying such customers against liabilities if the Company’s products infringe a third party’s intellectual property rights. To date, the Company has not incurred any material costs as a result of such indemnifications and has not accrued any liabilities related to such obligations in the accompanying condensed consolidated financial statements.

The Company accrues for warranty expenses at the time revenue is recognized and maintains a reserve for estimated future warranty obligations based upon the relationship between historical and anticipated warranty costs and sales volumes. If actual warranty expenses are greater than those projected, additional reserves and other charges against earnings may be required. If actual warranty expenses are less than projected, prior reserves could be reduced providing a positive impact on our reported results.

Inventories consist of raw materials, work-in-process and finished goods. Inventories are recorded at the lower of cost or market using the first-in, first-out method, after appropriate consideration has been given to obsolescence and inventory in excess of anticipated future demand. In assessing the ultimate recoverability of inventories, the Company is required to make estimates regarding future customer demand and market conditions. Although the Company strives to ensure the accuracy of forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of the Company’s inventory and commitments, and reported results. If actual market conditions are less favorable than those projected, additional reserves and other charges against earnings may be required.

The Company has accrued various restructuring liabilities, through charges to “Restructuring Expenses”, related to employee severance costs, facilities closure and lease abandonment costs, and contract termination costs in the Company’s condensed consolidated financial statements (See Note 2). The Company’s restructuring liabilities for facilities closure and lease abandonment costs include various assumptions, such as the time period over which abandoned facilities will be vacant, expected sublease terms, and expected sublease rates. These estimates are reviewed and revised periodically and may result in a substantial change to restructuring expense should different conditions prevail than were anticipated in original management estimates. These conditions may include, but are not limited to, changes in estimated time to sublease the facilities, sublease terms, sublease rates, and lease termination.

The Company uses the liability method to account for income taxes as required by the Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

From time to time the Company is involved in various claims and legal proceedings (See Note 3). If management believes that a loss arising from these matters is probable and can reasonably be estimated, the company records the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. Litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.

The Company accounts for stock-based awards granted to (i) employees and officers using the intrinsic value method and (ii) non-employees using the fair value method.

Under the intrinsic value method, when the exercise price of employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized as prescribed by Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees” and related interpretations. In accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation”, under the fair value method,

costs are measured on the earlier of either a performance commitment or the completion of performance by the non-employee provider of goods or services, and are determined based on estimated fair value of the consideration received or the estimated fair value of the equity instruments issued, whichever is more reliably measurable.

The following table illustrates the pro forma effect on net income (loss) and net income (loss) per share for the three and nine months ended January 31, 2004 and 2003 had the Company applied the fair value method to account for stock-based awards to employees (in thousands, except per share amounts):

On July 31, 2003, the FASB’s Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-5, “Applicability of AICPA Statement of Position 97-2, “Software Revenue Recognition,” to Non-Software Deliverables in an Arrangement Containing More-Than Incidental Software.” EITF Issue No. 03-5 discusses that software deliverables are within the scope of SOP 97-2, as are non-software deliverables for which the related software is essential to the functionality of the non-software deliverables. EITF Issue No. 03-5 is effective for fiscal periods beginning after August 2003. The adoption of EITF Issue No. 03-5 had no material impact on the Company’s financial position, results of operations or liquidity.

enterprises with VIEs created before February 1, 2003. The Company believes it has no investments in, or contractual or other business relationships with, VIEs. Therefore, the adoption of FIN 46 had no effect on the Company’s consolidated financial position as of January 31, 2004 or the results of our operations for the three and nine months ended January 31, 2004.

In November 2002, the FASB’s EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 were effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003, and the Company’s adoption of EITF Issue No. 00-21 on August 1, 2003 had no impact on its consolidated financial position and results of operations.

On January 1, 2003, the Company adopted SFAS No. 146, “Accounting for Costs Associated with an Exit or Disposal Activity.” SFAS No. 146 revises the accounting for exit and disposal activities under EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring),” by extending the period in which expenses related to restructuring activities are reported. A commitment to a plan to exit an activity or dispose of long-lived assets is no longer sufficient to record a one-time charge for most restructuring activities. Instead, companies record exit or disposal costs when they are incurred and can be measured at fair value. In addition, the resultant liabilities are subsequently adjusted for changes in estimated cash flows. SFAS No. 146 was effective prospectively for exit or disposal activities initiated after December 31, 2002. Companies may not restate previously issued financial statements for the effect of the provisions of SFAS No. 146, and liabilities that a company previously recorded under EITF Issue No. 94-3 are grandfathered. The adoption of SFAS No. 146 had no effect on the Company’s consolidated financial position and results of operations.

In February 2002, the Company’s Board of Directors approved a restructuring program to significantly reduce operating expenses and to further align the Company with market conditions, future revenue expectations and planned future product direction. In connection with this restructuring program, the Company implemented a reduction in workforce of approximately 200 employees, which represented approximately 45% of the Company’s workforce. The Company accrued approximately $12.9 million in the fourth quarter ended April 30, 2002, comprised of employee severance costs of approximately $2.7 million, facilities closure and lease abandonment costs of approximately $9.5 million and contract termination costs of approximately $0.7 million. All employees were notified of their termination prior to April 30, 2002. Estimates related to sublease costs and income were based on assumptions regarding sublease rates and the time required to locate sub-lessees, which were derived from market trend information provided by a commercial real estate broker. These estimates are reviewed on a periodic basis and to the extent that these assumptions materially change due to changes in the market, the ultimate restructuring expense for the abandoned facilities is adjusted. In July 2002, one of the Company’s facilities in Sunnyvale, California was subleased for the remainder of the lease term at a rental price that was consistent with initial estimates. The Company’s facility in Redmond, Washington was subleased in December 2002, for the remainder of the term of the original lease at a rental price consistent with initial estimates. Due to its financial difficulties, the tenant in Sunnyvale, California surrendered the premises and vacated the property in January 2003. The facility in Sunnyvale, California is again vacant and available for subleasing. As a result, the Company revised and increased the restructuring accruals for abandoned space by $1.6 million during fiscal 2003 based on new market trend information provided by a commercial real estate broker. The Company also reduced its estimates for contract termination costs by $0.3 million during fiscal 2003, as the Company was able to negotiate lower settlement amounts than originally estimated. During the second quarter of fiscal 2004, the Company further increased its restructuring accruals for abandoned space by $0.9 million to reflect another revision of market trend information provided by a commercial real estate broker. As of January 31, 2004, substantially all severance costs

related to domestic and international employees had been paid and $6.7 million remained accrued for lease abandonment and contract termination costs. The lease abandonment costs will be paid over the respective lease terms through fiscal 2008.

Changes in the Company’s restructuring accruals are as follows (in thousands):

Beginning on May 16, 2001, a series of putative securities class actions were filed against the firms that underwrote the Company’s initial public offering, the Company, and some of its officers and directors in the U.S. District Court for the Southern District of New York. These cases have been consolidated under the case captioned In re CacheFlow, Inc. Initial Public Offering Securities Litigation., Civil Action No. 1-01-CV-5143. An additional putative securities class action has been filed in the United States District Court for the Southern District of Florida. The Court in the Florida case dismissed the Company and individual officers and directors from the action without prejudice. The complaints in the New York and Florida cases generally allege that the underwriters obtained excessive and undisclosed commissions in connection with the allocation of shares of common stock in the Company’s initial public offering, and maintained artificially high market prices through tie-in arrangements which required customers to buy shares in the after-market at pre-determined prices. The complaints allege that the Company and its current and former officers and directors violated Sections 11 and 15 of the Securities Act of 1933, and Sections 10(b) (and Rule 10b-5 promulgated thereunder) and 20(a) of the Securities Exchange Act of 1934, by making material false and misleading statements in the prospectus incorporated in the Company’s Form S-1 Registration Statement filed with the Securities and Exchange Commission in November 1999. Plaintiffs seek an unspecified amount of damages on behalf of persons who purchased the Company’s stock between November 19, 1999 and December 6, 2000. A lead plaintiff has been appointed for the consolidated cases pending in New York. On April 19, 2002 plaintiffs filed an amended complaint.

Various plaintiffs have filed similar actions asserting virtually identical allegations against over 300 other public companies, their underwriters, and their officers and directors arising out of each company’s public offering. The lawsuits against us, along with these other related securities class actions currently pending in the Southern District of New York, have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings and are collectively captioned In re Initial Public Offering Securities Litigation, Civil Action No. 21-MC-92. Defendants in these cases have filed omnibus motions to dismiss. On February 19, 2003, the Court denied in part and granted in part the motion to dismiss filed on behalf of defendants, including the Company. The Court’s order did not dismiss any claims against the Company. As a result,

discovery may now proceed. The Company’s officers and directors have been dismissed without prejudice in this litigation.

A proposal has been made for the settlement and release of claims against the issuer defendants, including the Company, in exchange for a guaranteed recovery to be paid by the issuer defendants’ insurance carriers and an assignment of certain claims. The settlement is subject to a number of conditions, including approval of the proposed settling parties and the court. If the settlement does not occur, and litigation against the Company continues, the Company believes it has meritorious defenses and intends to defend the case vigorously. The Company believes the outcome would not have a material adverse effect on its business, results of operations or financial condition. Securities class action litigation could result in substantial costs and divert the Company’s management attention and resources, which could seriously harm the Company’s business.

On August 1, 2001, Network Caching Technology L.L.C. (“NCT”) filed suit against the Company and others in the United States District Court for the Northern District of California, alleging infringement of certain patents owned by NCT. The lawsuit was styled Network Caching Technology LLC vs. Novell, Inc. et al., Case No. CV-01-2079. On October 29, 2003, the Company and NCT entered into a settlement agreement by which the Company received a fully paid up license under the NCT patents for all Company products and services and a full and complete release from any and all claims of liability for any actual or alleged past and present infringement of the NCT patents. As consideration for the license rights and release, we paid a total of $1.1 million, expensed as a separate line item on the Company’s statement of operations named “ Legal settlement fees”. The Order of Dismissal regarding all causes of action between NCT and the Company was entered November 14, 2003.

Periodically, the Company reviews the status of each significant matter and assesses potential financial exposure. Because of the uncertainties related to the (i) determination of the probability of an unfavorable outcome and (ii) amount and range of loss in the event of an unfavorable outcome, management is unable to make a reasonable estimate of the liability that could result from any pending litigation described above and no accrual was recorded in Company’s balance sheet as of January 31, 2004. As additional information becomes available, the Company will reassess the probability and potential liability related to pending litigation, which could materially impact the Company’s results of operations and financial position.

From time to time and in the ordinary course of business, the Company may be subject to various other claims and litigation. Such claims, even if not estimable, could result in the expenditure of significant financial and other resources.

On September 18, 2003 the Company sold 1,311,807 shares of common stock, $.0001 par value per share, to investment funds and an individual affiliated with Sprout Group, a venture capital affiliate of Credit Suisse First Boston at a price of $9.91 per share. The share price was determined using the average closing price per share of Blue Coat’s common stock on the Nasdaq National Market over the five (5) trading days ending on the trading date prior to the date of closing. The offering resulted in net proceeds of approximately $13 million, which will be used for general corporate purposes including capital expenditures, potential acquisitions, working capital and any other purpose that the Company may specify in any subsequent filing. The shares of common stock issued in the transaction have not been registered under the Securities Act of 1933 and may not be offered or sold in the absence of a registration statement in effect with respect to the securities under the Securities Act of 1933 or an applicable exemption from registration requirements. See Part II Other Information, Item 2 “Changes in Securities and Use of Proceeds” included in this Quarterly Report on Form 10-Q for further discussion.

The Company reports comprehensive income (loss) in accordance with FASB SFAS No. 130, “Reporting Comprehensive Income.” Included in other comprehensive income (loss) are adjustments to record unrealized gains and losses on available-for-sale securities. These adjustments are accumulated in “Accumulated other comprehensive income” in the stockholders’ equity section of the balance sheet.

Significant components of the Company’s comprehensive income (loss) are as follows (in thousands):

Basic net income (loss) per common share and diluted net income (loss) per common share are presented in conformity with FASB SFAS No. 128, “Earnings Per Share,” for all periods presented. Basic per share amounts are computed by using the weighted average number of shares of the Company’s common stock, less the weighted average number of common shares subject to repurchase, outstanding during the period. Diluted per share amounts are determined in the same manner as basic per share amounts, except that the number of weighted average common shares used in the computations includes dilutive common shares subject to repurchase and is increased assuming the (i) exercise of dilutive stock options and warrants using the treasury stock method and (ii) issuance of committed but unissued stock awards. However, diluted net loss per share is the same as basic net loss per share in periods where a net loss from operations is incurred because loss from operations is the “control number” in determining whether potential common shares are included in the calculation. Consequently, the impact of including (i) common shares subject to repurchase, (ii) the assumed exercise of outstanding stock options and warrants and (iii) the issuance of committed but unissued stock awards were not dilutive to loss from operations for the nine months ended January 31, 2004 and 2003, and the three months ended January 31, 2003. The total number of shares excluded from the calculation of diluted net loss per common share was 1,055,119 for the nine months ended January 31 2004, 234,639 for the nine months ended January 31, 2003, and 410,992 for three months ended January 31, 2003.

The following table presents the calculation of weighted average common shares used in the computations of basic and diluted per share amounts presented in the accompanying consolidated statements of operations (in thousands, except per share amounts):

We operate in one segment to design, develop, market and support secure proxy appliances. Our chief operating decision maker makes operating decisions and allocates resources based on financial data consistent with the presentation in the accompanying condensed consolidated financial statements. Our sales consist of four product categories: Web security products, WinProxy, legacy products and services. Total international revenue consists of sales from our U.S. operations to non-affiliated customers in other geographic regions. During the three and nine months ended January 31, 2004 and 2003, there were no intra-company sales, and no material long-lived assets were located in any of our foreign operations.

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

The Company leases certain facilities and equipment under non-cancelable operating leases. Certain of the Company’s facility leases provide for periodic rent increases based on the general rate of inflation. As of January 31, 2004, future minimum lease payments under operating leases having an initial term in excess of one year are as follows (in thousands):

Of the $8.3 million in total operating lease commitments for abandoned facilities, as summarized above, $6.7 million is included in the captions “Other accrued liabilities” and “Accrued restructuring” in the accompanying condensed consolidated balance sheet at January 31, 2004. The remaining $1.6 million represents approximately $0.4 million of assumed operating lease liabilities from the Ositis acquisition and approximately $1.2 million of estimated sublease income.

The discussion in this Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this Report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements on revenue expectations, expense controls, product acceptance, product and sales development, future product deliveries, future operating results and cash usage, as well as statements on our expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those indicated in such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, uncertainty in the secure proxy appliance market, technological changes, increased competition, inability to implement our distribution strategy, inability to increase sales productivity or attract new sales personnel, inability to improve our infrastructure and implement new systems, uncertainty in future operating results, inability to integrate acquired companies, limited ability to forecast quarterly operating results, unpredictable macroeconomic conditions, product concentration, undetected product errors, unpredictable sales cycles, supply shortages, inability to defend our intellectual property rights, increased litigation, unpredictable demand for our products, product liability claims, inability to raise additional capital, inability to generate increased international sales, volatile stock price, inability to attract and retain key employees, potential charges to earnings resulting from the Ositis acquisition, disclosure of non-GAAP financial information, unpredictable internet usage, occurrence of a natural disaster, and other risks discussed in this item under the heading “Factors Affecting Future Operating Results” and the risks discussed in our other recent Securities and Exchange Commission filings.

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

Blue Coat^™ Systems, Inc., also referred to in this report as “we”, “us” or the “Company”, was incorporated in Delaware on March 16, 1996. We are focused on the secure proxy appliance market. Blue Coat high-performance proxy appliances provide visibility and control of Web communications to address today’s new business risks such as inappropriate Web surfing, viruses brought in via back door channels such as instant messaging and Web-based email, and network resource abuse due to peer-to-peer (P2P) file sharing and video streaming.

Our initial products, introduced in May of 1998, utilized caching technology to improve user response time for accessing Internet content. These systems were used by service providers and enterprises throughout the world and achieved a market leadership position. By 1999, the caching market began evolving into two distinct markets – enterprises looking for proxy caches to securely connect employees to the Internet, and service providers looking for increased bandwidth savings and response time for their subscribers. During this timeframe, service provider customers represented the majority of our revenues. We continued, however, to enhance our competitive position in both markets through internal development and external acquisitions. By early 2001, the demand for extending our enterprise proxy caches started to grow, while the service provider market decreased significantly. We accelerated our development and marketing efforts around our enterprise business, resulting in the launch of our ProxySG products in February 2002.

Our discussion and analysis of financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of our condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We evaluate, on an ongoing basis, our estimates and judgments, including those related to sales returns, bad debts, warranty costs, excess inventory and purchase commitments, investments, intangible assets, lease losses and restructuring accruals, income taxes and contingencies based on historical experience and other factors that we believe to be reasonable under the circumstances. However, actual results may differ from these estimates under different assumptions or conditions, and such differences could be material.

We have discussed the development and selection of critical accounting policies and estimates with our audit committee. We believe the accounting policies described below, among others, are the ones that most frequently require us to make estimates and judgments, and therefore are critical to the understanding of our results of operations:

Revenue Recognition and Related Receivable Allowances. We recognize appliance and WinProxy revenue upon delivery of the product, assuming that evidence of an arrangement between the customer and us exists, the fee to the customer is fixed or determinable and collectability of the sales price is probable, unless the Company has future obligations for installation or must obtain customer acceptance, in which case revenue is deferred until the obligations are met or acceptance is obtained. Revenues related to

shipments to our distributors who have certain stock rotation rights are deferred until a point of sale report is received from the distributor confirming that our products have been sold to a reseller or an end user. Maintenance contract revenue is initially deferred and recognized ratably over the life of the contract.

Delivery is considered to have occurred for our appliances when the customer takes title to the product and assumes the risks and rewards of ownership. WinProxy software delivery is considered to have occurred upon delivery of the software key. Typically delivery of the WinProxy software key is made electronically.

Probability of collection is assessed on a customer by customer basis. Our customers are subjected to a credit review process that evaluates the customers’ financial position and ability to pay for our products and services. If it is determined from the outset of an arrangement that collection is not probable based upon our review process, revenue is not recognized until cash receipt. During the course of the three and nine months ended January 31, 2004 and 2003, we deferred certain revenue based on this criteria and revenue from certain customers was recognized based upon cash receipts.

We also perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for estimated credit losses. We analyze accounts receivable and historical bad debts, customer concentrations, customer solvency, current economic and geographic trends, and changes in customer payment terms and practices when evaluating the adequacy of such allowance. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make payments, additional allowances may be required.

Warranty Reserves. We accrue for warranty expenses at the time revenue is recognized and maintain an accrual for estimated future warranty obligations based upon the relationship between historical and anticipated costs and sales volumes. If actual warranty expenses are greater than those projected, additional reserves and other charges against earnings may be required. If actual warranty expenses are less than projected, prior reserves could be reduced providing a positive impact on our reported results. See Item 1, Note 1 “Significant Accounting Policies – Guarantees” of the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further discussion.

Inventory and Related Reserves. Inventories consist of raw materials, work-in-process and finished goods. Inventories are recorded at the lower of cost or market using the first-in, first-out method, after appropriate consideration has been given to obsolescence and inventory in excess of anticipated future demand. In assessing the ultimate recoverability of inventories, we are required to make estimates regarding future customer demand and market conditions. Although we strive to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and commitments, and our reported results. If actual market conditions are less favorable than those projected, additional reserves and other charges against earnings may be required. See Item 1, Note 1 “Significant Accounting Policies – Inventories” of the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further discussion.

Restructuring Liabilities. We have accrued various restructuring liabilities, through charges to “Restructuring Expenses”, related to employee severance costs, facilities closure and lease abandonment costs, and contract termination costs in our condensed consolidated financial statements. Our restructuring liabilities for facilities closure and lease abandonment costs include various assumptions, such as the time period over which abandoned facilities will be vacant, expected sublease terms, and expected sublease rates. These estimates are reviewed and revised periodically and may result in a substantial change to restructuring expense should different conditions prevail than were anticipated in original management estimates. These conditions may include, but are not limited to, changes in estimated time to sublease the facilities, sublease terms, sublease rates, and lease termination. See Item 1, Note 2 “Restructuring Charges” of the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further discussion.

Income Taxes. We use the liability method to account for income taxes as required by the FASB SFAS No. 109, “Accounting for Income Taxes.” Under this method, deferred tax assets and liabilities are determined

based on differences between financial reporting and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.

Contingencies. From time to time we are involved in various claims and legal proceedings. If management believes that a loss arising from these matters is probable and can reasonably be estimated, we record the amount of the loss, or the minimum estimated liability when the loss is estimated using a range, and no point within the range is more probable than another. As additional information becomes available, any potential liability related to these matters is assessed and the estimates are revised, if necessary. Litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.

The following table summarizes operating results for the three months ended January 31, 2004 and 2003 and also quantifies (in dollars and percentages) the change in our operating results comparing the three months ended January 31, 2004, to the three months ended January 31, 2003 (in thousands):

The following table summarizes operating results for the nine months ended January 31, 2004 and 2003 and also quantifies (in dollars and percentages) the change in our operating results comparing the nine months ended January 31, 2004, to the nine months ended January 31, 2003 (in thousands):

Net Sales. Net sales increased for the three and nine months ended January 31, 2004 as compared to the three and nine months ended January 31, 2003. The growth in sales was driven primarily by increases in the number of our ProxySG appliances shipped. Market acceptance of our ProxySG line, coupled with a strengthening in overall IT spending by the market contributed to the increase in our sales. Demand in the final calendar months of 2003 was higher than what we had seen in the prior two years, and our sales organization exceeded forecasted amounts due to the strong demand. We anticipate that the market awareness of our secure proxy appliances will continue to grow.

As a result of our focus on increasing the use of indirect channels, one of our distributors accounted for 29% and 17% of sales in the three months ended January 31, 2004 and 2003, respectively.

The following table illustrates the geographic makeup of our revenues for the periods stated (in thousands):

Revenues in North America have been growing quarter to quarter for the past four quarters, revenues in Europe have been growing quarter to quarter for the past three quarters, and revenues in Asia increased over last quarter. As mentioned above, increased IT spending and calendar year end budget spending contributed to the growth in sales for the three and nine months ended January 31, 2004 as compared to the three and nine months ended January 31, 2003.

The following table demonstrates the composition of net sales by product category (in thousands):

We have become increasingly reliant upon our Web security product sales for revenue, and anticipate that our legacy product revenue will continue to decrease and may even cease. We also anticipate that our WinProxy sales may stay at current levels or increase slightly. Due to uncertain economic conditions, our visibility of the near-term demand for our products is limited; however, we currently anticipate that we may see modest net sales growth in the next several quarters.

Gross Profit. Gross profit increased for the three and nine month periods ended January 31, 2004 compared to the same periods in 2003. These increases in gross profit were primarily due to increased sales during the period. Gross profit as a percentage of net sales increased to 70.8% for the three months ended January 31, 2004 from 64.9% for the three months ended January 31, 2003. Gross profit as a percentage of sales increased to 68.2% for the nine months ended January 31, 2004 from 61.2% for the nine months ended January 31, 2003. The increase in gross profit as a percentage of sales for the three months ended January 31, 2004 was the result of several factors. Increased product volume while keeping fixed manufacturing costs contributed to improved margins. In addition, we experienced increased margins on third party software as a result of several factors: (i) We had an increase in our sales of streaming software compared to prior quarters, while paying a fixed quarterly royalty amount; (ii) we experienced higher margins resulting from negotiated discounts on royalty payments with our partners; and (iii) we benefited from third party agreements that exist for the WinProxy software products where margins are generally greater than what we have historically realized. We do not expect most of these benefits to margins on third party software to continue in future quarters. In addition, we reversed approximately $0.1 million of inventory obsolescence reserves as we have identified demand for all of our 6000 series product which had been previously reserved. We do not expect any significant inventory obsolescence reversals in future quarters as we have now reversed all of the reserves previously established for the 6000 series product. The increase in gross profit as a percentage of sales for the nine months ended January 31, 2004 as compared to the nine months ended January 31, 2003 was a result of lower fixed manufacturing and support costs in fiscal 2004 and continued reduction in the cost of components used in our products.

Our gross profit has been and will continue to be affected by a variety of factors, including competition, fluctuations in demand for our products, the timing and size of customer orders and product implementations, the mix of direct and indirect sales, the mix and average selling prices of products, new product introductions and enhancements, component costs, manufacturing costs and product configuration. If actual orders do not match our forecasts, as we have experienced in the past, we may have excess or inadequate inventory of some materials and components or we could incur cancellation charges or penalties, which would increase our costs or prevent or delay product shipments and could seriously harm our business.

Research and Development. Research and development expenses consist primarily of salaries, benefits, and prototype costs. The increase in research and development expense for the three month period ended January 31, 2004 compared to the three month period ended January 31, 2003 was largely due to the absorption of the Ositis engineering staff located in Latvia, which added approximately $0.3 million in costs. The decrease in research and development expenses for the nine month period ended January 31, 2004 as compared to the nine month period ended January 31, 2003 is primarily attributable to a decrease in headcount prior to the Ositis acquisition. Research and development headcount increased to 83 at January 31, 2004 from 71 at January 31, 2003 as we added the Ositis engineering staff. As a percentage of net sales, research and development expenses decreased to 16.1% for the three months ended January 31, 2004 from 23.1% for the three months ended January 31, 2003 and to 18.0% for the nine months ended January 31, 2004 from 26.8% for the nine months ended January 31, 2003. The decrease in research and development expenses as a percentage of net sales occurred due to increased sales of our product. Should demand for our products continue to increase, and after we realize potential efficiencies within our research and development organization, we expect to increase our research and development expenses in absolute dollars and increase headcount within the research and development organization to provide for the development of new products. However, should sales decline in future periods, we may implement cost reduction programs to reduce our research and development expenses.

Sales and Marketing. Sales and marketing expenses consist primarily of salaries and benefits, commissions, and promotional expenses. The slight increase in sales and marketing expense for the three month period ended January 31, 2004 compared to the three month period ended January 31, 2003 was largely due to increases in marketing program spending and in increased commission payments to the sales organization. A large percentage of the sales teams exceeded their assigned quotas and earned accelerated commissions. The decreases in sales and marketing expenses in absolute dollars for the nine month period ended January 31, 2004 compared to the nine month period ended January 31, 2003 were related to reductions in headcount in the first two quarters of the fiscal year. Sales and marketing headcount increased to 83 at January 31, 2004 from 78 at January 31, 2003, as we added Ositis sales personnel. As a percentage of net sales, sales and marketing expenses decreased to 33.0% for the three months ended January 31, 2004 from 52.9% for the three months ended January 31, 2003 and to 39.2% for the nine months ended January 31, 2004 from 58.1% for the nine months ended January 31, 2003. The decreases in sales and marketing expenses as a percentage of net sales were due to increases in the productivity of our sales organization. With demand for our products having increased, we have realized increased efficiencies within our sales and marketing organization but we expect to increase our sales and marketing expenses in absolute dollars in an effort to expand domestic and international markets, introduce new products and establish and expand new distribution channels. However, should sales decline in future periods, we may implement cost reduction programs to reduce our sales and marketing expenses.

General and Administrative. The increase in general and administrative expense for the three month period ended January 31, 2004 compared to the three month period ended January 31, 2003 was due to increased headcount. The decrease in general and administrative expenses in absolute dollars for the nine month period ended January 31, 2004 compared to the nine month period ended January 31, 2003 was related to decreased headcount in the first two quarters of our fiscal year 2004. General and administrative headcount increased to 31 at January 31, 2004 from 29 at January 31, 2003. As a percentage of net sales, general and administrative expenses decreased to 7.7% for the three months ended January 31, 2004 from 10.0% for the three months ended January 31, 2003 and to 8.2% for the nine months ended January 31, 2004 from 11.4% for the nine months ended January 31, 2003. The decrease in general and administrative expenses as a

percentage of net sales was a result of continued efforts to reduce costs in our general and administrative organizations and increased sales in the nine months ending January 31, 2004. We have realized potential efficiencies within our current general and administrative organization, but we may increase general and administrative expenses in absolute dollars and increase headcount to manage expanding operations and facilities. However, should sales decline in future periods, we may implement cost reduction programs to reduce our general and administrative expenses.

Legal Settlement Fees. Legal settlement fees were $1.1 million for the nine months ended January 31, 2004 as the result of a settlement made with Network Caching Technology L.L.C. to avoid further litigation risks and expenses. See Item 1, Note 3 “Litigation” of the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further discussion.

Write-off of In-process Technology. Upon the completion of the Ositis acquisition (November 14, 2003) we attributed value to certain in-process technologies acquired. As of the acquisition date, Ositis was in the process of developing its next generation eShield appliance, which was expected to feature increased performance and more robust capabilities. We currently plan on releasing this product within the next twelve months. We are aware that this project has identifiable technological risk factors, such that successful completion is not assured. Thus, although we intend to release the next generation as mentioned above, we cannot be certain that incurred in-process technology costs will ultimately provide benefit and so we have expensed $151,000 assigned to the identified in-process technology in our operating results. See Item 1, Note 1 “Significant Accounting Policies—Acquisitions” of the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further discussion.

Amortization of Intangible Assets. We recorded $2.3 million of intangible assets upon the acquisition of Ositis on November 14, 2003 consisting of developed technology, core technology, in-process technology and customer base, all with lives of 5 years except for developed technology, which has a life of three years. Amortization expense relating to identifiable intangible assets excluding the write-off of in-process technology, totaled $152,000 during the three months ended January 31, 2004. See Item 1, Note 1 “Significant Accounting Policies—Acquisitions” of the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further discussion.

Stock Compensation. As a result of the acquisition of Ositis (November 14, 2003), deferred stock compensation of $1.4 million was included in our shareholders equity on the balance sheet. Of this $1.4 million, approximately $0.3 million was amortized to stock compensation expense in our statement of operations during the three months ended January 31, 2004. In addition, stock compensation expense reflects the amortization of non-cash deferred stock compensation, as well as charges associated with stock options and warrants granted to non-employees for services and modifications to stock-based awards for certain departed employees. Stock compensation expense decreased for the three month period ended January 31, 2004 compared to the three month period ended January 31, 2003 as a result of decreased headcount and decreased amortization of deferred stock compensation for remaining employees. Our policy is to amortize such deferred stock compensation using a graded method. Graded amortization methods result in greater amortization in earlier years, and most of our deferred stock compensation was recorded in connection with our November 1999 initial public offering, certain below-market option grants in fiscal 2001 and unvested options assumed in our December 2000 acquisition of Entera Inc.

Interest Income and Other Income. Interest income was $0.1 million for the three months ended January 31, 2004 and 2003. Interest income was slightly lower in the three months ended January 31, 2004 due to lower cash balances at the beginning of the quarter and lower interest rates earned on our cash equivalents and short-term investments.

In February 2002, our Board of Directors approved a restructuring program to significantly reduce our operating expenses and further align our organization with market conditions, future revenue expectations and our planned future product direction at that time. In connection with this restructuring plan, we implemented a reduction in workforce of approximately 200 employees. We accrued approximately $12.9 million in the fourth quarter ended April 30, 2002, comprised of employee severance costs of approximately $2.7 million, facilities closure and lease abandonment costs of approximately $9.5 million and contract termination costs of approximately $0.7 million. All employees were notified of their termination prior to April 30, 2002. Estimates related to sublease costs and income were based on assumptions regarding sublease rates and the time required to locate sub-lessees, which were derived from market trend information provided by a commercial real estate broker. These estimates are reviewed on a periodic basis and to the extent that these assumptions materially change due to changes in the market, the ultimate restructuring expense for the abandoned facility will be adjusted. In July 2002, one of our facilities in Sunnyvale, California was subleased for the remainder of the lease term at a rental price that was consistent with our initial estimates. Our facility in Redmond, Washington was subleased in December 2002 for the remainder of the term of the original lease at a rental price consistent with our initial estimates. Due to its financial difficulties, the tenant in Sunnyvale, California surrendered the premises and vacated the property in January 2003. The facility in Sunnyvale, California is currently vacant and available for subleasing. As a result, we revised and increased our estimated restructuring accruals for abandoned space by $1.6 million during fiscal 2003 based on new market trend information provided by a commercial real estate broker. We also reduced our estimates for contract termination costs by $0.3 million during fiscal 2003, as we were able to negotiate lower settlement amounts than originally estimated. During the second quarter of fiscal 2004, we further increased our restructuring accruals for abandoned space by $0.9 million to reflect another revision of market trend information provided by a commercial real estate broker. As of January 31, 2004, substantially all severance costs related to domestic and international employees had been paid, and approximately $6.7 million remained accrued for lease abandonment and contract termination costs. The lease abandonment costs will be paid over the respective lease terms through fiscal 2008.

We believe the restructuring programs have achieved the expense reductions we desired, although the anticipated savings from the reduced headcount or facility consolidations may in the future be mitigated by changes in circumstances or subsequent increases in headcount and facilities related to our operating requirements. See Item 1, Note 2 “Restructuring Charges” of the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q for further discussion.

We believe the existing cash, cash equivalents, short-term investments and cash generated from operations will be sufficient to meet our operating requirements for at least the next twelve months, including working capital requirements, capital expenditures and potential future acquisitions or strategic investments. We may choose at any time to raise additional capital to strengthen our financial position, facilitate expansion, pursue strategic investments or to take advantage of business opportunities as they arise.

Since our inception, we have financed our operations and capital expenditures through private sales of preferred and common stock, bank loans, equipment leases, and an initial public offering of our common stock.

During the nine months ended January 31, 2004, we generated $2.1 million of cash from operating activities compared to a use of cash of $15.1 million for the nine months ended January 31, 2003. This increase was the result of a decrease in operating loss for the nine months ended January 31, 2004 adjusted for non-cash-related items. Working capital uses of cash included increases in prepaid expenses and other current assets, and a decrease in accrued liabilities. Prepaid expenses and other current assets increased over 2003 levels as a result of a large committed order with one of our vendors to obtain discounted prices on essential product. Accrued liabilities decreased over the prior quarter primarily as a result of cash payments made against the restructuring accrual recorded during fiscal 2003. Working capital sources of cash included a decrease in accounts receivable and inventory, and increases in deferred revenue and accounts payable. Accounts receivable decreased as a result of our concerted efforts on collections and the linearity of our shipments throughout the quarter ended January 31, 2004. Our days sales outstanding have decreased from 61.8 at April 30, 2003 to 31.8 at January 31, 2004. Inventory has decreased as a result of higher sales, which allowed us to use excess inventory from the prior year. Deferred revenue increased as a result of increased sales of service and support and in particular, we saw increased activity in our three year support orders. Accounts payables increased during the nine months ended January 31, 2004 as a result of a lower than usual accounts payable balance at April 30, 2004 and as a result of a large committed order recorded with one of our vendors in order to obtain discounted prices on essential product.

Net cash provided by investing activities was $6.5 million for the nine months ended January 31, 2004 and $11.2 million for the nine months ended January 31, 2003. Net cash provided by investing activities for the nine months ended January 31, 2004 and 2003 was primarily due to sales of short-term investments of approximately $10.4 million and $12.0 million, respectively, partially offset by purchases of property and

equipment of approximately $0.9 million and $0.7 million, respectively. Also during the nine months ended January 31, 2004 we acquired Ositis resulting in a total net effect on cash used by investing activities of ($3.1 million). In the future, we expect that any cash in excess of current requirements will continue to be invested in short-term investment grade, interest-bearing securities. During the nine months ended January 31, 2004 and 2003, our capital expenditures consisted primarily of the Ositis acquisition and purchases of computer equipment, software, furniture and leasehold improvements.

Net cash provided by financing activities was $13.7 million and $0.1 million for the nine months ended January 31, 2004 and 2003, respectively. The net cash provided by our financing activities for the nine months ended January 31, 2004 was primarily due to a private equity financing and the issuance of common stock through the exercise of stock options. On September 18, 2003 we raised $13.0 million from the sale of 1,311,807 shares of our common stock to investment funds and an individual affiliated with Sprout Group, a venture capital affiliate of Credit Suisse First Boston.

Our contractual operating lease commitments as of January 31, 2004 for the next five years were as follows:

We lease certain equipment and office facilities under various noncancelable operating leases that expire at various dates through fiscal 2008. The facility leases generally require us to pay operating costs, including property taxes, insurance and maintenance, and contain scheduled rent increases and certain other rent escalation clauses. Rent expense is reflected in our condensed consolidated financial statements on a straight-line basis over the terms of the respective leases. As of January 31, 2004, we did not have any other significant contractual obligations or commercial commitments.

As of January 31, 2004, we continue to have no outstanding debt and we do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities, nor did we have any commitment or intent to provide additional funding to any such entities. As such, we are not materially exposed to any market, credit, liquidity or financing risk that could arise if we had engaged in such relationships.

On July 31, 2003, the FASB’s Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-5, “Applicability of AICPA Statement of Position 97-2, “Software Revenue Recognition,” to Non-Software Deliverables in an Arrangement Containing More-Than Incidental Software.” EITF Issue No. 03-5 discusses that software deliverables are within the scope of SOP 97-2, as are non-software deliverables for which the related software is essential to the functionality of the non-software deliverables. EITF Issue No. 03-5 is effective for fiscal periods beginning after August 2003. The adoption of EITF Issue No. 03-5 had no material impact on our financial position, results of operations or liquidity.

In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements.” FIN 46 applies to any business enterprise that has a controlling interest, contractual relationship or other business relationship with a variable interest entity (“VIE”) and establishes guidance for the consolidation of VIEs that function to support the activities of the primary beneficiary. FIN 46 was effective immediately for enterprises with VIEs created after January 31, 2003, and will be effective January 31, 2004 for enterprises with VIEs created before February 1, 2003. We believe we have no investments in, or contractual or other business relationships with, VIEs. Therefore, the adoption of FIN 46 had no effect on our consolidated financial position as of October 31, 2003 or the results of our operations for the three and six months ended October 31, 2003.

In November 2002, the FASB’s EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 were effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003, and our adoption of EITF Issue No. 00-21 on August 1, 2003 had no impact on our consolidated financial position and results of operations.

On January 1, 2003, we adopted SFAS No. 146, “Accounting for Costs Associated with an Exit or Disposal Activity.” SFAS No. 146 revises the accounting for exit and disposal activities under EITF Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring),” by extending the period in which expenses related to restructuring activities are reported. A commitment to a plan to exit an activity or dispose of long-lived assets is no longer sufficient to record a one-time charge for most restructuring activities. Instead, companies record exit or disposal costs when they are incurred and can be measured at fair value. In addition, the resultant liabilities are subsequently adjusted for changes in estimated cash flows. SFAS No. 146 was effective prospectively for exit or disposal activities initiated after December 31, 2002. Companies may not restate previously issued financial statements for the effect of the provisions of SFAS No. 146, and liabilities that a company previously recorded under EITF Issue No. 94-3 are grandfathered. The adoption of SFAS No. 146 had no effect on our consolidated financial position and results of operations.

Our business, financial condition and results of operations could be seriously harmed by any of the following risks. In addition the trading price of our common stock could decline due to any of the following risks.

The market for secure proxy appliance solutions is relatively new, unknown and evolving, and subject to rapid technological changes. If this market does not develop as we anticipate, our sales may not grow and may even decline.

Sales of our products depend on increased demand for secure proxy appliances. The market for secure proxy appliances is a new and rapidly evolving market. If the market for secure proxy appliances fails to grow as we anticipate, or grows more slowly than we anticipate, our business will be seriously harmed. In addition, our business will be harmed if the market for secure proxy appliances continues to be negatively impacted by uncertainty surrounding macro-economic growth.

Market awareness of our product is essential to the growth and success of our company. One of our key business strategies is to increasingly market and advertise our company and our products. If our advertising and marketing programs are not successful in creating market awareness of our company and products our revenues and results of operations could be substantially impacted.

To maintain our competitive position in a market characterized by rapid rates of technological advancement, we must continue to invest significant resources in research and development. We need to develop and introduce new products and enhancements to existing products on a timely basis that keep pace with technological developments and emerging industry standards and address the increasingly

sophisticated needs of our customers. We intend to extend the offerings under our product family in the future, both by introducing new products and by introducing enhancements to our existing products. However, we may experience difficulties in doing so, and our inability to timely and cost-effectively introduce new products and product enhancements, or the failure of these new products or enhancements to achieve market acceptance, could seriously harm our business. Life cycles of our products are difficult to predict because the market for our products is new and evolving and characterized by rapid technological change, frequent enhancements to existing products and new product introductions, changing customer needs and evolving industry standards. The introduction of competing products that employ new technologies and emerging industry standards could render our products and services obsolete and unmarketable or shorten the life cycles of our products and services. The emergence of new industry standards might require us to redesign our products. If our products are not in compliance with industry standards that become widespread, our customers and potential customers may not purchase our products. There is no guarantee that we will accurately predict the direction in which the secure proxy appliance market will evolve. Failure on our part to anticipate the direction of the market and develop products that meet those emerging needs will significantly impair our business and operating results and our financial condition will be materially adversely affected.

We expect increased competition and, if we do not compete effectively, we could experience a loss in our market share and sales.

The market for secure proxy appliances is intensely competitive. Primary competitive factors that have typically affected our market include product characteristics such as reliability, scalability and ease of use, as well as price and customer support. The intensity of competition is expected to increase in the future. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any one of which could seriously harm our business. We may not be able to compete successfully against current or future competitors and we cannot be certain that competitive pressures we face will not seriously harm our business. Our competitors vary in size and in the scope and breadth of the products and services they offer. We encounter competition from a variety of companies, including Cisco Systems, Network Appliance, Microsoft and various others. In addition, we expect additional competition from other established and emerging companies as the market for secure proxy appliances continues to develop and expand.

Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger installed base of customers than we do. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of our industry. As a result, our competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements, or to devote greater resources to the development, marketing, promotion and sale of their products than we can. The products of our competitors may have features and functionality that our products do not have. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the market acceptance of their products. In addition, our competitors may be able to replicate our products, make more attractive offers to existing and potential employees and strategic partners, develop new products or enhance existing products and services more quickly, or bundle secure proxy appliances in a manner that we cannot provide. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We also expect that competition will increase as a result of industry consolidation.

If we fail to create additional sales through our sales channel partners, our business will be seriously harmed.

During the third quarter of fiscal 2004, over ninety percent of our revenue was generated through sales to our sales channel partners, which include distributors, resellers and system integrators. We increasingly depend upon these partners to generate sales opportunities and to independently manage the entire sales process. We provide our sales channel partners with specific programs to assist them in this process, but there can be no assurance that these programs will be effective or that our sales channel partners will be able to generate increasing revenues to us without significant additional investment on our part. In addition, our sales channel partners 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.

Any direct channel new hire or new sales channel partner will require extensive training and typically take several months to achieve productivity. If we fail to manage existing sales channels, our business will be seriously harmed. Many of our sales channel partners do not have minimum purchase or resale requirements and carry products that are competitive with our products. These sales channel partners may not give a high priority to the marketing of our products or may not continue to carry our products. They may give a higher priority to other products, including the products of competitors.

If we are unable to hire additional sales territory managers or increase productivity of our existing sales territory managers our revenue will not be able to grow.

During the three months ended January 31, 2004 the productivity rate of our sales territory managers was at or close to our Company’s expected full capacity. In order to meet anticipated increased sales levels in the future we need to hire extra sales personnel or increase sales productivity per person. If we cannot hire additional sales personnel or increase sales productivity our ability to reach increased sales amounts in the future will be seriously hindered.

Failure to improve our infrastructure may adversely affect our business. We will need to improve and implement new systems, procedures and controls, which could be time-consuming and costly.

We must continue to implement and maintain a variety of operational, financial and management information systems, procedures and controls. The enactment of the Sarbanes-Oxley Act of 2002 and other recent and anticipated Securities and Exchange Commission regulations will require us to devote additional resources to our operational, financial and management information systems, procedures and controls to ensure our continued compliance with current and future laws and regulations. If we are unable to implement and maintain appropriate operational, financial and management information systems, procedures and controls, this could have a material adverse effect on our business, results of operations and financial condition. Our ability to successfully implement our business plan requires an effective planning and management process.

Our ability to compete effectively and to manage future expansion of our operations will require us to continue to improve our financial and management controls, reporting systems and procedures on a timely basis. Our current or planned systems, procedures and controls may not be adequate to support our future operations. We need to continue to improve existing and implement new operational and financial systems, procedures and controls. Any delay in the implementation of or disruption in the transition to new or enhanced systems, procedures or controls could harm our ability to accurately forecast sales demand, manage our supply chain and record and report financial and management information on a timely and accurate basis.

We may incur net losses or increased net losses if we are required to record additional significant accounting charges related to excess facilities that we are unable to sublease.

We have existing commitments to lease office space in Sunnyvale, California and Redmond, Washington in excess of our needs for the foreseeable future. The commercial real estate market in the San Francisco Bay Area and the Seattle Area has developed such a large excess inventory of office space that we believe we will be unable to sublease a substantial portion of our excess office space in the near future. Accordingly, in the fourth quarter of fiscal 2002, we recorded an excess facilities charge of $9.5 million, which represented the remaining lease commitments for vacant facilities, net of expected sublease income. As of January 31, 2004, $6.7 million of this accrued liability remains on the balance sheet. In July 2002, one of our facilities in Sunnyvale, California was subleased for the remainder of the lease term at a rental price that was consistent with our initial estimates. Our facility in Redmond, Washington was subleased in December 2002 for the remainder of the term of the original lease at a rental price consistent with our initial estimates. Due to its financial difficulties, our tenant in Sunnyvale, California surrendered the premises and vacated the property in January 2003. The facility in Sunnyvale, California is currently vacant and available for subleasing. As a result, we revised and increased our restructuring accruals for abandoned space by approximately $1.6 million during fiscal 2003 based on then available market trend information provided by a commercial real estate broker. During the second quarter of fiscal 2004, we further increased our restructuring accruals for abandoned space by $0.9 million to reflect another revision of market trend information provided by a commercial real estate broker. We may be required to record additional charges if our existing tenant defaults on its lease obligation and if current market conditions for the commercial real estate market remain the same or worsen.

Although we have achieved profitability during the three month period ended January 31, 2004, we incurred losses since we commenced operations until this quarter, and our profitability could be difficult to sustain. If our revenue growth is slow or if operating expenditures exceed our expectations or cannot be adjusted accordingly, we may experience additional losses on a quarterly and annual basis.

If we are unable to successfully integrate recently acquired Ositis Software, Inc., our ability to execute our business strategy and timely deliver new products to market could be harmed.

We completed our acquisition of Ositis Software, Inc. on November 14, 2003. If we fail to develop and integrate the technology of this company into our products and services, our quarterly and annual operating results may be adversely affected. Other risks we may face with respect to the acquisition of Ositis Software, Inc. include the potential disruption of our ongoing business and distraction of management; the difficulty of assimilating and retaining personnel; the maintenance of uniform standards, corporate cultures, controls, procedures and policies; difficulties in integrating the operations, technologies, and products; insufficient revenues to offset increased expenses associated with the acquisition; potential difficulties in completing projects associated with in-process research and development derived from the Latvian research and development group; coordinating and integrating sales and marketing efforts to effectively communicate the capabilities of the combined company; cross selling related products to each other’s customers; and managing the combined sales force. Our inability to address any of these risks successfully could harm our business.

We may also make additional acquisitions in the future. Acquisitions of companies, products or technologies entail numerous risks, including an inability to successfully assimilate acquired operations and products, diversion of management’s attention, loss of key employees of acquired companies and substantial transaction costs. Some of the products acquired may require significant additional development before they can be marketed and may not generate revenue at levels anticipated by us. Moreover, future acquisitions by us may result in dilutive issuances of equity securities, the incurrence of additional debt, large one-time write-offs and the creation of goodwill or other intangible assets that could result in significant amortization expense. Any of these problems or factors could seriously harm our business.

Because we expect our sales to fluctuate and our costs are relatively fixed in the short term, our ability to forecast our quarterly operating results is limited, and if our quarterly operating results are below the expectations of analysts or investors, the market price of our common stock may decline.

Our net sales and operating results are likely to vary significantly from quarter to quarter. We believe that quarter-to-quarter comparisons of our operating results should not be relied upon as indicators of future performance. It is likely that in some future quarter or quarters, our operating results will be below the expectations of public market analysts or investors. When this occurs, the price of our common stock could decrease significantly. A number of factors are likely to cause variations in our net sales and operating results, including factors described elsewhere in this “Factors Affecting Future Operating Results” section.

We cannot reliably forecast our future quarterly sales for several reasons, including:

A high percentage of our expenses, including those related to manufacturing overhead, technical support, research and development, sales and marketing, general and administrative functions, amortization of intangible assets and amortization of deferred compensation, are essentially fixed in the short term. As a result, if our net sales are less than forecasted, our quarterly operating results are likely to be seriously harmed and our stock price would likely decline.

Unpredictable macroeconomic conditions could adversely impact our existing and potential customers’ ability and willingness to purchase our products, which would cause a decline in our sales.

Although we saw significant growth in revenue in the quarter ended January 31, 2004 when compared to the prior quarter, there is uncertainty relating to the prospects for near-term U.S. economic growth and growth within the international markets. This uncertainty could possibly contribute to delays in decision-making by our existing and potential customers and a resulting decline in our sales. Continued uncertainty or a decrease in corporate spending could result in a decline to our sales and our operating results could be below our expectations and the expectations of public market analysts and investors.

Because we depend on several third-party manufacturers to build portions of our products, we are susceptible to manufacturing delays and sudden price increases, which could prevent us from shipping customer orders on time, if at all, and may result in the loss of sales and customers.

We currently purchase from Mitac Corporation (“Mitac”) the base assemblies of most of our current products. Any Mitac manufacturing disruption could impair our ability to fulfill orders. We also rely on several other third-party manufacturers to build portions of our products. If we or our suppliers are unable to manage the relationships with these manufacturers effectively or if these manufacturers fail to meet our future requirements for timely delivery, our business would be seriously harmed. These manufacturers fulfill our supply requirements on the basis of individual purchase orders or agreements with us. Accordingly, these manufacturers are not obligated to continue to fulfill our supply requirements, and the prices we are charged for these components could be increased on short notice. Any interruption in the operations of any one of these manufacturers would adversely affect our ability to meet our scheduled product deliveries to our customers, which could cause the loss of existing or potential customers and would seriously harm our business. In addition, the products that these manufacturers build for us may not be sufficient in quality or in quantity to meet our needs. Our delivery requirements could be higher than the capacity of these manufacturers, which would likely result in manufacturing delays, which could result in lost sales and the loss of existing and potential customers. We cannot be certain that these manufacturers or any other manufacturer will be able to meet the technological or delivery requirements of our current products or any future products that we may develop and introduce. The inability of these manufacturers or any other of our contract manufacturers in the future to provide us with adequate supplies of high-quality

products, or the loss of any of our contract manufacturers in the future, would cause a delay in our ability to fulfill customer orders while we attempt to obtain a replacement manufacturer. Delays associated with our attempting to replace or our inability to replace one of our manufacturers would seriously harm our business.

We have no long-term contracts or arrangements with any of our vendors that guarantee product availability, the continuation of particular payment terms or the extension of credit limits. We have experienced in the past, and may experience in the future, problems with our contract manufacturer, such as inferior quality, insufficient quantities and late delivery of product. To date, these problems have not materially adversely affected us. We may not be able to obtain additional volume purchase or manufacturing arrangements on terms that we consider acceptable, if at all. If we enter into a high-volume or long-term supply arrangement and subsequently decide that we cannot use the products or services provided for in the agreement, our business will be harmed. We cannot assure you that we can effectively manage our contract manufacturer or that this manufacturer will meet our future requirements for timely delivery of products of sufficient quality or quantity. Any of these difficulties could harm our relationships with customers and cause us to lose orders.

In the future, we may seek to use additional contract manufacturers. We may experience difficulty in locating and qualifying suitable manufacturing candidates capable of satisfying our product specifications or quantity requirements. Further, new third-party manufacturers may encounter difficulties in the manufacture of our products, resulting in product delivery delays.

Our use of rolling forecasts could lead to excess or inadequate inventory, or result in cancellation charges or penalties, which could seriously harm our business.

We use rolling forecasts based on anticipated product orders and product order history to determine our materials requirements. Lead times for the parts and components that we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for a component at a given time. If actual orders do not match our forecasts, as we experienced in the past, we may have excess or inadequate inventory of some materials and components or we could incur cancellation charges or penalties, which would increase our costs or prevent or delay product shipments and could seriously harm our business.

Undetected product errors could cause us to incur significant warranty and repair costs and negatively impact the market acceptance of our products.

Our products may contain undetected operating errors. These errors may cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. The occurrence of these problems could result in the delay or loss of market acceptance of our products and would likely seriously harm our business. All of our products operate on our internally developed operating system. As a result, any error in the operating system will affect all of our products. We have experienced minor errors in the past in connection with new products. We expect that errors will be found from time to time in new or enhanced products after commencement of commercial shipments.

Our variable sales cycle makes it difficult to predict the timing of a sale or whether a sale will be made, which makes our quarterly operating results less predictable.

Because customers have differing views on the strategic importance of implementing secure proxy appliances, the time required to educate customers and sell our products can vary widely. As a result, the evaluation, testing, implementation and acceptance procedures undertaken by customers can vary, resulting in a variable sales cycle, which typically ranges from one to nine months. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing expenses and expend significant management efforts. In addition, purchases of our products are frequently subject to unplanned processing and other delays, particularly with respect to larger customers for whom our products represent a very small percentage of their overall purchase activity. Large

customers typically require approvals at a number of management levels within their organizations, and, therefore, frequently have longer sales cycles. The increasingly complex technological issues associated with secure proxy appliance solutions, combined with the macro-economic slowdown, contributed to longer sales cycles in fiscal years 2002 and 2003 and a resulting decline in our sequential quarterly sales through much of those periods. Although we saw solid sales growth in the quarter ended January 31, 2004 we anticipate we may still experience order deferrals or loss of sales as a result of lengthening sales cycles.

Because some of the key components in our products come from limited sources of supply, we are susceptible to supply shortages or supply changes, which could disrupt or delay our scheduled product deliveries to our customers and may result in the loss of sales and customers.

We currently purchase several key parts and components used in the manufacture of our products from limited sources of supply. The introduction by these suppliers of new versions of their hardware, particularly if not anticipated by us, could require us to expend significant resources to incorporate this new hardware into our products. In addition, if these suppliers were to discontinue production of a necessary part or component, we would be required to expend significant resources in locating and integrating replacement parts or components from another vendor. Qualifying additional suppliers for limited source components can be time-consuming and expensive. Any of these events would be disruptive to us and could seriously harm our business. Further, financial or other difficulties faced by these suppliers or unanticipated demand for these parts or components could limit the availability of these parts or components. Any interruption or delay in the supply of any of these parts or components, or the inability to obtain these parts or components from alternate sources at acceptable prices and within a reasonable amount of time, would seriously harm our ability to meet our scheduled product deliveries to our customers.

If the protection of our proprietary technology is inadequate, our competitors may gain access to our technology, and our market share could decline.

We depend significantly on our ability to develop and maintain the proprietary aspects of our technology. To protect our proprietary technology, we rely primarily on a combination of contractual provisions, confidentiality procedures, trade secrets, copyright and trademark laws and patents. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Our means of protecting our proprietary rights may not be adequate and our competitors may independently develop similar technology, duplicate our products or design around patents that may be issued to us or our other intellectual property.

We presently have several issued patents, and pending United States patent applications. We cannot assure you that any U.S. patent will be issued from these applications. Even with issued patents, we cannot assure you that we will be able to detect any infringement or, if infringement is detected, that patents issued will be enforceable or that any damages awarded to us will be sufficient to adequately compensate us.

There can be no assurance or guarantee that any products, services or technologies that we are presently developing, or will develop in the future, will result in intellectual property that is protectable under law, whether in the United States or a foreign jurisdiction, that this intellectual property will produce competitive advantage for us or that the intellectual property of competitors will not restrict our freedom to operate, or put us at a competitive disadvantage.

We rely on technology that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. If we are unable to continue to license any of this software on commercially reasonable terms, we will face delays in releases of our software or will be required to drop this functionality from our software until equivalent technology can be identified, licensed or developed, and integrated into our current product. Any of these delays could seriously harm our business.

There has been a substantial amount of litigation in the technology industry regarding intellectual property rights and we recently settled a suit that alleged infringement of certain U.S. patents by us. (See Item 1, Note 3 “Litigation” of the condensed consolidated financial statements included in this Quarterly Report on Form 10-Q) We expect that companies in the Internet and networking industries will increasingly be subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps. Any claims, with or without merit, could be time-consuming, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all, which could seriously harm our business.

We develop intellectual property in areas where the laws may not be as developed as in the United States and thus may not protect our ownership of these intellectual properties.

We rely on a combination of copyright, patent, trademark, trade secrets, confidentiality procedures and contractual procedures to protect our intellectual property rights. We currently operate in foreign locations and may increase the amount of research and development that is done internationally. The laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States. Should we be unable to defend our existing or developed intellectual property, or should the existing laws protecting intellectual property and its development deteriorate, our business and our results of operations would be adversely affected.

The legal environment in which we operate is uncertain and claims against us could cause our business to suffer.

Our products operate in part by storing material available on the Internet and making this material available to end users from our appliance. This creates the potential for claims to be made against us, either directly or through contractual indemnification provisions with customers, for defamation, negligence, copyright or trademark infringement, personal injury, invasion of privacy or other legal theories based on the nature, content or copying of these materials. It is also possible that if any information provided through any of our products contains errors, third parties could make claims against us for losses incurred in reliance on this information. Our insurance may not cover potential claims of this type or be adequate to protect us from all liability that may be imposed.

Our sales may not grow because our secure proxy appliances only protect Web based applications and content, and our target customers may not wish to purchase an additional network security device.

Our secure proxy appliances are specially designed to only secure Web based protocols such as http, https, ftp and streaming. While we believe that the majority of traffic traveling over the networks of our target customers is Web based, a significant amount of their network traffic may not be. Our products do not protect non-Web protocols. Our target customers may not wish to purchase an additional security device that only handles network traffic that is Web protocol based. As a result, our target customers may not purchase our products and our business would be seriously harmed.

We could be subject to product liability claims, which are time-consuming and costly to defend.

Our customers install our secure proxy appliance products directly into their network infrastructures. Any errors, defects or other performance problems with our products could negatively impact the networks of our customers or other Internet users, resulting in financial or other damages to these groups. These groups may then seek damages from us for their losses. If a claim were brought against us, we may not have sufficient protection from statutory limitations or license or contract terms with our customers, and any unfavorable judicial decisions could seriously harm our business. A product liability claim brought against us, even if not successful, would likely be time-consuming and costly. A product liability claim could seriously harm our business reputation.

As of January 31, 2004, we had approximately $35.1 million in cash and cash equivalents and $80,000 in short-term investments. On September 18, 2003 we sold 1,311,807 shares of common stock, $.0001 par value per share, to investment funds and an individual affiliated with Sprout Group, a venture capital affiliate of Credit Suisse First Boston, at a price of $9.91 per share. The offering resulted in net proceeds of approximately $13.0 million, which will be used for general corporate purposes including capital expenditures, acquisitions, working capital and any other purpose that we may specify in any subsequent filing. We believe that these amounts will enable us to meet our capital requirements for at least the next twelve months. However, if cash is used for unanticipated needs, we may need additional capital during that period. The development and marketing of new products will require a significant commitment of resources. In addition, if the market for secure proxy appliances develops at a slower pace than anticipated or if we fail to establish significant market share and achieve a meaningful level of sales, we could be required to raise substantial additional capital. We cannot be certain that additional capital will be available to us on favorable terms, or at all. If we were unable to raise additional capital when we require it, our business would be seriously harmed.

We may not be able to generate a significant level of sales from the international markets in which we currently operate.

For the three months ended January 31, 2004, sales to customers outside of North America accounted for approximately 42.3% of our net sales as compared to approximately 51.9% for the three months ended January 31, 2003. We expect international customers to continue to account for a significant percentage of net sales in the future, but we may fail to maintain or increase international market demand for our products. The downsizing of our international operations as the result of our restructuring plans may further hinder our ability to increase our market concentration internationally. Also, because our international sales are currently denominated in United States dollars, an increase in the value of the United States dollar relative to foreign currencies could make our products more expensive and, therefore, potentially less competitive in international markets, and this would decrease our international sales. Our ability to generate international sales depends on our ability to maintain our international operations, including efficient use of existing resources and effective channel management, and recruit additional international resellers. To the extent we are unable to do so in a timely manner, our growth, if any, in international sales will be limited and our business could be seriously harmed.

Our stock price is volatile and, as a result, you may have difficulty evaluating the value of our stock, and the market price of our stock may decline.

Since our initial public offering in November 1999 through March 9, 2004, the closing market price of our common stock has fluctuated significantly, ranging from $2.25 to $823.45. The market price of our common stock may fluctuate significantly in response to the following factors:

We are dependent upon key personnel and we must attract, assimilate and retain other highly qualified personnel or our ability to execute our business strategy and generate sales could be harmed.

Our business could be seriously disrupted if we do not maintain the continued service of our senior management, research and development and sales personnel. We have hired several senior executives in the past four quarters and have experienced and may continue to experience transition in our management team. We expect that it will take time for our new management team to integrate into our company. All of our employees are employed on an “at-will” basis. Our ability to conduct our business also depends on our continuing ability to attract, hire, train and retain a number of highly skilled managerial, technical, sales, marketing and customer support personnel. New hires frequently require extensive training before they achieve desired levels of productivity, so a high employee turnover rate could seriously impair our ability to operate and manage our business.

Charges to earnings resulting from the acquisition of Ositis Software, Inc., including the application of the purchase method of accounting and restructuring and integration costs, may materially adversely affect the market value of our common stock.

In accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”), we have accounted for the acquisition of Ositis Software, Inc. using the purchase method of accounting. Accordingly, we have allocated the total estimated purchase price to Ositis Software Inc.’s net tangible assets, amortizable intangible assets, and in-process research and development based on their fair values as of the date of completion of the merger (November 14, 2003), and recorded the excess of the purchase price over those fair values as goodwill. The combined company’s financial results, including earnings/(loss) per share, are affected by a number of financial adjustments required by U.S. GAAP, including the following:

These adjustments may negatively impact our earnings, which may have a material adverse effect on the price of our common stock.

We are the target of a Class Action Lawsuit, which could result in substantial costs and divert management attention and resources.

Beginning on May 16, 2001, a series of putative securities class actions were filed against the firms that underwrote our initial public offering, us, and some of our officers and directors in the U.S. District Court for the Southern District of New York. These cases have been consolidated under the case captioned In re CacheFlow, Inc. Initial Public Offering Securities Litigation., Civil Action No. 1-01-CV-5143. An additional putative securities class action has been filed in the United States District Court for the Southern District of Florida. The Court in the Florida case dismissed us and individual officers and directors from the action without prejudice. The complaints in the New York and Florida cases generally allege that the underwriters obtained excessive and undisclosed commissions in connection with the allocation of shares of common stock in our initial public offering, and maintained artificially high market prices through tie-in arrangements which required customers to buy shares in the after-market at pre-determined prices. The complaints allege that we and our current and former officers and directors violated Sections 11 and 15 of the Securities Act of 1933, and Sections 10(b) (and Rule 10b-5 promulgated thereunder) and 20(a) of the Securities Exchange Act of 1934, by making material false and misleading statements in the prospectus

incorporated in our Form S-1 Registration Statement filed with the Securities and Exchange Commission in November 1999. Plaintiffs seek an unspecified amount of damages on behalf of persons who purchased our stock between November 19, 1999 and December 6, 2000. A lead plaintiff has been appointed for the consolidated cases pending in New York. On April 19, 2002 plaintiffs filed an amended complaint.

Various plaintiffs have filed similar actions asserting virtually identical allegations against over 300 other public companies, their underwriters, and their officers and directors arising out of each company’s public offering. The lawsuits against us, along with these other related securities class actions currently pending in the Southern District of New York, have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings and are collectively captioned In re Initial Public Offering Securities Litigation, Civil Action No. 21-MC-92. Defendants in these cases have filed omnibus motions to dismiss. . On February 19, 2003, the Court denied in part and granted in part the motion to dismiss filed on behalf of defendants, including us. The Court’s order did not dismiss any claims against us. As a result, discovery may now proceed. Our officers and directors have been dismissed without prejudice in this litigation

A proposal has been made for the settlement and release of claims against the issuer defendants, including us, in exchange for a guaranteed recovery to be paid by the issuer defendants’ insurance carriers and an assignment of certain claims. The settlement is subject to a number of conditions, including approval of the proposed settling parties and the court. If the settlement does not occur, and litigation against us continues, we believe we have meritorious defenses and intend to defend the case vigorously. We believe the outcome would not have a material adverse effect on our business, results of operations or financial condition. Securities class action litigation could result in substantial costs and divert our management’s attention and resources, which could seriously harm our business.

We prepare and release quarterly unaudited financial statements in accordance with generally accepted accounting principles (“GAAP”). We may disclose and discuss certain non-GAAP financial information in the related earnings release and investor conference call. This non-GAAP financial information typically excludes special charges, including the amortization of purchased intangibles, deferred stock compensation, in-process research and development expense, restructuring costs and excess facilities and asset impairment charges. We believe the disclosure of non-GAAP financial information helps investors more meaningfully evaluate the results of our ongoing operations. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K and our quarterly earnings releases, and to read the associated reconciliation between such GAAP financial information and non-GAAP financial information, if any, disclosed in our quarterly earnings releases and investor calls.

Because sales of our products are dependent on the increased use and widespread adoption of the Internet, if use of the Internet does not develop as we anticipate, our sales may not grow.

Sales of our products depend on the increased use and widespread adoption of the Internet. Our business would be seriously harmed if the use of the Internet does not increase as anticipated. The resolution of various issues concerning the Internet will likely affect the use and adoption of the Internet. These issues include security, reliability, capacity, congestion, cost, ease of access and quality of service. Even if these issues are resolved, if the market for Internet-related products and services fails to develop, or develops at a slower pace than anticipated, our business would be seriously harmed.

Our operations could be significantly hindered by the occurrence of a natural disaster or other catastrophic event.

Our operations are susceptible to outages due to fire, floods, power loss, telecommunications failures and other events beyond our control. In addition, a substantial portion of our facilities, including our headquarters, are located in Northern California, an area susceptible to earthquakes. We do not carry earthquake insurance for earthquake-related losses. Despite our implementation of network security measures, our servers are vulnerable to computer viruses, break-ins, and similar disruptions from

unauthorized tampering with our computer systems. We may not carry sufficient business interruption insurance to compensate us for losses that may occur as a result of any of these events. Any such event could have a material adverse effect on our business, operating results and financial condition.

We develop products in the United States and sell them throughout the world. 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 all of our sales are currently made in United States dollars, a strengthening of the dollar could make our products less competitive in foreign markets. If any of the events described above were to occur, our net sales could be seriously impacted, since a significant portion of our net sales are derived from international operations. Net sales from international operations represented 42.3% and 51.9% of total net sales for the three-month periods ended January 31, 2004 and 2003, respectively. Alternatively, a weakening dollar would increase our expenses in foreign currencies.

As of January 31, 2004, we had approximately $31.3 million invested primarily in certificates of deposit and fixed-rate, short-term corporate and U.S. government debt securities, which are subject to interest rate risk and will decrease in value if market U.S. interest rates increase. We maintain a strict investment policy, which is intended to ensure the safety and preservation of our invested funds by limiting default risk, market risk and reinvestment risk. As of January 31, 2004, no significant changes to our investment portfolio have occurred since our Annual Report on Form 10-K for the year ended April 30, 2003.

(1) Our chief executive officer and our chief financial officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this quarterly report, have concluded that, as of the end of the period covered by this quarterly report, our disclosure controls and procedures were adequate and designed to ensure that material information relating to us and our consolidated subsidiaries would be made known to them by others within those entities.

(2) During the quarter ended January 31, 2004, there have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

our stock between November 19, 1999 and December 6, 2000. A lead plaintiff has been appointed for the consolidated cases pending in New York. On April 19, 2002 plaintiffs filed an amended complaint.

Various plaintiffs have filed similar actions asserting virtually identical allegations against over 300 other public companies, their underwriters, and their officers and directors arising out of each company’s public offering. The lawsuits against us, along with these other related securities class actions currently pending in the Southern District of New York, have been assigned to Judge Shira A. Scheindlin for coordinated pretrial proceedings and are collectively captioned In re Initial Public Offering Securities Litigation, Civil Action No. 21-MC-92. Defendants in these cases have filed omnibus motions to dismiss. . On February 19, 2003, the Court denied in part and granted in part the motion to dismiss filed on behalf of defendants, including us. The Court’s order did not dismiss any claims against us. As a result, discovery may now proceed. Our officers and directors have been dismissed without prejudice in this litigation

On August 1, 2001, Network Caching Technology L.L.C. (“NCT”) filed suit against us and others in the United States District Court for the Northern District of California, alleging infringement of certain patents owned by NCT. The lawsuit was styled Network Caching Technology LLC vs. Novell, Inc. et al., Case No. CV-01-2079. On October 29, 2003, Blue Coat and NCT entered into a settlement agreement by which Blue Coat received a fully paid up license under the NCT patents for all Blue Coat products and services and a full and complete release from any and all claims of liability for any actual or alleged past and present infringement of the NCT patents. As consideration for the license rights and release, we paid a total of $1.1 million expenses as a separate line item on our statement of operations named “Legal settlement fees.” The Order of Dismissal regarding all causes of action between NCT and Blue Coat was entered November 14, 2003.

On September 18, 2003, we sold 1,311,807 shares of common stock at $9.91 per share for cash consideration in the aggregate amount of $13.0 million to investment funds and an individual affiliated with Sprout Group, a venture capital affiliate of Credit Suisse First Boston. The shares of common stock issued in the transaction have not been registered under the Securities Act of 1933 and were issued in reliance upon Regulation D of the Securities Act of 1933 based on the status of the purchasers as accredited investors.

On November 19, 1999, we completed the initial public offering of our common stock. The shares of common stock sold in the offering were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (No. 333-87997). There have been no changes to the disclosure contained in our report on Form 10-Q for the quarter ended January 31, 2004, regarding the use of proceeds generated by our initial public offering and of our common stock. The $13.0 million received from the equity financing discussed above has been invested in investment grade securities to be used for general corporate purposes including capital expenditures, potential acquisitions, working capital and any other purpose that we may specify in any subsequent filing.

We filed four reports on Form 8-K during the quarter ended January 31, 2004. Information regarding the items reported on is as follows:

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.

BLUE COAT SYSTEMS, INC.

/s/ ROBERT VERHEECKE

Robert Verheecke

Chief Financial and Accounting Officer


DELAWARE (STATE OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)		91-1715963 (IRS EMPLOYER IDENTIFICATION)

650 ALMANOR AVENUE SUNNYVALE, CALIFORNIA (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)		94085 (ZIP CODE)


		PAGE
PART I. FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets as of January 31, 2004 and April 30, 2003	1

	Condensed Consolidated Statements of Operations for the three and nine months ended January 31, 2004 and 2003	2

	Condensed Consolidated Statements of Cash Flows for the nine months ended January 31, 2004 and 2003	3

	Notes to Condensed Consolidated Financial Statements	4–18

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	19–44

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	44

Item 4.	Controls and Procedures	44

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	44–45

Item 2.	Changes in Securities and Use of Proceeds	45

Item 6.	Exhibits and Reports on Form 8-K	46

	Signatures	47


	January 31,			April 30,
	2004			2003
	(Unaudited)			(Note 1)
ASSETS
Current assets:
Cash and cash equivalents	$	35,137		$	12,784
Short-term investments		80			10,538
Accounts receivable, net		7,806			8,080
Inventories		1,390			1,594
Prepaid expenses and other current assets		1,719			922

Total current assets		46,132			33,918

Property and equipment, net		2,203			3,024
Restricted investments		1,991			1,991
Goodwill		7,712			—
Identifiable intangible assets, net		2,001			—
Other assets		1,021			1,059

Total assets	$	61,060		$	39,992

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,531		$	616
Accrued payroll and related benefits		2,484			1,905
Deferred revenue		8,905			8,711
Accrued acquisition costs		5,673			—
Other accrued liabilities		5,334			5,767

Total current liabilities		24,927			16,999

Accrued restructuring		3,775			5,116
Deferred revenue		1,769			1,100
Accrued acquisition costs, less current portion		212			—

Total liabilities		30,683			23,215

Commitments

Stockholders’ equity:
Common stock		1			1
Additional paid-in capital		899,244			883,352
Treasury stock		(903	)		(903	)
Notes receivable from stockholders		(37	)		(28	)
Deferred stock compensation		(1,141	)		(607	)
Accumulated deficit		(866,789	)		(865,051	)
Accumulated other comprehensive income		2			13

Total stockholders’ equity		30,377			16,777

Total liabilities and stockholders’ equity	$	61,060		$	39,992


	Three Months Ended January 31,						Nine Months Ended January 31,
	2004			2003			2004			2003
Net sales:
Products	$	15,589		$	9,200		$	34,969		$	27,062
Services		3,525			2,520			9,973			6,911

Total net sales		19,114			11,720			44,942			33,973
Cost of goods sold		5,577			4,119			14,272			13,177

Gross profit		13,537			7,601			30,670			20,796

Operating expenses:
Research and development		3,082			2,712			8,092			9,109
Sales and marketing		6,314			6,202			17,606			19,743
General and administrative		1,480			1,177			3,670			3,862
Legal settlement fees		—			—			1,100			—
Write-off of in-process technology		151			—			151			—
Amortization of intangible assets		152			—			152			—
Restructuring expense		—			1,273			856			1,273
Stock compensation		403			599			811			2,505

Total operating expenses		11,582			11,963			32,438			36,492

Operating income (loss)		1,955			(4,362	)		(1,768	)		(15,696	)
Interest income		90			122			262			418
Other expense		(55	)		(60	)		(112	)		(73	)

Net income (loss) before income taxes		1,990			(4,300	)		(1,618	)		(15,351	)
Provision for income taxes		(28	)		(52	)		(120	)		(137	)

Net income (loss)	$	1,962		$	(4,352	)	$	(1,738	)	$	(15,488	)

Basic net income (loss) per common share	$	0.19		$	(0.50	)	$	(0.18	)	$	(1.77	)

Diluted net income (loss) per common share	$	0.16		$	(0.50	)	$	(0.18	)	$	(1.77	)

Shares used in computing basic net income (loss) per common share		10,455			8,790			9,668			8,745

Shares used in computing diluted net income (loss) per common share		12,286			8,790			9,668			8,745


	Nine Months Ended January 31,
	2004			2003
Operating Activities
Net loss	$	(1,738	)	$	(15,488	)
Adjustments to reconcile net loss to net cash (provided by) used in operating activities:
Depreciation and amortization		1,806			2,227
Amortization of intangible assets		152			—
Write-off of in-process technology		151			—
Gain on disposition of equipment		(29	)		—
Stock compensation		811			2,505
Restructuring expense		856			—
Interest on notes receivable from stockholders		(9	)		(11	)
Changes in operating assets and liabilities:
Accounts receivable		307			(2,905	)
Inventories		204			325
Prepaid expenses and other current assets		(556	)		642
Other assets		44			(4	)
Deferred revenue		689			2,459
Accounts payable		1,920			(1,146	)
Accrued liabilities		(2,517	)		(3,688	)

Net cash provided by (used in) operating activities		2,091			(15,084	)

Investing Activities
Sales of investment securities, net		10,447			11,981
Proceeds from sales of equipment		39			—
Purchases of property and equipment		(875	)		(738	)
Acquisition of Ositis, net of cash acquired		(3,078	)		—

Net cash provided by investing activities		6,533			11,243

Financing Activities
Net proceeds from issuance of common stock		785			105
Net proceeds from equity financing		12,944			—
Repayment of notes receivable		—			27
Repurchase of common stock from employees		—			(6	)

Net cash provided by financing activities		13,729			126

Net increase (decrease) in cash and cash equivalents		22,353			(3,715	)
Cash and cash equivalents at beginning of period		12,784			12,480

Cash and cash equivalents at end of period	$	35,137		$	8,765


Consideration and direct transaction costs:
Cash	$	1,083
Fair value of Blue Coat common stock		6,833
Estimated direct transaction costs		784
Fair value of assumed Ositis warrants		43

Total purchase price	$	8,743

Allocation of purchase price:
Cash and cash equivalents	$	350
Accounts receivable		379
Other current assets		50
Other assets		131
Debt assumed		(1,100	)
Moving, lease termination, and transition costs		(624	)
Legal and investment banking fees		(479	)
Deferred revenue		(174	)
Accounts payable and accrued liabilities		(1,402	)
Deferred employee compensation		1,596
Identifiable intangible assets		2,304
Goodwill		7,712

Total purchase price	$	8,743


Identifiable intangible assets	Amortization period	Amount
Developed technology	3 years	$	1,331
Core technology	5 years		339
In-process technology	n/a		151
Customer base	5 years		483

Total		$	2,304


Year Ended April 30,	Amortization
2004	$	152
2005		608
2006		608
2007		386
2008		165
2009		82

	$	2,001


	Three Months Ended January 31,					Nine Months Ended January 31,
	2004		2003			2004			2003
Revenue	$	19,114	$	12,716		$	47,523		$	37,480

Operating Income (loss)		2,756		(5,241	)		(1,721	)		(18,462	)

Net Income (loss)		2,763		(5,254	)		(1,635	)		(18,315	)

Basic Income (loss) per share	$	0.26	$	(0.58	)	$	(0.16	)	$	(2.00	)

Diluted Income (loss) per share	$	0.22	$	(0.58	)	$	(0.16	)	$	(2.00	)


	Gross Carrying Value		Accumulated Amortization		Net Carrying Value
Developed technology	$	1,331	$	111	$	1,220
Core technology		339		17		322
Customer base		483		24		459

Total	$	2,153	$	152	$	2,001


	Nine Months Ended January 31,
	2004			2003
Beginning balances	$	350		$	600
Warranties issued during the period		225			218
Settlements made during the period		(290	)		(87	)

Ending balances	$	285		$	731


	January 31, 2004		April 30, 2003
Raw materials	$	562	$	701
Work-in-process		247		47
Finished goods		581		846

Total	$	1,390	$	1,594


	Abandoned Space			Contract Termination and Other			Total
Balances as of April 30, 2003	$	7,989		$	48		$	8,037
Cash payments		(722	)		—			(722	)

Balances as of July 31, 2003		7,267			48			7,315
Cash payments		(748	)		—			(748	)
Additions		856			—			856

Balances as of October 31, 2003		7,375			48			7,423
Cash payments		(722	)		(8	)		(730	)

Balances as of January 31, 2004		6,653			40			6,693
Less: current portion which is included in “Other accrued liabilities”		2,893			25			2,918

Long-term accrued restructuring reserve	$	3,760		$	15		$	3,775


Year ending April 30,	Abandoned		In Use		Total
2004	$	761	$	507	$	1,268
2005		3,119		1,985		5,104
2006		3,187		437		3,624
2007		1,018		124		1,142
2008		258		124		382
Thereafter		—		93		93

Total minimum lease payments	$	8,343	$	3,270	$	11,613


	Three Months Ended January 31,						Changes for the Three Months Ended January 31, 2003 to January 31, 2004
	2004			2003			$			%
Net sales:
Product	$	15,589		$	9,200		$	6,389		69.4	%
Service		3,525			2,520			1,005		39.9

Total net sales		19,114			11,720			7,394		63.1
Cost of goods sold		5,577			4,119			1,458		35.4

Gross profit		13,537			7,601			5,936		78.1

Operating expenses:
Research and development		3,082			2,712			370		13.6
Sales and marketing		6,314			6,202			112		1.8
General and administrative		1,480			1,177			303		25.7
Legal settlement fees		—			—			—		—
Write-off of in-process technology		151			—			151		—
Amortization of intangible assets		152			—			152		—
Restructuring expense		—			1,273			(1,273	)	(100.0	)
Stock compensation		403			599			(196	)	(32.7	)

Total operating expenses		11,582			11,963			(381	)	(3.2	)

Operating income (loss)		1,955			(4,362	)		6,317		(144.8	)
Interest income		90			122			(32	)	(26.2	)
Other expense		(55	)		(60	)		5		(8.3	)

Net income (loss) before income taxes		1,990			(4,300	)		6,290		(146.3	)
Provision for income taxes		(28	)		(52	)		24		(46.2	)

Net income (loss)	$	1,962		$	(4,352	)	$	6,314		(145.1	)%


	Nine Months Ended January 31,						Changes for the Nine Months Ended January 31, 2003 to January 31, 2004
	2004			2003			$			%
Net sales:
Product	$	34,969		$	27,062		$	7,907		29.2	%
Service		9,973			6,911			3,062		44.3

Total net sales		44,942			33,973			10,969		32.3
Cost of goods sold		14,272			13,177			1,095		8.3

Gross profit		30,670			20,796			9,874		47.5
Operating expenses:
Research and development		8,092			9,109			(1,017	)	(11.2	)
Sales and marketing		17,606			19,743			(2,137	)	(10.8	)
General and administrative		3,670			3,862			(192	)	(5.0	)
Legal settlement fees		1,100.00			—			1,100		—
Write-off of in-process technology		151			—			151		—
Amortization of intangible assets		152			—			152		—
Restructuring expense		856			1,273			(417	)	(32.8	)
Stock compensation		811			2,505			(1,694	)	(67.6	)

Total operating expenses		32,438			36,492			(4,054	)	(11.1	)

Operating loss		(1,768	)		(15,696	)		13,928		(88.7	)
Interest income		262			418			(156	)	(37.3	)
Other expense		(112	)		(73	)		(39	)	53.4

Net loss before income taxes		(1,618	)		(15,351	)		13,733		(89.5	)
Provision for income taxes		(120	)		(137	)		17		(12.4	)

Net loss	$	(1,738	)	$	(15,488	)	$	13,750		(88.8	)%


	Three Months Ended January 31,
	2004				2003
	$		%		$		%
North America	$	11,024	57.7	%	$	5,632	48.1	%
Europe		5,761	30.1			3,690	31.5
Asia		2,329	12.2			2,398	20.4

Total net sales	$	19,114	100.0	%	$	11,720	100.0	%


	Nine Months Ended January 31,
	2004				2003
	$		%		$		%
North America	$	26,590	59.2	%	$	17,291	50.9	%
Europe		12,879	28.7			9,658	28.4
Asia		5,473	12.1			7,024	20.7

Total net sales	$	44,942	100.0	%	$	33,973	100.0	%


	January 31,
(In thousands)	2004			2003
Cash and cash equivalents	$	35,137		$	12,784
Short-term investments		80			10,538
Restricted Investments		1,991			1,991

	$	37,208		$	25,313

Percentage of Total assets		60.9	%		63.3	%

	Nine Months Ended January 31,
(In thousands)	2004			2003
Cash provided by (used in) operating activities	$	2,091		$	(15,084	)
Cash provided by investing activities		6,533			11,243
Cash provided by financing activities		13,729			126

Net increase (decrease) in cash and cash equivalents	$	22,353		$	(3,715	)


Number		Description

31.1		Rule 13a–14(a)/15d-14(a) Certification of Brian NeSmith

31.2		Rule 13a–14(a)/15d-14(a) Certification of Robert Verheecke

32.1		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002


Date		Item Reported On

November 12, 2003		On November 11, 2003 we issued a press release announcing revised expectations regarding our financials results for the fiscal quarter ended October 31, 2003.

November 19, 2003		On November 19, 2003, we reported our results of operations (including accompanying financial statements) for the fiscal quarter ended October 31, 2003.

November 28, 2003		On November 28, 2003, we filed a report regarding our acquisition of Ositis Software, Inc.

January 28, 2004		On January 28, 2004, we filed a report amending our report filed on November 28, 2003 regarding our acquisition of Ositis Software, Inc. to include financial statements of the acquired company and pro forma financial information.